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The Goldilocks Investing Newsletter — No. 6 — July 6, 2016
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Welcome to our occasional newsletter! Today's issue is designed for people who attended a recent beta-test Goldilocks Investing seminar in Boston or Seattle.
Please do not forward this newsletter to others. Our book on investing is in stealth mode, and people who did not attend a seminar would be baffled by the following discussion. Please don't share this information until the book is released in 2017.
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Brexit shows how Muscular Portfolios work
 By Brian Livingston
The big news on June 24 was Great Britain's vote on whether to leave the European Union, known as Brexit. The 51.9% "no" vote was the opposite of what polls and betting parlors had predicted.
The shock caused stock exchanges around the world to dive. On that Friday and the following Monday, global equity markets shed $3 trillion of value in just two days — worse than the day of the Lehman Brothers bankruptcy in 2008 — according to figures by S&P Dow Jones Indices.
Stocks in Europe and Asia, being closest to the crisis, lost the most. But America's S&P 500 fell almost as badly, losing more than 5% in those two gut-wrenching days. (See Figure 1.) The index has recovered in the past week, so it's getting hard to remember how agonizing June 24–27 felt. It seemed like the entire world economy might tank.
Meanwhile, the Papa Bear Portfolio — which I revealed for the first time in this newsletter on May 2 — showed its merit. This diversified set of global assets actually rose 2.6% on those two volatile days, mostly due to positions in bonds and real estate. Informed investors avoided heart attacks and regrets. Instead, you could blissfully watch your life savings rise as the rest of the globe freaked out.
From the close of May 31 through July 1 — the entire 23 trading-day period shown in Figure 1 — the Papa Bear rose a handsome 8.3%. The S&P 500 merely ended up where it began. (Our other portfolio — the Mama Bear, as we'll see later — was also up 2.6% in those two days. It gained 7.7% during the whole period.)
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Figure 1. During the worst two-day dollar loss in the history of global equity markets, the Papa Bear's diversified portfolio went up. A Muscular Portfolio is designed to keep losses small, in order to free you from stress and deliver long-term outperformance. Source: FolioInvesting.com.
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Mama and Papa are having a great 2016
Performance in a single month, to be sure, is way too short to be significant. Only a complete bear-bull market cycle — preferably longer — should be used to evaluate investing strategies.
I'm showing you graphs for short periods like June (Figure 1) and 2016 year-to-date (Figure 2) just to illustrate how Muscular Portfolios work. I'm so excited about their power and simplicity — which any investor can take advantage of for free — that they're the focus of my next book, which will be released in 2017.
Let us recap: Muscular Portfolios are asset-rotation formulas that hold each month only the three strongest exchange-traded funds (ETFs) out of a menu of global asset classes. Muscular Portfolios are a big improvement over old-style Lazy Portfolios, which hold a static asset allocation at all times, ignoring market conditions.
The relative-strength ranking of the ETF menu is determined by a Momentum Rule. This is a well-established financial principle: asset classes with the best total return over the past 3 to 12 months tend to perform well in the following one month or more. See the Mama Bear page and the Papa Bear page for free rankings of which ETFs have the strongest momentum at any given time.
Figure 2 shows the performance of the Mama Bear Portfolio since Dec. 31, 2015. The Mama Bear is up 10.5% in 2016 YTD. The S&P 500 total return (including dividends) is only 4.1%.
Muscular Portfolios are designed to keep losses small. This saves individual investors from the agony of declines worse than 25%. After this "human pain point," peoples' survival instinct takes control, compelling them to liquidate assets to "stop the bleeding." Throwing in the towel during bear markets is a big part of why most individual investors seriously underperform the S&P 500 over time.
As you can see in Figure 2, the Mama Bear never fell more than 2.3% during the S&P 500's terrifying correction during the first six weeks of the year. The S&P 500 collapsed 10.3%. Muscular Portfolios declined only moderately. The outperformance felt great, as the overall market fell off a cliff after the Fed in December raised rates a mere one-quarter of a point.
The bottom of Figure 2 shows a chronology of the Mama Bear's holdings. Following the Momentum Rule, the portfolio started 2016 with cash and REITs (real-estate investment trusts). As the months passed, the portfolio gradually rotated into long-term Treasury bonds, gold, and commodities.
At no point in 2016 did the Mama Bear have any exposure to US or international equities. In the US, developed countries, and emerging markets, stocks had weak momentum, ranking in the bottom half of the menu. For instance, the S&P 500 was already down 3% in July–December 2015, preceding its nose dive in January–February 2016.
The Momentum Rule kept our two Muscular Portfolios invested in whichever three ETFs were statistically likely to perform well going forward. (The Papa Bear's 2016 YTD performance was quite similar to the Mama Bear's. The Papa Bear was up 6.3% through July 1, 2016. It gained another 1.2% on July 5 alone, a day the overall market was down.)
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Figure 2. Keeping losses small is the secret to Muscular Portfolios outperforming the S&P 500 over complete bear-bull market cycles. Thanks to the small decline graphed above, the Mama Bear delivered 2.5 times the gain of the S&P 500 in 2016 YTD (10.5% vs. 4.1%). The chronology shows which ETFs the portfolio held each month to generate such good results. Source: FolioInvesting.com.
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The Mama Bear catches up after underperforming
The next graph illustrates the Mama Bear's real-money performance since Nov. 20, 2014, when I publicly revealed the strategy to a packed room of 200 people at AAII Boston. (I also explained the formula at smaller beta-test seminars in Seattle around that same time.)
Almost 20 months after the Boston seminar, people who started following the Mama Bear back then are doing fine. Figure 3 shows that a real-money tracking account — after subtracting all ETF fees and market friction — is up 3.6%. Sure, that's not really an explosive gain, but it's within 2.45 percentage points of the S&P 500 total return. The index is up 6.05%. The difference is not meaningful.
Muscular Portfolios, to many people's surprise, are expected to gain only two-thirds as much as the S&P 500 during bull markets. (See Figure 4 for the reason.)
Holding three global asset classes at all times harnesses diversification to reduce our risk of loss. That's a good thing. But when the S&P 500 is soaring, the index will always surpass a diversified portfolio.
Fortunately, we outperform in the long term, because Muscular Portfolios typically lose only half as much as the S&P 500 declines during crashes.
As a result, Muscular Portfolios tend to outperform the index over complete bear-bull market cycles. This trait is very rare for real-money portfolios (ones that are subjected to actual fees and market friction).
Calendar year 2015 was a year of underperformance for the Mama Bear and Papa Bear. That was true both in real-money results, as shown in Figure 3, and in simulations by The Idea Farm backtester (which I described in the May 2 newsletter). In 2015, the Mama Bear had a 9.5% loss, while the S&P 500 was virtually flat.
Small losses such as 9.5% are typical cold streaks, which will be followed by hot streaks. Only by committing yourself to any new formula for one complete bear-bull market cycle (in either order) do you give a strategy a fair trial.
The Mama Bear's real-money performance in 2016 YTD was 6.4 points greater than the S&P 500's. (As shown in Figure 2, the gains were 10.5% vs. 4.1%, respectively.) That's the kind of hot streak — after an unpleasant cold streak — that informed investors know to wait for.
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Figure 3. Calendar year 2015 saw the Mama Bear underperform the S&P 500 — but the portfolio caught up in just the first six months of 2016. The S&P 500's current trendless, sideways action may soon become a true bear market. If so, a Muscular Portfolio is designed to keep losses small, generating outperformance over the entire bear-bull market cycle. Source: FolioInvesting.com.
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Achieving 1/2 down and 2/3 up is the key
So much for the short, insignificant time periods that illustrate the above topics. You should compare these results with the simulated returns for the Mama Bear and Papa Bear over a 43-year period — four bear markets and four bull markets — as shown in my May 2 newsletter. From 1973 through 2015, the Mama Bear and Papa Bear would have achieved 14.3% and 16.2% CAGR (compound annual growth rate) after subtracting current trading fees and costs. The S&P 500 total return, with no trading fees or market slippage deducted, achieved only 10.0%.
You may remember one particular slide from my beta-test seminar that you attended. I showed that Muscular Portfolios tend to outperform the S&P 500 over complete bear-bull market cycles because of a basic but non-intuitive mathematical fact:
• If you lose only 1/2 as much as the S&P 500 during down months, and
• You gain only 2/3 as much as the index during up months,
• You beat the pants off the S&P 500.
I showed a chart that illustrated this exact pattern. From Aug. 31, 2000, through Aug. 31, 2014, the simulated "1/2 down, 2/3 up" portfolio would have returned 130%. The S&P 500 total return was only 70%. Slow and steady wins the race, just as in the fable of Tortoise and Hare.
How the heck can you keep your losses to only half of the index's declines? This sounds hard but is actually easy. Simply hold the three asset classes each month that have the strongest momentum. You automatically stay out of assets that are in the bottom half of the performance rankings. Those are the ones that tend to decline or crash, which you want to avoid.
The first half of 2016 clearly demonstrates how Muscular Portfolios behave during market stress. But most investors will never learn this fact. They are chasing a mirage: a strategy that will supposedly beat the S&P 500 every month. They will never find one.
But don't rely just on my theoretical calculations! As I showed in my slides, the famous Warren Buffett — the most successful investor of our time — gains only 2/3 as much as the S&P 500 during bull markets. He delivers his huge wins over time by outpeforming solely during bear markets. As a result, from September 2000 through August 2014, his Berkshire Hathaway portfolio (BRK-A) generated an astounding gain of 247%. The S&P 500 (SPY) rose only 66%.
Figure 4 shows BRK-A (blue) and SPY (orange) charted in a market-cycle graph. In the 2002–07 bull market, SPY went up 119% while BRK-A rose only 80%. In the 2009–14 bull, SPY gained 222% while BRK-A delivered only 159%. In both bull markets, Buffett delivered only about two-thirds the gains of the index.
Counter-intuitively, Buffett's portfolio over the full 14 years gained triple the index's return because he was diversified. His portfolio actually gained a little during the 2000–02 dot-com crash, and it lost less than SPY during the 2007–09 financial crisis. That's all it took for Buffett to rack up a spectacular overall return.
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Figure 4. Over the entire 14-year period, Warren Buffett's BRK-A portfolio gained 247%, while the S&P 500 rose only 66%. This market-cycle graph shows that Buffett achieved only two-thirds of the S&P 500's gains during the last two bull markets (2002–07 and 2009–14). He generated his gigantic long-term record solely by outperforming the S&P 500 in both bear markets (2000–02 and 2007–09). Source: Yahoo Finance and author's calculations.
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Why a formula that shadows the index will retain potency
The diversified holdings of Buffett — and the three ETFs of Muscular Portfolios — exhibit "gentle shadowing" of the S&P 500 during bull markets. This is actually a key reason why strategies like these will never become widely adopted, "overgrazed," and arbitraged out of existence.
Updating our data from Mar. 9, 2009 (the current bull market's start), through July 5, 2016 (yesterday), Buffett's portfolio has significantly underperformed the S&P 500 for 7 years and 4 months! But he doesn't throw in the towel. He knows the formula will outperform over time.
Armchair investors don't have the discipline to follow a sensible, long-term investing strategy. If a formula underperforms for a meaningless period of two or three years, it's abandoned. Short-term junkies leap from one strategy that has disappointed them recently, to another that will disappoint them in the next three years, to yet another, and then another, for life.
We can't reach everyone, but I'm pleased that you've been willing to give these simple, long-term portfolios a chance. Happy investing!
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Free stuff you might enjoy
If you've read this far, your reward is a downloadable, one-page overview of my entire book (updated as of July 2). For a limited time, you can download the PDF free of charge at:
Goldilocks Overview
If you missed any of our previous newsletters, links to them can be found in the lower-right corner of our home page.
If you have comments to contribute, start a new message to a special address that goes directly to me:
MaxGaines "AT" BrianLivingston "DOT" com
Thanks for your support!
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