Weekly Wrap

The Markets

Back when the S&P 500 was holding above 1200 I kept saying that I believed 1200 would hold but that if we break it then look out below as the fall will be painful. I never anticipated what transpired last week but while the swiftness of the decline was amazing the magnitude was not surprising as the charts made it clear prior that breaking 1200 could lead us down all the way to 800. The 800 level is not arbitrary. That area represents about 50% retracement from the all time high and back to the lows from 2002-2003.

The weekly chart of the S&P shows several things to take note of. First, the swiftness of the decline. Declines like this are extremely rare so it is very hard to draw many conclusions from them. I guess the two most likely events from here are a complete crash, leading to another 30-50% decline in the next week or two. While this is drastic it is not out of the realm of possibility. The Russian market is down close to 80% this year, most of it happening over the last few weeks.

The other possibility is that the forced selling is over and we see a massive short covering rally here. It becomes a self fulfilling prophecy as people would be worried about missing the bottom, especially those that sold on the way down and the rally would feed on itself.

I am of the opinion that we really here back to around the 1100 level. I think it is time to become more invested here in higher beta choices like tech and small caps. I also believe that the ensuing rally should be sold. Not because I see another leg to this bear market but because it will be selective sectors that lead the next bull market and it is much better to try to identify those sectors and ride them than to simply be invested in the broad market.

Part of the reason I believe that there will not be another leg to this bear market is that we already had two symmetrical legs. One that took us from the all time highs to the 1200 level. Followed by a rally and then a second leg from 1300 to where we stand now at 900. While the two legs were different in duration they were similar in magnitude and fit the measured move calculation which identifies how most patterns occur. One leg, followed by a counter trend rally, followed by another leg of roughly the same magnitude as the first one.

The other reason is that we have already reached the bottoms from the 2002-2003 levels and I find it hard to believe that we will break those levels. Finally, the reason for the swiftness of the sell off was hedge funds imploding, the Lehman CDS settlements, and margin calls. We do not know yet which hedge funds imploded but the folks on CNBC keep saying that several large ones have imploded and that we will know the names and details in the next couple of weeks as the news becomes public. If you recall earlier in January we lost 200 point son the S&P 500 in three weeks. At the time that was a dizzying decline, though now it feels like a walk in the park. We did not know then but eventually we found out that a French bank's trading operating imploded causing all the forced selling. This is similar to what just happened now, though we do not know who imploded yet.

The swift declines fed on itself. As the decline happened all the idiots using high leverage and caught on the wrong side of the market got caught in the sell off and had to liquidate to meet margin calls. As those liquidations happened, big investors, mutual fund companies and the individual investors, always late to the party, started liquidating their holdings, forcing their mutual funds to sell to accommodate redemptions and the sell off cascaded.

The individual investors are always late to the party. On Thursday, one of our neighbors told my wife that they are liquidating all their retirement and investment accounts and moving to cash. To me that signaled the bottom.

Finally, there are the Lehman Brothers settlements. Big players had to settle the CDO and CDS contracts that they had with the now defunct Lehman Brothers. These were tremendous settlements in size and many companies had to raise and hoard cash to make good on their end of the settlements. This caused massive sell offs as companies needed to raise cash in order to pay off their obligations. Now that is over, which means that a) The worry about it is now behind us, b) the companies that collected the cash have plenty of money to deploy, and c) the companies that paid off the cash are done with their selling.

 

Other interesting things to note from this chart. The action in Feb. 2007 foretold all this action. If you recall the massive selling we had that day when the Dow Jones Industrial Average dropped 500 points, most of them coming within seconds. At the time we were told that computer systems failed resulting in the abrupt move from 200 down to 500 down. The weekly volume that week was the highest in many years on the S&P 500. I did not blog at the time, but I made a comment on Roger's blog that this week reminded me of the bust of the Nasdaq bubble and that at the time another trader closed all his long positions after similar action in the Nasdaq Composite in 2000.  I was swiftly ridiculed by other commentators at the time. In hindsight it looks like that week was the first warning shot and that stepping to the sidelines would have been the prudent thing to do.

The other things to note about this chart is all the technical patterns that manifest themselves in this chart. The failure to follow through on the July 2007 highs and the subsequent break of the swing low in Jan 2008 is a classic 2B reversal pattern as identified by the master trader, Trader Vic. The massive topping action from June 2006 to August 2008 is also a classic top identified by many expert technicians such as William O'neil and Fast Money's frequent guest Carter Worth.

Carter warned of this impeding disaster on Fast Money numerous times. He was often laughed at by the other traders that proclaimed: "There are a ton of charts in the bottom of the ocean".

It is easy for novices like me to identify the patterns in hindsight. The real masters are the ones that capitalized on the decline. While I correctly identified the beginning of the Bear market back in the Fall of 2007, prior to anybody else I am aware of, I still could not capitalize on it. Oh well, live and learn.

 

 

The Portfolio

 

The portfolio hit another all time low this week due to the massive sell off on Wall St. The good news is that while the markets totally collapsed this week the portfolio merely retreated 3%. Also, important to note that the portfolio now stands at 10% ahead of the Market. So while being down 28% for the year is horrible news on its own, at least the active management have shielded the portfolio from another 10% hair cut.

More over, I believe that the portfolio is now positioned to widen the gap against the market and with any luck this would be the end of the slide for the portfolio and this week would mark the lows.

The portfolio still has a high level of cash, which would imply that it would still outperform the market if we continue crashing from here.

On the other hand, the portfolio holds higher beta positions which would imply that it will climb up faster than the market in case of a rally from here. In addition, I am holding DTO, the inverse OIL position. I believe Oil is going to continue its slide from here regardless of what the rest of the market does. Same for FXM.

Many of my positions have been beaten down quite a bit. Does not mean that they cannot go any lower but they may not go down as swiftly in continued decline. I also have sold some covered calls against two of my new positions in order to earn some cash and reduce the volatility a little bit.

I plan to continue deploying cash in the next two weeks. My focus would be on small caps, tech, currencies and beaten down high dividend stocks.