Saturday, May 13, 2006

The way I see it

Wow, I can’t help but pat my own back a little for taking decisive action in the past week. I gave a full description of my bearish view in The Sword of Damocles, and closed out a list of positions on Thursday. However, my visibility was limited to the precious metals sector where the weakness of the gold stocks relative to the underlying metal was again a telling sign. Despite my good timing with those IWM puts, it would be disingenuous to claim I saw either the immediacy or the breadth of the carnage in the last two days. I know saying the following will not make me popular -- but do I think a general market correction may well be underway.

Before going further, let me reiterate the underlying tenets of this blog since there may be some new readers. I like investing because it provides an objective and quantitative evaluation of my ideas. I share my major investment decisions and the reasoning behind them. If my readers find this blog thought provoking, then I have achieved my aim; otherwise, just laugh it off. This is in no way intended as investment advice. Human nature being what it is, if you make money based on what I say, you will get all the credit; if you lose money, I will get all the blame. So I ask that I be given neither.

Precious metals
My initial projection of the HUI (Amex gold bugs index) up to 390, first described in January, seems to be the right one. (If you are unfamiliar with the Elliot wave terminology, check out this free tutorial.) In addition to EGO, TRE, NTO and SSRI, I sold UNWPX and another PM fund held in retirement accounts on Friday. Currently, PMs take up 25% of my actively managed portfolio. 2/3 of that is in bullion and CEF (Central Fund of Canada). If previous corrective phases are any indication, this correction will last 6-9 months. A 50% retracement will take us back to HUI = 280, and 68% back to the beak out point of HUI = 250. Past corrections took the form of an ABC triangle, whether the same will happen this time is anyone’s guess. My big fear is that if the mountain of housing related credit crashes down, the dreaded “d” word will resurface, burying everything with it.

Other commodities
It was not a big surprise that other commodities took a hit along with the PMs. After all, copper, zinc and aluminum prices were hitting all time highs from the same dynamics: hedge fund buying and surging Asian demand. The natural resource story is intricately woven with that of the emerging markets. On the demand side there are China and, to a slightly lesser extent, India. On the suppliy side there are Russia, South Africa, and Latin America. The conventional wisdom is that if US sneezes, the export lead economies will catch pneumonia. Howver, I have always held the opinion that the Chinese government will use their massive reserve to stimulate their economy by initiating massive infrastructure projects if necessary. I have noted earlier that FXI (China FTSE/Xinhua 25 index) was outperforming the rest of the emerging markets. Now take a look at the screen shot below and see if you can spot the odd man out.

Click to see a larger version. Source: Yahoo! Finance, May 13, 2006

Asian markets close ahead of US, so this unusual show of strength happened before Friday’s plunge. It needs to be noted that SSEC went up 10% in the last week after Chinese investors returned from a weeklong national holiday. How this unfolds in the coming weeks will determine to a large extend my take on base metal and energy stocks going forward. If the Chinese economy holds up as reflected in an upbeat stock market, chances are the natural resources companies will continue do well in the intermediate term.

In spite of that (possible) oasis of strength, my bias is now towards selling. My CHK (Chesapeake) and half of DVN (Devon) were bought in early January, and are now slightly underwater. I would like to keep those losses to less than 10%. I was lucky with N (Inco) which became a take over target of Teck Comminco, so some profit taking might be warranted. Another selling candidate is International Uranium (IUC.TO) which has some long term gains but has been flat for a while.

As someone with a physics/EE background, I'm definitely in the minority in that I don’t own any tech stocks except for those in my company. And those were awarded as part of my compensation anyway. Well, I did buy into the tech bubble of the late 90’s. I had a significant (to me then) amount of EMC, Nortel and the like which I rode down 90%. After reading the triple water fall theory in Don Coxe’s The New Reality on Wall Street, I realized the tech stocks collectively had a lot more to fall (maybe not in terms of nominal value, but in terms of P/E). I now shun the entire sector. I may have missed out on Google and Apple, but I feel a lot more comfortable investing along a long term up trend.

The Naz is the weakest of the major indices. As I said in The symbiosis lives the malaise of the large cap tech stocks are a reflection of the lack of corporate spending despite their record cash hoard. The stock in my employer actually rose on Friday – such signs of relative strength are notable. Since I hold some company options and I’m forbidden from short selling or buying openly traded options in my employer, I have been looking into some inverse Naz funds for hedging purposes (check out my summary of bear market funds). If my company stock does well relatively, the bear funds can become a directional play as well. This purchase will most likely take place on a bounce (no, I don't think we've seen the last of the bulls yet).

The general stock market
I don’t think one can conclusively say the general market has gone into a bear phase, yet. Certainly, the signs are there. From a Dow Theory perspective, bear markets cannot start when the Transports are making new highs. On Friday, Dow Transports dropped 2% against Dow Industrials’ 1%. The Utilities peaked 6 months ago. If the Transports also top out now, look out below!

I picked up some IWM (Russell 2000 ETF) puts last week. The Russell is a more efficient way to play on the short side due to its beta of 1.5. That performance may not be repeatable though. From now on, if I were to increase my short side exposure, I plan to use bear market funds and avoid options as the time for straight put buying may have passed. I’m not versed in the more advanced option strategies so I’ll leave it to the experts.

So to summarize, I fear that we have/are entering a bear phase in the stock market. I have taken prophylactic measures but am still net long. I'm planning on selling certain natrual resource stocks and buying additional bear market funds. The above are personal opinions of an amateur investor, so please take it with a large pinch of salt. Best of luck and may your investments be safe.