April 2011

The paradox of underperforming to produce superior results

The S&P 500 continued its ascent, climbing 2.96% in April and 8.88% for the year. Our results are currently posted on our performance page. As impressive the performance has been, the fundamentals and technical internals remain favorable for further upside. Perhaps the one blemish, is that the generals (big cap stocks) are beginning to lead the troops (small and mid-cap) where they tend to follow in a healthy market. Whether this is forecasting a reversal, or is just a short term phenomenon in an ongoing bull market, it will be interesting to see how it plays out. To get a feel for how most bull markets come to a close, I've listed below the factors that the Bank Credit Analyst believe to have some predictive power in determining the start of a bear market.

• Monetary Conditions. In the eleven bear market cycles since 1950, only the 1962, 1976-78, and 1987 declines were not a result of tight money. With the Fed on hold until sometime in 2012, this should not be a factor in derailing the market.
• Valuation. While valuations are slightly elevated, compared to bond yields, stocks look inexpensive, and besides, stocks can get very expensive (1973 nifty-fifty, 2000 NASDAQ) before they ultimately collapse.
• Technical Internals. Sentiment, although high, has diminished in recent weeks. Up until a couple of weeks ago, breadth has remained strong, and momentum as measured by buying power and diminished selling pressure are at levels not seen prior to the start of a bear market.
• Time. The normal bull market post WWII has been thirty months. This bull market is a little over two years, but given that the shorter term bull markets were normally associated with inflation or tight monetary conditions, this bull cycle is likely to last longer than the norm.

Despite trailing the market for the past year, Zephyr Associates ranks Oristano #1 for performance and #3 in risk over the past nine calendar years against 274 large cap core managers. I'm not stating this to tout my own horn, but rather to point out the paradox: today's top managers are unlikely to be at the top over several cycles. This chart, Drawdown Chart, does a good job in illustrating why this is true: Notice that in the latest drawdown, we recovered all of our losses by April 2010; whereas, the S&P has yet to recoup their losses. Notice further, that the pain index (severity and duration of the drawdown) is a whopping 12.2% percent for the market, with a lot less pain (0% being no pain) of 4% for Oristano.

The whole point is that down markets kill you (if you're up fifty percent you have a $1.50, but if you're down fifty percent the next year you're left with $.75). The key to long term superior wealth building is to correlate your portfolios so as to capture most of the upside while dramatically reducing the downside. Based on the above logic, any near term weakness will not likely evolve into a bear market; nevertheless, I'll do my utmost to stay ahead of the curve when and if conditions should change.

 

-Joe