Last week was a volatile one filled with uncertainty that resulted in a sharp decline in stock prices. The Euro dropped to a four year low before rebounding a bit in what appears to have been a “short covering” rally. The 30-year bond yield hit fresh lows for the year and the S&P 500 closed on Thursday at the lowest level since February (taking out the so-called “fat finger” low).

There wasn’t a specific headline to account for the swings, though continued uncertainty about Europe is keeping negative investor sentiment in place for now.

Here at Hoxton Financial, we continue the process begun earlier this year of reducing managed portfolio exposure to stocks. So though the markets are significantly lower, portfolio performance has compared favorably on a relative basis. We stand ready to continue protecting portfolio values if the stock market continues its march lower.

Putting Things in Perspective:

Take a look at where the market (S&P 500) has been over the last few years:

10/07          1565           S&P 500 All time closing high

3/09             683            Down aprox 56% from the peak

4/10            1219           78% above its 3/09 low and 22% below the 10/07 high

5/20/10       1071           12% below its 2010 high, down 4% ytd

Therefore, after a 78% advance from the March lows, the S&P 500 (so far) is experiencing a 12% decline (as of May 20^th).

Why the recent increase in volatility?  Despite the confidence with which the media presents causality of any market event, you can never be sure of the direct cause of any short term changes in market sentiment.  Certainly, there are a number of qualified candidates:

•    Budget ”Crisis” in Portugal, Ireland, Italy and Greece (PIIGS)
•    Civil unrest in Greece due to the required reduction in entitlement spending
•    Lack of confidence in leadership (Legislative and Executive) to get U.S.budgets  under   control and  fear that the European budget crisis is a preveiw of things to come in the U.S
•    The implications of the ”Euro” crisis spreading and derailing the global recovery
•    China taking actions to SLOW their economy due to rising inflationary pressures
•    Fannie and Freddie’s continued drain on the U. S. taxpayer
•    Continued high unemployment
•    Irregular trading activity (most likely due to electronic order routing) which erodes      investor confidence in financial markets 

WHICH IS MORE IMPORTANT–making sure you participate in the market’s 10-best performing days or avoiding the market’s 10-worst performing days over any given period? Based on the 81 years between January 3, 1928 and March 31, 2009, here are some numbers to help us answer this question, according to data from Invesco Aim:

• The 10-best performing days in the S&P 500 index yielded a daily average return of 11.7%. The 10-worst performing days yielded a daily average return of -10.8%.
• If you missed the 10-best performing days, $1 would have grown to just $14.99.
• If you missed the 10-worst performing days, $1 would have multiplied to $143.47.
• If you missed the 10-best and the 10-worst days, $1 would have grown to $47.59.
• On a buy and hold basis, one dollar invested at the beginning of this 81-year period would have grown to $45.18 by March 31, 2009.
• All 10 of the worst performing days occurred during bear markets as did seven of the 10 best-performing days.

Here are a few thoughts on interpreting this data: 

• First, missing the 10-best performing days reduced your growth over the entire 81-year period by about two-thirds compared to staying fully invested during that period. This makes a case for staying fully invested so you don’t miss these big up days.
• Second, missing the 10-worst performing days more than tripled your results compared to staying fully invested. This suggests that historically, if you had magical powers to foresee the future and were out of the market on the 10-worst performing days, your return would have more than tripled the return of the fully invested buy-and-hold strategy. This makes a case for market timing.
• Third, missing both the 10-best and 10-worst days in the market had very little impact on your results compared to just staying fully invested during the entire period. Score another one for buy-and-hold.

But, let’s be realistic. The above numbers are based on historical data, you cannot invest directly in an index, and few people have an 81-year investment horizon. And, by the way, nobody we know has the ability to perfectly time the market and pinpoint the 10-best and 10-worst performing days before they happen.

This data helps support two of our beliefs. First, the historical data shows the importance of risk management relative to return maximization. Second, we design your investment plan to meet your financial goals, not simply to capture or avoid the best and worst days in the market. Ultimately, it’s your number that we are trying to achieve.

Rob Hoxton of Hoxton Financial and Anna Taylor of Anna Taylor Design will host a virtual meeting for members of the presitgious Phoenix Group to discuss the benefits and pitfalls of social marketing for financial advisors. The Phoenix Group represents the financial planning profession’s most forward thinking firms from across the United States. Membership is by invitation only.

THE HARDER THEY FALL, the higher they rise. Would it surprise you to know that the worst stocks during the bear market that ran from October 9, 2007 to March 9, 2009 turned out to be–by far–the best performing stocks over the next 12 months?

Bespoke Investment Group did an interesting study where they took the S&P 500 stocks and ranked them from 1 to 500 with 1 being the worst performer and 500 being the best performer during the October 9, 2007 to March 9, 2009 bear market. Then, they sliced this ranking into deciles, with decile 1 being the 50 worst performers, decile 2 the next 50 worst performers all the way to decile 10, which were the 50 best performers.

They discovered that decile 1 (the 50 worst performing stocks during the bear market) turned around and rose, on average, 371% during the next 12 months that ended March 9, 2010. Decile 2, the next 50 worst performers, rose 184% over the ensuing 12 months. By contrast, decile 10, the 50 best performing stocks during the bear market, only rose 30% over the following 12 months. Essentially, the worst stocks during the bear market performed the best during the bull market and vice versa.

The study also showed that the average change of all stocks in the S&P 500 was 122% over the 12 months following the March 9, 2009 low.    

This study points out one reason why understanding human emotion is an important factor in successful investing. Think of it this way: on March 9, 2009, at the bear market low, would you have been enthusiastic about buying stocks that had declined 80-90% over the previous 17 months? Probably not because your emotions would have been so rattled, yet, those were the types of stocks that turned out to be the best performers over the next 12 months, according to Bespoke Investment Group.

As the last few years have shown, successful investing sometimes requires that you gather your courage and do what seems most frightening because the point of maximum “frightening” may also be the point of maximum profit potential.

With the economy in difficult straights and the financial markets leaving investors wondering when the next shoe will drop, many do it yourself investors are rethinking whether or not to hire an investment advisor. For years investors have turned to investment representatives at large brokerage firms.   Lately though, informed investors have begun looking for greater options and in growing numbers they are turning to smaller independent firms which tout fee transparency, a fiduciary relationship, lower advisor to client ratios and lower costs. A diligent and capable advisor can help develop an investment strategy that may fit the investor’s needs, improve returns, manage risk and reduce the work-load and stress level.

One of the primary reasons that investors are reluctant to hire an advisor is perceived cost. Interestingly, investors are unaware of some of the more punitive hidden costs. When we think of cost, the first one that comes to mind is commissions. Commissions are fees paid to investment sales professionals for selling you an investment. We will limit our focus to mutual funds for the sake of this article. Five percent (5%) is a typical commission for the purchase of a retail mutual fund. Sometimes commissions are hidden in the form of surrender charges and 12b-1 fees but they are present nevertheless. Of course do-it-yourself investors buy “no-load” mutual funds. These are mutual funds that are sold directly by the mutual fund company without the help of a sales representative so no commissions are charged.

When considering whether or not to hire an investment advisor, you should always ask how the advisor is compensated. Where possible you should opt for an advisor who is paid a fee for advice rather than a commission, that way you will know that the advisor won’t be tempted to move you in and out of investments for the sake of generating commissions. Keep asking questions. There is often a big difference between what the advisor is paid and what you actually pay in costs. The better question would be “What are the total costs of the investment strategy?”

There may actually be three different costs associated with an advisor managed investment portfolio. The first is the advisor’s fee which is generally quoted as a percentage of assets under management. At many of the larger firms this fee may be as high as 3% per year. One way to determine an advisor’s maximum fee is to consult their Form ADV (Part II and Schedule F). This is the disclosure document required by the federal government for all Registered Investment Advisors.

The advisory fee is just the tip of the iceberg though. In addition to paying the advisor, you will pay the mutual fund company, even if you are buying no-load mutual funds. The mutual fund costs paid by the investor typically include the fund’s internal expense ratio which according to Morningstar averages 1.32% per year and the mutual fund’s trading expenses which according to a recent study by Virginia Tech, The University of Virginia and Boston College averages 1.44%. Total investment costs could easily top 4%.

You will want to make sure you get a clear answer to your question about costs. Amazingly, many investment advisors are unaware of a fund’s trading costs and this component of expense can be a big one. If the advisor doesn’t know they exist he/she is unlikely to quote them to you. Trading costs are the variable costs paid by a mutual fund to brokerage firms which place securities trades on behalf of the fund. One of the reasons that so many advisors and investors are unaware of these costs is that they are not usually disclosed in the prospectus. You will find them only in the fund’s Statement of Additional Information (SAI).

So when you ask an advisor what his/her fee is, be sure you get the complete answer, not just “My fee is one percent”.

Clients and friends of Hoxton Financial will be dazzled by the presentation skills of the Hoxton advisor team tonight. Forcasts, Past & Present 2010.

What a week! While the US market was only open for four days, there was no shortage of interesting information to digest.

First, the election of Scott Brown in the Massachusetts Senate race served to illustrate that voters have become dissatisfied with something. Of course, it depends on which pundit you ask but the possible culprits could include healthcare, unemployment, the economy or the environment. Whatever the cause, it cannot be denied that the tenor of the administration’s populist rhetoric was stepped up after the election. The markets have historically voted against this sort of political talk by selling off.

Second, the President announced his intention of limiting the size of big banks and reducing the potential for systemic risk by banning proprietary trading operations, ownership of hedge funds or private equity operations, forcing banks to sell these assets at fire sale prices.  Even the President’s own Barney Frank argued against this rapid fire re-regulation of the banks. You can’t put the Glass Stegall genie back in the bottle so fast! Not surprisingly, the markets hated the President’s comments and sold off.

Third, international news is not good. There is growing evidence that Greece’s fiscal problems are spreading to other vulnerable European countries such as Spain and Portugal. Further, China, which recently  initiated a massive stimulus plan is talking about raising interest rates in an effort to slow its economy down. 

These news items helped send the S&P 500 index to a weekly loss of 3.9%. While we may be out of the heat of the financial crisis that engulfed us in the fall of 2008, last week’s action shows that risks remain and we always have to remain vigilant.

DO THE WILD SWINGS WE’VE SEEN IN THE MARKETS over the past couple years defy explanation? How is it that the S&P 500 index can drop 56% between October 9, 2007 and March 9, 2009 and then turn on a dime and rise 69% over the next 10 months, according to data from Yahoo! Finance? How can a company like Bank of America decline 94% and then rise 380% – all in less than the 30 months ending December 31, 2009? Or, how about Alcoa dropping 87% then more than tripling during the same period as Bank of America, according to The Wall Street Journal?

Aren’t the markets supposed to be “efficient” and “rational?”

These massive swings seem to happen with frightening frequency and investors who are unprepared for them will likely pay a heavy price. Benjamin Graham, arguably the “father” of security analysis and author of a classic book by the same name, said the price of a stock reflects two components. The first component, investment value, represents the discounted cash flow of all the company’s present and expected future earnings. The second component, speculative value, is driven by sentiment and emotions such as fear and greed.

It is not much of a stretch to suggest that an oscillation between investment value and speculative value may help explain the head-spinning volatility of the past few years. In other words, as markets rise or fall rapidly in short periods, speculative value may take prominence. Conversely, when markets are stable or moderately trending, investment value may take the lead.

Keeping this idea of investment value versus speculative value in mind can help us do a better job of maintaining a disciplined perspective on market volatility. It can help us better understand and potentially profit from the market’s periodic “inefficiency” and “irrationality.”