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Life After Volatility


Is the volatility an opportunity to buy or a signal that a larger, more important trend, has started?

Volatility Returns - Now What?

A long time ago, someone uttered the famous quote, "Be careful what you wish for". Many investors who profit from volatility were begging for more volatile markets. Well, if you wanted them, now you have them!

How volatile are they? Just in the last two days, we saw one-month Treasury bill yields plummet by 1.75% at one point today. Gold shares as measured by the GDX (Gold Miners ETF) plummeted by nearly 25% in a week. Stocks like Goldman Sachs (GS) fell by nearly 70 points, yes, points, in about a month. Spreads on almost every corporate, agency and mortgage backed bond ballooned by as much as 100 basis points in the case of Ginnie Mae, to as much as 500 basis points in the case of CIT Group "hybrids".

The question, of course, is "Is the volatility an opportunity to buy or a signal that a larger, more important trend, has started (a.k.a. a bear market)?" To be honest, I can make a case for both, but the most important question is a question of your time frame.

Correction or Bear Market? What is your Timeframe?

Sometimes, it feels like a curse to be conservative and to hate the idea of losing money. Clearly, over long periods of time-like 50 years, stocks rise in price. I fully subscribe to this idea. Unfortunately, most investors barely have timeframes of 50 weeks, let alone 50 years.

So we must break down the ultra-long timeframes into smaller timeframes, namely secular market trends that tend to last 10-20 years and within the secular trends or cyclical trends that last a few years. Delving further, timeframes then shrink to weekly trends all the way down to traders in the pits of Chicago that can last seconds or minutes. So whether you are a bull or a bear depends on your time horizon.

To be frank, I have a little bit of 'all of the above' in my investing and trading style as I feel one can't be too consumed with one's macro view while trading and can't be consumed with the ultra short term view while trying to be positioned for the long term.

I bring this up because, just today, the S&P futures moved as much as 250 points in total intra-day, with moves of 30 handles, or points, in a matter of minutes over and over again. I sat it out: I felt it was better to sit and watch then to force the issue. One of the trading commandments I live by is "When in doubt, sit it out". Now, on to my time frames.

My macro view has been on the cautious, or even negative, side for the past several years, dating back to 1999. The amount of debt at nearly every level (consumer, corporate, government) is an issue that must eventually be dealt with. The sub-prime fallout is, in my opinion, a microcosm of the rest of the economy. While from a short-term view, the fundamentals may in fact be discounted (sell rumor, buy news) there are other shoes to drop down the road, I think.

My micro view is, well, micro. In other words, from a trading perspective, I always have the macro view in the back of my mind and am cautious towards credit risk and financial companies there are intermediate term opportunities. For example, I am a big fan of GNMA securities. Below, please see a chart of the spread, in basis points, of the yield of 30 year GNMA 6% pools versus the yield of 5 year Treasuries. To me, this is a wonderful opportunity and I took advantage of buying a good chunk today.

Click here to enlarge.

Clearly the baby is being thrown out with the bathwater. GNMA has the 'full faith and credit' of the U.S. government, which I can live with at this level. But what about FNMA ("Aunt Fannie" in Wall Street parlance)? It is cheap as well, and I bought there as well today.

While FNMA has an 'implied' guarantee of Uncle Sam, it is in my "too big to fail" category. In fact, according to, 122 mortgage companies have fallen this year, allowing, in my opinion, FNMA to gain more market share as soon as politicians realize the situation and act upon it. See the chart of that spread below.

"Nice!", as many of my fishing guide buddies would say when you hook a nice trout.

Click here to enlarge.

So while I am not buying poor credits when there could be more shoes to drop, I am buying what is high quality and unloved, a nice combination as an investor that wants to tilt risk/reward in my favor. I am not buying many financial companies' debt as I feel they are less liquid by a long shot ( I tried to get a bid on $10 mln of a high quality financial bond today and the bids were 150 basis points apart!) and, if I am wrong, I have much more "defined risk".

What about Stocks? Are They Cheap?

A few months ago, I penned a piece entitled Stuck in the Middle With You. My point at the time, and now, was and is that while the S&P 500 looked 'cheap' versus the 10 year Treasury note yield, the average stock was expensive. I will stick to that view, no matter how unpopular that view may be.

Can stocks rally from a short-term 'oversold' condition? Of course, but again, I must consider my timeframe. From an ultra short-term perspective, stocks, bonds and commodities (I added gold shares today on the nasty sell off) can do almost anything.

From a longer-term perspective, though, the macro picture of debt in an asset-based economy is dismal. Sooner or later, debt must repaid, or written off. Neither outcome is terribly bullish, I am afraid, but opportunities are everywhere for the nimble, open-minded trader/investor.

So I embrace today's turmoil. See in the charts below that the average stock is still not cheap, at nearly 21 times earnings and 5 times book value. Why do I use the average stock? There are two reasons. First, the S&P is dominated by financial companies and quasi-financial companies like General Electric (GE) and American International Group (AIG). Second, I believe the earnings estimates in many of these companies are woefully overstated.

Click here to enlarge.

Click here to enlarge.

The other reason I wonder about the index is that, as you can see from the chart above, most of the 'cheap stocks' are all financial or quasi-financial. The market is clearly voting with its feet.

What about the trend in stocks? The markets have been volatile for sure and traders around the globe are likely ready for the weekend. I wanted to take a look at the overall picture of stocks in this country, so I put together the chart below with commentary on the chart itself. The chart is the combination market cap of the S&P 500, Dow Jones Industrial Average, Russell 2000 and NASDAQ 100. Granted, there is overlap among the stocks in these indices but it tells an interesting story that the market has bent but not broken. The most likely scenario, in my opinion, is a move back up, completing a 'head and shoulders' pattern, then a nasty resumption of the bear trend that could last into 2008. Along the way, I expect many, many opportunities and look forward to the volatility. I hope this is not a "be careful what you wish for" scenario.

Click here to enlarge.

In summary, I think I need to stay flexible from short-term perspective and continue to respect the long term and secular trends, which keep me cautious. The trader in me likes to take advantage of the volatility and the investor in me makes me want to reduce risk exposure on every bounce.

If I am wrong? Well, the worst case is mild underperformance, which I can live with as the loss of capital is the worst possible outcome for any investor with nearly any risk tolerance.

The markets will be open every weekday (I hope) for the rest of my career. If I miss a move for a few days, weeks, or months that can always be overcome. A huge drawdown of capital, however, burns precious 'emotional capital', and makes a comeback that much more difficult.

Note to self: Slow and steady wins the race.

Oh, one last thing, the Fed just cut the discount rate by 0.5% and the market ran 70 S and P futures points. I am not stunned by this but think it is a sign of weakness and that the Fed will lose ALL CREDIBILITY over time. Just the other day, Fed Governor Poole said 'not desirable' for Fed to act before rate meeting. If you don't believe me, see the Bloomberg headlines from Wednesday nite. No acrimony here, just the facts.

No positions in stocks mentioned.

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