In classical economics, profit is viewed as a signal that guides the allocation of society’s scarce resources. High profits in an industry are a signal that buyers want more of what that industry produces. Low or negative profits in an industry are a signal that buyers want less of what the industry produces. We can see, for example, that society is not keen on overleveraged trading firms with large portfolios of toxic assets or on manufacturers of perceived low-quality gas-guzzling automobiles. We don’t have to hold this as an opinion—we can just follow the money. Right now those companies aren’t making any.
In the same way, relative strength is a signal in our Systematic RS accounts. The relative strength ranking of a security tells us whether our scarce portfolio slots want more of that type of security, or less of it. The relative strength ranking communicates a “sell” message if it falls below our minimum hold ranking. The relative strength ranking can only fall if the security underperforms for a period of time. In that sense, underperformance is desirable because it is the only way a security can communicate that it needs to be sold.
By the same token, high or rising relative strength ranks let us know that the portfolio wants more of the good stuff. Recently, there has been very strong thematic change in our Systematic RS equity portfolios. For example, look at the changes in our Systematic RS Aggressive model since the market bottom in March.
Selected SRS Aggressive macro-sector weights a/o 3/8/2009
Consumer staples 22.7%, Healthcare 17.1%, Utilities 15.0%: Total 54.8%
Consumer cyclicals 13.6%, Industrials 8.7%, Technology 10.0%: Total 32.3%
Before the rally began, traditionally defensive sectors had almost 55% of the portfolio weight, while economically sensitive sectors were at only 32%.
Selected SRS Aggressive macro-sector weights a/o 6/2/2009
Consumer staples 14.2%, Healthcare 16.9%, Utilities 0.0%: Total 31.1%
Consumer cyclicals 14.0%, Industrials 11.9%, Technology 27.7%: Total 53.6%
Now the tables have been turned! Economically sensitive sectors now account for almost 54% of the portfolio, while traditionally defensive sectors have shrunk to 31%. The mechanism for this change has nothing to do with our economic forecast or market outlook—we don’t have one. The portfolio adaptation has occurred simply as a result of declining relative strength of stocks in defensive sectors and ascendant relative strength of stocks in economically sensitive areas. When changes occur in our portfolios, it certainly is not random, nor is it because we are confused about the market or we can’t decide if something is undervalued or overvalued. Turnover is dictated by the changes in the relative strength of the holdings. When underperformance is significant enough to cause the relative strength ranking to drop below our minimum hold level, it’s “Hit the road, Jack” for that security. We replace it with a security that is highly ranked and in that way we can keep the portfolio exposed to a group of high relative strength assets.
