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Is It Time To Take Profits In Stocks?

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
October 24, 2006

IN THIS ISSUE:

1.  Why Stocks Could Turn Lower Just Ahead  

2.  The Economy – Growth Looks To Slow A Bit More

3.  Fed Meets On Interest Rates Today & Tomorrow

4.  Dow Finally Closes Over 12,000 – Now What?

5.  Potomac Fund Management, Inc. – One Of My Favorites

6.  Getting Potomac Fund Management On Your Team

Introduction

While Wall Street’s cheerleaders are giddy over the Dow reaching 12,000 and urge that now is the time to buy-buy-buy, I continue to believe that the equity markets will remain extremely volatile, with some big moves in both directions over the next year or so.  While the latest new record high in the Dow is a very positive sign, I can make a case for why stocks could go down, perhaps significantly, between now and the year-end.

The government’s preliminary estimate of 3Q Gross Domestic Product will be released this Friday, and it is expected to show that the economy slowed to a growth rate of only 2.0-2.2% in the July-September quarter.  If correct, you can bet the Democrats and the media will go ballistic about the poor economy, and predictions of a recession will increase even more next week.

Then we have the midterm elections just two weeks from today, and the polls continue to point to a Democratic takeover of the House and very possibly the Senate.  As this is written, the “generic ballot” is at +16.8 (a new high) for the Democrats according to RealClearPolitics.com this morning.  If Congress swings to Democratic control on November 7, the equity markets could take a big hit.

For these reasons and others I will discuss below, there is a good chance the stock markets could get hammered in the next couple of months.  Even if I’m wrong, the risk level has gone up significantly in the equity markets, and high volatility – in both directions – is likely over the coming months.

With that in mind, I will introduce readers who are not yet clients of mine to one of my favorite professional money managers, Potomac Fund Management.  Potomac recently celebrated the 10-year anniversary of its flagship investment program.  I will discuss how Potomac has been so successful over the years, how their active management strategy works, give you their actual performance numbers – and of course, tell you how you can easily get this strategy in your own portfolio.

Best of all, Potomac has recently increased its minimum to open an account from $25,000 to $50,000; however, for a limited time, my clients and readers can still open accounts at the $25,000 level through the end of this year.

In this week’s issue of Forecasts & Trends E-Letter, we will review the latest mixed economic data, contemplate what the Fed’s next move is likely to be, analyze the latest record highs in the stock market (Dow Jones, that is), and consider why the equity markets could be headed for a fall just ahead.  As you will see, the scenario I foresee makes a compelling case for adding Potomac Fund Management to your portfolio now, if it is suitable for your investment goals and risk tolerance.

The Economy – Growth Looks To Slow A Bit More

Regular readers of this weekly E-Letter know that I have been predicting a slowdown in the US economy since the early part of this year.  But I have also predicted that a recession is not the most likely scenario, and that the economy is likely to rebound in the second half of 2007 if not sooner.  As always, the gloom-and-doom crowd, and their accomplices in the mainstream media, continue to predict an economic recession, or worse.  

The latest economic reports have been mixed to a tad on the negative side.  You will recall that Gross Domestic Product fell to 2.6% in the 2Q, following the robust 5.6% in the 1Q.  The Commerce Department will release its first estimate of 3Q GDP on Friday (Oct. 27), and the consensus expectation is for a number in the +2.0% to +2.2% annual range, down from the 2Q rate of 2.6%.  The latest Wall Street Journal poll of 50+ leading economists yielded a consensus forecast for 2.7% average growth in GDP for the second half of this year.

It used to be that GDP growth of 2.5-3.0% was something to cheer about – solidly positive and non-inflationary - but these days it seems to be disappointing.  It is an election year after all, and Democrats and the media are spinning it in the most negative light possible.  If this Friday’s GDP report comes in at only 2.0-2.2%, you can expect to hear a new round of predictions of a recession, and the Democrats will go ballistic on the issue of the economy.

Here are highlights of the latest economic reports for September.  The Index of Leading Economic Indicators (LEI) rose 0.1% in September.  As I discussed in my October 3 E-Letter, the LEI is not trending significantly one way or the other this year, as evidenced by the incremental rise in September.

The closely watched ISM manufacturing index continued to edge slightly lower in September, falling to 52.9 versus 54.5 in August.  The factory operating rate (capacity utilization) eased marginally lower again in September to 81.9%, down from 82.5% in August.  And industrial production fell 0.6% in September, a bit more than expected.  Yet construction spending rose unexpectedly by 0.3% in September.  Mixed signals, more negative than positive, but still no sign of an impending recession.

On the consumer side, retail sales fell 0.4% in September, in line with expectations.  Early indications are that sales have rebounded in October.  The University of Michigan’s Consumer Sentiment Index jumped to 92.3 in early October, up from 85.4 in September.  Durable goods orders for September will be released on Thursday, and the consensus is for an increase of 2.3% last month.

The latest numbers on housing were mixed.  Housing starts surprised on the upside in September, while home building permit applications were lower than expected.  Existing homes sales for September will be announced tomorrow (Wed) and are expected to be slightly lower.  New homes sales for September will be announced on Thursday and are expected to be unchanged.  Overall, the housing slump continues, but so far it has not turned into the bust that so many have predicted.

Fed Meets On Interest Rates Today & Tomorrow

The Fed Open Market Committee meets today and tomorrow to decide what to do with short-term interest rates.  While Wall Street is hoping for a cut in the Fed Funds rate tomorrow, the consensus view of forecasters is that the Fed will leave rates unchanged once again at 5.25%.  That would be my bet as well.

On the inflation front, wholesale prices fell sharply in September (-1.3%), led by plunging oil prices.  It was the largest monthly decline in over three years.  The Consumer Price Index also fell 0.5% in September.  However, the “core rate” (minus food and energy) still rose 0.4% for wholesale prices and 0.2% for consumer prices.

As we have discussed often in the past, the Fed is believed to focus much more on the core rate of inflation rather than the headline numbers.  Thus, it should not be a surprise if the FOMC leaves rates unchanged at least until its next meeting on December 12.  We could see a rate cut at that time depending on the economy and inflation between now and then.

Dow Finally Closes Over 12,000 – Now What?

The DJIA finally managed to close just a hair over the 12,000 mark last week and is holding above that level as this is written.  I don’t remember this much hype and media attention over the equity markets in many years.  Predictably, new money is flooding into equity mutual funds.  September purchases of mutual funds were the second highest of the year, and I will venture to predict that October purchases will be even higher.  Hot money is flooding back into equities.

While a new record high in the Dow is indeed impressive, the risks of being in the market are definitely increasing in my opinion.  As discussed above, the economy is slowing down, and we are likely to get a disappointing GDP report this Friday.  If the 3Q GDP report comes in at 2.0-2.2% on Friday, you can bet the Democrats and the media will make a big deal about that, including new predictions of a recession.

With the economy slowing down a bit more than expected, the meteoric growth in corporate earnings seen over the last few years is on course to slow down as well.  On this note, The Bank Credit Analyst offered the following warning on Friday (even as the Dow closed over 12,000):

The unfolding global economic slowdown indicates that the robust earnings growth of the past three years will soon fade. Indeed, analyst earnings revisions are already declining and further cuts seem likely.

BCA continues to believe that equity prices will trend somewhat higher over the next year or so but not without some potentially scary downward corrections along the way.  And we may have just the ingredients falling into place to spark such a correction just ahead. 

Consider this scenario.  Let’s assume we get a GDP report of only 2.0-2.2% on Friday.  No doubt, the Democrats and the media will go bonkers over that next week.  Then you have BCA’s warning last Friday that earnings growth is set to slow down.  Typically, you see numerous other market analysts follow BCA’s forecasts, so we could see several similar negative earnings forecasts and warnings over the next week or two. 

And then there’s the election on November 7.  If the Democrats manage to retake majority control of the Congress, and that looks entirely possible as this is written, that will very likely spell bad news for the equity markets.  Don’t forget that the much broader S&P 500 Index has not reached a new high, and if it fails to do so just ahead, we could see a potentially nasty sell-off in equities between now and the end of the year.

For all these reasons, I believe the risks in the equity markets are increasing, just at the time that large numbers of investors are pouring back into the markets.   What else is new? 

If I were a trader, I would be looking to take some money off the table this week ahead of the GDP report on Friday.

Most of us are not traders, however.  With that in mind, let me introduce you to one of my all-time favorite money managers, one that has demonstrated the ability to manage risks in the markets for many years.  Now might be a very opportune time to consider getting this very successful money manager on your team

Potomac Fund Management, Inc.

Potomac Fund Management is a Registered Investment Advisor with the SEC and is located near Washington, DC.  I have had a portion of my personal equity portfolio allocated to Potomac for over a decade.  What I like about Potomac Fund Management (PFM) is their long record of delivering attractive rates of return.  What I like even more is how they manage risks when the markets go down.  As you can see in the table below, PFM’s Guardian Program has delivered average annual returns of over 11% with a worst-ever losing period of only –8.1%, and they’ve done it for over a decade in good markets and bad.  Past results are not necessarily indicative of future results.

PFM invests in a wide range of mutual funds, using a very sophisticated system to select which funds to be in, when to be in them, and when to move to cash or hedge positions in their effort to avoid large losses.  Take a close look at the performance numbers below.  Keep in mind that these are actual results, net of all fees and expenses.  After you review the performance numbers, I will tell you more about how Potomac Fund Management has produced these very impressive results.

Performance chart for Potomac Guardian

Summary

PFM Guardian

S&P 500

Nasdaq Composite Index

Beginning Month

Jun-96

Jun-96

Jun-96

Ending Month

Sep-06

Sep-06

Sep-06

# of months data

124

124

124

Total Return

208.7%

135.9%

81.6%

Annualized Return

11.5%

8.7%

5.9%

Worst Drawdown

-8.1%

-44.7%

-75.0%

Average Monthly Return

0.9%

0.8%

0.8%

Monthly Standard Deviation

2.5%

4.5%

8.3%

Best Month

6.8%

9.8%

22.0%

Worst Month

-4.8%

-14.5%

-22.9%

Best 12 Months

33.3%

52.1%

105.3%

Worst 12 Months

-7.5%

-26.6%

-59.8%

Three Year Average

12.4%

12.3%

8.1%

Five Year Average

9.1%

7.0%

8.5%

Potomac Guardian 10-year performance

PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

 Please see important notes & disclosures at the end of this E-Letter.

 

Getting Potomac Fund Management On Your Team

When I look at Potomac’s past performance record, I think it embodies the type of investment returns we all wish we could do on our own: good returns with very low drawdowns.  Unfortunately, most investors can’t duplicate these steady returns, especially when bear markets like 2000-2002 come along and the S&P 500 plunged over 44%.  While buy-and-hold investors were getting hammered in 2000-2002, PFM protected its assets, avoided the big losses and even made some money.  You can see why I have a chunk of my own money with PFM.

The way you get PFM on your team is simple.  With assistance from my company, Halbert Wealth Management, you open your own account at Fidelity Brokerage.  PFM is given written authority to buy and sell mutual funds in your account.  PFM selects among the hundreds of funds it considers and monitors them accordingly.  Fidelity provides a detailed monthly account statement showing all activity in the account.  You can close the account at any time.

PFM charges an annual management fee of 2.5% on amounts up to $100,000 and as low as 1.25% on amounts above that level.  PFM shares a portion of its management fee with my company for introducing the account and our ongoing client relationship.  The management fee is exactly the same whether you engage PFM through Halbert Wealth Management, or you go to PFM directly.  (FYI, all performance figures quoted herein are net of management fees and expenses.)

Best of all, PFM recently increased its minimum account requirement to $50,000, but my clients and readers can open accounts with PFM with only $25,000 for a limited time through year-end. You can call Halbert Wealth Management at 800-348-3601 to request account applications and more detailed information on the program.  Or, CLICK HERE to request more information online.

With those highlights noted, let me give you more details on Potomac Fund Management and their very successful investment program.  

The Story On Potomac Fund Management

Potomac Fund Management, Inc. is a Registered Investment Advisor with the SEC and is located in historic Easton, Maryland, near Washington, D.C. Founded in 1987, the firm has since grown to manage over $130 million in assets for hundreds of investors, and employs a growing number of investment professionals and administrative staff.

Potomac’s investment strategy is primarily “technical” and has evolved over time as continuing research has led to enhancements. There are three main components of the strategy.  First, research and technical analysis determine whether to be fully invested, partially invested or in the safety of cash (or hedged).  Second, further analysis determines which sectors of the market are selected. Third, additional analysis determines which particular mutual funds are best suited for the current market environment.  This is an ongoing, daily process and Potomac will make adjustments to clients’ portfolios as necessary.

While the technical systems are the driving force, at certain times Potomac’s investment staff will use its years of investment experience to assist in the portfolio decisions. This brings Potomac clients a combination of the discipline of a technical system, and the flexibility of seasoned professional judgment.

Potomac’s “Guardian” Program

The goal of Potomac’s Guardian Program is to deliver consistent positive returns with an emphasis on reducing volatility. While there is no guarantee that this goal can always be met, Potomac seeks to maximize risk-adjusted returns by employing an active management strategy that is longer-term than most. The trading model seeks to allocate investments across many sectors and/or asset classes, overweighting those Potomac deems to have the best risk-to-reward ratio. Potomac may include both domestic and international stock and bond mutual funds, as well as funds designed to track certain stock and bond market indexes.

If the trading model forecasts a market downturn, Guardian can hedge positions or move fully or partially to cash, though 100% cash allocations are rare. Guardian attempts to further control risk through its mutual fund selection process. Potomac screens the entire universe of funds, looking for those with a history of strong performance during both bull and bear market periods.

With this focus on potential risk-adjusted returns, Potomac rarely finds it necessary to frequently move in and out of the market. This is beneficial in that it reduces the chances of being “whipsawed” by frequent short-term changes in the market's direction. It is also an advantage in light of the fact that many mutual funds are charging “early redemption” fees if funds are not held for a minimum period of time.

In situations where Guardian signals a move to cash prior to the expiration of a fund’s minimum holding period, Potomac can use mutual funds designed to “short” the stock market in order to hedge long positions, rather than liquidating them and incurring early redemption fees.

Performance Evaluation

As clients and regular readers of this E-Letter know, the first criterion I use to evaluate any money manager is risk control. Did they preserve assets in a down market?  While buy-and-hold strategies typically incur large losses in bear markets (S&P 500 down 44% in 200-2002), a good actively-managed investment program is expected to deliver “absolute returns” (positive returns in up and down markets). In this regard, PFM has certainly delivered. 

The second criterion I use is overall volatility. How was the performance delivered? Were there just a few large market uptrends that provided the profits, or were there consistent monthly gains? Ditto for the losses along the way.  You have to research the performance data very carefully, both on the upside and the downside.

Potomac Guardian has delivered very impressive annualized returns after all fees and expenses, without the kind of downside volatility that many other stock market investments have suffered. As noted in the performance table above, PFM’s annual average return was over 11%, with a worst-ever losing period of only –8.1%, versus –44% in the S&P 500.  This is a rare accomplishment!  Of course, past results are not necessarily indicative of future results.

Guardian’s real objective, as noted above, is to deliver absolute returns with lower risk. Why is this so important? Studies have shown that many investors don’t reach their goals because they get uncomfortable during losing periods and give up. The Dalbar studies and others find that investors frequently give up and sell at or near the bottom of market cycles - and later end up buying back in near the highs (a phenomenon we may be seeing today). 

I believe most investors would be better served by an actively-managed strategy like Potomac Guardian which has delivered impressive returns without the large drawdowns – including the bear market of 2000-2002. 

Reporting & Management Fees

As noted above, customer accounts are held in the custody of Fidelity Brokerage. Each month, you receive a detailed account statement from Fidelity showing all activity in the account. You can access your account daily at www.fidelity.com.  You add to your account, or close it, at your discretion.

PFM charges an annual management fee of 2.5% for the first $100,000, and as low as 1.25% on amounts thereafter.  A portion of the management fee is shared with my company for introducing the account and our ongoing client relationship. The management fee is the same whether you access PFM through my company or go to them directly. (FYI, all of the performance statistics in this report are after all fees and expenses were deducted.)

Conclusion

It should be obvious by now why Potomac Fund Management is one of my favorite money managers.  With average annual returns over 11% and with a worst drawdown of only -8.1% - for over a decade – the Potomac Guardian program is indeed impressive.  While past results are no guarantee of future performance, PFM has demonstrated that it can deliver absolute returns with lower risk than many other traditional stock market strategies.

Best of all, you don’t have to have a million dollars to invest with PFM.  The minimum investment is only $50,000 and my clients and readers can invest for a limited time with only $25,000 until the end of this year.  This is our last opportunity to offer PFM at this lower minimum.

If you are ready to consider an actively-managed investment for a part of your portfolio, then I highly recommend that you consider Potomac Fund Management seriously, if it is suitable in terms of your financial situation and risk tolerance. Be sure to read the important notes & disclosures below.

If you are ready to get started or have questions, call us at 800-348-3601. One of our Investment Consultants will be glad to help you.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

What drastic changes to expect if the Democrats win.
http://www.opinionjournal.com/columnists/pdupont/?id=110009141

What’s really at stake in this election – North Korea & Iran.
http://www.realclearpolitics.com/articles/2006/10/a_blank_check_from_america.html

Control of Congress could be decided in the courts.
http://www.opinionjournal.com/diary/?id=110009139


IMPORTANT NOTES & DISCLOSURES

Halbert Wealth Management, Inc. (HWM) and Potomac Fund Management (PFM) are Investment Advisors registered with the SEC and/or their respective states.  Some Advisors are not available in all states, and this report does not constitute a solicitation to residents of such states.  Information in this report is taken from sources believed reliable but its accuracy cannot be guaranteed.  Any opinions stated are intended as general observations, not specific or personal investment advice.    Please consult a competent professional and the appropriate disclosure documents before making any investment decisions.  There is no foolproof way of selecting an Investment Advisor.  HWM receives compensation from PFM in exchange for introducing client accounts to the Advisors.  For more information on HWM or PFM, please consult the appropriate Form ADV Part II, available at no charge upon request.  Any offer or solicitation can only be made by way of the Form ADV Part II. Officers, employees, and affiliates of HWM may have investments managed by the Advisors discussed herein or others.

As benchmarks for comparison, the Standard & Poor’s 500 Stock Index and the NASDAQ Composite Index (which include dividends) represent unmanaged, passive buy-and-hold approaches.  The volatility and investment characteristics of the S&P 500 or the NASDAQ Composite may differ materially (more or less) from that of the Advisor.  The performance of the S & P 500 Stock Index (with dividends reinvested) and the NASDAQ 100 is not meant to imply that investors should consider an investment in the Third Day Aggressive Strategy trading program as comparable to an investment in the “blue chip” stocks that comprise the S & P 500 Stock Index or the stocks that comprise the NASDAQ 100.

Potomac’s performance results are based on the Model Portfolio.  The Model Portfolio is an actual account that is considered representative of the majority of client accounts with similar investment objectives.  Returns for the Model Portfolio are time-weighted, total returns that reflect the reinvestment of dividends and capital gain distributions.   Historical performance data was provided by the Advisor and where possible reviewed by HWM from selected customer account statements and/or independent custodian statements.  However, since only selected accounts were analyzed there can be no assurance that the performance in these accounts was consistent with others.   Statistics for “Worst Drawdown” are calculated as of month-end.  Drawdowns within a month may have been greater.  PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.  Any investment in a mutual fund carries the risk of loss. Mutual funds carry their own expenses which are outlined in the fund’s prospectus.  An account with any Advisor is not a bank account and is not guaranteed by FDIC or any other governmental agency.

When reviewing past performance records, it is important to note that different accounts, even though they are traded pursuant to the same strategy, can have varying results.  The reasons for this include: i) the period of time in which the accounts are active; ii) the timing of contributions and withdrawals; iii) the account size; iv) the minimum investment requirements and/or withdrawal restrictions; and v) the rate of brokerage commissions and transaction fees charged to an account. There can be no assurance that an account opened by any person will achieve performance returns similar to those provided herein for accounts traded pursuant to the Potomac Guardian’s trading program.

In addition, you should be aware that (i) the Potomac Guardian’s trading program is speculative and involves a high degree of risk; (ii) the Potomac Guardian’s trading program’s performance may be volatile; (iii) an investor could lose all or a substantial amount of his or her investment in the program; (iv) PFM will have trading authority over an investor’s account and the use of a single advisor could mean lack of diversification and consequently higher risk; and (v) the Potomac Guradian’s trading  program’s expenses will reduce an investor’s trading profits, or increase any trading losses.

Returns illustrated are net of the maximum management fees, custodial fees, underlying mutual fund management fees, and other fund expenses such as 12b-1 fees.  They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable.  All dividends and capital gains are reinvested.  No adjustment has been made for income tax liability.  Money market funds are not bank accounts, do not carry deposit insurance, and do involve risk of loss.  The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments.


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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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