Summer 2012
INSIGHT
P E R S P E C T I V E S F O R T H E G O A L- F O C U S E D I N V E S T O R
The Allure & Dangers of Market Timing
I
f you had a crystal ball and could see the future, what would
you do with it? See where you’ll be in five or ten years? See how
your kids or grandkids turn out? Use it for financial gain?
As much as we’d like a crystal ball, we don’t have one. However,
when it comes to investing, we sometimes act as if we do. For example, trying to time when to get in and out of the stock or bond
markets requires the ability to correctly guess the future direction of
those markets. But the truth is that no one knows with 100% accuracy where the market will go in the next year, the next week, or
even tomorrow.
But the lack of a crystal ball doesn’t stop many from trying because
the allure of timing the market is huge. If we knew where the market was headed, we’d be able to easily profit from it. Look at the bar
chart below and its comparison of various hypothetical $1 investments made in 1928. If we missed the worst 10 days of the S&P 500
from 1928 to 2011, we’d have three times more money ($226.14
for every dollar invested in 1928) than if we had stayed invested the
whole time ($71.21).
Growth of $1 in the S&P 500 Index from 1928 to 2011
$250
$226.14
$200
$150
$100
$50
0%
$75.01
$71.21
$23.62
All Days
Miss 10
Best Days
MIss 10
Worst Days
Miss 10
Best & Miss 10
Worst Days
There are dangers to timing as well. If we mistakenly didn’t avoid
the 10 worst days, but missed the 10 best days, our overall return
would have been a third of what it could have been if we had just
stayed invested.
Could it Really Happen?
Playing devil’s advocate, we could argue that extreme cases like these
really don’t happen to investors. However, consider how close many
of the best and worst days are in a given year. In 2008, when the
market suffered a significant calendar year loss of 37%, the best and
worst days for the market were only three days apart. In 2010, the
best and worst days for the year were 10 days apart. In 2011, the best
and worst days were back to back. So far in 2012, the best and worst
days have been 5 days apart.
Mistiming trading can be very costly. If we get out of the market after a big decline expecting a downtrend to continue, we could easily
miss out on a big increase.
The Lower Volatility Benefit
There is a fourth strategy represented on the bar chart that is worth
noting. This strategy successfully avoids both the best and the worst
10 days of the market. Surprisingly, this turns out to be the second
best strategy. It is an example of a lower volatility investment (i.e.,
one that dampens market extremes) that can do better than higher
volatility strategies over the long run. While it is another example of
an extreme case, the result of lower volatility is something that can be
pursued through diversification and effective asset allocation.
The next time you feel like you want to time the market or get scared
from a big, single-day decline, think about our market’s history and
how strategies that favor lower volatility, diversification and staying
invested have worked over the long term. That is… unless you have
a crystal ball.
Article by Jonathan Scheid, CFA
Source: Morningstar, Inc. Past performance is not indicative of future results. Standard &
Poor’s (S&P) 500 Index is comprised of 500 large U.S. stocks. Indexes are unmanaged baskets
of securities that investors cannot directly invest in; they do not include advisory fees or other
investment expenses.
The Rip Van Winkle Investment Strategy
T
he Tale of Rip Van Winkle tells of a man who slept for many
years only to awake and find a very different world than the
one that existed before he entered his prolonged slumber. If
Rip were an investor who fell asleep on June 30, 1999 he may have
woke up to find the price of the modern day S&P 500 (around
1,360) about where it hovered when he went to sleep. “Wow, not
much happened in the last thirteen years,” he may have said. How
wrong he would have been.
While the current price of the S&P 500 is, indeed, near where it
was thirteen years ago (and one, four, six and eleven years ago), “not
much happened” would be an understatement to say the least. In
the time since Rip fell asleep, investors who remained awake would
have seen a tech bubble and bust, a housing bubble and bust, a credit
crisis, the great recession, two Gulf wars and the on-again/off-again
European debt saga. With all of the volatility, the stock market has
been unable to sustain any of its advances in the last decade or more.
The chart below helps to show the volatility investors have witnessed
of late. The chart compares the percentage of days that the market
has moved + or – a certain percentage over two different time periods,
1976 – 2008 and 2008-present. Moves larger than 1%, 2% or 3%
have all been much more frequent since the financial crisis of 2008
than they were during the longer history back to 1976. In fact, 3%
moves were very rare in the period from 1976 – 2008, but they have
made upVolatility
about 8%
ofthe
all Financial
trading days
since 2008!
Increased
Since
Crisis
(Percentage of trading days w ith high volatility)
Increased Volatility Since the Financial Crisis
(Percentage of trading days with high volatility)
45%
% of high volatility days
% of high volatlity days
40%
35%
40%
30%
Recent Volatility: Jan 2008 - June 2012
25%
20%
15%
Historical Volatility: Jan 1976 - June 2012
23%
17%
10%
5%
4%
0%
+ or - 1%
+ or - 2%
1%
8%
+ or - 3%
Annualized volatility, defined by standard deviation, has also
increased compared to its historical average. What are investors—or
at least those who didn’t sleep through all of the volatility as our Rip
Van Winkle did—to do? Do we time the moves? Do we ignore the
news? Do we get more or less conservative?
It may sound overly simplified, but we suggest that you stick to basic
and time tested investing principles. Among them are:
Develop a financial plan, review it periodically, and stick to it
Invest with your goals in mind, not market gyrations
Manage the risks by diversifying them
The table below shows statistics on the S&P 500 (Stocks), the
BarCap Aggregate Bond Index (Bonds) and a portfolio that naively
diversified 50% into each and rebalanced quarterly (Diversified). In
it, we compare the full period from January 1, 1976 through May
31, 2012 to the volatile period from above.
1/1976 - 5/2012
Annual
Return
Standard
Deviation
1/2008 - 5/2012
Annual
Return
Standard
Deviation
Bonds
8.26%
6.58%
6.07%
3.55%
Stocks
11.20%
16.26%
1.24%
23.53%
Diversified
10.10%
9.23%
4.42%
11.35%
Source: Monthly Returns from Ibbotson. Our calculations.
Notably, bonds have seen their volatility decline over the volatile
period of 2008 through present, while returns have declined a little
on average. Stocks saw just the opposite. Their volatility increased
substantially, yet their annual returns went down by a lot. The
diversified portfolio fell somewhere in between on both returns and
volatility in both the volatile and the longer time frames.
While this portfolio is by no means an optimal portfolio for many
investors, the hypothetical investor who invested in the diversified
portfolio and stuck to a disciplined rebalancing strategy was able to
capture much of the long-term return of stocks with almost half of
the volatility. When the volatile period began in 2008, the returns of
the diversified portfolio declined, but the decline was much less than
the decline in returns of the stock portfolio. Further, the volatility was
less than half that of the stock portfolio during the period.
Volatility is part of investing. We don’t have to always enjoy it, but
we should recognize that it is normal. Sometimes it is high, and
sometimes it is low. We can try to make money timing the volatility,
but very few investors have consistently been successful doing so.
Successful investing for most involves understanding that volatility
exists, so that we are not shocked into reacting foolishly when it rears
its head. We are not suggesting that investors just setup a portfolio
and ignore it, or that investors should never make changes to their
portfolio as the world changes. We do, however, advise against
making broad changes in strategy based on the news of the day.
Focusing on our own financial plan, diversifying and focusing on
our goals, not market gyrations, should allow most investors to sleep
well at night…hopefully, though, not as well as Mr. Van Winkle.
Article by Kane Cotton, CFA
Past performance is no guarantee of future results. All Indices are unmanaged and are not available
for direct investment. Index returns are not subject to taxes, fees or expenses. All index returns
assume the reinvestment of dividends and other income. The Barclays Capital Aggregate Bond
Index is an unmanaged market value weighted performance benchmark for investment-grade or
better fixed-rate debt issues, including government, corporate, asset-backed, and mortgage-backed
securities, with maturities of at least one year. The Standard & Poor’s 500 Index (S&P 500) is
based on the cap weighted average performance of 500 U.S. large stocks.
T
Is the U.S. Headed Off the Cliff?
he U.S. economy is headed straight toward a fiscal cliff. After
years of providing economic stimulus through lower taxes,
many of these tax breaks are set to expire at the end of the
year. Additionally, a number of the automatic cost reductions from
the 2011 debt ceiling debate and other programs are scheduled to
take effect at the same time.
Specifically, these four programs are at the center of the fiscal cliff
discussion:
1. End of the Bush federal tax reduction which dropped the top
federal tax rate to 35% from 39.6%
2. End of the 2% payroll tax reduction
3. Implementation of $65 billion in ongoing spending cuts (half
of it comes from the defense department) mandated by the
debt ceiling debate
4. End of expanded unemployment benefits and a Medicare
program that limits the degree of reimbursement to doctors
potentially putting the economy into an immediate recession. While
the concept of a cliff is scary, the impact to the economy will take
time.
The truth is that any tax increase, spending cut or entitlement
reduction takes money out of U.S. consumers’ pockets and will
impact our economy. The total reduction from all components is
estimated to take 3.5-5% of Gross Domestic Product (GDP) out of
the economy. With the U.S. economy only expected to grow around
2% next year, this would likely put the U.S. into a recession since our
GDP would turn negative.
Obviously, this is a big deal. The government has consistently tried
to avoid another recession, and letting the U.S. enter one due to
their own inaction would waste many of their past efforts to date. It
would be a costly and ironic mistake.
Fortunately, we know we are heading toward this cliff. Federal
Reserve chairman Ben Bernanke has already testified to Congress
that action must be taken or we face a possible recession, the
Congressional Budget Office has estimated the impact of the cliff,
the media is starting to raise awareness about the matter and, with
a Presidential election approaching, dealing with the fiscal cliff will
shape many debates.
Will the debt ceiling debate fiasco that led to U.S. debt being
downgraded by Standard & Poor’s repeat itself as politicians bicker
over the details of dealing with the fiscal cliff? While there will be
bickering and politicking, both sides of the aisle should come to the
table and earnestly work to avoid being labeled as a recession maker.
The fiscal cliff gets its name from the fact that government stimulus,
spending and entitlements will significantly decline all at once,
Article by Jonathan Scheid, CFA
Source: Congressional Budget Office and Federal Reserve
What Will Your Tax Rate Be?
There is much uncertainty on taxes heading into next year. Will Washington allow all of the Bush tax cuts to expire? Will none of them
expire? Or will some form of compromise be reached? At this point, we simply don’t know. While not all inclusive—Title 26 which
contains the official U.S. tax code is thousands of pages long—the table below summarizes the major current Federal tax rates and what
they could revert to in 2013, should our leaders do nothing.
Federal Income Tax
Taxable Income
(Married Filing Jointly)
$0 -$17,400
$17,401 - $70,700
$70.,701 - $142,700
$142,701 - $217,450
$217,450 - $388,350
Above $388,351
Source: Internal Revenue Service
Long-Term Capital Gains
Qualified Dividends
Current
Next Year
Current
Next Year
Current
Next Year
10.0%
15.0%
25.0%
28.0%
33.0%
35.0%
15.0%
15.0%
28.0%
31.0%
36.0%
39.6%
0.0%
0.0%
15.0%
15.0%
15.0%
15.0%
10.0%
10.0%
20.0%
20.0%
20.0%
20.0%
0.0%
0.0%
15.0%
15.0%
15.0%
15.0%
15.0%
15.0%
28.0%
31.0%
36.0%
39.6%
Euro poker
I
n Poker, the strongest hand will theoretically win every time. But we all know that’s not always the case. So how do you win in Poker
with a weaker hand? You bluff, of course! In many ways, the ongoing debt saga in Europe is beginning to look like a game of high
stakes poker. We know that Germany has the strongest hand, and we know that Greece holds the weakeast hand, while other countries
in the game, such as France, Spain and Italy are somewhere in between.
Germany should win, but in many ways, the “game” in Europe has become one of bluffs. Germany does, indeed, have the strong hand,
but a Greek failure—not to mention one in a larger country like Spain or Italy—would put Germany under significant strains. Greece and
its people know this, and they have been toeing the line between accepting Germany’s conditions and threating an outright rejection of the
euro with their recent election. As we consider possible outcomes in Europe, we can’t help but remember the following quote by famed
British economist, John Maynard Keynes: “If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours.”
With the situation changing constantly, it is difficult to predict what will happen next. Below are some of the key players in the European
debt crisis. The rules of the game are outlined, as well as the key factors influencing the game:
Rules of the Euro Game:
All countries joining the Euro
monetary union agreed to the
Maastricht Treaty in 1992
which set limits on inflation,
debt, exchange rates and interest
rates. The two debt related rules
included:
1. National public debt should
not exceed 60%
2. Government deficit should not
exceed -3%
Article by Jonathan Scheid, CFA and Kane Cotton, CFA
Source: International Monetary Fund, Eurostat, CIA World Factbook. Data based on available information as of June 15, 2012. Most data represents year 2011 figures.
Advisory Services offered through RNP Advisory Services, Inc. – a SEC Registered Investment Advisor | 17190 Monterey St. Suite 202, Morgan Hill, CA 95037 800-700-5255 | RNPadvisory.com
Securities offered through Foothill Securities, Inc., member FINRA/SIPC. RNP Advisory Services, Inc. and Foothill Securities are not affiliated companies.
Copyright © 2012. All rights reserved. Bellatore Financial, Inc. is a registered investment advisor. 12.105.c.06.12