Just How Sick Is This Market?

Includes: RWM, SBB
by: Joseph L. Shaefer

Reality does not always conform to expectations.

I always said I wouldn’t buy a vacation home because everyone I know who owns one spends all their time there maintaining, gardening, fixing and working on it. Sort of like owning a boat. But here I am, working 12-hour days to build a dock, put in some landscaping, and buy furniture for our rental/alleged vacation home. So much for reality crushing my expectations. Of course, sometimes reality does conform to expectations. Just 26 miles west of where I am lies the Key West cemetery where one tombstone, with blinding insight into the obvious states simply, “I told you I was sick ...”

The confluence of expectation, reality and real sickness can be found outside the Keys, as well. Take the current market. Mr. Bernanke tells us we’ve hit a “soft patch” in our ongoing recovery. Virtually every brokerage firm’s chief economist intones that we’ve hit a “soft patch” in our ongoing recovery. Parroting these worthies (or unworthies depending on their credibility with you), most financial reporters relegated to the business beat say that we’ve hit a “soft patch” in our ongoing recovery. Well, maybe so, but most of our portfolios say this is the hardest soft patch in a long time.

The broad U.S. benchmarks are down. No surprise there. Markets never move in a straight line and this one has roared ahead through the first quarter and well into the second. It’s at least time for a pause.

But aren’t precious metals supposed to be a defensive hedge against declining markets? Actually, no. Contrary to what many believe gold does not always move counter to the stock market. Gold moves up in times of crisis or uncertainty. It just so happens that often the same factors that create uncertainty and crisis, pushing gold and silver up, pull the market down - as in the following possibilities:

(1) China's growth contracts to where it cannot employ new workers leaving the countryside for the cities, and there is blood in the streets. Stocks would likely go down because China would be buying less of everything (in this case, we should expect energy, metals, livestock grains and other commodities to contract because of lesser usage by the Chinese,) and gold would most likely rise - but not typically “just because” the market is down, but because of the uncertainty surrounding the stability of China.

(2) Greece, Ireland and/or Portugal go belly up. Fear would then attach to Spain, Hungary and Italy. And Germany and France because they would lose their best markets. The euro would be under intense pressure and even U.S. stocks would likely tumble because investors would fear currency dominoes would begin to fall, perhaps even the U.S. currency. Gold would likely rise as a safe haven for those who see their euros plunging.

In both cases markets would decline and gold would move opposite but not because there is some sort of magic inverse relationship between the two. Without crisis or uncertainty as the driver for declining markets gold and stocks are perfectly happy moving together, as for instance in any normal correction or advance.

Counter-intuitively, with all the crisis and uncertainty about, precious metals are unable to mount an advance and the miners of these metals are falling as severely as financials, tech, energy, consumer durables, et al.

Well, then, how about defensive stocks like agricultural and industrial commodities? This is the most frustrating of all for me because, while wheat is up, corn is up, sugar is up, plantings are increasing and more fertilizers are being ordered than ever before, great companies like our No. 1 holding in this area, Mosaic (NYSE:MOS), are raking in orders while their share prices tumble along with all other sectors.

It’s the same with healthcare stocks, energy stocks, utilities and even high-yielding stocks, all of which are traditionally considered “defensive” holdings. When the market rallies, it is mostly the Dow 30; when it declines, it drags everything down. That’s why I question if this isn’t a far more sick market than the head of the Fed, Wall Street shills, and cub reporters believe – or at least would have you believe.

I add to this malaise across all sectors, industries, categories and asset classes the backdrop in which it is occurring - rising inflation in virtually all the developing world, markets that are crumbling there, the end of QE2, cuts (necessary cuts!) in U.S. government and state government spending, a rotten housing market, high transportation and energy costs, and the concomitant slowing of the U.S. economy.

However - since I can’t see any logic in selling great companies at prices I would love to buy them, what can I do? Let me reiterate the recommendation I made for your own due diligence back on Saturday, March 19 here.

In that article I said,

Too many investors see this pullback as just another buying opportunity. That kind of complacency may seem impossible given what happened less than three years ago, but it is true nonetheless. Abetted by wildly optimistic underwriter reports like Credit Suisse’s call for Apple (NASDAQ:AAPL) to hit $500, and inured by markets that have climbed a wall of worry since March of 2009, it seems no one believes even a 10% retracement back to the 200 day moving average, which I’ve been calling for, is possible.

I gave some compelling reasons in that article why the market may have trouble climbing the proverbial Wall of Worry by summertime. I was early by a few weeks. Better early by a few weeks, sharing the last couple piggish points, than to be a few weeks late. Remember, bears move roughly twice as fast as bulls in covering the same ground. And remember, too, nothing goes straight up or straight down. If you aren't yet hedged, I imagine there will be bounces up along the path down just as there are inter-day or inter-month corrections on the way up. Be smart. (Definition: be patient and don't panic on the most emotional days.)

My suggestion was to place some hedges by purchasing non-leveraged inverse ETFs. The two I believe may afford the best hedge now would be RWM and SBB. RWM covers the small caps of the Russell 2000, which have had the biggest run and gotten the furthest away from their respective 200-day moving averages. SBB (the ProShares Short SmallCap600) tracks the inverse of the daily performance of the S&P SmallCap 600 Index – the smallest of the small, with similar characteristics. My logic in selecting these two for our clients is not only that they have run the furthest but also that they have the most difficult time in times of tight money securing financing.

I said in that article, “We are less interested in eating even better this month than we are in sleeping well every night.” We gave up a few extra calories but we are still sleeping well – without having to decimate our portfolios with every decline.

Disclosure: We, and/or those clients for whom it is appropriate, are long SBB and/or RWM. We also have a good cash cushion, some covered calls, and tight trailing stops in place.

The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: we do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.

Past performance is no guarantee of future results, rather an obvious statement but clearly too often unheeded judging by the number of investors who buy the current #1 mutual fund only to watch it plummet next month.

We encourage you to do your own research on individual issues we recommend for your analysis to see if they might be of value in your own investing. We take our responsibility to proffer intelligent commentary seriously, but it should not be assumed that investing in any securities we are investing in will always be profitable. We do our best to get it right, and we "eat our own cooking," but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.