April 10, 2012
The Short End of the Stick
The Investment View from Prescott, Arizona
By Bryan Jarman, CFA
While discussing the nuances of our Shock Absorber Growth Strategy with a friend, he asked me whether making money when the market went down was moral. Since the shock absorber in our flagship growth strategy is an investment designed to do exactly that, it was a good question, one that I thought I’d address publicly.
Owning an investment that makes money when the market goes up is called being “long” that investment. A “short” is when you can make money as an investment goes down.
On the surface it might seem that being able to make money when an investment goes down in value somehow supports the notion that you want the price to fall. However, there is a difference between actually wanting the price to fall and defending oneself if it happens.
Our Shock Absorber Growth Strategy includes some investments that will go up when the market goes down. These “short” positions are used to “hedge” or cushion the fluctuation of the portfolio values. If the long side of the portfolio goes down in value, the short side should go up, offsetting some of the loss.
Our approach is to systematically review the stock markets around the world, looking for the weakest market to use as the short or hedge. We look for a weak market because if it goes down a lot, the hedge goes up a lot – get it?
We can quickly increase our hedge if market conditions deteriorate, and in doing so become more conservative without pulling the rest of the portfolio out by the roots. This allows us to stay invested in the strongest segments of the markets – our long side – and keeps us from over-trading due to market volatility.
Some would ask: if there is a high probability of a market downturn, why not go 100% short? We could, but the risk is more than we want to take in this portfolio.
Market bottoms are often marked by sudden, sharp reversals that are just about impossible to time and can cause large losses for short positions when they occur. At those times long side becomes our shock absorber, so we need both long and short positions for this strategy to work the way it is designed.
If we are short the weakest markets and long the strongest, we should be able to make some money with much lower fluctuations in account values than by being long-only or 100% short.
To answer my friend’s questions (both spoken and unspoken): Is shorting legal? Is it ethical? And is it moral? Unequivocally, yes to all three!
Hedging the long investments with some shorts provides a defense mechanism so you don’t have to worry about getting the short end of the stick.
A Slice of Life
Bryan and I continue to spend a lot of time in the Valley to meet with clients that have come to us from Seleznov Capital. One of the fringe benefits is all the new restaurants I am discovering down there. This past week I was sent to Z’Tejas at the northeast corner of Tatum and Shea, and found a wonderful menu and a delightful atmosphere. After a trip to old Mexico that I remember fondly, the street tacos were tempting, but I was really glad I tried the Green Chile Barbacoa Enchiladas. Thanks for the recommendation, Kelly!
We will again be in Scottsdale on April 13th and have one opening left that day, at 2:00. Call the office if you would like to meet this week with Bryan or myself.
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How’s the Market Doing?
My newsletter from two weeks ago, commented on the stock market’s cooling off, and a very subtle deterioration has taken hold with volatility increasing, although not yet to alarming levels as of this writing on April 8th.
The HCM Safety Net Indicator we developed last year as a method to tame the market volatility has not given us a sell signal since July 29th of last year, just a few days before the 16% drop during the first week of August. Although volatility is increasing, we are not close to a sell signal yet – good news, for sure. But that can all change quickly, so we are monitoring the rising volatility closely.
At HCM, we have a list of over 150 market indicators that we follow on a regular basis. There are technical indicators (things from our charts) like moving averages, stochastics and more, plus fundamental indicators like interest rates, earnings, money supply changes, even the cost to lease ocean-going freighters. Last week produced a very large decline in our indicator list for a period where the stock markets had not really dropped much. This suggests trouble is brewing and the indices just have not begun to register it yet.
Investor’s Business Daily declared the stock market to be entering a correction last week despite several key indices being only slightly off their highs. IBD follows institutional selling on the presumption that that is the “smart” money. Smart or not, heavy institutional selling creates a headwind for individual investors, and as Jim Croce once sang, “You don’t spit into the wind”. If you’re smart you don’t, anyway.
I have been expecting gold to begin recovering from what was an expected, cyclical decline that was due last month. However, gold continues in its clear downtrend, so it is a market to be avoided right now.
I have written a couple of times over the past year or so about a very clear 60 year cycle in interest rates that goes back to the 1700s. Interest rates last peaked in 1982, so the half cycle (30 year) low in rates is due this year, 2012. Rates bottomed in September last year and again in February, before spiking sharply upward last month and driving the bond market down.
This pattern of testing lows a second time, then a sharp spike up often marks turning points in the market, so it is possible we have seen the lows in interest rates – perhaps for the rest of our lifetime. Bonds may have one more rally left in them, especially if stocks begin to struggle, but I would be very surprised if rates get any lower than what we have seen in recent months.
Mental Floss
Q:
Only one color, but not one size,
Stuck at the bottom, yet easily flies.
Present in sun, but not in rain,
Doing no harm, and feeling no pain.
What am I?
A:
A shadow.
What’s Going On In Your Portfolio?
We have had few changes in the portfolio in the past couple of weeks.
Shock Absorber Growth is designed to keep us from over-trading in volatile markets, and with volatility picking up the past few weeks, market stresses that in past years might have had us jumping out and back in markets are now being smoothed out by the shock absorber hedge in the portfolio.
Current holdings in this growth portfolio include funds with stocks of retail, automotive, technology, large value and Japanese companies, with the shock-absorber hedge being an inverse small company stock fund. With small caps being one of the weakest market segments, this holding has been our best performer over the past few weeks.
The stock market appears to be softening, and if that trend continues, you will see us cut back on one of the weaker funds on the long side and add those moneys to the hedge to become more defensive.
The Flexible Income side of things has seen performance flatten out since earlier this year. We are avoiding Treasuries, which have a huge risk of being caught by rising interest rates which will hurt their prices. Instead, we are focusing on high yield bonds which have been more stable recently than Treasuries.
We continue to hedge the Flexible Income portfolios with a small holding in an inverse Treasury fund, one that will go up with interest rates, opposite of what most bond funds would do.
Our Spotlight Strategy
Adaptive Growth:
The market strength earlier this year has pushed the Growth side of our Adaptive Growth portfolios to 80% of the portfolio, with only 20% allocated to Flexible Income. At the beginning of the year it was down to about 30% growth and 70% income.
[Read more about Adaptive Growth here.]
* The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed. Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account. Not all trades are profitable. It should not be assumed that current or future holdings will be profitable. A list of all trades in these accounts for the past 12 months will be provided upon written request.
** The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market. Investors cannot invest directly in the S&P 500 Index.
Traditional Income
Flexible Income
Adaptive Balance
Adaptive Growth
Shock Absorber Equity
This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable, however we cannot guarantee its accuracy. Please discuss any legal or tax matters with your advisors in those areas. Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.
