December 29, 2008
Brief Holiday Update
Last week was fairly quiet, though breadth is showing some favorable signs of divergence, suggesting that investors are indeed picking some wheat from the chaff. The market is not overbought, nor is it particularly oversold, so there is little pressure for price reversals on the basis of over-extension. Generally speaking, we continue to observe a gradual reduction in risk aversion as evidenced by credit spreads, corporate yields, implied volatility, and various measures of market action.
To the extent that investors may have lightened up on risk near the lows, a further rally could serve to make investors concerned that they “missed the bottom,” which I still believe could fuel a short-squeeze given the relatively light volume conditions at present. Still, we don't trade on that sort of expectation. Rather, we are aligned with the positive but moderate expected return/risk profile suggested by current valuations and market action.
It's difficult to give a “percent hedged” figure here, since our “delta” changes considerably as the market moves, given that the Strategic Growth Fund is essentially fully hedged with at-the-money and slightly in-the-money puts. As usual, we regularly shift our strike prices and expirations in order to reduce the impact of time decay wherever possible, so we certainly aren't just holding a static hedge. On a major decline, the puts would go gradually in-the-money so the Fund would look increasingly as if it were 70-80% hedged. On a major advance, the puts would go gradually out-of-the money so the Fund would look as if it were 70-80% unhedged. Locally, our delta looks about 40-50% here, but again, that will change as the market fluctuates. We don't have any strong views on whether or not we will recruit enough favorable market action to remove some of our put defenses altogether. I expect that if a strong advance fails to recruit very good internals and expanding trading volume, it would prompt us to tighten our hedges considerably to defend against a fresh market decline. So our willingness to accept market risk here will depend a lot on the quality of market action we observe. For now, we're comfortable with a moderate exposure to market fluctuations.
As of last week, the Market Climate for stocks was characterized by favorable valuations, moderately unfavorable market action on the basis of broad internals, but continued improvement in “early” measures of market action. In bonds, the Market Climate was characterized by extremely unfavorable yield levels and moderately favorable yield trends, however, the depressed level of yields holds sway since bond yields at this point are vulnerable to very sharp reversals. Given the level of extension in yields, it would not be difficult for the bond market to generate losses of say 10% in the 10-year Treasury bond, and as much as 20-25% in the 30-year Treasury bond over a very short period of time. Straight Treasuries may have safety from default risk, but the price risk is becoming downright dangerous. Corporate yields are much more reasonable, but there will be more fallout in this sector, and as I've noted before, taking a significant position in corporate would be essentially like a “bottom call” in stocks, since corporate bonds tend to trade much like stocks during periods of elevated default risk.
For our part, we strongly prefer Treasury inflation protected securities here. Despite near term deflationary prospects, the enormous expansion in government liabilities is unlikely to be accompanied by long-term inflation rates near zero, which is essentially the level that is priced into TIPS at present. On price strength in the precious metals market, we reduced our exposure to that sector in the Strategic Total Return Fund to about 10% of assets. The Fund also holds about 5% of assets in utility shares, and about 10% of assets in foreign currencies.
Wishing you a very happy New Year!
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