As with many technological advancements, it often takes time before the price point makes economic sense for the masses.  And so goes the case for installing a solar system to generate your home’s electricity, while actually saving money in the process.

The cost of panels has come down significantly due to a combination of increased efficiency in photovoltaic panels, and higher manufacturing production volume.

Pair that with the various local, state, and federal tax incentives presently in place and a financially compelling picture starts to develop.

The other change in the financial equation was the introduction of leases for solar systems, which effectively eliminated the need for a large up-front cash outlay and a potentially long pay-back period.

As with any major financial decision, it’s important to evaluate it thoroughly to understand the pros and cons as well as risks and rewards.  And of course living in a sunny climate makes a huge difference!

So, how do you determine if going solar makes financial sense?

Evaluate Your Usage & Costs

1.  Go online or to your filing cabinet and pull your electrical bills from the past 2 years or more

2.  Create a spreadsheet with usage (kWh) and cost by month (click here for a free downloadable spreadsheet).

3.  Calculate your average monthly usage (kWh) and costs as well as your annual usage and cost.

Armed with this information, you can begin the process of evaluating various solar options and configurations to determine if there are financial benefits.

Different Financing Options

There are two main ways of installing a solar system on your home, 1) buying it outright, or 2) entering into a lease.  Both have pros and cons, and depending on the various costs and details, one option may make more sense for you based on your situation than the other.

There are a large number of providers and installers to choose from in the market these days, and they each have different terms and pricing, but below are some guidelines that we’ve found to be fairly consistent across providers:

A Quick Case Study

Our 2-year energy usage analysis revealed that we on average use 1,027 kWh per month (12,330 kWh/year), and that we pay an average of $131.77/mo for electricity (incl. recent local rate increase of 6%).

We evaluated two local providers and found the efficiency of their panels and their pricing options varied quite dramatically.  Based on the pros and cons, we opted for the lease since it required $0 down, and came with $400 in cash incentives.

We have a fixed lease cost of $97/mo plus a $7/mo connection fee to our local utility.  Our system is guaranteed to generate between 12,746 – 14,088 kWh of solar energy in Year 1, more than our average annual usage.

This guarantee drops by 0.5%/year, and if we don’t generate that amount, we will be paid the difference by our lease company.

We will “bank” extra electricity that we generate rather than getting paid wholesale rates for it, such that if our usage ever exceeds our production in a given month, we can draw from our bank.

Long story short, we have a guarantee that all our electricity will get generated by solar, we were paid $400 up front and put $0 down, and will save about $27/mo right out of the gate.

Over time, the monthly savings will grow as electricity costs increase while our lease cost stays fixed.

And, of course, we’re “off the grid”.

If you think you may benefit from going solar, drop us a note and we’ll be happy to help you with your evaluation and/or point you in the direction of some local providers.

Every situation and configuration is different, so the financial picture will vary from home to home.

After a lackluster 2011 in US equity markets, and a downright ugly year overseas, returns for equity investors returned to the upside in early 2012.

US equities enjoyed a steady upward advance during Q1/2012, with a few daily corrections along the way, as underinvested parties bought on minor dips to get back into the market.

Emerging Markets (EMs) also jumped off to a hot start in January and February, rebounding off of lows from 2011.

While they cooled off in March, EMs still slightly outperformed US equities for the quarter, and they remain highly attractive going forward.

Chart I: Q1/2012 Equity Returns

For more conservative investors, traditional fixed income was disappointing in early 2012, with US treasuries delivering a slightly negative return.

However, high-yield and floating rate corporate bonds continued to advance.  With interest rates at very low levels, and the economy exhibiting increasing strength, treasury rates seem to have nowhere to go but up.

This will continue to erode returns for traditional fixed income investors, as bonds tend to decline as interest rates rise, and their paltry yields will not make up the difference for capital losses.

The multi-decade bull market in fixed income may be nearing an end, and traditional investors, who believe this area to be “safe” and “attractive”, relying on past performance as their guide, will most likely be sorely disappointed in the decade ahead.

In other diversifying sectors, commodities increased modestly, with the exception of gold pulling back in March.

Real estate was also a slight gainer, once dividends were factored in, but these two sectors both trailed the impressive equity returns during Q1 on a relative basis.

Healthy Gains for Portfolios

Portfolio Review (Q1/2012)

Heading into Q1, our indicators suggested that US equity markets were fairly valued, with average returns expected going forward.  Overseas, we anticipated a rebound in Emerging Markets given their significant undervaluation and expected policy easing.  We remained bearish on European equities, given their ongoing debt crisis.

Outside of equities, we stayed overweight high-yield bonds, opened a new position with floating rate corporate bonds, and remained short US treasuries.  We also held commodity mining companies, and high dividend-producing real estate companies.

In our Diversifier asset classes, we continued to hold a number of alternative funds as a substitute for overvalued US Treasuries. We also maintained our short volatility position on expectations of calmer markets in Q1 relative to the high volatility in 2011.

Q: What worked?

The following investments contributed positively:

• US equities performed nicely, continuing their rapid ascent which began back in late 2011
• Emerging Markets equities outperformed US equities, albeit they gave up much of that relative return in late March.
• Our Active Timing Models delivered half of portfolio returns, specifically a short volatility position (ticker: XIV) which surged 88%.
• Alternative funds and specific fixed income sector picks outperformed the bond market.

Q: What didn’t work?

The following positions underperformed:

• Our commodities and currency choices delivered positive returns, but slightly less than equities.
• Outside of our Active Trading models, our alternative fund selections delivered positive returns, but were also slightly less than equities.

Net Results

All client portfolios had strong net returns for the quarter. Active clients (greater than $150K in tradable assets) had more impressive returns than Emerging clients (less than $150K in tradable assets), given the strong quarterly showing from our Active Trading Models.

Such trading models are not appropriate for Emerging clients, as excess trading commissions/costs can erode their benefits when the position size of the trades are too small.

As we help clients grow/save towards their future, they eventually graduate into the Active group, and Active Trading is then added as a more appropriate strategy.

Net-net, 2012 is off to a good start.  However, there is additional room for gain in client portfolios.  While our short volatility position realized much of its potential in Q1, deep undervaluation potential remains in other major investment themes.

In particular, our Emerging Markets and short US Treasuries allocations remain significantly undervalued, and await a catalyst to trigger large gains ahead (timing TBD).

While we will inevitably have our ups and downs, we look forward to continued strong performances in the years ahead, rising from the March 2009 generational lows.

Market Digestion or Indigestion?

Looking Ahead

Markets are at an inflection point with the action moving from a bullish uptrend to a more mixed sideways trend in the last three weeks.

Investors are trying to figure out if the recent market stall is a standard pause before the resumption of gains (called digestion or consolidation), or whether we are about to hit a new rough patch (or what we might call indigestion).

Our own views are that we are in more of a pause mode, with the high possibility of a 4-8% market correction (we are currently down 3 – 4% from mid-March highs).

While most economic and market indicators are solidly bullish, markets are quite a bit overbought, with extremely high technical sentiment levels.

Consequently, a shallow correction would do well to tame the high sentiment levels, without harming the upward trend in the indicators.

We are currently in a neutral to slightly bearish stance for client portfolios, but are closely monitoring our Active Trading Models to decipher the near-term direction.  We will redeploy assets more aggressively if this turns out to be merely a pause.

However, we will position portfolios in an increased defensive posture if our models indicate the potential for a larger decline (e.g. if EU debt crisis, political wrangling in the US, or other issues begin to rear their ugly heads once again).

From an asset selection standpoint, we remain with our themes of overweight Emerging Markets exposure, decent US equity exposure, and little EU exposure.

We also remain short US treasuries, long commodities, and long real estate.  In our Diversifier asset class, we continue to hold alternative funds as insurance in case markets decline rapidly.

Finally, we have begun to lighten up our short volatility positions as the market begins to vacillate, booking some profits from our multiple low entry points in 2011.

Raise your hand if you’ve set a goal that you didn’t achieve.

Most of us have, save for the perfect few of you out there.

For the rest of us, it’s a worthwhile review to examine why we so often start out with the best of intentions to change a behavior yet end up back where we started, wondering what went wrong.

Setting Useful Goals

First, how do we make goals more concrete and tangible, instead of just being ‘a great idea you had on Dec 31^st’ for the following year?

Very simple, goals need to be SMART: Specific, Measurable, Attainable, Relevant, and Timely.

But having a SMART goal isn’t enough.

A study was done in 1979 on Harvard Business School students, who were asked “Have you set clear, written goals for your future and made plans to accomplish them?”  This study revealed a lot about the power of simply writing goals down.

Only 3% of Harvard MBA graduates that year answered yes and had written goals.  13% had goals, but not written, and the remaining 84% did not have defined goals at all.

What was the impact of not having goals, written or otherwise?

Ten years later, the study revealed that those 3% who had written goals were earning more than the rest of the entire graduating class combined!

The 13% who had un-written goals were on average making twice as much as those who had no goals.

Keys to Actually Achieving Goals

So, if we all just write down our SMART goals, we’ll surely achieve them, right?

While it’s more likely that you’ll achieve them, there’s still something standing in the way……..our own behaviors and habits.

Goals are what we should do; behaviors are what we actually do, so we have to change behaviors to reach our goals.

Changing behaviors is understandably difficult to do.

Behavioral Expert BJ Fogg has studied this very topic for almost 20 years, and has outlined the 3 ways in behaviors can be changed in the long term:

1. Have an epiphany
2. Change your context (what surrounds you)
3. Take baby steps

Epiphanies don’t come easy or painlessly in most cases, so the best path to success is to change your surroundings, or to take baby steps in developing habits that will ultimately change behavior.

Aristotle said long ago, “We are what we repeatedly do.  Excellence, then, is not an act but a habit.”

Five Simple Steps

Here are some simple steps to change a behavior through habits and small actions.

1. Start small and keep it simple.  The simpler and more specific the habit is, the easier it is to master.  Don’t take on too much at once.
2. Write it down.  As with the broader goal itself, it’s paramount to write down the good habit you are trying to establish or the bad habit you are trying change.
3. Develop a short-term action plan. The simple plan must detail exactly what you are going to do (or not do), how often, and/or under what circumstances.
4. Write down obstacles. Think through the situations you’re going to encounter that will trigger a relapse in the habit you’re trying to form or break.  This will help prevent it from happening since you’ll recognize it.
5. Give yourself adequate time. Research shows that it takes 66 days in order to instill a long-term habit, so give yourself adequate time for the habit to become routine.

Three Tiny Habits

BJ Fogg has developed an even simpler and shorter method, which is available to anyone free of charge called 3 Tiny Habits (http://tinyhabits.com/) which works like this:

Sunday: Write down 3 tiny habits you want to employ in a statement structured as follows: After I [something you already do], I will [your tiny habit].

Mon–Fri:  Do your 3 habits daily and communicate your results.

Good habits and behaviors on little things lead to short term successes, and short term successes lead to goals being achieved over a longer period of time.

Taking Action

Let’s put this all into action in a quick example.

You’re in sales and have a goal to increase your sales by 50% this year, so that you can save more into your retirement and buy something nice for your significant other (a lofty goal!).

To do so, there are a number of tiny habits you can employ to slowly transform your behavior, such as:

1. Get up 15 minutes earlier each morning.
2. Make 1 new sales call/pursuit each day.
3. Get 1 new business card each week.

As you achieve these small behavior changes week after week, they will become routine, and then you can go further, getting up an additional 15 minutes earlier each morning, making 1 additional sales call per day, getting 1 additional new business card each week.

Slowly, through these small actions, you will be taking the steps and changing your behaviors that will help you reach your bigger sales and savings goal.

If this still sounds like it takes too much initiative and discipline, we are here to help.

We specialize in behavior modification, and would love to help implement new tiny habits to help reach your goals.

The rally from Oct 2011 lows has continued into early 2012, with many asset classes joining the strengthening upturn.

Stronger economic data, such as improving GDP and unemployment figures, has been coupled with easing financial worries in Europe, resulting in rising prices across multiple markets.

Additionally, two of our three deep value themes from 2011 have begun to rebound as expected.

Consequently, portfolios are not only rising, but also beginning to recover relative returns surrendered in 2011 (see Chart 1).

Chart I – Deep Value Themes Gaining in Early 2012

While these themes are expected to outperform in 2012, we believe that investors may be overly optimistic in the short-term, leaving the market in an “overbought” condition (see Chart II below for an example).

While we tend to get aggressive when others are fearful, we also lean towards being more defensive when others are too euphoric.

Chart II – Investor Crowd Sentiment at Overbought Levels

Due to the temporarily overbought conditions, we have reduced risk in client portfolios by harvesting some gains through the sale of our XIV short volatility positions, and the reduction of Emerging Markets & US equities positions.

However, we believe near-term declines could be short-lived, given reasonable long-term valuations, strengthening technical indicators, and positive effects of the 4-year presidential election cycle kicking in during the back-half of this year.

As a result, we will consider using declines as buying opportunities for some of the cash recently harvested in client accounts.

Such opportunities will be evaluated using our proprietary quantitative models, providing us with indications as to whether we have a high probability re-entry point, or whether we should continue to remain defensive.

Our models don’t work every single time, but they do improve our odds of being right more often than not in each market cycle and over the long run.

It’s difficult to ignore the wild changes in poll results among the Republican primary candidates.

Every few weeks there’s a new candidate capturing the media’s attention and taking the lead, only to fall back to earth after the next flavor of the month emerges to center stage.

The parallels between this roller coaster ride of a primary and that of investor behavior are noteworthy.

It’s common this time of year for investors to review their portfolios and search for what’s done best over the past year or two.  They shift their investments into these leading areas and jump ship from the positions/markets that didn’t perform as well.

The obvious result of this is buying high and selling low, the antithesis of good investor behavior, yet it is the path most followed.

Here are a few actual examples:

1) The “Best Performing” Fund

CGM’s Focus Fund (CGMFX) returned an extraordinary 18.2% annually from 2000 – 2010.

Surely every investor in this fund made phenomenal returns over this time period, right?  Not so.

Morningstar published data that measured fund returns while accounting for money flowing in and out of the fund by investors. Here’s what the data showed:

The average investor in this fund had an annual return of -11%.

That’s negative 11%, a full 29% lower than the actual return of the fund.

How is this possible?

Very simple, the data shows that in 2007 the fund returned an eye-boggling 80%.

This was accompanied by “investors” in the fund pouring an additional $2.6 billion into it.

The fund subsequently dropped 48%, which was followed by an astonishing nearly $1 billion cash outflow from the fund, likely in search of a safe-haven or the new best performing fund.

2) 20-Year Investor Performance

In a similar tale, there is an annual study comparing US market returns vs. real investor returns.

The results published in 2011 for the preceding 20 years reveal the following annual returns:

• S&P 500:  9.14%/year
• Equity Fund Investor Returns:  3.83%/year
• Bond Index:  6.89%/year
• Bond Fund Investor Returns:  1.01%/year
• Inflation rate: 2.57%

The examples illustrate a stark reality: momentum investing, performance chasing, and panic selling lead to very disappointing long term results for investors.

Returns hardly outpaced inflation for equity investors, and in fact lost purchasing power for bond investors.

As a result, investors develop a general distrust and disdain for the markets for delivering such poor results.

In reality, it was their own behavior that did them in.

3)  Top Performing Money Managers

Still not convinced?

In a study of more than 1500 money managers analyzed over a 10-year period commencing in 2010, 600 managers were deemed ‘head of the pack’ based on their relative outperformance of their peers.

They beat their peers/benchmark on a relative basis by an average of 3%/year over this 10-year period.

Were they ahead during the entire 10-year period?

• All had at least one 12-month period of relative underperformance
• 85% trailed during at least one 3-year period
• 85% had six different 3-year rolling periods of underperformance.
• ½ trailed by 3% or more in 3 separate periods
• ¼ trailed by 5% or more in a 3-year period
• ¼ trailed by 15% or more in a 1-year period

Clearly, investors in these manager’s funds lost relative wealth at numerous points over the 10-year period, but only those that stuck with their given strategy actually reaped the higher long-term rewards.

The Bottom Line

Just like voters who are figuring out who to place their confidence in, the same psychology applies to investors.

As A.A. Milne said, “The third-rate mind is only happy when it is thinking with the majority. The second-rate mind is only happy when it is thinking with the minority. The first-rate mind is only happy when it is thinking.”

Those who pursue the latest leading strategy will only underperform over the long run.

Only first-rate minded investors apply thought in making financial decisions – and end up with excellent long term returns.

Global equity markets took investors for a wild ride in 2011.

To recap the year, we compiled the biggest headlines from a jam-packed year, offset against the S&P 500, which vacillated dramatically in a continued “risk on / risk off” manner.

Major investment market price-reversals occurred with a record frequency, especially during the second half of the year (as measured by 90% reversal days – a technical metric that triggers when 90% of stocks in an index move in a unison, opposite in direction to the recent trend).

It all made for manic investing, where many banks, investment managers, and individual investors either blew up (e.g. MF global), severely underperformed (e.g. famous hedge fund manager John Paulson reportedly lost over 52% in his Advantage Fund), or just headed for the sidelines (e.g. incredibly low market volume was recorded in 2H/11).

Chart I: 2011 – An Eventful and Volatile Year

Despite posting a flat -0.003% return, US equity markets were the best performing asset class in 2011.

This resilience to global turbulence was the direct result of a slowly and steadily improving US economy.

Foreign market equities underperformed significantly, with 15-30% declines due to direct crisis impacts, as well as indirect policy tightening in emerging markets to fight surging inflation.

Many Wall Street firms and analysts are prognosticating more fear and volatility heading into 2012.

However, while there will undoubtedly be some unexpected twists and turns in 2012, we believe there will be much lower volatility due to some EU resolutions, more reasonable growth globally due to a recovering global economy, and a reflation of assets that were taken to panic lows during 2011 (especially within Emerging Markets).

Early Recovery, But Still Shaky

Portfolio Review (Q4/2011)

Heading into Q4, our indicators suggested that US equity markets were fairly valued to slightly undervalued, while Emerging Markets were significantly undervalued following a major Q3 correction.

With inflation on the decline, we were on the lookout for a policy easing catalyst from Emerging Market countries.

In fixed income, we remained overweight high-yield bonds and held on to our short US treasuries positions, on the expectation of a relief rally and some modestly rising interest rates.

With our Volatility Timing Model, we held our largest possible short position, on expectations that Q4 would calm in comparison to an incredibly volatile Q3.

Q: What worked?

The following investments contributed positively:

• Allocations to US equities and short volatility contributed positively to absolute and relative returns as US markets rebounded and volatility began to subside.
• Selected stock picks in the US also outperformed equity indexes.
• Rotation out of natural gas and into oil was timely, as natural gas declined 20-30% while oil outperformed.

Q: What didn’t work?

While all portfolios had gains for the quarter, there were areas of relative underperformance.  Specifically, the following positions underperformed:

• Major positions in Emerging Market equities underperformed for two of the three months in Q3.  While showing some outperformance in November, they disappointed heading into year-end.  There are hints of easing to come in early 2012, which would help EMs to once again regain leadership.
• Short US Treasuries positions continued to defy conventional wisdom, with interest rates reaching record low levels as global investors poured into the “safety” of US debt (seems like an oxymoron to us, and one that will come to an end at some point in the near to mid-term future).
• Real estate and diversifiers delivered positive returns, but they lagged US equity benchmarks.

Net Results

Client portfolios all had positive absolute returns for Q4.

However, returns were less robust than expected as two of our three major recovery themes remained depressed (Emerging Markets and Short US Treasuries).

We were encouraged that our short volatility position began generating healthy returns, and expect our other themes will get going shortly as well.

The full year of 2011 proved to be challenging.

As discussed earlier in this newsletter, many investment legends closed their shops this year due to massive underperformance and sometimes full-on collapse.

Given our global exposure to investing, we too shared in the pain as the crisis unfolded.

However, these temporary losses were managed within individual client risk profiles, and we expect to gain back ground in 2012 as a recovery plays out and global growth once again resumes.

Continuing to Climb the Wall of Worry

Looking Ahead to Year 2012

From a long-term perspective, markets are still recovering from a potential generational low in March of 2009.

Portfolios are far higher today than during early 2009, despite record-level market volatility and EU debt crisis aftershocks.

We expect 2012 to continue with the longer term recovery theme.

The EU debt crisis will continue, but much of its potential affects are already priced in to expectations, and EU leaders are dead-set on improving stability.

In the US, we would become increasingly bullish if our government began seriously addressing long-term fiscal imbalances.

Overseas, our positions will be most influenced to the upside if inflation subsides further, allowing for emerging market policy loosening.

On the downside, we will closely monitor events with Iran, as escalating tensions could spike oil prices and cause economic contraction.

Finally, we have made a number of improvements to our investment models heading into 2012.

The past year did not disappoint in offering us some humbling new lessons about how markets can behave, which we formally evaluate in our quarterly review process.

The two new major improvements are:

Improvement #1

Policy actions are causing greater market movements than have historically been the case.

As such, we believe there are certain inflation trigger levels where policy actions tend to be initiated in specific emerging markets.

We are now tracking these specific inflation levels on a weekly basis.

Improvement #2

Our Volatility Timing Model is affected by what is called a “futures roll.”

Each day a fraction of the current month contract is rolled to the next month, and price differences in these contracts can be in your favor or not.

Adding this roll impact to our model helps us to better manage the size of our positions, and to improve the odds of success when we put the trades on.

(Photo: nickwheeleroz)

Global equity markets accelerated their declines during Q3/11 after the modest declines in Q2/11.  Three main factors spooked investors during Q3:

• A potential Greek default and its impacts on other European Union countries and banks that hold their sovereign debt
• Increasingly polarized debate in US politics, specifically around debt reduction approaches (cutting spending v increasing taxes)
• Continued policy tightening and slowdown in China

While US equity markets declined by nearly 16% over the last six months, European markets slid over 20%, and emerging markets dropped nearly twice the amount as US equities (see Chart I below).

Chart I – Market Returns Over Past Two Quarters

US equity markets tend to decline less than foreign markets during major declines, as they have a greater percentage of defensive industries such as consumer goods, healthcare and utility companies.

The rest of the world has a greater concentration of cyclical companies such as raw material producers and manufacturing.

Additionally, flight to safety reactions can cause a significant rise in the US dollar, as it did during Q3, which temporarily hurts foreign equities (e.g. some currency swings were in the 10-20% range during Q3).

As a result of the recent pullback, global investments are now quite attractively priced based on various valuation metrics (we will discuss this more in other sections of this newsletter).

Additionally, there should be a rapid snap back rally for riskier assets when the news flow becomes less bad (doesn’t need to actually be good…just less bad).

Once the various crises are finally addressed and fear recedes, we will be well into an established rebound.

Q: Why do we Sometimes Underperform at Market Bottoms?

It is not uncommon for our investment strategy to underperform before a major rebound.  We often load up on more volatile investments when they get inexpensive enough that we feel they are attractively priced, expecting an impending rebound.

When we are in a mild correction (more often than not), this strategy works immediately.  However, when we are in a deeper decline, we tend to temporarily go down farther than market benchmarks before we surge above and beyond the entry points post rebound.

Loading Up on Higher Beta

Portfolio Review (Q3/2011)

We entered into Q3 with an expectation that markets would remain range-bound between $1250-1365 on the S&P 500.

Equity models indicated that emerging markets would regain leadership, after temporarily underperforming during the previous three quarters.  In fixed income, we remained over-weight in high-yield bonds.

We also added to our short US treasuries positions on the expectation of either a positive rise in interest rates due to improved economic growth, or a hedge to the downside against a potential debt downgrade.

We also continued operating our relatively new VTM (Volatility Timing Model).

Q: What worked?

The following investments contributed positively:

• Diversifier funds worked  by either declining less, or in the case of our Absolute-Return Strategy (DSFYX) posted a positive return
• For the first couple of months of the quarter, our VTM approach contributed modestly

Q: What didn’t work?

Our expectation of range-bound trading was broken when markets turned down dramatically in early August, based on negative policy actions in the US and Europe.

We had incorrectly assumed that politicians would find reasonable solutions rather than sticking to polarized positions.  Consequently, portfolios were not defensive enough.

Specifically, the following positions underperformed:

• Long-term growth themes (Emerging Markets and Energy Commodities) underperformed as emerging market policy tightening continued in response to inflation fighting.  We expect outperformance should resume shortly.
• Defying conventional wisdom, our short US Treasuries positions declined when US debt was downgraded in early August.  While the position should have surged, market panic caused global investors to crowd into US dollars and treasuries.  We believe this move to be temporary, and await a snap-back rally soon.
• Our VTM model was short volatility when the VIX index spiked in early August.  Once VIX hit 40, a very rare event, we purchased more based on the historical pattern that volatility has always receded significantly within 1-2 years maximum of the peak.  While we are nursing a temporary loss on this position, we expect a 150-200% gain from current levels, and a 50% return from the average entry price.

Net Results

Client portfolios differed in their quarterly returns based on their risk profile as well as structure.

Portfolios with greater exposure to emerging markets, short US treasuries position, and VTM model positions temporarily underperformed .

However, these are the same portfolios where we bought back more into these depressed investments, and should see larger gains when the market rallies back as it always does (timing TBD).

As always, we applaud our clients for continuing to save and invest through downturns, allowing us to buy into lows on mass panic, and to generate long-term returns.

New Trading Range, Then Breakout?

Markets appear to have established a new sideways trading range from $1075-1220 on the S&P 500, as investors vacillate between major positives (e.g. strong corporate financials, inexpensive valuations, a rapidly growing global middle class), and ongoing negatives (e.g. EU debt/banking crisis, US debt/deficit issues, Emerging Market policy tightening).

In the US, our economic recovery continues to attempt a handoff from a highly indebted government to the healthier private sector.

This handoff is seen in the most recent September payrolls figures where the private sector added 137K jobs while the government shed 34K jobs.

However, there will be setbacks, such as a net zero jobs created in August (+17K private sector, -17K shed by government), which contribute to market angst.

We expect that economic growth will continue in a positive trajectory, albeit at a more muted pace relative to past recoveries, which has tended to be the case historically after major financial crisis.

Additionally, a new secular bull market (defined as a rise above old highs at $1565 on the S&P500) will require a number of outstanding negatives to be resolved in the near and longer-term:

Despite near-term volatility, we are bullish over the long-term as the massive rise of the global middle-class is setting the stage for incredible growth in equity markets for years to come.

We also believe that the March 2009 low may have marked a generational low in terms of valuations and pricing.

You sit at a table next to a wooden wall and the experimenter gives you the materials shown to the left: a candle, some tacks, and a box of matches. Your job is to fix the candle to the wall so that the wax doesn’t drop on the table. Think for a moment about how you’d solve the problem.     – “Drive”, Daniel H. Pink

STOP! Before you continue, take a minute to think about the problem and see what you come up with.

This experiment was conducted by a psychologist named Karl Duncker to see how fast people could solve a problem that took creativity. One group earned nothing; the other was incented based on speed. The faster they could solve it, the more money they got.

How did the incented group perform compared to the ones who did not get paid? It took the incented group three and a half minutes longer than the ones who did not get paid. That’s right, it took longer!

The experiment concluded that rewards narrow our focus, which is helpful when there’s a clear path to a solution. But when creativity is required, the narrow focus blinds people from the wide view that might have allowed them to see new uses for old objects.

This cognitive bias is called “functional fixedness” which limits how a person uses an object in a new way to solve a problem. It’s also known as Maslow’s golden hammer: “It is tempting, if the only tool you have is a hammer, to treat everything like a nail.”

This bias correlates to investors as well. Think about how volatile the markets are, how negative and sensationalist the news is, and how there are times when no good news is in sight. All the while, your portfolio’s value has temporarily gone down.

Now imagine you are presented with this problem: what is ONE thing you can do to increase portfolio returns?

What did your mind race towards? Asset allocation. Diversification. Day trading. Pick hot companies. Look for companies whose price is down. Etc.

In this scenario, you clearly have different ‘objects’ available to you and you have a strong incentive.

However, when looking for ways to increase portfolio returns, people fixate on the function of what is within the portfolio, and they forget about what they can do to the portfolio.

The solution is simple: add new money.

Now that’s not to say those other functions of investment strategy aren’t important. Once you have a well diversified portfolio that is actively monitored, you have to look outside the portfolio to outperform.

To illustrate just how important your behavior is to affecting returns, we ran three different scenarios of investor behavior during the Great Depression.

(Our current situation isn’t a depression; we just used that to back-test assumptions and illustrate impact.)

Take a look at the graph to see how these three people behaved during the Great Depression, and what resulted.

One client added money, one did nothing, and one withdrew money. Look at the difference in actual portfolio returns (gains) between each and notice how the only one to increase portfolio value was the one who added money throughout the downturn.

You can change the amounts, but the fact remains: adding money during downturns increases returns.

So that’s what you should do but we all know that this isn’t what people really do. As experts in behavioral psychology and economics, we decided to analyze our own clients to measure the effectiveness of our advice.

Did we motivate clients to behave in their best interests?

Here are the year-to-date results for all our clients, broken down by those who are more risky (Growth) and those who are risk averse (Conserve):

As you can see, the majority of our growth-oriented clients added money during the downturn.

For those who did not, they can see that this has consequences, and while not adding money is the mistake of the masses, it’s not what most of their enlightened client peers are doing.

Conservative clients are typically near or in retirement. Interestingly, an equal amount of those clients added money or remained neutral.

Nearly a third of these clients withdrew money and that is also expected for those in retirement, as they have more conservative portfolios and less impact during downturns.

This is a result of effective advice, thorough planning, and taking action.

Back to the Candle Problem (you didn’t think we would forget to tell you the answer?). Most people try at first to pin the candle to the wall or light the candle to melt the wax and affix it to the wall.

After five or ten minutes, they realized that they must empty the tacks from the box, affix the box to the wall, and place the candle inside the box.

Remember, your behavior is the number one determinant in earning real investment returns.

Investment markets have been in decline since recent highs in May, with major moves during late July and early August taking markets into or near bear-market territory (defined as a 20% decline or more).

This summer’s market issues are eerily similar to last summer’s, notably global debt worries and European bank panics.

However, this summer’s downturn has been more rapid in nature, generating higher levels of anxiety and market volatility.

Despite the meaningful declines, most markets remain higher today than they were one year ago.  Additionally, corporate earnings are significantly higher, and equity valuations are more attractive.

There are major variations in the returns of different sectors of the market, but in general, returns are up, earnings are higher, and investments look less expensive.

Q: So why all the recent panic selling?

The recent decline appears to have been triggered by a fear of the US debt default (which never materialized), the US debt downgrade (which counter-intuitively caused borrowing to get less expensive), and continued banking crisis in Europe (a legitimate issue that needs resolution).

Most importantly, investors appear to have a large store of negative “muscle memory” due to major downturns in 2007-2009 (The Great Recession) and 2000-2001 (The Dot Com bust), vowing to not get “caught” again.

Lingering fears and rapid selling are to be expected.  Investors are frustrated from having generated such little return over the past decade, while having had to live with such large degrees of volatility (see Chart I).

Chart I – A “Lost Decade”…or More (13 Years)

However, despite thirteen years of lackluster returns and high levels of volatility, there are reasons to believe we may be nearing a long-term market bottom.

Furthermore, today’s price levels present attractive levels for long-term investors to get fully invested, regardless of the possibility of more near term downside.

Are we near a potential turning point to the upside?

When markets sell off into major corrections or bear markets, investors can look to a number of indicators to provide clues of whether we are near a bottom.

Indicators used by LGA include the following:

• Low price-to-earnings (P/E) ratios
• Recovering leading indicators
• Base metal recoveries to indicate expansion
• Oversold sentiment levels
• Extreme spikes in the volatility index (VIX)
• Technical moving average crosses
• Etc.

In this newsletter, we will focus on two of the above indicators.

From a near term perspective, volatility (as measured by the VIX index) tends to spike incredibly high during major market selloffs.  Sometimes called the “Fear Index,” VIX tends to spike alongside a major capitulation in the markets, as investors sell heavily into a crescendo that often marks a point very near the bottom of the downward move.

Occasionally, there is a second, more muted market decline that finishes the move or retests the VIX crescendo low.  As VIX starts to calm, the worst of the decline is typically in the rear view mirror and it is time to be more fully invested.

Looking at the past five years, we have plotted the S&P 500 and VIX index on the same chart to illustrate the  predictive power of this technical indicator in identifying equity market bottoms (see Chart II):

Chart II – Volatility Spikes Mark Bottoms

As illustrated in Chart II, markets tend to bottom shortly after a volatility spike.

VIX spiked over 80 in 2008, with a market bottom occurring approximately 4 months later.  VIX also spiked over 40 during the summer correction of ’10, pre-dating the US equity market bottom by only two months.

In both cases, emerging market equities turned to the upside even sooner.  Recently, VIX hit 48 intraday on August 8^th, and subsequently receded back into the 30s.

Our research indicates that it is rare to see VIX re-accelerate to the upside once it begins to decline from peaks as it is currently doing.

Consequently, we would place good odds on the assertion that we have either reached or are within a short time period of a market bottom from the recent 20% correction.

Once again, it is possible that emerging markets lead out of this current downturn, beginning to rise sooner than US markets. Timing is all TBD, but VIX peaks have historically been useful for anticipating market bottoms.

Long-term valuations levels are attractive

The second indicator we will review is more long-term in nature: the price-to-earnings (P/E) ratio.

P/Es measure the price levels that investors are willing to pay for a given level of earnings.  High P/Es indicate that investors are extremely bullish and are willing to pay high prices for a given level of earnings, while low P/Es indicate a bearish outlook and low prices for a given earnings level.

Equity markets tend to go through long-term 10-17 year periods of flat returns, followed by 10-17 year periods of above trend returns.

The net average is a long-term return in the 8-10% range, with frustrating results during sideways markets, and down-right euphoric returns of of 16-20% annually during bull markets.

P/Es play a large role in determining the beginning and end of these long-term market cycles.  Typically, long-term sideways markets begin when investors have reached overly euphoric levels, willing to pay over $20 for each $1 of corporate earnings (in other words, a P/E ratio greater than 20).

Conversely, long-term bull markets tend to begin when investors are overly pessimistic, willing to only pay only $8-12 for each $1 of corporate earnings (or a P/E ratio of 8-12).

US equity markets have gone nowhere for the last thirteen (13) years, with a sideways market kicked off in 1999 at a blistering peak P/E ratio of 42.1 (during the euphoric dot com years)!

Since 1999, companies have continued to grow their earnings, but investors have been less and less willing to pay premiums for these earnings, causing the typical compression in P/Es that occurs during sideways markets.

Despite high levels of volatility over short-term 3-5 year cycles, this longer term trend of increasing earnings and compressing P/Es has marched onward and will continue to do so until bargain-basement valuation levels are reached (P/Es in the 8-12 level), and a new secular bull market is born (see Chart III below).

Chart III – Secular Market P/E Valuations

What should investors do?

There is no doubt that it has been painful for investors to cope with marginal returns over the last 13 years, especially for retirees who haven’t had new funds to reinvest into the market at depressed prices.

However, long-term P/E analysis leads us to believe that we may be within 1-4 years of a new long-term bull market, if we aren’t already in one (e.g. the long-term P/E ratio was near 8 in March of 2009 after markets plunged 55% from their peaks in 2007 to their lows of 666 on the S&P 500).

Bottoms can easily be identified in hindsight, but investors must make decisions in the present.

With S&P 500 earnings estimates for 2011 in the $100 range, an 8-12 bottom P/E ratio would suggest that an 800-1200 level would be the current low levels of support for the S&P 500.

Given that these levels are above the 666 lows of March 2009, one could make an educated guess that these lows will not be reached again, and we may have already started the long-term bull market.

Now, earnings can always decline and negate this analysis, but street analysts are estimating 10%+ growth rates in earnings for 2012, lending further support to the conclusions.

The above notwithstanding, long-term bottoming processes can often be incredibly volatile, as they can be accompanied by dramatic fights between doomsday prognosticators and deep value investors.

Furthermore, the general public seems to be disgruntled with equity investing, which causes low liquidity in the market and consequently larger volatility when large orders are placed by either the optimists or the pessimists.

However, history tends to repeat itself, and eventually we would expect the value investors to triumph.

What if there is more near-term downside ahead?

From a long-term perspective, short-term volatility is inconsequential.

What matters more is the relative levels of valuation for entries and exits.  If the market is near a major long-term bull market beginning, long-term investors don’t care about the last 10-20% move downward…they just want to be invested.

Let’s take a look at one of the most famous investors of all time, Warren Buffett.  While others shout out about the declines and massive volatility, Buffet has gone about using major declines to invest large amounts of his cash, making major investments in late 2008 as well as recently during the 18-20% decline.

While Buffett has occasionally suffered 20-40% declines after his initial investment, he tends to be rewarded over the longer term for having made an investment when valuations were low and others shunned such an investment.  Warren Buffet ignores the short-term volatility, and places his faith in the long-term future of America.  Once he has bought his investments at inexpensive prices, his favorite holding period is “forever.”

At LGA, we do not believe in holding forever, but we do believe holding current positions, and buying more, when valuation levels are extremely attractive, such as now.

We then use our models to improve results over the long-term 10-17 year cycles, the mid-term 3-5 year cycles, and sometimes even the shorter-term cycles where possible.

This can occasionally mean temporary declines if equities go from inexpensive to insanely inexpensive.

However, the approach allows you to have discipline around getting invested during panics, and outperforms over time relative to simple buy-and-hold strategies, and even worse…short-term gut reactions.

We believe that long-term investors will be well rewarded for being fully invested at current market levels, regardless of whether there is or isn’t any additional near-tem downside ahead.

No one can exactly predict what the lowest low will be and when it will occur.

Additionally, there will always by cyclical 3-5 year market cycles up and down…that’s just par for the course in investing.

However, we can determine when equities are a good long-term value, and that time is now.