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Does Short-Selling Have a Place in One's Portfolio?

(September 2, 2007)

Dear Subscribers and Readers,

Let us begin our commentary by first providing an update on our three most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7, 2006 at 11,385;

2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;

3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.

As of Sunday evening on September 2nd, we are still neutral in our DJIA Timing System (subscribers can review our historical signals at the following link). 

Let us now get on with our commentary.

In the last 7 ½ years, the general U.S. population has witnessed two life-changing economic events that have not had any precedents since the Great Depression:

  • A near 80% decline in a major U.S. stock market index (the NASDAQ Composite) from peak (March 10, 2000) to trough (October 9, 2002).  For those who would like to categorize the 2000 to 2002 bear market in the same “class” as the 1973 to 1974 stock market crash – it is to be noted that even then, the 2000 to 2002 bear market was a once-in-a-generation event.

  • In all likelihood, a year-over-year decline in U.S. median housing prices sometime later this year, as measured by the OFHEO HPI.

Many who were trading during the 2000 to 2002 bear market were utterly dumbfounded by both the magnitude and the extent of the bear market, especially those who have been used to trading in the bull market since 1982.  Support after support levels was broken.  Cuts in the Fed Funds rate only brought temporary relief (the first cut occurred in January 2001 – the U.S. stock market did not bottom until 21 months later) and were sometimes ignored altogether.  The “Fed Valuation Model” proved to be useless, as investors and analysts alike started discounting the possibility of a deflationary bust – a deflationary bust that would wipe out corporate profits and usher in an environment that even the Federal Reserve could not savage – ala “the Japanese scenario.”  During the early parts of the tech debacle, many folks had hopes for a “soft landing,” and, they most likely would have gotten what they wanted, based on recent stock market and economic history.

Indeed, this – extrapolating recent experience into the indefinite future – is the problem for virtually all investors, old, experienced, and new alike.  As discusses in our commentary last weekend, this is a perfect example of “inductive reasoning” – one of two kinds of human reasoning (as postulated by David Hume): 

More specifically, inductive reasoning assumes that what has occurred in the past acts as a reliable guide to the future, or that a sequence of events will always occur just as they have occurred in the past.  A commonly cited example is that since the sun has always risen in the east and set in the west, it can be inferred – by induction – that the sun will also rise in the east and set in the west tomorrow, next week, and next year (however, five billion years from now, it will not be true, as the Earth will most likely not exist).  Another example is the “Three Laws of Motion” as postulated by Isaac Newton – a world that came to an end with Einstein's Special Theory of Relativity in 1905.

An example that is closer to our hearts is the state of the world on the Friday before October 19, 1987.  Since the inception of the Dow Jones Industrial Average in May 1896 as a means to keep track of the performance of the overall stock market, the DJIA has never experienced a one-day decline of more than 20%.  Indeed, we have had some close calls, such as the 8.3% decline on March 14, 1907, the 12.8% decline on October 28, 1929, the 11.7% decline on October 29, 1929, the 9.9% decline on November 6, 1929, and the 8.4% decline on August 12, 1932.  Not even during the dark days of World War II, the Monday after the Eisenhower heart attack, the days of the Cuban Missile Crisis, or during the biggest down days of the 1973 to 1974 bear market have we experienced a one-day decline of more than 8%, let alone over 20%.  And yet – driven by an immense amount of leverage within the financial system, overvaluations, and the advent of “portfolio insurance,” the market did, indeed, decline 22% during that fateful day on October 19, 1987, despite the fact that the Dow Industrials had already declined by more than 17% from its peak on August 25, 1987 to the previous Friday on a closing basis.

In a way, inductive reasoning – when it comes to virtually all our daily activities – is very reasonable, in that, on a day-to-day basis, there are usually no major disruptions in our lives.  Aside from my earlier example of the sun, most people can expect to stay in the same home, job, and drive the same car on a day-to-day basis.  Most can also assume that his or her home will appreciate in price on a year-to-year basis (after all, CPI inflation is still trotting along at a 2% to 3% every year) – and that, despite the current wars in both Afghanistan and Iraq, another world war will most likely not break out anytime soon (note that when French soldiers initially embarked to fight in the “Great War,” the majority expected to be back at home within a few months – which in retrospect, turned out to be unfounded, as most never came back).  More importantly, such reasoning can usually be forgiven, as 1) not many of us possess the necessary simultaneous expertise in political science, military strategy, economic and military history, and human psychology to accurately predict outcomes in these areas, and 2) in the absence of sufficient knowledge, it is just human nature to utilize inductive reasoning – especially when one is working over 40 hours a day at a day job that is paying middle class or minimum wages.

In his “treatise” on human intelligence, Jeff Hawkins asserts that the neocortex – the newest addition to the mammalian brain in terms of evolution and the component that is most responsible for human intelligence – acts as a kind of efficient depositary for all our past experiences, and then applies that knowledge to solve both existing and new problems.  For example, assume that you have just upgraded your computer from a desktop to a laptop machine.  Based on your prior knowledge about operating a desktop machine, chances are that you know – in a general way – how computers work and how to use your prior experience to function in your new laptop environment.  Machine intelligence, however, will not know how to operate something that is different (even if it is similar) without specific instructions.

Assuming that Hawkins' theory is correct, then extrapolating the most recent past into the indefinite future is the most simple function of human intelligence.  However, because humans are inherently “learning machines,” we also look back and study past events which we were never a part of – in order to learn from those past events and hope to apply that knowledge to solve problems (or avoid them) in the future.  Indeed, what Hawkins suggested in his “treatise” is that most or virtually all humans use inductive reasoning in their everyday endeavors – whether it is driving a car, doing a “Google search,” or investing/speculating in the financial markets.  However, as discussed by Nassim Taleb in his book “The Black Swan: The Impact of the Highly Improbable,” the most important events within the financial markets (the ones that have the most impact on your pocketbook) are “Black Swans,” or those that cannot be gleaned from historical experience or from charts alone.

Here at, we are, no doubt, fans of stock market history.  In the majority of cases, looking at both recent and long-ago historical records of the stock market have been immensely helpful for us – both in calling bottoms (calling tops is an “art form” that no human being can do, especially on a consistent basis) and in understanding where the stock market is heading over the intermediate term.  We have also been able to take all this data – some going back to the turn of the 20th century – and determine what is applicable, when, and why certain studies have worked in the past and when they may stop working.  In other words, while we have used a great amount of “inductive reasoning” in our commentaries over the last few years, we have always tried to go a step further and ask ourselves: Is this still applicable today, and if so, what is this study telling us?  For example, in our August 19th commentary (“A Quick Word on the Discount Rate and the “Ben Bernanke Grand Experiment””), we noticed that many bloggers and websites alike were discussing the record number of new lows achieved on August 16th – and why that this alone 1) constituted a severe oversold condition, and 2) meant that we are now bound to make new all-time highs in the major indices going forward.  In doing so, they have often cited that on the three prior occasions that this has occurred (namely October 19-20, 1987, August 23, 1990, and August 31, 1998) over the past 20 years, the market has always gone on and rallied ahead in the days and weeks ahead, and as such, now is the time to go heavily long in the U.S. stock market.  More specifically, the daily NYSE high-low differential ratio (number of new highs minus number of new lows on the NYSE divided by the total NYSE issues outstanding), hit a reading of negative 33.93% on August 16th – a level not seen since August 31, 1998, when it hit a reading of negative 32.71%.

While a great number of bloggers was asserting that August 16th represented a major bottom (as opposed to a short-term bottom, which we asserted at the time and still do), we stated that “nothing is obvious.”  First of all, three readings over the last 20 years are hardly significant from a statistical standpoint, and therefore have no prediction value whatsoever.  Secondly, prior to the October 19, 1987 reading – there have been many more instances since 1965 when this reading had reached similar levels – only to see lower lows in the stock market going forward, sometimes by a wide margin.  Moreover, during the times when such readings have resulted in lower markets, they have occurred very soon after the peak (such as late July 1969, or May 1973), similar to what is occurring today.  In other words, as opposed to be a “bottoming indicator,” this latest “oversold reading” in the NYSE High-Low Differential Ratio is merely a reflection of significant downside breadth in the current markets – a picture which is not too surprising given the strong breadth (in all sectors, market cap segments, and in both growth and value stocks as well) we have witnessed in the stock market ever since the current cyclical bull market began in October 2002.  I encourage our readers to go back and read our August 19th commentary for a refresher.

The kind of analysis that we mentioned above is the least that any paying subscription should engage in.  Using “deductive” as opposed to “inductive reasoning,” this author would have to say that – given all the things that we have discussed over the last few months (both in our commentaries and in our discussion forum) – the conditions for a “Black Swan” scenario in the financial markets today are still relatively many.  At the very least, what has worked over the last five years will need serious reconsideration.  A perfect illustration is presented by the following chart, courtesy of the Bank Credit Analyst:

Asset Inflation Breadth and U.S. S&P 500

In the above chart, the BCA asserts that the recent shakeout in “risky assets” is merely a manifestation of a maturing bull market – not just in stocks but in housing, commodities, and corporate bonds.  In other words, while a Fed easing should provide immense support for equities going forward (given decent valuations and given that the stock market is exhibiting the most relative strength), there is a good chance that we have already seen the top in many other markets – and this is the most evident when it comes to U.S. housing, various commodities, and various sectors of the corporate bond market (such as junk bonds).

In light of a narrowing bull market going forward, the short-sellers may – at last – get some general relief.  Unless one has been in a cave since March 2003, we all know that many active mutual funds with great long-term records, such as American Funds, Dodge & Cox, Columbia Funds, and Oakmark Funds have not been blowing past their benchmarks or benchmarks as much as they have in the past.  Another example is the two Legg Mason funds run by Bill Miller – who have had a very tough time over the last 18 months given his heavy underweighting in the energy and materials sectors – two sectors which have been leading the stock market over the last couple of years.  The underperformance by the mutual fund managers with a great long-term track record is – for the most part – a manifestation of the strong breadth in the stock market over the last five years – a bull market that has been characterized by strong earnings momentum in all sectors of the U.S. stock market.  In such a market, adopting a growth approach (which Bill Miller has done) doesn't pay, as investors no longer care about long-term earnings quality or pricing power – given that one can get the same earnings growth in, say, the steel industry versus the health care sector, for example.  However, if breadth is really narrowing going forward (and we are already seeing some of this, especially in the financials sector), then having the stock-picking skills of these managers will invariably pay off, as I expect to over the next two years.  Moreover, this will also pave the way for short-sellers to thrive, even should the S&P 500 rise to 1,800 over the next two years.  This was also true when breadth narrowed significantly during the final two years of the late 1990s bull market (the NYSE A/D line actually topped out in April 1998) – as the majority of the small and mid caps (with the exception of technology companies) were already in an established downtrend by early 1998.

Another indication that short-sellers may now be getting some relief is the fact that the Prudent Bear Fund (BEARX) – one of the few active mutual funds with a bearish bias – has actually exhibited positive performance in 2005 (+2.02%), 2006 (+9.10%), and so far in 2007 (+3.33% as of August 31, 2007).  Moreover, as of July 31, 2007, the Credit Suisse Tremont Dedicated Short Bias Hedge Fund Index (August data isn't released until the middle of September) was actually up 4.83% on a YTD basis, after declining 6.61% during 2006.  Following is a table showing both trailing and calendar-year performance information for both BEARX and the CS Tremont Dedicated Short Bias Hedge Fund index over the last ten years:

Prudent Bear Fund (BEARX) and the CS Tremont Dedicated Short Bias Hedge Fund index over the last ten years

 Again, the above data is as of July 31, 2007, as hedge fund data won't be released until the middle of September.  That aside, our sharp-eyed readers should notice one thing: The Prudent Bear Fund (BEARX) has actually been the best mutual fund in the bear-market category over the last three, five, and ten years.  While that may not be so impressive for some folks (according to Morningstar, there are only two other active mutual funds in this category – the Grizzly Short Fund and the Comstock Partners Fund – so there isn't that much competition in this field anyway), one should keep in mind that there are other bear funds in this category – those being inverse equity and inverse bond funds.  Going back 10 years, there is a total of 22 funds in this category, so there is, of course, some competition.  More impressively, BEARX has also managed to make positive returns during 2005, 2006, and 2007 YTD – periods where the S&P 500 have exhibited positive returns.

Interestingly, if one compares the performance of BEARX with the CS Tremont Dedicated Short Bias Index, BEARX also wins hands-down, suggesting that David Tice and his nine analysts had actually beaten the average dedicated short bias hedge fund manager on both a short and a long-term basis (after-fees).  Also, unlike many other actively-managed funds that can go long as well as short, BEARX is truly a net short-only fund (note that the fund does hold some long positions, especially in gold miners).  That is, if you are bearish and want to short the market via a mutual fund vehicle, you can do so via BEARX without having to worry that David Tice will go net long the stock market anytime soon.  Case in point: During 2002, the fund returned 62.87% - the top-performing fund in the entire U.S. mutual fund universe during that year with the exception of gold and precious metal funds.  Even Steve Cohen – one of the best hedge fund managers of all-time, “only” managed to return 15% or so during that tough year.

Finally, from inception (January 1995) to July 31, 2007, the fund has exhibited a beta of –0.90 (relative to the Russell 2000 Value Index, which is actually a better benchmark than the S&P 500 as BEARX usually holds both long and short positions of companies within the small cap value world), and an alpha of 14.28%.  Over the last five years, the fund has a beta of –0.48 and an alpha of 8.05% relative to the Russell 2000 Value Index.  From an up/down capture perspective, the fund had, over the last five years:

  • 31 up months vs. 29 down months, while the Russell 2000 Value had 39 up months vs. 21 down months.

  • An average upside monthly return of 2.43% vs. an average downside monthly return of -2.60%. On the other hand, the Russell 2000 Value had an average upside monthly return of 3.70%, vs. a downside monthly return of -3.02%.

  • Using the Russell 2000 Value as a benchmark, the upside capture was -29.4%, while its downside capture was -113.6%. In a nutshell, that means, on average, when the Russell 2000 Value is up by 1%, the fund loses 0.294%, but that when the Russell 2000 Value declines by 1%, the fund usually rises by 1.136%.

From a statistical standpoint, the above numbers are definitely very impressive.  Note that the above “analysis” of BEARX should not be construed as a recommendation for those looking to short-sell the stock market, but it is definitely a good starting point.  I also believe – for those who are not trading or investing on a full-time basis, that short-selling should be left to the professionals, especially only to those who can withstand sudden bursts of success separated by long periods of “Chinese water torture” when the stock market is rising – a trait which 90% of the general population do not possess (but which David Tice seems to have no trouble handling).  For those who are sincerely interested, I would recommend calling the company to learn more about its investment processes and the experience of both its managers and its team of analysts. 

Now, moving on, given that we have just approached the end of August, it is now time to update the readings of our “Global Overbought/Oversold Model” – a model that we first discussed in our August 2nd commentary.  As we mentioned in that commentary, the inner workings of this global overbought/oversold “model” are rather simplistic.  For each country or region, we first compute the month-end % deviation from its 3, 6, 12, 24, and 36-month averages.  Each of these % deviations are than ranked (on a percentile basis) against all the monthly deviations (against itself only, not deviations for other countries or regions) stretching back to December 1998.  This way, we are comparing apples to apples and can control for country or region-specific volatility.  Following is our Global Overbought/Oversold Model as of the end of August, 2007 (note that we have also added the CRB Total Return Index in this model for the first time):

Global Overbought/Oversold Model as of August 31, 2007

All the percentile rankings highlighted in yellow in the above table represent rankings below the 15th percentile, or one standard deviation.  That is, relative to the historical % deviations of the same country or region, the current % deviation is more oversold than 85% of its readings going back to December 1998.  Relative to the July readings, our global oversold/overbought model has gotten slightly more oversold, as a few countries that were previously not highlighted in yellow in our July readings (such as Belgium, Australia, Singapore, and Hungary) are now highlighted, even as the North American region is no longer highlighted in our August readings.  Finally – in a way – the narrowing breadth within the global stock markets can also be witnessed in the above table, as only markets in countries such as Finland, Hong Kong, and China remain strong, while the majority of the world's stock markets continue to remain moderately or very oversold.

Let us now discuss the most recent action in the U.S. stock market via the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from January 2005 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2005 to August 31, 2007) - For the week ending August 31, 2007, despite the strength seen later in the week, both the Dow Industrials and the Dow Transports actually declined - with the former declining 21.13 points and the latter 37.20 points for the week. While the Dow Industrials is still above its close from three weeks ago, the Dow Transports is now 1.7% below its close from three weeks ago, suggesting that the Dow Transports is still exhibiting relative weakness versus the Dow Industrials. Note that the Dow Transports has nearly always been the stronger index over the last few years - as it has always led the Dow Industrials on the upside and had also risen more than the Dow Industrials during that period. As such, the relative weakness of the Dow Transports during the last six weeks is not a very good sign. At the very least, it signals a change in leadership from more speculative into less speculative, and more blue-chip type of stocks.

For the week ending August 31, 2007, the Dow Industrials declined by 21.13 points while the Dow Transports declined by 37.20 points, despite the widespread strength of the U.S. stock market during the latter part of the week.  Again, while the Dow Industrials has more than retraced its decline from the previous three weeks, the Dow Transports is actually 1.7% away from its close three Fridays ago, and as thus, has continued to remain the weaker index ever since the latest peak on July 19th.  Given that the Dow Transports has nearly always been the stronger index – as well as a leading indicator – ever since the cyclical bull market began in October 2002, subscribers should continue to be cautious here.  Moreover, while we did get a good bounce in the stock market last Wednesday and Friday, my current indicators are still saying that wasn't enough – and most likely, we should not take any current rally seriously until most of the mutual fund managers (most hedge fund managers have probably canceled their vacations from the Hamptons or have a high-speed connection and Bloomberg Terminal set up in their hotel rooms) come back from vacation during the first week after Labor Day weekend.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The latest four-week moving average of these sentiment indicators again decreased (for the 5th week in a row) – from last week's 7.8% to 4.9% for the week ending August 31, 2007.  Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending August 31, 2007, the four-week MA of the combined Bulls-Bears% Differentials again decreased (its 5th consecutive weekly decrease) - this week from 7.8% to 4.9%. While this reading is now more oversold than both the April 2005 and the October 2005 bottoms, this author would prefer this reading to reach levels last seen in June 2006, or a reading of 2% or less. Bottom line: Until these readings reach more oversold levels - preferably to levels last seen in June 2006, there is still no major capitulation, and as such, we will continue to remain neutral in our DJIA Timing System.

Note that the four-week MA is now at its most oversold level since the week ending August 11, 2006.  However, as I have mentioned in the last few commentaries, this author would prefer to see an oversold reading similar to what we experienced during the June 2006 (1.7%) bottom before we go long in our DJIA Timing System.  For now, we are still reluctant – given the many reasons we have cited previously, as sentiment is mostly a secondary indicator and is only meant as a confirmatory signal for other more important indicators, such as breadth and volume of the stock market, as well as liquidity and credit availability.  For now, these latter indicators are still not flashing buy signals, and as such, we will continue to hold off.  Given the bearish readings in our most popular sentiment indicators, however, it will not take much for us to go long once our liquidity and most of our technical indicators are “in place.”  For now, we are still not there yet.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator for the stock market, and it has had a great track record so far according to the following Wall Street Journal article.  For the history buffs out there, you may notice that we have extended our study period further back from November 1, 2002 to May 1, 2002.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present) - Since hitting a 14-month high of 152.9 in late July, the 20 DMA of the ISE Sentiment readings has literally gone into freefall - falling to a low of 99.9 last Tuesday before perking up, which, along with the late March lows, was the most oversold level since November 4, 2002. Meanwhile, the 50 DMA rose to a 5-month high reading of 140.9 on July 19th, before finishing at 124.2 on Friday. Even though the 20 DMA is now severely oversold, this author would like to see the 50 DMA reach a more oversold level before going long in our DJIA Timing System - an oversold level similar to what it achieved (at approximately the 115 level) during the Summer 2006 correction and earlier this year during the late February to mid March correction.

Over the last week, the 20-day moving average of the ISE Sentiment actually started perking up – rising from 100.5 to 104.2 points, after falling to a low of 99.9 last Tuesday (the most oversold level since November 4, 2002, not taking into account the late March lows) – after just hitting a 14-month high of 152.9 as recently as late July.  While the freefall in the 20-day moving average is suggesting that retail sentiment has turned very bearish in the short-run (and therefore bullish from a contrarian standpoint), this author isn't going long just yet – as the 50-day moving average is still not close to being very oversold, and chances are that we will need at least a couple of more weeks to see an oversold reading in the 50-day moving average.  Until or unless the 50-day moving average decline to a similar level we witnessed during recent bottoms (approximately 115), we will continue to avoid a long position our DJIA Timing System.

Conclusion: In conclusion, I want to reiterate that the potential for a “Black Swan” scenario remains in place – especially given that we did not reach a “fully oversold scenario” during the early to mid-August decline.  For now, capital preservation is still the name of the game.  Moreover, while this may be getting to be a cliché already, there is no doubt that the stock market will most likely become more selective going forward, as the housing bust takes its toll and as both the liquidity and credit environment continue to remain challenged.  As such, the doors may become more open to short-selling going forward – especially to short-sellers who have, in the past, been able to generate significant amounts of alpha, such as the Prudent Bear Fund managed by David Tice (note that we do not have any relationships with the Prudent Bear Fund or its management, and that this should not be construed as a recommendation to buy the fund).  At some point over the next several weeks, I will most probably write more on long ideas in preparation for the inevitable bottom.  For now, we will just take it one day at a time, and be glad that we have not been caught in the latest downdraft and volatility.

Signing off,

Henry To, CFA

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