One of the more confusing aspects of the financial markets is that so many numbers are casually thrown around. There are fractions, percentages, decimals, currencies, and more.

During market downturns, it is easy to get mixed up about what is lost and what is gained. Let’s explain some bear market arithmetic using some simplified numbers. Say we start with an investment of $1,000.  Imagine that the investment loses 60%. Now we have an account that has lost $600 after starting at $1,000. That leaves $400 in the account.

If there is a bear market rally of 25% many people mistakenly believe that the market gained back one-fourth of what was lost. It is important to remember that we are now talking about 25% of $400 and not 25% of the original account value. A 25% gain amounts to $100 and takes the account value to $500. So while a 25% gain sound impressive, it is really only 10% of the original value of the account. Even after a 25% gain, the account is still down 50% from its original value.

The chart below illustrates what has actually occurred with the S&P 500 during this current bear market. Since the most recent bottom in March 2009, the S&P 500 has advanced 33%. Although that sounds impressive, an investor who experienced the full 58% decline in his account value has only regained 23% of what was lost.

So the only people who have seen a 33% gain in their accounts since March would be those who were out of the market for the decline and who were perceptive and brave enough to buy in at the exact low point. After watching the S&P 500 lose 58% in the prior 16 months, I doubt there were many investors who recognized the bottom and were willing to jump in at that time.

I must admit that I would have liked to reap the rewards of that 33% gain. That is an unusually large bear market rally. But our indicators continue to show that the current advance is overextended and past due for a reversal. Buying at this point would be imprudent and could very easily result in a significant loss if stocks turn down again. And as the illustration above shows, avoiding losses is important in protecting the value of an investment account.
F.S.

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I don’t like walking (let alone running) on treadmills. The scenery doesn’t change and no matter how long you walk, you end up in the same place where you started.

For the past month, the financial markets have been on a treadmill. There have been some big up days and some big down days, but stocks have failed to make any real headway. For most of that time our indicators have shown that the next market move is likely going to be downward. It creates a frustrating situation for clients and for us when that move fails to occur when we think it should.

Below is a chart of the Dow Jones Industrial Average over the past six months. The blue line is a trend line I added to connect the most recent tops. Notice that the bear market rally that began in March seems to have been stopped right at the trend line. The middle portion of the chart is a moving average convergence divergence (MACD). This indicator has shown for several sessions that stocks are at overbought levels. It finally rolled over and is forecasting additional downward action.

The bottom portion of the chart is a relative strength index (RSI). It has also been hovering slightly above 50–the level that indicates the market has enough momentum to advance. But it appears on the verge of falling below that mark.

Seasonally the end of spring is a time of weakness for the markets and at this time in 2008 the chart pattern was very similar. The MACD did not quite reach the current oversold level but stocks experienced one of their better periods for the year with a rally in March and April followed by a sharp drop in May and June.

Of course there is no guarantee that this situation will turn out the same. But market risk remains high and those who jump in at these levels are taking unnecessary chances.
F.S.

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There has been little change in the financial markets during the past week. Major stock market indices remain at overbought levels and we continue to expect a downward correction. So far positive comments from President Obama and others have managed to hold the markets in a sideways pattern. While it is possible we could see markets break out to the upside, right now the long-term downtrend remains in place.

The latest Federal Reserve report released this week proved to be a bit of a disappointment. Everyone is hoping for some definite signs that U.S. economic activity is improving. What we got instead was a report that noted that five of the 12 Federal Reserve districts experienced “a moderation in the pace of decline.” In other words, in many cases the economy is still getting worse, but not as fast as previously.

The Beige Book report is published eight times per year. It gets its name from the color of the cover of the report. Each Federal Reserve Bank gathers information on current economic conditions in its district through reports from bank and branch directors and interviews with key business contacts, economists, market experts, and other sources. The Beige Book summarizes this information by district and sector. A summary of the 12 district reports is prepared by a designated Federal Reserve Bank on a rotating basis.

For anyone interested in reading the full summary or the complete report, here is the link:

http://www.federalreserve.gov/fomc/beigebook/2009/20090415/default.htm

If you have not ever done so, I would encourage you to visit the Federal Reserve web site at:

http://www.federalreserve.gov

The site holds a wealth of information about Federal Reserve activities as well as many resources for consumers. For example, today there is a link to a speech given by Federal Reserve Chairman Ben Bernanke at Morehouse College in Atlanta. He talks about the current financial and economic crisis and what the Fed is doing to try to resolve the problems. In his concluding remarks he said:

“The current crisis has been one of the most difficult financial and economic episodes in modern history. Recently we have seen tentative signs that the sharp decline in economic activity may be slowing, for example, in data on home sales, homebuilding, and consumer spending, including sales of new motor vehicles. A leveling out of economic activity is the first step toward recovery. To be sure, we will not have a sustainable recovery without a stabilization of our financial system and credit markets. We are making progress on that front as well, and the Federal Reserve is committed to working to restore financial stability as a necessary step toward full economic recovery.”

The site also includes a credit card repayment calculator. It allows consumers to enter an amount of credit card debt, the interest on that debt, and then it tells how long it will take to pay it off if only minimum payments are made. Just for fun, I entered $5,000 at an interest rate of 21%. At an estimated minimum payment of $100 a month, it would take 64 years to eliminate the debt. Over that time, there would be $29,398 paid in interest. That should help explain why credit card companies do not want you to pay off your balances.

F.S.

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Forecasting the stock markets is like forecasting the weather but much harder. There are a wide variety of tools available to help us measure and assess market conditions. What makes it so difficult to accurately forecast the movements of the financial markets is the virtually unlimited number of variables that can impact stock and investor behavior.

Locally our weather forecast today is for a storm to move in this afternoon, dropping temperatures and bringing rain to the valleys and snow to the mountains. I can see gathering gray clouds out my window at this moment, so I am inclined to agree with that assessment. I’m sure if I looked at a satellite map or a radar image, I would receive additional confirmation that a storm is imminent. But all the sophisticated equipment does not guarantee there will be rain.

Right now most of the technical indicators we use to assess the investment markets are forecasting a significant downturn in the near future. A few weeks ago I wrote about bear market rallies that Wall Street sometimes calls bear traps. During the 2000-2002 bear market there were several such rallies and each time major indices gained about 20% before falling again. If the current market follows through and turns down over the next few weeks, this will be a classic example of a bear market trap.

The chart below provides a good visual representation of the current situation. We are in the fourth week of this rally and major indices have generally gained about 17% to 22%. The technology sector has lead this advance so tech heavy indices like the Nasdaq have gained the most.

We saw another bear market rally that lasted about six weeks beginning in November 2008. The current rally has been much steeper and stronger. The steepness of a rally is often an indication of its sustainability and this one appears to be too steep to continue much longer.

The middle portion of the chart is a moving average convergence divergence (MACD) of the Nasdaq. This is a very good indicators for identifying periods of overbought or oversold extremes. In other words, it is kind of like measuring how much a rubber band is being stretched. When a rubber band is pulled tight, there is a lot of tension trying to pull it back to a relaxed state. Right now the MACD is showing that the Nasdaq has moved up far and fast and now there is a lot of tension trying to pull it back in the opposite direction.

The bottom portion of the chart is a stochastic cycle oscillator. This indicator is designed to measure random cycles–exactly like those found in the financial markets. When this indicator reaches levels above 70, there is a high likelihood that a correction of some kind will occur. There was a strong one-day pullback on Tuesday and this indicator reacted by dropping slightly below 80, but it still remains in an overbought area.

If this is a classic bear market trap, over the next few weeks we should see the indices decline to their previous lows and then continue to reach new lows. On the other hand, if the market really has bottomed and the worst is over, we will probably still see a correction of about half of the recent gains before major indices regain their upward momentum.

Markets will be closed Friday in celebration of Good Friday and the Easter holiday. Have an enjoyable spring weekend.
F.S.

One of the more common questions we receive is why we don’t take more short positions “so my account can make money in a bear market.”

For those who don’t know, shorting involves selling stock and then buying it back at what one hopes is a lower price. When it works as planned, the investor profits the difference between the selling price and the lower buying price. Naked short selling means the investor borrows the stock that he sells short.

In the past, shorting was considered a speculative practice not suited for retirement accounts or conservative investors. But with the introduction of short mutual funds, the practice gained more widespread acceptance–especially as the companies that offered these funds advertised them as a means to make money when the markets go down.

Today there are short funds for many common index funds. In theory, these funds move exactly inverse of the index they short. In addition, many companies offer enhanced Beta short funds. I’ll explain that concept, but first let’s go back to the initial question.

As investment managers who practice active risk management, whenever we enter a position on a client’s behalf, we must consider the damage that can occur if we are wrong and the market does exactly the opposite of what we expect. So when market conditions deteriorate, our focus shifts from trying to make money to doing all we can to protect client assets.

We use a variety of tools to help us make decisions about when to buy or sell. Our trading systems are geared toward longer-term trends. We make no attempt to participate in short trends that might last only a few days. This helps us avoid dangerous whipsaw trades and helps reduce our overall risk exposure.

Even in a prolonged bear market like we are currently experiencing, many of the downward moves are sharp and severe, lasting only a few days. In other words, by the time our indicators signal us to take a short position, most of the damage would already be done. Taking a short-term short position at those times would put assets at risk of a market retracement with a limited potential reward.

Making the situation even more complicated is the fact that during periods of high market volatility, most short funds do not behave as advertised. Let’s go back to the topic of Beta and then I can explain specifically what I mean. In the investing world, Beta is a measure of volatility correlation. Usually, the S&P 500 is used as the benchmark for measurement. An investment that is perfectly correlated or inversely correlated to the S&P 500 would have a Beta of 1.0. An investment that had double the volatility of the S&P 500 would have a Beta of 2.0.

The chart below shows the daily price movement of the Dow Jones Industrial Average (black line), compared to DOG, ProShares Short Dow 30, an ETF that shorts the Dow (gold line). This chart covers the period from October 2007 until March 31, 2009. This fund is promoted as having a Beta of 1.0. In other words, it should have a perfect inverse correlation with the Dow.

For the first year portrayed, that correlation is fairly true. But look what happens beginning in October 2008. The volatility of DOG suddenly becomes much greater than its benchmark index. I added the green and red arrows so you could see the difference in amplitude of between the two positions. All of a sudden the downward moves of DOG are four or five times as volatile as the corresponding upward moves on the Dow.

Notice also that for the period depicted in this chart, the Dow is down about 46%, while DOG is up only about 35%. That is an 11% spread on two positions that should have a 1-to-1 correlated return. At times this fund is falling or rising by double digits in a single session–much more than the index it is supposed to be mirroring.

Because these short funds do not behave as they should, it makes it very risky to use them. We sometimes will take a position in a short fund, but it is usually with only a small portion of the assets. We also sometimes use short funds to hedge a long position that we do not want to sell.

Next week we only have four trading days because the markets are closed on Good Friday. We should get a good indication over the next few days if the current rally will have enough strength to continue or if another downturn is coming.
F.S.

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