| Model Portfolios: | February | Y-T-D | 12 Mos. | 6 Years | 9 Years |
| Performance Xtender | -0.8 % | -2.6 % | 2.2 % | 121.9 % | 377.7 % |
| Max Xtender | -2.6 % | -10.3 % | -10.9 % | 205.1 % |
887.6 % |
| Compared to Traditional Strategy: | |||||
|---|---|---|---|---|---|
| Balanced Portfolio (60% stocks 40% bonds) | -1.9 % | -5.0 % | -2.2 % | 30.5 % | 37.6 % |
Dear Subscriber,
This issue of the newsletter includes the following:
Monthly Tracking Report: Get an update on the current performance of our Model Portfolios compared with a traditionally balanced buy and hold portfolio consisting of 60% stock funds and 40% bond funds.
Performance Analysis: See a comparison of the Model Portfolios' performance in Bull Market and Bear Market cycles.
Market Commentary: This month we look at where we are in the stock market from a very long term perspective.
Model Portfolio Allocations: Check the most current portfolio allocations for our Model Portfolios. (Note that allocation changes are announced by email in a separate Trade Alert.)
Performance Analysis
People like to say that "a picture is worth a thousand words." Here we offer two pictures to demonstrate the performance of our model portfolios in two distinctly different market environments:
- Bull Market performance since October of 2002
- Bear Market performance from March 2000 to October 2002
Both model portfolios are compared to a traditional "balanced" portfolio allocation of 60% stock funds and 40% bond funds.
Bull Market
Performance Over the Bull Market Cycle:
Both model portfolios have performed as expected over the period. The Performance Xtender has generated a significant increase in gains compared to a Traditional Balanced Portfolio. And the Max Xtender used leverage to generate almost 3 times the performance, although at the expense of significant volatility.
Bear Market
Performance During the Most Recent Bear Market Cycle:
Both model portfolios delivered a substantial increase in value during the Bear Market of 2000 through 2002. By contrast, a "buy and hold" investor ... holding an index fund representing the S&P 500 index ... would have lost about 45% during the 2 1/2 year bear market. An investor with a "traditional balanced portfolio" would have avoided huge losses during the period but still would have suffered a negative return.
The more significant benefit of following these model portfolios can be seen in the longer term ... over periods that are long enough to include two or more market cycles. A 9-year look back period is long enough to include both of the two most recent market cycles. Over this period of time, the cumulative return of the Performance Xtender (based upon a combination of live returns and "backtested" returns from computer simulation) was 377% ... about 10 times the "traditional portfolio" which returned a cumulative gain of only 37% in 9 years. The Max Xtender, which uses leverage aggressively to accentuate gains in both up and down markets, gained about 23 times as much as the traditional portfolio with a cumulative 9-year return of 887%.
- The simple reason behind the models' huge gains over a traditional portfolio is their ability to dynamically shift investment allocations to avoid huge losses and even make gains during bear market cycles. While a traditional portfolio will lose significant value during a bear market, the model portfolios can make money and are able to compound profits from the bear market period on top of profits earned during a bull market. The cumulative benefit of such compounding becomes huge over time after one or more bear market cycles.
While our model portfolios can be more volatile than a traditional portfolio in the short-run, they are much less volatile in the long run because they can avoid the very deep losses suffered by traditional buy-and-hold strategies from which an investor can take years to recover.
Market Commentary
The End of the Post Vietnam War Era
Executive Summary: Our quantitatively-based portfolio models are now postured according to a "Bearish" reading of stock market risk. While we expect the market may still make attempts to rally in the short to intermediate term, our technical indicators have now all turned bearish for the longer term. Moreover, our technical and fundamental analyses strongly suggest that the US stock market has reached the peak of a multi-decade expansion and is now only in the early phase of a long term reversal of direction. Our expectation is that the next five to ten years will prove to be a very challenging environment for buy and hold investors in US stocks.
[Every month we provide a commentary on the market which is based upon a basic charting and technical analysis approach. You will not find us often discussing the types of "fundamental" factors that most market analysts use to make their case. Hopefully, you will find our commentary refreshing and a welcome change of pace from mainstream analysts.]
We laid out the 'technical' evidence in last month's commentary to support the argument that a 'bear market' has begun in the US stock market.
While our bearish view has become increasingly 'mainstream' in recent weeks among pundits and investors, there is much discourse in the financial media now about the potential depth and duration of this new 'bear market' that may be upon us. Many commentators expect a fairly mild economic correction and a more 'garden variety' type of bear market, the likes of which have routinely occurred over 200 years of stock market history to periodically interrupt long economic expansions.
However in this month's commentary we will take in the 'longer view' and try to bring to bear an argument based more on 'fundamentals' than 'technicals' ... addressing the big picture question of where we stand today within the course of a 33-year 'secular' bull market in US stocks that began in 1974. We will argue here that we stand at the precipice of a major decline that may come to be viewed by future market historians as a reversal of the entire 33-year 'Post Vietnam War' economic expansion.
This is a grand claim no doubt. Because the 'technical' evidence for this argument can only be suggestive rather than decisive at this point, we will try to put some meat on the bones of this viewpoint with a 'fundamental' analysis.
To be a bit more specific, we will argue here that the primary 'fundamental' forces responsible for fueling the economic expansion of the last 33 years have reached their limits and have effectively now 'gone into reverse'. The effect of losing the dynamic benefit of these economic forces will be to 'unwind' some of the massive value creation of the Post Vietnam War Era and force our nation to discover a new basis upon which a new long term cycle of economic growth and wealth creation can begin.
To set up the argument, let's take a look at the value creation of the Post Vietnam War Era on a stock chart. The graph shows the history of the US stock market since 1970 as represented by the S&P 500 Index. The first thing to note is that the pattern of rising stock prices perfectly fits the technical definition of a bull market ... that prices proceed with a pattern of higher highs and higher lows. (By contrast a 'bear market' is defined as a cycle of lower lows and lower highs). Since the 1974 low in the market, stock prices reflect a fairly consistent economic expansion in the definitive pattern of a bull market ... in what we would call a 'secular bull market super-cycle'. While the 33-year expansion was interrupted by several bear markets, the declining periods amounted only to 'corrections' of the underlying bullish super-cycle.
From a 'technical' perspective, the long term pattern of 'higher highs and higher lows' has not yet been broken. However the stock market now rests on the verge of breaking the rising long term trendline of the bull market cycle since 1982 (see the red line on the chart). Technically speaking, trend line breaks signal a reversal of trend; and in this case, we are looking at the grand-daddy of trend line breaks. Furthermore, a trend line break here will add weight and confirmation to another 'technical' signal ... that the important S&P 500 Index has traced out a very bearish Double Top formation. The Double Top formation has been apparent for some time. We first discussed it in our June 2007 newsletter. A 'double top' formation signals the exhaustion of a trend and the onset of a reversal of that trend.
In this case, the Double Top formation is on a massive scale and represents not just the end of the more recent bull cycle in the market since 2003 but rather that of the bull cycle on a larger scale ... the secular bull super-cycle.
So the set up for our argument is based on 'technical' signals which have formed at a very large scale of the market's action over a period of decades. But now let's put some meat on the bones with a review of some of the key 'fundamental' forces that were largely responsible for the massive, 33-year expansion ... and were indeed behind the unique character of the economic expansion in the Post Vietnam War years.
First let's point out that the economic expansion of the Post Vietnam War Era was of a different character than previous secular periods of economic expansion in the United States. Think for a moment of how the basis of economic expansion in recent decades has differed fundamentally from that of the Post Depression economic cycle which ran from the stock market bottom in 1932 to the stock market peak in 1965.
What dynamic forces were unique to the Post Vietnam period that gave this massive economic expansion its special character? And what about those unique forces today ... ?
We would highlight the impact of five "fundamental" forces that we believe had a lot to do with shaping the special character of the 33-year expansion ... and now appear to have run their course. Not only has the flow of benefits from these forces 'run out of steam' but it would appear that the beneficial impact of each has actually now 'gone into reverse'. That is to say that the fundamental positive forces responsible for the economic expansion of the past three decades have now become negatives. What are these positive forces now turned negative?
- The galloping trend of globalization
- The taming of inflation, leading to a secular decline of interest rates
- The triumph of the American economic system and the US Dollar as reserve currency
- The innovations in credit extension
- The apparent availability and cheapening of natural resources
If we can say with any certainty that the fundamental forces shaping the past era have changed or shifted in important ways, then we can potentially understand why the Post Vietnam War Era must end and must transition to something entirely new.
Globalization
This important 'fundamental' is apparent to everyone. While many people have viewed it as a negative force, it is hard to argue with the central role it has played in shaping the character of the economic expansion since the Vietnam War. While the trend toward Globalization has by itself not 'run out of steam' by any stretch of the imagination, the positive array of benefits to the US economy may well have. So we need to consider how Globalization impacted our economy and provided dynamic uplift for several decades of value creation.
In many ways, the economic expansion of the Post Vietnam War Era has been all about adapting to the forces of Globalization. The manner in which America responded to the challenge had much to do with the unique character of the expansion. The US responded to the competitive threat to our manafacturing sector with a massive shift to a services based economy combined with a draconian restructuring of many enterprises to drive efficiency and competitiveness. Our response kept Americans working, even if it meant two jobs per family or two jobs per worker.
But we took it much further than did other 'developed industrialized nations'. We don't joke in this country about everybody becoming 'hamburger flippers' for nothing. The manufacturing sector still accounts for a significant percentage of the overall economy in most other developed countries (as does the export related component of their economies).
The arguments of 'comparative advantage' notwithstanding, the problem is we just don't make many 'things' in the US anymore. This reality is fast becoming a major disadvantage for us as the fundamental importance of export-led economic growth increases. The shift to a services-based economy has run its course and we may have taken it too far. We cannot rely much further on an expanding services economy to make up for the loss of manufacturing jobs and provide the long term basis for economic value creation.
Nor will we continue to be able to take massive advantage of the inherent disinflationary forces of Globalization in the form of cheaper consumer goods. The reduced cost of living made possible by the forces of Globalization has been an enormous boon to the US consumer as evidenced by any survey of the comparative cost of imported vs. American made goods. WalMart has became one of the central 'icons' of our economic prosperity over the past several decades as we have all become dependent upon imported cheap goods that help us to stretch our incomes.
This one huge factor underlying the character of the economic expansion over the past three decades is now shifting direction on us. Rather than floating downstream on a river of ever-cheaper imported goods, we may soon have to paddle upstream against a flood of increasing prices driven by a declining US Dollar compounded by expanding inflationary pressures overseas. It won't be easy to shift back to American made goods as the relative cost of the Dollar declines because in many cases we don't make those goods here any more. And the export sector of the US economy is not currently big enough to make enough difference right now to pull the US out of recession.
It must be said that this 'reversal of direction' of the benefits of Globalization may be quite healthy for the US economy in the long run. But in the short run, we will be swimming upstream and working to adapt to a new reality.
The point is that the special character of the Post Vietnam War Era expansion was shaped in part because of how America responded to Globabalization and took advantage of its benefits. But that fundamental reality has now changed as the benefits have shifted direction. This is one major reason for the 'end of an era' and why there must be a transition to a new one.
Inflation and Interest Rates
The raging inflation of the 1970's was finally quashed in the Reagan Recession of the early 1980's and by the policies of Fed Chairman Volker. But the triumph over inflation was sealed by a new inflow of cheap imported goods as well as the draconian rationalization of US industry triggered by global competition.
Inflation has been benign now for 30-odd years. And as a result, interest rates were allowed to decline in a long, multi-decade secular trend dropping from a high near 20% to a low of almost 1% for short term rates.
The fundamental force of stable and declining interest rates for a period of decades was a spectacular boon to the US economy and helped to shape the particular character of the final phase of the Post Vietnam War Era. Low interest rates helped to trigger multiple 'asset bubbles' that have helped to define the era ... in particular the boom in housing and the appreciation of real estate.
It is quite fair to say now that the US economy has pushed this trend for all it was worth. We will not see much more benefit from lower interest rates at this point. To the extent that lower rates are used to combat recession, it will help to further debase our currency globally and thereby cause the additional importation of inflation into our economy as we continue to consume huge amounts of goods from overseas.
Low interest rates were a very important fundamental factor that helped to define the Post Vietnam War Era. Now this factor is reversing direction on us. The new secular forces at work will put upward pressure on interest rates for many years. The dynamic of global economic growth is now sparking inflation across the world, driving foreign governments to increase interest rates in response. And the US government will be further pressured to raise rates to fight the flight of capital needed to help us manage our trade imbalances.
The Triumph of America and the US Dollar
The Post Vietnam War Era witnessed the end of the existential global battle between two antithetical economic systems. America emerged triumphant and its economic strength and military might dominated the world. The US Dollar reigned supreme as the effective reserve currency of the world.
The primacy of the "American system" had a lot to do with the special character of the 33-year economic expansion. Just about everyone was willing to take and hold US Dollars. Just about everyone wanted to sell their goods to the US consumer. And they did.
And Americans seemed to revel in the triumph and spend without abandon in the secure knowledge that the American system was now invulnerable and would persist forever. At the beginning of the era, Americans saved a significant portion of their incomes like most people everywhere. But by the end of the era, Americans were "dissaving", spending more than they earned in the aggregate and borrowing against home equity to keep it up.
But America no longer seems so invulnerable. Confidence in the American system has been shattered in many quarters. And the Dollar is losing its place as the world's reserve currency. Before long we will have to 'pay our bills' internationally and US Treasury Bonds could lose their AAA credit rating if we can't shore up the nation's finances. All of a sudden, America is looking more like an emerging market subject to the whims of foreign investors.
So another one of the primary fundamental forces that helped to make the Post Vietnam War Era what it uniquely was has shifted direction on us and is pushing in the other direction.
Innovations in Credit
We all know now about the 'credit crisis' and the 'credit bubble' that caused it. But very few of us saw this one coming. The many exotic and more pedestrian innovations in the extension of credit over the years have proved to be in retrospect a major fundamental factor that gave shape to the unique character of the 33-year expansion. Many of the innovations started in the early 1980's and slowly evolved to help create what is now referred to as a 'shadow banking system' that engaged ultimately in a massive and virtually unregulated expansion of credit both to individuals and commercial enterprises.
As it has turned out, this massive extension of credit, and the lack of adequate reserves to cover loan losses, is getting us individually and collectively into a lot of financial trouble. And the potential ramifications of this trouble are only beginning to be glimpsed as first one, then another, shoe drops.
Suffice it to say that 'cheap and easy credit' was a fixture of the multi-decade economic expansion and became a major cause of the apparent strength and durability of the expansion. But now it is gone and we have moved into a new era of the 'unwinding' of credit and the liquidation of debt.
What was once a major positive is now a major negative and the 'end of an era' is nigh.
Natural Resources on the Cheap
After the 1970's, concerns about the availability of oil and the pressures of a global population crisis fizzled. The relative prices of many commodities dropped.
Gas was cheap and so were many natural resources. The profligate waste of energy became a central feature of many aspects of the economic expansion as we built ever bigger cars, SUVs and homes with ever more power-hungry appliances, TVs and computers. The availability of cheap resources was another 'core fundamental' that drove the expansion and allowed us to purchase enhanced affluence on the cheap.
And then the rest of the world wanted to live like us. Now it appears we have a problem. And as a primary 'input' cost to the economy, natural resources are now driving inflation on a global basis.
The price and availability of natural resources is one more fundamental factor that was a positive for our economy in the Post Vietnam War Era and has now turned to a negative.
Convinced Yet?
The point of this analysis has been to make the case that we are not just in for some 'garden variety' bear market experience ... the US economy is not likely to just Muddle Through one more time.
The fundamental forces at work are simply too big and they have now turned against us ... or at least against the basic structure and character of our economy which had provided the impetus for growth over several decades.
What 'fundamental factors' can drive a brand new era of wealth expansion in the US? What factors are in place today that can drive growth for decades? What formidable economic strengths does the US have in light of the new reality? In our view, because the positive fundamental forces are missing, they will have to be discovered and developed over time.
Note that the decade of the 1970's was a similar period of 'coming-to-terms' with the structural contradictions of the previous economic era that reigned into the late 1960's. The coming decade could also prove to be a period of turbulance as we struggle to find a new way.
What we will need is a whole new set of fundamental strengths ... an entirely new basis upon which the economy can enter a brand new phase of wealth creation in the US.
Recommended Model Portfolio Allocations
Model Portfolio: 'Performance Xtender'
(A model portfolio that invests selectively in stock market index funds, plus certain market sectors such as Energy, Gold and Real Estate, and in an Inverse Fund ("Bear Fund"), depending on current market trends for each type of investment. The allocation mix is designed to beat the market significantly during both bull and bear markets with only a limited risk of volatility.)
... Portfolio as of March 2, 2008 ...
| Current Recommended Portfolio Allocations | Rydex Funds | ProFunds | ETFs | |||
|---|---|---|---|---|---|---|
| Allocation | Ticker | Allocation | Ticker | Allocation | Ticker | |
| Precious Metals Fund | 20% | RYPMX | 20% | PMPIX | 20% | GDX |
| Corporate Bonds, or Money Market |
80% Money Market Fund . Note that the gold bullion fund "GLD" is an alternative fund that should be less volatile than mining shares. | |||||
Model Portfolio: 'Max Xtender'
(A model portfolio that invests selectively in stock market index funds and in an Inverse Fund ("Bear Fund"), depending on current market trends for each type of investment. During strong market trends ... either bullish or bearish ... the model uses up to 2-to-1 leverage to magnify returns. The allocation mix is designed to beat the market substantially during both bull and bear markets but with a relatively high risk of volatility.)
... Portfolio as of March 2, 2008 ...
| Current Recommended Portfolio Allocations | Rydex Funds | ProFunds | ETFs | |||
|---|---|---|---|---|---|---|
| Allocation | Ticker | Allocation | Ticker | Allocation | Ticker | |
| - | - | - | - | - | - | - |
| Corporate Bonds, or Money Market |
100% Money Market Fund. | |||||
