Play The Percentages

8/13/2012


What do you want from your investment newsletter?

If you want pinpoint forecasts and price targets, all-or-nothing timing bets, and one-stock portfolios that "can't lose," you should be careful what you wish for. Few things are more dangerous than an overconfident expert.

You should also realize you're reading the wrong newsletter. Dow Theory Forecasts' consistently strong returns reflect a healthy respect for the unknown. We realize nobody is right every time, so we spread our bets and play the percentages. We curb risk by focusing on reasonably valued shares of high-quality companies, using our Quadrix® rating system to limit our selection pool to stocks with superior fundamentals. And we listen to the market, reducing our risk tolerance when the primary trend seems bearish according to the Dow Theory.

Our results suggest our approach has merit, especially since the introduction of Quadrix in 2000. Consider the following, all according to the independent Hulbert Financial Digest:

Dow Theory Forecasts ranks among a select group of newsletters that outperformed the S&P 500 Index for the five, 10, and 15 years ended June 30. Yet our returns were less volatile than the market, so we also outperformed on a risk-adjusted basis.

• The Focus List, representing our top picks for year-ahead returns, outperformed for the five, 10, and 15 years ended June. The Focus List also outperformed for the six months ended June — and since Hulbert began tracking it at year-end 1995.

• Each of the five portfolios tracked by Hulbert — our Focus List, Buy List, Long-Term Buy List, and two fund portfolios — outperformed the S&P 500 Index for the five, 10, and 15 years ended June.

YEARLY TOTAL RETURNS
Year
Dow Theory
Forecasts
(%)
S&P 500
Index
(%)
Relative
Performance
(%)
2012 *
8.5
9.5
(1.0)
2011
(2.4)
2.1
(4.5)
2010
14.1
15.1
(1.0)
2009
29.8
26.5
3.3
2008
(35.1)
(37.0)
1.9
2007
14.3
5.5
8.8
2006
13.6
15.8
(2.2)
2005
9.0
4.9
4.1
2004
14.7
10.9
3.8
2003
31.2
28.7
2.5
2002
(17.3)
(22.1)
4.8
2001
(8.5)
(11.9)
3.4
2000
1.1
(9.1)
10.2
* Through June 30.      Sources: Hulbert Financial Digest, Standard & Poor's.

 

Probabilistic approach

Our market-timing advice has helped reduce portfolio volatility. But we're not all-or-nothing timers, and we don't jump in and out of the market based on short-term trends or recent headlines. We take a gradualist and probabilistic approach, setting our stock-market exposure based on the market's primary trend and the opportunities available in individual stocks.

The last important signal under the Dow Theory was this year's move to new highs in the Dow Industrials and Dow Transports. But the Transports have not reached new highs since early February, and this lack of confirmation is one reason we are holding about 10% to 15% of equity portfolios in Vanguard Short-Term Investment-Grade ($10.80; VFSTX), a relatively low-risk bond fund with a yield near 1.4%.

A 10% to 15% position in short-term bonds won't provide much protection in an outright bear market. But this partial hedge will help limit volatility in a choppy market, and it will provide ammunition to take advantage of buying opportunities in individual stocks.

With a close above this year's highs of 13,279.32 in the Industrials and 5,368.93 in the Transports, the bullish primary trend would be reconfirmed — and we would be inclined to get more money into stocks. With a breakdown below the respective June lows of 12,101.46 and 4,847.73, we'd view the primary trend as bearish — and we would immediately reduce the stock-market exposure of our buy lists to 75%.

The Dow Industrials are less than 1% from 13,279.32, and many are likely to see a move above that level as an all-clear signal for stocks. But an unconfirmed move to a new high (or new low) in one average will not change the status of the Dow Theory. Both the Industrials and Transports must confirm for a rally to have significance under the Dow Theory.

A slowdown in corporate earnings growth has made it more difficult to find attractively valued growers. But the median stock in the S&P 500 Index trades at a 14% discount to the 20-year norm based on trailing price/earnings ratio, and we are still finding high-quality stocks with modest valuations and solid profit-growth prospects. Especially attractive names include Express Scripts ($61; ESRX) and Google ($641; GOOG).


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