Tuesday, February 27, 2007

Stocks Down Sharply, Fear Up Sharply, But Some Good News for Bears

As most of you are already aware, stocks suffered their worst loss today since the tragedy of 9/11. In total, more than half a billion dollars in stock value were wiped out. Markets were down world-wide indicating a broad scope of weakness.

Bears, it looks to me that our stock market just got a whole lot riskier. But don’t take my word for it.

There’s an interesting index called the CBOE Volatility Index that measures option prices on one of my favorite investment vehicles, the S&P 500 index. This volatility index is often referred to as the “investor fear gauge”, a whitepaper from the CBOE explains why:

“Historically, during periods of financial stress, which are often accompanied by steep market declines, option prices - and VIX - tend to rise. The greater the fear, the higher the VIX level.”

This index rose 64% today on extremely heavy volume, indicating a dramatic and wide-spread decrease in investor sentiment related to the stock market. And an increase in investment fear.

Prices down sharply, fear up sharply. Not good news for the stock market. So what’s a bear to do?

Well, I think the answer to that depends a lot on your particular situation, but I’d offer that the most important things for bears right now is to preserve their capital to be used for their eventual home purchase. Less risk and more liquidity are the order of the day. I wouldn’t hazard to make any specific suggestions, but I will share with you what I’ve done.

Up until this point, I had the HB Bear Family Fund (the collection of our assets including our future down payment) allocated roughly 70% stock ETFs, 20% bond funds and about 10% cash, what many would consider to be an aggressive portfolio. As of the end of trading today we are at about 45% stocks (including a significant new short position on QQQQ), 25% bonds and 30% cash--what I would consider to be a good allocation, if slightly too aggressive, for my 73 year-old mother.

Yes, I am investing like an old woman, but I feel good about it. Our return on these investments has been very good, but as the saying goes, “hogs get slaughtered”, and my down is too important to expose it and our other assets to unnecessary risk.

One ray of sunshine at least from a housing bears perspective is that contagion that struck subprime loans is spreading to “A” rated securities as well. We’ve all seen the BBB rated credit swap charts dozens of times by now, but no one seems to be showing the “A” rated credit swaps; so here it is:

Down, down, down. Meaning the cost of insuring against losses is up, up, up which likely means that this market will be tightening, just as the subprime market already has. If credit tightens for this segment, you can bet that demand will dry up even further, possibly profoundly so.

So take good with the bad, talk to an investment adviser about your situation, but most of all remain vigilant. The Chinese have a curse said in disdain to their enemies that loosely translated says, "May you live in interesting times." Friends, these times are becoming more intresting than I think anyone would like.

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