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Today the market took some sharp losses as I’m sure you’ve heard about excessively through your mainstream media channels. The major markets suffered losses around 5% just today (8/4/2011).  We thought it was important for you to know our thoughts about the market and more importantly about the performance of our client’s portfolios and how we have positioned our client’s accounts defensively before the markets topped a couple of months ago. To conclude we will discuss what our strategy will be going forward.  It’s important that you don’t become overly influenced by what you hear or see on the internet,  news or the radio and allow that to influence your decisions, but rather you should constantly focus on the realities of your life, situation and study the facts before you make any important decisions.  

The first chart below titled  “Head & Shoulders Breakdown” shows a classic reversal pattern called a Head & Shoulders pattern, the name comes from the visual appearance of a silhouette of person’s head and shoulders from the shoulder up (you may have to use your imagination!). Without getting into all the details of pattern let me simply explain what it means for the market.  The break below the neckline, which started to occur on 8/2 and was confirmed with today’s major sell off, from a technical point of view puts a high probability of further downside movements for the stock market.  The downside target is calculated by measuring the distance between the neckline and the top of the head, then take that exact distance and you project downward from the neckline.  As you can see on the chart below the downside target using this technique would be 1150 which is another 4% or so lower than today’s close.  This only gives you an initial intermediate downside target though and the market could go much lower.

Chart provide by (www.stock charts.com)

Looking at the next chart titled “Long Term Breakdown” illustrates another key technical breakdown of a long-term trend line that was broken decisively today.  A break of a long-term trend line usually indicates the end of that trend.  This does not always mean you start to go directly into a down trend, in fact sometimes it means you trade sideways for a period of time.  This break could point to the end of the bull market that has lasted since March of 2009.

Long Term Breakdown

Chart provide by (www.stock charts.com)

This final chart titled “Long Term Stagnation” illustrates what the S&P 500 has done over the last 11 years.  Since the market topped in 2000 the S&P’s price is lower now than it’s high 11 years ago.  Long-term resistance is near 1500 (high points of 2000 and 2007). Long-term support is near 750 (low points of 2002 and 2009).  In the last 11 years the market has traded in this range of 750 on the downside and 1500 on the upside.  This long-term sideways movement is typical of time period of stagnation.  Other similar periods of stagnation occurred during the great depression and the 1970’s (more specifically 1965-1982).  These periods of stagnation usually last around 15 years give or take a few years.  The typical trading pattern is to go back and forth from the upside of the trading range and the downside of the trading range.  If history repeats itself and it usually does, although with slight variations (in order to keep us on our toes), the market should gravitate back towards the low end of the range which is somewhere around 700-800.  We think this is a definite possibility and have prepared accordingly.  If we were to put a date on the next major market bottom (which is very difficult to do) we believe that it would be around the elections of 2012.  Election years are full of uncertainty and the market hates uncertainty.  Plus, this timeframe would coincide with our prediction of a major pop in the emerging market real estate bubble that we discussed in our recent commentary titled “Allgen’s Macro Economic & Market Update July 2011”.  Altogether presenting a period of extreme economic fear and enough selling pressure to push the S&P 500 and other markets around the world down toward their market lows of 2008-2009.  Going forward towards the time frame of the next market low could be extremely profitable especially if we are able to maintain significant purchasing power and be ready to buy when everyone else is frantically selling regardless of how undervalued the market is.

What does this mean for Allgen clients and their portfolios?  Allgen has been preparing for this scenario for a long-time.  Actually I admit that we started preparing and going defensive too early, but the defensive posture is really starting to pay off now.  At Allgen we manage two different styles of portfolios, a traditional asset allocation style portfolio which we call “Strategic Money Management” and  an actively managed style which we call “Active Money Management”. We have been defensive in both of these styles since before the infamous “flash crash” in May of 2010 and we have stayed defensive until now.

In the strategic portfolios the way we have postured the accounts defensively is as follows:

  • Investing in low-beta / high alpha funds that have a history of holding up well in down markets
  • Avoiding emerging markets that ran their course and made their big moves in 2009 and early 2010
  • Increasing our cash reserves
  • Holding safe havens like long-term treasuries in the form of an ETF (symbol TLT) which has currently skyrocketed in a flight to safety

In the strategic accounts we are attempting to protect from large losses which so far we have been able to accomplish with even our most aggressive (all stock) accounts only capturing about 60% of the what the market has recently dropped.  Our moderate to conservative accounts have lost only a small fraction compared to the markets since the market’s top.

Going forward with the strategic portfolios our strategy is to stay defensive until the market is showing signs of extreme fear at which point we will attempt to allocate some of our safe haven holdings and our cash into areas of the market that have suffered sharp price drops in the attempt to buy into stocks at undervalued levels.  We also periodically (on average once a quarter) rebalance the portfolios to sell from areas that have gone up significantly greater than other portions of the portfolio, then use the proceeds of the sale to buy into other areas of the portfolio that have lagged or gown down a significant portion more than the other holdings. This usually results in buying undervalued assets and selling overvalued assets. Rebalancing also helps to keep the portfolios in line with their target allocation attempting to prevent the portfolio from ever becoming too risky or too conservative compared to the client’s risk tolerance.

In our actively managed portfolios the way we have postured the accounts defensively is as follows:

  • Significantly increasing our cash (as high as two thirds of the client’s portfolio in some portfolios)
  • Investing in very few stocks which make up only a small portion of the overall holdings
  • Investing in safe havens like long-term treasuries and zero coupon bonds in the form of ETF’s (symbols TLT and EDV) both of these holdings have made major moves higher as the market has dropped
  • Investing in investment vehicles that are designed to trade inversely to the market and go up as the market goes down (VXX and EFZ)

Because we were postured defensively in our actively managed portfolios we have underperformed the S&P 500 over the last 12 months as market went up,  on the other hand the defensive posture really paid off during the flash crash (2nd quarter of 2010) and during this current market drop.  In fact on a day like today (8/4/2011), when the markets were down about 5% or more our active accounts on average we’re up approximately 0.25%, that’s around a 5% difference compared to the market in one day.  Taking a longer term picture we have outperformed the S&P 500  since its top in Oct. 2007 which includes two market cycles, the bear market from 2007-2009 and the bull market that has lasted since Mar of. 2009 up until now. Our strategy in the actively traded portfolios is to anticipate major intermediate to long-term market moves and position the portfolios accordingly ahead of time.  This could mean that we get very defensive ahead of an anticipated market drop (usually while the market is still going up), this is what we’ve done recently over the last year. Or it could mean that we buy heavily into a market that is falling and showing signs of high levels of fear in anticipation of it reversing and starting a new bull market like we did in 2008. We use the combination of technical, fundamental and quantitative analysis with an overlying contrarian mindset that understands the “herd” is usually wrong and if you do the opposite of the herd you will usually prosper overtime.  We also use the above analysis to carefully pick individuals stocks and sector ETF’s the we believe will outperform.

Going forward with the actively traded portfolios our strategy will be to stay defensive until the market is showing signs of extreme fear at which point we will attempt to allocate some of our safe haven holdings and our cash into areas of the market that have suffered sharp price drops in the attempt to buy into stocks at undervalued levels.  We will also look to exit out of our investments that are designed to go up as the market goes down.  Since we believe that the market is going to be in a down-trend until approximately election time of 2012 our plan is to stay defensive until then.  At certain points though like today’s current market condition where we have started to go into a free fall, we will attempt to make small purchases to take advantage of temporary oversold conditions.  From a big picture point of view we are looking to maintain as much buying power as possible until the market makes its next major market bottom which we believe will be sometime near the end of 2012 or beginning of 2013.  If we are successful we will look to take advantage of stocks that are priced very low during that bottom and try to buy in at very favorable prices in order to enjoy the next bull market.  It should be noted we understand it is impossible to predict future market movements consistently overtime to the exact day, or month for that matter, so we always keep an open mind to the possibility of us being inaccurate in our predictions and through studies of different indicators we will attempt to make adjustments as necessary.

Allgen’s Investment Approach
Allgen specializes in active and strategic money management. Through technical and fundamental analysis, along with a contrarian mindset, we strive to successfully navigate the markets during periods of prosperity and decline. We constantly research and study the markets to find the next emerging area even in asset classes that are typically not used in your “buy and hold” asset allocation portfolios. When we invest for Allgen’s clients there are two main objectives:

1) Manage Risk First – Preserve capital and avoid major losses
2) Produce superior risk-adjusted returns over a full market cycle (Bull and Bear Market)

Please feel free to call if you have any questions or concerns.  If you are not a current client and want to see how Allgen’s money management may help your investment portfolio then please email us at advisors@allgenfinancial.com or give us a call at 1-888-6ALLGEN (625-5436).

Written By:
Jason Martin, CFP®, CMT
Senior Partner & Chief Investment Officer
Allgen Financial Services, Inc.
martin@allgenfinancial.com
888.6ALLGEN