2010 3rd Quarter Newsletter

Are you hedged enough?

During the 2^nd Quarter, U.S. stock indices posted an 11% loss, while foreign stock markets lost 14%. All the stock market gains from the 1^st Quarter were erased, and globally, stocks are down approximately 9% so far for 2010.

We are regularly asked whether the stock market will continue to be this volatile. Unfortunately we believe volatility in the stock market is a permanent phenomenon. Why? A significant culprit is the options and derivatives market – the place where trades are made to bet that the market will go up or down, without buying or selling the actual stock asset. The derivative and options market for stock is more than 3 times larger than the stock market itself. If we consider that a share of stock could be involved in several derivative or options contracts at the same time, we can start to understand how a share of stock can go up or down so fast. Now compound that environment with internet trading both during and after market hours, faster computers, and the retail investor’s ability to make bets on market direction. The fact that anyone can buy a mutual fund that promises them $2 for every $1 that the market declines is an unsettling proposition.

We still believe in corporate America, and corporate China and Germany for that matter. So we will hold some stock on a long term basis. Frankly, though, our appetite for frequent freefall has decreased over the years. Excessive volatility hurts our ability to compound wealth in a steady way, and it dramatically affects the emotions of our clients. We increasingly believe our clients need downside protection to meet their goals.

To manage this phenomenon, we have been steadily decreasing our clients’ exposure to stocks while increasing our exposure to hedged investments. Our exposure to stocks now ranges from 15% to 44% of our portfolios. We expect that range is lower than many wealth management firms.

Our goal for hedged investments is simple. We invest in funds that trade in stocks, bonds, currencies and commodities to provide long-term returns better than bonds, while at the same time providing a measure of protection against stock market declines. In the long term, defined as the last 15-20 years, hedged investments have outperformed stocks and bonds by a wide margin. The same is true in the last 10 years, 5 years, and 3 years. In the short term, hedged investments have also worked well to protect against market declines. Hedged investments are generally down 1-2% in 2010, a long way from global stocks that are down 9%.

Another reason we continue in this direction is access. It used to be that these strategies were only available in private hedge funds with high minimums, creating risk of fraud, excessive borrowing to invest, and other problems that caused investors to lose their principal. Today, we can access hedged strategies in diversified mutual funds. Unlike a hedge fund, a mutual fund provides transparency so actual trades can be monitored.

The final reason for the change is the economic outlook. The U.S and China’s economic indicators have recently peaked, and job creation is stagnant. The peaking of economic indicators, combined with excessive government debt, leaves very little room for a prediction of robust economic growth, at least in developed countries. We don’t view this as a short term forecast, which leads us to believe that stock returns will be average. The current price for stock is 17 times earnings, about average historically. Investors will not likely want to pay 18-20 times earnings for stock in this environment, so corporate earnings must improve in order for stocks to substantially appreciate. We believe the risk/reward proposition will continue to be attractive in hedged investments. For our higher net worth clients, we also continue to favor private income producing investments, as long as the investment does not involve leverage.

We have come to believe strongly that reducing volatility in a portfolio is a key component to compounding wealth – and increasing sleep at night. We believe this investing philosophy is the right prescription for volatile times.

Please feel free to contact us with any questions or visit us in our new office at 210 University Boulevard, Suite 400, Denver, 80206. Our phone, fax and email remain the same.

Sincerely,

The Wagner Wealth Team

Wagner Wealth Management has been included in the National Association of Board Certified Advisory Practices' (NABCAP) Premier Advisor list for 2011, with special mention as a Risk Management Star. This list recognizes advisory practices in the Denver area that represent the best in quality wealth management.