Tuesday, February 24, 2009

A big up day with optimism. You know the drill.

See here, here and here.

Monday, February 23, 2009

Another new low, going 25% to cash

November 1996 was the first time that the S&P 500 index reached today's closing value of 743, which is the lowest closing price of the current bear market. The S&P 500 was as low as 740 in the middle of the day on November 21st last year, and we're now only three points away from there.

Surprisingly, today's market drop was accompanied by a slight increase in investor optimism, which is a bearish indicator for the market. I suspect that some investors are counting on a hard price floor near 740 to cause a bounce and launch the next bull market, and I think that they will be proven wrong in the not-so-distant future. There will probably be some positive days coming up, but I think they will only be wiggles on a downward trend that has further to go. Some of the positive days may be very big ones, as has happened before in this bear market.

My GRZZX position is up 14% from my average purchase price. In the interest of sleeping better tonight, I'm going to enter an order to cash out 25% of my holdings, which won't be processed until the market closes tomorrow (Tuesday PM). Sentiment is only slightly to the optimistic side of neutral, and one minor indicator might be signaling a short-term bottom. This is my least favorite time in a bear market, because a steep sucker rally can start with little warning after a long drop.

Friday, February 20, 2009

Some sleepless snippets

My astronomer duties have sent me to a remote observatory in west Texas for a week, where I'm staying up nights at a telescope and sleeping all day in a dormitory - or at least trying to sleep. Since I'm running a little low on eloquence right now, I'll just give a brief review of current events and answer a reader question.

Bear Markets: They're GRRRRRZZX!

As predicted, the S&P 500 broke down through the lower rising trend line on Tuesday and then kept going. (I didn't predict when it would happen - only that it would eventually happen.)

The Grizzly Short Fund (GRZZX) ended the week at a price of $9.91, which is a 9.7% gain from my average purchase price of $9.03. I haven't cashed out yet, but I'm going to remain vigilant for any signs that the current decline is coming to an end.

Earnings forecasts: From bad to worse.

The forecast real P/E ratio for the 3rd quarter of this year is now 62, or about four times the historical average "fair value" of 15. At this point Standard and Poor's still expect a modest earnings recovery by next year, but the forecast for the end of 2010 is still an overvalued P/E of 20. If you believe the long-term earnings forecasts, (questionable) and if you believe that earnings determine stock prices, (they don't) then, based on that more optimistic latter number, the S&P 500 could be expected to fall another 25% from today's level.

Thoughts on particular companies: None.

I don't follow any single companies in the stock market. In fact, if you ever catch me making a "buy" or "sell" recommendation for an individual stock (as opposed to an ETF or mutual fund) then it probably means I've been possessed by aliens ... while observing on a mountaintop at 3 AM in west Texas. Some people are good at picking stocks that outperform the S&P 500, and my hat is off to them. The problem is that there are approximately 9000 companies listed on the U.S. stock exchanges, and that's too many choices for me to wrap my head around.

Saturday, February 14, 2009

This Hodar guy is nuts!

I know what some of my readers are wondering: Is my GRZZX investment a good idea, or am I completely crazy? Nobody can be 100% certain of what the market is going to do, so I've never used language on this blog that specifically recommends any investment to anyone. I just report on where I'm putting my money and then I let time be judge. However, I'm going to break two rules for the first time by (1) suggesting some strategies for readers and (2) talking about investment strategies that I'm not actually using.

I realize that some folks are anxious about making the wrong investment at the wrong time, such as staying in/getting into stocks before another crash, or conversely following my lead and buying GRZZX right before a huge rally. First of all, remember that any money you've lost in this bear market is water under the bridge, and the worst attitude to have right now is "I've got to get it all back!!!" You'll make better decisions if you put the past behind you and focus on what's coming. My advice to anyone losing sleep over the stock market - if he doesn't trust my market-timing skills - is to hedge or diversify.


Any investor who prefers to own stocks in individual companies, but is afraid of a general stock market crash, can balance his stock positions by buying a similar amount of a bear fund like GRZZX or SH, which moves in the opposite direction of the market. This way a portfolio is shielded against a crash, and will only gain or lose money depending on how well the individual stocks perform relative to the market. The downside of this method, as with any hedge, is that it won't necessarily benefit from a rally, because the bear fund loses in that case. Keep in mind that general stock funds like SPY or index mutual funds can't be hedged with GRZZX or SH, because the price motions will just cancel out, meaning you might as well be in cash.


My whole strategy is based on not diversifying, so I may not be the best person to pontificate about it. Nonetheless, I do have a few suggestions that might be useful. My definition of diversifying goes well beyond owning a group of stocks; rather, it makes sense to dip into a wide range of investment types in order to minimize the risk from any one part of the economy. Fortunately there are some ETFs and mutual funds out there that make it extraordinarily easy to invest in a broad range of assets from around the world.

In the table below I've assembled a portfolio that I think achieves the maximum diversification with the minimum number of funds.

World Stocks
U.S. Bonds
Non-US Bonds

  • VT: Vanguard Total World Stock ETF. This exchange-traded fund (ETF) owns stocks from all of the major economic zones of the world. The breakdown is as follows: 47% in North America, 27% in Europe, 15% in the Pacific region, and 10% in emerging markets. All told, this represents roughly 80% of the world's stocks in one fund. (I will remind readers that I predict VT is poised to fall along with every other stock fund; that's why I'm in GRZZX right now. The above portfolio is for those who don't want to time the stock market.)
  • BND: Vanguard Total Bond Market ETF (U.S.). This ETF owns treasuries and other government debt, corporate bonds, and municipal bonds. It's got it all.
  • BWX: International Treasury Bond SPDR. This ETF owns treasury bonds from foreign countries. It's a good hedge against inflation of the dollar, but it will be more volatile than the U.S. bond fund.
  • RYMFX: Rydex Managed Futures Fund. This is the only mutual fund in the group, the only hedged fund I recommend, and the only one that uses derivatives. It tracks a wide range of investments, including agricultural commodities, energy commodities (oil), precious metals (gold), major world currencies, and US treasury bonds. The fund places bets either for or against each one of these commodities based on recent price trends, meaning it aims to go up in price whether commodity prices are rising or falling. Because of the phenominal diversification, one or two mistakes in divining price trends won't devastate the returns.
The following chart demonstrates why I like the idea of including a wacky fund like RYMFX in a diversified portfolio:

In the last two years, U.S. stocks (SPY), foreign first-world stocks (EFA) and emerging markets (EEM) have all collapsed, bonds (BND) have been characteristically flat, and oil (OIL) has been a gut-wrenching roller coaster ride - yet RYMFX ended up ahead of all of them. Here's a close-up of the chart without OIL, showing the relatively steady performance of RYMFX that has resulted in a 15% gain in 24 months.

There will obviously be occasional hiccups for this fund as there are with any investment, but its lack of correlation with other investments and its broad diversification make it too compelling for me not to include it. If the derivatives market runs into trouble, then this fund could really suffer, which is why I would never recommend letting it be more than 10% of your portfolio.

I will finish by reiterating that I have no plans to purchase any of these investments myself, because I'm convinced that I can do better by riding the next leg of the bear market with GRZZX.

Thursday, February 12, 2009

The China-Treasury Bubble?

It's dangerous for a self-styled market-timer like me to prognosticate about things as complicated as international trade and the global economy, but my gut reaction to this article in the Financial Times was too strong to ignore:
China to stick with US Bonds

China will continue to buy US Treasury bonds even though it knows the dollar will depreciate because such investments remain its “only option” in a perilous world, a senior Chinese banking regulator said on Wednesday. China has used the dollars it accumulates selling manufactured goods to US consumers to accumulate the world’s largest holding of Treasuries. However, the increasing US budget deficit and its potential impact on the dollar have raised questions about the future Chinese appetite for US debt.

Luo Ping, a director-general at the China Banking Regulatory Commission, said after a speech in New York on Wednesday that China would continue to buy Treasuries in spite of its misgivings about US finances. “Except for US Treasuries, what can you hold?” he asked. “Gold? You don’t hold Japanese government bonds or UK bonds. US Treasuries are the safe haven. For everyone, including China, it is the only option.”

The not-so-subtle message here is that China buys US Treasury Bonds, not so much because it wants to, but because it has to. The fact that it's even being discussed means that there is some doubt that China will always be willing to buy them in the future.

My crude understanding of trade between the US and China goes something like this:

  • The US buys manufactured goods from China with US dollars. (more than $300 billion worth in 2008)
  • China uses a small fraction of those dollars to buy goods, raw materials, etc. from the US. (only $70 billion in 2008)
  • China uses the dollar surplus to make investments in the US, including buying US Treasury bonds.
A Treasury bond is simply a promise by the US government to make future interest payments to the holder ... in dollars. So when China uses excess dollars to buy bonds, they're simply replacing dollars today with more dollars next year.

Here's my question: Doesn't China already have more dollars than it knows what to do with? If the Chinese can't find anything else to buy with hundreds of billions of dollars today, what makes them think they'll find something to buy next year or next decade with even more dollars?

It smells like a bubble to me. Granted, I'm sure there's some macro-economic logic behind what China's doing, such as maintaining stable exchange rates, but that doesn't mean that the current strategy will work forever. I can't think of any system for which too much of something today is solved by getting even more of it in the future.

In other news:

- The S&P 500 broke through the lower trend line this morning. There may be more on that later.

- GRZZX rose 6.1% on Tuesday (Feb. 10), the same day that the S&P fell 4.8%. I would be perfectly happy if GRZZX only moved 1-to-1 with the S&P, or even only half that rate, but I'm very pleased indeed when it actually outperforms the inverse.

Sunday, February 08, 2009

Minding Medium-Term Methods

Successful medium-term market timing requires some mental discipline - more, I believe, than either buy-and-hold or day-trading methods.

At one end of the investing spectrum, the successful long-term buy-and-hold investors are the ones who just don't care. These folks will often choose their 401(k) funds when they start their careers, and then they may never look at them again until they retire. This is not necessarily mental discipline on their part, but can simply be a lack of interest. The problem occurs when a buy-and-hold investor starts to pay attention, because then he may cash out near the bottom of bear market, only to miss out on the turn-around rally.

At the other extreme are the day traders. If buy-and-hold types ignore the stock market, day-traders eat, drink and breathe it. You might even say they drown in it. I realize that a few day traders may beat the market in the long run, but by definition most of them will not. Besides racking up trading fees and paying short-term capital gains taxes, I think day traders are prone to lose sight of obvious and important long-term trends; they don't see the forest for the trees, as the saying goes.

If buy-and-hold investors don't need any discipline, I think day trading actually results from a lack of it. In the most extreme case, a day trader is someone who sees a torrential flood of minute-by-minute market data, and determines that he should take in as much as possible in order to make as many trades in as little time as possible. Following this logic, more data is better, and profit increases the more one trades. I sometimes get comments and e-mails from people who have concerns about a single day's rise or fall in the stock market, and I think they risk falling into this trap.

My method lies in-between these two extremes. At the very least, I aim to be invested in stock funds during bull markets, and in bear funds during bear markets, so that I can make money in both directions. A perfect longer-term market-timing method would have followed the black arrows in this 8-year S&P 500 chart:

The highest effort I'll expend is to jump in and out of funds in order to take advantage of multi-month cycles of rally and retreat, illustrated by the blue arrows.

I say that this method requires more discipline because, unlike long-term investors, I have to pay attention to the stock market; and unlike day traders, I have to resist being overwhelmed by the data and making short-term decisions based on every wiggle in the charts. I don't claim to be a perfect practitioner by any means, but I'm always trying to anticipate how my own human failings might sabotage my efforts.

Friday, February 06, 2009

The technical picture

The S&P 500 index has actually been bouncing around inside of two converging trend lines since late November of last year.

The first trend line to be violated will probably determine the next medium-term trend. Given the phenomenally optimistic sentiment out there, I have a feeling the S&P will break down through the lower trend line first.

If my reading is correct, short-term traders have placed bets on a rally in numbers not seen since just before the March 2007 correction, and it may be related to the congressional vote on the stimulus package next week. If true, it means that these folks will be placing a large number of sell orders after the vote, either to cash in on some short-term gains, or to exit losing positions before the damage gets worse. In the former case the selling will stunt the rally. In the latter case the selling will accelerate the decline. GRRRR! (...ZZX)

Wednesday, February 04, 2009

Exaggerated Earnings and P/E Pipe Dreams

I am not a fundamental investor, which means I do not make investment decisions based on corporate earnings forecasts. Stock prices go up or down based on whether investors are primarily buying or selling stocks. Period. Sometimes a company loses money but the stock price goes up because people buy it anyways, and sometimes a highly profitable company sees its stock price plunge because of irrational panic. Predicting the stock market is more about understanding human behavior than reading balance sheets.

That being said, corporate earnings are not entirely irrelevant. As I noted in my previous post, the real "as reported" price-to-earnings ratio (P/E) of the S&P 500 typically varies between 10 and 20, meaning the grand average price of all S&P 500 companies is usually between 10 and 20 times their annual earnings, or about 15 times earnings on average. Therefore the S&P 500 is considered overpriced when the P/E is more than 15, and under-priced when it's below 15. One could imagine a simple market-timing strategy based on the P/E ratio which invests 100% in stocks at a P/E of 10, but cashes out completely if the P/E reaches 20.

Unfortunately, the majority of websites, newsletters, and media outlets don't use the real P/E ratio of the S&P 500. Instead, they usually provide the P/E ratio based on "operating earnings." Bob Brinker, for instance, uses operating earnings for his forecasts, and it's one of the reasons his portfolios have been decimated by this bear market.

Operating earnings are optimistic, idealized calculations that ignore one-time losses that companies don't consider to be part of their normal operating budgets. Right now, for instance, banks which have lost billions of dollars in defaulted loan payments are not necessarily subtracting them from their operating budget. Future projections of these earnings assume that their budgets will go right back to what they were before the losses, which is a highly dubious assumption. Real "as-reported" earnings, on the other hand, don't hide anything, and include every blemish in the budget.

The following table, using data from the Standard and Poor's website, demonstrates just how much of a difference there can be between the two earnings calculations:

Price-to-Earnings Ratio for S&P 500 Companies
QuarterReal P/E*Operating P/E*
2008 Q32518
2008 Q42414
2009 Q1**2815
2009 Q2**3217
2009 Q3**3017
*Earnings (E) are the total earnings of the previous 12 months (4 quarters).
**The 2009 forecasts predict what the P/E ratio would be if the S&P 500 index remained at its current level of 840. If the S&P 500 index falls, that would be a reduction in "P," and thus it would lower the P/E ratio.

It is curious that operating earnings remain 40% to 90% higher (P/E ratios lower) than real earnings for five straight quarters even though one-time losses supposedly constitute the only difference. To my eye, large differences between the two columns seem to be happening on a regular and consistent basis. Does anyone else smell something fishy? To make matters worse, earnings forecasts have been steadily decreasing for the past few months, which has raised P/E ratio forecasts to ever more over-valued levels. These forecast revisions may continue for a while still.

If you're not already baffled that anyone uses operating earnings, then take a look at what can be found on Yahoo Finance. There are two ETFs that mimic the S&P 500 index, SPY and IVV, and Yahoo reports today that their P/E ratios are between 10 and 11, which is even more optimistic than the best P/E ratio in the above table. I submit that the P/E numbers reported by Yahoo are pure fantasy, because there are no earnings numbers - past or future - high enough to give such low P/Es.

So the P/E ratio of the U.S. stock market is somewhere between 10 and 28 depending on whom you ask, and these numbers are being revised every week. What's an investor to do? Well, I mostly ignore earnings, because even the real earnings numbers can hide certain details.

The only fundamental number that affects my investment decisions is the dividend yield, because it can't be exaggerated. The dividend yield is the sum of all cash payments made to stockholders in the past 12 months divided by the stock price. That's it! There's nothing to fudge, hide, or imagine. Check various websites for the dividend yield of the S&P 500 index, (yahoo, google, Standard and Poor's, Wall Street Journal) and suddenly you find agreement where before there were different universes of earnings. The dividend yield of the S&P 500 has historically oscillated between 3% (overvalued) and 6% (undervalued), meaning a simple form of market-timing could be based on this one number.

Currently the yield of the S&P 500 index is an over-valued 3.4%. Assuming that the dividend dollar amounts remain the same into the future, the S&P would have to fall to 630 to reach a fairly-valued yield of 4.5%. In order to return to a yield of 6%, the S&P would have to fall to about 475. I doubt that U.S. corporations will be able to maintain last year's dividend payments this year, so there is a fundamental basis for expecting even greater declines.

Remember to take all of this with a grain of salt, however. If investors have the desire to buy stocks and the money to do it, then prices will rise regardless of the fundamentals, just like they did in 1998-2000. It just so happens that fundamental and technical analysis forecasts are in agreement that prices will keep falling for a while.

S&P 500 Fair Value: 450

If there is such a thing as a "fair value" for the S&P 500 index, it's a price-to-earnings ratio (P/E) of 15 using "as reported" earnings. Typically this ratio varies between 10 and 20, with rare excursions outside of that range.

For the past few months, reported corporate earnings have been falling so quickly that the P/E ratio of the S&P 500 now stands at 28, which is almost as over-valued as it was during the bubble of 2000. To reach a P/E of 15, stocks would have to fall 46% from here, which corresponds to an S&P index level of 450.

Have a nice day!

Sunday, February 01, 2009

Why GRZZX is the bear market fund of choice

I just realized that in all of my discussions about the Leuthold Grizzly Short Fund (GRZZX), I never actually showed a chart that compares it with the S&P 500 (SPY) or total market index (VTI). Here is a comparison over the past year:

The most important thing to notice is the day-by-day opposite price motions of GRZZX compared to SPY and VTI; that happens because GRZZX sells short a representative set of stocks. The fact that GRZZX has gained more (+60%) in 12 months than the S&P has lost (-38%), is just icing on the cake. The near-perfect inverse correlation and lack of exposure to derivatives is enough to make GRZZX the only bear fund that I'm comfortable owning right now.

The bottom line is this: if the S&P 500 were to lose 10% of its value tomorrow, GRZZX would gain approximately 10%. Even if GRZZX fell short and only gained 5% in that case, I would hardly complain.