“The One Horseman of Notre Dame”? 5 of 5

After an upset victory over Army’s football team, four of the victorious Notre Dame football players were tagged by a sports reporter with the moniker “The Four Horsemen of Notre Dame”.  A publicity agent took the picture and the legend was born for the four players who would eventually all find their way to the Hall of Fame.

In the final blog of a five part series we emphasize the sports reporter did not think to use the term The One Horseman, The Two Horsemen nor The Three Horsemen.  All four players were integral to the team’s overall success.  The four together possessed the speed, defensive skill, acceleration, passing skill and brains to win many football games.

This series examines our “four horsemen” portfolio strategies for use in a troubled economy:

Buy yield – fixed income

Forward valuation – growth plus fixed income

Joe DiMaggio streak – market timing

Flying under the Radar – growth for larger portfolios

A troubling trend has been the increasing number of investors asking our opinion on “all or nothing” “one horse” investments (e.g. high surrender indexed annuities, non-liquid real estate partnerships, etc.).  One must go back to the zany tax-shelters last seen in the 1970s to find such a willingness on the part of these investors to voluntarily surrender their investment maneuverability in order to be sold the peace of mind found on glossy advertising brochures.

In an effort to preserve investment maneuverability, an investor should urge their advisor to consider using multiple investment vehicles such as these “four horsemen” to match their risk-return profile to a suitable mixture of portfolio management strategies.

Buy yield – fixed income

Pros:

Known return (if held to maturity)

Historically, less principal volatility

Cons:

Lower investment yield

Many yields are less than projected inflation rates

Forward valuation – growth plus fixed income

Pros:

Higher return over past five years than fixed income alone

Zero trading friction with $0 commission on many ETF investments

Cons:

Over 20% principal drop in 2008-09

Popularity of ETFs means investments must be closely monitored by your advisor

Joe DiMaggio streak – market timing

Pros:

Market timing strategies beat return for popular S&P 500 index buy-and-hold strategies

Demonstrates record of avoiding brunt of big market selloffs

Cons:

Growing popularity may lead to diminishing relative advantage

Flying under the Radar – growth for larger portfolios

Pros:

Superior long-term returns over 2005-2010 test period

Reduced correlation to institution induced broad market swings over test period

Cons:

Trading commissions means best results appear for larger portfolios

Can be volatile at the individual security level; greater loss than fixed income during 2008-09

 

Concluding remarks:

If there is one word that will find its way into the description of what proves to be the winning investment strategy for 2011, we would suggest the word:

…Flexibility

The investment market of 2010 reacts to federal government intervention with unexpected swings.  Intervention of this sort has a track record of resulting in unexpected consequences.  Hume wrote: “All plans of government, which suppose great reformation in the manners of mankind, are plainly imaginary.”  Stay flexible; adapt to the unexpected.

However before an investor ducks and covers their investment portfolio in our Atomic Rome with “safe” bonds, we caution that a “One Horseman” of fixed income might lose money on an inflation-adjusted basis; albeit at perhaps lowered principal volatility.

Add some growth at least until it hurts

Work with your advisor to add potential growth investments until your risk-return profile is fully utilized.

For owners of larger portfolio, consider direct security ownership to complement low-cost Exchange Traded Funds (ETFs) in an effort to lower dependence on institutional traders’ behavior and their sometimes unpredictable computer-guided trading patterns.

If you have questions or comments on how to prepare your investments in our Atomic Rome , let us know.  Reply to this blog or email us at arlingtonhall@comcast.net

Flying under the Radar investing. 4 of 5

Executive Summary Page:

“Flying under the Radar” – The sinking of the German ship Bismarck seventy years ago illustrates how low technology action can sometimes triumph over state-of-the-art technology that conventional wisdom believed to be “unsinkable”

Investment managers of 2010 trade millions of shares of stock in milliseconds many using state-of-the-art technology to predict how human thinking will react based on past trading experience.

As investment managers hire more smart people to quicken their programs to add profit, an undeniable change in the investment markets has befallen us since 2008.

Computer-driven trading applications, such as High Frequency Trading (HFT) render unprofitable a breathtaking number of investment strategies that had been profitable in the past.

While investors’ fear of such technology-based changes in the investment markets has led to their inaction, we exploit the notion that perhaps the physics-trained PhD’s may be misguided in their technological hubris.  We suggest while they are basking in the brilliance of their complex calculations imbedded in their algorithms they may be neglecting one item: focus improving risk-adjusted portfolio return.

A Eureka moment?

So as institutional money managers employing state-of-the-art trading programs and dark pools are contesting each other for multi-continental bragging rights, is it possible we could make money for our clients by sidestepping the maelstrom?  Only time will tell.  In the meantime, we use a 3-step approach.

First, out of sight out of mind

We sought investments with low trading volume.  If a security trades 100,000 trades per day, it is less likely to be traded by an institution’s algorithm’s appetite that requires, say, 1 million shares to be traded per second.

Second, try to stay safe by demonstrating uselessness to those that may do you harm.

We scouted for investments that performed horribly using standard mathematically-based timing systems.  Institutional investors should find these investments undesirable.  For example, we smiled upon finding an all-weather investment which performed better as a buy-and-hold versus being traded according to market timing system.

Third, cut them off at the pass.

Acknowledging investors are presently enamored with dividend stocks, we searched for investments that dividend-paying companies might eventually purchase to strengthen and/or boost their dividend paying potential: buying a company to use their cash flow as an immediate boost to its dividend-paying potential.

Drawbacks?  The cost of regular trading activity used in a “Flying under the radar” portfolio to minimize tax liability is negligible on larger portfolios.  However the trading costs can become punitive on smaller-sized portfolios.

Result: During the very unique market path from 2005 to 2010, the “Flying under the Radar” growth portfolio outperforms all major indexes over the timeframe tested; though the post-tax returns are somewhat less.    

This chart is not meant to suggest similar outperformance is guaranteed in the future.  Instead, it is a road-test of a portfolio during severe market turbulence measured against major market indexes (and with the benefit of hindsight’s 20/20 vision) the top-performing index over that timeframe – emerging markets.

One can almost gauge their appetite for risk from this illustration; more specifically the “Flying under the Radar” growth portfolio suffers a 34% setback during the 2007-2008 peak-to-trough.  Allocate accordingly.

 

Expanded Commentary:

“Sink the Bismarck” was a term coined seventy years ago after the German battleship Bismarck was unleashed against British vessels in the Atlantic Ocean.  The world watched in fear as the Bismarck, only five days into its voyage, needed only five shots to sink the 41,000 ton British flagship H.M.S. Hood in three minutes.

A fortnight later with nearly the entire British navy in pursuit, the Bismarck prepared for its next fight, a fight it was prepared to win using state-of-the-art science and technology incorporated into the ship by German designers and scientists; technology more advanced than anything any navy had ever possessed.

Still jubilant over the sinking the British Hood is it any wonder that as German naval officers anxiously prepared their war machine to send the rest of the British navy to the bottom of the Atlantic Ocean.  Yet the German designers’ forecasts were doomed.  The Bismarck design was prepared based on forecasts to fight British aircraft flying at 400 miles per hour at 5,000 feet in the air; only the fastest aircraft would dare attack the Bismarck.  The German designers obedient to the planning forecasts dutifully protected the Bismarck with weapons to obliterate such an aerial foe.

Conventional wisdom proves inaccurate

Bismarck’s advanced design allowed for it to make quick work of destroying the best British aircraft during an attack.  But the German did not expect to fight the “worst” British aircraft.  For the aircraft attacking the Bismarck on that fateful day flew too slow to be destroyed by the German guns which fired at a rate to hit enemy planes flying at 400 mph.  Moreover, the Bismarck’s guns were unable to depress to fire on planes flying at wave-top levels, the forecasts assumed the attacking aircraft would descend from several thousand feet.

So it was.  One torpedo dropped from a slow, low-flying British “Swordfish” aircraft paralyzed the mighty Bismarck by disabling its rudder and thus sealing Bismarck’s fate.

Joe DiMaggio and the taxi cab driver – market timing. 3 of 5

With his record 56 game hitting streak on the line, New York Yankee slugger Joe DiMaggio hailed a taxi to his 57th game at the Cleveland Municipal Stadium.  While enroute to the stadium, the cabbie told DiMaggio he predicted DiMaggio would go hitless that afternoon thus ending his streak.  Upon hearing this, DiMaggio pulled himself out of the cab and walked the rest of the way to the stadium.  But the damage was done; the cabbie’s prediction came true.  DiMaggio went hitless that afternoon and one of baseball’s greatest winning streaks came to an end.

Today’s winning streak in the investment markets – ten years and running – is currently held by market timing.  Since 2000, investors who employ market timing strategies have enjoyed returns trouncing buy-and-hold, rebalance and momentum investors’ returns. (see http://arlingtonhall.com/and-the-winnah-is%e2%80%a6). 

In the third part of a series, we examine the question for investors entering 2011:

Will market timing’s win streak continue or will the “predictions” of another crash end the streak?

 

We are inclined to believe market timing’s performance from 2010-2020 may not crumble but instead may be blunted for the following reasons:

First, the “taxi cab driver predictions” abound.  Investment pundits regularly trumpet the imminent end of the market rebound.  We wonder if their predictions may become a self fulfilling prophesy. At times over the past six months, we find ourselves unable to find a single positive news story for the stock market; we scan several hundred daily.

Second, market timing’s growing popularity among investors may undermine its strength.  That is, market timing permitted investors to sidestep the devastating blow of that crippled many other investors’ portfolios during the 2008-09 financial crisis.  Consequently, investors, swayed by this past decade of success, increasingly implement market timing and too many disciples of one investment strategy tend to lead to disappointing outcomes based on our research.

Third, the proliferation of high-speed computer trading shortens the time window of opportunity in which market timers may react.  History suggests that when a manual activity meets new technology designed to replace that manual activity it is the manual activity that tends to succumb to the new technology.

In conclusion, we suggest investors may consider using a market timing strategy according to his or her risk profile prepared by their advisor.  However, those wishing to allocate 100% of their assets to market timing should beware the consequences of “buying high.”  Ask your investment advisor about complementing market timing with other investment strategies some of which we write of in this blog.

Atomic Rome is what our grandmother called the United States. 2 of 5

A recent blog painted the picture that was the economic decline of the Roman Empire.  The eye-opening chronology reminds us of the decay that can accompany Imperial Decline.  Lowered standard of living is our vote for the inescapable result of uninterrupted economic weakness.

The idea to compare The Roman Empire to the United States is credited to our grandmother.  As early as 1960, she began calling the United States “Atomic Rome.”  Decades later, her clever observation grows in importance.

In this second part of a five part series, fixed income and growth strategies are tested amidst economic decline.

After reading of the decline of Rome, it would not be unexpected for an investor to instruct his or her investment advisor to act with the utmost caution until further notice in the “Atomic Rome” economy; duck and cover as it were.  Naturally, bond investments would be at the top of the cautionary wish list.

The picture is worth the proverbial thousand words.

Ah, the tranquility of that purple-colored line’s trajectory from 2005 through 2010!  Bond investments (depicted as the purple “buy yield” line) anchored an investment portfolio that thrashed most other investment indexes about over the past five years.  For an investor who must avoid any or all volatility for any reason, bonds and other fixed income investments are integral portfolio ingredients. 

At the same time we believe in the likelihood that bond investors may have less principal in five or six years hence as inflation whittles away the bond’s principal.  If an investor is interested in shooting for any capital gains in their portfolio, other investments must be considered.

Adding growth investments to the mix leaves us with the “forward valuation” thick lime green-colored line below.  Although the growth investor suffers to the tune of being down ~22% in 2008-09 vis-à-vis the “buy yield” portfolio, the growth portfolio outperforms over a longer timeframe.

During the test period, the forward valuation outperforms most indexes save emerging markets.  Recall we inserted the best performing index – emerging markets index – with the benefit of 20/20 hindsight vision.  The purpose was to compare our trial balloons against the best investment available.

Our next blog will examine some less conventional portfolio strategies for “Atomic Rome” investors.