Roger Nusbaum Positions For 2014: Starting To Take Defensive Action

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By Roger Nusbaum :

This is the ninth piece in Seeking Alpha's Positioning for 2014 series. This year we have once again asked experts on a range of different asset classes and investing strategies to offer their vision for the coming year and beyond. As always, the focus is on an overall approach to portfolio construction.

Roger Nusbaum is an Arizona-based financial advisor at Your Source Financial who builds and manages client portfolios using a mix of individual stocks and ETFs. Roger's popular blog, Random Roger , focuses on 'top down' asset allocation. Regular readers of his blog know Roger is an avid global traveler, and he is constantly on the lookout for fresh foreign investment ideas.

Seeking Alpha's Abby Carmel and Jonathan Liss recently spoke with Roger to find out how he planned to position clients in 2014 in order to reach their long-term objectives, in terms of both domestic and global portfolio diversification.

SA Editors (( SA )): How would you describe your investing style/philosophy?

Roger Nusbaum ((RN)): We believe a globally diversified portfolio offers clients the chance for achieving their long-term goal which is usually having enough money to fund their idea of retirement. More specifically the portfolio is top down with decisions made based on fundamentals of what sectors and countries to be overweight/underweight or be out of altogether.

We also seek to take defensive action based on the S&P 500's 200 day moving average. A breach is often, but not always, an indication that the probability of a large decline has increased. We also consider an inverted yield curve as a warning as well but the next bear market is unlikely to involve an inverted yield curve.

We are big believers in studying market history because many of the behaviors exhibited in market prices tend to repeat cycle after cycle like industrials tending to go up more than the broad market during the bull phase of the cycle and down more during the bear phase. Being cognizant of history also serves as a reminder of basic but hugely important investing building blocks like the market going up most of the time but occasionally it goes down a lot. That should read very simplistically by design.

(( SA )): Do you prefer broad index funds, or individual stocks when constructing portfolios?

((RN)): Broad based index funds are absolutely a valid methodology for investing but there are many valid methodologies for investing. We use mostly individual stocks and some specialized ETFs for the equity portion of the portfolio with about a 2/3-1/3 ratio. Narrower exposures like stocks and specialized ETFs make it easier to express sector and country weightings as well as manage other portfolio attributes which could include volatility, yield, cap size as well as some others. The risk of course to individual stocks and specialized ETFs in this context is being wrong in the conclusions you draw.

(( SA )): How do you benchmark your performance?

((RN)): We benchmark to the S&P 500 which is not necessarily ideal for a global portfolio but back when we started there was no easy way for clients to access the constituency of the MSCI World Index or even to track it, whereas the S&P 500 is easy to follow. Also we think of it as if the client were investing on their own, there is a high likelihood that an S&P 500 index fund (or some other broad domestic index fund with a very high correlation to the S&P 500) would comprise the bulk of their portfolio.

(( SA )): While obviously no one has a crystal ball, what is the likelihood equities can continue their current run? At what point do you start taking risk off the table for clients (perhaps you already have)?

((RN)): In their quest for perpetual negativity, Zerohedge recently tweeted something along the lines of 2014 bringing us one step closer to "the end." Despite their biased selling of doom, the tweet in question was technically correct whether the end meant the next bear market in the next year or two or three or the end of humanity in the next umpteen thousand years or whatever.

The point is to tie in with the above regarding market history and stock market cycles. Bear markets come along every so often and based on the average duration of bull markets, we are about a year and half overdue for a bear market. The point here is not to predict when the next bear will come but simply to make sure clients remember that bear markets are a normal part of the stock market cycle. As sure as there is no daylight in Barrow, AK for about six weeks in the winter, there will be large declines in the equity market every few years.

No matter what is going on at any moment there is always a bull case for equities (or any asset class for that matter) and a bear case. That has been true all the way up from the bottom in 2009 and will be true all the way down from the top of the current move to bottom of the next bear.

The bear case now includes weak earnings guidance (94 of the S&P 500 have issued negative Q4 guidance), some economic data looking lousy, rates appearing to be on the verge of going up meaningfully, various sentiment gauges reading very bullish and the extent to which the rally is so long in the tooth.

There are just as many if not more bullish points including the Fed being accommodative for many years to come, interest rates are still low, there are some economic data points that look very good and so on.

We have opinions - markets are unlikely to keeping going with anywhere near the velocity of the last two years and with a nod to Zerohedge we are moving closer to the next bear market and no one should be surprised if it starts in 2014, but predictions like this carry far less value than a disciplined investment strategy. Regardless of how we think markets should work, we will start to take defensive action based on the indicators mentioned above.

(( SA )): Beyond allocating to stocks and bonds, what other asset classes do you use as diversifiers?

((RN)): We maintain a small weighting in gold with the SPDR Gold Trust [[GLD]] and the Index IQ Hedge Multi Strategy Tracker [[QAI]]. As part of our defensive strategy, we would increase exposure to other holdings that tend to not look like the stock market and perhaps add an inverse index fund or the Ranger Equity Bear ETF [[HDGE]].

It is interesting what a bad rap that gold got this year but it did exactly what an equity based investor would hope; it had an almost perfect negative correlation to equities. We've owned gold for a long time in the expectation that when bad things happen in the world or in markets, gold would do relatively well but long time readers may recall my saying that if gold is the best performer you have, chances are things aren't going well everywhere else. In the context of being a diversifier it continues to work, in the context of a core holding like in the permanent portfolio it is a big drag on returns.

(( SA )): You have been known to look outside the U.S. for investing ideas. Where are you looking right now and why?

((RN)): We are fundamental investors and where investing at the country level is concerned we care about things like debt, demographics, stability, quality of life, the country's role in the world's economic order, whether the country has something the world needs or any other fundamentally justified catalyst for success. Things often go up for reasons having little to do with fundamentals but it is difficult to explain an investment to a client that did not work out when the fundamentals were terrible going in.

The Global Greece ETF ( GREK ) is up 24% YTD which is a great return but there was no fundamental story there to presage that result. Great for anyone who made that trade, it's just not what we do.

Given the long-term things we look at, we continue to own most of the same countries we've owned for a while. The need for crops and dairy (things the world needs) from New Zealand is not terribly volatile, Norway will not take on a choking debt load while at the same time run out of oil in the next couple of years, the median age in Chile is not going to jump to 45 (the median age in Japan) from 33 next year nor will it be out of copper for when global demand ramps up again.

We also look at themes and a way to look at themes is look for where money is going to be spent. That takes us to infrastructure and the iShares Emerging Markets Infrastructure ETF [[EMIF]]. It has a decent mix of cash flow companies like toll roads and airports and builders/modernizers of infrastructure. The stocks involved may go up and down like anything else but there is no question that the money will be spent. We own Global X Fertilizer [[SOIL]] and PowerShares Water Portfolio [[PHO]] for similar reasons; money will be spent trying to solve the world's problems with food and water.

In addition to the countries above, we're also favorably disposed to Colombia, Canada, Sweden, Switzerland and Denmark. We have limited exposure to China through ETFs but we've been a little more tactical with China over the years and so that exposure could increase at any time. We are currently out of Australia but that is another one we keep close tabs on.

(( SA )): When you consider foreign investing ideas, how closely do you assess geopolitical risks? As a general rule, do you feel the market is efficient at factoring in potential risks of this nature into current pricing, or do you have your own assessments?

((RN)): As mentioned above, stability plays a role. Thailand has a coup every couple of years so we've avoided it. We were early to see economic instability in Europe but late with social unrest in Brazil. In this context, I don't think Europe and Brazil are permanently broken but it is not clear that Thailand has ever been stable. Turkey has been in a similar situation as Thailand most of the time but Middle Eastern markets seem to go back and forth with stability (even Qatar has had some protests).

(( SA )): Emerging markets significantly underperformed developed markets in 2013. What sort of exposure do you have to Emerging Markets? Is 2014 the year things revert to the mean?

((RN)): We currently target a 7-8% direct weight to emerging markets which is low for us based on what we've done in the past. We also have a couple of stocks like Scotia Bank [[BNS]] which is a beneficiary of emerging markets.

As far as reverting to the mean in 2014, after lagging for the last couple of years it is reasonable to expect a market segment like emerging markets to rotate back into relative favor. Regardless of whether 2014 turns out to be the year or not, investors who are capable of looking at the long term can see favorable long-term fundamentals in many EM markets, an ascending middle class with newfound discretionary income and a general improvement in the quality of life and equity prices that are relatively low. Buying the unloved market segment is not the worst idea in the world.

However there are markets that face some clear and obvious obstacles that might be better avoided. The reduction in asset purchases by the Fed and the eventual increase in interest rates hurts countries that most rely on foreign direct investment - no need to invest abroad when higher yields can be had back home in the US. The poster child for this has turned out to be Indonesia.

(( SA )): There has been growing interest in Frontier Markets, with assets flowing into funds like iShares MSCI Frontier 100 Index ETF [[FM]]. The thinking has been that as these economies are still relatively under-developed, getting in now will yield results similar to investing in Emerging Markets 15 years ago. What do you make of this line of thinking? Do you have any Frontier Markets exposure?

((RN)): The basis for investing in developing markets from the bottom up to is to capture an ascending, modernizing country on its way to playing a larger role on the world economic order. From the top down there is the potential for a diversification benefit for something with a low correlation to US equities.

Countries like South Korea and Taiwan aren't really emerging markets anymore but some broad EM indexes still include them. This serves to reduce the potential low correlation benefit that can be had by investing in developing markets.

Frontier is a valid way to capture developing markets but expecting a repeat of emerging market returns from ten years ago seems like a stretch. EM started to lift before most investors were looking for anything and your question captures today's sentiment looking for the next… A reasonable expectation is delivering a better risk adjusted return over long periods of time. If FM goes up 300% over the next ten years all the better but not as an expectation.

Investors most comfortable with broad based funds could look at the beyond BRICs funds from EG Shares which has symbol [[BBRC]] and the one from Global X which has symbol [[EMFM]]. The beyond BRIC fund from SPDR is heavy in South Korea.

(( SA )): Is there a single country or region (can be developed, emerging or frontier) that you are currently very bullish on and are overweighting in client portfolios as a result?

((RN)): Technically speaking we are probably most overweight New Zealand. We target a 3% weight with the iShares New Zealand ETF ENZL but the country only has microscopic weightings in any of the broad indexes. We own it for the agricultural theme noted above, it also tends to have low volatility and a high yield.

We have no exposure to Japan or the EU. The returns for the Nikkei and DAX were great this year but fundamentally Japan and the EU are basket cases and we aren't going to invest without a fundamental tailwind (printing yen is not a fundamental tailwind).

(( SA )): Any additional considerations you'd like to share with readers as they ponder their investing strategy in 2014 and beyond?

((RN)): Investing requires patience. The tilt to this interview has been toward foreign probably because I believe in foreign investing as a crucial way to help our clients achieve their long-term objectives. This is our strategy. In years where foreign outperforms domestic then a portfolio that includes foreign holdings has a good chance for outperforming a domestic only portfolio but when foreign lags domestic, a portfolio that includes foreign is likely to lag a domestic only portfolio. In the future, as in the past, there will be times when foreign outperforms domestic and times when it lags.

Now apply this to whatever your strategy is because your strategy cannot outperform every single year, no strategy can. However, even though your strategy or my strategy or anyone else's cannot be the best every year, it can still allow you to reach your goal which is presumably being able to fund the lifestyle you want when you stop working. Of course, other major determinants for success will be your savings rate, spending habits and avoiding succumbing to emotion.

Disclosure: Client and/or personal holdings in GLD, QAI, EMIF, SOIL, PHO, BNS, ENZL

To read other pieces from Seeking Alpha's Positioning for 2014 series,click here.

See also Reversion To The Mean Phenomenon: Part I on

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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