Thursday, August 02, 2007

Decision time

I haven’t been writing about this market downturn, since, well, I’m not sure I have much to say. On Wednesday the Dow rallied 200 pts in the last 40 minutes to finish up 140 pts, but the advance/decline was negative. Thursday’s 100-pt gained was accompanied by better breadth so we have likely seen a short term bottom. However, if it was truly a bottom, it felt a little flimsy. I won’t be surprised if another leg down starts within a week. At any rate, I believe in waiting for the second bottom to assess things. For now, I’m more concerned with the bigger picture.

The mess with housing/mortgages was entirely foreseen, it just took some hard evidence for the market to finally take notice. After all these drama this past week, we are still only 5% from the highs. Cutting through the myriad of data and spin, I see two broadly interacting cross-currents:

  1. Liquidity waning due to MBS market implosion, mortgage lender restraint and corporate spreads widening
  2. The global economy, especially Europe and the emerging markets, continues to power forward and placing high demands on energy and other commodities

Due to #1 above, the probability of a recession is likely 50/50. As mentioned before, I’m not at all focused on the employment data which is a lagging indicator, not to mention the birth/death adjustments. Consumer spending is something like 70% of our economy. I keep hearing that because the top 20% consumers are responsible for 40% (some say 60%) of the spending, and they are holding up well, overall consumer spending will remain resilient. But how can one just ignore the bottom 60% when it takes so little to tip the economy from regular expansion (3% per year) into recession (2 quarters of GDP contraction)?

The million $ question is whether #2 will be sufficient to counteract #1 in preventing a US recession. We use to say that when US coughs the rest of the world catches a cold. This time around, emerging market’s growth rate may be slowed by a US recession but I’m certain a positive rate it will remain. Whether a recession in the US can be averted remains to be seen but even if there is one, its severity is likely limited.

I don’t consider myself a buy-and-holder, instead I follow a long-term indicator which I will discuss in more detail later. For now, all I need to say is that this indicator is slow-moving enough that it will miss the true top or bottom by a couple of months and 10% or more. The idea is not to get me out of a 10% correction, but to get me out of the really nasty 30-50% down bear markets that come once a decade or so.

The indicator hasn’t flashed a sell signal yet, but it’s not too early to explore some options. The plan is to keep my asset allocation plan intact (see the bottom of the pyramid), and use options/shorts/inverse funds in my actively managed accounts for hedging, so I need to consider the hedging efficiency for the money spent. Ideally, I will target a high beta index/sector with good correlation to the S&P. When all markets move in tandem, the options that present themselves are traditionally the techs (QQQQ), emerging markets (EEM) and small caps (IWM). Of these, I would only seriously consider IWM now, again due to the macro perspective mentioned above. Today IWM is sitting at its long term trend line and I’ll consider breaking below $75 a very ominous sign.