ValidFi News and Articles

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

 (Correction: this article is corrected version from the previous one published on 10/23/2009. In the previous artilce, we used nominal PE10 instead of real PE 10, that resulted in higher PE10 ratio, which is incorrect).
Yale Professor Robert Shiller has devised and maintained a so called "Cyclically Adjusted Price Earning Ratio" (CAPE10) as an alternative to the popular PE ratio to value the US stock market. CAPE10 is defined as the ratio of price to the average of last 10 year trailing S&P 500 annual earnings. In his now famous book titled as "Irrational Exuberance", Shiller popularized this ratio as a long term stock market valuation metric.  As it stands on last Friday October 30, 2009, the current CAPE10 is 18.88 while the long term average CAPE10 (since year 1881) is 16.38. This implies that the current US stock market is 16% over valued.

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 metric, ValidFi implements and maintains a live strategy called Shiller Cyclically Adjusted PE 10 Stock Market Timing Strategy. One of its model portfolios buys stocks only when this ratio is deemed to be significantly under valued (the current CAPE10 is 33% lower than the long term CAPE10 average) and goes into cash when such as ratio signals significant over valued (if the current CAPE10 is 50% higher than its long term average). The stock market exposure is through buying Wilshire 5000 total return index (^DWC).

From 12/31/1970 to 11/2/2009, the weekly adjusted portfolio achieves 6.8% annualized return and standard deviation 11.9% compared with Wilshire 5000 total return's annualized return 6.77% and standard deviation 19.5%.  Such a portfolio was in cash from 5/12/1995 all the way to 2/20/2009! See the following chart:




It is hard to believe that an average investor would have such patience to stay out of the stock market for such a long time, especially during the bull markets. However, a prudent investor would utilize such an indicator to carefully manage the risk during over valued periods.

Some readers might ask that since Shiller's indicator is a long term indicator, what strategies one could use during the long time periods when it is out of stock market. We will have follow up articles on how to combine such a long term indicator and some safe strategies to achieve safe and more reasonable returns.

Interested readers could find the up to date information of both Shiller and Buffett indicators on ValidFi's 360 Degree Market View page.

Labels: ^DWC, BWX, CFT, EEM, EFA, IWM, MDY, Portfolio_7018, SPY, Strategy_629, TLT, VFINX, VTSMX

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