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Inflation and deflation are the two most important factors for a well designed wealth management investment strategy. Inflation destroys the long term purchasing power while deflation reduces the effectiveness of the capitalism's basic profit machine. A well designed long term strategy thus needs to have a well balanced hedge in both economic cycles. Harry Browne's permanent portfolio is designed over various major asset classes to tackle this problem. A more actively managed strategy is Doug Roberts' Follow the Fed Strategy. In this article, we will discuss this well balanced strategy ValidFi maintains in some detail.

This strategy is simply based on the fed monetary policy to follow the Fed. Research shows that big caps behave better than small caps when money is tight while small caps outperform big caps when money is easy. Similar relationship is also found in gold and Treasury bonds. Gold is doing better than Treasury bonds when the Fed's money policy is easy, and vice versa. Switching between large and small stocks, gold and Treasury bonds depends on the Fed's monetary policy.

To lower the risk still further, simple intermediate government notes are added to the portfolio. Thus this strategy allocates assets equally among large/small stocks, gold/Treasury bonds and intermediate government notes.

1. Determine whether money is tight or easy

• The indicator we use is T-bill -12 month  value minus Inflation - 12 month value, as described in the Barrons' articles. If the former is larger than the latter, then Fed's money policy is tight.
  
• The T-bill - 12m is the trailing 12 - month compound return using the last twelve monthly T - bill's values.
  
• Similarly the Inflation -12m measures the trailing 12-month compound return using the last 12- month inflation values. Inflation is calculated as the change in CPI index between this month and last month divided by last month's CPI index.
  
• We can also compare the above indicator value with the 64-day simple moving average value of the indicator. If the former is larger than the latter, then the Fed's tight, and vice versa.

2. Portfolios
A conservative model portfolio would be simply allocating 1/3 each to large/small cap equity,  gold/long term treasury and intermediate treasury notes.

• If money is tight, the portfolio is composed of:
  
  
  • 33.33% in large stocks
    
  • 33.33% in Treasury bonds
    
  • 33.33% in intermediate treasury notes
    
  
  
  
• If money is easy, the portfolio is made up of:
  
  
  • 33.33% in small stocks
    
  • 33.33% in gold
    
  • 33.33% in intermediate treasury notes
  
  

3.  Switching frequency
The strategy adjusts portfolios every month according to the money status.

• If short-term T-bill rate remains higher/lower than inflation, no adjustment is made to the portfolio because money remains tight/easy.
  
• Similarly, if the indicator value stays above/below 0, or it's higher/lower than the 64-day simple moving average value of the indicator, no adjustment needs to be done to the portfolio.
  
• However, if the money status changes, for example, money is tight right now while it was easy last time, investors must adjust the portfolio accordingly. In this case, portfolios should be switched to the other type so that investors can achieve higher returns while remaining lower risks.

We have found that using the 64-day simple moving average performs much better than  simply basing on whether the indicator's value is positive or negative.

The following table compares the performance between the conservative portfolio and the permanent portfolio (PRPFX) from 1/1/1997 to 11/27/2009.

	Last 1 Years	Last 3 Years	Last 5 Years	Since 1/1/97 to 11/27/09
Roberts Portfolio Annualized Return	22.3%	7.4%	9.4%	9.9%
PRPFX Annualized Return	28.7%	7.3%	8.5%	8.46%
Roberts Portfolio Sharpe Ratio	1.7	0.5	0.68	0.77
PRPFX Sharpe Ratio	1.66	0.41	0.54	0.65

Doug Roberts' strategy is one of those well balanced long term strategies adopted by wealth managers to preserve capital and purchasing power while achieving reasonable growth. At the moment, the strategy decides that "money is easy" (which is obviously true) and invests in both small cap and gold.

Labels: GLD, IEF, IWM, NAESX, Portfolio_5667, PRPFX, SPY, Strategy_582, TLT, VFINX, VFITX, VUSTX

What? Are you Madoff? These days, anything related to 'low risk' or 'steady' returns generates skepticism. It is very understandable and perfectly reasonable for investors to have such a feeling, given what have happened in the financial industries.

However, if an investor does follow sound and safe investment principles consistently and disciplinarily, yes, Virginia, there is a hope! In the following, we will show how one could achieve a 10% return in the past 9 years by simply incorporating Buffett or Shiller long term stock market timing indicators in your investing.
The idea is simply that, when the stock market is significantly undervalued, one should fully invest in the stock market; when the stock market is significantly overvalued, one should sell the stocks and fully invest in bonds using some fixed income strategies. The proxy to invest in stock market is Wilshire 500 total return index while the strategies for fixed income investment are Alpha Dynamics for Multi Sector Bonds. This strategy evaluates 32 multi-sector bond mutual funds every quarter based on their trailing one year's Alphas and then select top 3 three funds for next quarter investment. The quarterly rebalancing frequency allows investors to avoid the short term redemption fee charged by brokerages or fund companies. It switches to Cash (13 week treasury bill) when none of the funds has positive 1 year alpha.

The following table illustrates the performances for the two portfolios from 12/31/2000 to 11/20/2009.

	Annualized Return	Standard Deviation	Maximum Drawdown
Buffett Indicator based Bond as Cash	12.73%	1.21	11%
Shiller Indicator based Bond As Cash	10.38%	11.1%	20%
Wilshire 5000 Total Return	-0.58%	22.2%	56.6%

A portfolio with much longer history (from 12/31/1990 to 11/20/2009) using Shiller's metric and alpha based high yield bond fund quarterly switch strategy shows a similar result (9.75% annualized return).

The above are just some of examples to show that if one is patient enough and avoids the hype in a long term period, he/she will be rewarded with  low risk reasonable returns.

Labels: ^DWC, BWX, CFT, EEM, EFA, IWM, MDY, Portfolio_6961, Portfolio_7145, Portfolio_7259, Portfolio_7261, SPY, Strategy_613, Strategy_629, Strategy_638, TLT, VFINX, VTSMX

John Hussman, manager of Hussman Strategy Growth Fund (HSGFX) proposed price to peak 10 year average earnings as a long term stock market valuation gauge. Compared with the normal one year price to earning ratio, Price to Peak Earnings would eliminate short term noise. This is similar to Shiller's Cyclically Adjusted Price Earning ratio (CAPE10) and Warren Buffett's stock market GNP/GDP metric. In his weekly commentary on Dec 5, 2005, titled as 'Earnings Revert to the Mean, Stocks Will Struggle', he proposed a simplistic method: "buy when Price to Peak Earnings is lower than 15 and sell when it exceeds 19.5". John Hussman has been using this as the valuation yardstick to manage the Hussman Strategic Growth Fund HSGFX.
It is interesting to examine how effective using such a metric as a long term stock market timing indicator. Similar to the Warren Buffett's stock market GNP/GDP metric and Shiller's CAPE, the following strategy characterizes the stock market valuation into the following five categories based on the ratio of the current Peak PEs to the long term average Peak PEs:

• Significantly Overvalued (SO): such as if the ratio >= 150%
  
• Modestly Overvalued (MO): such as if   117% <=  ratio < 150%
  
• Fairly Valued (FV): such as if 83% <= ratio < 117%
  
• Modestly Undervalued (MU): such as if 67% <= ratio < 83%
  
• Significantly Undervalued (SU): such as if ratio < 67%

These five categories are determined by four valuation parameters (such as 150%, 117%, 83% and 67% in the above). At each rebalancing (adjusting) period (such as weekly or monthly), the strategy decides at what region the US stock market valuation is and then does the following rebalancing:

• SO: 0% in stock, 100% in cash.
  
• MO: 25% in stock, 75% in cash.
  
• FV: 50% in stock, 50% in cash
  
• MU: 75% in stock, 25% in cash
  
• SU: 100% in stock, 0% in cash

The stock market exposure is through buying Wilshire 5000 total return index (^DWC) or it could be set by users. Users could adjust the valuation parameters to get an effect like only buying at significantly undervalued (SU) level and selling at significantly overvalued (SO) level. Some of model portfolios of this strategy are:

• SO: >=150%, MO: [117%, 150%), FV: [83%, 117%), MU: [67%, 83%), SU: <67%
  
• SO: >=150%, MO, FV, MU: [67%, 150%), SU: <67%

A model portfolio called P Hussman Peak PE Market Timing Strategy Buy 15 Sell 19.5 Weekly is also maintained to live monitor the strategy suggested in 'Earnings Revert to the Mean, Stocks Will Struggle'.
The following table compares the performance of the three long term stock market indicators. All of the portfolios are based on 'buy at significantly undervalued and sell at significantly overvalued' strategy.

	12/31/1970 to 11/13/2009
Buffet GNP Metric Annualized Return	9.74%
Shiller CAPE10 Annualized Return	6.9%
Hussman Peak PE Annualized Return	8.02%
Wiilshire 5000 Total Return Annualized Return	6.9%
Buffet GNP Metric Sharpe Ratio	0.53
Shiller CAPE10 Sharpe Ratio	0.25
Hussman Peak PE Sharpe Ratio	0.33
Wilshire 5000 Total Return Sharpe Ratio	0.15

All of the strategies have achieved better returns and much higher Sharpe ratios compared with Wilshire 5000 total return index.

On Friday 11/13/2009, Both Buffett and Hussman metrics indicated the market was fairly valued: Buffet Total Stock Market Valuation to GNP ratio was 78.6% while Hussman's Peak PE10 to the long term Peak PE10 average was 1.04 (current peak PE 10 was 12.4 and the long term average was 11.9). Shiller CAPE10 to its long term average indicates the market was 22% overvalued.  It should be noted that John Hussman has been very cautious recently, pointing out the uniqueness of the current economic situation. Interested readers should read his latest weekly commentary here.

Labels: ^DWC, BWX, CFT, EEM, EFA, IWM, MDY, Portfolio_7145, SPY, Strategy_613, Strategy_629, Strategy_638, TLT, VFINX, VTSMX

It is well recognized that asset allocation is perhaps the most important determining factor for investment return and risk. Tracking professional money managers' asset allocations in a timely fashion is thus of great interests. Moreover, being able to track timely smart pros moves is even better.
Various techniques have been used for this purpose. One of widely followed methods is to track mutual funds monthly money flows. This approach could only give us monthly information, which is not exactly very timely in a fast changing market. A more serious problem with this is that it only could tell us how the investors move money among various assets such as equities, fixed incomes and commodities. It does not really reveal what allocations mutual fund managers are making. Furthermore, this would not give us any information how 'smart' managers are doing.
Some other similar approaches are mostly focused on sentiments. For example, Hulbert Financial Digest has been tracking investment newsletters' bullish/bearish sentiments on equity and gold. Investment newsletters represent a small fraction of the investment opinions. Other well known sentiment indicators include Investors Intelligence's bullish/bearish poll as well as AAII (American Association of Individual Investors) bullish/bearish poll. These indicators offer insights into certain types of investors. They are mostly used as contrarian indicators.
ValidFi recently introduced Pro Money (Asset Allocation) Indicator and Smart Money (Asset Allocation) Indicator. Both indicators track moderate allocation funds' asset exposures US equities and US aggregate bonds. The technique behind these indicators is to derive  timely quantitative asset exposures by directly analyzing a fund's beta exposures for various assets such as US equities and fixed income. The Pro Money Indicator is based on the aggregate asset exposure from majority of US moderate allocation mutual funds (481 funds total). The Smart Money indicator is based on the average exposure among a selected list of top funds. These top funds are selected based on their past risk adjusted returns as well as their consistent performance during market downturns. The indicators are updated weekly.
Using Pro Money and Smart Money Indicators, we create weekly adjusting portfolios separately. The asset allocations of US equities and US bonds (using Vanguard Total Stock Market Index Fund VTSMX and Vanguard Total Bond Index Fund VBMFX as proxies) are derived based on the indicators' allocations. The following table compares these two portfolios and Vanguard Balanced Index Fund VBINX.

	2008	2009	1/1/2008 to 11/5/2009 (Annualized Return)
Smart Money Return	-8.2%	6.48%	-1.23%
Pro Money Return	-19.12%	15.73%	-3.56%
VBINX Return	-22%	14.9%	-5.6%
Smart Money Sharpe	-0.82	0.56	0.7
Pro Money Sharpe	-0.93	0.97	0.8
VBINX Sharpe	-1.05	1	-0.5

From the table, one could see that Pro Money is closely matched to VBINX. This is not surprising as Pro Money is tracking the majority of US balanced funds asset allocation. Arguably, the above table only shows a short history. The model portfolios of strategy Guru Asset Allocation Clone have longer history.  This strategy uses the same technique to arrive at asset allocation decisions. The risk and return of model portfolios like this show the effectiveness of this technique. 
So what are the current Pro and Smart Money allocations? From the following two charts, one could see that the Pro US equity allocation has steadily risen since April until late September.  The Smart Money US equity allocation is somewhat interesting: with a steep rise since July (recall Dow Theory, along with other indicators, gave buy signals during that time), it had a large reduction in early September but immediately increased to around 75%. Also pay special attention to the last week's  (10/26-10/30) allocation changes: instead of reducing the equity allocation along with the general market correction (during the week, VTSMX  dropped 5.6%), the Pro actually slightly increased the equity allocation while Smart Money decreased its equity exposure 9% (from 78.4% to 69.2%)! Call it stubborn bullishness! 

Labels: Portfolio_4406, Strategy_544, VBINX, VBMFX, VTSMX