You don’t have to be a grizzled value investor to agree with Warren Buffet’s two key rules of investing: “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.”
Since we opened our first trade for March expiration, the S&P 500 index (NYSEARCA:SPY) is down almost 100 points - that’s a loss of over 6.6% in a little over one month, and the index is now off 12% from it’s January open.
Continued weakness in the U.S. dollar means that the Euro zone now surpasses the United States as the world’s largest economy. Bear Stearns (NYSE:BSC) investors were baffled by what simply had to be an entire day’s worth of bad ticks on Friday. In this environment, playing good defense is as important as ever, and in light of the above, it should be sufficient for us to report, happily, that we didn’t lose money over the March expiration cycle. (In fact, our March trades averaged 8% return on capital risked.) But enough about us, let’s talk about the market.
This Is a News-Driven Market
In our list of predictions for 2008, we claimed that “buy-and-hold will be a losing proposition,” and unfortunately we’ve been completely right about that so far this year. The churn since January 23 has been pretty remarkable: for example, after all the excitement and dramatic news we saw this past week, we closed Friday in basically the same place where we started on Monday. We could offer some detailed technical and fundamental explanations about why the markets are acting the way they are, but we think the general market environment can be explained pretty well by these three broad themes:
- Investor Uncertainty - there’s a lot of money sitting on the sidelines right now, as nobody wants to be the greedy hero who steps in front of the freight train, or the fearful milquetoast who misses out on the next major rally. Money flow indicators and on-balance volume suggest that once we establish a clearer sense of direction on the major indexes, capital may start flooding back in on whichever side makes more sense. So any sustained rally or strong selloff may be magnified by people trying to get in on the trend; but until a trend is established, prevailing uncertainty will keep things churning.
- Government Action - The Bernanke Fed has shown some creativity and flexibility in dealing with problems (including our nation’s lack of arcane financial acronyms), and that adds another element of uncertainty to this market climate. On one hand, there’s the justified assumption that the Fed will keep acting to keep the financial system as sound as possible, acting as the lender of last resort. On the other hand, while the Bernanke put is still in effect, the Fed’s ability (and possibly its desire) to prop up equity markets is seriously in doubt. Ironically, the Bear Stearns debacle may turn out to have provided Bernanke with a nice “out”: previously, there seemed to be a gathering storm of criticism for his dovish attitude toward inflation and his willingness to slash rates - where a major crux of the objection was that he did this “just to fend off a market recession”. Now, some of the criticism seems to have abated, as few are willing to criticize decisions the Fed claims are necessary to ensure the integrity of the financial system. And if softening the Bear Stearns blow also requires cutting rates some more, who’s going to complain?
- Economic Uncertainty - It’s hard to “bake in” all the bad economic news when we keep getting more (and new types of) bad economic news. He that hath ears to hear and eyes to see also knows that inflation is, and will continue to become, more of a problem than the government is letting on. Additionally, compared to the global situation during the last major American recession, the global economy is different in some important ways. While the myth of decoupling seems to have been disproven for now (i.e., Americans need not worry about the world continuing on pleasantly while we fall into despair - which would be a selfish and myopic thing to worry about, anyway), the simmering move away from dollars and towards euros isn’t going to do much to hasten a recovery in the US. The healthcare sector, which was a major growth story as recently as a couple of years ago, is going nowhere fast, nobody expects anything from financials anytime soon, and the tech leadership seems to have evaporated. Housing is obviously a joke, and the energy/commodity boom is reaching a point where it should be seen as a drag on the economy, not as market leadership. So, really, what sector or industry is going to lead us back into recovery? Agribusiness? Solar power? Gaming? Sex scandal-related music downloads?
Our Iron Condor Trades
Perhaps one of the few upsides to this market environment is rising volatility (cf. the weekly 5 year VIX chart), which is great for us. We’re not short volatility on anything but a monthly (or shorter) basis, but when we get major spikes on the daily charts, we’re pretty happy to sell premium.
We traded four positions for the March expiration cycle, and closed out the last of them back on Tuesday during the rally, which proved to be quite prescient (or lucky). Our average gain per trade for March was 8.71% on capital risked. Our IWM trade - which we opened on February 5 and closed out on March 5 - was a real winner, netting 23.77%, and we protected gains in our DIA position of about 8% Our two other trades were closed out flat to reduce our risk exposure.
Sometimes readers ask why we trade on multiple indexes, rather than just sticking to one index. It’s an intuitive question - after all, correlation is typically extremely high among the major indexes and their tracking ETFs, so what’s the point? Well, in environments like this one, where exposure to event/news risk is present not just in individual stocks but in the indexes as well, there can be materially significant divergences in the indexes on a short-term basis. So it often makes sense to trade different index products in order to reduce that event risk.
We are neutral-to-bearish going into April, and we are skewing our trades slightly. The Fed meets on Tuesday, March 18, and this is a shortened week as the markets are closed on Friday.
Also of note: Visa (NYSE:V) IPOs on Thursday, March 20, to much bullish fanfare. Given how well Mastercard (NYSE:MA) has performed recently relative to the broader markets, we can’t help but be optimistic about them as well.