December 10, 2008

Reversal of Fortune...
OR Bear Market Bounce?

The question on many investors' minds right now: Have financial markets reached an extreme inflection point, at least in the short term?

Like a big rubber-band stretched to its breaking point, stocks and bonds could be in store for a sharp snap-back... in the opposite direction. A rally in stocks and sell-off in long-term bonds, from today’s extreme levels, would not be surprising. In fact, such a move may already be unfolding... here’s why.

Many historic comparisons have been made to this year’s unprecedented market stress. Investors are running away from stocks, commodities, and other “risky” asset classes at an unprecedented pace and for good reason.

In the last 12 months alone, stocks worldwide have lost a staggering $32 trillion in market value under extreme selling pressure. The benchmark S&P 500 Index plunged 40% in 2008 — its worst yearly decline since 1931 — during the Great Depression.^[I]

At the same time, investors are flocking to the relative safety of government bonds — and into cash. Money market fund assets rose for the past 10 weeks straight (ending Dec. 3, 2008), to an all-time record total of $3.74 TRILLION in cash held by retail and institutional investors.^[II]

While the S&P 500 stock index is the most OVERSOLD it has been since the 1930s... 10-year Treasury bonds have reached the most OVERBOUGHT levels in the past 30-plus years. In fact, the dividend yield on S&P 500 stocks (3.1%) now EXCEEDS the yield on 10-year U.S. Treasuries (2.7%) — a most unusual event — which shows you just how unusual financial market stress levels have become in 2008.^[III]

Given these conditions, it would not be surprising to see both stocks and bonds rebound toward the “mean” considering how extreme stock selling (and bond buying) has become. In fact, on Monday the S&P 500 closed up 20% from its recent low on November 20th — which "technically" puts stocks in a new bull market. Don't celebrate just yet.

A sharp rally does NOT necessarily mean the ultimate bottom is in for the stock market. Nor would a steep back-up in Treasury yields (falling bond prices) signal an end to credit market stress... not by a long shot. Remember, sharp rallies happen all the time — especially during extreme bear market conditions.

Considering the rapid deterioration we have seen in the economy recently, and continued high stress levels in credit markets, we are more likely to experience a temporary bear-market-bounce at this stage, than any lasting recovery in share prices. It’s critical to understand this and not to be lulled into a false sense of recovery when this bounce occurs.

Don’t forget, extreme volatility is the hallmark of most bear markets — the current climate should be no different from that standpoint — in fact, it may be even worse.

The chart above from Bespoke Investment Group’s blog shows us that volatility in the S&P 500 Index (as measured by the average one-day percentage move in the index over the past 50 trading sessions) has reached an extreme level never before seen in history! In fact, recent volatility has been about four-times what might be considered "normal." This unprecedented market turbulence has been even more intense than the 1929 crash, and the Great Depression that followed.

A closer look at recent market action illustrates the manic-depressive extremes we’ve seen in just the last few weeks. On November 19th and 20th, the S&P 500 Index dove 12.4% lower over a short two-day stretch. But then, stocks turned on a dime, rallying 13.2% higher over the next two trading days. This rally seemed to run out of gas when bears pushed the S&P 500 down nearly 9% on December 1st. But with visions of a Santa Claus rally coming to town, bullish investors bid stocks higher again last Friday and Monday, notching a two-day 7.6% gain.^[IV]

A trading environment like this one can give you a severe case of whiplash.

It’s very difficult to be an active trader in such a climate — even for professional day-traders who relish this type of action. But if you’re a long-term investor instead of a trader, then it’s very a good idea to be prepared for an unstable climate by hedging your investments, in anticipation of more whip-saw market conditions ahead in 2009.

In last week’s issue of Weiss Advice we discussed the Weiss Bear Strategy and the Weiss Managed Treasury Program; two programs we offer at Weiss Capital Management that are designed to help defend your wealth during a bear market.

Another strategy we offer is specifically designed to capitalize on the kind of intense market volatility we are seeing today. The WCM Sector Series ETF Sector Rotation: Concentrated Program uses ETFs to either go long (buy) the market or go short (sell) the market based on our proprietary signals.  This unique strategy gives you the potential to earn gains whether markets rise OR fall with the ability to invest — both LONG and SHORT — in stock, bond, and commodity-based exchange traded funds.

The Weiss ETF: Concentrated Program rotates its ETF holdings among various market sectors and asset classes to take advantage of changing financial market conditions. The goal is to maximize returns through all market cycles: up trends, downtrends and directionless markets.

In today’s market, this ability to  “switch-hit” between long and short investment can help your investments survive and thrive in volatile conditions.

Bottom line: If you’re an active investor, then it’s critically important to remain nimble in today’s volatile market climate. A flexible approach that includes BOTH long and short investment holdings may be among your “best-bets” until we see a greater degree of stability return to financial markets.

In the next issue of Weiss Advice, we’ll take a closer look at our expectations for the economy and financial markets in 2009, with some detailed discussion on how long this recession could last. For now: stay on your toes and keep your investments well hedged!

Mike Burnick
Director of Research & Client Communications
Weiss Capital Management, Inc.

^[I] Bloomberg: “Cheapest Stocks Since 1995 Show Cash Exceeds Market”, 12/8/08
^[II] Cumberland Advisors: “None. Zilch. Zip.”, 12/7/08
^[III] Bloomberg data, 12/8/08
^[IV] Bloomberg data, 12/8/08