October 13, 2017
By Steve Blumenthal

“Long-term Investors need to be invested in long-term assets, but pay special attention to limiting downside losses.
The best way to make money in the long term is not losing it in the short term.”

– Dr. David Kelly, Chief Global Strategist
J.P. Morgan Asset Management

Long-time readers know I’m an avid Ned Davis Research fan. I’ve been a loyal client since the 1990s.  Ned Davis built a fact-based, technology-driven research organization. Some years ago, Ned wrote a book titled, Being Right or Making Money and I believe that title sums up NDR’s investment research culture.  Much of what you and I hear every day is nonsense.  NDR seeks to identify key data relationships that matter most and presents their research in a mathematically sound way.

One of Ned’s great beliefs is that we investors need to avoid the really big mistakes. Right… but how and by what process?  Is the process viable?  The probabilities favorable?  Do you believe in it?  Can you stick to it?  No process is perfect, but there are processes you can put into place that may help you minimize mistakes.

The great trader, Paul Tudor Jones, teaches his MBA students that if you do nothing else, put a 200-day moving average stop-loss on everything you own.  Tested, you’ll find it is a pretty good trading strategy rule.  Here is a look at a simple “Moving Average Cross” trend following system.  The blue line is the S&P 500 Index.  The gray line is its 50-day moving price average and the green is its 200-day moving average.  Signals occur when the shorter-term trend line crosses above or below the longer-term trend line.

As you can see, a pretty good risk management process.  The sell signal in late 2007 would have gotten you out of the market near 1450 on the S&P 500 and the subsequent buy back in near 850 in mid-2009.  Since then, there have been a few whipsaw trades but generally you would have participated in most of the upside. Not perfect, but overall pretty good.

“It’s about not losing it in the short term.”  Roger that.

Buying-and-holding is an investment process and it works over many years. If you believe in it and have the years to let it work, and strong belief in it, go for it.  The problem is that many individuals can’t stick to the process; that is, buying and selling at the wrong times.  And if you sold, when do you decide it’s safe to get back in. Emotion plays a big role in the decision process… mostly a negative role.

The great Sir John Templeton said, “To buy when others are despondently selling and to sell when others are avidly buying requires the greatest of fortitude and pays the greatest ultimate rewards.”  That’s an investment process.  My mother-in-law is a great investor and her process is much like Sir John’s.  I’ve come across just a few people that can follow that process.  It requires conviction and patience and an ego that is ok with being wrong at times.  Sir John was one of the greats and so is Paul Tudor Jones.  And, of course, my mother-in-law is fantastic.

A number of years ago, I approached NDR to do some custom work for CMG.  One of the most popular indicators on NDR’s site is Ned’s “Big Mo.”  It’s an excellent momentum indicator that’s done a fine job at signaling risk-on or risk-off, but we wanted a proprietary risk management process for our clients.

One of the things that tends to happen when cyclical bull markets peak is that fewer and fewer of the stocks that make up the S&P 500 Index continue to rally.  Just a few companies carry the index on to higher highs; yet more of the underlying company stocks are breaking down.  Stocks tend to be a leading economic indicator and, at the individual company level, if more and more companies are breaking their trend lines, it is a signal that perhaps there is something bigger going on economically.  At bull market cycle tops, investors are euphoric and margin leverage is high.  Tops generally roll over while bottoms tend to “V” bottom.  It has nothing to do with fundamentals and a lot to do with the unwinding of leverage (forced margin call selling).  That’s when fear kicks in and margin debt pressures lead to forced selling.  Weaker hands can’t take the heat and unload their equities as well.  At market peaks, investors are typically overweight equities and any would-be buyers simply step away.  Market behavior at a bull market top is different than at a bear market bottom.

We wanted to improve upon the 200-day MA stop-loss rule that many people use.  If too many investors use the same signal point, you can imagine the number of hedge fund vultures and flash traders looking to take advantage of the activity that occurs at such knowable price points.  Yet, absent other risk management processes you can believe in and follow, it is still a pretty good rule.

“Long-term investors need to be invested in long-term assets, but pay special attention to limiting downside losses.”  Sound advice from JP Morgan’s Dr. David Kelly.  Trend analysis is a way to help minimize short-term loss.

This week, I’d like to share with you a paper I wrote for VanEck entitled, Risk Management for All Markets.  It’s a quick overview on how the NDR CMG US Large Cap Long/Flat Index process works.  You’ll also find a few charts you may find helpful in your work with your clients.

• There is an updated chart showing all of the secular bull and bear market periods since 1900 along with the return data (without and with inflation). For example, since 1900, the market has been in a bull market cycle 54% of the time.
• On a price basis, an investor spent 70% of the time in a bear market or recovering from one. That means that just 30% of the time a buy-and-hold investor is creating new wealth.  I bet most people don’t know these stats.  With dividends factored in, 41% of the time is creating new wealth.  Better, but still much lower than your client might guess.  My personal guess was 60%.  I was surprised.
• There is also a helpful chart showing just how much return is required to overcome various amounts of loss. “The best way to make money in the long term is not losing it in the short term.” Indeed!

You can find it by clicking below:

Risk Management for All Markets

Enter your email address and VanEck will send the paper to your inbox.  And please feel free to email me if you have any questions.

Why VanEck?  CMG and NDR licensed our index to VanEck and they created an ETF.  What started with a coffee with a close and trusted friend, Kol Estreicher, three years ago grew to become a new ETF.  Kol had just joined VanEck, knows CMG’s history well and asked me if I had a strategy or two that might work well packaged inside an ETF.  Certain strategies may work well inside of an ETF.  I told him about the work we did with Ned Davis Research and a light was lit.

While we are really excited about the ETF, please know my goal is to simply message that there are processes that may help you both participate in the market and manage risk.  None are perfect.  Ours is one idea.  I believe it is important to diversify to several trading strategies.  To wit, find experienced managers with defined processes.

I believe that by mixing together different strategies you can fine-tune the risk and return metrics in a way that suits your investment profile: risk, needs and goals.  If you are more aggressive and willing to take on more risk, then combine several equity-focused processes.  If you are more moderate or conservative, broaden the choice of asset classes.

The good news is that technology has advanced so far that you can run analyses to see how different asset classes and strategies may fit together to align with your return and risk goals.  The tools available to you and me are far advanced from where we were just a handful of years ago.  Talk to your investment advisor.

I’m writing from Washington, DC this week.  Dr. Kelly’s presentation was exceptional.  His quote couldn’t have been timelier for this week’s missive.  Last night we had a behind-the-scenes tour of the National Museum of Natural History, then dinner at the National Museum of American History.  It was great fun.  I wanted to share Dr. Lacy Hunt’s latest quarterly letter.  He sees low inflation and low growth ahead… he makes a compelling case but let’s bump that to next week along with my notes I’ll share from David Kelly’s presentation.

Grab a coffee and let me know what you think about the research paper.  When you click through, you’ll find the latest Trade Signals and a few photos from DC.

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And I got a big kick out of these early Band Aid boxes:

How many of those did our moms throw out?

I’m in Dallas on October 24 and 25 for a Mauldin Solutions advisor event, followed by a trip to Charleston on the 30^th.  Some golf is in the weekend plans.  Matthew is coming home from school and we are teamed together in a fun tournament at Stonewall.  But he’s really home to celebrate his brother at today’s home soccer game.  It’s senior day.  I’m heading to the train for home soon.  Can’t wait.  Wishing you and your family the very best!

Have a great weekend!