Over the past two quarters, there have been conflicting views about the longevity of the global economic recovery that began late in 2009. There is a growing consensus among economists and market strategists who are of the opinion that we are on the precipice of another global economic recession: a period which would bring on a decline in economies across the globe, increased unemployment, reduced corporate profits and, of course, declining stock prices. A 2008-09 redux, if you will. On the other hand, there are those of us who clearly see an economy whose growth rate is slowing, but who would argue that there is not enough evidence that another full blown global economic recession is just around the corner. Regardless of whose “camp” one is in, there are risks to embracing either view with any certainty in regard to investment strategy.

Over time, the biggest investment risk we face is depleting our assets too early in life and having no resources to sustain the lifestyle to which we have become accustomed, and/or depleting assets intended for the next generation. This risk has become more pronounced in the past decade as investment markets have left most investors with meager returns and loads of frustration. For example, if one simply invested in an S&P 500 index fund over the past 10 years, the total return as of this writing would be slightly negative – a far cry from what we grew up learning about the superior long term returns of stocks and why this period has been declared the “lost decade” for investors. On the contrary, investors who have chosen a more active approach to investing – our firm for example – have been able to add value during this period through actively managing downside risk and by careful sector and stock selection.

The challenge in today’s environment is that many investors are worried about the health of the economy and are undecided whether to be “in” or “out” of the stock market. We view this as a dangerous set of alternatives. Let’s look at both of these possibilities closely: if you choose what may appear to be the “safe” choice by getting out of stocks then markets race ahead (Murphy’s Law), you will lose the ability to attain the growth rate that you need to make your assets grow during your lifetime. You may know the old saying: “if you miss the twelve best days of a bull market, you end up with surprisingly poor results.” On the other hand, if you’re in stocks and the economy collapses (Murphy’s law again!), then you end up feeling “sorry,” your asset values shrink, and you really have a challenge making your assets last your lifetime and for future generations. So what is an investor to do when there is so much conflicting, fearful information about the economy and markets?

It is during these periods that we closely embrace our discipline and principles of risk management and “prepare” for a number of possible outcomes, the first of which is to make sure that you only take the amount of risk that you need over the long term. If your long term growth rate requires that you are 50% invested in stocks…keep it that way. In fact, today we likely have you a bit less invested than your growth rate suggests given the uncertain environment. This is not the time to take more stock exposure or risk than you require. Secondly, within your stock exposure, we are being very careful of what percentage is in each economic sector. For instance, you are underweighted in the financial sector (particularly bank stocks) – an area that we consider to be of greater risk. Additionally, we are monitoring the financial condition of each of your companies to insure that they are physically fit for the changing economy. Lastly, we are using carefully placed stop loss orders on your economically sensitive stocks to avoid catastrophic loss.

During periods like today, a well disciplined risk management process can assist us from having to decide to be “in” or “out” of the market and to avoid the pitfalls of such extreme behavior and changes in investment strategy. Granted no process is “fool proof.” Over the years, however, these disciplines have added value.

Lastly, we want to mention that it is very common for economies to slow for a bit after the first year of recovery. This type of slowdown can make investors nervous, but is usually only the “pause that refreshes” and is typically followed by increased strength and rising stock prices. We look forward to that possibility as we are sure you do as well.

We hope this note finds you well. If you have any questions or thoughts, please feel free to contact us at your earliest convenience.

Sincerely,

James E. Demmert
Managing Partner