Margin Call

In a scene from the movie Margin Call, a banker looks out of his car window and says “look at these people, wandering around with absolutely no idea what is about to happen.” That’s an accurate portrayal of the current state of the perspectives of many advisors, who fear that an EU sourced Armageddon may be just around the corner, and consumers, who just helped push Black Friday results up 6.6% over last year’s holiday frenzy.

News flow moves between extremes from the sometimes positive news about the US economy to the “terrifying” (word choice of Mohamed El-Erian) news out of Europe. These divergent perspectives have peaked advisors’ concerns about both the outcome and volatility associated with this crisis.

At Toews, the concerns expressed by several of our advisors (especially those new to Toews) relate to our how our system will perform given all of the unrest. “We’ve never seen volatility like this,” commented one advisor. And the follow-up, “how can the Toews system function when the markets behave indecisively, and with such big one day moves?” A question that hasn’t been asked, but that is poignant, is “what is the historical outcome when one day volatility increases.”

As scientists of the markets, I thought this would be a good time to share not only our experiences in navigating volatile markets, but a portion of our studies that look all the way back to 1928, providing a thorough historical examination of volatility as it relates to our system.

Let’s start with the first assertion: “We’ve never seen volatility like this!”

Why this is important:
One day volatility has a direct impact on our system’s primary vulnerability. When we exit, if market moves are significant before we re-enter, the Toews system can under perform or have outright losses.

Using Dow Jones Industrial Price data that looks back to October of 1928, the market has moved by an average of .75% per day (monthly average), with a range of .2% to 5.4%. The current monthly average is 1.45%.

As the above graph shows, while daily volatility is elevated, it’s not at unprecedented levels. During our period of management, we’ve seen similar levels of volatility on 11 separate occasions. Each time, news flow and huge market gyrations bring calls to our office like those that we’re receiving now. Our system is modeled to address this volatility. Despite the elevated volatility that we’ve experienced, our system has produced a compelling performance advantage relative to the markets, and has dramatically reduced downside participation during significant downturns.

Now on to the more relevant question: What is the historical outcome for the markets when one day volatility increases?

The answer: High one day volatility is a predictor of significant market trends, an environment that our system favors.
When the market has one day moves averaging between 1.5% and just over 2%, as it has over in the past few months, the index has ended roughly 30% higher or lower one year later.

How this relates to Toews

We refer to this as a best/worst type of market for our system. As one day volatility increases, the system becomes more vulnerable to under performance. However, the outcome from that same volatility tends to produce big market moves. If the market moves significantly higher, we are in a position to potentially capture those gains. If the market makes a big move lower, our relative performance improves, and we aim to capture big gains during the market rebound (as we did during 2008/2009). Further, the size of the trends tends to dwarf any under performance or losses that occur during whipsaw markets.

Despite all of the headlines and volatility, our management team prefers the current environment to lackluster markets that rarely produce significant market moves. The key for advisors is to avoid exiting the system before big trends play out (cautionary data point: peak redemptions from our system occurred in late 2007/early 2008).

Market Environment

The coordinated efforts by central banks to alleviate the EU crisis produced significant gains on Wednesday this week. Yet, even as global equity markets surged, the cost to fund Italian debt remained static. We offer two critically important observations: 1) if larger EU economies (Italy, Spain) become unable to fund their debt, the problem may escalate outside of the capacity of even Germany and France to contain, and; 2) if the situation expands to encompass all of the EU as stated above, we face the prospect of a debt/banking crisis that will surpass the sub-prime crisis in its likely impact on financial assets and the global economy.

This is overtly not a market that will be friendly to modern portfolio theory based portfolios. As we saw in 2008/2009, when the turbulence of crises escalates, correlations across asset classes tighten, and all assets move lower together.

Even fixed income may not be the panacea of safety that it has been over the past 3 decades. As we discussed in our webinar series earlier this year, and as documented in the book This time is different by Rogoff and Reinhardt, sovereign debt crises tend to ultimately produce hyper-inflation. Fixed income tends to be the most vulnerable asset class during these periods.

The path to navigate these markets is straightforward, but requires constant execution: 1) Stay committed to equity markets, the best performing asset class that helps protect investors against inflation; and 2) hedge your equity portfolios against losses. Both are pillars on which the Toews system is built.

Prior performance is no guarantee of future results. There can be no assurance, and individuals should not assume, that future performance of any of the portfolios referenced will be comparable to past performance. There can be no assurance that Toews will achieve its performance objectives. There is the potential for loss as well as profit when investing in this, or any, investment strategy. No part of this document should be considered unless accompanied by these disclosures.

This commentary may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.

This commentary is intended to provide general information only and should not be construed as an offer of specifically-tailored individualized advice. Please contact your investment adviser, accountant, and/or attorney for advice appropriate to your specific situation.

This document refers to the performance of the majority of Toews portfolios to illustrate the effect of Toews management on US and intl. stocks and high yield bonds. Performance of individual accounts varied based on the client’s investment risk profile and their specific investment funds. For your individual account performance, please refer to the enclosed quarterly statement or the quarterly statement recently sent to you. In addition, not all model portfolios were referenced in this letter. It is not, nor is it intended to be, a comprehensive accounting of Toews asset management. There are other portfolios that Toews manages that performed differently than what is referenced in this letter. For a complete list of GIPS firm composites, their performance results and their descriptions, as well as additional information regarding policies for calculating and reporting returns, please go to www.toewscorp.com. Toews Corporation acts as the investment advisor that implements the asset allocation and models for each of the portfolios. Investors cannot invest directly in an index and is an SEC registered investment advisory firm incorporated in 1994.

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