On My Radar: Rick Barry and The Wisdom of Limiting Losses

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1 On My Radar: Rick Barry and The Wisdom of Limiting Losses May 1, 2017 by Steve Blumenthal of CMG Capital Management Group The hardest part in trying to limit losses is not necessarily timing the market, but imparting the wisdom of limiting losses upon your clients. To limit drawdowns advisors and their clients cannot fully embrace raging bull markets that are excessively valued. They must also have the iron stomach required to buy when everyone else is selling and assets are cheap. 720 Global I enjoy reading 720 Global s research blog. Quick, crisp and to the point. The message in their most recent piece is about human behavioral tendencies and ego. Ultimately, it s about how to weave behavior and ego into our investment thinking. In their piece, they told a story about NBA great Rick Barry. Do you remember him? He shot his free throws underhand, a.k.a. granny style. From the piece: In 1962, Wilt Chamberlin scored 100 points in a single game, which to this day stands as a record. Less well known is, in that same game, he made 28 free throws which is also a single game record. Chamberlin, a career 51% free thrower shooter, shot 88% from the free throw line on that record-breaking night. It was not a fluke. That was the only game of his career that he shot free throws underhanded. Despite his historic achievement that night, he never shot underhanded again. In his words I felt silly, like a sissy shooting underhanded. I know I was wrong I just couldn t do it. Malcolm Gladwell, in his podcast series Revisionist History The Big Man Can t Shoot, highlights how ego, pride and the opinion of the masses can prevent us from doing the smart thing. Investing is much the same. Our brain is somehow wired to copy people follow the herd, blend in. To act counter to the Page 1, 2017 Advisor Perspectives, Inc. All rights reserved.

2 majority may prove embarrassing. Shooting granny style is silly. Except it works. Last night at dinner, we discussed what my son, Matthew, is learning in his macroeconomics class. I was actually impressed. Such teachings are largely absent in our schools. Missed are some of the most important basics. The most important miss to me is the lack of understanding in math in how money compounds. He and his classmates now get it. Losses have to be minimized for the math to work; yet, too few think about employing a loss management process. Why? I believe it takes time, requires discipline and requires you to do something that at times (like 1999 and 2007) require you to go against the crowd. It requires you to risk being wrong at times when you neighbor is right. Rick Barry explains why shooting underhanded is not only more natural but produces a softer shot which increases the probability of it going through the hoop. For investing, the growth is in the math and the math works when you limit your downside. Most investors are primarily oriented toward return, how much they can make and pay little attention to risk, how much they can lose. Seth Klarman In a separate piece Limiting Losses, 720 Global examples two simple scenarios to why limiting drawdowns is essential to building wealth. From the piece: Scenario A is a buy-and-hold portfolio with a 100% allocation to the S&P 500 at all times. In scenario B, the portfolio is also fully allocated to the S&P 500 except during the bear markets of 2000 (1/1/2000 3/31/2002) and 2008 (10/01/ /30/09). During those bear markets, the portfolio had a 50% allocation to the S&P 500 and the other half was in cash. At the troughs of the downturns, portfolio B shifted back to a 100% equity position. The graphs and table below show the cumulative total percentage return, cumulative annualized percentage return and other relevant performance statistics for both scenarios. Page 2, 2017 Advisor Perspectives, Inc. All rights reserved.

3 Page 3, 2017 Advisor Perspectives, Inc. All rights reserved.

4 Source: 720 Global No one can time the market perfectly in the manner described in this scenario (SBB here and I certainly wouldn t recommend this particular process. The simple 200-day MA rule is effective.), but the point of the analysis is to illustrate just how important it is to avoid large losses. There are two big takeaways from the data above. The most obvious is the significant difference in returns over the period. After two bull and bear market cycles, scenario B s value grew at a significantly faster clip than that of scenario A, they noted. It is also worth noting that from , scenario A s return was negative 72% of the time over those 12 years. (SBB here. Remember the trial lawyer in the movie My Cousin Vinny staring Joe Pesci? I can picture the prosecuting attorney looking at the jury saying in his southern accent, 72% of the time. ) Scenario B produced positive cumulative returns uninterrupted since 2004 despite the second large drawdown in 2008 and was negative only 21% of the time. A far better emotional ride for the investor. Further on point, Compounding and the illusion of percentages are key factors that help explain why losses are hard to recover. Equal percentage gains and percentage losses are not, in fact, equal. This may sound confusing, but again consider an investor with $100,000. If the investor loses 25%, the portfolio value is only $75,000. A 33% gain ($25,000/$75,000) is then needed to regain the original 25% loss. The table below shows the percentage gains required to offset percentage losses. As highlighted, the gains necessary to recapture losses are manageable with limited losses but they get increasingly more challenging as percentage losses increase. The message is simply another gentle reminder that the ability to suppress the ego is needed if one is to mitigate the potential consequences of the current market bubble. Page 4, 2017 Advisor Perspectives, Inc. All rights reserved.

5 Source: 720 Global Rick Barry once approached Shaquille O Neal about trying his underhand style. Shaq s reply was I d rather shoot zero. Investing requires work and to be successful, as Rick Barry pointed out, the best odds of success are doing something that may look and feel unconventional. It s hard to go against the crowd at market extremes. I d rather shoot 90% underhand. Or like Wilt Chamberlin, shoot 88% underhand vs. 51% average. But that wasn t somehow good enough for him to stick with the process. I believe a majority of investors do the same with their money. Thirty three years of witnessing individual behavior has taught me a great deal. Crowd psychology, ego, poor behavior. I believe if we are aware of risks, we will be better prepared to act on the opportunities that risk dislocations create. Putting a risk management plan in place is not hard to do nor does it look as silly as a grown man shooting underhand but is does require work; it requires discipline, conviction and the courage to stay on plan. Limiting losses and controlling drawdowns is paramount to successful long-term wealth accumulation. You can read the full piece Play the Game to Win here and also their excellent piece Limiting Losses here. Next week we ll take another look at April 2017 month-end valuations. We ll see the equity market remains expensively priced and forward 7-year and 10-year return probabilities remain low (estimated at approximately -2% to +3% nominal). Grab a coffee and find your favorite chair. Below I touch on tax reform and today s low GDP number and share with you a few great charts from JP Morgan Asset Management. You ll find several risk management processes that I favor posted each week in the Trade Signals blog (link below). Unless you have 30-years and can dollar cost average along the way, don t get pulled into the passive buyand-hold story. Especially if you are one of the many who are a pre-retiree or retired. Put risk management into your investment process and don t be afraid to shoot granny style. Please feel free to reach out to me if you have any questions. If you are not signed up to receive my weekly On My Radar e-newsletter, you can subscribe here. Included in this week s On My Radar: The Era of Financial Engineering Charts of the Week Trade Signals Bullish Equity and Fixed Income Trends Remain; Sentiment Neutral Personal Note Sonoma The Era of Financial Engineering Page 5, 2017 Advisor Perspectives, Inc. All rights reserved.

6 As a precursor to next week s valuation and forward return update, I thought I d share with you an interesting thought around what I believe is largely routine for corporate CFO s nowadays in this era of creative financial engineering. Ned Davis wrote an excellent piece about IBM that suggested that IBM might be the poster child for such practices. IBM s sales growth has fallen and has actually been negative since 2015 (chart below), despite many acquisitions. However, through acquisitions and creative accounting, such as non-recurring write-offs to lower taxes, IBM has reported better-than-expected earnings almost every quarter. Here s how you read the chart: The upper section of the chart shows IBM s sales growth has fallen to nearly 0% The bottom section shows how earnings were aided by a steep drop in IBM s effective tax rate NDR Disclosure Page 6, 2017 Advisor Perspectives, Inc. All rights reserved.

7 The point isn t to throw IBM under the bus. They are doing what they should be doing in regards to legally maximizing their tax opportunities. The point is that this may tell us something about U.S. economic growth rates since 2000 overall. It may also tell us that if a company cannot grow its yearover-year sales, we should not simply look at the earnings numbers, as they may have been reached by creative engineering of earnings. When we look at price relative to earnings next week, I believe it is fair to say that the high prices relative to current earnings may be actually more out of skew than in past points in history due to creatively engineering earnings much as IBM has done. Again, not a bad thing, but we have to wonder how much room remains for additional engineering. IBM has successfully adapted over many years and likely will in the future. But sales growth matters and we should consider that in comparison to current earnings and how they were calculated. Bottom line: The market is very richly priced. Charts of the Week Chart 1: S&P 500 Forward P/E, Dividend Yield and 10-year Treasury yield at inflection points Here s how to read the chart: Red arrows show forward P/Es when the market peaked (today s 17.5x number (based on overly optimistic Wall Street estimates is higher than the 2007 peak) Green arrows show forward P/Es when the market bottomed Red circle take a look at dividend yields and 10-year Treasury yields at peaks Page 7, 2017 Advisor Perspectives, Inc. All rights reserved.

8 Chart 2: Annual Returns and Intra-year Declines Here s how to read the chart: Solid bar shows the return in % for the year The red negative numbers show the intra-year declines each year Page 8, 2017 Advisor Perspectives, Inc. All rights reserved.

9 Chart 3: The length and strength of economic expansions Page 9, 2017 Advisor Perspectives, Inc. All rights reserved.

10 Chart 4: Consumer confidence and the stock market Here s how to read the chart: The chart is a plot of the University of Michigan Consumer Sentiment Index from 1970 to present. As you view the chart, think about the data this way: when consumer sentiment is optimistic (high), it is generally bearish for the market in terms of forward returns. When consumer sentiment is pessimistic (low), it is generally bullish for the market. Not too dissimilar with the you want to buy when everyone else is selling and sell when everyone else is buying. What moves the market is supply and demand. More buyers than sellers bids prices up. The logic in this chart is that by the time investors are optimistic they are largely fully invested in stocks. So less buying power to drive prices higher. With the reverse being true when consumer sentiment is low. The green arrows mark the low points in the consumer sentiment index and the subsequent 12- month return for the S&P 500 Index (which excludes dividends). The red arrows mark the peaks in consumer sentiment and also show the subsequent 12-month return. Page 10, 2017 Advisor Perspectives, Inc. All rights reserved.

11 We ll look at April month-end valuations next week. What caught my eye in Chart 4 above is that this gives a feel for what 12-month returns might look like. Past performance guarantees us ziltch, nada, zippo. Chart 5 Tax Reform Page 11, 2017 Advisor Perspectives, Inc. All rights reserved.

12 Source: The Wall Street Journal Page 12, 2017 Advisor Perspectives, Inc. All rights reserved.

13 Source: The Wall Street Journal Chart 6: Atlanta Fed s GDPNow projecting 0.2 GDP growth for Q1 Page 13, 2017 Advisor Perspectives, Inc. All rights reserved.

14 GDP was reported at 8:30am today. This from Market Watch: U.S. economy bogs down in first quarter with slowest growth in 3 years, GDP shows. This from CNBC: US first-quarter growth weakest in three years, as consumer spending falters. No matter how you slice and dice it: GDP growth is poor. Chart 7: European Central Bank in the news this week Page 14, 2017 Advisor Perspectives, Inc. All rights reserved.

15 Source: WSJ The Daily Shot Trade Signals Bullish Equity and Fixed Page 15, 2017 Advisor Perspectives, Inc. All rights reserved.

16 Trade Signals Bullish Equity and Fixed Income Trends Remain; Sentiment Neutral S&P 500 Index 2,394 ( ) Notable this week: I thought I d share with you one of my favorite recession watch charts. In short, no sign of recession. The small red arrows show the point at which the monthly percentage change in the Employment Trends Index turned negative. The slightly larger red arrow on the bottom right shows where we are today. I ll be sharing this data with you from time to time. Trend signals: The Zweig Bond Model remains in a buy signal. The equity market, as measured by the Ned Davis Research CMG U.S. Large Cap Long/Flat Index, remains bullish. The CMG Managed High Yield Bond Program remains in a buy signal. The CMG Tactical Fixed Income is positioned in muni bonds and emerging market sovereign debt. The CMG Tactical All Asset Index is positioned 45% in equities and 55% in fixed income (seeing a meaningful reallocation to fixed income). Both the longterm and short-term gold trend indicators are in buy signals (suggesting some exposure to gold). Page 16, 2017 Advisor Perspectives, Inc. All rights reserved.

17 Investor sentiment is neutral neither excessively optimistic nor pessimistic, which is historically neutral for equities. On the economic front: from global and domestic perspectives, risk of recession remains low; however, risk of inflation is elevated and warrants monitoring. Click here for the charts and explanations. Personal Note Sonoma Sonoma was beautiful. My only previous visit was to attend my fraternity brother s wedding nearly 30 years ago. It was foggy then and I didn t get the full picture though the wine was yummy. This past week, we co-hosted a dozen advisors at the Fairmont Sonoma Inn and Spa. We did a wine tour, had dinner in an underground cellar, met in the mornings and had Tuesday and Wednesday afternoons free. I m checking in happy! I ll be in NYC next Thursday for a video interview with S&P Global as it relates to our Ned Davis Research CMG U.S. Large Cap Long/Flat Index. S&P is the calculation agent for the index and we re really excited to be working closely with them (and my friends at Ned Davis Research and VanEck). Dallas follows on May for a Mauldin Solutions Advisor Due Diligence Meeting. I see a lot more of Dallas in my future we are one of four ETF strategists selected by John for his Mauldin Solutions Smart Core investment strategy. An exciting opportunity for us. I ll be in Orlando on May for the Strategic Investment Conference. I ll be taking notes and sharing them with you. The line-up includes David Rosenberg, Dr. Lacy Hunt, Mark Yusko, Neil Howe, Ian Bremmer and David Zervos from Jeffries. You can learn more about the conference here. It s good to be home. The weekend weather is looking pretty good and it s time to get the outdoor furniture back out. It almost has become a bit of a yearly ritual. Hate when we store it away, love the feeling when we bring it back out. Good thing Susan and I have so many boys. An easier job now that they are young men. An ice cold Head Hunter IPA while sitting in the backyard sounds like the perfect remedy to a productive but long week. Sharing that beer with Susan, well, priceless. I m a lucky man. Hope you have fun plans in your immediate future and time shared with those you love most. Have a wonderful weekend! If you find the On My Radar weekly research letter helpful, please tell a friend also note the social media links below. I often share articles and charts during the week via Twitter and LinkedIn that I feel may be worth your time. You can follow me on and on LinkedIn. Page 17, 2017 Advisor Perspectives, Inc. All rights reserved.

18 If you are not signed up to receive my weekly On My Radar e-newsletter, you can subscribe here. With kind regards, Steve Stephen B. Blumenthal Executive Chairman & CIO CMG Capital Management Group, Inc. Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, On My Radar. Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management. The objective of the letter is to provide our investment advisors clients and professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and client communication. Click here to receive his free weekly e-letter. Social Media Links: CMG is committed to setting a high standard for ETF strategists. And we re passionate about educating advisors and investors about tactical investing. We launched CMG AdvisorCentral a year ago to share our knowledge of tactical investing and managing a successful advisory practice. You can sign up for weekly updates to AdvisorCentral here. If you re looking for the CMG white paper, Understanding Tactical Investment Strategies, you can find that here. AdvisorCentral is being updated with new educational resources we look forward to sharing with you. You can always connect with CMG on Twitter and follow our LinkedIn Showcase page devoted to tactical investing. A Note on Investment Process: From an investment management perspective, I ve followed, managed and written about trend following and investor sentiment for many years. I find that reviewing various sentiment, trend and other historically valuable rules-based indicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that are included within a broadly diversified total portfolio solution. My objective is to position in line with the equity and fixed income market s primary trends. I believe risk management is paramount in a long-term investment process. When to hedge, when to become more aggressive, etc. Page 18, 2017 Advisor Perspectives, Inc. All rights reserved.

19 IMPORTANT DISCLOSURE INFORMATION Investing involves risk. Past performance does not guarantee or indicate future results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by CMG Capital Management Group, Inc. or any of its related entities (collectively CMG ) will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. No portion of the content should be construed as an offer or solicitation for the purchase or sale of any security. References to specific securities, investment programs or funds are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities. Certain portions of the content may contain a discussion of, and/or provide access to, opinions and/or recommendations of CMG (and those of other investment and non-investment professionals) as of a specific prior date. Due to various factors, including changing market conditions, such discussion may no longer be reflective of current recommendations or opinions. Derivatives and options strategies are not suitable for every investor, may involve a high degree of risk, and may be appropriate investments only for sophisticated investors who are capable of understanding and assuming the risks involved. Moreover, you should not assume that any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice from CMG or the professional advisors of your choosing. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisors of his/her choosing. CMG is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. This presentation does not discuss, directly or indirectly, the amount of the profits or losses, realized or unrealized, by any CMG client from any specific funds or securities. Please note: In the event that CMG references performance results for an actual CMG portfolio, the results are reported net of advisory fees and inclusive of dividends. The performance referenced is that as determined and/or provided directly by the referenced funds and/or publishers, have not been independently verified, and do not reflect the performance of any specific CMG client. CMG clients may have experienced materially different performance based upon various factors during the corresponding time periods. NOT FDIC INSURED. MAY LOSE VALUE. NO BANK GUARANTEE. Certain information contained herein has been obtained from third-party sources believed to be reliable, but we cannot guarantee its accuracy or completeness. In the event that there has been a change in an individual s investment objective or financial situation, he/she is encouraged to consult with his/her investment professional. Written Disclosure Statement. CMG is an SEC-registered investment adviser located in King of Prussia, Pennsylvania. Stephen B. Blumenthal is CMG s founder and CEO. Please note: The above Page 19, 2017 Advisor Perspectives, Inc. All rights reserved.

20 views are those of CMG and its CEO, Stephen Blumenthal, and do not reflect those of any sub-advisor that CMG may engage to manage any CMG strategy. A copy of CMG s current written disclosure statement discussing advisory services and fees is available upon request or via CMG s internet web site at CMG Captial Management Group Page 20, 2017 Advisor Perspectives, Inc. All rights reserved.