Today was a rotten market day, in a rotten market month, in a rotten market year, in a troubled economy.  Otherwise, things are OK.

The Good News:

Aggregate bonds (AGG or BND), Treasuries (SHV, SHY, IEI, IEF, TLH and TLT) and investment grade bonds (LQD) were up.

The Bad News:

Municipal bonds (MUB), below investment grade bonds (HYG), international sovereign bonds (BWX), and emerging market bonds (PCY) were down.

Key equities asset categories were all down significantly.

The Bond Picture Today:

Bellwether Asset Categories:

We watch these ten key asset classes as macro level representations of the larger world of investment assets (asset type / proxy fund):

• US Stocks (VTI)
• Non-US Developed Market Stocks (EFA)
• Emerging Market Stocks (EEM)
• US Real Assets (VNQ)
• Global Commodities (DJP)
• US Aggregate Bonds (AGG)
• US Treasuries 7-10 Years (IEF)
• US Dollar Index (UUP)
• Crude Oil (USO)
• Gold Bullion (GLD)

Bellwether Asset Category Performance Since September-End:

Here is how the bellwether funds performed over the last 36 days (essentially October and November to-date).

Key bonds and the Dollar are up.  The rest are down — mostly down hard.

The chart for each bellwether fund shows price change in percentage terms, and is contrasted with price change for SPY (proxy for S&P 500 index), as well as the fund’s 20-day, 50-day and 200-day simple moving averages.

The returns in the labels are the price change over the 36 days.  The subject asset category is plotted with candlesticks, and SPY is plotted in gray as a line chart of closing prices.

click images to enlarge

US Stocks (VTI, down 31.4%)

Non-US Developed Market Stocks (EFA, down 32.1%)

Emerging Market Stocks (EEM, down42.7%)

US Real Assets (VNQ, down 56.5%)

Global Commodities (DJP, down 28.1%)

US Aggregate Bonds (AGG, up 0.2%)

US Treasuries 7-10 Years (IEF, up 3.0%)

US Dollar Index (UUP, up 9.5%)

Crude Oil (USO, down 45.3%)

Gold Bullion (GLD, down 16.8%)

Longer Historical View of Key Asset Category Performance:

Our November 17 post, provided longer historical data for the ten key asset categories — from 200 days to a year — in several different formats, including calculations of the price change necessary for each asset category to reach its highs, lows, and moving averages.  It also provides volatility risk ratings from the Risk Grades data service for each key asset category.

What To Do With Cash?

We have major portions of our portfolios in cash, and have had since July. While we don’t believe in market timing, this situation, which began to show itself in the summer, is an historic storm that we chose to let pass. The sky became dark, the air changed, and the wind began to blow.  We went into the storm cellar.

It’s was not timing.  It’s was self-preservation.  There’s a difference.

Our problem now, is when and how to re-enter profitably with limited risk of loss, while not missing too much of the upside.  Since we haven’t lost much on the way down, we can miss the early beginning of the up cycle and still be ahead.

We don’t think the right conditions exist today to commit cash to equities.

Whether we are near a bottom or not, we will let braver souls probe and test before we commit more risk capital.  In the meantime, one of our key investment activities is observation, study and thinking about re-entry.

Critical Dimensions for an All Clear:

Here are the things we are thinking about as we seek a prudent re-entry point — information we will use to become comfortable that the storm we avoided has passed by:

1. Technical Market Factors
2. Valuation Fundamentals
3. Risk Levels
4. Government Intervention Policies
5. Economic Conditions

This very difficult period will eventually end, and those with cash will probably generate substantial returns after re-entry.  While waiting for that new day, this is what we would like to see for each of the five critical dimensions.

1) Basic traditional price and volume charts need to stop flashing danger signals and show a period of sustained flattening or rising prices — we’ll sacrifice the very early gains to reduce risk of loss.

2) Valuation fundamentals based on reported historical growth and profitability, not estimates of future growth and profitability, need to stabilize and be at attractive levels.

3) Risk in terms of actual and feared corporate bankruptcies and frozen credit market situations need to decline, and price volatility needs to moderate substantially.

4) Government policy in the US needs to become clear — installing the new President and new Congress, and seeing what they say they are going to do.  Governments here and abroad need to stop announcing new budget busting rescue programs and abandoning or converting old programs to solve financial market and general economy programs.

5) General news about the major domestic and international economies needs to become less threatening.

Next Steps:

We and our clients each have our own individualized long-term asset allocation plan, based on our own facts and circumstances — some conservative, some aggressive, etc.  However, we all have more cash than the long-term plan contemplates.

We will be legging into our long-term allocation plans over multiple periods, and will use persistent trailing stops to partially protect against being too early or wrong in our decisions.

If strong rallies materialize in certain asset classes before our general criteria are satisfied, we may chose to participate with some of our capital at a faster pace than our basic legging-in plan, but with fairly tight trailing stops to potentially capture rally benefits while avoiding riding the rally back down if it fails to continue.

On to tomorrow …

Richard Shaw
QVM Group LLC

This entry was posted on Wednesday, November 19th, 2008 at 9:16 pm and is filed under Asset Allocation. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.