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Long/short equity, registered investment advisor, portfolio strategy
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Good Morning. I started writing my "State of the Markets" missive in the late 1990s and I began publishing it on the web in 2003. I decided to put my thoughts out there for all to see for a couple of reasons. First, I wanted to bring a professional risk manager's point of view to the newsletter world. I was of the mind that far too many investors had been hurt badly by the tech bubble bear market and that much of the damage could have been avoided. Second, I saw there were far too many shysters on the internet telling the public that every move they made was a huge winner. I felt that transparency and honesty were missing traits of the industry. As such, I wanted to bring the good, the bad, and the occasionally ugly to light - all in real time.

In keeping with that goal, I need to disclose that I closed out a losing trade yesterday in our disciplined active risk management programs. You see, when our market environment model is neutral (as it has been since 5/31), our system tells us that the best way to be ready for the next big move in the market is to try and stay in tune with the short-term trend of the market. The positive to this approach is that the system tends to get us "in" the big moves relatively early on a fairly consistent basis. The negative is that the market oftentimes experiences fits and starts in between the big moves, which produce a fair amount of small(ish) whipsaws along the way. And since the last big move ended on 5/22, we've experienced three such whipsaws.

Our test of the system shows that when our environment model is neutral, only 53% of the trades are positive. As such, the question becomes, why would I want to employ such a system? Why use something that is only profitable 53% of the time? In short, why would I want to subject myself, my clients, and my subscribers the misery of all those losing moves?

"Why don't you just buy into weakness and sell into strength?" I am asked. Just yesterday, I was asked, "Why do you want to sell on a down day?" Then there was, "Why not wait for a rebound?" And finally, "Why don't you just wait for the gap on the S&P to be filled before selling?"

The answer to all of the above questions is the same. You see, unlike all of the geniuses on TV, I don't "know" what is going to happen next in the market - and I don't pretend to. To be honest, on Tuesday I was feeling pretty good about our most recent long position and I found myself wishing my system had called for a leveraged position. Two days and 560 Dow points later, it looks like Tuesday's breakout to the upside has morphed into a meaningful correction. And for the record, while the market often bounces in the near term after a severe thrashing, there are times when additional downside follows - and it is this type of waterfall decline that needs to be avoided. So, since one never "knows" when such a decline will ensue, we believe it is prudent to follow a disciplined sell strategy.

Although I believe that the current freakout in the markets (i.e. gold, bonds, currencies, emerging markets, and U.S. stocks) is likely a bit overdone, I don't "know" what will happen next. Sure, I can guess with the best of them. But, the bottom line is that I've been in the business of managing other people's money for more than 25 years and I can with absolute certainty that no one has been able to consistently "call" the intermediate moves of the stock market right for any length of time.

Speaking of "knowing" how things work, let's spend a moment this morning looking at the current market environment. Ask yourself, when was the last time that the prices of stocks and bonds went the same direction in a major way? Aren't you supposed to diversify your portfolio into stocks AND bonds because bonds tend to go up when stocks go down? I will bet that everybody "knows" this is what diversification and modern portfolio theory is all about.

How's That "Known" Diversification Working Out?

But let me ask you; if you currently have a classically diversified portfolio of stocks, bonds, gold, real estate, commodities, emerging markets, etc., how's that working out for you right now? Everybody knows that stocks have been struggling for the past month. But have you taken a look at how the rest of that diversified portfolio is doing? Take a quick peek at the charts of the SPDR Gold ETF (GLD), the PowerShares Commodity index ETF (DBC), the iShares 20+ Treasury ETF (TLT), the iShares Emerging Markets ETF (EEM), and/or the iShares DJ Real Estate ETF (IYR).

The point is that the smart folks who "know" an awful lot about investing believe wholeheartedly that it is smarter to utilize a diversified portfolio than a portfolio consisting only of stocks. Many financial advisors will likely tell you that such a prudent, diversified approach has been "known" to outperform when times get tough. And yet, real estate (IYR) is down -1% on the year, gold (GLD) has plunged -23.1% in 2013, bonds (TLT) are off -9% YTD, commodities (DBC) have lost -7.9% so far this year, and the emerging markets (EEM) have declined -16.8%. Oh, and I almost forgot - although it's been a rough month, the S&P 500 is still up +11.36% this year.

So, from my vantage point, what is "known" to be prudent and effective appears to be encountering a bit of a problem. In fact, a diversified portfolio of 40% stocks, 30% bonds, 10% gold and emerging markets, and 5% real estate and commodities would be down -2.6% YTD as of yesterday's close. Classically diversified. "Known" to be effective. But still very "wrong" right now.

And lest you forget, this isn't the first time that the markets have "gone haywire" and caused the "known" strategies to blow up in recent history. Anybody remember what happened less than 5 short years ago in 2008?

I Admit It: I don't "Know" What Will Come Next. So ...

I accepted long ago that I don't really "know" much of anything about what is going happen next in the markets. Thus, I made the decision to utilize disciplined systems to guide my exposure to the markets. I recognize that no system is perfect. I recognize that I will make losing trades (sometimes several in a row). I recognize that every system struggles from time to time. I recognize that sometimes you get unlucky in the timing of moves. And I recognize that the markets will make you look like the village idiot from time to time.

However, I will accept these difficulties. I will accept the disparaging emails when we make a bad move or two (or three). I will accept the calls suggesting that I need to change this or that. I can accept that fact that my approach isn't the Holy Grail of market systems. And unlike most investors/traders, I can accept that I don't "know" what's going to happen next. No, the best I can do is try to put the odds in my favor before we make a move. And while it can be challenging at times, I "know" that this is what we attempt to do here each and every day.

Turning to This Morning ...

After the dramatic sell-off on Thursday, foreign markets did not follow through to the downside overnight. In fact, European bourses are bouncing and Japan rallied 1.7%. Part of the reason behind the rebound is said to be tied to an improvement in Chinese lending rates. In addition, it is a quadruple witching expiration Friday, which tend to enjoy a positive bent. Finally, U.S. futures are following Europe higher and point to a rebound at the open. However, there is now significant overhead resistance that the bulls will need to deal with if they are going to turn things around.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell ...

Major Foreign Markets:

- Shanghai: -0.53%

- Hong Kong: -0.59%

- Japan: +1.66%

- Germany: +0.22%

- France: +0.73%

- Italy: +0.33%

- Spain: +0.28%

- London: +0.88%

Crude Oil Futures: +$0.40 to $95.54

Gold: +$6.60 to $1292.80

Dollar: lower against the yen, higher versus euro and pound

10-Year Bond Yield: Currently trading at 2.415%

Stock Futures Ahead of Open in U.S. (relative to fair value):

- S&P 500: +12.61

- Dow Jones Industrial Average: +100

- NASDAQ Composite: +19.93

Thought For The Day ... "Yesterday is history. Tomorrow is a mystery. Today is a gift. That's why it is called the present." --Alice Morse Earle

Positions in stocks mentioned: none

Source: Daily State Of The Markets: I Don't 'Know' Anything ...