Moving More to the Sidelines

With more red flags waiving, we took another step toward the sidelines by selling another position to build up our reserve. We have gradually reduced our equity stake. Of our ten positions, “cash” has now built up to around 30 percent of the portfolio. In addition, we own gold stocks (gold was again up, today, despite a falling stock market). We continue to own two positions in high yield (junk) bonds. Our traditional stock market investments are down to only about 40 percent of the portfolio. As we’ve suggested in previous posts, investors should think of junk bonds as being “equities,” and in that light they are outperforming most other sectors and asset classes in our universe.

In addition to the red flags in our previous post, we have been very concerned about the deteriorating prices in the junk bond arena. If junk bonds are going to have difficulty, then equities are toast. If debtholders are increasingly at risk, then shareholder earnings are going to get slammed.

The “technicals” (equity market charts and squiggles) are also waiving a red flag. Though we don’t heavily rely on technical analysis in building the portfolio, it is hard to ignore that last week’s “rally” looks like the market jumping from “oversold” to “overbought” over the course of a few days, and the subsequent decline moves the major trend to unambiguously lower. It will likely take some good economic news to re-route the trend upward, but good news has been in notoriously short supply in recent weeks.  If good news doesn't bring a trend reversal, then lower valuations ultimately will.

Our “Flexible Beta” approach calls for taking risk when risk-taking is well rewarded. Owning volatile stocks when the market is in rally mode, benefiting from the good side of volatility, helps portfolios grow. Now, however, we believe that upside is limited, the market environment is quite risky, and investors would prefer we proactively reduce our exposure to risk in this market.

In addition to our cash, junk bonds, and investments in gold companies, approximately 40 percent of our appreciation-oriented portfolios own healthcare and pharmaceutical companies, and technology (mostly software and hardware) companies.

We could still add a “bear market” fund to get slightly more defensive, but probably wouldn’t want to do that unless the economic fundamentals clearly and unambiguously get negative. We will update the May-Investments Leading Economic Indicator in a few weeks and may get a clearer sell signal from it, but the last reading was reasonably positive. Whether we’re in a correction (traditionally defined as a market drop of 10% to 20%) or a bear market (a decline of more than 20%) will likely depend on whether the economy does, in fact, double-dip. I think it will. I hope I’m wrong. In either event, this just doesn’t seem like the sort of market where investors ought to be neck deep in volatility.
 
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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