Private Advisory Group

Winning by Not Losing–A Long Term Approach

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The Holy Grail in the investing world is a manager who is able to repeatedly time the markets—meaning they are fully invested when the market is moving up and fully in cash while the market is moving down. While many have claimed the ability, thus far no person or team of people have been able to successfully get in at the market lows and get out at the market highs on a repeated basis.

Nevertheless, after extensive research we found an investment team (Stadion) that has a proven track record of capturing most of the market upside while missing most of the market downside. Stadion is introduced in greater detail on the Current Commentary section of our website for those interested. (http://www.theprivateadvisorygroup.com/currentcommentary/category/investment-management/investment-managers/).

Over the past 12 years, Stadion has more than a respectable track record. They have a 68% upside capture with only a 27% downside capture. Despite that high standard of performance, Stadion’s management team clearly acknowledges the following shortcomings, which have been borne out over the same 12 year period:

• They are not able, and do not try, to predict the future
• They are not able, and do not try, to pick market tops or bottoms
• They are not able, and do not try, to beat the market in the short term

Their ability to capture most of the good times, and miss most of the bad times rests in their entirely quantitative process where they use the weight of evidence to determine both market exposure and stop-loss parameters. Each data point in their proprietary matrix consists of multiple, complex indicators, which are run daily.

Essentially, the indicators they use measure the fundamental strength of the market, and based on that perceived strength they make calculated decisions about where and how much to invest. The primary weakness of this process is using quantitative approach to measure a qualitative entity. While medium to long term trends are based on fundamentals, short and especially hyper-short term trends are typically based on emotion or other qualitative parameters. Hence, short-term performance can be a disappointment to investor’s who harbor less than realistic expectations.

By design, Stadion’s approach is void of emotion or other subjective inputs, which means they are not subject to short-term, emotional reactions We see this as a positive and use them precisely for that reason. We want them to make decisions based on their calculated analysis of market fundamentals.

Such a focus on fundamentals can lead to some short-term anxiety as was the case recently on November 9, 2009 when the S&P 500 was up 2.22% and Stadion’s current allocation was 80% cash 20% commodities. At first analysis, it is easy to be frustrated that they missed the rally. However, as noted in the Wall Street Journal’s November 10, 2009 cover story, the November 9th rally was a “skeptics rally—fed by money managers who feel they must make risky bets in order to keep up with the market, but who don’t like what they see.” We hope you are beginning to better appreciate their time-tested wisdom.

While this ‘skeptics rally’ might continue long enough for market fundamentals to sustain it, we are not sure that is going to be the case. Stadion’s rules-driven approach dictates they avoid emotionally driven rallies and directs instead that they remain uninvested until the broader market measures indicate a more substantiated opportunity for growth. Conversely, during times when market fundamentals conclude additional market upside potential even while there may be an impulsive, unsubstantiated market pullback, Stadion would remain invested and might also miss on the short term.

So while we are confident that Stadion’s objective, disciplined research-driven approach will prove successful over a full market cycle, we acknowledge they will often, by design, lose to the market during the short term. This is especially true with repeated emotional, radical swings up or down like those we have recently experienced. For investors who are more interested in meeting or beating the market on a day-to-day basis, Stadion is not a viable option.

Just as a golfer with a bag full of clubs, each designed for a specific application under specific circumstances, we have manager teams that perform well in specific market conditions based on specific time horizons. Stadion is clearly a more defensive ’club’, and might be the right choice for an investor who would rather not “make risky bets” in order to keep up with the market, (even when they) don’t like what they see.

Inflation–The Real Monster

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The United States is running up record high levels of debt. In fiscal 2009, we will increase the debt by more than we did during the last five years combined. We have essentially four ways to service the debt:

1. Spend less
2. Tax more
3. Default on the debt
4. Encourage inflation

In recent memory, there has not been an administration that has even remotely come close to reducing annual operating budgets. Despite the empty promises we hear ever four years, even the most conservative Republicans find ways to spend more and more of our money. So, we can cross the first option off the list, there is no way we are going to pay down the debt by spending less than we currently spend.

Most readily agree increased taxation in one form or another will be in the future. There still is some debate as to what type and how much increase will exist but it certainly seems inevitable. Unfortunately, even with higher taxes it does not look like that will be enough to pay off the increasing debt load.

Defaulting on our debt is not really a viable option. Not only would the US’ defaulting on our debt completely destroy modern banking, finance, and trade on a global scale, it would also likely lead to a war between China and the US.

Inflation makes servicing debt easier because future dollars are not worth as much as today’s dollars. Additionally, in inflationary environments, people need more money to buy goods and services. Salaries typically rise to meet this demand, creating increased tax revenue for the government. So, not only will the government be paying back debt with lower-valued US dollars, but they will have more of them to do it with.

Due to our current national debt, our future will include some combination of increased taxes and inflation, neither of which is ideal, but both of which are inevitable. While it may not seem like it, taxes are somewhat controlable. Inflation, however, is not.

When policy makers want some inflation, like they do now, they use powerful but crude tools to create it. The problem is they are not always able to control how much inflation they get and often overshoot–meaning prices prise higher than they intended. Not bad for our national debt, but it will dramatically impact your quality of living unless you plan accordingly.

Most conservative financial pundits plan on an average of 3% annual inflation. This translates to prices doubling on average every 25 years. Recall the price of a stamp 25 years ago ($0.20) versus the price of a stamp today ($0.44), and you’ll see that on average the 3% inflation rate has held. However, during the United State’s worst inflationary periods prices have doubled every five years. A far cry from countries like Zimbabwe where last year prices doubled, at times, each day, however even a five year 100% increase in prices could have a heart-stopping affect on retirement plans beacuse a 100% increase in prices is equal to a 50% reduction in your investments.

In 2008, we learned that projections of acceptable long-term market risk and return include some painfully difficult years. Many have now redefined long-term from 10-20 years to 3-5 years. As noted in a separate posting, we need to learn from 2008 by reevaluating our allocation of investment approaches and asset classes, our perspective of long versus short-term, and our willingness to accept appropriate levels of market risk. However, we cannot drive forward by looking in the rear-view mirror. If we do, we risk hitting inflation potholes that can wreak even further havoc to retirement plans.

In this post, we outlined the inevitable inflationary push that will occur at sometime in the future. The questions of how should this eventuality be addressed, what asset types are inflation resistant, and which ones are to be avoided will be posted shortly.

As Good as Gold

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In an article in Smart Money, Jack Hough recently pointed out that we associate gold with wealth and safety only because its chemical properties once made it ideal for making coins by hand. Gold is incredibly malleable, doesn’t corrode, tests easily for purity, is exceedingly rare and has relatively few industrial uses. It’s perfect for just sitting around and representing value. But that value must come from somewhere, and today that value comes primarily from perception, not reality. Today gold value is primarily driven by fashion and speculation, the latter made easier than ever by companies that that hawk investment funds and comemorative coins.

Before you rush out stake your claim, you need to identify the primary reasons behind your desire to join the gold rush of 2009.

COLECTIBLES–If you are looking for a collectible item that you can pass on to future generations, or one that might improve in value due to excess demand for a unique item, then you would be wise to avoid purchasing anything offered online or in a television commercial. Despite their promised 10-coins-per-household minimum, there is in fact an endless supply of these items, and therefore they hold no value in excess of the current price of the gold used to cast it. If you are looking for something with collectible value, go to a reputable dealer of rare coins and spend your money there.
EMERGENCIES–If you subscribe to some of the doomsday scenarious where the modern banking system as we know it implodes and our society is reduced to a barter economy and you think that gold coins will be a convenient mode of trade, unless you want to be caught looking for someone to break a full-ounce coin to purchase your groceries or toilet paper, you would be wise to consider buying tenth ounce coins instead. Inidentally, that is how the term quarter started. The first quarters were literally an ancient Roman coin cut into four pieces to facilitate trade in small denominations. You might be better off spending your money now on things necessary for survival if the financial world really does implode. Food, water, toilet paper, jeans, Advil, toothpaste, and the like. These are items that you and your family will need anyway, and will more than likely be the primary means of trade in any basic barter economy. Who knows, maybe a Snickers bar will have more intrinsic value to soemone who is really hungry than one ounce of gold.

INFLATION–If your desire to buy gold is as a solution against the inevitable inflation lies around the corner, you would be well advised that without any actual value, gold’s price might soar or plunge during inflation, depending entirely on whether people believe or stop believing the continually perpetuated gold myth. Isn’t it better to own the goods you’ll need to live and enjoy life, or at the very least own the companies that make those goods? Along those lines, the best inflation-fighting investments are stocks. Specifically stock in companies that make, sell, and distribute goods and services that people need including food, medicine, oil, and the like. As prices rise, which is what happens in an inflationary environment, the values of these companies will also rise in direct proportio, which will effectively hedge your portfolio against inflation.