Sunday, April 16, 2006

Market review; more on hedging

It’s time to inject a little rigor into my hedging strategy. But first, let’s review the market action of this holiday shortened week. My portfolio took a hard hit as described in this earlier post. The market made feeble attempts to reclaim lost ground on Wednesday and Thursday. The big boys were away pre Easter/Passover, so the volume was pathetically low. Such holiday shortened weeks tend to produce counter trend moves, almost as if the “kids” were allowed to run the show while the “adults” return for house cleaning after the long weekend. The last such instance was the down week before New Years that ushered in the rally at the beginning of the year. We may find next week that much more weight should have been assigned to the fact that the 10 yr is now over 5%.

The S&P chart below illustrates my thinking. I'm looking at divergences in both RSI and MACD. The first downside target is 1245 followed by 1165 which represents a 10% correction from here.

Gold continues to be an enigma. I’m an unwavering long-term bull but the next short term moves are baffling. Marc Faber, Richard Russell and Ed Bugos’ latest articles do not help matters either. If pressed for a prediction, I would have to side with Faber and say the gold stocks will follow the general market down. As said numerously before, the 350 level on the HUI bears watching.

We are now in the traditional shoulder season when rising inventory levels place the energy stocks under strain. Oil prices are elevated right now due to the situation with Iran, but I don’t think it’s going back to the 40’s. Heck, I don’t even think it will go below $58! China is almost certainly filling up their own strategic petroleum reserve right now as would any other country run by people with half a brain.

More hedging considerations
So, in the event of a 10% drop in the S&P, what is the down side to my portfolio? A rough back-of-the-envelop calculation runs like this: the bonds will be pretty much flat; the PM positions may take a 20% hit; other commodities 15%; general stock exposure 10% -- adding up to about $60k in a reasonably bad scenario. This would wipe out nearly all my YTD gains.

Now say I want to hedge half of that potential loss, i.e., I need to find $30k of gains in the event of a 10% correction. Assume that my current holding of BEARX will provide $2k, URPIX $1k and the BZH short another $2k, I need to find another $25k of short side protection. I’m not going to assume a $250k short position in the S&P which leaves buying some puts. SPY closed at $128.71. Its December at-the-money, $129-strike puts closed at $4.70. I’ll need 20 contracts which will cost around $9400 + commissions (or less if there is still time premium when I sell). So the question is whether I should commit almost $10k for $25k worth of short side protection. For now at least, I’m not initiating any positions until there is more evidence of a correction. Incidentally, the December $129 calls closed at $6.80, $2.10 more than the puts. Does that mean the crowd is bullish still?

It’s always beneficial to examine the portfolio against macro trends and potential risk factors:

  • I continue to bet on the secular bull in commodities, especially precious metals. The best thing for my portfolio is a sharp decline in the dollar. However, it is both unlikely and unwelcome in view of our other dollar based assets and the social stress that may ensue from such an event.
  • By longing commodities and shorting the general market and housing, I’m most vulnerable to a decline in commodities without a corresponding decline in the general market. This could happen in a US slow down if the market sees a decline in the export-driven emerging economies while placing (an inordinate amount of) faith in the Fed and the financial sector.
  • In my calculations above, I already assigned higher “betas” to the commodities as the majority of investors continue to take a US centric view of commodity demand.
  • The FED could stop raising rates sooner than I anticipate. Although I think there will be at least two more hikes, “once and done” is a real possibility. In that event, I need to re-examine my hedging positions. I expect the commodities to rise faster than the general market at that point. Foreign denominated bonds should do well, but long treasuries may not if the Fed is perceived to be soft on inflation.