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

The concept of core satellite portfolio construction has been adopted for several years by many investment and wealth managers. The EDHEC has collected several papers detailing this concept. ValidFi has maintained a so called Simple Core Satellite Portoflios strategy to show case this concept. In this article, we will discuss the effectiveness of combining simple timing and passive allocation to achieve better risk adjusted returns.

The key idea behind the core satellite portfolios is that, while the traditional passive (buy and hold) strategic asset allocation is suited for long term investment, the short term or intermediate term risk is too much for an ordinary investor to bear with. A portfolio with over 20% peak to trough drawdown (i.e. loss) is probably the maximum for many investors. On the other hand, an actively managed portfolio, while reducing short term risks, could suffer from a stream of short term loss. For example, a moving average based equity portfolio buys into the stock market when the stock market index such as S&P 500 index SPY rises above its 200 days moving average and sells out of the market when the index drops below the 200 days moving average. This strategy works well to protect capital during severe market downturns such as 2008's but it could suffer from loss when markets whip saw in a side way fashion. Furthermore, it could forgo a significant portion of profits when markets rise from depressed low levels. The following table illustrates correlations between the two strategies:

	Early Bull	Late Bull	Bear	Side Way
Passive Buy and Hold	Good	Good	Bad	OK
Moving Average Timing	Miss	Good	Good	Bad

Apparently, these two strategies complement to each other in various market or economic cycles. Furthermore, both strategies have exhibited good long term average returns. Combining these two strategies in a portfolio should be able to maintain the long term return while reducing the risk or smoothing out the return curve.

We employed ValidFi's portfolio tool to construct core satellite portfolios based on the above two strategies. The following are three such portfolios that ValidFi now lively monitors.

	Buy and Hold Equity	Fixed Income (Total Bond Market Index)	200 Days Simple Moving Average Equity (Satellite)
75% Stocks and 25% Bonds Buy and Hold	75%	25%	0%
30% Stocks and 40% Bonds and 30% Satellite Timing Equity	30%	40%	30%
25% Stocks and 25% Bonds and 50% Satellite Timing Equity	25%	25%	50%

The first two columns combined represent the core part of a portfolio and the last column represents the satellite (actively managed) part of a portfolio. For the stock investment, Vanguard 500 index VFINX (ETF equivalent SPY) is used and for the fixed income part, Vanguard Totoal Bond Market Index VBMFX (ETF equivalent AGG) is used.

The following table shows the characteristics of the portfolios from a period 6/30/1988 to 12/7/2009.

	Last 1 Years	Last 3 Years	Last 5 Years	Since 6/30/1988
Annualized Return 75% Stocks and 25% Bonds Buy and Hold	24.3%	-1.98%	2.42%	8.2%
Annualized Return 30% Stocks and 40% Bonds and 30% Satellite Timing Equity	19%	4.3%	5.7%	8.9%
Annualized Return 25% Stocks and 25% Bonds and 50% Satellite Timing Equity	20.3%	5.4%	6.7%	9.5%
Max. Drawdown 75% Stocks and 25% Bonds Buy and Hold	20.8%	42.4%	42.4%	42.4%
Max. Drawdown 30% Stocks and 40% Bonds and 30% Satellite Timing Equity	8.75%	17.7%	17.7%	17.7%
Max. Drawdown 25% Stocks and 25% Bonds and 50% Satellite Timing Equity	7.2%	16.3%	16.3%	16.3%

It is evident that core satellite portfolios not only enhanced returns (from 0.7% to 1.3% annually) but also reduced the maximum drawdown (risk) dramatically. The buy and hold portfolio had gut wrenching 42% maximum drawdown which, we suspect, very few investors had stomachs to tolerate. 

The above is a simple example to utilize ValidFi's portfolio platform to construct, study and monitor composite portfolios. For investors who desire to have more diversification over various assets and strategies, such a platform could be handy.

Labels: AGG, Portfolio_7355, Portfolio_7357, Portfolio_7359, SPY, Strategy_374, VBMFX, VFINX, VTI

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