Use Leveraged ETFs to your advantage

Leveraged ETFs have gained a lot of popularity, and some scorn, in their relatively short history. They are popular because they allow retail investors to take aggressive positions without using margin or buying options. Inverse ETFs, whether they are leveraged or not, allow investors to short indices without a margin account. These funds are disliked because they do not accomplish what some might expect them to, which is to double the returns of the underlying index over an unspecified time period.

Exiting a foul trade from last year

On July 30 of last year, I recommended taking a long position in the market as I considered it oversold on a short-term basis (using the CRB Stock Market Momentum Indicator) and was anticipating a bear market rally. As it turned out, the market was just in the beginning stages of a massive collapse and the trade turned out to be a miserable one. A closing signal for this trade finally came after the close on June 17. During the 323 days the trade lasted, the S&P 500 fell 27.4%. A graph with entry and exit points for this trade is shown below as well as a table with historical results from this momentum trading strategy.

Time to play defense

We now have two consecutive unprofitable signals. To keep that in context, these signals have come during what has been one of the most vicious bear markets in the last hundred years. I have not lost faith in the usefulness of this momentum indicator as a timing tool, but to avoid blunders of this magnitude in the future I will be using a stop-loss rule for the trade. Furthermore, given the current overbought conditions, I think this is a good time to close some long positions or perhaps sell near-the- money call options on existing long positions with expiration anywhere between July and October.

Jon Stewart and personal responsibility

With all the ranting going on everywhere these days, I feel entitled to indulge in a rant of my own. My beef is with people who are unwilling to take responsibility for their actions. I will use as an example Jon Stewart’s public flogging of Jim Cramer about a month ago. Stewart is in the habit of engaging in serious discussions while hiding behind the cover of being a comedian. It would be just as ineffective if someone serious, such as Larry Summers or Alan Greenspan, were doing stand-up comedy while regularly reminding the audience that he is an economist and should therefore not be expected to be funny.

Inflation risk is underpriced

One of the many unusual things in the financial markets these days is the relationship between the growth in the money supply and inflation expectations. At the same time, as unprecedented growth in the balance sheet of the Federal Reserve is taking place, inflation expectations, as witnessed by the narrow yield spreads between inflation indexed treasuries and regular treasuries, are extremely low.

Low inflation expectations

Inflation expectation for the coming 12 months, as measured by a University of Michigan survey of consumers, have been coming down rapidly, from 5.1% last July to 1.7% in December. Given the current weakness in the economy and falling commodity prices, it is perhaps not surprising that people are expecting low inflation in the near term (although deflation fears seem to have diminished recently).

Is long-term investing dead?

Recently, many people have been denouncing buy-and-hold investing. Among phrases heard: “long term investment died as a thesis” this year. Of course, these voices are featured most prominently after a huge fall in the market, when the outlook for returns from long term investments has actually improved.

The best example of this is a Business Week front-page story titled “The Death of Equities,” published in August of 1979. Then, as now, investors were weary of a long, painful bear market. The story didn’t mark an exact bottom in the market, however in the two decades that followed the S&P 500 increased more than tenfold.

Creating a shopping list for the coming year

As simple as “buy low, sell high” sounds, events and sentiments seem to conspire to get us to do just the opposite. Stocks are cheaper than they have been for a long time. The S&P 500 index, currently at 930 points needs to climb 18% to reach the closing price of October 30, 1998. Yet, as high as stock valuations were in 1998, people were generally very eager to buy stocks then, just as people cannot seem to get rid of stocks, or any risky assets, quickly enough now. Given the uncertainties ahead it is understandable that many investors are waiting to see clear signs of a bottom — there is nothing to keep cheap stocks from getting cheaper. However, bottoms are only visible in hindsight. For those who are fortunate enough to have some cash on the sidelines, there are some enticing opportunities for deployment.

One of those Septembers

Historically, September sticks out as a noticeably poor month in the stock market. In fact, it is the only month that has yielded a negative return on average since 1926. This September is likely to reinforce that statistic. The current slide in the stock market may have more to do with unusual events than with seasonality, but then again it may not. The credit crisis has been unfolding for over a year and it is quite possible that an already weak market was pushed into distress by seasonal weakness. In other words, it did not necessarily have to come as a surprise that stock and credit markets would be pushed to their limits in September.

To trade or to invest

Different factors affect stock prices in the short run and the long run. In the short run, recent and imminent developments as well as investor psychology matter most. In the long run, however, the fundamental viability of a business matters more as the intrinsic value of a business is realized in the market sooner or later. In the words of Benjamin Graham, known as the father of value investing: “In the short run, the market is a voting machine but in the long run it is a weighing machine.”

Graham and his disciples, the most famous of whom is Warren Buffett, choose to focus on the long term by finding stocks that are underpriced relative to their intrinsic value. For Buffett and many others, this has worked very well. Of course, many have also done well by focusing on shorter term price movements in the markets. While this is frowned upon by some value investors and not always feasible for casual investors, people who are serious about their involvement in the markets have all the options at their finger tips. They only need to think clearly about their time horizons.

Playing the bear market rally

The recent slump in the market occurred rapidly and indicates oversold conditions. My preferred method of monitoring — and acting on changes in — momentum in the market is the Stock Market Momentum Indicator (SMMI), as constructed and calculated by CRB. I had been anticipating a signal and it finally appeared after yesterday’s close.

The last time this indicator flashed a buy signal was on August 31 of last year. I wrote about the signal at the time and gave my reasons for taking action cautiously. In short, the market was still near peak levels, a credit crunch was starting and the economy seemed to be heading towards a recession. The caution was warranted, as the signal, which closed on May 29, turned out to be the only unprofitable such signal since the indicator’s inception in 1994.

Investing in Africa

As discussed in my last post, getting exposure to the markets’ least developed economies is hard to do with exchange-traded funds. The African continent seems to garner only slightly more investor interest than Antarctica and that interest has thus far mostly been focused on Africa’s most developed countries.