The SweetSpot® Investment Strategy

“Do not start the Star-Spangled Banner on too high a note.”

It’s easy to see that the best time to invest in stocks is at the end of a down market — prices only go up from there.  The end of a down market is reached when people have been selling for some time until, eventually, the selling is done (or overdone). The next person who wants to buy will have to offer a higher price. The downward trend reverses and a bottom is formed.

We want to find that bottom. How do we do it?

First, let’s break down our investment universe into 90-100 market sectors, represented by several hundred sector mutual funds and exchange-traded funds.  Each sector is moving within its own market cycle — going strong, going bust, or going nowhere. Then, we’ll just follow the money. Money moves into each sector and money moves out, like the movements of the tides. We’re looking for the lowest of the ebb tides.  Those are the sectors that are most likely to be at or near the “sweet spot.”

The Sweet Spot

In stock investing, the sweet spot is that point in a market cycle where a downward trend begins to level off — for the first time in a long time, potential rewards now outweigh potential risks. At the sweet spot, the market is saying something like, “Things can’t get any worse and they’ll never get any better” (which is silly if you think about it). The human drama has just about played out, dampening the downward pressure. Even if more bad news emerges, the worst has already been factored into the price, so nothing much happens. But if the news is unexpectedly good, the trend reverses upward and a new market cycle is born:

The Strategy

Let’s buy several of the most-unloved sectors from the previous year.  We know the market has shunned these sectors for a reason — we’ll be ready to hold our noses as we place the trades. Tax-loss selling that occurs in November and December often depresses the prices of already-beat-up sectors even further, so we’ll make our picks based on end-of-year numbers.  We’re hoping to see a last-minute selling frenzy in the sectors we’re about to buy.

It can take a long time to recover from extreme circumstances, so we’ll give our sectors three years to turn things around. Let’s perform the same exercise one year later, buying a like number of additional sectors, and again the year after that. At that point we’re holding a diverse basket of positions. At the end of the third year we’ll sell what we bought in the first year, using the proceeds from those sales to fund the purchases for the upcoming year. We’re left with a nicely diversified, self-perpetuating portfolio that lets us turn our attention to other matters the rest of the year.

SweetSpot’s Results

The SweetSpot^® Investment Strategy has been traded in real time since December 1998.  In 12 years it has outpaced its market benchmark by double-digit percentage points per year, on average. [1]  That’s pretty special — it’s a rare strategy that can consistently beat the market [2] by just one or two points per year.  Moreover, a backtest performed in 2006 showed market-beating returns going back to 1989, the earliest it would have been possible to trade the strategy using sector funds [3].  Looking at each year’s picks as one three-year trade, every completed trade through 2010 has outperformed the market.

SweetSpot’s Prospects

SweetSpot is a stock-investment strategy, and as such it did not escape the carnage of the 2008-09 market debacle.  Through it all, however, SweetSpot managed to adhere to its Prime Directive:  beat the market.  Yet the best evidence of SweetSpot’s validity may be found in what we wrote near the market’s 2009 bottom:  “Looking forward, we may be entering a period when SweetSpot can shine as never before:  As of February 2009, the chart of just about any market sector shows an asset whose price is headed straight for its sweet spot, if it’s not there already.”

Soon after those words were written, the market reversed upward and sustained the kind of advance most investors had never seen in their lifetimes.  SweetSpot outpaced the market by more than 10 points during the snap-back.  Moreover, throughout this period of market turbulence, SweetSpot’s long-term track record has remained outstanding.  When we factor in the hedge program that was adopted in 2009, and the many advantages SweetSpot offers that are unrelated to charts or numbers, the SweetSpot approach to investing looks as special as ever….

Getting Rich is Not Our Goal

Imagine you put forth much effort to get rich, only to find that being rich made you no happier:

Most SweetSpot investors are not seeking riches (but if we were, SweetSpot might well be our preferred method).  We simply want our investments to help us meet our future needs and wishes instead of sabotaging them.  We don’t count on our investments to make us happy; we just want them not to make us unhappy. It’s not too hard to feel happy about our chances going forward….

How to invest in the SweetSpot Portfolio.

Sketches from behaviorgap.com are reproduced here with the permission of the artist, Carl Richards.

Notes:

1] SweetSpot’s reported track record relates to trades that were entered and exited in real time on the dates indicated.  All reported returns, both gross and net, assume the reinvestment of dividends and other fund distributions.  Gross returns show SweetSpot’s record in identifying investment candidates compared with buying and holding a representative-market-index fund.  Net returns show what an investor would have earned after SSI’s advisory fee is deducted.  SweetSpot investing is about the method and not the manager.  Reported returns do not reflect the effects, if any, of material market or economic conditions on trade sizing or intra-trade activity that would have affected actual returns for better or worse.

[2] Performance is expressed as the dividend-adjusted percentage returns an investor would have achieved if she had entered each trade at the beginning of the trade period and exited at the end, neither adding nor selling any shares along the way.  Returns are measured against the corresponding dividend-adjusted returns of SweetSpot’s most-representative market-index ETF(s).  From 1998-2006, SweetSpot trades were selected from a universe of mostly domestic Fidelity sector funds, making the U.S. stock market — as represented by the S&P 500 SPDR ETF (SPY) — the appropriate benchmark for that period.  When SweetSpot converted to a global program in 2007, its benchmark became the global stock market.  Because the S&P 500 has been and remains the performance benchmark most commonly used by domestic money managers, its performance corresponding to all trades is provided.  For trades entered in 2007 and later, global returns are also provided.

Until 2008, there was no ETF available to investors that tracked the global stock market.  Therefore, global stock-market returns corresponding to SweetSpot trades entered in 2007 and 2008 are represented by the combined performance of the three pre-existing ETFs that together comprise the global stock market, in proportion to the size of their constituent markets:

1) S&P 500 SPDR ETF (SPY) (U.S. stocks);

2) iShares MSCI EAFE ETF (EFA) (foreign developed-market stocks); and

3) iShares MSCI EMIF ETF (EEM) (emerging-market stocks).

Beginning with trades entered in 2009, SweetSpot’s global benchmark is represented by the iShares MSCI ACWI Index ETF (ACWI).

[3] Most strategies fall short when investors attempt to duplicate backtested results. Here, however, while the backtest showed a clear advantage over the market, SweetSpot’s real-time results far exceeded what the backtest would have predicted. The backtest merely confirmed that the strategy would have worked over a longer time horizon than the period in which it has been actively traded. Still, no representation is made that investors will see profits similar to either actual or hypothetical past results.

Disclosures:

The principal member of SweetSpot Investments LLC is Neil Stoloff, a former federal environmental lawyer and a student of investing for over 25 years.  Since 2005, Neil has had all of his equity assets invested in The SweetSpot^® Investment Strategy.

The SweetSpot Portfolio’s past trading record is reported here.  When the performance of current positions is reported, information available only to clients that would identify open Portfolio positions is omitted.

Disclaimer:

SweetSpot Investments LLC is a registered investment adviser in the State of Michigan, USA, and is authorized to do business under various exemptions in other States and foreign Nations.  The firm will not solicit or accept business in any jurisdiction in which it is not properly qualified to conduct business.  None of the information presented here constitutes a recommendation that any particular mutual fund or exchange-traded fund, portfolio of funds, transaction, or investment strategy is suitable for any specific person. To the extent any such information is deemed to be investment advice, it is impersonal in nature.

The SweetSpot Portfolio’s past results are not a guarantee of similar future performance.  It should not be presumed that current or future recommendations will be profitable or will equal or exceed the returns of past trades.  Money invested in the stock market is risk capital that can be lost.