Sunday, June 17, 2007

BEARX as a Defensive Fund

The Prudent Bear fund (BEARX) is the only true mutual fund that I've ever considered owning. It is actively managed, so it comes with a high expense ratio (1.75%) in addition to potential penalties (1%) for buying and selling within a month. Despite these shortcomings, I'm getting to like BEARX.

The Prudent Bear fund has an uncanny ability to go up in value during corrections (as any bear fund should) and during slow rallies - exactly the kind of behavior I'm looking for in a defensive fund. The managers use a combination of options, selling short, and buying long positions in certain companies to achieve these surprising results.

Now, this fund has not always performed well during weak markets. It actually fell 5% or so during the long downturn in 2004, and it's been pretty flat during the slow rallies so far this year. However, in combination with other funds that I've discovered more recently like CSD and DBV, I think BEARX provides exactly the kind of diversification that my defensive portfolio needs. In the short term, BEARX always goes up during corrections, so it makes sense to buy it during slow rallies. The probable, but not guaranteed, ability of BEARX to actually go up during slow rallies is then icing on the cake. If it rises with the S&P 500, great! If not, it's still providing insurance against a correction while CSD and DBV are doing their thing.

The following charts show BEARX (red) and the S&P 500 (blue) during the 5 most recent slow rally+correction phases. CSD and DBV are also included in the final two.

Wednesday, June 13, 2007

Why my method will work

Since the market dipped below the 1505 threshold that I marked in a post last month, I've been transferring gradually to the 2x leveraged funds, with one purchase made per day. Today I'm starting to see how this strategy will pay off, as the S&P 500 gained 1.5% and the 2x funds gained about 3% on average.

There is no guarantee that this correction is over, and it may not have reached bottom yet, but my portfolio will have made a substantial gain by the time the market recovers.

Saturday, June 09, 2007

Correction, Recovery and Trend

On the following graph of the S&P 500 I've drawn lines indicating the three phases of each market cycle:Red lines mark corrections where the market has fallen 5% or more from a previous high. (Note that the current correction has only fallen 3% so far.) Green lines indicate fast rallies (recoveries) where the S&P erases its earlier losses and reaches new highs. Yellow lines are where the S&P 500 returns to its long term upward trend, making steady gains at a slower rate than a recovery.

In the last 5 cycles over the past 2+ years, every single correction (red) has completely erased the gains from the previous trend phase (yellow). In other words, buying at the bottom of each correction, selling when the market returns to the trend, and holding cash until the next correction, would have been better than buying and holding the S&P 500 throughout the entire period.

Of course it's difficult to sit on the sidelines during the the trend phase and watch the market going up further without participating in it. That's why I've spent so much effort looking for funds which can result in net gains during the trend+correction phases of each cycle.

In hindsight it would have made sense to buy an inverse S&P fund like SH at the beginning of each trend phase, since it ultimately would have resulted in a net gain at the bottom of the following correction. But watching an inverse fund shrink while the S&P goes up is even more difficult than being in cash, since there's no way of knowing when the next correction will occur, nor any guarantee that the next correction will fall far enough to make an inverse bet pay off.

Currency ETF as a Defensive Fund

I've just discovered another new ETF which can act as a defensive fund. The Currency Harvest Fund (DBV) takes positions in 6 of the world's top 10 currencies based solely on their interest rates. It takes a leveraged bullish position (2x) in the 3 currencies with the highest interest rates, and takes short positions in the 3 with the lowest rates.

My understanding of why this works is that economies with high interest rates tend to attract foreign capital from people who want high-yielding fixed income investments, so those currencies tend to rise in value. Similarly, economies with the lowest rates tend to lose fixed-income investors. Since the fund takes positions in 6 currencies, a wrong move by one or two will not ruin the overall returns.

DBV already has an impressive track record of hanging with the S&P 500 in the long term while preserving its value through stock market corrections. Over the past 6 months, DBV (red) has actually outgained the S&P 500 (blue) by 2-1! (14% to 7%)

Impressive as that is, I'm more intrigued by what DBV did during the corrections. From February 20th to March 5th, when the S&P 500 lost 6% of its value, DBV lost only 3%.

In this most recent correction, the S&P was down by as much as 3% from its June 4th high, and today is down more than 2%. DBV has gained 1.5% since June 4th.

Friday, June 08, 2007

Defender: What have you done for me lately?

We've now been through two corrections since the Defender Fund (DEF) was created, and it hasn't defended diddly-squat.So I'm dropping DEF from my fund lineup. It will remain off my list until I see some evidence of DEF outperforming the S&P on down days - which was the whole point of the fund in the first place.

Monday, June 04, 2007

The Bull is Back!

It's official.

The stock market has broken its all-time record highs, meaning we are offically in a bull market. Hang on and enjoy the ride!