With the stock market waiting on both earnings and the economy to improve in order to justify current valuation levels, it would appear that traders are basically trying to decide which way to go from here. (IMO, a meaningful break below 2320 would embolden the bears while a move above 2400 would reinvigorate the bulls.) As such, this appears to be as good a time as any to continue our discussion on portfolio design.

So far, we've talked about establishing goals, selecting time frames, and identifying the correct benchmarks. We've reviewed my take on the three ways to generate alpha (timing, selection, and leverage). Now it's time to get to question of how one goes about trying to outperform.

To be clear, what I'm about to present is merely one man's opinion on the subject. It is worth noting that every active manager in the game attempts to provide outperformance with their methodology. As such, there are any number of ways to try and skin the outperformance cat. But what follows is my take.

First and foremost, it is important to understand that I'm a risk manager - I always have been, I always will be. And cutting to the chase, to me, this is where outperformance and long-term investing success is born.

I agree that "markets work." I also "get" that investors need to "stay in their seats" and ride out the vast majority of volatility events in the markets. However, I firmly believe that investors would prefer not to see their portfolios lose 30%, 40%, or 50% the next time a really big, really bad bear market hits.

Go ahead, do your own survey. Go out and ask 10 investors the following question: If you had a choice, would you choose to stay fully invested in stocks during the next big, bad bear market? In my experience, the answer is, "Uh no."

Therefore, I believe that there are times when the best offense a portfolio can have is to employ a good defense.

But to be clear, I'm talking about the big-picture market cycles here. I'm not talking about trading in and out of the market every week. No, my goal is to get it "mostly right, most of the time" in terms of the really big, really important bull/bear cycles.

Do The Math

I'm sure everyone has seen the "mathematics of loss" stuff. If so, the benefits of "losing less" during the big, bad declines should be obvious. If a market loses 30%, it needs to rise 42.9% from the bottom in order to recover the fall. A decline of 40% requires a rebound of 67%. And if the decline hits 50%, well, a 100% gain is needed to get back to breakeven.

This is why Warren Buffett's first rule of investing is, "Never lose big money." And then rule number two is: "Never, ever forget rule number one."

Here's the key. According to Ned Davis Research, the average gain of the 36 bull markets that have occurred since 1900 has been 85.5%. And during the 18 "cyclical" bull markets that have occurred within "secular" bull trends (which is what NDR believes we are seeing now), the average gain improves to 106.7%.

Furthermore, the average bear market since 1900 has experienced a loss of -30.6% and the average "cyclical" bear that occurs during a "secular" bull (which is what NDR expects the next bear to look like) loses -21.8%.

This is probably why we're told to "stay in our seats" during market declines - the bull markets gain 80% to 107% and the bears see declines of 20% to 30%. Up 100%, down 30%, rinse and repeat. The math works for long-term investors, right!

The problem is if investors "stay in their seats" and ride the bear down, winding up with a decline of 30% in the process, they are forced to "use up" more than half of the gain the average bull enjoys (and 40% of the average gain that occur during cyclical bulls taking place in secular bull trends).

But, if we can somehow manage to "lose less" during the bears, we need to "use up" less of the next bull - and can wind up with more money in the long run. Again, it's about the math.

My Plan

So, like everybody else on the planet, I strive to make as much money as I can during bull market trends. But I believe the real key to long-term outperformance is to manage the risk of severe market environments. In short, I strive to "lose less" during the long, nasty bear markets.

For example, my trusty solar calculator says if we could somehow limit the losses during big, bad bears to say 15% to 20% (instead of 30%), we would need a recovery of 17.6% to 25% (instead of 42.9) in order to get back to where we were before the big, bad bear began. Better, right?

So, my goal is to create portfolios designed to (a) "be around" the benchmarks returns during most calendar years and (b) to "manage risk" when the bears come to call.

Next time, we'll discuss how to put it all together...

Thought For The Day:

Those who have knowledge don't predict. Those who predict don't have knowledge. -Lao Tzu

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

1. The State of Geopolitical Issues
2. The State of Earning Season
3. The State of Trump Administration Policies
4. The State of the U.S. Economy

Wishing you green screens and all the best for a great day,

David D. Moenning
Chief Investment Officer
Sowell Management Services

Disclosure: At the time of publication, Mr. Moenning and/or Sowell Management Services held long positions in the following securities mentioned: none. Note that positions may change at any time.

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Disclosures

The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed constitutes a solicitation to purchase or sell securities or any investment program.

Any investment decisions must in all cases be made by the reader or by his or her investment adviser. Do NOT ever purchase any security without doing sufficient research. There is no guarantee that the investment objectives outlined will actually come to pass. All opinions expressed herein are subject to change without notice. Neither the editor, employees, nor any of their affiliates shall have any liability for any loss sustained by anyone who has relied on the information provided.

The analysis provided is based on both technical and fundamental research and is provided "as is" without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.

David D. Moenning is an investment adviser representative of Sowell Management Services, a registered investment advisor. For a complete description of investment risks, fees and services, review the firm brochure (ADV Part 2) which is available by contacting Sowell. Sowell is not registered as a broker-dealer.

Employees and affiliates of Sowell may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Positions may change at any time.

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