Despite an overtly timid mindset among investors, the bulls are the victors for 2010. The market advance in December capped off a rising year to put the S&P 500 ahead 13% for the year. The Toews system was invested through the majority of the fourth quarter. Our system exited developed international stocks and high yield bonds due to a decline near the end of November, only to re-enter those markets in the first part of December. Our U.S. Stock positions remained fully invested throughout the quarter. We finished the year fully invested across all asset classes.
The mid-year decline that began in April and bottomed with a decline of 16% in early July proved to be a deterrent to equity investors. For the year through December 21st, a net $81 billion flowed out of equity mutual funds*, making this the third consecutive year of net outflows from stock mutual funds. Despite a cumulative gain of 86% in the S&P off of the bottom in 2009, retail investors are not yet convinced that it’s safe to own stocks. As a contrary indicator, this may be a positive sign for stocks moving into 2011. At the very least, outflows from retail funds show that we’re not approaching a euphoric top in the market.
Strong Trends Create Opportunities for Profit
With the gains in 2010, this has now become a sizable move off of the market bottom that we saw in 2009. Our system prefers strong trends over indecisive markets. As markets rise and become over-extended, we aim to capture the over-shoot and lock in those gains for our investors.
Since we’ve been managing portfolios, we’ve experienced two prior stock advances (see below).In each prior instance, the case could be made that the market was over-extended from the perspective of both corporate earnings and historical averages. Currently, however, the market is priced at 13.1 times estimated 2011 earnings, which puts it several percentage points below historical averages. Solely from that perspective, the market may continue to advance into 2011.
However, the latent effects of “the great recession” along with several underlying macroeconomic factors, could easily derail the rally. From our perspective, a primary risk factor is that the government (and the Fed) may be out of ammunition. Any number of events could trip up this economic advance, including the fear of sovereign debt defaults abroad or a continuation of the decline in housing prices. Typically the government is able to deploy fiscal or monetary stimulus to help assuage economic down turns. Yet, monetary stimulus is already fully deployed with interest rates near 0% and the Fed making unprecedented purchases of treasuries.
Our federal debt level as a percent of GDP is higher than at any point since the Great Depression, and is believed by many to be near the tipping point. Should the US Government attempt to deploy additional fiscal measures, such as additional state or local government aid or aggressive tax cuts, we risk our own sovereign debt crisis. To frame the situation in the simplest possible language, the enemy is any event (housing prices, bank failures, etc.) that will cause a downturn in GDP growth. If GDP growth remains strong, unemployment improves, and housing prices stabilize; we may see this rally continue for several more years. However, if GDP growth falters for any of the reasons stated above, it’s likely to set in motion a feed back loop that could prove disastrous for financial markets. Our government will have little capability to intervene. The crucial question is: will the enemy advance?
The Benchmark Paradox
A milestone of success in any industry is the ability to objectively measure the value of contributions made by its companies. In the field of investing, we assess the value added by managers in two ways: How a manager does relative to broad benchmarks such as the S&P 500; and how a manager does relative to his peer managers. Our assessment of these performance measures is that, while they are essential at ranking performers, they grossly underserve investors. The reason? The benchmarks that we measure the performance of managers against correlate poorly with what investors are trying to achieve.
To illustrate, imagine two airplane manufacturers. One produces planes designed to fly at 500 miles per hour, but are built to endure all levels of turbulence. Another produces planes designed to fly at 600 miles per hour, but are only built to fly safely at low levels of turbulence. At high levels of turbulence these planes are vulnerable to…break up. Now, what’s your perspective about a service that rates airlines exclusively on the basis of their speed of travel between cities, and doesn’t say anything about the fact that faster planes may break up if air conditions are poor? Welcome to the world of investment performance measurement.
The self regulatory organizations that oversee the investment industry demand that investment advisors compare their performance against market benchmarks. These market benchmarks measure how well the market does as a whole, but they do nothing to tell us about the risk of loss. For advisors whose objective IS to out-perform benchmarks, there may be some value in making the comparison. However, for firms like ours, these benchmarks can represent a constant temptation for investors to leave risk managed products and jump into products that are unsuitable based on their risk profile.
As a result of this disconnect, this quarter we’ll begin including “chance of loss” metrics with our published performance reports. Initially we’ll include two measures. First, we’ll show how many times our portfolios and their benchmarks have lost more than 50% (the equivalent of a plane breaking up in mid-air) since their inception. Second, we’ll show the chance of loss of 20% or greater within any one year for portfolios and their benchmarks. Our flagship Aggressive Growth Portfolio, as an example, has never experienced a loss of 50% or greater during its 15 year history. Its benchmark, however, has lost 50% on two separate occasions: during the 2000-2002 period and from the peak in 2007 to the market bottom in 2009. Similarly, our Aggressive Growth Portfolio has never had a loss of 20% within any one year period. Its benchmark, however, has lost 20% or more during 6 out of 15 years, giving it a 40% chance historically of experiencing a 20% loss in any one year.
We’re constantly attempting to find new ways to build products around our investors’ needs. By including these new risk measures, we hope to help investors better assess our ability to achieve that goal.
Prior performance is no guarantee of future results and 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.
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 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.
This article 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 article 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.