Defenders of EMH On The Defensive

July 17, 2009

The Economist has a nice discussion about the current state of support for the Efficient Markets Hypothesis (click here to read.) However, it seems that as the weaknesses of the EMH have become evident to a broader audience in recent years, many still seem to conclude that there is no better alternative.

To those who are still confused about a better approach, I would suggest that they start by reading Mebane Faber’s paper, A Quantitative Approach to Tactical Asset Allocation, which was published in 2007 in The Journal of Wealth Management (click here to read.) The numbers speak for themselves.

Our work on Global Tactical Asset Allocation strategies can be seen in the Arrow DWA Balanced Fund (DWAFX) and, more recently, in our Global Macro strategy which is currently available as a separately managed account, but will soon be available as a mutual fund with Arrow Funds.

Click here to visit ArrowFunds.com for a prospectus & disclosures. Click here for disclosures from Dorsey Wright Money Management.

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Posted by Andy Hyer

Birds of a Feather

July 17, 2009

Economists have a lot of the same problems as believers in the Efficient Markets Hypothesis. (See article here.) It turns out that people are not completely rational in their economic choices—surprise, surprise. And it turns out that unfettered free markets do not allocate resources and rewards perfectly. There are always plenty of bubbles and artificial shortages. Now there is a new field of behavioral economics, not unlike behavioral finance, where they are trying to understand the impact of human behavior in economic systems.

Eventually, they may strip economics down once again to what really works: the basics of supply and demand. Technical analysis can be useful because it makes no assumption of rationality—and let’s face it: lots of times the rationale for either supply or demand is ridiculous. A technical analyst is willing to follow the trend until it ends, and then switch to another trend. Economists and EMH types are burdened with trying to justify why the rationale was sound.

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Posted by Mike Moody

Efficient Markets

July 17, 2009

For markets to be efficient, investors must react rationally to new information as it enters the public domain. One of the big problems with the Efficient Markets Hypothesis is that investors do some crazy things. They are not always rational!

General Motors recently emerged from bankruptcy as two new entities. There is the “new” General Motors Corp that will continue to sell cars, and there is also a Motors Liquidation Corp that owns all of the bad assets the new GM didn’t want anymore. Matt Phillips wrote an interesting column for the Wall Street Journal (click here to read it) about what happened to GM stock on the day it emerged from bankruptcy. People who still held the old stock were thrilled that GM came out of bankruptcy and bid the stock up 35%. But there was one small problem. Those GM shares have nothing to do with the company that is still selling cars. They represent ownership in Motors Liquidation Corp, which is still looking to sell all of GM’s bad assets.

The stock price reaction to GM emergence from bankruptcy was so irrational FINRA had to step in to protect all the investors that hadn’t bothered to consider what stock they owned. They changed the name to Motors Liquidation Corp and the symbol to MTLQQ to avoid any confusion. The stock promptly dropped 50%.

Investors do strange things. Humans are not hard wired to be good investors. As a result, there are market inefficiencies that a disciplined process can exploit over time.

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Posted by John Lewis

Technical Adaptation vs. Technical Prediction

July 16, 2009

“What do your models expect the market to do from here?” Some variation of this question is asked most every day. This type of question generally comes from someone who has not really internalized what a trend-following process is designed to do.

The following section from Michael Covel’s, Trend Following, addresses this question by explaining the two broad categories of technical analysis:

There are essentially two forms of technical analysis. One form is based on an ability to “read” charts and use “indicators” to divine the market direction. These so-called technical traders use methods designed to attempt to predict a market direction… This is the view of technical analysis held by the majority-that it is some form of superstition, like astrology. Technical prediction is the only application of technical analysis that the majority of Wall Streeters are aware of as evidenced by equity research from Credit Suisse First Boston:

“The question of whether technical analysis works has been a topic of contention for over three decades. Can past prices forecast future performance?”

However, there is another type of technical analysis that neither predicts nor forecasts. This type is based on price. Trend followers form the group of technical traders that use this type of analysis. Instead of trying to predict a market direction, their strategy is to react to the market’s movements whenever they occur. Trend followers respond to what has happened rather than anticipating what will happen. They strive to keep their strategies based on statistically validated trading rules. This enables them to focus on the market and not get emotionally involved.

Since nobody knows exactly what the future holds, the better question for our strategy is what types of market environments are favorable and unfavorable for trend following. Trend-following strategies do well when there are longer-term trends in place. Environments in which stock market or asset class leadership is changing every couple months tends to be an environment in which trend-following strategies underperform. Investors shouldn’t get overly concerned about time periods when leadership seems to be in flux, given that it is impossible to look back in history and find even a decade where longer-term trends weren’t plentiful.

With the understanding that prediction has no place in a trend-following strategy, an investor is bettered prepared to focus on the process employed to adapt to longer-term trends. Focusing on a well-constructed investment process is much more productive than focusing on the unpredictable future.

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Posted by Andy Hyer

Good News for the Stock Market?

July 15, 2009

Last quarter, bond funds outsold stock funds. Bond funds had their largest net flows in at least 11 years. Investors seem to have given up on the idea of owning a piece of America and would rather opt for security, or at least the apparent security of owning bonds with interest rates at 40-year lows.

On the other hand, one of the experts quoted in the article says, “The retail mutual-fund investor is the worst market-timer known to mankind.” Maybe there are worse market timers, but the Dalbar data shows pretty clearly that retail investors don’t do too well. The love being showered on the bond market right now might turn out to be good news for the stock market in the near future.

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Posted by Mike Moody

Hunting for Unicorns

July 14, 2009

Morningstar has a nice article on absolute return funds, a possibly mythical beast like the unicorn. Systematic relative strength is not an absolute return strategy. On the contrary, it is a trend following strategy.

Trend following has warts, like everything else in real life. It doesn’t like trendless markets, and it will miss the turn on every bottom and every top. On the other hand, research shows that it tends to generate excess return over time.

The unicorn funds, not so much. Judging from Morningstar’s take, it appears this fund style has over-promised and under-delivered.

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Posted by Mike Moody

PDP: The Pioneer Receives Validation

July 14, 2009

On March 1, 2007, the PowerShares DWA Technical Leaders Index debuted as an ETF on the New York Stock Exchange, under the ticker symbol PDP. Tom Dorsey rang the opening bell. Now that AQR Capital Management LLC has listed (see article here) three new momentum index funds, I guess we can claim that PDP was the pioneer.

Having AQR (which stands for “applied quantitative research”) come out with momentum index funds is a big deal. AQR manages $20 billion in hedge funds and is extraordinarily well-regarded in that world. We think their decision to launch momentum indexes is a watershed event that will give similar strategies—like our relative strength strategies—much more exposure. We hope it will finally be recognized for its ability to add value to portfolios as a systematic, high-return methodology that is largely uncorrelated to the overall market and complements both value and growth.

There are a few differences between PDP and the AQR Momentum Index, which is the most similar index. Both draw from a similar universe of 1000 large cap stocks. AQR ranks stocks using a trailing 12-month return, whereas PDP uses a proprietary relative strength measure (which shows better returns in our test window). The DWA Technical Leaders Index plucks out the top 100 stocks and rebalances quarterly. The AQR Momentum Index also rebalances on a quarterly schedule, but includes the top third of the universe, about 330 stocks. Finally, DWA Technical Leaders is weighted by relative strength, whereas AQR uses traditional capitalization weights. As of 6/30/2009, Morningstar reports the YTD return of PDP as -0.71%, whereas the AQR Momentum Index is reported at -8.29%.

AQR may be the new kid on the block, but we are very pleased to see them in the neighborhood.

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Posted by Mike Moody

Oil’s Ups and Downs

July 14, 2009

This article from BBC makes it clear that predicting commodity prices is pretty hazardous. When oil was $150 per barrel, many oil producers even thought it was too high, yet there were plenty of people forecasting $200 oil at that point.

The fact is that no one know what the price will be. That’s what markets are for—to let supply and demand slug it out. The beauty of using relative strength in a systematic way is that it allows exposure in the portfolio when an asset is strong and trending, and removes it when it weakens. No forecasting required.

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Posted by Mike Moody

Asness on Momentum

July 10, 2009

Clifford Asness runs AQR Capital, a very large and successful hedge fund firm. He has long been an advocate of using momentum (a similar factor to relative strength) as an investment factor. He was on CNBC this morning and gave some insightful comments about using a momentum or relative strength strategy for investing. The clip is well worth watching.

I think there are a couple of points he makes that we would totally agree with:

  • Don’t put all your eggs into an RS basket
  • Using a value strategy to “offset” an RS strategy is a good idea
  • RS works, and it has worked for years and years. It has periods of underperformance, but it works in both bull and bear markets.
  • It is difficult to time an RS strategy (just like it is difficult to time the market)

Click here for a link to the CNBC video.

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Posted by John Lewis

The Death of Strategic Asset Allocation?

July 10, 2009

It must be official—a long article appeared in the Wall Street Journal today, replete with correlation graphics, that discussed the issues the strategic asset allocation has had over the past year or so.

The base problem is that diversification did not help as much as it typically has. We feel there is some merit in strategic asset allocation—at least it is a systematic approach to building a portfolio and then rebalancing to the target weights periodically. It just may not be the optimal approach for the real world, where correlations are notoriously unstable. A well-executed tactical approach (like our Systematic RS Global Macro portfolio), with a mixed universe of high-volatility and low-volatility assets is, we think, more likely to get the job done.

This article is a must read for “recovering asset-allocationists.”

Click here for disclosures from Dorsey Wright Money Management.

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Posted by Mike Moody

Getting With the Program

July 9, 2009

Target date funds, according to this article, are suddenly filing for changes that allow tactical asset allocation. We’ve written frequently about the potential hazards in having a fixed glidepath that piles into fixed income as a client ages, not to mention the issues inherent in strategic asset allocation generally. As one expert points out, “target-date asset allocation theory does not survive a down market.”

This should not be a surprise. We have advocated a tactical asset allocation approach from day one, because markets do a lot of things that finance textbooks say they shouldn’t. The most important thing is not which theory of market behavior you believe, but having the ability to adapt as conditions change. We believe relative strength is the mechanism most capable of building adaptability into portfolios of all kinds.

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Posted by Mike Moody

Second Quarter Review Podcast

July 8, 2009

John Lewis, Tammy DeRosier, and Tom Dorsey discuss the performance of Dorsey Wright managed products in the second quarter. This is a good refresher on the basics of relative strength and how we apply it to different strategies.

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Posted by Andy Hyer

Stabilization

July 8, 2009

I haven’t posted much in the way of performance of the RS quartiles and deciles because lately there hasn’t been much to write about. The market has pulled back during the first 5 trading days of the quarter, and it seems as if everything has moved together. In looking at the data you can see the top 2 deciles have outperformed the universe average, and the bottom decile has really taken it on the chin. But other than that, all the other deciles are pretty close to the universe average.

The bottom decile has really been hurt by some of the low-priced laggards that are beginning to come back to earth.

This is actually a good thing given the laggard rally we had last quarter! These periods of stabilization often occur before the spread between the high RS and low RS names begins to widen. We certainly haven’t seen the relentless outperformance by the laggards that characterized the second quarter so far this quarter.

2 Comments | Markets | Permalink
Posted by John Lewis

Debt Bomb

July 8, 2009

Here in California, the state government is already handing out IOUs—which the big banks say they won’t accept after July 11. California’s debt has already been downgraded to BAA and it might fall out of investment grade completely if they can’t get the latest budget crisis resolved.

The same thing is going on in a dozen other states and with the federal government. Too much borrowing and not enough tax revenues to pay for it. (Or, to my way of thinking, too much waste, fraud, and abuse.) To cushion the blow of the current recession, more money has been borrowed-and now economists are wondering if debt is the next bubble. If you want to scare yourself, you can click here to see a real-time debt clock.

The debt problem could get resolved in a lot of ways, but however it turns out, we could see a materially different environment going forward-one in which adaptability is key. Relative strength, we believe, is unparalleled in its ability to adapt and that might prove to be a lifesaver.

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

Millionaires Tumble

July 8, 2009

Clients have had a rough year, according to this graphic from The Economist. Millionaire households lost almost 20% of their net worth last year and their ranks thinned notably, especially in North America. Most high net worth individuals are quite diversified and this is testimony to how difficult financial markets have been over the last year.

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Posted by Mike Moody

The Power of Data

July 8, 2009

What is the root cause of the foreclosure crisis? In the popular imagination, it is rapacious mortgage companies making irresponsible loans to a bunch of naive borrowers. So government policy now addresses that scenario and tries to modify loans so that people can stay in their homes. Yet, data shows that the biggest single foreclosure risk is someone who never had equity in their home-the no-money-down crowd.

Data is funny like that. Often a thoughtful analysis of the data reveals something unexpected. We have found this to be true repeatedly as we’ve done research for our Systematic Relative Strength accounts over the years. At least once a week, we get a call suggesting that if we handled stops or rotation or something differently, our results would be better. We are always open to improvement, so I always ask for their data so we can take a look at it. “Data? Well, I don’t have any data,” is the inevitable response.

Data, in fact, is critical to distinguish between something that has worked recently and something that has worked consistently over a decade or more. I ask for the data so that we can compare it to the testing we have already done. (We’ve already tested for everything that we normally get inquiries on-usually in multiple ways. I’m not always sure callers generally realize that.) We have two hurdles: 1) the method has to be capable of being applied in a systematic way, and 2) the method has to have consistent success over a long period of time. When both hurdles are met, we may have something useful that can be applied to accounts in a rules-based way over many years that will give clients a shot to build real wealth.

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Posted by Mike Moody

Sink That Putt!

July 7, 2009

This is a fascinating piece about how golfers, consciously or unconsciously, behave more conservatively on birdie putts than on par putts, costing themselves—on average—a full stroke over 72 holes, and for a top golfer, more than $1 million in annual prize money. The reason for their conservatism is loss aversion, a psychological phenomenon noted by Nobel Prize winner Daniel Kahneman and his collaborator, Amos Tversky. In short, people try harder to avoid perceived losses than they pursue gains. Kahneman realized loss aversion is in full bloom in the financial markets, which is why (among other related investor irrationalities) he was awarded the Nobel Prize.

Articles like this point out why it is so important to have a systematic, rules-based approach to the markets. By doing so, we are able to treat every putt the same way, so to speak. A systematic approach does not vary depending on whether our last transaction was a success or a failure, or whether we’ve recently been outperforming or underperforming. We just keep pounding away at a strategy that has been shown to add value over time. By not pulling any psychological punches, we are more likely to capture whatever excess returns are available in the strategy.

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Posted by Mike Moody

Volatility and Personal Responsibility

July 7, 2009

I have to confess that I am a little confused about this article. First, the author presents information from Morningstar that confirms the QAIB information that Dalbar has been pointing out for many years—that investors in funds do not do as well as the underlying funds themselves.

Then, he appears to blame volatility for making investors behave badly and suggests that funds with lower volatility will create better investor performance. After which he quotes Warren Buffett, who indicates the opposite—that he would rather have the higher return and accept the volatility than take the lower return. All of this is a little unclear to say the least.

Let me clear up a few things then. First, I’m not at all sure it is true that lower volatility enhances investor returns. Dalbar’s QAIB shows that bond fund investors lag bond funds by approximately the same margin as stock fund investors lag stock funds. Bonds are significantly less volatile, but that doesn’t seem to help at all. Dalbar shows only a marginally longer holding period for asset allocation funds than for stock funds, where again there is a significant difference in volatility. If volatility were really the determining factor in whether investors could hang in and perform well or not, these metrics should reflect it.

Second, I believe it is the investor and the advisor’s responsibility to do due diligence and know what they are buying. If you buy an emerging markets growth fund, for example, the fund is not exactly trying to hide that it may be volatile. You accept the volatility as your tradeoff for the potentially higher return. That’s the American way. To blame the volatility for poor returns, to me, is symptomatic of current, soft-headed American culture where no one is ever responsible for their own decisions. After all, wasn’t it that mortgage broker who made you buy a house you couldn’t afford?

No, Mr. Buffett has it right, I think. Ultimately, what makes you wealthy is the return. That means you have to deal with the volatility. And really, what is the big deal? The only ”investment acumen” a fund investor has to have to earn the NAV return is to sit like a slug! That’s it—you don’t really have to do anything clever. There is no magic trick involved, just patience. Research a strategy thoroughly, take a stand, and make a commitment, for goodness sake!

1 Comment | Investor Behavior | Permalink
Posted by Mike Moody

Nugget of Wisdom…from 1922

July 7, 2009

Steve Leuthold’s July research included the following quote:

“Stock price movement represents the aggregate knowledge of Wall Street and, above all, its aggregate knowledge of coming events. The stock market represents everything everybody knows, hopes, believes, anticipates, with all that knowledge sifted down to…the bloodless verdict of the market place.” -William Peter Hamilton, The Stock Market Barometer, 1922.

This is the very reason why price is the primary input into our models.

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Posted by Andy Hyer

Go BICs!

July 6, 2009

Only two of the world’s 15 biggest economies are expected to grow in 2009: China and India. If emerging economies, like Brazil, China, and India continue to grow at a much faster rate than the U.S. economy it could very well mean an end to America’s reign as the driving force in the global economy. However, such a decline in global economic leadership does not necessarily mean a decline in the absolute living standard of Americans. As Time points out in their article, it could be much more similar to the relative decline of Britain than to the absolute decline of the Roman Empire.

Furthermore, to a global investor a gain in an international investment spends the same as a gain in a domestic investment. The world is open for investment; it just requires overcoming the home-country bias that causes so many to miss out on international investment opportunities.

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Posted by Andy Hyer

The Problem With Prediction

July 6, 2009

Marketwatch ran a rare mea culpa today. They had originally written an article in December 2008 to tell readers what investments they should buy for the coming year. Like all crystal balls, theirs was apparently cracked. Almost every prediction they made turned out to be incorrect. I give them a heap of credit for running the follow-up article to discuss what actually happened and what went wrong with their predictions.

Unfortunately, this wouldn’t be so nice if you still owned all of these investments. Investors love hearing predictions, but they often believe the forecasters have actual ability to predict. Imagine a scenario where you are flipping a coin. Only one of two outcomes are possible—heads or tails. I am the wise forecaster who will tell you which of the two you are about to flip. Do you believe that I have forecasting ability in this case?

Probably not, since you know that coin flips are random. Yet at least the forecaster has 50% odds of being correct in the coin flip scenario. With thousands of economic and stock market variables, I would venture to say that the real odds of a correct prediction in financial markets are far lower than 50%—it is a vastly more complex system.

Our investment methodology does not involve prediction. We follow the trend until it ends. When it ends, we find a new strong trend to get involved with. Sometimes following trends leads us to surprising places, and it certainly is not always profitable every quarter, but we don’t have to make guesses about what to do. Trend following is something that can be rigorously tested and we think that puts it more than a few steps ahead of trying to use a crystal ball.

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Posted by Mike Moody

Endowment Returns

July 2, 2009

Barron’s recently ran an article on large college endowment returns (see the table below). Most of the schools use a 6/30 fiscal year and are reporting losses on the order of -25 to -30%. Most of these funds use some type of strategic asset allocation, and in recent years they have had large allocations to private equity and hedge funds.

2009 Endowment Returns (courtesy of Barron's)

click to enlarge

Our own Arrow DWA Balanced Fund (DWAFX), rather than strategic allocation, uses tactical allocation to domestic equities, international equities, fixed income, and alternatives. We do not have access to some of the asset classes of the large endowments like private equity and hedge funds, which were believed to be high return-low volatility opportunities. Despite the lack of access, the trailing one-year return for DWAFX compares favorably with the major endowments. Perhaps there is something to tactical asset allocation after all!

Click here to visit ArrowFunds.com for a prospectus & disclosures. Click here for disclosures from Dorsey Wright Money Management.

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Posted by Mike Moody

Zen Investing

July 2, 2009

A useful article from Forbes about the patience required to be a successful investor. Two damaging trends are discussed: 1) bailing out simply because the markets have encountered a difficult period, and 2) measuring performance expectations over a time period that is far too short.

Perhaps these points seem overly elementary, but evidence from mutual fund asset flows and holding periods show that many real-world investors really struggle with these concepts. Resisting the impulse to cut and run from a long-term strategy that you have researched thoroughly can be remarkably profitable in the long run.

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Posted by Mike Moody

The World Turned Upside Down

July 2, 2009

When General Cornwallis surrendered at Yorktown to George Washington, his military band played “The World Turned Upside Down.” It didn’t seem in the natural order of things for a collection of colonies with a rag-tag army to defeat a global power, but it was a foreshadowing of things to come.

This article from the Financial Times (free subscription if you can’t read the whole article) points out that China was able to float more debt in the last year than Japan. We are witnessing one of the post-war global powers being eclipsed in its own region.

We can safely assume that expected rates of return and expected risks in various capital markets will be very different going forward. A more tactical approach may be required—relying on historical assumptions could be quite dangerous in this environment.

Leave a Comment » | Markets, Tactical Asset Alloc | Permalink
Posted by Mike Moody

High Correlations: Here to Stay?

July 1, 2009

“The problem of correlations is growing, and I don’t think it goes away.” -Joseph Mezrich, head of quantitative research at the U.S. brokerage unit of Nomura Holdings.

The quote above was taken from a Bloomberg article by Eric Martin and Michael Tsang in which they point out that the correlations of stocks, commodities and emerging markets are again moving in lockstep. In fact, the correlations between the S&P 500 and the Reuters/Jefferies CRB Index of commodities over the last sixty days is now at the highest level in 5 decades.

It’s always entertaining to see people extrapolate very recent performance, correlations, or standard deviations in to the distant future. That is quite a statement by Mr. Mezrich that high correlations are never going away.

Check out the following chart of the correlations of the S&P 500 and the MSCI EAFE over a 20-year time horizon.

(Click to enlarge)

Contrary to Mr. Mezrich’s opinion, I think we can expect correlations to do what they have always done in the past: change. Any strategy whose success is dependent upon the stability of performance, correlations, and standard deviations is very likely to experience risk and return characteristics wildly different than they imagined. Data is readily available on each of those factors showing their wide variability over time.

In contrast, Tactical Asset Allocation is not dependent on the stability of performance, correlations, and standard deviation. The success of a Tactical Asset Allocation approach is only dependent upon trends. And trends aren’t going away.

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Posted by Andy Hyer

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