The current measures to address European debt and the broader economic concerns are insufficient, says Jamie Cornehlsen. When it comes to actionable ideas, he offers his thoughts on specific defensive-sector ETFs, and his strategy for using inverse ETFs.

Kate Stalter: Today, I’m on the phone with Jamie Cornehlsen of Dunn Warren Investment Advisors.

Jamie, you use a number of technical and fundamental metrics to determine strength in the market, as well as individual stocks. You just had a conference call recently, so maybe you can give us some highlights that retail investors should be aware of right now.

Jamie Cornehlsen : Absolutely, it’s an uncertain time on two levels. The first being the economy, the second being the concern about European debt.

The title of our recent conference call was “The Emperor Has No Clothes.” That’s obviously a theme from children’s book, basically stating that the economy and/or what’s going on in Europe, the market performance and/or government practices that are coming out of Europe, really have no clothes. Meaning that the strategies that are being employed really don’t have any basis behind them.

So that was certainly the basis of our call and how we’re doing things now. I’d be happy to go into that more specifically, if you’d like.

Kate Stalter: Well, one thing that comes to mind right away, given all the intraday rallies we’ve seen in recent weeks and months, even on conflicting headlines coming out of Europe: It would seem to suggest that if there really is nothing of any substance going on, perhaps the markets might be in for some more sell-offs?

Jamie Cornehlsen: Yeah, that’s certainly the potentiality. On a technical basis—and I’m not much of a technician—but you can certainly see that the markets seem to bounce off of about 1,100 on the S&P and rise up to about 1,220.

The earnings that have come out this quarter, that being the third quarter, have been mixed. You’ve got some good reports and poor reports, both from the historical, backward-looking basis to company outlooks. From that basis, it would seem hard to see why earnings would suddenly start improving from here, like some analysts would suggest.

We look at what we refer to as the economic market indicators, and from that standpoint, it’s composed of 16 economic indicators. It’s good to break down those indicators into leading, coincident, and lagging.

What I think a lot of the press hinges on is, they see an indicator that increases or does better and start saying that the economy is improving. However, without diagnosing whether that’s a leading, coincident, or lagging indicator, that might not have much relevance.

Specifically, leading indicators tend to start declining on a year-over-year basis six to 18 months before a downturn in the economy or the market. Whereas a coincident indicator generally turns about the same time as the economy, and a lagging indicator turns after the beginning of a recession or a downturn of the economy.

So I think it’s important to cite whether those are leading, coincident, or lagging, and from our purview those leading indicators have begun to turn down.

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Kate Stalter: Let me ask you this then, for the investors who are listening to this conversation and wondering what they should do to protect their capital..obviously, that’s just been a huge question in recent years. What are you advising your clients at this point?

Jamie Cornehlsen: Yeah, we have a position where we’ve taken more out of economically sensitive investments, and moved into less economically sensitive investments.

So therefore utilities, consumer staples, and healthcare. Generally we use a broad ETF that covers those areas, and that’s how we position a portion of the portfolio.

Then we’ve also used, historically, inverse funds. Those tend to move in the opposite direction of the market. We use broad indices, whether it’s the S&P 500, Dow Jones, the Nasdaq-100 or the Russell 2000.

So those indices usually increase in value if the market goes down, but conversely, they decrease if the market goes higher. If you add a portion of that to the portfolio, you can limit the downside action of your overall portfolio and reduce some of the volatility.

Kate Stalter: With some of these inverse ETFs, a lot of these advisors I’ve talked with suggest that these are not the type of buy-and-hold plays that people may be used to with other types of funds. What is your take on that?

Jamie Cornehlsen: Yeah, it’s most certainly correct. It’s because of the way they’re structured, the day-to-day positioning changes. You need to think of it more like an option. To that regard, the actual holding changes from one day to the next.

So for example, if you had an inverse fund and the market was up let’s say 10% one day and you had $100 invested, it would go up to $110. The following day, if the market is down 10%, then your value would go down to $99.

If the market is varying from one day to the next, the value of this inverse fund is not linear. So as a result, holding it for long periods of time is not appropriate.

Kate Stalter: So investors really need to be prepared to function as traders, in some sense, to get in and out of there more quickly than perhaps people with a longer-term horizon might be accustomed to?

Jamie Cornehlsen: Yes, but I would suggest thinking of it in another way as well: This is insurance, not unlike you buy insurance for your car or for your home.

So rather than thinking of it as a buy-and-hold type position, you’re thinking of it as: “I am trying to reduce some market exposure for the overall portfolio.” By adding or subtracting that inverse position, you’re changing the overall level of market exposure.

It’s different than saying, “I’m going to buy this position to go up in value.” Certainly your hope is to have all your positions go up in value, but because you’re thinking of this as insurance, it’s actually you need to think about the entire portfolio and how that is positioned within that portfolio.

Kate Stalter: I want to come back for a moment to the idea of sector ETFs that we were talking about a moment ago. Any specific ETFs that you like, that maybe investors should do some research on?

Jamie Cornehlsen: Yeah, certainly I will talk about the exchange traded funds that we have in place currently. So note that we’ve already purchased them and we’re holding them.

What we have currently, in terms of the long side, what we’re expecting to go higher is the iShares US Healthcare Providers ETF (IHF), the Market Vectors Gold Miners ETF (GDX), and then we have the iShares S&P Global Healthcare Index (IXJ), as well as the SPDR Consumer Staples (XLP).

All of those we are currently in the portfolio, because they have less impact during an economic downturn, and people continue to buy those products for services that we feel comfortable being in that position currently.

Kate Stalter: Are these the kinds of positions that you believe should be held even at the time when the market does go into a new bull rally?

Jamie Cornehlsen: Great question. No, do not believe that.

There are two things that we believe in terms of a bull rally, that we don’t think we’re going into a bull rally and that’s based on the extent of valuation currently. We believe that valuations are high. But the beginning of a new bull rally, if valuations are low.

Second, if we see that the economy is improving. Then looking more at financials, at basic materials, it would be a good time to do that. As well as companies that have seen a decline in value, where the balance sheet is pretty stable and that the amount of cash and/or debt is low.

Great time to be looking at those, but we haven’t reached that point yet.