Sentiment has been compressed for weeks, not making lower lows, and the markets finally exploded today.
It's possible that a correction has been in effect in SPX and other indexes since 2004. The chart below shows that the recent correction is almost identical in percent as the one in 2004: about 9%. It's plausible that it is done. The bullish percent of NYSE charts more clearly shows the correction I am talking about.
However, I am a realist and live on my money. I will be away for most of July. So I have sold some of my more agressive long positions on today's close and redeployed along the lines I have discussed in some of the recent portfolio posts. I am still long and committed, but I have decided to reduce volatility further as a prudent provider. Plus, who can argue with 5% money market funds at Vanguard for part of the portfolio while on vacation?
The best system for the past three years was buying and holding, and for three years before that selling and holding or sitting it out. My wistful desire for a simple trading system is futile. That's why I try to overcome the normal human inertia of following the sheeple.
Michael Steinhardt of WisdomTree used to talk about this endeavor as developing "variant perception", his humorous name for sentiment. But now after 40 years he is into portfolio selection. Perhaps that's a natural progression as you get older and have amassed enough funds to require a portfolio instead of just winging it on speculative vehicles time after time, week after week, year after year.
The idea of dividend weighting an index or fund or portfoio is very simple. Most measures of business activity can be faked: sales, overhead, compensation, earnings, book value, etc., but it's hard to fake a dividend. It's there or it isn't, and its value is unquestionable. That's a fundamental "black box system". So weight your index or portfolio by dividend heft instead of by capitalization. Especially since so much of long term gains comes from reinvested dividends.
Here's just one of the twenty Wisdomtree funds' ten year index total return compared to its benchmark. The idea speaks for itself:
Michael Steinhardt, truly one of the market wizards of our era (see Jack Schwager's "Market Wizards", and Jeremy Siegel are starting up a whole deck of new ETFs tomorrow. These new funds are based on a research finding: "From 1926 through 2004, reinvestment of dividends accounted for 96% of the stock market’s total return after inflation." (The Future for Investors, Jeremy Siegel, 2005).
This turns indexing, which I have never liked very much, on its head. Instead of indexing by cap weighting they are going to do it by dividend weighting! You have to register at their site to get into the really good material, since this is legally a "quiet time" around launch time, but they are launching 19 different sector funds, US and foreign, based on this concept. The ten year annualized total return differences between their indexes and an appropriate standard benchmark index range from a 108% advantage for Japaese small caps to a 230% advantage for European small caps. There is a 187% advantage for their US small cap index. All sectors and geographic regions are covered.
Funds which intelligently raise cash instead of always being fully invested have big advantages, which is one reason why I prefer them to index funds, but this Steinhardt/Siegel indexing is of comparable impact to being in tune with the market and raising cash near market highs. Very exciting!
Even if you have 20 or 50 million dollars and several homes and other physical assets, a 1929-32 or 2000-2003 bear market could have reduced your investments to a solitary million, or worse, if you were leveraged and had mortgages and other debt as well. I personally know of one casualty of this magnitude, but there are stories everywhere about other people like the one person I knew.
My own awakening three to four years ago was realizing that low versus high volatility funds, or income versus capital gains funds, were a better way to diversifiy than simple bond versus stock portfolios which the marketers trumpet. There are a lot of income funds which are run more or less like hedge funds. In this sense Dodge & Cox's Balanced Fund (DODBX, since 1931) is an income fund, and so is Vanguard/Wellington's Wellesley fund (VWINX). Both feature bonds of variable duration (maturity)and stocks paying high dividends or with superior growth. Since 1988 Wellesley Income Fund has returned 7.3% and Dodge & Cox Balanced has returned 10.6% annually. Berwyn Income Fund (BERIX)is another slighly more complicated balanced income fund which I like. Hussman Growth Fund is variably hedged in mid caps, but it also captures the short term interest rate on top of its hedge record. HSGFX returned over 13% per year from 2000 to today.
The other low volatility income fund development is in bond funds themselves. There are a lot of bond categories other than Treasuries and high-grade corporates: high yield (junk) bonds, foreign developed country sovereign bonds, foreign emerging market bonds, quasi-bond convertibles, and high yield municipals, among others. As in any other area of investment, there are people who are experts and who win consistently. Many of these categories trade more in line with equities but in a less volatile manner. Some of my favorites are Loomis-Sayles Bond Fund (LSBRX or LSBDX), Hussman Total Return Fund (HSTRX), and Vanguard hi-yield municipal bond fund (VWAHX or VWALX). These are funds with excellent long term management and performance in these challenging but rewarding areas. Pimco's Asset Fund (PAAIX or PASDX) is another income allocation fund much like a hedge fund and advised by Robert Arnott, but it has several layers of cost as it is a fund containing other Pimco funds.
To traditional investors these low voaltility income funds may sound exotic or risky--they did to me--but these funds have been around and have proved themselves over several decades. And they have very low cost structures compared to hedge funds which they emulate. They have returned 9-12% annually over the past 18 years with low price volatility or downside price loss. Funds of this type, including Wellesley, Dodge & Cox Balanced, Hussman Growth and some of the others have become 70% of my overall retirement portfolio.
But we also need some exposure to volatility for long term capital growth and inflation protection. For that 30% of my total portfolio, I have divided it into six sectors which can be hot at different times: small caps, mid caps, globals, health, resource, and volatile incomes, about 5% of total portfolio in each.
In the small caps sector I have a new strategic Vanguard fund, VSTCX, paired with Perritt Micro-Caps, PRCGX. In the mid caps sector I really like Fairholme Fund, FAIRX. In the global sector I have my all-time favorite, First Eagle Global, SGENX or FESGX. In the health sector, I like mainly Vanguard Health Care VGHCX and a much smaller piece in Fidelity BioTech, FBIOX. In the resource sector Vanguard Energy and Vanguard Precious Metals, VGENX and VGPMX, and a few individual stocks. In the volatile income sector Vanguard REIT, VGSIX, and the Vanguard Utility ETF, VPU, or their mutual fund version, VUIAX work. All of these have excellent returns and do not all go up or down together.
I ran a simulated study of six low volatility and six high volatility stocks first from September 1, 2000 to March 11,2003 and then from March 11, 2003 to June 9, 2006. 70% of the portfolio is made up of equal amounts of the six low volatlity funds, and 30% is made up of equal amounts of the high volatility stocks. I added the annual total returns for each of the two major categories. Then I multiplied the categories by 0.7 (low volatility) or 0.3 (high volatility) and summed these. From 2000-2003 the total annualized return for the whole portfolio was 7.05% of which 0.7 times the 5.24 annualized total return was 5.24% from the low volatility funds. The six high volatility funds added 1.82% in total returns(6.05% times 0.3) for a grand total of 7.05% annualized total return during the worst bear market in a generation. Even though the SPX dropped 49% (-21.7% annualized) from its 2000 high to the March 11,2003 low, the simulated 70/30 portfolio gained 7% annualized.
Using the same approach and funds, from March 11,2003 to June 9, 2006 the low voalitilty funds contributed 7.44% annualized to the return (10.62 times 0.7) while the high volatility funds contributed 8.91% (30% of 29.7) for a grand total of 16.35% per year for the portfolio. SPX gained 15.28% during the same period.
For the whole period from September 1, 2001 to last Friday, the low voaltility funds returned 9.21 times 0.7 or 6.45% to the total, and the high volatility funds returned 19.91% times 0.3 or 5.67%. The total annualized return for the portfolio was 12.12% per year. The Vanguard Institutional class S&P 500 fund (VIIIX) with very low cost and with all dividends reinvested had a total annual return of -1.49% per year from September 1, 2000 to last Friday. 12% annualized returns for ten years takes $10,000 to $33,000, and by taking profits and rebalancing you would not have needed ANY market timing with this type of portfolio, even with the worst bear market in decades raging during the first half of the study.
Obviously I did not have this whole 70/30 portfolio at the time, and no one did. Husssman didn't even begin operations until 2000. I did own some of these funds, particularly the inflation sensitive metals, energy and real estate funds due to my Kondratieff bias beginning in 1999. I also had Dodge & Cox. The others are ones I discovered while looking for low volatility gainers. But as my studies evolved over the past few years I have come to own all but one of them now and will add the one I don't have. (In my own account I have given Hussman Growth HSGFX a double weighting to the other low volatility income funds.) The point of the study is to demonstrate that low volatility income funds with good managements can reduce the volatility of a high beta capital gains portfolio, such as my 30% portion. Even the high volatility funds tend to have consistent gains but gains are of course much lower or absent during a severe bear market when the income funds are pulling the portfolio cart.
The fund keys are MANAGEMENT, CONSISTENCY, and LOW VOLATILITY. Two internet websites which have been of great help to me in finding such funds are http://www.fasttrack.net and http://moneycentral.msn.com/investor/research/fundwelcome.asp?Funds=1 FastTrack also has a splendid program which they sell, or sell the data for, but their free total return charts at their site are fabulous. FastTrack also will let you use their program and data for a month for free with no credit card disclosure. MSN also has a good free chart program one can download.
The two FastTrack charts below show the entire investment period, 2000-2006, one with the low volatilty funds, the other with the high volatility funds. For the study I made separate charts for each period, but these two will suffice to give you the flavor of the results as well as of the FastTrack program I am evaluating on their free trial.
Getting back to the fund study, I have mentioned in an earlier article that many of these funds have substantial foreign holdings, so despite the fact that I have only 5% in globals, the overseas markets are well represented overall. Many US funds now routinely contain world stocks in both general funds and in sector funds. The fact of the matter is that foreign and niche stock sectors, like the 30% of my portfolio, are much more volatile than seasoned large caps and US bonds. They tend to outperform greatly for 2-5 years and then lie dead for ages. They have been hot for five or six years now, so they may be due for a rest. This fits with my concept, which I have presented here at the blog, of an interlude in the Kondratieff Wave inflationary bull market. The important thing is to think long term but use intermediate term changes to adjust long term investments and trading. Gold and commodities may have peaked and the dollar and US bonds may have bottomed for a while, as I have previously suggested. We don't need to go overboard and dump or change all investments, but we can adjust them and take profits in extended niches and markets, which I have done. In fact I have made very few changes except to take profits in the metals, energy, and international sectors as a rebalancing exercise.
In this fund study I left out of consideration gold bullion coins and bars and silver which are held separately as a long term asset, like my home and other personal assets. They are a part of the larger picture but not immediately relevant to retirement investment planning.
Regard all of this series, and this whole site, as my diary of investment and my technical approaches to analysis. I am not and do not want to be an investment advisor, and am merely telling you what I am thinking and doing, for what it's worth. Do your own homework and due diligence.
Several academic studies of the 1970's and 1980's promoted the idea of balanced portfolios for reduced risk. Not that this was suddenly a new idea, but the devastating stock losses of the 1970's and 1980's made for a more attentive audience for the idea of not putting all one' s eggs in the same basket. Or perhaps put better, for putting several different eggs in one's big basket.
Thanks to the power of modern marketing, everyone now knows that she should have a mixture of stocks and bonds to reduce "risk". The first balanced mutual fund I know of was Wellington Fund which was started on July 22, 1929 by and is still advised by Wellington in Boston for Vanguard. The second surviving balanced fund was the Dodge & Cox Balanced Fund started in 1931 and still run by Dodge & Cox in San Francisco. Both funds had and have approximately 60-70% in stocks and the rest in bonds and/or cash. Wellington Fund gives a lifetime record from 1929 of 8.35% compounded annually, including reinvestment of all dividends and net of fund expenses, but not net of taxes. If you'd put $10,000 of Wellington one time only into a tax free trust on July 22, 1929 you would have had $6,020,254.33 as of Friday of this past week. And 1929 wasn't a great year to start investing. I wonder what the $10,000 was worth in 1932, and more important, what was the yield from the 1932 low to now? On the other hand, knowing that 8.35% came to a long term holder from a month before the worst bear market of the past 100 year began is also a comforting statistic.
There aren't a lot of data on how well bonds actually protect against devastating stock losses and vice versa over very long periods of time, but I found a summary of a survey done by Alliance Bernstein which sheds a bit of light on the subject: http://therightmix.alliancebernstein.com/TheRightMix/Overview.aspx?cid=25926&pid=1 The study only goes back to 1970, but it shows that in every stock bear market of more than a 10% decline since 1970, bonds went up.
The two biggest bond bull markets during those stock bear markets were 1981-82 and 2000-2003 when funds like Wellington and Dodge & Cox actually made money while most funds lost hugely. But even if the bonds don't make you a lot of money in every stock bear market, they at least keep you from losing a lot more than if you had been 100% in stocks, as does cash. So there is clearly a benefit in stock bear markets from stocks/bonds mixing. Of course there is a cost in reducing your gains in roaring stock bull markets when bonds may reduce your overall gains. Nevertheless Wellington made 8.35% compounded over a very long period of time and that doubtless would have let you sleep better.
However, it occurred to me (and many others) that in an era of brilliant portfolio strategists and hedge fund growth world wide, I needed to rethink the standard idea of bonds and stocks. As I prepared to sail into retirement it became quite clear that I didn't want to have a big draw down early in that retirement period. A deep or very long bear market at the beginning of your retirement can devastate all your plans. Pre-retirement investment planning always seems to stress the need for bonds, but bonds can have bear markets too. as they did form the 1960's to 1980's and a bond bear will likely happen again once it becomes common knowledge that inflation is here to stay beyond rising gasoline prices.
What we need to get right when we're heading into retirement is generating income and reducing the volatility that comes with major bearish moves. The only sure way to do that is in money market funds or T Bills and bank CD's. Right now with some money market funds yielding 4.75%, a million dollars will bring you $47,500 per year or just under $4000 per month. With Social Security or other pensions, this may be enough if you own your home and live modestly. Not too long ago money market funds were yielding 1% or less, so we all know that money market funds are not guaranteed. But you could spread a million dollars around in 5-10 year bank CD's at 4-5% in enough banks to retain FDIC insurace coverage in case of bank failures. If you have enough money to generate income for a decent life, either in taxable or tax free short term money market instruments, by all means do it and forget the rest. Many people live very happily in just this manner.
I'm not beating the drum for Wellington Fund, but 4-5% in Tbills or money market funds or CD's is only half what you'd expect to get, on average, based on Wellington's almost 77 year history. Your same one million dollars in Wellington would get you $83,500 per year,on average, leaving you with your million dollars and just shy of $7,000 per month. You would get less than that some years and more in others, but you could safely take out $80,000 per year without too much worry. Based on data I have for total returns since September 1988, Wellington averaged 7% and Dodge & Cox Balanced Fund 10.6% per year. But you get the idea. Also bear in mind that if you are taking out a fixed amount each year you aren't compounding it, so your real yield will be smaller and before tax.
Another way to look at a million dollars at age 65 is as an annuity. If you structure your million dollars in T bills, zero coupon T notes and zero coupon T bonds at a 5% return, which is currently very nearly do-able, you could draw out $72,000 per year before taxes for the next 24 years before you run out of money. (See chart.) That would make you 89 years old, beyond the current normal life expectancy for either a 65 year old American woman or man. Or you could buy multiple 30 year US treasury T bonds and cash one in each year. If you bought 25 of the 30 year T bonds at 5%, you could cash in one each year and collect the 5% on the remaining balance.
These are four fairly simple ways of providing a modest but steady income from a million dollars for your entire retirement at current interest rates. The lesson to be learned is that you need a fairly large amount of cash to start with in retirement and must have a modest budget to make it, but it can certainly be done. Recent studies show that most people have or will have far less than a million dollars. I don't think they are all going to make 20-30% a year on their $250,000-$500,000, but apparently they think so.
I do think it is possible to increase your yield from 4-5% to a low volatility 7-8% or more with a little work and planning and with rigorous budgeting. $500,000 at 8% gets you $40,000, and with Social Security of $1000 per month that would give you $4,333 per month or more if you annuitize it as above. I realize that many reading this will have far in excess of a million dollars when they retire, as I do, but many do not, and the future looks quite bleak for them.
Next time I'll cover what I see as the important portfolio structuring approaches for increasing yields while keeping price volatility or downside risk fairly low.
The main contribution of sentiment gauges is to tell you whether the market is in either a excessively bullish or bearish phase. In the past ten years I have run the 2C Sentimemeter (2CS) which is the five day running total of the daily product of VXO times the CBOE combined put/call ratio. A lower number indicates options buyers are bullish, and a higher number that they are bearish.
In the 1990's and up to 2003, tops were made when the 2CS was in the 60's. Since the bull market began in 2003, there has been a "range shift" so that it takes more bullishness to turn the market down and less bearishness to turn it back up than it did from 1996 to 2003.
A reading from 90 to 120 has always been sufficient for a low except during the 1998 crash, and 2002 and 2003 lows when readings exceeded 200.
Thus if the drop from May is a "normal" correction in a continuing bull market, we should turn up before long.
In late 2000 I started looking at a new indicator on a daily basis to see if I could improve on the slower 2CS. It evolved by spring 2001 to include an "amplified" options component plus up/down volume and breadth (up/down stocks) components in a "cocktail" of my own.
In this daily Sentiment Oscillator, under -3 and over +13 have indicated excessive bearishness and excessive bullishness respectively on a short term (days to weeks) basis.
In sentiment work there is always a danger of a "range shift" when longer term sentiment is changing. We saw that for the upside when sentiment ranges expanded upward in 2003-2004. this trapped a lot of bears who expected a resumption of the bear market when sentiment got "too" bullish on a short term basis. Instead all we got were modest corrections to the new bullish trend.
That can happen to bulls too, and it demands honesty and thoughtful observation. If this decline drags on with sentiment staying down under zero or -3, and/or a rally fails to be robust, the market may be telling us that the longer term trend has changed to down. I don't see that happening yet, but this drop is a bit deeper and quicker (momentum) than we've seen since August 2004, so it's best to be careful and to be honest with oneself.
Frankly I got tired of trying to present a timely and useful service for free, and I have no desire to do it for money. Not surprisingly the method is something that cannot be canned and marketed as a sure thing. It is a method which gives early and very impressive hints of intermediate term trend changes, but it requires for execution some judgement derived from other sources: sentiment, volume, long term cycles, experience, etc.
I may sometimes refer to it in the future, but take it simply as a trend change signal as you would the mention of a moving average or trend line break.
Sentiment got very bearish in the past few weeks, so much so that I suspect we have a good rally yet to come. I am working on putting my daily sentiment oscillators (2SO) into Excel so I can begin to show it. Normally it needs to get to 12-14 at least to signal that a downturn is coming, and under zero for an upturn. It got down to -9 and is still only up to 7.5.
The 2CS, which is a five day running total of the daily product of VXO and the CBOE P/C ratio, and which is "upside down" compared to price and the 2SO, got to a high of 100 the week before last and is now at 78. The 2CS has been reaching the 50's or 40's regularly at highs.
The ISEE ratio of their in house buy-to-open put /call ratio (kept by long time cyberfriend Chairman Mao) reached levels not seen since the 2004 swoon. MaoXian's eclectic blog can be seen at: http://www.maoxian.com/ He always puts an index or ETF chart with his sentiment charts, but it is just a chart of interest and not directly related to the ISEE chart data.
I have put together a portfolio of mutual funds which have decent gains but low volatility. Money in retirement funds and money earned in the futures accounts are invested in this long term failry conservative manner. I have had a lot of help from FastTrack's fine website
The total portfolio lost 2.7% peak to low on the May spill. It has recovered to 1.17% as of Friday.
The portfolio is up 4.35% on the year, up 12.84% from one year ago, and up 13.2% annualized from its inception on September 1, 2003.
http://www.fasttrack.net/ I am now using FasTrack's one month free trial of their program and whole data base. More on this another time, but I recommend the free website for seeing total return charts (dividends reinvested) on funds and stocks too. Their "ulcer index" and risk-adjusted return indicators are excellent ways to see what your fund choices "really" are doing for you.