January 8, 2007
With 2006 now ended and 2007 before us, I thought it would be a good time to review the annual and long-term performance of the Strategic Growth Fund. Though our annual and semi-annual reports always contain full financials, investment positions and a detailed letter to shareholders, a more immediate, though informal, analysis might be useful as well.
As of December 31, 2006, the Strategic Growth Fund achieved annual total returns of 3.51% (1 year), 4.79% (3 year), 9.70% (5 year) and 12.38% (since inception). An initial $10,000 investment in the Fund at its inception of July 24, 2000 would have grown to $21,206. This compares with a value of $10,783 for an equivalent investment in the S&P 500, and $16,638 for an equivalent investment in the Russell 2000.
The performance of the Fund is driven by two factors. First, the Fund invests in a broadly diversified portfolio of stocks at all times. Of course, those stocks are sensitive to fluctuations in the general market. So in addition, the Fund periodically hedges its exposure to those market fluctuations, based primarily on the status of valuations and market action (price behavior, trading volume, breadth, industry action, and other asset types such as bonds, commodities, and so forth).
Importantly, the intent of the Fund's investment approach is to achieve strong investment performance as measured over the full market cycle (bull and bear markets combined), with smaller periodic losses than experienced by a buy-and-hold strategy in the major indices (primarily the S&P 500). We emphasize long-term, full-cycle returns and managed risk, with a very open lack of emphasis on tracking shorter-term market fluctuations. In richly valued markets - particularly when short-term price action is overbought and the broad consensus of sentiment is overly bullish - the Fund will tend to hedge against market fluctuations.
With regard to stock selection, the chart below presents the performance of the stocks (including small day-to-day money market balances) held in the Strategic Growth Fund, after fees, but excluding the impact of hedging transactions.
On a stock selection basis, the Fund's holdings have strongly outperformed the S&P 500 (as well as the Dow Industrials, Russell 2000, and Nasdaq) since its inception in 2000. On balance, this performance has been largely as intended, and in the context of long-term historical tests and experience, has been neither extraordinary nor disappointing overall.
Clearly, I have no intention of readily abandoning the value-conscious stock selection approach that produced these results. What might be surprising is that the stock selection performance depicted above was my primary source of disappointment last year, and largely explains the tepid returns achieved by the Strategic Growth Fund in 2006.
To see this, the chart below presents the ratio of the performances depicted in the foregoing chart. A rising line indicates that the stocks held in the Strategic Growth Fund are outperforming the S&P 500. A falling line indicates that our stocks are lagging, at least temporarily.
Note that after hitting a fresh high in early May of 2006, the performance of our stocks - relative to the S&P 500 - trailed off modestly. During the final 8 months of the year, the stocks held by the Fund achieved a total return, after fees, of 5.18%, while the S&P 500 achieved a total return of 9.65%.
I've detailed the reasons for this gap in prior comments - essentially, we've observed an increasingly selective "garbage-stock" rally, where a declining number of individual stocks are outperforming the S&P 500, and those outperformers have increasingly featured poor financial quality (on the basis of S&P's quality ratings). These are generally not stocks that I view as appropriate investments, and over the long-term, for good reason.
Now, a modest, brief period of lagging performance is nothing particularly unusual from a long-term perspective, but unfortunately, this event occurred precisely at a point when the Fund was hedged due to a combination of overvalued, overbought, overbullish investment conditions. To understand the effect of this modest shortfall in stock selection performance over the past 8 months, recall that when the Fund is hedged against the impact of market fluctuations (and provided that our long-put/short-call index option combinations have identical strike prices and expirations), its returns are roughly equal to:
the difference in performance between the stocks owned by the Fund and the indices we use to hedge;
plus the implied interest earned on those hedges (usually somewhere near short-term Treasury bill yields).
Notice in the last bit of this chart how that small - and historically insignificant - period of slightly lagging stock performance has impacted Fund returns since May.
Suffice it to say that had our stock holdings performed in line with the S&P 500 over the past 8 months (which, again, they did not), the Fund would have achieved a 2006 return of about 7.98%. In my view, such a return would have been both satisfactory and reasonable, given the very low volatility and risk profile of the Fund during the year just ended. In any event, I certainly have no reason to believe that the flat performance that we've experienced recently is anything more than a temporary feature of a market transfixed on garbage stocks.
Given any particular set of market conditions, we establish our exposure to general market fluctuations based on the average historical return/risk profile those conditions have produced. I explicitly do not attempt to "time" or "catch" or "call" the direction of the market in any particular instance, but instead align our exposure to market fluctuations with what can be expected on average. The performance of the market in any particular instance is rarely identical to that average. In 2006, the difference was wider than usual.
Still, given the market's rich valuation, one would have expected in advance that the Fund would be largely hedged, and to that extent, the Fund's hedging approach performed in 2006 basically as expected - it muted the impact of market fluctuations on the Fund, and contributed several percent in "implied" interest.
Certainly, it is a constant effort here to better classify and characterize market conditions in a way that captures more periods of positive market returns without substantially increasing our vulnerability to negative ones. Yet despite extensive and ongoing research and historical testing, I still have not identified considerations that would have allowed us to substantially increase our exposure to market fluctuations last year, without also resulting in a large increase in historical losses, and generally a deterioration in overall long-term performance. It's oddly reassuring that our existing approach is so difficult to improve, but I also believe that improvement is always possible.
In statistical terms, we can reduce our "Type II errors" (being hedged in a rising market) only by increasing our "Type I errors" (being exposed to market risk in a falling market). Indeed, it would be possible to cut our Type II errors by half, if we were willing to double our Type I errors. Trivially, a strategy of never hedging would completely eliminate our Type II errors - we would always track market advances, but only at the cost of quadrupling the depth of our worst losses. Yet even while there is a tradeoff to alternative hedging strategies from the standpoint of these types of risk, it isn't difficult to choose between them: altering our current approach to increase exposure to rising markets (at the cost of accepting greater periodic losses) typically results in a lower long-term return.
With regard to the current market cycle, the period since 2000 has been unique in that it has reflected an environment of persistently rich valuations. Not only did the 2000-2002 bear market begin at the highest valuations on record, the recent bull market also began at the highest valuation recorded at the start of such a run. Even so, we lifted about 70% of our hedges in early 2003, so it should not be assumed that we require historically normal valuations in order to accept market risk.
Since the inception of the Fund (as well, of course, in long-term historical tests), our present approach to risk management has both added to returns and reduced volatility - not necessarily in any short period, but over the complete market cycle. Given that the period from the Fund's inception to the present represents the traversal from one bull market peak to the next, including an intervening bear market, this full period is the most appropriate horizon over which to evaluate the Fund's investment strategy.
In the end, of course, it is my responsibility to manage the Fund in a way that not only adheres to its investment discipline, but also achieves its investment objectives. From the standpoint of the most recent peak-to peak market cycle (i.e. from the 2000 bull market peak to the present), the Strategic Growth Fund has strongly outperformed the major indices with substantially less risk. My own evaluation of this is reflected in the fact that the majority of my personal assets are invested in the Strategic Growth Fund (nearly all the remainder, outside of a small amount in money market funds, is in the Strategic Total Return Fund).
True, the Strategic Growth Fund has not outperformed the market over the past few years, which is a modest disappointment. But this is also an incomplete trough-to-peak measurement period. I remain certain of this: we will eventually look back on this cycle from trough-to-trough - and it is over that period that the decisions I take today will eventually be weighed. It is easy for investors lose a long-term perspective when they look only at a portion the market cycle. My responsibility is not to lose that perspective.
As of last week, the Market Climate in stocks was characterized by unfavorable valuations, moderately favorable price action, but still overbought and overbullish features, which taken together have historically been associated with market returns below Treasury bill yields. Still, I did increase the Fund's call option purchases near the end of the week, and expect to add to that position toward 2% of assets if the market clears its overbought condition by a decline of a few percent further (provided that we don't also observe a substantial deterioration of internal market action).
This course of action is reasonably forecast-free: if the market advances, our current position in call options is sufficient to gradually mute more than half of our hedges. In the event of a sustained decline, the call options will lose their value, which will place the Fund again in a fully hedged position. A narrow sideways trading range will induce a certain amount of time-decay, but this would be modest because option premiums and implied volatilities remain low.
In bonds, the Market Climate continues to reflect unfavorable valuations and modestly favorable market action. Wage inflation is now becoming persistent. Average hourly earnings have grown at 4.22% over the past year, and even taking productivity into account, unit labor costs have grown at 2.85%. While the job growth figures came in moderately stronger than anticipated, these figures have also been subject to so many revisions that it is difficult to draw much from them.
The broad evidence on price pressures, meanwhile, indicates enough firming to keep the Fed on hold (which matters, in my view, primarily because investors believe it does). Yet even if the FOMC was to cut the Fed Funds rate in a few months, it would take 3 cuts simply to bring Fed Funds under the 10-year Treasury yield, and more than 8 cuts to truly normalize the yield curve, even leaving 10-year yields alone. Barring a deflationary scenario, which would most likely be preceded by a substantial widening of credit spreads, it's difficult to see how long-term bond yields stand to decline substantially lower even if the economy softens.
With the prevailing Market Climate holding the Strategic Total Return Fund to a duration of less than 2 years, the primary source of fluctuation in the Fund remains its position in precious metals shares, at about 20% of assets. The U.S. dollar has cleared the oversold condition that developed in early December, helped by relatively small indications of economic strength. Overall, however, the bulk of the evidence continues to suggest tepid economic growth with moderate but persistent inflation pressures, and the Market Climate for precious metals remains favorable on our measures.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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