“Seasonality: Sell in May and go away?”

Last Friday was May 1st. For many, this date signifies the real beginning of spring, welcoming “May flowers” and the holiday May Day. In the investing world, it is the trigger point for some investors of an old stock market adage “Sell in May and go away.” This seasonality based risk management theory, is rooted in the idea that the market is softest from May to November for equity investors. Theoretically, you could sell your equities in May, buy in November and be better off than if you held them for the entire year.

Is seasonality real or just stock market lore?

According to the Stock Trader’s Almanac, since 1950, the Dow Jones Industrial Average has had an average return of only 0.3% during the May-October period, compared with an average gain of 7.5% during the November-April period.

So, is it real?

Well, our feeling is yes (and no). The problem with any hard-and-fast rule for investing is that it does not always work. In 2011, the seasonal theory might have had you looking brilliant, but in 2012, 2013 and 2014 – not so much.

Is just ignoring it the best policy?

Ignoring long term, statistical, unbiased data is rarely a good plan. We do utilize seasonality as a factor when we are making a change to our equity holdings in a portfolio. Is it the sole factor? No.

How about a simple sports analogy:

A football coach is calling a play that includes a pass. It is raining out and the ball is slippery. A good coach would most likely take these conditions into account when determining if a pass is worth the risk. The rain is a factor in the coach’s decision making process. Rain is not a deal-breaker every time for a pass – clearly, quarterbacks pass in the rain all the time. However, it is an additional risk that has to be considered and may change the call from the coach in some situations.

Would it be a great play to sell all your equities simply because it is May 1st? Maybe, but it would just be a guess. Seasonality data is real and it should be an added factor in upcoming portfolio decisions.

Read more on Investopedia about Sell in May: Here

“Sector Rotation”

Over the past couple of weeks we have mentioned the international equity sector gaining momentum and potential portfolio changes as a result. This idea of making portfolio changes based on the change in leadership or ranking is all part of a strategy we utilize called Sector Rotation.

Sectors are specific sub-categories of a market. For example, the broad stock market can be broken down into 10 sectors such as technology, utilities, healthcare etc. . If you look at the returns for each sector over time you notice that the returns can be dramatically different from sector to sector; often having as much as an 80% difference between the top and the bottom year to year. Here is a link to Morningstar’s Sector Returns page.

The term Sector Rotation strategy in non-market-jargon could simply be “category change” strategy. By ranking the various sectors (or categories) in any given market and monitoring it over time, you can clearly see those that are the leaders, those that are rising and those that are falling. By employing Sector Rotation strategy we can own more of the categories that are performing well and less of those performing poorly. As the leadership changes we look to replace the categories that are falling in ranking with ones that are rising.

The theory is not too complex. Having the time, expertise and data to put it into practice is a bit more involved and not something the average investor is likely to engage on their own. As portfolio managers, employing strategies such as sector rotation is a big part of what we do for our clients.

Here are links to Investopedia’s definition of Sector Rotation.

“Patience” Making a move AFTER buy sell indicators change

In last Monday’s Weekly Wire, we talked about the rise in ranking of the international equity sector. Over the past week, we saw that momentum continue. Whether this is due to the quantitative easing overseas that we mentioned last Monday or other factors, the beauty of relative strength indicators is that the “why” something is happening is not nearly as important as the fact that it “is” happening.

Speculating on the “why”, although sometimes interesting to debate, can unfortunately lead investors into decisions based on plain old guessing. The problematic assumption with a guess is that whatever the investor is attributing the momentum to is – a) correct and b) will continue.

We follow a less emotional or gut-based decision making process, focusing on what actually has happened as the inflection point for changes to any portfolio. The key is – patience. Our indicators have to actually move from buy to sell or vice versa for us to make a change. It’s not enough to just guess that an indicator move may happen, guessing is not part of a repeatable process.

So for now, we wait. Would we be surprised if our international equity indicators move to buy signals in some portfolios? No. Are we making portfolio changes early based on a hunch? Also no, but stay tuned!

In case you missed them last week, Here are links to Investopedia’s definitions of Quantitative Easing and Relative Strength.

“International” Quantitative Easing having an effect overseas ?

For the past few years the US stock markets have been the consistent front-runners for growth investing. That said, we are seeing early signs of strength from the international markets.

In Europe, quantitative easing was announced last year, much like the US government’s quantitative easing from a several years prior which helped boost the US stock markets. The latest numbers may indicate that this action has begun to have a similar positive effect overseas.

On a relative strength basis, we are still seeing the US stock markets as the leaders with US fixed income coming in second. However, international equity markets are now third and gaining momentum. Not enough movement for any wholesale change in strategy, but another indicator that is a ping on the RADAR that we are watching closely.

Here are links to Investopedia’s definitions of Quantitative Easing and Relative Strength.

This is the first of our new Weekly Wire series.  Our clients often ask us for our take on recent events or market conditions. Weekly Wire’s are short and sweet, but we hope they will give you some insight into our thought process and spark some great questions.  Let us know what you think, we always like to hear from you!

“Exhale” Signals from an overbought market

Last week the US equity markets pulled back a little. The Dow Jones Industrial Average and the Standard & Poor’s 500 Index each fell every day last week before edging higher on Friday. Our short-term indicators predictably switched to sell; however, medium and long term indicators remained substantially unchanged.  Our collective take on the week was that it represented a bit of a collective exhale from an overbought market, which is not too surprising.

What this means to our clients is that the recent pullback is part of the normal ups and downs of the capital markets. Our short term indicators are not used to “time” the market with existing accounts. Rather these indicators work well in deciding when to use a dollar cost average strategy when committing new cash to invest.

Here is a link to Investopedia’s definition of overbought market

All investment strategies have the potential for profit or loss. Changes in investment strategies, contributions or withdrawals may materially alter the performance, strategy and results of your portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio. Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there are no assurances that it will match or outperform any particular benchmark.  

The Cost Of Waiting to Invest:

39 Reasons Not To Invest

It is relatively common for us to talk to clients and prospective clients who have money that is parked in a bank savings account or money market fund.  These funds could be from a real estate deal, a business sale, inheritance or even a maturing CD / annuity.  It could be simply a remnant from the last perceived bear market event; where at some point, the losses or fear of losses, were just too much to emotionally take so money was moved out of the market to cash.  So here the money sits, earning next to nothing on the sidelines, sometimes for years.  The question is – now what?

Often we hear “I really want this money to grow, but I have to wait and see what happens with [insert news or market event here] first.”  That news or market event changes all the time and there is no shortage of media hype to fuel investor concerns.  We sometimes see investors getting caught in a cycle where there is always some concern that keeps the money out of the market earning very little.

So the investor is at crossroads: Do they wait for the “perfect time” to do something with the money or do they throw caution to the wind and jump in with both feet despite that big story on CNBC yesterday? The reality is, there is never a “perfect time.”  Intuitively most people get that, but that alone often isn’t enough to allow them to comfortably make the decision to get the money off the sidelines. We find having a disciplined system in place that gets the funds invested based on a sound process using impartial data rather than media hype, is a better alternative.

If you’re considering all the reasons why you should not be investing in the stock market, the table linked below lists some of the reasons that have kept others (and maybe you too) on the sidelines in the past. You may notice however, the waiting can be a costly decision. Every year there are problems that look like they will derail the market. And this year’s problem always seems far more serious than anything that’s ever occurred in the past. But it never is.

Click here for the 39 Reasons NOT to Invest

Diversification: Cure or Curse

Investment terms and investment language have a tendency to be confusing and frustrating. However one term that seems to reach immediate common understanding is diversification. It’s so universal that most times there is no need for explanation. That’s the good news. The bad news is that “diversification” is used so liberally, that it is not how the word is defined that is critical, it’s how the word is used.

Diversification as a broad concept is simply the law of large numbers. As an investor, the greater the number of different investments that you hold, the more protected you are against absolute loss. “Don’t put all your eggs in one basket.” A good example of this involves the now defunct corporation Enron. If you owned 100 different stocks, one of which was Enron and you watched Enron go bankrupt, you could say to yourself, “thank goodness I was diversified, I still have 99 stocks.” You were, in fact, protected from absolute loss by having a diversified portfolio.

When the term is used in connection with managing market volatility, things get a bit more complicated.  Simply owning hundreds of large US stocks when the US stock market is in decline, won’t do much to protect the investor from market volatility risk.  If you owned an S&P 500 index fund in 2008 and simply rode out the year, you were by definition diversified; however, your portfolio experienced the same volatility as the market.

Being able to manage market volatility is about enjoying the ride, and surviving catastrophes. The term asset allocation and diversification often get incorrectly used synonymously, though they are related in terms of managing market volatility. The term asset allocation is simply diversification of capital across the broad asset classes. So for example, the six broad asset classes are: US equity, international equity, commodities, fixed income, currency, and cash. Over the last 40 years, the investment community has focused on the decision on how much to allocate to the six asset classes.

There are three benefits to that decision:

1. Reducing volatility (the month-to-month change in portfolio value)
2. Improving portfolio response to financial catastrophes
3. Improving performance using the right combination of investments.

In general, diversifying a portfolio across the broad asset classes changes the inherent risk of market volatility. Simply stated: the more money that you have in stocks, the greater the risk and the more money that you have in bonds and cash, the lower the risk.

Okay this is where it gets really complicated. Asset allocation can be applied passively or actively. Passive allocation, often called “buy and hold” means that you are able to determine, as a rational human being, what the best combination of asset classes for you is and you hold that through the ups and downs in the market. This is the current “cure-all” that is often offered to private investors.

There are a few problems with this cure-all though. First, it’s very difficult for us all to be rational and unemotional about money. After all, the loss of money means reducing our personal options in life, which is no fun for anyone. In addition, once you admit to the desire to change the allocation to your investments in any of the broad asset classes, you open the door to the curse of when and how do you do it. (You shift from a passive approach to an active or tactical approach) Tactically allocating or diversifying among the broad asset classes allows investors to take a more proactive approach to managing market volatility risk. However, the “tactics” that you might use to make the decision of redeployment of capital open the door to the same problem that you had before you started the process, which is how do I best allocate and diversify my portfolio?

Instead of falling through the trap door of diversification, we believe instead, the following: diversification using the law of large numbers is a good thing to protect against absolute loss. A good example is the use of index funds covering either broad market indexes such as the S&P 500 or the Dow Jones industrial average, or sectors like financial services or healthcare. Additionally, decisions on making tactical changes to your asset allocation need to be handled on an ongoing basis, and this diversification among the broad asset classes, when done properly, can help protect against short-term volatility and long-term catastrophe.

Is your investment strategy based on a solid plan or hope?

In mid-October a client called in a slight state of alarm to discuss the recent pullback in the U.S. stock market. As a retiree, his main concern was if the markets continue to fall what will happen to his nest egg. At that time the S&P 500 stock index had fallen approximately 9 percent from its high in late September. The decline was all over the nightly news and all the talking heads were having a field day making wild predictions ranging from what we call “doom and gloom end of world scenarios” to more moderate, run-of-the-mill gyrations of the stock markets that soon will pass.

The conversation was an opportunity to reinforce the differences between an investment strategy with a plan of action vs. investing with a plan of hope.A plan of action has a predefined set of steps (buy and sell strategies) to take in response to both positive and negative market trends.

In the case of negative market movements, you employ your sell discipline; sometimes called risk management. Risk management involves defining a series of buy/sell indicators that drive your action. Based on factors that measure supply and demand levels, indicators help create exit points in a falling market. It’s like drawing a line in the sand for a particular investment. If the line is crossed on the downside the decision to sell is executed. Your risk tolerance and your overall temperament for portfolio fluctuations may influence exactly where that line is drawn. If you are a conservative investor your indicators may trigger getting out of the market sooner than someone who is aggressive.

On the flip side, you need to watch the same indicators for signs that the market has bottomed out and it’s time to start getting back in the game. In addition to defining buy/sell indicators, it’s helpful to rank various asset classes and sectors and have the willingness to rotate your money into those areas when they’re performing well. In most years the difference between the top-ranked sectors of the stock market versus the bottom sectors can exceed 50%. If you’re unwilling to establish criteria for when you’ll move your money in and out of them, you could end up leaving a lot of cash on the table.

An established plan of action with pre-determined buy/sell points – and adhering to the plan – is at the heart of a disciplined investing.

Without a plan or discipline, you’re left with a strategy based on hope – hope that the markets will stop going down, hope that a sector will turn around, etc. Grasping at intangibles like these often leads to either inaction or terribly misdirected action; neither of which brings you any closer to a comfortable retirement or provides a nest egg that will last throughout retirement.

“I knew it all along” – Avoiding the Hindsight Bias Trap

How many times have you looked back at some event that, at the time, was a surprise but with the benefit of hindsight seemed so obvious? It happens frequently, and the common adage of “hindsight is 20/20” gets repeated all the time. It’s the tendency for people to look back on an event and say “I knew it all along!” In reality it would have been impossible to “know” for sure the outcome until after it occurred.

In investing this also occurs on a regular basis and is known as “hindsight bias.” This bias helps people save face after a bad decision (I knew that was going to happen), and possibly the most dangerous effect in investing is creating over confidence after a series of good decisions, which then leads to excessive risk taking.

For example, over the last 18 months many health care and biotech stocks have been soaring. Fifty, seventy-five and even one hundred percent gains in a short period of time have been common. With hindsight bias at work, investors can fall into the trap of thinking the reason this sector has done so well is obvious, and have a false impression that this is what will happen going forward. A large portion of their portfolio gets allocated to one sector because they believe their predictive skills are finely tuned. Too much confidence in one’s predictive ability can be harmful to one’s wealth.

One of the ways to become a better investor is to learn from past investment mistakes. Hindsight bias can get in the way of that. After the fact it’s very easy for people to attribute the wrong reasons why an investment didn’t go well and, conversely give the wrong reasons why a certain investment did very well.

A good way to overcome this bias is to keep notes at the moments you are making your investment decisions. Do your analysis, write down the reasons why something is being bought or sold and keep a journal of your decisions. This way you can look back and read your actual notes from months and years ago, and not be subject to hindsight bias’ revisionary history.

This also reinforces the idea that investing process trumps investment product. The focus should be on the process of how you make your investment decisions, and by fine-tuning, practicing, and continually improving the way you make your investment decisions your track record will improve and you will see a bright investment future.