Defensives Leading, Again

Since we’ve moved to a much more defensive investment position over the past few weeks, we are watching very closely and trying to keep an open mind that we could in fact be wrong with our change in call. The stock market is now bouncing, with the S&P 500 up about +8.5% from the August 8th low through yesterday, which doesn’t really surprise us that much. After all, the intensity of the sell-off earlier this month was such that some technical measures indicated that stocks were nearly as oversold as they were in the worst of the 2008 financial crisis! So even while we believe this is essentially an oversold bounce and not the beginnings of a new, sustained advance, we are watching various indicators closely to make sure we aren’t missing anything.

One of the biggest clues supporting our overall call may be the fact that defensive sectors like Telecom, Utilities, and Health Care are leading on the bounce (as shown in the table below), just like they did this spring prior to the market’s peak in late April following the mild correction in February and March. Defensives leading to the upside would seem to go against the conventional wisdom that the cyclical sectors that have been hit the hardest lately would thus be poised to bounce the most, and to us is a warning that additional volatility in the weeks ahead is likely. Therefore, we continue to believe that a below benchmark risk posture is appropriate for the time being.

Spending Confounds, Confidence Plummets

Yesterday brought the latest income and spending report from the Bureau of Economic Analysis. With spending still driving the U.S. economy, and arguably world growth, we watch these numbers closely. I’ve been increasingly bearish on the economy recently, but I have to admit that the print was surprisingly good, even when stripping out the effects of inflation and energy prices. As always, one data point isn’t enough to change an investment call, and in my mind we’ll need to see a few more positive data points to confirm that the number was anything but noise. However, it was nice to see a positive piece of data within the current sea of negativity, and if consumer spending continues to improve, I think it will be meaningful for the economy in a positive way.

Today brought the August report on consumer confidence, and it was a miserable number. This made a lot more sense to me given high levels of unemployment, the latest stock market swoon’s impact on net worth, recent regional surveys that have been melting, and a fleeting faith in policy makers around the globe. To be honest, we’ve never given a lot of weight to confidence as a leading indicator for the stock market, as it is often coincident at best and lagging at worst. But currently we appear to be in the midst of a crisis of confidence not seen since 2008, and common sense tells me that confidence can affect prospective decisions regarding hiring, capital spending, and even whether I decide to make a meaningful purchase in the near future. So having confidence does matter.

Two days and two data points that paint very different pictures about the world we live in. I am hopeful that the spending number can propel the economy going forward and help us avoid economic contraction. But hope is not a strategy, and we will stay defensive until more positive evidence materializes.

More Confusion about Buy and Hold Investing

I watched with a mixture of horror and amusement the other day as Tyler Mathisen, guest host on CNBC’s Squawk Box, introduced a segment with Ron Baron, an iconic value manager, by saying that Baron claimed that “buy and hold is alive and well.” As regular readers of this blog know, as the author of a book called, “Buy and Hold is Dead (AGAIN)”, I try to keep readers abreast of the latest misrepresentations and misinterpretations about the subject in the media and elsewhere. This latest nonsense comes under the category entitled, “value money managers whose definition of buy and hold has nothing to do with modern portfolio theory and is the absolute opposite of the ‘buy and hold’ message taught to investors by the media and the majority of investment advisors.”

Let’s review. Value managers begin the investment process with the somewhat conceited idea that they can better value individual securities than “the market.” Since the market is made up of literally millions of investors, the notion that any one investor has a better understanding of the true value of a security than the masses of investors who set the price on a daily basis seems unlikely. Yet, since Graham and Dodd published their book, Security Analysis, back in the mid 1930’s, where they explain how to analyze a company’s balance sheet and profit and loss statement in order to determine the fair value of a company’s stock, the best value investors have attempted to beat the market. Anyone who knows the investment business knows that Ron Baron is a long-time, ultra-successful, traditional value investor who tries to buy company shares at a discount to their fair value. For investors like Baron, or the most well-known value investor, Warren Buffet, the investment time horizon that they operate in is very long-term. Baron does not mind that it may take years for the rest of the market to discover the value of the securities he discovered through his own research. He believes the market will ultimately bid the price of his shares to their fair value, and when it does he will earn a profit. Therefore, the only context that Ron Baron believes in buy and hold is to say that he is willing to own discounted shares for as long as he needs to for the market to discover the true value of the business franchise that he owns.

In the world of strategic asset allocation, or the buy and hold investing that I refer to in my book, there is no such thing as an individual investor finding a discounted security. In the fairy tale world of buy and hold, securities are considered to always be fairly priced due to an absurd notion called The Efficient Market Hypothesis. Because markets are always deemed to be fairly valued, there are no values to be found, and so investors should simply buy and hold securities in order to earn whatever returns the market will give them. In this context for buy and hold, investors are expected to believe that the historical average returns of markets are theirs for the taking, if they are only patient enough. Clearly, patience has not proven to be a very good investment strategy since the dot-com bubble burst in March of 2000. To put Ron Baron on the air as a spokesperson for buy and hold investing reflects a fundamental misunderstanding of what he does for a living and insults his reputation as a truly outstanding value investor. It is also an example of how the investment industry and the media crush individual investors with terrible investment advice. Baron, and Buffett, would throw-up at the notion that markets are always efficiently priced and that investors can earn historical average returns regardless of the price that they pay for a security. They are perfectly happy to buy and hold their discounted shares and wait for the rest of us to figure out what they already know about the fair value of the stocks in their portfolio.

What Goes Up…

Gold has been powering ahead and we watched in awe as our hedge worked fantastically over the last month. Stocks fell 17% but gold rose 21%, and this parabolic-esque move seemed too enticing to ignore. The price of gold stretched to 20% above its 200-day moving average which historically is a very overbought level. So we decided to act, reducing our gold target for the five models we run from 4% to 3%. The price of gold at the time of our sale was around $1775 per ounce (marked by the green line in the chart below). The next 7 trading days were hard to watch.

The rise continued, and I’m sure Ken was grinding his teeth since he was reluctant to sell. Our 3% position moved to $1917/ounce, an 8% move, during the trading day on August 22nd. The term gets used a lot today but gold was possibly entering bubble territory. That was 3 days and $158 dollars/ounce ago as gold fell to $1760. That is a two day, 9% move lower. What goes up, must come down, and many times it will plummet.

This parabolic rise and quick fall is eerily similar to the movement of silver in April and May. Silver lost 25% of its value falling from $40/ounce to $30/ounce in a few weeks. If gold follows that pattern the price could fall to $1450/ounce. That is not our base case but we did feel the rapid rise needed to be addressed.  Now that it's falling, we may be looking for an opportunity to increase our position again. You have to love tactical management!

The Day the Fed Put Died?

“I went down to the sacred store
Where I’d heard the music years before,
But the man there said the music wouldn’t play”
Don McLean – American Pie

Ken wrote a timely blog yesterday regarding the upcoming Federal Reserve meeting in Jackson Hole later this week, and how markets might be gaming the possibility of more monetary stimulus to be unveiled. Beyond the Fed’s upcoming rhetoric, I’ve been wondering lately whether the Fed is out of policy options that will have a real effect on business cycles and markets going forward. After all, short-term interest rates have been pegged at zero for some time and two unconventional quantitative easing programs have been enacted.  Yet, none of it has ended the liquidity trap that the economy appears to be in. In short, despite heroic efforts by this Federal Reserve to bring the horse to water, it simply refuses to drink.

Over the past couple of decades, investors have grown to count on the Fed to enact countercyclical policies in times of economic and market stress, and the muscle memory of the markets is programmed to believe that more Fed stimulus leads to higher asset values. But could we be in the midst of a sea change occurring regarding the value of Fed policy? In other words, has the Fed simply run out of bullets? Jackson Hole should give us some clues about the likelihood that Chairman Bernanke will attempt to ride to Wall Street’s rescue one more time. But regardless of whether or not the Fed delivers QE3 on Friday, I think the bigger question to wrestle with is does the Fed still have effective tools it can use to create sweet music for the markets, or are we living through the era that the "Fed put” died? Only time will tell.

Gaming the Jackson Hole Economic Summit

Last week a certain presidential candidate, speaking about Federal Reserve Chairman Ben Bernanke, said, “….printing more money to play politics at this particular time in American history is almost treacherous – or treasonous in my opinion.” I don’t know if he meant it was almost treasonous, or it was actually treasonous, but either way the notion that current and future Fed policy is treasonous is ludicrous, in my opinion. The candidate also said that Bernanke would be “treated pretty ugly down in Texas.” I don’t know about Texas, but we do tend to spend a lot of our time thinking about Wall Street, where I can assure you, a lot of thought is being given to the possible tactics of the Fed Chairman. On August 26th at 10AM E.T. the Chairman will give his annual speech about the future prospects of the economy at the Economic Symposium of the Federal Reserve Bank of Kansas City, in Jackson Hole, Wyoming. The short-term fortunes of bullish and bearish investors will have much to do with what Chairman Bernanke has to say. Last year, at the Jackson Hole Symposium, Bernanke gave his speech on August 27th and strongly hinted at a new Federal Reserve program to expand the Fed’s balance sheet by buying bonds in the open market. While the Fed called this program “quantitative easing,” for many it amounted to simply printing money. So it is no accident that money printing…whether treasonous or not…is in the news.

There is much debate in economic circles about the effectiveness of the program, called QE2. It was announced during a period of time last summer when there was great fear about the strength of European sovereigns, namely the PIIGS countries of Portugal, Italy, Ireland, Greece, and Spain. Many feared that the global economy would fall into recession. One year later many of the same fears are still with us, and critics note that commodity prices and inflation are higher, unemployment and housing prices have not improved, and consumer confidence is very low. However, from the day Chairman Bernanke gave his speech last year, the stock market put in one of the strongest rallies of the bull market that began in March of 2009. From the date of his speech in late August until February 18th, 2011, the stock market exploded higher to gain +27%. Stock market bulls are hoping for a similar program, with similar results, this year. And stock market bears are terrified that the Chairman will come up with some kind of innovative and effective program that will stop the current market correction in its tracks, with the same result as last year.

As I see it, there are several possible outcomes from Bernanke’s Jackson Hole speech. 1) No new program is announced and bulls are disappointed (bearish), 2) A new program is announced and the market is so oversold it doesn’t matter how effective the program is, the market will rally (bullish), 3) A new program is announced and investors don’t believe it will be effective (bearish). If you are bearish and think stock market prices are headed lower, Chairman Bernanke is a crafty, innovative, and brilliant adversary. He has stated on many occasions that a bull market in stocks provides a positive “wealth effect” that is good for the economy. His past actions show he is willing to break all of the rules in order to put a floor under U.S. stock prices, if he can. Unfortunately, I believe that at this point in the cycle the world’s economic problems can’t be solved by monetary policy alone, and I believe that the majority of investors agree with me. In short, if the stock market does rally on Bernanke news out of Jackson Hole, I think it is likely to be a short-lived rally. We have positioned our portfolios to defend against further declines.

Credit Market Message: Banking Risk is Rising

One of the lessons learned from the 2008 credit crisis was not to ignore warning signs that emanate from the credit markets. Lately we are watching credit market relationships move in a way that indicates that stress is increasing in the global banking system. One measure that is raising concerns is the rise in interbank lending rates, as measured by the spread between Euribor and Overnight Indexed Swaps (OIS). This measure is higher than it was in 2010, and rising fast.

We have also been following credit default swap pricing on several European and domestic banks. Credit Default Swaps (CDS) are contracts that investors buy to protect against company defaults, and the price of this insurance has been rising quickly, particularly in European banking names like Societe Generale, which was rumored last week to be having short-term funding problems. Some believe that CDS prices are overshooting actual problems, and that the Societe Generale rumor was nonsense.

We can’t be sure that rumors aren’t helping to fuel the fire, but we have learned over a long period of time to respect the message from the credit markets. We’ve already been in de-risking mode at Pinnacle due to our call that a recession is probable, and that we are likely trapped in a bear market rather than a deep correction. The current message from the credit markets just adds another element of risk at an already risky time.

Valuation Getting Cheaper, Not Yet Compelling

One of the three core tenets of the investment management process at Pinnacle is valuation. More often than not, market valuation will be at or near neutral levels, and our focus will be on the other two tenets, the business cycle and technical conditions. However, every once in a while, valuation levels become compelling and catch our attention.

In order to assess the level of valuation at any point in time, we typically look at a large variety of at times contrasting indicators. Our quantitatively-oriented valuation model uses all these indicators as inputs and returns a single score ranging from 0 to 10, where higher values signal more attractive valuations. This helps remove a certain degree of subjectivity from the analysis. Currently, the model is an equally-weighted average of 14 different indicators grouped into 4 different categories called P/E Measures, Non-Earnings Measures, Yield-Based Measures, and Intrinsic Value Measures. As part of the constant effort to improve on the efficacy of the model, the team is currently evaluating alternative weighting systems based on the specific explanatory power of the individual components of the model. Regardless of what system is used, since 1981 (the beginning of the sample) our valuation model has exhibited an outstanding ability to forecast future S&P 500 returns, having a roughly 50% correlation with 2-year forward S&P 500 returns and a roughly 70% correlation with 5-year forward S&P 500 returns.

Following the turmoil experienced by the stock market in the last few weeks (at the time of writing the S&P 500 is 13.5% off its April 29th high on a closing basis), we would expect valuation to have improved some. The important question is, by how much? Updating our valuation model as of the end of last week returns a score between 6.07 and 6.8, depending on what weighting system is used. This constitutes a great improvement from the score of around 5 seen at the end of July, before the worst of the latest market sell-off. Since the model’s inception, valuation scores in the 6-7 range have been associated with median 5-year forward S&P 500 returns of around 11% (standard deviation of 2%). However, the forecasting power over shorter time frames was less impressive, with 1-year forward S&P 500 returns coming in still at around 11% but with a standard deviation of 12%.

All considered, a score in the lower 6-7 range is not yet overly compelling in our view, especially given the high level of uncertainty that is pervading global financial markets as of late. In addition, the other two tenets of our investment management process suggest that the market may become cheaper before it gets expensive. As a result, we will keep an eye on the model and give it increasing consideration if valuation keeps improving.

Alpha Trades and Beta Trades

Rick Vollaro has introduced the investment team to a new term, “trading with a hatchet.” You can find his blog on the subject in this space (posted yesterday). I can assure you that we don’t let Rick get near anyone in volatile markets with a hatchet, especially when the markets are going in the wrong direction. However, his point was a good one. For the past month or so we have been gradually and incrementally changing the construction of our managed accounts to reflect our view of deteriorating economic fundamentals. When we do inter-sector trades, or sector rotation trades, we call them “alpha trades,” meaning they can impact our ability to outperform our benchmark on a risk-adjusted basis (positive alpha), but they are not necessarily going to have a major impact on portfolio volatility. Over the past month our scalpel trades, or alpha trades, included rotating from Equal-Weight Industrials to Aerospace & Defense in the industrials sector, from Managed Care to Pharmaceuticals in the health care sector, and from Energy Exploration & Production to a broad-based Energy ETF in the energy sector.

Trading with a hatchet is a colorful description of what the team calls beta trades. Beta trades can make a significant difference in the volatility of the overall portfolio. These trades typically involve buying and selling highly volatile risk assets to or from cash or other low risk assets. Over the past month we took out the hatchet rather infrequently to reduce risk, but we did execute a few beta transactions along the way. Examples of beta trades included selling our remaining commodity futures ETF position, buying a long-term U.S. Treasury bond ETF from cash, and selling High Yield bonds to cash. While these transactions had more of an impact on portfolio volatility than our scalpel trades, up until the past few weeks we were still trying to give the bull market the benefit of the doubt and the overall impact of our transactions was to get slightly more defensive as our view of the economic cycle began to change.

Last week, however, as the data clearly indicated that the economy is slowing, or perhaps slipping into recession, the scalpel was put away and the hatchet came out. In the past week we sold the Energy SPDR, Consumer Discretionary SPDR, Equal-Weight Industrials, and Gold ETFs, all with the goal of reducing our most volatile equity positions by a total of 10%. As of today we have 7% of the sales completed, and we are targeting the remaining 3% at an S&P 500 price of somewhere close to 1,250. Our models tell us that the hatchet has done its work well. Our best guess is that the beta of the DMG model is approximately 0.4, meaning we are gathering around 40% of the downside moves in the S&P 500 Index. With portfolio volatility properly managed, it may be time to take out the scalpel for the remaining 3% of our equity trades. If so, look for us to rotate within the U.S. equity allocaiton – selling a volatile, cyclical equity position to buy a more defensive position like Consumer Staples our Utilities.

Trading in Our Scalpel for a Hatchet

Somewhere during the last few weeks the weight of the evidence changed enough in our minds to declare that we are likely at the beginning of a new bear market. As always, the ultimate decision to call for a bear market was part quantitative, part qualitative, and part pure judgment. We wouldn’t single out any one data point in particular as a catalyst. Instead, the decision rested on a growing assessment that many economic and technical data points had deteriorated over a period of time, and that valuation isn’t cheap enough to provide a cushion against further possible losses.

Time will tell if we are correct or incorrect in our determination that this is a bear market versus a deep correction, but in real time this distinction has brought major implications for current market positioning. The difference between correction and bear is critical, because if we thought this was a replay of last summer (a deep correction), it would be time to get more aggressive in client portfolios. However, considering that the the median and average market losses in a bear market are approximately -28% and -35%, respectively, the label of bear market carries with it plenty of further downside risk to protect against at this time. In short, if we are correct that this is a bear market, then it makes sense to be looking to sell the rallies.

As Carl Noble pointed out in his last piece, we have already begun to sell the rallies, and we have clearly changed tactics in the way we are looking to scale out of risk assets. Our prior bull market view gave us the luxury to execute a number of relative value trades to try and dampen portfolio volatility. Those trades consisted of sector rotation in the equity market, selling alternatives and corporate credit for cash, and building exposure to long maturity bonds. That strategy served us well to varying degrees over the last few weeks, but I’ve characterized it as surgical in approach, and as we made those defensive trades we always had an eye on the bigger picture that the bull market was getting the benefit of the doubt.

The last few trades we have executed have become much more absolute in nature, as we have been selling equity volatility and swapping it for the stability of cash. These trades are much more aggressively defensive, and we are now at much higher risk to trail our performance benchmarks to the upside if we are incorrect in our forecast. Different environments require different tactics, and for now our bear market call has us trading in our scalpel for a hatchet as we reposition the portfolios for the change in our overall market view.

Springing into Action

And we thought last week was volatile. Apparently, it was just a mild preview to this week’s fireworks in the stock market. Just in case you haven’t been paying attention, the daily S&P 500 returns so far this week are -6.6%, +4.7%, -4.4%, and +4.6% (through Thursday). Whew.

If you’ve been following along, you probably noticed that there’s been a significant shift in our outlook. After writing for weeks that we were getting more concerned, but the data was still too ambiguous to reach the necessary conviction to make a definitive call one way or the other, we now believe the market has probably entered a new bear market, and the odds of the economy slipping into another recession have grown considerably. And if you’ve noticed the blizzard of trade confirms arriving this week, you’ve also realized that we’ve sprung into action. In short, we’ve executed several transactions, starting last Friday and through the course of this week, to materially reduce risk across all of our model portfolios.

With the extreme moves in various asset classes, we’ve gone to great lengths in our trade execution to try and maximize our exit points, with mixed results. With our equity sales, we’ve had a couple that we feel pretty good about, like last Friday (since the market is still lower than it was then) and yesterday (when the S&P was up nearly 5%), and one really frustrating day (Tuesday, just after the Fed announcement and before the big end of day rally). We also had what may have been a well timed trim in two of our two hedges that have been on fire, gold and long-term Treasuries, when we sold a little of each yesterday morning right around their highs. Of course, if our bigger picture outlook is correct in that ultimately stocks are headed lower in coming weeks, then any sale around current levels will look great in hindsight.

For now, the proceeds from all of these trades have simply gone to cash. We’re fully aware that cash is currently yielding 0%, which obviously isn’t going to get anyone to their long-term return objectives. We simply view cash as an attractive place to hunker down for the time being while we patiently wait for opportunities to develop. One of the issues currently is that the obvious asset classes that we would normally turn to when getting more defensive (gold and Treasuries) have had such extreme moves higher that we’re not comfortable adding to them at current prices, since they are both very volatile in their own right.

So, as the clock winds down on a whirlwind of a week, we believe that the flurry of activity has lowered portfolio volatility by the largest degree since early 2008, which was the last time that we drastically reduced portfolio risk. There may be more changes to come, but we feel we’ve done enough this week to take a step back and take a breath. Make sure to stay tuned, though…

Trim the Hedges?

At the moment we have concluded as a firm that the higher probability is that we are in a new bear market rather than a severe correction like we witnessed last year. Therefore we have been busily crafting and re-crafting strategies to deal with this hostile period for the market. Luckily we have some hedges in the portfolio that are providing the exact inverse qualities to the stock market that we expected from them. Specifically, gold and long-term Treasury bonds have been our most productive hedges during the latest sell-off, and we have definitely been rewarded for holding these positions in our portfolios to date.

But looking backwards at performance is always dangerous. Both of these assets are very volatile, and contain their own risks. So as we’ve been setting stops and removing equity risk in portfolios, we are faced with a decision as to whether we should trim our hedges and lock in some gigantic gains in the process. On the one hand it is very tempting to take the latest run up in gold or long maturity bonds and sell them to cash right here. It seems like you can’t lose with a huge win booked, right? The downside would be if the bear market intensifies, and we now have less of these hedges to help defend in our portfolios. It’s a tough choice, and one I’ll be mulling over so I can give the investment team a definitive answer in the very near future.

Discounting a Recession

It seems clear that the financial markets have moved past any rational response to a credit downgrade by Standard and Poor’s of U.S. debt from AAA to AA+, and moved on to worrying about recession. Bond investors clearly shrugged off any concerns yesterday as Treasury yields actually fell and bond prices rose on the day. Municipal bonds had a miserable day, perhaps reflecting investor concerns that a downgrade of the sovereign country could lead to downgrades in specific counties that currently have a AAA rating. Pinnacle clients in Howard County and Montgomery County as well as AAA rated counties in Northern Virginia should take note. While bond investors appear relatively sanguine about the downgrade, at least for the moment, clearly stock investors are not. Yesterday’s market riot continues a vicious sell-off that began last week that has now taken the S&P 500 Index down 17% from the highs of early July. While this decline still technically falls into the camp of a market correction, and is the same magnitude in terms of a peak to trough as last summer’s decline, as pointed out in last Friday’s Special Report, the selling over the past several days has been relentless. The question is whether or not it is warranted in terms of the actual conditions we see in the real economy.

For us, the answer is “maybe.” There is ample evidence that the economy is slowing. Last week’s release of second quarter GDP, the ISM Report, and consumer income and spending data all show the economy is potentially reaching “stall speed.” Last Friday’s payroll number was better than expected, but still not good enough for anyone to feel encouraged that employment is improving. In fact, the second quarter GDP growth estimate of +1.3% missed the expected number of +1.8%, and many pundits have pointed out the high likelihood that such a low number will ultimately be revised to a negative print. Coming on top of the first quarter revision to GDP growth that reduced growth to only 0.4%, the stock market seems to be suggesting that the economy may already be in recession. Yesterday morning, during a long discussion about portfolio policy and market conditions, the consensus of Pinnacle analysts seemed to put the odds of recession somewhere around 50 – 50, with the most bearish assessment being a 75% chance of recession. It looks to me like the stock market has put the odds of a recession somewhere between 80% and 100%.

The next question is how to adjust our portfolio construction to reflect the new economic reality. Our strategy is to reduce risk assets in the portfolio by 5% to 10%, depending on the portfolio policy. Last Friday we sold our first 2% and in the coming days we will try to sell an additional 2% - 3% of stocks, if the market will let us. And therein lies the problem. When the market goes into free-fall, as it has the past few days, it quickly becomes so oversold in the short-term that the high probability is that prices will actually bounce, rather than keep falling. History and experience tells us that it is best to wait for the bounce before wading into a market so full of sellers. So our thinking is to see if we can get a near-term bounce to finish our first 5% of selling, and then see if we can sell the remaining 5% of stocks at higher prices. Note that this strategy is far from going 100% to cash, or as we say on the investment team, “closing the blast doors.” We are simply continuing a pattern of risk reducing transactions that we have been executing for the past few months. We think the current trades will properly discount the odds of a recession. If the economy continues to slow, we should see U.S. corporate earnings estimates begin to fall sharply soon. We will see.

The Golden Mean

Boy, it is ugly out there! On the back of European problems and a disappointing world growth outlook, US markets are down more than 4% today as I write this. The S&P is now negative for 2011, the key support zone of 1250 has been broken and the cyclical trend line from March 2009 has been broken. It feels like a dementor (for all the Harry Potter fans out there) has sucked the happiness out of the world leaving us with only memories of 2008. And it is at this exact time that we must reflect and examine but never give in to our basic emotions including fear.

Below is a price chart of the S&P 500 from 10/1/07 through today. I have overlaid a Fibonacci retracement indicator on the price chart using the 2007 high and the 2009 low. Fibonacci was a mathematician who is credited with “discovering” the golden mean. The golden mean occurs everywhere in nature, and that includes the stock market which is moved as much by human nature as it is by fundamentals. The golden mean is the green line on the chart and you can see how this line has acted as resistance or support (marked by white circles).

It is mystical but very important nonetheless. After 9 out of 10 days down and a 4% (it’s getting worse as I write) down day today this level could provide some support even if temporary as in 2008. And it is here where we make a stand. If we get a bounce and unemotionally believe more selling will occur then we will most likley reduce risk. If this level fails to hold, which is very possible because tomorrow is payroll Friday adn the report could be pretty bad, then we may have to stop giving the bull the benefit of the doubt. But we must never panic because that is when mistakes are more likely to happen.

Hedges Are Making a Difference

There’s no point in sugarcoating it – the market has taken a pretty good beating over the past couple of weeks. The S&P 500 is off by about -7% since its most recent high on July 7th, and yesterday was just plain ugly as the selling intensity picked up throughout the day and ended with a -2.5% loss.

Today, stocks opened with even more selling – dipping all the way down to 1234 and in the process blowing right through what seemed like pretty good technical support at both the March and June lows around 1250 on the S&P. But, stocks staged an impressive turnaround and actually managed to close higher on the day, so perhaps a bounce is finally developing after 8 straight days of selling.

With investor angst reaching feverish-pitch levels on the heels of the debt ceiling drama and the latest market decline, there is actually some good news in all of this. Many of the portfolio hedges that we currently own for exactly this type of volatility are working as expected – gold continues to make a new record high almost daily, and Treasury bonds have rallied like crazy the past several days.

So, we’ve been able to dampen the blow from the equity markets somewhat. But we’re not just remaining complacent, either. Recent economic data and market action has been increasingly poor, and if this continues for much longer, we may need to take additional defensive measures in portfolios.

Chart: S&P 500 (black), 20+ Year Treasury ETF (brown), Gold ETF (blue)

ISM Getting Everyone Refocused

The latest Institute of Supply Management (ISM) manufacturing number came out this morning and it was disappointing (shown in the chart below). The 50.9 number was much less than the 54.5 print that was expected by the market, and predictably stocks immediately sold off on the news. Virtually every component, including prices paid, production, new orders, inventories, and employment were down from last month. Interestingly, both exports and imports showed some improvement. This comes on top of last Friday’s big downward revision to first quarter GDP to 0.4% from 1.9%. Considering that many of the other leading economic indicators have been trending lower for some time, this latest news will serve to refocus everyone’s attention on the current “transitory” soft patch in the economy.

As I wrote in this space last week, it seems like a long time since we’ve been able to focus on economic and market conditions as opposed to the amazing, entertaining, frightening, and absurd debt ceiling debate. Assuming that the compromise bill gets passed (we will know by the end of the day today), investors will begin to discount the odds of whether the bill does enough to avoid a debt downgrade, especially by Standard and Poor’s, which has been pretty clear that the deal needed to cut $4 trillion from the deficit in order to avoid a downgrade. Since this proposed legislation doesn’t get there, it is very possible a downgrade will occur over the next several weeks. For those who are keeping score, the 10-Year U.S Treasury bond yield was all the way down to 2.72% as I walked in to write this post.

In the meantime, this August may well be a replay of last August as economic indicators gradually weaken and the threat of a recession grows palpable. Last year the Federal Reserve came to the rescue with a quantitative easing program. Call me crazy, but it almost feels like home to be able to go back to wondering about QE3, unemployment, corporate balance sheets, residential real estate, consumer credit, earnings surprises, and all of the other good stuff we usually do around here.