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

 

 

 

 

Ventures in Constructing an All-Weather Investment Portfolio

In an attempt to prepare investment portfolios for any one of a host of future economic environments we may find ourselves, consider three models:

(I) Canary in a Coal Mine investment model

In a word, this model was designed to help adjust to the future potential of a 1970’s like stagflation (slow/no growth with inflation).  This model is by no means a foolproof method of investing in all environments.  However it was one of the indicators we found that first signaled a shift out of bonds after a period of market turbulence in the mid- to late-1970s.  We know that as the 1970’s wore on, interest rates increased driving down bond prices.  The result was a period of stock out performance.  The indicator has added support as today’s fair valuations of investments suggest stocks may outperform bonds on a real basis over the next market cycle.

At the time of this post, the indicator suggests investing in stocks.

Here is a graphic depiction of the indicator from 1970-1981 compared to stock and bond index prices.

(II) Sector Selector investment model

After the canary in a coal mine indicator would suggest an investment move, look next to the sector selector.  This indicator compares different sectors of the market in order to determine whether to invest.

The three blue arrows on the chart below highlight time frames where the sector selector suggested slow growth or recessionary conditions.  Again it is not fool proof but has a respectable record of cautioning for a future recession.  The two most recent recessions are depicted on the graph as well as a current indicator that suggests slow growth/recession could be ahead.

At the time of this post, the indicator suggests recessionary conditions ahead.

(III) Flying Under the Radar investment model

A final model aims to add additional growth to the previous models when warranted.  The flying under the radar model is more volatile and therefore requires gauges to suggest when to buy and sell.  The gauge we employ is: investor confidence.

The graph depicts modeled hypothetical portfolio growth over time.  More importantly, entry and exits points are noted with an “O” when investors are believed to have maximum optimism and a “U” when they display minimum confidence (or under confidence).

At the time of this post, the model suggests holding investments; the gauge is neither at a peak nor a trough.  A trough developed on August 24, 2011 [designated by the rightmost black-colored “U” in the graph below]; a suggested date to “buy” the portfolio.  More specifically as the red investor confidence line approaches a peak, long term investors should wait to invest new funds or hold funds until a new confidence trough materializes and aggressive investors may consider selling positions until a new confidence trough appears.

Again, not perfect timing necessarily.  However by combining more than one market gauge, we submit investors are better suited to navigate whatever climate our economy should deliver.

The aforementioned material is not meant to be construed as specific investment advice for a specific investment portfolio.  That would be a foolish interpretation.  Instead, each investor should consult his/her investment advisor for advice as to how to invest based on their specific investment profile.

Moreover as each graph title implies, these results are not meant to guarantee future returns.  Rather they are the fruits of many hours of research in which we discarded over 100 other investment models/indicators as either unsuitable and/or ineffective in the present market.  The presentation of this material is a research opinion not unmistakable proof.

 

“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

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.