Portable Alpha Daily: Thank You Sir, May I Have Another?

Friday marked a rough ending to an even rougher week as selling pressure mounted amid a weakening global investment environment. For the week, Dow Jones industrial average lost 4.2 percent, the S&P 500 index slid 4.4 percent and the NASDAQ Composite Index tumbled 5.9 percent, wiping out the stock indexes' gains for the year. The question on every investors mind now is whether last week’s global drubbing is done or if it was a harbinger of things to come?

Perhaps even more important than defining last week as a “correction” or otherwise, is understanding what exactly led to the sell-off. By and large the market had long been over-extended, which was well-known on and off Wall Street.

Furthermore, the U.S. markets are in the midst of a credit crunch brought on by sub-prime mortgage defaults. This in turn is manifesting itself on the balance sheets of several large financial service institutions.

Additionally, the simultaneous unwinding of the yen carry trade is influencing global liquidity. Because interest rates were so low in Japan, investors were borrowing in yen and allocating in other assets, fueling equity speculation and propelling the markets. But interest rates in Japan are beginning to increase, making the spreads less attractive for the carry trade. With traders and hedge funds alike closing out their positions, the influx of liquidity is reversing.

Those factors coupled with Greenspan’s media-hyped recessionary warning resulted in a perfect storm of sorts, which ultimately led to a mass re-evaluation of the risk vs. reward scenario.

Will the market rebound this week? Doubtful, at least in our opinion. The mechanics at work last week are still paramount and the only potentially positive influences might be through various economic reports. Although there is a decent collection of economic analysis released throughout the week, the most important, monthly payroll data, doesn’t come out until Friday. The median forecast according to a Reuter’s survey is a rise of 100,000 in non-farm payrolls in February, and the jobless rate holding steady at 4.6 percent. On Monday, the Institute for Supply Management will issue a report on service sector activity. The median forecast calls for the index to slip to 57.2 in February from 59.0 in January.

How did last week translate into our alpha analytic? Every major market, style or sector group with the exception of three, fixed income / bond, foreign currency and inverse funds, was down for the week. The scope of the declines ranged from -1.78% to -7.67%.

Conversely, the flight to quality was picked up by our model as the ETF Fixed Income / Bond group saw a weighted-return of 0.77% for the week. Additionally, the ascension of the yen to its highest level in almost three months against the dollar was also factored into our model, with the ETF Foreign Currency group up marginally at 0.06%. But the real alpha was found in the Inverse Fund and Inverse Sector Fund groups located on the ProFund and Rydex pages of our newsletter. Fortunately we adjusted our model portfolios to include several inverse funds, which hedged our long exposure on Thursday and Friday. Below are our top rated inverse funds as of Friday.