Systematic Relative Strength

Bankers can make more money doing business in Asia than in the West-more projects to finance and more credit-worthy customers. And that’s likely where the capital will flow. Money tends to go where it is treated best. Our relative strength process is just a systematic way to help make that determination.

In most soccer leagues, if a team performs poorly enough, they get “sent down” to the next division. (Clippers, Raiders, and Pirates take note.) The same thing is now happening to the U.S. dollar as world central banks decide in which currency to hold reserves. Since 1999, an average of 63% of central bank reserves have been held in dollars. Last quarter, foreign central banks added $413 billion to reserves, but only 37% went into dollars. The bulk of the reserves went into euros and yen, where central bankers felt more comfortable with fiscal policies.

As a matter of prudence, central bankers have to consider global macroeconomic factors when investing their billions. As a matter of prudence, maybe it’s time we all looked a little more carefully around the globe for investment opportunities.

We have been noticing an interesting anomaly over the last couple of months. Gold and U. S. bonds have both been rallying. Mark Hulbert, founder of Hulbert Financial Digest has noticed it too. He commented on this phenomenon in an article “Who Will Blink First?” on October 7.

In theory, this should not be happening, since what is good for gold (purportedly an inflation hedge) should be bad news for bonds. If nothing else, this points out that trend following may be more useful than only following the fundamentals. In the article, Mr. Hulbert suggests a couple of explanations for both markets being up at the same time. In the long run, however, it seems likely that one of the markets will crumble. Based on contrarian sentiment analysis, Mr. Hulbert favors gold to be the ultimate winner. (We’ve also talked about the possible bubble in the bond market many times on this blog.) This may well be correct, but I am just going to let relative strength sort it out for me.

Since launching the Global Macro strategy earlier this year, everyone in our office has thought much more about things in macro terms-not just how things affect us immediately, but how changes affect the entire system.

David Malpass has a very interesting editorial in the Wall Street Journal today where he discusses what happens to an economy with a weak currency. He argues that there is a flaw in the weak dollar argument: ”Some weak-dollar advocates believe that American workers will eventually get cheap enough in foreign-currency terms to win manufacturing jobs back. In practice, however, capital outflows overwhelm the trade flows, causing more job losses than cheap real wages create.”

From a macro perspective, Mr. Malpass points out what has happened to American shareholders:

Equity gains provide cold comfort when currencies crash. From the euro perspective, the S&P peaked at 1700 in 2000, finally reattained 1100 in the 2007 bubble, fell below 600 in March and now stands at 700 (see nearby chart). With most of the market capitalization of U.S. stocks held by Americans, the dollar devaluation has caused a massive decline in the U.S. share of global wealth.

U.S.-based investors, for the most part, are not really aware of these changes. They just want “the market” to come back. But the market is no longer just a domestic one. Thinking more broadly and flexibly will be essential to investment survival.

Click here for disclosures from Dorsey Wright Money Management.

Some economists have mused about the way spending behavior changes following a recession. The last couple of recessions were fairly mild and didn’t seem to change consumer behavior at all. But people who lived through the Great Depression in the 1930s did change their spending habits, many of them permanently. The experience of the Depression was so vivid and their fear of a recurrence was so big that they were essentially scared into becoming savers.

I’ve seen a couple of recent articles about consumer spending. One article in the Washington Post points out that debit card spending is rising at the expense of credit cards. Consumers are choosing only to spend what they have and are not comfortable extending themselves on credit any longer. Another article in the Wall Street Journal talks about the deleveraging process that consumers are going through. For the first time in a long time, consumers are paying down their debt rather than adding to it.

When there is a regime change like this, there will inevitably be investment implications. As in the 1930s, things might never go back to the way they were before. (Consequences seem to be like matter—they can neither be created nor destroyed. For every obvious consequence, there seem to be a dozen that are unforeseen!) Perhaps we will see a recovery led by business and industrial investment for a change, because consumers will still be busy rebuilding their balance sheets. Maybe we will see more growth in sales for small-ticket items rather than for big-ticket items. But beyond any obvious guesses I can make, there will be hundreds of other implications, both macro and micro. If domestic consumer spending drops for big ticket televisions, for example, what happens to the economies in Asia that survive by exporting them? What happens to their currency vis-a-vis the dollar? How does it affect their domestic politics and what kind of political leaders come to power overseas? And how does that circle back to affect us?

The necessity for an adaptive investment process is really highlighted under these conditions. With so many variables and so many unknowns, it’s really impossible beforehand to pick out what investment themes might work going forward. Our systematic relative strength process will continue to adapt as the themes change.

Barry Ritholtz succinctly makes the case for relative strength (without actually using the term relative strength.)

Investors are being forced to play Where’s Waldo? with the economy. Is it stronger? Is it weaker? Where is it today? Will the economy continue to recover, or are we headed for a double-dip recession? This story from the Washington Post shows just how many cross-currents there are right now. With such mixed data, you are going to see divergent opinions from analysts—as well as a lot of confusion. If you are trying to navigate the markets, it’s easy to let your emotions dictate your asset allocation, depending on how the market reacted to the last set of data. And, of course, the data changes every day.

Rather than being trapped on an emotional rollercoaster, we think it makes sense to navigate the market using an unemotional, systematic process. The news of the day does not affect the systematic process, except to the extent that it creates actual changes in price levels that can be distinguished from noise. In other words, wait to identify a trend and then go with it. A systematic relative strength process is not a panacea. Some trends work out well; others don’t. In my opinion, the most important thing with a systematic, adaptive process is the emotional space that is created. (It helps that relative strength has exceptional performance over time too.) You no longer need to worry about every economic report, or to try to figure out the report’s implications for your portfolio. You have the space to be patient and calm, and to let the adaptive process work.