Buy and Hope Part 2 Alternative strategies for

Buy and Hope? Part 2 Alternative strategies for prudent investors Leigh Anderson <leigh@houstoninvestors. com> Houston Investors Association / Getting Started SIG / Leigh Anderson Presentation at www. tayara. com/hia 9 May 2009

Today’s Discussion n “Buy & Hold” • Hold a portfolio of diversified assets, in fixed proportion n E. G. , 60% stock, 40% bond • Rebalance periodically n Risks are greater than previously perceived • • • Long periods where returns are lousy Large drops in portfolio value possible Buy-and-hold investors have effectively lost at least a decade of accumulated wealth. • History offers many examples of markets that have spent a quarter century or more mired in a trough. n Can investors improve results with “active” strategies? • In particular by timing or dynamically switching assets n n Look at one simple system based on moving averages What is the evidence for/against? 9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 2

Conventional Wisdom n n You can’t successfully time the market "It's one thing to get out of the market at the perfect time, " says John Bogle, "and quite another to get back in at the perfect time. - how many people can do that? - You've got to be right twice. " 9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 3

Conventional Wisdom n n To be successful, traders must repeatedly overcome numerous costs associated with trading. Research indicates that professionals are poor short-term prognosticators. Market timing is generally a losing activity You have to be in the market to profit • if you removed the 10 best days for the Dow Jones Industrial Average in the 1900 -2008 years, two thirds of the cumulative gains were lost. n But nobody ever tells you that • if you missed the 10 worst days, the actual gain on the Dow tripled. • stocks fall a lot faster than they rise. 9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 4

Mebane Faber n n “A Quantitative Approach to Tactical Asset Allocation”, Mebane T. Faber, Spring 2007, The Journal of Wealth Management, February 2009, Update A very simple strategy based on moving averages • Simple, purely mechanical logic. • The same model and parameters for every asset class. • Price-based only. 9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 5

The 200 Day Simple Moving Average (SMA) n n n The 200 day SMA is the average of the price for the preceding 200 trading days, plotted against today’s price (200 trading days = 10 months) Yahoo Finance http: //finance. yahoo. com/ n Click on S&P 500 Or enter symbol of an ETF or mutual fund n n Click on “Basic Technical Analysis” Click on “Moving Avg 200” 9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 6

Faber’s Trading Rules n BUY RULE • Buy when monthly price > 10 -month SMA. n SELL RULE • Sell and move to cash when monthly price < 10 -month SMA. n Note: • The model is only updated once a month on the last day of the month. Price fluctuations during the rest of the month are ignored. 9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 7

Faber Timing Strategy: 100% stock if P > 10 mo SMA 100% cash if P < 10 mo SMA 9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 8

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Faber Exit 9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 10

9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 11

9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 12

9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 13

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Are We “Data Mining”? n n Have we tried so many systems, rejecting the ones that don’t work, until we found one that works by chance? Possible tests for data mining: • Try system on different assets n Non-US stock, real estate trusts (REIT), Bonds, commodities • Try different averaging lengths n 9 May 2009 Something magic about 200 days? Houston Investors Association / Getting Started SIG / Leigh Anderson 15

Various Moving Average Timing Lengths 9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 16

International Stocks 9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 17

Multiple Asset Classes? 9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 18

What if we apply to multiple invest. ments (asset classes)? n Apply timing rule to five asset classes, independently • S&P 500, EAFE, NAREIT, 10 yr bond, GSCI, over 1972 -2005 9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 19

Professors say: Technical Analysis Doesn’t Work n n The Disappearance of Momentum • Technical Trading Revisited: Persistence Tests, Transaction Costs, and False Discoveries • n We investigate the robustness of the momentum premium in the US over the period from 1927 to 2006 using a model that allows multiple structural breaks. We find that the risk adjusted momentum premium is significantly positive only during certain periods , notably from the 1940 s to the mid-1960 s and from the mid-1970 s to the late 1990 s, and we find evidence that momentum has disappeared since the late 1990 s. Our results further suggest that momentum profits have been slowly eroded away since the early 1990 s , in a process which was delayed by the occurrence of the high-technology stock bubble of the 1990 s. In particular, we estimate that the bubble accounted for at least 60% of momentum profits during the period from 1995 to 1999. We revisit the apparent historical success of technical trading rules on daily prices of the Dow Jones index. First, we use the False Discovery Rate as a new approach to data snooping. The advantage of the FDR over existing methods is that it is more powerful and not restricted only to the best rule in the sample. Second, we perform persistence tests and conclude that an investor would not have been able to select ex ante the future best-performing rules. Finally, we show that the performance fully disappears once transaction costs are taken into account. Technical Analysis Around the World: Does it Ever Add Value? • Technical analysis is not consistently profitable in the 49 countries that comprise the Morgan Stanley Capital Index once data snooping bias is accounted for. There is some evidence that technical trading rules perform better in emerging markets than developed markets, which is consistent with the finding of previous studies that these markets are less efficient, but this result is not strong. While we cannot rule out the possibility that technical analysis compliments other market timing techniques or that trading rules we do not test are profitable, we do show that over 5, 000 trading rules do not add value beyond what may be expected by chance when used in isolation. 9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 20

Professors say: Technical Analysis Works n Re-Examining the Profitability of Technical Analysis with White’s Reality Check and Hansen’s SPA Test • n In this paper, we re-examine the profitability of technical analysis using White’s Reality Check and Hansen’s SPA test that correct the data snooping bias. Comparing to previous studies, we study a more complete “universe” of trading techniques, including not only simple rules but also investor’s strategies, and we test the profitability of these rules and strategies with four main indices. It is found that significantly profitable simple rules and investor’s strategies do exist in the data from relatively “young” markets (NASDAQ Composite and Russell 2000) but not in the data from relatively “mature” markets (DJIA and S&P 500). Moreover, after taking transaction costs into account, we find that the best rules for NASDAQ Composite and Russell 2000 outperform the buy-and- hold strategy in most in- and out-of-sample periods. It is also found that investor’s strategies are able to improve on the profits of simple rules and may even generate significant profits from unprofitable simple rules. MARKET-TIMING STRATEGIES THAT WORKED • In this paper, we present a few simple market-timing strategies that appear to outperform the “buy-and-hold” strategy , with real-time data from 1970 to 2000. Our focus is on spreads between the E/P ratio of the S&P 500 index and interest rates. Extremely low spreads, as compared to their historical ranges, appear to predict higher frequencies of subsequent market downturns in monthly data. We construct “horse races” between switching strategies based on extremely low spreads and the market index. Switching strategies call for investing in the stock market index unless spreads are lower than predefined thresholds. We find that switching strategies outperformed the market index in the sense that they provide higher mean returns and lower variances. In particular, the strategy based on the spread between the E/P ratio and a short-term interest rate comfortably and robustly beat the market index even when transaction costs are incorporated. 9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 21

What’s going on? The “Proof” Dilemma n n n Same data (historical stock record) is used both to discover rules, and to test them Analogy to drug testing: imagine using different experimental drugs on same patients, over and over To compensate for lack of independent stock price data, statistical techniques become very blunt instruments. • Not sensitive enough to prove success n To a statistician, if you can’t prove the positive, then you have to assume the negative (the “Null Hypothesis”) • Assume that a drug doesn’t work and try to prove that it does • Failing to prove that it works is not the same as proving it doesn’t work n Question: suppose someone gave you a method that had a 3 in 4 chance of success, with little downside. Would you use it? 9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 22

Support for Technical Analysis: The Complete Resource for Financial Market Technicians by Charles D. Kirkpatrick, Julie R. Dahlquist 9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 23

Caveats for Faber Strategy n n n Faber paper is in “Top 5 Papers” at SSRN Taxes and transaction costs: Turnover 70% A trend-following will underperform buy and hold during a bull market but avoids lengthy bear markets. • Consequently, the value added by timing is evident only over the course of entire business cycles. n Psychological Requirements • Patient, determined, disciplined and persevering n n • • • Have to wait for indicators to move into a pattern that signals a buy or sell decision. Determination and discipline to stick to strategy, persevering despite setbacks Independent — Many people will offer advice, opinions and criticism. Realistic — Sometimes buy and hold will outperform timing Decisive — People who see-saw between alternatives never taking action can’t time successfully • Emotionally steady — People who let their emotions carry them away should not try to time the market. 9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 24

References n n n n n “A Quantitative Approach to Tactical Asset Allocation”, Mebane T. Faber, Spring 2007, The Journal of Wealth Management, February 2009, Update http: //papers. ssrn. com/sol 3/papers. cfm? abstract_id=962461 Faber, Mebane T. , A Quantitative Approach to Tactical Asset Allocation(February 17, 2009). Journal of Wealth Management, Spring 2007. Available at SSRN: http: // ssrn. com/abstract=962461 Timing Is Everything Barron’s http: //online. barrons. com/article/SB 124061347806354619. html The Ivy Portfolio (links) http: //www. theivyportfolio. com/links/ “Trading Places” CFA Magazine, June 2009 Price Momentum -- A Twenty Year Research Effort (August, 2001) http: //www. columbinecap. com/pdf/PRICE%20 MOMENTUM. pdf MARKET-TIMING STRATEGIES THAT WORKED Pu Shen Research Division, Federal Reserve Bank of Kansas City MAY 2002 RWP 02 -01 http: //www. kc. frb. org/Publicat/Reswkpap/pdf/rwp 02 -01. pdf Technical Analysis: The Complete Resource for Financial Market Technicians http: //www. amazon. com/Technical-Analysis-Complete-Financial-Technicians/dp/0131531131/ Technical Analysis: An Academic Perspective • • • n This video by Andrew Lo (one of the heavyweights in academic finance) is well worth listening to. http: //event. on 24. com/clients/default/presentation/default. html? titlecolor=000000&eventid=110220&sessionid= 7&username=&partnerref=&format=rmmulti&key=28 A 828822 AD 18023 FD 5 FDB 8 F 5 F 090792&text_language_id= en&playerwidth=880&playerheight=640&eventuserid=16993198 It has a downloadable pdf file of slides http: //event. on 24. com/event/11/02/20/rt/7/documents/slidepdf/07_andrew_lo_20080516. pdf Is buy-and-hold dead and gone? (10/29/2008) • http: //money. cnn. com/2008/10/24/magazines/fortune/buyandhold_okeefe. fortune/index. htm 9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 25

John Hussman n What we can observe is that valuations are now in the high-normal range on the basis of normalized earnings. Stocks are no longer undervalued except on measures that assume that profit margins will permanently recover to the highest levels in history (in which case, stocks would still only be moderately undervalued). For instance, the price-to-peak earnings multiple on the S&P 500 is only about 11, but those prior peak earnings from 2007 were based on record profit margins about 50% above historical norms, largely driven by the excessive leverage that has since sent the economy reeling. On normalized profit margins, valuations are above the historical average, and prospective long-term returns are below the historical average. Overall, I expect the probable total return on the S&P 500 over the coming decade to be about 8% annually, provided we don't observe much additional deleveraging in the economy. At the 1974 and 1982 lows, based on our standard methodology, the S&P 500 was priced to deliver 10 -year total returns of about 15% annually. While it has become quite popular to talk about 1974 and 1982, the stock market is presently not even close to those levels of valuation. Meanwhile, market action in recent weeks has been excellent from the standpoint of breadth (advances versus declines), uneven from the standpoint of leadership (where much of the strength has been focused on speculation in companies with extraordinarily poor balance sheets), and rather uninspiring on the basis of trading volume. 9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 26

Hussman, cont n n n From an economic standpoint, the main argument for an oncoming recovery is simply that the knuckles of investors and consumers are no longer absolutely white. A backing-off from extreme risk aversion is certainly helpful, since it puts banks at less risk of customer flight, but the underlying assets of banks are still deteriorating. For the time being, the recent revision in accounting rules has prevented balance sheets from showing negative capital and revealing insolvency, but the reality is that the mortgages underlying bank assets are still defaulting. If this was simply a temporary problem of fluctuating asset values that would recover time, the problem would not be serious. … In the case of mortgages, once the loan goes into foreclosure, there's an asset sale, the loss is taken, and the game is over. Overall, then, the fundamentals of the market and the economy are not nearly as positive as they are being spun by analysts. Stocks are at best only moderately undervalued if one assumes that profit margins will recover to the historical extremes we saw in 2007, and are otherwise mildly overvalued. The financial system is in cosmetic remission, looking better on the surface, but still deteriorating internally. Still, we can't discard the fact that the extreme risk aversion of recent months has eased. Breadth has been quite strong, but is also overbought (with over 80% of stocks above their 20 -day and 50 -day averages). The mixed picture offers neither certainty that the bear market will resume, nor that a bull market will emerge. Hussman Funds May 4 2009 http: //hussmanfunds. com/wmc 090504. htm 9 May 2009 Houston Investors Association / Getting Started SIG / Leigh Anderson 27