While many of you are hopefully enjoying the summer on a beach, in the mountains, or just living life at a more relaxed pace, I don't mind telling you it has been pretty "hot" in some of our investment committee's meetings recently.  At issue: stock and bond markets that to some fail to reflect the grim reality of the global economy.

 

Yet to others, this is simply the by-product of traders and large institutional investors having their way, while "mom and pop" investors sit on the sidelines, wondering what to do with their wounded confidence about everything financial.  It seems as if those with a time horizon shorter than a stop on the PGA Tour (the pros play their weekly tournaments from Thursday-Sunday) are in there, driving stock prices up in a panic based on some new piece of economic data, only to reverse course with the next piece of news the next day.  If stock traders went to summer camp, this is what we think it would look like.   

 

As mentioned earlier, it's not all fun and games for us this summer.  So, let's talk about what we see going on and how our portfolios are positioned.

 

There is no shortage of "real world" reasons to believe that the environment for stocks is weak, if not outright dangerous.  For example:

 

a.       Debts and deficits of record proportions

b.      Consumers learning what "austerity" means

c.       Governments in the developed markets acting as if they can continue to delay enforcing real, sustainable improvement

 

Maybe these real-world concerns will matter this autumn, when stocks are historically very vulnerable.  (September has the reputation of being the worst month statistically for stocks.)  But the world's troubles seem to have little meaning to the summer campers.  Instead of a follow-through from the twin losing months of May and June, July was outstanding, with the S&P 500 gaining over 7%, gains that have been extended into early August.  This is part of the "deception" of 2010's market performance.  Allow me to explain:

 

So far, we have seen (roughly speaking, in S&P terms) a drop of 5% from 12/31/2009 through 2/8/2010, a gain of 15%  from 2/8/2010 through 4/23/2010, a loss of 16% from 4/23/2010 through 7/2/2010 and a gain of 9% from 7/2/2010 through 8/9/2010.  That is a lot for investors to deal with in just over seven months.  What we also find is that it has caused people with long-term time horizons to shorten them by analyzing those swings and believing they can conclude anything important from what managers have done in that period.

 

It was not long ago when investors (those not on the sidelines) were starting to feel another round of the shock and misery of 2008 coming on.  A 16% drop in 10 weeks will do that.  But memories, like summer itself, seem to be fleeting, and the problems mentioned earlier seem to again be of little concern to those spending their summer being active participants in the stock market. 

 

To be clear, we at Emerald are not shortening our overall time horizon.  What we are doing is what we have always done: invest capital across three time horizons:

 

1.      Short-term

2.      Cyclical

3.      Secular

 

We then focus on adjusting the emphasis on each time frame within an entire portfolio.  That emphasis differs in that our more conservative Hybrid strategy will typically allocate more of its portfolio to a short-term time horizon (for risk-management purposes) than the other two strategies we manage (Concentrated Equity and Global Cycle), which tend to tilt toward the Cyclical and Secular time frames.  That is, we can look past some of the near-term bumps we expect in the stock market and start planning, gradually and carefully, for what we think will be some very nice multi-year growth opportunities in specific market areas, via specific mutual funds or ETFs.

 

Despite this longer-term optimism, we still keep a watchful eye on near-term developments, but we don't necessarily react to all of them.  That would make us traders, which we are not.  To paraphrase Bruce Berkowitz, the highly successful manager of the Fairholme Fund, there are three boxes on our desks for ideas and strategies: in, out and too tough.  The latter is filled now.  It is filled with the numerous tradeoffs we see now, such as with corporate earnings.  They have been strong, but they are not being driven much by revenue growth (cost-cutting and price restraint are the sources, as opposed to a strong, sustainable increase in demand).  That matters not to the summer campers, who bid up the stocks of such companies. 

 

However, as our technical analyst Michael Kahn has observed, the sharpest reactions to earnings seem to be when companies miss analysts' expectations: often the stocks get crushed on the news.  But again, that's for the trader crowd to debate and react to.  In our view, it's important to keep it all in perspective.  It is tempting to join that trader-like mentality, but not for those whose investment objectives are well beyond a trader's time-frame.  The temptation is easy to understand.  I-Phones, Blackberries, cable news, etc. put the wrong headlines in our faces wherever you are, and whether you invest professionally or not. 

 

I often mention that my team and I do watch some CNBC and read a wide variety of financial media, including sources we consider to be less meaningful.  We do so not because we expect to gain highly valuable knowledge from it; rather, it helps us maintain a pulse on the very critical sociological aspect of what we do.  We like to know what is being conveyed to the general public, so we are aware of the investment ideas (and in some cases, misguided ideas) that are likely to arise from the mass-consumption of the financial information they absorb.  Some of this information can be questionable, and like the toxins we are warned about in what we eat, the impact on your wealth, like the impact on your health, may not be immediately apparent. 

 

As for us, we are as bearish as we've been all year, but that does not mean we are not positioned to gain from higher stock prices.  Our prevailing theme is waiting for the "other shoe to drop" - that the credit market and sovereign debt problems of recent years will lead to one more stock market decline.  For now, it appears the bulls are winning "color war" at traders camp. 

 

(c) Emerald Asset Advisors

www.emeraldassetadvisors.com