There Will Be Days Like This

By Charles Webb

It's never easy to sit back and watch the Dow drop five hundred points. But it happens. From a technical standpoint, the last two weeks have put the U.S. and most foreign stock indices in "market correction" territory (down 10%).

Yesterday's action was the culmination of a steady deterioration in the fundamental data over the last two months in the U.S. and continued liquidity uncertainty coming out of Europe. The primary emphasis here has been poor Jobs data and revised lowering of GDP for 2011. In Europe, it's just been more of the same - declining quality of sovereign debt.

From a technical trading standpoint, a number of key thresholds have been crossed on the downside leading to more momentum lower. All of this adds up to a glut of bad news and very little to look forward to.

After today's rout, most stock indices have erased their year-to-date gains and are now negative for the year. The Dow Industrials are down 1.67% and the S&P lower by 4.58%. Higher quality corporate bonds have been the place to be in the past four weeks with those indices up 4-5%.

There really isn't anything unusual about what is going on right now and we've seen plenty of days like this over the years. Admittedly, it's hard to remain optimistic after a big selloff, but our outlook for the year is still positive on stocks, although slightly less than we had at the beginning of the year. The problem now is that we don't see a catalyst for a change in sentiment in the near future. Until then, stocks are likely to drift lower.

So what can we do in the meantime? Since the economy crashed in 2007, our investment strategy has been to focus on increasing the cash flow in our client portfolios and adding predictability to the returns with bonds. Those efforts are still paying dividends today (literally). While many of our highest yielding securities have paid down over the last couple of years, our overall portfolio income remains strong and valuations less volatile. In most cases, our clients' portfolios are cash flowing around 4% and the values are back to the pre-crash levels. That's no small feat considering the Dow Industrials are still down 18% from the highs in 2007.

Going forward, we want to stay out of cash. You'll probably be hearing a lot in the financial press about cash being a safe haven. In real terms though, (taking inflation into account), cash balances only guarantee losses. The Federal Reserve has been pushing investors out of cash for several years in order to get that capital working in the economy. They've done this by keeping short-term rates near zero. We don't see that attitude changing anytime soon.

Instead, we'd like to keep everyone fully invested and slightly over-weighted in bonds. Our expectation is that stocks will struggle for the next month or two and then come back in the fourth quarter. We think the market needs to see two months of a positive trend in employment and GDP to really turn around. Growth is now just about flat and there are real fears of slipping back into a recession. We don't think that will happen but even if it did, it would likely be very short and shallow.

The best real-time gauge of market sentiment will be the news coming out of Europe. The Euro Zone economy is larger than the U.S. and thus is a significant global trading partner. The fear is that a significant slowdown in their economy would have a ripple effect around the world. This is especially a threat here in the U.S. and could be the difference between slow growth and no growth in our economy.

We of course will keep our clients informed as things change. For now we feel that everyone is situated about as best as can be hoped for. Once again, we think cash flow is the key to avoiding the need to sell into this market. Remember that the only two days you care about what something is worth is the day you bought it and the day you sell it. You don't want to be in a position to have to sell into this market. That's when investing becomes gambling.