Annual Performance Review for 2012

| January 27, 2013

Every January, we conduct a comprehensive review of our forecasting, investing and trading performance during the previous year. Accountability is very important to us and this performance review is another way for us to demonstrate our commitment to providing you with a highly reliable service. The audit process itself is admittedly tedious and time-consuming, but we believe it ultimately provides great benefit to both you and us.

Forecasting Audit

In every short-term, intermediate-term and long-term forecast, we provide outlooks based on technical and cycle analysis of the markets that we monitor. Our forecasting methodology identifies two scenarios, one bullish and one bearish, along with the approximate probability of the more likely scenario, providing there is one. These outlooks fall into one of four broad categories.

  • If both scenarios are equally likely, they each have about a 50% chance of occurring.
  • If one scenario is slightly more likely, it has about a 60% chance of occurring.
  • If one scenario is more likely, it has about a 70% chance of occurring.
  • Finally, a highly likely scenario is at least 80% likely to occur.

The likelihoods associated with these outlooks are intentionally imprecise. We do not believe it is possible to calculate probabilities with a high degree of precision when it comes to financial market forecasting, so each category covers a relatively large range and offers only a rough estimate. However, rough estimates are all you need as an investor or trader to be successful over the long run. A disciplined strategy of aligning yourself with the likely scenarios and protecting yourself from the unlikely ones will invariably produce gains over time. With the odds consistently on your side, you will be successful.

The key, of course, is to have reliable probabilities on which to base your decisions. We may claim that a given scenario is ~70% likely, but what assurance do you have that this assessment is reasonably accurate? The only way to know for sure that our forecasting process is reliable is to review the results of past predictions. We performed this auditing process for every forecast during 2012 and the results are summarized in the following tables.

Click here to download the forecast audit data spreadsheet

Each column displays the actual performance of a given forecast category during 2012. The top row, labeled “All Markets,” compiles the results for every forecast in every market that we monitor, and then subsequent rows display the results for individual markets. As usual, there was a great deal of variance from market to market, especially in the equally likely category, reflecting underlying long-term trends. If you would like to check the results of the audit yourself, click on the link below the table to download the spreadsheet containing the data.

Our forecasting methodology performed extremely well during 2012. Our computer models produced 1,779 forecasts during the year and actual probabilities closely aligned with predicted probabilities in every category. The actual probabilities for all categories since we began auditing our forecasts are displayed in the following table.

Inflection Point Identification Audit

Our cycle analysis (CA) methodology identifies temporal inflection points across all time frames for the markets that we monitor. Once a confirmed cycle low is in place, we use CA to determine the window during which the next low is likely to occur. We have tested our methodology using several decades of historical data and the results of this validation process indicate that approximately 70% of all cycle lows should occur within the predicted window. Of the lows that develop outside of the window, about 20% should occur before it begins and 10% should occur after it ends. The following table summarizes the performance of our CA during 2012.

There were 63 cycle lows across all markets and 39 (61.9%) of them occurred in the predicted window, which was slightly lower than theoretical expectations. Of the remaining lows that formed outside of the window, 17 (27.0%) occurred before the window and 7 (11.1%) occurred after it, which was slightly higher than expected for the occurrences before the window. While it is important for actual forecasting results to align closely with theoretical expectations, the ultimate goal of CA is to reliably identify temporal inflection points as they are developing. In this regard, we had another very successful year, as 59 (93.7%) of the 63 lows were correctly identified in real-time as they formed. Even when a given low does not develop within the predicted window, having an accurate time frame for its arrival still enables it to be reliably identified, regardless of whether it is “early” or “late.”

With regard to all inflection points (including alpha highs, alpha lows, beta highs and beta lows), our methodology correctly identified 95.0% of all turning points, while issuing false signals only 6.5% of the time.

The following series of charts displays the identified turning points for each market, along with the accompanying false signals.

S&P 500 Index Short-term Inflection Points

10-year Treasury Note Yield Short-term Inflection Points

US Dollar Index Short-term Inflection Points

Gold Market Short-term Inflection Points

Oil Market Short-term Inflection Points

S&P 500 Index Intermediate-term Inflection Points

10-year Treasury Note Yield Intermediate-term Inflection Points

US Dollar Index Intermediate-term Inflection Points

Gold Market Intermediate-term Inflection Points

Oil Market Intermediate-term Inflection Points

Overall, our inflection point identification process performed exceptionally well in 2012 and we do not foresee making any meaningful changes to the methodology.

Model Investment Portfolio

The PMI Index, which tracks the value of our model investment portfolio, produced a gain of 2.9% during 2012.

The portfolio remained fully defensive throughout 2012 as our analysis indicated that stock market risk had increased to historic extremes. Additionally, the duration of the cyclical bull market from 2009 exceeded three years and late stage cyclical uptrends that occur during secular downtrends carry elevated risk. Our Secular Trend Score (STS) moved further into negative territory after approaching the zero level in 2011. The sharp rise off of the low in late 2009 suggests that the secular bear market from 2000 is maturing. However, a secular buy signal will not be issued until the score moves above the 80 level, so it is highly likely that the secular downtrend is still several years away from its terminal phase.

The stock market experienced another volatile year of violent price swings in both directions, finishing the year with a gain of 13.4%. This type of extreme price behavior is typical during the final stage of a cyclical bull market that occurs during a secular downtrend and it will likely continue in 2013.

Given that the broad stock market, as represented by the S&P 500 index, is the benchmark by which we measure the relative performance of our model portfolio, the PMI Index underperformed by 10.5%. It is highly likely that the cyclical bull market from 2009 will terminate in 2013, so our model portfolio will remain fully defensive. Asset preservation is our top priority in the current secular environment and our model portfolio continues to outperform stocks by a wide margin since its inception at the beginning of the secular bear market in 2000.

Inception Date: January 3, 2000
PMI Index Compound Annual Return Since Inception: 10.2%
S&P 500 Index Compound Annual Return Since 1/3/00: 1.7%

Cyclical Trend Trading System

Our cyclical trend trading system generated a sell signal on April 9 after our Cyclical Trend Score (CTS) moved into sell territory following the violent decline in August 2011. The short position was opened at 1,382.20 on the S&P 500 index when the rally from October 2011 broke down. The stop level for the trade was set 5 percent above the entry point at 1,454.95.

Following a violent decline into the low in early June, the S&P 500 rebounded and violated the stop level in September, forcing the short position to be closed with a loss of 5%.

The cyclical bull market from 2009 is overdue for termination and the next cyclical top could form at any time, so it will be important to monitor the CTS closely for the next potential sell signal.

Summary

Our forecasting based upon technical and cycle analysis provided highly reliable outlooks throughout the year, with actual probabilities closely aligning with theoretical probabilities across all forecast categories. Our inflection point identification process had a very successful year as well, correctly identifying developing lows in real-time 93.7% of the time and identifying 95.0% of all inflection points while issuing false signals only 6.5% of the time. The PMI Index underperformed the S&P 500 index by 10.5%, but the year was characterized by extremely violent moves higher and lower in stocks, and we believe that our defensive portfolio positioning was, and continues to be, well justified. Finally, our cyclical trend trading system generated a sell signal in April and the accompanying short swing trade was stopped out in September for a loss of 5%.

Overall, it was another violent, volatile year in the markets that we monitor, which is precisely what we anticipated during this stage of the secular bear market in stocks that began in 2000. The current cyclical bull market from 2009 could terminate at any time, so it will be important to monitor market behavior closely for the development of a cyclical top. The secular bear is still several years away from its terminal phase, so we expect the current environment of volatility and violent price behavior to persist during the coming year.

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