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March 02, 2009

What, If Anything, Can Help Your Portfolio?
by Tom Madell

Summary: Changing one's overall asset allocation to stocks in reaction to newspaper and other media-presented suggestions that things seem to warrent such action are commonplace among traders and investors. Unfortunately, there is little evidence to confirm taking such action, which really amounts to stock market "timing," can achieve better future returns for investors. Rather than altering your overall exposure to stocks, one can realize significantly better returns by instead altering which categories of stock funds you are exposed to, without changing your stock allocation at all. This is extremely important now since no one can likely guess where the overall market is headed; however, our research has shown that you can be much better off in certain stock (and bond) fund categories than others in spite of the poor performance of the overall market.

Trying Unsuccessfully To Outguess the Market

It is probably undeniable that virtually all media reports, analyses, and newsletters that discuss the stock market attempt to offer a view, either subtilely or not, as to where the market might be headed. One need look no further than recently published items to clearly see that what people seem to want (and that which is provided to them by reporters and market experts), is nearly always an attempt to shed light on whether the market is more likely in the future to be going up or going down.

• From the New York Times (Reuters) Feb 25

  "Stocks fell on Wednesday as investors found little new in a major speech by President Barack Obama on how he planned to stabilize the economy, while gloomy home sales data weighed on the market ... [and] added to the negative tone... [I]nvestors found little in what he said to help the market sustain its attempted rebound on Tuesday from 1997 lows."

• From Mark Hulbert's commentary published on Feb 24 at marketwatch.com "According to ... Richard Russell, editor of Dow Theory Letters, a major bear market can be expected to obliterate between one-half and two-thirds of the previous advance ... We've already erased around half of the bull market that began in 1982. A two-thirds retrenchment would take the Dow down to around the 5,200 mark ... Russell outlined just such a possibility nearly a year ago, in April 2008, [when] Russell wrote: 'Somewhere ahead we're finally going to enter a true primary bear market, maybe one of the greatest and most tragic in history.'"

• From a video on bloomberg.com Feb 25 entitled "Prechter Sees `Two More Years' of U.S. Stock Bear Market" Note: Prechter is a long-time investment forecaster. Interviewer: "What's next, Bob? Prechter: "The bear market has a long way to go ... I think there are at least two more years to go."

This seems to reflect the fact that, as investors (or potential ones), we would like to think that it is possible for someone to be able to accurately "read the tea leaves," leading him or her (and us as readers/listeners) to have a better sense whether the time is right to either invest in the market or not (or add to or reduce our current investments in stocks). But such a belief flies in the face of stark evidence that it is nearly impossible to "time" the stock market. Thus, while many people give lip service to this unpredictability, most everyone who regularly consults media reports, analyses, and newsletters about the stock market perhaps secretly still harbors the notion that somehow, someone (even themselves) can know with any greater probability than chance when the market is going to tank, or when it will prove rewarding. That is why a whole advice industry has evolved in order to meet this need.

Lest you think that I am being hypocritical since I myself write a newsletter which provides advice on stock market investing, among other things, let me again as I have many times in past issues, state that I do not think it is possible to successfully time the overall stock market. Perhaps, I myself have contradicted this principle by offering my overall quarterly recommended allocations to stocks which might be taken to imply that I believe in market timing. Before discussing this further, let's look at the facts:

• Virtually no one has been able to provide consistently forward-looking, market-beating advice on when one should be heavily in the market vs when one should lighten up or be totally out. For example, a few "experts" were likely able to successfully predict with accurate timing the demise of the bull market in early 2000, and likewise, a few perhaps correctly foresaw with the proper timing the advances between Oct. 2002 and Oct. 2007.

  But, as far as finding one and the same person who has been able to regularly foresee the multiple ups and downs with a close sense of when these might happen, I am not aware of any one such individual.

  In fact, if there was such an individual, it is highly likely that he/she would have become extremely visible. Since success in investing has been such an important (and might I add now, necessary) goal of so many 'ordinary' people these days, IF there was such a person, the investing public would have flocked to his/her advice, making investing simply a matter of finding that person and continuing to follow their advice.

  If you have any doubts about the failure of almost all market experts to help their followers by providing them with accurate stock market timing advice, I highly recommend the following website, http://www.cxoadvisory.com, to help dispel that notion. Using what appears to be a vigorous analysis of over 50 "gurus", Steve LeCompte, himself somewhat of a statistical guru who has been mentioned in sources such as the San Francisco Chronicle and Business Week magazine, points out that "stock market experts as a group do not reliably outguess the market." In fact, his data show that only a few experts appear reliably to obtain at least a 55% accuracy rate in their timing calls, with a 50% rate being pure chance. The average of all his gurus, all well-known in the investment forecasting business, was about a 48% rating.

  According to LeCompte, all three of the named analysts cited in the forecasts mentioned at the start of this article have less than stellar accuracy: Hulbert's Stock Newsletter Sentiment Index "has little or no predictive power for stock returns over the short and intermediate terms", Russell has a 42% accuracy, and Prechter's accuracy rate is about 33%. These 3 individuals are among some of the most well-known experts in terms of how long they have been at their "craft" and the number of investors who follow them. If it is hard for them to accurately assess where the stock market might be going next, one can be highly assured that almost no one else is likely to be successful either.

• A fact that most newsletter editors and advisors would not like to publicize is that the market timing of advisors as a whole is most often a negative indicator when predicting the future returns of the overall stock market. That is, when advisors are quite negative on the market, the market has a tendency to go up, and vice versa. So, for example, both Mark Hulbert's Financial Digest and Investors Intelligence, sources that analyze investment newsletter performance, regard extreme newsletter bearishness/bullishness as one of the most important indicators of market turning points. But because evidence has shown these sentiments to be contrary indicators, extreme bearishness can be interpreted as suggesting the market will turn positive.

  Think back to Oct. 2002. There were considerably more bearish than bullish advisors. This turned out to be a great time to buy the market over the following 5 years. Note also that in Oct. of 2007, positive investor advisor sentiment, as measured by Investors Intelligence, was at its highest point in nearly 3 years! (As of Oct. 2008, sentiment was extremely bearish vs bullish, suggesting the outlook for the market was a lot brighter than the feelings expressed.) But even using contrary indicators such as provided by the above two sources does not usually lead to successful market timing, beyond perhaps just a very short-term effect.

  While the bearish to bullish ratio was at its highest this past Oct. going back to the end of the 2000-2002 bear market, how could we know back in Oct. whether it would go still higher? (Most stocks are lower now, over 4 mos. later, while the ratio of bearish/bullishness has dropped suggesting that perhaps the ratio will need to get even more extreme before the market turns around. Thus, ambiguity remains in the way of interpreting the Oct. data as a clear "buy" signal.)

Given these facts, I reiterate my belief that no one, nor any market data, can reliably tell you or forecast when one should confidently invest in the market or smartly get out.

However, there are certain givens over time: a) the market goes up more than it goes down, and b) there tends to be a reversion to the mean after long periods of either extreme underperformance or overperformance. Apart from these, there is no apparent advantage in thinking that you (or probably anyone else) can "figure out" the market and time it successfully on a regular basis. It logically follows that you should invest in the stock market only in terms of how much risk you can tolerate (something which can admitted change over time), and not in terms of attempting to time the market, or overall projections as to market 'badness' or 'goodness'.

As an example of how your risk tolerance can change, as you age you may have less tolerance for risk because you may no longer feel you can make up for big losses in the fewer number of years that you have available to invest. Or, if you have been lucky enough to be successful in already accumulating a sufficient 'nest egg', you may become reluctant, or no longer need, to continue to invest as aggressively.

But regardless, as stated above, many investors act as if they can time the market. They look for answers anywhere they can, to try to figure out if they should add to their overall stock position or not.

Here is where my Newsletter (Mutual Fund Research Newsletter) comes in. Since the beginning of 2000, I have provided investors with Model Portfolios which encompass two main elements: 1) a suggested overall asset allocation to stocks, bonds, and cash, and 2) a breakdown into which types or 'categories' of mutual funds your stocks (and bonds) should be strategically allocated into percentage-wise to try to be best positioned over the next several years for returns that will (hopefully) beat the overall stock (and bond) benchmark, namely the S&P 500 Index (and the Vanguard Total Bond Market Index).

I have always emphasized that the category allocation is, by far, the most important aspect of my Models. And here is something else I have, since very early on, emphasized: Neither my quarterly category allocations (nor my overall allocations) are not meant to imply that anyone who invests on the basis of any particular quarterly recommendation can expect to see outperformance over the short term. Rather, each Portfolio should best be viewed as a multi-year prediction of categories that are currently undervalued and could/should show above average performance with a year or two timeframe, or perhaps even over the next five years. That, incidentally, is why the measure of 'success' I use is not based on how my recommendations perform in the quarter following, but over the following 1, 3, and 5 years.

Any attempt to use my Model Portfolios, especially the overall allocations to stocks (vs bonds/cash) as a short-term market timing tool would not be at all consistent with the information they were designed to predict, that is, intermediate to long-term investment results. Therefore, realistically, it makes no sense to try to use my overall allocations (nor, likely, the category allocations) to keep alternating your overall stock allocation in the hope that you will profit by as soon as one quarter later.

I must point out that, I too, am not exempt from the truism that it is nearly impossible to predict the future direction of the overall stock market. Therefore, one should not interpret my allocations with this unrealistic goal in mind.

When, in the past, I changed an overall allocation to stocks such as I did in Jan. '09 from 42.5% to 37.5% for 'moderate risk' investors, I was weighing not only what I expected to be the prospect of future returns, but also, how much risk one would be putting themself at by remaining invested in stocks vs. my previous recommendation. In practice, then, my Newsletter has been geared toward NOT ONLY helping people do well in their investing performance-wise, but keeping in mind a commitment to avoid excessive risk. So, when stocks were getting mauled, I have urged caution as as opposed to only shooting for the absolute best performance since it is usually the case that just when things look the bleakest, is among the better times to invest. The purpose of this caution was so that ordinary people (including myself) who make decisions based on the Models won't get hurt too badly if things turn out poorly, perhaps longer than most people might expect.

This is the "contradiction" investors face. It is one of the hardest things an investor must deal with: Your stock portfolio is getting killed; the media are filled with countless pieces suggesting that things will most likely continue to get worse. During such times, I think many small investors should take some risk off the table. Yet, in the past, such times have proven to be among the best times to increase, rather than decrease, your allocation to stocks.

So unless one is willing to risk losing a great deal of one's nest egg, they are probably not going to take advantage of 'an empirically "favorable" situation'; financial prudence will likely dictate that I should lower my allocations to stocks, rather than raise them.

Only you can judge your own level of risk tolerance, not me as a newsletter writer. Therefore, it makes sense for each reader to decide his own risk level - whether conservative, somewhere in the moderate range, or aggressive. It does not make much sense for me to suggest what your overall level of allocation to stocks should be; only you can decide that, based on your own situation and how much risk you want to/are able to take.

Adjusting Your Fund Category Allocations

While market timing rarely produces good results beyond mere lucky guesses approximately half the time, huge benefits can be realized no matter what your overall percentage allocation to stocks, by establishing a position in or adding to those categories that are the most likely to do well under the current set of circumstances.

The following data starkly illustrate this point:

Between the start of 2000, all the way through the last quarter of 2002 (that is, for 12 straight quarters), we recommended that investors establish an allocation position of as much as 20% of your stock portfolio ranging down to around 5% in funds that invest in real estate (REITs). As of the first quarter of 2003, we no longer recommended the category at all. These recommendations corresponded closely to the dates of the 2000-2002 bear market.

What was the outcome for investors who followed our recommendation?

Over the first year after our initial recommendation, the category returned +25.6%. Since the overall stock market of which REIT funds are a part, had started suffering already from the onset of the bear market returning -9.1% as measured by the S&P 500 Index, the advantage of having some of your portfolio in REITs proved huge. The difference between the two returns meant a +34.7% better return for that segment of your portfolio!

By three years later, by maintaining or increasing your position in REITs as we had recommended, your return on your initial investment would have been +12.7% per year in spite of the bear market elsewhere in stocks; the S&P 500 was down -14.6% per year, for an advantage of +27.3% per year for that portion of your stock portfolio.

By 5 years after our initial recommendation, REITs were up an amazing 21.4% per year while the overall market was still negative (-2.3% per year). Your total advantage for that portion of your portfolio would amount to 23.7% per year!

But what if you had not started following our recommendation initially? Perhaps you established a position in the REIT category at the start of some other quarter during 2000 through 2002. By taking the average gain for REIT funds over the 12 quarter period and comparing it to the average gain for the S&P 500, you will clearly see the value of our REIT recommendations for long-term investors regardless of when you established your position. Thus, the one year average return during that period for REIT funds was +13.3% vs a one year average of -12.1% for the S&P 500 - a 25.4% difference. Likewise, the average REIT fund returned +17.6% annualized 3 years subsequent to the start of any of the 12 quarters vs -1.7 annualized for the Index - a 19.3% difference per year.

Although we stopped recommending REITs for our Model Portfolios beginning in 2003 which proved to be somewhat too early, had you, as a long-term investor continued to hold a REIT position taken up during any of the 12 quarters during 2002-2003, your average 5 year return would have equalled +20.6% annualized vs only +3.6% annualized for the S&P 500, a 24.2% difference also annualized.

In other words, although our Model Portfolio recommendations are made on a quarterly basis, we believe, as illustrated here, you can make better than average returns by holding any given Model Portfolios recommendations for up to 5 years.

Incidentally, although REIT funds continued to outperform for nearly 5 years after we stopped recommending them, their luck started to run out by mid-2007, although even someone who purchased the category at the end of 2002 would have still done better than the Index a full 5 years later. But currently, over the last 1, 3, and 5 yrs, REITs have been just about the poorest performing category of all. So, following our recommendation regarding REITs for up to, but no longer than 5 years after we stopped making it, would have helped you a great deal.

Down through the years, we have made many allocation category recommendations which similarly outperformed for years after we recommended them, such as small and mid-cap (especially value), international, and natural resources. We generally correctly stopped recommending them, or reduced our allocation, when we felt these categories no longer offered good long-term perspects. All told, then, it was our category allocations which were far more valuable to our readers than our changing allocations to stocks as a whole.

In the present market climate, we continue to favor Growth funds, especially Large Cap Growth. In addition, we are strongly recommending that our readers establish at least a small to moderate position in the Long-Short category. While this category may be unfamiliar to many, the best and safest such fund, one that I have been recommending on and off for over 5 years, is the Hussman Strategic Growth Fund (HSGFX). Over that period, this fund's return has been a positive 1.3% annualized (It is UP 4.1% over the last 3 mos.). While this may not sound great, compare it to the S&P 500 which is down 6.3 annualized for the last 5 years and is down 17.3 over 3 mos.)

While we did extremely well down through the years with our International category (including Emerging Markets) exposure, we currently see these categories as among the poorer performers for at least the next year or two. We still highly recommend a strong position in high quality bonds.

Tom Madell, Ph.D.
Publisher
Mutual Fund Research Newsletter

Mutual Fund Research Newsletter is a free newsletter which began publication in 1999. It has become one of the most popular mutual fund newsletters on the Internet, ranking number 7 on the Google Directory page for Mutual Funds News and Media Newsletter websites. Since we began publishing our quarterly Model Portfolios, 29 out of the 36 Stock Portfolios have outperformed the S&P 500 Index over the following year (data as of Sept., 2009). Since 2000, 28 of our Model Stock Portfolios have had the opportunity for at least 3 years to pass since we first published it. 25 out of 28 of these Model Stock Portfolios have outperformed the S&P 500 Index over the following 3 years, and ALL Stock Portfolios (20 out of 20) have outperformed over 5 years as well. Mean level of outperformance has ranged from about 3% over 1 year to over 4% PER YEAR over 5 years.

Copyright © 2003-2009 Tom Madell

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