My dog got hit by a car Wednesday night. He is going to survive, but he is very sore today. He has about 20 stitches in his head and lots of bruises but no broken bones. I got very little sleep last night because I had to monitor his IV fluids. Toby is an 18-month-old Brittany that spends most of his time in the house. But he loves to be outside and he took advantage of a momentary lapse in vigilance, snuck out and got into trouble.

This is not Toby’s first misadventure with a vehicle. Six months ago he was struck by a trailer and broke his femur. That incident required three surgeries and many weeks of recuperation. He still has a rod, plate, and several screws in his left hind leg. Although he is a smart dog about most things, when it comes to staying away from huge moving objects, he struggles to learn his lesson.

This is relevant to investing because I see many investors who exhibit similar behavior. One of the first times I witnessed this behavior was back in the late 1980s when a client with a managed account decided to cancel his account and put all his money in gold. Gold was at a record high of more than $800 at the time. Unfortunately, over the next couple of years gold dropped sharply and this gentleman lost a lot of money. Eventually he got out of gold at a huge loss and reopened a much smaller managed account.

Over the first few years of the 1990s, we earned him respectable double-digit annual returns. Then the day came when he told us he was closing his account and investing everything in Fidelity Select Energy Services (FSESX), a fund that had more than doubled in less than two years. Against our advice, he went ahead with his plan and FSESX dropped by more than 70% over the next six months. Fortunately or unfortunately, depending on your viewpoint, his wife maintained a separate account with us. He failed to discuss any of this with her and when she eventually found out, she was very unhappy that the bulk of their retirement savings had disappeared in such a short time.

Just like my Toby can’t seem to remember that moving vehicles can be deadly, there are plenty of people who never seem to learn that speculative investments always carry high risk.

The next lesson came in 2001. Many investors had witnessed huge gains in the technology sector and moved the bulk of their assets into tech stocks and funds. When the technology bubble burst, We personally witnessed individual who lost more than 90% of their investment portfolio value.

Fast forward a couple of years and many of those investors vowed that they would never be so foolish again. Many told us they had learned their lesson about the risk of market investment and instead were opting for the security of real estate. Many of these folks stripped all of the equity from their homes so they could buy additional highly leveraged property they hoped would quickly increase in value. Today many of these folks are relearning the lesson they forgot in 2001. The Utah Department of Consumer Protection noted that in 2007, seven of the 10 most common frauds involved some sort of real estate scam.

It doesn’t matter whether the fast moving object is a truck or a car, it still hurts when it hits. Similarly, a speculative investment is dangerous, whether it involves the stock market, real estate, currency trading, oil futures, precious metals, etc.

Today, I don’t know where the next speculative bubble will appear. What I do know is that there are thousands of people working very hard to come up with speculative schemes that appear to be low risk because that increases the chance that they can separate greedy investors from their money.
F.S.

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I learned in elementary school that I could not control the actions of other people. Undersized and wearing glasses as thick as Coke bottles, I was sometimes a target for bullies. I soon learned that although I could not prevent their harassment, the way I reacted could often influence their continued behavior.  For example, if I responded to their taunts with with verbal jabs, an escalated conflict was virtually guaranteed. Ignoring the provocative behavior or offering a passive response generally meant the bully would seek a different target. While that type of response kept me in one piece, it wasn’t very satisfying.

Similarly, I have learned that I cannot control the financial markets. But I can control how I react to market movement and that can have a significant influence on my portfolio.

Most investors are familiar with the concept of asset allocation. In a general sense, it simply means that an investor diversifies assets among several different market segments. The theory is that by so doing, an investor limits the risk exposure he would have compared to only being invested in a single market segment. The rationalization is that no one knows exactly what the markets will do, so this passive approach is the safest response. It is kind of like ignoring the bully–it might work to some degree, but it isn’t very satisfying.

Fortunately, there is another alternative we call “active management” of “active asset allocation.” Instead of merely diversifying assets across a broad market spectrum, we attempt to move away from segments that are weak and allocate toward those that are stronger, while still maintaining a level of diversification.

During strong bull markets virtually every sector earns positive returns and the best strategy is often pick good investments and then just leave them alone as long as they continue to trend upward. The real value of active management only becomes apparent during periods of overall market weakness, like we have experienced the past several months.

Active management can use mathematical models. For example, Rod Jackson, a strategy consultant at Strategis Financial Group, uses differential equations to help him identify the momentum of various investments and to decide when to move from one market segment to another. I am not smart enough to do that, so I rely more on watching trends using a combination of can involve technical, cyclical and fundamental analysis. 

Below is a chart that provides an illustration of what I am describing. The black portion of the chart shows the Nasdaq over the past year. We can see that it has lost nearly 20% from its peak in October 2007. The other three lines are exchange-traded funds (ETFs) that represent three of the strongest market sectors over the past year. The red line is streetTRACKS SPDR S&P China (GXC). China was the top-performing international sector for most of 2007. The gold line is iShares S&P Latin America 40 Index (ILF). Finally, the blue line is streetTRACKS Gold Shares (GLD).

Right now, these three funds have each returned about 44% over the past year. I’ve highlighted their convergence with a green circle. Although their returns are similar, that doesn’t mean they are moving in the same direction. Gold is continuing its uptrend, ILF has mostly gone sideways for several months, and the China fund is in a sharp downtrend.

Over the past year in my personal investment account I bought Latin America in early August, after it had seen a fairly significant correction. I held while it continued to correct for a couple of weeks, and then proceeded to watch it post some nice gains. I sold it in December after it was stalled for several weeks. My gain in the position was about 25%.

I missed the big gain in China and instead bought it in November after a pullback, hoping it would resume its upward trend. It rallied nicely for a couple of weeks but then it plunged. I sold it in mid-December and was lucky to break even on the trade.

I haven’t participated in the rally in gold. In spite of the nice uptrend I’ve been reluctant to buy because it remains near record highs. I’m afraid if I buy at this level it will drop, because I’ve been been burned by gold more than once in the past.

As the Nasdaq shows, the U.S. market offered few opportunities over the past year. The bottom portion of the chart is a moving average convergence divergence (MACD) of the Nasdaq. This tool turned up in February, signaling that there might be an opportunity for a rally. But overall the U.S. market remains weak, so I would anticipate any advance to be relatively short–a few weeks at most.

It is important to realize that the investments I’ve described here represent a small portion of my overall retirement portfolio. The bulk is invested much more conservatively. But an active management approach allows me to manage the overall risk exposure by moving away from volatile positions during periods of market weakness.
F.S.

If you would like active investment strategies that attempt to minimize risk but still provide the opportunity for solid growth, contact Strategis Financial Group at 800-279-3377.

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This week’s report is early and abbreviated because I’ll be spending the next couple of days talking to dentists at the Utah Dental Association’s annual seminar. I’m anticipating hearing some horror stories from dentists members of their office staffs who have seen their retirement accounts decline significantly over the past several weeks.

Fortunately, this week we’ve seen major indices recoup some of their lost ground. I anticipate there will be more follow through on this rally. I think the Dow is likely to climb back at least to the 13,000 area–about where it started the month–with other indices also climbing.

Today President Bush signed the economic stimulus bill and people should start seeing checks in May. Today investors also took encouragement from a Commerce Department report on January retail sales. The increase of 0.3% was a surprise to analysts who were expecting a decline of 0.3% to match that of December. In addition Treasury Secretary Henry Paulson today promised aggressive government action to help troubled homeowners. He said he believes the economy will continue on a path of growth.

The bottom line is that while there is plenty to be worried about, we’ve seen interest rate cuts and a number of other government actions designed to help the struggling economy. So far Wall Street’s reaction to these moves has been subdued. We’ve seen a significant correction over the past three months and cyclically and technically stocks are poised for a short-term rebound.

At this point investors need to remain cautious, but don’t be surprised to see stocks continue to rally over the short term.
F.S.

Some types of investor behavior are expected during periods of market weakness. For example, investors tend to move away from technology funds. As a result, we see the Nasdaq decline more sharply than blue chip indices because it is heavily weighted toward tech stocks.

When investors move away from the tech sector because of concerns about economic weakness, money often flows toward the health care or utility sectors. Traditionally, these industry sectors have been considered more resistant to economic downturns.  Right now these sectors are breaking even– better than the major indices, but not providing positive returns investors seek.

At times money taken from stocks has been invested in the real estate sector. We saw quite a bit of that during the last recession. Obviously we are not seeing it now as real estate remains one of the weakest sectors.

The chart below shows how ETFs representing some of the strongest market sectors have fared over the past six months.

Long-term government bonds are viewed as a safe haven during significant stock market corrections. But during the major downturn we saw in 2001 and 2002, even bonds did not perform very well. During this current correction, bonds have returned to their traditional role and are one of the few market sectors that are performing well right now. On the chart, the brownish red line is iShares Lehman 10-20 Year Treasury Bond (TLH).

Over recent weeks the best performing sector has been precious metals. After reaching a record high in January, gold has pulled back slightly, but shows no signs of breaking its long-term upward rise. The blue line is streetTRACKS Gold Shares (GLD)

The energy sector has been up and down. The black line is iShares Dow Jones US Energy (IYE). Energy showed strength in December, but has declined sharply since then.

The gold line on the chart is the Nasdaq. It has fallen about 20% since its peak at the end of October 2007. So when one does a ranking of ETFs over the past three months, those that have done the best are funds that short the U.S. market. That is obviously a sign of an extremely weak equity market.

Unfortunately, right now investors can’t find any significant relief by moving assets to foreign markets. A handful of international ETFs are showing gains over the past three months, but most are faring no better than the U.S. market. The weakness is widespread as the whole world watches to see if the U.S. economy is going to fall into a recession.

After equities rallies last week, I expected to see more follow through to the upside. The fact that there has not been a more sustained advance in the wake of two rate cuts and talks about an economic stimulus package shows that traders and investors see little reason to be optimistic about the economy over the next few months.
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 me, Flint, at 800-279-3377.

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