First Quarter Letter To Clients {Part III}

The Playbook

Be that as it may, stocks have experienced a change of character this month. Irrespective of what we think might happen we must deal with the market as it is and not how we hope it might be. One of our primary market tools is to study money flows into and out of stocks. We believe that investors reward asset classes by injecting liquidity {more buyers than sellers} and punish by taking that liquidity away. Studying liquidity will not insure portfolios from all losses and it will almost certainly never prevent losses when we have a sudden unlooked for event such as a market crash. But understanding liquidity should in general raise cash in portfolios before a crisis hits and will help uncover clues on the current state of the market.

Equities today react almost instantaneously to information. Our development of the playbook is a response to this. The playbook is situational analysis based on historical market results. Using our studies of money flows along with the disciplines of fundamental and valuation analysis we formulate a game plan based on what the playbook tells us has historically occurred. This game plan attempts to take into account certain market outcomes and adjusts these to the investment profiles of our clients.

We know of no system that will totally inoculate a portfolio from market declines. What we attempt to do is to mitigate that risk based on a client’s comfort level. Thus we are constantly asking “What If….?”, we try to develop responses based on those results and then look for ways to tactically implement these ideas in client portfolios based on what we understand to be the client’s risk/reward equation, We constantly evaluate our game plan and stand ready to change it when conditions change.

Please note we manage portfolios based on clients’ personal criteria. What follows is a broad statement of our thinking, a general statement of how portfolios are currently positioned and our current investment posture Client portfolios may therefore not exactly match the following general analysis. Factors influencing a client’s risk profile can include portfolio size, legacy positions, tax considerations and targeted rates of return.

We’ve chronicled over at our blog how we have become increasingly concerned since mid-January about the way stocks were trading. This has caused us to develop a more defensive posture at the moment. In some instances this has prompted us to raise cash. It has also prompted us to review every portfolio in order to identify what we might do in case this decline turns into something more serious. We do not know whether this current corrective phase will burn itself out soon or has further to go. Instead we find it prudent to let our indicators be our guide on what should be our next move. We recognize that we will likely never completely sell out of our holdings at market tops or be all in cash when markets trough. However, we would like to have cash to redeploy when stocks inevitably bottom out. We are in the process of trying to determine at this point what these amounts should be.

We think we will be able to better understand market direction over the next 3-6 months by how stocks react to any rally that we think should soon follow this decline. If stocks rally straight back to previous highs and manage to burst through those levels, they will act much like they did for most of 2009. That would be indicative of a market that wants to go higher in a shorter period of time than most investors currently anticipate. On the other hand a market that has trouble rallying from current levels or fails after a feeble attempt to move higher would be indicative of a situation that could lead to more downside or a certain period of consolidation. We’ll let our indicators be our guide at this point as to what to expect.

Our current strategy is to: (1) Reposition into what we believe to be attractive market sectors. (2) Reposition our core broad market ETFs. We have done this by splitting these sectors, one portion looking for longer term value while the other portion is utilizing in appropriate accounts some of our Targeted Investment Growth strategies to look for shorter term investment opportunities. (3) Take advantage of market dislocations which have given rise to attractive dividend yields. In general our investment focus continues to be on ETFs.

{Tomorrow:  Conclusion}