The Market: What We Found Works and Why at Arlington Hall

 

Hello I am the Future Nametag Sticker Change

Executive Summary:

Amidst a flurry of recent news calling the investment market “rigged”*, you should know what our work finds effective and what is not effective in the investment markets, rigged or not. Whether you believe a best-selling author’s claim that a small group of traders use computer trading programs to “rig” the market or if you believe that the central command economy of the U.S. Federal Reserve has turned the stock market into a “casino”, there are three changes that an investor must understand for his or her investment portfolio to thrive if our work is correct.

(1) It is different this time – our work reviewing market and academic research found over 70% of the investment models and investment tools available to use by investors and investment managers prior to 2012 prove useless in the current market. If you lean on convention as we found, expect your investments to perform below expectations.

(2) If you use only those investment tools that continue to show usefulness in building attractive investment portfolios, our work demonstrates you could have the potential to beat the S&P 500 stock index over 99% of the time and over 94% of the time after paying taxes.

(3) Yet even if we could have built an investment portfolio for you using an investment model that beat the S&P 500 index, it may be the wrong course of action for you. More specifically, our work indicates the S&P 500 stock index may be only the 7th best investment choice of all the investment categories we track for the upcoming market cycle. Consequently, an investor must be prepared to use (a) these newly-discovered useful tools (b) in those investments that are valued to gain the most in the coming market cycle (5-7 years).

We suggest two areas for investors to consider: growth and income.

(3a) What we found works is: constant attention to test and re-test the usefulness of your investment strategies to adapt to the complexity of the investment market.

 

Expanded commentary:

In late 2011 and 2012 as computer-based trading and Federal Reserve actions exerted a greater dominance on the investment market, our portfolio’s performance began to underperform our standards that we had set for ourselves. Our first stop was to question the strength of our investment design that included tools and conventional strategies — some in use since the mid-1990s. Subsequently, a review of rigorous testing of over 400 investment models was made. The results were as follows: only 96 demonstrated any use in our new market, 20 showed some use but were losing effectiveness and we found 319 to be of no use.

 

20140505 image test 435 investment models for usefulness jpg

Moved to action by these findings, those tools and models we found to be effective were put to work and two upgraded investment models were built in mid-2012 (one based on investment reports produced by a third-party and one based on investment reports available to the general investing public).

The upgraded testing results exceeded our expectations. The model based on reports produced by the third party out-performed the S&P 500 stock index 99% of the time during the test period and 94% of the time after reducing the return to pay for taxes (to simulate investments made in a taxable account).  More detail on this can be found at the end of this memo (Addendum A)

After reading these test results, an investor may be inclined to (1) be elated with these results, (2) consider preparing a list of these “winning” stocks to buy and (3) expect to out perform the S&P 500 index ad infinitum. Not so fast, my friend…

It is true these encouraging results warrant attention and indeed these stocks now make up a larger piece of the portfolios we manage. However, we must look to the future. Past performance, as we know, is no guarantee of future results and the future requires we look to other investments outside of just the S&P 500 stock index. To be sure, a number of earnings and profit-based forecasts** suggest the S&P 500 index may have a lower likelihood of being the top performing investment for the next market cycle. (Addendum B)

Investment in stocks and bonds outside the U.S. and hard assets are therefore the focus of our current work to complement our U.S.–based S&P 500 investing. Putting money to work in investments outside the U.S. requires a different approach than investments inside the U.S. Lower trading volumes and trading on different exchanges around the world for example require U.S. stock models to be modified. Have you ever tried to buy a stock on the Korean exchange?  Our growth model adds international stocks and Exchange-traded Funds (ETFs) to our U.S. stocks mentioned above. Our income model uses a blend of U.S. income securities and bonds as well as international bonds to complement the growth model.

Conclusion: For one reason or another, the market appears to have evolved (or “adapted”) rendering a great many investment models and tools obsolete if our work is correct. Make sure you or your financial advisor subject your investment strategies to rigorous testing to determine if they remain effective. We have heard of financial advisors using very dated rationale for the investment of their client’s funds.  Do so at your own peril.  Be diligent and adapt with useful strategies. We have demonstrated the potential for investing to meet or beat the S&P 500 stock index and have begun investing in areas outside the S&P 500 index to capture growth expected to occur outside the U.S. over the next seven years. Updates will be provided in this space periodically.

*Rigged -an unfair advantage is given to one side of an investment trade

**Hussman, Wells, Grantham, et al.

 

ADDENDUM A

In order to avoid showing test results made attractive by data mining and/or survivor bias, what follows is an illustration of randomly chosen purchase dates and sales dates. Therefore purchase dates and sales dates have no discernible pattern in an effort to put additional rigor into our test of the investment models.

 2012 Test sample results

 FOR ILLUSTRATION PURPOSES ONLY: DO NOT BUY THESE STOCKS TODAY BECAUSE THEY ARE ON THIS LIST. THE DATES TO PURCHASE THESE STOCKS WERE AT A SPECIFIC TIME WHEN THEY WERE DEEMED ATTRACTIVE. THEY MAY NOT BE ATTRACTIVE TODAY. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

October 9, 2012

Number of holdings:

16 (commission cost: ~$143 ($8.95×16))

Holdings:

CRDN, CTB, CYD, DAL, HDB, HOGS, IBN, KB, KKD, LGND, PC, RDC, REGI, RIG, RNDY, TA

Hypothetical return greater than S&P500 before tax

Hypothetical return greater than S&P 500 after tax

 

October 19, 2012

Number of holdings:

6 (commission cost: $54)

Holdings:

AVT, EZPW, MUSA, OLN, STLD, TYC

Hypothetical return greater than S&P500 before tax

Hypothetical return greater than S&P 500 after tax

 

November 13, 2012

Number of holdings:

11 (commission cost: $99)

Holdings:

ANW, DAL, GT, HA, HMC, HXM, LCC, RJET, VLKAY, WDC, ZAGG

Hypothetical return greater than S&P500 before tax

Hypothetical return greater than S&P 500 after tax

 

December 17, 2012

Number of holdings:

6 (commission cost: $54)

Holdings:

ANW, DAL, FRX, GT, HA, LCC

Hypothetical return greater than S&P500 before tax

Hypothetical return greater than S&P 500 after tax

FOR ILLUSTRATION PURPOSES ONLY: DO NOT BUY THESE STOCKS TODAY BECAUSE THEY ARE ON THIS LIST. THE DATES TO PURCHASE THESE STOCKS WERE AT A SPECIFIC TIME WHEN THEY WERE DEEMED ATTRACTIVE. THEY MAY NOT BE ATTRACTIVE TODAY. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

  2013 Test sample results

through June 6, 2013

 FOR ILLUSTRATION PURPOSES ONLY: DO NOT BUY THESE STOCKS TODAY BECAUSE THEY ARE ON THIS LIST. THE DATES TO PURCHASE THESE STOCKS WERE AT A SPECIFIC TIME WHEN THEY WERE DEEMED ATTRACTIVE. THEY MAY NOT BE ATTRACTIVE TODAY. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

 November 12, 2012

Number of holdings:

9 (commission cost: $81)

Holdings:

APFC, FBIZ, NSIT, CASH, RGA, SANM, STRT, UNTD, WCRX

Hypothetical return: 39.7%

S&P 500 return: 19.1%

 

February 27, 2013

Number of holdings:

5 (commission cost: $45)

Holdings:

AEL, FBP, PRU, WDC, XRX

Hypothetical return: 19%

S&P 500 return: 9%

 

March 21, 2013

Number of holdings:

4 (commission cost: $36)

Holdings:

AEL, NNBR, PRU, WDC

Hypothetical return: 20.9%

S&P 500 return: 4.5%

 2013 Test sample results

through December 19, 2013

 FOR ILLUSTRATION PURPOSES ONLY: DO NOT BUY THESE STOCKS TODAY BECAUSE THEY ARE ON THIS LIST. THE DATES TO PURCHASE THESE STOCKS WERE AT A SPECIFIC TIME WHEN THEY WERE DEEMED ATTRACTIVE. THEY MAY NOT BE ATTRACTIVE TODAY. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

 June 6, 2013

Number of holdings:

3 (commission cost: $27)

Holdings:

HPQ, RJET, VOXX

Hypothetical return: 20.16%

S&P 500 return: 13.69%

 

September 19, 2013

Number of holdings:

8 (commission cost: $72)

Holdings:

SCOR, HPQ, ORRF, RJET, GTS, TPC, UAL, UIHC

Hypothetical return: 7.54%

S&P 500 return: 5.39%

 

FOR ILLUSTRATION PURPOSES ONLY: DO NOT BUY THESE STOCKS TODAY BECAUSE THEY ARE ON THIS LIST. THE DATES TO PURCHASE THESE STOCKS WERE AT A SPECIFIC TIME WHEN THEY WERE DEEMED ATTRACTIVE. THEY MAY NOT BE ATTRACTIVE TODAY. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

 

ADDENDUM B

 

Possible ranking of best investment value based on earnings and profit reversion:

 

1. Hard assets

2. Emerging market stocks

3. Emerging market bonds

4. International stocks

5. U.S. Global stocks

6. TIPs

7. S&P 500 Stocks