Weekly Market Commentary, February 26th 2008

Sean Hannon

Posted on Tue 26th Feb, 2008 05:00:50 PM

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                 In theory, investing is simple.  Determine a stream of cash flows, plug in a discount rate and let the math work.  Simple.  However, as the stress we have witnessed in quantitative hedge funds over the past six months shows, investing is anything but simple. 

                When I graduated college and headed to Wall Street, I was excited about the future.  Armed with a solid business degree and mountains of enthusiasm, I thought I would constantly learn new techniques, improve my skill sets and determine how to profit in today’s international financial system.  Knowing there were many traits I would need to develop, I expected the learning process to be long.  However, I did not expect it to be infinite.

                What I could not appreciate at that early age is how complex and changing the financial markets can be.  If you are looking for concrete answers, this is not the proper industry.  If you are looking for a continual challenge that never ceases, you are in the right place.  Over time, markets adapt and change.  What was relevant information in the past no longer matters?  Information once deemed esoteric now controls everyone’s attention.  The ability to anticipate and react to theses changes is what allows one to survive and thrive.

                The first two months of this year are among the most confusing I have witnessed.  During the fall of 2007, I was bearish in general and particularly bearish on the technology leaders (i.e. – Google, Apple, Research in Motion).  While bearish bets on these stocks had not worked during 2007, the last two weeks of the year showed that weakness was coming.  I positioned myself short of these names and reaped large gains during the first few weeks of 2008.

                As the technology leaders slumped, commodities held firm, all the major indices dropped and long-term values became apparent.  From my view, this was the perfect scenario.  I profited from my shorts, redeployed profits into core holdings and waited for success.  While the Dow Jones Industrial Average (DJIA) initially bounced of its January 22^nd lows and rallied 7% over 8 trading days, the market then faded and pulled within 2% of its prior low.  Was this another chance to add equity exposure or was the prior reaction a bounce that was unwinding?

                I settled upon the former and began adding to my portfolio’s equity position.  Over a few weeks, I increased my portfolio exposure from 40% long to 80% long.  While doing this, I expected the markets to reflect fair value and move higher.  Instead, they bounced, drifted and showed little life.  By mid-day Friday, February 22^nd, the DJIA was within less than 2% of its January low. 

In the current environment, traders have been unwilling to hold stocks over the weekend and Fridays have had a down trend (i.e. – during 2008, February 1^st is the only Friday that has finished with a positive change on the DJIA).   With the market fading, I expected a technical breakdown that could jeopardize the market’s chances of moving higher over the coming weeks.  Then a late day news release about rescue plans for the monoline insurers led to a fierce rally that nearly erased the day’s losses.  The rally continued Monday as the DJIA rose 189 points.  Within little more than a trading day, we went from imminent breakdown to a potential bullish break higher.  Who said the markets were easy to understand?

Where do we go from here?  I still believe there are handfuls of stocks that look strong and can move higher.  At the same moment, many stocks appear broken and will most likely head lower.  This offers the opportunity to implement your research and profit from the disparity.  My approach has been to buy beaten down, undervalued companies, maintain a sizable position in commodities, increase my general equity exposure via index products and look for opportunities to trade both long and short of stocks where I view strong technical patterns to hold.

Although this approach appears sound and reasonable, a prudent investor must always consider adverse outcomes.  While the inclination of most commentators is to focus upon facts that support their point of view, I will resist.  My concerns about this market are many.  As the DJIA has received countless negative news stories about the credit crisis, housing disaster and pending recession, it has held above the January lows.  However, volume has been light and institutions have not shown conviction.  Only when I see large buyers entering this market at any price will I believe the worst is behind and we can head higher.

On the trading side, how do you trade around some of the former hot technology names that have since crashed?  As an example, consider Apple (AAPL).   During 2007, the maker of iPods rose from $83.27 to a high of $199.83 (140%).  Since it achieved that peak price on 12/28/07, Apple has declined to a closing price of $119.74 on February 25^th (a 40% drop).  The current price is in line with where the stock traded in May 2007.  How do you trade this stock?  After all, if you liked the price near $200, you must love it at $120.  Also, if you shorted near $200 and have reaped a gain of 40%, shouldn’t you cover?  This logic would lead you to take a bullish view of the stock.  Over the past week, that view would have lost you money.

So the question remains, how do we navigate this market?  My answer- carefully.  While I am still 80% long of this market, I am warily watching events unfold.  Beaten down stocks like Apple offer opportunity as well as risk.  Indices looking to head higher offer opportunity as well as risk.  Today, the best approach is to focus upon valuations, take position sizes you can manage and watch for events that could alter your view point.  In an ever changing, confusing market, flexibility and an open-mind are the most important attributes.