Thursday, July 12, 2007

Beta Beware

"Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums."

Alan Greenspan


This is a simple chart of the S&P 500 Index and the Nasdaq 100 Index. The bottom section of the chart shows the spread ratio between the two, NDX / SPX. The blue line is a 21 period moving average of this ratio. The slope of this average is getting stronger and stronger since early June. This signifies that technology stocks have been outperforming the overall market. This could be a result of a rotation out of the financial and banking sectors. The chart below shows the ratio between the S&P 500 and the XLF Financial Spdr.

One of the stronger groups leading the S&P 500 higher has been the energy sector. These are powerful movers at times when they are in rally mode, and having felt the pain of being on the short side of this group at times, sellers seem to almost disappear at times in areas of strong short covering. Lately the stocks that have received analyst downgrades have only suffered a day or two of weakness and then are off to the races again. Valero Energy has been the subject of strong short-selling over the past months, but it is still holding strong and as a result has some guaranteed buyers if it goes much higher. Below is a chart of the S&P 500 comparing the XLE Energy Spdr.

As can be seen, this chart is showing the XLE close to an upper resistance line. This line might not act as strong resistance, but when compared to the move oil has made lately and the Natural Resource ETF-IGE, this could point to a spot to take some profits.

The chart of the U.S. Dollar Index below shows the dollar is approaching an important level from the low it made in 2004. What will be the reaction globally if and when the dollar makes a new low? Is it already factored in or will it cause people to take a second look at the macro picture. Just how great is the recent global expansion?

"This is far and away the strongest global economy I've seen in my business lifetime," U.S. Treasury Secretary Hank Paulson.

He went on in an interview to say:

On risks: "We haven't had a global financial shock since 1998. I believe that these large and dramatic increases in private pools of capital [hedge funds and private equity] and in the credit derivatives markets since then have helped manage and disperse risk and make the economy more efficient. When we do have one - and it's when, not if; that's not me being negative, it's just that we're not going to defy economic gravity - we'll be seeing for the first time how some of these instruments perform under stress."

One preventive solution is to review portfolios to ensure that diversification and balance match the initial intent when they were created. It has been very easy to fall in love with the high flying energy and metal stocks. This could result in a portfolio that is severely overweighted in these areas. It is worth booking some profits and regained a diversified weighting. This does not mean sell all your winners. It means taking some profits from a group that has rewarded you well for taking risk and re-establishing found fiscal discipline so you won't have to take the same action when possible economic gravity shows it still exists. In the crash of 1987 because of the strong performance leading up to this fall, many money managers were not balanced correctly and this resulted in them doing this re-balancing out of necessity rather than planning. At a time when they should have been buying stocks they were selling. Stay ahead of the herd. Discipline pays off in the long run. Look at the record of David Swenson who has run Yale's endowment for the past 2 decades and averaged 16.1% return. His book, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment, is a great resource for what really goes in a well run endowment. He also has a book, Unconventional Success - A Fundamental Approach to Personal Investment, that is written with the individual investor in mind. Both of these books have a lot to offer and are genuinely written educate the reader. Not a lot of hype, just honest wisdom from a true master.

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