August 24, 2015

Shorts pays off as market declines

I have a great deal of respect for the capital I have managed to accumulate and for the investments made by my investors.

Though my risk profile is relatively conservative for a hedge fund manager, at times I get aggressive when the upside or downside is compelling.

I believe that this is one of those times where some should consider being relatively aggressive and bearish -- and short -- in portfolio construct.

As I have often written, shorting is not for most traders and investors. Accordingly, most market participants should err on the side of conservatism now by maintaining above-average cash positions in this time of uncertainty.

From my perch, 2015 will be seen as having made a broad and important top for global equities. Contributing to my concerns have been both fundamental and technical issues.

My specific technical concern, which has led up to the summer schmeissing, had been the narrowing market leadership, which nearly always is a signpost of impending market weakness. As I wrote in "The Market Without Memory From Day to Day" in early August:

    -"One of the most important investment-history lessons that I've learned is that when leaders begin correcting as laggards rally (which happened last week), that's historically a precursor to a larger, meaningful correction.

Examples of major sector changes occurred most prominently in 1973, 1981 and 2000 and were all followed by bear markets:

     -   In 1973, the Nifty Fifty consumer-growth stocks led the market while industrials lagged. But when relative weakness began to emerge in the Nifty Fifty, the depressed industrials began to stabilize and exhibit relative strength -- and a bear market emerged.

     -  Similarly, energy and other inflation-oriented stocks led the market in the early 1980s. But then energy stalled in 1981 and the depressed consumer sector stabilized and began to rally -- a shift that preceded the 1981-82 cyclical market correction.
     -   The big bear market of 2000-2002 emerged when the Nasdaq faltered in early 2000 and consumer-defensive stocks rallied.

Though today's bifurcated market is occurring under the umbrella of easy money, it still closely resembles the three cycles mentioned above as the relationship between leaders and laggards changed (which is happening now).

    The most popular and extended stocks -- like Apple (AAPL), which broke its 200-day moving average for the first time in two years amid the weakest relative action since 2012 -- are becoming victims. And as in the past, such drops are swift -- providing little chance for trend-chasing traders and investors to exit stocks that had previously been in clearly defined uptrends (think Disney (DIS) or Comcast (CMCSA)).

    And just as in 2000, a loss of momentum in IPOs could presage broader weakness."

    --"The Market Without Memory From Day to Day" (August 2015)

At best, the reward versus risk ratio is unattractive and, as captured in my recent columns, at worst The Big Short is at hand.

My "Fair Market Valuation" for the S&P index is at around 1990, and I expect it to be breached in the fullness of time as markets move quite often to extremes and overshoot equilibrium levels. More importantly, there are more dire economic scenarios that could signal much lower market price targets.

As Warren Buffett has written, "The Market is here to serve you .... This imaginary person out there -- Mr. Market -- he's kind of a drunken psycho. Some days he gets very enthused, some days he gets very depressed. And when he gets really enthused, you sell to him and if he gets depressed you buy from him. There's no moral taint attached to that."

Mr. Market has been enthusiastic (and, at times, borderline drunk) for six years. It's time for it to take a collective chill pill and for investors to be more concerned with return of capital than return on capital.

There will be plenty of buying opportunities -- at some time -- in the period ahead. But just not now.

Risk happens fast.

Position: Short SPY

Originally published:  August 20, 2015