Managers’ Special Report: Tactical Model Perspective

Based on data from August 3 , 2010

As the market entered 2010, our models indicated that stocks were generally over-valued and investor sentiment was too complacent (see past comments for details). The rally was still intact, but was showing signs of moderation after an incredible run off the March 2009 lows.

The market hit its first speed-bump between mid-January and early February, with the S&P 500 index correcting by about 8% before rallying to new highs in April. By late April, our measures of sentiment and valuation were again very stretched. The next correction was stronger and deeper, as the S&P 500 index lost 17% from peak to trough, and many foreign and small company stock indexes dipped into bear market territory (decline of 20% or more). Then, just as investors began throwing in the towel, citing a dow theory sell signal of “death crosses” (when the 50-day moving average crosses below the 200-day moving averages) and renewed fear of a double dip recession, the market bounced in July, pulling back up to flat for this year-to-date.

The year has been quite a roller coaster ride. Our tactical portfolios were much less volatile and boast modest gains.

Investor confidence was badly damaged by this sharp correction.  Our measures swung sharply, from excessive complacency to excessive pessimism. In our tactical portfolios, we hold considerable cash, and, until the market breaks out to new highs, we are maintaining a partial hedge.

Managers’ Special Report: Tactical Model Perspective

Based on data from June 4 , 2010

Prior to the correction, we observed that investors were too complacent and stock prices were gaining faster than underlying fundamentals (see past comments below). Now, investor pessimism has reached an extreme that suggests that many of those who are willing to sell their stocks may have already done so. Also, while our measures do not suggest that stocks are under-valued, we no longer measure stocks as over-valued. So the recent sell-off may become something more ominous, but we can clearly observe that it has already “corrected” many of the concerns that had held us to a fully defensive posture.

Our trend analysis is neutral at this time. Obviously, trend strength is under pressure. Still, most market indexes remain in up-trends. The easiest way to observe this is by looking at the direction of the 200-day moving averages. When a large percentage of market indexes and mutual funds are priced below their intermediate-term moving averages and the averages continue to slope upwards and to the right, that fact indicates that the market is “oversold”. If the selling continues, the moving averages will roll over indicating a confirmed change in market trend. Absent further deterioration, it is dangerous to bet against an oversold market, especially when accompanied by extreme investor pessimism.

We must be willing to take some risks at times, even when concerns remain, if we hope to participate in market gains. We prefer to make incremental changes and establish clear limits and triggers so we don’t get stuck in or out of the market. Presently, the weight of the evidence warrants moderate equity exposure and a willingness to add exposure to highly ranked funds and ETFs on weakness as long as the major indexes continue to hold support levels and the intermediate term trend remains positive. We have no forecast for near-term market direction. We continue to hold some cash and take advantage of modest hedging techniques to allow us to manage risk while we monitor for renewed trend strength or weakness.

We acknowledge that many investors are more comfortable investing in our fully invested portfolios and managing risk through asset allocation. For “do-it-yourself” investors, we believe that asset allocation is the most practical and certainly the easiest way to effectively manage risk. If any of our readers have questions or concerns about risk management, we hope that they will call us as we are happy to help.

Our tactical portfolios are designed to take a more active approach to risk management. Our goal with these portfolios is to earn more in advances than we lose in declines and therefore to add value over time. Of course, we risk being invested when the market declines and being hedged when the market advances. We are committed to managing these risks, but they are part of any tactical investment strategy.  The most important element to long-term investment success is that you understand the risk, reward potential and philosophy of your investment strategy and remain disciplined and focused on your long-term goals.

Summary: The market indexes have suffered their first true correction (peak-to-trough loss of 10% or more) since the March 2009 lows and are struggling to hold support. On balance, our models are more bullish than they have been for some time. Our trend model is neutral. Our tactical portfolios have weathered the recent storm with minimal damage. We are cautiously more bullish and although we are not fully invested, we are allowing for the possibility that the correction will give way to a continuation of the recent bull market.

Summary: The market indexes have suffered their first true correction (peak-to-trough loss of 10% or more) since the March 2009 lows and are struggling to hold support. On balance, our models are more bullish than they have been for some time. Our trend model is neutral. Our tactical portfolios have weathered the recent storm with minimal damage. We are cautiously more bullish and although we are not fully invested, we are allowing for the possibility that the correction will give way to a continuation of the recent bull market.

Prior to the correction, we observed that investors were too complacent and stock prices were gaining faster than underlying fundamentals (see past comments below. Now, investor pessimism has reached an extreme that suggests that many of those who are willing to sell their stocks may have already done so. Also, while our measures do not suggest that stocks are under-valued, we no longer measure stocks as over-valued. So the recent selloff may become something more ominous, but we can clearly observe that it has already “corrected” many of the concerns that had held us to a fully defensive posture.

Our trend analysis is neutral at this time. Obviously, trend strength is under pressure. Still, most market indexes remain in uptrends. The easiest way to observe this is by looking at the direction of the 200-day moving averages. When a large percentage of market indexes and mutual funds are priced below their intermediate-term moving averages and the averages continue to slope upwards and to the right, that fact indicates that the market is “oversold”. If the selling continues, the moving averages will roll over indicating a confirmed change in market trend. Absent further deterioration, it is dangerous to bet against an oversold market, especially when accompanied by extreme investor pessimism.

We must be willing to take some risks at times, even when concerns remain, if we hope to participate in market gains. We prefer to make incremental changes and establish clear limits and triggers so we don’t get stuck in or out of the market. Presently, the weight of the evidence warrants moderate equity exposure and a willingness to add exposure to highly ranked funds and ETFs on weakness as long as the major indexes continue to hold support levels and the intermediate term trend remains positive. We have no forecast for near-term market direction. We continue to hold some cash and take advantage of modest hedging techniques to allow us to manage risk while we monitor for renewed trend strength or weakness.

We acknowledge that many investors are more comfortable investing in our fully invested portfolios and managing risk through asset allocation. For “do-it-yourself” investors, we believe that asset allocation is the most practical and certainly the easiest way to effectively manage risk. If any of our readers have questions or concerns about risk management, we hope that they will call us as we are happy to help.

Our tactical portfolios are designed to take a more active approach to risk management. Our goal with these portfolios is to earn more in advances than we lose in declines and therefore to add value over time. Of course, we risk being invested when the market declines and being hedged when the market advances. We are committed to managing these risks, but they are part of any tactical investment strategy.  The most important element to long-term investment success is that you understand the risk, reward potential and philosophy of your investment strategy and remain disciplined and focused on your long-term goals.

Managers’ Special Report: Tactical Model Perspective

Based on data from May 11, 2010

Current Tactical Model perspective

Our tactical portfolios have held considerable defensive positions for several months, and have lagged much of the bull market advance.  Our defensive posture paid off during periods of increased volatility, such as we saw in early May. During the panic-selling through May 7th, we increased equity exposure, allowing us to capitalize on the rally May 10^th.

For the last several months, we have expressed concern about investor complacency and the notion that the market’s steady grind higher could eventually encounter turbulence. Although we did not expect the speed and force of the recent sell off, we were well positioned to mitigate any significant damage. Our tactical portfolios are positive this month-to-date through May 11, 2010

We re-hedged our tactical portfolios into the powerful rally on Monday, May 10^th, but  we are not bearish.  In fact, the recent correction helped alleviate concerns that the market was over-bought. The up-trend has clearly weakened, but has not broken down to a point of concern.

Intra-day, this latest pullback took most indexes down by more than 10%, although the S&P 500 index has yet to close 10% below its recent peak. We can’t know whether or not the correction is truly over and we don’t attempt to forecast future market action. Our models are neutral, and although we currently hold considerable defensive positions,  we also expect to modestly participate in further gains if the rally resumes.

Summary: The market rally continued through April, then corrected sharply in early May. Several prominent indexes gave back all of this year’s gains in less than 2 weeks. Our models are neutral. We hold considerable defensive positions, but also seek partial participation if the recent correction has ended and the market resumes its relentless rally.

Managers’ Special Report: Tactical Model Perspective

Based on data from April 1, 2010

Current Tactical Model perspective

Our indicators started last month in a cautious stance, indicating that January’s correction could continue before the bull market rally would resume.  March turned out to be very strong and all of the major indexes are at new highs. Our tactical portfolios lagged, but did benefit from the advance as our models became progressively less defensive as the month progressed. Year-to-date, last month’s impressive rally propelled our fully invested portfolios ahead of our tactical portfolios.

We continue to hold defensive measures in our tactical portfolios but acknowledge that the uptrend has resumed and we have made adjustments to allow greater market participation. Since the rally’s resumption, the S&P500 has gone 29 trading sessions without even a 1% correction. Valuations are stretched, the market is “over-bought” and our sentiment models indicate that investors are increasingly complacent. All of that said, we have seen very little selling pressure and until new evidence emerges, we see no reason to fight against the rising tide. We are not fully invested, but we reduced the sensitivity of our hedges to allow greater market participation.

We continue to respect that the rally off the March lows has matured and an eventual 10% to 20% correction is inevitable.  The question is when and from what level. As the market continues to grind higher, we think it is important to participate in harmony with the uptrend. If you have missed this entire rally, you probably don’t want to jump in here with both feet. Instead, you should either consider dollar cost averaging in or include defensive measures to allow you to avoid a potential whip-saw if market volatility resumes. Simply sitting in cash waiting for the next bear market has been a losing proposition over the last year and is probably not a sustainable long-term strategy for most investors.

Summary: The market rally resumed early last month, propelling the major market indexes to new bull market highs. We are not fully invested in our tactical portfolios but we also see no reason to fight the current rising tide and we have adjusted our tactical portfolios to allow greater market participation while still holding some defensive measures.

Managers’ Special Report: Tactical Model Perspective

Based on data from March 1, 2010

Current Tactical Model perspective

Composite:      Bearish
Trend:              Neutral (weakening)
Valuation:        Bearish
Sentiment:       Neutral

Equities bounced back in February following January’s declines although most remain slightly negative year-to-date. Our tactical portfolios held up well in the January’s pullback but did not participate in February’s rally as we remain defensive based on continued deterioration in our models. The net effect of this is favorable year-to-date versus our fully invested portfolios.

Last month we discussed how the correction that began in January had helped reduce excessive optimism and, when combined with good earnings, valuations were moving closer to their long-term average. We expressed our hope that the correction would ultimately set the stage for a continuation of the bull market as sentiment became more supportive, the market less over-bought, and valuations pulled back within a more normal range. The February rebound reversed those improvements (prematurely by our measures), leaving the market vulnerable to further correction once this bounce fades.

Perhaps the 2010 correction is over, and the bull market that began in March 2009 is set to resume. Only time will tell. Based on the current weight-of-the-evidence, our tactical portfolios remain defensive, holding considerable cash and well hedged through a combination of covered calls and protective puts. We may diversify our hedge to include inverse ETFs in lieu of protective put options.

As always, our long portfolio is based on Upgrading. We therefore emphasize domestic mid-cap funds and ETFs, especially mid-cap Value. We have modest exposure to core foreign funds and some speculative exposure to diversified emerging markets ETFs.

At this time, we are looking for a trigger to increase long exposure and/or reduce our defenses.  That trigger could be a thrust higher, but we expect that a continued correction would be required for our models to turn more bullish.

Summary:  We remain cautious. Our Tactical portfolios held up well in January’s pullback due to considerable defensive posturing – and did not participate in February’s bounce for the same reason. The net effect of this is favorable year-to-date versus fully invested portfolios.

Renewed trend strength could trigger a buy, but the weight of the evidence leans towards a continuation of the correction before the bull market resumes. For now, our tactically portfolios are defensive.

Managers’ Special Report: Tactical Model Perspective

Based on data through February 1, 2010

Current Tactical Model perspective

Composite: Neutral (from Bullish)

Trend: Neutral

Valuation: Bearish (but improving)

Sentiment: Neutral to Bullish (from Bearish)

January 2010 started strong but finished poorly, with all stock indexes posting losses. Leading sectors like technology were punished and emerging markets fell sharply. Our tactical portfolios held up nicely as we were prepared for a correction.

Last month, we perceived excessive optimism (or investor complacency) and high valuations as potential headwinds, and observed bullish but weakening trend momentum. The recent pullback has dramatically corrected the sentiment picture and our sentiment models are now either neutral or bullish. Valuations remain stretched, but a combination of lower prices and improved earnings has moved us closer to a neutral reading.

We continue to view this move as a correction in an ongoing bull market, but our composite model is now neutral and our attention is squarely on trend momentum.

As always, the core of our portfolios is based on Upgrading. We therefore emphasize domestic mid-cap funds and ETFs, especially mid-cap Value. We have modest exposure to core foreign funds and some speculative exposure to diversified emerging markets ETFs.

Last month we talked about using put options and covered calls to hedge our long positions so we could “take advantage of a possible correction.” In addition to hedging with options, we also hold some cash. We remain cautious. If we turn bearish, we would raise more cash by selling ETFs and possibly replace some of our put options with inverse ETFs.

At this time, we are looking for a trigger to increase long exposure and/or reduce our defenses. That trigger could be a thrust higher, but odds favor a continued correction first.

Summary: We remain cautiously optimistic. Our Tactical portfolios held up well in January’s pullback due to considerable defensive posturing. We are not bearish – but we remain cautious. Our attention has shifted away from sentiment and valuation and we are now focused squarely on trend momentum.

Managers’ Special Report: Tactical Model Perspective

Based on data from January 1, 2010

Current Tactical Model Perspective
Composite: Bullish
Trend: Neutral
Valuation: Bearish
Sentiment: Bearish

Following the massive bear market of 2008 through the trough in March 2009, nearly all broad market indexes enjoyed remarkable gains. Despite these gains, most indexes are well below the peaks of 2007. In fact, the broad benchmark S&P 500 index has re-traced only about half its loss from the 2007 highs.

Initially, this rally was fueled by excessive investor pessimism, low valuations and incredibly accommodative monetary conditions. As the rally progressed, gains were confirmed by market breadth and trend strength. Recently, trend strength has eased (it had to sooner or later) and valuation and sentiment are now headwinds. Some characterize this as a market that has come too far too fast. Monetary conditions, however, remain very loose, with the domestic Fed funds rate at zero, and global monetary and fiscal bodies providing considerable support in an unprecedented effort to stimulate growth.

The market indexes, including the S&P 500 index, have been very resilient throughout the rally, with no correction greater than 7% for the S&P 500. Recently, the rally’s trajectory has shifted from essentially vertical to relatively sideways. Based on our measures of high valuations and excessive investor optimism, we believe that a moderate correction would be healthy, allowing fundamentals to catch up to prices, and restoring a more balanced outlook.

As our signals are mixed, we maintain healthy exposure to equity mutual funds and ETFs, but we have also raised considerable cash, and we hold protective “put” options to hedge our portfolios against a possible correction. Another tool that helps us manage our risk while maintaining significant long exposure is the ability to sell “covered call” options (allowing us to generate income on ETFs by selling the option. This enables a counterparty to purchase our shares at what we believe is a reasonable price within a fixed time period). This income helps offset the cost of buying protective “put” options. We continually monitor our model, and we expect to put cash back to work incrementally, unless a correction materializes that offers a more attractive buying opportunity in which case we could invest more quickly. We may also add long exposure through purchasing “call options” should trend strength improve without a correction.

Summary: We remain cautiously optimistic, but see the trend as weakening and valuations and investor sentiment as headwinds. Our Tactical portfolios have considerable defenses in place, but we are not bearish – we are cautious and prepared to take advantage of a possible correction.

Tactical Portfolio Overview

Most of our portfolios are fully invested at all times, and we manage risk through the total number of holdings, limiting the allocation to more speculative funds, and by allocating part of most client portfolios to multiple strategies including our Flexible Income strategy.

We also manage Tactical portfolios designed to increase and decrease equity exposure based on objective measures of current market risk. We use our Upgrading strategy for buy and sell decisions in all portfolios including our Tactical portfolios, but Tactical portfolios may also hold considerable cash, and their equity holdings may be hedged in a variety of ways based on our current observations of market risk vs. reward potential.

Our primary tactical model is a composite of risk measures (signals) based on valuations, investor sentiment, the strength of a market trend, market breadth, monetary conditions and the relative attractiveness of stocks versus bonds and cash. We weight our allocation decision based first on a composite score across the model’s signals, but we also may respond to divergences between the individual signals that shape the tactical model.

Our Tactical portfolios hold mutual funds and ETFs based on Upgrading, very similar to those held in a growth portfolio. We emphasize ETFs so we can more actively add or reduce equity exposure, and we can raise cash and buy or sell options to help manage risk exposure. We may also hold “inverse ETFs” that gain when a market index declines and decline when the index rises. Our Tactical Total Return strategy includes an allocation to our Flexible Income strategy.