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In the midst of all the issues that continue to confront the global financial markets, the economy and the overall investment landscape, there is good reason for all investors to tread with caution. Given our investment objectives at Emerald, we generally take a hedged approach...but given the current investment climate, we recently elected to increase our cash level even further as an added cushion against a potential market pullback. The following quote from a well-known hedge fund manager sums up our views rather well:

 

The confluence of unresolved first order economic issues and the absence of authoritative, credible global leadership have rendered markets perpetually anxious. Fear of being carried out is quickly overridden by fear of missing out, and the schizophrenic swings we are continuing to witness make investing treacherous. Until we see solutions for the twin perils facing the United States and Europe - and with our existing leadership focused on scoring political points and Europe's problems increasingly complex, we cannot say with any certainty when that will be - we are inclined to be cautious with your capital. - Dan Loeb, Third Point LLC 2Q2011 Investor Letter

 

Systemic Risks Persist...

 

Each of the strategies we manage is distinct and managed according to different time horizons and risk characteristics, but the approach we take is the same. Our goal is to capture a meaningful share of the market's gains while limiting our clients' exposure to downside risk. We aim to deliver competitive returns over time, but do so with low correlation to global stock and bond markets and modest Beta. To achieve these objectives, we diversify across multiple strategies and styles within a range of asset classes, including cash.

 

There are times when we believe that a lower exposure is a prudent course of action, and now is one of those times. Cash and short exposure can be used as defensive weapons, if even for a temporary period of time.

                                                                                                                   

In our view, the financial markets are currently facing risks that extend beyond garden-variety challenges, such as valuations, a feeble economy, high unemployment and the threat of rising interest rates, among others.

 

We believe that current risks have tipped the scales in favor of a more cautious stance, so we elected to throw a small wet towel of cash and shorts on our portfolios to prevent a potential spark from becoming a fire. We view this move as a prudent and temporary measure until we gain more confidence in the case for increased exposure to "risk" assets.

 

We are not making an explicit call on the market's short-term direction but we are hedging our exposures. However, we do believe there are unusually high risk factors that could provide future opportunities to invest at more attractive valuations. These include:

 

The Debt-Ceiling Crisis

 

By the time you read this, the drama over raising the nation's debt ceiling may have already been resolved...at least for the time being. But as of this writing, no deal has been finalized and the markets remain on edge. This situation bears close watching, as a potential U.S. government default, if the Administration chooses that path, poses an unprecedented, systemic risk to the markets and the global economy.

 

The pricing of risk assets is based on the notion that U.S. Treasury securities are "risk free" - that is, credit risk is zero. If Treasuries are no longer risk-free, then we enter the great unknown of capital markets in which risk assets may be subject to a serious re-pricing against another, as yet undetermined, benchmark. In the event of a U.S. government default, the credit rating agencies would likely downgrade U.S. debt. The degree of the downgrade is anyone's guess, but regardless of the new rating level, the impact of it could be very serious. This could drive up interest rates for government and private sector borrowers. While we are hopeful that cooler heads will prevail and Washington's game of "debt-ceiling chicken" will be resolved, the risk of a default, at least in August, is not completely out of the question.

 

Euro Zone Worries

 

If you think things are a mess in Washington, our European friends are facing their own sovereign debt crisis, with Greece's inability to pay its debts grabbing most of the headlines. Over the course of many years, European governments borrowed excessively to support bloated and expanding government bureaucracies and overly generous retiree benefits. Now, these Governments must face up to the dire consequences of their longstanding policies.

 

Time will tell whether the new $157 billion bailout and austerity plan for Greece will be a sufficient tourniquet to staunch further bleeding there or if it is simply another taxpayer funded band aid. If not, there is a very real possibility that the situation in Europe could spiral out of control spreading to the other PIIGS nations - Portugal, Italy, Ireland and Spain - all of which have similarly dire economic and fiscal circumstances. Should contagion spread, we would expect significant hits to the balance sheets of banks and financial institutions around the world that hold much of these sovereign bonds. This could lead to the demise of the Euro and the European Union. We are not predicting that such a calamity will occur, but if it does, we believe having additional cash on hand could provide additional opportunities to capitalize on market declines.

 

The End of Quantitative Easing

 

The Federal Reserve recently concluded its second round of quantitative easing (QE2). You may recall that when the Fed concluded its first round of quantitative easing in April 2009, stocks and commodities both lost significant ground until a second round of easing was announced. Initially after QE2 ended, Fed Chairman Ben Bernanke had indicated that unless the economy were to show signs of a serious decline, the Fed seems unlikely to embark on a third round of quantitative easing. His tune has softened quite a bit since then and Mr. Bernanke has left the window open for a possible QE3. Time will tell the course of action taken...but if there is no QE3, some observers have speculated that the Fed could start raising short-term interest rates as early as this fall or early in 2012. These developments could have negative implications for stocks and bonds.

  

Conclusion

 

These are interesting times, to say the least, for politicians, businessmen and investors alike. Given the systemic challenges and political standoffs in the U.S. and Europe, we believe it's wise to keep a little extra powder dry. While we generally prefer to be fully invested, we believe our more conservative stance may help dampen the impact of what could be some extreme market volatility in the weeks/months ahead. The situation is fluid and we intend to redeploy the cash and short exposure into the markets as some of these risks dissipate, but for the time being, we're trimming the sail a bit amidst these rough waters.

 

The information herein has been obtained from sources believed to be reliable, but Emerald Asset Advisors, LLC ("Emerald") does not warrant its completeness or accuracy. Prices, opinions and estimates reflect Emerald's judgment on the date hereof and are subject to change at any time without notice. Any statements nonfactual in nature constitute current opinions, which are subject to change. Projections are not guaranteed and may vary significantly. Further information on the firm and its advisory fees may be obtained from the firm's Form ADV Part II, which is available without charge upon request. Complete descriptions of all Emerald's products and benchmarks are available upon request.

(c) Emerald Asset Advisors

www.emeraldassetadvisors.com

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