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December 2009 Update

December 8, 2009

By Tim Chapman

Internals Give a Different Look

I have been on the road for much of the last few months and even though I'm tired of airports, rental cars, and hotels, I do enjoy visiting with financial advisors and their clients. It is always fun to share the Stadion story and our long-term success in helping clients get a decent return over time without suffering debilitating losses brought on by bear markets.

Recently I've gotten a few questions about our participation, or more accurately, lack of participation in much of the 2009 rally that started in March. We have been in a defensive mode for much of the year and during those times when we have chosen to participate in equities we've had a few "whipsaw" trades where we get in but then have to get back out because our stop-loss measures are triggered. The net result is significant underperformance for 2009.

Underperforming isn't fun. After all, we like big returns as much as any equity manager does, but in 2009 underperformance doesn't bother me. Let me explain why.

It is important to understand that we are not trying to "beat the market" in the short-term and we fully expect to lag a little in strong up markets. However, this year the reason we've underperformed is because of our safety measures - the same safety measures that allowed us to avoid major losses in 2000-02 and again in 2008.

Since March, the stock market has been in a rip-roaring, headline making bull run. Prices have really soared in the short-term. But we are not seeing a whole lot of support for this price action. Let me give you an example of an "internal" look into the market using our advance/decline indicator.

Let me explain the significance of the advance/decline indicator. As the name suggests, this indicator is measuring how many stocks are going up in price everyday and how many are going down. As a general rule, strong robust bull markets have a majority of the stocks participating (advancing). When that is not the case and there are only a few stocks pushing prices higher, the market is not as healthy and risk levels are elevated.

2009 looks like 2007 in many ways so let's check out those charts first. In this chart (click to view chart), the top line is the S&P 500 and the bottom line is our advance/decline indicator.

It is easy to see that prices were going up but the internals were getting progressively weaker. We call that a negative divergence - prices going one way, internals going another - and eventually they must get back in sync. That can happen one of two ways: internals getting stronger or prices getting weaker. Our winning by not losing approach forces us to assume prices will get weaker and in that environment we tend to be very defensive. It doesn't mean we cannot be invested at all, but when we are invested we make sure to use close sell criteria measures to move to safety if prices turn down. That is why we were so prepared to move to cash in the 4th quarter of 2007 and pretty much stayed in cash during 2008. As a result, while the market dropped more than 50% peak to trough, we added significant protection to our client accounts.

So now let's look at 2009. The similarities are clear. This chart (click to view chart) is the NASDAQ instead of the S&P 500 but the advance/decline concept is the same.

As you can see, the rally off the March low was pretty dramatic with price (external) and the advance/decline indicator (internal) improving significantly. But since that time we've been in a long period of divergence. Look at the price appreciation from early May (first arrow) to the first of December (second arrow) and then look at the deterioration in the market internals over that same period. Even though prices are much higher than they were in May, there is no way this market is as healthy today as it was months ago.

So, the reason we've been so defensive most of the year is quite simple. We follow the rules of our trading model. When it comes to investing, there's no such thing as perfection. We know there will be times like 2009 when we have more whipsaw trades than usual, or times when we underperform in the short-term. But we think that trade-off is worth it if our clients get nice long-term results without suffering the losses that are inevitable with a bear market.

One closing thought. While everyone gushes over the last few months, consider this: The S&P 500 has to go up another 41% from current levels to get back to where it was in October 2007! Doesn't it make sense to not lose all that money in the first place so it's not always a fight to just break even? We think so. That's why at Stadion we will always keep the proper balance between safety and return, even when it causes us to miss out on some short-term rallies. We will trade short-term frustration for our long-term success any day!