Mousetrap 8/20/2011

[Timothy Clontz]

Condition Bear Market
S&P Target 970

Position Date Return Days Call
BKI 5/31/2011 -4.96% 81 Hold
CFI 6/22/2011 -3.64% 59 Hold
SE 6/27/2011 -9.11% 54 Hold
AWR 7/5/2011 -3.64% 45 Closed
CLH 7/6/2011 -12.25% 45 Hold
GCI 7/14/2011 -26.16% 37 Hold
AGO 8/5/2011 -7.27% 15 Hold
DISH 8/10/2011 -1.20% 10 Buy
NA NA NA NA NA
NA NA NA NA NA
Mousetrap Return -8.53%
S&P Return -12.20%

Mousetrap Annualized -72.03%
S&P Annualized -102.99%

Annualized Advantage 30.97%


After the worst 4 week drop since the last bear market ended, the market is due for a bounce. Most of the reasons are simply anecdotal: every indicator on the planet is oversold, etc. On my sector configuration model, however, I’m showing a divergence of money flow into the bullish sectors. Technology (XLK) and Basic Industry (XLB) are both in positive accumulation now. The greatest negative divergence is now Energy XLE, again, replacing XLF.

On sector timing, then, the long position would be XLK, and a short position would be XLE.

I’m using an occasional XLE short position as a hedge against the long positions on my Mousetrap model, since the model itself is untimed. I closed that short position when we first hit the 1120 range (where we are now).

Finally, the other reason for a bounce is that the annualized performance of the S&P is once again greater than 100%. Since the market cannot lose MORE than 100% in a year, it really should bounce or pause here.

Currently I am outperforming the S&P by over 30%, but that’s obviously not as good as cash.

[Timothy Clontz]

First the elements:

A fundamental investor seeks to make money off of the cash flows into the company.

A technical investor seeks to make money off of the cash flows into the stock.

My hybrid model seeks to make money off of good companies at a time that investors are beginning to notice it; when cash is flowing into the stock and the company at the same time.

The fundamental aspects are based on Joel Greenblatt’s “Little Book that Beats the Market.” Although he tested it beating the market by 30% a year, my own tests have basically confirmed those of Validea.com and Haugen – it does beat the market, but at closer to 10-15% than 30.

The technical aspects are based on my sector adaptations of Len Mansky’s work. He’s a private investor with an uncanny ability to time up and down movements of the market.

Back tests of my sector adaptations show 20-25% annual returns.

The goal of my hybrid model was to add the minimum performance advantage of Greenblatt’s fundamentals (10% minimum) to the minimum performance of my sector adaptations of Len Mansky (20% minimum). The target outperformance, then, was to beat the S&P by 30%.

So far, the model is a complete success, beating the S&P by an annual rate of 30%. Unfortunately, as I noted in my previous post, the S&P is losing money at a faster rate than that.

Now the problems:

Market timing has become a precarious position during the Bernanke tenure. The end of QE1 catapulted us into a premature bear market in 2010 that was suddenly cancelled by QE2. The resultant flow of US dollars has destabilized entire governments in the Middle East, which are toppling because of inflation in the price of food. People put up with their dictators until they can no longer afford to eat. Then it’s either a fast death from a battle with the government or a slow death of starvation. Starvation wins that competition for most folks (remember Marie Antoinette’s famous quip “Let them eat cake”; to which they responded by chopping off her head).

Worst for us is the toppling of the Euro into a deflationary spiral.

Quantitative Easing creates abnormal market conditions.

Deflation sets those market conditions on their head.

One cannot, therefore, be entirely sure WHAT is truly happening out there.

Venezuela is now demanding its gold reserves held in European banks (of which JP Morgan also has exposure). That wouldn’t be a problem if the banks actually HAD the gold. They don’t. Those banks are leveraged up to 10 to 1, and don’t have enough of the metal to pay. Venezuela can topple the entire house of cards like a small gust of wind.

The United States M2 money supply has also exploded in the last two months as European deposits are being pulled out and pushed into American treasuries and cash. Once that is complete we’ll face massive inflation in the United States (payback for the inflation we exported to the third world during QE2), while Europe descends into a deflationary spiral. We will NOT escape if that happens – we’ll have a massive inflationary bubble followed immediately by our own deflationary spiral: basically wiping out everyone’s savings AND their ability to earn an income (and wiping out 99% of market timers who will short when the market rallies and go long when the market collapses – losing in both directions). Perhaps someone like Soros could win in such an environment, but I see that even Soros is scared into retiring.

Buffet himself called for higher taxes on billionaires, knowing full well that his assets are tied into UNREALIZED (and therefore untaxable) gains. The reason for his op-ed was not to actually generate money for the government but instead to stave off investor panic with a smokescreen.

And it is a smokescreen. We are poised over a deflationary abyss. My own S&P forecasts are the most rosy I can conjure. The base yield ratio model has a bottom of 94.49 on the S&P (that’s NOT a typo). With the 3month note pegged at .01%, there is NOTHING that can flatten the yield curve – not even a QE3. I’ve “corrected” that forecast by averaging it with a typical Presidential cycle to get a 684.16 bottom. The 970 number is based on the progression in sector rotation (we are 2/5ths into a bear sector rotation, and so would be 2/5s of the way through the decline).

Again, I keep posting 970 because the other numbers are too bad. But 970 is bad enough.

So, how DOES a hybrid model invest in such an environment? Shorting is as perilous as staying long, and (as I’ve experienced first hand) shorting fundamentally bad companies can blow up in your face if they get bought out and skyrocket on you overnight. Besides, shorting fundamentally bad companies is really hard to do because those short allotments are already taken – and therefore I have been unwilling to share what few positions I could get into.

That leaves sectors. Although sectors have greater beta than the market as a whole, they will not double or triple on a morning gap. Also, the nine sector ETFs in my sector model are very heavily traded, and so I can share those short positions without eliminating my own ability to enter them.

In a bear market, then – one does not simply invest long or short, but both at the same time; eliminating the volatility and squeezing out returns. Since my model beats the S&P by 30% (even during a bear), shorting SPY is an option. But I’ve also been testing short positions on the model and found that during the testing period XLE and XLF were the two shorts I encountered, and both did even worse than the S&P.

The timed model, then, hedges Mousetrap selections against bad sectors, for a target performance of 30%. That’s 30% total return, mind you, and not merely S&P + 30%.

In a bear, the model hedges. In a bull, the model does not hedge.

Total performance during the testing period would have been as follows:

Position Date Return Days Call Hedge Hedge% Net
BKI 5/31/2011 -4.96% 82 Hold XLE -16.86% 11.90%
CFI 6/22/2011 -3.64% 60 Hold XLE -13.74% 10.10%
SE 6/27/2011 -9.11% 55 Hold XLF -17.82% 8.71%
AWR 7/5/2011 -3.64% 45 Closed XLE -16.86% 13.22%
CLH 7/6/2011 -12.25% 46 Hold XLE -17.37% 5.12%
GCI 7/14/2011 -26.16% 38 Hold XLE -16.07% -10.09%
AGO 8/5/2011 -7.27% 16 Hold XLE -7.99% 0.72%
DISH 8/10/2011 -1.20% 11 Buy XLE -3.38% 2.18%
NA NA NA NA NA
NA NA NA NA NA
Mousetrap Return -8.53%
S&P Return -12.20%
Hedged Return 5.23%

Mousetrap Annualized -70.60%
S&P Annualized -100.95%
Hedge Annualized 43.29%

Annualized Advantage 30.35%
Hedged Advantage 144.24%


Requirements of the model:

Since a fundamental model invests in a number of stocks, one cannot simply jump in and out of the market without paying huge trading costs. While someone could switch from long to short SPY with only two 9.99 costs (less than 20 dollars), a fundamental type of switching would cost at least ten times that much, and whipsawing would drastically consume a large portion of the returns.

I also needed a model that worked even when it was wrong – that is, a 30% return rate is still a healthy return rate even in a bull market. So, investing long into a bear reduces losses by 30%, while investing hedged into a bull limits gains to only 30%. The model satisfies the requirement of surviving wrong timing and broad market whipsaws by such “once in a lifetime events” as QE or Euro implosion.

The model needs to be something that other people could follow – using sectors as hedged shorts instead of individual companies allows this to happen.

The model needs to be safe from short blow ups caused by an acquisition during a bear market. I recently had a small short explode by several hundred percent. Even at only 10% of a hedged portfolio such an event would cause damage.

Finally, the model needs to gradually rotate. Since my own yield ratio and sector configuration timers are long term, I do not need to jump into and out of hedges. I will simply enter all new positions into a bear hedged, and all new positions into a bull un-hedged. And then remove or apply hedges as a new buy or sell position occurs. If Bernanke pulls another rabbit out of the hat, I do not need to make sudden changes myself, but merely rotate into them as market conditions change. Normally a major market change will create a sudden shift then a sharp reversal, then a continuation of the first move. My rotation will smooth out such manic moves.

How this changes my test:

I plan to apply the hedges and show unhedged and hedged returns (as above), starting from the time the hedges were actually entered. The numbers will represent real money, and not backtested hypotheticals (as above).

I am still looking for a slight bounce, and expect the hedged positions to UNDER perform if that bounce is a strong one. There’s not much I can do about that. The market had to collapse on me before I was able to complete all my testing and integration of the various aspects of the model. Going forward, the model should make 30% in a bear market, and more than 30% in a bull. While not into the Buffet realm, we have to remember that Bill Gates and Warren Buffet basically put all their chips into one stock and none of us can rely on those kinds of returns in a truly balanced portfolio.

Tim

[Timothy Clontz]

Condition Bear Market
S&P Target 970
Hedge XLE 3.30%

Position Date Return Days Call
BKI 5/31/2011 -4.60% 83 Hold
CFI 6/22/2011 -6.29% 61 Hold
SE 6/27/2011 -9.71% 56 Hold
AWR 7/5/2011 -3.64% 45 Closed
CLH 7/6/2011 -11.45% 47 Hold
GCI 7/14/2011 -26.60% 39 Hold
AGO 8/5/2011 -8.80% 17 Hold
DISH 8/10/2011 -3.41% 12 Buy
NA NA NA NA NA
NA NA NA NA NA
Mousetrap Return -9.31%
S&P Return -12.18%
Hedged Return -6.01%

Mousetrap Annualized -75.59%
S&P Annualized -98.82%
Hedge Annualized -48.80%

Annualized Advantage 23.24%
Hedged Advantage 50.02%


The application of the hedge today was a little unnerving as the market gapped up. I still expect the hedged position to underperform on the way up, but that’s what hedges do. As it stands, the market gapped up and then fell back, giving an unusual head start to the hedge.

A little about hedging. A hedge is usually some kind of tangential or contrary position to the core positions being held. In this model, it is a short of a sector that has a negative money flow divergence from price. On my sector rotation model the long sector selection is XLK (technology), and the short is XLE (energy).

Technology is an odd long selection in a bear market. It does outperform near the beginning of a bull, but in this case the sector is attracting a lot of positive volume at what appears to be a bet toward a rally. When the rally does happen, I expect it to be a ferocious one – so much so that people will likely think there was no bear at all and it was just a correction.

THIS IS NOT A CORRECTION.

We are not even halfway through a bear market, and this is a very very nasty one.

Just a little anecdotal evidence: I run several macros that analyze 1100 stocks in 9 sectors and 98 industry groups. In the past three months since this model became active I’ve averaged one stock disappearing from existence a month.

TODAY FOUR DISSAPEARED.

This is NOT a correction.

Europe is about to make Lehman Brothers look like a cake walk. If you cannot hedge, consider lightening up on the next rally.

[Timothy Clontz]

Condition Bear Market
S&P Target 970
Hedge XLE -1.23%

Position Date Return Days Call
BKI 5/31/2011 2.10% 85 Hold
CFI 6/22/2011 -3.52% 63 Hold
SE 6/27/2011 -6.05% 58 Hold
AWR 7/5/2011 -3.64% 45 Closed
CLH 7/6/2011 -6.93% 49 Hold
GCI 7/14/2011 -23.95% 41 Hold
AGO 8/5/2011 -4.61% 19 Hold
DISH 8/10/2011 -0.61% 14 Buy
NA NA NA NA NA
NA NA NA NA NA
Mousetrap Return -5.90%
S&P Return -9.52%
Hedged Return -6.98%

Mousetrap Annualized -46.11%
S&P Annualized -74.41%
Hedge Annualized -54.51%

Annualized Advantage 28.30%
Hedged Advantage 19.89%


I’m still looking for that bounce (for admittedly anecdotal reasons):

1) The technology sector, XLK, has been accumulating a lot of positive volume – trouncing all of the other sectors by a significant margin.
2) That, and the fact that I added my hedge at what SHOULD be the worst possible time, makes me think this will be such a strong bounce that people will think the bear market never started (and I’ll even be itching to unload that hedge).

Len Mansky, however, tells me that he doesn’t think we’ll break the previous highs from earlier this month.

I’ll defer to him on the short term.

LONG TERM THIS IS A BEAR MARKET.

Do not be fooled by any bounces out there.

[Timothy Clontz]

Condition Bear Market
S&P Target 970
Hedge XLE -1.83%

Position Date Return Days Call
BKI 5/31/2011 3.02% 85 Hold
CFI 6/22/2011 -0.88% 63 Hold
SE 6/27/2011 -3.51% 58 Hold
AWR 7/5/2011 -3.64% 45 Closed
CLH 7/6/2011 -2.72% 49 Hold
GCI 7/14/2011 -22.34% 41 Hold
AGO 8/5/2011 -2.51% 19 Hold
DISH 8/10/2011 0.52% 14 Buy
NA NA NA NA NA
NA NA NA NA NA
Mousetrap Return -4.01%
S&P Return -8.47%
Hedged Return -5.61%

Mousetrap Annualized -31.31%
S&P Annualized -66.21%
Hedge Annualized -43.82%

Annualized Advantage 34.90%
Hedged Advantage 22.39%

After a good run today the Mousetrap selections are again outperforming the S&P by more than 30%. The hedged option, as I said before, will underperform on any upward moves, but XLE did not go up by very much.

Anecdotally (i.e. I have not measured or quantified this), sectors which normally lead in bull markets are leading in both volume and breadth, while bearish sectors are trailing. Short term this appears to confirm a rally, but long term this remains a bear market, with price momentum and acceleration still strongly confirming the bear.

Based on Len’s analysis, this should fade soon, and in fact he is considering this a good place to take profits off of the table.

I’m a long term timer – and long term the model will remain hedged (as in fact the full model would have done from the very first trade, since this model was in a bear configuration from the beginning of May).

Any long buys, such as DISH, must be hedged against an equal amount shorting XLE, to conform to the complete model. To put this into perspective, the XLE short from the other day has a 1.83 percent loss. From May 31, however, it would have a 16.49% gain. Although I was personally shorting the energy sector during that time, I am not including it in the model because I had not yet combined my hedging strategy into the Mousetrap as a single model. The protection I experienced as I finalized my tests shows the purpose of hedging in a bear market. One can still profit from fundamental selections in outperforming the S&P, but only if balanced against a short position which will go down as fast or faster than the S&P.

If you are not hedged – taking profits off of the table would indeed be a good thing.

Tim

[Timothy Clontz]

Condition Bear Market
S&P Target 970
Hedge XLE 0.32%

Position Date Return Days Call
BKI 5/31/2011 -1.19% 86 Hold
CFI 6/22/2011 1.40% 64 Hold
SE 6/27/2011 -5.22% 59 Hold
AWR 7/5/2011 -3.64% 45 Closed
CLH 7/6/2011 -5.95% 50 Hold
GCI 7/14/2011 -24.76% 42 Hold
AGO 8/5/2011 7.97% 20 Hold
DISH 8/10/2011 -1.42% 15 Buy
NA NA NA NA NA
NA NA NA NA NA
Mousetrap Return -4.10%
S&P Return -9.74%
Hedged Return -3.82%

Mousetrap Annualized -31.45%
S&P Annualized -74.67%
Hedge Annualized -29.31%

Annualized Advantage 43.21%
Hedged Advantage 45.36%

Tomorrow is Jackson Hole, where Ben Bernanke will confirm that the economy is not bad enough to warrant another round of Quantitative Easing. Granted, he’ll have something else he’s doing under the table, but the time for bluffing and pushing the market is over.

Expect more volatility, perhaps a strange calm for a brief while – and then the bear resumes.

XLE (energy) continues to be the short sector.

XLK (technology) continues to be the long sector.

We may still see a rally, but rallies are profit taking or shorting opportunities.

The hurricane hits my house on Sunday. I could lose power for a few days. If I don’t post right away, everyone please be safe.

Tim