If a person is out gathering eggs and the eggs are all together, a single misstep or drop can destroy all of the eggs at once. Long ago someone figured out that if the eggs were divided and the person carrying the eggs fell or dropped the basket, at least some eggs would remain for that day’s needs. Six eggs might not be as good as a dozen, but it is better than no eggs.

Unfortunately, diversifying investment assets can be more difficult than just separating eggs into different baskets. A few weeks ago I touched on this subject and pointed out that even assets than seem dissimilar sometimes are highly correlated in their movements.

http://www.marketowl.com/2012/01/13/the-importance-of-diversification-and-correlation/

This concept can be difficult to explain and to understand, so I’m going to use the illustration of a star to help. Each point of a star is separate and distinct from the other points. To achieve true investment diversification, we want asset categories that have a low correlation—that are separate and distinct from each other like the points on a star.

The image below shows five asset categories that generally have low correlation rates: U.S. equities (S&P 500), U.S. bonds/dollar, energy, precious metals, and emerging markets.

The flaw with most attempts to manage risk by diversifying assets is that investors choose assets that are highly correlated. For example, if we added small cap stocks, value stocks, large cap stocks, international stocks and high-yield bond funds to our star, they would all gravitate near the same point as the S&P 500 because they all behave about the same.

Below is a chart that shows how ETFs representing the five asset classes on our star have performed over the past six months. As you can see from the price movements, there have been periods when one or more of these asset categories have moved in concert. But over the six months spanned by this chart, there have also been separate, distinct movement from each.

An investor holding a portfolio of equal positions of each of these investments would have achieved a return of about 14% over the period represented. That is less than the 20% return that an investor could have earned by being invested solely in the S&P 500. But the investor would not have endured the 10% decline the S&P experienced from its peak in October to its November low.

Imagine that each of the performance lines on the chart above was a road. There are hills and valleys and lots of potholes. There are really only two choices when it comes to dealing with the bumps and obstacles in each road. An investor can try to avoid the bumps, but that is difficult simply because there are so many and some might be difficult to see in the road ahead. The other way to deal with the bumps is to try to mitigate their impact.

The purpose of diversification is to act like a shock absorber for a portfolio. The goal is to smooth out the ride so one can attain performance that is something like the green line shown on the chart.

Some market experts argue that this type of diversification dilutes returns in a rising market. That is true, but for conservative investors who cannot afford big drawdowns or who cannot endure volatility this type of diversification offers an option for reliable risk protection.

Flint Stephens

Stocks have moved steadily upward since the middle of December. The rally is now six weeks old. As a result, it isn’t surprising that stocks are taking a breather. It is the first time in many months that stocks have been able to sustain a pattern that looks like a positive upward trend.

The chart above shows performance of the New York Stock Exchange Composite (NYSE) of the past year. Because this index includes all of the stocks on the NYSE, it sometimes lags indexes like the S&P 500. Even so, this index has broken through technical support and is now trending above its 200-day moving average (gold line).

The bottom two sections of the chart are a moving average convergence divergence and a relative strength index (RSI). Both of these indicators remain at strongly positive levels—a bullish sign.

Because this advance has already persisted longer than any we have seen in recent months, it would not be unusual to see stocks continue to consolidate in this area or even to retreat somewhat from this level. But currently there is nothing to suggest that a significant correction is on the near horizon.

Flint Stephens

Given the poor performance of stocks for 2011, such nervousness is understandable. However, right now technical indicators agree that stocks are finally headed in the right direction for a time.

The chart below shows performance of the S&P 500 (SPX) over the past year. This index reached its low for 2011 in October and has since staged a sharp but volatile advance. In fact, since bottoming in October, SPX has gained about 20%.

The top portion of the chart contains two significant features. The gold line is a 200-day moving average (MA). The S&P crossed above its 200-day MA at the beginning of 2012 and has moved strongly past it.  The blue line marked a technical resistance level that was about the same level as the MA. In November and December SPX tested this area without the strength to break through. Now it has done so in a convincing manner.

The 200-day MA is a longer-term indicator of trend. The previous two instances when SPX broke strongly above its 200-day MA ushered in advances that persisted for many months. Obviously, there is no guarantee that this time will also be the beginning of a long-term advance, but at this point, it should be viewed as a strong positive for stocks.

The middle section of this chart shows a moving average convergence divergence (MACD). This indicator is also in an up-trending positive pattern—something that is generally bullish for stocks. Once again, the last time this type of pattern appeared was followed by a market advance that persisted for many months.

Finally, the bottom portion of the chart is a relative strength index (RSI). The RSI also shows a consistent rising pattern over the past few months. It is currently trending well above the 50 level, which is usually a sign that the underlying index has strength and momentum to sustain a strong advance.

I could have added several other indicators. However, they are all giving a similar picture: stocks could well be at the beginning of their strongest rally for many months.

For all those who remain nervous about stocks, the apprehension is understandable. And when one looks at economic fundamentals like unemployment rates and the debt burden, there is still much about which one should be concerned. But these technical indicators look better than they have for quite a while and they are unclouded by emotion or personal opinion. Long ago I learned to trust them rather than my own judgment.

Flint Stephens

“Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries and other categories. It aims to maximize return by investing in different areas that would each react differently to the same event. Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk.” www.investopedia.com.

The problem is that true diversification is difficult to accomplish. That is because many investments are highly correlated. In other words, they react in similar fashion to market forces.

Many investors buy index funds believing that their investment is protected because the index fund invests in hundreds of stocks. Buying an index fund will provide protection against company risk—the risk that the stock price of a single company could plummet. However, index funds provide little protection against market risk—the danger that unforeseen events will cause overall economic upheaval.

According to a report about diversification from Welton Investment Corporation, “During the financial crisis many ‘diversifying’ investments readily followed the equity markets as they collapsed in 2008 and 2009. This lesson forced investors to revisit their longest-standing beliefs about asset allocation, leading many to suspect that their allocation frameworks needed refining.”

Let’s consider a specific situation. Many investors believe they can protect their portfolio against risk by adding precious metals—gold or silver. Purchasing actual gold or silver is not always practical or possible, especially in an IRA or 401K account. Buying a gold or silver index fund is often used instead as the best available alternative to owning real gold or silver.

What many investors don’t realize is that the movement of gold and silver funds is highly correlated to the movement of stocks. In fact, often these funds are more volatile, meaning that when the stock market falls, gold and silver funds can decline even more sharply.

Below is a chart to help illustrate this point. The black line is the S&P 500 (SPX) and the gold line is the Philadelphia Gold and Silver Index (XAU). The period is October 2007 to October 2009.

Most investors remember the painful period between October 2007 and March 2009 when the S&P 500 declined by more than 50%. Investors relying on their gold and silver funds to protect them during the decline were undoubtedly disappointed because from July 2008 and October 2008, the XAU decline by about 65%.

The reality is that traditional diversification across asset classes offered little protection during the 2008-2009 downturn. Large cap stocks, international stocks, utility stocks, small cap stocks and even real estate all fell in concert during that serious correction. Even bond funds were not immune. High yield bond funds saw declines ranging from 35% to 50% during that time.

Treasury bonds held up well for much of that time. IShares 20+ Year Treasury Bond Fund (TLT) rose almost 30% between November 2008 and the middle of December 2008. Then it proceeded to decline by 26% over the next five months.

It is clear from the experiences of 2008-2009 that traditional methods of diversification were not sufficient to protect investment portfolios from market risk. The previously cited report by Welton Investment Corporation offered this statement in its conclusion: “As investors discovered following the lessons of the current financial crisis, asset-class-based allocation frameworks and legacy terminology failed many investors seeking guidance in constructing well-diversified investment portfolios.”

For investors who hope to protect their portfolios should the economic crisis of 2008-2009 recur, there are some possible options.

Insurance companies are experts when it comes to mitigating risk and the industry has created many products designed to protect people against investment risk. These include vehicles like fixed annuities, indexed annuities, income benefit riders, and more. Many of these products offer higher returns than traditional protected products like Certificates of Deposit.

These are not risk-free investments, but they may be viable alternatives to traditional market risk. Like any insurance product, they are subject to the stability of the insurance carrier. They also vary widely from one insurance company to another depending on things like the ages of the beneficiaries, the length of the policy, and the expected return. So it would be wise for investors to consult an experienced adviser before making any decisions.

Another possibility is to consider hiring an investment manager that uses tactical rather than passive strategies. Instead of relying on traditional asset allocation, tactical managers take an active approach and try to move assets away from high-risk sectors during periods of market weakness. Some rely on technical analysis and tools to help them decide when to shift investments. Others rely on a more fundamental approach. This is the type of approach favored by many Wall Street managers and institutional investors.

Finally, diversify the diversification. While it is tidy to have all one’s accounts with a single company or adviser that is likely an unsafe approach. A broad mix of investments and managers might offer better protection the next time there is a serious market sell off.

Flint Stephens

For example, in January 2011, CNNMoney surveyed 32 experts and asked them how they thought the S&P 500 would perform in 2011. The consensus was that the S&P 500 would finish 2011 at 1,391. The highest estimate was 1,520 and the lowest was 1,300.

In other words, the most pessimistic expert surveyed believed at the beginning of 2011 that the S&P 500 would perform better than its actual record for the year. The S&P 500 began and ended 2011 at 1,258, something that is highly unusual. The actual return was 10.5% lower than the consensus of the 32 experts.

I readily admit that I have no idea how the markets will fare in 2012. I am hopeful that it will be a better year than 2011 and based on historical returns and small signs of improvement in the economy, it seems reasonable to believe that could be the case.

Fortunately, we have some good technical indicators that can help us make assessments about market strength and direction. As a result, we are not left to merely guess or hope about what stocks are likely to do.

As we begin 2012, most of those indicators are positive.

For example, the chart below shows the S&P 500 (SPX) performance over the past six months. I added the blue line to highlight the upward trend that began in October. The green line marks the resistance level. Right now, the S&P 500 is right at that mark. If it breaks through sometime in the next few days or weeks, the resistance area will become the new support and the index should have the momentum to sustain a longer advance.

The gold line is a 50-day moving average (MA). It is a positive sign of strength and momentum when an investment can trend above its 50-day MA, something that the S&P 500 has generally done since early October.

The bottom two portions of the chart are a moving average convergence divergence (MACD) and a stochastic oscillator. Both of these indicators are also positive and showing good strength and trend.

None of these indicators is foolproof when it comes to forecasting market behavior. They cannot foresee events like an unexpected spike in jobless rates or default on debt by some European country. However, they are good about identifying trends, strength and momentum and right now, the consensus appears to be that those things are all positive.

Flint Stephens

Year 1: The first year of a presidency usually sees weak performance in the stock market. Of the four years in a presidential cycle, the first-year performance of the stock market, on average, is the worst.

Year 2: The second year, although better than the first, is also is noted for below-average performance. According to Hirsch, bear market bottoms occur in the second year more often than in any other year.

Year 3: The third year is normally the strongest of the four years.

Year 4: In the fourth year of the presidential term and the election year, the stock market’s performance tends to be above average.

The chart below shows how the Dow Jones Industrial Average (DJIA) has performed on average during the four years of each presidential cycle over the past century-plus.

Below is one more chart to substantiate the validity of the theory. This one shows that the third and fourth years of a president’s term produce market gains more than 80% of the time.

Of course, we are just about finished with the third year of the current presidential term and the market is not going to experience the type of gain illustrated by the first chart. In fact, this could turn out to be one of the 6% of times when the third year of a presidential cycle produces a loss rather than a gain, as shown in the second chart.

The problem with a theory like this is that it is considering the impact of a single factor and then trying to make a forecast based on incomplete data.

Here is a comment from an Investopedia article about the presidential cycle:

“One of the problems with drawing conclusions from the presidential election cycle is that the theory is based on relatively few observations. Since 1900, there have been only 27 presidential cycles to 2008. Many of the studies done on the theory are based on even fewer observations. For example, since 1948 there have been only 15 different terms - when it comes to statistics, this is a very small sample, which makes it difficult to draw accurate conclusions.

“As such, the theory could be attributed to data mining. In other words, if people are constantly looking at enough data for specific patterns, patterns can emerge, even if there is no significance to them.”

The stock market is incredibly complex. Millions of variables, many of which could be unknown and immeasurable, influence it. For well over a century, extremely smart people have devoted enormous amounts of time and money trying to learn to forecast accurately what the financial markets will do next. Yet to date no one has devised a method that is consistently reliable, let alone foolproof.

When it comes to the presidential cycle, there might be some correlation between presidential terms and market behavior. But there certainly is not a cause-and-effect relationship. And 2011 has again proved that just because something happened in the past does not mean it will be repeated in the future.

Have a great holiday season. Our next market update will probably not be until January 6 unless something unusual and unexpected occurs between now and then.

Flint Stephens