Kelly Letter

My Tier 2 Maximum Midcap strategy receives a lot of attention because it’s one of the permanent portfolios in my stock book. It’s supposed to beat the Dow over time, and has, even including its old methodology that took such a hit in 2008. Starting in 2009, it brings the added benefit of timing to avoid future disasters like the credit crisis of 2008.

Here’s a chart of these various strategies against the Dow since Dec. 31, 2002:

Both Maximum Midcap and Value Averaging have beaten the Dow over time, but on wildly different trajectories.

Notice how powerful the Max Midcap (marked in yellow) is when it’s firing on all cylinders, which is to say when the market is rising. It nearly tripled in five years before running into a threshing machine called the subprime mortgage crisis. Those adding more money along the way higher, as my subscribers did, made even more than the chart shows. We popped lots of champagne bottles in those years.

Then came 2008. It was the rappel drop down from the 2007 high to the 2008 low that inspired the introduction of charting to the 2010 edition of my book. My critics — of whom there are many, all blessed with much louder voices than those possessed by my admirers — cried that “Kelly was wrong!” after sitting frustrated during those several years when the strategy worked.

Was the strategy wrong, though, or just incomplete? I told myself that if I could find a way to lessen the impact of that drop from 2007 to 2008, and then participate in the resumption of performance to follow, I’d be in business. I embarked on a quest for better timing. The charting techniques I came up with for the 2010 edition are my best foot forward so far, and did indeed guide Maximum Midcap investors to good stepping-off points before the drop and good stepping-on points after.

I would like to point out, for my critics, that even the strategy in its original form is already back ahead of the Dow, and those who followed its advice to invest more money during the stomach-turning lows of 2008 and 2009 came out even better than the raw performance shown on the chart.

Now, to value averaging.

There are three performance tracking methods for the strategy plotted on the chart. The green bar tracks just the core account, which is the steady 3% quarterly growth achieved by buying and selling. The red bar tracks the core account plus the balance of the plan’s cash account, which ebbs and flows based on the quarterly buys and sells, and can go negative during long periods of weak prices like we saw in 2008-2009 when the plan demanded more buying power than the cash it previously kicked off. The blue bar tracks the core account plus cash flow to show the effect of buys and sells regardless of whether they were made with cash generated by the plan or new cash injected into the plan.

Notice that the core account’s green bar did, indeed, grow steadily all through the housing bubble rise and subsequent collapse. That’s as planned, and is a mathematical certainty. Still, it builds confidence to see its reliable presence on the chart.

The red core-plus-cash-account and blue core-plus-cash-flow bars illustrate what had to happen to make that steady quarterly growth possible in the core account. The reason the core account continued rising on its predetermined 3% quarterly growth pace is that new cash infusions propped it up when prices were cheaper. Look at 2008. The core account grew steadily as evidenced by the green bar being higher. New cash had to work hard to make that possible, however, as shown by both the red and blue bars being lower. The net profit, seen on the red bar by including the new cash needed to keep the plan on track, fell from 2007 to 2008 even as the core account grew on pace.

Eventually, though, the core-plus-cash-account and cash flow always win out. Why? Because those extra dollars invested during low-priced times like 2008 come out as fat profit when prices recover. Hence, in 2009, the red bar shot 47% higher and the blue bar shot 129% higher. The blue bar left everything else in the dust, proving yet again that the tortoise is a better bet than the hare.

The 7-year compound annual growth rate for each bar in the chart was as follows:

3.1% Dow via DIA bought and held

6.1% Maximum Midcap via UMPIX bought and held

9.5% Value Averaging core account plus cash account

12.6% Value Averaging core account only

14.9% Value Averaging core account plus cash flow

We should take a moment to appreciate that Maximum Midcap doubled the Dow’s performance even in its most basic form of just buying and holding. That improves when factoring in monthly buys in most environments and tactical sales in what appear to be dangerous environments, such as the one facing us now.

Even more worthy of appreciation, however, is the outperformance of Value Averaging. Depending on how we track the strategy, its results were either three times, four times, or five times better than the performance of the Dow. That happened during a period that saw both a bubble-based bull market and a bubble-burst bear market, the two most extreme environments.

CXO Advisory Group has maintained an independent audit of my performance since September 2001, from which the following is taken:

We conclude that:

• Over the past few years, Mr. Kelly’s forecasts have been accurate about 60% of the time, which is pretty good.

• His style might be characterized as intermediate-cycle Buffet-like (patience awaiting intermediate-term value), focused on entry and exit points for a few stocks in the context of overall market climate. He sometimes buys, sells and rebuys the same stocks.

• Mr. Kelly looks to buy (sell) during states of maximum gloom (euphoria) stemming from what he regards as superficial indicators. Seasonal trends are an important consideration for him.

In summary, Mr. Kelly’s intuition regarding intermediate- term stock market trading merits consideration by investors and traders.

This is a performance and audit result that you should not underestimate. Most investment services, including the famous and expensive ones, deliver inferior performance — yet cost considerably more than The Kelly Letter. Let’s look at some examples.

James Cramer’s Action Alerts PLUS email service costs $59.95/month. Mr. Cramer is the host of Mad Money on CNBC and Co-founder of TheStreet.com. Here’s an excerpt from the CXO Advisory Group’s report on his performance:

• Mr. Cramer is right about 46% of the time with his stock market predictions, just below average.

• His predictions sometimes swing dramatically from optimistic to pessimistic, and back again, over short periods. It is difficult to infer his guiding valuation theory, if he has one. We wonder whether he tends to be swayed by the arguments of forceful advocates with whom he most recently interacted.

• [Mr.] Cramer’s assessments of viewer-proposed stocks probably have no economic value. His typical viewer would be better off in a broad index fund.

• He sometimes anchors on historical analogies (samples of one), such as: “it’s ‘91 all over again” or “I’m placing my bets for 2004 strictly using 1994’s tip sheet.”

In summary, Mr. Cramer’s stock market calls since May 2000 have low consistency and an accuracy somewhat south of coin-flipping (just below average). He seems more a stream of uncalibrated opinion than a stock market maven.

Surely you can trust Standard & Poor’s right? Wrong. Its newsletter The Outlook costs $29.95 per month. Here’s part of CXO Advisory Group’s report on its performance:

• Based on subsequent stock market performance and our judgments about the accuracy of “The Outlook’s” forecasts, its bottom-line advice about market direction has been correct 49% of the time, about average.

• If we had traded the S&P 500 index based on Outlook suggestions, we would have decreased U.S. equities exposure four times and increased it three times during 5/9/03 through 2/18/05. Assuming that returns on cash would have offset trading fees, following the Outlook suggestions would have slightly underperformed a buy-and-hold approach, mostly because suggested reductions in stock exposures come after significant market declines.

There are many additional eye-opening reports from CXO Advisory Group’s unbiased audits. A sampling:

On Dan Sullivan (The Chartist, $175/year): “His view is generally long-term; his short-term calls have coin-flip accuracy. The summary writings available at Zacks.com are unclear, even contradictory, with respect to exactly when he called the current bull market [and] advised a 100% investment level.”

On Richard Moroney (Dow Theory Forecasts, $24.95/month): “Mr. Moroney is reactive, moving toward cash after a market decline and toward equities after an advance, reminiscent of S&P’s Outlook. Moreover, his adjustments in his recommended cash-equity ratio are too small to make a substantial difference in returns. His short-term calls are equivocal, sometimes right and sometimes wrong.”

On David Dreman: “When Mr. Dreman speculates about the magnitude and/or direction of future changes in the overall market, he is right 52% of the time, which is about average.”

On Doug Fabian (Successful Investing, $99.95/year): “Over the past decade [ending Oct. 2005], his newsletter’s U.S. stock market timing advice has significantly lagged a buy-and-hold strategy. . . . Fabian’s system generated a sell signal on 10/10/05 — pretty bad timing. . . . For the 12 months ended July 31 [2004], VIP Investor lost 33.6%. In contrast, the dividend-reinvested Wilshire 5000 gained 18.3% during this time. Obviously, this is a particularly catastrophic result for Fabian. . . . Fabian the younger is not up to his father’s performance standard. Other sources of market advice likely offer more value.”

Now back to The Kelly Letter. After reading the above reports, you can see why I’m proud of my track record, and why the letter is such a bargain at just $5.48 per month.

Finally, all strategies that I use are explained fully in my Neatest Little Guide series of financial books which includes the Business Week best seller, The Neatest Little Guide to Stock Market Investing (currently in its 2010 edition). The proof that these strategies work is clearly presented for all to see anywhere books are sold.

Few advisory services can say the same.

Intended Audience
Investors looking for a steady hand in a market that is awash in more conflicting information than ever before, yet abides by the same time-tested rules it has always observed.

Anybody can put up a website. Anybody can send email. Anybody can get interviewed by the ever-growing list of print media, radio programs, websites, and television shows. This does not make them experts, nor does it make their advice sound, nor does it mean you need to take action whenever a call is issued. Their posing as experts makes them tempting advisors to a public that has been taught that investing is easy and necessary. It is neither.

However, when approached with emotional control and a firm grasp on the fact that the phrase “get rich quick” should be struck from the language, it can be profitable.

Guided Tour
Many investment services send convoluted or noncommittal market calls that can be interpreted several different ways. This is an attempt to cover for later mistakes. “Well, we never actually said to buy, you see. Please go back and read carefully and you’ll notice . . .” goes the typical refrain.

Not here. I send clear notes with precise buy and sell points. If I change a price, I send a note immediately so you can update your own orders to reflect the new price. You know what I plan to buy or sell and at precisely the price I plan to do it. When and if that price hits, I update the portfolio and send a note. When I make a mistake it’s plain for all to see and I don’t try to hide it. Nothing could be clearer.

This guided tour shows you exactly how each section of The Kelly Letter helps you.

Permanent Portfolios
One of the defining elements of my books is their constant quest for automated, successful investment strategies. These are the permanent portfolios, designed to beat the Dow and S&P 500 over time. There are two shown in The Kelly Letter:

Tier 1: Value Averaging for 3% Quarterly Growth

Tier 2: Maximum Midcap with Timing

Here’s how they’re presented in the letter:

——
TIER 1
——

Steady 3% Quarterly Growth by
Value Averaging the S&P SmallCap 600 Index

Trading Frequency: Once at the end of each quarter

iShares S&P SmallCap 600 (IJR)
- So far this year: -4.2% (from $43.82)
- Last action: Bought 48 shares at 36.20 on Mar. 30
- Shares currently owned: 276
- Next action during: Week of June 28
Last week: IJR 41.96 +0.3%

——
TIER 2
——

Beat the Market by
Leveraging and Timing the S&P MidCap 400 Index
Trading Frequency: Monthly buys, rare sells to avoid big drops

ProShares Ultra MidCap 400 (MVV)
- So far this year: -1.0% (from $24.86)
- Recent action: Bought at $19.52 on Mar. 30
- Trend: Sideways
- Next action during: Week of May 3
Last week: MVV 24.62 -0.3%

The two strategies are explained in Chapter 4 of my book, The Neatest Little Guide to Stock Market Investing.

Up to 2008, the Maximum Midcap strategy that is currently Tier 2 was a fully automated approach that invested more money at the end of each month regardless of the stock market environment. The beauty of that approach was that people could continue running the strategy without my input.

However, the strategy prohibited me from using charting and other timing techniques I use with stocks and ETFs to get Maximum Midcap into the safety of cash ahead of any big market drops I saw coming. The damage of 2008 proved that Maximum Midcap needed more flexibility to limit downside damage from its leverage. That leverage is why the strategy does well in up markets, but also why it gets decimated in down markets.

That’s why I changed to the new three-tier format. The new, fully automated strategy is in Tier 1 and its value averaging approach helps it get through rough markets better than the dollar-cost averaging approach used in the former Maximum Midcap strategy. I want to be able to offer subscribers some type of fully automated system because there may well come a time in their lives when I’m not available to provide advice. That’s why I’m pleased to include automated, steady growth via Tier 1.

The strong outperformance of Maximum Midcap in good times proves that it’s almost always a great approach for putting money to work because the market rises twice as often as it falls. However, the leverage in the strategy needs assistance during the one-third of the time that the market falls — especially in big bears like we saw in 2008. That’s why Tier 2 keeps the spirit of the former Maximum Midcap alive, but with the added safety of my being able to get to cash in times of crisis to protect the gains made in up markets.

Trading Positions
Next is Tier 3, the investments we own outside of the permanent portfolios. Some of them we hold for weeks, others for months, still others for years. Here’s how they’re shown:

——
TIER 3
——

Improve Portfolio Performance by
Trading Individual Stocks and ETFs

Trading Frequency: Variable

OPEN POSITIONS

Bought Name (SYMBOL) at $18.15 on 1/31/08,
at $14 on 10/3/08, and at $10 on 10/22/08 (basis is $13.24)
- Closed 5/1 at $11.77
- Since last monthly issue: +28.6%
- Since investing: -11.1%
- Action to take: hold

Bought Name (SYMBOL) at $47.20 on 10/4/08
- Closed 5/1 at $74.75
- Since last monthly issue: -0.7%
- Since investing: +58.4%
- Action to take: set 5% trailing sell stop

Bought Name (SYMBOL) at $30 on 3/17/09
- Closed 5/1 at $32.66
- Since last monthly issue: +1.2%
- Since investing: +8.9%
- Action to take: hold

These listings are pretty straightforward.

The “Action to take” is what you should assume I think about the position until you receive an email informing you otherwise. Sometimes I specify a limit order to put in place. For example, in a recent issue, the action to take on one position was to double down at $25. We had previously bought it at $28. When it did indeed hit $25, we invested the same dollar amount that we invested the first time. (That’s the meaning of double down.) Our new average buy price became $26.42.

You should know that I often buy more shares of positions that have gone down in value. I research thoroughly and believe firmly in my picks. When they decline in price, I usually view it as a chance to get a better bargain for the same great idea.

In the early 1990’s, I bought IBM (IBM) nine times before it finally bottomed out and made a fantastic recovery, as shown here:

I’ve averaged down on many stocks since then, including Deckers Outdoor (DECK), Dell (DELL), Google (GOOG), Intel (INTC), Maxtor (MXO at the time, but since acquired by Seagate [STX]), Starbucks (SBUX), and Sun Microsystems (SUNW at the time, now JAVA). Every one of the ones I already sold turned around and made money for me; I’m confident that the ones I’m still holding and/or acquiring will become profitable one day, too.

To read more about my way of building a position and then return to reading at exactly this point, click here.

Actions Taken Since The Last Issue
Here I list everything that happened in the previous month. You will have received an email either telling you to place the order if it’s for something that was not mentioned in the previous issue, or confirming the order execution if it was for something from the previous issue. In the example above, subscribers received a note saying that the stock had hit $25 and we bought.

Notice that when a position is completely closed, I show its history. It’s common for me to buy and sell in stages rather than all at once. Gradual moves are helpful in a fluctuating market. Below you can see one stock that was sold in stages, and one that was sold all at once.

Here’s the section:

Actions Taken Since The Last Issue

Sold all remaining shares of Name (SYMBOL) at $20.70 on 4/14:
- Bought at $18.09 on 11/11/08
- Sold half at $19.66 on 1/16/09
- Sold one quarter at $21.29 on 3/17/09
- Sold one quarter at $20.70 on 4/14/09
- Average sale price: $20.33 (+12.4%)

Sold Name (SYMBOL) at $22.33 on 3/23
- Bought at $14.50 on 3/09
- Sold at $22.33 on 3/23
- Performance: +54.0%

Open Orders
These are the orders that are actually placed, ready to execute. They are usually stop losses on positions we own or limit orders to buy a target position or add to an existing position. Very rarely, I’ll take a short position.

Here’s the section:

Open Orders (orders already placed)

Buy Name (SYMBOL) at $7.75 (to initiate)
Buy Name (SYMBOL) at $3.60 (to double down)

If there’s an “Action to take” in the Strategy Summary section, it’s duplicated here. The Open Orders section provides you with a quick glance at what you should have on the books.
Note that I sometimes change the prices of these open orders and inform you via email of the new price. For example, if the first stock falls quickly on bad news to close at $7.78, I might move the buy price down to $7.50 in search of a slightly better bargain. I do my best to inform you of changes well in advance so you have time to adjust your orders.

I almost never send notes requiring split-second action on your part. Don’t expect to receive an email with the subject “SELL NOW!” from me. The market is volatile and unpredictable and I have sent notes requiring same-day action, but it’s very rare. I detest timing strategies. They don’t work and they’re too stressful. The Kelly Letter is not one of them. The standard plan around here is to research carefully, set target prices calmly, and let the market wander where it will. Adjustments, if they happen at all, are not frantic.

Watch List
These are investment ideas that I’m watching, but for which I have not set firm price targets yet. There are no orders on the books. The prices listed are just the levels at which I would start looking carefully to find the best entry point. When one of these price levels is hit, I usually send a note mentioning that XYZ Company has “come into range” and warrants consideration.

I sometimes watch stocks for months and, in one case, years before I buy. Usually I don’t buy. Watching is a big part of this business. Doing nothing is often the best choice. Subscribers receive updates from me weekly, but we sometimes go a month or two without buying or selling anything.

Please understand this before joining me. If you’re looking for fast paced, shoot-from-the-hip stock trading, my letter is not for you. When you are poorer and wiser from having tried that approach, please come back and give The Kelly Letter a try.

If, however, you’re seeking a methodical, leisurely paced approach to the market with little action but big results, then consider joining me.

Here’s the Watch List section:

Watch List (orders not yet placed)

[L] Buy Name (SYMBOL) at $30

[M] Buy Name (SYMBOL) at $10

[H] Buy Name (SYMBOL) at $2.50

[H] high risk | [M] medium risk | [L] low risk

Articles
The investment techniques above work, and work well, but what really sets this letter apart from other services is its curiously readable articles. There’s more to investing than numbers. Investing is an ideas business, and ideas are best when they’re interesting. There’s no reason we can’t have a little fun when we’re making money.

Many subscribers say the letter is the high point of their Sunday mornings. More than a newspaper, TV show, radio broadcast, or magazine, The Kelly Letter provides an erudite summary of all you need to know — which is far less than popular media would have you believe. If you’re tired of mass market information packaged for kiddie culture as insulting to your intelligence as it is useless to your portfolio, join me. You’re not alone. There are other thinkers on Earth, though fewer every year.

To read article excerpts and then return to reading at exactly this point, click here.

Unsubscribe
At the bottom of every note I send to you is a link to unsubscribe or change subscriber options. You can unsubscribe or change your name, email address, and so on using that link.

Of course, unsubscribing is a step I hope you never take. Happily, few people do. As of December 2009, only 17% of all people who’ve ever tried The Kelly Letter have unsubscribed. That’s one of the industry’s lowest figures, and one of my proudest talking points.

Why the high satisfaction? Because it’s cheap, it works, and it’s pleasant. So many investment services are unapproachable or mysterious about their methods, as if they’re doing something that ordinary folks wouldn’t understand. Don’t fall for it. They’re not doing anything that’s beyond anybody else. Just look at their results to see.

You may be able to find a service better than mine somewhere, but you won’t find a friendlier, more accessible voice to accompany you on a profitable journey through the stock market.

It’s a pleasure to work hard for you. We make a lot of money, more than almost any other subscription service including the most famous and expensive ones, and yet the monthly cost is less than a trip to McDonald’s.

If the key to making money in the market is to find bargains, then consider The Kelly Letter to be your first success.

What Others Are Saying
“I have learned a great deal in the short time I have subscribed to your letter, not only about stocks, but about business in general. … I find your enthusiasm infectious and encouraging, enjoy your writing style, and while I don’t always agree with your analysis and opinions on things, I really enjoy reading them and always look forward to reading your weekly letter and updates.”
– Martin Triggs

“You have helped me turn my average portfolio to a market crushing portfolio.”
– Jeremy Miller

“No one else has ever sent me any of these personal ‘best wishes’ sort of emails. That says something about you. The world could do with a few more Jason Kellys. This sort of thing takes just a minute and is good for business but I don’t get the sense that this is the only (or main) reason you do it.”
– Mark Bray

“I wanted to thank you for your sincerity, honesty, and candidness in your latest newsletter. I think you, and Warren Buffett, are the only two stock analysts that ever make it a point to tell the people they represent that they may have missed something.”
– Cade Ruhlman

“I do not use any other subscription service. I enjoy your wit and humor, and especially your philosophy that great investing advice shouldn’t be expensive.”
– Sam Fong

“Your readers get to hear from a ‘real’ person, and they gain more of an appreciation of the soul behind the words.”
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“I now subscribe only to IBD and the Kelly Letter because they are both the best value.”
– Daniel Dahlke

“This newsletter remains the most understandable review of the market, and the most prescient outlook, that I’ve ever read.”
– Tim Patnode

“This holistic approach is much more ‘real world’ to me than books, websites, or newsletters that only address specific trading techniques.”
– Sid Norris

“I really like your style of writing. I sometimes re-read a section, not for the stock info, but because I love the way you write.”
– Sami Abu-Saad

“Your insightful notes, colorful comments, and unexpected humor make for an exceptionally interesting and valuable letter. Thanks for all your work in sharing it with us at a great price.”
– Paul Langrock

“You have caused me a time management problem. I used to spend 1-2 hours a day studying the WSJ, IBD, NYT, Fortune, Forbes, etc. and now I just match what you do and am doing much better than before.”
– Ron Davis

Getting Started
Subscribing is a snap, and pretty low-risk at just $5.48 per month. If at any time you want to cancel, no problem. The automatic charges will stop immediately. You can stay on my free email list forever.

After signing up below, you’ll receive the most recent monthly issue in a day or so, along with a user name and password for accessing the subscriber area of my website where you can see the most recent notes and complete archive. All future updates and issues will be emailed to you immediately after I finish writing them.

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