By proceeding, I acknowledge that I have read and understood the Disclaimer and Copyright Statements .

Possibly, one the most egregious acts of deception made by Wall Street is to downplay the impact of market volatility. Wall Street does an exceptional job of “selling” the investing public on the importance of “staying invested” because it serves their best interest. The only way for Wall Street to make big money off of you is for you to be invested in equities.

Unfortunately, the majority of financial planners discount the impact of volatility when they do financial planning for their clients.

So, what’s the big deal? Well, let’s take a simple look at it. Say, you have a $100,000 account and in year one it earns 20%. Then in year two, it loses 20%. Wall Street would tell you that your average return is 0% – which is accurate, however, the “true return” on your account would be -4% for the period or just above -2% annually.

In order to calculated the difference between what Wall Street promotes as the historic returns in the market and what an investor would have truly realized, I calculated returns for the Dow Jones Index (DJI) from 1920 to 2005. (I calculated this figure by taking the index’s price returns [% change in prices] and added the appropriate dividend yield.)

The annual average return of the Dow Jones Index (DJI) was 11.8% while the true internal rate of return or as I like to say the “true return” of the index was only 9.9% - almost a full 2% less. [The performance figures for the DJI are skewed up. Click here for explanation]. So, how big of a difference does 1.9% make? Assuming that you start with $100,000 and invest it over 30 years, the difference between an 11.8% and 9.9% “true return” would be $1,141,607 ($2,839,580 @ 11.8% vs. $1,167,973 @ 9.9%).

At The MAC, our goal is to participate in bull markets but protect our clients from losses in bear markets. Since it’s near impossible to “get out” right at the top of the market, here’s the critical question that I’d like to answer. Is an investor better off missing all of the bear/down markets if it means missing a fraction of the bull/up markets? To determine the answer I calculated the following scenario. Assuming an investment in the DJI missed all the down years, but only participated in 70% of all the up years, it would have realized a 10.25% true return versus 9.88% true return with a buy-and-hold strategy - almost a full 0.50% improvement. I calculated this by simply assuming a 0% return in down years and multiplied the return in up years by a factor of .7.

For this example, I assumed a 0% return in down years, when, in reality, an account invested in cash would have earned a modest return. Assuming a 3% return in cash during down years, the true return on this scenario jumps to 11.10% – a 1.22% improvement! In conclusion, it is definitely prudent to avoid down years assuming that you still are able to participate in the majority of the up years.

If you would like a MS Excel spreadsheet of my work, simply submit a comment to this blog with your e-mail address, I’ll be more than happy to send it to you.

It’s important to point out that the return for the DJI is skewed up due to the nature of the index and something called survivorship bias. The DJI consists of 30 stocks that theoretically represent the makeup of the entire stock market. Of the original 30 stocks in the index, only one company is still included, which is GE. The vast majority of these companies are either out of business or have been acquired or merged with another company. The index has replaced old failing companies, with new successful companies. Just in the last 5 years, the DJI replaced 4 of the 30 companies in its index.

The S&P 500 index, which includes 500 stocks, does a much better job of eliminating any survivorship bias. This is why the DJI is hitting all time highs, while the S&P is still 7% below its all time high. Studies by Ibbotson and Morningstar put the S&P’s performance for the same period around 10.4%. I was not able to easily obtain the dividend history for the S&P 500 so I had to use the DJI instead. Furthermore, the purpose of this section in not to calculate expected market returns but rather to establish the importance of factoring in volatility when doing financial planning. From this exercise, we can assume that if the average return of the S&P 500 is 10.4%, the true return of the index should be in the neighborhood of 8.5%.

By proceeding, I acknowledge that I have read and understood the Disclaimer and Copyright Statements .

Dear Clients,

In my October Update, I listed three fundamental reasons why I’m emphasizing SLV over GLD. Recently, I came across a fourth reason in an article on savehaven.com called Leveraging Gold with Silver by Roland Watson.

In his article Leveraging Gold with Silver , Mr. Watson argues that Silver is essentially a means of leveraging the price of gold. He says:

It may seem strange to call silver a gold derivative but that is essentially what it is. It may have its own unique fundamentals that distinguish it from gold but by and large when gold goes up, silver goes up and when gold goes down, silver goes down. However, being a derivative, when gold goes up, silver goes up higher and when gold goes down, silver goes down lower.

What I really appreciate about Mr. Watson’s work is that he went back and ran the numbers to determine the nature of the relationship between silver and gold and he discovered something that I find very encouraging for our portfolio. He discovered that not only is silver a leveraged derivative of gold over the long-term, but the amount of leverage that silver is providing over gold has been increasing gradually since 2003. Furtherfmore, according to his technical analysis, this trend should continue. He says:

…silver eroded as leverage to gold until [it bottomed at] 0.65 in June, 2003. The leverage from June 2003 has since risen to 1.54 today…Not only is silver outperforming gold, but also it is increasingly outperforming gold! If we extend [the] trendline it hits 1.80 by the end of 2010.

Therefore, according to Mr. Watson’s research, silver should outperform gold by 54% - 80% over the next 3 years.

As your investment advisor, I see this relationship take place daily. Movements in SLV are almost always larger in percentage terms than movements in GLD. Since I’m bullish on gold, emphasizing SLV over GLD allows me to use a smaller percentage of your portfolio to gain the total exposure that I’m looking for which allows me to put the rest of capital to use in other plays.

Here’s a link to Mr. Watson’s blogsite if you would like to check it out.
The Silver Analyst

By proceeding, I acknowledge that I have read and understood the Disclaimer and Copyright Statements .

On last Friday, January 5th, Powershares in partnership with Deutsche Bank launched the following 7 commodity based EFT’s:

DBA - PowerShares DB Agriculture Fund (25% S, 25% KW, 25% C & 25% SB)
DBB - PowerShares DB Base Metals (33% AL, 33% LZ & 33% HG)
DBE - PowerShares DB Energy (25% CL, 25% NG, 25% HO & 25% RBT)
DGL - PowerShares DB Gold * (100% GC)
DBO - PowerShares DB Oil Fund (100% CL)
DBP - PowerShares DB Precious Metals * (80% GC & 20% SI)
DBS - PowerShares DB Silver * (100% SI)

Finally, there is a easy, simple and efficient way for the average investor to invest in commodities outside of a mutual fund that tracks a diversified index. The problem that I’ve always had with an index of commodities is that it assumes that all commodities are correlated similar to equities, which they are not.

On Sept 1, ’07, I liquidated my clients’ position in PIMCO’s Commodity Real Return Fund (PCRAX) because I was concerned about the prospect of energy and base metals (The fund is down over 8% since I liquidated it – insert “pat-on-the-back” here). PCRAX has approximately 33% and 20% exposure to energy and base metals, respectively. However, by liquidating the fund, we lost our exposure to agricultural commodities of which I was and still am bullish on.

Which is why I’m very excited about the offerings from Powershares as they afford me the opportunity to invest my clients in a specific sector of the commodity space and minimize exposure to commodities that I’m not in favor of. For my clients, I’ll be adding the PowerShares DB Agriculture Fund (DBA) to your portfolio (I would have already executed this trade but since I believe in maintaining a fully invested portfolio, I do not have any cash in your portfolio and therefore I have to decide what to liquidate in order to free up cash to make the trades). I’m very bullish on the “grains” and I think this will provide you with substantial gains over the next 12-18 months. It’s time for the agriculture commodities to catch up with energy, base and precious metals.

The only regrettable aspect of this fund is that it doesn’t include Coffee. I think Coffee has the most appealing risk/return parameters of all the agricultural commodities.

* Important Note regarding the Precious Metals funds: There is a notable distinction between the the Powershares DB Gold and Silver funds and the other Gold and Silver ETF’s available to investors [iShares Silver Trust (SLV), the iShares Comex Gold Trust (IAU) and Streettracks Gold Shares (GLD)]. The Powershares ETF’s own futures contracts on gold and silver where as their predecessor’s own the physical asset.

This has multiple ramifications for the investor. By using futures to gain precious metal exposure, PowerShares frees up a large portion of the fund to be invested in low-risk treasuries that earn interest which should offset the cost of the fund. However, these funds will also be susceptible to roll yield which can be negative or positive depending on whether the commodity is trading in contango or backwardation. On the flip side, some investors may appreciate the security of knowing that their fund holds the physical commodity just in case our financial markets have a complete meltdown.

By proceeding, I acknowledge that I have read and understood the Disclaimer and Copyright Statements .

2006 was a much better year for the equity markets than I expected it would be. Here’s how the performance of my portfolios shook out against the major indexes.

Core Portfolio………………….……….……..7.5%
Focus Portfolio……………………….…..……6.1%

S&P (VFINX)……………………………….….15.4%
NASDAQ (QQQQ)…………………………..…6.9%
Benchmark (Couch Potato Portfolio)……8.0%

While I got beat by my benchmark index, it wasn’t by much. It’s important to note than less than a quarter of all money managers beat Scott Burn’s Couch Potato Portfolio. Considering that I see myself in the top quartile of money managers, I’m certainly not pleased with trailing my benchmark. There were two primary causes that resulted in me underperforming.

First, I underestimated the ability of the Yen “Carry Trade”, Hedge Fund leverage and the recycling of petrodollars to continue to push asset prices up in spite of significant fundamental issues. I focused too much on the fundamental weakness in the market and not enough on the technical strength of the market. While this type of risk aversion will help you in the long run, I should know better than to discount technical strength in the market. I take responsibility for not sticking with your equity positions in light of the market’s technical landscape. If I hadn’t prematurely pulled out of my foreign equity positions we would have smoked the averages.

Second, your account lost out on some profit opportunities as I shifted from an equity focused portfolio to a precious metals based portfolio. The market’s technical strength weakened as it pulled back in May and June. At that time, I assumed an equity neutral position. In July and August the technical indicators began to improve but I decided to build positions in precious metals versus rebuilding equity positions in light of my long-term outlook. I’ve stated numerous times that I believe that gold and silver will outperform equities by a significant margin over the next 24 months.

We made money in precious metals, but equity gains outpaced gold and silver in the second half of the year. While I built these positions, a lot of your money was in cash, which was adding little value to your account. Furthermore, there is no way to perfectly time a transition such as this. While this hurt your account in the short run, at some point I would have had to shift your account from equity based to precious metals, therefore we would have experienced the hit at some point in time. From a selfish standpoint, I wish my portfolio could have taken the hit when equity markets were declining so it wouldn’t look so bad. But in all fairness, it really does not matter in the long run. Whether we took the hit last year or this year is of little consequence in the grand scheme of things.

While it’s disappointing to miss out on some market gains, I’m not discouraged about getting out of an ageing bull market. I am certainly not alone in missing out of some late gains in this bull market. In my December update, I mentioned several notable investment icons who felt that the current equity market was not worth participating in. None have changed their outlook and I am adding Bill Miller to the list. Bill Miller is the manager of Legg Mason’s Value Trust, which had beaten the S&P 500 for 15 straight years - until 2006. His value fund only returned 5% in 2006.

I’m very optimistic about the opportunities in the market in 2007. I fear that the US equity markets may see a substantial pullback but there are all sorts of opportunities outside the US equity space. In the next 24 months, there will be a much better time to buy equities than today. In the meantime, we can make money in alternative strategies and asset classes.