After a turbulent year in 2011, the markets moved steadily higher to finish the first quarter up 12.6%. The Toews dynamic hedging strategy bought US and international equities and high yield bonds during the first few weeks of January and stayed invested throughout the quarter. Toews systems were fully invested in all asset classes at the end of March.
Last year was defined by indecision and volatility that was not kind to our system. So far this year, we’ve seen just the opposite: a clear trend with significantly reduced turbulence. In markets that trend higher, the Toews system can remain fully invested for considerable periods of time. After the system bought into stocks in March of 2009, it remained fully invested for over 10 months as the S&P 500 increased over 37%. Because we’re attempting to track market indices instead of betting on individual stocks or market sectors, we are optimistic that we’ll capture a majority of these market moves higher*.
There is a competitive advantage that we realize over traditional portfolios, however. As the market trends higher, our target exit level ratchets up too, creating an opportunity for our system to “lock in” gains. This is hardly a trivial characteristic. The market continues to have monumental challenges. Gains realized during this bull market trend could be erased in a few months if momentum turns the other way.
An entire generation of investors has been trained during a 30 year bond bull market without meaningful declines. Bonds are not, however, immune to losses. The past 100 years has seen two prominent bear markets (see figure below). Between 1915 and 1926, the Dow Jones Bond Total Return Index realized real (after inflation) losses of 6.5% over an 11 year period, producing a maximum drawdown during its first 6 years of 50% . The second secular bear market in bonds produced real losses of 30% over 36 years. Few investors understand how to address these risks and continue to position bonds as the “risk-off,” conservative investment in their portfolios.
Two factors have been associated with long trend bond market losses: Excessive government debt and low interest rates. When government debt reaches extreme levels, it has an incentive to increase inflation, which hurts the real returns of bond holders. Similarly, when interest rates are at historic lows, chances are that they’ll increase. As interest rates move up, existing bond holders are vulnerable to losses of principal.
Both factors are signaling risk in portfolios. US government debt is approaching levels not seen since post WWII, and interest rates have decreased to the lowest levels in a century, with the 10 year US Treasury interest rate dropping as low as 2% in recent months.
Our new Dynamic Fixed Income Portfolios attempt to address bond risk by managing two categories of fixed income portfolios within each account: High Yield and High Quality Bonds.
We aim to lower the risk of investing in high yield bonds by attempting to exit these bonds during the preliminary phase of declines, before large losses are realized. When high yield bonds are rising, that portion of the portfolio aims to be fully invested. When high yield bond prices begin to decline and meet the parameters for a sale, the high yield bond portion of the portfolio will be allocated to short term bonds or money market funds in an attempt to avoid losses. Toews has a 16 year history of managing HY bonds as a part of its tactical strategy.
For High Quality Bonds, we deploy our tactical methodology in an attempt to maintain exposure to the highest income high quality bonds, while lowering the risk of losses from increases in interest rates and inflation. During benign markets, the high quality portion of portfolios will be fully invested across the duration spectrum. If rising interest rates cause bonds to begin to lose principal value, the Toews system will attempt to mitigate risk by allocating a greater portion of the portfolio to intermediate or short term bonds, where risks of principal losses are lower. When the portfolio is subject to erosion due to higher inflation, the Toews system will attempt to mitigate risk by shifting assets to inflation protected bonds.
Three portfolios are now available to advisors on our separate account (iVest) and FTJ Fundchoice Platforms. Our Conservative Income Portfolio is allocated 40% to high yield bonds and 60% to high quality bonds. Our Moderate Income Portfolio maintains a 30% allocation to high quality bonds, with 70% committed to high yield bonds, and our High Income Portfolio is allocated 100% to high yield bonds.
Would you describe your state of mind about your investments as confident and informed, but largely passive, or vigilant, critical, and prone to make changes? In our experience, frame of mind is the best predictor of investor success and can be illustrated by looking at two completely different types of investors:
One example is the very first Toews investor who began with us in 1995 and is still invested 17 years later. She reviews her investments once per year. But her attitude during these reviews is largely passive. If she experiences losses, which have been rare occurrences but have happened on occasion, she takes no other action other than to understand what happened and ask if any changes are necessary. If she experiences gains, she’s grateful and, again, largely passive regarding these short term market movements. Her investment portfolio has quadrupled over the past 17 years.
The opposite example is an investor described to me by one of our Massachusetts-based advisors. This client called his planner to discuss his investments …every day. No doubt 2011 was an anxiety-inducing year. With EU governments heading into default and the market down as much as 20% at one point, 2011 kept threatening to become another 2008, even though the stock market ended the year flat. Each market spike or drop was matched by this investor’s angst. Exhausted by allowing his emotions to ride along every bump in the market, he moved his investments to cash near the end of last year, where it remains.
Our Zen Investor who has four times her money looks at her investments each year, while our Apprehensive Investor looked at his each day. That’s a big difference, but what transcends this difference is that our Zen Investor is disinclined to make changes even when the portfolio appears to be going in the wrong direction. Why? Even one year is far too brief to effectively evaluate results. To successfully evaluate a portfolio strategy requires a full market cycle, which typically means a period of six years or longer.
The riddle that the market plays on investors is that, unlike virtually every other aspect of life, passivity as it pertains to short-term events works in favor of investors rather than against them. To make matters more complicated, when action is advisable it’s often counter-intuitive. If the market makes big moves lower, it’s desirable to invest more, not a good time to exit. If the market makes big gains, it’s more likely to drop and typically not a good time to add to investments.
To become more like our Zen Investors, Zoom Out! Performance over any one quarter or year can be a distraction. By focusing on results over a full market cycle, you will dramatically increase your chances of success. You’ll also lower anxiety about your investments and improve your state of mental health.
If you’re evaluating performance and are unsure about your situation, ask yourself (and your advisor) three questions:
- 1. Is my portfolio designed to meet my long-term needs?
- 2. Is my investment strategy built to profit from market gains but also to protect against extreme market crises?
- 3. Does my advisor continue to feel that my portfolio and managers are the best for me?
If the answers to these questions are yes, you’re probably on the right track.
We’ve talked about divergent opinions on the economy before, and we continue to see them today. Two weeks ago CNBC ran a story headlined: Goldman Sachs: Best time to buy stocks in a decade. Three weeks ago, however, the venerable Economic Cycle Research Institute (ECRI), arguably the most reliable firm at predicting recessions, re-iterated and bolstered its prediction that the US was likely to fall into a recession imminently. The ECRI has correctly predicted the last three recessions, without any false alarms in between.
Stock market participants would appear to favor Goldman’s view, as stocks have advanced 26% in just over six months. However, if the ECRI is correct, it would mean a recession that market participants haven’t anticipated. This outcome would likely produce a dramatic sell-off of stocks. Should that happen, we’ll gladly move to the sidelines while the market goes into retreat.
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.
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.