Don’t Invest Like It’s 1974

10/14/2011 10:30 am EST

Focus: MARKETS

Nick Atkeson

Partner, Delta Investment Management, LLC

The 1970s has many similarities to what we’re going through now, and here are some  lessons you can take from the past, writes Nick Atkeson of Delta Investment Management.

The late sixties and most of the 1970s was a time of turmoil, culturally, politically, and financially.

The United States struggled with the Cold War, cultural awakening, political scandal, the rise of OPEC, stagflation, and a myriad of other issues. This had many believing our best days were behind us, and that Japan was the next major superpower.

The headline news regarding Vietnam, protests, Watergate, oil price shocks, price controls, high tax rates, government regulation, and runaway inflation was reflected by a stock market that had high volatility with a bearish trend. Owning the Dow from 1965 through 1981 was a losing experience.

Chart1

In many ways, the past decade has been a lot like the 1970s. The headline news is filled with war, protests, government regulation, high energy prices, etc. Many believe America’s best days are behind it and China will soon become the world’s next great superpower.

Chart2

What is interesting is that not only is the headline news similar, the secular bear-market pattern of the stock market is also very similar.

Buy-and-hold investors have not made money for the past 11 years. Interest in owning stocks continues to fade. Over the past four months, investors have withdrawn $87 billion from US stock mutual funds, the worst rate of exodus since 2008.

Watching your net worth dramatically rise and fall is more than most people can live with emotionally. The strain of having retirement seem to fade into a feeling that you will have to work for the rest of your life causes many investors to make suboptimal investment decisions during these choppy times.

According to JP Morgan, the average investor has achieved an average annualized return of 2.6% over the past 20 years (1991 to 2010), versus a 7.7% return for the S&P 500 and an inflation rate of 2.4%. Clearly, most of us have a lot to learn about how to manage our money in times like the 1970s.

In thinking about how successful investors made money in the 1970s and how money is being made today in stocks, the first step is back: look at a longer-term history of the market. By placing the 1970s and today’s market in a broader context, we can gain insight into the duration of these secular bear markets and how best to invest.

Shown below is a chart of 110 years of the S&P 500. It shows the market stair-steps higher over time, with long periods of volatile, non-trending activity followed by a stretch of buy-and-hold steady appreciation.

Chart3

NEXT: Lesson 1

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Lesson 1: Secular bear markets of 17 to 20 years are not uncommon. In fact, if history is a guide, we should expect the current market trading pattern to persist for another five to ten years.

Modern Portfolio Theory (MPT), developed in the 1950s and 60s, gained widespread adoption in the 1980s and 1990s.

The essential concept of MPT is that an investor can combine assets that have low correlation (one goes up while the other goes down) but equal expected return and create a portfolio that has an enhanced risk-adjusted return. In other words, diversification can lower portfolio volatility and enhance return.

During the 1982 to 2000 green period on the chart above, MPT worked really well. Owning any stock worked really well. Buying and holding stocks was the key to making money during that time frame.

Since 2000, we have found that MPT is somewhat a case of the emperor has no clothes.

Where MPT has fallen down most significantly is that diversification has not provided your portfolio with the protection you thought it would. The reason for this is that correlation between assets changes over time and may not be entirely predictable. After the collapse in 2008, we know in times of crisis, correlations between all types of stocks approaches 1.

The box below shows the correlation of returns between US and international stocks in January 2009. A correlation of positive 1 indicates two asset classes move exactly in sync in the same direction. Assets that move together are not offering you protection through diversification.

Notice how close to 1 the correlation numbers are:

chart
Click to Enlarge

What we are also learning is violent market sell-offs occur much more frequently than what a normal distribution curve of probabilities would suggest. In layman’s terms, bad things are happening frequently and raising havoc in our carefully constructed, well diversified portfolios.

Lesson 2: Modern Portfolio Theory has been a straitjacket keeping investors fully invested in stocks no matter how high they go or what is going on in the economy. Investors have been scared out of trying to time the market.

As we all know, life is all about timing. This is particularly true when it comes to investing. Most people do most of their savings over a 15- to 20-year period from their mid to late 40s to their early to mid 60s.

Depending on when you were born, you could have excellent or poor investment results, depending on how your prime investment years overlap with the market super-cycles.

If your primary investment years were the 1970s, you would have had a tough time growing wealth with a buy and hold strategy. A $1 million net worth held in bonds, housing, and stocks would grow to only $1.1 million from 1966 through 1980.

On the other hand, if your personal investment cycle overlapped the 1981-2000 time period, you likely performed very well. Using the same example, $1 million grows to $4.2 million.

Since 2000, housing and stocks have performed poorly, while bonds have worked well with interest rates falling. In all likelihood, if you are at all like the average investor, your asset base has not shown the appreciation you expected.

NEXT: Lesson 3

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Lesson 3: Because of our age span limitations and the capital requirements of our life cycles (buying a home, children going to college, retirement), almost all of us cannot afford to wait it out. We need the appreciation that stocks can offer without the major set-backs. We need to participate in up markets and avoid the down markets.

Let’s just say it. We have to time the markets. Before the widespread use of Modern Portfolio Theory and at a time when stock investors felt free to apply common sense, many investors made money through market timing.

The Big Lesson: The big lesson from the 1970s is that those investors that employed a disciplined, non-emotional method to getting into bullish markets and out of bearish markets made money. You need active money management in an active market that is non-trending.

Many of the successful investors from the 1970s are now retired. Going back 40 years to find winning trading strategies takes some digging. But it can be done. And some of those strategies are alive and well today.

One of the most successful, robust trading strategies is based on a moving average crossover (MAC) model. The principal behind using a MAC model to determine when to own stocks and when not to is momentum. Price trends tend to persist until they do not. Your objective is to attempt to discover when the market has established an upward trend and buy, and when it has set a downward trend and sell.

In 2009, Theodore Wong—a graduate from MIT with BSEE and MSEE degrees—combined his engineering analytics and econometrics modeling skills to study risk management in both up and down markets. What he discovered is that an investor who bought the market when the market broke above its six-month moving average, and sold them when they traded below, far outperformed a buy and hold investor.

If you invested $1 in 1871 and used the six-month MAC model to drive your trading activities, your compound average growth rate (CAGR) would have been 9.6% with an average drawdown of 2% and a maximum drawdown of 13.8%. $1 would have grown to $319,000 by April 2009 over this 138-year span.

The $319,000 return compares to $84,660 that would have resulted from a buy and hold investment strategy during this same time frame. The average drawdown from buy and hold was 25.9% and the maximum drawdown was 84.8%.

In December 1971, a new-to-Wall Street man named Mike Kress began selling a proprietary marketing timing service based on a moving average crossover model to his institutional clients. His model was based on a 15-week moving average on a group of several thousand stocks.

Those investors that listened to Mike did well. From December 1971 through 1981, Mike’s model put up a 242% return. The Dow was down about 10%.

Mike and his clients learned two important lessons:

Mike Lesson 1: Mike and his clients never saw an investor lose much money in a bullish market (markets trading above the MAC).

Mike Lesson 2: Mike and his clients never saw an investor make much money in a bearish market (markets trading below the MAC).

We are not the only ones who believe that it is possible to time the market. From the late 1990s to today, hedge funds have attracted about $1.7 trillion in assets.

Hedge-fund managers are paid to be tactical. Timing is a major way they add value. Think of John Paulson, who made billions in a perfectly timed short trade on the subprime housing market.

Conversely, the dissatisfaction with buy-and-hold mutual funds is near all-time highs. The investment landscape is changing. Investors are waking up to the realization that the do nothing approach of modern portfolio theory and buy and hold was too good to be true.

Investing takes work and common sense. It requires active management based on tried and true investment discipline.

We strongly encourage you to explore the research behind moving average crossover trading principles, and participating in up markets while avoiding the downs.

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