What happens to us in a bear market?
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The Goldilocks Investing NewsletterNo. 4Feb. 10, 2016
An update on the Mama Bear Portfolio

Welcome to our occasional newsletter! Today's issue is designed for people who attended a recent beta-test Goldilocks Investing seminar in Boston or Seattle.

Please do not forward this newsletter to others. Our book on investing is in stealth mode, and people who did not attend a seminar would be baffled by the following discussion. Please do not share this information until the book is released in late 2016.

Reminder: Our Web site updates the Mama Bear's recommended exchange-traded funds on the following page every 10 minutes while the market is open:

Mama Bear Portfolio statistics page

What happens to us in a bear market?

Brian LivingstonBy Brian Livingston

Investors are having a tough year. Small-cap stocks are officially in a bear market, as measured by the Russell 2000 index (IWM). It's down 25% since June 23, including dividends.

The S&P 500 (VOO) isn't technically in bear-market territory yet, since it's down "only" 11.6% from last year's peak. But with collapsing oil prices, China's slower growth, and war in the Middle East, it sure feels like the index could fall much farther.

Even when the broad indexes were up, trouble was just beneath the surface. The Nasdaq index appeared to buck the year's losing trend, finishing 2015 up 5.9%. But if you excluded just four so-called FANG stocks — Facebook, Amazon, Netflix, and Google — the index would actually have been down, according to a CNBC article.

That's what analysts call "a lack of breadth." A few major stocks push an index up, but most companies are falling in price. This situation is typical at the beginning of a bear market.
The Mama Bear started tilting toward bonds in mid-2015

There's good news and bad news for followers of the Mama Bear Portfolio. The good news is that the strategy's asset-rotation rules detected the weakness of equities and has been moving into the safety of bond funds since the end of August.

Figure 1 shows that the bond-friendly portfolio kept us from experiencing the gut-wrenching losses that the S&P 500 has subjected investors to since New Year's Day. Through Feb. 8, our real-money tracking portfolio has held most of its value, being down only 1.35% including all transaction costs and fund fees. By contrast, the S&P 500 collapsed more than 9% in just 26 trading days.

Mama Bear Portfolio since Jan. 1, 2016
Figure 1. The Mama Bear Portfolio started rotating into more bonds and fewer equities when stocks lost momentum in mid-2015. Source: FolioInvesting.com.
Post-seminar performance is like the S&P 500 itself so far

As you may know, I presented a test seminar on Nov. 20, 2014, to the AAII Boston chapter. A packed room of 200 people received complete details on how to determine which exchange-traded funds (ETFs) were called for by the Mama Bear formula. These attendees, and a smaller test group in Seattle, were given the tools to reallocate a real-money portfolio on any day of the month they chose.

As I said at the time, periods of 1, 3, and 5 years are too short to judge any investment strategy. But it's fair to ask how an attendee would have done if he or she had put money into the Mama Bear the day after my seminar.

Figure 2 (recorded by FolioInvesting.com) shows that the real-money portfolio:

1. Outperformed the S&P 500 from November 2014 through April 2015;

2. Fell during the China yuan devaluation crisis of August 2015 along with the overall market; and

3. Rotated largely into bonds, keeping us out of the "sucker's rally" in November and winding up at the same level as the index.

A person who invested on Nov. 21, 2014, is now down 8% (the blue circle). That's almost exactly the same performance as the S&P 500. If the index continues declining and is declared a bear market, the Mama Bear will presumably stay mostly in bonds. This would preserve our savings and add some yield this year.

Mama Bear Portfolio Nov. 2014 through Feb. 2016
Figure 2. The Mama Bear and the S&P 500 have almost exactly the same performance since the portfolio was revealed. Source: FolioInvesting.com.

The bad news is that anyone who started investing in February, March, or April of 2015 is now down about 5 or 6 percentage points more than those who started on the day after the seminar.

I've repeatedly said that a portfolio such as this can go down 25% at any time. The Mama Bear is designed to keep losses smaller than that, even during crashes, but bear markets are never fun.

Fortunately, even people who started at an unlucky time are nowhere near a 25% pullback. The question is when the portfolio will recover and reward us in the long run.
New 43-year simulations show how momentum helps

A constant challenge is whether we want to be speculators, reacting to today's events, or long-term investors. My forthcoming book, which is now scheduled for fall 2016, will illustrate why informed investors measure investing strategies solely over complete bear-bull market cycles — the only time period that really matters.

I've been using a new backtester that's been updated with fresh data through Dec. 31, 2015, by Mebane Faber (co-author of The Ivy Portfolio). The revised tool will be made available later this year to paying subscribers of his Idea Farm newsletter.

Figure 3 shows a 43-year simulation for the Mama Bear. In this chart, I've adjusted the figures for dividends and inflation, but that's not all. I've also subtracted realistic transaction costs and fees, based on the actual ETFs that the Mama Bear uses.

During previous bear markets, the Mama Bear suffered only small drawdowns and even a few remarkable gains. The overall performance is the kind of return that individual investors have long sought. However, participants must have the discipline to ignore incomplete rating periods like 1, 3, and 5 years.

S&P 500 vs. Mama Bear 1973-2015
Figure 3. Rotating each month into the 3 best-performing assets — out of a menu of 9 index ETFs — is the most reliable way to outperform over complete bear-bull market cycles. In the chart, the bear-market returns are emphasized with large numerals, since the performance during crashes powers the long-term results. Simulation by The Idea Farm backtester.

Of course, a simulation is not a guarantee, it's just a model. I've tried to make the simulation as realistic as possible by subtracting realistic market friction, as follows:

The chart is a projection, not the historical performance of any actual portfolio. Because of huge commission costs, it would have been very unprofitable to follow an asset-rotation strategy in the 1970s, 1980s, and 1990s. Today's micro-commissions and a complete set of low-cost ETFs didn't exist until well into the 21st century. We don't really care what the costs were 43 years ago, we care what might happen to our savings in the next 43 years, taking advantage of today's bargain-rate fees.

The average one-way bid-ask spread of the Mama Bear ETFs today is under 0.025%. In Figure 3, this 0.025% number is doubled to include today's low commissions, and then doubled again to arrive at a round-trip transaction cost of 0.1% for the Mama Bear. The S&P 500, by contrast, is not charged any transaction costs. Details on the low trading costs of today's major ETFs will be in my book.

The average annual fee of the ETFs used by the Mama Bear is 0.198%. This haircut was subtracted from the Mama Bear's performance in the chart. The S&P 500 was charged only 0.05%, which is the annual fee for holding Vanguard's VOO index ETF. Most academic studies blithely ignore dividends, inflation, trading costs, and fees, but these are accounted for in Figure 3 and the book's graphs. After-tax returns will also be shown in the book, in case you keep your savings in a taxable account.

The Mama Bear outperformed the S&P 500 in 8 of the last 9 primary cycles. A primary cycle is a bear market followed by a bull market, or vice versa. There have been nine overlapping primary cycles since 1972. If you have the discipline to ignore shorter periods, the Mama Bear formula is the closest thing to reliable growth that you get in investing.

Figure 4 shows the returns for each rolling primary cycle. The winner is in green, the loser in red. It doesn't matter whether you start with a bear market or a bull market. The relative strength of an asset-rotation plan shines through, if you stay the course for one complete cycle.

S&P 500 vs. Mama Bear in primary cycles
Figure 4. The Mama Bear formula surpassed the S&P 500 in every primary cycle except one, and quickly recovered even from that. Simulation by The Idea Farm backtester.

The only case of underperformance was the 1987–2000 cycle. The 1999 dot-com bubble, powered by "Internet story stocks," soared more than any diversified portfolio could match. Even then, if you continued to follow the formula through 2002, the Mama Bear pulled ahead yet again. The dot-coms crashed the market, but your portfolio actually went up another 12% in those same two years.
What’s next? Other portfolios and the actual book

When I've finished the book's research and testing — about three months from now — I'll send you another occasional newsletter with the complete picture. This will include three related strategies for people who have different goals:

The Papa Bear Portfolio uses 13 global asset classes. Expanding on the Mama Bear's nine ETFs, the Papa Bear gives you more choices. This strategy tilts toward value stocks when they're in fashion and growth stocks when they're the rage. The extra asset classes enable even better performance than the Mama Bear.

The Baby Bear Portfolio is a starter plan. If you have less than $10,000 to invest, or you can't find the time to tune up a portfolio once a month, the Baby Bear is for you. You hold ETFs indexing nothing but 50% US stocks and 50% US bonds at all times, rebalancing back to the original percentages just once a year. It's not a Muscular Portfolio, but over complete primary cycles, the Baby Bear's stone-simple formula actually matches the performance of the S&P 500 with smaller crashes.

The End Game Portfolio is a wealth-preservation plan. If you've amassed all the money you'll ever need, you can protect it by holding just 20% in a Muscular Portfolio and 80% in defined-maturity bond ETFs. This is a true low-volatility strategy that produces predictable income.

A Muscular Portfolio is an investing strategy that's designed to never lose more than 25%, even during market crashes, resulting in great long-term performance. With today's tiny fees and a full collection of low-cost ETFs, it's now a piece of cake to construct portfolios like the Mama Bear and the Papa Bear.

If you've read this far, your reward is a new, one-page overview of my entire book. For a limited time, you can download it free of charge at:

Goldilocks Overview

If you missed any of our previous newsletters, links to them can now be found in the lower-right corner of our home page.

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