After a prolonged period of sideways trading in global stock markets (meaning no significant spikes or drops in price) finally some volatility has returned. Those who read our monthly articles posted on www.wealthmanagedwell.com know that we not only anticipated this recent correction and when to expect it but have been taking steps all year long to prepare for it. Now that we’re here let us share what we know, what we believe and what we question.

What we know.

Economists and academics believe that stock market corrections (defined as a drop of at least 10% in a stock market’s price, which are generally temporary) are natural and healthy occurrences. Anthropomorphism aside we concur. Over the past year we have been increasingly concerned with the absence of recent corrections in our now six and a half year bull market.

There are many different ways to categorize investment managers. One of the more interesting ways is to separate them into relative managers and absolute managers. Relative managers are managers who try to outperform versus something, generally an index like the S&P 500 or blend of indices. Relative managers are thought to have performed well if their performance is superior to their benchmark index even if that index has a negative return. Absolute managers have little concern for indexes and strive to earn more than zero regardless of how stocks, bonds, commodities, real estate or any other asset class performs. Absolute managers generally trade the potential for higher returns for the confidence that returns will be positive.

To be sure in normal times clients favor relative strategies and in poor markets clients favor absolute strategies (let us participate in good stock market returns when markets are rising and avoid negative returns in downturns). Savvy market participants understand that while this objective is nearly impossible to attain over longer periods it is nevertheless a worthwhile pursuit.

What we believe.

The best positions to own in correcting or bear markets are “shorts”, securities that increase in value as individual stocks or whole markets go down. These securities are inherently risky and we use them sparingly. Generally speaking the second best position to hold in correcting or bear markets tends to be cash or cash-like securities. While not completely free of risk (one must consider the opportunity cost of owning cash if markets reverse course and shoot right back up) cash is a much more appropriate holding for our clientele.

While markets are up today (9-8-15) over 300 points we think there is a better than 50% chance that markets will re-test recent market lows. If we are right and equity markets drop back to around recent lows we expect one of two outcomes. The hopeful outcome is buyers identify recent lows as buying opportunities and rush in supporting the market from dropping further. This would be a very bullish signal and Monarch would consider moving from its heavy cash position back into stocks.

The second and less desirable outcome is as follows: re-testing recent lows without sufficient buyers to keep the market from dropping further. Should that happen an additional 10-15% drop is likely. We would then have to start the process over again, finding and then retesting new lows before moving into stocks.

What worries us.

A third alternative is that we are entirely wrong and stocks have already bottomed. This is particularly troubling as we hold very large cash positions in our clients’ accounts. In both of the two scenarios above we have a very clear plan of action. This alternative is problematic because if we are hesitant to buy today and the stock market goes up tomorrow then by definition are we even less likely to buy tomorrow?

Here’s the tradeoff. Our goal is to provide solid relative returns however we believe the real trick to long term wealth accumulation and preservation is not losing large amounts of money during market pullbacks. To that end we have recently adopted a slightly more absolute-return focus. To be clear we are not absolute return managers but we are perfectly comfortable owning large cash positions in volatile times. We are willing to risk not making as much money if markets rebound and move sharply higher for the comfort of cash in very erratic market swings. We don’t worry about the consequences of being correct, we worry about the consequences of being wrong. If we are going to be wrong we intend for that to happen in periods of holding too much cash than owning too much stock. So for now even if we see a few strong up days back to back we will resist the temptation to buy back in.

Without clear direction from re-testing recent lows the next event which we will be watching is the Fed’s decision on raising interest rates later this month.