Monday, August 15, 2011

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.