Gary D. Halbert President & CEO

How to Approach the Stock Market With All the New Threats We Face

by Gary Halbert

There is a theory I subscribe to which says that market volatility inherently increases as prices rise.  Certainly we have all seen how much more volatile the markets have become in the last 10-15 years as stock prices enjoyed the greatest bull market in history.  I think we can all agree that market volatility is going to remain very high in the years ahead, especially given the new threats we face.

We all saw the effects of a terrorist attack on the markets in the days just after 911.  While I doubt we'll see another attack of that magnitude, there will be other shocks due to the war on terror and other geopolitical events.  There will also be occasional unexpected problems like the Enron debacle in which isolated events can cause the whole market to dive.

In January, for the first time ever, The Bank Credit Analyst recommended that investors use "market timing" strategies for a good portion of their equity holdings due to these new threats and the likelihood of even greater volatility.  In this issue we will look at a combination of buy-and-hold and market timing and how it makes a lot of sense.

The main benefit to buy-and-hold is that you are always in the market.  If the market goes into an unprecedented bull market, as we saw in the mid-to-late 1990s, your buy-and-hold positions make sure that you don't miss out.  Buy-and-hold has been an excellent strategy for most investors over the last 10-15 years.

One benefit of a market timing strategy is that you have the potential to be out of the market during significant downtrends and bear markets.  Another benefit is the potential to make money when the stock markets are in broad trading ranges with no major direction.

While both strategies have their potential benefits, they also have their problems.  No system is perfect.  The hope is that by using both strategies, you will do well in the good times and not lose as much in the bad times.  Over the last two years, however, we have seen that many market timing systems lost money or made very little at the same time that buy-and-hold portfolios lost money.

Many investors, including some of our own clients, were frustrated over the last couple of years when their market timing systems remained fully or partially invested in the market, yet the market declined significantly.  Most market timing systems were tripped-up over the last year or  two due to extremely choppy markets and/or the fact that interest rates plunged, which is historically very bullish for stocks.

As a result, we have had to find market timing systems that worked, even in this new environment.  As Mike Posey will discuss below, it is possible to have a combination of buy-and-hold and market timing that works, even in the extremely difficult equity markets we have seen in the last two years.  This is an article you need to read and consider.

Using Buy-And-Hold & Market Timing To Navigate Today's Difficult Markets

by Mike Posey

Originally, this article began with several pages of research and analysis, and the results were at the end.  But rather than keep you in suspense, let me give you the performance results at the beginning and, hopefully, that will make you want to read the analysis that follows.

What I have done is compare the results over the last five years of: 1) a successful buy-and-hold portfolio; 2) a successful market timing program; and 3) a 50/50 combination of each.  I used the last five years as the time period since it includes two great years for stocks (1997/1998), one year of mixed results (1999) and two bad years (2000/2001).

As you can see in the chart below, the market timing program outperformed the buy-and-hold portfolio over the last five years.  For some, this will suggest that you put all of your equity assets into market timing.  But as Gary has discussed above and in this month's issue of Forecasts & Trends, most investors should have a combination of both market timing and buy-and-hold. 

Jan 1997 - Dec 2001

Performance Summary Buy & Hold NCMRisk-Mgd 50/50 Comb. S&P 500

Annualized Return 13.1% 21.2% 17.4% 10.7%

Total Return 85.2% 161.7% 123.5% 66.2%

Worst Drawdown -8.0% -9.9% -7.6% -30.5%

Average Monthly Return 1.1% 1.7% 1.4% 1.0%

Monthly Standard Deviation 2.3% 5.2% 3.5% 5.2%

Best Month 4.8% 26.6% 15.6% 9.8%

Worst Month -7.5% -7.2% -6.1% -14.4%

Best 12 Months 25.9% 56.9% 37.3% 48.0%

Worst 12 Months 0.1% 0.4% 0.3% -26.6%

The market timing program averaged 21.6% over the five years, with a worst losing period (drawdown) of only -9.9%, whereas the buy-and-hold portfolio averaged 13.1% with a worst losing period of -8.0%

A combination of 50% in buy-and-hold and 50% in the market timing program produced an average return of 17.4% with a worst losing period of only -7.6%.

All three portfolios beat the S&P 500 Index which averaged 10.7% with a worst losing period of a whopping -30.5%.  This is what happened to most index fund investors in the last five years.

The market timing system shown in the chart  is NIEMANN CAPITAL MANAGEMENT'S "Risk Managed" program which we first recommended to you in September.  This program has a minimum investment of $50,000 but only until March 1st  when the minimum goes back up to $100,000.

The buy-and-hold portfolio is a diversified group of mutual funds selected by our DYNAMIC ALLOCATION PROGRAM. (Details on this portfolio are included later.)

Why Would You Want Both?

As discussed above, there are periods when a buy-and-hold strategy will outperform most market timing strategies.  And there are periods when the opposite is true. 

Let's take the 1997-1998 period as an example.  The S&P 500 gained 33.4% in 1997 and 28.6% in 1998.  Well selected buy-and-hold portfolios did  better than most market timing programs in those years, and in some cases substantially better. 

Of course, the stock markets were going virtually straight up during 1997 and 1998.  For the most part, anytime market timers were on the sidelines, they were missing out on profits.

There are other times, as we all know, when the market either goes down or is in broad trading ranges.  It is these periods when market timers have the potential to really demonstrate their value. 

Some market timers, such as Niemann, have delivered very nice returns, even in a down market.  Niemann's "Risk Managed" program, for example, gained a whopping 29.1% in 2000 when the S&P 500 lost -9.1%.

The bottom line is, most investors would do well to follow a strategy that has money allocated to both a buy-and-hold portfolio and a market timing program.

Diversification In Investment Strategies

Over the past year, Gary has written about Modern Portfolio Theory (MPT).  This concept, first introduced in the 1950's, concludes that the way assets are allocated in your portfolio can account for up to 90% of its performance.  Virtually all brokerage and financial planning firms now offer asset allocation strategies based on MPT, including the ProFutures Dynamic Allocation Program.

It works like this.  Using computer software, an investor's financial situation, goals and risk tolerance are used to determine the optimum allocation of money among the various asset classes (growth stocks, value stocks, bonds, real estate, etc.).  This means the portfolio is custom-designed for each individual, and not just a hodgepodge of investments accumulated over the years or the "deal-of-the-week" stock and mutual fund offerings.

Once the allocations among the various asset classes are determined, the appropriate investment vehicles must be identified.  We at ProFutures use software analysis tools as well as the experience of our staff to comb through the thousands of mutual funds and find the best long-term performers.

Asset allocation is based on the historical performance of an asset class in relation to other asset classes.  However, no matter how well constructed, at its core, asset allocation is a buy-and-hold strategy.  An asset allocation portfolio of stocks or mutual funds will generally follow the trend  in the stock market.  A good asset allocation portfolio, such as the one shown in the chart at left, will tend to outperform the S&P 500, especially during down periods.

Also, if properly designed, an asset allocation portfolio should not be as volatile as an unmanaged index like the S&P 500, but it will still follow the general trend.  The presence of bonds or other asset classes may offset or partially offset the effects of a downturn in the stock market, but lately we have seen times when stocks and bonds have forgotten about their past inverse relationship, and both went down.

Buy-And-Hold Keeps You in the Market

Let's face it: most of our clients have opinions about where the markets are going - either up or down (and so do we).  Often times, our opinions (or perhaps the opinions of those we read or hear) are strong enough that we want to get out of the market.  At least until the last couple of years, getting out was almost always a bad decision.

We have written often in the past about the annual Dalbar studies.  If you recall, the Dalbar studies have consistently shown that investors who jump in and out of the market tend to earn far lower returns than those who were in a buy-and-hold portfolio.  This also applies to those who switch from fund to fund to fund frequently.

Unfortunately, many investors who do get out of the market never get back in.  The market continues to go higher; they tend to wait, hoping the market will come back down; but frequently, they never get back in.

Having a buy-and-hold component in your equity portfolio - that you never intend to sell until you retire - means that you will always have at least some exposure to the stock market.  Even if your market timing program misses a move up, your buy-and-hold component should catch it.

For all these reasons, most investors would be well-served to have a good buy-and-hold component in their equity portfolio.

The Problem(?) With Buy-and-Hold

A buy-and-hold strategy should only be considered as a long-term investment.  The problem with buy-and-hold, if you can call it one, is that even a great buy-and-hold portfolio will lose money when the stock markets move significantly lower.  As we all know, this can be frustrating. 

No one should implement a buy-and-hold strategy unless they are confident that they will not panic and sell out during market downturns.  Other than making minor adjustments in the mutual funds held, from time to time, you should simply leave this portion of your portfolio alone and let it work over a long period of time.

You have to be confident that when the gloom-and-doom crowd promises that the sky is falling, or  when the talking heads predict a bear market, you won't get scared and sell out.  Usually when this happens it is at the worst possible time.

One way to help insure that you don't panic and sell out is to allocate only the amount of money to buy-and-hold that you are comfortable with holding for the long-term.  Another is to diversify into other strategies.

Diversifying With Market Timing

We obviously believe that market timing programs are an excellent addition to a buy-and-hold portfolio.  As Gary has written in the last two issues of F&T, The Bank Credit Analyst has, for the first time, recommended that its subscribers consider market timing systems for a part of their equity portfolio.  They believe, as we do, that market risks have increased, especially since September 11th. 

In the past, BCA has only recommended a buy-and-hold strategy, with occasional adjustments between the stock and bond components.  Only now, due to their current outlook for increased volatility, have they advised their subscribers to add market timing systems to their equity portfolios.

With the very difficult markets we've seen over the last two years, many investors are now looking for market timing programs that will get partially or fully out of the market and into the safety of cash if we go into a significant downward trend.

The problem is, many market timing programs have not performed well over the last two years, at the same time that buy-and-hold was getting hurt.  I would be remiss not to acknowledge that several of the market timing programs we have recommended at ProFutures lost money, or didn't perform very well, over the last year or two.

We've seen a lot of very unusual and unprecedented things happen in the last year that tripped-up previously very successful market timing systems.  Take interest rates, for example.  Most market timing systems use interest rates as one of the key indicators of market trend.  Lower interest rates have historically been bullish for stocks.  The Fed cut interest rates 11 times in 2001.  This huge move down in rates contributed to many market timing systems staying fully or partly in the market during a period when stocks declined sharply.

I could continue listing unusual or unprecedented events over the last year or two that led to disappointing performance by many market timing programs, but I think most people reading this are well aware of them.

The good news is, there were a number of market timing programs that performed reasonably well over the last two years.  Niemann just happens to be the best performer we have found.

The point is, we believe that a combination of buy-and-hold and market timing makes a lot of sense.  Yes, there will be times when both systems make very little money or lose; however, given the increased market volatility, we believe a combination of strategies will work very well over time.

Our Buy-And-Hold Portfolio

Here is how I constructed the buy-and-hold portfolio shown in the chart on page 2 and again below.  First, I developed an asset allocation portfolio for an investor with a "moderate" risk tolerance using our Modern Portfolio Theory software.  After determining the percentage of the portfolio to go to each asset class, I selected mutual fund investments from our list of funds available through the ProFutures Dynamic Allocation Program.  These funds are among the top long-term performers in their asset class (growth, value, etc.).  The portfolio looked like this:

Large-Cap Value Stocks:            30%

Mortgage Backed Bonds:            25%

Large-Cap Growth Stocks:            14%

Real Estate Investment Trusts:  14%

Corporate Bonds:                9%

International Stocks:               8%

Next, I used another of our software programs to back-test the entire portfolio for performance over the last five years.  [By the way, it is so cool to have sophisticated software that allows us to simply hit a few keystrokes and be able to evaluate the past performance of a portfolio in minutes.]

I used the last five years because Niemann's actual performance history is only five years.  However, this period of time is also good for illustration because it includes two years of a raging bull market in stocks, a mixed year and two years of bear markets.  This MPT portfolio, standing alone, has impressive results as you can see below.

To avoid having to include long disclaimers that would take up lots of space, I am not showing the name of the specific mutual funds selected.  However, I will tell you that the funds included in our Dynamic Allocation Program were selected early in 2001.  I'm telling you this so you won't think we just went to our analysis software and picked the funds that had the best 2000 and 2001 performance for this illustration.  That would be exercising "curve fitting" to optimize performance, a practice we don't believe in.

As you can see, the MPT buy-and-hold portfolio hypothetical return compares very favorably to the S&P 500 Index's average annual return of 10.7% and worst drawdown of -30.5%.  The allocation of the portfolio among various asset classes created a return that was greater than that of the S&P 500 Index over the past 5 years, but not nearly as volatile.

By using an allocation of 50% to buy-and-hold and 50% to Niemann, the return improved significantly over buy-and-hold alone.

As you can see, the average annual return of 17.4% for the 50/50 mix is higher than the buy-and-hold portfolio but lower than Niemann's returns.  The worst drawdown was less than either the MPT portfolio or Niemann's.

More importantly, when reviewing individual monthly drawdowns, the combined program produced a much smoother ride over the past 5 years than the buy-and-hold program alone.  If you could look at the monthly returns, you would see months when Niemann offset losses in the buy-and-hold portfolio and vice versa.

Investors get cold feet and exit the market when they feel a monthly loss is greater than they can bear.  This is especially true when the talking heads on the financial news shows on TV and the radio are saying the sky is falling. However, the combined effect of the two investment strategies together produce a synergy in the above example.  This reduction in volatility may just be enough to keep you in the market rather than heading for the exits. 

What's more, there is a significant psychological relief from knowing that a portion of your portfolio can go to cash if the market experiences a downturn.  Obviously, Niemann has done a very good job of doing that over the last two difficult years.

Conclusions

One of the most prominent firms that tracks market timers has developed an indicator they call the "Ulcer Index."  This index seeks to identify the point at which the volatility of an investment program is likely to start giving you ulcers (figuratively, of course).  While the Ulcer Index is only applied to market timing programs, the concept highlights a common investment truth:  When volatility is high, investors frequently seek psychological relief by bailing out of their investments. 

This article has discussed the value of diversification as an alternative to bailing out for reducing portfolio volatility.  Using the 50/50 sample portfolio, we illustrated how asset allocation would have helped to provide a better return than the unmanaged S&P 500 Index, and with less risk.  Taking diversification on to the next level, we showed how you can increase returns and decrease volatility by combining a good buy-and-hold portfolio and a proven market timing investment strategy.

The psychological relief obtained by the various diversification tools differs with each individual investor.  More aggressive investors can take more volatility, while conservative investors cannot.  Your state of life and investment goals also have much to do with the level of risk you should take.  Therefore, it is important that each investor accurately determine their investment goals and risk tolerance, and evaluate these each and every year.  There are no "one size fits all" solutions.  You need a customized plan just for your needs.

Most brokers and financial planners can't (or won't) sell you a market timing strategy because they have been indoctrinated with the mantra "market timing doesn't work."  Rather than spending time trying to find different strategies to fit your needs, they make your needs fit the buy-and-hold products they have to sell.

ProFutures, on the other hand, is uniquely positioned to be able to help you meet these goals.  We do this through our Dynamic Allocation Program for the buy-and-hold asset allocation and our ADVISORLINK service for the market timing allocation.  Together, they can work very well.

Finally, I have focused on Niemann Capital Management in this article.  While Niemann has delivered outstanding results in the last two difficult years, we have other market timing programs in our ADVISORLINK service that have impressive performance records as well.

IMPORTANT NOTE:  Niemann agreed to a temporary minimum investment of $50,000 for ProFutures clients.  Unfortunately, that minimum goes back up to $100,000 on March 1st.    However, as long as you get your paperwork in process by March 1st, the account can be funded with $50,000 later on.  Thus, if you have any interest in Niemann, you need to call us TODAY at 800-348-3601.

How To Get Started

The planning process starts by requesting our  Confidential Investor Profile, a questionnaire that provides vital information necessary to determine your goals and risk tolerance.

We have found that many people are hesitant to  provide their financial information for purposes of investment planning.  They don't want anyone knowing their net worth or how much they make (or don't make).  Some don't want anyone to see their other investments. 

Many people fear that the investment or brokerage firm will sell that information or share it with outside parties.  Let me assure you that we do NOT do that at ProFutures.  That's why we call it a CONFIDENTIAL Investor Profile.

Some people also fear that if they reveal their other investments to their broker or financial planner, that person will automatically recommend they sell any positions not held at that firm.  While that practice may be true at other firms, it is not true with us!

When we analyze a client's holdings, we let them tell us which investments they want to keep and where they want to keep them.  Often times, clients will ask us to analyze the performance of some of their other investments.

Once we have your basic financial information,  goals and risk tolerance, we can develop a customized plan with the right mix of buy-and-hold, market timing and other investments if appropriate.  When this is complete, we send you the formal investment proposal, and we call you to discuss it and answer any questions you may have.

The key to meeting your financial goals is to have your entire portfolio reviewed with an eye toward proper diversification.  Again, the first step is to give us a call and request our Confidential Investor Profile questionnaire.  This initial review is free of charge and there is no obligation to invest in any of our programs.

If you are interested in obtaining a financial checkup, give one of our Investor Representatives a call at 800-348-3601.  Phil Denney, Spencer Wright and Brad Unruh are all very experienced in the investment and financial planning field and will be happy to help you.  And feel free to call me, Mike Posey, at any time.  You can also contact us by e-mail at mail@profutures.com.

Dorset Financial Services Gold Timing Program Gains 15% Since January 1st

by Gary Halbert

Gold prices turned sharply higher in late January and early February.  As of today (Feb 6th), gold is at $300/ounce.  This is the highest gold has been since February/March 2000.  Dorset's gold/precious metals timing program caught this move.  As this is written, Dorset has gained apprx. 15% for the year, with most of that profit occurring in just the last week or so.

Interestingly, because the price of gold has shot up so quickly, Dorset has placed a trailing 2% stop-loss on its current long position in gold.  If gold reverses lower, Dorset will be stopped-out quickly.  I think this is a very smart move on Dorset's part to protect this very nice profit.

There have been some positive developments in gold in recent weeks, but I am not confident that these developments will mean a lasting bull market for the yellow metal.  The most surprising development in gold came from none other than Blanchard & Company, the largest precious metals and numismatic coin dealer in the US.

Blanchard announced that it will no longer sell or promote gold bullion to its clients.  The announcement said Blanchard would continue to sell numismatic coins but not gold bullion and bullion coins.  This is big news, especially coming from Blanchard which was founded decades ago by the now deceased James Blanchard, one of the original "gold bugs!"  Here is what Blanchard said in its January 1st letter to its clients:

"Effective as of January 1, 2002, Blanchard and Company is changing its business practices and policies in order to limit its exposure to falling gold prices, and recommends to its clients that they do the same.

As of that date Blanchard will not maintain inventories of gold bullion or gold bullion products, nor will it market gold to, or solicit gold sales to, Blanchard clients.  Gold is no longer a hedge against inflation, devaluation of the dollar or falling stock prices. It is no longer a store of value."

When I read that, I said to several of my associates, "It's probably time to buy gold!"  Why?  When the largest gold dealer in the country finally turns bearish, gold is probably at a bottom.  Even so, I'm not a buyer.

I do not recommend that you buy gold or precious metals on your own, especially after such a sharp rise in price.  But you can consider Dorset Financial Services and its gold/precious metals timing program at any time. 

The minimum investment is $25,000.  Call us at 800-348-3601 for more information and applications.