Temporary Respite or Beginning of a Larger Bounce?

I don't know the answer to the above question. No one does. What I can see is are some massive short term gains in the financials and commercial real estate names - so this gives some opportunities to build up some exposure on the "insurance" side (buying some Ultrashorts to offset the long exposure). Hopefully, this is the beginning of a decent sized move up (before what I think will be an inevitable move down to follow) but in case it's not I do want to have more short exposure.

While the past few days have seen tremendous moves in the "worst of breed" washed out sectors - retailers, commercial and residential real estate, financials, etc - this is probably just a condition of short covering and dead cat bounce buying, rather than any serious turn back to these sectors for the longer term. We still have a lot to deal with in these groups. To seriously buy these areas you have to believe that financial balance sheets won't continue to degrade due to (a) more mortgage issues not just in subprime but alt A and prime (b) no increase in defaults due to consumer loans, auto loans, credit card debt, student loans, etc and (c) consumer spending will suddenly be coming back in a large way. I find this thesis improbable.

If one looks at a 18 month chart in any homebuilder, even the best of breed (for example a Pulte (PHM)) this is what I can see in store for many of the names in these sectors - a long secular downturn punctuated with huge oversold rallies. On the long side, great for short term spurts but much much easier to play from the short side. One day, one of these rallies will hold and it will be time to change the view, but I don't think this is it. With that said, others like Cramer think it is. :) So I could be wrong and "the bottom is in". Surely many of the government intervention actions we are seeing borne of late (and more to come in the future I am sure) will ameliorate the worst case scenarios but even the "middle case" scenarios does not bode well for these sectors in my book. As discussed yesterday I do think recent actions will allow those who bought homes in 2004 and previous to now recapitalize their debt (back into their homes) as they pull out equity to pay for consumption and current debt, but we still have a large swath of people under water in 2007, 2006, and parts of 2005. Plus we still have those renters and working poor with no shelter from the various storms hitting the economy.

So I will begin to layer in some short exposure here; still hoping for a more sustainable move up (and thus potentially losing money on this layer of short exposure I am adding today), but trying to focus on the big picture. Also keep in mind what has led to the fund success was this paired trading idea - buy good stuff, buy short exposure against bad stuff. This works very well, except in times the market goes haywire and "everything goes down" such as the past 3 weeks. Contrast that to December where "good macro trends" were rewarded (and thus long positions in those areas went up) concurrent with "bad macro trends" were punished (and thus short exposure in those areas went up)... so we had a perfect storm many weeks where even as the market moved sideways or slightly down, the good sectors (which we were long) went up, and the bad sectors (which we were short) went down. This is hopefully an era we can return to. But as we have seen when panic rules, nothing works and everything is sold.

So with that said, and noticing my Mosaic (MOS) exposure is approaching 9% and Potash (POT) 5%, I am going to take some short term gains out on both to raise cash, along with selling a portion of coal play Consol Energy (CNX) which has also bounced nicely. I think true value in all these names is far higher, but since I have been buying these type of names on the dips down I have some good short term gains I can "book" while maintaining sizeable long exposure for potential further moves upward. I will use this cash to start wading into some short exposure - I am buying pieces of all 5 of the Ultrashorts that have done well for me in the past - Financial, Real Estate, Russell 2000, Emerging Markets, and China.

To show how violent the moves have been Ultrashort Real Estate (SRS) peaked over $150 2 days ago and is now below $110. Ultrashort Financial (SKF) peaked around $145 and now is $105, 2 days later. Now these were "panic peaks" but even in the depths of the abyss SRS was trading around $135-$140 and SKF $125-$130. So this is quite a large discount from where they have been trading of late.

If/when the market strengthens I would like to increase this short "bucket" exposure from 5-6% to something closer to 20% (which is what I entered 2008 with), and then also build a cash stake. Again, nothing is guaranteed to us and for all we know the bounce ends here. That would be atypical, but nothing about the market the past 6 months has been typical. However things have sold off so substantially we can make a 10% gain from here in the indexes, and still be within a longer term downtrend. (which I still believe we are in). However the hope is the next move down is not quite so violent and not all stocks are considered evil from the long side. This way, good stock picking can still be rewarded.

Long all names mentioned except Pulte Homes in fund; long Mosaic, Potash, Ultrashort Real Estate in personal account