Seeking Higher Return / Lower Volatility: A Risk-Managed Approach That Alternates Between Offensive and Defensive Based Methodologies.

Gregory J Mistovich Senior Director - Investments Omega Portfolio Management

Is Your Investment Methodology Flawed?

The classic Wall Street investment advice is to hire good managers that buy good stocks, and like watching paint dry, hang in there for the long term, and forget about it. And yes, in a classic study done in 1964 by the University of Chicago Center for Research in Security Prices, stock returns from 1926 to 1992 have averaged over 10% compounded annually1. Bonds have averaged about half of that. And inflation has averaged about 3% during that period. The problem is we cannot all afford to take this decades long approach! Historically there have been extended periods of time of outperformance and extended periods of time of underperformance. For example, from 1965 to 1982 the average annual return was less than 1% compounded annually. This is whats called a secular bear market. From 1982 to 2000 the average annual return was about 14% compounded annually, a secular bull market. Keep in mind though, that past performance is not indicative of future results. Another problem is investor psychology. Many investors tend to buy late into a market rally and sell when prices drop as the psychological stress to avert increasing capital loss becomes too great to bear. In a 20 year study ending 12/31/2008 by Dalbar Associates2, Individuals who had invested in funds that tracked the S&P 500 and the Barclays Bond Index and held their funds for the entire 20-year time period would have theoretically earned reasonable average rates of return, 8.35% and 7.43%, respectively. In reality, however, based on actual mutual fund inflows and outflows, the average rates of return experienced were 1.87% and .77%, respectively. The fact is, When the going gets tough, investors sometimes panic. The traditional wisdom is, Its not timing the market, but your time in the market that leads to good results. I believe the problem with that thinking is..What if one bought the Market in 1929? It took 25 years just to get back to even. What if one bought just before the 1973 oil embargo? It took about 7.5 years just to get back to even. In 1988 the major index in Japan peaked out, and is still down almost 70% after 20 years. In the last decade, there have been two declines in the S&P 500 of over 45%.
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Even if one were a more conservative bond investor, there have been several sharp declines in the bond markets. From 1977 to 1982, long term bonds dropped as much as 50% as the yield on a 30 year US Treasury bond rose from approximately 7% up to 14%. These were some gut wrenching times in the stock and bond markets.

A Sages Advice: Breaking with Tradition.

It is impossible to produce a superior performance unless you do something different from the majority (Sir John Templeton). A slightly different corollary, Adhering to a value approach will tend to lead you to be a contrarian naturally, as you will be buying when others are selling and assets are cheap, and selling when others are buying and assets are expensive. 3 Humans are prone to herd because it is always warmer and safer in the middle of the herd. Indeed, our brains are wired to make us social animals. We feel the pain of social exclusion in the same parts of the brain where we feel real physical pain. So being a contrarian is a little bit like having your arm broken on a regular basis.4 What I will introduce you to in the following pages is an approach that breaks with the traditional hang in there no matter how much money you may lose strategy. Just like a football game alternates between offense and defense, we shall investigate an investment management strategy and asset allocation strategy that alternates focus between scenarios seeking to maximize your income and capital, and scenarios seeking to protect your capital. We shall examine tools that seek to help you grow your income and capital when risk probabilities are low, and tools that seek to help you focus on protecting your capital when risk probabilities are high. We are seeking positive investment results with potentially lower volatility. We will explore a series of processes that allow us to make, with a raised level of confidence, those difficult investing decisions that will separate us from the majority. I would like to share with you some of what I have learned after 35 years of study and experience, first as an advisor, then as an investment management consultant, and now as a portfolio manager. I have also adapted insights from a 45 year record study by James OShaughnessey in his book, What Works on Wall Street. Shall we begin?

What Small Institutions and the Average Investor Would Like.

The largest institutions generally measure their performance against some type of major
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benchmark, e.g. the S&P 500, the Russell 1000. They may also measure performance against a more refined index that measures certain styles or sectors. Generally they are looking for good relative performance. For example, if the Dow went up 10%, they might be happy if they were up 11% or 12%. Conversely, if the Dow went down 10%, they might be satisfied if they only declined 7% or 8%. Not so the typical individual investor. They would like what would be called good relative performance in up markets, in other words, something close to the benchmark. But in down markets, they would like what is called absolute performance. That is, they dont want to lose money when the market goes down. Impossible? Lets see. Is it possible to strive for good results with lower volatility? What if we approached the problem in a different fashion? Lets look at another study, one done by the Society of Asset Allocators and Fund Timers Inc.5 For the 16 year period studied between July 1984 and October 2000, the average annual return of the S&P 500 was 14.83%. The typical buy & hold approach, that Wall Street espouses, only shows part of the issue. That part represents the results of missing the best days in the market. As you can see in the chart below, if you missed the best 40 days, your results dropped to 5.59% annualized. So traditional wisdom therefore says one must hang in there for the long term. What if you were able to miss the 40 worst days? Your results would have climbed to an average of 27.71% annualized. But maybe we cant walk on water. So lets get real. Unfortunately, if you look at history, most often some of the best and worst days are clustered together, both at market low points and market high points. Another impossible minefield to navigate. What we can ascertain is that these clusters of good and bad days occur during periods of high volatility and oftentimes at significant turning points, tops or bottoms. What if we were able to measure the risk levels in the market? A way which might help us stay out of the market during these high stress periods. Ah, but we would then possibly miss some of the best and the worst days. So if we missed both the best and worst days our results would be better than 17% vs. 14.83%, thereby avoiding a lot of psychological stress and market volatility. Reducing volatility, a worthy goal? Yes.

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Causes of Price Movements.

What causes prices to go up and down? More buyers than sellers, and prices go up. More sellers than buyers, and prices go down. Brilliant! The first law of economics, supply and demand. There are a myriad of reasons why individuals and institutions may choose to buy or sell, including everything the standard textbooks teach, e.g. value analysis, growth analysis, economic analysis, and on and on and on. Dont forget greed and fear.
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To boil it down, it is the collective decision of all investors, both large and small, at any point in time, that choose to buy or sell, for whatever reason, that determines prices. It is that collective decision to ultimately accept higher and higher prices (more demand), as there are fewer willing sellers and less supply, that sends prices higher. And conversely, it is the collective decision to ultimately accept lower and lower prices (more supply) by an onslaught of sellers, that will send prices lower.

Power Law Theory.

In a series of not well known, but nonetheless important studies (A theory of power-law distributions in financial market fluctuations. Others also cited.) by a group of scientists at MIT and Boston University6, we find that it is the behavior of the largest institutions in the world that is predominantly responsible for fluctuations in stock prices. The study analyzed millions of transactions from all over the world and encapsulated their study in power law mathematical formulations. You can read the studies if you wish. Bottom line as I described above: it is the collective decision of all investors, both large and small, at any point in time, that choose to buy or sell, for whatever reason, that determines prices. Add to this: the largest institutions (including mutual funds, registered investment advisory firms, hedge funds, government central banks, and sovereign wealth funds, etc.) in the world command the most assets, and by their sheer size, dramatically impact prices, by their overall willingness to accept higher and higher prices as they move large quantities of money into an asset; and conversely, their willingness to accept lower and lower prices as they move large quantities of money out of an asset. It does not matter what methodologies or processes they used to come to a conclusion to buy or sell. It only matters at what decisions they arrived. Again it all boils down to Econ 101, the laws of supply and demand, but with a deeper layer of understanding. Look at it in a different way. If in the spring of 2007, you decided that the excesses of the credit boom were beginning to unwind, and you had a few hundred shares of a major bank to sell. You could sell as soon as you decided with virtually zero impact on the market. If you were a major institution, and you controlled a stock portfolio of $300,000,000,000.00 ( thats $300Billion), and you had a typical S&P 500 financial sector weighting at the time of almost 25%, that means you had about $75Billion invested in the financial area. You see the crisis starting to unfold, and you would like to reduce your exposure to the financials to about 10%. That means you have made a decision to sell 15% of your position, or over $11Billion of stock. If you were to call your friendly broker and give
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him/her that order to sell in one fell swoop, you would overwhelm demand and crush the prices of the stocks you intended to sell. Add to this the probability that very many of the large, larger, and largest institutions in the world are probably coming to the same decision. Collectively, large institutions could have had $Hundreds of Billions of financials to sell. You read the same books, you think the same thoughts. Ditto for the same research. And how can one managers actions be faulted if he/she remains comfortably in the middle of the pack? With virtually no buyers and mostly sellers, the prices would collapse. The most logical decision would be to parcel your selling into pieces over a period of days, weeks, and months. You dont want to tip your hand so that others recognize your decision, and create a stampede for the exits. But the die is already cast and the relentless selling march begins, ultimately driving some financial prices down over 95%. It is these major decisions carried out over a several months-long execution process that can be noticed by even the casual observer. Well call these long-to-execute decisions, trends. It is estimated that the total amount of tradable global investment assets is around $120 Trillion! As these monies are managed, and reallocated, no matter how subtle a large institution may try to be, footprints are left, sort of like a bowling ball going through a python effect. It takes these institutions weeks and months to complete stock and sector reallocations. Again, it is the culmination of these institutions collective decisions, that by their sheer size, takes a protracted period of time to execute, that creates a trend, whether up of down. If you were to physically move your house off its foundation and down the street one mile, do you think you could do it without anyone noticing? Fat chance! You know the story of the ocean-going super-tankers. It will take them a good while to get up to max speed. It will take them miles to slow down and come to a stop. It will also take them miles to change direction while creating a super-giant arc. If we were in a speed boat next to one of these super-tankers, we would have some decided advantages in a race, even if we didnt know where they were going! Lets say we were in a race with ten super-tankers. We would first lay back and wait for them to get underway. Once the tankers got underway and set their course, we would then be able to project their trajectory, and then put the metal to the pedal. If they decided to change course, we would throttle back and simply wait for them to chart their new course. We then repeat our strategy again. Mutatis mutandis, as small institutions and individuals, this is the advantage we could garner as we compete against larger institutions.
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Remember, it does not matter what fundamental and technical tools collectively drive these large institutions colossal investing decisions, we simply wait for them to make their move, and then we kick our strategies into action. Bottom line, institutions that spend $Hundreds of Millions on proprietary research have a distinct knowledge advantage over the average investor or institution. [If you think you are smarter than their research teams, and have the ability to buy what they will invest in next, then this is where we part company.] But these institutions clearly have one very serious disadvantage relative to an individual and small to mid-size institution. It is their massive size which translates into their inability to move massive amounts of money without effecting prices. When you add in the collective decisions of multiple institutions probably coming to similar decisions, the inability to move quickly is even more compounded, no matter how surreptitious they may be, or how stealthily they may trade. They will move prices higher or lower for as long as it takes to complete their new decision and reallocation. This is our advantage. We will use it like David versus Goliath. When Disney decided to buy 30,000 acres near Orlando on which to build Disneyworld, do you think they put out a press release? No. They established several dummy corporations, and used several brokers, seeking to buy different parcels of land, very stealthily, and below the radar screen. But there were some astute individuals that noticed that acres and acres of land and property were being purchased and did not readily sell an attractive price, but held out for a significantly higher price, making a small fortune in the process. Disney made no announcements until after they acquired every property they wanted. We are waiting and watching for the cumulative giant footsteps of large institutions.

A Quantitative Method of Measuring the Flow of Money Into and Out of Markets.
Is there a quantitative and probabilistic method we can use to chart the flow of money into and out of various markets? Voila! Eureka ! I think so. What I am about to show you is the result of some 35 years of study and experience. The tools which I am about to introduce to you, are just that, tools, not rules. Unfortunately the process is still 50% art and 50% science, no black boxes, but the best compilation of tools in my estimation, nonetheless. We will first start with some tools introduced by Charles Dow over 100 years ago that will begin our process of the quantitative measurement of money flows. They will ultimately assist us in measuring money flows into or out of stocks, bonds, mutual funds (from the positions in their underlying portfolio), commodities, sectors, styles, asset
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classes, currencies, international markets, etc. They will also assist us in the development and maintenance of risk management tools. Continued sophistication of computing power, and years of enhancements to Charles Dows tools have afforded us better insight and analysis of net money flow data. We are still left with tools that are still only 50% science and 50% art. Nonetheless, the best probabilities that I have seen. Okay. So let us begin. I will keep the concepts simple. This white paper is intended to be an introduction and not a treatise. The first concept: the Buy Signal and the Sell Signal.

25 24 23 22 21 20

X Buy Signal X X X XOXOX XOXOX XO O X

25 24 23 22 21 20

O OX X OXOXO OXOXO O O O O Sell Signal

The first column is the price, 20 through 25. On the left we then have a column of Xs. Xs represent a rising column. The price goes from 20 to 24 and then reverses down. That reversal down is represented by a column of Os. Os represent a declining column. The price goes down to 21. It then reverses up again to 24, another column of Xs. It then reverses down to 21 again, the second column of Os. Finally the price reverses up again into a column of Xs and ultimately trades higher to 25. That we will call a buy signal, represented by the ultimate decision to pay a higher price, an X that exceeds a previous column of Xs. Demand (the willingness to pay higher prices) causes the price to eventually go higher. We dont care how long it takes. That is noise. We only concern ourselves with the end result. In our second example on the right, again, the first column is the price. In this example we start in a column of Os which represent a declining movement, with the price going from 25 down to 21. The price next reverses up represented by the column of Xs, going from 22 up to 24. The price then reverses down again into a column of Os going from 23 to 21. The price then reverses up again represented by the second column of Xs. Ultimately the willingness to sell at lower prices takes over with the final column of Os taking the price from 23 down to 20, the sell signal, the O that falls lower than a previous
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column of Os. Supply wins. A column of Xs represents rising prices. A column of Os represents declining prices. The columns alternate between Xs and Os. Each column can have only Xs or Os. We need at least 3 Xs or 3 Os to change columns. There are other variations of Buy & Sell signals. That is a lesson for another day. The ultimate concept is still the same. Does the willingness to buy at higher and higher prices win out, or does the willingness to sell at lower and lower prices win out? The second concept: The Bullish % Every stock that we chart is either on a Buy or a Sell Signal. It does not necessarily mean that we buy the Buys and sell the Sells. What we do is calculate the total number of stocks on a Buy signal and on a Sell signal and then calculate their percentage. For the sake of discussion, lets say there are 2,000 stocks on the New York Stock Exchange. 1,500 are on a Buy signal and 500 are on a Sell signal. We can then calculate the Bullish % by dividing 1,500 Buys by 2,000 total stocks and come up with a result that 75% of stocks at this time in our example are on a Buy signal. We say the Bullish % is at 75. We calculate these numbers every day and come up with the new Bullish% every day. We can then put these figures on a graph that simply goes from 0 to 100%. We use the same Xs and Os method. You can see this in the chart below (courtesy of Dorsey Wright & Associates):

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74 | | | 6 74 72 | | | X O 72 70 |-------|-------------------------|---X-O---------- 70 68 | | | X O 68 66 | | | 5 O x 66 64 | | X X O X 64 62 | X | X O X O X 62 60 O-X-O---|-------------------------X-O-X-O-X-------- 60 58 O A O | X O X 7 X 58 56 O X O | 1 O X O X 56 54 O X B | X X O X O X 54 52 O X O | X O X O X O 52 50 O-X-O---|-----5-O-----------------X-O-X------------ 50 48 8 X O | X 6 X X O X 48 46 O X O X | X O X O X O X 46 44 O 9 O X O X O X X O X O 4 44 42 O X O X O X O X O X O X X O X 42 40 O-X-O-C-O-X---X-O-8-O-X-O-----X-O-X-2-X------------ 40 38 O X O X O X O 4 O X 9 X O X O X O X 38 36 O X O X 1 X O X O X O X O X O X O X 36 34 O X O O X 3 X O X O X O B O X O X 34 32 O X O X O X 7 X O X O X O X O X 32 30 O-------O-2-O-X-O-X-O---O-----X-O-X-O-X------------ 30 28 | O X O X O X O X O C O X 28 26 | O X O O O X O X O X 26 24 | O X A X O X O X 24 22 | O X O X X O X O X 22 20 |-------O-X-------------O-X-O-X-O-X-3-X------------ 20 18 | O X O X O X O X O X 18 16 | O O X O X O X O X 16 14 | | O X O X O X O 14 12 | | O X O O X 12 10 |-------|---------------O-X-----O-X---------------- 10 8 | | O X O | 8 6 | | O X | 6 4 | | O | 4 2 | | | 2 0 |-------|-------------------------|---------------- 0 --- 0 0 0 ------ 7 8 9 ----

Again you can see that we alternate between columns of Xs and Os. When the Bullish Percent is in a column of Xs we are in a capital appreciation mode. When the Bullish Percent reverses into a column of Os we change to a capital preservation mode. Just like a football game alternates between offense and defense, we do the same. Also when the chart level is above 70%, we get cautious because the majority of the buying decisions have been made. The risk level is high. Simplistically, everybody is mostly invested and waiting for some new magic supply money to arrive and push the markets higher. Once the indicators reverse into a column of Os, we go into capital preservation mode.
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Once the Bullish Percent drops below 30% we get more positive. This means that the level of risk is decreasing, and we get ready to change to capital accumulation mode when the indicator reverses up into a column of Xs. For the most part, whoever wanted to sell, has done so. Generally both shoes have already dropped. We wait for a reversal up into a column of Xs and change to a capital accumulation stance. We can also calculate the Bullish Percent on the Amex, S&P500, NASDAQ, the whole world, the EAFE, all the sectors, various countries, etc. The third concept: the Trendline. This is a tool to help us determine the probabilities of longer term movements. We do this by drawing a 45 degree descending line from the top of a series of Sell signals, after the price breaks through a previous trendline and reverses direction. This is a Bearish Trendline. The probabilities are that issues trading below this trendline tend to stay there for an extended period of time.

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38.0 37.0 36.0 35.0 34.0 33.0 32.0 31.0 30.0 29.0 28.0 27.0 26.0 25.0 24.0 23.0 22.0 21.0 20.0 19.0 18.0 17.0 16.0 15.0 14.0 13.0 12.0 11.0 10.0 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 -------

| | | | | | | X | | |-X---X-O--|-------------------------------|--------O X O X O | O X O X O | | 8 O B C | | O X O | |-------O-X-O------------------------------|--------| O O X | | 1 X O 5 | | O X O X O | | O X 2 X O | |-----------O---3-X-O----------------------|--------| | O X 6 X | | | O O X 9 X O | | | O X O X O X O | | | O X O X O X O | |-----------|-------7-X-O---O-X-O----------|--------| | O X O X O | | | O X O A | | O O X | | | O X O B | |-----------|-------------------O-X-O-X-O---|--------| | O X O X O | | | O O O C | X Top | | O X O 5 | | O X O X Med |-----------|---------------------------O-X-1-4-------Bot | | O O X | | 2 X | | O X | | 3 |-----------|-------------------------------|--------| | | | | | | | | | | | 0 0 0 7 8 9

38.0 37.0 36.0 35.0 34.0 33.0 32.0 31.0 30.0 29.0 28.0 27.0 26.0 25.0 24.0 23.0 22.0 21.0 20.0 19.0 18.0 17.0 16.0 15.0 14.0 13.0 12.0 11.0 10.0 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 ---------

Conversely, in a Bullish Trendline we draw a 45 degree ascending line from the bottom of a series of buy signals, after the price breaks through a previous trendline and thus reverses course. The probabilities are that issues above their Bullish Trendline tend to stay above the line. See the chart below. (both charts again courtesy of Dorsey Wright & Associates.)

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51.5 51.0 50.5 50.0 49.5 49.0 48.5 48.0 47.5 47.0 46.5 46.0 45.5 45.0 44.5 44.0 43.5 43.0 42.5 42.0 41.5 41.0 40.5 40.0 39.5 39.0 38.5 38.0 37.5

| | | X |---------X-O----------------| X O | X O | X O | X O | X O | X O | X O | X X O X X | X O X O X O X X |-----X-O-6-O-X-O-X-O-X------| X O X O O X O X Med | X O X O X O | X X O O X | X O X O X | X O X 7 X | X O X O | X O X | 5 O X | X O |-X-------------------------| X | X O X O

51.5 51.0 50.5 50.0 49.5 49.0 48.5 48.0 47.5 47.0 46.5 46.0 45.5 45.0 44.5 44.0 43.5 43.0 42.5 42.0 41.5 41.0 40.5 40.0 39.5 39.0 38.5 38.0 37.5

The fourth concept: Relative Strength. In the book What Works on Wall Street, James OShaughnessey tested, in a rigorous manner, what investing strategies can actually be proven to work in the stock market. He got access to the Compustat database and tested everything that had been purported to work: investing based on market capitalization, P/E ratios, price-to-book ratios, price-tocash flow ratios, dividend yields, earnings per share, profit margins, return on equity, and relative strength - - over a long period from 1951 to 1996. He tested them independently and in conjunction with other variables. He found that the market clearly and consistently rewarded certain attributes and consistently punished others over a long period of time. His results were rather conclusive. He wrote, Relative strength is one of the criteria in all 10 of the top-performing strategies. In another study encompassing 1971 to 2003 Dr. John Brush did a study of common return factors and their failure rates. He found that one factor led all the others: Relative Strength7.
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We calculate Relative Strength by taking the price of one item and dividing it by another and plotting it on a chart. The example I have used takes a broad index of Chinese stocks and divides it by a broad world index.

113.692 | 110.113 | 106.647 | 103.290 | 100.039 | 96.890 | 93.840 | 90.886 | 88.025 | 85.255 | 82.571 | 79.972 | 77.455 | 75.017 | 72.655 O 70.368 O 68.153 O 66.008 | 63.930 | 61.918 | 59.969 | 58.081 | ------- 0 ------- 8

| | 6 | X | 4 | 3 X | X X O 2 C O X X 1 X X O X | X | B | X | X | X | | | | | | | 0 9

113.692 110.113 106.647 103.290 100.039 96.890 93.840 90.886 88.025 85.255 82.571 79.972 77.455 75.017 72.655 70.368 68.153 66.008 63.930 61.918 59.969 58.081 ---------------

A reversal occurred on October 30, 2008 indicating that the probabilities favored China outperforming the broader markets. We can use these relative strength calculations on individual stocks, sectors, styles, countries, commodities, currencies, cash, bonds, etc. We can create matrices using massive calculations to help us discern where those supertankers of money are going. It is the collective culmination of our giant institutions decisions to buy at higher and higher prices, or to sell at lower and lower prices, that will eventually manifest themselves in bullish or bearish trendlines, and relative strength buy or sell signals.

Adding Alpha.
Thus, there are many tools we can use to try to add incremental positive results to our portfolio. Just one more example: Sectors. You have most likely seen the various periodic
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tables of investment results sliced and diced multiple ways. One you have probably seen is a periodic chart of performance by sector. Several years ago, Charles Ellis of Greenwich Associates, did a 33-year study of the comparative results of perfect market timing versus perfect stock selection. In the period from 1940 to 1973, he first assumed that he got fully invested (using the Dow) at every bottom and got completely into cash at every top. This resulted in his original $1,000 investment climbing to $85,000 at the end of 33 years. Then he took another approach, assuming he would stay fully invested but would always be in the best group. Over the 33 years, only 28 switches were made, and $1,000 grew to $4.2 billion.8 Obviously nobody is going to achieve either perfect market timing or perfect sector selection. The point is that sector selection is a very important component of improved overall investment performance. Each little tool that we use can incrementally help our overall results.

Chaos Theory.
Ill make it simple. Things happen. The best laid plans can be affected by events coming from left field. Unfortunately, there are many weak links in the current global financial, economic and political environment. Any one of those weak links could snap at any time, and depending on which link were to snap first, could set off its own set of deleterious events. There are thus myriads of potential outcomes when you factor in the combinations of high probability events and random events. This is where a set of proactive risk management tools comes in. (Another discussion for another day.) Its okay to be wrong, but its not okay to stay wrong. Change when the facts change, because its easier to make up opportunity than it is to make up money. Capital preservation and risk management tools are very important.

Playing the piano with both hands.

Yes, fundamental research is very important. Use it to develop a fundamental world macro-economic, financial, and political view. Use it to assess how it translates to the U.S. economy and its markets, and concomitantly to its global counterparts.

A Gestalt Working Method. Putting it all Together.

So we try to play the piano with both hands, using the most effective tools of fundamental, quantitative, and technical analysis (or is that three hands?). We remain
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flexible, using an asset allocation model that is dynamic. We can change when the facts change. We then overlay everything with our risk management tools. We are seek to use a full complement of our tools to help us answer the perennial questions of deciding when to buy and when to sell; what sectors to overweight and underweight; what styles to focus on; how to allocate globally; whether to add currencies or commodities, etc. Even if your focus is on income, these various tools can still offer an investment management overlay. Should we buy long term, or short term bonds? Is money going into government, corporate, municipal, foreign bonds, etc.? Should we have any money invested in foreign currency denominated bonds? When a confluence of our indicators reverses down and suggest caution and heightened risk, we focus on capital preservation strategies. There are also strategies in our defensive playbook that may seek to profit during a defensive period. When money is leaving certain areas, we seek to underweight those areas. When our indicators reverse up suggesting risk has significantly diminished, we focus again on capital accumulation. We seek to focus on those areas that are experiencing a net inflow of money. If you remember the term gestalt from Psych 101, it is the collective form (connecting all the dots of information, opinion, and probabilities) that we put together from the preponderance of the evidence at our disposal at any one point in time. Our decision will be weighted by all the evidence we have at any one point in time from all disciplines. Even at this point, our new craft is still 50% science, and 50% art.

Our Current Hand, Still.

Under the placid surface, there are disturbing trends: huge imbalances, disequilibria, risks call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember I dont know whether change will come with a bang or a whimper, whether sooner or later. But as things stand, it is more likely that it will be a financial crisis rather than policy foresight that will force the change. Paul Volker, former Federal Reserve Chairman, Washington Post, April 10, 2005

An Invitation.
Without any cost or obligation, you are cordially invited to learn more about these methodologies and how they can assist you in the denouement of your investment objectives within your particular risk parameters, whether income and/or growth. How can I assist you in developing your investment policy statement or implementing your investment policy plan?
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Although this tutorial was very basic in tenor, I welcome the opportunity to expand upon it, and discuss with you some of the competitive advantages you might garner by implementing these additional tools and processes into your portfolio investment management, and asset allocation decisions. We are seeking to manage our investment portfolio similarly to that of a world-class professional football team. We want the best players on the field at all times. Each player has their specific role and function. We do this with both an offensive and a defensive team. This is where many individuals and institutions fail. They are always on offense, or have a very shallow defensive playbook. They also do not have a very refined and defined methodology to discern between the times and situations to focus on offense and defense. When should they focus on growing their income and/or capital, and when should they focus on protecting their capital? We have a definable and adaptable process of managing our world-class professional team of offensive and defensive players. We are going to use our processes to determine whether to run our offensive or defensive team and playbook. We are seeking above average results with below average risk. It has been said that history repeats itself, but with a twist. We are continuously seeking to adapt to whatever hand we are dealt. Again, we say its ok to be wrong, but its not ok to stay wrong. We certainly can be wrong, and, at times, will be wrong. As soon as we realize we have the wrong team on the field, or the wrong player, we will adjust. Admitting one is wrong and making the necessary correction as soon as possible is one of the most challenging components of investment management. We will take small losses. But letting them turn into large losses is unacceptable. Mastering this skill and process is a key trait of a world-class investor, consultant, or manager. So even though our processes and methods are 50% art and 50% science, we still have a definable and adaptable series of skills that I believe are better that the vast majority. We are ready for battle in the best of times and in the worst of times. Please allow me to teach you more, and show you how these tools and processes can be adapted to your investment objectives and risk parameters. As Earl Nightingale would say, I wish you the best of everything.

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1 2

Common Sense on Mutual Funds, John Bogle, pgs 7-9. Quantative Analysis of Investor Behavior, Dalbar Associates, March 2009 3 James Montier of GMO, The Seven Immutable Laws of Investing. 4 Ibidem. 5 Advisors group rejects strategy of buy and hold. Denver Post, Sunday, November 5, 2000. 6 Xavier Gabaix, MIT, Parameswaran Gopikrishnan, Vasiliki Plerou, and H. Eugene Stanley, BU Institutional Investors and Stock Market Volatility. http://pages.stern.nyu.edu/~xgabaix/papers/volatility.pdf See also: ibid. A Theory of Large Fluctuations in Stock Market Activity. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=442940 See also: ibid. A Theory of Power-law Distributions in Financial Market Fluctuations. http://www.nature.com/nature/journal/v423/n6937/abs/nature01624.html 7 Dr John Brush, Columbine Capital Services, Inc. 8 The Dick Davis Digest, pg 2, June 7, 1993 Past market performance is not indicative of future market results. Technical analysis is based on the study of historical price movements and past trend patterns. There is no assurance that these movements or trends can or will be duplicated in the future. Point and Figure charts are prepared without regard to any particular investors investment objectives, financial situation and needs. Accordingly, investors should not act on any recommendation (express or implied) or information without obtaining specific advice from their financial advisors and should not rely solely on this type of information as the primary basis for their investment decisions. Any statements nonfactual in nature constitute only current opinions and interpretations of their indicators, which are subject to change without notice. There may be instances when fundamental, technical and quantitative opinions may not be in concert. Any opinions expressed or implied herein are not necessarily the same as those of Oppenheimer & Co. Inc. This material has been prepared and is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available on request. The Omega Group is a program through Oppenheimer & Co. Inc. It offers a unique managed money program in which experienced Financial Advisors act as portfolio managers for their clients. The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted Index (stock price times number of shares outstanding), with each stocks weight in the Index proportionate to its market value. The Index is one of the most widely used benchmarks of US Equity Large Cap performance. Barclays Capital Aggregate Bonds Index (formerly The Lehman Brothers Aggregate Bonds Index): is an unmanaged index comprised of U.S. investment grade, fixed rate bond market securities, including government, government agency, corporate and mortgage-backed securities between one and ten years. Russell 1000 Index (Russell 1000): measures the performance of the 1,000 largest companies in the Russell 3000 Index. Frank Russell Co. ranks the US common stocks from largest to smallest market capitalization at each annual reconstitution period. The Russell 1000 Index represents the vast majority of the total market capitalization of the Russell 3000 Index. It is considered to be generally representative of US Equity Large Cap performance. Morgan Stanley Capital International, Europe, Australia, Far East Index (MSCI EAFE) is an index in US Dollars based on the share price of companies listed on stock exchanges in 20 developed countries outside of North America. This Index is created separately. It is considered to be generally representative of overseas stock markets. 18 of 19

This white paper was prepared by Gregory Mistovich, a Financial Advisor with Oppenheimer & Co. Inc. Oppenheimer & Co. Inc. does not give legal or tax advice. Advisors will work with clients, their attorneys and tax professionals to ensure all of their needs are met and properly executed. Indices are unmanaged, hypothetical portfolios of securities that are often used as a benchmark in evaluating the relative performance of a particular investment. An index should only be compared with a mandate that has a similar investment objective. An Index is not available for direct investment, and does not reflect any of the costs associated with buying and selling individual securities or management fees.

Gregory J Mistovich, CRC Senior Director - Investments Omega Portfolio Management 617-428-5720 800-828-6726 Oppenheimer & Co. Inc. One Federal Street, Floor 22 Boston, MA 02110 Transacts Business on All Principal Exchanges. Member SIPC.

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