|
This is part 2 of an article on using the
trend to limit risk. ~ editor
Back to
Part1
Risk Management In
Trending Markets Part 2
By Chris Ciovacco
July 25, 2008
To Make Money Find
Trending Investments
Based on the charts of
most stock markets above, the trends will
have to change before long-term investors
can again make money. If a trend has to be
in your favor to make money, then you should
overweight investments which are doing just
that. The inverse Financial ETF above fits
the bill. Let’s see what other markets are
in clearly defined trends.
Commodities: Clear
Uptrend (DBC)
Commodities are experiencing
a long-overdue correction as I type. Based
on past corrections above, within the
context of the ongoing uptrend, the current
correction is not yet alarming (in physical
commodities - stocks are more of a concern).
However, you should watch the situation
closely due to the slowing global economy
and recent run-ups in prices. The commodity
bull-run will end some day, but we don’t
need to call a top. We can wait for evidence
to mount which supports the probability of a
trend reversal. Look at the sharp correction
which occurred in March of this year. The
press and many professionals called a top in
commodities for the countless time during
this bull-run. The gain from the March
bottom is significant. Please do not
interpret these comments as bullish. A top
will come – it may be happening right now –
but even if this is “the top”, in the long
run in order to stay with profitable trends,
you are better off waiting for more evidence
prior to giving up on commodities. We may be
wrong doing so now, but over time and over
many instances we will be right more often
than not, which is an important concept in
the process of making money. One way to help
take some emotion out of the decision making
process is to make consistent decisions
based on specific criteria. You evaluate the
decision based on its merits rather than on
the outcome. In the markets, to make money
we know we can still be wrong on some
decisions as long as we do not let the
losses run too far. Risk control, which
includes cutting losses, is important in all
markets, including commodities. Moving on to
other markets or investments which are
currently trending favorably:
Gold: Uptrend, But
Taking A Breather (GLD)
Metals & Mining
Stocks: Uptrend, But Correction of Concern (XME)
Agricultural
Stocks: Uptrend, But Correction of Serious
Concern (DBA)
Agricultural
Commodities: Uptrend, But Currently Drifting
(MOO)
Steel Stocks:
Uptrend, But Correction a Concern (SLX)
Energy Stocks:
Uptrend, But Once Again Current Correction
Very Concerning (XLE)
U.S. Dollar Index:
Firm Downtrend, But…
… Investments Can
Take Advantage Of The Weak Dollar (CYB,
MERKX, etc.)
You may have noticed that all the up
trending markets are commodity related or
weak dollar related. Since commodities have
a strong correlation to a weak dollar it is
obviously a concern in terms of portfolio
risk. In recent months we have continually
searched for other alternatives with very
limited success.
Biotech Stocks:
Not a Strong Trend, But Better than the S&P
500 (XBI)
Medical Device
Stocks: Not Really Very Attractive (IHI)
Since there are very few
markets trending upward, the inverse funds
of downward trending markets offer some
alternatives to commodity and weak dollar
plays. Shorting and inverse investments
should be managed by experienced investors
or experienced professionals due to their
high volatility and rapid price moves.
2x Inverse S&P
500: Clear Uptrend
2x Inverse EAFE /
Developed Foreign Markets Stocks: Volatile,
But Profitable
In an attempt to provide some
diversification to counterbalance the
commodity and weak dollar plays, we also
have other somewhat attractive investment
options.
Long-Term U.S.
Treasury Bonds: Inflation A Concern (TLT)
Timber: Good on a
Relative Basis, But No Strong Trend
Investment Correlations to
Inflation (CPI) Point Toward Higher
Inflation
In a recent analysis
conducted by PIMCO and Morgan Stanley which
explored the correlation of S&P 500 Industry
Groups to inflation (CPI) from 1975-2007,
the groups with positive correlations to
inflation (CPI) were quite limited in scope.
Only energy, media, healthcare equipment &
services, transportation, materials,
utilities, and food & staples, were able to
post positive returns as inflation rose. The
remaining fourteen industry groups including
diversified financials, banks, tech hardware
& equipment, and telecom services all were
losing bets during periods of rising
inflation. If you look at the positive
trending charts above, it is quite clear
history is repeating itself. It is
interesting to note, the S&P 500 as a whole
posted a strong negative correlation to the
CPI from 1975-2007, which means if inflation
continues to pick up steam, stocks will be
fighting an ongoing historical headwind.
A Word about Position
Sizing Within the Context of the Entire
Portfolio
Investors will be well
served in the current environment to more
closely monitor their portfolio as a whole,
rather than isolating more volatile
components such as gold (GLD) or financial
stocks (SKF). If the percent allocation or
size of the position is small or within
reasonable bounds relative to the balance of
the portfolio, the risk of volatility has
been properly accounted for. For example, if
your allocation to physical gold is 5% of
your entire portfolio, including CDs and
money markets, a 20% fall in the price of
gold will only cause a 1% decline of your
total holdings. A 1% decline is much easier
to stomach than a 20% decline.
Housing, Fannie &
Freddie, and Financial Stocks
You often hear defenders
of Fannie and Freddie’s say, "Most of their
mortgages are 30-year fixed and not
delinquent." That is somewhat accurate, but
leaves out the ongoing damage to their
balance sheet as housing prices continue to
fall. You can make all the payments you want
on time and that has no effect in terms of
the blow to the value of their mortgages
which results when the underlying assets,
single family homes, drop in price. The text
below, concerning Fannie and Freddie, is
from the Wall Street Journal dated Friday,
July 18, 2008:
The two companies – which are rivals
in the same business – have reported a
combined $11 billion of losses over the
past three quarters, largely because of
increasing defaults by homeowners on
mortgages. When homeowners don’t make
mortgage payments, Fannie and Freddie
must reimburse the holders of securities
backed by those defaulting mortgages. At
the same time, falling home prices cut
the value of the collateral backing the
loans, increasing losses for Fannie and
Freddie. Investors and analysts can only
guess how bad the losses might be as
several million American homes go
through foreclosure. Analysts at Goldman
Sachs Group Inc. this week estimated
that Fannie faces default-related losses
of $32 billion and Freddie $21 billion.
As far as banks, and to a lesser extent
the financial markets as a whole go, nothing
is more important than falling home prices.
Until home prices at least show some real
signs of stabilization, all bullish bets or
calls for a bottom in stocks should be made
cautiously. In my view we cannot even begin
to think about stabilization in home prices
until the inventory of unsold homes comes
back in line with historical norms. The
basic laws of supply and demand are still
out of balance. Currently, there are
somewhere in the neighborhood of eleven
months of supply of unsold homes on the
market versus a six to seven month supply we
would expect to see in a more healthy market
for price appreciation. When this gap begins
to close, it will be more reasonable to
consider lasting rebounds for the economy
and stocks.
How Are Value Investors
Doing In The Current Environment?
Rather than try to pick on anyone in a
tough environment, my purpose here is to
demonstrate the limited number of places to
seek investment gains in the last year. As
most of us know, the king of value investing
is Warren Buffet. Historically value
investors, who buy companies based mainly on
their value as a business, have fared
relatively well in bear markets. Even Mr.
Buffet’s Berkshire Hathaway has not been
immune to the bear.
Mr. Buffet May Be Human After All
A Tough
Environment: Inflation Is Rising, Equity
Markets Are Falling, and Commodities
Correcting
As a portfolio manager, options in the
current environment are somewhat limited. We
have no particular fascination with
commodities, they just happen to be the only
source of strength. We would much prefer
never to use inverse funds, but a 100%
commodity portfolio is not prudent. Global
inflation is on the verge of getting away
from central bankers, which means investors
who wish to protect their long-term
purchasing power cannot afford to park funds
exclusively in CDs and money markets. Our
approach will continue to use a mix of
multiple asset classes in an effort to grow
and protect principal within the context of
volatile and increasingly interfered with
markets. While in an environment where the
source of strength is basically limited to
commodities and inverse or bear market
vehicles, we have to tread with extra care.
We are willing to give investments a
reasonable amount of rope on the downside
based on recent volatility characteristics.
However, a continued pullback in commodities
could quickly morph into rapidly falling
prices. In that event, principal protection
must become the primary focus in order to
preserve capital to fight another day.
While some shortsighted stock investors
see an opportunity in stocks based primarily
on a possible correction in commodity
prices, they should not ignore the fact that
continued global economic deterioration is
the driver behind falling commodity prices.
This serves as another reason to be
skeptical of what appear to be textbook bear
market rallies. The markets and economy
would be better served if the Feds backed
off on the tinkering and just let the
markets deal with those who made poor
decisions in the form of overbuilding, real
estate speculation, securitization, and a
general lack of managerial oversight and
discipline. Recessions do many things to
help the economy move closer to a
sustainable recovery including the all
important purging of bad debt from the
system. Unfortunately, we will most likely
see just the opposite from the Feds in the
form of continued “unprecedented”
intervention into what is inaccurately
described as a free market economy. In the
end, all the tinkering will simply prolong
the recovery process. As always, if we keep
an open mind (recognizing things may not
unfold as described above) and pay attention
to what is actually happening versus being
concerned with what may happen, the markets
will guide our asset allocations if we are
willing to follow.
Back to
Part1
Chris Ciovacco
Chief Investment Officer
Registered Investment Advisor
Ciovacco Capital Management
www.ciovaccocapital.com
All material
presented herein is believed to be reliable
but we cannot attest to its accuracy. The
information contained herein (including
historical prices or values) has been
obtained from sources that Ciovacco Capital
Management (CCM) considers to be reliable;
however, CCM makes any representation as to,
or accepts any responsibility or liability
for, the accuracy or completeness of the
information contained herein or any decision
made or action taken by you or any third
party in reliance upon the data. Some
results are derived using historical
estimations from available data. Investment
recommendations may change and readers are
urged to check with tax advisors before
making any investment decisions. Opinions
expressed in these reports may change
without prior notice. This memorandum is
based on information available to the
public. No representation is made that it is
accurate or complete. This memorandum is not
an offer to buy or sell or a solicitation of
an offer to buy or sell the securities
mentioned. The investments discussed or
recommended in this report may be unsuitable
for investors depending on their specific
investment objectives and financial
position. Past performance is not
necessarily a guide to future performance.
The price or value of the investments to
which this report relates, either directly
or indirectly, may fall or rise against the
interest of investors. All prices and yields
contained in this report are subject to
change without notice. This information is
based on hypothetical assumptions and is
intended for illustrative purposes only.
PAST PERFORMANCE DOES NOT GUARANTEE FUTURE
RESULTS.
|
