Special Bulletin May 9, 2011

Improving how we invest in equities — specifically, in domestic industry sectors — is the subject of this second bulletin in our series covering Brinton Eaton’s new risk management enhancements and how we plan to make them available to you.

We have created and refined a proprietary strategy that helps us to identify —more accurately and quickly than previously possible — when downward trends are developing within a particular equity sector. These “momentum indicators,” as we call them, have been carefully and extensively tested and we are very pleased with the results. Our momentum-based strategy will enable us to move very nimbly to mitigate impending risks to your portfolio, with the goal of significantly enhancing your long-term portfolio performance.

Sector Rotation Itself Is Not a New Concept

We have long employed equity “sector rotation” as an integral component of our investment approach. This involves dividing the domestic large-cap stock portion of your portfolio into industry sectors, and moving among sectors during different phases of the economic cycle. For example, during periods of economic expansion, consumer discretionary and industrial stocks tend to do relatively well; on the other hand, consumer staples and healthcare — the so-called recession-proof industries — tend to outperform during a contraction. Adjusting your portfolio in accordance with these tendencies is a common application of sector rotation.

Our sector rotations have always taken place on the same schedule as our time-intensive, full-scale asset allocation reviews, during which we analyze numerous asset classes and subclasses in addition to equity sectors. However, much can happen in the markets between these broader reviews. Some asset classes and sectors can have quickly developing, yet protracted, periods of significant decline. We asked ourselves: “How can we more nimbly identify the right time for moving in and out of particular equity market sectors?”

We Believe We Have Achieved a Significant Breakthrough

We are pleased to report that, after more than a year of research, analysis, modeling, and rigorous testing, we have created and refined a strategy that helps us to detect, with greater certainty and speed, when downward trends are developing within a particular sector. In doing so, we have identified signals particular and internal to each sector. These signals are called “momentum” indicators.

Momentum strategies, as the name implies, look for inertia in market behavior. They do so by examining sufficient historical data to indicate that a decline in a particular sector is probably not just another blip in the market, but is likely part of a sustained downward trend. Once such a downward trend has been identified, the proprietary strategy we have developed gives a “sell” signal. Subsequently, when an upward trend is identified, the strategy gives a “buy” signal.

In other words, when the sector is in a downturn, it’s time to get out. When it’s on the upswing, get back in. It sounds simple enough, but as the cliché goes, the devil is in the details.

When you see a sector declining, at what point does it go from being a temporary gyration to the beginning of a downward trend? This can be known for certain only after the fact. So, the question becomes: At what point is it highly probable that a decline will continue? This is the question that we focus on with our new strategy.

Distinguishing Signals from Noise

The mathematics behind the momentum signals we will employ are based on those in the field of electrical engineering, where much work has been done in distinguishing signals from noise. While the technical details are beyond the scope of this bulletin, the underlying concepts can be successfully applied to investing, and there is much support for these concepts among respected financial professionals.

It is possible to design a momentum strategy that is very sensitive to movements in the market. However, this strategy will give frequent buy and sell signals, and can often be wrong. It is also possible to design a strategy that is far less sensitive to market movements. This kind of strategy will be very stable, providing relatively few buy and sell signals. The problem with it is that those signals are often quite late—typically too late, on the way out, to avoid much of the decline, and, on the way in, to capture much of the appreciation.

This tradeoff between sensitivity and stability is a hallmark of momentum strategies, and constructing an appropriate strategy is about balancing sensitivity to market movements with signal stability. We can design a momentum strategy so that it lies anywhere we want on the sensitivity/stability spectrum. And, importantly, we can dynamically change just how sensitive the strategy is. For example, if there are external warning signs (e.g., from economic indicators) that the market is about to suffer significant losses, we can dial up the sensitivity of the strategy. Also, we can have the strategy automatically become more or less sensitive depending on things such as market volatility within the sector.

This ability to dynamically go from being more sensitive to more stable — and the way we have layered multiple signals into this decision — is one of the characteristics that we believe distinguishes Brinton Eaton’s proprietary momentum strategy from most others. It is part of our overall approach to being more nimble in responding to fundamental market changes.

What’s in it for You? Winning by Not Losing

We have tested our momentum-based sector rotation strategy against numerous potential market environments. In each of those test environments, the strategy performed at least as well as the relevant benchmark (the S&P 500 Stock Index) and significantly outperformed the benchmark in times of substantial market decline. Over the long term, spanning several market cycles, the strategy tends to build up a sizeable cushion over the S&P Index.

To illustrate this behavior, the following graph shows the results of our backtesting the strategy using actual sector performance over the last 20 years.

This 20-year period includes four very different market environments: two extended bull markets, one bear market exhibiting a protracted decline, and one bear market with a sudden decline. Below is a set of graphs isolating how the strategy would have performed during each of these markets.

As can be seen, the strategy tends to avoid much of the losses in down markets, while more than keeping pace in strong markets. Importantly, it also does a good job of distinguishing between declines that are isolated to specific sectors and those that are spread across the broader equity market.

By finding a reasonably reliable way to avoid big losses, you can be a big winner over the long term. This is an extremely potent investment strategy available to true long-term investors — a strategy whose advantages most investors simply fail to appreciate or exploit. The strategy we are discussing here differs from buying and holding an equity index fund solely by virtue of being out of the market for certain sectors at opportune times. When the strategy says to be in the market, it is not amplifying your returns through leverage, use of derivatives, or any other means of financial engineering — you are simply in the market. Our approach is, therefore, purely a risk management device. It is winning by not losing.

Seizing Opportunities during Equity Market Declines

What is done with the proceeds if and when we exit an industry sector? Since this strategy is intended as an equity investment — specifically, an investment in large cap domestic stocks — we want to stay invested in equities most of the time, to capture long-term growth. Therefore, when we exit a sector, we will typically reallocate the proceeds to other industry sectors that may still have a “buy” signal. This also will present an opportunity to rebalance among those remaining sectors.

There may be times, though, when a preponderance of sectors are getting simultaneous “sell” signals. Should this occur (as it occasionally did during our backtesting period described above), our first course of action is to hold the proceeds in cash. That is the tactic employed in our backtesting illustrations.

But at certain times, this multi-sector sell-off may be signaling a fundamental change in the equity markets that can be exploited. For example, if these signals, combined with other signals from our “dashboard” (introduced in our preceding bulletin) so indicate, we may invest the proceeds in other vehicles that tend to do well in such environments. These investments would be made only to the extent that we believe they would improve the risk management of your portfolio. If we do not see such opportunities, the proceeds would reside in cash until attractive opportunities (including, perhaps, subsequently signalled re-entry into industry sectors) present themselves.

How the Strategy Fits within Your Portfolio

As we pointed out in our preceding bulletin, we continue to firmly believe in asset allocation and rebalancing as the bedrock principles of sound investing. The sector rotation/momentum strategy we describe here in no way supplants those approaches; they coexist harmoniously and mutually enhance each other’s effectiveness. In fact, momentum signals can be viewed as enhancing our systematic rebalancing process, making it more nimble and proactive.

We want to emphasize that our sector rotation strategy is not a forecasting method. We are not trying to identify the top or bottom of a market in advance — we continue to believe that this is impossible. Instead, our goal is to reliably identify a trend as soon as possible after it begins, and react appropriately to position your portfolio accordingly. It is therefore critical that we move quickly on our signals, as they become clear only after the trend is under way. We will return to the importance of nimbleness in our next bulletin.

Note that this type of momentum-based strategy has the potential to be applied to other asset classes as well, including commodities. We will be researching those other possible applications over time.

Again, we have painstakingly tested our momentum strategy and are enthused about the results we believe it will bring to your portfolio. Part 3 of our series of bulletins addresses how we will efficiently deliver this innovation — as well as the “safety net” protection we have developed, and the asset allocation risk enhancements we discussed in our first bulletin — to your portfolio. Please watch for it over the next week.

As always, be sure to let us know if you have any questions along the way.

Please Remember: Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by Brinton Eaton Associates, Inc. d/b/a Brinton Eaton) will be profitable.

Please Also Note/Limitations: Hypothetical back-tested results were achieved by means of the retroactive application of a back-tested portfolio and, as such, the corresponding results have inherent limitations, including: (1) the portfolio results do not reflect the results of actual trading using client assets, but were achieved by means of the retroactive application of each of the referenced portfolios, certain aspects of which may have been designed with the benefit of hindsight; (2) back-tested performance may not reflect the impact that any material market or economic factors might have had on the adviser’s use of the hypothetical portfolio if the portfolio had been used during the period to actually mange client assets; and, (3) Brinton Eaton’s clients may have experienced investment results during the corresponding time periods that were materially different from those portrayed in the portfolio. Performance results have been compiled solely by Brinton Eaton, are unaudited, and have not been independently verified.