09/25/2011 Mousetrap

Condition Bear Market
S&P Target 970
Hedge XLE 9.96% Closed
Hedge XLF -1.88%

Position Date Return Days Call
BKI 5/31/2011 -1.07% 116 Hold
CFI 6/22/2011 -6.77% 94 Hold
SE 6/27/2011 -7.75% 89 Hold
AWR 7/5/2011 -3.64% 45 Closed
CLH 7/6/2011 -2.95% 80 Hold
GCI 7/14/2011 -33.21% 72 Hold
AGO 8/5/2011 -17.99% 50 Hold
DISH 8/10/2011 20.95% 45 Hold
GTAT 9/8/2011 -33.84% 16 Buy
NA NA NA NA NA

Mousetrap Return -9.59%
S&P Return -10.63%
Hedged Return -2.40%

Mousetrap Annualized -51.91%
S&P Annualized -57.56%
Hedge Annualized -13.02%

Annualized Advantage 5.64%
Hedged Advantage 44.54%

First a recap of the model:

The “Mousetrap” is an experimental model that selects industries based on their technical configuration and stocks based on their fundamentals. The goal is a hybrid technical-fundamental model with a target of outperforming the S&P500 index by 30% per year.

Currently the model is fully hedged with a short position in XLF (which replaced an earlier hedged position in XLE).

The model is designed to have ten long positions once it is fully loaded, and is up to eight positions. Each long position holds 10% of the portfolio. Although the model could be all long, all the time, during bear markets I overlay it with an equal short position to control volatility.

I initiate new trades with a 10% long position in the daily “Buy” selection, with a short hedge in XLF. For a 100,000 portfolio with a margin account that would be (for instance) 10,000 in GTAT long, with 10,000 in XLF short. If I already own the stock listed as a Buy, I take no action.

Currently the long only basis for the model is only outperforming the S&P at a 5.64% annual rate – which is well below the target of 30%. The hedged portfolio, however, is currently outperforming at a 44.54% annual rate. This still represents a 2.4% current loss, but that’s significantly less than the loss I would have simply holding SPY.

MARKET COMMENT

Last year’s QE2 created a surge of inflation in emerging countries, destabilizing the middle east because food became too expensive in Arab countries. When faced with a dictator’s bullet or slow starvation, starvation became the bigger threat and a number of dictators were overthrown.

The inflation, however, remains – as does the danger of continued violence.

In Europe the collapsing dollar created a rise in the value of the Euro, which destabilized Greece and other debtor countries by increasing the value of their debt burden and lowering their competitive edge in international markets.

I expected another round of quantitative easing which would create a brief rally in the S&P, while tipping Europe into a domino of national defaults, starting with Greece.

That didn’t happen. Instead of pumping more money, Bernanke shifted it around in a manner that actually flattens the U.S. yield curve – effectively tightening monetary policy and strengthening the dollar. The fall of the market this week was the response of the “twist”.

I was surprised – but I was PLEASANTLY surprised. The fall in the market with a rise in the dollar is actually the best thing that could have happened, because each rise in the dollar lowers the Euro in comparison, giving Europe a little breathing room. While I don’t believe that Europe will correct their problems, I was pleased that Bernanke’s action gives them a little more opportunity to do so.

We are in a global economy, and each economy is either directly or indirectly tied to the others. Pushing Europe over the edge would be like a horse pushing his cart over the edge – it’s bad for the horse too.

We still have an opportunity for a rally before the bear market finishes, which would be in the 1250 range. Since the model portfolio is hedged, it doesn’t matter whether the market goes up or down. It only matters that my long positions rise faster (or fall slower) then my short hedge.

Tim

PS I will be offline for a few days this week, and will not be posting for Thursday or Friday's market. Since the hedged position is stable regardless of market direction, it's safe to walk away for a spell.

Condition Bear Market
S&P Target 970
Hedge XLE 9.96% Closed
Hedge XLF -6.41%

Position Date Return Days Call
BKI 5/31/2011 3.13% 118 Hold
CFI 6/22/2011 -6.65% 96 Hold
SE 6/27/2011 -5.33% 91 Hold
AWR 7/5/2011 -3.64% 45 Closed
CLH 7/6/2011 -0.75% 82 Hold
GCI 7/14/2011 -30.20% 74 Hold
AGO 8/5/2011 -16.62% 52 Hold
DISH 8/10/2011 24.88% 47 Hold
GTAT 9/8/2011 -35.03% 18 Buy
NA NA NA NA NA

Mousetrap Return -7.80%
S&P Return -8.76%
Hedged Return -4.65%

Mousetrap Annualized -41.16%
S&P Annualized -46.22%
Hedge Annualized -24.51%

Annualized Advantage 5.06%
Hedged Advantage 21.71%

The High Frequency Trading algorithms are clipping off day traders on both ends, and traditional technical analysis is being turned against itself. These algorithms know every move, pivot, stop limit, and trendline – and they are breaking these limits just before reversing. The day traders are low hanging fruit.

Most people cannot micromanage a bear market. They don’t have the skill or the nerves – nor even the time to constantly monitor the market.

Long only investors are being shown volatility that exceeds even 2008-2009, when using daily price ranges as the volatility measure rather than the VIX, and are constantly reminded of the possibility of a Euro implosion that would:

1) Create a deflationary collapse, coupled with
2) A currency crisis, and
3) Sovereign debt contagion, topped off with
4) Massive inflation once the deflation is done.

Since no one has a crystal ball, the glaring headlines in market op-eds are enough to make someone stuff his last remaining resources under his mattress and stock up on canned goods.

In reality, we’ll probably have at least a reasonable bear market, rather than a total system collapse. My own target is 970, with a recession, a Euro tarp, and eventual stag-flation. We’ve had the stagnation for a while, but we’ve been exporting the inflation all year. It WILL come our way. But first, a cyclical bear market (instead of Armageddon). It’s bad, it’s scary, but it probably isn’t the end of the world.

The beauty of a hedged position is that I don’t really have to be bothered with it.

GTAT remains the buy, with XLF as the hedged short position.

Tim

Condition Bear Market
S&P Target 970
Hedge XLE 9.96% Closed
Hedge XLF -6.93%

Position Date Return Days Call
BKI 5/31/2011 5.16% 119 Hold
CFI 6/22/2011 -2.08% 97 Hold
SE 6/27/2011 -4.01% 92 Hold
AWR 7/5/2011 -3.64% 45 Closed
CLH 7/6/2011 1.01% 83 Hold
GCI 7/14/2011 -28.14% 75 Buy
AGO 8/5/2011 -9.28% 53 Hold
DISH 8/10/2011 26.15% 48 Hold
GTAT 9/8/2011 -29.85% 19 Hold
NA NA NA NA NA

Mousetrap Return -4.96%
S&P Return -7.88%
Hedged Return -2.27%

Mousetrap Annualized -25.86%
S&P Annualized -41.07%
Hedge Annualized -11.83%

Annualized Advantage 15.21%
Hedged Advantage 29.24%

Hedged position is back into the performance target range of 30%.

Since the model is hedged, not much is likely to happen for a few days. Since the market recently stopped out short traders, it will likely stop out long traders next before the anticipated rally. Europe is trying to kick the can down the road, but we’re already at the end of that road now.

It’s in the hands of politicians and high frequency traders.

Good luck to everyone.

Tim