Tuesday, October 4, 2011

Crossing a Line in the Sand

The S&P 500 Index has flirted with crossing below 1100 three times since early August. The market has been bouncing around since August 9th, when it first traded to an intraday low of 1101. It rallied to a high price of 1230 on August 31 and exhibited a record breaking amount of volatility over the past month. Yesterday the S&P 500 made a new closing low of 1099 and invalidated many of the arguments for bullish investors who hoped that the 1100 number would be the low from which the market could rally through the remainder of the year. After all, at today’s prices the stock market has declined by 19.4% from its 2011 high of 1363, set this past April. Since 20% is the unofficial decline needed to declare a bear market, the bullish case held that the market must have fully discounted the chances that the U.S. and global economy would fall into recession. As Pinnacle clients know, we have been systematically reducing risk in our managed accounts for months as the weight of the evidence continues to indicate that the risks of recession are growing.

In our view, yesterday’s market action suggests that prices will decline further. Since 1946 the average bear market decline has been 27%. When the bear market occurs during a secular bear market like the one we are currently experiencing, the average decline is more like 35%. Considering the number of analysts now willing to make a call that the U.S. is either currently in a recession, or will imminently enter recession, we believe it is prudent to continue to lower portfolio volatility. As of last Friday, we have been adding 1% to our current position in the U.S. Dollar ETF, selling 2% from our energy ETF position, and selling the remainder of our Equal Weighted Industrial ETF in our Appreciation and Ultra Appreciation models. In addition we are selling our entire position in the Merger Fund and trimming 1% from our High Yield Bond Fund positions. We are also completing a number of rotational trades within the Healthcare, Financial, and Consumer Discretionary sectors. The result of these transactions is that our portfolio strategies will be more defensively positioned with the majority of our equity allocations invested in low volatility sectors like Health Care, Consumer Staples, and Utilities.

With these latest trades, we believe that our portfolio construction properly reflects the risks of further market declines. There are still risks to our bearish outlook, notably the possibility of massive intervention by central banks and governments to provide excess liquidity to markets through programs like quantitative easing. A multi-trillion dollar bailout of European banks, along with central bank intervention in currency and bond markets (as well as other risk asset markets), could propel stock markets higher around the world. In addition, economic data is still somewhat mixed. However, considering the latest market action and negative changes in the economic forecast, we believe it is prudent to put aside fears of missing higher returns and concentrate on defending portfolio principal.

We will be explaining these transactions and our latest market outlook in great detail in our upcoming Quarterly Market Review, which should be released within the next two weeks.