Monday, February 21, 2011

Looks like an artificial rally

The S&P 500 index has been almost perfectly confined to an extremely narrow and straight rising channel pattern for the past six months.
Are we supposed to believe that this calm rally has continued through (1) a major shift in power in Congress, (2) an escalating series of collapsing governments in the Middle East, and (3) only the first of dozens of economic implosions at state capitals?

I don't buy it for a second.

Obviously stock prices did follow this pattern, but I don't think the collective action of mutual fund managers, day traders, hedge funds and individual investors could produce such a regular pattern for so long. I don't think the normal forces of supply and demand, buying and selling, or bidding and asking are at work here.

The good news is that, in the long run, it won't matter whether or not this overpriced rally was caused by illegal price manipulation or not. The higher the stock market goes into bubble territory, the harder it will eventually fall, and the more money I can make with a bear fund like HDGE when the time comes.

Wednesday, February 02, 2011

Two cycles complete

I began investing in the stock market in the late 1990's with very little idea of what I was doing. The 2000-2002 bear market then discouraged me so much that I stopped paying attention for several years. By 2005 the S&P 500 index had returned to my original investing starting point, and I started paying attention to stocks again, this time with the intention of learning how to time the market. Cycle 1 was complete.

By 2007 I'd learned enough to cash out (temporarily) at the precise market peak in October, and to switch to a bearish stance by January 2008. It was during the 2007-2009 bear market that I learned one of the most important lessons in market timing: stock valuations (P/E ratios) are meaningless. However, as I'm sure many people have done in previous bear markets, I found reasons to believe that "this time it's much worse than before", and could not get myself to take a bull market stance when prices turned around in 2009. The housing market was still tanking, the derivatives market was a house of cards, the federal government was $13 trillion in debt, unemployment was hovering around 10%, and our first socialist president had just been elected - I was surprised that enough people still had spare funds with which to buy stocks. (To be fair, I also had some career issues in 2009 and 2010 that contributed to my lack of attention to the market.) However, in the subsequent rally that's still going on, I've finally seen first-hand that the stock market is blind in both directions, and that a rally can occur despite obvious economic warning signs. The S&P 500 index is now back to the point where I originally started thinking about market timing. Cycle 2 is complete.

In hindsight, my biggest market-timing obsession - and my biggest obstacle to making a straightforward mathematical timing model - was to find a method that would turn bearish before a stock market crash like the one on October 19, 1987. I found a method alright, but it was difficult to integrate it with the schemes that worked better during the remaining 99% of the stock market's history. I think that finding such a method was more a point of pride than it was a way to improve returns, since such crashes are exceedingly rare, and because I already knew of signals that would at least tell me to cash out to a neutral position before that particular crash. I'm not worried any more about being bearish before the next 20%-in-one-day crash - I'll be happy to be in cash if it happens again.

Tuesday, February 01, 2011

The New Armageddon Fund

By an amazing coincidence, in the same week that I decided to resume my market timing analysis, a new type of bear market fund has emerged. AdvisorShares has created the first short ETF that actually sells stocks short: the Active Bear ETF (HDGE). I've been waiting for this ETF for more than three years, and it's almost the perfect bear fund.

As discussed in a previous post, my ideal Armageddon fund would (1) short a market index like the S&P 500 rather than a managed portfolio of selected stocks, (2) be easy to buy or sell in minutes without trading penalties, and (3) gain value in any bear market even if the derivatives market collapsed.

The following table shows how HDGE stacks up against other bear funds that I've used before:

Min. Invest None None $2,000 $10,000
Min. IRA None
None $1,000 $1,000
No Yes
Expense 1.85% 0.95% 1.73% 2.86%
Trading penalty None None 1% (30 d) 2% (5 d)
Long stocks No No Yes No
Managed Indexed Managed Managed

Although dozens of inverse/short ETFs like SDS and SH have become popular investment tools, they may be extremely risky in a serious bear market due to their use of derivatives in place of actually selling stocks short. Indeed, during the worst part of the bear market in 2008 some of these ETFs temporarily stopped trading. My wish to avoid derivatives led me to search for less popular but safer alternatives to these funds.

The Federated Prudent Bear mutual fund (BEARX) was the first bear fund I found that actually held short positions in some stocks, but since BEARX also has long positions in some stocks and uses derivatives, I later dropped it in favor of the Leuthold Grizzly Short fund (GRZZX) which strictly sells stocks short. Neither of these was a completely satisfactory replacement for the derivative ETFs however, because they aren't indexed to the S&P, and because mutual funds take more than one day to complete a buy or sell order and come with hefty short-term trading penalties.

The Active Bear ETF meets my requirements for simple instant trading and the safety of real short positions in stocks. It would be nice if it were an index fund instead of a managed fund, but so far its price movements are close enough to the inverse of the S&P 500 index that its a pretty safe bet it will gain some value in bear markets - and that's the most important property of any bear fund in my market timing strategy.