The markets can surprise us to the upside and the downside. In spite of the market setting new lows, and now down about 57% from its October 2007 high, the AI 75-50 Portfolio is accepting more downside risks while ready to change course and re-short Beta risks.

Although we expect lower lows before this bear market ends, AI 75-50 knows its limits. The portfolio has met its downside objective of experiencing no more than half of the S&P's bear market loss. We have about 26% to spare, which gives us bullets to fire.

Our "Clint Eastwood Moment"

Our aim is to hit some upside targets and then run for cover. Before turning our focus on our long/short ETF portfolio, we will define what's good, bad and ugly for stocks, the economy and asset classes.

The Good (For Stocks As A Discounting Mechanism)       

Since the Great Depression, our nation is less dependent upon manufacturing. We are a service economy with less than 8% of GDP derived from making products. The foreign emerging economies now produce the world's goods. Manufacturing requires more labor than our service-based economy, heavy equipment and inventories. Although emerging economies grow much faster than our own, they are prone to bigger booms and busts, much like our experience from 1850 to 1968. These factors are being more heavily discounted in foreign equity markets today than they were during the Great Depression. Consequently, U.S. markets may be close to fully discounting a lesser great depression, which historically bottomed near current levels.

The Bad (For The Economy)

Many investors know the worst bear market in the U.S. was an 86% decline in nominal and a 76% decline in real terms (net of deflation), which took place during the calendar years 1929-1931. Few investors realize that during these years, a composite of global stock markets was down less than the U.S., -64% nominally and -54% after deflation. Globally the current bear is much worse than the one experienced during the Great Depression in real terms. Global stocks, excluding those in the U.S., are down about 61% nominally and 64% in real terms, while the S&P 500 is down 57% and about 60% after inflation (see Figure 11, last column for exchange-traded fund equivalents).[1]

From the above, it is reasonable to say that global markets are pricing in a Great Depression. While anything is possible, it is probable that Mr. Market is correctly pricing a 19^th century-style depression. Lesser great depressions have experienced negative real gross domestic product (RGDP) growth steeper than 10% but less than 20%. If so, a 12%-or-higher unemployment rate may result. This rate would be equivalent to an unemployment rate near 16% if calculated in the same manner as in 1982, which was the last time unemployment neared 12%. We are approaching economic conditions that rival past depressions.

The Ugly (For Asset Prices Not Lifted By High Inflation)

The current production-consumption structure also makes it likely that our flirtation with deflation will be brief, if at all. Our nation's dependency on foreign capital will result in high inflation and slow economic growth. The powers that be will do everything they can to lighten private, public and consumer debt loads with cheaper dollars. Long ago, the economist Milton Friedman posited that inflation is always a consequence of government policy. Federal Reserve Chairman Bernanke is the expert on the Great Depression.

His playbook for avoiding another Great Depression borrows much from Mr. Friedman. However, their defense against deflation also relies upon their ability to rein in their expansionary monetary policies after economic growth improves. Bernanke and the Friedman crowd (including Greenspan) are on record saying that bubbles (in stocks, credit and homes) can only be seen after they burst.

Many in 1999 and 2006 saw and warned of the wreckage to come from the wakes of bursting bubbles. The Fed could have read these works and acted prudently by first talking down exuberance, and if needed, raising investment margin and then if needed, the Federal funds rate. How then will they know when conditions are right for reining in $10 trillion in stimulus? Their task is impeded by a world swimming in U.S. dollars at a time when our nation is too dependent upon foreign capital.

Eric Janszen of www.itulip.com taught me that as a nation's GDP and Federal funds rates approach zero, the cost of their goods and services either deflate or inflate. Like Japan since 1989, deflation is the outcome only if the nation can internally finance its deficits (stimulus & debts). Contrarily, nations like the U.S., when faced with the same circumstance, will most likely experience high inflation and subpar (or worse) growth.

Why? Foreign creditors are in a global crisis that requires them to stimulate their domestic consumption and to diversify sovereign wealth where they can harvest the highest real returns.[2] They tried a Financial sector lead world order. They recognize its instability. They will shelter themselves from it by building a stronger domestic consumer-based economy. Our nation will eventually do the inverse: We will produce more and consume less.

Investors can read additional research for details on this view. Nouriel Roubini, Chris Whalen and Martin Feldstein are good sources of information.[3]  

Applied Research

Our focus is on understanding economic fundamentals in a manner that preserves risk-capital for hedging and advancing portfolio values. Fundamentals drive price trends until others recognize that the fundamentals no longer support prices. This is true for cheap and dear assets. Fundamentals and raw prices are quantitative, while investor recognition is behavioral (fear-greed). For a grasp on how to tie economic fundamentals with trading and investment opportunities, my favorite sources are John Murphy, Jim Rogers, Victor Sperandeo and George Soros.

Earnings & Recovery

Issue 1 of our February 2009 InFocus raised the possibility that trailing 12-month reported earnings (TMT) for the S&P 500 might crash from near $86 in 2007 to about $16 by 2009 Q2. Analysts at Standard & Poor's Equity Research are entertaining this result. Sixteen dollars is only 12.5% below S&P‘s $18.29 estimate for S&P 500 companies for all of 2008 (Figures 1 & 2). Figure 1 was first published in the July 2006 Active Indexer.

It was adapted from research that I published in Corporate Finance Review (Thompson Financial) in 1998, which included contributions from John P. Hussman, Ph.D, who was then a professor at the University of Michigan. John is now the founder and portfolio manager of Hussman Funds. Figure 1 is at the heart of John's investment thesis. A pillar of his thesis is that stock valuations are supported by earnings growth that has averaged 6% annually since 1940 (red trend line). Hussman calls it the sustainable growth line, which is at the core of stock returns. Stocks are fairly valued when their reported earnings trend line (green) hugs the red line.

Extreme readings above and below the red line are periods of extreme over- and undervaluation. Since 1940, the greatest overvaluations were near Peak Earnings in 2000 ($54) and in 2007 ($85). Stock were cheapest near trough earnings in 1982 ($13), 1987 ($16), 1991 ($16) and 2002 ($25). TMT estimates are $18.29 for 2008 Q4 (-79% below peak 2007 earnings).

A table from Standard & Poor's is in Figure 1. It shows a -73% crash in earnings from 2007 Q4 to year-end 2008 with a price-to-earnings ratio (P/E) of 38.31. Their TMT estimates for 2009 Q2 range from $14 to $16.

The S&P is near trough earnings levels that have rewarded investors handsomely since 1940. Our investor appetite is restrained by a climate that resembles a world more like the one that existed prior to 1940.

Figure 2 was updated. It first appeared in Defend & Advance and Panic P/Es at http://www.indexuniverse.com/ in March 2008 and October 2008, respectively. Our defensive posture since May 2006 was warranted. Since October 2008, reported earnings have collapsed from $52 to $18. Panic P/Es found eight credit panics since 1873 when stocks troughed near 12 times (x) deleveraged earnings. Figure 2's 12x results are all negative. They put S&P prices well below levels seen at 16x TMT (the mean leveraged P/E). De-leveraged troughs will ultimately support a bottom near 219 to 607. A bottom about 11% below the S&P's March 5 price is likely because we are near the final solution for our debt crisis centered around dollar debasement, which will likely keep the S&P near 600 (nominally).

The Paper Panic

Paper stocks are one of my favorite leading economic indicators. They lead broad market price indices by a few weeks to a few months. The Dow Jones U.S. Paper Index ($DJUSPP) did not plunge as much as the S&P 500 ($SPX) during the 2000-2002 bear market. Paper stocks did not fear a severe recession during the last bear. The S&P plunged 47% then because the largest 100 Technology-Telecom stocks represented 38% of $SPX, which raised the index's P/E greater than 40 when the market was near its peak in earnings.

A paper panic began in May 2007, five months before $SPX's price peak in October 2007. $DJUSPP knew that $SPX was a paper tiger as it rallied in spite of widening credit spreads and a collapse in commercial paper prices during the summer-fall of 2007. Study Figure 3 for insights gleaned from its price trend overlaid with $SPX. Paper and credit spreads (not shown) knew that we were headed for the worst economy since the 1930s.

Paper stocks are low-quality assets (LQ) that lack consistent earnings growth. Notice that the trend lines for DJUSPP and S&P TMT earnings have both plunged since 2007 Q2. In the future, they will trough together with $DJUSPP basing as earnings begin to rise.

Notice too in Figure 1 that near peak earnings, it is wise for investors to overweight their stock holdings in high-quality (HQ) firms. HQ firms have strong balance sheets, ample free cash flow and consistent dividend growth. In 2006, our views on credit helped us to determine that a sampling of HQ stocks would exclude the Financial sector. Fundamental analysis determines what stocks are in your HQ basket.

Savvy investors ride on the backs of LQ stocks as TMT rises above the red trend line, and then jump off to ride HQ as TMT drops below Hussman's sustainable earnings line. Today we are near a trough in TMT earnings and low-quality stock prices. Consider that it is time to buy LQ stocks and to nimbly hedge your holdings with short positions (inverse equity ETFs) and corporate bonds (equity substitutes with equitylike returns). Given that there is a high likelihood that we are 10% to 20% from a capitulation low, the AI 75-50 portfolio is reducing short and gross portfolio weights.

The Best News Yet - This Week's $NDX: $SPX: & $NDX: IYK Ratios

Issue 2 of our February 2009 InFocus looked at the NASDAQ 100 as buying offense. I prefer to track the NASDAQ 100 ($NDX) as the numerator in ratios to broad market and sector indices. $NDX represents growth with large growth companies absent the Financials found in most broad indices (like $SPX). No one wants signals contaminated by Financials.

An indicator of an appetite for future growth, like the $NDX: $SPX ratio, is a measure of sentiment. It measures the relative strength of large company growth stocks to the S&P 500. $NDX: IYK tracks the relative strength of growth stocks to consumer noncyclicals. Over the past few months investors, have been willing to purchase cyclical growth ($NDX) over more stable earnings growth (IYK). This a good sign, in that they are looking past the current economic contraction.

Figures 4 & 5 display both of these $NDX ratios rising since the market's November 2008 low and its new March 2009 lows. This pattern is constructive for building a firm base off the market's ultimate low. If this ratio remains above 1.44 over the next 3-6 months, it enhances the odds of at least an intermediate term bottom for the S&P 500 near 600-650. Someday, with hindsight, the bottom might lie in this price range.

Although $NDX: IYK (Figure 5) has failed to record a new high like $NDX: $SPX, it has made a series of higher highs and lows since November 2008. This chart tells us that investors are not liquidating assets in fear, and are discriminating between firms with weak and strong future earnings.

After a strong rally from late December 2008 through January 3, 2009, high yield bond prices have declined 20% and have repriced a Great Depression as they did in November-December. HYG is attractive here, even though in 2009, it has trailed investment-grade (LQD), foreign (GIM) and inflation-indexed (TIP) bonds.

Treasury notes rallied recently partly because the British government has begun a policy to purchase its government and corporate bonds, which fueled speculation that the U.S. would too. Government suppression of rates is temporal. U.S. Treasury notes are expected to rise to near 5% over the next 6 to 12 months.

Figure 9 has not been updated since it was constructed on February 27. Closing below the November 2008 lows on a month-end basis was very bearish in relation to price and timing. Month-end closing lows are more significant than weekly or daily readings. Since then, the S&P has plunged another 7.3% on high volume.

Most investors view gold as an inflation hedge. Historically it has been a storehouse of value during times of inflation and currency devaluation. Gold rose with the dollar during the Great Depression as long as the dollar's conversion to gold was stable. President Roosevelt debased the dollar by reducing its conversion rate to gold on April 18, 1933. By July 1933, the dollar had declined by about 40% against the British pound. By the end of 1933, virtually all countries had devalued, and an economic recovery began.

Since today's dollar has no ties to gold, when economic growth rates collapse as they did in the fall of 2008, gold declines and the dollar rallies as foreign dollar debts are called. This negative correlation lasts as long as global investors are confident that the remedy for declining growth rates and stock prices does not entail severe currency devaluation. Figures 10 depicts the recent negative relationship between gold (GLD) and gold stocks (GDX) to the dollar (UUP). It was mostly negative until mid-December 2008. Since then, it has been quite positive. Between GLD and GDX, GLD is the best hedge against currency devaluation.

Doing Nothing Since February 2008

As indicated in my February 2009 Active Indexer column at http://www.indexuniverse.com/, the best course would have been to have stayed with our February 2008 allocations while timely covering our shorts during the fourth quarter of 2008. No changes since then would have resulted in 7.8% and 7.3% positive returns over the past 12 months, and for year 2008 versus the AI 75-50 Portfolio's -10.5% and -2-2% results for these periods.

A static allocation bested our active allocations by 18.3% and 9.5%. How? Instead of selling Consumer Staples stocks (FDFAX), 1-3 year Treasury Notes (SHY) and Health Care stocks, and buying Energy Income & Growth Fund (FEN) and Macquarie Infrastructure (MIC) in June 2008, we should have stayed with an original Beta, Non-Beta Mix. Over the past 12 months, our best-performing long positions were the yen (FXY), gold (GLD), Consumer Staples (FDFAX), 1-3 year Treasuries, and Health Care stocks (VHT). The best shorts were the carry trade (DBV), emerging market stocks (EEM), the S&P 500 Equal Weight (RSP), Basic Materials (SMN) and Consumer Discretionary stocks (XLY).

We began to cover shorts in September 2008, covering all by November 21, but we were too early to sell defense and buy offense. Our sins contributed to our worst month-end drawdown, of -17.5%, from February 2008 through October 2008.

AI 75-50 recovered nicely from November 21 through January 2009, with a 14.6% gain. We beat our benchmarks handily. Trading in the most volatile 90-day period on record (September through November) was very stressful. Very few investors were prepared for the massive liquidation and the pounding that stocks and credit took during the Panic of 2008.

The Do Nothing Results is proof that our Beta - NonBeta asset allocation process is sound. It entails recognizing Betas on the Cusp (low beta assets behaving like beta assets). We covered this process in more detail in: Defend to Advance: Minsky Moments.

Portfolio Exposures & Convictions

Figure 11 is a focused list of indexes and asset classes (we keep an eye on many more) and corresponding exchange-traded funds (ETFs). Returns are through March 1, 2009. AI 75-50 portfolio weightings are labeled in the third column. Red highlights are for sectors that were shorted through 2x inverse ETFs (Figure 13). Our long ETFs are either overweight (OW) or neutral weight (NW) relative to the Dow Jones Global Index.

Here we show YTD returns of 2x inverse ETFs before selling all of QID, ECC and SMN in late February and in March 2009. These sales might aid our objective of capturing 75% of the S&P 500 upside.

AI Portfolio Performance

Like the Hedge Fund Research Global Hedge Fund Index (HFRX), AI's secondary objective is to provide an absolute return (consistently positive returns). Neither hedge funds nor the AI 75-50 Portfolio have done so since the S&P 500's peak in October 2007. AI 75-50 has outperformed its benchmark, HFRX and the S&P 500 (Figure 14). AI 75-50's primary objective is to capture 75% of the S&P's upside and 50% of its downside, which requires us to hedge S&P beta nimbly while maintaining core Beta (equity and bond exposures). The portfolio's 11.1 annualized standard deviation (ASD) is higher than that of HFRX, but much lower than that of the S&P since the market's peak.

Upside & Downside Risk

Our estimation is that there is significantly more risk from being too short (low Beta exposures), which reduces future returns. The market is extremely oversold after being down about 60% since its prior peak. Oversold Panics, even those that lead to depressions, experienced 30% to 90% countertrend rallies while remaining in a bear market.

Even if we are wrong in hindsight for enhancing Beta exposures now, AI 75-50 should still best the S&P 500 if the S&P's 660 price support fails and stocks trade down from here. If so, the market should give us an opportunity to reduce Beta and reestablish defense as we did in December 2008 when we added EEV, SCC and SMN. We also added QID in early February 2009, and then sold all 2x inverse ETFs except for EEV, which we are attempting to sell at $80.

The PowerShares DB Crude Double Long ETN (DXO) was also added in late February as a proxy for Energy sector beta. Crude will turn up in anticipation of economic recovery. DXO is no enterprise risk. We will sell DXO at $3 and then employ the proceeds to buy Energy sector shares. Our time horizon for this trade is 12 months, or as soon as it hits $3, which should be met if crude prices rise to $50 per barrel.

All positions and our strategy view for each holding are listed in Figure 15 along with our Beta-Non Beta allocations and themes (see Defend to Advance: Minsky Moments ). Our strategy objective has been to reduce gross exposures and to increase net long exposures over the past three weeks as the S&P 500 nears a 62% retracement of its entire gain from August 1982 through October 2007. If this level is breached, the next major price support level is in the 450-500 range, which sets up beta assets for significantly more downside risk in spite of the market's oversold condition.

Month to date (MTD) as of March 6, 2009, we are down 2.5% while also down 1.5% year to date (YTD). Our strategy is also more dependent upon hedging inflation over deflation risks, which has caused us to be down since our 4% gain in January 2009. Deflation concerns have dominated since the market broke its November 2008 lows late in February 2009.

Endnotes

1. Giles Keating & Stefano Natella, Credit Suisse Global Investment Yearbook, February 2009, page 6.
2. Mohamed A. El-Erian, CEO of Pimco, and author of "When Markets Collide: Investment Strategies for the Age of Global Economic Change," a timely alert to the fundamental changes taking place in today's global economic and financial systems.
3. John Serrapere, Driving Mr. Market, Fundamentals Lead, Meet Mr. Credible, Active Indexer, March 18, 2008

John Serrapere is the investment analyst and portfolio strategist for Foster Holdings Inc. in Pittsburgh. He also works on research and consulting projects through Arrow Insights.