The first quarter of this year could not have ended soon enough. Frought with volatility this past quarter was the most dissappointing of our 17 years in the market. The only quarter that delivered as much pain was back in 1998 and the close second occurred in 2003.

Most all of the hurt came in January, followed by a sucker punch in mid-March. We then got very defensive and remain so at this writing. It does feel like a bottom is in but I think it too early to tell with certainty.

I read with interest that a fellow money manager, the famed Bill Miller of the Legg Mason Value Trust posted his biggest first quarter drop in 26 years. You may know that he held the throne for beating the S&P 500 for 15 straight years (though many years it was by just a smidge). He put up a negative 20% for Q1… Yes Bill, it was a bugger… Here’s the story

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“Live to fight another another day” was what I told a client yesterday after going to a large cash position and putting on the protective hedge. Discipline, and sticking to the discipline, is key to making sustainable long term profits in the stock market. In the case of going defensive yesterday the discipline came from having a YTD downside threshold below which we would not want to see the portfolios break.

Of course, today the market has its best day in five years. As I shake my head at the irony of that I remain comfortable with where we are. We made money today, not as much as we could have, but still recouped some today. The current portfolio set-up has still a bias to the long side of the market so if we get follow through we will still capture upside.

Over the many years of being in the market I have always said that when I get to a point where I think significant protection is required it is usually the bottom. While one day does not make a trend this may signal a turning point for the market and our portfolios. I hope so, but I am not so certain we are out of shark invested waters just yet. As a result we will see over the next week or so how the market acts and perhaps put some of the cash back to work.

It is very likely that today was simply a relief rally sparked by the Fed’s infusion of fresh liquidity to the banks. Short covering also played a factor today giving an extra boost to the upside of the market.

After being beaten up for over three months Wall Street breathed a sigh of relief today and reveled at the news. I look forward to see what the rest of this week brings.

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The market action over the last two months has been nothing short of horrendous. Today the averages pierced our downside floor of comfort and we raised 30% cash across all portfolio models. In addition we initiated the hedge using equal percentages of two double inverse ETF’s, the (QID: 37.44 -0.08%) and (SDS: 54.67 -0.31%); double short the Nasdaq 100 and S&P 500. We will potentially add to these positions should the market break below 1250 on the S&P.

In addition we have established stop levels on the remaining long positions and will evaluate whether or not to exit should these prices be touched.

We were motivated to take this defensive posture as it has become clear that all stocks are being sold regardless of quality. It is my suspicion that the credit crisis has evolved into a virus that is permeating all areas of credit, including specifically margin credit. As a result investors are selling stock to meet the calls, and more specifically the multitude of hedge funds that are leveraged 100% to 300% are being asked to reduce the exposure by their respective banks.

My clue to this has been the destruction and carnage I saw last week, and today, in the Basic Materials Sector. According to our research this sector has led all other sectors in performance for over one year. This sector has been down every day for a week anywhere from 1 to 4%. Energy is also being sold but I think for other reasons than the need to raise cash.

Basic Materials is a large and far reaching sector containing many high quality, blue chip companies. Our clients profited handsomely from our investments in the sector over the last year, but today we sold most all of our Basic Materials stocks. Our research remains fond of these stocks but this is a sick market that has no logical pattern for now.

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Just a brief comment as to our desire to hedge using the QID and SDS.

Market timing is very difficult, if not impossible (especially in this market). Years ago, no years and years ago, I fancied myself as quite the market technician, scanning the charts and producing divine wisdom of direction and opportunity. Most of the calls were pretty good, and many weren’t. Over time I found my knowledge of technical analysis to be useful, but certainly not the method to produce sustainable returns over time.

Hence why I gravitated to Qauntitative Analysis as the backbone of our research. It is far more objective and has proven to be extremely profitable over time, whereas the market techicians are faced with subjective analysis and as a result spotty returns at best.

That said, when a decision has to be made as to when it is best to put on a protective hedge it involves primarily “feel” and a large dose of technical analysis. The decision must also be made carefully over a period of time so as to not find ourselves “short” when the market decides to be “long”.

This market has been ragged for some months now, going back to October of last year. The pull back in November that left the market barely up on the year was met with a huge rally into December effectively zeroing the decline. Unfortunately since then it has been a horrible tape with the benchmark Russell 3000 down nearly 11% from that point.

Here is the analysis… Market sentiment plays a key role, and while there have been concerns over sub prime, going into the end of 2007 it seemed that most of the problem was factored in. However, it is important to note that since the Fed meeting on December 2007, which netted only a 25bps cut in rates, the market has taken on the fear of recession in addition to financial struggles in the mortgage industry. There is now a significant lack of faith in the Federal Reserve having what it takes to properly steer our economy. This in addition to concerns that the Bush administration may not be acting fast enough to produce a stimulus package.

In a nutshell, sentiment is very poor. Sentiment is also a contrarian indicator, so as it sours it presents a greater likelyhood that an upside reversal is soon to come.

Technically the market has been in a wide trading range going back to about June of 2007. We have been able to capitalize on this volatility which contributed to our 17.5% net return for our Multi-Cap Growth & Value portfolio in 2007.

With the market in a confirmed trading range it becomes difficult to choose where and when to put on a hedge. Most all periods of decline last year were very short and steep. Just since October we have recorded several of our worst one day declines in the history in our 15 years of running money.

Therein lies the problem with hedging this market. First, the declines are steep and last for only a few days, with most of the pain coming on day one. Second, by the time enough information is available to make a determination it is more than likely we will have put in a bottom and reversed. This continues to be an issue today.

The Dow Industrial Average, a reasonable proxy for the market, had a lower trading range, and some considerable support, at 12,700. It has come down and tagged these levels four times in the last 12 months and held. In fact we went through five days of what appeared to be natural base building just a week ago.

At the end of last year we had built up a significant level of profit and held a strong cash position going into the last few days of the year. As a result there did not appear to be any urgent need to add a hedge during the last week or so of tax loss selling of 2007. In fact, the rally into year’s end was seen as a typical reversal and we went back to 100% invested. In hindsight that didn’t help us at all…

Right at the beginning of this year the Dow dropped nearly 4% in three days, leaving no time for retooling and putting on a hedge. The next five days were very volatile with 2%+ moves up, then down, up then down. We perceived this as signaling the end of the bearish declines and were given no reason to expect any further significant down moves.

Of course, the Dow lost over 5% in two days following and finished the week whimpering.

Thankfully our positions in energy and basic materials allowed us to recoup +1% on Friday while the market finished -1/2% lower. A sign that we remain properly positioned in the right stocks in the right sectors.

While there is little to do at this point relative to a panic sell off tomorrow, we will be closely monitoring the markets and your portfolios. I have a mind to be a buyer, but we will see how the day plays out.

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We generated cash in the portfolios last week, and very happy to have done that. As I write this Monday holiday it appears the oversea’s markets have behaved horribly and our Dow Jones futures market is down 480 points, or about another 4%. I expect a very ugly open tomorrow and am thankful to have cash available, for if history is any guide this will be a buying opportunity. Virtually every deep, panic selloff has been met with significant rallies in the days and weeks after.

In our case it seems to me that we are going to have to step up the pace and take on more of a trading mentality. The sentiment of the market is very poor at the moment, and at least for the short term investors may look at any upside as an opportunity to move out of stocks.

As most of our market is traded by mutual funds and hedge funds it is likely that we may begin to run into redemption selling which further exacerbates the problems we already have in the market.

Several bellweather tech stocks announce earnings this week which, if IBM was any indication, should meet expectations. If so this may help the market, at least for now.

The Bush stimulus plan discussed on Friday was met with a lack of confidence from Wall Street. If we get a rate cut from the Fed that may stem the tide sooner than waiting for Congress to pass the stimulus plan. Frankly, at this point any good news would be appreciated.

This market now feels very much like early 2000. 1999 was a great year for us, as was 2007. The decline started on January 19, 2000 and did not stop until early March, a decline of 15%. So far the DJI is down 10% from the high December 11, 2007 and 9.3% YTD. So, with an early sell off of 4% tomorrow we will have more or less equaled the initial drop in 2000, but in just 12 trading days rather than two and a half months in 2000.

Regrettably the market has taken back all of the gains of 2007 and then some. We have to go back to August 2006 to find these current levels, effectively nullifing 16 months of hard work.

Of course, we are in the business of making money out of money and are only as good as the market will allow. Though things appear pretty bleak right now the selling will abate and investors will return with more confidence. There really is nowhere else to invest domestically, and with bond yields soon returning negative yields after discounting inflation and taxes there will be better times ahead for stocks.

We have survived and profited from several of these markets in our 15 year history of managing money. They certainly don’t feel good, but we know from experience that recovery is eventually certain.

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This week we took profits and sold the laggards. Sold were:

ATVI - Activision
AMZN - Amazon.com
ASEI - American Science and Engineering
FLR - Fluor
GMCR - Green Mountain Coffee Roasters
HANS - Hansen Natural

We did very well in AMZN and FLR, nicely in ATVI, about neutral in GMCR, and were happy to see HANS & ASEI go for some tax loss harvesting.

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The anxiously awaited Fed decision on Tuesday threw a wrench in the gears of the market. Wall Street had convinced itself that a 50 bps cut in the Fed Funds rate was a given, and when Bernanke and Co. only went a quarter the selling was immediate.

We had been ready for this and closed out 25% of the portfolio(s) prior to the announcement, leaving us with a relatively high level of cash.

Of course, the next morning it was as if Tuesday’s concerns were a distant memory as the market surged at the open, recouping most all of the previous day’s losses. Should it come as no surprise there was a late day sell off, finishing the day in the red. Our defensive position paid off as we closed out Wednesday with a healthy gain.

This market continues to narrow and we are seeing some sector rotation in our work. Further analysis via the December research cycle should reveal a leadership change. As for whether or not we advantage the change by investing our cash into the end of the year is a story yet to be told. Typically this is a torrid time of year to the upside, and often accounts for a significant portion of our overall return. However, with all of our portfolios significantly ahead of benchmarks, or any other measure for that matter, we may very well put the hedge back on and ride the year out in neutral.

Developing…

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Annoncement today that Activision (ATVI) has agreed to be aquired by Vivendi for $27.50 per share. Read the full story here. This gave the stock a nice 15% pop this morning.

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Typically November is a rather calm month with volatility expected to be moderate to light. This has not been the case for Nov ‘07. Our Multi-Cap Growth & Value Portfolio (MCGV) surged ahead in October after completing a huge third quarter, booking a year to date gross figure of 21.5% at quarter’s end. This versus the benchmark Russell 3000 year to date of 8.8%, giving us a huge advantage.

Th MCGV added another 4.3% in the month of October for a year to date gross of fees figure of +26.4%, again handily beating the Russell 3K’s 10.7% YTD figure for the same period.

Then came November. Right from the start the volatility hindered performance with us giving back virtually all of the October gains in the first seven trading days. This was not so bad as the benchmark lost over half its YTD return the first week of November.

The next week the market caved in, taking us with it. As of November 16 the MCGV was now up just 10.1% for the year, a devasting blow. This was due primarily to the exposure we had to energy and basic materials stocks. These sectors had been very good to us for more than a year so it came as no surprise that these two groups would experience profit taking in any severe correction. This however was very overdone.

Nevertheless, it was prudent to raise cash and minimize exposure to theses volatile sectors. Soon we went to 31% cash, but because the sell off had been so swift and deep we did not reinvest in the inverse ETFs as we had in early October.

This proved fortuitous as the MCGV only lost 1% the next week while the Russell 3K gave back 2%. That left us on November 23rd with a YTD of 8.9% versus the Russell 3K’s 2.8%.

This current week has been amazing. After recently experiencing the worst four day decline since 2003 the market definately had the jitters. On Monday the 26th the Russell 3K had virtually wipes out its YTD gains, ending the day up only 1/2 percent for the year. Our MCGV was unfazed.

After careful analysis it became clear that the market was very oversold and we put the cash to work on Tuesday. Now fully invested, the MCGV was poised to reap the benefits of any rally.

We picked up 2% that day, and yesterday the MCGV experienced its largest one day gain in the history of the portfolio, adding a huge 4.9% on the day. This put us ahead by 15.9% for the year to date compared to 4.9% for the benchmark’s YTD. A difference of fully 10 percentage points.

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Having been 31% cash for about 10 days it was time to come back into a fully invested allocation. With the market so oversold Tuesday’s action felt like the bottom was in, at least for now. At around 2 pm est the following stocks were added to the portfolio in various weights…

CBI - Chicago Bridge and Iron
BOOM - Dynamic Materials Corp
WFR - MEMC Electronic Materials
MBT - Mobile Telesystems
GR - Goodrich Corporation
LLL - L3 Communications
MHS - Medco Helath Sysytems

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