Bread Vs. Cake Part II

October 22, 2009

John Serrapere of Arrow Insights adjusts his portfolio for the troubles to come. M&A funds, VIX ETNs and commodities are attractive.


Investors eat more bread. Speculators eat more cake.

Speculation improves the health of free markets if it is the province of the skillful and the few who let their gains and losses improve economic efficiency. In pure capitalism, we all sink or swim. Anything else is something else. Globalization has benefits, but it also risks empowering nation-states that seek greater autocratic rule. Capitalism thrives on freedom.

Throughout history, privileged classes seeking the rewards of their political economy have ruined nations. They direct commerce while seeking exemption from fiscal responsibility. Many historic superpowers spent their end-days with their economies dominated by the financial sector, which has been the sector most prone to political influence and government favor.[1]

Since the mid-1980s, our national policies and the global economic system have become dependent upon excessive risk taking with huge rewards going to the few and losses allocated to the many. Archived in the research section is Issue 6 (July 2009), Deflating Fears & Inflating Hopes. This issue focused on a dysfunctional system run by gamblers who got their chips funded through nonpartisan and global economic policies.

In our September issue, we showed that the great economic moderation of the 1990s heralded as a New Era was actually a central-bank-managed economy. Bankers and regulators got out of the way of free markets while they applied increasingly asymmetrical remedies for the few.

Too much cake (debt accumulation) weakened the financial system because central banks and their political economies implemented planned economies designed to recover from the 1997-1998 and 2000-2002 financial crisis. Their plans rode the back of highly indebted

Consumers were fed primarily Asian-made products. Our energy policy also became very dependent upon oil-rich dictatorships in which freedom is a crime. These central imbalances between our domestic and global economies are currently receiving much attention. We are attempting to implement Plan #3, designed as a re-recovery from past plans!

Prior plans culminated in The Panic of 2008. Central planning has been the cause of three 100-year floods since 1997, namely an emerging markets/sovereign debt default crisis, the collapse of the technology/telecom bubble in 2000 and the pricking of the grand credit bubble in 2007. The first flood was fed by storms brewed from China-led competitive currency devaluations during the 1990s; the second monsoon rode a wave cresting from hundreds of global central bank rate cuts and overly accommodative emerging market export as well as
consumption policies initiated in 1998-1999. “Made in the U.S.A” was stamped all over the clouds that rained on our globe from 2007 to 2009. From 2005 to 2007, a debt typhoon was our largest export.

Why History (Research) Matters

Part II expands on these themes because secular alpha (long-term investment reward) is dependent upon positioning core asset allocations to advance and defend against economic fundamentals influenced by structural factors that can be imbalanced. In 2003 and 2006, we recognized conditions conducive to bull markets in the energy sectors and commodities market and a bear market initiated by an implosion in the credit markets precipitated by declining home values.

In 2003, core positions were overly weighted to energy stocks. In 2006, core positions were put on credit-watch, and during the first week of August 2007, all asset-backed credit instruments were sold along with exposures to the financial sector.[2] Tactical hedges were also traded within the context of the outliner risks resulting from energy/commodities and credit factors that impact security price trends. Energy exposures were then brought to a neutral weight in 2007-2008.[3] Currently, our portfolio is positioned to weather social/political turmoil accompanied with a
U.S. sovereign debt crisis. It is not easy to research and implement investment policies for these risks.

Wealth/income inequality is not a pleasant topic. It is emotionally charged. However, we are not at a family picnic, where it is wise to avoid political/religious talk. This is no picnic! We are at a stage of this crisis where there is an extreme risk of a long-term inflation accompanied with acute bouts of deflation.

Events may soon unfold that spill forth social unrest ignited from a powder keg of polarized political views and a sense of futility from an ongoing crisis. If so, investing will be treacherous due to exploding uncertainty premiums. Investors will demand these premiums.

Higher consumer price volatility (severe inflation-deflation) and currency volatility has been the post hoc of most global financial crises. Our Price Index Score (PIS) attempts to measure this uncertainty. We have covered PIS extensively in past issues. PIS remains in a high-risk zone.

At this time, The Arrow Insights (AI) 75/50 Portfolio favors commodities, commodity-based equities, developing market stocks, foreign bonds, inflation-indexed bonds and gold bullion. Our tactical hedges are to be short long-term Treasury bonds, short real estate stocks and long stock market volatility. Beginning with this issue, we are reporting gross returns, which produce a simulated year-to-date (YTD) return of 18.8 percent.



Cake And Bread Eaters

A comparative review of Wells Capital Management's strategist James Paulsen’s Six Good Reasons to Like Stocks, featured in the August 2, 2009 Barron’s magazine, and Ned Davis of Ned Davis Research’s (NDR) take on secular vs. cyclical bull markets posted at on July 30, 2009, shed light on secular vs. cyclical views.

Mr. Paulsen likes cake. He is a secular bull. Mr. Davis prefers bread. He is a cyclical bull and a secular bear.

Ned Davis’ Seven

To figure out whether we are in a bear or a bull, Ned Davis identified seven factors to determine if any given market low is a secular low, setting up the next multiyear bull market.

His seven factors are followed by his take on things:

1. Money, cheap and amply available (neutral);

2. Debt structure that’s been deflated (bearish);

3. Large pent-up demand for goods and services (bearish);

4. Stocks that are clearly cheap (now bearish);

5. Investors who are deeply pessimistic (bullish);

6. Major investor groups with below-average stock holdings (neutral);

7. Fully oversold, longer-term market conditions (neutral).

A couple of months back, Mr. Davis found just one of the seven foundations for a new secular bull market. Three were neutral and three bearish.

James Paulsen’s Six

Mr. Paulsen never clarifies if we are in a strong cyclical bull or a new secular bull market. He simply couches his views with “it seems like we are in conditions like we were in the summer of 1982, when one of the strongest and longest bull markets in history began.”

His six factors are as follows:

1. Stocks are still cheap, signaled by their current price/earnings ratio of 15;

2. Corporate profits are spring-loaded to catapult higher even without strong economic growth;

3. The "dominance of doubt." Investors are too pessimistic;

4. Cash holdings amounted to about 95 percent of the value of
U.S. stocks;

5. Productivity, or output per man hour, has risen even during the economic slide;

6. One shouldn't fight the Fed and global government stimulus.

Mr. Paulsen’s views on the market are in line with “V”-shaped or strong and sustainable economic growth. Mr. Davis’ views are in line with “W”- or “L”-shaped economic growth associated with a double-dip recession and sub-par growth.

Mr. Paulsen mistakes a strong cyclical bull market for a new bull, and his view on a strong recovery is not in line with the historic climates seen for years following past global financial-crisis-led recessions. For example, his estimation that current times are like 1982 is wrong.

Things are not like 1982.Then, the unemployment rate had already peaked. More importantly, we have been in a once-in-a-century structural shift in global production, consumption and saving since globalized trade and production accelerated in 1989. Since then, following both the 1990-1991 and the 2001 recessions, unemployment has remained high and lagged the recovery. For all prior recessions in our history, unemployment was a coincident indicator.

Also unlike nonfinancial-crisis-led recessions, our current downturn began with plunging home values and a credit crisis that led to a rapid contraction in credit. Normally, the recession-recovery sequence begins with higher interest rates, declines in stock values and junk bonds, higher unemployment, declines in consumer confidence/spending, declines in business spending, a rise in personal savings, declining or stagnant home values, declines in commercial real estate values and tight credit conditions.

Unlike past recessions, this one began with a decline in home values in June 2006. Although the Fed did raise rates to initiate this downturn, higher rates simply kicked off a cycle of asset deflations and a credit panic/freeze. Despite positive economic signs since March 2009, the rate of job loss remains high and the unemployment rate has continued its rise, credit remains tight, savings is too low and business spending is anemic. History is full of instances where recessions have relapsed after two or three quarters of growth.

A Great Short

Figure 1 helps us to prepare for a big shorting opportunity coming soon from companies and funds recently driven to nosebleed levels of valuation. Most of these securities are dependent upon health in the commercial real estate sector. Commercial real estate exposure in
institutions is $3.54 trillion. Losses are expected to range between $142 billion and $248 billion based upon 4 percent and 7 percent loss rates. Our best guess is the latter. An area of opportunity exists for shorting securities that will be out some of the $129 billion in private funding shortfalls estimated on loans that need to be rolled in 2009-2010.




To date, we have selected three short candidates based upon having 50 percent or more of their constituent holdings in office and retail real estate stocks and our ability to short the stock at a reasonable cost. After reviewing the entire universe of ETFs and closed-end funds, we selected the Nuveen Real Estate Fund (AMEX: JRS, Figures 2-3), the iShares Dow Jones US Real Estate iShares (NYSEArca: IYR) and the iShares FTSE NAREIT Retail Capped Index Fund (NYSEArca: RTL). We have been short JRS since Aug. 27 (4 percent of exposures). We will opportunistically add IYR and RTL.



Strategic & Tactical Asset Positioning

On Sept. 29, 2009, we sold the rest of our iShares iBoxx High Yield Corporate Bond Fund (NYSEArca: HYG) and our iShares iBoxx $ Investment Grade Corporate Bond (NYSEArca: LQD). They were purchased in late 2008 and in early 2009 as equity substitutes at a time when a depression might have loomed. Our returns were near 38 percent on HYG and 18 percent on LQD. Our strategy was to sell these equity alternatives when they hit our expected price and return targets, which were harvested sooner than we expected.

Short-term gains from these trades will also offset the many short-term losses that we have realized to date in 2009.This trade enables us to show attractive tax efficiencies, which high-net-worth investors love.

Over the past few weeks, corporate bonds seem to be topping. They have experienced violent sell-offs with a couple of 2-3 percent daily declines on rising volume. Although HYG steadied last week, LQD did not. LQD ended last week at a new low for the month and it is testing its 50-day average. Last week's downturn shows that we were correct to raise a caution flag on corporate bonds.

We will be employing about 60 percent of proceeds from the sale of HYG and LQD (18 percent of gross exposure in the AI 75/50 Portfolio) into The Arbitrage Fund (ARBFX) and The Merger Fund (MERFX) soon. On Oct. 6, 2009, we allocated close to 70 percent of the sale proceeds from corporate bonds sales to the above two merger arbitrage (M&A) mutual funds. Additionally, 3.75 percent of portfolio assets were allocated to ARBFX with 3.75 percent allocated to MERFX. We will soon add 3.5 percent more (divided equally) to these funds to round out our target allocation.

On the date that we bought these funds, Charles Schwab provided the following market commentary about the day’s climate: “Stocks are solidly higher for the second-straight session on more M&A activity and carryover of economic enthusiasm from yesterday’s surprisingly strong reading in the ISM Non-Manufacturing Index.”

We are bullish on M&A because this strategy style seems to have bottomed. Year-over-year M&A deal volume collapsed. It is very unloved. However, weak domestic bank activity, combined with a hoard of domestic and foreign cash on the sidelines and deep value in direct company assets, attracts us. The strong are buying the weak with sound enterprise values but limited access to financing. A weak U.S. dollar also is a factor because enterprise assets are a hedge against inflation and an alternative to Treasury allocations, where much money is sitting that is normally targeted to M&A. M&A cash is hiding (but not for long).






Although corporate bond prices seem to be weakening, this was a fundamental trade. It was not a technical move. M&A should provide less risk than corporate bonds if a market panic returns. MERFX’s worst loss in 2008 was about -18 percent, while HYG and LQD experienced maximum drawdowns of -34 percent and -29 percent, respectively (Figure 4). ARBFX’s drawdown was a little less than MERFX’s. Longer term, we expect M&A funds to provide 7-10 percent in annualized returns, which is much better than our expectations for HYG and LQD.

On Oct. 1, 2009, we added 6 percent to gross exposure (3 percent before imbedded leverage) to the ProShares UltraShort 20+ Year Treasury ETF (NYSEArca: TBT) at $43.25, which brings our exposure to near 24 percent (Figure 5). Our original weighting was 20 percent before selling some shares at $58 on June 10, 2009.

We seek to buy the NASDAQ 100 Index (the PowerShares QQQQ) at $39 and $37 (each trade equals about 7.5 percent of gross exposure). Portfolio beta will be limited until year-end, when we rebalance assets (Figure 5).




Cusp beta = assets whose prices do not normally synchronize with stock prices. For much of this summer, the Reuters/Jefferies CRB Index (commodities) and the United States Oil Fund, LP (USO) decoupled from stocks, while gold continued to advance with the S&P 500 Index ($SPX). We are long energy shares (PowerShares Dynamic Oil & Gas Services (NYSEArca: PXJ) and Energy Select Sector SPDR (NYSEArca: XLE)) which is primarily beta (things that usually move with $SPX). We are long agricultural commodities (PowerShares DB Agriculture (NYSEArca: DBA)), gold (SPDR Gold Shares (NYSEArca: GLD)) and gold stocks as a source of cusp beta.



When we manage risk, we factor beta and cusp beta as a single source of return that is directionally correlated with $SPX price trends (Figure 6). The above examples represent 37 percent of the AI 75/50 Portfolio’s gross exposure, which total 127 percent (Figure 13).

Gold will decouple from stocks if its currency value is prized more than its inflation hedge value when and if deflation risks reappear, which is one instance when gold might lose its cusp beta status; another instance would be severe inflation. Severe deflation or severe inflation would also cancel cusp beta for commodities.



The Risk Trade, Going Long Market Volatility

We have been long the stock market’s implied volatility through the iPath S&P 500 VIX Short-Term Futures Exchange Traded Note (NYSEArca: VXX) since July 27, 2009. We originally accumulated a 20 percent position through Aug. 27, 2009. VXX now represents 15 percent of gross portfolio exposure because it has lost -25.4 percent of its value from its cost basis through Oct. 14, 2009.

Here we also review the iPath S&P 500 VIX Mid-Term Futures ETN (NYSEArca: VXZ). VXZ is exposed to a daily rolling long position in the fourth-, fifth-, sixth- and seventh-month VIX futures contracts and reflects the market’s implied volatility. Figure 13 plots simulations that will cause us to sell half of VXX and invest the proceeds in VXZ. This trade will create an equally weighted allocation to VXZ and VXX.

Before and after investing in ETNs designed to track futures contracts, it is necessary to have performance expectations and to monitor your position against simulated futures exposures. Figure 13 reviews performance from July 31, 2009 through Oct. 14, 2009 for VXX and an equally weighted allocation to VXX and to (VXZ), VIX at its spot price (basis) and to two alternative simulations. The first is an equal weight of the two front-month contracts (VIX Futures 1+ 2 Month). The second is an equal weight of the futures contracts that are 1.5 months and 2.5 months out from VIX spot prices (VIX Futures 1.5 + 2.5 Month).

Alternative VIX futures simulations provide us with a lot of information about how to be long equity volatility. It is clear that VXX has under-performed the spot VIX Index by 15.4 percent. It also clear that the VIX Futures 1.5 + 2.5 month simulation bests the returns of VXX by 18.8 percent, while the 1 + 2 month strategy bests the execution of VXX exposures in the iPath note by 10.6 percent.

Our simulation of VXZ + VXX (equally weighted) under-performs spot VIX by only 3.1 percent, while VIX Futures 1.5 +2.5 months beats it by a little more than 6.5 percent. VXZ + VXX outperforms the 1+ 2 month strategy by 1.7 percent.

Figure 7 demonstrates the difficulty of capturing futures returns and basis risk, which is a trader’s deviation in returns from the underlying source of returns that he seeks to capture.



We originally chose to be long the VIX via VXX because we believed that it would be like being short two times (2x) the Russell 2000 when we account for their hedge potentials. We also believed that should panic return to the markets, being long VIX would hedge portfolio losses better than being long the 2x inverse UltraShort Russell 2000 ProShares ETF (NYSEArca: TWM). A 15 percent allocation to VXZ + VXX is a more attractive hedge.

Figure 8 compares VXX to TWM, the inverse Russell 2000 ETF. This comparison from July 31, 2009 through Oct. 12, 2009 was -26.3 percent for VXX and -21.3 percent for TWM since July 31, 2009 (Figure 8). Long VXX has the potential to reduce hedging costs should investor fears remain near recent levels, which since June 1, 2009 have produced spot VIX prices near $23-$26 when investors have been bullish and $33 when bearish.



Up until the past week, VXX was a cheaper hedge than TWM. Spot VIX closed below 23 on Oct. 13, 2009.

We sold half of our VXX position at $44.36 on Oct. 16 after VIX recorded three consecutive daily closes below $23. We employed the proceeds to open a 7.5 percent position in VXZ at $80.45 per share.



Portfolio Exposures & Convictions

Figure 9 is composed of a focused list of indexes and assets classes and corresponding ETFs. Returns are through Sept. 30, 2009. The AI 75/50 portfolio weightings are labeled in the third column. Red highlights are for sectors that were shorted through 2x inverse ETFs (also red in Figure 10). Our long equity ETFs are either overweight (OW) or neutral weight (NW) relative to the Dow Jones Global Index. The bond allocation is managed opportunistically and to enforce our desired risk exposure without reference to a bond index.














(To see a larger version of this table, click on the above image)





AI Portfolio Performance (Objectives should be evaluated over 36-month periods)

Like the Hedge Fund Research Global Hedge Fund Index (HFRX), AI’s secondary objective is to provide an absolute return (consistently positive returns). As of Oct. 19, 2009, hedge funds and the S&P 500 are down -16.1 percent and -25.7 percent, while the AI 75-50 Portfolio is up 19.1 percent since the October 2007 peak. The AI 75/50 model has outperformed its benchmark, the HFRX and the S&P 500 during all periods shown in Figure 11.



AI 75-50’s primary objective is to capture 75 percent of the S&P’s upside and 50 percent of its downside, which requires us to hedge beta nimbly while maintaining core beta (equity and bond exposures). The portfolio’s 13.6 annualized standard deviation (ASD) is higher than that of the HFRX, but much lower than that of the S&P’s volatility since the market peaked in October 2007.

Recent Trades, Open Orders And Current Positions (Percentages are relative to gross exposures)

All positions and our strategy view for all holdings are listed in Figure 13, along with our beta/non-beta allocations and themes (see the February InPerspective for more).

We were up 0.3 percent for the month in September 2009.

Our gross YTD return as of Sept. 30, 2009 was 15.2 percent and 18.8 percent through Oct. 19.

In September 2009, we made four trades. So far, in October 2009, there have been five trades (Figure 12).



Open orders: We have orders to initiate a 7.5 percent position in QQQQ at $39 plus 7.5 percent more at $37. There are additional orders to buy 6 percent more of the JP Morgan Alerian MLP Index ETNs (NYSEArca: AMJ) at $23.

Forward-Looking Trades

We will sell 10 percent of TBT at $64 if it ever hits this price (rebalance).

We will be looking to short IYR near $48 and RTL near $23. IYR and RTL will each represent 4 percent of our gross exposures, which would give us a 12 percent short position in real estate stocks after accounting for JRS.

Twenty percent of GLD will be sold if gold hits $1,250 per ounce. Twenty percent of gold stocks will be sold if the Market Vectors Gold Miners ETF (NYSEArca: GDX) hits $75.

Gold recently ended a midterm secular consolidation begun in March 2008 with gold trading from $640 to $1032. After a commodity has been in a bear market for decades, as gold was from 1982 to 2001, a very wide consolidation range usually ends with a big scary washout of all the boys, leaving only MEN to buy. We got this washout in the fall of 2008, and we then tested the 1000-1032 range and failed three times. Last month, when I was in
, the land of gold bulls, too many investors at the Canadian Hedge Watch conference were expecting another failure near $1,000.

Recall that in September, we added 3 percent more of to GLD to the Arrow Insights 75/50 Portfolio. Even one of the best P&F technicians at Investors Intelligence called for gold to fail near 1032 on Tuesday of last week. It broke to new highs the next day.

Another adviser emailed recently and asked me to consider this: "In September, the Hulbert Gold Newsletter Sentiment Index (HGNSI) stood at 25.2 percent. Yesterday with gold nearly $100 higher, the HGNSI fell as low as 18 percent!"

A rising market with fewer bulls is a rare. It is usually bullish when accompanied with breakouts and good fundamentals, which are also bullish but not covered here.






(To see a larger version of this table, click on the above image)



1. Kevin Phillips, “Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism,” 2008, Penguin Group,

2. John Serrapere, “Peak Risk, The Greenspan Depository of Hazardous Waste,” May 2006, and Escape From Normalville, November 2006, and

3. John Serrapere, “Black Gold, Texas Tea,” 2006, Journal of Indexes,

John Serrapere works on research and consulting projects through Arrow Insights. He welcomes comments and suggestions for future columns at [email protected].



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