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Getting Somewhere When The Market Goes Nowhere

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
June 21, 2005

IN THIS ISSUE:

1.   Wall Street’s Biased View Of Active Management

2.   Using Misleading Statistics To Prove Their Point

3.   A More Realistic Analysis

4.   More Experts Jumping On The Active Management Bandwagon

5.   The ProFutures AdvisorLink® Program

Introduction

As I have written over the last year or so, many market analysts, including the editors at the globally respected Bank Credit Analyst, believe that stock market returns will be lower in the next 3-5 years than they have been in the past.  Over the last 75 years, stocks have delivered annual average returns in the 10%-11% range. 

Yet more and more analysts (including BCA) are now predicting that equity returns over the next 3-5 years or longer will only be in the 5%-6% range on average, dividends included.  Put differently, more and more analysts are forecasting a generally sideways market with a slight upward slope for the next several years.  Unfortunately, most analysts agree that overall market volatility will remain at least as high as it is today.  If correct, “buy-and-hold” investors will be earning lower rates of return but with just as much (or even more) risk along the way.

During these sideways markets, active management strategies offer the best potential for absolute returns with reduced risk. Generally speaking “active management strategies” are those with the flexibility to move in and out of the market from time to time, with the goal of increasing returns by avoiding large losses.

For decades, Wall Street types have argued that active management strategies don’t work because it is impossible to “time” the market, which is categorically false.  To try and prove their point, these people use a very misleading set of statistics to convince investors to stick solely with buy-and-hold strategies.  Your broker may have used some version of this misleading argument on you.

This week, I will blow a hole in this longstanding Wall Street misrepresentation and show you precisely why it is so misleading.  I will explain why so many investors fall for this hook-line-and-sinker.   I will also show you precisely how active management strategies can lead to higher potential returns with less risk than buy-and-hold strategies, especially during sideways markets.  So let’s get going.

Wall Street’s Flawed Theory On Active Management

Most large investment firms and brokerage houses have criticized active management strategies for decades (although this is beginning to change).  For years they have claimed that active management strategies either don’t work or don’t generate any higher returns than a buy-and-hold investment, and they carp that active management strategies always result in higher fees.  

They begin their assault on active management strategies by referring to statistics showing average stock market returns in the 10%-11% range over the last 75 years, and infer that investors will get similar results if they just put their money in stocks or mutual funds, buy-and-hold and leave them alone.

What they don’t tell you is that there have been several multi-year periods within that 75 years when the stock markets either went sideways (no returns) or down (bear market losses).  Can you wait 75 years for the market to produce decent returns?  I can’t.

They also don’t point out that even during periods of positive market returns, gains are sometimes minimal.  Two weeks ago, in my June 7 E-Letter, I reprinted a chart which showed that the stock market moved essentially sideways for 16 years from 1966 to 1982.  But brokers don’t like to talk about that!

Purposely Misleading Analysis On Active Management

The most popular argument against active management strategies goes as follows.  1) Historically, much of the stock market’s upward moves are concentrated in a relatively low number of days (which is true).  2) Active management strategies, by design, have you out of the market from time to time (which is true).  3) If you happen to be out of the market on some of the good days, then your returns will suffer dramatically (which is also true). 

Therefore, they conclude that you should always be fully invested (buy-and-hold) so that you will not miss these good days.  Avoid active management strategies that might result in you missing some of the good days.

As usual, Wall Street types have “statistics” to back them up.  Here’s a good example they often like to cite.  Over the 16-year period from April of 1984 through May of 2000, the S&P 500 Index produced an average return of 15.02%.  Then they cite a study that shows if you missed just the 10 best days in the market during that period, your return fell to 11.59%. 

Missing more of the best days means even lower returns.  For example, if you missed the 40 best days in the market, your average return would only have been 5.77%.  Thus, Wall Street reasons, if you want to maximize your returns, you have to stay in the market so that you don’t miss the good days.

While the numbers they quote are accurate, this analysis is obviously skewed to fit the viewpoint of the buy-and-hold crowd.  It is flawed because it assumes that an active management strategy would be out of the market on ALL of the best days.  Many investors never think to question this ridiculous assumption.

But it gets even worse.  This line of reasoning also assumes that an active management strategy would also have you in the market on ALL of the worst days.  Never mind that a good active management strategy is designed to have you out of the market on many of the worst days.

Unfortunately, many investors buy this argument hook-line-and-sinker without thinking to ask the question…

What If You Miss The Bad Days In The Market?

This is a very critical point that Wall Street types almost never mention, so let’s bring it out into the light!

The National Association of Active Investment Managers, Inc. (NAAIM) is a trade association of money managers, including active managers. NAAIM saw the obvious fallacy in the above argument on missing the good days in the market and did further analysis that paints an entirely different picture. 

Their analysis found that while upward moves in the market are concentrated in a relatively few number of days, the converse is also true that downward moves are also concentrated in a relatively few number of days.

Instead of missing the good days in the market, let’s say that an active manager allows you to miss only the worst days in the market.  Using the same data as above from April of 1984 through May of 2000, if you missed just the 10 worst days in the market, your return would have been 20.89% vs. the 15.02% S&P 500 Index return.  Now that’s impressive!  As you increase the number of worst days missed, the numbers get even better, resulting in a return of 28.13% if you missed the worst 40 days in the market over this 16-year period of time.

Of course, this analysis is as flawed as the first one, since it assumes that the Advisor is smart enough to be out of the market on all the worst days, but in the market on all of the best days. 

A More Realistic Analysis

Since both sets of performance numbers discussed above are skewed to fit one approach or the other, neither is useful to the knowledgeable investor.  However, NAAIM continued in their study to see what would happen if an Advisor missed BOTH the best and worst days in the market over the 16-year period discussed above.  The results are pretty amazing. 

If you missed the 10 best AND 10 worst days in the market, the resulting return would have been 17.29%, as compared to the 15.02% S&P 500 Index return.

As the number of best and worst days missed is increased, the percentage return stays essentially the same.  For example, if the best and worst 40 days are all missed, the return would have been 17.83%, still over 2% better than the S&P 500 Index return over the same time period.

What About The Recent Bear Market?

Since the NAAIM study analyzed numbers only through May of 2000, just as the bear market in stocks was in its infancy, I wondered what effect the bear market had on the best/worst analysis.  Since my company is a member of NAAIM, I contacted them and asked if they could update the numbers for me through the end of 2002, which they gladly agreed to do.

The NAAIM update of the S&P 500 Index performance from April of 1984 through December of 2002 showed the Index produced an average annual return of 9.66%.   This drop from the 15.02% average return of the previous study illustrates the obvious effect of the three-year bear market on the long-term average return of the Index.  The table below shows the effect of missing various combinations of best and worst days in the market over that 18+ year period.

If you missed just the best:                Your return fell to:

                        10 days                                           6.44%
                        20 days                                           4.16%
                        30 days                                           2.18%
                        40 days                                           0.47%

If you missed just the worst:            Your return rose to:

                        10 days                                         14.67%
                        20 days                                         17.28%
                        30 days                                         19.46%
                        40 days                                         21.46%

If you missed best and worst:            Your return was:

                        10 days                                         11.30%
                        20 days                                         11.39%
                        30 days                                         11.31%
                        40 days                                         11.31%

(Source: National Association of Active Investment Managers, Inc. (“NAAIM”).   This data is for illustrative purposes only and is not indicative of the actual performance of any investment.)     

Thus, while the average annual return percentages showed the results of the bear market, the basic result stayed the same: missing bad days in the market can more than compensate for missing out on the good days.  Even when the general direction of the market was downward, missing out on the worst declines still proved effective in enhancing performance.

Putting The NAAIM Study In Perspective

While it may be the goal of every active manager to be in the market only on the good days and out of the market on all of the bad days, we all know that such a perfect system doesn’t exist.  In my Special Report on active management and market timing strategies, I discussed that the ultimate goal of active management, in my opinion, is not necessarily beating the market, but to attempt to control the downside risk of being in the market. 

I base my opinion upon studies such as those done by the Dalbar organization that demonstrate the negative effect of emotional trading upon investors’ long-term returns.  We all know how it is when we lose money on an investment.  Should we stay the course, bail out and go to cash, or move to something that seems to be performing better?

The above analysis by the NAAIM organization shows the value of being out of the market on the worst days, even if you miss some or all of the best days.   Much of the reason that missing the best days doesn’t matter as long as you also miss the worst days is that the worst days are often far worse (in terms of percentage loss) than the best days are good.  For example, if you calculate the sum of the 10 worst days over the 16-year period of the original study, the total comes to -75.47%, while the sum of the 10 best days is only +49.68%.

Plus, there’s the impact of the mathematics of gains and losses, as I discussed in my April 26, 2005 E-Letter.  If you lose 20% on your investment portfolio, you have to make a 25% gain to return to breakeven.  If you lose 30%, you have to make a 43% gain to breakeven.  During the recent bear market, the S&P 500 Index experienced a drawdown of –44.71%.  It will take total gains of over 80% just to get back to break-even, and there’s no guarantee that it will ever happen.

BCA Recommends Traditional “Market Timing”

Since January of 2002, the venerable Bank Credit Analyst has advocated market timing as a way to navigate the uncertain markets that they see on the horizon.  Here’s an excerpt of what I said when BCA first started recommending market timing to its subscribers:

“In the 25 years I have been reading BCA, I don’t ever remember them embracing market timing.  Their approach has typically been buy-and-hold with only the allocations between stocks and bonds changing periodically.  However, a couple of issues ago when they predicted that the economy and the stock markets would recover in 2002, they suggested the use of market timing strategies, for the first time I can remember.  Now, in their latest two reports, BCA says buy-and-hold is not the best strategy, at least for the next year or so.
Yet in the volatile scenario they envision, I can certainly understand why they would switch to this position.  First off, investors who buy individual stocks are going to have to be very adept at selecting those stocks where the valuations are not still dangerously high.  Most investors are not good at this.  Second, even investors who buy only mutual funds are going to have to be flexible and able to switch among sectors from time to time.
Third, and most important, investors will have to be much more watchful of economic developments and may need to get partly or fully out of the markets from time to time.  That is the definition of market timing.”

(You can read the entire discussion about BCA’s stance on market timing in the January 2002 issue of my Forecasts & Trends newsletter as well as in the August 3, 2004, November 2, 2004, and March 8, 2005 issues of this E-Letter.)

As the bear market laid waste to many investment portfolios during 2000-2002, more and more traditional investment advocates started to widen their list of acceptable investments.  Some formerly staunch buy-and-hold advocates have now concluded that much more flexibility is necessary in portfolio management, though most can’t bring themselves to use the term “market timing.” 

Much of the movement to more flexible investment strategies has benefited the hedge fund industry, many of which employ traditional market timing strategies.  Unfortunately, hedge funds are unavailable to most individual investors because of net worth requirements and high minimum investments.  But there are other ways to access this flexibility, as I will discuss later.

Another unlikely advocate of market timing is Ben Stein, an exceptional individual who has served in such varied occupations as speech writer for Richard Nixon, attorney, actor, game show host and prolific columnist and editorial writer on political, economic and investment topics.   Stein co-authored a book entitled “Yes, You Can Time The Market” that disputes the myth that you can’t tell when the market is going to go up or down.  Stein backs up his case with a wealth of historical statistical data.

Going It Alone Vs. Professional Management

In my Special Report on active management strategies, I provide a wealth of information designed to help do-it-yourself investors employ market timing.  This information is based on my many years of experience in analyzing successful professional money managers, as well as my own personal experience.  At the end of the day, however, it is usually not feasible for individual investors to try to time the market on their own. 

The reasons for this are many, but the most common one I get from my clients is that they don’t have time to develop a trading system, and then monitor market data continually.  Most investors have a life outside of their investments and do not want to commit the time and effort necessary to attempt to time the market effectively.

Another reason that individual investors don’t do well in timing the market is a matter of emotions.  When losses occur in your account, do you have the discipline necessary to stay with your system and ride them out?  Many investors do not.  They start questioning the validity of their trading methodology and sometimes get into or out of the market at the wrong times.

For these and many other reasons, I learned long ago to trust my money to professional active managers who have developed and tested their own systems, have successful actual trading records, and have an operation set up to monitor the markets and execute the trades necessary to move in and out of the market.

Active Management Strategies For The Individual Investor

Earlier I mentioned the NAAIM organization and how it is a trade association of professionals who practice active management strategies.  NAAIM is a good source for information on active managers who direct accounts for individual investors.

Let me caution you, however, that selecting an effective active manager is not as easy as going to a database of Investment Advisors or an Internet search engine and picking a name from a list.  Sure, you can find plenty of firms claiming to be active managers, but are they really successful?  There is a great deal to investigate to determine if a manager is really successful.  You must do your “due diligence.”   There are many questions to ask.

How long have they been managing money for the public?  Do they have an actual track record with real money, or are the past performance results just hypothetical, “paper trading” results?  How much money do they manage?  Do they have a strong “back-office” to be able to handle the administration of the accounts they manage?  What type of back-up and contingency plans do they have should one or more of the principals become incapacitated?   Etc., etc., etc.  

Then there is the question, is it necessary to actually visit the Advisor’s office in person?  I believe it is, but this can be very expensive and time consuming.  At ProFutures Investments, we do an advance on-site due diligence visit for EVERY active manager we recommend to our clients.

ADVISORLINK® – The Smart Way To Own Mutual Funds

In 1995, I started our AdvisorLink® program at the request of my clients who were searching for money managers who could potentially limit the downside risk of being in the stock market.  Because most clients did not have the time or expertise to find answers to all of the questions discussed above, the AdvisorLink® program was designed to do the legwork for them. 

So how does AdvisorLink® work?  First of all, there are thousands of Registered Investment Advisors that manage money for investors.  They are located all across the country.  Unfortunately, there are many more unsuccessful or mediocre managers than there are truly successful ones.  So our first step was to narrow that list down to only a few hundred possible money managers.  With the use of sophisticated databases and research publications, we narrowed the field down even further.

The next step was to request specific information from each Advisor we wanted to take a closer look at.  Most professional Advisors are happy to mail you a package of materials including information about the company and its principals, information about the money management system they use, the past performance record, etc.  This initial information, plus some follow-up phone calls, allows us to narrow the field even further.

As noted above, at my company we require an on-site due diligence visit to the prospective money manager’s offices.  Typically, at least two of my most experienced officers will visit a prospective money manager in person.  We meet the principals of the company and have lengthy discussions with them about their money management system.  We also meet and visit with their key employees that run the back-office.  We want to see that their operation is well organized.  We have a long list of due diligence items that must be satisfied during this visit.  I will tell you that there have been several instances where we found problems during the due diligence visit, and we simply packed up our briefcases and left.

We do all of this on an ongoing basis, year-round, and we spend hundreds of thousands of dollars a year on staff, attending conferences where active money managers gather, research publications and conducting our required due diligence trips around the country.  Few investors have the time, money and expertise to do this on their own.

Once we have recommended an Advisor to our clients, we monitor that Advisor’s performance on a daily basis.  We do that simply by looking at my own personal account with the Advisor.  I have my own money invested with every money manager we recommend. 

Our Recommended List Of Money Managers

AdvisorLink® currently has 10 different active management programs covering everything from equities to high-yield bonds, but all with the common thread of being actively managed.  With one exception, all of the programs have the flexibility to get out of the market (partially or fully) and move to the safety of a money market fund.  Some of the programs will “hedge” their positions if they get an indication that the market is likely to move lower.  One of the programs will actually “short” the market occasionally.

Investors can see information on most of the Advisors we recommend at our websiteThe next step is to call us at 800-348-3601 and speak to one of our experienced Investor Representatives.  Together, we decide which Advisors and which of their programs are suitable.  In most cases, we conclude that investing in a combination of the programs is the best approach, for diversification purposes.

Once these decisions are made, investors open “managed accounts” at one or more of the custodians where the Advisors execute their trades.  The Advisor is given the authority to buy and sell mutual funds in the accounts according to its active management system.  Investors receive periodic account statements (but remember that we are monitoring all of the Advisors and programs on a daily basis).

Should we ever change our recommendation on an Advisor, clients are notified immediately, in writing.  There have been a few occasions in the past when we have withdrawn our recommendation of a money manager.  Things can change, and if they do, we do not hesitate to withdraw our recommendation of an Advisor and suggest that our clients move their money elsewhere.  This is very important, because no money manager is going to tell you that you should close your account with them!

While we recommend that clients invest in these programs for the long-term, all of the recommended programs have daily liquidity, no surrender charges, and no “lock-up” periods should an investor need his/her money in an emergency.

Conclusions

I hope this article has helped you to better understand the merits of active portfolio management, including traditional market timing.  I have been a firm believer in active management strategies for over a decade.  Recently others, including some very prominent names such as BCA, are coming to agree with me.  The bear market of 2000-2002 and the sideways market we are currently in has caused many in the investment profession to seek alternatives to the buy-and-hold strategy.

The objective of active management, at least in my opinion, is to reduce risk while earning reasonable risk-adjusted returns.  If the returns on stocks are going to be lower in the years ahead, but the risks will be the same or higher, a buy-and-hold-only strategy is not attractive to me.  The active management strategies represented in our AdvisorLink® Program is where I have the bulk of my equity and bond investments. 

Because we represent a large number of clients with tens of millions invested, we have the necessary resources to:

1.         Continually monitor the Investment Advisor universe to find successful managers for our clients;

2.         Perform our rigorous due diligence on potential Advisors, including on-site visits to their offices;

3.         Monitor each Advisor on a daily basis and communicate with them frequently or as needed; and

4.         Recommend that you move to a different Advisor(s) should performance or risk management not meet expectations.

Most importantly, we’re on your side of the table, providing independent, objective information as well as diversified options for your investment portfolio. 

If you would like more information about the various investment programs recommended under our AdvisorLink® service, feel free to give us a call toll free at 800-348-3601 and talk to one of our Investor Representatives.  You can also visit our website at www.profutures.com, or send us an e-mail at mail@profutures.com.

Very best regards,

Gary D. Halbert

 

SPECIAL ARTICLES

Comparing Nixon and Clinton.
http://www.aim.org/media_monitor/3751_0_2_0_C/

No time to go wobbly.
http://www.opinionjournal.com/columnists/bminiter/?id=110006848

Durbin's degrading drivel.
http://www.washtimes.com/op-ed/20050616-100859-7287r.htm

How powerful is productivity?
http://www.techcentralstation.com/061705A.html

The Media Vs. The Military
http://www.aim.org/media_monitor/3755_0_2_0_C/


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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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