by Tony Fiorillo, President/CEO of Asset Management Strategies, Inc.
Another economic drama! What now? Worldwide markets have been rattled by the latest catastrophe de jour. Although mitigating circumstances exist in the case of the Cyprus money-grab, one must wonder, “Could that happen to us?” We fear that Obama is sitting in the Oval Office saying, “Wait. What? We can do that?” Since our debt to GDP is not 3X, like Cyprus, hopefully, we’re a long way from that being a possibility here in the US. But if this isn’t the one that brings the whole house of cards crumbling down, what, or when, will it be and what can I do to protect my assets now or until it happens?
In the course of working with individual investors on a daily basis, I often explore this question in conversations and it can lead to extremes. Hypothecating the worst case scenarios usually leads to discussions about gold, Swiss Francs, real estate, coffee cans, holes dug in the back yard and bundles of cash stuffed under mattresses. In these Financial Armageddon doomsday predictions, I fear that none of these agreed upon mediums of exchange will hold up. The only currency that matters at that point will be Smith & Wesson and it would be the universal language. The principals of supply and demand would still be valid except the transaction would be completed with an exchange of gunfire instead of an exchange of dollars. All of your dollars would be as worthless as Confederate money and your gold would only be good for throwing at someone to keep them from taking what you still consider to be your property. Weapons, food and water would be the new currency. Don’t believe me? Couldn’t happen in our society? Really? Maybe this excerpt from Wikipedia about the aftermath of Hurricane Katrina will give you an idea of how it could look:
“The looting is out of control. The French Quarter has been attacked,” City Councilwoman Jackie Clarkson said. “We’re using exhausted, scarce police to control looting when they should be used for search and rescue while we still have people on rooftops.”
Incapacitated by the breakdown of transportation and communication, as well as overwhelmed numerically, police officers could do little to stop crime, and shopkeepers who remained behind were left to defend their property alone. Looters included gangs of gunmen, and gunfire was heard in parts of the city. Along with violent, armed robbery of non-essential valuable goods, many incidents were of residents stealing food, water, and other commodities from privately owned grocery stores. There were also reports of some police officers looting. Significant looting continued in areas of the city with few, if any permanent residents, such as the Lakeview, Gentilly, and the Midcity regions.
If you don’t have a vivid enough imagination, go watch the three seasons of The Walking Dead. Not once in their battle to stay alive and fend off flesh eating zombies have they mentioned money or gold. So that proves it.
So let’s just back up a bit from this complete Mad Max meltdown and talk about what has the highest probability of actually happening. Suppose we don’t reach this level of widespread lawlessness and we’re able to continue under some semblance of the world as we currently know it. Tell me what to do with my money.
If you haven’t noticed, the stock market is up over 6% this year while gold is down over 4% so the looting mobs (or zombies) apparently aren’t here yet. On our current course of action, it does appear that it is only a matter of time unless we get realistic about how to begin to address the 16 trillion problems we have. We want returns, but it’s a very scary world out there. How can we participate and still sleep at night? Unfortunately, most investors don’t have a defined sell discipline and are, therefore, fearful from being in the market at all. And for good reason.
A possible solution could be trend following. By definition, trend following is the process of measuring the price movement of an asset (stock, mutual fund, ETF, bond, etc) to determine whether or not, or to what extent, to be in or out of the market. There is no argument about fundamentals or why, only the absolute bottom line: price movement. If price is moving up, people are buying. If price is moving down, people are selling. End of discussion. By utilizing trend following in your investment strategy, studies have proven that you can nearly double the return of the S&P 500 over various time periods, all while lowering the risk by almost half. That’s a complete game changer. Throw out your traditional fixed income/equity allocation models. Throw out your sophisticated planning software and its Monte Carlo simulation. Throw out your antiquated low retirement withdrawal rates. According to Bloomberg, in the second quarter of 2012 Goldman Sachs had 60 out of 66 trading days that were positive for their trading desks from trend following methods; Bank of America had 63. These are not statistically insignificant numbers.
So why hasn’t your broker or advisor suggested trend following? There are three very valid reasons. First, most large firms dictate compliance from the top down. That’s good in that it generally is for your own protection; however, it can also be limiting. They will never turn their 10,000 brokers loose with the flexibility that trend following demands. In trend following, when all the red lights come on, sales need to be made immediately. Imagine the compliance challenge to stay on top of all the approvals for all of the transactions. Not going to happen. The second reason is that, until recently, costs played a major factor in barring trend following from the masses. Those costs have come down on several fronts: trade costs, software costs and tax deferral wrappers. Lastly, ignorance; there is a learning curve in understanding trend following and its implementation. Some brokers are not up for teaching an old dog a new trick. They may deflect any suggestion by relegating trend following to nothing more than market timing. They are not likely to confess that, “it’s a great idea and can make you more money and save you some heartache, but our compliance department doesn’t allow us to use it.” Ask your broker or adviser this question and then be prepared for the chill that will run all the way down your spine to your wallet when they answer no: “If you don’t believe in market timing or trend following, is there any set of circumstances that will be bad enough for you to say we’re selling everything?”
What is the difference between trend following and market timing? Market timing is based on someone’s subjective assessment of the current situation and the making of a judgment call. It is opinion or attitude drawn from years of experience, education, gut instinct or their ability to read the tea leaves. It is as fallible as the human being making the call and doesn’t work. Trend following, on the other hand, is a documented, verifiable process that is a discipline and has proven to work.
Anyone in these markets that doesn’t have a sell discipline is asking for trouble. I don’t know when it will come and I don’t have to. Trend following will monitor price movement and tell us everything we need to know about being in the market or being out. Yes, you can still be in the market and ride it in this uptrend and have time to seek safety quickly if the trend reverses. Keep in mind that the worst monthly loss in the S&P since 1988 was -16.94%, nothing close to the total market drop of 45-50% that we’ve seen twice in the last 13 years. Trend following can’t be expected to protect you from all losses, but the goal is to avoid massive losses and be relatively in the markets in uptrends and relatively out of the markets in downtrends.
If Cyprus isn’t the end or the next politically produced economic calamity doesn’t bring the system completely down and you’re not quite to the point of a backyard asset graveyard, yet you do have credible concerns without having an exit strategy, trend following might be the solution.
Tony Fiorillo is President/CEO of Asset Management Strategies, Inc. (http://www.amsria.com). He has a degree in Economics, studied International Business at the University of London and Behavioral Finance at Harvard University. He can be reached by email firstname.lastname@example.org or phone 317-577-6912.