As many of our clients know, the Compass Portfolios are designed to simultaneously address the need to build an investment portfolio that will participate in as much market growth as possible, and at the same time manage market uncertainties along the way. During the first part of the New Year, our models had remained positive, prescribing a fully invested allocation to all major market segments. However, weakness in market index prices have caused our models to become much more cautious, and so we have recently reallocated much of the equity components (stocks and equity mutual funds) to more of a defensive posture. As a result, many of our portfolio models now carry an extreme overweight position in cash, money market, and inverse (bear market) funds.

The recent reallocation to defensive instruments comes at a time when the overall economic conditions in the U.S. are slowly improving. During their January meeting, Federal Reserve Chairman Alan Greenspan and the Federal Open Market Committee (FOMC) decided not to change the targeted fed funds rate (an extremely short-term debt instrument). Citing recent data which suggests the U.S. economy may have bottomed, the Federal Open Market Committee wrote: “With the forces restraining the economy starting to diminish, and with the long-term prospects for productivity growth remaining favorable and monetary policy accommodative, the outlook for economic recovery has become more promising.” At the same time, the FOMC also cited the possibility of further deterioration in the economy, writing “The degree of any strength in business capital and household spending, however, is still uncertain. Hence, the Committee continues to believe that, against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future.” Given this cautions stance, and a flurry of negative fallout from the Enron situation, the market is understandably apprehensive to allocate cash reserves to new equity positions.

Given the reluctance to allocate additional capital to the markets at this time, the Dow Jones Industrial Average is meeting a significant amount of resistance at the 10,000 point level. Likewise, the Nasdaq Composite has encountered significant resistance at the 1,900 point level, and the S&P 500 at 1150. Recent bounces off of market lows have been short-term, and quickly rescinded. These resistance points must be conquered if the markets are to make any significant headway over the intermediate term. Lacking leadership, the market posture we have recently adopted seems prudent.

Given the schizophrenic nature of the market over the past six weeks, our models have responded admirably, and are generally performing better than the overall market. It is our intention to remain ever vigilant for signs of further weakness; however, we are eager to participate in market advances which will likely occur when an economic turnaround becomes more evident.

“For an increasingly complex financial system to function effectively, widespread dissemination of timely financial and other relevant information among educated market participants is essential if they are to make the type of informed judgments that promote their own well-being and foster the most efficient allocation of capital.”

Alan Greenspan