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The past week’s market activity has done a lot of technical damage to the major indices. The long-term uptrend is at risk and investors need to be taking steps to protect their portfolios. 

For example, I am a primary consultant for the Foundation Strategy at Strategis Financial Group, Inc. This strategy normally holds six mutual fund positions. The objective is to hold high quality funds with low betas that are in long-term advances. As a defensive strategy, this week we sold the two funds that had shown the most recent weakness. One of those positions will remain in cash and the other was replaced with a short fund called Prudent Bear (BEARX).

So the composition of the strategy is now 66% long, 17% short and 17% cash. But the short position effectively neutralizes an equal portion of the long position, meaning the strategy effectively has a long exposure of less than 50%. In the financial world, protecting a long or short position with an offsetting investment is called hedging. 

The chart below illustrates how hedging works. The black line is the daily price movement of the Nasdaq over the past two years. The gold line is BEARX, a fund that shorts the stock market. Notice how the two positions are inversely correlated. By purchasing BEARX right how, our objective is to offset losses that might occur in our long positions if the market continues to decline.

With the market headed down, one might wonder why we don’t either move all of the positions to cash or to short funds. The simple answer is that when this correction ends, stocks can move up very quickly. We don’t want to be sitting on the sidelines when that occurs. This correction still looks like a downturn in a bull market rather than the start of a new bear market. And there are signs that the market is oversold and could experience a significant bounce fairly soon.

The bottom portion of this chart shows a moving average convergence divergence (MACD) for the Nasdaq. Notice it turned negative a few days ago and has quickly reached a level that indicates oversold market conditions. Compare the current situation to the correction that occurred in the summer of 2006. The MACD is already at the level where that recovery took place. Someone using the MACD (or RSI or a moving average) as a trigger to get back into the market would miss some substantial gains as the market headed back up.

Of course, there is no guarantee that this is the bottom. That is why we are taking defensive action.

Federal Reserve trying to calm markets

The irony is that there does not appear to be a substantive reason for a correction of this magnitude. Corporate earnings are strong. Unemployment is low. Interest rates are low by historical standards. Major indices are not at irrational valuations. The driving force of this correction is fear and uncertainty about the sub-prime mortgage market.

Wednesday St. Louis Federal Reserve Bank President William Poole said the U.S. economy remains strong and there is no need for the central bank to stimulate the economy with an emergency rate cut. Poole acknowledged the problems in the housing market and said the slump would likely continue. But Poole said there is no evidence that the housing problems are spreading into the business fixed investment or the consumer segments.The next regularly scheduled meeting of the Federal Open Market Committee is September 18. Poole said that barring a “calamity,” there is no need to consider cutting interest rates before then.

So far in the past week, the Federal Reserve has added $71 billion in liquidity to the financial markets. Today the central bank released a statement saying it is prepared to do more, if needed. The Fed can add liquidity in a variety of ways. It can increase the amount of money available to member banks at the federal funds rate. It can repurchase government debt instruments like government backed mortgage securities. It can also increase the money supply. All of these actions have a similar impact of making more money available for banks to lend. In essence, the effect is the same as an unofficial rate cut.

So you might be wondering why the Fed doesn’t just go ahead and cut interest rates. The Fed’s number one enemy is always inflation. Right now rising inflation remains a very real threat. Last week the Fed stated that “a sustained moderation in inflation pressures has yet to be convincingly demonstrated.” The latest report from the Labor Department showed that core inflation remained at a 2.2% rate in July, exactly the same as May and June.

Interestingly, it is quite possible that the Fed’s injection of money into the financial system might very well undermine its own attempts to curb inflation. The U.S. money supply (M2) has been increasing steadily for many months. Below is a chart from the Federal Reserve showing the money supply growth rate.

M2 includes currency and demand deposits (the components of M1) plus time deposits, savings deposits, and non-institutional money market funds.

A growing money supply means more money available for spending, which contributes to inflationary pressures. Below is a link to a speech given by current Federal Reserve Chairman Ben Bernanke where he gives an historical account of the Federal Reserve and its attempt to accurately monitor money supply and the impact on the economy.http://www.federalreserve.gov/boarddocs/speeches/2006/20061110/default.htm

For now, the Fed is walking a tightrope of trying to keep inflation in check by avoiding an interest rate cut, while trying to convince the public that there is no reason to be worried about the overall health of the financial markets. Whether or not it can pull it off remains to be seen, but in the meantime, it makes sense for investors to take some preventative action.
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 Flint Stephens, Mark Sumsion or Scott Garbutt at 800-279-3377.

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