Our Increasing Conviction

Changing the asset allocation of Pinnacle portfolios is often the result of a change in our forecast for various market segments. Even saying the word, “forecast,” raises the specter of foolishly staring into a crystal ball, trying to predict the future. Because we are in the business of making accurate forecasts, we readily admit that we will make forecasting mistakes, because, regardless of what you may have heard, we really can’t predict the future with complete accuracy. However, we can assign probabilities to future events and try to identify good investment values based on what we call “the weight of the evidence.” At any point in time the investment team has a view of where we are in the market cycle, market valuation, and investor enthusiasm for taking risk. The results of our view can be seen in our current portfolio asset allocation, where we compare the changing risk in our managed portfolios to the fixed risk in our benchmarks. One of the most important elements in our work is to assess the level of conviction we have as a team about our forecast. When the team has low conviction, our portfolios tend to hover close to benchmark levels of risk. When the team has high conviction in our forecast, then the portfolios can be structured to have dramatic differences in risk than the benchmark.

Lately the weight of the evidence has not been kind to investors who are predisposed to a bullish point of view, and our conviction in a bearish forecast continues to grow. One of the “big guns” in the bullish case was to stay out of the way of fiscal and monetary policy conjured up by central banks and governments to reflate assets in an attempt to mitigate the problems in Europe and the U.S. This week the U.S. stock market has effectively voted “no” on the $400 billion proposed jobs bill and the Federal Reserve’s much anticipated Operation Twist. We are beginning to suspect that bearish investors are less fearful of a strong and coordinated policy response to slow growth and too much debt. If you are bearish, there is always the concern about what policy actions remain in store for us as we slog through the “bogey man” months of September and October. However, at the moment it seems as though the Federal Reserve isn’t overly interested in QE3, and even if they did more quantitative easing, it’s uncertain to us whether the market would respond favorably. In other parts of the globe, Europe’s problems continue unabated by any effective policy action. And, yesterday China printed a disappointing industrial production number signaling more weakness ahead in their GDP growth. Financial markets are rioting.

All of the above has created a greater level of conviction among Pinnacle investment team members that the market is headed lower, perhaps significantly lower. Our current conversation is about reducing risk positions even further if the S&P 500 Index falls below the important support level of 1100. At that point the market will have invalidated much of the bullish thinking that the market was forming an important base through the summer and setting the stage for a significant rally through year-end. We may still get a rally later this year, but our conviction is growing, based on the weight of the evidence, that more price declines are just ahead. 1100 on the S&P represents a 20% decline from the market top. Unfortunately, the median bear market, with secular bear cycles, is a 34% decline. The bearish case seems to be getting stronger.