“I strongly believe that what we are experiencing is a normal bull market downturn and that we will soon see the market return to its recent highs.”  I wrote those words in the March 8 MarketOwl commentary. My earlier assessment proved to be correct and now we have seen the Dow reach an all-time high and other major indices climb to multi-year highs.

If you’ll look at the chart below, you can notice several things. First you’ll see that when I wrote those comments on March 8 the indices were near their lowest point during that recent correction. As usual when the market dips, there were plenty of folks predicting that the markets were on the brink of a major decline. Next you’ll see that the Nasdaq (black line), Dow (gold line) and the S%P 500 (blue line) have all recovered and exceeded their February highs. Over the past year all of these indices have made nice gains. One thing that has been a little unusual is that the Nasdaq has trailed the other two major indices. Normally the Nasdaq leads bull market advances.

For today, about all that’s left to write is to give an opinion about what is likely to occur next. Watch for the markets to continue to advance during May, but probably at a much slower pace. At that point expect to see the markets move sideways or drift downward for most of the summer.

On the early portion of the chart you can see that a year ago, the Nasdaq corrected steeply during the summer and the other two indexes also declined. There is always downward pressure on stock prices during the summer. Traders and investors don’t want to hold exposed long positions when they are on vacation, so more selling than usual takes place. In addition, trading volume tends to be lower because of people on vacation. So it is fairly common to see indices drift lower.

One of the reasons for the recent acceleration of stock prices is that first-quarter corporate earnings were stronger than expected–in many cases much stronger. Combined with overall strength in the economy, it seems unlikely that we will se any kind of a sharp drop in the indices in coming weeks.

Have a great weekend.
F.S.

If you would like an investment strategy that attempts to minimize risk but still provides the opportunity for solid growth, check out the Foundation Strategy from Strategis Financial Group.  This actively managed strategy is designed to take advantage of the experience and expertise of some of the nation’s best mutual fund managers. To learn more, call Mark Sumsion or Scott Garbutt at 800-279-3377.

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Articles in financial publications often tout the need for investors to have a diversified portfolio. According to the theory, one can gain a measure of protection against market risk if investments are divided among a variety of asset classes. Unfortunately, true portfolio diversification is difficult to achieve and often does little to help investors reach their financial objectives. 

Sit down with most investment managers across the country and they will advise you to put a portion of your investment assets in large cap stocks, another portion in small cap stocks, a portion in government bonds, another portion in international stocks, etc.

The assumption is that during times when small caps stocks are doing poorly, government bonds will do well. When bonds falter, then international stocks might perform better, etc. Because one never knows which asset class is likely to perform best, this is generally practiced as a buy-and-hold type of investment management. 

There are a number of flaws in this line of reasoning. The most glaring is the implicit acceptance that while some of the assets might go up, it is just as likely that other asset classes will go down.

This type of portfolio allocation did well during the 1980s and 1990s, because most asset classes were going up. Things fell apart starting in 2000, because when the market corrected, almost every asset class plunged. That’s because there is a high level of correlation among most market-based financial products. As a result, one really can’t achieve true portfolio diversification by purchasing different categories of stocks.A good friend of mine, Ken Trester, teaches investors how to insure their stock portfolios by buying put options (put options rise in value when the price of the underlying stock goes down). He says that as long as the options are highly undervalued, the underlying stock is not important. In the event of a major market crash, virtually all stocks will go down and almost all undervalued puts will go up. 

Most of us tend to think of investing as a two-dimensional game: is the market going up or is it going down? But the complexity of global investing requires more of a three-dimensional view. In addition to market cycles, we must also consider the movement of business cycles. For example, a major market crash like we saw in 2000 sends many investors fleeing to bonds. While bonds generally outperformed stocks in ensuing months, falling interest rates also meant a decline in bond yields. So while bond prices rose, yields declined and a bond investor’s overall return might have actually declined.

An investor following a passive, diversified approach would hold a position through any downturns, even if it meant giving up all the gains and sustaining a loss. The rationale would be that it is just a small portion of the overall portfolio and some other asset class will likely take up the slack. We would rather adhere to an active approach that shifts at-risk asset classes to cash or to another investment that is performing well.

There are several methods investors can use to minimize market risk other than traditional asset allocation. We call this active diversification or active management and it involves allocating assets toward sectors that are doing well and moving them away from those that are performing poorly. In addition, assets can be protected using hedging strategies or by moving to cash when market conditions warrant. 

Below is a chart that shows some components of a traditional asset allocation process. The following indices and classes are represented:

Black line–Dow Jones Industrial Average, large cap stocks
Gold–Russell 2000, small cap stocks
Blue–iShares MSCI - EAFE Index Fund, international stocks
Orange–Philadelphia Gold and Silver Index, precious metals
Red–Shearson Treasury Bond Index, bonds

Notice that the only period where these positions showed the type of negative correlation necessary for real diversification was 1999-2002. Since then there has been a fairly high level of correlation. So an investor who bought these sectors looking for diversification was instead actually buying increased volatility and decreased return–exactly the opposite of what he was hoping to achieve. 

Instead of this passive approach, let’s consider active diversification in the context of a horse race with 10 horses running. Because I want to increase my chances of winning, I go to the betting window and place bets on five of the 10 horses. I choose my five horses based on their performance in recent races.While I have increased my chances of picking a winner, there is still a chance that one of the five horses I didn’t choose could win. But what if I could wait until the middle of the race to place my bet?  This time three of the horses are well ahead of the pack, so I bet on each of them. The fourth horse is rapidly losing speed, so I elect to bet instead on horses five and six. There is still no guarantee that one of those horses will win, but we can argue that it is easier to make a good decision in the middle of the race. We’ve seen how the horses are running and can eliminate any that have dropped well behind the pack.

The difference between the two racing/betting examples is similar to the difference between active and passive investment management. Active diversification allows us to bet during the race. For instance, a look at the chart above shows that during seven of the past 10 years an investor would have gained nothing by being invested in government bonds. The same is true of gold.

Since the beginning of 2003, investors would have been wise to overweight their portfolios toward international and small cap positions. But doesn’t overweighting defeat the purpose of diversification? It certainly can, so it is important to use some common sense. Even though international funds are the top performers right now, it would not be smart for an investor to put all of his assets into international positions. But instead of allocating assets to sectors that are currently doing poorly, our approach will be that when a horse starts to lag, we will move our bet to one that is running better.

As someone who has watched and investigated dozens of investment methods over the past two decades, I must admit that this type of approach is much easier to describe than to implement. On the other hand, it can work and certainly makes more sense to me than to hang on to losing positions simply for the sake of diversification.

F.S.

If you would like an investment strategy that attempts to minimize risk but still provides the opportunity for solid growth, check out the Foundation Strategy from Strategis Financial Group.  This actively managed strategy is designed to take advantage of the experience and expertise of some of the nation’s best mutual fund managers. To learn more, call Mark Sumsion or Scott Garbutt at 800-279-3377.

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After the market corrected sharply the last week of February, many investors feared the U.S. was on the verge of beginning a new major bear market. At the time I believed (and still do) that the downturn was just a normal corrective pause and that the market’s three-year upward trend was still intact. In fact, on March 8 I indicated that investors with money on the sidelines should be buying back into the market on down days.

In the four weeks since then, the U.S. market has climbed steadily upward. There have been plenty of bumps along the way, but many of the technical indicators that turned negative have swung back to the positive side. We saw another down session Wednesday after the Federal Reserve minutes revealed that a cut in interest rates is unlikely in the near future. While that might not be the most welcome news, it does mean that Federal Reserve officials believe the economy remains strong. Today stocks rebounded and gained back those losses.

The chart below shows the Nasdaq (black line). Since bottoming in March, this index has gained about 5%. Two or three good days would push it back to recent highs and I suspect that will occur sometime in April. The gold line is a simple 50-day moving average. While the index is currently hovering right at that level, the bias appears to be upward.

The middle portion of the chart is a moving average convergence divergence (MACD). It turned positive again at the beginning of the month. The bottom portion of the chart is a relative strength index (RSI). Market conditions are favorable when the RSI is trending above the 50 level. Once again, the Nasdaq moved back into that territory last week.

This latest correction is fairly typical of the past two or three years. Downturns tend to be sharp and most of the damage occurs in just a few days. In those situations it is generally better to ride out the correction than to try to bail out. In many cases, exiting those positions merely creates a new dilemma: When do I get back in?

For example, if an investor used the 50-day moving average to sell his long position during this latest correction, he would have lost about 3% and prevented an additional loss of about 4%. But that same investor would have missed the 5% gain that has occurred since the bottom and would just now be contemplating jumping back into the position.

While timing can sometimes be an effective tool to guard against catastrophic market risk, it is generally ineffective and often detrimental in short and intermediate-term corrections.

In this case, it certainly appears that holding our positions through this correction was the right thing to do.
F.S.

While U.S. markets have languished for the first quarter of 2007, there have been some profit opportunities in international positions. The tricky part about investing internationally is that all countries or regions are not equal. So an investor must carefully pick and choose positions.

For example, so far in 2007 some of the best performances have come from the Far East. Some of the top-performing exchange-traded funds (ETFs) year-to-date include Malaysia +20.85% (EWM) and Singapore +14.03% (EWS). South Korea is up 5.76% (EWY) and Hong Kong is up 3.64% (EWH). But China is down almost 4% and Taiwan is off nearly 2% (EWT).

The strongest overall region has probably been Europe with a number of country funds turning in nice three-months gains. They include: Netherlands +9.88% (EWN), Germany +9.70% (EWG), Austria +7.75% (EWO), Spain +7.29% (EWP), Sweden +7.11% (EWD), Belgium +6.35% (EWK).

Another country fund that has done well is Australia, up 12.57% (EWA).

Latin American and emerging markets funds have also been strong. Mexico is up 8.91% (EWW) and Brazil is up 8.57% (EWZ).

How does all this compare to the overall U.S. market? Check the chart below.

The gold line is Australia (EWA). The black line is iShares S&P Latin America 40 Index Fund (ILF), a fund we have commented on frequently over the past couple of years. Both are markedly ahead of the Nasdaq (QQQ) shown by the reddish brown line and ahead of the S&P 500 (SPX) shown by the blue line.

It is important for investors to keep in mind that international funds tend to be volatile. A glance at the above chart reveals that the two international funds are significantly more aggressive than the U.S. indices portrayed. As a result, they are not suitable for many investors–at least in large doses.

The stock markets are closed Friday in observance of the Easter Holiday. Have an enjoyable weekend.

F.S.