Tuesday, May 30, 2006

Tall Trees can't grow to the sky ...

It is often said that "Tall trees can't grow to the sky", meaning that things cannot continue past their natural boundaries.

Although current stock market bull commentators often act as if this doesn't apply to today's stock market, the fact is, is that natural "rules" apply. And the two key rules remain impenetrable as always and they relate to PE ratios and interest rates: when PEs are above historical norms, and interest rates are on the way up - then stocks will inevitably fall (exact timing is, as always, the only question).

Nevertheless, as small investors today, we don't simply have to hope for a bull market to make money - we can use quasi-shorting techniques, even in tax-protected accounts. Given that this is one of the longest bull markets in the past fifty years, the direction of interest rates is up, and PEs are above averages, it doesn't take a rocket scientist to prepare for the worst.

That doesn't mean pulling everything from the market - the market often proves people foolish, by adding a few more points than expected. But it does mean doing a balancing act, that might produce a more stable portfolio over the mid-term. For some investors who agree with the thesis that we are in the prelude to a bear plunge, this means retaining solid core positions, and raising some cash, and perhaps using inverse leveraged positions to gain alpha on the downside.

Given that the last major bear market lasted 16 years, and produced numerous plunges (and subsequent near recoveries), a correction (at the minimum) seems in order - fairly soon. So, by investing 5%, 15% or 25% into a levered bear position, such as that available from ProFunds.com, this can allow you to profit while the market is in decline, and then allows you to throw it into the market, when it's hit what you consider to be the bottom.

The risk is that you dampen your return should the bull continue on longer than you thought, but the reward side is the potential to significantly mitigate the downside damage, and be ready to put more funds into the market when it's "on sale".

Just be sure that you aren't risking an excessive amount on the "downside" bet. Remember, it's having a well-reasoned approach - often contrary to popular thinking - that produces the best investment returns. Something to ponder (but not for too long), while this aging bull looks for a face-lift.


JW

The Confused Capitalist

3 comments:

CrossProfit said...

We are all tired of hearing that this time around it is going to be different. The antagonists claim that the stock market will not endure a prolonged bear market dwindle being that corporate America is sitting on a pile of cash and when the time is right the bottom support will come from share buy back programs thus sustaining values. I don’t think that will happen.

Having said that, I would humbly submit that we are not in the throws of a bear market. In order to qualify for being in a bear market multiples such as PE have to come down substantially over a broad spectrum. This is not the case. You stated that “when PEs are above historical norms…”. PE ratios are not above historical norms today. In fact some sectors are below their historical norms. For the past 3 year we have witnessed double digit growth both in revenue and profits. Some stock valuations have kept pace with these desirable increments and others have not.

Take for instance GE. According to its historical PE the stock should be trading around $39.00 per share. It is trading in the $33.50-$35.00 range. This is a full 10% below the levels needed to trigger a bear market. If GE manages to grow its bottom line by 8% in 2006 this would translate to $36.20-$37.80 while retaining the 10% cushion of being below its historical PE multiple.

Disclosure: This comment was written by a CrossProfit advisor and may not be the opinion of CrossProfit.com. http://www.crossprofit.com

Jay Walker said...

Thanks for dropping by;

for a little context relating to my comments of "historical" highs. I'll refer you here:

http://bigpicture.typepad.com/
comments/2006/05/will_cheap_stoc.html

and here ...

http://hussmanfunds.com/wmc/wmc060522.htm

and here ...

http://bigpicture.typepad.com/.shared/image.html?/
photos/uncategorized/spxbndyld_1.png


and most particularly this ...

http://bigpicture.typepad.com/
comments/2006/05/what_will_the_s.html

Let's check back in a year or so; if the S&P didn't drop at least 20% from it's recent high somewhere in that time frame, I'll eat some humble pie.

In the interim, I advise caution and using some hedging techniques to reduce overall risk. Selling some junk out of your portfolio never hurts either..

JW

CrossProfit said...

I still remember the NIKKEI at 38000, went down to 7500 over a 7 year period and today it’s at 16000.

All humble pie bets are off. I still think were safe through the first half of 2007. After that it’s anyone’s guess.