Systematic Relative Strength

Banks, for more than a year now, have been reducing the amount of lending they do. It may be because there are very few creditworthy borrowers, or it could be that banks have decided they need to shore up their own balance sheets and take more reserves against bad debt. Whatever the actual reason, it’s very difficult to keep the economy growing when many companies do not have access to capital.

Rationing of credit may act to differentiate companies that can still thrive in this environment from companies that will struggle to have enough cash flow to stay afloat. Markets where there are stark differences between the best stocks and the worst stocks are often markets in which relative strength shines as a strategy. Relative strength can help locate the strong companies and avoid the weak ones—and in the meantime, the market return is an average of the two. If the trend continues, we may begin to see high relative strength names outperform on a more sustained basis than the week-to-week choppiness we have seen so far.

According to the head of the International Monetary Fund, banks have disclosed only about half of their losses. Monetary authorities may have no choice but to keep interest rates down long enough for banks to rebuild their balance sheets—a choice which will inevitably cause dislocations in other parts of the economy.

You can guess at what might happen (called “forecasting” in polite company) or you can choose to use a systematic, adaptive investment process. I know what my choice will be.

Jason Zweig’s usually wonderful Intelligent Investor column in the Wall Street Journal had a real winner this week. He wrote about a finance professor that did some studies on diversification. The idea that diversification is essentially a free lunch is ingrained in modern finance. Investors are taught that proper portfolio construction involves owning enough companies, generally 20-30, to reduce stock-specific risk.

Mr. Zweig describes the base case for diversification when looking at aggregated data:

Don Chance, a finance professor in the business school at Louisiana State University, asked 202 students to select one stock they wanted to own, then to add a second, a third and so on until they each held a portfolio of 30 stocks.

Prof. Chance wanted to prove to his students that diversification works. On average, for the group as a whole, diversifying from one stock to 20 cut the riskiness of portfolios by roughly 40%, just as the research predicted. “It was like a magic trick,” Prof. Chance says. “The classes produced the exact same graph that’s in their textbook.”

Aggregated data, though, is tricky stuff. It’s one thing to see a pattern across a large number of cases, but what happens when you drill down into the individual portfolios that were constructed? This type of micro-analysis is often not done in finance, which can create a less nuanced view of reality. Indeed, when Dr. Chance looked at the data closely, there were some surprises.

But then Prof. Chance went back and analyzed the results student by student, and found that diversification failed remarkably often. As they broadened their holdings from a single stock to a basket of 30, many of the students raised their risk instead of lowering it. One in nine times, they ended up with 30-stock portfolios that were riskier than the single company they had started with. For 23%, the final 30-stock basket fluctuated more than it had with only five stocks.

The lesson: For any given investor, the averages mightn’t apply. “We send this message out that you don’t need that many stocks to diversify,” Prof. Chance says, “but that’s just not true.” What accounts for these results? Leave it to a professor called Chance to show that even a random process produces seemingly unlikely outliers. Thirteen percent of the time, a 20-stock portfolio generated by computer will be riskier than a one-stock portfolio.

The averages might not apply because of interaction effects within the portfolio, and because outliers are perhaps more common that we would like to believe. Even a portfolio built by throwing darts might not have the diversification that an investor is seeking.

Diversification is just one form of risk management, and it is clearly not a complete solution. Our Systematic Relative Strength accounts, for example, also break the investment universe into baskets and require portfolios to be built from a number of different baskets. Even so, portfolio volatility can change over time as new securities come into the portfolios and underperformers are eliminated. At times, risk is rewarded and portfolios might be loaded with risky securities; in fearful investment climates, portfolios might instead have a large helping of cement-like securities. Along with diversification, having a systematic investment process that adapts to the environment can be helpful in managing risk.

Financing costs for the U.S. Treasury are projected to go from $202 billion now to $700 billion or more in the next ten years. As this New York Times article points out, the additional $500 billion is more than the combined federal budgets this year for education, energy, homeland security and the wars in Iraq and Afghanistan.

One complicating factor is that the rapid increase in debt service payments is coming at exactly the same time the Treasury is trying to finance giant increases in Medicare and Social Security as a result of the baby-boomers reaching retirement age.

One consequence of this debt buildup is that credit default swap volume against sovereign debt default for industrialized countries has doubled over the past year, while the swap volume to insure against default in emerging markets has dropped. Investors are increasingly betting that the debt wave will be unsustainable and may result in defaults in large economies.

The growth in debt service costs is already running at a much higher rate than growth in GDP, which means it is no longer possible to grow our way out of the problem. We are headed toward an inevitable showdown between Congress’ propensity to spend and the bond market’s reluctance to finance all of that spending. The investment environment could change radically and it will be important to have a flexible investment policy that can adapt.

Much has been made in the financial press about how equities are inversely tracking the U.S. dollar - when the dollar falls equities rise, and when the dollar rises equities fall. Some have argued that this relationship makes sense. For example, David Brown at Seeking Alpha argued the following:

Frankly, this inverse relationship between the dollar and the market is not that surprising since a weak dollar means more exports and fewer imports for the U.S. and higher material prices. That also explains the strength of large-caps over small-caps, since as general rule large-cap stocks have much more revenues from exports than small-caps.

Others have explained the inverse relationship between the U.S. dollar and equities by arguing that whenever there is rising risk aversion (including aversion to equities), a rising dollar is the result.

So, can we expect this relationship to hold up in the future? If so, should that information factor in to our investment decisions?

Perhaps, we can gain some insight by looking at how this relationship has held up in the past (hint: it hasn’t!)

(Click to Enlarge)

That is not much of a pattern. Sometimes there is an inverse relationship between the dollar and equities and sometimes there is a direct relationship. Given the unstable nature of correlations, it seems to make sense not to depend upon correlations.

Relative strength models evaluate each security in a given investment universe on its own merits, not on any real or perceived relationship that a given security has had with other securities in the past.

There are very few things that can be counted on in the financial markets. Correlations should not be counted on given their unstable nature. One thing that we have found that has occurred with regularity over time is the existence of long-term trends. It is the existence of long-term trends that make it possible to earn excess returns by executing a systematic relative strength model.

Did it ever occur to you that the weak dollar is biting you in the rear every time you put gas in your car? According to Rex Tillerson, the CEO of Exxon, oil is probably $20 higher than it would be otherwise because of the weakness in the dollar. In the meantime, the oil producers are so upset about the weak dollar that the Gulf Cooperation Council is thinking of ditching the dollar peg. We might have $2.25 gas in Southern California and a vastly lower cost of importing oil if the dollar were stronger. But, of course, the stronger dollar has its own set of consequences as well.

It’s always interesting to me how changing one little factor in global markets causes effects throughout the system. I’ve referred to it before as beanbag economics: when you smush down one part of the beanbag chair, it poofs out somewhere else. It’s the best argument for adopting a systematic investment process that is truly adaptive.

Headline from the New York Times: Geithner Says U.S. Is Committed to a Strong Dollar.

Chart courtesy of FreeStockCharts.com

My goodness, what would the dollar index look like if the government weren’t committed to a strong dollar? It’s important to measure relative strength rather than to listen to the banter, especially when people have an axe to grind. And who doesn’t have an axe to grind?