Lyons Tactical Allocation Portfolio. A Different Approach to Tactical

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1 Lyons Tactical Allocation Portfolio A Different Approach to Tactical

2 What Will the Future Hold For Equity Markets? Will we see rapid market growth similar to the 80s and 90s? Or will we experience further prolonged periods of market uncertainty? History suggests that over time we will continue to encounter both. Many investors have a strategy in place for bull market rallies but have failed to effectively prepare for sustained bear market declines. We believe the concern is not if we will experience prolonged market declines, it s where we will be in our investment time horizons when these declines occur. Today more than ever investors are looking for proactive solutions for their investments. How do we prepare for the future of equity markets? Should we continue using those approaches that were successful in the 80s and 90s, or should we adapt to the ever evolving investment landscape? From hedge funds to high frequency trading and dark pools, our equity markets today look much different than they did just 20 years ago. We believe an active approach to investing harnesses these market changes better than a traditional passive strategy. In managing the Lyons Tactical Allocation Portfolio, we take an active approach while not losing sight of sound investment principles. 2

3 Buy-and-Hold Works Until it Doesn t Investors are frequently reminded that the stock market has returned an average of 9% per year over the last hundred years, and therefore a steadfast buy-and-hold approach is expected to be successful. One look at this statement quickly reveals an inherent problem: investors don t have a hundred year time horizon to rely upon these return expectations. Our individual time horizons are diverse, and market conditions can vary dramatically over time. If left to buy-and-hold investing, our investment returns are largely dependent on the market conditions we encounter % 9 yrs % 18 yrs % 5 yrs. Cumulative Returns 1.69% 25 yrs. Market Cycles % 11 yrs. 0.83% 17 yrs % 17 yrs. 0.69% 11 yrs. 14, ,000 1, Value of Dow Jones Industrial Average Sideways markets have been prevalent since the early 1900s 1900s 1910s 1920s 1930s 1940s 1950s 1960s 1970s 1980s 1990s 2000s 10 Logarithmic graph of Dow Jones Industrial Average from 5/26/ /30/2010 Source: Graph created by Lyons Wealth Management using data from Maintaining a buy-and-hold investment strategy during prolonged sideways markets can inhibit an investor s ability to realize their long-term investment objectives. With passive investing, returns can be largely dependent on the market conditions. Sander Read, CEO Lyons Wealth Management 3

4 Which Losses Are Most Impactful? When assessing which losses are most impactful, we focus on three key aspects: magnitude (depth of loss), duration (length of loss period), and frequency (how often losses occur). Research shows that while short-term market declines are more frequent than longer-term declines, the short-term declines tend to retrace quickly. Furthermore, we find the deeper the decline, the greater the return needed to recover from loss and break even on an investment. Greater the Loss, Longer the Duration, Harder the Recovery On average, the deeper the market decline, the longer the duration of the loss period. When measured from peak to trough, a 5% decline historically averages 47 days in length, while bear markets last a much longer 338 days nearly a full year (source: Capital Research and Management Company SM ). Furthermore, the greater the loss, the larger the gain needed to recover and break even. While a 10% loss requires only an 11% gain to break even, a 40% loss requires a 67% gain. S&P 500 Drawdowns (Declines & Recoveries) January April % Decline Duration Recovery Decline Recovery -10% 1998 Decline -20% -30% Bear Market Bear Market Depth -40% -50% Frequent short-term losses Sustained losses -60% Graph of hypothetical investment in the S&P 500 Total Return Index from 1/1/1990 4/30/2012 and assumes reinvestment of dividends. You cannot invest directly in an index. Source: Graph created by Lyons Wealth Management with Zephyr StyleADVISOR using data from 4

5 Sustained Losses Matter Most The 15% market decline in the summer of 1998 was a short-term decline that had little impact on a buy-and-hold strategy. The S&P 500 Total Return Index returned to breakeven and recovered from this loss in just three months. The deeper, more painful declines during the bear markets of the 2000s resulted in sustained losses from which recovery took more time and required larger market gains. These are the market declines that can be detrimental to an investor s portfolio and are the reason why an alternative to buy-and-hold may be advantageous. Market Loss Duration of Decline Magnitude of Decline Recovery to Break Even Time to Recover 1998 Summer Decline 1 2 months % 18% 3 months Bear Market 25 months % 81% 47 months Bear Market 16 months % 104% 37 months 1 Russian financial crisis of summer 1998 led to brief U.S. market decline from June to August. Based on a hypothetical investment in the S&P 500 Total Return Index and assumes reinvestment of dividends. You cannot invest directly in an index. Suffering through years of flat cumulative returns can be exhausting for investors. The total time spent in decline and recovery represents significant periods of opportunity lost to bear markets. For example, it took six years for the S&P 500 Total Return Index to return to the level it had reached in 2000 before the bear market, and over four years to return to levels last seen in Protecting a portfolio from large losses that result from deep market declines may yield measurable improvements in portfolio performance. 5

6 Identifying a Bear Market During the formation of thunderstorms and hurricanes, barometric pressure falls, indicating that bad weather is forthcoming. Scientists, weathermen, pilots and captains use this signal to forecast upcoming weather conditions to not only determine when the storm will come, but more importantly, how severe it may be. We often hear folks say nobody saw this coming to explain inactivity during the bear markets following the 2000 technology bubble and 2008 subprime mortgage crisis. Market pundits often suggest bear markets are only identifiable when looking in the rear view mirror. Yet by definition, a bear market is an equity index decline of 20% or more. Our research suggests most bear markets roll-over gradually and exhibit significant warning signs in advance. Most bear markets don t happen suddenly but instead develop through a broad fundamental shift in prices. The severity of loss experienced in bear markets can have a negative impact on an investor s long-term financial goals. 2,000 1,800 1,600 1,400 1,200 1, Bear Market Cyclical Bull and Bear Markets January April 2012 Bull Market Bear Market Bull Market Graph of S&P 500 Index from 1/1/2000 4/30/2012 Source: Graph created by Lyons Wealth Management using data from Incorporating downside protection in a portfolio may allow an investor to reduce the negative effect bear markets have on long-term returns. 6

7 Introducing the Quantitative Risk Indicator We ve constructed a systematic approach intended to capitalize on the fundamental market price shifts that often precede bear markets. We call this the Quantitative Risk Indicator (QRI). The QRI focuses on minimizing the impact of equity bear markets. It assesses market conditions on a monthly basis and drives our allocation between equities and Treasuries or cash. Two Base Allocations QRI Positive Signal Equities Treasuries or Cash QRI Defensive Signal We determine whether market conditions are favorable by quantifying the rate of change in equity prices over set time intervals. Incorporating this process into the Lyons Tactical Allocation Index has allowed the index to effectively navigate through the bear markets of 2000 to 2003 and 2008 to ,000 1,800 1,600 1,400 1,200 1, QRI Defensive Signal QRI Market Signals January April 2012 QRI Positive Signal QRI Defensive Signal QRI Positive Signal 600 Bull Market Bear Market The QRI is designed with the intent to properly navigate bear markets and is not constructed to miss short-term daily, weekly, or monthly declines. In fact, the QRI only signaled to move defensively twice during the 2000 to 2012 time period, and both instances were during the early stages of the last two bear markets. Graph of S&P 500 Index from 1/1/2000 4/30/2012 Source: Graph created by Lyons Wealth Management using data from We believe that avoiding sustained drawdowns instead of short-term volatility allows us to construct an equity portfolio that is both defensive and tax sensitive. 7

8 Tactical Allocation Portfolio There is no investment potion for this new environment other than steady income-producing bond and equity investments in companies with strong balance sheets and high dividend yields. Bill Gross, Founder and Chief Investment Officer of PIMCO The objective of the Tactical Allocation Portfolio is to outperform the S&P 500 during extended market uptrends and long-duration market declines. We take a systematic approach to selecting a portfolio of 25 stocks based on relative price and return on capital. We then apply the Quantitative Risk Indicator (QRI) to our portfolio to help us navigate sustained bear markets. In all aspects, the Tactical Allocation Portfolio is based on our fundamental beliefs. Fundamental Beliefs Dividends are Important Dividends are a large component of market returns Tax Efficiency Matters Taxes on gains affect compounded performance Minimized Internal Expenses ETF expenses add to overall costs Quality Stock Selection Quality stock selection can outperform basic indexing Dividends are Important Historically, even in non-bear market years, dividends have accounted for a significant portion of S&P 500 returns. By incorporating dividend-paying stocks in S&P 500 Total Return in Non-Bear Market Years S&P 500 Total Return Dividends as % of Total Return Dividend Year Yield % 2.11% % % 2.28% 15.14% Bear Market % 1.96% 35.76% % 2.18% 13.77% % 1.91% 38.90% % 1.89% 17.36% Bear Market % 1.52% 7.20% % 1.91% 6.68% % 2.36% 7.06% % 2.70% 11.74% % 3.47% 9.23% % 2.86% % % 3.02% 30.00% % 3.16% 41.41% % 4.16% 13.65% % 3.45% % 8 our Tactical Allocation Portfolio, we provide our investors with income and the potential for return above capital appreciation. From , in non-bear market years, dividends have accounted for over 42% of the annual returns of the S&P 500 Total Return. Table of S&P 500 Total Return Annual Returns for non-bear market years from Source: Table created by Lyons Wealth Management using data from

9 Tax Efficiency Matters By calibrating our QRI model to focus on sustained market declines and not shortterm dips, we aim to construct a portfolio that is both tactical and tax efficient. Impact of Taxes on Investment Returns S&P 500 Total Return: $87,379 $67,193 $37,410 $10,000 Pre-tax 15% Tax Bracket 35% Tax Bracket Year-End Graph above presents value of a $10,000 investment in the S&P 500 and assumes reinvestment of dividends. The S&P 500 Index is an unmanaged index of stocks considered a broad representative of the U.S. stock market. You cannot invest directly in an index. Past performance does not guarantee future results. Source: Graph created by Lyons Wealth Management using data from Minimized Internal Expenses By focusing the equity allocation of our Tactical Allocation Portfolio on individual stocks, we eliminate the internal expenses incurred by using ETFs, and offer our clients the potential to outperform a basic indexing strategy. Quality Stock Selection To build our portfolio, we use a systematic process that enables us to find attractively priced companies generating superior returns on capital. Our process, based on our dividend and market capitalization parameters and key fundamental criteria, is described on the following page. 9

10 Methodology A systematic portfolio construction process allows us to take a proactive, unemotional approach to investment management. The process begins by establishing a universe of stocks that meet minimum dividend yield and market capitalization parameters. The stocks are then ranked using fundamental criteria that include measures of return on capital, free cash flow and enterprise value. These measures help us evaluate the ability of the companies to produce returns for shareholders, and determine which of those companies are priced attractively. Our Risk Management process is established by applying the Quantitative Risk Indicator to our entire portfolio on a monthly basis. If the QRI signals negative, we shift 100% out of stocks and into a defensive position to Treasuries or cash. STEP 1 Establish Universe of Stocks - Quarterly Screen for dividend yields of at least 1.5% and minimum market cap parameters Rank stocks by return on capital and free cash flow to price STEP 2 Select Stocks - Quarterly Select and equal-weight the top 25 ranked stocks Run screen and rebalance STEP 3 Apply the Quantitative Risk Indicator - Monthly If QRI is positive, remain 100% invested in stocks If QRI is negative, shift 100% to Treasuries or cash 10

11 Forward Thinking. Proactive Management. Lyons Wealth Management, LLC is a registered investment advisor based in Winter Park, Florida that serves as an asset manager and sub-advisor to a broad range of clients and investment professionals. Our mission is to create unique investment solutions that help our clients meet their long-term goals. We take great pride in complementing our investment programs with quality service and support. Conventional buy-and-hold investment strategies can fail to keep pace with rapid globalization of economies and financial markets. We seek to innovate forward-thinking investment strategies that address the needs of the evolving investment landscape. Accordingly, Lyons Wealth applies a proactive investment management philosophy to navigate diverse market conditions. Important Disclosures The Lyons Tactical Allocation Index ( the Index ) is the exclusive property of Lyons Wealth Management, LLC ( Lyons Wealth ). Lyons Wealth has contracted with The NASDAQ OMX Group, Inc. (collectively, with its subsidiaries and affiliates, NASDAQ OMX ) to calculate and maintain the Index. NASDAQ OMX shall have no liability for any errors or omissions in calculating the Index. You cannot invest directly in an index. The Index does not represent actual trading, but was achieved by the retroactive application of a model. No system or methodology has ever been developed that can guarantee profits or ensure freedom from losses. No representation or implication is being made that using the methodology or system discussed in this presentation will generate profits or ensure freedom from losses. Lyons Wealth registered as an investment adviser in July of 2009 and was not managing money for the entire time period shown. Hypothetical trading does not involve financial risk and no hypothetical trading record can completely account for the impact of financial risks associated with actual trading. In addition, no representation is being made that any account will or is likely to achieve profits or losses similar to those shown. Actual client accounts may experience losses. 11

12 Lyons Wealth Management, LLC 807 W Morse Blvd #105 Winter Park, FL (877)