UNDERSTANDING MARKET TRENDS & YOUR INVESTMENTS Wedbush Securities Chris Henderson/VP Investments “Member NYSE/FINRA/SIPC”
Presentation Goals Learn a modern method of portfolio management that is designed to lower risk compared with “buy and hold” strategies ○ Tactical investment method supported by well- published research ○ Infrequent buy and sell (flat) signals ○ Tax efficient in historical models
Presentation Goals § Learn simple technical tools to help identify the long term trend of the stock market and other asset classes (e. g. REITs, bonds) § Define and utilize the 200 day moving average of an asset class for trend identification § Reduce risk by allocating to asset classes that are in long term up trends and avoid asset classes that are in down trends to lower volatility within your diversified portfolio
Myth or Fact? “You cannot successfully time the market” Evidence the financial services industry uses to support position ○ Poor performance of most actively managed mutual fund managers Indexed/passive mutual funds historically have outperformed 60 - 90% of actively managed funds ○ Missing the 10 best days in stock market history would markedly have lowered overall performance Over a 40 year period would cost 1/2 of capital gains (Javier Estrada IESE Business School)
Myth or Fact? Evidence against “buy and hold” Missing the 10 worst days in the market over a 40 -year period would have dramatically improved your stock holding performance ○ Missing those days increased total capital gains by 2. 5 X! (Javier Estrada IESE Business School)
Myth or Fact? Evidence against “buy and hold” “Buy and Hold” strategies have performed poorly for individual investors over the past decade (and for several periods of similar duration over the past 100 years) ○ retirement plans ○ 529 s ○ savings.
Myth? Historical data analysis suggests that there are technical methods to increase the likelihood of avoiding many but not all of the worst days and periods in market history
Reasons to Forget the Myth § Secular bull and bear markets lasting a decade or more have occurred in all asset classes throughout history § Risk free asset classes do not exist § Moves within a secular market can be profound
What asset class is this? Chart of tulip mania
Tulip Mania (17 th century Holland) Price of tulips increased by 20 X in a year At one point a tulip was selling for 12 acres of land Bubbles/chart patterns have occurred for hundreds of years
What was the worst performing asset class for the 40 year period ending 2008?
Gold § Safe haven? § Secular bear § Early 1980 s - 2001 § Worst performing asset class over a 40 year period dating back from 2008 (Richard Bernstein, Merrill Lynch)
Gold (1980 - 2000)
Japan Secular bull (1970 s - 1990) Secular bear (1990 - present) Level of the Japanese stock market in 2010 was equal to that observed in 1983 ○ Nearly 30 years of the Japanese stock market creating zero value for buy and hold investors
Japan (1980 - 2010)
Secular Bear Markets US Stocks Great Depression Bear market loss 69. 45% over 20 years ○ Nearly 30 years to recover losses from market peak of 1929 (inflation adjusted prices) Vietnam/Oil Shocks Bear market loss 66. 31% over 17 years ○ 24 years to recover losses from market peak of 1965 (inflation adjusted prices) Tech Bubble/Financial Crisis As of August 2011, investors who held stocks from March 2000 were still hoping to break even.
Using Moving Averages to Define Trends Moving average Price action smoothing mechanism 200 day moving average Often used to define bull and bear markets Definition ○ Sum of the prices of an asset class or stock at close of each market day for the past 200 days divided by 200
Moving Averages § Should you pay attention to the S&P 500 price relative to its 200 day moving average?
Moving Averages Famous bear markets during which the majority of losses occurred after the S&P 500 index had crossed below its 200 day moving average (MA) The Great Depression Tech Bubble ○ S&P 500 crossed below the 200 day MA on 9/18/00 Index lost nearly 50% of its value in the next 24 months (Yahoo Finance) Financial Crisis ○ S&P 500 crossed below the 200 day MA on 11/11/07 Index lost nearly 55% of its value by March 2009 (Yahoo Finance) The S&P 500 remained consistently below the 200 day MA from January 2008 till May 2009 (Yahoo Finance)
Moving Averages Volatility and the 200 day MA ○ The stock market is historically 50% more volatile when the S&P 500 is below the 200 day MA (Source: Faber) ○ Avoiding stocks when the S&P 500 was below the 200 day MA would have led you to miss 72% of the 50 worst days in market history between 1951 - 2007 (Source: Faber) Significant improvement in hypothetical portfolio performance even though biggest days were often missed as well Past history may not reflect future performance
S&P 500 vs. 200 day MA
Moving Averages § Problems with a simple 200 day MA cross strategy § Holding the S&P 500 only when it is above a 200 day moving average § Majority of simulated trade cycles are losing ones § 181 trade cycles from 1950 -2010 § 73% losing § Unnecessary frequent trading
Moving Averages § Siegal Method § Stocks for the Long Run Jeremy Siegal, Ph. D (Wharton) § Buy the stock market when it trades above the 200 day moving average by more than 1% § Sell when the stock market when it trades below the 200 day moving average by more than 1% and hold US Treasuries § Improves risks adjusted returns § Winning trade cycles approximately 50% § Tested on the NASDAQ 1972 - 2006 historical data § Annualized hypothetical returns are 4% greater than buy and hold
Moving Average § Problems with the Siegal Method § Must pay attention day to day anytime price action is in range of the 200 day moving average § Frequent trading cycles § 74 (1950 - 2010) § Winning trading cycles still occur only 50% of the time
Moving Average Tactical Asset Allocation Method ○ “A Quantitative Approach to Tactical Asset Allocation” (February 17, 2009). Journal of Wealth Management. (Faber) Working paper published in 2006 Improves on the Siegal method and shows stability across asset classes in simulated historical testing Can be utilized to manage risk within a diversified portfolio of asset classes
Moving Average Tactical Method Uses the 10 month moving average as the signal line ○ Analogous to the 200 day moving average as there are 5 days per trading week All buy and sell decisions are based on the last day of the month ○ Price movements of an asset class within the month otherwise are ignored Reduces the number of trade signals significantly Seemingly reduces “whipsaw” trades Portfolio on “autopilot” for 29 -30 days each month
Moving Average Tactical Method ○ If the price of the asset class is above the 10 month moving average on the last day of the month then buy/hold the asset class ○ If the price of the asset class is below the 10 month moving average on the last day of the month then sell the asset class and buy/hold 90 day US Treasury fund Alternatively buy/hold money market fund
Tactical Method / US Stocks
Tactical Method / REIT
Tactical Method / International Stocks
Tactical Method / 7 -10 year US Treasuries
Tactical Method / Commodities
Tactical Method S&P 500 Tactical S&P 500 Annualized Return Standard Dev. 9. 21% 10. 45% 17. 87% 12. 01% Best Year 52. 88% 52. 40% Worst Year -43. 86% -26. 87% Source: Faber 2009 *Total Simulated Returns (1900 - 2008) Simulated historical returns may not be predictive of future performance
Tactical Method § Equal allocations to 5 different asset classes using the monthly timing model on each § § § US Stock Market (20%) International Stocks (20%) REITs (20%) Medium-Long Term US Treasuries (20%) Commodities (20%) If a particular asset class is on a monthly sell signal, the 20% allocated to that asset class is held in 90 day US T-Bills
Comparison of Buy/Hold vs. Tactical Method 5 Asset Class Portfolio (1973 - 2008) Buy & Hold 5 Asset Class Portfolio Tactical 5 Asset Class Portfolio 9. 77% 11. 27% Annualized Return Standard Deviation Best Year 9. 73% 6. 87% 26. 58% 26. 20% Worst Year -30. 09% -0. 59%* *2008 *Total Simulated, Historical Returns Source: Faber 2009 Simulated historical returns may not be predictive of future returns
Tactical Method 5 asset class tactical portfolio may be constructed with low-fee index ETFs and/or low expense, no-load index mutual funds ETFs trade like stocks, have low fees, and are often designed to mirror the performance of a given asset class ○ Low-fee structure of funds within portfolio reduces expense drag on a portfolio Potential Tax efficiency Many Profitable simulated trade cycles are long term gains Source: Faber
Tactical Method Several ways to utilize the Tactical Method Substitute for the stock portion of your portfolio ○ Similar simulated historical return profile with lower volatility** Add as an “alternative” asset class ○ Perhaps 5 -15% of portfolio depending on risk tolerance Comprehensive, diversified portfolio with intrinsic design to balance risk** ○ Best suited for investors with a long-term investment horizon **Simulated historical performance and future performance may vary significantly
Questions for your financial advisor? What is your method for reducing portfolio exposure to asset classes that are in longterm downtrends? If the stock market remains in a secular bear market for the next decade, what is your strategy to grow a portfolio?
We now know when to own different asset classes, how do we further reduce portfolio risk and try and grow a portfolio in a secular bear or sideways market?
Question What’s your method for reducing portfolio exposure to asset classes that are in long term downtrends? We’ve seen that a move below the long-term moving average has often proven to be a sign of turbulent times. Therefore, avoiding these asset classes has historically improved your returns and lowered volatility.
Benchmark Indexes Major indexes including the S&P 500, MSCI EAFE, MSCI EM, & GSCI Commodity Index are made up of multiple sectors, countries, or other components. Within each index we have historically seen secular and cyclical trends of the different components.
So What Can You Do? If the stock market remains in a secular bear market for the next decade, what is your strategy to grow a portfolio? Determine the trends of the individual subsectors, countries, or commodity components. ○ Identifying out of favor sectors allows an investor to focus only on those areas that have momentum behind them.
How Do We Identify Current Trends? Relative Strength (RS) Measures the price movement of an investment compared to a set benchmark or universe of its peers. ○ RS improves if the price increases more than the average in an uptrend or decreases less than the average in a downtrend. Allows investors to focus on the strongest trends, wherever they may be found. It offers the ideal framework for allocating among these trends.
Relative Strength can be used in many ways. For our purposes we will focus only on market relative strength. We will also focus solely on sector, country, and commodity related ETFs.
Relative Strength Market relative strength. (ETF price/S&P 500)*100 = market RS score (XLF/SPY)*100 = RS ($15. 58/$138. 99)*100 = 11. 21 ○ If the RS score rises it signals relative strength vs. the S&P 500. ○ If the RS score declines it signals relative weakness against the S&P 500.
A move to a column of O’s in August 2007 suggested the end of the trend. Financials were now showing weakness. A move to a column of X’s in April 2000 signaled strength vs. the S&P 500
Relative Strength For the period April 2000 -August 2007, while the financials exhibited relative strength, XLF returned 60. 58% compared to the S&P 500’s (SPY) return of 11. 22% (Source Stockcharts. com, Morningstar)
A move to a column of O’s in October 2003 signaled weakness in the healthcare sector. A move to X’s in August 2007 suggested that the weakness had ended and the healthcare sector was starting to exhibit strength.
Relative Strength For the period October 2003 -August 2007, while healthcare exhibited weakness to the market, XLV returned 27. 03% compared to the S&P 500’s (SPY) return of 56. 16% (Source Stockcharts. com, Morningstar)
Relative Strength Across Asset Classes Relative strength is checked the last trading day of each month. If a subsector, country, or commodity component is in a column of X’s it is included in the portfolio. If any subsector, country, or commodity component that is in a column of O’s it is excluded from the portfolio.
Relative Strength Universe S&P 500: XLY, XLP, XLE, XLF, XLV, XLI, XLB, XLK, XLU MSCI EAFE: EWU, EWJ, EWL, EWQ, EWA, EWC, EWG, EWP, EWI, EWD, EWN, EWH, EWS, EWK, EWO MSCI EM: FXI, EWZ, EWY, EWT, EZA, RSX, INDY, EWW, EWM, EIDO, THD, ECH, EPU, TUR, EPHE GSCI: DBC, DBA, DBB, DBE, DBO, DBP, GLD, SLV
Relative Strength Across Asset Classes Buy & Hold Relative Strength S&P 500 (2002 -2012) 3. 95% 6. 80% MSCI EAFE (2002 -2012) MSCI EM (2002 -2012) GSCI (2007 -2012) 5. 79% 10. 15% 13. 89% 17. 83% -3. 28% 8. 01% (Source Stockcharts. com, Morningstar) Simulated historical returns may not be predictive of future performance.
Relative Strength Across Asset Classes Relative strength, when applied to major asset classes, (S&P 500, MSCI EAFE, MSCI EM, & GSCI Commodity), has been shown to markedly improve returns compared to a “buy and hold” strategy. (Dorsey Wright)
Relative Strength Across Asset Classes Each major asset class is equally weighted. ○ 4 Asset Class portfolio receives 25% weighting. ○ 5 Asset Class portfolio receives 20% weighting. Each major asset class will equally weight those sectors exhibiting RS. ○ If Major Asset class weighting is 20%, all sectors with RS will be equally weighted to equal 20%. Example: If 5 sectors of the S&P 500 exhibit RS each will have a portfolio weighting of 4%.
Relative Strength (4 Asset Class equal weighted) (SPY, EFA, EEM, IYR) 2002 -2012 Buy & Hold Relative Strength Average Return 9. 11% 12. 16% Standard Deviation Best Year 23. 69% 25. 15% 40. 15% 44. 63% Worst Year -39. 42 -41. 19 (Source Stockcharts. com, Morningstar) Simulated historical returns may not be predictive of future performance.
Growth of a Dollar (4 Asset Class Portfolio)
Relative Strength (5 Asset Class Equal Weighted) (SPY, EFA, EEM, GSG, IYR) 2007 -2012 Buy & Hold Relative Strength Average Return 1. 74% 6. 02% Standard Deviation Best Year 25. 96% 27. 64% 33. 13% 44. 39% Worst Year -41. 55% -36. 26% (Source Stockcharts. com, Morningstar) Simulated historical returns may not be predictive of future performance.
Growth of a Dollar (5 Asset Class Portfolio)
Correlations of a New Market. Creation of new investment products is quickly disrupting correlation of asset classes. (Commodity, International, and Futures ETFs) Gold, Oil, and International stocks can now be traded easily through the use of ETFs. GLD, DBO, i. Shares Country Indexes
Commodities Not The Diversifier They Once Were
I see how relative strength can help me during the good times but what can I do to maximize returns during the bad times?
Treasuries Are a Natural Hedge Against Fears in The Market The Inverse relationship between stocks and treasuries remains mostly unaffected by the recent changes in correlation. As a constant component of a Tactical Model treasuries may negatively impact portfolio returns in a bull market. Treasuries perform best when market fears are present. Owning treasuries only when the S&P 500 fell below its 200 DMA significantly improved both returns and volatility versus a 50/50 mix. (Stoken, 2010)
Gain to Pain Ratio 90 day T-bill: Risk free rate of return (3. 62% 1926 -2010) Average Underperformance (AU): Sum of all underperforming years divided by the number of years observed. Excess Return (ER): Compound return of an investment minus the compound return of the 90 day T-bill. Average return above that is the risk free rate. Gain to Pain Ratio (Risk/Return): Amount of excess gain each 1 percent of risk yields. (ER/AU=G/P)
Gain to Pain Ratio Investment CMPD Return 9. 87% 6. 25% (4. 98%) 1. 26% LT Treasuries 5. 50% 1. 88% (2. 56%) . 73% Int. Treasuries 5. 35% 1. 73% (1. 11%) 1. 56% S&P 500 ER AU G/P Ratio *85 year period 1926 -2010 (Stoken 2010)
Treasury Risk & Return IEF 2002 -2011 S&P 500 < 200 S&P 500 > 200 DMA Average Monthly Return . 93% . 39% Monthly Volatility 2. 62% 4. 19% (Source Yahoo Finance, Morningstar)
Buy & Replace A tactical strategy utilizing a long term moving average has proven considerably less volatile than a stand alone buy & hold strategy while still providing a better return. Building on this strategy we need to decide what to do with cash when it is not invested in stocks
Buy & Replace To expand on the Tactical Method discussed earlier we believe the use of Intermediate term treasuries provides a better hedge against market fears. We’ve also shown that relative strength has provided increased returns over Buy & Hold during our test period. Past history also clearly favors the intermediate term government bond, which sports a very low 1. 11% average underperformance, excess return of 1. 73% above the riskless 90 day T-bill and a gain to pain ratio of 1. 56% as the preferred fixedincome vehicle.
Buy & Replace When an asset class is above its long term moving average use monthly relative strength to determine sectors or countries to own and hold until the asset class falls below its long term moving average. When an asset class falls below its long term moving average sell that asset class and replace it with intermediate term treasuries until the asset class rises back above its long term moving average.
Buy & Replace S&P 500 (2002 -2012) Buy & Hold Relative Strength RS Buy & Replace Average Return 3. 95% 6. 80% 14. 80% Standard Deviation 19. 63% 19. 06% 7. 41% Best Year 28. 18% 30. 85% 26. 53% Worst Year -36. 81% -31. 98% 3. 40% (Source Stockcharts. com, Yahoo Finance) Simulated historical returns may not be predictive of future performance.
Buy & Replace MSCI EAFE (2002 -2012) Buy & Hold Relative Strength RS Buy & Replace Average Return 5. 79% 10. 15% 16. 03% Standard Deviation 23. 08% 25. 16% 13. 94% Best Year 39. 79% 45. 03% 36. 73% Worst Year -41. 02% -36. 82% 0. 92% (Source Stockcharts. com, Yahoo Finance) Simulated historical returns may not be predictive of future performance.
Buy & Replace MSCI EM (2002 -2012) Buy & Hold Relative Strength RS Buy & Replace Average Return 13. 89% 17. 73% 19. 33% Standard Deviation 33. 62% 37. 93% 23. 21% Best Year 68. 93% 80. 59% 60. 90% Worst Year -48. 88% -50. 69% -4. 34% (Source Stockcharts. com, Yahoo Finance) Simulated historical returns may not be predictive of future performance.
Buy & Replace GSCI (2007 -2012) Buy & Hold Relative Strength RS Buy & Replace Average Return -3. 28% 8. 02% 13. 46% Standard Deviation 25. 63% 24. 62% 17. 47% Best Year 31. 69% 38. 39% 32. 32% Worst Year -45. 75% -24. 38% -16. 24% (Source Stockcharts. com, Yahoo Finance) Simulated historical returns may not be predictive of future performance.
RS Buy & Replace (4 Asset Class equal weighted) (SPY, EFA, EEM, IYR) 2002 -2012 Buy & Hold 9. 11% Relative Strength 12. 16% RS Buy & Replace 18. 99% Average Return Standard Deviation Best Year 23. 69% 25. 15% 11. 35% 40. 15% 44. 63% 39. 48% Worst Year -41. 19% -39. 42% 6. 65% (Source Stockcharts. com, Yahoo Finance) Simulated historical returns may not be predictive of future performance.
Growth of a Dollar (4 Asset Class Portfolio)
Relative Strength (5 Asset Class Equal Weighted) (SPY, EFA, EEM, GSG, IYR) 2007 -2012 Buy & Hold Average Return Standard Deviation Best Year Worst Year 1. 74% Relative Strength 6. 02% RS Replacement 16. 37% 25. 96% 27. 64% 9. 06% 33. 12% 44. 39% 30. 28% -41. 15% -36. 26% 4. 98% (Source Stockcharts. com, Yahoo Finance) Simulated historical returns may not be predictive of future performance.
Growth of a Dollar (5 Asset Class Portfolio)
Conclusion Moving averages have been a good indicator of changes in market direction. An equal weighted portfolio of diverse asset classes has provided investors better risk management as well as better long term returns. The use of relative strength has provided extra alpha (return above the market) in different asset classes. The use of Intermediate term treasuries to hedge fears in the market has markedly lowered volatility on a variety of asset classes and portfolios.
Disclosures The S&P 500, Morgan Stanley Capital International EAFE (MSCI EAFE), Morgan Stanley Capital International Emerging Markets Index (MSCI EM) & DJ REIT Index returns exclude reinvested dividends and the three-, five-, and 10 -year returns are annualized. Past performance is no guarantee of future results. Indices are unmanaged and cannot be invested into directly. **Timing data provided by Yahoo Finance using the 200 day simple moving average. Performance data provided by Morningstar. com, i. Shares, and State Street Global Investors. Relative Strength information provided by Stockcharts. com
Chris Henderson AAMS VP/Investments Wedbush Securities 14851 N Scottsdale Rd. #201 Scottsdale, AZ 85254 602 -332 -5252/480 -778 -8572 Chris. henderson@wedbush. com Member NYSE/FINRA/SIPC
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