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Market neutral strategy


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The S&P 500 is now around $920. Reported earnings are quite poor to support this index level and if you look at normalized earnings, we are probably trading around 13 times earnings. It is really hard to estimate normalized earnings going forward since there has been a major distortion in earnings from the financial sector which was until recently a huge contributor.

 

In Canada, the financial sector has been on fire. With banks now trading around 13 times 2010 earnings and around twice book, I think that the move up is largely done.

 

The multiples above are around normal vs the past 100 years. To me it means that you are very unlikely to see a 50 to 100% advance in the S&P 500 or Canadian financials in the next 12 to 18 months. Add to this the mountain of uncertainty related to massive issues of U.S. treasuries, a likely California default and very few signs of green shoots and it is hard to imagine large growth in index earnings or very much improved investor sentiment. 

 

If you look at smaller companies, there are still opportunities despite the market advance since March 9. But 10 to 20 cents on the dollar opportunities have largely disappeared. You have to be very selective and aware of recessionary impacts on small companies especially if they carry debt. 

 

So what I am investigating is to be short the market and long individual opportunities. I am typically close to fully invested, but I had to sell some positions since they got close to fair value or quite above my portfolio valuation. Cash is now building up and I am having difficulties finding new mouthwatering bargains. If the market retreats I will likely be able to easily reload.

 

In the meantime, cash is earning nothing. I could wait for opportunities to simply appear or for me to find them to redeploy this cash. It just seems to me that some bear ETF's could provide some "income" if the market pulls back, same as cash if the market stays flat and could hurt me if the market advance. The latter should simply mean fewer gains since some of my stocks should explode with a better economic climate.

 

Another strategy previously described by Mohnish Pabrai is to buy BRK when cash is building up. It would seem very smart at this time since BRK seems very attractive. Buying FFH or ORH currently also seem to fit the mold since they have a built-in discount vs the S&P: they should be valued higher due to their gains in S&P stocks, but the market has not reflected it.

 

Anyone in this situation or looking to employ such strategy?

 

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Mungerville, 

 

If you don't mind, I am curious... have you used an S&P500 Short ETF? Or something more sector targeted?

 

What ratio of short to long investments did you choose for this arrangement?

 

Have you discovered any pitfalls with this approach over the last two years? (I like to learn vicariously)

 

Thanks in advance for your thoughts.

 

-nodnub

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Been doing something similar for a very long time.

That said:

 

(1) Cash is not earning nothing; its also earning you the opportunity gain x the P(x) of the adverse event occurring. You are seeing only the tip of the total return.

 

(2) Reinvesting the cash immediately is doubling risk - unless you're absolutely certain that the investment will immediately move up if your adverse event occurrs. No one can be that certain.

 

(3) This comes from arbitrage & the pressure to 'keep the cash working'. As in the martial arts; redirect vs fight that pressure & you emerge smelling like roses.

 

SD

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