Author: Ralph J. Doudera, CEO Page 2 of 6

The Current Market Environment: Where is the Risk?

Markets have historically had psychological booms and busts since the beginning of time. The fear/greed syndrome will continue to drive investors into making emotional decisions at the wrong time. Human nature will remain the same. Mania has always gripped the markets from season to season. Gold, tulip bulbs, real estate, tech, oil. Bubbles tend to develop, and while “bubbles” can continue a lot longer than predicted, they will all come to a very unpleasant ending. For example, Japan’s market hit it’s high in 1989 and 18 years later it was still down 55% from its high. Knowing which markets to avoid and when to exit them is an important philosophy to have present in a portfolio. While I expect the markets to continue their bull market run, we always need to sit close to the exits when technical market conditions deteriorate.

In April of 2007, I wrote the paragraph above in our quarterly newsletter to our clients. In January of 2008 we received our bear market signal and saved clients a lot of money by going to cash. Liquidity is a pillar of risk management, and our clients were positioned to make double digit returns in 2009. In 2017 I have the same feelings: While I expect the markets to continue their bull market run, we always need to sit close to the exits when technical market conditions deteriorate.

The chart below illustrates our Market Environment Model. This model has indicated a bull market environment since early 2016, following a significant market sell-off beginning in mid-2015. The indicators that we utilize illustrate higher market risk, and can cause us to significantly reduce exposure to stocks. We currently use a proprietary combination of four components: (1) Moving average model of major equity indexes, (2) Weekly Directional Movement Index model, which defines the quality of the trend, (3) Negative Leadership Composite as defined by Investech, and (4) Spectrum’s High Yield Bond signal, which confirms a healthy economy. These four indicators together are not a forecasting device, but they give us insight into levels of market risk. Depending on this evaluation, we adapt trading strategies to become more aggressively invested or more defensive to reduce risk.Created with TradeStation. © TradeStation Technologies, Inc.  All rights reserved.

With the stock market hitting new highs, investors are beginning to get overly-excited about this bull market. Since 1932, there have been 16 bull markets, the average of which lasted 3.8 years. The current one is 8.4 years old and is approaching the longest of 9.4 years in the 1990s. Clients, managers and allocators tend to forget about risk when they are making money. I always think about risk because I have seen a lot of those 16 bull markets. I remember quite well 1987 when the market corrected 30% in two weeks. That changed a lot of plans for a lot of people. Are you evaluating risk in 2018?

Selective Leverage: Achieving Returns and Low Beta

If you could purchase an apartment building today that produced a cash flow after all expenses of 8% a year, you might be pleased with your cash on cash return in the current interest rate environment. If you financed your property with a 50% mortgage which had an interest rate of 4%, you could purchase two apartments for the same equity. Scenario one has a net investment return of 8%, but the second scenario will generate a 12% net rate of return on the same investment. A downturn in real estate values might depress the investment return upon sale, but increasing values will give an even higher return. This uses the concept of leverage which can have significant advantages in certain market conditions.

The chart below illustrates the performance of the SFI Floating Rate Index since 2012. This index is an average of four short-term senior floating rate mutual funds which accrue a daily dividend. It is normally a low risk investment that has a dividend payout currently of about 5%. Let’s say if I were able to borrow funds currently at 1.5% , and have a 50% loan amount like the previous example, I will enhance my return by 3.5% a year on the portfolio. The difference between this example and the real estate example is

with liquid investment vehicles there is daily liquidity on the investments- you must have liquidity to manage risk well.

You can go to a liquid cash position without a real estate commission or waiting around for a buyer to come along. The liquidity of the investment vehicle combined with the low volatile characteristics of this asset class can make the use of selective leverage low risk. This concept can enhance returns while still controlling investment risk when you layer a low volatile investment, like the floating rate exposure, with maybe riskier asset classes, like high yield bonds in a fund.

Selective leverage is one tool to use to meet the objectives of enhancing returns and controlling investment risk- something every investor and shareholder want. I have been applying leverage to high yield bonds and other fixed income asset classes since 1996 in SMA strategies and later in the mutual funds I manage, via derivatives and swap contracts, with the ability to still maintain low beta. Why? Because I think about risks before returns, I always use liquidity, and I know the characteristics of my underlying investments. There are times to use leverage and times when the entire portfolio should be in a liquid cash position. There must be expertise present to determine when, and where, to put leverage on or take it off. Leverage and the tools you use to present leverage in your funds or portfolios does not always mean higher risk.

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