Insight of the Week

Last week's point of the week was that the markets would bottom with a waning of severe deflation fears. Our view was that the first waning had begun. For the week ending March 13, this change in sentiment was most evident in 12.9% and 8.0% rallies in emerging market debt (EDD) and domestic high yield bonds (HYG), as well as a 1% move in Treasury Inflation Indexed Bonds (TIP) and a 12.3% surge in global equities (VT).

Last week, Betas on the Cusp—assets that normally display no or low beta but express high beta during debt deflations—also got their mojo back. Commodities and gold stocks did not rally with stocks. They were flat to down slightly. Most importantly, they did not sell off as stocks rallied, which is normal when inflation fears are greater than deflation fears. Absent extreme panic, inflation hedges display slightly negative to slightly positive correlations to stock prices. We anticipated that this change in sentiment would soon lift asset prices. Since we have covered this thesis thoroughly before, this paper is letting price (Figures 1 through 6) support of our views.

Below is a histogram of the percent of stocks trading above their 200-day moving price average ($NYA200R). It is plotted with the returns of the Nasdaq 100 ($NDX) divided by returns of the S&P 500 ($SPX) (the $NDX to $SPX ratio or $NDX:$SPX). Figure 1 overlays strength and weakness in this ratio to weekly readings in $NYA200R.

Generally, 50% or more of New York Stock Exchange (NYSE) issues trade above their 200-day moving price average during bull markets. Anything less is evident in bear markets. Extreme readings below 20% are only common when the equity market remains oversold for protracted time periods (usually declines greater than 25% without a new price high for more than six months).

On February 24, in Issue 2 of Arrow Insights' In Focus weekly review, the Nasdaq 100 Index ($NDX) was introduced as the numerator in various relative strength ratios. $NDX represents large growth stocks without Financial sector representation. The appropriate ratios can measure sentiment for risk appetite. When $NDX rises relative to defensive sectors such as the Consumer Noncyclicals (IYK) and broad indexes such as the S&P 500 ($SPX), investors are more willing to invest for future earnings growth than they are when these ratios decline.

From July 2006 through August 2008, investors preferred $NDX over $SPX. They abandoned growth stocks more than the broader market as investors panicked over credit default and deflation risks in September, October, to November 20, 2008. The $NDX:$SPX declined 11.2% as $NYA200R collapsed from near 40% to less than 5% during this period. $NDX:$SPX rose 18% from $SPX's November 2008 low at 741 (not shown) in spite of $SPX setting a new low at 667 on March 9, 2009. A waning of deflation fears near last week's lows was evident with more stocks above their 200-day moving averages ($NYA200R) than there were at last fall's lows.

Although these measures may seem miniscule, in an extremely oversold market, they are very significant when confirmed by lower realized and implied price volatility on S&P 500 stocks (VIX) and other measures of sentiment. In Issue 3 (March 9, 2009), Figure 3, the VIX was shown declining from 87 to below 45 even as stocks were at prices not seen since 1996. Figures 2-4 also lay a foundation for additional strength in stock prices over the next few weeks to months. Strong rallies are common in bear markets. The $NYHILO records the 10-day average of the stocks trading on the NYSE that are hitting new 52-week high prices minus those setting new 52-week lows (Figure 2). Like $NYA200R, this indicator normally trades above 50% in bulls and below 50 in bears. Over the past couple of weeks, it also has remained above its November readings as the market recorded a series of new lows in late February and March 2009. Again, the November lows held, which may support a bounce in equities until $NYHILO nears 40.

Figure 3 displays weekly new 52-week highs minus new 52-week lows ($NYHL). It shows $NYHL's trough near -2400 issues during the second week of October 2008, when security liquidations by investors peaked. It was also when investors began to fear that a $700 billion government bailout for financial institutions might not prevent a severe recession, exasperating credit defaults and asset deflation. Last week, as the S&P 500 fell 10% below its prior trough, the $NYHL never fell below -800. The moving average convergence/divergence indicator (MACD) was also nowhere near the levels seen near last November's lows.

Point Of The Week

The point of the week is this: The markets have most likely made intermediate-term bottoms on March 9 that may take the $SPX back to the 850-950 price level over the next couple of months. Figure 4 supports our decision to embrace more beta (selling inverse ETFs) over the past few weeks. It shows that the market was recently at the nadir of its 12-day price channel. This oversold condition often is followed by an immediate rally back to the channel's midpoint at 1087. Although we do not expect it, a 1087 price is more likely if the market continues to gain strength after some backing and filling over the next 12 months. Our aim is to add back short positions near 850 or when the $SPX rises 27% above its last low. So far, it has climbed 13.5%, which is halfway to our initial target.

Model Portfolio: The Arrow Insight (AI) 75-50 Portfolio Long/Short Exchange-Traded Funds (ETFs) & Closed End Funds (CEFs)

AI's Axiom: "Capturing desired source returns while avoiding unwanted beta and limiting default risk."

Primary Objective: 75% of the market's (S&P 500 Index) positive and 50% of its negative returns over 12-month periods. This profile drives the model's strategic allocation and tactical trades.

Secondary Objective: The portfolio satisfies a need to employ a capital originally allocated to hedge funds into a proxy but without their baggage (excessive fees, limited transparency, illiquidity and high business risk). Consequently, AI 75/50 has an absolute return objective consistent with meeting our primary objective over 36-month rolling time periods.

Summary Objectives: AI 75/50 first seeks capital appreciation while attempting to provide positive returns over all 36-month time horizons since the portfolio's inception date on March 19, 2004. The portfolio also attempts to best the returns of the S&P 500 Index (S&P) and The Hedge Fund Research (HFR) Investable Global Index (HFRX) during these periods.

Recent Returns: Last week, we were up 3.5%.

As of March 13, 2009, month-to-date (MTD) we are up 1.0% while year-to-date (YTD) up 2.1%. Returns for the last three calendar years were -2.2% in 2008, 8.8% in 2007 and 18.3% in 2006. Since the portfolio's inception, the cumulative return has been 45.7% (Figure 8).

Weekly Trades

The Old

Last week, there were no trades. Since we were late with Issue 3, readers might have missed that during the last week of February and through March 9, we sold all our remaining shares of ultra short (double inverse return) ETFs with the exception of the UltraShort MSCI Emerging Markets ProShares ETF (EEV), which we may sell soon. We also added a 5% position in Energy Growth & Income Fund (FEN), a master limited partnership.

Figure 5 reviews major index and asset class fund returns for the week ending March 13, 2009 along with month-to-date (MTD) and year-to-date (YTD) returns. It also lists the AI 75-50 Portfolio's over weight (OW); neutral (N) or underweight (UW) positions relative to the Dow Jones Global Stock Index. Here you can see that we will soon be long the NASDAQ 100 Index (QQQQ) and short Eurozone stocks (EZU).

Figure 6 plots the prior week's returns by index and asset class exposures. Short exposures are highlighted in red. Shorts are sourced through the imbedded leverage had by double inverse ETFs and from directly shorting ETFs. Long positions are colored green.

The New

This week we will be selling (covering) EEV. We will then look for an opportunity to short the iShares MSCI Euro Monetary Union Index (EZU) with the same exposure as we had to EEV. We also will soon be selling the PowerShares FTSE RAFI US 1000 (PRF) and Telecom Holders Trust (TTH). The proceeds from these sales will be used to buy the PowerShares Nasdaq-100 Index (QQQQ).

Figure 7 depicts the average return of all shorts and longs (indexes & assets classes) held in 2009. Absent our nimble trading of short positions, the portfolio would be at a loss in 2009. Without short positions, AI 75/50 would still be outperforming the S&P 500 in 2009, but it would be lagging the HFRX, our absolute return benchmark. The results below assume that all positions were held from January 1, 2009 through the close on March 13, 2009, which was not the case for AI 75/50. We frequently review the static returns of aggregate longs and shorts to evaluate our asset selection process. In any long/short portfolio, absolute returns are more likely when short positions (absent inverse leverage) decline more than long positions.

Below are asset weightings for each position, our beta/non-beta balances, source of return themes, gross, short and net long percentages and other relevant currently held position data. To the far right, are strategy views that express core holdings and tactical trades. We are targeting gross exposure of 115% down from our current 133%.

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.