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: Month-to-date (MTD) we are up 9.1% through May 21. Year-to-date (YTD) we are up 17.7%.

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 68% (Figure 4).

Recent Trades, Current Positions, Indexes & Asset Classes

Since our last InFocus on April 24, all trades have been defensive. We will cover the rare employment of put options first (Table 1). On May 12, we purchased 10 long July 875 puts on the S&P 500 (SPX) at $35 (SPXSO). At the time of purchase, SPXSO represented 3% of our 146% in gross exposures. On May 19, we established a sell limit order at $19.50 on 5 contracts (Figure 1). We were taken out of our 5 contracts at $19.90 early in morning the next day, which was May 20, an outside-reversal day (Figure 7). Although sell limit orders control losses, we sold at SPXSO's at the low of the day. We were left with 5 contracts valued at $46.40 at the May 21 close.

To compensate for the losses on the contracts sold and to limit out opportunity costs, we canceled orders to sell half of SPXSO at $55 and half at $70 and entered an order to sell the remaining 5 contracts at $80. We also added 3% (1.5% before leverage) more exposure to the UltraShort Consumer Services ProShares Fund (SCC) on May 21. Investors often get taken out of their best defense on outside-reversal days. Since these days are a bearish indicator, option investors need to reestablish defense soon after they lose their positions. We chose not to rebid the 5 contracts sold.

Table 1. Option Trades

Figure 1. SPXSO Strategy

Table 2 lists the rest of our trades since April 24. We also were taken out of the PowerShares DB Crude Oil Double Short ETN (DTO) on May 20. We feel better about this trade than we do about SPXSO. Intermediate-term fundamentals are more supportive crude oil prices near $50, so we shorted crude through DTO when it was near $60. Our TA showed potential resistance near $61 with a potential pullback near $50. For now, crude is not trading with fundamentals. It is trading as a U.S. dollar hedge. About two years out, fundamentals support crude oil at $100 and higher longer term.

We added 5% more in defensive exposure through the shorting of the iShares MSCI EMU (EZU, EURO Zone) Index and the iShares Russell 2000 Index (IWM, small companies) shares on May 8. These shorts will be covered if prices decline to $25 and $41, respectively, or shares will be closed if prices remain above $32.50 and $53.50 for three consecutive days.

We also sold the Energy Growth & Income Fund (FEN) on May 19 because it was trading at a 19% premium to its net asset value (NAV). Over the past year, we have purchased FEN near its NAV and sold it at 15% or more above its NAV on three occasions.

We held the UltraShort Gold ProShares Fund (GLL) from April 20-22. Gold bullion was technically weak at the time of purchase. After gold prices firmed, we sold GLL at a slight loss.

Table 2. ETF Trades

Figure 2 reviews major index and asset class fund returns for the trade week ending April 17, and MTD and YTD through April 17. Here we also list the AI 75-50 Portfolio's overweight (OW); neutral (N) or under-weight (UW) positions relative to the Dow Jones Global Stock Index.

Figure 2. Indexes and Major Asset Classes

Figure 3 plots the prior week's returns by index and asset class exposures. Short exposures are highlighted in red. Shorts are sourced through the embedded leverage had by double-inverse ETFs and from directly shorting ETFs. Long positions are colored green.

Figure 3. May MTD Returns for AI 75-50 Long & Shorts

Figure 4 shows 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 long-term (3 years) strategy views that express core holdings and tactical trades. We are targeting gross exposure of 102%, down from our current 150%.

Figure 4. The Arrow Insights (AI) 75-50 Portfolio

The Economic Roots of Beta Climates. Expect a W!

How does Mr. Market know more than blue-chip economists and Wall Street experts? Before answering this question, we must make a distinction between big bank/broker research findings (Wall Street), which tend to err on the side of Ms. Rosy Scenario, and research that is independent of Wall Street. After that, we will address how independence can tell you if the beta climate is too hot, too cold or comfortable.

Six years ago, Wall Street and the Securities & Exchange Commission (SEC) reached a settlement on correcting conflicts of their client interest between their investment banking activities and investment research. This deal was supposed to clean up the Street. To a degree, it did, but it did not enhance the quality of Street macro and micro research.

The settlement required the funding of "independent research." It was an attempt to mend the losses had by investors who were "done in" from following the advice given by Wall Street firms during the late 1990s and the early 2000s. Around 1997, the Street began to wrap its equity recommendations around pro forma forecasts. Their make believe resulted in the Nothing but Nasdaq Bubble and then the Tech/Telecom Wreck, which precipitated the bear market of 2000-2002.

If you want good advice, leave the Street and hit the alleyways. Figure 5 ranks the top 15 equity (micro) research firms in 2008. Market Profile Theorems (MPT) was the to- ranked firm. MPT is a quantitative shop (quants). It provided more than 21,000 buy/sell recommendations last year.

Figure 5. Equity Research Rankings for 2008

Quants often foster high turnover rates that cut into their client returns, but with a 38.4% gross return in 2008, MPT clients have a lot to churn away before the No. 2 shop catches up. That said, American Tech Research's 206 recommendations are more executable and appealing to investors. Their 10.2% result was fantastic in a year with most equity indices down about 40%. You need to find a style/integrity fit before buying research. For me, firms ranked No. 2 through No. 10 are a better fit. Avoid outliers.

Small/independent shops dominated 2008 because they had great sell recommendations, which provided 100% of their positive results. Large shops tend to be too close to the views of Wall Street's biggest client firms. This culture hinders their ability to provide top-performing contrarian sell lists. The SEC cannot enforce away bias. Investors should avoid firms that provide very limited and low-quality sell lists.

Big Corporate Bias (Wrong Macro View) Hampers Asset Allocation Results

It is what it is! The quote below is from Yves Smith of Naked Capitalism on July 7, 2008. It comes from her article titled: "Lehman, Deutsche Bank Strategists Predict Best 6 Months for S&P Since 1982."

"Since I seldom am the bearer of upbeat news, I thought I'd pass along the cheery forecast from market strategists at Lehman and Deutsche Bank, namely, that the Standard & Poor's 500 Index will have its best six months since the second half on 1982 in the second half of 2008."

Little commentary is needed to show how the Street was too sanguine just as we began to fall into the abyss on August 7, 2008, which was exactly one month after the above call. The rest is history, as is Lehman Brothers! In 2008, stocks experienced their worst half of any year since 1931. Sometimes we need bad news.

Figure 6 presents more 2008 folly. Here are the equity year-end forecasts of Wall Street strategists presented in Business Week on December 20, 2007, in "Where to Put Your Cash in 2008." The average forecast was for the Dow Jones Industrial Average and the S&P 500 to close 2008 at 14,569 and 1,612. They closed at 8776.39 and 903.25. Rob Arnott of Research Affiliates at 12,500 and 1,350 came closest to actual results. Tom McManus of Banc of America won the prize in 2007 by forecasting the S&P at 1,465 (yellow highlight). His wide miss in 2008 makes it likely that he was betting on serial correlation and not fundamentals when making his forecast.

Figure 6. Business Week's Wall Street Strategists Survey For 2008

The consensus failed miserably in 2008! Here is more folly from Where to Put Your Cash in 2008. Tobias Levkovich, Chief U.S. Equity Strategist at Citigroup (C) expected S&P 500 reported earnings to rise 5.2%. They fell by a whopping 58.3% and are down 83% from their 2007 peak. David Bianco, Chief U.S. Equity Strategist at UBS Investment Research (UBS) made this brilliant observation: "2008 will bring clarity on U.S. economic health and the sustainability of robust earnings growth that the S&P 500 has generated in recent years." How can they miss the worst financial crisis since the Great Depression? In December 2007, could they have not at least suspected a typical recession where earnings fall by 15%-20% and equity prices decline 25%- 35%? The handwriting was on the wall for all who chose to read it.

Street Pros make the big bucks to get it right. You would think that with all of their resources and contacts that they could have heard the train wreck coming. I can excuse their blindness but not their deafness too. My views in December 2007 were bearish. I was only looking for a 25% to 35% recessionary decline off the October 2007 highs sometime in 2008. I only got more bearish as the crisis accelerated.

Big Corporate Bias Hampers Blue Chip Economic Research Results

As I am typing this report, I am listening to a Bloomberg interview of Nouriel Roubini. The interviewer comments: "Mr. Roubini, many investors follow your economic research and then employ it to make investment decisions. What is your take on the recent equity rally? What does it say about the economy?"

There are two points that strike me about the Bloomberg interview, the first being that Mr. Roubini is an independent economist who has never been closely aligned with Wall Street. The second point is that the commentator is wise to ask about the linkage to the economy (economic factors and equity prices).

I discovered Mr. Roubini's dire economic forecasts in the spring of 2006, while doing research for my May 2006 article, Peak Risk, which identified acute and growing investment risks stemming from a credit bubble. Back then only independent sources like Mr. Roubini and Eric Janszen, the founder of www.itulip.com, were providing fellow researchers with information about the credit bubble and the linkage between Wall Street (debt securitization) and Main Street (excessive housing/consumer debts).

Escape from Normalville, published in November 2006, was a follow-up to Peak Risk. The 1981 movie, "Escape from New York," depicted the dire consequences from not getting out of a city in social and moral decline (not true). The cult flick was a contrarian indicator -1981 was near the end of a secular bear market and the quality of life in New York City has improved dramatically since then.

My escape drama defined the risks stemming from the mass illusions rooted in excessive debt creation. Wall Street was abnormal. I saw tight credit spreads, low default rates, cheap credit and other factors seen in 2006 as being in the right fat tail of a huge normal distribution dating back to 1920. I also sensed that quants had transformed Wall Street into Normalville. Normalville was a new American town that included Main Street via a colossal housing bubble. Normalville is a metaphor for quantitative modeling risk, which enabled the initial 5% decline in home values to be the prick that burst the credit bubble.

Finding Leading Indicators To Fit Current Times

Figure 7 shows some factors that helped me to know that we should Escape from Normalville in 2006.

Figure 7. Stocks Prices Normally Are Independent Of Home Builder Sentiment (HMI)

Back then, I analyzed the relationship of economic growth and stock prices to homebuilders sentiment (HMI or housing), which is a very leading indicator. Like other indicators, HMI turned up during the first quarter (Q1) of 2009 from an all-time low reading of 8. It was 33 in 2006 when we first published Figure 4. HMI's mean since 1985 is near 52. Before conducting research on HMI, our hypothesis was that a bubble would distort the normal relationships between homes values, equity prices and economic growth.

The first column in Figure 7 lists factors that are compared to HMI's correlations during various periods. The base period is 1984-1994. Ten years is not a long period for confident statistical findings, so our results were cross-referenced with other studies that showed stock prices and home values with slightly negative correlations to economic growth (Real Gross Domestic Product or RGDP) while 12-month forward (12-MF) home values displayed positive correlations. Throughout most of history, one's home has offered diversification benefits for homeowners with stock portfolio (through their negative correlations).

After finding HMI to be a leading indicator of home values, it was chosen as a gauge of the strength/weakness in the direction of 12-MF equity prices (12-MF S&P 500 Index or S&P) and 12-MF RGDP growth. If homes were in a bubble, their values should strongly influence RGDP and stock prices. My original analysis was updated through March 2009 with the 2006 period extended through December 2006.

Figure 7 observes four periods: Normalville 1984-1994; the Equity Boom 1994-1999; The Housing (HSE) Boom 1999-2006; and the Credit Bust or Bust 2006-2009. Please follow the notes in the far right column and reference the yellow highlights.

During the equity bubble, current RGDP (0.91), current S&P (0.90), household and non-profit debt growth (HseHld-NonProfit Debt, 0.91) and housing sentiment (HMI) were ONE! The 12-MF stock price was negatively correlated (-0.51) to HMI because the housing bubble was not yet strong enough to drive future stock prices.

The equity bubble collapsed in 2000-2002. A housing boom (HSE Boom) began near the S&P's trough in October 2002. A negative wealth effect caused HMI correlations to current RGDP, current S&P prices and HseHld-NonProfit Debt to be -0.26, -0.35 and -0.29, respectively. However, improving homebuilders sentiment went from being negatively correlated (-0.51) to slightly positive (0.01). The HSE Boom was having its intended effect of raising all asset prices. It was now a primary driver of stock prices.

Home values peaked in June 2006, which ushered in a period of peak risk for all credit instruments. Housing also became the primary driver of future economic growth (12-MF RGDP, 0.78). As the housing and wider credit bust unfolds (2006 through March 2009), correlations to housing sentiment became very positive for current S&P and 12-MF S&P prices (0.71 and 0.87).

Figure 8 shows the tail (HMI) wagging the dog (the S&P 500). In November 2006, we had asked: Will the 12-MF S&P decline with housing (HMI)? The HMI had fallen from 76 in 2005 to 33 in November 2006, when this question was poised. Escape from Normalville expected the S&P to follow, which it eventually did after peaking in October 2007. Housing sentiment hit its nadir at 8 at the end of 2008 and in January 2009. At its worst, stocks experienced a -43.3% 12-month decline, which answered our question affirmatively.

The recent upturn in housing sentiment will be a more reliable indicator of higher home values and stock prices if it continues to base near current levels with HMI's trough holding.

Figure 8. Housing Market Index (HMI) and $10 Growth Of S&P 500 1985-Present

After a study of Figures 7 and 8, first published in November 2006, how could Street forecasts made in December 2007 (Figure 6) be so far removed from peak risk? The Street pros got too comfortable living in Normalville. They were under tremendous pressure to go with the flow. To a degree, I sympathize with them. Wall Street's culture and their huge asset bases require them to be in for the long haul and to turn the ship slowly. If not, they face career risk.

It is best to source researchers who are paid to be contrarians. There are those who often get it right. Last week's Barron's featured "The Incomparable Stephanie Pomboy." Here are direct quotes:

Under the elegant title "Burping Out Loud," Stephanie stands the conventional wisdom on its head on corporate profits and the stock market. We should warn you that recovery isn't currently a prominent part of her lexicon.

Absent the powerful stimulus provided by the unprecedented boom in housing, she sees a huge hit still in the offing for nonfinancial corporate profits. A worst-case analysis is that such profits would sink to 2003 levels, a further decline of $450 billion, or 54%. Under a less exacting (and frightening) estimate, using their relationship to GDP, they would return to their pre-bubble percentage of 3.5%, which translates into a drop from here of $340 billion, or 41%.

Ms. Pomboy often gets it right because she searches for new and old factors that link prices (the micro) to economic fundamentals (the macro). She also believes that the current cycle of recovery, credit, profits and stocks are dependent upon home values and confidence in the financial sector.

Getting it right is dependent upon the identification of primary drivers that move secondary factors. Home values peaked in June 2006 when they were 60% above trend and near a peak in a wider credit bubble. Extreme readings for home values, debt levels and credit spreads (risk premium) in April 2006 were my primary motivators for seeking a leading indicator of housing sentiment, which leads me to builder's sentiment (HMI). Sentiment always leads price. Our hypothesis was confirmed. Housing and credit were bubbles.

Do you recall Federal Reserve Board Chairman Ben Bernanke's estimate of bank loan losses stemming from home mortgage defaults in August 2007? He estimated they would be "up to $100 billion." Back then, he was still living in Normalville. In November 2007, during the New York Economic Club Dinner, he was asked by the renowned economist Henry Kaufman: "If you had a crystal ball, what question would you ask it in an effort to help you with the credit crisis?" His response was: "How the hell do you price these things?" At that moment, I knew we were in very deep trouble. The entire Street was there too. What did they hear? They were deaf.

Building More Alternative Indicators

Our April InPerspective showed how we employ economic scenario frequencies to build all-weather portfolios. Asset diversification has economic roots dominated by inflationary and deflationary boom and bust climates. Asset allocation is aided by economic and asset price indicators. Since consumer spending has represented 65% to 72% of RGDP since the late 1960s, it is an important determinant of our economic view.

Figure 9. Consumer Confidence (Conference Board)

Figure 9 tracks the Conference Board's future (F) and present (P) economic outlooks of U.S. consumers and the National Bureau of Economic Research (NBER) recession periods. Represented here are the monthly ratios of F and P (F:P) and the 36-month moving average of F:P readings since 1997. In 2009 Q1, the short-term (F:P) and long-term (F:P 36m) indictors troughed and then turned higher, which is supportive of a stronger economy. This is one view and below is another.

Figure 10 adds F:P 24m and the Chicago Fed National Activity Index (CFNAI), which is a composite of many factors relevant to economic growth. CFNAI was -2.96 in March, down slightly from -2.82 in February. All four broad categories of indicators continued to make negative contributions to the index in March.[1]

Since 1967 (not shown in Figure 10), seven consecutive negative CFNAI readings (3-month moving average (MA) minus 6-month MA) have preceded all recessions. In November 2007, our diffusion method of CFNAI told us that a recession was imminent, which gave us about a one-year lead over blue-chip economists. In November 2008, NBER officially declared that a recession had begun in December 2007.

Our prior CFNAI readings have foretold a recession within one month of their birth. Following the severe recessions of 1980 and 1982, our CFNAI readings remained negative for only two months after each recession ended. After the mild contractions in 1991 and 2001, they stayed negative for 20 and 23 months primarily because these were jobless recoveries with very low median income growth.

The consumer's 24- and 36-month future-to-present expectations ratios (F:P 24) 36-MA (F:P 36) are employed to enhance our recovery readings during jobless recoveries. Since 1967, all recoveries were led by the F:P 24 trend line crossing over the F:P 36 trend line. Adding these consumer sentiment measures also confirms our CFNAI readings. Since 1977, only the 1981-82 recession was not accompanied with the F:P 24 below its 36-MA (F:P 36). Although our consumer confidence indicators point to an economic recovery within the next two-to-six months, CFNAI readings need to turn positive for at least two consecutive months to confirm a recovery.

Figure 10. Consumer Future + Present Expectations & Chicago Federal Reserve Nat’l Business Activity Idx (CFNAI)

The Current Climate

Employment is a coincident indicator. Recently the media has been referencing the 1990 and 2001 recessions when unemployment peaked after recessions ended and has determined the same is true for this cycle. The 1990 and 2001 cycles were exceptions to the rule. The peak in the unemployment rate will most likely exceed 10% and it will peak close to the date of the recession's end.

Default rates are also a coincident indicator. They peak one month before to two months after a trough in economic growth. Employment trends also follow defaults. The current YOY default rate is close to 8%. Moody's and Standard & Poor's expect this rate to peak at 14%–16% YOY during this cycle (by 2009-2010).

So, expect unemployment, defaults and RGDP to trough some time in 2010. This might not occur until after we get one or two quarters of positive RGDP. The equity rally is telling us that this is likely, but other factors indicate that we will then double-dip with our economic contraction resuming in a W pattern with the cumulative decline in RDGP near 10%. RGDP is currently off -4.2% from its June 2008 peak, which means that the last leg of the downturn after a brief economic recovery will be steeper than the first or current leg. Most likely, we are less than halfway through a garden-variety 19^th-century depression.

Another Independent View

Capital Economics Group is an independent macroeconomic research firm based in London whose managing director is Roger Bootle. Mr. Bootle's best-seller, "The Death of Inflation," was published in April 1996. Back in 1997, this book helped us to formulate the view that the future would look more like the 1930s than the 1990s. Views that are independent of Wall Street enhance your chances of remaining on top of economic and market trends. Our central tenet is that deflation has the upper hand on the economic/market cycle until we reach a sustainable level of debt-carry. We also hold the view that a massive government-led reinflation will prevent severe consumer price deflation and a Great Depression.

The Capital Economics Recovery Index (CERI) was designed to monitor how close or far the economy is to the end of a recession. As of April 2009, the CERI puts the probability that the recession has ended at less than 10%. I am very impressed with CERI because it incorporates 20 leading indicators. It is more extensive than traditional leading indicators. CERI pays more attention to areas that are the keys to this recession, such as banking and housing.

Mr. Bootle's firm places emphasis upon quality measures in relation to what drives the current cycle. CERI is not a black. Bootle also believes that the current cycle of recovery, credit, profits and stocks is dependent upon home values and confidence in the financial sector.

Figure 11 focuses on the 10 factors that we have grouped from CERI factors as the most relevant to our credit (crisis) cycle. The first column lists negative/positive readings for factors that historically trough before/after a recession ends. Negative numbers are for troughs reached before a recession ends, while positive scores are for post-recession troughs. The group below troughs about a month before a recession's end.

Figure 11. Capital Economic Business Cycle Indicators

More importantly, only half of the factors most relevant to this crisis have bottomed. Consequently, it is too early to tell when the recession is likely to end. Capital Economics employs a recovery scoring method that compares current troughs to the past 10 NBER recessions (appendix). The appendix lists CERI factors and our groupings of factors irrelevant to our current crisis and factors that have not yet troughed.

Recessions With And Without A Financial Crisis (Global And Local)

Figure 12 was extracted from a paper dated March 2009 by Marco E. Terrones, Alasdair Scott and Prakash Kannan of the International Monetary Fund (IMF), titled "From Recession to Recovery: How Soon and How Strong?" It was compiled from data since 1960. Their paper focused on all recessions/recoveries. A typical recession persisted for about a year, whereas expansions lasted more than five years. The longest expansion lasted 15 years. Recoveries are usually quicker than contractions, with RGDP growth outpacing the prior contraction by 25%.

Figure 12. Timing Is Everything

This paper distinguished between cycles associated with financial crises and cycles that were highly synchronized (global events). Financial crises are episodes that coincide with the start of recessions. Each crisis wreaks havoc in a dysfunctional system that leads to the insolvency of many institutions. Of the 122 events studied, 15 were associated with a financial crisis.

In addition to the 2007-2009 crisis, there have been only three other episodes of highly synchronized recessions: 1975, 1980, and 1992. Synchronized recessions are those in which 10 or more of the 21 advanced economies in the sample were in recession at the same time.

Terrones, Scott and Kannan found that the mean decline in RGDP for all recessions was -2.71%, while RGDP rose by almost 4.1% one year into their recoveries. Six nations experienced synchronized recessions associated with financial panics. They had a mean contraction of -4.8%. Their RGDP's rose only 2.8% after one year. The lower amplitudes of these recoveries are a consequence of declines in private consumption.

Dynamics Of Recovery From The Current Financial Crisis

The prior study excluded the Great Depression. Kenneth Rogoff from Harvard University and Carmen Reinhart from the University of Maryland published a study called "The Aftermath of Financial Crises (January 2009)."[2] This paper examined the mean depth and mean duration of the economic factors that have followed severe financial crises. They sampled 18 post-World War II episodes plus the 1899 Norway and the 1929 U.S. crisis. This study is more relevant than the Terrones, Scott and Kannan paper because we are currently in a crisis that resulted from lax regulation of credit, which led to consumer credit and asset bubbles and their deflations.

They found asset market collapses were deep and prolonged. Real housing prices declined 35% over 5 to 7 years, while real equity prices plunged 55% over 3.5 years.[3] The unemployment rate rose 7% from where it stood prior to the down phase of the cycle over 4 years. Real Gross Domestic Product (RGDP) falls 9.3% over 1.9 years.

Reinhart and Rogoff also reported that nations stimulating their way out of financial panics saw their real government debt explode by 86%. These debt explosions primarily resulted from declining tax revenues. Government debt, which excludes the intragovernmental debt obligations such as the debt held in the Social Security Trust Fund, was $5.3 trillion (t) when fiscal stimulus began in Q2 2008. Adding 86% brings our future government debt to $9.9t after we are well into a recovery. It was already $6.4t at year-end and it is on a course to be more than $8t by October 2009.

Their estimates of the rise in U.S. government debt are likely to be conservative, as they do not include potential liabilities accruing form government guarantees that back financial institutions. These backstops are close to $10t.

Reinhart and Rogoff found that a one-standard-deviation (SD) increase in government consumption cut the median duration of financial-crisis-led recessions by one-quarter. They also found that the degree of public indebtedness reduced the effectiveness of fiscal policy. This factor is crucial for estimating future scenarios.

The red line in Figure 13 plots the impact of public debt (debt) on economic growth (Nominal GDP or GDP and RGDP).[4] Historically, debt to GDP ratio greater than 60% dampens the impact of the fiscal stimulus employed to ward off a financial crisis. Gross federal debt stood at $11.239t as of April 30, 2009, up by $1.861t from April 2008. GDP was $13.809t as of March 31, 2009 (estimate), which puts debt/GDP at 81.4%. If past effects hold true, debt will shave 0.2% from annual RGDP growth. Every 0.2 increase in this ratio reduces growth by -0.2% for a total hit to economic growth of -0.8% when debt/GDP hits 1.4.

Figure 13. Public Debt To GDP Hampers Stimulus

Given that RGDP peaked at 11.8t in June 2008, our current contraction is -4.2%. Yet, we might see RGDP decline by another -5.1% from where RGDP estimates stand for Q1 2009 (RGDP of 10.7t). This event would match Reinhart and Rogoff observations. An additional contraction of 5.1% would bring our current contraction close to the depression thresholds of -10% experienced by the U.S. during the 19^th century, which is well below the Great Depression's real decline of 29% (last two rows in Figure 14).

Figure 14 does not plot NBER's officially declared recession periods. It plots the peak-to-trough RGDP periods employed in Reinhart and Rogoff 2008. Given their findings and RGDP's June 2008 peak, our current contraction might not trough until sometime in May-June 2010.

Figure 14. Past RGDP Cycles & Banking Crises: Peak-to-trough (Reinhart & Rogoff, 2008)

Our Current View And Beta Climate

We expect the U.S. experience to be weaker than the 9.3% mean RGDP contraction found by Reinhart and Rogoff in their study of financial-sector-led episodes. Our expectation is partially based upon our nation's inability to have a strong export-led recovery. The nations observed by Reinhart and Rogoff benefited from strong global demand for their exports. The decimation of the U.S. manufacturing base and the global nature of the contraction of U.S. exports will hinder our nation's export growth. In addition, the other samples never had their economies dominated by the financial sector. In 2007, the U.S. financial sector contributed 1.5% to RGDP (43% of RGDP) and 41% to corporate profits. Financial sector contributions are likely to be no more than 0.4% or 20% of RGDP in a 2% year-over-year recovery by 2009 Q3 or Q4.

The recent bounce in financial markets, notably equities, seems justified by the improvements in the business surveys, the global fiscal stimulus and the stabilization in consumer confidence. However, further large gains in equity prices require a V-shaped economic recovery. This scenario is unrealistic in the U.S., the Euro zone and Japan (EAFE). It is more likely that the recovery falters as the temporary stimulus and other factors fade and then go into reverse. EAFE economies also face the growing risk of new shocks in the form of falling wages, rising energy prices and reduced tax revenues, which further balloon their rising fiscal deficits.

Restoring confidence in the financial sector is the key to recovery. Confidence will fade if it does not recognize financial firm losses and restore solvency to the financial system, which is why we were so critical of the stress test in Scrap the SCAP in our last InFocus dated May 24, 2009.

Asset Allocation For Recovery And Reinflations

Company-specific factors that weigh on profit growth the most during past recoveries from financial crisis are external debt dependence and product tradability/export growth. During recoveries from financial panics, industries with a high dependence on outside funds grew annual profits by 1.5% less than firms that fund their growth with internal funds. Firms with strong export markets mitigate this factor. Industries with high product tradability grew annual profits 3.3% more than firms with limited exports.

Figure 15. Sectors & Regions In Recovery Phases*

To date, 51% of the portfolio is set to harvest these factors. The best of breed are firms with low external debts and high exports. The PowerShares Nasdaq 100 Index (QQQQ) is our pick to best source these factors, which it does from its 53% technology and 19% healthcare weightings. By year-end 2009, we target a 15% allocation in QQQQ.

A global macro perspective impacts our asset selections. Independence from the consensus tells us that the current beta climate has gotten a little too hot about a V-shaped economic recovery. An expected retest of the March 2009 lows will not be as cold and panic ridden as the 2008 and early 2009 experience. Eventually investors will get comfortable with a W cycle. Potential trading profits lie in wait.

Figure 16. Indexes And Major Asset Classes

Portfolio Exposures And Convictions

Figure 17 is composed of a focused list of indexes and assets classes (we keep an eye on these and many more) and corresponding ETFs. Returns are through April 30, 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 11). Our long ETFs are either overweight (OW) or neutral weight (NW) relative to the Dow Jones Global Index.

Figure 17. Last Month's Returns for AI 75-50 Long & Shorts

AI Portfolio Performance (objectives should be evaluated over 36-month periods)

Like the Hedge Fund Research Global Hedge Fund Index (HFRX), AI's secondary objective is to provide an absolute return (consistently positive returns). As of April 30, 2009, hedge funds are down -23.4%, while the AI 75-50 Portfolio is up 6.6% since the S&P 500's peak in October 2007. The AI 75/50 model has outperformed its benchmark, the HFRX and the S&P 500 (Figure 18). 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 beta nimbly while maintaining core beta (equity and bond exposures). The portfolio's 11.7 annualized standard deviation (ASD) is higher than that of the HFRX but much lower than that of the S&P's volatility since the market's peak.

Figure 18. Since S&P Peak, 2008, & YTD

Recent Moves And Returns

Near the beginning of March 2009, our view has been that there was significantly more risk from being too short (low beta exposures). We saw the market as being extremely oversold.

On May 8, 2009, the S&P peaked at 930.17 intraday, which was nearly 40% advance off its intraday low at 666.79 on March 6, 2009. It is now quite overbought and at risk of a quick 10%-to-15% pullback with a retest of the March 2009 more likely later in 2009 or in early 2010.

Since the third week of March 2009, we have been reducing beta and reestablishing defense incrementally after covering shorts and selling most of our inverse equity ETFs in late February and early March.

In April, we added 1% (2% after leverage) to ProShares UltraShort MSCI EAFE (EFU) and initiated a 5% position in PowerShares DB Agriculture Fund (DBA).

All positions and our strategy view for all holdings are listed in Figure 19 along with our beta-non beta allocations and themes (see the February InPerspective for more).

We were up 1.9% month-to-date in April 2009, while also up 7.9% year to date (YTD).

Month-to-date (MTD) in May we were up another 5.6% or 13.9% YTD through Friday May 15, 2009 (not shown). We will update positions, performance and provide a technical view of the markets through last week in our next InFocus. We also will review why we recently added July S&P 500 875 puts and the PowerShares DB Crude Oil Double Short ETN exposure.

Figure 19. The Arrow Insights (AI) 75-50 Portfolio

Appendix - Since 1999, Stocks Have Become More Dependent Upon Housing

Figure 20. Stocks Prices Normally Are Independent of Housing Prices

Appendix - Default Rates Will Dominate This Economic Cycle

Figure 21. Capital Economics - Business Cycle Indicators

Endnotes

1. The index is a weighted average of 85 indicators of national economic activity. The indicators are drawn from four broad categories of data: 1) production and income; 2) employment, unemployment, and hours; 3) personal consumption and housing; and 4) sales, orders, and inventories. A zero value for the index indicates that the national economy is expanding at its historical trend rate of growth; negative values indicate below-average growth; and positive values indicate above-average growth.

2. Alan Abelson, "Woe Is Us," Barron's, January 26, 2009.

3. Real equity price declines for the U.S. (1929) and Japan (1992) of about 65% and 60%, respectively, because those two crises resulted in significant deflation. The nominal peak-to-trough equity declines in those two crises were more like 90% and 80%, respectively.

4. "Scrap the SCAP," May 24, 2009, InFocus. The midpoint of the 90% confidence interval.

Disclaimer

This report does not provide tailored investment advice. It was prepared without regard for specific circumstances and objectives. The securities shown may not be suitable for all investors. Arrow Insights recommends that investors independently evaluate particular investments and strategies. The appropriateness of an investment or strategy will depend on investor circumstances and objectives.

The contents are not an offer to buy or sell any security or to participate in any trading strategy. Arrow Insights and its affiliates or its employees not involved may have investments in securities or derivatives of securities of companies mentioned in this report, and may trade them in ways different from those discussed in this report.

Arrow Insights and its affiliate companies do business that relates to securities covered in its research reports, which may include market making and specialized trading, risk arbitrage and other proprietary trading, fund management, investment services. Arrow Insights makes every effort to use reliable, comprehensive information, but we make no representation that it is accurate or complete. We have no obligation to tell you when opinions or information in this report change apart from when we intend to discontinue research coverage of a subject company.

Reports prepared by Arrow Insights research personnel are based on public information. Facts and views presented in this report have not been reviewed by, and may not reflect information known to, professionals affiliated with Arrow Insights. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. There may be time limitations on the exercise of options or other rights in your securities transactions.

Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.