Does Market Timing Work?

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1 Summer 2011 Should I Stay or Should I Go? Mick Jones Inside this Issue + Does Market Timing Really Work? page 1 + What I m recommending today page 3 + Income Tax Alert page 5 Does Market Timing Work? After the two best years in the past 30 years, the TSX Composite has taken a pause and has declined by about 5% since March. Many investors are wondering if they should stay in the market, or if it is time to take their gains off the table and go away for the rest of the summer. This leads us to the question; is it possible to outperform the market using market timing strategies? Most of us have seen the mutual fund promotional materials touting the virtues of buy and hold strategies and reminding us that by missing the best 10 days of individual returns, we will miss most of the market s return. Many of these charts are based on a study by Javier Estrada who painstakingly calculated the daily returns for 29,190 trading days of the Dow Jones Industrial Average and concluded that missing the best 10 days in a 107 year period from 1900 to 2006 would reduce capital gains from $25,746 to $9,008, assuming a $100 investment. One mutual fund firm even went as far as to trademark the phrase Buy, Hold and Prosper to summarize their optimistic perspective on Estrada s study for use in their marketing. Unfortunately, or fortunately depending on your perspective, they are no longer with us. However, the obvious question is what happens if you miss the 10 worst days of the market? As you may have guessed, removing those gut wrenching days, when nightly news anchors direly warn you to check your portfolio, improves investor s returns by an even larger amount. As it turns out, the declines on the down days have tended to be much more violent than advances on the up days. Looking at the following chart, we can see that the best advances over the past 10 years were at a significantly slower rate than the rapid declines of , and 08. Even the correction last spring was steeper than the late summer rally. That same $100 would have increased to $78,781 over the same 107 years, by missing the 10 worst days. Sitting out the worst 100 days, or 0.34% of 29,190 trading days, results in an astounding terminal wealth of $11,198,734.

2 Source: Wikipedia However as Yogi Berra once observed, in theory there is no difference between theory and practice. In practice there is. Lacking a crystal ball to predict the exact moment the market will decline, and frankly feeling overwhelmed by the 107 year time horizon, I decided to investigate some practical options available to investors who wish to time the market. One of my competitors regularly mails an invitation to my home inviting me to attend her seminar at a local country club extolling the virtues of market timing. She claims she has identified a money manager who is able to consistently outperform the market by shifting assets to cash just moments before the market declines. Why she sends this to me I don t quite know. Intrigued by her claim, I looked further to discover her program was offered in conjunction with a Toronto based investment counsel firm. One of the principals of the firm regularly appears on TV touting his acumen at identifying and buying only those stocks that are participating in the market. While the manger in question doesn t reveal his portfolio or his performance on TV, his performance is available on his website. Turning to the performance of this manager, he indeed missed some of the carnage in 2008, with less than average decline of about 20%. So far, so good. Many investment managers experienced declines of closer to S&P TSX composite decline of 33% in Those who remained more or less fully invested also participated in the market s recovery of 35.1% in 2009 and 17.6% in In the end, the investor in the market timing fund earned 4.26% over the 5 year period ending May 31, 2011, which while sufficient to earn a 1st quartile performance, paled in comparison to both the 6.18% return of the major market weighted (XIU) and the 7.31% return of the major fundamental weighted (CRQ) index funds. Perhaps Yogi was on to something? 2 Summer 2011

3 But how can this be, when we know that missing the bad days has a significant impact on pretax investment performance? To answer this question, I turned to a study by Nobel laureate William Sharpe, who compared the results of buy and hold investing with shifting from cash to stocks over a 44 year period. During this period the stock market outperformed cash in 27 years, or about 62% of the time. However, in part because the average return on stocks was higher than the return on cash in most years, being right 62% of the time was not sufficient to outperform a buy and hold strategy. Sharpe concluded you would have to have been right 68% of the time. In addition the cost of trading must be factored in. Assuming a cost of 2% per annum to change the entire portfolio annually, Sharpe concluded that accuracy of around 80% was required to outperform those investors who simply bought and held for extended periods of time. In conclusion, market timing can work to the investor s advantage, provided they have a fail proof system that allows them to be right at least 80% of the time. The talking head that I am picking on this month is certainly bright, well educated, hard working and in all probability has a well programmed Black box to tell him the direction of the market. Unfortunately, like the vast majority of investors, his tools lack the consistency to predict the direction of the market with more than 80% accuracy. As a result he, like the military, is extremely well prepared to fight the previous war, but lacks sufficient resources to fight tomorrow s battle. As for me, I find it extremely difficult to invite a black box to become a partner in my business, and have therefore resisted any slavish devotion to market timing rules. What I m recommending today Is the market fully valued? The two years between March 2009 and March 2011 have been a bit like the rising tide. It has lifted all the boats in the harbour, including the rusty scows anchored in the back bays. The growth rates for housing starts, employment, and trade activities generally remain on a positive trend, however many indicators have slowed, or even reversed in recent months. The equity markets, which have responded as expected to quantitative easing, government bailouts, and massive infrastructure spending, appear to me to be fairly valued. Valuation debates are never ending, particularly at the inflection point, however one measure that I like to look at is the stock price divided by the average earnings over the past 10 years. This methodology allows for a full business cycle to be reflected in the data. The 10 year price earning ratio stands at 23.6X, based on 10 year simple average earnings of the TSX Composite of $562, which is close to its long term range of around 21X. For those who think in terms of interest rates, the earnings yield is the inverse, i.e. 4.25%. This represents the return on the cost of an equity share that investors demand as compared to buying an interest bearing investment. As current interest rates remain in the 2-3% range, this earnings yield also appears to be reasonable. Summer

4 Source: courtesy of Robert Shiller, Yale Department of Economics* *As cyclically adjusted price earnings ratios (CAPE) are not readily available for the S&P TSX Composite, I have shown the S&P 500 CAPE as a point of comparison. As I believe the market to be fully valued for today s level of earnings and expectations for growth, and in view of the old Wall Street adage that balance sheets don t matter until they matter, and then nothing else matters, I have been selling those stocks that have weak balance sheets and/or have speculative business plans. These would be the rusty scows of the back bays which must be sold while they are still floating. This exercise had no impact on the Core Equity Portfolio as a strong balance sheet and a sustainable business plan are prerequisites for inclusion in the portfolio. The Core Equity Portfolio significantly outperformed both its benchmark and the majority of its competing asset classes. Accordingly no changes were made to the Core Equity Portfolio during the 2nd quarter, other than to add the dividends earned on the Canadian equities to an index fund bases on the TSX S&P Summer 2011

5 As a June 30, 20110, the Core Equity Portfolio is as follows: BCE Inc. 4.9 % Canadian National Railway 5.6% Canadian Natural Resources 4.6% Cenovus Energy 5.7% Enbridge 5.1% EnCana Corp. 5.8% Fortis Inc. 5.8% Imperial Oil 5.4% Innergex Renewable Energy 5.4% Power Financial Corp. 4.7% Royal Bank of Canada 4.5% Suncor Energy 4.9% TD Financial 8.0 % TransCanada Corp. 5.5% Pro FTSE RAFI Canadian Index 0.3% Canadian Weighting 76.6% Claymore Broad Emerging Market ETF 8.1% Claymore S&P/TSX Global Mining ETF 8.9% Claymore US Fundamental Index ETF 5.6% Front Street Growth Mutual Fund 0.8% Global Weighting 23.4% 100% Year to date non-annualized return of the Core Equity Portfolio for the six month period December 31, 2010 to June 30, 2011 was 4.79%. As a point of comparison, The Standard & Poors TSX Composite Index Total Return for the same period was 0.16 %, while the MSCI World Index declined 0.9%. The blended benchmark return is a loss of 0.11% based on a 75/25 weighting. Income Tax Alert The United States has recently expanded its attempts to enforce taxation of US Persons living outside of the US. As their interpretation of who is a US person can often include people who have never lived in the US, including direct descendants of US citizens, and holders of Green Card visas, some Canadians are unaware of their requirement to file a US federal tax return. In many situations no additional taxes are owed as a result of tax treaties and liberal foreign income exclusions, however the obligation to file remains. An amnesty program is currently in effect, however it ends on August 31, If you suspect that you may fall under the definition of a US Person, you should discuss your situation with a qualified accounting or legal professional. Summer

6 Should you have any questions whatsoever on your investments, insurance or your financial plan, or would like further information on either the ETF or the core equity portfolios, please call me at or me. As always, in the event any member of your family, or one of your friends, has any concerns about their investments, insurance or their financial plan, I would be pleased to provide them with a no-obligation second opinion. Regards, PI Financial Corp. is licensed as a broker-dealer in all provinces and territories of Canada and is a member of the IIROC and the Canadian Investor Protection Fund. The contents of this newsletter are not intended, and should not be construed, as a solicitation of customers or business in any jurisdiction in which we are not registered as a dealer in securities. This newsletter is intended for investors who reside in British Columbia or Ontario. Insurance products are provided to BC residents by PI Financial Services Corp. The opinions expressed in this letter are those of Brian Hayes and do not necessarily reflect the views of PI Financial Corp. or PI Financial Services Corp. The information contained comes from a variety of sources, and while every effort is made to ensure accuracy, is subject to change and is not guaranteed. Any portfolio changes discussed may not be suitable for all investors. Please contact me if you have any questions on your portfolio. PI Financial Corp. Suite 1900, 666 Burrard Street, Vancouver, BC, Canada V6C 3N1 ph: fx: Members: All major Canadian Stock Exchanges, Investment Industry Regulatory Organization of Canada, Canadian Investor Protection Fund and International Financial Centre (British Columbia). Estimates and projections contained herein are our own and are based on assumptions which we believe to be reasonable. Information presented herein, while obtained from sources we believe to be reliable, is not guaranteed either as to accuracy or completeness, nor in providing it does PI Financial Corp. assume any responsibility or liability. This information is given as of the date appearing on this report, and PI Financial Corp. assumes no obligation to update the information or advise on further developments relating to securities. PI Financial Corp. and its affiliates, as well as their respective partners, directors, shareholders, and employees may have a position in the securities mentioned herein and may make purchases and/or sales from time to time. PI Financial Corp. may act, or may have acted in the past, as a financial advisor, fiscal agent or underwriter for certain of the companies mentioned herein and may receive, or may have received, a remuneration for their services from those companies. This report is not to be construed as an offer to sell, or the solicitation of an offer to buy, securities and is intended for distribution only in those jurisdictions where PI Financial Corp. is registered as an advisor or a dealer in securities. Any distribution or dissemination of this report in any other jurisdiction is strictly prohibited. For further disclosure information, reader is referred to the disclosure section of our website.