Portfolio manager Andrew Laubie: Hard to imagine how this market could go higher

Author: Andrew Laubie

Model: Russell 2000 Long-Short

How long can a plane out of gas keep on flying?

For 2011, I am trying to follow the advice of my mother and be more positive. To a large extent she is right: being optimistic paid very well in the last six months of 2010. The Russell 2000 Long-Short model critically underperformed the Russell 2000 as I was leveraged short on that year-end rally. Yet as volume significantly declined, I wondered what crazy or genius investors would keep buying stocks at current price levels. The answer is surprising, yet logical: the shorts got squeezed out. According to the NYSE short interest updates for November and December 2010, the number of shares short on the NYSE group has dropped to the lows of 2010*. So outside of the bears covering their short positions for risk management purpose, low volume indicates that there are no real buyers in this market.

Fundamentally, it is very hard to imagine how this market can go much higher. Do investors really think that current equity valuations are cheap? Not if we look at a historically accurate indicator: the Q Ratio, a market valuation method developed by Nobel Laureate James Tobin. The Q Ratio concept uses data released by the Federal Reserve to divide the total price of the market divided by the replacement cost of all companies. Currently, it values the market as 75% overpriced (1.14) from its geometric mean (0.70)**. Since 1900, the only time the Q Ratio went 75% above its geometric mean was in 1999, as it indicated a 178% overbought distortion from its geometric mean. The only previous times it reached similar levels was prior to major bear markets (1906, 1929, 1930 and 1968).

I see this market rally as a plane flying out of gas, flying solely because it is being pulled by another plane piloted by Ben Bernanke. The question I ask myself is how long can the market plane keep on flying once Bernanke’s plane runs out of gas too? Adding water to the plane’s gas tank does indeed fill it up, Mr. Bernanke, but there is a reason planes run on fuel and not just any liquid[ity]. But then again, that loving haunting voice reminding me “stay optimistic”… and perhaps this new liquid is none other than the renewable energy solution we all dreamed for!

This month, the model will occasionally go long the Russell 2000. However, these would only be short term technical trades. The main idea is still to be short the Russell 2000 with leveraged ETFs (especially TWM and SRTY).

*source:  http://online.wsj.com/article/BT-CO-20101227-705260.html, 12/27/10
** source: http://dshort.com/articles/three-valuation-indicators.html