Below is an excerpt from Breakfast with Dave, February 9, 2010.
"We highlighted yesterday what this means for asset classes and sectors: If past is prescient, it would mean a test of 900 on the S&P 500 with defensive "yield" sectors taking over leadership (utilities, staples, health care — in fact, biotechs have held in very nicely during this recent market selloff). Bonds outperform stocks (with the Treasury market undergoing a bull-steepener — though see below why a bond rally may be led by the longer end of the curve this time around). Volatility increases substantially. Credit spreads widen and commodities get crushed. This is a time for conservative investing with cash on hand to be put to work once better valuations emerge — we are not quite there yet, in our view.
"It always pays to look and see how the market is positioned — this would have helped a lot when the appetite for risk peaked in late 2007 and reappeared in early 2009. So, we look to the Commitment of Traders report that is published every week and look at the "net" long or short position across the various asset classes (futures and options), particular among the 'non commercial' accounts, which is a proxy for the 'speculators' or momentum investors.
We found that even after the move towards risk aversion and defensive positioning in recent weeks, there may be more to go. The VIX still has a net short position of 2,395 contracts. There are 9,225 net long Dow contracts and as far as the S&P 500 is concerned, speculators are still net long 99,675 contracts. The Australian dollar still commands a net long position of 33,524 contracts; and 17,209 net long contracts out there for the Canadian dollar.
There are 90,709 net short contracts with respect to the 10-year Treasury note, but 173,637 net long positions for the 2-year Treasury note (this would actually augur then for a bull flattener if these shorts on the 10-year not close out). The long bond is still net short by 92,358 contracts — again, if these shorts are covered then we could get one humdinger of a rally at the back end of the Treasury curve.
In the commodity space, only natural gas has a net short position (81,010 contracts) – there are 160,232 net long crude oil contracts, 222,282 net long gold contracts and 18,069 net longs on copper. Invest accordingly.
All we can say is that here we are with a 0% policy rate, a $2.2 trillion Fed balance sheet and a massive 10.5% deficit-to-GDP ratio and the strong undertow of deflation has not gone away, and governments have few, if any, bullets left in the chamber. We have industrial metals prices coming under downward pressure, price wars in the telecom sphere, and of course, ever since the Department of Agriculture told us last month that this year will provide a bumper crop of farm products, we have seen the likes of corn prices plunge 16% and soybeans by 7% (see page C1 of the WSJ for more). Below we list how to position the portfolio for a deflationary backdrop."
FIVE WAYS TO PROTECT A PORTFOLIO IN A DEFLATIONARY BACKDROP
- A focus on safe yield, wherever you can get it. High-quality corporates (non-cyclical, high cash reserves, minimal refinancing needs)
- Equities: focus on reliable dividend growth/yield; preferred shares ("income" orientation)
- Whether it be credit or equities, focus on companies with low debt/equity ratios and high liquid asset ratios – balance sheet quality is even more important than usual. Avoid highly leveraged companies at all costs.
- Ultra-selectivity with regard to financials. Same for retailing.
- Focus on sectors or companies with these micro characteristics: low fixed costs, high variable cost, high barriers to entry/some sort of oligopolistic features, a relatively high level of demand inelasticity (utilities, staples, health care).
