Asymmetric Investment Returns - Insights into portfolio management beliefs, strategies, and tactics that aim to create a positive imbalance between risk and reward

The following chart is from my friend Ed Easterling at www.CrestmontResearch.com. I'm proud to say I was one of the very first to read and comment on Ed's book back in 2005: "Unexpected Returns". Prior to 2005, we had completed extensive research on historical Secular and Cyclical Bull and Bear Markets. Primarily, I had studied the trends going back over 100 years and tested tactical systems across those various trends. Our conclusion was that long term (Secular) Bull and Bear market's had occurred over and over throughout history. When Ed came out with his research in his book, we compared notes. His work was more focused on why Secular trends occur and under what circumstances. "Unexpected Returns" is a necessary study to understand the big picture. I can tell you that it was my understanding of market trends that motivated us to create the money management systems we benefited from the past five years. You can probably see how the timing of Secular situation correlates with our tactical asset management style - we built the Ark before the flood.

Though we studied and tested decision-making systems on much more detailed data, I thought I would show what these trends look like. Clearly, the U.S. stock market has been in a Secular Bear Market for a decade. Based on history, the current Secular Bear could last as long as another decade. Notice this chart goes back to 1900.

Below we show what the last Secular Bear Market looked like. This chart appeared in 5 of our quarterly portfolio commentaries before the waterfall in 2008. We continued to discuss these cycles so our investors were prepared for the possibilities. The last Secular Bear Market was about 16 years. We call the cycles oscillating up and down over time Cyclical Bull and Bear Markets. They typically last 1 - 4 years. At this point, the U.S. stock market has been in a defined Cyclical Bull Market since March 2009, however it is currently under pressure.

You can probably see the risk of a passive strategy and the potential value of actively managing risk and dynamically adapting to these systematic directional price trends. It doesn't require perfection.The average uptrend was 38%, the average decline was -25%. It was 343% cumulative peak to trough drifts, an average of 21% a year.

From this wisdom, we have some understanding of what is possible. Sadly, investors who do not actively control their risk may experience more waterfall losses and possibly panic selling before the current Secular Bear is over.Of course, just "being" tactical isn't enough. Portfolio management is a craft that requires wisdom, skill, and experience. Like any craft, it's learned over time.

"Those who cannot remember the past are condemned to repeat it"

- George Santayana

In a post titled Golden Cross Goes "Dark". Barry Ritholtz over at The Big Picture, points out the "Dark Cross" signal has occured on the NYSE Stock Index. It is sometimes called a "Death Cross". A Dark Cross signal means the 50-day moving average has crossed below the 200-day moving average on a major stock index. He quotes a comment from Mary Ann Bartel regarding the current status:
 

June 23, 2010 marked the 1-year anniversary of last June’s bullish Golden Cross of the 50-day moving average above the 200-day moving average. This Golden Cross signal preceded a 12-month return of 22.4% on the S&P 500. The average 12-month return for the 42 Golden Crosses that have occurred since 1928 is 9.6%. More importantly, the June 23, 2009 signal occurred during the NBER recession that began in December 2007 and Golden Crosses associated with recessions show a much stronger average 12-month return of 19.5%. The average 12-month return for the S&P 500 over the same period is 7.2%.[...]

The bearish counterpart of the Golden Cross is called a Dark Cross. This signal occurs when the 50-day moving average crosses below the 200-day moving average. For the S&P 500, Dark Crosses are not all that bearish. The 42 Dark Cross signals that have occurred since 1928 have generated an average 12-month return of 2.4% for the S&P 500 vs. the average S&P 12-month return of 7.2%.[...]

 

Below we show that the NYSE Composite Index has indeed signaled a Dark Cross.

^{Chart courtesy of eSignal}

However, we point out that the S&P 500 index hasn't yet crossed. We also point out that the current price is "at" the point we previously called "the line in the sand" we most recently discussed here. The current price range has been supported by buying interest at the February low and the more recent lows in May. So, I will suggest this index is at an important spot. If it does indeed move below the support line, it changes the short term trend to lower highs, and lower lows (a down trend). If the price continues to drift much lower, it could also signal a Dark Cross. Though the signal itself isn't a "cause" for futher systematic price decline, it would be evidence that suggests a reversal of the rising trend over the past year has ended, as defined by the Golden Cross (50 > 200) and then a Dark Cross (50 < 200). What does history tell us about these signals? Keep reading...

Our friends Ron Griess and Mark Cremonie over at www.thechartstore.com did some analysis on the S&P 500 Composite from 1930 and present the following two tables. The first table shows the performance of the S&P 500 Composite for the time periods listed when the 50-day moving average is falling and crosses the 200-day moving average while the 200-day moving average is still rising.

The second table shows the performance of the S&P Composite for the time periods listed when the 50 day moving average is falling and crosses the 200 day moving average and the 200 day moving average is also falling.

 Like many things in life, success has nothing to do with predicting the future. It's more about responding and adapting to things as they unfold. At this point, it seems there's a good chance this price level will hold since investor sentiment is rather negative (which is a positive). But if it doesn't, this will define a trend change. It's how we adapt to it that makes all the difference... 

We consider a "full market cycle" to be a period that includes both an upward trending market and a downward trending market. The past five years have been an extraordinary example of a complete market cycle. Clearly, it has been a period that has separated the skilled investment managers from the unskilled and the skilled investment managers from the passive investors who claim no skill at all (those who passively buy and hold). 

After a recent discussion with someone about the past five years, we thought we would share some simple line charts so you can visually see how these markets have performed over a full market cycle. Below we show monthly charts of several market indexes over the past five years.

S&P 500 Stock Index: This index was around 1200 five years ago, on Friday it closed at 1064.This popular stock index is down approximately -13% in price since 5 years ago (1064 - 1200) / 1064)).

 source: eSignal

Russell 2000 Index: Below we show a monthly 5 year line chart of the Russell 2000 Small Company Stock Index. The Russell 2000 index represents the small company segment of the U.S. stock market. (Small company stocks are considered by many to be more risky than larger stocks). The price trend of this index is at around the same point it started 5 years ago.

source; eSignal

Since we are willing and able to trade and invest in various markets, we also include the S&P GSCI Commodity Index. The S&P GSCI® is designed to provide investors with a publicly available benchmark for investment performance in the commodity markets.The commodity index was very strong before its vast waterfall in 2008. But unlike the other markets, although its waterfall was even steeper than stocks since 2008, the commodity index has gained some ground over the past 5 years. Its price has increased from around 350 to 475 for a price appreciation of approximately 26%.

 Source: eSignal

One "sign of the times" of the past 5 years is that the next index had a different name at the start of the period. What is now known as the Barclays U.S. Aggregate Bond Index was formerly known as the Lehman Brothers Aggregate Bond Index. Lehman Brothers, of course, didn't survive. So much for "too big to fail" (it was the largest bankruptcy in U.S. history). When Lehman failed, Barclays took over the bond index. Of course, the index was only maintained by Lehman, their failure didn't necessarily directly affect it. However, if you look closely at 2008, you'll see that this broad based bond index experienced a sharp price decline along with other markets. In fact, between 9/9/2008 and 10/10/2008 this bond index dropped -13.18%. The Barclays U.S. Aggregate Bond Index is intended to represent the United States investment grade bond market. This bond index price is slightly higher over the past 5 years.

Source; eSignal

And finally, we show the MSCI EAFE Index. It is an International stock index that is designed to represent the stock performance of 22 non- U.S. countries. As you can see, this index is down somewhat from its price point 5 years ago.

source: eSignal

We hope that we have provided you with a interesting visual representation of a wide range of indexes covering stocks, bonds, commodities, and international stocks, by using some of the most popular indexes. As you can see, the past 5 years have been a fine example of a "full market cycle" made up of a rising trend, a falling trend, and then a new rising trend.

The Securities and Exchange Commission requires the following disclosure about indexes: Indices are unmanaged and cannot be invested in directly. Returns represent past performance and are not a guarantee of future performance.

In the table below we show the S&P 500 Stock Index when it reversed down -10% or more over the past 10 years. Declines of -10% or more are not very common: they primarily happen during Cyclical Bear Markets. Out of 11 such declines, ALL OF THEM occured within a Cyclical Bear Market or marked the beginning of one. Over the past decade, when the stock index does decline -10%, on average it declined -22.3%. (Note: A -20% decline is commonly called a "bear market"). As a side note in regard to the average: 11 events isn't enough to be statistically significant, so we look back 82 years. Since 5/14/1928 there were 92 declines of more than -10%. On average, they lasted 102 days and the average decline was -19.65%. That isn't a lot different than the last decades mean of  -22.3% over an average of 100 days. You can probably see how we use studies like these to quantify, define, and understand, what is normal, or not.

10% Gains also occured 11 times over the past decade. IN ALL INSTANCES, the 10% or more upward drifts occured within a bear market or it marked the end of a Cyclical Bear Market and the beginning of a new Cyclical Bull Market (no one knew that then, so we could also state that all instances occured within a Cyclical Bear Market). For example, the first low point that made the list was on 4/14/2000. The 3/24/2000 close of 1527 had previously marked the highest point and the beginning of a Cyclical Bear Market that lasted through the lowest close on 3/11/2003. That same date marked the beginning of the Cyclical Bull Market the continued through it's end on 10/9/2007. You may notice that these dates are also marked on the table below since they were "picked up" by the 10% swings. Of course, the end of a Cyclical Bull Market is the beginning of a Cyclical Bear Market marked by that same date. Finally, the last 10%+ gain in the index started on 3/9/2009, which we now know was the beginning of the current Cyclical Bull Market as the Primary Trend today.

When the index gained 10% which it did 11 times over the past decade, its average gain was 30.52%. That isn't far from the 33.7% average gain that occured the 93 times the index gained 10% in the past 82 years going back to 2/20/1928. And, during the past decade the move averaged 234 days and that is comparable to 222 days over the past 82 years. We could suggest that this data is more meaningful when we separate the it by cyclical trends. For example, we could remove the Cyclical Bull Markets (3/11/2003 - 10-9/2007 and 3/9/2009 -NOW) and probably have more meaningful information.  Without those two cycles, the 10%+ move averaged 55 days and the average gain was 18%. You can probably see how far we could take this to better quantify, define, and understand, directional trends... We'll build on this, later.