Here's How I'm Preparing for Next Market Down Cycle

Author: Bin Hong

Covestor model: Long-Short Macro Trends

The last up (long) cycle starting from 12/20/12 hit RSI level of 0.75, a sign of overbought, on 1/24/12. In order to protect the 17.7% since inception profit in my Long Short Macro Trends portfolio, I closed all long positions on 1/25/12 and maintained a cash position since then to get ready for the next down (short) cycle. This proved to be a bit of an early decision and I could have gained another 10% up to 2/10/12.

As I followed the macro trend from VectorVest, I have noticed the first market reversal signal on 2/10/12 (see below).  Both MTI (>1.6) and RSI (>0.75) turned downward after reached their short term peaks and index VVC crossed the middle-line in the price envelope. This has triggered a call for down cycle.

My approach in the down cycle is to short stocks which have run up for a while with weak fundamentals (i.e., stock price > value) and have also shown a reversal pattern. For example, one of the winning short trades so far is American Reprographics Company (ARC) with a profit of 23% as of 3/2/12.  ARC provides business-to-business document management services.

Two main drivers of the last up cycle for ARC were:

• 11/2/11: ARC reaffirms FY 2011 EPS guidance.
• 12/9/11: ARC upgraded to buy from neutral at Sidoti.

However, the value of ARC has been at 2.49 since 11/8/11 while the spot price of ARC has reached the peak of 6.99 on 2/6/12.  On 2/10/12, ARC has shown a price reversal by both MACD turning negative and the spice crossing middle-line of the envelope (see below).

Similar patterns happened to my other two short selections: Insmed (INSM) and RealNetworks (RNWK). These three stocks started their reversal patterns around 2/10/12 and maintained the trend afterwards although the general market has shown a flat pattern. The main contributing factor to the winning short trades is the poor fundamentals.  Due to less pronounced short cycle of the market, I only deployed 5 short positions CONFIRMED and will add another 5 short positions if the market turns further negative.  The gain for the total 5 short positions is 5% as of 3/2/12 and I have two losers in this cycle: Nautlis (NLS) and BioCryst (BCRX).

BCRX is a biotechnology company, designs, optimizes, and develops small-molecule pharmaceuticals that block key enzymes involved in infectious diseases, cancer, and inflammatory diseases. BCRX also had the price reversal pattern on 2/10/12.  However, BCRX announced promising results from preclinical studies of BCX5191 for Hepatitis C on 2/15/12.  BCRX stopped its price reversal since then and turned back to uptrend again.  If the macro trend of the market won't maintain a pronounced short cycle, I might close this short position soon.

Overall, I still maintain a positive view for 2012 as I foresee another multi-year bull cycle will come soon.

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