Expose Yourself to the Long Side

For the time being, it may be prudent to expose yourself to the long side of the market. The incredible correction and volatility the market has enjoyed these past few weeks has been nothing short of mind-numbing, heart attack-causing, hair-loss catalyst action. Just look at the following chart of the S&P 500 while bearing in mind the VIX closed at 53 and change from a peak of 80 or so.

click to enlarge image

Mean Reversion

An investor who bought an S&P 500 index fund in 1998 would barely have seen a return over the past decade…. we're talking less than 1% per annum on average - you would've been better off investing in CDs!

S&P 500: Decade of Nothingness

Now I'm a fan of the concept of mean reversion. I even developed an intraday indicator based on the concept. Over the last thirty years or so the approximate average compound annual return of investing in an index was 12%. Thus one could conclude that earning a return of next to nothing for the past decade or so is a sign of one of two things: either we enter a long, drawn out bear market which brings us to a 5,000 Dow Jones Industrial Average or we revert back to the mean and see significant price appreciation in the equity markets. I'm a believer of the latter viewpoint.

Understand The Risk

We expect a rally but respects the potential for a crash. The current financial crisis was not a Black Swan because it was predicted and expected. If there was ever a time for a Black Swan event it's now to within six months. Life's irony dictates that things happen when you least expect them and as this market learns how to walk again don't be surprised if it gets knocked down a couple times. This is fine - capitalism is not over and the equity markets will continue to march higher. Every generation has the doom sayers who prance around screaming that the world is ending because of an oil shock, or a world war, or a food shortage, etc. If you want an asset class with high potential for growth over the next ten years - look no further than equities.

Put Me In Coach!

There is currently an enormous quantity of money on the sidelines that will soon be yelling "Put me in Coach! I'm ready to play!" Read here and here for figures,  but we're talking in the hundreds of billions of dollars. This is what happens at market bottoms…. everyone becomes terrified and pulls their investments into cash positions. Then they chase the market back up.

Overview of Our Argument

• VIX peaked at 80 or so (may go higher but at the moment I don't expect it to)
• Money on the sidelines in cash was pulled out of the financial markets and will go back in at some point
• Respectable double-bottom in place
• Mean reversion dictates that for the thirty years prior to 1998 the market yielded 12% or so per annum. In the last ten we have been yielding just about nothing. This leads me to believe we're going to see a period of drastic outperformance for a period of five to ten years.
• RISKS: There is the risk of a Q4 selloff in hedge funds as they close down their shops and reopen in 2009 (it's much easier to start from zero than have to make up your losses prior to getting paid). Also while you're not supposed to bet on a crash since the odds are so minute it is a very real possibility.

Either way the equity markets should be around in twenty years and should be much higher than today. I'd find some companies with mega quantities of cash relative to debt in semi-strong forward-looking industries and snap them up. If you read my prior posts I've highlighted a couple such as Yahoo (YHOO) and Gushan Environmental Energy (GU). Check back shortly for some more ideas.

Comments

[investor88:]

Good article and excellent chart of the sp500. The way things go and from the looks of the chart of the sp500, things likely [never certain??] to get worse before sunshine. So I would look to bypass the coming storm [in case one develops] and then step; in this process I might miss the bottom but it is an acceptable price to pay. Meanwhile devote a portion of capital for trading with stop loss.

2008 Oct 22 03:49 AM

[SchraderTrader:]

I agree that things could certainly get worse. However I'm of the opinion at this point that the more significant risk is in missing the upside and not in being caught in the downside.

2008 Oct 22 08:40 AM