ValidFi News and Articles

John Hussman's weekly comment on 12/14/2009: Any virtue of stocks here is decidedly speculative. Stocks are overvalued to a level from which uninspiring returns have always followed. That fact is true regardless of whether or not the economy is in a sustainable recovery. More detailed here. Hussman has been negative since September this year. Recently, however, he has adopted a slight speculative stance on US stock market through call option exposure. Based on his commentary and our estimate here, the stock exposure beta of Hussman Strategic Growth Fund HSGFX is less than 10%. The following are some key points from his above commentary.

• S&P historical return: Using Barsky-Delong model, to achieve annual real return of 4.2%, the S&P would need to be at 810. Or putting it the other way, Hussman stated that "the conclusion is not that stocks must decline immediately, but rather, that long-term total returns for the S&P 500 are likely to be less than 4.2% after inflation." "Alternatively, on the assumption that future growth rates match what we've observed over the past two decades and indeed over most of the past century, an expected long-term total return of 10% for the S&P 500 (what investors generally carry in their heads as the 'typical'long-term return on stocks) would currently be consistent with an index level of 672".
  
• 'Second wave' concerns begin to appear: Hussman has been warning that the second wave of housing credit crunching (the mortgage reset) is approaching the peak at this moment. He quoted Meredith Whitney's interview on CNBC which was very negative on the outlook of 2010: "which is so disturbing on so many levels to have so many Americans be kicked out of the financial system, and the consequence both political and economic of that is a real issue you can't get around. It's never happened before in this country or in the modern economy. The biggest trend in 2010 will be seeing who gets kicked out of the banking system."

So the question is whether the banks could withstand the upcoming credit loss, even with their newly raised equity from public markets this year. Furthermore, with the bailout in effect, how much the banks could shift the loss to the government, i.e. tax payers. Based on the 'stealth stimulus' theory reported by Wall Street Journal, consumers are foreclosing homes and freeing their cash flow to 'stimulate' the economy. Thus consumers -> banks -> taxpayers flow will do a 'stealth' wealth redistribution with 'banks' being intact!

Any way you put it, we are definitely at a situation with many potential landmines. The best approach at this moment is to rebalance your portfolio's asset allocation back to a risk level you could tolerate (remember 2008?) and then stick to the strategies/plans you have chosen.

Labels: AGG, IWM, NAESX, SPY, VBMFX, VFINX

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

Mark Hulbert recently published a story on marketwatch.com: Hybrid Halloween Indicators. The original Halloween indicator (or sometimes called "sell in May and go away") has been studied extensively. In his story, Hulbert mentioned a research paper published in 2002 in his article. The paper found that most stock markets around the globe indeed exhibited such abnormality: "sell in  early May and buy in late October" could achieve excessive risk adjusted return.
The improved strategy proposed by Sy Harding (detailed description could be found here and here) issued a buy signal on Friday Oct. 16, 2009. This strategy uses MACD to further pinpoint the buy/sell dates around April and October time frames. It is pertinent to compare such a strategy with the original strategy as well as with the buy and hold strategy at this time.
The "original" strategy dictates that one sell on April 26th and buy on October 16th. The following table compared the performance of the three strategies from 7/1/1971 to 10/16/2009. All of them use Wilshire 5000 total return index as the proxy to the stock market investment and use 13 week treasury bill as the cash when they are out of the stock market.

	Since 1971	Last 5 Years	Last 3 Years	Last 1 Year
AR (%) Original	7.769	2.544	-1.938	-7.138
AR (%) Improved	8.236	2.696	1.364	3.777
AR (%) Wilshire 5000	6.733	0.693	-6.55	17.488
Sharpe (%) Original	28.915	3.211	-15.331	-20.388
Sharpe (%) Improved	38.481	5.097	-1.172	14.826
Sharpe (%) Wilshire 5000	16.064	-5.257	-27.383	45.033
Max. Drawdown (%) Original	35.107	35.107	35.107	32.114
Max. Drawdown (%) Improved	33.073	33.073	33.073	27.306
Max. Drawdown (%) Wilshire 5000	56.645	56.645	56.645	32.13

From the table, one could see that the "improved" strategy does the best in terms of overall return and risk. Overall, one could clearly see that both "original" and "improved" strategies have outperformed the buy and hold strategy.



From the above graph, we could see that the "improved" strategy waited till the end of 2008 to get into the stock market, thus sidestepping some loss that the "original" strategy incurred during the October to December time frame. Unfortunately, both of them suffered a great deal from the March steep decline.  This is a clear reminder that such strategies are not fool proof and they are still subject to stock market's big swing.
Given the steep run-up of the stock market so far, a favorable seasonality backdrop should be treated just as a backdrop: one should not blindly follow the strategy alone but instead, taking such a statistical evidence into consideration during your portfolio management such as portfolio rebalancing.

Labels: ^DWC, IWM, NAESX, Portfolio_3444, Portfolio_6869, SPY, Strategy_480, VFINX, VTI, VTSMX