I’ve been thinking about my forecast for this year. At the highest level I believe that market neutral is a great idea for the next 12 months. There is a good chance that the US will see a recession this year and a great chance that we will see a quarter or two between negative 2% and 0% growth. Of course a recession is an aggregate measure of the performance of the economy and many sectors can perform reasonably well while a few perform terribly, this bifurcation will be the hallmark of the recession or at best very low growth (VLG) period. Credit spread expansion is probably the low risk high reward trade of the next 12 months but I'm not planning on making the trade.
Commodities are going to perform incredibly well over the next 5 years but the next 1 year could on balance see a period where prices end the year little changed or even moderately down from here (which is significantly down from their highs, especially oil, silver, gold and copper). Throughout this forecast you can measure commodities by looking at Silver, Gold, Oil, Coal and Uranium as these are the ones that I have a position in.
You can obviously sell all these holdings but I have decided not to for two reasons. Firstly because of an event that will happen coincident with the recession/ VLG scenario. Bernake will flood the system with liquidity because he doesn’t want our hosing bust to turn out like Japan. This will be wildly bullish for commodities and the exact timing of it is very hard to predict. This will be the setup for the next big leg up in commodity bull market. Secondly selling the holdings would incur significant tax payments.
I plan on implementing this with a mixture of QQQQ (Nasdaq 100) puts and keeping my long positions. Probably on a 2:1 short for long basis as the beta of my longs is at least double that of my shorts. The danger of a market neutral strategy is both sides of the trading going against you. The worst possible scenario would be good tech performance and poor commodity performance. This is very unlikely but possible. At least on the QQQQ side I’ve used options so I can only loose the premium which was very cheap about 8% of my equity for equal net beta coverage.
The best scenario for the year would be terrible tech performance and great commodity performance; a scenario which is somewhat realistic given that the BRICS (Brazil, India, China, South Korea) economic growth will not necessarily moderate and even if it does, as long as it’s not negative then their consumption in ’07 will be greater than last years
The consensus forecast for this year is the Goldilocks forecast with moderating but still significant economic growth leading into a reacceleration in the later half of the year. While I’d loose on my puts, my commodity heavy portfolio will do excellently. The consensus never picks recessions or other turning points and I think they’ve got it wrong.
I’m looking forward to commodity prices dropping and Nasdaq dropping at the same time. I’m going to try to pick the bottom (which I will fail miserably at) and then sell the puts and buy whatever of my favourite stocks have dropped the most. I’m excited about ending the year in a much better position than I started it.
It’s worth saying that I’ve though the recession/VLG scenario was possible in late’05 mid ’06 but less likely, hence I had less downside protection. This time around the chance is more than 50/50
VLG/ Recession scenarios – 70%
- Nasdaq up, commodities down – 10%
- Nasdaq down, commodities down (standard recession VLG fare) – 50%
- Nasdaq up, commodities up (strong growth resumes by EOY) – 20%
- Nasdaq Down, commodities up (massive reflation)– 20%
Goldilocks – 30%
- Nasdaq up, commodities down -10%
- Nasdaq down, commodities down – 20% (liquidity and/ or growth reduced in BRICS)
- Nasdaq up, commodities up (standard fare in global economic synchronised boom- see last 3 years ) – 50%
- Nasdaq Down, commodities up – 20%
I make money on 3, 4, 7 & 8 (50% chance). I stand to loose on 1 & 5 (10% chance).
2 & 6 (40% chance) are the most interesting because whether I make a little money, breakeven or lose depends on how the Nasdaq compares with commodity prices. I actually think that the Nasdaq 100 has more to loose than commodity stocks because its components are more highly valued and generally technology is deflating while commodity prices are inflating.
I expect to end the year moderately up and owning more shares of my favourite commodity stocks bought at cheaper prices. I expect to outperform the major indices, I expect to see a lot of volatility (which helps my puts make money) and a year of moderate capital gains.
Let the year begin!