High Probability Investing Robert B. Drach AAII Research Triangle February 13, 2016

Drach Market Research

2

Monetary Infusion Cycles

• Economic Growth • Inflation • Some of the strongest bull

markets in history

Result in:

• Fiscal Stimulus (Legislated) • Monetary Stimulus (Federal

Reserve)

Combination of:

CRISIS

NORMALIZATION

EXPANSION

New Deal and 2nd New Deal

+370% 4 Years 8 Months

4

0

50

100

150

200

250

300

350

9/1929 9/1931 9/1933 9/1935

DJIA

World War II

+129% 4 Years 1 Month

5

80

100

120

140

160

180

200

220

12/1941 4/1943 9/1944 1/1946

DJIA

The 1990s

+295% 7 Years 9 Months

6

20003000400050006000700080009000

10000

8/1989 8/1991 8/1993 8/1995 8/1997

DJIA

+172%

“Irrational Exuberance”

6000

8000

10000

12000

14000

16000

18000

20000

10/2007 10/2009 10/2011 10/2013

DJIA

Financial Crisis

+149% 6+ Years

7

Never Look Back

8

40

400

4000

1929 1943 1957 1970 1984 1998 2011

DJIA

FUNDAMENTALS

Stocks are expensive.

KOMPLET

10 Historical Analogs

Each analog has been followed by a major market crash and depressed long term returns

1929

Decline from peak

-89%

Decline from signal*

-89%

Time to break even

24 years 10 months

Lagged T-Note

20 years 1 month

1964

Decline from peak

-48%

Decline from signal*

-22%

Time to break even

10 years 9 months

Lagged T-Note

10 years 6 months

*Signal is when we first saw record earnings and ~19x P/E ratios in each cycle

KOMPLET

11 Recent History

1996 1999 2004

Decline from peak

-19% -49% -57%

Decline from signal*

N/A -43% -40%

Time to break even

N/A 6 years 4 months

7 years 4 months

*Signal is when we first saw record earnings and ~19x P/E ratios in each cycle

KOMPLET

12 Recent History

One Cycle 1996-2009

Decline from peak

-57%

Decline from signal

-4%

Time to break even

12 years 7 months

Lagged T-Note

16 years 3 months *Signal is when we first saw record earnings

and ~19x P/E ratios in each cycle

15.00

20.00

25.00

30.00

35.00

40.00

45.00

50.00

1996 1998 2000 2002 2004 2006

S&P 500 P/E Ratio

KOMPLET

13 Hope for 1990s

Paying 20x P/E within 12% of earnings highs.

1929 1962 1987 1994 1997 2003

Drawdown -85% -21% -22% -5% -5% -30%

KOMPLET

14 High P/Es and Heading Higher

1991-1993 2009 P/E 22.83 – 25.15 42.12 - 123.73

Earnings 22-37% below 1989 Peak

70-92% below 2007 peak

Price/Max Earnings

15.30 - 17.65 8.92 – 12.57

TECHNICALS

Too far too fast.

-50%

0%

50%

100%

150%

0 200 400 600 800 1000 1200 1400 1600 1800

1928 1937 1987 1997 2014DJIA

What too far too fast looks like. Dow up 158% in just over 5 years.

16

17 The Aftermath

1928 1937 1987 1997

Decline from peak

-89% -51% -36% -54%

Decline from signal*

-84% -50% -21% -21%

Time to break even

> 22 years > 12 years < 2 years

< 12 years

Signal is a 158% gain over ~5 years

Is it different this time?

Probably not.

SELL HIGH

BUY LOW

Retail Wholesale

RULE #1

Know your customer

NOT • Corporate Insiders

• Market Makers

ARE • Those seduced by misinformation/hype/

Wishful thinking/media • Scared

RULE #2

Know your inventory

Construct an investment universe of 60 or more quality names

Basic Application • Buy stocks in your universe when they are down

10% or more over the last 4 weeks.

• Sell those same stocks when they have returned over 10%.

• Sell losing stocks only if they have been eliminated from your universe for quality reasons – not price performance ALWAYS sell into strength.

• Target full investment, but if not enough opportunities, hold cash.

DrachResearch.com “NBR” model portfolio

Initiated 5/5/1995

Closed Positions 559

% Profitable 91%

vs S&P 500 (annualized)

+56% (+0.74%)

Excludes trading costs and Dividends

Not an offer to sell securities. Past returns are not indicative of future returns. Data is provided by past advisors and third parties, and accuracy is not guaranteed.

Increase Probabilities: Add Timing

• Buy when 75% or more of your universe is trading down over the last four weeks. (Technical)

• When public/media sentiment are low (Psychological/Media)

• Specialists & Insiders are long. (Professional Positioning)

• Buy gradually over 4-5 weeks. • Probabilities can be improved by adding ancillary

data sets.

Newsletter: Ancillary data

Look for a majority of the following to confirm a BUY indication: • Technical • Psychological/Sentiment • Professional Positioning • Media • Fundamental • Federal Reserve • Non-Professional Cash Reserves • Structural • Macroeconomic

What to Buy – (Newsletter) Concluded Trades EARNINGS YIELD PRICE

Total Positions 759 759 729

% Profitable 93.54% 92.62% 91.50%

Average Gain 8.27% 5.44% 9.32%

# of Weeks Held 28.69 27.23 29.83

Annualized Return 14.99% 10.39% 16.25%

Sell Discipline

• Sell only if you have a sell indication • 75% of your stocks have advanced over the

last 4 weeks. • When public/media sentiment are positive • When specialists & Insiders are short.

• Can confirm with ancillary data sets.

• Sell gradually – over 4-5 weeks • Lock in biggest winners. Only take losses on

stocks that have been removed from your universe for fundamental reasons.

Time Overlay Portfolios 15 Years

Closed Positions 199*

% Profitable 92%*

vs S&P 500 (annualized)

+56%** (+2.43%)

*Sampled from one account as of 9/30/2015 ** Median return of accounts with a 15 year history that have not

deviated from strategy. Time-weighted. Includes trading and management fees as of 9/30/15

Not an offer to sell securities. Past returns are not indicative of future returns. Data is provided by past advisors and third parties, and accuracy is not guaranteed.

Not an offer to sell securities. Past returns are not indicative of future returns. Data is provided by past advisors and third parties, and accuracy is not guaranteed.