How do we position ourselves to both participate in some of the market's upside, yet play defense against the big decline we fear is out there?  Part of the answer is the three time horizon approach mentioned earlier.  Another part is our continued vigilant use of the "defensive weapons" of shorting, raising cash temporarily, buying gold and doing anything else that is opportunistic. 

 

For example, our turnover tends to go way up during periods of market stress.  Why?  Because our flexible nature allows us to!  We are long-term investors, but we also don't stay hunkered down and hope for the best when trouble is approaching or upon us.  The reverse is true as well - we may think, as we do now, that the fundamental condition of the investment world is on the edge of danger.  But we also know that the market doesn't care what we think, and doesn't have any interest in falling when we want it to.  In our position, it is just as big a problem to sit on our hands waiting for the market to fall as it is to stay stubbornly fully invested during a strong decline in prices.  Balancing reward potential with risk-management is the cornerstone of our investment approach and what we continually strive to achieve. 

 

Technical analysis has, in our opinion, been a very good gauge of when markets reach extremes.  However, as Michael Kahn pointed out recently in his daily QuickTakesPro newsletter, "Stocks and bonds do have the ability to make us money as long as we are cognizant of the risks. Right now, the risk comes from an unstable market where day to day changes and intraday swings are huge. News of government intervention (aka not free market forces) make charting, which is based on pure free market forces, a challenge."

 

So, to make sure you can distinguish this issue of GreenThought$ from a sour grapes letter, let's make another critical point.  Years like 2010 may test the patience of investors in many asset classes, but the key is to keep plenty of perspective.  Those who invest in growth assets are hopefully doing so without the requirement that their portfolios avoid losses or near-zero returns for short periods of time.  While it is nice to think about the possibility of a smooth return in all environments, the truth is that there is a reward-risk tradeoff in all assets.  The key is to not forget that risk-reward tradeoff concept when markets move to either extreme, such as the middle of this year when we saw double-digit percentage moves in the S&P 500 in both directions. 

 

So rather than try to out-guess the summer campers on their own turf, and fixating on every jog higher or lower on data that is forgotten months later, we are combining our multi-time horizon and defensive weapons approach noted earlier with another important tenet of long-term investing: buying your favorite investments when their prices "come to you."  We have seen some of our favorite investment themes and funds fall in price during this year.  But even though the prices are down a lot from their highs, the threat of an all-encompassing market decline is out there.  We will likely continue to believe it is out there until it finally happens.  But, unlike kids at summer camp do in their lakes and pools, we are not going to hold our breath waiting for it to happen. 

 

Instead, we have already begun to slide into our strategies some small, introductory positions in mutual funds or ETFs that we believe will pay off over time horizons beyond the comprehension of a trader.  This has worked for us before, as recently as early 2009, when we picked up several funds at prices which, a year later, were judged to be greatly undervalued at the time we bought them.  This is about buying the first tranche of some new ideas and also adding a tranche to some existing names in our portfolios.  All the while, we are keeping our overall market exposure at a level that we consider to be below average, evidence of our continued skepticism of the "summer rally" that appeared out of nowhere starting in early July. 

 

Thanks go out to our friends Stan Rickner, Steve Ellis and Leigh Powell of Seasons Financial in Tulsa, OK, who put into words what we are doing now.  Leigh compares investment behavior to clothes shopping.  She explains that buying things on sale is the smartest way to go.  Yet many investors still feel most comfortable buying what is currently going up.  Buying the best brands at a discount, which are out of favor and not currently the hottest thing, is a disciplined, opportunistic strategy that can work in investing as it can in clothes shopping.  At the same time, however, you can't just wait for sales to buy every article of clothing if you want a quality wardrobe.  

 

To translate this to investment strategy: we try to buy our favorites at levels we think are inexpensive, great long-term risk/reward.  That also means we have to be accurate in determining which styles and managers can be the "best brands" over one of our three time horizons.  You might think that simply looking at past performance would accomplish that.  Actually, that has very little to do with it, unless you make the assumption that future market conditions will mimic the past.  That is something that cannot be counted on.  That is why the research process has to go so much deeper than simply buying what you wished you had owned in the past (i.e. the best past performers).

 

Now, even if we forecast a very grim market scenario, that's just a forecast...a very educated guess, so we need to own either relatively small positions in many of our long-term favorites (and add to them later on market declines) or shorten our list of holdings and own modest positions in them. 

 

So, we will stick to our longstanding philosophy of trying to achieve a healthy balance or risk-reward at all times.  That may cause some statistical quirks that make us underperformers during some shorter, finite periods of time.  But our role, which we believe is the same as for any investment advisor who uses our services, is to help build financial futures and retirement nest eggs. In years like 2010 (so far), that means, keeping it all in perspective and trying not to fall into the wild rides that the market swings (and media attention) may engender.  In our view it is best to leave those rides to the summer campers, not the end clients!

(c) Emerald Asset Advisors

www.emeraldassetadvisors.com