The US economy just keeps rolling along.  4Q GDProse 3.8% according to the Commerce Department, following the gain of 4% in the 3Q.  Personal consumption spending rose by 4.2% in the 4Q, indicating that consumers are still in buying mode.  The Index of Leading Economic Indicators has risen in three of the last four months, although in small increments.  The unemployment rate fell to 5.2% in March.  On the negative side, consumer confidence fell in February and March.  This suggests that economic growth has slowed a bit from last year’s pace but should manage a 3-3½% pace for the rest of the year.  No recession is in sight.

The Fed raised interest rates for the seventh time at the latest FOMCmeeting, putting the Fed Funds rate at 2.75%.  BCA believes the Fed will continue to raise the Fed Funds rate to near 4% over the next year.  Recent statements from the Fed indicate that the monetary authorities are now more worried about checking inflation than growing the economy.

Rising interest rates are not positive for either the stock markets or the bond markets.  Many analysts had expected the Fed to stop raising rates at the 3% level in Fed Funds, but in recent weeks the Fed has made it clear that it intends to go further.  As a result, the broad stock indices have moved to the low end of the recent trading range, and bonds have been falling since late February.  BCA believes that stocks will continue to move gradually lower as the Fed continues to raise rates, but they do not believe stocks are headed for a bear market.  They believe there will be a good buying opportunity in stocks and bonds later this year.  BCA continues to recommend market timing and sector rotation strategies for the stocks markets.

Along that line, it is my pleasure this month to introduce you to one of the most impressive Investment Advisors we have ever found.  Enclosed is detailed information on Scott Daly’s Asset Enhancement Program.  This program has averaged 15.7%  a year over the last 10 years.  It has averaged 13.5% a year over the last five years, including the bear market of 2000-2002.  Amazingly, the worst drawdown over the last five years was less than 1%, even though we went through a bear market.   You’ll definitely want to check this Advisor out!  Click here to view the Advisor Profile on this program.

Introduction

There are many different types of risks involved in investing, and investors should only commit their hard-earned capital once they have fully identified all of the risks and are sure they are comfortable with them.  Unfortunately, many investors reach for the brass ring of high returns rather than evaluating the risks associated with those returns. 

There are some investors who are of the “no pain, no gain” school of investing, that figure you have to take a lot of risk to get above-average returns.  Even after the bursting of the tech bubble a few years ago, these investors still insist that you have to take a lot of risk in order to make good returns and meet your financial goals.

The problem with this approach is that while they may be able to get above-average returns along the way, they also subject themselves to the potential for severe drawdowns in value.  When this happens, it takes a much higher return to get back to where you were before the loss occurred.  The table at right  illustrates this idea more clearly:

Notice that if you lose 20% in the market, you have to earn 25% just to get back to breakeven, because you have less capital at work after such a loss.  Note that if you lose 30%, you have to make almost 43% just to get back to breakeven.  Lose 50% and you have to make 100% just to get back to breakeven. 

The table at right should clearly illustrate to anyone why I believe that avoiding large losses is the most important objective of any worthwhile investment strategy.  Unfortunately, most major Wall Street firms do not agree with me.  Most on Wall Street and elsewhere continue to advocate buy-and-hold strategies that, by definition, are going to incur large losses when the equity markets fall hard.

Amount of Loss             Return Required 
     Incurred                    To Break Even 
          10%                        11.1%
          15%                        17.7%
          20%                        25.0%
          25%                        33.3%
          30%                        42.9%
          35%                        53.9%
          40%                        66.7%
          45%                        81.8%
          50%                       100.0%      
          60%                       150.0%      
          70%                       233.3%

Wall Street’s “Relative” Approach

As noted above, I’m sure that all of you are aware of Wall Street’s typical approach to risk, which is to allocate your assets among a variety of asset classes, and then buy-and-hold securities within those asset classes.  This is based on a concept known as Modern Portfolio Theory (MPT), which suggests that asset allocation helps to stabilize returns and reduce risk relative to the markets.

While the concept of asset allocation for diversification purposes is valid, I do not agree with the premise that it sufficiently addresses portfolio risk.  Even though investments are allocated to different asset classes, the portfolio still rises and falls along with the overall markets.   In the bear market in 2000-2002, for example, the S&P500 Index fell over 44%.  Making matters even worse during the last few years is the fact that stocks and bonds broke their typical inverse relationship and we saw both go up and down at the same time.

Adherents to MPT will tell you that it works because their portfolios had smaller losses relative to the overall market.  However, this claim is deceiving.  As noted above, the S&P 500 Index lost over 44% of its value during the 2000-2002 bear market.  A good “relative” performance could be a loss of only 20% or 30%, as compared to 44% in the S&P, but that is still far more loss than most investors would be comfortable with.

Unfortunately, when Wall Street types are asked about actively managed strategies (better known as traditional market timing) to help control risk and avoid losses, they use the most flawed piece of statistical investment mythology I have ever seen as the reason not to try to time the market.  Most brokerage firms and mutual fund companies have a stock answer for market timing (Don’t try it!), based on any number of statistical studies using historical stock market performance.  But their most popular theory is flawed!

The story goes like this:  Historically, much of the stock market’s upward moves are concentrated in a relatively few number of days (which is true).  If market timing takes you out of the market on those days, then your returns will suffer dramatically.  Therefore, they say, it is important that you stay in the market so that you will not miss these good days.

One such study that I reviewed analyzed performance over a period from April of 1984 through December of 2002.  Over that period of time, the S&P 500 Index produced an average return of 9.66%.  However, the study shows that if you missed the 10 best days in the market over that period, your return fell to only 6.44%. 

Missing more of the best days resulted in even lower returns.  For example, if you missed the 40 best days in the market, your average return would only have been 0.47%.  Thus, Wall Street reasons, if you want to maximize your returns, you have to stay in the market so that you don't miss the good days.

While the numbers they quote are accurate, this analysis is obviously skewed to fit the viewpoint of the buy-and-hold crowd.  It is flawed because it assumes that a market timer would be out of the market on all of the best days, but in the market on all of the worst days.  Unfortunately, many investors buy this argument hook-line-and-sinker without thinking to ask the question, “What happens if you miss some of the bad days in the market?”

Instead of missing the good days in the market, let’s say that a market timing Advisor allows you to miss only the worst days in the market.  Using the same data as above from April of 1984 through December of 2002, if you missed just the 10 worst days in the market, your return would have been 14.67% vs. the 9.66% S&P 500 Index return.  Now that’s impressive! As you increase the number of worst days missed, the numbers get even better, resulting in a return of 21.46% if you missed the worst 40 days in the market over this period of time.

Of course, this analysis is also just as flawed, since it assumes that the Advisor is smart enough to be out of the market on all the worst days, but in the market on all of the best days.  The point is, no one is going to catch all the good days and miss all the bad days, or even most of them.

A More Realistic Analysis

Since both sets of performance numbers discussed above are skewed to fit one approach or the other, neither is useful to the knowledgeable investor.  Fortunately, the study also analyzed what would happen if an Advisor missed BOTH the best and worst days in the market over the 18-year period discussed above.  The results are pretty amazing. 

If you missed the 10 best and 10 worst days in the market, the resulting return would have been 11.30%, as compared to the 9.66% S&P 500 Index return.

The table below shows the effect of missing various combinations of best and worst days in the market over that 18 year period. If you missed some of the BEST days, your return fell to:

              10 days       6.44%
              20 days       4.16%
              30 days       2.18%
              40 days       0.47%

If you missed some of the WORST days, your return rose to:

              10 days           14.67%      
              20 days           17.28%      
              30 days           19.46%      
              40 days           21.46%

    If you missed the best AND worst, your return rose to:

              10 days           11.30%      
              20 days           11.39%      
              30 days           11.31%      
              40 days           11.31%

(Source:National Association of Active Investment Managers, Inc.  This data is for illustrative purposes only and is not indicative of the actual performance of any investment.)

The lesson to be learned from the study is clear: missing bad days in the market can more than compensate for missing out on the good days.  Even when the general direction of the market was down-ward during 2000 through 2002, missing out on the worst declines still proved effective in enhancing performance.

Putting It All In Perspective

While it may be the goal of every market timer to be in the market only on the good days and out of the market on all of the bad days, we all know that such a perfect system doesn’t exist. 

The ultimate goal of market timing, in my opinion, is not necessarily beating the market, but to attempt to control the downside risk of being in the market.  Think about that.

I base my opinion upon studies such as those done by the Dalbar organization that demonstrate the negative effect of emotional trading upon investors’ long-term returns.  We all know how it is when we lose money on an investment.  Should we stay the course, bail out and go to cash, or move to something that seems to be performing better?

From the client surveys we have conducted over the years, I know that the average ProFutures client is over 60 years old and has accumulated a significant amount of assets.  In some cases the assets have come from a lifetime of saving and investing, while in others it is the result of a retirement plan distribution, sale of a business or an inheritance. 

Whatever the source, the average age and portfolio size of the typical ProFutures client makes risk management an imperative investment consideration.  The ability to sustain significant losses is no longer viable, since the money may be needed for retirement before losses are recovered.  Therefore, strategies like Scott Daly’s Asset Enhancement Program are worth your serious consideration.  Please review the Advisor Profile on Scott Daly’s program by clicking here.  Scott is one of the most impressive Advisors we’ve ever seen, especially when it comes to controlling losses.

Move To New Location Is Complete

As I indicated last month, we have relocated to a brand new building just down the street from our old office.  The move was a major pain in the neck (literally), but we are now completely moved and settled into our new office.  The new address is 11719 Bee Cave Road, Suite 200.  All of our phone numbers remain the same.  If you happen to be in the Austin area, please give us a call and come by and visit.