Unacceptable Portfolio Declines can Destroy the Benefit of Long Term Compounded Returns

Unacceptable Portfolio Declines can Destroy the Benefit of Long Term Compounded Returns

Posted on June 01, 2012

Recap: On May 1st, the S&P 500 closed at 1406, which was the high for the month. Our Portfolio Thermostat Matrix was in Market State 1 - Bullish and our Canterbury Volatility Index (CVI) was at 69. The CVI at 69 was 2 points from its lowest level since July of 2011 (Rational - Low Volatility).

Market State 1 - Our studies, from1929 through 2011(20,516 trading days), show that Market State 1 has been in place more days than any of the other 11 Market States (7,364 trading days or 35.89% of the time).

Market State 1 reflects a Bullish and rational environment. The typical downside fluctuation (risk), in Market State 1 (highest point to the lowest point), is about -2% to -4%.

Our Thermostat Matrix shifted from Market State 1 to Market State 2 on May 5th after a -2.63% decline (normal).

Market State 2 is marked by a short term pullback (correction) during a long term Bull Market. Market State 2 is long term Bullish, has low daily volatility but high intraday fluctuations and is short term Bearish. It is common and normal to see days when the Dow Jones Industrial Average advances or declines 100 to 175 points while in Market State 2. Both Market States 1 and 2 will experience a 200 to 250 point “isolated” (not back to back) advance or decline on a “rare day.”

May’s biggest (DJIA) one day advances and declines:

5/04 -168.32 = -1.27%
5/14 -125.35 = - 0.98%
5/17 -156.06 = -1.24%
5/21 +135.10 = +1.09%
5/29 +125.86 = +1.01%
5/30 -160.83 = -1.27%

The typical downside fluctuation, while in Market State 2, is around -4 to -7% from the previous market high. The S&P 500’s peak was 1406 on May 1st the low was May18th at 1295 (-7.89% during 13 trading days). From the May 18th low through May 29th the S&P 500 rebounded +2.86%. It then closed at 1310 or down -6.83% for the month.

Observations:

  • Markets fluctuate both up and down. It is important to manage the downside fluctuations within an “acceptable” level to get the benefit of consistent long term compounded returns.
  • The fact that the market opened on the high for the month and closed at the low made May feel like it had an abnormal fluctuation.
  • The market’s downside fluctuations were on the high side but within the normal range for Market State 2.
  • May’s daily market fluctuations were within the normal range expected when in Market State 2.
  • Canterbury portfolios were down less than the market and were within the acceptable range.

What is the difference between an “acceptable” and “unacceptable” decline?

  • When The Thermostat Matrix is in one of the “low risk” Market States, a downside fluctuation of -4% to -9% would be considered normal and acceptable.
  • When we are in one of the “high risk” (irrational) Market States, a downside fluctuation of -10% to -12% is acceptable.
  • When portfolios decline -20%, -30% or more, the ability to generate compounded and consistent returns are dramatically compromised. As a result, such declines would be unacceptable.

“Unacceptable” portfolio declines DESTROY the ability to obtain consistent returns and negate the benefit of long term compounding.

The last month has caused high investor emotion. May opened at the high for the month (DJIA Peak was on 5/1 at 13279.32) and closed at close to the low. The news was more negative than normal as a result of the poor jobs report and Greece financial crisis.

The Thermostat Matrix generated several purchases and sells during May. Each transaction served to reduce portfolio risk. We will be making more adjustments today as a result of the increased volatility.

It is inevitable that portfolios will experience declines. The key is to limit portfolio fluctuations to a single digit percentage. Single digit percentage declines are no more than noise and annoyances and have little impact on long term success.

The Canterbury Portfolio Thermostat identifies 12 different Market States (environments). Of the 12 Market States, 6 are Bullish Market States, 4 States are Bearish, and 2 States tend to precede a transition to a Bearish Market State, meaning caution. Please call me with any questions.

Canterbury Investment Management: Tom Hardin

More About Tom Hardin

As Chief Investment Officer, Tom Hardin, Chartered Market Technician (CMT), makes all the final decisions on all investment and portfolio management decisions for Canterbury Investment Management. Tom has more than 30 years experience in the investment management industry and has broad breadth of knowledge. He is known as an innovator, educator and been revolutionary in the advancements in portfolio and risk management.

Every effort was used to provide accurate data and mathematical calculations to provide, what we believe to be, accurate results. Canterbury Investment Management, LLC, and its principal owners, make no guarantee of completeness or accuracy of data or calculations as well as conclusions of any statistical data or information contained in the simulation illustrated on this page. Past results or performance is in no way a guarantee of future results.