If the stock market climbs a wall worry, then the bull market is far from over and investors have significant gains to look forward to!

Permabears Marc Faber and John Mauldin are sounding the alarm about stocks – both in terms of fundamental overvaluation and technical overboughtness. Faber boldly (recklessly?) says it will happen this year, whereas Mauldin is uncertain as to timing. Nevertheless, Mauldin is expecting a stock-market crash of 50 percent in the ambiguous “future” and recommends diversifying into managed commodity futures (inflation hedge) and government bonds (deflation hedge). Mauldin claims that now is a “terrific time” to take stock profits, because it is “impossible to accurately predict” when a market crash will occur.

“Doom and Gloom” Sells, But Only Enriches the Prognosticator

Mauldin has been scaring investors out of the stock market for years – much to the detriment of their long-term wealth. As financial blogger Barry Ritholtz recently wrote, many investors have completely missed the huge “once-in-a-generation” stock-market rally that has occurred since March 2009. These unfortunate souls kept their money in cash because they listened to doomsday pessimists. It may titillate, but following such fear mongering is damaging to your long-term wealth:

People I speak with who have missed this huge move have been consuming a diet of doom and gloom. If you think that it doesn’t affect you, you’re kidding yourself. Constantly reading about hyperinflation and the collapse of the dollar and the end of the United States as a world power and the student loan crisis and omigod Obamacare is going to crush America and the Chinese are taking over the world and . . . STOP! Right now.

It is recession porn, a focus on the negative that is a leftover effect of the crash and great recession.

Go through your bookmarks, and delete all of these sites: the goldbugs, the end-of-worlders, the doom-and-gloomers, the outraged Fed critics, the Obama haters. They all have agendas that typically have to do with selling you subscriptions or advertising. They are not at all concerned with your returns, your portfolio or your retirement.

Although stocks are vulnerable to a correction, Lowry’s short-term indicators suggest the probabilities favor a rather modest market decline. Beyond the short-term, though, signs of an impending major top, or even of a major correction, remain scarce. Seasonal factors are, historically, far less important than an analysis of current market conditions. And, an analysis of current conditions suggests a still-healthy bull market.

While I agree that modest corrections 5-10 percent corrections are difficult to predict, I completely disagree with Mauldin that market crashes come without warning.

Mebane Faber is a Quant

All one has to do to avoid getting hurt by a stock-market crash is to follow the “Ivy Portfolio” market-timing system, which is based on simple 10-month moving averages (since there are about 20 trading days per month, the 10-month MA is similar to the 200-day MA). The Ivy Portfolio system was developed by Mebane Faber, a 2000 graduate of one of my alma-mater schools (University of Virginia) who majored in both engineering and biology.

Prior to co-founding Cambria Investment Management in 2006, Mebane (pronounced “meb-in”) worked as both a biotech equity analyst and hedge-fund quant, and interviewed for many jobs in between that he didn’t get. He is the portfolio manager of three ETFs, Cambria Global Tactical (NYSE: GTAA), AlphaClone Alternative Alpha (NYSE: ALFA), and Cambria Shareholder Yield (NYSE: SYLD). GTAA (a fund of funds with double layer of ETF fees) has been around the longest (3 years) and has severely underperformed its benchmark, ALFA attempts to clone top-performing hedge funds, has been around 15 months, and has underperformed a similar ETF (GURU), and SYLD focuses on high shareholder yield companies and has done well but is only three months old. I guess real-life investing is not as easy as writing an investment book!

Yale and Harvard Have Outperformed the Rest of Us

The market-timing system is associated with Faber’s 2009 book entitled The Ivy Portfolio: How to Invest in the Top Endowments and Avoid Bear Markets. The gist of the book is that individual investors typically limit their portfolios to two asset classes: common stock (e.g., S&P 500) and bonds (e.g., 10-Year U.S. Treasury notes). In contrast, the multi-billion-dollar endowments at the Ivy League universities of Yale and Harvard invest in many “alternative” asset classes — in addition to stocks and bonds — that significantly improve investment performance. I wrote about the diversification benefits of adding non-correlated asset classes in my four-part series on asset allocation. The Ivy League investment returns over a 25-year period speak for themselves:

June 30, 1984-June 30, 2008

Source: Bloomberg, The Ivy Portfolio

Perhaps even more impressive are the relative performance of the Yale and Harvard endowments during the horrible bear market between June 2000 and June 2003 when the S&P 500 lost 30%. In contrast, Yale generated a 20% positive return and Harvard was up 9%.

Diversification Among Non-Correlated Asset Classes Improves Investment Returns

Of course, Ivy League endowments have access to the best hedge funds, private equity funds, and venture capital funds – all of which are inaccessible to the average investor. But Faber – not to mention Yale Chief Investment Officer David Swensen — believes that the average investor can go a long way towards mimicking the diversification benefits of alternative asset classes by utilizing low-cost ETFs. In a research paper, Faber constructs an equally-weighted (i.e., 20% each) portfolio composed of five asset classes:

• US stocks (VTI)
• Foreign stocks (VEU)
• Bonds (BND)
• Real estate investment trusts (VNQ)
• Commodities (DBC)

Swensen’s model portfolio substitutes inflation-protected bonds (TIPS) for commodities and separates emerging-market foreign stocks from developed-market foreign stocks, but the principle is the same. Faber then compared the performance of his 5-asset portfolio compared to the S&P 500 over the 40-year period between 1973 and 2012 (indices were used for periods when ETFs did not yet exist):

1973-2012

Volatility and Sharpe ratio are much improved, but the annualized return and maximum drawdown (i.e., peak-to-trough decline on a monthly basis) are disappointingly similar. A large portion of the disappointment can be traced to the severe bear markets of 1973-74, 2000-03, and 2008-09 when correlations among asset classes increased markedly at the worst possible time, resulting in all declining in price at the same time. Faber uses 2008 as a prime example (page 4):

The normal benefits of diversification disappeared as many non-correlated asset classes experienced large declines simultaneously. Commodities, REITs, and foreign stock indices all suffered drawdowns over 50%.

If only there were a way to avoid exposure to risk assets during the most severe bear markets, the problem of converging correlations could be avoided and the diversification benefits of different asset classes with normally low correlations could be fully realized . . .

Market Timing Using Moving-Average Crossovers Avoids Crashes

Market timing to the rescue! Faber demonstrates that an extremely-simple trend-following system based on the 10-month moving average dramatically reduces the maximum drawdown of any asset class and increases annualized rate of return to boot.  For each asset class:

1. Wait until the market close on the last trading day of a calendar month.
2. If the asset’s current market price is above its 10-month moving average, invest a full allocation in the asset class for the next month.
3. If the asset’s current market price is below the 10-month moving average, invest in either cash or intermediate-term U.S. Treasury notes (anywhere between 5-10 years).
4. Ignore price fluctuations above or below the 10-month MA during the month – all investment decisions occur only once at the end of the month.

That’s it. The results are amazing. As Faber states, the diversification benefits of a five-asset portfolio are turbocharged by market timing with moving averages:

The additional advantages conferred by timing are striking. Timing results in a reduction of volatility to single-digit levels, as well as a single-digit maximum drawdown. Drawdown is reduced from 46% to less than 10%, and the investor would have only experienced one down year of less than -1% since inception in 1973.

You read that right – over a 40-year period, the portfolio lost money in only one calendar year (2008) and then only by -0.59%! Isn’t the ability to sleep at night with such peace of mind incredibly valuable? Of course, hiding your cash in a mattress also would significantly reduce the maximum drawdown and prevent nominal market declines in any calendar year, so the market-timing system is only useful if the annualized return is similar in magnitude to a buy and hold portfolio. Fortunately, it is not just similar – it is higher:  

1973-2012

If you’re worried that the humongous decrease in the maximum drawdown only occurs because of commodities or bonds and says nothing about the potential for a stock crash, consider this: since 1900, during the 8 calendar years when the S&P 500 (or its large-cap index equivalent prior to 1957) lost 20% or more, the most-negative return an investor in the S&P 500 using the 10-month MA system ever experienced was -4.6%:

After seeing this table, how can you ever become scared reading permabears like Marc Faber or John Mauldin? If they predict the S&P 500 is going to suffer another 40% decline similar to 1931 or 2008, you can just laugh and say “bring it on!” because you will be confident that the 10-month moving average system will totally protect you.

Avoiding the “Big Loss” Does Not Sacrifice High Investment Returns

And don’t feel bad that you will be sacrificing any upside for this peace of mind because you won’t be. Between 1901 and 2012, the compounded average return of the S&P 500 using this market-timing system is 10.2% — higher than the 9.3% buy-and-hold return. Given these fabulous results, why doesn’t everyone trade stocks this way?

Discipline and Long-Term Thinking is Needed to Follow the System

I think the reason the market-timing system is underutilized is because its primary benefit is in avoiding the rare – but deadly – crash, which means that most of the time the system appears unnecessary and a hindrance. The market-timing system can significantly underperform buy-and-hold stock investing during bull markets and trails the returns of buy-and-hold investing slightly more than half the time over the past century. After a few years of underperforming, market-timing investors “give up” and decided to chase higher returns, which usually occurs just before a bear market hits and the market-timing system starts to outperform. Most recently, the market-timing system has underperformed buy-and-hold for four consecutive years (2009 through 2012). How many investors have the discipline to withstand four consecutive years of underperformance and still stick with the system?

Over the Next Few Years, Market Timing Should Shine!

Since 1973, market timing has underperformed buy-and-hold for four consecutive years two other times: 1977-80 and 1983-86. In both instances, the following four years saw market timing outperform buy-and- hold. If the stock market stays true to form this time around, the next four years (2013-16) will see market timing outperform buy-and-hold yet again. Are you ready?

It’s easy to follow the market-timing system – at the end of each calendar month, just visit one or both of the following websites: (1) Doug Short and (2) Mebane Faber. Right now, the system recommends staying fully invested in U.S. stocks, foreign stocks, and REITs, while cashing out of commodities and bonds. Until stocks fall below the 10-month moving average, Marc Faber and John Mauldin should be completely ignored.

Lastly, Faber has an interesting video on his website that suggests ways that the Ivy market-timing system can be modified to produce even better investment performance. Promising modifications include: (1) using a 9-month or 14-month moving average instead of a 10-month, (2) expanding the number of asset classes from five to 10, but then only investing in the four asset classes with the strongest price momentum; and (3) using intermediate-term bonds instead of cash to park the sale proceeds of asset classes that are currently under their moving average.

Even without any complicating changes, however, it’s nice to know that the original Ivy market-timing system enables you to easily avoid stock-market crashes without sacrificing the high-return benefits of long-term stock investing.

Around the Roadrunner Portfolios

CommVault Systems (Nasdaq: CVLT) reported excellent first-quarter financials that saw earnings up 29% and revenues up 21%, blowing past analyst estimates for both. CEO N. Robert Hammer said the company’s success is:

driven by continued demand for our Simpana 10 data and information management software platform and excellent results from our services organization. Our first quarter revenue and earnings performance continues to validate our market leadership and technological innovation combined with our operating discipline.

In the conference call, management said the macro environment is “improving” and the second half of 2013 should be “better” than the first. The stock jumped 10% in a single day and hit a new all-time high. With new highs, CommVault’s price correction that started in March is now officially over, short sellers have given up, and the stock’s positive momentum has reasserted itself.

Darling International (NYSE: DAR)  hit an all-time high on August 5^th, but sold off a few days later by 5% when it announced second-quarter financials that reported revenue down 3% and earnings down a whopping 29% from the year-earlier period. Both figures missed analyst estimates. Despite the miss, CEO Randall Stuewe called the results “solid” and I agree with him because the earnings decline was caused by startup expenses and $2.0 million in deferred profit related to the Diamond Green Diesel (DGD) joint venture with Valero Energy. With DGD now operating and expected to reach full production capacity by the end of the third quarter, Darling’s future is brighter than ever.

Other causes of the earnings decline also are related to important investments that will produce higher growth in future quarters: (1) installation of an Oracle enterprise resource planning (ERP) database system; and (2) acquisition of Terra Renewal Services, which recycles industrial residuals and used cooking oil (returns on investment could hit 30-40%).  In the conference call, management called the pending Terra acquisition, which is expected to close by the end of August, “very exciting.” Even after the recent price sell-off, Darling has gained 8.7% since being added to the Roadrunner Momentum Portfolio, and I expect this second-quarter pause to be followed by explosive growth in coming fiscal quarters — similar to the current success of FutureFuel (see below).

Fresh Del Monte Produce (NYSE: FDP) reported strong second-quarter financials, with earnings up 11% and revenues up 7%, both of which topped analyst estimates. In the conference call, CEO Mohammad Abu-Ghazaleh attributed much of the growth to expansion in emerging markets: the Middle East, Turkey, and the countries of the former Soviet Union. All three major business segments of bananas, fresh-cut produce (except pineapples and melons), and prepared foods grew nicely. The company is buying back its own stock ($64.3 million worth compared to zero in the year-earlier quarter).

Analysts upgraded Fresh Del Monte after the Q2 report and the stock subsequently hit a five-year high on news that competitor Dole Foods is being taken private at $13.50 per share, which values Dole at an EV-to-EBITDA ratio of 11.5. Since Fresh Del Monte is currently valued at only 8.1 times EBITDA, the company could see a takeover premium of more than 40% if an acquirer were to value the company similarly to Dole.

FutureFuel (NYSE: FF)’s second-quarter earnings more than doubled and revenues were up a more modest 3%, but both figures beat analyst estimates. In the conference call, President Lee Mikles characterized the second quarter as a “record quarter for financial performance.” Investors liked the news, sending the stock up 6% on August 9^th.  Biodiesel is the definitely the growth driver for FutureFuel right now, which is benefitting from government subsidies like the $1 per gallon blender’s credit and the Environmental Protection Agency’s renewable volume obligation (RVO) rule.

Since the blender’s credit may not be extended beyond this year, the RVO rule is becoming more important and investors are hoping that the EPA will significantly increase the RVO for biodiesel from 1.28 billion gallons in 2013 to 1.8 or 1.9 billion gallons in 2014 – a development that President Mikles said “would be extremely positive for the business.” Although the EPA has not yet decided the RVO for 2014, one analyst is confident that the biodiesel component will not be reduced because of “in light of the Obama administration’s 5-year record on the subject of green-house gas emissions.” Wedbush raised its price target on FutureFuel to $20, which signifies more than 18% upside from its current stock price.

GrafTech International (NYSE: GTI) reported weak second-quarter results with earnings down 86% and revenues down almost 5%, yet the stock barely reacted because the company matched analyst earnings estimates and actually beat on revenue! Forward guidance for full-year EBITDA and cash flow from operations was reduced.  Moody’s affirmed the company’s credit ratings, but warned that things need to get better soon or a downgrade could occur.

Reason? Steel products make up 75% of GrafTech’s business and the global steel industry remains in a deep recession and there is a glut of graphite electrodes thanks to Chinese entrants, resulting in a sharp drop in selling prices midway through the second quarter. As CEO Craig Shular said during the conference call:

I don’t know if it’s the bottom yet. I know many producers are struggling. They are reporting their numbers. Chinese producers are losing a lot of money. The economics in the industry are very-very stressed. So time will tell. I think big picture, looks like the rate of decline in the EU is starting to slow. So it looks like that EU is trying to find a bottom. That’s about 35% of our sales. So that would be a key part to recovery. U.S. is better for sure; probably our best steel market has been in the U.S. But even that’s not without challenges. And then of course you have seen, everyone has seen that China slowed down. So I don’t know if this is the bottom. I think bottoms we always see in the rearview mirror.

So our team is continuing to drive productivity improvements, costs out of the door, a lot of quality improvements. When we do emerge from this trough, we have got four great acquisitions. They are integrated. Our cost structure will be much better. Our product offering would be much broader. Engineered Solutions will have the girth to be a nice profitable growth business. When the economies really do recover for the steel sector, you will see us well positioned to beat all of our historic financial numbers.

Things currently appear gloomy, but that is almost always the case with deep value stocks and I’m convinced that all of the bad news is already priced in. After all, GrafTech has gained almost 13% since joining the Roadrunner Value Portfolio despite the worsening steel-industry problems! 

Let’s remember that the Engineered Solutions division (25% of company revenues) is going gangbusters, achieving record sales in the second quarter.  One thing is certain: the steel industry will recover at some point and GrafTech will be one of the survivors given its strong balance sheet and leading market-share position in graphite electrodes. When the recovery occurs, watch GrafTech fly!