After the successful investment returns in 2007 I began to spend considerable time developing a model that would assist is replicating the returns in future years. This project turned into a three year immersion into Quantitative Analysis and investment strategy development which combines both stock selection and market timing in one package. Anyone who knows me would probably agree I loathe hyperbole in the financial press but the back-testing and real time present day monitoring of the models results continue to be consistent. The returns generated in individual stock portfolios since this past October are exciting and an example of its potential. However, as in any case of investment modeling and strategy the standard warning of “Past performance is not a guarantee of future performance” is always true.
The model went into full time use for RMHI clients in October when the anticipated mid-term election rally (see 4th Quarter 2010 client letter) was emerging, the single largest rally in the four year Presidential term. So far, the results speak for themselves.
The RMHI models give our accounts a distinct advantage over mutual funds or large pooled portfolios in several ways:
- The model allows our portfolios to focus on the best 30-40 stocks our model identifies rather than diluting accounts with 200 to 500 or more common in most mutual funds. Included is, as always our screening for negative animal and environmental companies.
- Market timing with Hedging is built into the model which is not generally present in SRI or mainstream mutual funds.
- RMHI being a “small” investment management firm allows for a distinct advantage since not only does it allow for greater concentration of the best potential holdings but also for investments in smaller capitalized companies where larger funds must pass over due to size restrictions. As the studies below indicate “small” with a value bias tends to be relative outperformer.
- By and large the best investment managers in the world are capable of generating returns in the 30% zone and they frequently use some form of investment modeling. Our small size allows us to “be under the radar” which enables us to invest in small and micro cap stocks which provide higher rates of return* and which most mutual funds or hedge funds are unable to.
A portion of the initial foundation of research for the model can be attributed to James O’Shaughnessy exhaustive research in his book “What works on Wall Street” where his research suggested that value factors such as Price/Earnings, Price/Book, Price/Cash Flow and particularly Price/Sales have consistently exceeded their benchmark indices and offer better guidance in stock selection rather than many Growth oriented factors. In other words, stocks that are valued cheaply tend to outperform their peers.
The model has two primary functions: Stock Selection and Market Timing.
Stock Selection: Stock selection is based on the time tested method of identifying potential investment candidates based on three measures:
Low Price to Revenue with Low Price to Cash Flow: In addition to O’Shaughnessy’s research there is a significant amount of research which has determined the effectiveness of value-based selection criteria:
Robert Shiller stated in 1984 that fundamental value was probably the most important determinant of future price expectations.
Labonishok, Shleifer and Vishny (1994) determined that Value consistently outperformed “glamour” aka Growth stocks regardless of size or business cycle.
Fama and French (2007) determined that Value stocks (with low ratios of price to book value) have higher average returns than growth stocks (high price-to-book ratios) see graph below.
The ability to invest in the “Smallest” “Value” stocks will provide our investors with a distinct advantage over large institutional investment managers and mutual funds. As the chart from Eugene Fama reveals: The ideal sweet spot for stock selection is the crossroads of “Smallest” company size and “Value” which outperforms “Biggest – Growth” by almost 300%.
Short Interest: Research shows that growth stocks are more heavily shorted than value stocks and that short sellers tend to be right. Asquith and Meulbroek (1995), Desai et al. (2001), and Dechow et al. (2001) provide evidence that more heavily shorted stocks tend to perform poorly. A reduction in short selling/interest over recent months indicates less bearishness and potential future price appreciation.
Price Momentum: Simply stated, stocks that are cheap based upon their balance sheet assets relative to the stock price tend to outperform over extended time periods. But! It’s not enough to have just a cheap stock….you need a cheap stock that is moving higher, otherwise the market could be rising but your cheap stocks are stuck in the mud and not making any progress.
Jagedeesh and Titman (1993) observed a pattern of price momentum whereby past winners tend to outperform past losers over the next three to twelve months.
Conclusion: Value stocks and in particular Small Value stocks have provided a much better return historically than popular Growth Stocks. Using the historical results and applied with the use of Quantitative Analysis a diversified portfolio built upon the RMHI model should improve the expected rate of return without a significant increase in volatility, resulting in a much better risk-reward than could be achieved without the model.
In the RMHI model approximately 5000 stocks are scanned daily and ranked based upon our formula. Stocks selected for investment are generally ranked in the top 2% and are held until they fall out of the top 5% category.
Market Timing: The goal of the RMHI Market Timing module is not to attempt to identify average market downdrafts but to catch major market swings up or down which tend to be driven by earnings. In addition, it’s impossible to anticipate news events that could drive the stock market lower such as 9/11 or the JFK assassination. Such events are random and typically short-lived. Eventually markets resume the path they were on before the random event. In addition, I wanted to avoid unnecessary trading or frequent signals that could have us trading excessively. Essentially we’re looking for the big moves and ignoring the minor moves that would create unnecessary trading and reduce returns.
There are many tools that can be utilized to aid in predicting future market direction. The accuracy and predictive ability of an indicator can and do change. One of the most accurate in the past decade has been the rate of increase or decrease in earnings expectations by analysts for the S&P 500 Index. Markets have moved in the direction of earnings expectations quite closely for the past 20 years.
In the past 10 years the stock market has been especially vulnerable when earnings expectations for the S&P 500 begin to falter.
In the 1990’s Dr. Ed Yardeni, based on statements made by then Federal Reserve Chairman Alan Greenspan developed the “Fed Model” as a method of valuing stocks versus bonds. Simply stated, the original Fed Model was a tool that assisted in determining whether stocks were a better value relative to bonds.
The financial theory was simple enough: money would flow to the asset value which was relatively more attractive and away from the overvalued asset. In reality, the Fed Model by itself was a relatively poor indicator by itself but the basic theory was a good foundation to start from.
From 2000 to mid 2002 the Fed model gave a good account for itself as the model determined that stocks were of poor relative value to bonds and stocks did endure a prolonged Bear market.
In an effort to bridge the gap from theory to actionable buy-sell signals I experimented with many alternative indicators (including Sentiment, Monetary Policy, simple moving averages for the stock market) but determined that the Consensus Earnings Estimate for the S&P 500 provided the best indicator when combined with the Fed model.
As the red line in both charts below show, risings estimates for the S&P 500 index tend to be associated with good returns for investors even when bonds are of better relative value to stocks. But rising earnings estimates combined with an attractive stock to bond comparison as determined by the Fed Model foretold extremely strong returns. And, declining earnings tend to be associated with declining returns as well, especially when equities were poor value relative to bonds.
Blending the Fed Model with current forward looking earnings estimates proved to be an accurate and reasonable combination of effective and actionable buy – sell signals for U.S. equities since 2001.
The chart below shows the timing mechanism of selling when earnings move below the 20 and 40 week moving average and buying when rising above the 20/40 week average. In case you’re curious, the last sell date was June 2008.
Back Test Results of the RMHI Model: The data and test results date back to March 2001. The effects of compounded returns over the 10 year period are self evident which accounts for the accelerating appreciation in value (red line). The shaded areas are periods when the Market Timing module indicated that risk was very high for stocks and Hedging of portfolios was in place. Hedging consisted of selling 50% of the value of the portfolio of stocks and replacing them with the Proshares Ultra Inverse S&P 500 ETF (symbol SDS), creating a market neutral risk profile.
| Annualized Rate of Return net of trading expenses |
54.86% |
|
Average Total number of positions
|
30 |
| Total Return net of trading expenses |
7139% |
| S&P 500 return |
11.87% |
| Annual Turnover |
241% |
| Maximum Drawdown |
-28.4% |
| Percentage Winners |
52.77% |
| Sharpe Ratio |
1.87 |
| Standard Deviation |
Model 28.4% versus 26.19% S&P500 |
Model Returns by Year including trading expenses gross of management fees
| |
2001* |
2002 |
2003 |
2004 |
2005 |
2006 |
2007 |
2008 |
2009 |
2010 |
| RMHI Model |
106.96% |
78.99% |
158.43% |
112.9% |
21.46% |
59.38% |
2.02% |
23.94% |
72.51% |
39.21% |
| S&P 500 |
-1.38% |
-23.37% |
26.38% |
8.99$ |
3.00% |
13.62% |
3.53% |
-38.49% |
23.45% |
12.78% |
| Excess Return |
108.34% |
102.36% |
132.05% |
103.91% |
18.45% |
45.76% |
-1.51% |
62.43% |
49.06% |
26.43% |
Investors are typically loath to endure a cyclical Bear Market which can last for 6 to 9 months or more. My hope is that the use of Hedging of portfolios during periods of predicted market weakness will incline antsy investors to stay put.
Frequently asked questions:
“If your model indicates risk is high and the chances of a big market selloff are large, why not sell off all your stocks and put 100% into the SDS?” A very valid question, back testing this concept showed that volatility of the portfolio would be much larger without any stocks to offset the “SDS”. Bear Markets tend to have some very strong rebound rallies or whipsaws which cut into the gains made on the SDS and make any investor nervous. You could get lucky and sell at or near the bottom, that’s certainly possible since investor sentiment at bottoms is extreme. My preference is for the less volatile strategy.
“Is there an aspect to the model that you’re not completely happy with?” Yes, the market sell signal in 2008 was excellent but the buy signal, which required earnings to exceed the 20 week moving average was slow in my opinion. The absolute bottom for most stocks was November 2008 but the model did not go into buy mode till May 2009. Ideally the hedges should have been removed when sentiment was truly extreme in November and slowly adding stocks afterwards.
“Is this the only model you have developed? Are there others in case this one loses effectiveness? Yes, in addition to the present model there are at least three others that I continue to monitor closely. However, models can run hot or cold from one year to another. I gave special preference for long term consistency which is why I’m using the present RMHI model.
“No model is perfect, what do you consider your models biggest weakness?” There remains the risk of annual short term draw-downs or pullbacks in the portfolio. I wish those could be smoothed but it’s not realistic at present and trying to do so can severely impair returns. In an effort to temper this risk I’m considering employing the Ned Davis annual cycle chart as a roadmap. It is predicting the start of a Bear Market in equities beginning in August 2011.
“Have there been any extended time periods where you believe the model would not have been effective?” Yes, but this based upon experience rather than data. The late 1990’s when the mania for Growth stocks, particularly Technology stocks was a rough time for Value stocks in general. However the pendulum swung back sharply in the early 2000’s and the normal outperformance of Value reinstated itself.
“Why not simply sell all the stocks and just hold cash instead?’ This is another “all or nothing” approach which has significant risk in terms of “Opportunity Cost” or what you could have made had you held on to the portfolio with hedging. The chart below shows this option:
Using cash in lieu of the SDS Hedge drops the annualized rate of return to 48.5% but the real cost is the impact on the compounding when compared to the chart using the hedge.
To sum it up, I’ve attempted to be as comprehensive as possible with this presentation by detailing the academic and data research that is the foundation for the model. Some aspects such as Momentum and the weightings of the model elements must remain proprietary. No model is perfect but based on everything I’ve monitored to date, the model does work effectively. There are also the normal risks associated with any equity investments in particular surprise events. However, one very important lesson that must be acknowledged is that subjective opinions will, in general hurts returns. Maintaining discipline is essential to the performance of the model and I will maintain the effort to do so.
Disclosure regarding the SDS: Each Short or Ultra ProShares ETF seeks a return that is either 300%, 200%, -100%, -200% or -300% of the return of an index or other benchmark (target) for a single day. Due to the compounding of daily returns, ProShares’ returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. Investors should monitor their ProShares holdings consistent with their strategies, as frequently as daily. For more on correlation, leverage and other risks, please read the prospectus.
Investing involves risk, including the possible loss of principal. ProShares are non-diversified and entail certain risks, including risk associated with the use of derivatives (futures contracts, options, forward contracts, swap agreements and similar instruments), imperfect benchmark correlation, leverage and market price variance, all of which can increase volatility and decrease performance. There is no guarantee that any ProShares ETF will achieve its investment objective. Please see the prospectus available at www.proshares.com for a more complete description of these risks.
“Don’t want to be an American idiot
Don’t want a nation under the new media
And can you hear the sound of hysteria?”
Green Day “American Idiot”
Investing has always been a process that included controlling your emotions. When you have them under control not only do you tend to make better decisions, they also tend to be much more profitable. Investors love the chorus of “buy low and sell high” but when emotions take over, the reverse is generally what happens. Its always hard to buy at the bottom, if it was so easy then we’d be a nation of very successful investors but the undisciplined investor is far from successful.
Consider the plight of the investor who took his lumps in the crash of 2008 only to give up on equities and turn to bonds as a means to sooth their nerves. Bonds could never be considered an option as the primary means of replacing what was lost in ’08 but the consistent drumbeat of downbeat news bordering on the hysterical and unfounded has been consistent in both the conservative and liberal media.
Despite the extremely strong run in equities since the Spring of ’09 investors have continually been pulling out of Domestic Equity funds and their primary landing spot has been bond funds. Investors (likely based on the media) continue to believe that the another crash is just around the corner. Just last week on Fox a commentator strongly suggested that the market would crash again should the tax extensions not be granted by Congress. Last week individual investors pulled out $1.8 billion from domestic equity funds bringing total net 2010 redemptions to $81 billion, despite equity returns being resoundingly double digit for many classes! In contrast, taxable bond fund deposits have totaled $245 billion despite Treasury yields at rock bottom.
Its been our belief for months that the 30 year bull market in bonds was peaking and that a new bear market in bonds would commence, it appears we were on target. Pity the poor investor who was persuaded by the hysteria this summer to buy bonds only to see close to three years of yield evaporate.
We completely understand that investors are concerned with potential losses but solutions to losses should not come at the expense of return. Hence, the RMHI Hedging feature which we’ll be writing about at length shortly.
Be Careful Out There
Brad
The double top formation in Treasuries is looking very ominous but now the media and investors have caught on to the trouble in bonds. Franklin Resources is reporting outflows and negative returns in fixed income accounts which is astonishing considering how significant inflows have been for years. For this reason we must consider that if stock strength remains, investors could finally return to equities to propel prices much higher, probably to 2007 levels in 2011.
In the meantime, I’ve sold our TBT position today for a nice profit which was a bearish play on Treasuries. Sentiment has reached an extreme with Treasuries and my guess is downside is limited for the time being.
Over the past year I’ve preached that one of the primary requirements for investors to maintain and recoup from 2008 is perseverance. That has been especially true in 2010 as the investors who reacted due to fear in the past two years are now being treated to negative returns while RMHI equity accounts are coming much closer to our 2007 valuations. The “fear trade” almost never works yet the hardest trade (to be able to buy in spite of rampant fear) almost always does.
To accumulate wealth via investing is not easy, it takes courage and determination in the face of frequent bouts of fear. If you hang tough and have your assets managed effectively your returns should far and away exceed fixed income and guaranteed return investments.
No positions
Brad
When you look at socially responsible or green investment mutual fund performance do you ever wonder why the returns are so closely correlated?
This does not happen by chance as the correlations of fund groups tend to run very tight regardless if they’re SRI funds or not. Investors, both professionals and amateurs alike tend to invest with a herd-like instinct. But there is another factor might be the single largest reason and that is Market Capitalization or Liquidity.
Mutual funds are businesses first and foremost and become more profitable as they grow larger in size. The problem with being larger in size is that it forces the fund to only consider stocks large enough to absorb the funds purchases without significantly moving the stock price. By moving higher up in capitalization there are not only fewer stocks to choose from but the returns are correspondingly reduced*.
Hence the vast amount of mutual funds especially U.S. Large Cap funds are choosing to fill their portfolios from typically no more than 1000 stocks. If they choose to benchmark the fund to the S&P 500, there may be no more than 500 stocks for the fund manager to select from. These 1000 stocks are the most heavily researched and scrutinized as well so that its hard to possess information that is not already dispersed amongst investors, this is a very hard arena to compete with.
There are alternatives and solutions to herd-like returns on investment and that is to own a portfolio not trapped by the restrictions of considering such a small number of investments. For example, in our privately managed portfolios we consider over 10,000+ investments every day. This allows us to avoid herd behavior and research investments that could never be considered for a larger fund, a considerable advantage in our opinion.
In sum, there is very little deviation in the holdings of U.S. mutual funds especially Large Cap funds. This is primarily due to their business structure which demands that investments trade on scale that can absorb tens of millions of dollars daily. There is also the issue of career risk as no manager wants to stand out on the downside in annual reviews, hence it may be better to join the pack rather than deviate from them. Either way, socially responsible investors should not expect above average performance over a multi-year time horizon as informational advantages are minimal at best.
Brad Pappas
*(See “Contrarian Investment, Extrapolation and Risk by Lakonishok, Shleifer and Vishny. Journal of Finance, December 1991)
For the first time in many months we’re doing some serious selling. Learning when to do some selling is essential for any socially responsible investor as many of our holdings have run quite far.
We’ve sold off all leveraged ETF holdings which were purchased this summer during the midst of the deflation debate.
We have also sold our shares of Dorman Products as the rise has become parabolic. Yesterdays decline was a tip that the momentum crowd has taken hold of the stock, so today’s sharp rebound in shares seems opportunistic.
Investor sentiment has simply gotten too extreme and I believe the upside is limited until we increase investor negativity. Earnings growth remains positive so this is not a call for a bear market or anything severe, its just a matter of investors getting too aggressive betting on the upside.
Brad
No positions
The 4th quarter of the investment year frequently reminds me of the 4th quarter of an NBA game. The earlier quarters are played when the “time on the clock” has little meaning since there’s so much game time left. But the 4th quarter is played with a sense of urgency as the clock winds down. While bench players frequently get their playing time in the earlier quarters while the best players play in the last minutes. Red Auerbach used to say that it was more important to be the player on the court who finished the game rather than who started the game.
In the 4th quarter of the investment year the equity markets tend to come alive with an upward bias that usually extends into the New Year. Mutual funds and Investment managers keep score of how well they are doing and the unfortunate may be suffering from a bout of “performance anxiety” which has way of keeping a bid underneath the markets. Those managers who’ve been underweight or underperforming coming into the quarter start to deploy capital swiftly, so as to not be left behind. While we’ve had a modestly successful year so far, the finale of the year could make the difference from a modest year to a very good year.
Just as a coach wants the best players on the court at the end of the game, lagging stocks holding must give way to better performers. In my 20 years of investing one of the most important tenets is to sell underperforming assets quickly as they will drag down returns.
Stocks: As I wrote this past January I expected the U.S. Equity markets to be relatively flat within a trading range for the majority of 2010, until the 4th quarter. This is typical action for the second year of an economic expansion and 12 to 24 months from a major market bottom. Consider it a period of digestion from the big move up in 2009, its normal and not generally a precursor to a major move down. I mentioned that the most likely time frame for a move up from the trading range would be in the 4th quarter. It’s starting to appear that the move past the top of the range of 1130 on the S&P 500 to 1140 may be a signal that we’re ready to move up to at least 1200-1210. Market indicators have improved measurably in the past two weeks but the risk of the market failing and moving below 1130 is still very real, so near term caution should be observed especially when considering that October is infamous for market declines. That being said, sell-offs occurring within a strengthening market tend to be short and shallow.
If we continue to rally higher it will coincide with the anticipated Mid-term Presidential elections which tend to be a catalyst for a significant equity rally. In fact, the next 9 months have historically been the three best quarters for equities during the entire 4 year period. Mid-term rallies tend to range from high single digits to 30% or more with duration of six to nine months.
In sum, since 1900 the DJIA has tended to rise after the mid-term elections with the next 9 months being the most profitable of the Presidential term. It’s possible that investors are looking at the polls which show a loss for the Democrats which will likely split Congress. Since 1900, when we have a split Congress and a Democrat as President the DJIA has averaged 7% per annum.
Stock selection during the next 9 months will be critical in order to maximize the opportunity. Third year rallies should be viewed from the perspective of Secular Bull or Secular Bear markets as the DJIA gain since 1900 during a Secular Bull has been 16.% while during Secular Bear’s are a subdued 6.4%.
Emerging Market stocks especially in Latin America should do quite well in absolute and relative terms compared to US equities. EM and Latin America are in Secular Bull mode while the U.S. is in Secular Bear mode. Our positions in IRSA Inversiones Y Representaci (IRS), Companhia de Saneamento Basico do Estado de Sao Paulo (SBS) and Telecom Argentina (TEO), Enersis (ENI) are starting to perform with good relative strength.
Green Screens: On our Green screen where our proprietary model filters the sea of Green for the best are two new names. These two Green Investment names could run fast if we rally into the year end:
Solarfun (SOLF) – Chinese developer of solar energy equipment including the sale of photovoltaic products
Sunopta (STKL) – An organic food maker focusing on soy and oats for the organic and natural food markets. Packaged products include soy milk and a whole array of grain based food products.
US markets: Since the market bottom in March 2009 there have been nine rallies of 5% or more. In all nine cases the Materials and Industrial sectors have lead in performance. Representative of these two sectors which also showed near the top of our model selections are WHX Corp, (WXCO), Material Sciences (MASC) and very strong performers: TPC Group (TPCG), Motorcar Parts of America (MPAA) and Dorman Products (DORM).
Bonds: In a statement made by the Federal Open Market Committee they outright stated their concerns about deflation and that at present the inflation rate was “somewhat below” their intended goal. In addition, the Fed statement mentioned that inflation expectations are “subdued for some time before rising to levels that the Committee considers consistent with its mandate.” The mandate of the FOMC is for stable asset prices and full employment. In addition the Fed made a remarkable statement: The FOMC stands ready to “provide additional accommodations if needed to support the economic recovery, and return inflation, over time to levels consistent with its mandate.”
The change in language likely means that the Fed could initiate another round of Quantitative Easing (QE2) sooner rather than later. QE is a process where the Fed goes to the open market or the major banks and buys Treasury bonds in an effort to drive the prices higher thus lowering the yield. By purchasing the bonds in exchange for cash, the banks primarily, can become flush with cash which hopefully will cause them to initiate more loans thus helping the economy. The media often states that the Feds actions resemble “cash thrown out of a helicopter” when in fact, QE does not “create” new monies at all, it exchanges bonds for cash in a zero sum transaction.
There are two major risks to the QE strategy (amongst others):
1. The banks will hoard the cash and not initiate loans. While distasteful to most of us, it’s essential for the Federal Reserve to stand behind the banking industries sensible loans. Otherwise, banks have little incentive to loan with the flatter yield curve and principal risk. The opposing argument is that if the Fed lowers long term rates to the point of near term rates, the incentive to make loans with higher interest rates becomes all the more attractive. If you can issue a mortgage at 5% then it’s obviously better than earning 2% or less with a Treasury.
2. Assuming QE2 is successful, we’ll be faced with the issue of a banking system flush with cash and a Treasury market artificially supported by the Fed. Should our economy prove itself to be self sustaining, (employment increases to acceptable levels) the cash that was injected into the economy will have to be addressed. It’s very possible that inflation above what we’ve seen since the very early 1980’s could return which was a byproduct of government spending the 1970’s. Inflation is an easier enemy to deal with than deflation, so the lesser of evils might be our friend.
For those of you that don’t remember or weren’t around in the early 80’s, short term bonds yielded 20%! I can remember municipal bond investors who wouldn’t accept less than 12% tax free yields. It would be an understatement to state that the 70’s and early 80’s were devastating to bond investors.
Eventually, the Fed will withdraw support to Treasury prices and the Treasury bond market will revert from its current significant overvaluation to historical mean valuations, in other words a significant decline in value but the magic question is “when?” In terms of the Macro investment perspective, the best trade for the next half dozen years may be shorting the US Treasury market via symbol “TBT”.
Positive themes from QE 2:
1. Increase in incentive for banks to loan and increased consumer spending. A by-product of this will be an increase in mortgage refinancing which will free up cash and spending for the consumer.
2. Increase the odds of stabilizing the real estate market. Lower rates imply higher affordability and easier debt service ratios.
3. Investment choices are continually evaluated for relative value and attraction. With Treasury rates at 2% or less for longer term Treasuries, the “real return” adjusting for inflation will likely approach 0% and drop into negative “real returns” should the economy pick up steam or a return of inflation. Asset prices for stocks should continue to grow as investors defect from bonds with little return to assets with better potential.
4. Lower dollar: Lower rates probably mean the dollar continues to be weak. But a weak dollar helps exports and would continue to support Gold. It also supports commodity based economies such as Latin America.
It’s my best guess that the Federal Reserve will do everything possible , even at the risk of higher inflation in a couple of years to keep the economy away from Deflation. This means generally higher valuations for assets, which by the way was one of the most important failures of the Japanese response to their deflation.
Recently John Paulson who made a fortune for his hedge fund by shorting the US Mortgage backed securities market had this to say about bonds/fixed income:
“The purchase of long-dated bonds, either Treasuries or corporate, should turn out to be a horrible trade. Rates are at record lows, and the economy is turning and should continue to churn higher. Paulson expects roughly 2% GDP growth for both 2011 and 2012. Quantitative easing should contribute to significant inflation over the next few years, with inflation possibly hitting low-double digits by 2012. This is bad for the 10- and 30-year and bad for the U.S. dollar. The U.S. dollar should fall and the yields on long-dated U.S. Treasuries should rise.”
RMHI Model, Research and Hedging update: I’ve made significant progress in the past year on refining our models and including a hedging option. Results from the equity selection model have been quite good in recent months but most of my energies have been devoted to finding a reliable mechanism in which the Hedging option should be deployed. In the past my focus has primarily been to concentrate on Investor Sentiment, however further research has steered me to concentrate on corporate earnings shifts.
There were several factors I wanted in a model if Hedging was to be employed:
1. Low Hedging Frequency: I was not looking for a hedging strategy that created a lot of “noise”. In other words, a low number of hedging situations over an extended time period matched with a high probability of success. We’re not looking to catch every downdraft as that’s impossible and turnover costs would be enormous. I’m looking for the big move down where a measureable deterioration in corporate earnings is accelerating.
2. Foundation of the strategy had to be relatively simple with common sense: Complexity tends to be its own enemy as the number of issues that can go wrong increases when the number of factors to consider increases.
3. The use of Hedging had to exceed the rate of return of cash. The Hedging strategy had to create significant and measureable value beyond the rate of return of a money market fund; otherwise it would be wise to simply invest in money market funds while the strategy determined that stocks were to be avoided. The choice of Hedging options has increased in recent years. Hedging with the use of Treasury bonds and bills, Money Market funds, Inverse Exchange Traded Funds for the Russell 2000 and S&P 500 were considered, including those with and without leverage. Options and Futures were not considered at this time. The best results came from the Proshares Ultra Short S&P 500 ETF symbol “SDS”.
My test results revealed that low frequency/high probability hedging model could be created by focusing on current earnings estimates for the S&P 500 index. In nine years of back-testing the RMHI Model with Hedging triggered only three instances where Hedging was in order and all three instances were “profitable”. The
The model did prevent major erosion in value for the sample account in the Bear Markets of 2002 and 2008 and boosted the annual rate of return significantly. The actual data will not be published publicly but only available upon client request.
I’m still searching for a way to do “out of sample testing” such as testing the model in the 1970’s for example. The back test period dates from 2001 to the present.
The Hedging feature of the RMHI is primarily a Bear Market identifier and not designed to catch short market corrections such as what we experienced early this year. The model identifies potential Bear Markets which are attributed to the potential of a Recession due to significant declines in S&P 500 earnings.
At present earnings estimates for the S&P 500 have been rising. After bottoming at $79.53 in late July/early August, it rose to $79.93 at the start of September and is now sitting at $80.32. The trend is up, and the market is following the earnings, as it always does. Soon 2011 estimates will be driving the markets as 2010 moves to the rear. Analyst estimates are $92.41 and rising for the S&P 500 in 2011. Hence the Hedging option for the RMHI Model is not close to signaling a potential for a Bear Market.
To sum it all up: For the mean time the list and strength of the positives for equities continue to outweigh the negatives, the negative being the anemic rate of earnings growth…but it remains in “Growth” mode. Furthermore it is my opinion that the Federal Reserve will do whatever it takes to resuscitate the economy and housing even if means inflation down the road.
Equities have just entered what is historically the strongest 9 month period as defined by the Presidential term. It many ways, it’s all about politics and the need to get reelected. Just as President Clinton moved to the center of the political spectrum after his second year, President Obama may inch toward the center himself to prepare for his own re-election. A shift towards the center combined with a more deliberate attempt at job creation with a less antagonistic stance towards business would lower the risk of adding employees.
Copper prices which are a great economic barometer have moved to a new 2010 closing price high.
Select bonds are still producing here, especially High Yield and Emerging market debt. However, the overwhelming bullish consensus on bonds, especially Treasuries is disturbing. The US Treasury market is likely topping out. In addition, there now many non confirmations in Sovereign bonds, as British, German and French bonds have not made a new high in price while US Treasuries have done so. This may mean the move up in bond prices is losing steam and a change in direction is forthcoming.
All the best,
Brad Pappas
