Thursday, April 26, 2007

Overbought and Over Bullish

With new headlines peppering the media about how the stock market (or, more accurately, the dow) is reaching all time highs, its worth taking a step back and evaluating your holdings and market exposure. As a general rule, when we see headlines like this, I get nervous. A rule of thumb I have is that when your taxi driver and everyone you know if bragging how much they are making with a certain kind of investment, you know you have reached a top. Though that may not be the condition of the market now, conditions seem unlikely to produce good long term value from here, and run the risk of a deep, prolonged downturn.

Though I have the majority of my investments in stock holdings, I have hedged out most of my market exposure through shorting individual stocks, as well as indexes. In conditions such as these, the performance of my portfolio is the difference between the performance of my long holdings, against those of my short holdings. In conditions such as now, where I believe short term returns to be negative to flat, this investment stance has the benefit of lower volatility and higher returns than a simple long only strategy woudl afford me.

For those of you interested in a great catious view of the stock market, I strongly urge you to take a look at Hussmans new article, posted here. As always, his weekly articles are gold.

Catious investing to all

2 comments:

Ohad said...

Eric,
I think you are right about the coming months. i don't think equity markets will crash, but a 7%-10% correction sounds pretty reasonable, even healthy.

To be honest, I never understood shorting stocks as a strategy. why would you want to expose yourself to unlimited losses and very limited gains? It seems to me that the reasonable step is simply selling part of your holdings or perhaps buying some PUT options.
could you elaborate about what is the logic behind keeping your stocks combined with shorting some of them.

btw,are u still in Asia?

Research Intensive Investing said...

Ohad,

Thanks for the comment. I am still traveling, but will be returning to the US soon (when I do, my posts, both to comments on to the blog itself, should once again be more frequent).

I plan to write an article on shorting soon, but I will give you the general overview. Shorting can be very dangerous, if you short the wrong stocks. For example, I do not short fast growth stocks with unlimited growth prospects (this is how people lose their shirts). I usually short overvalued, moderately growing companies who are likely to miss earnings in the near term. I have a specific catalyst in mind, and if it does not materilize I exit the position. Value investors club has some great short ideas on there that may be worth looking into (my favorite, currently, is shorting the REIT index).

The main benfits of shorting is that you significantly reduce volatility while simultaneously potentially increasing your absolute returns.

I have used puts, at times, but they are a bit more complicated and require more attention than I am able to give them.