My 'Bold' Plan: Getting 'Extremely' Defensive And Liquid

Includes: IVV, VB, VEU, VNQ, VO, VWO
by: Matthew Pixa

OK ... admittedly my title is a play on the recent popularity of, like him or not, Herman Cain. As most readers and Americans will know by now, this successful Georgia business executive is now a candidate for the 2012 U.S. Republican Party presidential nomination. Aside from his direct style of communicating, often coupled with a great sense of humor, Mr. Cain has made headlines with his “bold” plan of “9-9-9.” If you’ve ignored the debates thus far, which I call the “entertainment phase” of the election process, you may not know the basics of Cain’s plan. It essentially throws out the current tax code and would institute a 9% Business Flat Tax, a 9% Individual Flat Tax, and a 9% National Sales Tax. I’m not writing to endorse or provide banter about what candidates and platforms that I like. I do, however, welcome the idea of something bold and refreshing. How does this relate to an investment advisor in Orange County, CA?

It doesn’t … aside from the fact that this past Veteran’s Day, November 11, 2011, my firm made perhaps the boldest decision we’ve implemented in a very long time. With the markets whipsawing back and forth, and in what appears to be a narrowing “range bound” pattern, we made a decisive move to get extremely defensive and liquid. All of our clients have some sort of model allocation to which we then customize. I’m sure some portfolio models, that hold for example, a 40/60 type mix of equities to bonds, would eventually weather the storm and do just fine. Why then, make a drastic move and sell most of our equity exposure?

We went to about 35% cash on 11/11/11 for a specific number of reasons. When assessing markets we take into account three initial factors: (1) Fundamental Analysis (2) Investor Sentiment and (3) Technical Analysis:

Fundamentals -- How are we doing fundamentally? We actually see some improving, albeit deathly slow, signs of economic recovery. Domestic economic news has not been all that horrible and in some spots is showing life. Some “perma-bulls” will sugar coat everything and spin any report into one that is promising. This is typically seen with reports on earnings announcements. Even though we’ve witnessed some decent reports come out, once you take a peek under the hood you’ll find that it’s not as pretty as we’re led to believe. I’m simply saying that we could be worse, far worse … and at this point the domestic markets are getting slammed more than they normally would because of Europe’s woes and China doing its best for a softer economic landing. The fiasco in Greece may appear like a distant memory but the story in Italy and the entire eurozone is far from over. Having the Fed print more dollars (yes … I did say that correctly…print more dollars) and “coordinate” with the European Central Bank to stumble into more quantitative easing is not a solution to erasing debt. How has printing more money from thin air and prior “bail-outs” worked out before? It’s simply delaying the inevitable. This analysis could be far more involved here but simply understand that when you purchase a brand new flat screen television for a Super Bowl party you still have to pay for it at some point in time. Don’t you?!?

Italy has government debt that exceeds 120% of its gross domestic product. Similar ratios exist in Spain so it should be a massive warning sign that investors are demanding 7.5% and 6% interest respectively when lending to these two major European countries.

Circling back to the domestic front, we still have insane unemployment numbers and a consumer base that is not spending. Government reports of unemployment hovering around 9% are grossly underestimating our reality. Let’s of course hope that things improve but for the time being there are far more than 9% of Americans out of meaningful work. With regard to consumer confidence, don’t let a few reports of a “record breaking” Black Friday this past week fool you. I wasn’t pepper spraying other shoppers for the hottest children’s toy but headlines like this are not a signal of robust economic demand or that of a resurging and confident consumer.

Investor Sentiment -- One of the oldest economic indicators is to chat with your friends, neighbors, or colleagues that are not in the financial services industry. Even those that are in the business of managing money have been giving us all the signals I need that it could be the time to take a defensive move. Regardless of our sample size it’s almost inevitable that the herd gets it wrong just about every time. After a horrific September for the equity markets we witnessed the strongest October in about 50 years. How many partook in this massive rally? Too many sold after September and let October’s surprising rally slip away. After making a move towards a more defensive position, the market peeled off 8% to the downside. As of now we’ve had two days of rallies ... which one should argue were overdue. Markets never move in straight up or down patterns. Is this the proverbial “dead cat bounce” or a euphoria for what appears to be a “solution” to the major global economic and debt ridden headlines? Bargain hunting is inevitable after sell-offs. The average investor will typically get baited into buying into a rally on dramatic news or a simple resurgence in the broad markets.

Technical Analysis -- What do the tealeaves tell us from a charting perspective? Is all this range bound trading and increased volatility a signal that we are about to break out higher or retest some lows? There are some differing opinions on what the charts tell us but from the systems we rely and use, a clear signal to sell most major indexes was given on 11/11/11. Where we go from here is only a guess but most will get it wrong. Again … that’s just our opinion. Technical patterns aren’t always perfect but they often provide a decent roadmap as to what may come. This is only one factor from which we help guide us in decisions to get defensive or aggressive. As of late the charts tell us that we are at a true impasse. A narrowing S&P 500 chart could signify a break to the upside or one that breaks down to the next level lower. Obviously we felt that there was more of likelihood to the latter and therefore made the move to get defensive. In our opinion, there is little upside considering all other factors to move the markets higher in the foreseeable future so why risk being overly exposed?

What Next?

All of our clients will see each of the ETF’s (Exchange Traded Funds) we sold on 11/11/11 being repurchased. At a minimum we use about six major ETF’s to build our core exposure to the global equity markets. (IVV, VO, VB, VEU, VWO, VNQ) The pace and amounts as to what we’ll repurchase will be gradual but the overall intent and rationale is to buy them all back at full percentages to our respective models except at a lower price than where we sold them. Ideally, we would expect to see most purchases at about 10% below where we last exited. Even if we buy them back and the markets drift lower we have already avoided about a 7.6% decline in just over two weeks. Nobody can time markets consistently and trying to be greedy typically ends poorly. As mentioned before … when one attempts to “time” markets you have to be right twice: once when getting out and then again on when to get back in. Our intent is to simply enjoy our liquidity and defensive position and prepare our shopping list for a sunnier day.

Lastly, why the big deal with “11-11-11”? Admittedly … it has zilch to do with politics, tax codes, or Herman Cain. As of this writing, Herman Cain is all but done with his ambitions to be president. He has serious baggage, proven or alleged that I don’t care to get involved with. I am tattooing this date as one where we did more than a slight tactical move or portfolio adjustment. We made a “bold” decision to shelter our clients from what, in our opinion, is very risky equity environment in the near-term. If we’re flat out wrong we actually did better than most for 2011 even if we do rally to new highs. The old adage of “Pigs get fat and hogs get slaughtered” truly applies here. Some investment advisors will pop up once the dust settles and mention moves they made. Many defensive moves made by advisors are typically prompted by nervous and under-guided clients. Realistically most of these adjustments don’t move the needle or improve the bottom line; this bold move already has and we’re not done yet …

Disclosure: I am long BND, TIP, LQD, IEI, AGG, AA, AAPL.