Cumberland Advisor’s Latin American Perspective

From Cumberland Advisors, a 2/25/09 update on four Latin American countries (Mexico, Argentina, Chile, and Brazil):

family:Arial;font-size:85%;color:#333333;">This commentary was written by Bill Witherell, Cumberland’s Chief Global Economist. He joined Cumberland after years of experience at the OECD in Paris. His bio is found on Cumberland’s home page, family:Arial;font-size:85%;color:#0000ff;">www.cumber.comfamily:Arial;font-size:85%;color:#333333;">. He can be reached at">family:Arial;font-size:85%;color:#0000ff;">Bill.Witherell@cumber.comfamily:Arial;font-size:85%;color:#333333;">.

family:Arial;">With the return of David Kotok from a week of matching his wits against the wily trout of Patagonia, it is a good time to look at how Argentina is handling the challenges of the global recession. We will also discuss the three major Latin American economies in which we can invest using country-specific ETFs: Mexico, Brazil, and Chile. It will become clear that selectivity will be very important for investing in the Latin American region this year.

family:Arial;">Argentina family:Arial;">

family:Arial;">Riding on the global boom in commodities, Argentina experienced a strong economic rebound from the deep recession of 2001-02, with annual GDP growth averaging 8.8% in the 2003-07 period. Since then, however, Argentina’s increasingly discretionary and interventionist growth-at-any-price policies, including ignoring the IMF, abandoning price stability objectives, breaking contracts with foreign investors, and shafting bondholders, are finally slowing the economy sharply. This comes at a time when the external environment has become decidedly negative, with export volumes tanking. The Kirchner government (Peronist Party) is rapidly declining in popularity. Rising tensions with farmers are threatening a repetition of the costly March 2008 farmers’ strike.

family:Arial;">Investors’ confidence has deteriorated sharply. Credit default swaps soared to 4300 in early January and are now at 3120. That means one must pay $3,120,000 per year to protect $10 million of Argentine debt against default. Investors have not forgotten that in 2001 Argentina was responsible for the largest sovereign debt default in history. The government’s nationalization of pension funds in November, a transparent grab of assets to fill a growing gap in debt-service finance in 2009, dealt a serious blow to business confidence and eliminated a significant portion of the domestic capital market.

family:Arial;">Argentina’s equity market is moribund except for the Buenos Aires-listed Brazilian company Petrobras and the Luxembourg firm Tenaris. The situation can be summed up by last week’s action by MSCI Barra, which is downgrading the Argentine market to “frontier-market” status from “emerging-market” status in its indexes. Others sharing that status are Sri Lanka, Lebanon, and Kazakhstan. This is a sorry situation for a country, blessed with ample natural resources, that once had one of the strongest economies in the world. The blame rests solely on the shoulders of those who have been guiding economic policy.


family:Arial;">The very close interrelationship with the US economy, which in boom times is a great benefit to the Mexican economy, is bringing the latter sharply to a halt. Merchandise exports (non-oil) to the US (24% of GDP) have been hit particularly hard. The negative effects on government finances of the global downturn in the oil market have been offset significantly for 2009 by a successful hedging program. The full brunt of lower oil prices will hit in 2010. Remittance flows from the US are contracting.

family:Arial;">Economic policy responses have been behind the curve and too timid. In particular, monetary policy has not eased sufficiently to keep credit flowing. The banking system is largely foreign-owned, and US and Spanish parent banks, under great pressure in their home markets, have significantly reduced their lending while increasing credit costs.

family:Arial;">Along with these substantial economic headwinds, Mexico is experiencing a sharp increase in violence on three fronts: between the authorities and the drug cartels, among the drug cartels, and between the general public and a wide range of criminal elements. Increasingly, this violence involves the use of military weapons. Mexico has become a dangerous place for businesses to operate. Heightened security risks together with a likely increase in social tensions due to economic problems will weigh heavily on investor and consumer attitudes.


family:Arial;">As signaled by recent credit default swap trends, investors have a more favorable view of Brazil than they do of Mexico. Nevertheless, Brazil’s growth has also collapsed, hit by the global confidence crisis and the plunge in Brazil’s global markets, particularly China. In December Brazil’s industrial production was down 14.5% year-over-year, the worst decline ever recorded. In part, this appears to reflect a sharp inventory correction. While the slowdown no doubt will continue in the first half of 2009, there are reasons to expect that a recovery will become evident by the summer.

family:Arial;">First, the Brazilian economy is not suffering from a crisis in the housing sector, nor is the Brazilian consumer overextended. Second, the government has moved rapidly to adopt important policy stimulus measures. The central bank, drawing upon the country’s ample foreign reserves, stepped in to provide funds to companies with important foreign liabilities. It has also encouraged large banks to buy the loan portfolios of relatively weak smaller banks. Third, Brazil’s economy is becoming increasingly linked to China and the rest of Asia, while links to the US economy are weakening. The relatively positive outlook for the Chinese economy and non-Japan Asia is bullish for the Brazilian economy and for its equity market.


family:Arial;">Economic and central bank policies in Chile have for a long time stood head and shoulders above those of other Latin American countries, and the Chilean economy and markets are now realizing the benefits. Of course, Chile, a small open economy, has not been able to avoid the downdraft from the global recession and financial market problems. The price of its major export, copper, has plummeted. Economic growth for the year may be on the order of 2%, compared with 3.5% in 2008.

family:Arial;">Nevertheless, relative to other countries in the region, Chile has outperformed. Indeed, its equity market has been one of the few bright spots in a global sea of red. Over the past three months the Chilean equity market increased by 10.7%. This compares with a 2.6% increase in the Brazilian market and declines of -19.8% in Mexico and -18% in Argentina, according to the MSCI indices for these countries.

family:Arial;">Because of past rigorous fiscal policies (a cumulative fiscal surplus of 21.7% of GDP over the 2006-08 period), the government was in a good position last month to announce a $4 billion fiscal stimulus package. The proactive central bank followed up on February 12 with a swinging 250-basis-point reduction in the policy interest rate. While this cut might have been expected to lead to a weakening of the currency, the Chilean peso strengthened by more than 2% after the announcement, a striking market endorsement of Chile’s economic fundamentals and policies. Lower interest rates are likely to be more effective in Chile than elsewhere in the region. Years of sound regulation have resulted in a capital market that is far deeper than those of Brazil and Mexico (measured by credit as a % of GDP).

family:Arial;">Investment Implications

family:Arial;">All Latin American economies have been hit by the global recession and will continue to be affected by swings in global risk aversion. However, the prospects for the national equity markets of the four countries under discussion differ markedly. Only one of the four, Argentina, is suffering from the self-inflicted wounds of seriously unsound economic policies. One other, Mexico, is confronting domestic security concerns on an unprecedented level as well as the (temporary) disadvantage of very close linkages to the declining US manufacturing sector. The economies of the remaining two countries should outperform during the coming months and the eventual global recovery. At Cumberland, we have positioned our ETF portfolios accordingly, overweighting Chile and Brazil and significantly underweighting Mexico.

Bill Witherell, Chief Global Economist, email:">

Copyright 2009, Cumberland Advisors. All rights reserved.

John Mauldin Update

For those who do not read John Mauldin, I highly recommend it. His recent article, courtesy of the The Big Picture, paints a bleak picture for Europe. An excerpt:

The problem is that in Europe there are many banks that are simply too big to save. The size of the banks in terms of the GDP of the country in which they are domiciled is all out of proportion. For my American readers, it would be as if the bank bailout package were in excess of $14 trillion (give or take a few trillion). In essence, there are small countries which have very large banks (relatively speaking) that have gone outside their own borders to make loans and have done so at levels of leverage which are far in excess of the most leveraged US banks. The ability of the “host” countries to nationalize their banks is simply not there. They are going to have to have help from larger countries. But as we will see below, that help is problematical...

This has the potential to be a real crisis, far worse than in the US. Without concerted action on the part of the ECB and the European countries that are relatively strong, much of Europe could fall further into what would feel like a depression.

Moving onto portfolio management and the pain many have felt in recent months, Mauldin lays out how volatile equity markets can be:

Historically, average investment returns over the very long term (we’re talking 40-50-70 years) have been some of the best available, but the seasons of the stock market tend to cycle with as much variability as Texas weather. The extremes and the inconstancies are far greater than most realize. Let’s examine the range of variability to truly appreciate the strength of the storms.

In the 103 years from 1900 through 2002, the annual change for the Dow Jones Industrial Average reflects a simple average gain of 7.2% per year. During that time, 63% of the years reflect positive returns, and 37% were negative. Only five of the years ended with changes between +5% and +10% — that’s less than 5% of the time. Most of the years were far from average — many were sufficiently dramatic to drive an investor’s pulse into lethal territory!

Almost 70% of the years were “double-digit years,” when the stock market either rose or fell by more than 10%. To move out of “most” territory, the threshold increases to 16% — half of the past 103 years end with the stock market index either up or down more than 16%!

Read those last two paragraphs again. The simple fact is that the stock market rarely gives you an average year. The wild ride makes for those emotional investment experiences which are a primary cause of investment pain.

On Earnings and the market’s current valuation:

The higher the P/E ratio, the lower (in general) the subsequent 20-year average return. Where are we today? As I have made clear in my last two letters, we are well above 20. Today we are over 30, on our way to 45. In a nod to bulls, I agree you should look back over a number of years to average earnings and take out the highs and lows of a cycle. However, even “normalizing” earnings to an average over multiple years, we are still well above the long-term P/E average. Further, earnings as a percentage of GDP went to highs well above what one would expect from growth, which is usually GDP plus inflation. Earnings, as I have documented in earlier letters, revert to the mean. Next week, I will expand on that thought.

And given my thesis that we are in for a deep recession and a multi-year Muddle Through Recovery, it is unlikely that corporate earnings are going to rebound robustly. This would suggest that earnings over the next 20 years could be constrained (to say the least).

In all cases, throughout the years, the level of returns correlates very highly to the trend in the market’s price/earnings (P/E) ratio.

This may be the single most important investment insight you can have from today’s letter. When P/E ratios were rising, the saying that “a rising tide lifts all boats” has been historically true. When they were dropping, stock market investing was tricky. Index investing is an experiment in futility.

Updates From Bears

Today’s tests with new lows on the DJIA are certainly not encouraging and most likely signal some lower lows in the near future (6000?). Some recent realistic (‘bearish’) articles detailing our current sad economic state:

From Jon Markman, he says we’re Stuck in a Not-So-Good Depression and has the following price targets:

The next phase of concern, and potential for new leg lower, will be despair over poor first-quarter 2009 profits, which ought to kick in around the third week of March. If you want to play it safe until bulls prove their case and any stimulus money kicks in — and trust me, there are plenty of major investors doing just that — keep your investment portfolios at an allocation of 20% diversified big-cap stocks and 80% high-quality Treasury, muni and corporate bonds, or simply wait this out in cash. Conservative investors will add to stocks only on a sustained move above the 870, 940 and 1,125 levels of the S&P 500, and cut stock allocation to zero on sustained moves below 800.

In short, there will be plenty of time to take advantage of the next bull market soon after it begins, so unless you’re a seasoned, nimble risk taker, there’s still no need to be a hero and jump the gun.

Secondly, from Bennet Sedacca, a not-so-bright assessment of our economy:

I wish I could actually sit here and BELIEVE that any of the trillion dollar bandaids will actually do any good. Unfortunately, it seems that the pain will need to be endured longer and longer. Think for a moment what happens if half of your money disappears a few years before retirement and your advisor/consultant just says to you, “buy and hold.” Do they give any consideration to how much money you must earn to get back to square one, let alone to keep earning to attain your goals? I think not, which is why I continue to believe that, despite the amount of pain that has been afflicted, more pain lies ahead.

The longer term picture however is bleak and a move, as I have been talking about for over a
year to S & P 450-550 that should not be ruled out. After all, we expect earnings for the S & P
500 to be no greater than $35-40 per share in 2009, and given a P/E of 10-15 yields a target
in the 500 area

And from family:arial;font-size:100%;" >Vitaliy Katsenelson:

family:arial;font-size:100%;">family:arial;">Even based on 2010 “E” estimates ($40) stocks in the S&P 500 are trading at 21 times earnings.

family:arial;font-size:100%;">family:arial;">Despite the decline, the market is still not cheap. Sorry, we are not likely to embark onto the new secular bull market anytime soon. History and data suggest that the choppy markets that we have seen since 2000 will likely continue. Owning a broad market index will not pave a road to prosperity. It comes down to not just owning stocks but owning the right stocks.

family:arial;font-size:100%;">family:arial;">P.S. As a side note I believe significant earnings write-offs will continue well into next year as financial stocks will pass their write-off torch to companies in energy, materials and industrial sectors – stuff stocks – that will be writing off the investments they’ve made over the last five years.

family:arial;font-size:100%;">family:arial;">By the time, I finished putting these thoughts together, which on and off took about two weeks, 2008, 2009 and 2010 estimates were taken down by about 20-25%.

On S&P Earnings and Potential Further Declines

The S&P 500 is not as cheap as it will be later this year, according to John Mauldin:

Last week I said that 2009 as-reported earnings estimates for the S&P 500 would be dropping. 2008 earnings had dropped to $29.57 as I wrote the letter. They are now down to $28.60. One of my favoriteanalysts is David Rosenberg of Merrill Lynch. His forecast for reported earnings for 2009 is now down to $28. That puts the P/E for the S&P 500 at 30.

He also projects “operating” earnings to be $55 for 2010. And, as he writes today:

“For those looking for a silver lining, at least we are going to have a deeper bottom to bounce off. Applying a classic recession-trough multiple of 12x against a forward EPS estimate of $55 would imply an ultimate low of 666 on the S&P 500, likely by October if our estimate of the timing for the end of the official downturn is accurate.”

That is a 20% drop from today’s close of 829. That is not what you will hear from “sell-side” managers who want you to invest in their mutual funds and long-only management programs.

I noted the problem with the rest of the world earlier. 40% of the earnings for the S&P 500 are from outside the US. It is hard to see how those earnings are not going to be deeply affected. Let me reiterate my continued warning: this is not a market you want to buy and hold from today’s level. This is just far too precarious an economic and earnings environment.

Given the probable ongoing bad news from financial and consumer stocks, plus the depressing news on bank losses coming down the road, why take the risk?

Also, from The Big Picture, a couple of charts here and here showing that we may not be as ‘cheap’ on a valuation basis of the s&p 500 as we may think. S&P 600 here we come??

How to Buy, Sell and Choose ETFs

For those interested in trend investing in ETFs, I would recommend visiting ETF Trends; in a recent post, Tom Lydon details some FAQs on his trend investing strategy:

We love hearing from our readers when they have questions about exchange traded funds (ETFs) or the trend-following strategy. This reader had specific questions about when we buy ETFs, when we sell them and how we choose them.

1. Is the 200-day moving average the SMA or EMA?

We use the 200-day EMA. What’s the difference? The simple moving average (SMA) is calculated by tracking the price of a security over a particular time period. The exponential moving average (EMA) involves a trickier mathematical formula which puts greater weight on the most recent price movement rather than an equal weight over past 200 days. The moving average you choose is a matter of personal preference, but the EMA is consistently closer to the actual price, which is why we use it.

2. When selling an ETF after it declines 8% from a high, do you set an 8% trailing stop loss order at the time of purchase?

Yes, this is what we do. A trailing stop loss order is when the stop loss is set at a fixed percentage below the market price. As the market price rises, the stop loss prices rises proportionately. If the price falls, the stop loss stays in place.

3. How do you determine when you buy an ETF back once the 8% trailing stop loss triggers?

Cash obtained from the sale of an ETF is considered a free agent – it can go anywhere you’d like it to, as long as the trend is there. Look at other sectors, asset classes and global regions – is anything else trending in the right direction? We have a daily report we use to track the 800-plus universe of ETFs, and we use it to spot these trends and help determine areas we should be exploring further.

And sometimes the trends just aren’t there, in which case, we keep cash on the sidelines until it’s safe to go back.

4. What ETFs are included in the portfolio and does the lineup ever change?

What ETFs we choose to include in our portfolio is simply a matter of where the trends are. We don’t employ an asset allocation model. Instead, we look at which funds are above their long-term trendlines (the 200-day moving average). We also consider other factors, such as assets, trading volume, any particulars of the sector or global region and so on before we make a buy.

And while we don’t employ traditional asset allocation, it is necessary to consider where you’re already invested. For example, if you’re holding an energy fund, you may not want to invest in Latin America or Russia, since those areas are heavily allocated toward the energy sector and could leave you overweight.

5. Does the 200-day discipline work the same for all ETFs?

The 200-day discipline can be applied to nearly any security, but it works especially well for ETFs. Having a buy signal at the 200-day moving average mark gives you a chance to have your money invested when a potentially new uptrend is beginning. Having a sell point that has you out when an area is below the 200-day or 8% off the recent high provides you the chance to get out before things could potentially worsen, while also working to protect any gains you may have had.

An Article and a Website

First, a website I think anyone interested in market timing trading systems should check out: Decision Moose

Decision Moose is run by William Dirlam and the system he has developed is intent on outperforming the stock market while trying to minimize the risk in doing so. According to the site since 1996, his system has returned 2213% vs. 27% on the SPY and in the last year the system is down 1% vs. -39% on the SPY.

Secondly, an article by Jon Markman doesn’t paint a pretty picture (what’s new) but is a dose of reality with this collective economic nightmare ultimately ending in nationalization of banks:

Once the government truly socializes the banking system’s losses by taking on the ruined loans, there will be little credit left for all the things that were so much fun in the past two decades. It will be hard to persuade banks to lend their precious money to dads for unproductive assets like leisure boats or even to real-estate investors for new apartment buildings, or to farmers for new tractors.

Salaries and living standards will come down, as instead of borrowing and spending we will have to develop a culture of saving and waiting.

Eventually, we will innovate and grow our way out of this hole, but it will take patience and time. Politicians don’t want to tell us this, so they have planned a final $800 billion-plus party paid for with taxpayer appropriation and borrowing.

But eventually, when that money is spent, there will be no other choice but to admit our mistakes and buckle down for a world with less credit and lower asset values. Call it a depression, a prolonged recession or a flat spot in the road, but it will likely lead to a string of one-term presidencies and the relegation of the name Tim Geithner to trivia contests….

….Realistic experts — at least the ones without political agendas — all agree that the only way to seriously deal with this colossal blunder is for the government to force banks to admit they screwed up and write the value of these loans down to zero. That would wipe out the assets of most major banks, making their equity worth nothing and their bonds worth little. They would be forced into bankruptcy, a process that would allow them to be recapitalized over time and then, later, re-privatized…..

….Nationalization would not be the end of the world, but it is a concept that is so anathema to Americans that it seemingly cannot be said in polite company. So instead we have this long, dragged-out Kabuki theater in which the banks have essentially been nationalized in everything but name, and yet no one will admit it to the American people. And the cost of this denial is another trillion-dollar program that will do nothing, most experts agree, except buy time until nationalization must be done later.

Jim Jubak is Mad as Hell….

Jim Jubak is mad as hell in his 2/10 article, Why the CEO Salary Cap is a Joke. Jubak asks “Why isn’t there ever a bloodthirsty sociopath with dictatorial powers and no regard for legal niceties around when you need one?” Many of us are asking the same question. He wants heads to roll and not just CEOs but everyone responsible for our current mess:

And heads do need to roll. Not just to satisfy a widespread desire for revenge on the masters of the financial universe who got the world into this mess — although that’s certainly a plus. But because the greedy, shortsighted and, in some cases, downright crooked people must be punished this time. That includes everyone from middle-class speculators who lied to get mortgages they couldn’t afford to CEOs who took extreme risks because they thought they’d be out the door before the pyramid collapsed.

Jubak lays out his issues with the ‘salary cap’ on executive pay for bailout banks:

  • The cap won’t apply retroactively. If your bank has already received its $45 billion in taxpayer money, there’s no cap on pay.
  • The cap won’t even apply to all banks that take taxpayer money in the future. A bank that takes billions in “normal” bailout money from TARP II could get around the cap by disclosing pay and by holding a nonbinding shareholder vote on the pay. (It’s nonbinding, so why wouldn’t a company that wanted to pay more hold the vote? Because they’d be too embarrassed to pay the higher salary if they lost the vote? These companies, embarrassed? Remember the Citigroup (C, news, msgs) $50 million jet?) Only if your bank took “exceptional” assistance from taxpayers in the future would the cap be mandatory. It’s not clear how the proposal would separate “normal” from “exceptional” bailout billions, but however the term is defined, the cap clearly affects fewer companies than it seems.
  • The cap doesn’t apply to all compensation — just to salaries. Banks could still give CEOs huge bonuses, but the bonuses would have to be in the form of restricted stock that couldn’t be sold until after the company had repaid taxpayers.
  • And finally, and this is perhaps the most troubling, the cap, if finally triggered, would apply only to the top 25 or so executives at any bank. In other words, some Wall Street rocket scientist in charge of slicing and dicing subprime mortgages could make $5 million as long as he or she was far enough down the corporate ladder. Makes a lot of sense, right?

Jon Markman Gives Us Another Prozac-Popper

From Jon Markman, we get another dreary take on the potential direction of the economy in his article ‘Too Late to Avoid a Depression?’. Markman was mostly correct about the crisis of 2008, so I think he is worth listening to. He paints a pessimistic picture while also admitting to having his ‘contrarian antennae’ up. The news from Davos was not good, thus the need for the contrarian in us ready to act if things end up not being as bad as predicted. However, Markman is adamant that policy makers must act quickly and decisively to fend off economic disaster:

To prove the Davos set wrong, in short, congressional leaders must make the right choices at warp speed under pressure from special interests. It’s a public-policy version of the Steelers’ final drive Sunday with time running out in the Super Bowl. Pittsburgh quarterback Ben Roethlisberger, scrambling to elude a rush, had one good shot at throwing the football at an oblique angle to a receiver leaping among three defenders in the corner of the end zone. In times like these, the result set is stark and binary: hero or goat in football, recovery or disaster in the economy.

The Davos pessimists’ case for a severe economic dislocation over the next year — let’s go out to the extreme and call it a potential depression — is easily made, as four key ingredients are in place. Their recipe calls for a blend of cyclical recession, severe deleveraging, a shift of demographics favoring savings over consumption, and inappropriate fiscal and monetary responses by policymakers.

The first three are well under way, so the last one is the decider. Looking back at the Great Depression of the 1930s and Japan’s depression of the 1990s, it’s clear that government leaders in each case failed to respond quickly enough, then overcorrected, and in general took steps that at the time were considered best economic practices but actually worsened the problems. Our leaders will likewise now try to do the right thing based on currently popular theories, but we cannot confidently say whether they will turn out to be appropriate. You just never know.

The only certainty is that measures must be taken immediately, and every day lost on minutiae such as bank executives’ pay or Cabinet nominees’ tax follies dampens the likelihood of success. Speed is of the essence, like putting up sandbags to stop a levee break, as we can see in daily headlines now that the darkness of Davos is descending….

…In summary, total ruin can be averted and the Davos prophecy squelched if lawmakers seize the moment, aim true and get lucky. Even if the result is low growth amid a newly chastened business and social culture, re-ranking of national priorities to celebrate saving over consumption and acceptance of a lower stature in the world, it’s superior to depression and chaos. Cross your fingers.

Time the Market, Buy and Hold!!

size:100%;">I read a size:100%;" >recent Seeking Alpha article by Matthew Hougansize:100%;"> of size:100%;" >IndexUniverse.comsize:100%;"> that was, to borrow a phrase from Mr. Hougan, ‘laughable’. The inherent contradiction in the article is clear: Hougan declares that ‘if there were ever a time for buy-and-hold, that time is now’. Hougan states that ‘Far from being dead, now is the best time in a generation to be a buy-and-hold investor.’ Just to summarize, while he scoffs at the idea that any active trading strategy could provide superior alpha to buy-and-hold for the average investor, he is encouraging his readers to do the one thing he scoffs at and which is completely contradictory to a ‘buy and hold’ mantra: he wants us to time the market by buying and holding right now.

size:100%;">Apparently Matt is convinced now is the bottom of the market? It very well could be the bottom of the market and the point here is not to debate that, but he sure seems absolute in his conviction by declaring now the best time to buy and hold. I’m sure Matt has been out of the market the last 10 years since he’s declared now the best time to buy and hold (clearly we’ve been waiting for this moment since previous moments could not, by definition, be ‘the best’?). The point is that there are tangible, documented strategies with low turnover that have superior risk-adjusted returns to buy and hold and I will provide links for further research on one such strategy. That is not to say there aren’t many other good strategies, but since Matt brought up Tom Lydon I though it would only be fair to focus on one alternative, the moving average system.

size:100%;">Beyond the obvious contradiction in Matt’s article there are other obvious oversights or just gross misrepresentations of alternative investment strategies. For starters, he quotes size:100%;" >Tom Lydonsize:100%;"> extensively. The implication in the rest of the article is that Lydon is somehow associated with active trading strategies that average investors could never hope to succeed at due to high turnover. I’m not sure if Hougan is familiar with Lydon’s website or strategy (actually, it is clear from the article that he is not or he just chose not represent them accurately), but Lydon lays his trend system out fairly clearly on his site. The strategy is far from a daytrading strategy that will leech returns with high turnover as Matt implies.

size:100%;">For Matt and other readers I would advise doing some research on alternative strategies such as the moving average system before grossly misrepresenting those alternatives. Start by reading size:100%;" >Mebane Faber’s blogsize:100%;"> and size:100%;" >articlesize:100%;"> (he will be issuing an updated version of the paper in the next couple of weeks) on Tactical Asset Allocation. The strategy in a nutshell is to go long when each index is trading above the 10 month simple moving average. There are many variations one can use, which I will detail in follow-up articles in the coming weeks. A brief summary: Faber splits his study into 5 assets: the S&P 500, EAFE, 10 year Treasury bonds, NAREIT, and GSCI index. When each index is trading above its moving average, an investor would go long the index. When it is below, sell and go to cash. For a basic ETF portfolio representing this strategy an investor could invest in the following ETFs in equal parts:

size:100%;">S&P 500 Index – SPY

size:100%;">EAFE – EFA

size:100%;">10 Year Treasury – IEF

size:100%;">NAREIT – VNQ, IYR, or ICF

size:100%;">GSCI – GSP

size:100%;">Of note, only the IEF is currently above its 10 month SMA, meaning the majority of the portfolio would be in cash (which it also was in 2008, allowing it to make positive gains in 2008). Some points in Faber’s article I’ll highlight here: the point is not just to ‘time the market’ but just as important is a diversified portfolio including commodities (which I’m sure Matt and I would agree on). Secondly, from 1900-2005, his basic timing model using the 10 month SMA on the S&P 500 had a compound annual growth rate of 10.66% with stdev of 15.38% and a sharpe raio of .43. Buying and holding the S&P 500 had a CAGR of 9.75% with a standard deviation of 19.91% and a sharpe of .29. Thirdly, from 1972-2005 his timing strategy on the S&P had an average of .59 round trips per year, clearly evidence that it is a relatively low turnover strategy. Combining all 5 asset classes in one portfolio from 1972-2005 the timing model had a CAGR of 11.92% with a a 6.61% standard deviation vs a basic buy and hold portfolio of the same investments of 11.57% and 10.04% standard deviation.

size:100%;">In addition to Faber, check out size:100%;" >Tom Lydon’s strategysize:100%;"> and momentum research done by size:100%;" >Blackstar Funds.size:100%;"> The site size:100%;" > size:100%;">does a great job of monitoring moving averages and I would also advise reading their articlesize:100%;" > ‘The Rational for Moving Averages’size:100%;"> which discusses the effect of serial correlation in moving average signals using data as far back as the 19th century (take note of how little the serial correlations have changed the last 130 years). Jeremy Siegel in his book Stocks for the Long Run discusses using a 200 day moving average strategy on the DJIA as a way to reduce risk: ‘the major gain of the timing strategy is a reduction in risk. Since you are in the market less than two-thirds of the time, the standard deviation of returns is reduced by about one-quarter. This means that on a risk-adjusted basis the return on the 200-day moving average strategy is quite impressive.’ The site size:100%;" >Fundadvice.comsize:100%;"> has several articles detailing moving average strategies they use for clients (in addition to buy and hold). These are just a few resources to get one’s research started and I don’t intend it to be a comprehensive list.

size:100%;">Let me be clear on two points: Buy and hold as a strategy will outperform moving average trend systems in certain years on a nominal basis and vice versa. However, the evidence is apparent that low turnover moving average strategies will have comparable returns over the long run (and in some cases better returns) while significantly reducing risk. Surely this is a strategy Hougan should applaud if he is concered about the ‘average’ investor. The primary flaw with him declaring ‘now is the time to buy and hold’ is that we are at his mercy to declare some day in the future ‘the market is oversold, buy and hold will underperform, sell!’ In essence, Matt wants us to time the market based on his advice (and of course, to watch the expense ratios of the funds we purchase. However, most market pundits now recognize that diversification and low expenses alone are not enough, especially when correlations approach one (see 2008). Secondly, I would like to say that I applaud the work of size:100%;" >IndexUniverse.comsize:100%;">, there is much on their site worthwhile so please check it out. However, I know that investors, and Matt, can do better.

size:100%;">I will be detailing more moving average portfolios in depth in the coming weeks.