All That Glitter

It’s been a minute since I wrote a blogpost focusing solely on gold. Now is a good time.

Many investors struggle to understand the benefits of investing in gold and what role gold can play in a portfolio. But gold has been an important investable asset for millennia. While it is no longer a medium of exchange due to the dominance of fiat currencies, gold can be a strong diversifier in a buy and hold portfolio, as Harry Browne’s famous Permanent Portfolio indicates. In that portfolio, Browne includes a 25% allocation to gold, equal to that of stocks, while the remainder of the portfolio is in cash and long-term treasuries.

The presence of gold in the portfolio, and the reduced exposure to stocks, is one of the reasons that the portfolio experiences low drawdowns relative to other buy-and-hold portfolios. In the worst 20 quarters of the stock market since 1967, for instance, gold’s return was positive three-fourths of the time:

Indeed, since the beginning of the 21st century, gold has outperformed both stocks and bonds:

However, we do not advise holding gold indiscriminately at all times. Instead, we utilize momentum methods to invest in gold when it is in an uptrend, and to invest in other investable assets when it is not. In our Gold Long Trend model (GLTR), we hold gold ETFs about half the time. The other half of the time we hold ETF positions in our all-asset A-GEM momentum model. Last year that meant holding U.S. growth stock ETFs at times, as both those ETFs and gold ETFs had a strong year.

In this backtest from January 1999, our GLTR model outperforms all of the following: gold itself, the S&P500, and a balanced portfolio of stocks and bonds:

Note: see the disclaimer at the end of this blogpost for information about the limits of backtesting.

Gold is notoriously difficult to trade because it can spend long periods of time flatlining or declining, even if it does have long bullish periods. This is a year-by-year continuous futures contracts chart of gold prices from 1970 to the present:

Gold had a roaring 1970s related to certain fundamental factors like inflation and permitting U.S. citizens to old gold other than through numismatic coins. But then gold went dormant for almost two decades in the 1980s and 1990s as inflation abated and geopolitical risk declined.

But in the 2000s, after 9/11 and the rise of China as a consumer of world commodities, gold had another heyday, that is, until the 2010s when disinflation and zero interest rate policy (ZIRP) held firm. That began to change, however, in the months before the COVID pandemic began:

This is a monthly chart of the same gold instrument showing a breakout of a price consolidation that occurred in the months before the COVID pandemic. In that respect, I wrote about gold’s rise during this time as our momentum models shifted into gold and long-term U.S. treasuries before the pandemic selloff in equities here and here.

Eventually, another consolidation pattern would emerge from 2021 until an indisputable breakout in 2024, a breakout that continues to this day. Additionally, that most recent consolidation bears the hallmarks of a bullish inverse head-and-shoulders pattern.

Of course, we always follow our models, and momentum works on any asset that can experience times of trending, but there are fairly obvious reasons that gold prices have been rising. A firm I follow, Crescat Capital, has been one of the best sources for understanding the rise in gold prices.

Of note in Crescat’s chart are explanations for why gold experienced bull markets in the 1970s, the 2000s, and now. The list supporting the current rise is three to four times longer than that supporting the prior bull markets. Where in the past falling gold production, inflation, and demand from central banks and China were in place, now the same factors are in place, plus additional geopolitical risk and major fiscal deficits.

To be more specific, central bank gold buying has doubled in the last ten years, as an excellent blogpost from Callum Thomas indicates:

Thomas further notes that these fundamental drivers of higher gold prices are not changing anytime soon. Additionally, he notes that the retail investor has yet to come on board to gold investing, suggesting that there is much room to run, just as in the 1970s and the 2000s.

For these reasons, we believe our GLTR model is well-positioned to take advantage of another multi-year bull market in gold.

A Breakthrough Year: Our Alternative Asset Models in 2024

Without question, 2024 was a strong year for stocks. Both the Nasdaq 100 and the S&P500 were up about 25% after dividends.

But alternative assets were up more. Gold was up 26.7%, and Bitcoin was up a whopping 121%.

As dual momentum investors, we apply our methods not simply to stocks, but also to fixed income, gold, and digital assets, including blockchain technology and Bitcoin. In this respect, we utilize ETFs, as the universe of asset classes accessible via ETFs continues to grow.

In their inaugural years, our alternative asset models exhibited unusually strong performance. Our Gold Long Term Trend model (GLTR) strongly outperformed both gold itself and our expectations derived from our backtest (see below), and our Bitcoin and Digital Asset Synergistic System (BADASS) picked up most of the 2024 return of Bitcoin, despite that the model did not include exposure to Bitcoin ETFs until October.

Bitcoin ETFs became tradable in the U.S. beginning in mid-January and were excluded from our digital asset model until several months later when we found that we had enough data to justify their inclusion. Before that time, our digital asset model’s primary asset was the Amplify Transformational Data Sharing ETF (BLOK). BLOK contains exposure to public companies that make use of blockchain technology and exhibits strong correlation to Bitcoin futures contracts. BLOK was up over 53% in 2024. Currently, our digital asset model’s primary ETFs are BLOK and IBIT, the iShares Bitcoin ETF.

However, our digital asset model contains exposure to digital assets only about half of the time. Under our dual momentum approach, there is no point in holding these ETFs when they are not in an uptrend. When the model does not hold one or both of these ETFs, it holds whatever GLTR is holding. For its part, GLTR holds gold ETFs about half the time, and the other half of the time it holds what our all-asset dual momentum model A-GEM holds. A-GEM can hold just about any asset for which an ETF exists, and it can shift into fixed income or cash if there are no better opportunities.

By layering exposure to these three models, our investors can benefit from relative strength momentum, reduce whipsaw trades, and shift aggressiveness up or down, as conditions warrant.

According to this logic, 2024 left us with an embarrassment of riches. When otherwise strongly performing digital asset ETFs were not candidates for investment, strongly performing gold ETFs were, and when otherwise strongly performing gold ETFs were not candidates for investment, strongly performing U.S. growth and tech ETFs were. According to the above chart, U.S. growth ETFs were up over 33% in 2024.

In this way, our digital asset model could stay on the right side of the market in 2024. At the start of 2024, however, there was no reason to hold BLOK, or a gold ETF, over U.S. growth stocks. As a result, we started the year holding what our A-GEM model held, specifically these tickers: IYW, XLG, and SCHG. After rebalancing two times before we received a buy signal on BLOK on February 12, the digital asset model held IYW and XLG throughout. Between them, these ETFs gained a powerful 8% in the first six weeks of 2024.

Our February 12 buy signal on BLOK resulted in a holding period of just three days, given its explosive move upward. We sold into strength in order to protect profits and apply mean reversion trading principles on BLOK. Unlike with Bitcoin ETFs, BLOK contains exposure to corporations with cash flow, which prevents BLOK’s momentum from continuing up or down as much as Bitcoin does. We picked up another 7.5% gain for the model in just three days.

At that point it was back to growth ETFs before we received another signal to buy BLOK on February 22. This trade resulted in a small loss, which we closed on April 16. Despite this trade, our digital asset model picked up over 33% after fees and commissions in the first quarter of 2024.

The model suffered a correction in April, giving back more than half of the first quarter’s strong gains. Nevertheless, the model was up to a strong start in the first four months of 2024.

On June 5, we received another buy signal on BLOK that we would hold until July 26, when received a buy signal on gold. We picked up about 6.5% on this BLOK trade and closed out the second quarter with a loss of about 10.8%. However, the model remained up over 19% YTD as of the end of the second quarter.

Gold was the story in the third quarter, as the model held a full position in BAR, a physical gold ETF until September 6, and a half position until October 17. By September 6, the model had incorporated IBIT as another primary asset besides BLOK and would enter a half-sized position in IBIT on October 17 when the gold position was sold.

The gold trade worked beautifully. The first half position was sold for more than a 5% gain, and the second half was sold for more than 12% gain. On September 6, the model re-entered BLOK in a half-sized position that it would hold until nearly the end of the year. The digital asset model gained another 18+% after fees and commissions in the third quarter.

The half-sized September 6 entry in BLOK was especially well-timed, and gained more than 21% until another signal to buy gold occurred on December 20.

To cap off a brilliant 2024, the model entered a half-sized position in IBIT on October 17 and held to the end of the year, picking up another 39%.

The model picked up another 32% after fees and commissions in the fourth quarter, with the great majority of those gains occurring in November. For its part, GLTR finished the year up more than 35% after fees and commissions.

Our alternative asset models’ gains in 2024 were truly extraordinary, but they were no accident. Dual momentum is designed to keep investors on the right side of the markets, and the models’ exposure in 2024 was dominated by the best performing assets in 2024: Bitcoin, gold, and U.S. growth stocks.

But it is also the case that the model’s performance is dependent on how the assets it trades perform, and these best performing assets performed unusually well. These are the backtested performance metrics for GLTR and BADASS since 2018, when BLOK began trading.

Future years will not likely bring as many opportunities for these models as did 2024, especially for GLTR. GLTR’s performance in 2024 approached two standard deviations above its compound annual growth rate in our backtest. But while it is true that the digital asset model’s performance in 2024 greatly exceeded expectations from our backtest, it did not exceed more than one standard deviation above that rate. As a result, we have high hopes for the model in the years to come, and GLTR will remain an excellent diversifier in a portfolio of our models.

The 2024 Post-Election Landscape

Now that the dust has settled on the election, we can more easily assess where we are in the markets and where they are going.

As I’ve made clear in other contexts, the actual winner of the election doesn’t matter that much. What matters is eliminating the uncertainty of the election so that market participants can take action more freely--action they were inclined to take before the election. Before and after the election, the investment landscape has been in a firmly risk-on mode. That will likely continue until at least the end of the year as lagging professional money managers attempt to catch up to the major stock market indices. The recession that many had expected never arrived.

In this election, one of the biggest foreseeable risks to market participants was not who would win the election, but the risk that the election might not be decided for several weeks or months. When that risk was eliminated, market participants were free to take on risk in many ways, and in some ways to cut risk. In that vein, it’s worth assessing who the winners and losers appear to be in this early post-election moment.

The winners are big business generally, as the major US stock market indices climbed to new highs immediately after the election, especially growth stocks. That’s also true for companies subject to higher levels of regulation like financials, including those that were potential targets of antitrust enforcement, such as big cap tech companies.

Certainly, cryptocurrencies are big winners with the prospect of a US strategic bitcoin reserve and increased liquidity in the financial system due to the Fed’s cutting the short rate. Further, the new President is a crypto supporter, and strong seasonal factors are in play for crypto currencies currently and for the next several months.

(Full disclosure: I have a position in GOOGL.)

On the other hand, bonds were sold, consistent with how they were selling off in the weeks before the election, as Trump‘s odds of victory were increasing. Losers really include just about all interest rate plays except for financials, such as gold, real estate, and high dividend paying stocks.

Why is this the case, especially with the Fed's cutting the federal funds rate? After all, stocks and assets that are more sensitive to interest rates tend to do better when the Fed cuts.

On the other hand, a major risk for bond investors is that the US will cut taxes under Trump and not decrease spending, creating a ballooning deficit consistent with what occurred in his first administration. That’s especially the case now that the Republican party controls both houses of Congress as well as the presidency. If deficits balloon, bond investors may require a higher interest rate from the US government to take on the increased costs of servicing the debt. That’s bad news for homebuyers and sellers as longer-term rates remain high. 

Recessions have started under every Republican presidential administration since my birth in 1968. The trend of cutting taxes, while not decreasing spending, can often lead to a “sugar high” in the economy as asset prices inflate dramatically for time. That then can lead to inflation increases and rising interest rates, or rates that stay higher than they would be otherwise, leading to a recession due to the burdens of heavier borrowing costs.

It doesn't have to go this way, but it often has. If this pattern holds like it has before, our dual momentum approach provides a good answer. As prices swing high and then begin to break down, a dual momentum approach like ours will ride the trend up and then begin cutting risk as the trend breaks down. That's precisely what happened when we sold our gold positions last week.

If there is a recession in the next four years, long-term US treasuries should be a big winner as the fed will have to cut rates to stimulate the economy anew. Gold and other interest rate plays will probably perk up and do well again in that environment as the economy recovers.

For now, however, investors can enjoy the risk-on environment in certain assets and ride the wave up, while avoiding those that are selling off. In our models, we are long digital assets and growth stocks. In our fixed income models, we are increasingly hewing to the short end of the duration curve. This is a reversal of course from the summer when it appeared as though long-term interest rates would fall. At the same time, we hold positions in high-yielding bonds because those are correlated to stock prices, which remain strong.

It's important to note that we take actions like these because our dual momentum metrics and parameters dictate it, not because of our outlook on the macro economy. Under our dual momentum approach, we expect the price action in the markets to give us the most important information, and that is precisely what has led us to make these good investment decisions.

Emotions are Information

The longer I trade and invest, the more I am convinced that the emotional aspects of investing are not merely an offshoot of successful investing. Instead, they are primary.

Emotion rules the markets, and investors should monitor closely both their own emotional states and their perceptions of the emotional tone of the markets. In essence, emotions are information, and in an sea of information of various types and value, emotions can often serve as the most reliable information.

In this vein, I had the pleasure recently of re-reading Tom Basso’s wonderful short book, Panic-Proof Investing (1994). For those who don’t know, Basso has participated in the markets as an investor since the 1960s when, as a child, he would invest the earnings from his paper route in a mutual fund. After training as an engineer, Basso started his own fund based on trend-following principles and methods and became highly successful. His profile and interview in The New Market Wizards (1994) is worth reading closely. Jack Schwager, the editor of the excellent Market Wizards series, dubbed Basso “Mr. Serenity,” given Basso’s calm emotional state. Since his retirement and long before, Basso has ben an invaluable teacher of the markets and how to interact with them as an investor.

In Panic-Proof Investing, Basso stresses the value of maintaining a balanced emotional state when investing. When investor emotions reach an extreme, most commonly in fear/panic or greed/exuberance, investors are much less likely to make good decisions. Certainly, since the inception of the COVID pandemic, the markets have taken investors on a wild emotional ride, from the 30%+ selloff in February/March 2020, to the tremendous rally off the bottom shortly thereafter, to the crushing bear market in 2022 once the Fed began hiking the federal funds rate aggressively, to the bottom in October 2022, including the current powerful rally off the dip in October 2023.

The markets will always test investors emotionally. I see the issue in my advisory practice frequently. Often when clients of Stillpoint either reduce the value of their accounts, or divest completely, the markets are at or near a bottom. By contrast, when new clients invest, or when existing clients increase their investments, the markets may be near a top. Obviously, this does not occur in every instance, and most clients of Stillpoint are very clever about their investment decisions, but these patterns are unmistakable.

It’s worth pointing out that making financial decisions when in an unbalanced emotional state can lead to disaster. This is precisely how financial scammers operate. In part, they succeed by inducing a state of panic in their victims. In case you might be thinking, “It can’t happen to me,” it happens much more commonly than we might like to admit. Indeed a financial journalist was recently scammed into handing over a package to a fraudster containing $50,000 in cash.

How can investors maintain a balanced emotional state? Basso offers one answer, and that answer is both cognitive and imaginative. Whenever Basso feels that his emotional state has become unbalanced, he visualizes himself from a distance, sitting at his desk, monitoring the markets and making trades. Performing this exercise enables him to take a mental step back from the emotions to defuse them and bring context and distance to the circumstances. In that way, Basso will not act on impulse to gratify a pressing emotional need.

I take a different approach. For me, emotions are more difficult from which to distance myself than they are for Basso. What I do instead is to do my best to observe the emotion itself and to observe myself feeling the emotion in the moment. But I also attempt to contextualize the emotion with the memory of similar emotions that the markets have induced in me in the past. My emotional memory in this regard can reach back decades. For instance, I remember many of the extreme emotions I felt in 2008, which also happened to be the year my first client had hired me. I remember the exuberant extinction event the commodities markets experienced in the summer of 2008, as well as the crushing selloff in equities just a few months later. In this way, the more bull and bear markets I have seen, the more easily I can literally feel my way through responding to the markets in a balanced emotional state.

For instance, the current emotion that risks overwhelming me now is greed/exuberance, the false assumption that market conditions will be as good as they are for a lot longer. But it was just sixteen months ago, in the depths of the recent bear market, when my emotions were very different. At the time, instead of mourning the loss of the good times, I tried to imagine the good times to come, and they certainly have arrived. I also haven’t felt this way since 2021. Remembering, and feeling, these different scenarios can bring balance to my emotional state.

Of course, another way to bring balance to an investor’s emotional state is to invest with a rules-based approach grounded in investment principles that have been validated over vast swaths of data. In this respect, it’s no accident that momentum and trend-following investing, the same kind of investing that Basso and I utilize, can itself make managing emotional states easier. Without such an approach, an investor is often swayed from one extreme to another emotionally, which typically brings about poor decision making.

Having said that, I think we are early in the stages of this new bull market, most obviously because I am not yet seeing a rush of investors yet who want to become new clients of Stillpoint. Even traders I know who have traded for decades have had trouble adjusting to and accepting the new bull market, as they continually expect a crash that never seems to arrive. So, if you are considering becoming a new client of Stillpoint, now is not a bad time.

What is your way of maintaining a balanced emotional state? Do you use emotions as information, too?

2022: An Outlier of a Year

Most of us have seen the classic film, “A Few Good Men,” with Jack Nicholson and Tom Cruise. It’s most quotable line occurs in a courtroom scene after Cruise, playing a Navy JAG attorney, states to Nicholson’s character, a decorated Marine Corps officer whom Cruise is cross-examining, “I want the truth!” Nicholson’s response is, “You can’t handle the truth!”

This line from Aaron Sorkin’s screenplay brilliantly captures a certain ethos that uniquely befits the U.S. Marine Corps. I know this because I was raised by a Marine Corps officer and Vietnam vet, Captain Jack Richardson. I have heard my father make many statements in this vein.

Captain Jack Richardson, Vietnam, 1967

As a result, it rang a bell when I first heard the following piece of market wisdom many years ago: the market doesn’t care what we want. There are many iterations of this wisdom. Just google “the market doesn’t care”: “The market doesn’t care what you think”; “the market doesn’t care what you paid for a stock”; “the market doesn’t care about your opinion.” This market wisdom is really an inversion of Nicholson’s line, where the market and truth are at odds with us in some important way.

Upon hearing a market maxim in this grain, my first response was, “So what? Why would the market care about what I want?” But there was more here than I initially understood.

2022 has been a year for investors in which the markets—and I mean just about all markets—have made their indifference to the desires of investors shockingly apparent. For nearly all investors, success wasn’t measured by how much was gained, but how little was lost. 

With few exceptions, the best investors could do was to limit exposure to market risk. There has been no safe haven, and bonds have had their worst year since the early 1930s, even as stocks sold off from the first trading day of the year and never regained their highs. The typical 60-40 portfolio of stocks and bonds has had one of its worst years in history.

Even momentum strategies, which limit market exposure at key times, did not perform a lot better, including momentum strategies that diversify into assets other than stocks and bonds. And avoiding all market exposure presented a different form of pain: real losses, if not nominal ones, because of high inflation.

In 2022, the markets have delivered the worst news since 2008. Both 2008 and 2022 were outlier years for the markets, specifically negative outlier years. Others were 1974, 1931, and 1929. These were years in which even the most reasonable and rational goals of investors were profoundly frustrated.

How investors respond to such an outlier year is important. It’s only human to feel frustration and pain at such negative feedback from the markets, and those feelings should not be ignored. But neither should they drive investors from understanding that the markets will give us outlier years from time to time. Nor should such feelings drive investors away from executing a plan that succeeds over time despite the outliers.

This is another way of saying that investors should not place too much weight on short-term performance, even performance that lasts for a full calendar year, especially when market results deviate so strongly away from their long-term results. I saw this happen in the wake of the 2008-2009 financial crisis. Even though the stock market had bottomed in March of 2009, many traumatized investors stayed out of stocks for many years afterward, missing out on substantial gains.

Investors face the same risk today. Currently, because the Fed has been hiking the federal funds rate at the most rapid pace in history, investors are tempted to lock their funds in high-yielding fixed income instruments, swearing off market risk altogether, despite that inflation remains high. But it’s important not to fight the last war for too long because current market conditions will change, and the base rate is likely reassert itself. After the 1929-1931 period, the stock market bottomed in 1932. After 1974, it bottomed in 1976. After 2008, it bottomed in 2009. With the likely end of Fed tightening in sight, and a likely recession coming, bonds may have already bottomed. Stocks generally bottom before the end of a recession.

For these reasons, in a year when the market became shockingly indifferent to the goals of investors, investors should accept, instead of resist, the fact that the markets will give us negative outlier years from time to time, as in 2022. There is a time for feeling the pain of a negative outlier year like 2022, especially before it becomes clear that the year is in fact a negative outlier. That pain lies in the gap between reasonable investor expectations and market realities that go in a different direction. By now, however, that pain should transform into acceptance and moving on.

For investors who rely on modeling to direct their portfolios, as momentum investors do, models should not be based on on outlier years. Otherwise, the benefits of the base case are at risk. But models should be at least robust to the outlier, instead of fragile. This is a key way in which momentum investing succeeds over time, by limiting exposure when asset prices are in downtrends.

This is how investors can handle the truth of the markets—with perspective and crucial information from market history. Although 2022 was an outlier, outliers come and go.

In that spirit, I wish you all a Happy 2023.

Marilyn, Jack, and Matthew Richardson, 1970

A Key Treatment for the Bear Market Blues -- Momentum

To state the obvious, stock indices around the world are in bear markets and clear downtrends. Nor are other asset classes, like fixed income, providing relief. Indeed, longer-dated U.S. treasuries are actually performing worse this year than U.S. stocks in the weakest year for bonds since 1949.

What to do about this? What are some treatments for the bear market blues?

Before I discuss the best way I know of to manage bear markets, I need to make a broad point about bull markets and bear markets. As a general rule, bull markets are for growing capital, and bear markets are for protecting it. As a result, expecting to grow capital during a bear market is often futile and can easily end in tears. The best that most investors can do in bear markets is to limit losses and drawdowns to prepare to compound capital better in the next bull market.

Readers of this blog and clients of Stillpoint know the obvious answer to treating the bear market blues—momentum. Momentum approaches applied to differing asset classes have a centuries-long track record of limiting the downside and capturing much of the upside in security and commodity prices. These approaches provide better risk/reward profiles than does simply buying and holding the market for stocks and bonds.

So far this year, the momentum approaches that Stillpoint deploys have seen portfolios decline substantially less than that of buy-and-hold portfolios. The generic buy-and-hold portfolio that I follow is down more than 20% YTD as of this writing. The portfolio consists of the following ETFs: VTI (30%), for U.S. stocks; EFA (30%), for foreign stocks; and IEF (40%), for fixed-income. Here is how the elements of that portfolio have performed thus far in 2022:

Total return performance data on a buy-and-hold portfolio consisting of 60% stocks and 40% bonds for 2022 YTD as of September 25, 2022. Past performance is no guarantee of future results.

If you check the performance of numerous other buy-and-hold portfolios, you’ll find that many are performing much worse than this, and few are performing better. All are down at least 13% YTD.

Momentum’s relative outperformance in 2022 is also notable because there have been few alternative asset classes in sustained uptrends in 2022. As I mentioned, stocks and bonds are both in downtrends, but gold is also down in 2022, as is real estate. While commodities provided strong uptrends in the first half of 2022, they have since corrected and provided no edge.

Total return performance data of selected ETFs for gold, real estate, and commodities for 2022 YTD as of September 25, 2022. Past performance is no guarantee of future results.

What has worked better than these common alternatives is yet more exotic, specifically short-dated floating-rate U.S. treasuries and actively managed commodity futures instruments.

This is how Stillpoint has outperformed: by standing aside for most of the big market declines in stocks and bonds and placing capital where it is treated better.

Not surprisingly, 2022 has been the year for many buy-and-hold investors to consider momentum approaches, either solely or to diversify against the weaknesses in the buy-and-hold approach. In this way, Stillpoint welcomes the opportunity to discuss how prospective clients can improve their portfolios’ risk/reward profiles.

How to Survive When the S&P500 Loses Seven Weeks in a Row

In every week from April 4 to May 20, the S&P500 ETF (SPY) lost ground The total loss came to just over 13%.

Did it help to diversify with treasuries? Not at all. The most liquid U.S. Treasury ETF (TLT) lost just over 11% during that period.

Without question, the typical 60-40 portfolio of stocks and bonds, which had performed well for so long up to this year, is under a lot of pressure. Many investors have not encountered a market in which both stocks and bonds go down at the same time.

The reasons for this are everywhere in the news—inflation and higher interest rates. Inflation is a bond-killer when bond yields are low because it becomes a self-defeating exercise to lock up your funds for years at 2% interest while inflation is multiples higher. Inflation and higher rates hurt stocks as well, but it hurts some stocks more than others.

They really hurt growth stocks because their valuations and prices fluctuate greatly depending on interest rates. Growth stocks are correctly perceived as “longer-dated” instruments because investors are wiling to tie up their capital in them based on the expectation that the stocks’ growth rates are so high that higher valuations and stock prices are justified. When interest rates are low, growth stocks can soar as they did since the Great Financial Crisis because the stock’s future earnings are worth more today than when interest rates are high. This is why the Nasdaq 100 ETF (QQQ), which is heavy with growth stocks, has suffered so much lately. During this seven-week period, QQQ lost more than 20%.

A similar principle holds true the longer dated the bond instrument is. When inflation is high and interest rates are rising, longer-term bonds suffer more than shorter-term bonds do. By contrast, stocks with lower valuations and ones that pay dividends suffer less because, in effect, these are shorter-dated instruments. Investors can receive the benefits of their investments sooner. For example, the First Trust Dividend Leaders ETF (FDL) was nearly flat during this 7-week period.

But passively buying and holding stocks and bonds is not the only way to go. Investors who diversify by style can avoid or minimize the slings and arrows of a buy-and-hold portfolio when inflation is high and interest rates are rising. Utilizing a momentum approach on assets, in addition to stocks and bonds, can help keep a portfolio strong in conditions like these because momentum does an excellent job of minimizing losses and portfolio drawdowns.

In that respect, the portfolios that Stillpoint manages performed much like the FDL ETF during this period—flat or nearly so after fees. Some of our strategies and portfolios actually gained during this time. Positions in commodities, gold, high dividend paying stocks, and short-dated fixed income made the difference.

This is important because minimizing portfolio drawdowns in times of market stress plays a crucial role in compounding gains over time. The bigger the portfolio drawdown, the harder it is to compound gains, and the harder it is for investors to reach their long-term goals. Of course, maintaining an investor’s peace of mind is crucial, too.

In 2018, I wrote this blogpost about how buy-and-hold investors could achieve better risk-adjusted returns by diversifying with momentum. I closed the blogpost with this sentence: “No one knows how passive investors will fare in the next decade, but incorporating a simple momentum strategy is one straightforward way they can manage the risk that the next decade will not be as kind as the current one.”

Since then, the case for diversifying with momentum has only grown stronger.

Stocks and Geopolitical Events

An old investment saw, from one of the Rothchilds (Nathan), has it that an investor should “[b]uy on the sound of cannons, sell on the sound of trumpets.”

There is truth to this maxim, which resembles, and inverts, a more commonly known one: “Buy on the rumor, sell on the news.”

Tom McClellan has researched the question and found that the lead in to war is generally bearish for stocks but that the period near the outbreak of war is bullish, consistent with the first part of Nathan Rothchild’s statement. “Actual wars are usually bullish. But the descent into war is bearish.”

A case in point is the selloff that occurred in the summer of 1990 in the weeks before Desert Storm.*

It’s tempting to believe that geopolitical conflict, like the one we are witnessing now between Russia and Ukraine, would be obviously bearish for stocks. But because the stock market is a forward-looking discounting mechanism, the outbreak actually reduces uncertainty and provides market participants with a better sense of where the economy is going and the earnings of individual companies. As a result, the effects of a full-scale Russian invasion are already priced in.

Barry Ritholtz has pointed this out more generally, charting the market’s reaction to numerous geopolitical conflicts over the decades.

Notice how the market tends to shrug off geopolitics for the most part. According to Ritholtz, “[m]ost of the time, markets are hardly affected by these sorts of terrible events. Even the US entry into World War 2 after the Pearl Harbor attack took a little more than one year to recover. The worst war in human history and markets were higher in 307 days (it did take 143 days to bottom).” Additionally, two of the bear markets during this 80-year time frame, from 2000-02 and 2008-09, occurred without major geopolitical events preceding them.

Ritholtz is further correct about the way our perspective can be distorted in emotionally charged times such as these, overweighting the the shock and horror of the moment and overlooking favorable long-term trends that continue on:

“The lesson here is to never bet against human ingenuity, creativity, or progress. In the face of horrific existential threats, while the headlines are terrible, gradual improvements are always taking place beneath the surface. Morgan Housel likes to say that ‘Progress happens too slowly for people to notice, while setbacks happen too fast for people to ignore.’”

Where does that leave stocks in 2022? We have already seen significant declines in stocks, especially in the tech/growth sector, at a level where the Nasdaq has rallied since the start of this long-running bull market. It doesn’t mean that stocks can’t go lower, and it doesn’t mean that stocks can’t chop sideways for months. But risk-reward metrics are looking better for stocks now than since last November.

On the other hand, wars are inherently inflationary, and the recent economic sanctions levied against Russia could easily create additional inflation, causing the Fed to tighten liquidity and risk a recession.

Real assets, like oil, gold, commodities, and real estate, continue to be favored over financial assets, like stocks and bonds. This is a key reason that the typical 60-40 portfolio of stocks and bonds has not fared well recently. To that end, Stillpoint clients have seen their portfolios diversify into real assets to be positioned for gains in these areas.

*Note that, as with 1990, 2022 is a mid-term election year. Mid-term election years frequently see large declines in stocks, but that stocks typically surge in the 12 months following the bottom that year, often after the elections occur and uncertainty declines, as in 1990.

Some Perils of Stock Picking

Despite that the COVID pandemic continues in yet new forms, it is beyond doubt that stocks around the world are in clear uptrends and have been since the March 2020 bottom.

One of the issues that arises when stocks are in strong bull markets like we have seen over the last 18 months is the apparent benefits of stock picking. While an index like the S&P500 has nearly doubled over this short period of time, individual stocks have gained far more, as the chart below indicates.

As a result, it’s tempting for many investors to seek out individual stocks and attempt to outperform the indexes. Strong recent performance in certain stocks even leads to stories in the media about the enormous rates of return that investors would have gained if they had simply held a particular stock, like Apple or Amazon, over very long periods of time.

The problem with an approach like this is that the odds are stacked heavily against the individual investor. As Meb Faber put it in his "Invest Like the House,” from 1983-2007, a very bullish time for stocks, nearly two-thirds of stocks underperformed the broad market index. Even worse, more than one-third of stocks did not earn a positive return at all, and one in five stocks lost at least 75% of its value. Only 25% of stocks were responsible for ALL of the market’s gains during this time frame.

Further, stocks that are the darlings of today, like Microsoft and Amazon, have experienced major declines over long periods of time. Microsoft and Amazon have each returned well over 1000% over the past ten years, but each stock has suffered from major declines that did not resolve until years later. Microsoft, for instance, lost 70% of its value during the entire 2000-2009 decade, and Amazon suffered a 94% decline during the years after the dot-com bubble of the 1990s had burst. It’s hard to imagine that “long-term investors” would be able to tolerate such impairment of their capital over such long periods of time.

This is one reason that to the extent investors want to own individual stocks for the long term, I tell them to “date,” not to “marry” stocks. Today’s winner may easily be tomorrow’s loser, and investors can often conduct their buying and selling at the worst possible time, buying at the top and selling at the bottom.

It’s not that an approach like this cannot succeed. It’s just that the odds are not in favor of the individual investor, and there are clear alternatives that put the odds more in the investor’s favor. One such option is simply to buy a low-cost index ETF or mutual fund. That way, the investor can be assured not to underperform the market by picking the wrong stocks. Individual stocks can go to zero, but not indexes of stocks. This is an approach that has succeeded strongly since the Great Financial Crisis ended in March of 2009.

Another possibility is to buy individual stocks but to protect against a severe decline. One way to do this is to enter a trailing stop-loss order on the stock after it is purchased to avoid a pre-determined amount of decline. A common way to do this is to put a 25% trailing stop order in place. With such an approach, the sell order price increases as the share price increases, minimizing potential loss protecting gain. Even if the stock takes an immediate dive, the worst loss the investor would suffer is a 25% loss. If the size of the position is managed so that a 25% loss in the stock amounts only to a loss of 1-2% of the portfolio, the stock’s dive will not hurt the overall portfolio very much.

Of course, it is also worth pointing out that buying index ETFs and mutual funds carry with them their own risks. After all, stocks declined over 50% during the 2008-2009 Great Financial Crisis and further declined by a similar amount over a three-year period from 2000-2003. These bear markets devastated many portfolios, delaying retirement for many workers and forcing many recent retirees back to work.

But there is a way to avoid losses from investing in index ETFs and funds. The answer is momentum. Momentum holds the index fund when the prices are on the rise and sells it after the prices have begun to fall, avoiding severe losses and gaining ground when stocks are in uptrends.

Momentum can succeed with individual stocks, too, but the odds are better with index ETFs and mutual funds, as Gary Antonacci has shown in his “Dual Momentum” book, which is among my five favorite books on trading and investing.

A few simple, yet effective methods like these can make a world of difference for investors.

"It's a bull market, you know."

In early June of last year, Stillpoint posted a blog entry here to the effect that a new bull market had begun in stocks. The basis for this claim was that the S&P500 index had moved above its 200-day moving average and had refused to move below it. Nothing has occurred since then to contradict this assessment. Indeed, since that blogpost was published, the total return of the S&P500 index fund (SPY) is up over 30%.

In this respect, the equity markets have illustrated a timeless principle of market speculation, one immortalized in Edwin Lefevre’s Reminiscences of a Stock Operator. Aside from this principle, investors should know that this book is essential reading for any serious market participants. Additionally, it’s one of the finest memoirs I have ever read of any kind.

Reminiscences of a Stock Operator depicts the career of Jesse Livermore, a colorful and successful American trader in the early twentieth century. The principle the book illustrates in this context derives from a conversation Livermore overhears between two other traders, Elmer Harwood and a Mr. Patridge, also known as “Old Turkey.” Here is the conversation:

Elmer: “Mr. Partridge, I have just sold my Climax Motors. My people say the market is entitled to a reaction and that I’ll be able to buy it back cheaper. So you’d better do likewise. That is, if you’ve still got yours.”

Turkey: “Yes, Mr. Harwood, I still have it. Of course!”

Elmer: “Well, now is the time to take your profit and get in again on the next dip,” said Elmer, “I have just sold every share I owned!”

Turkey: “No! No! I can’t do that!”

Elmer: “Didn’t I give you the tip to buy it?”

Turkey: “You did, Mr. Harwood, and I am very grateful to you.

Elmer: And didn’t that stock go up seven points in ten days? Didn’t it?”

Turkey: “It did, and I am much obliged to you, my dear boy. But I couldn’t think of selling that stock.”

Elmer: “Why not?”

Turkey: “Why, this is a bull market!” (The old fellow said it as though he had given a detailed explanation.)

Elmer: “I know this is a bull market as well as you do. But you’d better slip them that stock of yours and buy it back on the reaction. You might as well reduce the cost to yourself.”

Turkey: “My dear boy, if I sold that stock now I’d lose my position; and then where would I be? And when you are as old as I am and you’ve been through as many booms and panics as I have, you’ll know that to lose your position is something nobody can afford; not even John D. Rockefeller. I hope the stock reacts and that you will be able to repurchase your line at a substantial concession, sir. But I myself can only trade in accordance with the experience of many years. I paid a high price for it and I don’t feel like throwing away a second tuition fee. But I am as much obliged to you as if I had the money in the bank. It’s a bull market, you know.”

What Livermore gleans from this conversation is essential information to any investor. Its essence is that once a trend has asserted itself, in this case a bull trend, the investor is better off riding it instead of selling when prices seem to be overextended and buying it back cheaper. For longer-term investors, which is what most of us are, the message is not to miss the big picture, the overall trend, and try to maneuver around market noise.

As Livermore put it,

“Nobody can catch all the fluctuations. In a bull market your game is to buy and hold until you believe that the bull market is near its end. To do this you must study general conditions and not tips or special factors affecting individual stocks. Then get out of all your stocks; get out for keeps! You have to use your brains and your vision to do this; otherwise my advice would be as idiotic as to tell you to buy cheap and sell dear. One of the most helpful things that anybody can learn is to give up trying to catch the last eighth-or the first. These two are the most expensive eighths in the world.”

Notably, market participants were skittish a year after the beginning of the last bull market in March 2009, worrying that the bull market would end, and a nasty bear market would return, as it had in 2008. But that isn’t the way the business cycle usually works. Bull markets typically last for years, while bear markets are much more short-lived. It’s not that bear markets should not be feared—obviously Livermore did not feel that way—but that it pays to know the general trend of the market, regardless of what may be occurring in individual stocks on a short time frame.

By now, almost no one would doubt that the new bull market that started in March 2009 continued one year later and beyond. Many agree that the same bull market did not end until last year’s short bear market in February and March 2020. As it turns out, Ryan Detrick of LPL Research has shown that the inception of the new bull market in March 2020 looks remarkably similar in performance to that of the bull market that started in March 2009.

It’s not that there won’t be dips and corrections during a bull market because there always are. Instead, the crucial investing principle is to know that it pays more to ride a bull trend that it does to trade around market fluctuations.

At some point in the future, stocks may dip below their 200-day moving average, and they may stay there, refusing to reassert the bull trend. At that point, the bull market will be over, and it will make sense “to get out for keeps,” as Livermore put it. But that time is not now.