Wedbush Securities
Chris Henderson/VP Investments
“Member NYSE/FINRA/SIPC”
Presentation Goals
 Learn a modern method of portfolio
management that is designed to lower risk
compared with “buy and hold” strategies
○ Tactical investment method supported by well-
published research
○ Infrequent buy and sell (flat) signals
○ Tax efficient in historical models
Presentation Goals

Learn simple technical tools to help identify
the long term trend of the stock market and
other asset classes (e.g. REITs, bonds)
 Define and utilize the 200 day moving average of
an asset class for trend identification
 Reduce risk by allocating to asset classes that are
in long term up trends and avoid asset classes that
are in down trends to lower volatility within your
diversified portfolio
Myth or Fact?

“You cannot successfully time the market”
 Evidence the financial services industry uses to
support position
○ Poor performance of most actively managed mutual fund
managers
 Indexed/passive mutual funds historically have outperformed 60-
90% of actively managed funds
○ Missing the 10 best days in stock market history would
markedly have lowered overall performance
 Over a 40 year period would cost 1/2 of capital gains (Javier Estrada
IESE Business School)
Myth or Fact?

Evidence against “buy and hold”
 Missing the 10 worst days in the market over a
40-year period would have dramatically
improved your stock holding performance
○ Missing those days increased total capital gains
by 2.5X! (Javier Estrada IESE Business School)
Myth or Fact?

Evidence against “buy and hold”
 “Buy and Hold” strategies have performed poorly
for individual investors over the past decade (and
for several periods of similar duration over the past
100 years)
○ retirement plans
○ 529s
○ savings.
Myth?

Historical data analysis suggests that
there are technical methods to increase
the likelihood of avoiding many but not all
of the worst days and periods in market
history
Reasons to Forget the Myth

Secular bull and bear markets lasting a
decade or more have occurred in all
asset classes throughout history
 Risk free asset classes do not exist
 Moves within a secular market can be
profound
What asset class is this?

Chart of tulip mania

Tulip Mania (17th century Holland)
 Price of tulips increased by 20X in a year
 At one point a tulip was selling for 12 acres
of land
 Bubbles/chart patterns have occurred for
hundreds of years
What was the worst
performing asset class for
the 40 year period ending
2008?
Gold

Safe haven?

Secular bear
 Early 1980s - 2001
 Worst performing asset class over a 40 year
period dating back from 2008
(Richard Bernstein, Merrill Lynch)
Gold (1980 - 2000)
Japan

Secular bull (1970s - 1990)

Secular bear (1990 - present)
 Level of the Japanese stock market in 2010
was equal to that observed in 1983
○ Nearly 30 years of the Japanese stock market
creating zero value for buy and hold investors
Japan (1980 - 2010)
Secular Bear Markets US Stocks

Great Depression
 Bear market loss 69.45% over 20 years
○ Nearly 30 years to recover losses from market peak of 1929
(inflation adjusted prices)

Vietnam/Oil Shocks
 Bear market loss 66.31% over 17 years
○ 24 years to recover losses from market peak of 1965
(inflation adjusted prices)

Tech Bubble/Financial Crisis
 As of August 2011, investors who held stocks from
March 2000 were still hoping to break even.
Using Moving Averages to Define Trends

Moving average
 Price action smoothing mechanism

200 day moving average
 Often used to define bull and bear markets
 Definition
○ Sum of the prices of an asset class or stock at close of each
market day for the past 200 days divided by 200
Moving Averages

Should you pay attention to the S&P 500
price relative to its 200 day moving
average?
Moving Averages

Famous bear markets during which the majority of losses
occurred after the S&P 500 index had crossed below its
200 day moving average (MA)
 The Great Depression
 Tech Bubble
○ S&P 500 crossed below the 200 day MA on 9/18/00
 Index lost nearly 50% of its value in the next 24 months (Yahoo Finance)
 Financial Crisis
○ S&P 500 crossed below the 200 day MA on 11/11/07
 Index lost nearly 55% of its value by March 2009 (Yahoo Finance)
 The S&P 500 remained consistently below the 200 day MA from January
2008 till May 2009 (Yahoo Finance)
Moving Averages

Volatility and the 200 day MA
○ The stock market is historically 50% more volatile when the
S&P 500 is below the 200 day MA (Source: Faber)
○ Avoiding stocks when the S&P 500 was below the 200 day
MA would have led you to miss 72% of the 50 worst days in
market history between 1951 - 2007 (Source: Faber)
 Significant improvement in hypothetical portfolio performance
even though biggest days were often missed as well
 Past history may not reflect future performance
S&P 500 vs. 200 day MA
Moving Averages

Problems with a simple 200 day MA cross
strategy
 Holding the S&P 500 only when it is above a 200
day moving average
 Majority of simulated trade cycles are losing ones
 181 trade cycles from 1950-2010
 73% losing
 Unnecessary frequent trading
Moving Averages

Siegal Method
 Stocks for the Long Run Jeremy Siegal, PhD (Wharton)
 Buy the stock market when it trades above the 200 day
moving average by more than 1%
 Sell when the stock market when it trades below the 200 day
moving average by more than 1% and hold US Treasuries
 Improves risks adjusted returns
 Winning trade cycles approximately 50%
 Tested on the NASDAQ 1972 - 2006 historical data
 Annualized hypothetical returns are 4% greater than buy and hold
Moving Average

Problems with the Siegal Method
 Must pay attention day to day anytime price action is in
range of the 200 day moving average
 Frequent trading cycles
 74 (1950 - 2010)
 Winning trading cycles still occur only 50% of the time
Moving Average

Tactical Asset Allocation Method
○ “A Quantitative Approach to Tactical Asset Allocation”
(February 17, 2009). Journal of Wealth Management. (Faber)
 Working paper published in 2006

Improves on the Siegal method and shows
stability across asset classes in simulated
historical testing
 Can be utilized to manage risk within a diversified
portfolio of asset classes
Moving Average

Tactical Method
 Uses the 10 month moving average as the
signal line
○ Analogous to the 200 day moving average as there are
5 days per trading week
 All buy and sell decisions are based on the last
day of the month
○ Price movements of an asset class within the month
otherwise are ignored
 Reduces the number of trade signals significantly
 Seemingly reduces “whipsaw” trades
 Portfolio on “autopilot” for 29-30 days each month
Moving Average

Tactical Method
○ If the price of the asset class is above the 10
month moving average on the last day of the
month then buy/hold the asset class
○ If the price of the asset class is below the 10
month moving average on the last day of the
month then sell the asset class and buy/hold 90
day US Treasury fund
 Alternatively buy/hold money market fund
Tactical Method / US Stocks
Tactical Method / REIT
Tactical Method / International Stocks
Tactical Method / 7-10 year US Treasuries
Tactical Method / Commodities
S&P 500
Tactical S&P 500
Annualized
Return
Standard Dev.
9.21%
10.45%
17.87%
12.01%
Best Year
52.88%
52.40%
Worst Year
-43.86%
-26.87%
Source: Faber 2009
*Total Simulated Returns (1900 - 2008)
Simulated historical returns may not be predictive of
future performance
Tactical Method

Equal allocations to 5 different asset classes
using the monthly timing model on each






US Stock Market (20%)
International Stocks (20%)
REITs (20%)
Medium-Long Term US Treasuries (20%)
Commodities (20%)
If a particular asset class is on a monthly sell
signal, the 20% allocated to that asset class is
held in 90 day US T-Bills
Comparison of Buy/Hold vs. Tactical Method
5 Asset Class Portfolio (1973 - 2008)
Buy & Hold 5 Asset
Class Portfolio
Tactical 5 Asset
Class Portfolio
9.77%
11.27%
Annualized
Return
Standard
Deviation
Best Year
9.73%
6.87%
26.58%
26.20%
Worst Year
-30.09%
-0.59%*
*2008
*Total Simulated, Historical Returns
Source: Faber 2009
Simulated historical returns may not be predictive of future returns
Tactical Method

5 asset class tactical portfolio may be constructed
with low-fee index ETFs and/or low expense, no-load
index mutual funds
 ETFs trade like stocks, have low fees, and are often
designed to mirror the performance of a given asset class
○ Low-fee structure of funds within portfolio reduces expense drag
on a portfolio

Potential Tax efficiency
 Many Profitable simulated trade cycles are long term gains
Source: Faber
Tactical Method

Several ways to utilize the Tactical Method
 Substitute for the stock portion of your portfolio
○ Similar simulated historical return profile with lower volatility**
 Add as an “alternative” asset class
○ Perhaps 5-15% of portfolio depending on risk tolerance
 Comprehensive, diversified portfolio with intrinsic
design to balance risk**
○ Best suited for investors with a long-term investment horizon
**Simulated historical performance and
future performance may vary significantly
Questions for your financial advisor?

What is your method for reducing portfolio
exposure to asset classes that are in longterm downtrends?

If the stock market remains in a secular
bear market for the next decade, what is
your strategy to grow a portfolio?
We now know when to own different
asset classes, how do we further
reduce portfolio risk and try and grow
a portfolio in a secular bear or
sideways market?
Question

What’s your method for reducing portfolio
exposure to asset classes that are in long
term downtrends?
 We’ve seen that a move below the long-term
moving average has often proven to be a sign of
turbulent times. Therefore, avoiding these asset
classes has historically improved your returns and
lowered volatility.
Benchmark Indexes

Major indexes including the S&P 500,
MSCI EAFE, MSCI EM, & GSCI
Commodity Index are made up of
multiple sectors, countries, or other
components.
 Within each index we have historically seen
secular and cyclical trends of the different
components.
So What Can You Do?

If the stock market remains in a secular
bear market for the next decade, what is
your strategy to grow a portfolio?
 Determine the trends of the individual
subsectors, countries, or commodity
components.
○ Identifying out of favor sectors allows an
investor to focus only on those areas that
have momentum behind them.
How Do We Identify Current Trends?

Relative Strength (RS)
 Measures the price movement of an
investment compared to a set benchmark or
universe of its peers.
○ RS improves if the price increases more than
the average in an uptrend or decreases less
than the average in a downtrend.
 Allows investors to focus on the strongest
trends, wherever they may be found. It
offers the ideal framework for allocating
among these trends.
Relative Strength

Relative Strength can be used in many
ways. For our purposes we will focus
only on market relative strength.

We will also focus solely on sector,
country, and commodity related ETFs.
Relative Strength

Market relative strength.
 (ETF price/S&P 500)*100 = market RS score
 (XLF/SPY)*100 = RS
 ($15.58/$138.99)*100 = 11.21
○ If the RS score rises it signals relative strength vs.
the S&P 500.
○ If the RS score declines it signals relative weakness
against the S&P 500.
A move to a column of
O’s in August 2007
suggested the end of
the trend. Financials
were now showing
weakness.
A move to a
column of X’s in
April 2000
signaled strength
vs. the S&P 500
Relative Strength

For the period April 2000-August 2007,
while the financials exhibited relative
strength, XLF returned 60.58%
compared to the S&P 500’s (SPY) return
of 11.22%
(Source Stockcharts.com, Morningstar)
A move to a column of O’s in
October 2003 signaled
weakness in the healthcare
sector.
A move to X’s in August 2007
suggested that the weakness
had ended and the
healthcare sector was
starting to exhibit strength.
Relative Strength

For the period October 2003-August
2007, while healthcare exhibited
weakness to the market, XLV returned
27.03% compared to the S&P 500’s
(SPY) return of 56.16%
(Source Stockcharts.com, Morningstar)
Relative Strength Across Asset Classes
 Relative strength is checked the last trading day of
each month.
 If a subsector, country, or commodity component is
in a column of X’s it is included in the portfolio.
 If any subsector, country, or commodity component
that is in a column of O’s it is excluded from the
portfolio.
Relative Strength Universe

S&P 500:
 XLY, XLP, XLE, XLF, XLV, XLI, XLB, XLK, XLU

MSCI EAFE:
 EWU, EWJ, EWL, EWQ, EWA, EWC, EWG, EWP,
EWI, EWD, EWN, EWH, EWS, EWK, EWO

MSCI EM:
 FXI, EWZ, EWY, EWT, EZA, RSX, INDY, EWW, EWW,
EWM, EIDO, THD, ECH, EPU, TUR, EPHE

GSCI:
 DBC, DBA, DBB, DBE, DBO, DBP, GLD, SLV
Relative Strength Across Asset Classes
Buy & Hold
Relative Strength
S&P 500
(2002-2012)
3.95%
6.80%
MSCI EAFE
(2002-2012)
MSCI EM
(2002-2012)
5.79%
10.15%
13.89%
17.83%
-3.28%
8.01%
GSCI
(2007-2012)
(Source Stockcharts.com, Morningstar)
Simulated historical returns may not be predictive of future performance.
Relative Strength Across Asset Classes

Relative strength, when applied to major
asset classes, (S&P 500, MSCI EAFE, MSCI
EM, & GSCI Commodity), has been shown
to markedly improve returns compared to a
“buy and hold” strategy. (Dorsey Wright)
Relative Strength Across Asset Classes
 Each major asset class is equally weighted.
○ 4 Asset Class portfolio receives 25% weighting.
○ 5 Asset Class portfolio receives 20% weighting.
 Each major asset class will equally weight those
sectors exhibiting RS.
○ If Major Asset class weighting is 20%, all sectors with
RS will be equally weighted to equal 20%.
 Example: If 5 sectors of the S&P 500 exhibit RS each will
have a portfolio weighting of 4%.
Relative Strength
(4 Asset Class equal weighted)
(SPY, EFA, EEM, IYR)
2002-2012
Buy & Hold
Relative Strength
Average Return
9.11%
12.16%
Standard
Deviation
Best Year
23.69%
25.15%
40.15%
44.63%
Worst Year
-39.42
-41.19
(Source Stockcharts.com, Morningstar)
Simulated historical returns may not be predictive of future performance.
Growth of a Dollar
(4 Asset Class Portfolio)
$400,000
$350,000
$300,000
$250,000
$200,000
$150,000
$100,000
Relative Strength
$50,000
Buy & Hold
$0
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Relative Strength
(5 Asset Class Equal Weighted)
(SPY, EFA, EEM, GSG, IYR)
2007-2012
Buy & Hold
Relative Strength
Average Return
1.74%
6.02%
Standard
Deviation
Best Year
25.96%
27.64%
33.13%
44.39%
Worst Year
-41.55%
-36.26%
(Source Stockcharts.com, Morningstar)
Simulated historical returns may not be predictive of future performance.
Growth of a Dollar
(5 Asset Class Portfolio)
$160,000
$140,000
$120,000
$100,000
$80,000
$60,000
$40,000
Relative Strength
$20,000
Buy & Hold
$0
2006
2007
2008
2009
2010
2011
2012
Correlations of a New Market.
Creation of new investment products is
quickly disrupting correlation of asset
classes. (Commodity, International, and
Futures ETFs)
 Gold, Oil, and International stocks can now
be traded easily through the use of ETFs.

 GLD, DBO, iShares Country Indexes
Commodities Not The Diversifier They Once Were
I see how relative strength can help me
during the good times but what can I do
to maximize returns during the bad
times?
Treasuries Are a Natural Hedge Against Fears in
The Market




The Inverse relationship between stocks and
treasuries remains mostly unaffected by the recent
changes in correlation.
As a constant component of a Tactical Model
treasuries may negatively impact portfolio returns
in a bull market.
Treasuries perform best when market fears are
present.
Owning treasuries only when the S&P 500 fell
below its 200 DMA significantly improved both
returns and volatility versus a 50/50 mix. (Stoken, 2010)
Gain to Pain Ratio




90 day T-bill: Risk free rate of return (3.62% 1926-2010)
Average Underperformance (AU): Sum of all
underperforming years divided by the number of years
observed.
Excess Return (ER): Compound return of an investment
minus the compound return of the 90 day T-bill. Average
return above that is the risk free rate.
Gain to Pain Ratio (Risk/Return): Amount of excess gain
each 1 percent of risk yields. (ER/AU=G/P)
Gain to Pain Ratio
Investment
CMPD
Return
9.87%
6.25% (4.98%)
1.26%
LT
Treasuries
5.50%
1.88% (2.56%)
.73%
Int.
Treasuries
5.35%
1.73% (1.11%)
1.56%
S&P 500
*85 year period 1926-2010
ER
AU
G/P Ratio
(Stoken 2010)
Treasury Risk & Return
IEF
2002-2011
S&P 500 < 200 S&P 500 > 200
DMA
DMA
Average
Monthly Return
.93%
.39%
Monthly
Volatility
2.62%
4.19%
(Source Yahoo Finance, Morningstar)
Buy & Replace


A tactical strategy utilizing a long term moving
average has proven considerably less volatile than
a stand alone buy & hold strategy while still
providing a better return.
Building on this strategy we need to decide what
to do with cash when it is not invested in stocks
Buy & Replace



To expand on the Tactical Method discussed
earlier we believe the use of Intermediate term
treasuries provides a better hedge against market
fears.
We’ve also shown that relative strength has
provided increased returns over Buy & Hold during
our test period.
Past history also clearly favors the intermediate
term government bond, which sports a very low 1.11% average underperformance, excess return
of 1.73% above the riskless 90 day T-bill and a
gain to pain ratio of 1.56% as the preferred fixedincome vehicle.
Buy & Replace

When an asset class is above its long term moving
average use monthly relative strength to
determine sectors or countries to own and hold
until the asset class falls below its long term
moving average.

When an asset class falls below its long term
moving average sell that asset class and replace it
with intermediate term treasuries until the asset
class rises back above its long term moving
average.
Buy & Replace
S&P 500
(2002-2012)
Buy & Hold
Relative
Strength
RS Buy &
Replace
Average
Return
3.95%
6.80%
14.80%
Standard
Deviation
19.63%
19.06%
7.41%
Best Year
28.18%
30.85%
26.53%
Worst Year
-36.81%
-31.98%
3.40%
(Source Stockcharts.com, Yahoo Finance)
Simulated historical returns may not be predictive of future performance.
Buy & Replace
MSCI EAFE
(2002-2012)
Buy & Hold
Relative
Strength
RS Buy &
Replace
Average
Return
5.79%
10.15%
16.03%
Standard
Deviation
23.08%
25.16%
13.94%
Best Year
39.79%
45.03%
36.73%
Worst Year
-41.02%
-36.82%
0.92%
(Source Stockcharts.com, Yahoo Finance)
Simulated historical returns may not be predictive of future performance.
Buy & Replace
MSCI EM
(2002-2012)
Buy & Hold
Relative
Strength
RS Buy &
Replace
Average
Return
13.89%
17.73%
19.33%
Standard
Deviation
33.62%
37.93%
23.21%
Best Year
68.93%
80.59%
60.90%
Worst Year
-48.88%
-50.69%
-4.34%
(Source Stockcharts.com, Yahoo Finance)
Simulated historical returns may not be predictive of future performance.
Buy & Replace
GSCI
(2007-2012)
Buy & Hold
Relative
Strength
RS Buy &
Replace
Average
Return
-3.28%
8.02%
13.46%
Standard
Deviation
25.63%
24.62%
17.47%
Best Year
31.69%
38.39%
32.32%
Worst Year
-45.75%
-24.38%
-16.24%
(Source Stockcharts.com, Yahoo Finance)
Simulated historical returns may not be predictive of future performance.
RS Buy & Replace
(4 Asset Class equal weighted)
(SPY, EFA, EEM, IYR)
2002-2012
Buy & Hold
9.11%
Relative
Strength
12.16%
RS Buy &
Replace
18.99%
Average
Return
Standard
Deviation
Best Year
23.69%
25.15%
11.35%
40.15%
44.63%
39.48%
Worst Year
-41.19%
-39.42%
6.65%
(Source Stockcharts.com, Yahoo Finance)
Simulated historical returns may not be predictive of future performance.
Growth of a Dollar
(4 Asset Class Portfolio)
$800,000
Relative Strength
$700,000
Buy & Hold
Relative Strength Replacement
$600,000
$500,000
$400,000
$300,000
$200,000
$100,000
$0
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Relative Strength
(5 Asset Class Equal Weighted)
(SPY, EFA, EEM, GSG, IYR)
2007-2012 Buy & Hold
Average
Return
Standard
Deviation
Best Year
Worst
Year
1.74%
Relative
Strength
6.02%
RS
Replacement
16.37%
25.96%
27.64%
9.06%
33.12%
44.39%
30.28%
-41.15%
-36.26%
4.98%
(Source Stockcharts.com, Yahoo Finance)
Simulated historical returns may not be predictive of future performance.
Growth of a Dollar
(5 Asset Class Portfolio)
$300,000
Relative Strength
Buy & Hold
$250,000
Relative Strength Replacement
$200,000
$150,000
$100,000
$50,000
$0
2006
2007
2008
2009
2010
2011
2012
Conclusion




Moving averages have been a good indicator of
changes in market direction.
An equal weighted portfolio of diverse asset
classes has provided investors better risk
management as well as better long term returns.
The use of relative strength has provided extra
alpha (return above the market) in different asset
classes.
The use of Intermediate term treasuries to hedge
fears in the market has markedly lowered volatility
on a variety of asset classes and portfolios.
Disclosures
The S&P 500, Morgan Stanley Capital International EAFE
(MSCI EAFE), Morgan Stanley Capital International
Emerging Markets Index (MSCI EM) & DJ REIT Index
returns exclude reinvested dividends and the three-, five-,
and 10-year returns are annualized.
 Past performance is no guarantee of future
results. Indices are unmanaged and cannot be invested
into directly.
 **Timing data provided by Yahoo Finance using the 200
day simple moving average. Performance data provided
by Morningstar.com, iShares, and State Street Global
Investors.
 Relative Strength information provided by
Stockcharts.com

Chris Henderson AAMS
VP/Investments
Wedbush Securities
14851 N Scottsdale Rd. #201
Scottsdale, AZ 85254
602-332-5252/480-778-8572
Chris.henderson@wedbush.com
Member NYSE/FINRA/SIPC