Two Big Questions for the Market

11/03/2008 1:00 pm EST

Focus: OPTIONS

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

Bernie Schaeffer, editor of the Option Advisor, says investors shouldn’t assume the worst is over, because there’s lots of danger in the market.

There are two huge uncertainties facing the market.

1. No one knows how the credit situation will play out, even with the bailout, and no one knows all the unintended negative consequences of the bailout, which already include a very unwelcome increase in mortgage rates and a rise in the value of the dollar that has further weakened the commodities market and thus contributed to additional devastation of hedge-fund portfolios.

2. No one knows how much more hedge fund unwinding there is going to be of their heavy long exposure in such sectors as commodities and technology, due to an ongoing vicious circle of devastating market losses leading to investor redemptions leading to forced liquidations and to further investor redemptions.

This was a two-trillion-dollar market player at the beginning of this year—that exerted an even greater impact on the market due to huge portfolio turnover and leverage—that is already well on its way to imploding. And it may be far from over. “The chief executive of a leading alternative investment manager said he expected the hedge fund industry to shrink by 50% in coming months—with half the decline coming from withdrawals and half coming from investment losses,” according to the Financial Times.

While many will equate uncertainty with opportunity, it is actually unfortunate for the prognosis for this market that so many are doing so at this time. Yes, there is fear out there, and certainly there is panic on individual days, but the talking heads and the typing heads and the bloggers have had a strong tendency to tell us it is too late to sell and that there is “value” out there.

The much-cited spike in the CBOE Market Volatility Index (VIX) and its validity as a “fear gauge” has been compromised by the fact that VIX levels have actually been tracking (and, for the most part, trailing) actual market volatility. And our proprietary equity put/call ratio, as well as that of the International Securities Exchange that tracks “buy to open” option activity, have been reflecting a less-than-impressive degree of put activity relative to call activity given the devastation in the market.

I [have] placed a very high degree of importance on the Standard & Poor’s 500 Index (SPX) holding at support at its 160-month moving average, as it had at the 2002-2003 market bottoms. But the S&P [recently] closed about 20% below this key moving average, which is currently at about 1,127.

So where do we go from here? The market is certainly “oversold” and could bounce hard, but I would remain quite defensive, looking to hedge any long stock exposure with shorts or with put positions on exchange traded funds (ETF), including the “double inverse” ETFs on such still-vulnerable sectors as energy and technology.

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