Economic Improvement or Double Dip? Strategy for Volatility

I'm clueless as to where the market is going from here. Continued economic improvement, or double dip recession? Clearly the market isn't sure either given that it dropped 2% after Bernanke said today he's not pursuing QE3 just yet but nevertheless the market still proceeded to bounce and then rally to end the day positive ~1.5%. Why all the crazy volatility?

Empathizing with the Enemy

There's a phrase about how Wall Street analysts know the price of everything but the value of nothing. In a sense, that is this environment. People are scared out of their willies on the concern that we're going into a double dip. If this happens, everything should be fundamentally worth less (not "worthless") because economic conditions are worse. In which case, don't buy anything, because you'll be able to buy everything cheaper in the coming months.

On the flip side, what if the recent sell-off was just a function of political dysfunction and a ratings downgrade? If that's the case, and the economy is actually fine, shouldn't the stock market rebound to its previous high? If this plays out and you are a hedge fund manager sitting on the side with lots of cash, you're going to look really dumb given that you're now under-performing the market!

So if you bet, and the economy tanks, well, hopefully you lose less than everyone else and investors don't redeem too much of your assets under management. If you don't bet, and the market rallies you face career risk. This reflects the unpleasant set of circumstances for most money managers and I think is the heart of why the market can have such volatile intraday price movements. The market is skittish, because the investors are!

Strategy


My strategy is a bit odd, stressful and more time consuming than usual but it works for me (so far). I'm currently tracking my largest positions and if I notice that the price action starts moving against me, I'll completely hedge my bet with put options. This of course limits my near-term upside if they have 1 or 2 days of favorable gains, but I think it's worth it if a double dip does happen. After all, rule #1 is NOT that you have to make as much money as possible. Rule #1 is "Don't Lose Money."
 Despite this focus on preserving capital, I'm currently down about ~2.5% vs. -5% for the S&P and negative 11% for the Russell. 

Bargain Bin?

I don't see an overwhelming list of companies that strike me as dirt cheap bargains, so I'm not really expecting to vary dramatically from 20-40% invested. That said I currently only have 20% net exposure as I shorted the S&P yesterday (5% that I'll probably unwind Monday if the market continues to show strength) and I completely hedged my SWY this morning (another ~5% of the portfolio). Both hedges lost me money today, so it's a painful strategy, but I think it's the right one.