The Price of Prudence

Most financial advisory firms preach the virtues of investing with a “buy and hold” mentality, which is very similar to the emerging investment trend of “low cost indexing” being popularized across the internet. The general idea of both of these investment philosophies is simply to diversify your investments across a variety of different asset classes, and then to hold-on regardless of what occurs in the market place; with the latter also placing strong emphasis on cost control. The biggest benefit of these strategies is that an investor will always participate in all market growth, but they will unfortunately get all of any loss that occurs as well. Because of this full participation both upwards and downwards, these strategies have produced one heck of a roller coaster ride for investors over the last 20 years.

We do not expect the future to be any different. In contrast to those strategies, one of the main CWM investing maxims is that downside protection is vastly more important than full upside participation. This means we are willing to sacrifice some potential gains in order to avoid the majority of devastating market years, like 2008, that can cause significant setbacks to achieving financial objectives.

The primary goal of our Performance Targeting System (PTS™) is to get relatively stable long-term investment outcomes regardless of the short-term market environment, which can only be achieved by mitigating the commonly occurring sharp downside market moves. To do this, at some point, we take on protective positions that will eventually cause some level of underperformance to the general market (like the S&P 500 stock index) if valuations continue to climb higher. That is the price of prudence.

This underperformance during a portion of market rally is generally okay, so long as the strategies causing that underperformance do, in fact, protect account values when markets eventually sell-off.

A Twitter-Worthy Executive Summary

Downside protection is more important than participating in all upside market gains. Prudence often comes at a cost of market underperformance for an indeterminate amount of time.

The Roller Coaster of Markets and Emotions

Humans are inherently behavior driven creatures, and since all investors are human, it logically follows that those behaviors manifest themselves in stock markets. This often results in booms of euphoria following extended periods of rising prices and creates despondency following periods of falling valuations. This emotional roller coaster leads regular investors to frequently buy at market highs and sell out at market lows (the exact opposite of what a successful long-term investor will do). The below graphic continues to be my favorite way of demonstrating this issue.

_{Source: Moussa, M. (2015). Investment Decisions: Stop Acting So Rational and Just be Normal. IMCA.}

Unlike the average investor, who has been proven to increase and decrease market exposure at the wrong times, the CWM PTS process looks to decrease market exposure as market values increase, and the rally ages, and then conduct the opposite action during market sell-offs, where our process seeks to increase stock exposures to take advantage of cheaper prices. To demonstrate, we have mimicked the above graph and depicted, simplistically, a hypothetical example of how the PTS philosophy is utilized. As the market rally ages, the correlation of CWM investment models with the market decreases, and then after a sell-off occurs, the correlation is increased. The graphic displays 100 percent market exposure being brought down to 50 percent as the market increases in value, and then the correlation is brought back up to 100 percent after the sell-off occurs.

Again, the above is a simplistic example of the basic theory and philosophy behind PTS modeling. For a numerical example (for math geeks like me), consider that on average, since 1980, there has been a market drawdown of more than 20 percent about every six years with an average rate of growth per year around 10 percent for positive market years. Let’s assume that as a market rally ages, the CWM model reduces its market exposure by 10 percent, like shown in the graphic above, and that the overall market crashes 20 percent every sixth year. The numbers break down as shown below over a 12-year period (two cycles):

Any rates of return shown are for illustrative purposes only and are neither guaranteed nor implied. Actual rates of return will be based upon the actual performance of selected investments. Taxes and fees are not a consideration in the illustrated returns.

A graph of the above data:

What if instead of a 20 percent loss every sixth year, it was a 40 percent loss like in the 2000s dot-com crash and the 2008 financial crisis (both events actually saw worse than a 40 percent max drawdown)? The picture below is now even more sharply in favor of risk-adjusted models and is a clearer demonstration of why downside protection is more important than fully participating in all market upside.

Any rates of return shown are for illustrative purposes only and are neither guaranteed nor implied. Actual rates of return will be based upon the actual performance of selected investments. Taxes and fees are not a consideration in the illustrated returns.

A graph of the above data:

As shown in both examples above, the model can hypothetically underperform, even significantly, eight out of the 12 years and still potentially end up at roughly the same outcome or better, as long as the inevitable sell-offs are mitigated successfully. This demonstrates that some underperformance is not truly a real problem if that underperformance occurs as a result of taking on prudent protective strategies in preparation for the next market sell-off. The magnitude of the eventual sell-off will determine how beneficial these efforts are. We have found that this somewhat counterintuitive method can provide investors with potentially more predictable long-term outcomes and also possibly protect them from the drama of market sell-offs.

In reality, our CWM PTS models aim to stay more fully correlated to markets well into the later stages of market rallies until our proprietary indicators are triggered. This ideally allows CWM client’s to more fully participate in market gains before protective positioning is taken on. Generally, market correlations will not be raised or lowered in such small and regular intervals as demonstrated in the simplistic example above.

As previously stated, a 20 percent market drawdown has occurred, on average, about every six years since 1980. The current market rally, which began in March 2009, is now over nine years long and is the longest bull market on record. This does not mean a market crash is imminent, only that, based on history, the current rally is old and downside protection planning should be becoming more of a priority for prudent investors.

We, of course, aim to outperform on both the upside and downside and are continuing to research, develop and refine our processes to improve portfolio results. While we pursue greater upside participation, we do not want to give up the downside protection our firm is known for. As financial planners and managers, it is very important that we create dependable portfolio growth that does not violently swing from positive to negative at the whim of the market. As demonstrated above, downside protection is obviously much more important to long-term investment success than getting every bit of upside potential. It isn’t necessary to outperform the market every rally year, but it is vitally important for long-term investment success to do so during markets sell-offs, especially violent ones like in 2008.

Market Items of Interest with Some Brief Commentary

U.S. stock valuations have sharply diverged from emerging market stocks. We have been big on emerging market stocks for some time and believe this price movement reflects already relatively cheap assets getting even cheaper.

_{^{Source: Vaishampayan, S., Wursthorn, M., and Russolillo, S. (September 11, 2018). Hong Kong’s $2.1 Trillion Benchmark Stock Index Tips Into Bear Market. The Wall Street Journal.}}

The Federal Reserve has been hiking rates since December 2015. The current hiking cycle (red line) is fourth longest of the last 11 and has seen the highest S&P 500 performance during a hiking cycle. Fed hiking cycles are usually followed by periods of poor investment returns.

_{^{Source: Ponczek, S. (September 12, 2018). S&P 500's Rally Is Strongest Ever During a Fed Tightening Cycle. Bloomberg.}}

For the first time in 10 years, the yield on two-year treasuries is higher than the dividend yield on the S&P 500. This means persons interested in income can finally get a decent return on conservative investments.

^{Source: Two-year U.S. Treasury Yields vs. S&P 500 Dividend Yield. American Funds.}

In our opinion, the most important thing to watch right now is the yield spread (the difference) between the U.S. 10-year and 2-year treasury. When this spread has inverted (became negative) in the past, economic recessions (grey bars in the chart below) soon followed. Assuming the current rate of decline continues, an inversion could occur by December. The spread currently stands at +0.24.

^{Source: 10-Year Treasury Constant Maturity Minus 2-Year Constant Maturity. (September 18, 2018). Federal Reserve Bank of St. Louis.}

CWM Projections and Positioning

To ease client understanding, we have decided to shift away from displaying our PTS behavioral macro score and will now be providing our two-year projections for the S&P 500 and the long-term treasury bond as a means of more clearly displaying future return possibilities for those assets. This will include an actual 2-year projection along with statistical ranges (high/low possibilities) of possible outcomes around those points.

IMPORTANT: The projections or other information generated by CWM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. It is possible that the markets will perform better or worse than what is shown in the projections.

Though there is potential for stocks to move higher, current valuations reflect a high probability of a negative future outcome, a risk we are striving to mitigate for our clients. The risk/return potential of bonds continues to be favorable relative to that of stocks and CWM PTS models continue to be invested conservatively as a result. The CWM team will continue to be disciplined in our efforts to provide the best risk adjusted returns possible for our clients.

Please pass this article on to any one you know who may be interested in or might benefit from the information. We are always looking for more great clients just like you and would welcome any opportunity to assist them.

If you have questions or comments about the above subjects or other investment topics, I would love to have a conversation! Feel free to email me or, if you are interested in more regular financial tidbits, follow me on Twitter.

Morgan Arford
Chief Investment Officer

P.S. My wife Debbie and I are pleased to announce the birth of our third child, and the only girl in the family! Welcome to the world Nalia (Na-lee-a) Lynne Arford.

This article has been prepared and distributed for informational purposes only and is not a solicitation or an offer to buy any security or investment or to participate in any trading strategy. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice as individual situations will vary. For specific advice about your situation, please consult with a financial professional. Past performance is no guarantee of future results.