Adapt or Fail

The previous article in this series discussed the ebb and flow of stock markets as they move through long periods of strong and weak returns, often lasting 15 years or more at a time. As such, there are periods when investors can set their sails and ride the prevailing winds to a sunny investment horizon. Alternatively, there are long periods where markets go sideways or down, and where any growth in investment portfolios must necessarily come at the expense of someone else.

Unfortunately, our analysis suggests that we are in the early, or perhaps middle stages of a multi-year period of low market returns, where investors will need to ‘row’ their way to positive investment performance. During such ‘rowing’ periods it is important to consider active strategies that have the potential to provide substantial risk-adjusted returns in any type of market.

Heave Ho

One such rowing strategy was recently outlined in a paper entitled Optimal Momentum by Gary Antonacci. This paper has practical relevance because it closely mirrors the general principles we apply in our proprietary investment models for clients. In the study, Antonacci constructs an investment universe that broadly captures the set of global opportunities available to investors. We simplified the strategy presented in the paper slightly, and altered the investable universe in our study to accommodate the options available to Canadian investors by investing in Exchange Traded Funds (ETFs).

At any given time, our model was able to invest in any two of the asset classes below (in bold) via a corresponding ETF (in italics).

·      US Real Estate - iShares Cohen & Steer Realty REIT

·      Gold Bullion - SPDR Gold Shares

·      Japanese Stocks - iShares MSCI Japan Index Fund

·      European Stocks - iShares S&P Europe 350 Index Fund

·      Cash - Barclays Low Duration Treasury

·      Asian Stocks (ex-Japan) - iShares Pacific ex-Japan

·      US Treasury Bonds - iShares Barclay 7-10 Yr. Treasury - 7-8 Yr.

·      US Stocks - Vanguard MSCI Total U.S. Stock Market

ETFs trade on the major stock exchanges just like regular stocks, but they behave largely like very low-cost index mutual funds. That’s because each Exchange Traded Fund, or ETF, is constructed to deliver the same performance as a very broad index of underlying securities. For example, investors can purchase a single ETF to experience the exact returns of the entire S&P/TSX Index, the S&P 500, theNasdaq, gold, European stocks, or a wide variety of other asset classes or indices.

In his paper, Antonacci presents a strategy that ranks the investment opportunities above based on how each investment has performed over the prior six months. The concept is based on the well-documented phenomenon in markets called ‘Momentum’, whereby securities that have done well over the recent past have a high probability of continuing their positive performance over the subsequent 1 to 3 month period.

Accordingly, in our study we ranked the above basket of investments at the end of each month according to their relative price performance over the previous six months. At the end of each month, we altered the holdings of the portfolio so that the portfolio always held the two most highly ranked investments. In other words, the portfolio adapted at the end of each month to hold the most prospective investments over the following month based on our ranking criteria.

Table 1.
SYMBOL	EXCHANGE TRADED FUND (ETF)/ INVESTMENT MODEL
ICF	US Real Estate - iShares Cohen & Steer Realty REIT
GLD	Gold Bullion - SPDR Gold Shares
EWJ	Japanese Stocks - iShares MSCI Japan Index Fund
IEV	European Stocks - iShares S&P Europe 350 Index Fund
SHY	Cash - Barclays Low Duration Treasury
EPP	Asian Stocks (ex-Japan) - iShares Pacific ex-Japan
IEF	US Treasury Bonds - iShares Barclay 7-10 Yr. Treasury - 7-8 Yr.
VTI	US Stocks - Vanguard MSCI Total U.S. Stock Market

To illustrate the effect of this ranking and rotation into the most prospective markets each month, in the diagram below, we tracked our model’s holdings for each month of the year 2008 in Figure 1. to demonstrate how the ETF holdings of our model change over time. The numbers represent the monthly total returns for each investment, and coloured squares identify the months where our model actually held the investment.

You can see that our model rotated into gold (GLD) and U.S. bonds (IEF) for the first 7 months of 2008, and then moved out of gold and into cash (SHY) for the remainder of the year.

Figure 1: Highlighted Monthly Model Holdings in 2008

	January	February	March	April	May	June	July	August	September	October	November	December
VTI	-6.17%	-2.50%	-0.90%	4.89%	2.02%	-8.12%	-0.62%	1.46%	-9.24%	-17.48%	-8.01%	1.78%
IEV	-8.80%	-0.47%	1.18%	4.43%	0.41%	-9.34%	-2.57%	-3.97%	-12.36%	-21.25%	-6.72%	7.70%
EWJ	-4.29%	-1.49%	-1.28%	7.36%	1.96%	-7.47%	-3.77%	-4.92%	-6.57%	-15.57%	-3.78%	11.56%
EPP	-7.88%	-2.57%	-2.09%	7.76%	2.86%	-9.16%	-4.66%	-4.95%	-12.67%	-26.52%	-6.90%	9.45%
SHY	1.65%	1.03%	0.25%	-0.84%	-0.35%	0.24%	0.43%	0.47%	0.78%	1.10%	1.10%	0.56%
IEF	3.36%	1.24%	1.34%	-2.41%	-1.78%	1.14%	0.72%	1.53%	-0.14%	-0.87%	7.75%	5.15%
GLD	10.84%	5.23%	-6.00%	-4.16%	0.92%	4.52%	-1.44%	-9.29%	4.11%	-16.14%	12.57%	7.73%

   Source: Antonacci (2011), Butler|Philbrick & Associates (2011)

It Pays to Row


In terms of performance, our modified Antonacci Model achieved a 407% total return between 2003 and July 2011. In the same period, the S&P 500 index of the largest U.S. stocks returned 68% including dividends. This works out to an average annual return of 21.8% for our simple strategy versus 6.6% annualized for U.S. stocks. Further, while U.S. stocks were dropping over 50% in 2008 our Antonacci study portfolio delivered a positive return of 16.1% (see Figure 2 below). Figure 2. demonstrates the relative performance of our model in each calendar year relative to all of the available investments. Notice that from 2003 to 2011 our modified Antonacci Model never dropped out of the top half in terms of annual calendar-year performance, and never experienced a losing year.

Figure 2:

Source: Antonacci (2011), Butler|Philbrick & Associates (2011)

SYMBOL	EXCHANGE TRADED FUND (ETF)/ INVESTMENT MODEL
ICF	US Real Estate - iShares Cohen & Steer Realty REIT
EWC	Canadian Stocks - iShares MSCI Canada Index Fund
GLD	Gold Bullion - SPDR Gold Shares
EWJ	Japanese Stocks - iShares MSCI Japan Index Fund
IEV	European Stocks - iShares S&P Europe 350 Index Fund
SHY	Cash - Barclays Low Duration Treasury
SPY	US Large-cap Stocks - SPDR S&P 500 Index
ANT	Modified Antonnacci Model
EPP	Asian Stocks (ex-Japan) - iShares Pacific ex-Japan
IEF	US Treasury Bonds - iShares Barclay 7-10 Yr. Treasury - 7-8 Yr.
VTI	US Stocks - Vanguard MSCI Total U.S. Stock Market

Even more impressive, the modified Antonacci model’s worst full calendar year return was positive 10%, versus minus 35% or more for the major stock markets. In fact, the Antonacci model never dropped more than 10% from any peak to trough on its ride to the top, while markets dropped 50% or more!

The Long and Short

The take away from this study is that, if left alone, and especially during low-return periods, financial markets do not deliver returns in a consistent fashion.  As such, it is of paramount importance that any investment strategy be able to adapt over time as markets change - moving to bonds, cash or perhaps gold when markets are falling, or into the most prospective markets when markets are rising – rather than sticking with a constant allocation to one market or another over time, per the traditional approach.

After studying the performance of Antonacci’s momentum based strategy over the past decade and considering the returns that buy and hold investing delivered during the same period, it should be clear that a systematic adaptive investment strategy has the potential to add tremendous value in all types of market environments, and especially during highly uncertain and volatile times like today.

For more information about how adaptive, systematic strategies may work well for you, or to read our Estimating Future Returns piece, please visit us on the Web at  http://www.macquarieprivatewealth.ca/specialist/butlerphilbrick/case-studies .

Time to Row

We have discussed at length the merits of our “Estimating Future Returns” model and its history of providing more accurate forecasts of future returns to stocks than traditional methods (for more on our real returns model click here).

It is essential to consider the myriad potential outcomes and the likelihood of each outcome occurring when determining whether your current investment strategy is appropriate, or whether an alternative strategy is warranted.

Considering the expected returns for the foreseeable future allows the wealth management process to be more adaptive to market conditions, a characteristic that can add tremendous value to a portfolio and a wealth plan over time. One of the single greatest failings of the traditional wealth management approach is its inability to integrate these ever changing projected future returns into the portfolio management process.

In fact investors almost never receive the very long-term rate of return that the dominant investment theory would predict (Dalbar, 2011). Instead, investors have historically received a random mix of very low and very high returns year in and year out. Worse, these high return and low return periods often cluster together over many years at a time. This is problematic if you happen to retire during a period of sustained below average returns.

These types of multi-decade bull and bear markets exist and are driven by market regimes where economic and psychological forces compel prices to move broadly higher or lower over many years at a time. If you refer to Figure 1 below you will see that retiring in a regime of persistent low returns is just as likely as retiring in a period where markets experience sustained above average returns.

The question becomes: What type of market are you retiring in? Further, what can you do to maximize your chance of a successful retirement?

Our “Estimating Future Returns” model allows us to better inform investors about where they sit today and what their likely prospects are for the medium term. As Ed Easterling of Crestmont Research puts it, valuation models allow us to more accurately gauge whether investors will need to ‘row’ for the foreseeable future or whether they can ‘sail.’

Over the last 100 years there have been four extended periods during which investors were forced to ‘row’ and three periods where investors could ‘sail.’ There was the raging bull market of the roaring twenties, which seemingly defied Washington’s policy makers. The brutal bear market of the Great Depression followed the ‘Roaring Twenties’, and lasted until the end of World War II.

The end of the Second World War preempted the post-war economic boom and concurrent long-term bull market that raged from the late 1940s to the late 1960s. The almost decade and a half long stagnation that followed was sparked off in earnest by the 1973 OPEC oil crisis and the subsequent dramatic rise in inflation expectations which pushed interest rates to their century highs by 1981.

This period was followed by the longest sustained bull market in the history of the United States, from the early 1980s to the ‘Tech Bubble’ in 2000. We have subsequently experienced the current decade’s financial turmoil which has seen financial markets recover from the depths of the Tech Bubble only to be met with substantial difficulties stemming from the collapse of the U.S. housing market in 2008; a state from which the market still has yet to fully recover.

Figure 1

   Source: Butler|Philbrick & Associates (2011)

What this should illustrate is that markets come in all shapes and sizes, and that the traditional ‘Buy & Hold’ approach to investing may not be the optimal strategy in all market environments.  Additionally, sustained bear markets inevitably follow sustained bull markets. Unfortunately, no one knows precisely when the switch will flip from one market regime to the other.

This creates the need for a strategy that is not only effective during both rowing and sailing environments, but which can also be effective during the transition between these two market regimes.

Rowing requires a dynamic and adaptive approach with periodic readjustments, while ‘sailing’ only necessitates letting the prevailing wind propel you toward your financial goals, while making minor adjustments once in a while to stay on course. Passive strategies like ‘Buy & Hold’ work adequately, but only in ‘sailing’ markets. In ‘rowing’ markets the only positive returns that investors receive are necessarily taken from someone else, as it is a zero sum game.

If you look at Table 1 below, you will notice that our “Estimating Future Returns” model very accurately estimated the forward fifteen-year market environment for both bullish and bearish market regimes of the past century. While traditional Advisors would have you believe that the best estimate of portfolio returns is always the very long-term average of 6.5% after inflation, our model has historically delivered much higher levels of accuracy. You can see in Table 1. that in sailing environments this 6.5% estimate is usually too low, while in rowing environments it is much too high.

Table 1

Source: Shiller (2011), Doug Short (2011), Butler|Philbrick & Associates (2011)

If the model’s past success is any indication, then we observe a high likelihood that investors will face a rowing environment over the next fifteen years. During these types of market regimes, it is essential to have a strategy that is adaptable to many different market environments, and can scour the globe for the best opportunities. In our next installment, we discuss a strategy that has the potential to deliver substantial risk-adjusted returns in all market environments, and demonstrate how it managed to deliver positive returns, even during one of this decade’s most challenging years.

Buy and Hold? Dead Money.

At Butler|Philbrick & Associates, we don’t take anything on faith. Nor do we take expert opinions to heart, as we have shown time and again that experts make poor oracles. Instead, we believe in crunching the numbers ourselves to discover meaningful relationships in data. Where meaningful relationships exist, we apply statistical models to improve our chances of success.

Now that we have developed and deployed Version 2 of our systematic investment model, we decided to shift our attention to the development of a more robust model for forecasting long-term stock market returns. Traditional Advisors assume that the best estimate of future market returns in all market environments is the simple long-term average return on stocks: about 6.5% per year after inflation.

We hypothesized that it is possible to construct a statistical model using long-term market data which will allow us to make much more accurate predictions about long-term returns. It turns out that we were right. Those who are interested in the process we used, and the specifications of our model, are encouraged to read our full report.

There are several reasons why it may be useful to have a more robust estimate of future expected returns on stocks:

• People who are approaching retirement need to estimate probable returns in order to budget how much they need to save.
• A retiree’s level of sustainable income is largely dictated by expected returns over the early years of retirement.
• Investors of all types must make an informed decision about how best to allocate their capital among various investment opportunities.

Many investors do not know that traditional wealth advice is rooted in the assumption that the best estimate of future returns is always the average long-term return to stocks. No matter where markets are on the continuum from very cheap to very expensive, traditional Advisors will make recommendations on the assumption that investors should expect 6.5% inflation adjusted returns on stocks over all investment horizons.

To illustrate, imagine a retiree who visited a traditional Investment Advisor at the peak of the technology bubble in early 2000, when markets were more expensive than at any other time in the prior 130 years. This investor would have been advised to expect returns on his stock portfolio of 6.5% per year over his or her investment horizon, based on very long-term averages.

Our models suggest that this retiree should have expected inflation-adjusted returns to his portfolio of negative 2% per year over the subsequent 15 years, a difference in returns of 8.5% per year versus the long-term average. In fact, this investor would have experienced returns of negative 1.55% per year through December 31, 2010, and would need a return of almost 22% per year through 2015 to realize the traditional advisor’s year 2000 projections.

Table 1. applies this same analysis to other important periods over the past 100 years. We contrasted the return forecasts from a traditional long-term average approach with the forecasts from our valuation-based model, at a variety of transitional dates in stock markets, to demonstrate the improved accuracy of our valuation-based approach.


Source: Shiller (2011), DShort.com (2011), Butler|Philbrick & Associates

You can see that forecasts derived from long-term average returns yield over 400% more error than estimations from our valuation-based model over these 15-year forecast horizons (1.24% annualized return error from our model versus 5.24% using the long-term average). Clearly our model offers substantially more insight into future return expectations than simple long-term averages, especially near valuation extremes.

Chart 1. shows how closely our valuation-based model forecasted actual market returns over subsequent 15-year periods. The blue series is our model forecast, and the red series tracks actual market returns. The red line near the middle of the chart reflects a 6.5% annualized return.


Source: Shiller (2011), DShort.com (2011), Butler|Philbrick & Associates

So what does our model suggest about current market valuations and future expected returns? You can see from the chart’s blue line that expected returns from current levels are well below average. Even at the market’s lows in March of 2009, expected returns to stocks over the subsequent 15 years was just average, suggesting that markets simply achieved long-term average valuations at the market’s low. We were, and are, a far cry from the generational low valuations achieved around 1920, 1950, and 1980. If history is any guide, we may achieve those generational-low valuations – which represent once-in-a-lifetime opportunities to buy stocks – at some point in the next 5 to 10 years. Of course, we must endure another period of very low returns to achieve such low valuations.

So what level of annualized returns should we expect from stocks, after adjusting for inflation, over the next 5, 10, 15 and 20 years based on current valuations? Table 2. summarizes our model’s forecasts over these horizons. Only time will tell how accurate they might be, but history clearly proves that future returns will be much closer to these values than the long-term average of 6.5%.

Source: Shiller (2011), DShort.com (2011), Butler|Philbrick & Associates

The investment industry has a large vested interest in convincing you that the same approach that delivered poor returns over the prior decade will deliver much more robust results over the next few years. That way, you will be convinced to hold your money in the same traditional, high margin products that made banks so much money, and lost investors so much money, over the last 10 years.

In periods of low returns, investors must have the courage to adopt a different approach if they hope to achieve better-than-average results. Our Gestalt Architecture was engineered to deliver strong returns in all markets, including markets which drop in value over several years or months. How does your Advisor plan to deliver robust results in the likely event that future returns are well below average?

For a wealth of evidence about momentum investing, market timing, asset-class rotation and ETFs, please visit our Case Studies web page at www.ButlerPhilbrick.com/CaseStudies.html.