Systematic Relative Strength

That’s the title of a must-read article on credit spreads from David Ranson, who is the chief of economic research at H.C. Wainwright. He writes:

The best market predictor I know of is the yield spread between investment grades in the industrial bond market as defined by Moody’s. The sudden widening of these spreads accurately predicted both the magnitude and timing of the downturn last year, and their equally rapid return to normalcy is now predicting an explosive recovery.

This simple market-based indicator has several advantages over the confusing plethora of theoretical arguments being tossed around by forecasters. First, its track record is pristine; during its 90-year history it has faithfully mirrored the economy’s cyclical ups and downs. Second, it has credibility; as a derivative of transaction prices, it reflects the objectivity of the financial-market system.

Moreover, it has a natural interpretation as an index of risk tolerance, in that it quantifies the changing uncertainties that influence the willingness with which capital is placed at risk and put to work.

It’s nice to see an economist that relies on market-generated data. It also matches up with the forecast from other market-generated data like the yield curve. The most powerful part of Ranson’s argument is that

The narrowing of the spread this year has been the largest since the 1930s. From the second to the third quarter the Baa/Aaa spread fell back by 108 b.p., more than twice the 40-b.p average for the four incidents that saw seven-percent growth. This suggests that a forecast of seven percent for the fourth quarter and the first quarter of next year may be conservative.

The next couple quarters should be very interesting. We’ve got economists lined up on both sides of the argument and both sides are persuasive: explosive growth based on market-generated data or sluggish growth based on all of the continuing problems with housing, banking, and unemployment. By mid-year 2010 we’ll get to see who was right, but that hardly matters. The immediate problem for investors is how to deal with their portfolios when forecasts are so widely disparate. There’s a real risk of letting our underlying emotions of pessimism or optimism creep into the investment decision-making. What’s needed is an unemotional, systematic way to navigate portfolios through what could be a tumultuous period. Our Systematic RS strategies attempt to do just that, by measuring the relative performances of securities or asset classes and keeping the strongest ones rotated to the front of the portfolios.