Another Step Forward

Along with a lot of volatility and drama, 2010 brought us another positive year in the market. After selling off during February, the market surprised most investors and reversed and rallied hard through mid April. At this point investors moved from fear to greed with most becoming very optimistic. 

Their optimism was dashed by five months of back and forth volatility. European markets were in turmoil with Portugal, Ireland, Greece and Spain leading the way down. In May, the Dow Industrials suffered its biggest one-day point drop ever. The "flash crash" brought a high level of fear and uncertainty back into the market.   

Many forecasters talked about another recession. They were convinced that the dreaded "double dip" was just around the corner and would be the next shoe to drop. The daytime talk shows recommended that everyone run for the hills. As a result, the markets spent the next five months in turmoil, seesawing back and forth with swings of at least four percent up or down each month.

With the financial meltdown of 2008 fresh in their minds, investors mistakenly looked in the rear view mirror and assumed the worst. They withdrew about $80 Billion from domestic growth funds and put $250 Billion into bonds. 

About the time many investors gave up on stocks and sold out their positions, stocks spent the last three months of the year in rally mode. It was the strongest December in 20 years. In total the market increased 20 percent off of the July lows. Bonds, now that everyone wanted them, spent the last quarter going down in value.

The government intervention trend continued forward in 2010. European governments moved to bail out and stabilize Portugal, Ireland, Spain and Greece. Bernanke and the Fed moved to buy $600 Billion worth of treasuries to keep interest rates low in the U.S. , which in turn props up stocks and bonds. The Bush tax cuts were extended for two more years. Each of these actions contributed to the second half rally.

Our Portfolio Performance

Our conservative portfolio, Managed Income, performed relatively well all things considered. It delivered, net of fees, a return of 6.39 percent for the year. Coincidentally, its compound annual return since its inception in 2001 is also 6.39 percent. Our target for Managed Income is 6 percent plus, and it fell right in that range.

Managed Income was difficult to manage this year because our research showed that there was a high likelihood that interest rates would increase. That forced us to avoid asset classes that get hurt when interest rates go up. For example, we could not hold many of the bond classes that we usually hold in order to generate yield. In order to maintain the safety of Managed Income, the asset classes we could work with also limited us. It was similar to playing a piano with one arm tied behind our backs.

Considering the constraints we were working with, our Managed Income portfolio had good performance in 2010.

Our growth portfolio, Top Flight, performed well in absolute terms, but just all right in comparative terms. It delivered 9.39 percent, net of fees, for the year. In other words, most investors are happy with an absolute return of 9 percent plus. However, the benchmark that we attempt to beat each year is the S&P 500. In 2010 we underperformed that benchmark.

It is important to put this year in context to understand what happened. Over the long-term, Top Flight portfolio has beaten the S&P 500 benchmark soundly. The Top Flight portfolio is up 403 percent, net of fees, versus 63 percent for the S&P 500, over the past 13 years.

Our long-term track record is made up of a lot of shorter-term periods. Including this year, we have only underperformed the S&P 500 four times during the past 13 years, or 31 percent of the time.  While underperformance in the short-term is not what we seek, this short-term lag has been overcome significantly over the long-term.

To break it down even further, our Top Flight Portfolio has outperformed the S&P 500 in three of the past four years. Also, it has beaten the S&P 500 over the past three, five, seven and 10 years. It has also beaten it since its inception in 1998.

Buy and Hold vs. Active Management

So which strategy worked best this year? Unlike most years, the Buy and Hold Strategy outperformed most active strategies in 2010.

Let me explain why this happened. The "Active Management" versus "Buy and hold" argument has gone on for years within the investment industry. Some managers will argue their side with almost a religious zeal. For the record, we firmly support Active Management. 

This year the Buy and Hold Strategy won the competition. Why? Buy and Hold is pretty simple. A position is taken and held onto. It doesn’t matter if the market is going up or down, the position is still held onto. In some cases it is virtually held onto for dear life. 

When your investment is going down, you hope it will reverse and go back up. Sometimes it does go back up and other times it keeps tanking. This year investors who followed the Buy and Hold Strategy were rewarded by just shutting their eyes and hoping. Over the past 10 years, investors who followed a Buy and Hold Strategy of holding indexes, have received almost nothing for their efforts (except maybe a lot of stress).

Active management strategies are much more complicated. What hurt active strategies this year was all of the back and forth market action. There were five months in a row where the market reversed direction four percent or more. 

With an Active Management Strategy, when the market starts down, we are forced to reduce exposure in order to protect our portfolios from the potential downside. When the market reverses, we are forced to add exposure to capitalize on a potential move to the upside. Each time this occurs we potentially incur a small loss. Underperformance in January and July affected our performance the most.

Essentially this small loss is the price that we pay to protect ourselves if the market continues into freefall. This year had several scary moments that may have continued down if not for government intervention.

In summary, active management works best when you have solid trends to work with. The trends can be either up or down, but they need to last more than a month. This was a year with a lot of nervousness and a lot of back and forth market action. This was the type of year where buy and hold usually comes out on top.

Going Forward

We are relatively optimistic about 2011.  As I've mentioned before, historically the third year of a presidential term is positive for the markets. The incumbent wants to get re-elected so they usually pull out all the stops in order to make the economy look good. If the economy looks good, then they look good. If they look good then they get re-elected. This is politics 101.

That is why the previously demonized Bush tax cuts were so easily passed by a left leaning administration at the end of the year. They want to do all they can to stimulate the economy for the next election.

Stock valuations are better now than they were at the beginning of last year, which is positive. This is a result of extraordinary corporate profits this year.

The only negative I see is in the short-term. Right now, too many people think the market is going up. I don't like to see market sentiment this positive. Ideally, we would see the market sell off early in the year. That would bring optimistic sentiment back down to more desirable levels and potentially set up a good first half for 2011.   

We wish you the best in the upcoming New Year. Feel free to contact us if you have any questions or concerns.