After Half-Term Ponderings: Portfolio Thoughts

In the last post, Our Man discussed what he thought of the world and the factors that were a part of that decision.  While opinion is important, it’s how it’s executed within a portfolio that determines success; so, as promised, let’s have a look at what this all means for Our Man’s portfolio.

Since early August the market had largely been pinned in a range between 1,120 and 1,220 and as we came into October, Our Man’s hope was that it might tumble in the low 1000’s before a combination of oversold stocks and some “positive” news flow would spark a rally.  However, while the S&P did dip beneath 1,100 for a few days, it rallied far sooner than Our Man expected, and thus he only eased out some of the existing puts (IWM) early in this rally.

The rally has broken out of the top-end of the 1,120 to 1,220 range (reaching 1,280+ today) but Our Man remains of the belief that it’s a bear market rally, that’s being driven by a number of issues including:
- a European solution that’s full of leverage and hope but short on specifics;
- a solid but unspectacular Q3 Earnings (and the subsequent cries of  “see, companies are fine”);
- a blind belief that China’s problems are behind it; and
- a focus on decent US macro coincident data (e.g. Q3 US GDP, +2.5%) but the ignorance of weak leading data.
Like all bear market rallies, Our Man expects it to end on good news (think TARP being approved back in 2008), and thus is predominantly looking for opportunities to roll some of the existing puts (i.e. sell the SPY puts that expire in Dec-11 with a strike at 100, and use the funds to help partially fund Dec-12 puts with a 100 strike) and add more puts/hedges as the market rallies to broaden out the Puts/Hedges portfolio and fully reflect his bearishness. 

Thus, while the portfolio has a small bearish tilt to it at the moment, it’s likely to have a far more pronounced bearish tone in the coming months.  So, what will OM be buying puts on to express his bearishness?

- Market indices
This is the broadest hedges that OM is looking at.  They are predominantly broad US Indices, with strikes 20-25% out of the money (i.e. the market would need to fall this amount, before the puts would be profitable, if held till expiration).  These would likely be on the IWM (Russell 2000) and SPY (S&P 500)

- Consumer Discretionary, especially high-end
The era of easy credit in the US, especially since the 1990’s, has managed to fuel a number of major bubbles.  Most of the obvious ones, the Tech and the Housing bubbles, have burst but another remains; the US consumer.  Like the Housing bubble (“House prices don’t fall nationally”) the US consumer has its own little tagline; “don’t bet against the US consumer”.  What’s more the stocks in this space, especially at the high-end, have benefited from a boost from Emerging Markets consumers and investors’ extrapolation of how large this impact will be in coming years.  This has resulted in the stocks comfortably out-performing the market (e.g. XLY – the S&P Consumer Discretionary ETF)  and a number reaching all-time highs.  With Our Man’s thoughts on deleveraging (if you’re saving, you’re not spending….and if you’re unemployed, you’re spending on staples not discretionary items) and skepticism on the China consumer story, it’s not a surprise that Consumer Discretionary is an area that falls into the nexus of things he’s looking at.  Our Man’s focus is on the ETFs in the space (e.g. the aforementioned XLY) and especially some high-end retailers (e.g. TIF – Tiffany’s).

- China-Thesis
I’m sure you don’t want Our Man to repeat his thoughts on China, though if you do then I’d go here, then here and finally here.  Things like recent (and largely ignored) Bank recapitalizations/bailouts and inflation at c6% (before any possible ECB/Fed/etc quantitative easing) help Our Man remain a skeptic.  The ways he’s looking to play it haven’t changed much either and the focus remains on the commodity-related companies and countries (e.g. Brazil and Australia).  Additionally, some of the above-mentioned plays on consumer spending (which will be in the Puts/Hedges book) will be strongly correlated to the China thesis.

So, now that we know where Our Man will be looking to build up his bearish exposure, all that remains is how large will this exposure be and when will he do it.  Unfortunately, that’s not a simple answer as the price of the put options (once you know the strike price and expiry) depends on many things including the time to expiry, implied volatility and the current price of the underlying instrument.  Thus the best explanation is to say that if everything goes as Our Man’s hoping (a small pull-back, followed by a rise to new highs during November) he’ll be looking to build up the positions over the next month until the portfolio has 250-400bps of risk.  Should the market continue to rally into 2012 and Our Man retain his bearishness, he’ll likely add another 100bps or so of risk to the portfolio.  In this way, Our Man will have defined risk (a maximum loss of 4-5% of his capital, by the end of 2012) should his expectations of significant declines prove mistaken, but retain significant short exposure to the market in the meantime.  Given this likely significant negative exposure, Our Man may take the opportunity to partially offset this by adding to some the existing themes in the book including Energy Efficiency (through battery or LED companies), Value (if he can find compelling opportunities, or if the existing positions warrant being added to) and potentially finally starting investing his Water theme.