Investing in Bull and Bear Markets: What’s the Difference?

1. Investing in Bull and Bear Markets: What’s the Difference? Presentation to AAII Baton Rouge Chapter Meeting September 10, 2011

2. Don Lansing (donl@stedwards.edu)

3. Mutual Funds • Mutual Funds originally offered pre-packaged diversification • Modern Portfolio Theory where risk is managed through diversification • John Bogle (Vanguard) championed passive investing noting that it was almost impossible to consistently choose outperforming managers • Focus was on driving costs lower – the one variable in the passive equation • Fidelity launched sector funds to further the passive investing landscape Don Lansing (donl@stedwards.edu)

4. Exchange-traded Funds (ETF) • ETFs are like funds in structure (baskets of securities) but trade like stocks (trade throughout the day based on prevailing market price). • ETFs offer some advantages over mutual funds: • Cheaper in cost (typically 0.5% versus 1.5%) • Give investor control over tax effects • Give investor control over timing of trade Don Lansing (donl@stedwards.edu)

5. Exchange-traded Funds (ETF) • ETFs initially offered an alternative to passive index investing (e.g. SPY). In the past decade, they went beyond: • Easy access to previously inaccessible markets • Individual countries – e.g. Brazil, Thailand, Israel • Individual commodities – e.g. Sugar, Cotton, Crude oil • Built-in leverage • Allows leverage in IRA accounts • Use less money for hedging • Accelerate returns (and losses) Don Lansing (donl@stedwards.edu)

6. ETF Considerations • Consider liquidity when investing • More volume = better pricing • Less volume > use limit orders • Exchange-traded Notes (ETN) • Sort of a bond backed by issuing firm • Notes typically have 10-20 year+ term • Simpler tax treatment than ETFs • Dependent on ability of firm to pay off note Don Lansing (donl@stedwards.edu)

7. Discussion of Risk • What is risk? Often viewed as standard deviation of return – up and down swings in return • Deviation is typically viewed as change from account peak – what we call “drawdown” • Investors emotionally “own” an asset value • Deviation is dangerous because it pushes emotional buttons in individual investors  makes them anxious, induces fear, … • Thus, the goal is to minimize drawdown and hold on to the vast bulk of gains

8. Discussion of Return • Stock investors refer to S&P 500 as the expected return • Rarely adjust that number for risk • Bond investors, however, recognize that the rising or lowering tide will create the “opportunity universe” • e.g. “I can’t achieve a 10% return if interest rates are 3%” Don Lansing (donl@stedwards.edu)

9. Examples of Risk-Return Tradeoffs Don Lansing (donl@stedwards.edu)

10. Examples of Risk-Return Tradeoffs Don Lansing (donl@stedwards.edu)

11. What Drives Market Prices? • Fundamentals  Economic Cycle; Corporate Earnings (S&P 500 at $90/share in earnings) • Liquidity  Availability of capital; money flow; Fed policy can influence this • Investor Sentiment  Enthusiasm drives P/E ratios for stocks; Yield spreads for bonds Don Lansing (donl@stedwards.edu)

12. Managing Risk with Sector Cycles Don Lansing (donl@stedwards.edu)

13. Market Cycles • Markets move in broad cycles driven by a combination of fundamentals and sentiment • SECULAR cycles last 15-20 years, typically • Subcycles last 2-3 years, typically • Most stocks follow the market • Secular cycles peak when investor sentiment (good or bad) reaches a “fever pitch” pushing prices well beyond norms. • Subcycles change more on events/fundamentals – e.g. perceived economic expansion/recession Don Lansing (donl@stedwards.edu)

14. Secular Market Cycles • Secular bull cycle – i.e. 1982-2000 for stocks • Investment rarely loses money • Pricing reaches very high levels • P/E ratios for stocks are a good general barometer • Secular bear cycle – i.e. 2000-today for stocks • Investment struggles to deliver real return • P/E ratios gradually slope downward to under 10 Don Lansing (donl@stedwards.edu)

16. Don Lansing (donl@stedwards.edu)

17. Don Lansing (donl@stedwards.edu)

18. Don Lansing (donl@stedwards.edu)

19. Investing in Secular Bull • Buying and holding stocks works • Not surprising that much of the buy-and-hold mantra comes from studies conducted during these periods • Aggressiveness defined by sector and/or leverage • Risk of loss from broader market, over anything beyond a few months, is rare and temporary • More standard deviation should generally equal better return because market is moving higher Don Lansing (donl@stedwards.edu)

20. Investing in Secular Bear • Investment opportunity lies in market swings • Called Tactical investing – recognizing tendency for market to move sharply up and down • Key becomes recognizing market subcycles and moving to cash/short when negative • Market offers lots of yearly standard deviation • Tactical Asset Allocation and simple timing Don Lansing (donl@stedwards.edu)

21. Don Lansing (donl@stedwards.edu)

22. Identifying Changes in Subcycle • Definitions (During Secular Bear Market): • Cyclical Bull market – 2-3 year trend higher marked by market “corrections” of 10-15% • Cyclical Bear market – 2-3 year trend lower marked by counter-trend rallies of 10-15% • Do not pay attention to earnings! • Market cycle will peak before earnings do • Pay attention to market behavior: • Which sectors are outperforming • Whether investors are buying or selling risk  high yield bonds as a market “tell” Don Lansing (donl@stedwards.edu)

23. Simple Timing Mechanisms • 50-200 Simple or exponential moving average Don Lansing (donl@stedwards.edu)

24. Results from Simple Timing Don Lansing (donl@stedwards.edu)

25. Using ETFs to Implement Tactical Stock Market Strategy • When the Subcycle bear market trigger is hit: • Can exit all stock positions and transition into bonds • Can hold favored long-term stock positions but hedge them • Hedge them using inverse ETFs, such as SH/DOG or more specific sectors, if applicable • E.g. own XOM, hedge with DUG (inverse large-cap energy) • 2x/3x inverse can be used for brief periods, but negative compounding makes them less desirable. Don Lansing (donl@stedwards.edu)

26. Cyclical Downtrend Portfolio • Expect 18-24 months of higher volatility and general downtrend • Core holding of BND/AGG or similar (or cash) • Focus is on protecting assets and generating low-risk yield • Being aggressive • Add short positions (DOG, SH) • Play sharp counter-trend rallies Don Lansing (donl@stedwards.edu)

27. Cyclical Uptrend Portfolio • A cyclical uptrend suggests we can safely take more risk. • Uptrend should last for 2-3 years • Core Stock Holding of VTI • Add some punch with IJK and/or IWO • If international is strong, EFA and/or EEM • Use High yield bonds for bond piece Don Lansing (donl@stedwards.edu)

28. Down/Upshifting a Portfolio • We can also take half-steps in making our portfolio more tactical • Reduce our risk by adding more yield • Move from stock index position to • High yield stock ETF (DVY or SDY) • Preferred stock ETF (PFF/PGX/PGF) • Note: mostly financial companies • Hybrid yield ETF (PCEF) • High yield bonds (HYG/JNK, VWEHX) • Corporate bonds (LQD) Decreasing Risk Don Lansing (donl@stedwards.edu)

29. A Different Approach • Take a Core-Satellite Approach • Use Asset Allocation Funds as your conservative core • Will offer some exposure to equities • But manage risk to varying degrees • Favored Asset Allocation Funds (instead of a Balanced Fund) • Sierra Core Retirement  SIRIX • Pimco Asset Allocation  PAAIX Don Lansing (donl@stedwards.edu)

30. Core-Satellite • Up/Downshift the Satellite based on market cycle • In an Uptrend use the higher-beta choices • VWEHX, FSICX, FLVCX • In a Downtrend use the defensive choices • PTTRX, BND, inverse ETFs Don Lansing (donl@stedwards.edu)

31. The Impact of Inflation • Inflation impacts interest rates • Higher inflation = higher interest rates • Higher interest rates creates competition for stocks • Inflation impacts earnings • Can improve pricing power  higher margins • Ultimately margins hit a wall • Inflation creates anxiety among investors • Lowers their “sentiment” Don Lansing (donl@stedwards.edu)

32. Building an Investment Strategy • Objectives • Long-term (retirement) vs Short-term (project) • Personality Profile • Knowledge • Maintenance • Stomach (Ability to Handle Volatility) Don Lansing (donl@stedwards.edu)

33. To Summarize • Understanding where we are in broad market cycles should frame our investment strategy. • There are decades+ secular cycles and 2-3 year subcycles, the combination of which drives our investing approach. • ETFs have dramatically enhanced our ability to take advantage of market cycles, both to profit from them and protect against losses. • We have entered into a new bear market where caution is the watchword. We expect stocks to be generally weak with occasional rallies for the next 12-18 months. • This market will offer good values during this process for buy low-sell high, traditional investing. • Tactical investing is another way to manage through these cycles. Don Lansing (donl@stedwards.edu)

34. What About Gold? Don Lansing (donl@stedwards.edu)