Being Cautious Can Still Be Profitable

09/27/2012 8:45 am EST

Focus: STRATEGIES

Stephen Hammers, CIMA

Co-Founder, Managing Partner, Chief Investment Officer, Compass Efficient Model Portfolios, LLC

Just because you're not taking flyers or grabbing stocks with the biggest yields, it doesn't mean you can't make money over the long term in these markets, argues Stephen Hammers of Compass EMP Funds.

Gregg Early: I'm here with Stephen Hammers, co-founder and Chief Investment Officer of Compass EMP Funds (CAICX, CAITX, CAIAX). Stephen, I wanted to get your take on where you see the global markets at this point.

Stephen Hammers: There is really one word to sum it up, and then I will go into a little bit more detail, but the best word is: sluggish.

In the US, we're expecting economic growth in the 2% range, which is actually the worst post-recession growth we've ever seen...and I'm talking about since 2008 and early 2009, which actually is surprising on why the stock market's been going up lately. And in Europe, we're actually expecting flat and slightly negative growth.

Inflation is expected to be relatively low. So if you look at the US market, it's a slightly positive outlook but a lot more volatility coming after the election. There's not a lot really happening at this point. And a flat and negative outlook for international markets.

Commodity markets are also expected to be fairly sluggish, simply because of the US demand for products and unemployment and underemployment still being relatively high. It's very difficult to pick that economy up.

Gregg Early: So you see the volatility staying fairly languid here until the elections are over?

Stephen Hammers: Yes. If you look at the last three months for the stock market in terms of volume, it's been very, very low. The commodity markets have been high, but a lot of folks are in the stock market and a lot of people are just waiting for the election.

Between Obama and Romney, you have completely different views, which is really going to determine where our country is going to go. There's been a lot of "let's just wait and see," and we could most likely expect a lot of volatility after that, like we saw in 2011.

Gregg Early: People will reposition for what they expect to see ahead once the election is determined and there is a shift in the marketplace, but until then, everybody's just sitting on their hands?

Stephen Hammers: Very much so. And that's why a lot of corporations or balance sheets look the best they ever have. They have a lot of cash, but they're just not wanting to do anything yet, because businesses, investors in stocks, they want to see a pro-business environment. And right now, it's just been very, very difficult, so volume has been very, very low.

Gregg Early: Well, what's your strategy on asset management in a risk-heavy environment like this?

Stephen Hammers: That is a great question. Investors really, really need to look at using assets that can help grow. It doesn't matter if they're volatile or not, but they also need to look at something that can hedge that risk.

You know, the definition of "hedge" is "reduce my downside." It doesn't mean necessarily reduce my upside, so most investors have been used to a stock portfolio and a bond portfolio just to diversify that out.

They really need to start looking at other assets and how I can diversify that. For example, looking at commodity or commodity strategies that can either follow the commodity market, or when certain commodities go up and certain commodities go down they can hedge that. That can provide very low correlation to a stock and bond portfolio, which can help.

There's another example. Strategies that can hedge to cash or do what's called long-short, which means when the markets are trending up you can enjoy that, but when the markets are trending down that manager or that fund can hedge that downside risk, which is what we do. That really helps over time.

If you look at a five-year return by adding funds that can hedge that risk, it's significantly better than just saying "I want to put all my money in stock." And unfortunately most people don't pull out of the market until it's at its bottom and they don't get back in until it's at its top and that happens a lot.

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Gregg Early: Also, when you were talking about low-correlation strategies. The markets have become more and more correlated as well, right? So, to get a low correlation is the ideal hedge in a market where everything seems to be moving on the risk on, risk off switch, right?

Stephen Hammers: That is true, and if investors only look at, "OK, I've got US stocks, international stocks, and maybe a commodity fund or a real estate fund," when the economy starts slowing down, all those assets can fall together.

People stop buying stocks, they're pulling out, they stop buying commodities, those sorts of things. But if they can focus on funds that actually, when the markets fall and they have a stock fund, that stock fund can short stocks or it pulls out of stocks. That forces low correlation, and you need something that can force low correlation when you really need it and that's during the tough times.

Gregg Early: Sure. Where do you see the most opportunity now?

Stephen Hammers: That is a really good question. Ironically, it is really in the US stock market. I know that's hard to believe. There is a lot of risk there. Maybe in the next 12 months it's in the Treasury market, but in the next several years it's still the US stock market.

Let me give you an example why Treasuries now. Treasuries have a very low return here. They can go down a little bit more, not a lot. When yields fall, prices go up-that helps. But when people run to safety, they tend to run to Treasuries even though our government has $16 trillion in debt and climbing, and we are on a fiscal cliff.

For stocks, the stock market for the US is still appropriately valued. It's not really overvalued or undervalued. But over the next three years, you're most likely going to get a lot better return on the US stocks than you will Treasuries, because if Treasuries start going back up, which they will, we've seen the lowest we've been in 80 years.

What's going to happen to your bond price? It's going to fall, and a lot of people that have bond funds do not understand that.

So believe it or not, there's a lot of room for growth in the stock market, because a lot of companies have a lot of cash that they're willing to put back in. They're just waiting right now.

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