2013 Tom Madell, Ph.D.

Aug. 2013

Email: funds-newsletter@att.net

Mutual Fund/ETF Research Newsletter

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Small Cap Mania: Is the Sky the Limit?

An important note to investors:

If you think the overall stock market is perched at a potentially dangerous level, consider this: Since hitting a closing low of 343 on March 9, 2009, the Russell 2000 index of small cap stocks is now at 1041. That represents over a 200% gain, not including dividends through 7-29. (Correction: This was incorrectly stated as over 300% in the initial article.) By contrast, the S&P 500 index of large cap stocks is up a "mere" 149% from its low, not including dividends.

While no one knows if, and for how long, this outperformance will continue, I suggest that moderate or conservative risk investors, and maybe even aggressive risk ones, take heed of the fact that there is far more danger in small caps now than in large caps. (Actually, this has been true for quite some time.)

Perhaps investors will want to follow the strategy outlined in our main column presented on your right, reducing one's exposure at key milestones, to large cap, and additionally, to small cap funds in particular.

Incidentally, I hope you will be able to see after reading our main article why I have chosen the name Mutual Fund/ETF Research Newsletter for this publication.

Some people may think of research as dry and boring. However, I don't. I try to present a topic in each of our articles that explores some new ground and then provides new data on questions which I think investors should examine. Articles, for me, then, involve not just speculating on what might be helpful but coming up with new evidence that should be persuasively convincing. This is all the more important in an area such as investing where convincing data is particularly hard to come by.

Best wishes,
Tom Madell, Publisher


A Convincingly Better Strategy Than Buy and Hold

by Tom Madell

In a recent headline story on marketwatch.com, one of my favorite columnists, Mark Hulbert, reports that merely owning two Vanguard index funds, one for the entire US stock market and the other for high grade US bonds, 80% in the former and 20% in the latter, outperformed the average market timer. He regularly monitors investment newsletters (although not mine) which gives him access to this kind of data.

The two-fund portfolio would have gained an uninspiring average 3.7% a year from early 2000 through this past June 30, while the average market timer only 2.1%. And, it would have also done better than the 2.9% return for a portfolio that was 100% invested in just the stock fund alone with no further diversification. Therefore, he concludes that such a buy and hold approach is likely a better strategy than trying to get in and out of the stock market at the "right" time, or which shuns bonds altogether.

I highly respect Hulbert's history of providing high quality research and commentary. In fact, he has often written about some of the same issues as I have, and reached similar conclusions. But if he really now advocates what this article suggests, it would go against the fact that most of his columns have long been geared toward those investors trying to gain a trading advantage in the markets, often based on short-term considerations, rather than to investors who merely wish to buy and hold.

The timeliness of his article (which I highly recommend all readers read at least once) should be apparent. Stocks are perched near all-time highs and have been in a massive bull market for over 4 straight years. Although there have been three corrections of 10% or more since its beginning in March 2009, we now have gone nearly 14 months since the last one and many people, it seems, are engaging in the perpetually never-ending effort to look into their own particular crystal ball and attempt to somehow successfully sidestep the next big drop.

continued below

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Aug. 2013



(A Convincingly Better Strategy Than Buy and Hold, continued from page 1)

In my June Newsletter, I expressed the opinion that the current uptrend in the stock market may, based on my own empirical research, change course some time this fall. This is mainly due to data that suggest that without a significant correction, stocks will fall into overvalued territory by then, and overvalued assets are pretty synonymous for me with assets that are likely to show disappointing forward performance.

Is it possible to know with any degree of certainty when one should avoid stocks, either because they have reached near unsustainable levels or even perhaps because of any of a myriad of economic indicators that seem to suggest trouble? Not to my way of thinking. But while it is so hard to do since investors are much more likely to sell when prices are already dropping, investors do have the option to try to anticipate and then act early when returns are still rising but appear unlikely to continue at a satisfactory pace.

In my Feb. 2010 Newsletter, I presented a relatively simple strategy requiring no market timing skills nor what really amounts to using a crystal ball (i.e. guesswork), which if had been followed over the prior decade, would have lead to much better results than by merely buying and holding stocks. Since the exact details of this strategy, although not the general thrust it recommends, were only devised "after-the-fact" (that is, in analyzing what had already been the case, which might have just been by chance), one might readily argue that while it would have worked during 2000-2009, we do not at all know whether it would also work projecting forward.

A Buy and Sell Strategy

Here is the strategy in a nutshell: Sell some of your stocks every time there is a 25% rise in the S&P 500 index; buy additional stocks whenever there is a 10% drop in the index. Each additional rise or drop calls for an additional sale or purchase. For example, a rise of 50% without a 10% correction, requires one sale at 25% and one at 50%.

The strategy helps to ensure that one buys low and sells high. Further, when strictly practiced, it takes all the subjective and/or emotional elements out of your decisions. You don't have to "figure out" when the time is ripe to take action based on anything else.

The Feb. '10 article has already shown that the strategy could have prevented the losses many investors suffered who merely held on to their stocks during the last decade; instead, it led to modest gains. So the question arises as to how the strategy would have performed beginning in the current decade, that is, starting in Jan. 2010, when stocks have been predominantly strong, at least thus far.

When the strategy is applied continuing from gains achieved after the 2007-2009 bear market ended, the results show a huge improvement from even the already outstanding results investors have been getting over the last 3 1/2+ years.

The following table shows, along with the key selling and buying and mileposts, the results for anyone using the strategy with the Vanguard 500 Index Fund, as compared to someone who merely held a $10,000 investment continuously in the Fund without any sales or new purchases. ETF investors should note that I could also have used data reflecting the performance of the Vanguard S&P 500 ETF (VOO) and obtained nearly the identical results.

I used the following assumptions in showing the results:

  1. Decisions began based on where the index was off the March 9, 2009 low.
  2. Milestone 10% drops or 25% rises are percentage change in the index in relation to an earlier high or low point; two or more consecutive drops or rises use percentage change from the original level.
  3. As in the above article, each buy/sell was for $3,000. However, this time cash resulting from sales were held in a non-interest bearing account and, if available, was used to fund any subsequent purchases.







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Fund Sales and Purchases for the Period
Beginning Jan. 2010 through July 2013
Date S&P Index
at
Percent Gain/Loss From
Earlier Milestone
(Action)
Share Price of
Vanguard 500 Idx (VFINX)
Value of
Investment
Plus Cash
on This Date
   vs.Value of
Buy and Hold
on This Date
3/17/2010 1168 +75% (Sell) 107.83 $10,503    $10,503
5/20/2010 1098 -10% (Buy) 98.97 $9,886    $9,640
1/27/2011 1301 +25% (Sell) 119.79 $11,966    $11,668
8/4/2011 1234 -10% (Buy) 110.70 $11,286    $10,782
10/4/2011 1097 -20% (Buy) 103.51 $10,553    $10,082
2/3/2012 1344 +25% (Sell) 124.01 $13,237    $12,079
6/1/2012 1280 -10% (Buy) 118.21 $12,618    $11,514
4/10/2013 1584 +25% (Sell) 146.42 $16,345    $14,261
Note 1: The S&P 500 index began 2010 at 1115 and is currently at 1692; VFINX began 2010 priced at 102.67 and is currently at 156.08 (data through July 26)
Note 2: Values shown for investments are based on net asset values only; they do not reflect any additional dividends or capital gains that may have been distributed, nor do returns shown below.

Based on the current VFINX price of 156.08,

  • the value of buy/sell investor's account would be $17,423 for a cumulative return of 74.2% (20.8% annualized) over the period.
  • the value of buy/hold investor's account would be $15,202, for a cumulative return of 52.0% (14.6% annualized) over the period.
  • In other words, the buy/sell investor would currently have $2,221 more in his/her account than the buy/hold investor, or a 6.2% better annualized return.

Why the Strategy Proved Superior

It is important to grasp why the buy/sell investor would have done so much better. After the first sale, the market did experience a 10% correction, not surprising after it had already gone up 75% without experiencing one. Since the price went down and the investor had less shares, this investor lost less. By buying when the price dropped, the investor purchased more shares at a lower price than they were at the start of the decade and now had more shares than the buy/hold investor, and thus, was already doing better after several months of rising prices.

The process of selling high and buying low kept repeating a number of times. Thus, by the end of the period, while the buy/hold investor held the same number of shares as when the decade began (remember, we are not including dividends or capital gains), the buy/sell investor had 14.2 more shares than the buy/hold investor. While each share was worth the same on July 26th for both investors, having more shares meant the buy/sell investor was far ahead in the value of his account.





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Aug. 2013

Note that if the price of shares had continued going up without any 10% drops over the entire period, the investor who gradually sold some shares would have come out behind. But such a "straight up" rise in the market is relatively rare. Likewise, if the price of shares had just gone down steadily, an investor who bought on 10% drops would also now be behind because he would have lost more and more money after each purchase. This too would likely almost never happen over the course of a decade, the period for which this strategy is recommended.

Some Additional Considerations

Of course, one's performance results might vary depending upon what percentage one decides to sell or buy in relation to their original investment. In the above example, I chose to sell or buy 30% of the original investment at each milestone (i.e. 3K in relation to a 10K original investment). If, however, I had chosen 50% instead, the outperformance in this case would have been even greater.

Also, there is no reason why an investor would have to monitor the performance of the S&P index on a daily basis to implement this strategy. Close approximations to the +25% and minus -10% milestones could likely work as well which might require perhaps a weekly glance at where the index is percentage-wise compared to where it was at the last low or high point. (Note: The last low point was 1267 back in early June, 2012. We do not yet know where the next high point will be recorded since it will only be of relevance after a new 10% drop.)

Some investors might wonder if they would always be able to afford to make additional purchases when a milestone drop was reached, especially if their net worth was down significantly as a result of the market dropping. But for investors who keep at least some of their portfolio in either bonds/cash, they would merely swap out of these alternative assets to make the required purchases.

For investors who might think of this strategy as too much like the "market timing" Hulbert's article advocates against, one should rather think of it as just another form of rebalancing a portfolio. Traditional rebalancing is based on bringing your portfolio back to some predefined percentages of stocks vs. bonds over certain predefined periods of time. The strategy outlined here, rather, allows you to make these changes whenever an external measure of stock performance exceeds or drops below a predefined level. In either case, the presumed longer-term advantage comes from buying low and selling high. Like with rebalancing, there is never a guarantee that the strategy will always put you ahead, but the odds greatly favor it over long periods.

And for investors who do decide to try to implement this strategy, remember this: The strategy is easy to think about in the abstract, but very difficult to follow through on when the time comes. For example, back in 2007 and 2008, the S&P reached five consecutive drops of 10% each, within about 12 months. How many among us would have the discipline to keep buying stocks after each new plunge? Likewise, it's even hard to step up to the plate after just one or two 10% corrections. But kudos should eventually await those who do.

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Most subscribers have not read our July 8th performance update, since it was published after we notified you of the availability of the July Newsletter. This information on our long-term Stock Model Portfolio is highly significant and provides further validation of the usefulness of our quarterly recommendations. I strongly recommend you take a look.

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For anyone who wishes to find out more about our approach to investing, along with some interesting links to other sites and to what other readers have said about our site, we remind you there is much additional content available at our site Archive by clicking here, or also accessible off our home page. Although some of the images may not be displayed, the text is exactly as was originally published.

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