ProFutures Investments - Managing Your Money
How To Boost Returns In A Low Yield World

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
June 7, 2005

IN THIS ISSUE:

1.  Are We In A Perpetual Sideways Stock Market?

2.   Most Investors Don’t Do Well In Sideways Markets

3.  Two Of The Most Impressive Managers I Have Ever Seen

4.  How Combining Managers Can Be A “Win-Win” For You

5.  Good Timing – A Buying Opportunity May Be Just Ahead

Introduction

Serious readers of this weekly E-Letter know that it has been difficult to make good returns using traditional strategies in the market environment we have been in since late 1999 and the end of the greatest bull market in stocks.  Some nice returns were enjoyed in the bond market over the last two years as yields surprised everyone (yes, everyone) on the downside, but we all know that bond yields aren’t going to zero (0%).   The run in bonds is close to over, as I see it.

The major stock indices have been in a broad, sideways trading range since the beginning of 2004.  As this trading range has persisted, more and more stock market observers are concluding that we may be in a trading range for another year or longer.  While this may or may not be true, it is consistent with the view that we are now in a low return world in the equity and fixed income markets.

This week, I am going to tell you what many sophisticated investors and hedge fund managers are doing to make decent returns in this new environment.   As I have reported in recent months, sophisticated investors are increasingly shifting to more “active management” strategies where the money managers have the ability to get out of the markets from time to time, hoping to avoid downturns in trends, and wait for better opportunities to get back in.

The buy-and-hold mantra that has dominated Wall Street for decades is slowly losing favor.  The active management strategies that I have recommended over the last 10 years are now being embraced by many who preached only buy-and-hold for years.  Surprise, surprise!

If you are a buy-and-hold investor, and if you want to achieve success in the low return world we are now in, you need to consider some active management strategies.  As you will read below, you should also consider combing active management strategies within your portfolio to help reduce risk and boost returns.  Best of all, you don’t have to be a multi-million-dollar investor to do this.  In fact, if you have only $100,000 you can easily do this. 

So take this E-Letter seriously, and hopefully you will learn something if I do my job.  Let’s go.

Are We In A Perpetual Sideways Market?

As noted above, more and more market analysts are concluding that we are in a sideways equity market that could continue for another year or even longer.   No one knows for sure, of course, but there have certainly been extended periods in the past when stocks went essentially sideways in a broad trading range for years on end.  Take a look at the chart below.


Source: Bloomberg

As you can see, the stock market as measured by the Dow Jones Industrials went essentially nowhere from 1966 to 1982 when the great bull market began.   The Dow was in a broad trading range mostly between 700 and 1,000 for 16 years.  If you bought in 1966 at the left side of the chart and sold in 1982 at the right side of the chart, you made little more than dividends.

However, if you look closely at the chart, you can see that there were several good buying opportunities AND selling opportunities.  And I’m not talking about picking the tops and bottoms – no one knows how to do that.  But if you bought any time in late 1966 and sold anytime in early 1969, you would have made good money.  If you bought anytime in mid-1970 and sold anytime in late 1972, you would have made good money – and you would have avoided the big dive in the market during the 1973-74 recession.  I could go on, but you get the point.

The problem is, most investors do not know how to identify changes in the trend.  In fact, it’s even worse.  Studies have shown that most investors who try to “time” the markets frequently end up buying high and selling low.  This is precisely why I recommend that you use professional money managers that have sophisticated systems to indicate when the trend is changing, and the discipline to follow their indicators.

Finding A Manager & A System That Works

Most financial advisors will tell you that “active management” strategies don’t work in the stock markets.  And in one sense, they are correct.  For every one active management system that truly works, there are dozens of others that either do not work or do not add value above the fees they charge.  So in general, it is true that most active management strategies don’t work.

Yet as I have shown for over a decade, there are some really successful Investment Advisors with time-tested systems for moving in and out of the market on occasion.

The problem is finding these successful Advisors.  Most of them don’t advertise.  The successful ones we’ve found are scattered all over the country.  We spend hundreds of thousands of dollars a year researching money managers, attending conferences and making “due diligence” trips around the country to visit Advisors in their own offices to check out their performance records, how their particular strategies work, their internal systems and their back-office operations.

The point is, if you have the time and money – and the knowledge to evaluate these managers – you will find some who are truly successful at trading the markets.

So what makes the good ones successful?  There are many things, but the most important is that they have a mechanical system that generates a signal to buy or sell.  The word “mechanical” in this case can mean many things, but the bottom line is that mechanical systems take emotion out of the trading decision. 

Almost all of the systems we see today utilize computerized software that analyzes market data in various ways to detect changes in the trend.  Some use moving averages; others use technical data; still others use historical data; and others use various other data and indicators that may be helpful in identifying changes in the major trend.  Most of the systems we see incorporate some combination of these indicators and others.

But the most important thing is that their system generates an automated, mechanical signaland not just some guy’s opinion - if and when there is a major change in the trend.  The next most important thing is that the manager consistently follows those signals.  It is not uncommon for managers to override their system due to emotional factors and/or unusual events that may be happening in the markets or in the world at large.

In some cases, the use of “discretion” and overriding signals can be a good thing.  Yet if the system is truly a good one, overriding signals can be a very bad thing, in that opportunities for profit are lost.  In our due diligence process, we investigate carefully whether a manager has overridden his system’s signals in the past and why.

Advisors I Have Recommended To You This Year

So far this year, I have written about two very successful Investment Advisors that we recently added to our stable of recommended money managers.   On January 18, I wrote about Third Day Advisors and their outstanding program.  On April 5, I wrote about Scott Daly’s Asset Enhancement Program.  Many of you have requested information on these two programs.

Today I want to revisit Third Day and Scott Daly – just as two examples of how you can combine two very different programs and to achieve a different risk/reward ratio. 

Third Day, as you may recall, is a more aggressive program.  In addition to buying mutual funds when the market is trending higher, Third Day will actually “short” the market occasionally during market downturns.   So Third Day can be long, short or in cash.  Scott Daly’s program is a more conservative strategy in that it only buys mutual funds or goes to cash.

Below are the actual performance numbers, net of all fees and expenses, for Third Day and Scott Daly going back to when Third Day started managing money for the public in November of 2001 through April 2005.

Third Day

Scott Daly

Average Annual Return

21.4%

8.3%

Worst Losing Period

-12.2%

-1.3%

Best Month

14.8%

3.4%

Worst Month

-7.9%

-0.8%

Best 12 Months

39.4%

16.1%

Worst 12 Months

8.1%

3.9%

3-Year Average Return

20.0%

8.9%

Standard Deviation (ann.)

15.3%

3.5%


Past results may not be indicative of future results.  See disclosures below.

As you can see, both Advisors delivered good results over the last 3½ years ended in April.  While Third Day had the best upside returns, you can also see that they were considerably more volatile on the downside with a worst losing period (drawdown) of –12.2% versus Scott Day’s worst drawdown of only –1.3%.

Because Third Day is more aggressive, and because they will occasionally short the market, and because they have a relatively short record (3½ years), they are not suitable for all investors, even though they have a higher return.

Now Let’s Put Them Together

Let’s say that you hired both Third Day and Scott Daly 3½ years ago.   Here are the hypothetical results if you had given each of these Advisors $50,000 back in November 2001 and kept it there through April of this year.

Third Day & Scott Daly

Average Annual Return

15.3%

Worst Losing Period

-6.5%

Best Month

8.5%

Worst Month

-4.1%

Best 12 Months

26.2%

Worst 12 Months

8.0%

3-Year Average Return

15.0%

Standard Deviation (ann.)

8.6%

In this 3½-year period, the initial investment of $100,000
would have grown to apprx. $165,000.

The hypothetical returns shown above combine the referenced programs into a single portfolio to illustrate what the performance of the portfolio would have been over the stated time period.  The results do not represent an actual portfolio and are for illustration purposes only.  These are past results and are not necessarily indicative of future results.   Please read all of the important disclosures for each Advisor at the end of this E-Letter.

As you can see, if you had money with both Advisors, your returns would have been “smoother” than the ride with Third Day alone and considerably higher than with Scott Daly alone. The average annual return was 15.3% and the worst drawdown was only –6.5%.  I suspect that most investors reading this would be thrilled with that performance over the last 3½ years!

Third Day & Scott Daly Have Low Correlation

One of the factors we consider when we look to combine active management strategies is the level of correlation between the programs.  By correlation, I mean the tendency of one program to go up or down in relation to the other program.  You don’t want to diversify in multiple strategies if they all have a strong tendency to go up and down at the same time.

The good news is that Third Day and Scott Daly have almost no correlation.   They do not tend to make money or lose money at the same time.  We actually have software that calculates the level of correlation.  A reading of 1.0 indicates perfect correlation – they make and lose money at the same times.  In the case of Third Day and Scott Daly, the level of correlation is 0.001 which is about as close to zero as you can get.  So they don’t generally make or lose money at the same times, at least based on their past performance records.

A Little More Information About The Two Programs

Third Day uses a proprietary trading system developed by its founder, Ken Whitley.  During the late 1990s, Ken developed a sophisticated system for trading the Nasdaq 100 Index, initially just to manage his own portfolio.  As noted above, he started managing money in November of 2001.

Normally, we would prefer to see a longer performance record, but if we consider what has happened in the markets since late 2001, Third Day’s system has a lot of experience with very different types of markets.  Just as Third Day began managing money in November 2001, the Nasdaq Index began another very steep decline which didn’t end until late in 2002.  Yet Third Day managed to make 25.3% in 2002, despite the bear market.

The Nasdaq recovered fairly strongly in 2003, and again Third Day did well that year, making 19.5%.  In 2004, the Nasdaq was in a broad trading range, yet Third Day still managed to make 20.3%.  The point is, they’ve done well in three very different market environments.  In fact, Third Day has the best absolute return of any Advisor we have seen over the last 3½ years.

Third Day uses the very popular Rydex mutual funds, so client accounts are established at Rydex, and Third Day is given authority to buy and sell.  And as noted above, Third Day will short the market occasionally by using the Rydex Venture Fund which shorts the Nasdaq with leverage of 2X (200%).  The management fee is 2½% a year, billed quarterly in advance.  The minimum account size is $50,000.

Scott Daly’s Asset Enhancement Program is very unusual in that he has developed a way to minimize losing periods while delivering impressive results on the upside.  For example, from January 1, 2000 to the end of April 2005, the worst drawdown was only 1.3%, even though we were in a bear market until late in 2002.  During that same period, Scott’s average annual return was 14.6%.  On a “risk-adjusted basis,” Scott Daly has one of the best performance records I’ve ever seen.

Scott invests in a wide range of low-volatility mutual funds which are available through Trust Company of America (TCA).  Clients accounts are established at TCA, and Scott is given authority to buy and sell.  The management fee is 2½% per year, billed quarterly in advance.  The minimum account size is $50,000.

One question that may occur to some of you reading this is: With these kinds of numbers, why aren’t these guys more well known?  Good question.  One reason is that neither of them advertises to any extent.  Through our network of contacts, we were introduced to Ken Whitley a couple of years ago at an industry conference for active managers.  Scott Daly’s name came to us by way of a specialized newsletter we subscribe to that focuses on active money managers.

Another point that may interest you is the fact that both Ken Whitley and Scott Daly have a lot of their own money invested in their programs.   I also have a large amount of my own money invested in these programs as well.  

A Word About Management Fees

Management fees for actively managed accounts are typically in the 2-2½% range per year.  Many investors who first look at actively managed programs balk at the fees as compared to mutual funds and other passive strategies.  When you hire an active manager, one of the primary reasons is to reduce risk. 

Third Day and Scott Daly (as well as the other managers we recommend) have proven that they can significantly reduce risk while also delivering impressive results on the upside.  Remember that in the bear market of 2000-2002, the S&P 500 Index fell over 44% and the Nasdaq plunged over 70%.  Most buy-and-hold investors and “index” fund investors lost about the same amount if they held on during that period.

Yet during the recent bear market, Third Day’s worst losing period was only –12.2%, and Scott Daly’s worst losing period was an incredible –1.3%.   Compare those to the loss of over 44% in the S&P 500 and over 70% in the Nasdaq.

Not only are you looking to an active manager to reduce losses during market downturns, you are also paying him to get you back in the market during significant upturns.  A large active manager told me the following a number of years ago (more or less verbatim):

Investors think they are paying us fees to get them out of the market during downturns.  But actually, designing a successful system to get you out of the market is the easy part.  It’s the getting back in part that is much more complicated and difficult to design.

In short, you are paying for expertise that you don’t have but definitely need, especially in a market like we’ve seen for the last 18 months.  Over time, the real test for active managers is whether they add value (performance) over and above the fees they charge.  Many don’t, but as you’ve seen with Third Day and Scott Daly, they have definitely added value well above the fees they charge.

Reminder: all of the performance figures quoted above are “net” after all fees and expenses are deducted.

Finally, in the spirit of full disclosure, you should know that my company receives a portion of the management fees for accounts that we introduce to them.  You should also know that they charge clients the same fee, regardless if they came through my company or went to them directly.

There are several advantages to accessing these managers through my company, rather than seeking them out directly.  First, we monitor all of the managers we recommend on a daily basis (I have my own money with all of them).  Second, if we ever revoke our recommendation of a manager, you will be notified immediately.  Third as one of our clients, you will also receive information on any new managers we find and recommend in the future.

Good Timing – A Buying Opportunity Lies Ahead

Over the past month, I have argued that the Fed may be nearing the end of its rate-hiking cycle, and that this should produce another good buying opportunity in stocks and mutual funds.  Well last week, the president of the Federal Reserve Bank in Dallas made some remarks that support my theory.  He said that the Fed is in “the eighth inning”of its rate-hiking cycle.

While his remark is open for interpretation, I could read that to mean another quarter-point rate hike later this month (8th inning) and a final one in early August (9th inning) – just as I have been suggesting.  If correct, the equity markets could get quite a boost during the rest of the year.  This is why I believe that now is an excellent time to open accounts with Third Day, Scott Daly and the other equity managers we recommend.

And one last point.  The US economy has surged ahead at a 3-4% growth rate in GDP for the last 18 months, yet stocks have gone nowhere.  Stocks potentially have a lot of catching up to do.  Also, if stocks break out of this long trading range on the upside, we should see a lot of buying come into the market just based on technical (chart) indicators alone.

Conclusions

I chose to revisit Third Day and Scott Daly this week for the following reasons.  First, I don’t know if we are in a perpetual sideways market, and I don’t know if equities will break out of the sideways trading range to the upside in the weeks ahead.  No one else does either. 

It is precisely this kind of uncertainty that argues for active management strategies and systems that will generate trading signals to follow the market whichever way it goes.

The second reason is that I wanted to demonstrate for you the potential benefits of combining two actively managed programs – in particular a more aggressive program like Third Day along with a more conservative program like Scott Daly's Asset Enhancement program.  And you can do this even if you only have $100,000 to invest.

On a stand-alone basis, Third Day is too aggressive for some investors.  However, if you combine Third Day with Scott Daly's program, with its incredibly low drawdowns, then the combination may indeed be suitable for many of you.

Third Day and Scott Daly are two of the most impressive programs I have ever seen in the world of active managers.  I recommend you give them a serious look if you haven’t already.  Be sure to read the important disclosures at the end of this E-Letter.

I invite you to call us for more detailed information on Third Day and Scott Daly at 800-348-3601 or visit the “Top Performers Page” on our website to see information on all of the equity and bond managers we recommend.   

Wishing you profits in a sideways market,

Gary D. Halbert

SPECIAL ARTICLES

What will future generations say?
http://www.realclearpolitics.com/Commentary/com-6_7_05_TS.html

The cost of the War On Terror.
http://www.spectator.org/util/print.asp?art_id=8261

 

IMPORTANT DISCLOSURES

General Disclosures

ProFutures Capital Management, Inc. (“PCM”), Third Day Advisors, LLC, New Century Financial Group, LLC and Purcell Advisory Services, LLC are Investment Advisors registered with the SEC and/or their respective states.  Third Day Advisors, LLC (“TDA”) and Scott Daly (through New Century Financial Group, LLC, his affiliated Registered Investment Advisor) have formed business relationships with Purcell Advisory Services, LLC (“PAS”) of Tacoma, Washington whereby they communicate their trading signals daily to Purcell, and Purcell executes the trades and maintains client accounts.  Purcell currently provides back-office and administrative outsourcing for a number of Investment Advisors nationwide.

PCM receives compensation from PAS in exchange for introducing client accounts.  For more information on PCM, TDA or PAS, please consult the respective Form ADV II for the Advisor, available at no charge upon request.  Officers, employees and affiliates of PCM may have investments managed by Advisors discussed herein and others.

This report does not constitute a solicitation to residents of any jurisdiction where the program mentioned may not be available.  Information in this report is taken from sources believed to be reliable but its accuracy cannot be guaranteed.  Any opinions stated are intended as general observations, not specific or personal advice.  This publication is not intended as 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.  Investments mentioned involve risk, and not all investments mentioned herein are appropriate for all investors.  As a benchmark for comparison, the Standard & Poor’s 500 Stock Index and the NASDAQ Composite (which includes dividends) represent an unmanaged buy-and-hold approach.  The volatility and investment characteristics of these benchmarks may differ materially (more or less) from that of the Advisor. 

Investment returns and principal will fluctuate so that an investor’s account, when redeemed, may be worth more or less than the original cost. 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.

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. Individual account results may vary based on each investor's unique situation. Statistics for “Worst Losing Period” are calculated as of month-end.  Such losing periods within a month may have been greater. No adjustment has been made for income tax liability.

Performance for other programs offered may differ materially (more or less) from the program illustrated. 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.

PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Disclosures Specific to Scott Daly’s Asset Enhancement Program

The Asset Enhancement Program’s performance represents actual accounts in a program named “Annuity Enhancement” and has been verified by Steve Shellans of MoniResearch to AIMR standards.  The Asset Enhancement Program utilizes the same signal as the Annuity Enhancement Program. 

The signal is purchased from Scott Daly, an affiliated advisor with New Century Financial Group, LLC.  The signals are generated by the use of a proprietary model developed by Scott Daly.  Actual performance of a specific account may differ due to several factors, including, but not limited to, account restrictions, differences in transaction costs and other expenses.

Disclosures Specific to Third Day Advisors, LLC

Historical performance data represents actual accounts in a program named Third Day Aggressive Plan, custodied at Rydex Series Trust, and verified by Theta Investment Research, LLC.  The trading signal is purchased from Third Day, an unaffiliated investment advisor.  The signals are generated by the use of a proprietary model developed by Third Day.  Actual performance of a specific account may differ due to several factors, including, but not limited to, account restrictions, differences in transaction costs and other expenses.

Combination Portfolio Disclosures

The hypothetical performance of the combination of the Third Day Aggressive Strategy and Scott Daly’s Asset Enhancement Program assumes an equal investment in each program as of November 1, 2001.  Accumulated portfolio values were not periodically adjusted or rebalanced since the assumed initial investment.  The performance statistics may have been different had the positions within the portfolio been periodically rebalanced to reflect the original investments. Neither portfolio returns nor holding returns are adjusted for taxes, and if adjusted for, would reduce the returns stated.  The returns stated assume the reinvestment of dividends and capital gains.  Mutual fund returns include all ongoing fund expenses.


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