Welcome to this week's edition of the Big Saturday Interview. I'm delighted to have with me Wall Street Veteran Mark Hulbert. Mark has been writing and publishing The Hulbert Financial Digest for over 20 years, tracking the advice of over 180 newsletters since 1980. In addition, Mark writes regular columns on MarketWatch, a bi-weekly column for the Sunday New York Times and a quarterly column for the Journal of the American Association of Individual Investors. You may have seen him on Wall Street Week, ABC's World News This Morning, or CNBC. Mark is regularly quoted in The Wall Street Journal, Barron's and Money Magazine.

Eddie: Welcome, Mark. A lot of people certainly know your name, but can you explain what it is that you actually do?

Mark: Well, what I do with the Hulbert Financial Digest is almost like a Consumer Reports, I guess is the best analogy--we rate the performance of the investment advisory newsletters. We are not advisors ourselves, which is important because we are not in competition with those whose performance we do track. What we have to offer is our objectivity in tracking the performance who are tracking advice as investments.

The reason I got into it is really just a series of accidents. I had just got out of graduate school, and I had a job that took me to an investment conference. I was to interview one of the speakers at the conference for a magazine article. That was my first exposure to investment newsletter medium, and I was frankly shocked at what I saw. The way I recall it is that newsletter editor after newsletter editor would get up on the podium and brag about how much money that each one of them would have made if they were smart enough to follow their advice over the last year. We knew that they couldn’t all be telling the truth because they were contradicting each other. But because no one really had historical memory to remember what was said the year earlier, there was no way to verify if any of them were even telling the truth. . So it was a way of setting up a system that in concept is incredibly simple. All we are doing is doing what the newsletter is telling us to do, and that is to see if you would have made or lost money by following the advice of their model portfolio.

Eddie: Logic would say that these newsletter writers should have some impressive background to actually write these newsletters. To a beginning investor or trader, what has your research over the years found about that assumption?

"...there is no correlation between educational attainment and performance in the market."

Mark: Well, quite a bit. I want to endorse what you are saying--that everyone appears to be an expert, but in fact they are not. The fact is that there are no requirements to become a newsletter editor. There are requirements to become an investment advisor; you can become registered with the S.E.C. as an investment advisor by jumping over a relatively small hurdle. I don't know all the there's a filing fee and you have to fill out some questionnaires and so forth , but there are no educational requirements or professional achievements that are required to become an investment advisor. Now having said that, I don’t know what educational requirement I would actually put to become an investment advisor. Something we have found is that there is no correlation between educational attainment and performance in the market. If the government were to start getting involved in saying there is a certain requirement to become an investment advisor, I would oppose it, because there is no evidence which shows that only certain approaches work, or that a certain type of education works. The sobering fact is that, Ph.D.s have no higher performance in the market than high school dropouts. Now there are plenty of people who claim to be experts, but are not. So skepticism seems to be the best approach to much of this part of the business.

Eddie: Something I have personally noticed is that newsletter advisors do not generally trade or invest their own money. I would venture to say that a vast majority of these newsletters do not perform well because these people are not themselves traders or investors. Am I correct to assume that?

Mark: I am sure what you are saying is largely true, but most newsletters are affiliated with some money management arm as well. In fact, a lot of money managers use newsletters as a way to get clients.

Eddie: But whether they live or die is not based on how correct their forecasts are--they get paid whether they are wrong or right, correct?

"...It's a business that does require an enormous amount of promotion..."

Mark: Well, I think I see the direction you're going and I'm not sure I totally agree with the sentiment. Yes, on the one hand, newsletters get paid regardless of whether their performance is good or bad, but that is true for a lot of money managers--they get paid on a percentage of assets--so I'm not sure there's any distinction there. Most newsletter editors--privately and off the record--will say they don’t make much money from putting out their newsletter, that where they make their money is from money management. In fact, I saw a survey a number of years ago by a trade association in which the vast majority of newsletters editors said would have made more money doing something else. It's a very tough business. Even though it looks like it's easy--just hang out a shingle and send out a thousand newsletters and if can get people to pay you a couple hundred dollars each, that's not a bad business. But it turns out the advertising costs involved in getting that many people interested in paying you that much money are enormous and even if you get them to do that, very, very few ever do. It's a treadmill in that you're constantly having to advertise and keep your name out there. That, by the way, leads to one of the distinguishing features of the industry: you see an enormous amount of self-promotion. It is a turn-off to a lot of people; a lot of these editors have huge egos. They're on CNBC and other places always promoting themselves, and that is because they're on a treadmill--if they stop, they would have to close up shop right away and probably go bankrupt. The reason is that at any given time they have a year's worth of unfulfilled subscriptions from all their newsletters and they've already spent the cash that they got from selling their subscription but have a year's worth of obligations down the road, but they have to stay in business or they would have to refund the money that they already spent. It's a business that does require an enormous amount of promotion.

Eddie: Let us take a look at a bit of your research. I think the crown jewel of your research is the correlation between sentiment extremes among investment advisors. A vast majority of bullish is bearish, and a vast majority of bearish is somewhat bullish. Can you elaborate a little on that finding and how that correlation has performed among the years?

"...We found that sentiment is best at predicting the market's direction for the next three months..."

Mark: The overall philosophical viewpoint that my data supports is known as contrarian analysis. I'm not by any means the first person to look at, nor do I represent I am the first person to look at contrarian analysis. A lot of people look at sentiment indicators; they like to look at that as a reliable gauge or barometer of what the mood is of the markets. What I think the contribution of my work is to use investment newsletters in a unique way as a gage of a popular mood in the market. What is different about my gauge of sentiment based on newsletters is that we are looking at what newsletters are actually doing in their portfolios. For example, Investors Intelligence, which is a very respected service that has been looking at investment advisory sentiment for now over 40 years, and newsletters are the basis for their sentiment gage. They actually tried to gauge newsletters by their word choices they make and the prose with which they describe their particular opinion, which we find enormously difficult--I don't envy their job at all--because it's very difficult to decide at times whether somebody is bullish or bullish but expecting a correction, which is a distinction they make. I frankly don't know of any bullish newsletter that doesn't also acknowledge the possibility of a correction. It's somewhat of an art form to decide which group to put a newsletter in. We just avoid and side-step all those difficulties by measuring what percentage exposure to the market each newsletter is recommending.

We've been tracking newsletters since 1980, so we have an enormous amount of data with which to measure this. We've found that it is a very good measure, though nothing is a guarantee. It does, however, have a lot of statistical significance, enough to convince a skeptical statistician that this is more than just random. As you said earlier, when there is extreme bearishness, it is more than likely to be followed by positive market action. And by the same token, when there is extreme bullishness, it is more likely to be followed by sub-par market action. We've looked at what time frame is the most reliable basis for looking at those forecasts. We found that sentiment is best at predicting the market's direction for the next three months. It does an okay job for the next one month, but it does better for three months. Interestingly enough, it does a better job with the NASDAQ than it does for the broader market.

Eddie: Do you think that is because of the emotionalism that you find among traders in the NASDAQ?

Mark: Yes, I have come to the same conclusion as you have. The NASDAQ--perhaps more than the broader market--is one dominated by emotion and therefore emotional swings tend to tend to correct themselves more than in a more diversified market.

Eddie: Do you have an idea of the methodologies these newsletters use to come up with their opinions? Which metholodogies do you see working--and not working--for them?

"I find over and over again between two newsletters that will each follow decent strategies, the one that will do the best over the longer term is the one that will stick with its strategy"

Mark: If you asked me this question 25 years ago when I first started doing this, I would have thought I could give you a simple answer by telling you "these are the methodologies that work" and "these are the ones that don’t work." I now am of the opinion that there are an enormous number of decent strategies that will work in the right hands, and will not work in the wrong hands. So my statistical work does not show the methods that work and the methods that don’t work. Of course there are methods that are just silly and will never work, but the subset of strategies that could work is fairly large. The difference between a strategy that works in one hand and doesn't work in another is the discipline that actually followed that strategy through thick and thin. I find over and over again between two newsletters that will each follow decent strategies, the one that will do the best over the longer term is the one that will stick with its strategy during those temporary times when it perhaps is not in sync with the market. The one that ends up over time having the poorer performance will be the one that doesn't have the courage of its convictions and when it's not in sync with the market, it decides to jettison the strategy and adopt something new.

Eddie: Let’s say you have a well-disciplined advisor, using a good strategy. With this assumption, what strategies do you find work in the hands of a person who applies correctly?

Mark: It's a wide, wide range. All the way from short-term trading to longer-term buy and hold stock picking strategies, from fundamental analysis to all kinds of technical analysis strategies and charting strategies. It is an amazing array. We track 190 newsletters and between them we have about 550 separate portfolios. So you can name any strategy, and my guess is could I could come up with the name of a newsletter that has done very well sticking to that strategy. I can also come up with another newsletter that has performed poorly using that same strategy.

Eddie: That's very interesting because it almost means that performance is strategy-independent and that it really depends on the practitioner of the strategy.

"...this was a guy who had discipline..."

Mark: You can take that too far, but yes, that is the direction my work has taken me. I think the great unsung virtue of the investment world is discipline. Without appreciating it you see commentators being put into all of these backflips to try to explain that. A good example is a newsletter that is at the top of my rating for the past 25 years. It's called The Prudent Speculator, founded by the late Al Frank in the late '70s and now being run by his successor, John Buckingham. Throughout the '80s and '90s people would call him and try to explain why his newsletter has done so well. Basically, he bought undervalued small cap stocks for the long term. He bought them on margin, on the theory that he'll make enough to pay for the loan rate. And he has done phenomenal. The portfolio beat any other newsletter that we've tracked by a large margin. I have seen articles that have commented that he is a great market timer. When they ask me for a comment I say that he isn’t trying to time the market, he's basically making a bet that the growth of the American economy is enough to pay for the broker loan rate. People would say that he was a stock picker extraordinaire. And in fact he is not a bad stock picker, but my data actually showed that his stock picks were not doing any better than the market as a whole. So let's say 25 years ago you had a hypothetical Al Frank, and that every time the real Al Frank put money into an individual stock, he instead went out and bought on margin to the same degree and dollar investment that the original Al Frank had, the same dollar portion into an index fund. The hypothetical al Frank would have made just as much money, if not a little more. So in other words, Al Frank was not a stock picker extraordinaire, he was not a market timing extraordinaire--and this is where I think the insight comes in--this was a guy who had discipline.

Eddie: Your explanation of why his methodology works and the fact that he transferred all of his skills to knowledge to his successor suggests he had a systematic approach--he basically had a set of rules that he followed.

"...Al Frank’s portfolio...was down nearly 60% that day..."

Mark: There are plenty of other newsletters that have had variants of that approach who have gotten scared away along the way. A classic example is the crash of ’87, which I remember well. Al Frank’s portfolio--because it was on margin--was down nearly 60% that day, which is enough to scare almost everyone away and the next morning we get a bulletin from Al Frank saying "buy more." In retrospect that looks like "well, of course that's what you do--you always buy when stocks come down in price," but that took guts and there are very few people who have that kind of guts. He had the steel-stomached courage to adhere to his rules even when the psychological cost of that and the anxiety must have been huge. That, in the end, is the key to his long-term success. He was an okay stock picker, but there are plenty of other stock pickers I've tracked that were better. He wasn't a market timer. It was the fact that he had courage that was very rare.

Eddie: That's excellent news for people reading this because a lot of the audience that will be reading this interview are professional traders and money managers and in order to be successful they often have to make a very difficult decision to buy when the market is going against them and to sell when the market looks like it's going to go up forever.

Mark: In that regard, Jack Schwager, in Market Wizards, quoted a couple of very successful traders who said they wouldn't mind if they were to have published every morning their rules they were following each day in The Wall Street Journal.

Eddie: That sort of commits them to following their own rules and their own advice.

Mark: It's amazing to me, though, how many people can still find a way of getting around it. There are newsletters I track who will say at the beginning of the year "we're going to follow this strategy--even if it's temporarily not working--for the next 12 months. Then in the middle of the year when it's not working, they turn around and say they were wrong and they get rid of it. All I can figure out is that they give in to the pressure of the subscribers to do something to turn things around.

Eddie: I read in one of your articles that said the degree of bullishness among newsletter writers as the holiday season starts to kick off is a little on the excessive side. Can you tell us a bit more about that?

Mark: Sure, the current average exposure to the equity markets among the short term market timers that we track is around 67%. That is the highest reading since 2001. In other words, we are at the highest bullishness among advisors today than in over four years. From a contrarian point of view, the market are less likely to do what the majority expects it to. That is not an encouraging sign. From a contrarian point of, one would feel the market is on stronger ground if there was more skepticism out there.

Eddie: Would that lead you to believe that we are going to a minor pullback, or do you think a more severe correction is ahead?

Mark: There may be ways that I can use the sentiment data, but I don’t know at this point. Based on the short term indicator, my interpretation of it so far, I have yet to be able to differentiate between a short-term pullback, or a short-term pullback that turns into something bigger. If indeed on the next pullback that I anticipate will happen, if advisors quickly run to the bearish camp, then it's more likely to be just a short term pullback. But if in the face of that pullback, advisors stubbornly stay bullish, or get even more bullish, that would be an extremely pessimistic sign for the future.

Eddie: You have also done some research on gold, and have said that the sentiment that is prevalent in gold is somewhat bearish for stocks. Can you comment on that?

Mark: Right, one way to look at how bullish sentiment is among stock market timers are, is to compare them to gold timers. I have every reason to expect that gold timers are exuberant given that gold is at a 20+ year high. Yet the average gold market timer is less exposed to the gold market than is the average stock market timer. The comparable number for gold is 50% exposure whereas it is 67% in the stock market. So, what that suggests to me is that, relatively, gold is more likely to be a good bet for the next three months than stocks.

Eddie: On November 16, you wrote an article saying that with the Dow transports hitting a new high, that will put some pressure on the Dow Industrials to follow suit, or else it would be a critical bearish signal for Dow theorists. Given the action that we have seen since you wrote that article, what is your current assessment?

Mark: Well, I find it interesting that the Dow has come up and touched its level from March on a number of occasions, but always seems to pull back. So I think from the Dow theory point of view that has to be a source of concern. As I pointed out in that column, as soon as the Dow Transports reach that new high, it sets that clock running. The Dow Industrials have a reasonable amount of time to reach a new high as the transports, however it does not have an unlimited amount of time. A number of Dow theorists we have tracked, for example Richard Russell, of Dow Theory Letters, often make this point: The longer it takes for the second average to confirm the first, the less meaning that confirmation will have. Let's say the Dow Industrials soon does rise above the March level, there is then an even bigger question, which is even if it rises above its level of March, the Dow would still not be at its all-time high reached in 2000. That itself might be a non-confirmation even though we might have a secondary confirmation that the Dow has further to go.

Editor's Note: I hope you enjoyed this interview with Mark Hulbert. Please feel free to email me with your questions or comments.

Eddie Kwong
Editor-in-Chief
TradingMarkets.com