Trader’s Narrative

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For obvious reasons, the current bear market has been relentlessly compared to the previous one that we lived through just a few years ago. But while a long term chart of the S&P 500 Index (SPX) would suggest, through a massive double top formation, that the two are similar in scope, that isn’t really the case:

In fact, if we look at the stock market as would the the average investor, we find that the average “Joe” has lost much more money in this bear market than the last.

That’s because no one really allocates their portfolio according to the capitalization of the stocks they are buying. Instead, they buy a smattering of mutual funds, individual stocks, sector ETFs, etc. So a more accurate representation of this “average” portfolio is the equal weight indices. For example, as represented by the Rydex S&P 500 Equal Weight (RSP) ETF:

Although the chart above is for the ETF, it is confirmed by the more widely used equal weighted index, the Value Line Arithmetic Index - a much wider index with 1700 individual constituents. It has also fallen approximately 60% in this bear market.

The other interesting aspect of the market that we see through this chart is that in both cases, capitalization weighted and equal weighted, price has approached (and seemed to have bounced off) support.

There a few ways to take advantage of the January effect this year:

Small & Micro-Cap ETFs
The simplest would be to buy small cap stocks or ETFs before the year end and hold until they have a pop. Since the definition of “small-cap” has been continuously revised up over the past few years, it might be a good idea to look at “micro-cap” stocks. Here are a few ETFs:

• iShares Russell Microcap Index (IWC)
• First Trust Dow Jones Select MicroCap ETF (FDM)
• Powershares Zacks Micro Cap Portfolio ETF (PZI)
• Powershares Dynamic OTC Portfolio ETF (PWO)
• iShares S&P SmallCap 600 Index Fund (IJR)
• iShares Russell 2000 Index Fund (IWM)
• iShares Morningstar Small Core Index Fund (JKJ)
• SPDR DJ Wilshire Small Cap ETF (DSC)
• Vanguard Small-Cap ETF (VB)
• PowerShares Dynamic Small Cap Portfolio (PJM)
• PowerShares Zacks Small Cap Portfolio (PZJ)

Closed End Funds
Last week I mentioned a method to capture January effect alpha which uses CEF and specifically, municipal/bond CEFs. This year is a bumper crop for this specific strategy because of the vast number of these funds which have severe losses.

Value Line Futures Index
Yet another way to play the January effect is to use the Value Line Arithmetic Index futures. This is a little known equity index compiled by Value Line Inc. - the investment research outfit. It is comprised of approximately 1,650 stocks which are equally-weighted, as opposed to capitalization weighted as in the S&P 500 Index.

The futures for this index are traded at the Kansas City Board of Trade with each contract valued at $25 times the value of the index (appx. 1324). The Value Line January effect strategy is pretty straight forward:

Buy the Value Line contract (nearby month of course) and (sell short) equal value ratio of the S&P 500 Index. Close the position in the first week of January. Depending on the calendar, around the 9th of the month. That’s it.

This simple spread trade has a remarkably high profitability ratio but sadly it only comes once a year. And the advantage it has to the other two year end strategies is that it is market neutral. Although I suppose you could short SPY to offset a long position in small/micro-cap ETFs.

Usually I have trouble parsing Cramer’s advice. But just a while ago he was surprisingly lucid. I’m referring to Cramer’s call for people to take out money that they would need in 5 years’ time. Remember that? Here it is again, in case you missed it:

Well, it turns out a very reliable indicator is now flashing buy. The funny thing about this indicator is that it isn’t a short term buy signal. But whenever it has indicated a buy point, as it is now, the market has been higher four years in the future.

VLMAP
The indicator is the Value Line’s Median Appreciation Potential which is the median measure of how much higher or lower a large sampling of stocks will be trading as indicated by Value Line’s analysts. VL itself frowns on using it as an indicator but according to a market timing system devised by others, VLMAP signals a buy when it rises above 100 - meaning that in 4 year’s time, stocks will be trading higher by 100%.

As Mark Hulbert reports (link above) the last two times that VLMAP has given a buy signal were after the tragic events of 9/11 and at the bear market bottom in 2002. It also gave a signal in mid-July when the markets spiked lower.

Hulbert was kind enough to send me the in depth study he cites in his article. It concludes:

While it is clear from the above regressions and analysis that VLMAP is not a perfect predictor of the market, it is also true that VLMAP does have strong statistically significant forecasting powers. …The Value Line Composite Indexes, especially the geometric version, have the best track record in comparison to VLMAP. During the decade of the 1990s, the Russell 2000 is the best market measure as predicted by VLMAP.

While VLMAP may not represent the long sought after Holy Grail for predicting the market, it nonetheless proves to be beneficial and worthy of investors’ attention.

You can download & read the whole report in my Free Trading Resources section (under Reports & Articles). But be careful you don’t get stuck there rummaging through all the other free stuff there.

I don’t have a crystal ball and this indicator is, like everything else, far from an iron-clad guarantee that the market will indeed be higher… but watching Cramer put in that sober performance, I couldn’t help but think that he will regret it. It was a gut feeling but now there is quantifiable data to back it up.

But of course, considering the short term memory of the average “Cramerican” within four years, even if the market is higher, they won’t bother to remember it. Just like they ignore his call at the top of the tech bubble cheerleading bloated stocks even higher or his most recent disasterous calls:

In March, he said Bear Stearns “is not in trouble.” After Bear Stearns tipped over, he wrote in his New York magazine column that the bottom had finally come. “I feel the bear has been tamed, and the worst of the clawing is over,” he said. And on Sept. 15, he hosted his friend Robert Steel, chief executive of Wachovia, and suggested that its $10.71 share price was a bargain. Two weeks later, it was at $1.84.
Source: Cramer Retreats Along With The Dow

Booya?