Hedge Your Bets – McLean, VA
The thinking here remains the global economy will perform decently this year, although a US recession in 2007 can’t be ruled out. Yet, there are some signs that many markets around the world are due for a correction.
I’ve previously commented on a potential correction in Japan, our long-term favorite market (see “The Butterfly Effect”). Given the risks, be careful when adding beta and add defensive names to your portfolio. In addition, some investments must be avoided.
The following chart depicts a ratio I use to develop tactical (i.e., short-term) market moves. The value is the Nasdaq 100 divided by the S&P 500. When the ratio falls below the rough support level, the risk for a selloff increases.
Bloomberg
Given that a downturn can last for some time, it could hurt overextended or high-volatility investments. Hence, the potential for a market correction needs to be addressed.
The first market sector in which a correction should be expected is commodities. There’s a strong case to be made for a multiyear commodities multiyear bull market. After all, this is one of the themes in a book I’ve co-authored with my colleagues Ivan Martchev and Elliott Gue, The Silk Road to Riches. In a nutshell, commodities are in a new bull market that started in 2001 and should last beyond 2010.
And yet commodities, especially the hard commodities (e.g., metals), look ready for a substantial pullback. The following two charts illustrate this point, but also demonstrate that nothing is clear yet, as is usually the case on an early move.
On a longer-term chart, the commodities index, although showing weakness, seems to be doing what it’s done since the beginning of 2002: taking a breather before the next leg higher.
Bloomberg
But if you look at a shorter-term chart, say from January of last year, the move–as expected–looks more pronounced.
Bloomberg
The main fear in the commodities market is that China might need to take a breather. The wild speculation–there are so many new funds that have been created for the sole purpose of investing in hard commodities that it’s easy to lose count–built into the metals will therefore cool off.
A selloff in commodities is more likely than not. And given that no one knows at what level it will stop, although some people claim they do, investors should be prepared. Take profits off the table and reduce your exposure to mining stocks and the like. There will be better entry points ahead.
The more adventurous can also take a short position in one of the big mining stocks. One suggestion is BHP Billiton (NYSE: BHP). If the selling commences, it will suffer as much as any other, although it will fair better than the little mining stocks speculative money has been buying. If you short the BHP Billiton, place your stop at 37.75.
Bloomberg
A friend in the money management business recently returned from Brazil. His assessment was that everyone is mesmerized by the market and is trying to get extra money so they can play the market. Initial public offerings (IPOs) are soaring, and people can’t get enough. Long-term businessmen have found this the opportune time to sell their businesses, as valuations are off the charts. It seems that after a three-and-a-half year bull market and 350 percent gains, no one wants to be left behind.
My friend’s description of Brazil’s situation reminds me of the market frenzy in my home country, Greece, in the mid-to-late 1990s when a ride in a taxi came with the day’s stock tips. I used to work in a brokerage house, and although it was one of the best times for the business, it was also perplexing, as there seemed to be no limit to what people would say or do to participate in the market. Greece was one among many countries where the public thought the stock market equaled easy money.
Note that I was one of the few to write positively about Brazil’s future when its current president was elected with an agenda more socialist than his predecessor’s. Nevertheless, Brazil is now a market in which investors need to take some profits off the table.
True, the market remains cheap on a valuation basis, but pullback would provide an opportunity for better buys. Investors who want to remain long in Brazil should set tight stops, especially if they’re trying to trade the market. Shorting is also an option, although you need to be careful, as the market can easily defy our rationale–just ask the poor souls who have been trying to short Google since its IPO days at around 100 all the way up to 475. Readers interested in shorting should use the iShares MSCI Brazil Index Fund (NYSE: EWZ) and place a stop at 44.
Bloomberg
Portfolio Talk
With the above analysis in mind, expect stocks to have another decent year in 2006. The degree of success will significantly depend on non-company specific factors, such as the Federal Reserve’s tightening cycle and a soft landing for the US economy.
Also important is whether companies can show that their earnings growth is on a sustainable path. These two conditions are related, in the sense that if the Fed tightens more than the economy can endure, then the US is in danger of slowing down more abruptly than what is good for earnings.
Finland-based paper giant UPM-Kymmene (NYSE: UPM) is added to the Portfolio. The company offers a defensive move, as well as a solid yield of 4 percent and exposure to an interesting and developing situation.
An increased tightness in the pulp market is driving prices higher. High costs have forced many companies to announce mill closures and shut down box-making plans, especially in North America. Opening new factories is becoming more difficult for environmental reasons, as pulp-mill waste and fast-wood plantations are being blamed for the death of endangered species and the destruction of rain forests. At the same time, demand remains fairly strong, especially in emerging countries, with inventories for some products (e.g., container boards) low. Buy UPM.
Bloomberg
There has also been a dramatic selloff in US Treasurys, especially last week. Bonds are weak because the market thinks the US economy is in reasonably good shape. If the February non-farm payroll data, due at the end of this week, come in at or above expectations, the bonds may weaken further. As a result, the 10-year Treasury yield will remain at the upper end of its range during the past several years.
Bloomberg
This is the time to take a position in bonds. Use the iShares Lehman 7-10 Year Treasury Bond Fund (AMEX: IEF). Even if there is short-term risk, now is the time to gain exposure to the Treasury market.
Treat this as a more permanent hedge for the Portfolio because, later in the year, this hedge will become important to achieve positive returns. As previously explained (see “The Rules Of Engagement”), hedges will be monitored separately since the Portfolio is a long-only portfolio. Buy IEF.
Bloomberg
Finally, this being a new service, there are many requests for clarifications regarding portfolio construction and stock selection.
The approach is top-down. I first identify long-term investment themes (or, as my colleagues and I call them, global secular trends). Because of the long-term approach, the Portfolio must be able to endure short-term volatility as long as we continue to be on the correct side of the global secular trend. To achieve this, the Portfolio is being constructed to offer a diversified set of holdings, while we also offer hedging ideas for more complete advice.
A characteristic common to the Portfolio companies is suitabilitiy for the new realities of a changing world. They will benefit the most from the changes taking place in the global economy.
That said, no one knows how long it will take for the global economy to navigate the secular trend identified here. This is the reason investors need to remain focused and have a portfolio that can last and perform well on a tactical basis. After all, the way to stay in the game is by not losing all the money, and tactical mistakes can cause that. This is the main reason I won’t put convictions above analysis and will avoid suggesting only one type of attitude or trade, especially short-only strategies.
It is, therefore, important that you look at the Portfolio as a whole and not as an assortment of stock tips. Although few people will buy the Portfolio in its entirety, you, at the very least, need to buy SRI’s investment theme in order to diversify. Buying only banks or tech companies because you like the stories might offer a reward, but such an approach won’t provide the lasting benefits of the overall Portfolio.
Keep in mind that SRI comes to you weekly and always offers current advice. Adding and subtracting stocks from the Portfolio can be done easier this way. There’s always another week and neither readers nor the editor need to rush. Patience has always been a good thing to have when investing.
See you next week.
I’ve previously commented on a potential correction in Japan, our long-term favorite market (see “The Butterfly Effect”). Given the risks, be careful when adding beta and add defensive names to your portfolio. In addition, some investments must be avoided.
The following chart depicts a ratio I use to develop tactical (i.e., short-term) market moves. The value is the Nasdaq 100 divided by the S&P 500. When the ratio falls below the rough support level, the risk for a selloff increases.
Bloomberg
Given that a downturn can last for some time, it could hurt overextended or high-volatility investments. Hence, the potential for a market correction needs to be addressed.
The first market sector in which a correction should be expected is commodities. There’s a strong case to be made for a multiyear commodities multiyear bull market. After all, this is one of the themes in a book I’ve co-authored with my colleagues Ivan Martchev and Elliott Gue, The Silk Road to Riches. In a nutshell, commodities are in a new bull market that started in 2001 and should last beyond 2010.
And yet commodities, especially the hard commodities (e.g., metals), look ready for a substantial pullback. The following two charts illustrate this point, but also demonstrate that nothing is clear yet, as is usually the case on an early move.
On a longer-term chart, the commodities index, although showing weakness, seems to be doing what it’s done since the beginning of 2002: taking a breather before the next leg higher.
Bloomberg
But if you look at a shorter-term chart, say from January of last year, the move–as expected–looks more pronounced.
Bloomberg
The main fear in the commodities market is that China might need to take a breather. The wild speculation–there are so many new funds that have been created for the sole purpose of investing in hard commodities that it’s easy to lose count–built into the metals will therefore cool off.
A selloff in commodities is more likely than not. And given that no one knows at what level it will stop, although some people claim they do, investors should be prepared. Take profits off the table and reduce your exposure to mining stocks and the like. There will be better entry points ahead.
The more adventurous can also take a short position in one of the big mining stocks. One suggestion is BHP Billiton (NYSE: BHP). If the selling commences, it will suffer as much as any other, although it will fair better than the little mining stocks speculative money has been buying. If you short the BHP Billiton, place your stop at 37.75.
Bloomberg
A friend in the money management business recently returned from Brazil. His assessment was that everyone is mesmerized by the market and is trying to get extra money so they can play the market. Initial public offerings (IPOs) are soaring, and people can’t get enough. Long-term businessmen have found this the opportune time to sell their businesses, as valuations are off the charts. It seems that after a three-and-a-half year bull market and 350 percent gains, no one wants to be left behind.
My friend’s description of Brazil’s situation reminds me of the market frenzy in my home country, Greece, in the mid-to-late 1990s when a ride in a taxi came with the day’s stock tips. I used to work in a brokerage house, and although it was one of the best times for the business, it was also perplexing, as there seemed to be no limit to what people would say or do to participate in the market. Greece was one among many countries where the public thought the stock market equaled easy money.
Note that I was one of the few to write positively about Brazil’s future when its current president was elected with an agenda more socialist than his predecessor’s. Nevertheless, Brazil is now a market in which investors need to take some profits off the table.
True, the market remains cheap on a valuation basis, but pullback would provide an opportunity for better buys. Investors who want to remain long in Brazil should set tight stops, especially if they’re trying to trade the market. Shorting is also an option, although you need to be careful, as the market can easily defy our rationale–just ask the poor souls who have been trying to short Google since its IPO days at around 100 all the way up to 475. Readers interested in shorting should use the iShares MSCI Brazil Index Fund (NYSE: EWZ) and place a stop at 44.
Bloomberg
Portfolio Talk
With the above analysis in mind, expect stocks to have another decent year in 2006. The degree of success will significantly depend on non-company specific factors, such as the Federal Reserve’s tightening cycle and a soft landing for the US economy.
Also important is whether companies can show that their earnings growth is on a sustainable path. These two conditions are related, in the sense that if the Fed tightens more than the economy can endure, then the US is in danger of slowing down more abruptly than what is good for earnings.
Finland-based paper giant UPM-Kymmene (NYSE: UPM) is added to the Portfolio. The company offers a defensive move, as well as a solid yield of 4 percent and exposure to an interesting and developing situation.
An increased tightness in the pulp market is driving prices higher. High costs have forced many companies to announce mill closures and shut down box-making plans, especially in North America. Opening new factories is becoming more difficult for environmental reasons, as pulp-mill waste and fast-wood plantations are being blamed for the death of endangered species and the destruction of rain forests. At the same time, demand remains fairly strong, especially in emerging countries, with inventories for some products (e.g., container boards) low. Buy UPM.
Bloomberg
There has also been a dramatic selloff in US Treasurys, especially last week. Bonds are weak because the market thinks the US economy is in reasonably good shape. If the February non-farm payroll data, due at the end of this week, come in at or above expectations, the bonds may weaken further. As a result, the 10-year Treasury yield will remain at the upper end of its range during the past several years.
Bloomberg
This is the time to take a position in bonds. Use the iShares Lehman 7-10 Year Treasury Bond Fund (AMEX: IEF). Even if there is short-term risk, now is the time to gain exposure to the Treasury market.
Treat this as a more permanent hedge for the Portfolio because, later in the year, this hedge will become important to achieve positive returns. As previously explained (see “The Rules Of Engagement”), hedges will be monitored separately since the Portfolio is a long-only portfolio. Buy IEF.
Bloomberg
Finally, this being a new service, there are many requests for clarifications regarding portfolio construction and stock selection.
The approach is top-down. I first identify long-term investment themes (or, as my colleagues and I call them, global secular trends). Because of the long-term approach, the Portfolio must be able to endure short-term volatility as long as we continue to be on the correct side of the global secular trend. To achieve this, the Portfolio is being constructed to offer a diversified set of holdings, while we also offer hedging ideas for more complete advice.
A characteristic common to the Portfolio companies is suitabilitiy for the new realities of a changing world. They will benefit the most from the changes taking place in the global economy.
That said, no one knows how long it will take for the global economy to navigate the secular trend identified here. This is the reason investors need to remain focused and have a portfolio that can last and perform well on a tactical basis. After all, the way to stay in the game is by not losing all the money, and tactical mistakes can cause that. This is the main reason I won’t put convictions above analysis and will avoid suggesting only one type of attitude or trade, especially short-only strategies.
It is, therefore, important that you look at the Portfolio as a whole and not as an assortment of stock tips. Although few people will buy the Portfolio in its entirety, you, at the very least, need to buy SRI’s investment theme in order to diversify. Buying only banks or tech companies because you like the stories might offer a reward, but such an approach won’t provide the lasting benefits of the overall Portfolio.
Keep in mind that SRI comes to you weekly and always offers current advice. Adding and subtracting stocks from the Portfolio can be done easier this way. There’s always another week and neither readers nor the editor need to rush. Patience has always been a good thing to have when investing.
See you next week.