Sunday Morning Coffee

How about that stock market? It is up 48% off of the low and we are hearing calls for 1060, 1100 and higher. Sweet! Someone on CNBC on Friday noted that the market is 45% (from 666 to 987 I get 48%) and this person asked how much higher can it really go?

A reader noted that I felt a huge rally, really huge, would come but I should note that it came a little over two months after I would have thought and has exceeded any duration I would have thought reasonable. Going up 40-50% is not necessarily shocking only because it has happened before in short violent spurts but in another week the rally (or bull market) will be five months old which seems like a long time for this sort of whatever it is.

For months I felt there would be a big rally (mostly because big feel good rallies occur regularly in scary events) followed by one more scare-the-hell-out-of-them decline. When the SPX was at 900 I probably thought down to 700 would scare some folks. From here maybe 800 would do it. I don't recall trying to guess where it would go down to so much as hope clients would realize what could be in store and thus not panic if it happens. Mental preparation for a big decline is a good way to avoid panic selling.

While I have not changed my mind the scenario could turn out to be wrong. In getting defensive in the portfolio (still am defensive but less so than a year ago) I said I would hope to go down less but that the trade off would be to go up less on the snapback. This of course is another way of saying I'm less volatile than the market which during the bear phase which is not a bad idea.


Personally the last couple of months have been more difficult to figure than most parts of the current cycle. I still have cash and a small double short position. One idea for moving in to equities can be to swap holdings that might be less volatile for ones that might be more volatile keeping the same cash level. So for example someone owning Exxon Mobil (XOM) could sell that to buy something like Murphy Oil (MUR). I don't own either name it is just an example.

That type of swap does a couple of things. XOM has a market cap of $340 billion, Murphy is $11 billion. The average cap size of your portfolio comes down quite a bit, smaller historically does better for most of the cycle starting early on. It only takes a couple of swaps like that to bring the portfolio's market cap way down. The XOM for MUR swap also juices up the beta a little. Yahoo Finance has XOM's beta at 0.41 and MUR at 1.02. I won't vouch for those numbers but if correct then you increase the overall beta a little. If that is not enough juice you could go with Weatherford International (WFT) which has about the same market cap as MUR and a beta of 1.78. WFT is also a name I do not own, this is just an example.

Another type of example along these lines is to swap a narrow ETF for a stock. Typically a stock is more volatile than a related ETF, I say typically.

Hopefully it is clear that if the volatility of the portfolio is increased while keeping the same cash then the portfolio will likely track closer to the market in both directions.

One other point to make is about psychology. There was a period there where a lot of people were convinced that we were going to have a depression as bad if not worse than the one in the 1930s. Not just the financial system was in jeopardy but the American way of day to day living was in for some serious trouble. I tried to convey that it was not as bad as that. Clearly a lot of the details causing the event were different but as I pointed out then and will point out in the next scary event the most extreme outcome is a low probability. People tend to bring more fear than is actually warranted. I'm not saying this hasn't been plenty bad because it has but I would not describe the outcome as a complete tearing of the social fabric.

In that same vein I believe a lot of people are bringing too much faith that it can be over so quickly. Jobs don't appear to be on the path of going positive anytime soon, GDP estimates for when they turn positive appear to be below a level that provides job growth, current equity prices appear to be well ahead of what revenue will be in the next few quarters and if you were afraid of deflation or inflation six months ago I doubt you've changed you're opinion. While things were not as bad as some feared they were/are bad and so believing things are now all better seems unrealistic.

I feel that being in (with some defense) lets you capture at least some of the move up no matter how high it goes. And obviously a moderately effective defense should mean you go down less if a decline starts tomorrow. Being right or should not be the priority. The priority should be reducing the consequence of being wrong.

I did not take that picture. I believe it was in the WSJ quite a few months back.