The Merriman Research Team discusses our TrendWise Investment Program

Recently, our Research Team of Dennis Tilley, Rafael Villagran, and Alex Golubev got together with Financial Advisor Mark Metcalf to discuss our TrendWise Investment Program. Many of the program’s details were covered, including the following:

  • Harnessing market momentum using objective data
  • Rules based trend following
  • Limiting subjective interpretation
  • Dealing with whipsaw trades
  • Small/Value tilt in the program

Enjoy!

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Don’t let your emotions invest for you

Monday, October 19, 1987—aka Black Monday—was a fearful day for investors across the globe. The damage exceeded 20% in stock market declines by the time the exchanges closed. In the wake of such steep declines, investors too often are driven to act by their emotions. In this case, fear. Fear that the decline will continue. Fear that their hard earned savings will be sucked dry by the markets. A more recent example of this fear was invoked by the financial crisis. In both cases the markets recovered in short order. But, the market never recovers for those who sell out of it. Clearly, fear selling is a bad idea.

Fear is not the only emotion that muddles our investment decisions. Greed is just as dangerous.

The 1990s seemed too good to be true. Investors could not lose money in technology stocks. Valuations seemed to have changed and the exponential rising prices were within the new norm. People got greedy. Some went so far as to use their home equity to purchase stocks. And then, just like that, the party was over. The end of the decade saw technology stocks come crashing down. Those who got greedy and concentrated all of their holdings in technology stocks paid the price.

Anytime the sky is falling or the markets seem too good to be true, remember the mantra—be greedy when others are fearful and fearful when others are greedy.

While fear and greed top the list of emotions that can wreak havoc on your investments, there are others: angst and excessive pride, for instance.

The issue with angst is if you wait for events to happen (government shutdown, fiscal cliff, quantitative easing, etc.) or for the markets to “normalize,” you often miss the boat.

Excessive pride can sometimes drive people to buy individual stocks. It’s the classic cocktail party conversation where someone tells you they bought Microsoft stock in the 1990s or Apple stock at the turn of the century. They do not tell you about the other 10 stocks they bought that went south. By focusing on the one home run, people subconsciously convince themselves that investing in individual stocks is a wise venture. It’s not. In fact, it’s speculation, not investing. Do not let pride get in the way of making smart investment decisions.

Clearly we cannot let our emotions guide our investment decisions. Emotional investing is not successful investing.

Follow these steps to help avoid the pitfalls:

1)     Build a plan. Write it down and stick to it. If the markets turn over, do not deviate from your plan. If anything, rebalance your accounts back to their initial targets.

2)     Turn off the news and tune out the financial pundits. In the age of information, the evening news is not going to give you a leg up on investing. That is, everyone knows everything and it is all factored into the price of securities.

3)     Do not assume things are correlated when they are not. GDP is not nearly as highly correlated to stock market returns as people think. Nor, for that matter, are political events.

4)     Diversify your portfolio. Put another way, do not put all of your eggs in one basket. Remember what happened to technology stocks in the 1990s.

5)     Focus on what you can control. You can control how much you save and whether or not you succumb to your emotions. You cannot control the markets and politicians.

Here’s the exciting part: if you can keep your emotions at bay, invest wisely and let the markets work, you can reduce your stress and increase the likelihood of a successful retirement period.

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An alternative to the financial news treadmill

Every day, financial news sites and channels provide a steady stream of conflicting opinions and predictions that often leave investors feeling confused, frustrated, and paralyzed. Don’t believe me? Please allow me to elaborate.

In addition to reading a wide range of investing and personal finance pieces each day, in the evening I often browse a site called RealClearMarkets.com to make sure I take a look at some of the interesting and/or important articles I might have missed during the day. RealClearMarkets.com is basically a consolidator of articles from a number of other sources. You might want to take a look at it just so you can see what I mean.

When I review the list of approximately 50 headlines, I always find it interesting to see how many compelling yet contradictory articles and videos are in one spot, one right after another. It’s common to see one claiming one view, with another of the exact opposite view right below it. China is imploding/China is still a sleeping giant, Gold is headed much lower/Gold will touch new highs by the end of the year, The stock market is about to re-visit the lows of 2008/The stock market is pausing before reaching new highs by year end, Stick with large cap U.S. stocks/America’s best days are behind us and one should look abroad for better investing opportunities, A bond catastrophe is upon us/Don’t believe the bond bust hype, Inflation is about to run rampant/Deflation is the new worry, Emerging market stocks and bonds are to be avoided at all costs/The long term secular growth story of the emerging markets is still very much intact. Good grief! What’s an investor to do?

We’ll continue to see these contradictions, but one does not need to feel paralyzed by them or compelled to decide which one is the better path to follow. The truth is that they all have elements of truth and quite often are written by some very bright people. This month marks my 27th year in this business, and I have seen investors get caught up wrestling with these contradictions in each and every one of those years. Please let me offer an alternative.

Rather than struggling to decide if this is the right or wrong time to hold stocks or bonds in your portfolio, or which types of each to hold, how about always holding a portion in stocks and a portion in bonds, along with an adequate cash reserve for emergencies or opportunities that may arise? Of the portion devoted to stocks, hold U.S. and foreign (including emerging markets), small  and large cap, growth and value, and also some REITs (both foreign and domestic). Of the portion destined for bonds, hold those of the highest credit quality (which tend to hold up relatively well when the stock market severely declines), and those with short- to intermediate-term maturities (which have lower interest rate risk in a rising rate environment).

With regard to cash reserves, the rule of thumb in the financial planning community is to maintain enough to cover 6 to 12 months of living expenses, depending on your situation, but often these targets tend to be on the low side. My experience has been that during periods of severe market or personal financial stress, nothing provides peace of mind like cash. Nobody ever complains about having too much cash on hand during these times. And when opportunity knocks, it’s nice to have plenty of cash on hand to take full advantage. Even when yields are as low as they are now, cash is king. The purpose of your investment portfolio is to deliver returns in excess of inflation over time. Cash is for liquidity, flexibility, and peace of mind.

The appropriate mix of these various asset classes, of course, depends on your individual circumstances and objectives. A big part of my job as an investment advisor is to help clients establish and maintain this mix in the face of unrelenting alarmist news headlines.

If all this advice sounds like nothing more than common sense and things we’ve all heard before, you’re right. But interestingly enough, many people tend to get caught up in all the predictions and hype out there, and they tend to ignore or forget these time-tested principles. As Paul Merriman once said, “There is a Grand Canyon of difference between what people know they should do and what they do.”

If you are tired of feeling confused, paralyzed, and frustrated and would like to jump off the financial news treadmill, I invite you to contact us. If you are not quite there yet, I wish you luck and a quiet mind as you continue down your path. We’ll be here when you need us.

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Book review: “Abundance – The Future Is Better Than You Think”

As the S&P 500 reaches new highs, it is interesting to think about the volume of bad news we have faced over the bull market of the past 4 years. We were subjected to what seemed to be an epidemic of economic challenges, from the fear that Troubled Asset Relief Program (TARP) would lead to runaway inflation, to the debt ceiling debate and the “fiscal cliff” we were sure to tumble over at the beginning of the year. There was news of more global concerns over the world, with new challenges faced in feeding and providing fresh water for the ever growing global population, which now exceeds 7 billion people. There have been many headline stories building a case for a grim outlook of the future. It seems to me that the good news is usually more subtle and harder to find.

I recently picked up a copy of  “Abundance – The Future Is Better Than You Think.” The authors, Peter Diamandis and Steven Kotler, make a case for optimism. They present a neurological reason for why we are more sensitive to bad news than we are at recognizing opportunity. Fear has served the human race well in many ways for many years; it activates our limbic system, which manages our “fight or flight” circuitry. Diamandis and Kotler then look at how we have solved problems of scarcity in the past, and examine amazing advances in science and engineering that are being made right now.

This book presents a different perspective than we are bombarded with in the daily news, and I think it’s worth reading. Diamandis and Kotler explore some very exciting new technologies that are making giant strides against some of the world’s biggest challenges, like scarcity in access to energy, clean water and good medical care.

“I’m not saying we don’t have our set of problems; we surely do. But ultimately, we knock them down” -Peter Diamandis.

Before finding the book, take a few minutes out of your day to listen to his inspirational and educational TED talk here.

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Investing and uncertainty

There are many things in short supply, but uncertainty is not one of them. Three economists1 have compiled an index of uncertainty, which is comprised of newspaper coverage of policy-related uncertainty, expiring federal tax code provisions and disagreement among economic forecasters. You can see the trend in Figure 1 below. The index peaked with the debt ceiling imbroglio in late 2011, fell in the early part of 2012 and then rose again.

Throughout the year there has been a great deal of focus on a number of worrisome issues, including the U.S. deficit, debt ceiling and the fiscal cliff, high unemployment, and the European debt situation. Reflecting all this angst, investors through November withdrew a net $88.9 billion from actively-managed U.S. stock mutual funds (net of inflows into U.S. stock exchange-traded funds).2 Yet for 2012, stocks were up nicely.

How could stocks have gone up while uncertainty increased? While many people naturally worry about the past and still feel burned by previous sharp plunges in stock prices, the stock market is forward looking, incorporating the perceptions of millions of investors. While national economies are still relatively sluggish, actions taken by the U.S. and European central banks to combat economic weakness are having a positive impact.

Housing, while not rosy, is seeing some welcome improvements, with 6.9% of U.S. consumers planning to buy a house in the next six months, the most since August 1999.3 Confidence among U.S. homebuilders reached a 6 ½ year high in December.4 U.S. sales of previously occupied homes increased to their highest level in three years in November.5 And home prices rose 4.3% in the twelve months ending October 2012 in the S&P/Case-Shiller 20-City Composite.6

Another positive, with major longer-term implications, is the widespread development of hydraulic fracturing (or fracking, the process of extracting oil and natural gas from shale rock). The International Energy Agency projects the U.S. will become the largest global oil producer by around 2020, and a net oil exporter by around 2030.7 While there are important environmental issues associated with fracking, including potential contamination of local water supplies and massive use of water in the process, electricity produced by natural gas gives off 43% less carbon dioxide versus coal. Due to a combination of increased use of natural gas, the weak economy and more fuel-efficient cars, America’s emission of greenhouse gases has fallen to 1992 levels and is expected to continue to fall.8 So, like any energy source, there are costs and benefits. Cheaper energy will lead to more manufacturing being done in the U.S., which is good for the economy. One analyst estimates the U.S. will add three million new jobs by the end of this decade due to the natural gas industry.9

Waiting for that perfect time to invest when there is no uncertainty could lead to cash unproductively sitting on the sidelines. Investing only after good news also means buying stocks after they have gone up. A good example of this is the S&P 500 going up by 2.54% on January 2, the day after the fiscal cliff legislation passed. Another example is the MSCI EAFE index of developed countries in Europe, Australasia and the Far East, which increased 6.57% in the fourth quarter, reflecting the relative lack of bad news, and some stabilizing events, in Europe.

While uncertainty is an uncomfortable fact of life, it is easier to handle by following a well-formulated diversified investment plan that invests in stocks and bonds, the allocation to which incorporates your risk tolerance and long-term needs.

1. Scott Baker, Nicholas Bloom and Steven J. Davis at www.PolicyUncertainty.com.
2. Wall Street Journal, “Investors Sour on Pro Stock Pickers”, 1/4/13.
3. Ned Davis Research, 12/10/12.
4. http://finance.yahoo.com/news/us-homebuilder-confidence-6-1-150113216.html
5. Wall Street Journal, 12/20/12.
6. http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff–p-us—-
7.Wall Street Journal, 11/12/12.
8. U.S. Energy Information Agency, as discussed in http://finance.yahoo.com/blogs/daily-ticker/fracking-good-economy-environment-155325507.html
9. As reported in New York Times, “Welcome to Saudi Albany”, Adam Davidson 12/11/12.
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Dangerous words: “It’s different this time.”

During periods of significant volatility in the capital markets, investors can lose patience and/or perspective and draw the conclusion that long term risk/return dynamics no longer apply because somehow “it’s different this time.”

I’ve been in this business for over 25 years, and time and again I have seen investors come to this conclusion, making big portfolio shifts because of it, only to regret these decisions later.

I vividly recall conversations with folks in the 1980s who insisted that Asian stock funds should constitute the bulk of one’s portfolio since America was in decline and Asia was rising. In the1990s, it often was very difficult to have meaningful conversations about asset allocation and thorough diversification when so many genuinely felt that all they needed was a few technology stocks or technology stock funds. In 2008 and early 2009, few had the stomach to trim their nicely performing government bond funds and add to their stock funds during the worst stock market environment since 1932.

In each of these examples, the phrase ‘it’s different this time’ crept into many conversations. Obviously, none of the above decisions worked out well.

At Merriman, we’ve always maintained the portion of clients’ accounts invested in stocks at 50% US and 50% foreign. This has served our clients well for many years. We invest this way because the US represents less than 50% of the world stock market capitalization, and because maintaining this kind of allocation can serve to increase returns while lowering overall portfolio risk.

Lately, foreign stocks have been significantly underperforming US stocks, and this has been causing some people to ask if maintaining our desired 50/50 US/foreign split still makes sense. And once again, we are starting to hear the ‘it’s different this time’ comment again. It is human nature to think this way, but history would suggest that one should not make a big shift in allocation because of it, other than some routine portfolio rebalancing.

Keep this in mind: While it’s always a different set of circumstances driving the capital markets, rarely is it wise to conclude that a paradigm shift is at hand and make major portfolio shifts in response. As legendary investor Sir John Templeton used to say, “The four most dangerous words in investing are ‘it’s different this time.’”

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It’s not what you know, it’s what you do

Behavioral finance is a fascinating field to me. It’s the study of how our emotions and judgment can affect decision making with regard to investments. In the time I have spent advising people on their investments, I have witnessed the power fear and greed can have over logic and reason. The good news is that the more we understand where our intuitions and biases come from the better chance we have at making good investment decisions.

Studies continue to find that investors earn lower returns than the funds in which they invested. Dalbar, a market research firm, issued their 2011 report showing investors achieved a mere 41.9% of the S&P 500‘s performance over the twenty years ending December 31, 2010. In other words, investors managed to leave a staggering 58.1% on the table. What could possibly explain missing out on these returns? It is largely due to investor behavior.

The goal of investing is to buy low and sell high – that’s a given – but our emotions, intuitions, and bias frequently work against us. Most investors did not begin buying technology related stocks in the early 90’s when prices were still reasonable; the vast majority bought in the late 90’s at astronomical prices, just before the “tech bubble” burst. Similarly, it was incredibly difficult to keep many investors positive about the prospects of the future during the first quarter of 2009 – the market bottomed on March 20, 2009 from the “housing bubble”- just before the markets began a climb to double in less than 2 years.

I recently read a wonderful new book written by Larry Swedroe & RC Balban, called “Investment Mistakes Even Smart Investors Make, And How To Avoid Them,” and I think it’s worth adding to your reading list.

I won’t re-write their book for you here, but Swedroe and Balban have done a great job of compiling a list of the most common mistakes and what you can do to avoid making them. This book will help you better understand why our investment strategies work, even though they can sometimes seem counterintuitive.

If you are not a client of ours and are considering hiring an advisor, this book may help you understand the mistakes a disciplined investment strategy can help you avoid.

By studying history and behavior, we can learn to avoid the same mistakes in the future. We can also understand why the disciplined investment decisions are sometimes the most uncomfortable. If we do our job well, you’ll be encouraged to stand by them anyway, knowing that discipline will pay off in the long-run.

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Maintain a long-term perspective

The last several weeks have been trying times for investors.

Since July 22nd, the S&P 500 has fallen sharply including large drops on August 8th and 10th. The main catalysts for this sharp decline include a U.S. debt deal that did not address the underlying fundamental issues in a satisfactory way, some weak U.S. economic numbers which may presage a double‐dip recession, the realization that there is little flexibility with regard to either fiscal or monetary stimulus, the S&P downgrade of U.S. debt, and the continuing debt problems in Europe.

There is a long list of troubles, and things may get worse before they get better. There are also many positives, including the following:

  • A 28% decline in the price of oil from its recent high, which has reduced inflationary pressure and helped consumers.
  • The four‐week average of initial unemployment claims declined to the lowest level since April.
  • Continuing low interest rates, on both the short and long end.
  • Greatly improved corporate profitability and cash flow, with increasing capital spending.
  • Healthy corporate balance sheets and improving consumer balance sheets.
  • A depreciating dollar which could enhance exports.

We think that the best course for long‐term investors is not to sell now. While it may be emotionally difficult, we believe it is best to stick with the asset allocation that you (and possibly your financial advisor) calmly chose which was appropriate for your circumstances and risk tolerance.

Stock prices incorporate all available public information, are forward looking and exhibit both risk and return. Selling after a sharp and sudden market decline means suffering through the market’s risk without being able to benefit from any subsequent return.

For example, there was a double‐dip recession in 1980 – 1982, with unemployment reaching a high of 10.8% while mortgage rates went above 18%. Six months after the end of the second dip, the stock market was up almost 20%.

We can’t call the market bottom with any certainty. What we do know with certainty is that institutions, investors and markets react to events. Congress may finally become serious after the S&P downgrade and work together to credibly tackle the long‐term deficit issue. Investors may look at cash‐rich companies with good earnings and lower‐than‐average valuations and eventually decide to buy. The European Central Bank has started large purchases of Italian and Spanish bonds, helping to lower rates and trying to calm the debt markets.

We certainly empathize with any distress you may have experienced due to the recent market drop. It is human nature to panic and consider selling after a steep market decline. If you are considering that, think about those portfolios which were sold at the bottom of the market in March 2009 and did not get the benefit of the subsequent recovery. Stocks have an expected positive return over time, which just became more positive with the steep price drop.

For your own benefit, avoid short‐term panic and maintain a long‐term perspective.

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A little perspective

In managing investments, making decisions based on feelings of excessive optimism or excessive pessimism rarely ends well. Maintaining a balanced perspective in an ever-changing and often chaotic world is a difficult yet critically important part of achieving long-term investing success.

To be sure, the news lately has been enough to scare many people into believing that things are shaping up for another 2008 debacle. Seemingly at every turn we hear of the debt crisis in the Eurozone, the possibility that the United States might not meet its deadline to raise the debt ceiling and the ramifications that may have, China potentially slowing down, and the U.S. housing and unemployment figures remaining at disappointing levels. And this is just to name a few!

While the United States and the rest of the world are facing many significant obstacles, and while nobody knows for sure how future events will unfold, I offer the following examples of recent positive, noteworthy items that went largely ignored:

  • Japanese auto manufacturers and parts suppliers resumed shipments after being forced to essentially shut down because of last winter’s earthquake, tsunami, and nuclear incident.
  • Foreign and domestic auto manufacturers established new plants and/or increased hiring in the United States, and sales increased meaningfully. (more…)
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The gap between fund returns and investor returns

We advocate that investors choose a diversified portfolio of stocks and bonds, with the percentage in each depending, to a large degree, on their overall risk tolerance (the higher the risk tolerance, the higher the allocation to stocks). When the markets move and the actual weights deviate from the target weights, investors should then periodically rebalance by trimming those asset classes which have done best and buying those assets classes which have not done as well. This simple rebalancing technique removes much of the emotion from investing.

Emotions can have a negative impact on investment returns. Many investors respond to short-term market moves by buying assets after they have gone up and selling assets after they have declined in price. This is just the opposite of what we do when rebalancing our client accounts. (more…)

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