Consumer Sentiment Improves

January 27, 2012

The final University of Michigan Consumer Sentiment Index came in at 75.0 for January.  That’s a sharp improvement from where it was last summer and fall, but it’s still in the lower part of the range over the past 30 years.  Check out the fantastic graphic from Calculated Risk:

Source: Calculated Risk  (click on chart to expand)

Maybe the world isn’t ending after all.  One never knows exactly how investors will respond to economic data, but movement from low levels to consumer sentiment to high levels of consumer sentiment is usually associated with decent equity markets.  The best entries tend to occur when sentiment is very poor—i.e., investors are perhaps overly pessimistic.

Leave a Comment » | Investor Behavior, Markets, Thought Process | Permalink
Posted by Mike Moody

Harnessing the Power of Momentum

January 27, 2012

That’s the title of a recent article in Advisor Perspectives about relative strength investing.  (Academics call it momentum.)  The article was written by a principal at a Canadian money management firm, Michael Nairne, so it’s nice to see a little cross-border validation.  From the article:

Numerous academic studies have confirmed that, when measured in periods of approximately three to 12 months, past investment winners tend to keep on outperforming while past losers tend to keep underperforming.

Momentum is not simply a US phenomenon. A recent study2 covering equities in 23 countries from November 1989 to September 2010 found evidence of strong momentum returns in North America, Europe and Asia Pacific; only Japan was an exception. Another study tracking the largest 100 stocks in the British market from 1900 to 2009 found that a portfolio comprised of the 20 best performers over the prior 12 months outperformed the worst performers by 10.3% annually3.  The same authors found momentum in 18 out of 19 markets, dating back to 1975 in larger European markets and 1926 in the US.

Momentum is not confined to portfolios of individual stocks – it exists in a variety of asset classes. A recent study4 has found that momentum exists in government bonds, commodities and currencies as well as country equity indexes. Momentum has also been found in corporate bonds5 as well as the financial futures market6.

The article is well-footnoted.  I recommend you read the original, which I linked to above.  The article does a good job discussing both the pros and cons of relative strength.  For example, the author points out that:

…there are prolonged periods where stocks with positive momentum underperform the market.  Despite an overall annualized premium of 3.9%, there have 22 periods where stocks with positive momentum have underperformed the market by greater than 5%, with durations as long as several years.

Although investors have a marked tendency to abandon strategies when they underperform for a period of time, that might not be a good idea with relative strength.  Despite periods of underperformance, long-term results have been remarkable:

The $1.00 investment in momentum stocks grew to $67,309, nearly 30-times larger than the $2,321 earned in the S&P 500. [August 1927 to July 2011]  For long-term investors, this outperformance has been remarkably enduring. In 99.6% of the 10-year rolling periods since July 1937, momentum stocks have outperformed the S&P 500. [my emphasis]

Investors have a lot of choices when it comes to selecting an investment strategy, but not many have been as well validated over as long a period of time in multiple markets as relative strength.

Leave a Comment » | Markets, Relative Strength Research, Thought Process | Permalink
Posted by Mike Moody

From the Archives: Another Way To Look at Modern Portfolio Theory

January 27, 2012

This week the noted management consultant, Russell Ackoff, passed away.  He was famous for gathering data and trying to use it to make the correct decision.  His fundamental theory was this:

All of our social problems arise out of doing the wrong thing righter. The more efficient you are at doing the wrong thing, the wronger you become. It is much better to do the right thing wronger than the wrong thing righter! If you do the right thing wrong and correct it, you get better!

Since the origination of Modern Portfolio Theory in the 1950s, academics and practitioners have been polishing it up and implementing in better and better ways.  It may just have been a case of getting more efficient at doing the wrong thing—and the wronger it got.  After 2008, even many of its supporters began to acknowledge that there were problems with its implementation.

This recognition has fueled a rush to the new magic potion, tactical asset allocation.  If tactical asset allocation is indeed the “right” thing, it should work out better than doing something wrong.  Yet there are significant challenges in the design and execution of a systematic tactical asset allocation process as well.  I think going forward, it’s going to be important to distinguish between marketers who are trying to exploit the latest fad and practitioners who have a well-thought-out and well-executed process for tactical asset allocation.

—-this article was originally published 11/13/2009.  It’s hard to do the right thing right, but don’t settle for doing the wrong thing righter!

Leave a Comment » | From the Archives, Tactical Asset Alloc | Permalink
Posted by Mike Moody

Sector and Capitalization Performance

January 27, 2012

The chart below shows performance of US sectors and capitalizations over the trailing 12, 6, and 1 month(s).  Performance updated through 1/26/2012.

Leave a Comment » | Markets | Permalink
Posted by Andy Hyer

Whole Wide World

January 26, 2012

Sometimes we focus so much on our own situation that we forget there is a whole wide world out there–and lots of investment opportunities.  A chart that was eye-opening for me appeared recently on Dr. Ed’s Blog, written by the estimable Wall Street economist Ed Yardeni.  Check it out:

Source: Ed Yardeni   (click on image to expand)

Ok, so the developed world isn’t really boosting oil demand.  There could be a lot of reasons for that besides a lack of economic growth: conservation, increased efficiency, substitution of other energy sources, etc.  But emerging markets—wow!  The financial crisis was barely a blip in oil demand.

Money will go wherever it is treated best–and it tends to seek out growth.  Markets are global and your portfolio should be too.

Leave a Comment » | Markets, Thought Process | Permalink
Posted by Mike Moody

Tactical Management and Flawed Forecasting

January 26, 2012

Bob Veres is a highly respected columnist for Financial Planning magazine.  He’s been in the forefront of advocating good practices in financial planning.  He had an interesting article about the dangers of tactical management last month–and the longer I chew over that article, the more problems I see with forecasting, explicit and implicit.

First, let me set the scene for you.  Mr. Veres indicated that he had spent a month doing data analysis of a survey of over 1000 financial planners.  One of the most interesting takeaways:

Perhaps the most striking thing I learned is that, post-2008, activities once labeled “market timing” are now solidly in the mainstream.  No, planners are not moving into or out of the market based on reading the entrails of animal sacrifices. But they seem to be taking a much more active approach to protecting clients from downside risk. The survey asked whether advisors planned to raise or lower their allocations to each of 35 different investment classes or vehicles in the next three months. A remarkable 83% are anticipating at least one tactical adjustment – and the great majority expects to make several.

Mr. Veres raises a legitimate question about how accurate planner’s forecasts are, and what the possible consequences of poor forecasts could be.  As an example, he cites inflation forecasts:

One of the most provocative set of responses came when advisors were asked to forecast the inflation rate and the real (after-inflation) return of both equities and 10-year Treasuries over the next 10 years. On inflation, the majority of responses clustered between 3% and 5%, and the remaining responses had a center of gravity on the 6% to 7% part of the chart. If there is wisdom in the crowd, the crowd of advisors seems to believe we will experience above-average inflation for at least the remainder of this decade.

But we also had responses as low as -4% a year (projecting severe Japanese-style deflation), several as high as 10% and one advisor who anticipates annual inflation of 13% over the coming decade. One or the other group on the fringes is going to be spectacularly wrong (or both will), and I suspect that damaging consequences will show up in the portfolios they recommend.

He is absolutely correct in his belief that a strategic allocation based on a wildly incorrect forecast will be damaging to a client.  And, he indicated that expectations for real returns were even more widely dispersed.  It’s where he goes next that made me think.  He writes:

Say what you will about the buy-and-hold ethos that lasted until September 2008. It may not have been an ideal strategy during the worst of the bear markets, but it did keep the members of the herd from straying too far from the center – and, more important, it kept the profession from getting the kinds of black eyes I think advisors are going to encounter in the future.

I think there is a critical error in this line of thinking.  Buy-and-hold strategic allocations are typically based on historic returns.  Those historic returns, of course, are the same for everybody and they do have the effect of keeping everyone in the middle of the herd.

This is the critical error: basing your allocation on historic returns is also a forecast–it’s simply an implicit forecast that historic returns will continue along the same path!  If that doesn’t happen, you will end up just as horribly wrong as the advisors on the forecasting fringes!  Yes, you will fail conventionally along with everyone else in the middle of the herd, but you will fail nonetheless.  (How do you think most clients feel right now, with their equity allocations based for the last decade on an 8-10% historic return, a return that has not materialized?  And there’s always Japan.)

Frankly, if you’re going to do strategic asset allocation at all, research shows that naive equal-weighting performs as well as anything else.  The reason advisors are gravitating toward tactical management in the first place is because traditional strategic asset allocation has so much trouble with tail events, and 2008-2009 was a big tail event.  Clients have memories, and advisors are simply responding to client demand for a more active form of risk management.  Now, like Mr. Veres, I’m not very confident in the forecasting abilities of financial planners.  I’m not very confident in the forecasting abilities of anyone, for that matter, including me.

All forecasting is flawed, whether it is explicit or implicit.  To me, there are only two realistic choices for asset allocation.  Either 1) equal-weight a large number of asset classes and rebalance periodically or 2) commit to a systematic method of tactical asset allocation.  There are funds that use valuation triggers and funds that use relative strength to rotate among asset classes–and I suspect either will perform acceptably over time if it is systematic and disciplined.

3 Comments | Tactical Asset Alloc, Thought Process | Permalink
Posted by Mike Moody

Getting Professional Guidance

January 26, 2012

Lots of studies show that investors do better when they have qualified professional help.  David Edwards of Heron Capital wrote a clever piece in Advisor Perspectives that puts a humorous twist on investors’ tendency to panic and try to do everything themselves.  He wrote:

We recently developed a series of scenarios  for our clients and prospective clients to consider as a way to establish how  they really feel about investment risk.

Scenario 1:

You’re on a plane preparing land at LaGuardia Airport in New  York City during a thunderstorm.  With  minutes to go before landing, the plane is suddenly rocked by violent down  drafts.  Do you:

  • Buckle your seatbelt tighter, clutch your armrests and toss a  prayer to your personal deity.
  • Rush down the aisle, kick open the cockpit door and seize  controls of the plane yourself.

Scenario 2:

You’re at the dentist having root canal.  Suddenly, you feel acrid dust on your tongue  and smell smoke.  Do you:

  • Ask for a moment to rinse your mouth and clear your throat (this  will be over soon.)
  • Grab the drill and finish the operation yourself.

Scenario 3:

You’re a defendant in a major product liability case.  If you lose, you could be out $500,000.  After two weeks of trial, the case could go  either way.  During the final summation  do you:

  • Rely on your attorney to finish the trial – win or lose, he’s  the one who went to law school.
  • Address the judge and jury yourself.

Scenario 4:

Your three year old car develops a case of “mushy” brakes and  won’t stop as quickly as you expect.  Do  you:

  • Take the car into the dealer for a thorough inspection.
  • Tinker with the master cylinder, calipers and brake pads  yourself.

Scenario 5:

Stock prices have fallen 20% over the last 6 months, and  leveraged investors everywhere are vomiting up securities.  On the television, investment analysts  soberly explain how you must hedge your portfolio by “loading up on the  UltraProShares Triple-Short ETF.”  Your  brother-in-law is buying gold and dividing his cash up among 6 different banks,  in case one of them fails.  Do you:

  • Hang tight, knowing that you won’t draw on your assets in stocks  for at least five years, and think about maxing out your 401K contributions a  bit early this year.
  • Fire your investment advisor (“that idiot!”) and convert all  your stocks to cash.

If you would select option “B” in any of these scenarios, please  write a few sentences as to why.

A good tongue-in-cheek reminder of why it sometimes makes sense to take professional advice and stick with a well thought out strategy!

Leave a Comment » | Investor Behavior, Just for Fun | Permalink
Posted by Mike Moody

Fund Flows

January 26, 2012

The Investment Company Institute is the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs).  Members of ICI manage total assets of $11.82 trillion and serve nearly 90 million shareholders.  Flow estimates are derived from data collected covering more than 95 percent of industry assets and are adjusted to represent industry totals.

Leave a Comment » | Markets | Permalink
Posted by Andy Hyer

Why Capitalism Works

January 25, 2012

Incentives!  I first saw this story on Carpe Diem, the blog of economist Mark Perry at the University of Michigan.  He excerpts a story from NPR‘s Planet Money that details a secret contract that Chinese farmers made in 1978, during a period of communist rule.  Everyone in a small village essentially agreed to become capitalists!  And the results were remarkable.  From NPR:

In 1978, the farmers in a small Chinese village called Xiaogang gathered in a mud hut to sign a secret contract. They thought it might get them executed. Instead, it wound up transforming China’s economy in ways that are still reverberating today.

The contract was so risky — and such a big deal — because it was created at the height of communism in China. Everyone worked on the village’s collective farm; there was no personal property.

“Back then, even one straw belonged to the group,” says Yen Jingchang, who was a farmer in Xiaogang in 1978. “No one owned anything.”

At one meeting with communist party officials, a farmer asked: “What about the teeth in my head? Do I own those?” Answer:  No. Your teeth belong to the collective.

In theory, the government would take what the collective grew, and would also distribute food to each family. There was no incentive to work hard — to go out to the fields early, to put in extra effort, Yen Jingchang says.

“Work hard, don’t work hard — everyone gets the same,” he says. “So people don’t want to work.” In Xiaogang there was never enough food, and the farmers often had to go to other villages to beg. Their children were going hungry. They were desperate.

So, in the winter of 1978, after another terrible harvest, they came up with an idea: Rather than farm as a collective, each family would get to farm its own plot of land. If a family grew a  lot of food, that family could keep some of the harvest.

This is an old idea, of course. But in communist China of 1978, it was so dangerous that the farmers had to gather in secret to discuss it.

One evening, they snuck in one by one to a farmer’s home. Like all of the houses in the village, it had dirt floors, mud walls and a straw roof. No plumbing, no electricity.

“Most people said ‘Yes, we want do it,’ ” says Yen Hongchang, another farmer who was there.   “But there were others who said ‘I don’t think this will work — this is like high voltage  wire.’  Back then, farmers had never seen electricity, but they’d heard about it. They knew if you touched it, you would die.”

Despite the risks, they decided they had to try this experiment — and to write it down as a formal contract, so everyone would be bound to it.  By the light of an oil lamp, Yen Hongchang wrote out the contract. The farmers agreed to divide up the land among the families. Each family agreed to turn over some of what they grew to the government, and to the collective. And, crucially, the farmers agreed that families that grew enough food would get to keep some for themselves.

The contract also recognized the risks the farmers were taking. If any of the farmers were sent to prison or executed, it said, the others in the group would care for their children until age 18.

The farmers tried to keep the contract secret — Yen Hongchang hid it inside a piece of bamboo in the roof of his house — but when they returned to the fields, everything was different.

Before the contract, the farmers would drag themselves out into the field only when the village whistle blew, marking the start of the work day. After the contract, the families went out before dawn. “We all  secretly competed,” says Yen Jingchang. “Everyone wanted  to produce more than the next person.”

It was the same land, the same tools and the same people. Yet just by changing the economic rules — by saying, you get to keep some of what you grow — everything changed. At the end of the season, they had an enormous harvest: more, Yen Hongchang says, than in the previous five years combined.

Listening to this story makes me much more optimistic about the possibility for eventual intelligent economic reform.  The power of incentives to transform behavior is truly remarkable!  Thoughtful incentives make the economy better for everyone.  I hope it is not lost on policymakers that a 15% tax on the huge harvest generates more revenue than a 70% tax on the lousy harvest.  (Even bad incentives, I suppose, make the economy better for certain groups while making it worse for others.  Relative strength is a good way to detect who is benefiting and who is being held back.)

HT to FT Alphaville.

Leave a Comment » | From the MM, Markets, Non-partisan op-ed | Permalink
Posted by Mike Moody

From the Archives: Will I run out of money?

January 25, 2012

The number one concern among many investors approaching retirement is, “Will I run out of money?” This question is causing sleepless nights for many approaching retirement.  In fact, at the end of October, the U.S. Center for Retirement Research released a report that 51% of Americans are at risk of reduced living standards in retirement – including 42% of those in high income households. And if the cost of health care and long-term care were included, these numbers would be even higher.  It is just a fact that many people, including high-income earners, will enjoy a reduced standard of living in retirement due to inadequate savings.

However, simply pointing this reality out to a client with inadequate savings who is approaching retirement doesn’t do them a lot of good.  That information may be motivational to younger people who still have the time to increase their savings, but those approaching retirement need two things.  First, they need financial planning help to determine a prudent withdrawal rate on their portfolio to minimize the risk that they actually do run out of money.  Second, they need help determining a prudent approach to asset allocation to take them through the next 30 plus years.

One of the most influential studies on withdrawal rates and asset allocations in retirement was a 1998 paper by three professors of finance at Trinity University.

Its conclusions are often encapsulated in a “4% safe withdrawal rate rule-of-thumb.” It refers to one of the scenarios examined by the authors. The context is one of annual withdrawals from a retirement portfolio containing a mix of stocks and bonds. The 4% refers to the portion of the portfolio withdrawn during the first year; it’s assumed that the portion withdrawn in subsequent years will increase with the CPI index to keep pace with the cost of living. The withdrawals may exceed the income earned by the portfolio, and the total value of the portfolio may well shrink during periods when the stock market performs poorly. It’s assumed that the portfolio needs to last thirty years. The withdrawal regime is deemed to have failed if the portfolio is exhausted in less than thirty years and to have succeeded if there are unspent assets at the end of the period.

The authors backtested a number of stock/bond mixes and withdrawal rates against market data compiled by Ibbotson Associates covering the period from 1925 to 1995. They examined payout periods from 15 to 30 years, and withdrawals that stayed level or increased with inflation.   The table below shows the percentage of trials in which the portfolios survived for the entire testing period.

Table: Portfolio Success Rate: Percentage of all Past Payout Periods From 1926 to 1995 that are Supported by the Portfolio After Adjusting Withdrawals for Inflation and Deflation

Note: Numbers in the table are rounded to the nearest whole percentage. The number of overlapping 15-year payout periods from 1926 to 1995, inclusively, is 56; 20-year periods, 51; 25-year periods, 46; 30-year periods, 41. Stocks are represented by Standard and Poor’s 500 Index, bonds are represented by long-term, high-grade corporates, and inflation (deflation) rates are based on the Consumer Price Index (CPI). Data source: Calculations based on data from Ibbotson Associates.

Source: Retirement-Income.net

It becomes clear from reviewing this table that being “conservative” and allocating heavily to bonds may be safe in the short run, but it may very well lead to eating dog food over the long term.  Furthermore, any withdrawal rate over 3-4% is likely to be disastrous over a 30 year period of time.

The biggest opportunity for a financial advisor to be able to add value to their client’s dilemma is to be able to help them commit to an appropriate withdrawal rate and then to focus on the asset allocation.  The financial advisor who is able to clearly explain how a global tactical asset allocation strategy may be able to address the weakness of static asset allocation or strategic asset allocation and potentially decrease the probability of running out of money is the financial advisor who can make a real difference for their clients.

—-this article was originally published 11/24/2009.  The payout tables are based on 1926-1995 returns and suggest real conservatism in withdrawal rate assumptions.  Returns since 1995, and especially since 2000, have been lower than the long-term averages.  If you had opted for a high withdrawal rate, things would be tough right now.  Investors need to save more and invest intelligently and patiently to have retirement success.  Consider incorporating portfolio fecundity into your withdrawal assumptions because it will better reflect the current investing environment.

Leave a Comment » | From the Archives, Investor Behavior, Tactical Asset Alloc | Permalink
Posted by Mike Moody

Divergent Investment Market Scenarios

January 25, 2012

TFC Financial Management makes an argument for divergent market performance:

The global financial markets today appear to be divided into three distinct economic modes: 1) Europe with its sovereign debt crisis seemingly headed into recession; 2) the emerging countries and Asia, most apparently back on a moderate growth track; and 3) the U.S. entering a surprisingly improved economic recovery which seems to have caught the “experts” unaware.  What may be unfolding is a global picture of divergent investment market scenarios, not the free market convergence which investors have come to accept as gospel these past 15-20 years.

As a general rule, the larger the dispersion in returns in a given investment universe, the better the environment for relative strength strategies.

HT: Real Clear Markets

Leave a Comment » | Markets, Thought Process | Permalink
Posted by Andy Hyer

High RS Diffusion Index

January 25, 2012

The chart below measures the percentage of high relative strength stocks that are trading above their 50-day moving average (universe of mid and large cap stocks.)  As of 1/24/12.

The 10-day moving average of this indicator is 88% and the one-day reading is 87%.

Leave a Comment » | Markets | Permalink
Posted by Andy Hyer

Tasty Flavor of the Month: Low Volatility

January 24, 2012

Low volatility funds have been hot lately.  They are easy to market right now.  Low volatility sounds appealing and they have performed well.  According to the Wall Street Journal:

…it’s not difficult to see why investors might prefer a low-volatility strategy. It certainly paid off last year: The S&P 500 Low Volatility Index returned 10.9% in 2011, more than eight percentage points higher than the Standard & Poor’s 500-stock index.

But there is a caveat:

If the market continues to rally this year, low-volatility strategies could underperform.

Since 2008, the S&P 500 Low Volatility Index has underperformed during years when the Chicago Board Options Exchange Market Volatility Index, or VIX—which  tracks investor expectations for market volatility—dropped, while outperforming when the VIX rose. (One exception: In 2007, the VIX rose, but the Low Volatility Index underperformed.)

Low volatility funds tend to lag when markets get hot.  Investors, wrapped in their current bearish gloom, aren’t worrying about that right now.  But flat market years like 2011 are often followed by above-average years.

One way to use low volatility funds in your portfolio without perhaps taking the full brunt of underperformance is to pair the low volatility return factor with relative strength.  Examine, if you will, an efficient frontier constructed from SPLV and PDP.  Relative strength often outperforms when markets trend.  It’s a nice efficient frontier and might smooth out your core equity exposure over time.

Source: Dorsey Wright Money Management (click on chart to expand)

For the time periods when hypothetical returns were used, the returns are that of the PowerShares Dorsey Wright Technical Leaders Index and of the S&P 500 Low Volatility Index.  The hypothetical returns have been developed and tested by the Manager (Dorsey Wright in the case of PDP and Standard & Poors in the case of SPLV), but have not been verified by any third party and are unaudited. The performance information is based on data supplied by the Dorsey Wright or from statistical services, reports, or other sources which Dorsey Wright believes are reliable.  The performance of the Indexes, prior to the inception of actual management, was achieved by means of retroactive application of a model designed with hindsight.  For the hypothetical portfolios, returns do not represent actual trading or reflect the impact that material economic and market factors might have had on the Manager’s decision-making under actual circumstances.  Actual performance of PDP began March 1, 2007 and actual performance of  SPLV began May 5, 2011.  See PowerShares.com for more information.

2 Comments | Markets, Thought Process | Permalink
Posted by Mike Moody

From the Archives: Why Americans Are in Debt

January 24, 2012

James Surowiecki has a fantastic article in the New Yorker about why Americans take on so much debt.  Incentives work and we have incentives to use debt embedded in our financial structure.  I’m a big fan of his writing anyway, but this short piece explains a lot.

John Kenneth Galbraith wrote that all financial crises are the result of “debt that, in one fashion or another, has become dangerously out of scale.”

That’s his thesis and in a couple of paragraphs he explains how we got there so efficiently.

—-this article was originally published 11/16/2009.  This article has a fantastic explanation of how effectively incentives work.  And a couple of years down the road we can see even more clearly how debt has saddled Western economies.

Leave a Comment » | From the Archives, Markets | Permalink
Posted by Mike Moody

What’s Hot…and Not

January 24, 2012

How different investments have done over the past 12 months, 6 months, and month.

 1PowerShares DB Gold, 2iShares MSCI Emerging Markets ETF, 3iShares DJ U.S. Real Estate Index, 4iShares S&P Europe 350 Index, 5Green Haven Continuous Commodity Index, 6iBoxx High Yield Corporate Bond Fund, 7JP Morgan Emerging Markets Bond Fund, 8PowerShares DB US Dollar Index, 9iBoxx Investment Grade Corporate Bond Fund, 10PowerShares DB Oil, 11iShares Barclays 20+ Year Treasury Bond

Leave a Comment » | Markets | Permalink
Posted by Andy Hyer

Debt and Deleveraging

January 23, 2012

This is the title of a new report from McKinsey & Company on global debt.  So far, things are playing out pretty much like Ken Rogoff and Carmen Reinhart suggested they would.  To wit:

…major economies have only just begun deleveraging. In only three of the largest mature economies—the United States, Australia, and South Korea—has the ratio of total debt relative to GDP fallen. The private sector leads in debt reduction, and government debt has continued to rise, due to recession. However, history shows that, under the right conditions, private-sector deleveraging leads to renewed economic growth and then public-sector debt reduction.

In many countries, debt is still growing.  In a few, debt has gone down in the private sector (corporations and individuals), mostly offset by rising debt in the government sector.  The good news is that the public sector debt may start to drop when the economy begins to grow.

The Economist has some nice graphics from the McKinsey study.  It’s very interactive and allows you to see what happened around the world over time.  And they make a good point about debt and wealth:

Wealth ebbs away a lot faster than debt. Our interactive guide shows levels of debt as a % of GDP for a selection of rich countries and emerging markets. With a few exceptions, such as Germany and Japan, most rich countries saw a huge rise in debt levels in the years running up to the crisis. Unwinding these dues will take a lot longer. In many rich countries the process of debt reduction hasn’t even started.

I added the bold.  It will take some spending restraint and renewed economic growth to start to pare the debt burdens.  By the way, this is true on an individual level as well as a national level!  When asset values implode, the debt remains.

It’s too early to tell if the US market has turned the corner and will pay more attention to growth than debt going forward.  There are still a lot of things up in the air in Europe and in domestic politics.  Once again, relative strength may be the best option for sorting out what assets are going to perform over time.

Leave a Comment » | Markets, Thought Process | Permalink
Posted by Mike Moody

Hotel Occupancy

January 23, 2012

Recessions are usually death to hotels.  Hotel occupancy falls, which often results in an orgy of price-cutting to fill the rooms.  Prices can’t rise until occupancy picks up again.  Since most travel is for business or vacation, it is really, really discretionary.  Cutting out the family vacation or skipping that conference in Cleveland is often the first thing to go when budgets get tight.  As a result, hotel occupancy is a very sensitive indicator of economic health–and there’s finally some good news on that front.

Calculated Risk points out that 2009 was the worst year for hotel occupancy since the Great Depression.  But it has sinced picked up and is now back to its median level from the 2000-2007 good old days.  As usual, Calculated Risk has a gorgeous graphic:

Source: Calculated Risk (click on image to expand)

Good economic news is no longer a rarity.  Consumer sentiment seems to be slowly improving.  Perhaps animal spirits in the market will not be too far behind.

Leave a Comment » | Sentiment | Permalink
Posted by Mike Moody

Weekly RS Recap

January 23, 2012

The table below shows the performance of a universe of mid and large cap U.S. equities, broken down by relative strength decile and quartile and then compared to the universe return.  Those at the top of the ranks are those stocks which have the best intermediate-term relative strength.  Relative strength strategies buy securities that have strong intermediate-term relative strength and hold them as long as they remain strong.

Last week’s performance (1/16/12 – 1/20/12) is as follows:

The laggards had another strong week last week.

Leave a Comment » | Markets | Permalink
Posted by Andy Hyer

Dorsey, Wright Client Sentiment Survey – 1/20/12

January 20, 2012

Here we have the next round of the Dorsey, Wright Sentiment Survey, the first third-party sentiment poll.  Participate to learn more about our Dorsey, Wright Polo Shirt raffle! Just follow the instructions after taking the poll, and we’ll enter you in the contest.  Thanks to all our participants from last round.

As you know, when individuals self-report, they are always taller and more beautiful than when outside observers report their perceptions!  Instead of asking individual investors to self-report whether they are bullish or bearish, we’d like financial advisors to weigh in and report on the actual behavior of clients.  It’s two simple questions and will take no more than 20 seconds of your time. We’ll construct indicators from the data and report the results regularly on our blog–but we need your help to get a large statistical sample!

Click here to take Dorsey, Wright’s Client Sentiment Survey.

Contribute to the greater good!  It’s painless, we promise.

Leave a Comment » | Investor Behavior, Markets, Sentiment | Permalink
Posted by JP Lee

Cut Your Losses and Let Your Profits Run

January 20, 2012

Carl Richards has a great piece in the New York Times on why people delay correcting financial mistakes.  Most of the time they are trying to avoid regret or avoid recognition of a poor decision/loss.  He writes:

Being wrong isn’t fun. When there’s a problem, it’s often because we’ve made a mistake. We’ve been conditioned to believe that making a mistake is something shameful. Embarrassed, we tell ourselves stories to avoid recognizing that we’re in trouble. We tell ourselves that things aren’t actually that bad. We tell ourselves that things will get better. We even look for others to blame.

No one likes losing. For most of us, the pleasure we get from gain, like our investments doing well, is dwarfed by the pain we feel from loss. While this pain can be chronic from a continuing issue, it becomes acute when we decide to face the facts and do something about it.

…big mistakes almost always start as small mistakes. Then we delay doing something about them, and they grow until we find ourselves in a hole that we thought unimaginable just a short time before.

By the way, psychological studies verify that we feel the pain of loss 2x-3x more than we feel the pleasure of a gain.  It’s not your imagination.  Losses are definitely hard to take.

The most important reason that we use a systematic investment process that ranks everything using relative strength is so we have an objective guideline to make portfolio changes.  Did a stock fall in the ranks?  Then we cut our losses and out it goes, no questions asked.  Is a stock or asset class still ranked highly, however toppy it might feel to us at the moment?  Then it stays in the portfolio and we (perhaps reluctantly) let our profits run.  On any one transaction we never know if we made the correct decision–that’s something you can only find out in hindsight.  But the discipline of a systematic way to cut losses and let profits run gives you a much better chance of coming out ahead than caving in to your emotions at every turn.

Successful investing, whether you use relative strength or value or any other method, is more about temperament and discipline than analysis.

HT to Abnormal Returns.

Leave a Comment » | Investor Behavior | Permalink
Posted by Mike Moody

Sector and Capitalization Performance

January 20, 2012

The chart below shows performance of US sectors and capitalizations over the trailing 12, 6, and 1 month(s).  Performance updated through 1/19/2012.

2 Comments | Markets | Permalink
Posted by Andy Hyer

From the Archives: Value Trap: Eastman Kodak

January 19, 2012

Bill Miller at Legg Mason Value Trust had one of the longest mutual fund outperformance streaks in history, 15 years through 2005.  His record may end up like Joe DiMaggio’s longstanding consecutive game hits record—never equalled and rarely even approached.  Yet even superstar fund managers may occasionally have feet of clay.  According to a Bloomberg article, his fund has had a rough time with Eastman Kodak:

Legg Mason Capital Management Value Trust (LMVTX), run by Miller since 1982, disclosed in a semi-annual report last week that the fund sold 18.2 million Kodak shares late last year and during this year’s first quarter for about $3.89 each on average. The fund realized a $551 million loss through the divestiture, according to the report.

Miller, 61, began loading up on Kodak shares in 2000 and, by the end of 2005, his firm owned as much as 25 percent of the Rochester, New York, company. Value Trust, one of several Legg Mason funds and accounts to hold Kodak stock, kept the bulk of its stake for more than a decade, only to sell after the film company had lost more than 90 percent of its market value.

Someone took the Kodachrome away

Source: www.photographymonthly.com

One of the challenges that value investors must take on is the value trap.  A value trap is a stock that looks cheap, but turns out to be cheap for a reason.  EK didn’t necessarily hold Bill Miller back; he had quite a number of years of market outperformance with Kodak included in the portfolio.  Other selections did pan out and more than offset the problem stocks.  The problem with value traps is psychological.  The Bloomberg article goes on:

“Part of it was just this mentality that this was just a temporary setback and Kodak would be able to get quickly back on track,” said Bridget Hughes, an analyst at Morningstar Inc., a Chicago-based stock and fund research firm. “It was not only a mistake, it was also causing a lot of client angst.”

I put the psychological problem in bold.  It drives clients crazy to see a big loser in the portfolio quarter after quarter, year after year. Even when buying cheap stocks is obviously part of the investment philosophy and when patience is required to get good returns, clients sometimes struggle with it.

Portfolio management using a systematic relative strength process has different strengths and weaknesses.  Clients are less likely to see a big loser sitting in the portfolio quarter after quarter, but are more likely to see more numerous transactions that result in small or moderate losses.   I suspect clients are no happier about a string of small losses, but they often seem to be able to let it go.  On the plus side, when using relative strength, most of the big winners will be retained in the portfolio for an extended time.

No investment approach is perfect, and every investment methodology will have its fair share of mistakes.  Still, clients choose to stick with some investment managers and bail on others, even when their long-run performance is comparable.  The client’s choice is often made primarily on the basis of emotion—sometimes just how they feel about how things are going.  All other things being equal, why would you elect to have your big losers show up on client statements for an extended period of time?

 

—-this article was originally published 6/30/2011.  Today EK filed for bankruptcy.  Someone finally took their Kodachrome away.  Kodak has had persistently poor relative strength for years.  Relative strength has its issues, but getting stuck in value traps is not one of them!

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Posted by Mike Moody

Your Inner Beardstown Lady

January 19, 2012

Most of the whippersnappers in the business don’t even remember the Beardstown Ladies.  They were grandmotherly-looking members of an investment club in Beardstown, Illinois who had generated 23% returns on the investment pool for many years.  According to an 1998 story in the Wall Street Journal:

The Beardstown Ladies are members of a famous investment club formed in the early 1980s. The ladies rose to prominence in the mid-1990s after the club proclaimed fantastic investment results. For 10-years ending 1993, the club reported a compounded return of 23.4% in their stock portfolio versus 14.9% for the S&P 500. The ladies bought stocks of companies they knew, like McDonald’s and Coke. The investment success propelled the ladies into stardom. They appeared on TV shows and in commercials, spoke on radio programs, and not to miss a moneymaking opportunity, published best selling books on the subject of personal finance and investing. The world changed for the Beardstown ladies in late 1997. A reporter from the Chicago magazine noticed something peculiar about their published investment results. After calculating the numbers several times, he concluded that a gross error had been made. The error was so large, that the accounting firm of Price Waterhouse was called in to clear the air. In the final tally, the clubs worst fears were realized. The ladies’ actual return was only 9.1%, far below the 23.4% they reported, and well below the S&P 500. For years the ladies deposited monthly dues into their account and classified it as an investment gain, rather than additional capital. An embarrassed treasurer blamed the error on her misunderstanding of the computer software the club was using.

Unfortunately it’s not just the Beardstown Ladies who can’t do math.  No one questioned the returns initially because they wanted to believe it was true.  The exact same error is repeated by most 401k investors who often count their contributions as part of their performance.  Even in the absence of contributions, the rest of us favorably mis-remember our results anyway.  Psychology Today explains:

What was your portfolio return last calendar year? How did you perform relative to market indexes and other investors? Most investors don’t know the answers to these questions. But their belief in their performance is quite flattering to themselves!

Two interesting studies illustrate this point. In the first study, William Goetzmann and Nadav Peles surveyed a group of investors belonging to the American Association of Individual Investors (AAII) and a group of architects about their retirement plan investment returns. The AAII investors are presumably very knowledgeable about investing from their participation in the association. When asked about their return the previous year, they overestimated their performance by 3.4% (= estimate – actual). Architects are very intelligent with a high degree of education, though they may not be knowledgeable investors. They overestimated their return by 8.6%. Both groups were also asked about their performance relative to a benchmark made up of the same asset allocation. The groups overestimated their relative performance by 5.1% and 4.2%, respectively.

Markus Glaser and Marin Weber also conclude that investors have biased views of their portfolio performance in the past. They surveyed individual investors from a German online brokerage firm and compared their self-assessments to their actual returns over four years. They reported a belief of an annual return mean of 14.9% over the period. Their actual return was more like 3.3%. Now that is overconfidence! In fact, there was no correlation between the actual return and the beliefs about the returns in the sample.

Cognitive dissonance strikes again.  According to Goetzmann and Peles in the Psychology Today article:

The authors attribute this to a psychological phenomenon called cognitive dissonance. The investors are mentally distressed by the conflict between a good self-image and empirical evidence of poor choices. To reduce the discomfort, investors adjust their memory about that evidence and those choices. This is then selectively re-enforced by noticing the returns of just their good performing stocks and mutual funds in the portfolio and not the poor ones.

Self-image wins every time.  A keen observer will note that investors never vastly underestimate their aggregate returns!

What can we learn from this, other than Germans are the most confident investors on the planet?  I’ve bolded the return estimates, just so you can see clearly how large the gap in perception created by cognitive dissonance really is.  The bottom line is that we all want to imagine we are getting or can get fantastic returns.

Right now we are smack in the middle of crazy season, where investors are examining their prior year returns and determining whether to stay with their current mutual fund or investment manager.  As an investment professional, one of the things you quickly realize is that you are being compared with imaginary numbers–what the client believes you should have done, or what they imagine they would have done!  Of course, as discussed above, the imaginary numbers are always terrific.

Cognitive dissonance, I believe, accounts for a lot of the manager turnover in the industry, not just volatility and style rotation.  As evidence, consider that according to DALBAR, the average holding period for mutual fund investors is about three years–whether they own a stock fund or a bond fund.  The volatility of the average bond fund is probably not enough to shake investors out, but when comparing the bond manager’s actual returns with imaginary returns, investors can only handle three consecutive years of disappointment!  Ok, I’m being a little sarcastic here, but this corresponds perfectly with studies of black-box trading systems, which indicate that investors who purchase even a profitable system abandon it after three consecutive losses.  (For fans of Markov probability chains, an average of only fourteen coin flips is required to get three heads in a row.)

When it comes to returns, we are all Beardstown Ladies at heart.  Our imagined returns are always going to be significantly higher than what we actually get.  Keep in mind that, according to the Psychology Today article, there was no correlation between the actual return and the beliefs about the returns.  Instead of being bamboozled by your inner Beardstown Lady, step back and really think about your investments.  Do they meet your needs?  Is the underlying return factor still sound?  Keep in mind that the only investment acumen required to actually earn the mutual fund NAV returns is to hold the fund!  You don’t have to condemn yourself to DALBAR-type returns.  Sure, if something has gone really wrong, you might need to make a gradual change in course–but more often than not, if the return over a multi-year period is in the ballpark, you’re quite possibly better off leaving it alone.  If you want to be a successful investor, you need to learn to deal with the real world and not imaginary returns.

Reject your inner Beardstown Lady!

 

1 Comment | From the MM, Investor Behavior, Thought Process | Permalink
Posted by Mike Moody

From the Archives: Punting When the Chips Are Down

January 19, 2012

Sunday night’s football game between the Patriots and the Colts was one for the ages.  Two future Hall of Fame quarterbacks on the two winningest teams in recent years faced off.  Ultimately the game turned on a decision that had to be made by the Patriots’ coach, Bill Belichick.  The Patriots had a fourth down with two yards to go deep in their own territory.  If they succeeded in getting it, they could run out the clock and win the game.  If they failed, the Colts would have the ball and enough time to score.

A statistician cited in the Wall Street Journal article about the play points out that the numbers are clear.  The Patriots had a 79% of winning the game by going for it on fourth down, either by converting or by stopping the Colts from scoring afterwards, but only a 70% chance of winning if they had to stop the Colts from driving down the field after a punt.  The Patriots, going with the numbers, elected to go for it, failed, and ended up losing the game.

The most interesting thing about the decision was not that the Patriots went with the odds and ended up with the short end of the stick.  The interesting thing is how vocal fans and the sports press have been about Mr. Belichick’s “bad” decision.

The kind of thing comes about because people have a tendency, in matters of probability, to confuse decisions and outcomes.  The Patriots indeed had a bad outcome, but the decision seems to have been statistically correct.  The reason that people are responding to the decision so harshly has to do with the cognitive bias of regret avoidance.  The Wall Street Journal article points this out very nicely:

In a recent study, researchers from Duke and UCLA found that when faced with a decision involving risk, people have an overwhelming tendency to make the supposedly safe choice—to err on the side of caution—even though doing so may lead to worse results.By studying thousands of hands of blackjack played by random people, the researchers found that when they strayed from the “book” or the optimal strategy, those players who did something aggressive were more successful than those who did something passive.

In fact, the subjects made four times as many passive mistakes as they did aggressive ones. And these passive mistakes—holding on a 16 when the dealer has a king showing, for example—were more costly: They cost $2 for every $1 won, versus $1.50 for every $1 won on aggressive mistakes.

Why do people embrace caution? “It’s because of the regret that people face when they take an action and it doesn’t turn out well for them,” says Bruce Carlin of UCLA’s Anderson School of Management, who worked on the study.

Think about that for a few minutes: people made four times as many passive mistakes as they did aggressive ones.  And the passive mistakes were more expensive.  Maybe risk aversion is not such a good idea in certain circumstances.  True, it feels better because we don’t have to feel dumb if we take a risk and it doesn’t work out.  Maybe feeling comfortable is overrated.  If we are truly concerned about outcomes over the long run, often it makes sense to err on the side of aggressiveness rather than passivity.

One of the biggest benefits of a systematic investment process is that it is unemotional.  Our process is designed to expose the portfolios to high relative strength picks–whether it feels comfortable to us or not–simply because research suggests that high relative strength outperforms over time.  If you punt when the chips are down, you won’t have the benefit of the odds working in your favor over time.

—-this article was originally published 11/17/2009.  No doubt we will see some NFL team this weekend make a conservative mistake as well.  Investors, like football coaches, have a conservatism bias due to fear of regret.  Interestingly, the bias toward conservatism often tilts the odds so that being aggressive is the more correct strategy.  Investors often cost themselves money by being too conservative.  The safe choice isn’t always the smart choice.

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Posted by Mike Moody

Fund Flows

January 19, 2012

The Investment Company Institute is the national association ofU.S.investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs).  Members of ICI manage total assets of $11.82 trillion and serve nearly 90 million shareholders.  Flow estimates are derived from data collected covering more than 95 percent of industry assets and are adjusted to represent industry totals.

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Posted by Andy Hyer

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