Opportunity thinking

Most of the financial news outlets are posing the question:  keep stocks or sell?

The opportunities transcend the binary choice of liquidating your portfolio or simply holding on for dear life.  No doubt about it, the next twelve to eighteen months are going to be volatile.  I think the general trend will be weakness but there will be flashes to the upside as well.  A few months ago the Dow had a +9.0% day which was huge.  I was impressed, only to find out that it was merely the sixth largest in history.  The other five times occurred in the period 1929 – 1933, in the wake of the Great Depression.**  So expect big down days and big up days occasionally.  Volatility.

In Do-it-Yourself Hedge Funds I discuss opportunity thinking.  In other words it is a way to take today’s news and  turn it into actionable market opportunities.  It is not a secret sauce but provides a starting point for your strategy objectives and implementation.

There are infinite possibilities that could yield desired results for the current year, but they will all likely derive from high volatility, and declining fundamentals, both economic and company-specific.  For example, if you have a portfolio of blue chip stocks, selling volatility premiums against it is not a bad idea.  The VIX has been hovering between 40 and 80 which allows the average investor to sell “volatility premiums” to the market.   Yes, it could limit the upside, but if you look at the equity markets since October 2008, they have been trading a fairly tight range.  Selling premia is a way to capture that vol as cash until there is a breakout either way.

You should also think of pairs trades, especially for individual securities versus their peers individually or the sector at large.  For example one thing I noticed, going into the fourth quarter of last year, is that McDonald’s (MCD) and Walmart (WMT) performed relatively well for then year-to-date, despite the prevailing predictions of gloom and doom.  Part of the reason is that these companies, while categorized as Consumer Discretionary companies, really trade like Consumer Staples in tough times.  When dollars are tight, people go to McDonald’s and Walmart to stretch their dollars.  Sad that MCD behaves as a Consumer Staples company.  But true.

Rather than take a naked buy on these companies (even they are laying off and experiencing declining performance), a relative-value trade would have provided significantly more return and arguably less risk.  A “pairs trade” of buying MCD and WMT while shorting the broad retail sector (such as XRT, the S&P Retail Sector ETF) generated a relatively stable return (>40%) in 4Q 2008. That may seem like 20/20 hindsight but, believe me, there were many hedge strategists in that trade and others that reduced full market exposure while taking advantage of relative performance.  The narrative for this trade was derived from simple daily news.

I said in an earlier post that these markets require extraordinary measures.  Yes, it would seem right now that the only thing better than money is cash.  But also keep an eye out for the opportunities that manifest themselves by very virtue of the toxic mess into which we have gotten.

-Wayne Weddington

**  I recalled these market stats from memory.. they may be approximate.

Why is this man laughing?

I share the floor of my office building with two other hedge funds.  It is an open office lay-out, partners in glass offices along the walls and the executors (traders and assistants) in the middle.  We are distinct companies but the layout makes us seem a seamless one organization.

We see each other every day but other than the traders and assistants of my own group I could not even hazard a guess as to most of the names of the other 30-odd people that work within my view.  All very nice people.  No matter…. a smile, a grunt or an empathetic nod to current market conditions is sufficient to signal camaraderie.

Interestingly we all have a different reaction to the markets on any particular day.  Each of the three fund groups here concentrates on a particular aspect of the market.  I run a Long/Short equity strategy and a Global Opportunity strategy (both doing well, detailed in a previous post as a Tale of Two Cities).

The other two groups are each fixed income shops focused on distressed commercial debt and distressed residential mortgage portfolios.  One buys up the distressed debt of the very failed institutions that have made the headlines, and the other buys residential mortgages.  They have raised a lot of money for their strategies in a relatively short period of time.

On market days when most would be crying, those arbiters of distressed securities are audibly giddy.  They sure do laugh a lot.  Lots of smiles. One cannot help but conclude that distressed debt funds are doing OK these days.

-Wayne Weddington