Seeking Alpha in 2008 With ProShares' UltraShort S&P500 ETF

"Ad augusta per angusta" [to high places by narrow roads]… it seems as though our Latin predecessors were seeking alpha as well!

2008 is shaping up to be a difficult market to navigate for individuals as well as professionals. The croupier is about to spin the roulette wheel and wealth managers are placing their bets. Will the ball land on red (recession) or black (progression)? Let's examine a core-strategy for red. This is intended to make suggestions on a few key areas which should not be ignored, not as a design for an entire portfolio.

As a certain Wesley Snipes explained to us in the movie Blade, we should "always bet on black". Unfortunately for investors, employees and business owners across this nation Mr. Snipes is incorrect in this regard. The economy is incapable of consistently remaining in the black. There are always recessionary periods that lie in wait for the country to overextend itself by developing a bubble (see definition below). So how would one prepare their portfolios for a potential recession? Below are a few plays you can make to protect or grow your portfolio in 2008, assuming the economy declines further.

Pick up the UltraShort S&P500 ProShares ETF (SDS). The companies that the S&P 500 consists of are the pulse of the United States of America's economy. While this ETF does not short the economy, it does bet on a decline in the stock prices of those companies that make up a strong portion of the economy. In my opinion, the market players have yet to factor the negatives of our current economic state into the S&P 500. If we enter a recession it's a fairly safe bet that this ETF will outperform many of your other positions.

Pick up high-quality, high-potential healthcare stocks. Seek out stocks whose companies have a good balance between a current product base and a strong product impact potential [PIP]. An example would be Company X having $500 million in annual sales from 2 existing products and another product in Phase III testing which has sales potential of $50 million per annum (10% of sales). Here the company is already on solid footing (patents, etc. assumed valid for years to come) but can achieve a significantly higher stock valuation if Phase III completes successfully. If a healthcare company provides something people require and don't simply need, they're a pretty safe bet during an economic downturn. You'll have to do your own research on this one.

Finally stay away from retail and consumer discretionary. The American consumer will probably not be able to sustain its current strength following the one-two punch of a depressed housing market and inflation's rise (commodity prices are soaring from already-elevated levels).

DEFINITION: A Bubble, in economic terms, occurs in two phases. Phase one, the seed of a bubble, is when demand outstrips supply and causes prices to rise. Phase two, the actual bubble formation, is when supply proceeds to surpass demand yet prices continue to rise. Phase two can continue for months or years. It creates an illogical economic environment which in time will correct itself through mild or severe contraction.

Please comment with variations of a definition or comments on mine. I'm interested as I have yet to see a fully accurate definition.

Disclosure: David Schrader's firm is long SDS

Comments

[HarMegiddo:]

and how bout the div on the SDS or QID. that can be a nice little bonus. gotta stick with SDS though, S&P chart looks like death!

2008 Jan 04 04:59 AM

[JohnDough:]

Wouldn't shorting the Russell 2000 via TWM be a better option?

Smaller cap companies are going to be much more dependent on the U.S. Economy vs. the Large Caps.

Thoughts?

2008 Jan 05 11:32 AM

[David Schrader:]

One would think so. However as we've all experienced a stock and its company don't necessarily move in tandem. I expect small cap stocks to perform better than large cap for 1H 2008, even if the small cap companies are doing worse.

2008 Jan 05 12:39 PM

[David Schrader:]

My movie reference is wrong.... it should be "Passenger 57", not "Blade"

2008 Jan 07 10:01 PM

[Sterling Ne...:]

Although you are well spoken, I completely disagree with your perception of the S&P 500. I believe that 90% of the bad news (recession, sub-prime mortgages, etc.) is already priced into the market. The stock market is priced for the future not the present. In my opinion, if the economy continues to in a negative direction domestic small cap stocks will certainly be more damaged because they are relying solely on the US consumer/market. Many of the S&P 500 companies are global and will maintain strong earnings from overseas. Interest rates are low and I believe they will be even lower in the future, while the P/E ratio of the S&P 500 is around 16 which tells me those stocks are relatively inexpensive. Just my opinion...........

2008 Jan 27 08:36 PM

[David Schrader:]

Jo Shmo

Thanks for the complement. As you said, keep in mind the market is priced for the future not the present. You're right - on a logical basis small caps should be hurt more from a recession/slow down. However the market is not a logical man, it's an emotional child. Based on the performance of the S&P for the month of January relative to the

YTD Russell ( - 8.28% )
YTD S&P

2008 Jan 29 02:15 PM

[David Schrader:]

It got sent while I was typing... haha all apologies.

S&P (-7.65%) these figures according to money.cnn.com 2:15pm, 01/29


That would make you right so far but the Russell has come down from a high of 856 to 702 (-21.4% from its high). The S&P, over the same period, has gone from a high of 1576 to 1356 (-14% from its high). Therefore the R2000 has already been punished and as you stated it's been priced in.

However the impact on a global scale is yet unknown which means Mr Market has been unable to fully price in the negative impact of a US slowdown on internationally-linked companies such as those you mention in the S&P. That's why the R2000 will rebound stronger and more rapidly than the S&P - while the players are still figuring out the S&P impact they'll already know the R2000 impact.

2008 Jan 29 02:23 PM