From the September 2004 issue of Investment Advisor • Subscribe!

September 1, 2004

My Way of Growing

Do you proclaim yourself to be a professional investment advisor? Are you proud of your investing acumen? Let's face it, investing is a difficult task that ironically was made more difficult when we were blessed, or more accurately, cursed, with that wonderful long-running bull market. Then came the sobering bear market. More recently, the market is performing in odd ways--neither bull nor bear. Now is the time when professionalism should manifest itself in what we recommend to our clients. However, many of us are struggling with finding alpha in these market conditions.

When the market was running on all cylinders, we were less likely to worry about how to add alpha, how to create value for our clients. It was simple--just buy anything and watch those stocks or mutual funds go up. These days, it's different. No one knows with certainty where the market is heading, though many say they do. Since I seem to have lost my crystal ball, I have instead relied on my own wits to conclude that I have no idea where this market, or any market, for that matter, is going. All I can do is try to manage the risk and attempt to avoid painful losses for my clients. After all, that's my job, and I want to retain those clients who hired me for my professionalism.

In my previous article for Investment Advisor (May 2004, "A Matter of Principles"), I detailed my personal journey of investing. I explained how I discovered, through trial and error and some poor decisions, that there are no guru managers or easy ways to compound wealth. I discussed how I had started a hedge fund of funds and explored the benefits that such an investing vehicle could bring to accredited investors. My key goal in the article was to share with readers how my partners and I attempt to create value for clients and preserve their capital.

In 1999, many were confident that investing in Nasdaq stocks was the sure way to create value, not only to preserve capital but to grow it. That confidence was misplaced--many investors are still shellshocked and leery of the market five years later. Other individual markets are no better. Take Japan, for instance, which has been in a bear market for 15 years. It would be hard for me still to be a buy-and-hold investor if I were solely invested in the Japanese stock market.

If it were easy to be a successful investor, everybody would do it and we'd all be wealthy. But it's not easy, and most investors don't even come close to reaching their potential for building wealth. There are two ways to build wealth: having a well thought-out investing methodology, and having the time for that methodology to work. Putting these two concepts together--having a plan and letting compounding work its magic--can provide the potential for long-term success. Here's how we do it at Abraham Bedick Capital.

The Methodology

At the end of 1999 we started managing client accounts as well as our own money using the method I will describe. We did not have an opinion on market direction, just a strong desire to preserve capital. Given that we knew that most money managers and investors greatly underperformed the overall stock market, we thought we should focus on determining when to buy as opposed to what to buy. The market shows clear signs of trending at some times more than others. We wanted to position ourselves to participate in opportunities when the overall market was trending up, but more important, to protect our capital when a bear market was signaled. We were not interested in predicting the course of the market, but in participating in rising market trends and exiting markets that we could discern were declining.

We did this using groups of simple mechanical systems based on price and breadth of the market, using advancing issues and declining issues, advancing volume and declining volume, new highs and new lows. Any mechanical system can be easily back-tested and used as a guide. I learned the value of testing and back-testing systems as a commodities broker at a firm that trades via mechanical systems for clients. As a commodities broker, I saw how combining simple concepts that traded under several timeframes and managed risk gave investors the greatest chance for success. However, I also saw how systems that worked well in the past greatly underperformed going forward, or even just stopped working. Even the most productive system from the past may be a mediocre performer in the future, and the reverse could also be true.

So instead of relying on only one signal to buy or sell, I devised a method of using 10 simple mechanical models. I will only scale into the market when there is a strong consensus among those 10 systems. Each component system will experience its prospective drawdown at different times, thus reducing overall account drawdown. The reduced drawdown makes it psychologically easier to continue trading. I have faith in the models as a group. I don't have enough faith in any one system to let it govern the whole portfolio.

No mechanical system can come close to perfection at calling the tops and bottoms of market swings. But I'm not looking for perfection. Rather, I am satisfied with catching most of the wave of bull markets while avoiding most of the undertow of bear markets. I tested more than 60 different systems and saw how they held up over various market conditions. In picking my 10 systems, I have mixed trading systems that use concepts in the public domain, as well as some of my own devising. Simply put, when there is a consensus among the component systems, I need to be invested, and when there is no consensus, I need to be in cash. To make money, I want to be invested when the indexes are going up. To protect clients from losses, I want to be on the sidelines when prices are going down.

Some might argue that this is market timing. I prefer to use the words "capital preservation." I am sure that some buy-and-hold investors think market timers are grossly misguided, and at the same time many so-called market timers just can't understand why buy-and-holders leave their portfolios exposed to potentially huge market risks. My humble goal has always been to avoid major drawdowns and to attempt to stay out of trouble.

To give you an idea of these mechanical systems, I will first show three market breadth systems we use, followed by two market price systems, all of which are based on market internals. A listing and short description of all 10 indicators can be found on the next page.

The Breadth Systems

#1: The McClellan Oscillator. One market internal is gained by using the McClellan Oscillator, which is included in many technical software packages. The Oscillator is the difference between the 39- and 19-period moving averages of the daily advancing issues on the New York Stock Exchange, minus the NYSE declining issues, smoothed with a two-day moving average. The McClellan Oscillator issues a buy signal whenever it crosses from below to above zero, while a sell signal is issued whenever the Oscillator crosses from above to below zero. As I write this, the Oscillator is showing a sell. The first table on page 122 shows the signals given by this one indicator over the past four months.

DateSignal Given

04/08/04CASH

05/19/04BUY

07/21/04CASH

07/30/04BUY

08/04/04CASH

#2: Daily Highs & Lows. Another system using market breadth looks at the number of new highs and lows on a daily basis and adds these two numbers together to get a daily combined value. You then divide the daily number of new yearly highs by this sum, which calculates a 10-day exponential moving average of the results. When the daily value of the moving average exceeds a certain level, a buy signal is given. If it drops below a certain level, a sell signal is given. Here are the buy and sell signals given by this indicator since

April 2003:

DateSignal Given

04/01/03BUY

04/30/04CASH

05/27/04BUY

08/04/04CASH

#3: Yearly Highs & Lows. Another system using the market breadth concept is to take the six-day moving average of new yearly highs and divide by the six-period moving average of the sum of new yearly highs and new yearly lows. Long positions are established whenever the sum of that division is greater than 0.5. The exit signal, in which the user of the indicator goes flat, is given when the six-period moving average of the new yearly lows divided by the sum of the yearly highs and yearly lows is greater than 0.8. Here are the signals provided by this indicator since last year:

DateSignal Given

03/21/03BUY

05/07/04CASH

05/26/04BUY

08/02/04CASH

The Price Systems

The next group of systems is based on price, and is the most powerful group of systems. The price systems can be the difference in values of two moving averages, price rates of change, or simply being above a certain moving average. The two major approaches can be summed up using the following two concepts:

#4 Swing Chart. To increase our odds as far as reliability, I like to see consensus with the various stock market indexes and the broader market such as the the Dow Jones utilities, transports, and industrials, and the S&P 500. This can be accomplished by plotting moving averages for each of the component indexes. If the closing price on a given day is above the prospective index, strength is shown. Probably the most famous proponent of this approach was Dick Fabian, who developed a methodology that signals a buy if the S&P 500 and either the DJIA or the transports are above their prospective 39-week moving average.

#5: The 200-Day Moving Average. This system also follows Dick Fabian, who argued that when you're above a 200-day average, you want to be in the market, and if you fall below that 200-day average, you want to be out of the market. Here's how to use it: Every day, calculate the average of the most recent 200 days' closing prices of the fund or index you are invested in. Then compare the current price of the fund with the moving average. If the current price is above the average, buy the fund or index or hold it if you already own it. If the current price is below the average, sell it if you own it. After you sell, park your proceeds in a money market fund until the fund price is once again above the average.

Working with multiple systems can help investors stay on the right side of the market and avoid drawdowns. The hardest part of all of this is having the discipline to follow a methodology.

Depending on the time frame of the investor, using mechanical models probably does not increase returns and in fact might generate the same cumulative return as the buy-and-hold approach. But using those mechanical systems can potentially provide a much smoother ride for clients. That's a large part of the value I provide to clients, and it helps me to retain them as clients.

Andrew Abraham is a partner with Abraham Bedick Capital in Ft. Lauderdale, Florida, and co-manager of the AB All-Weather fund. He can be reached at a.Abraham@abrahambedick.com.

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