Systematic Relative Strength

Rob Arnott is a thought leader in tactical asset allocation, currently well-known for his RAFI Fundamental Indexes. In his recent piece, Lessons from the Naughties, he discusses how investors will need to find return going forward.

The key to better returns will be to respond tactically to the shifting spectrum of opportunity, especially expanding and contracting one’s overall risk budget.

It’s a different way to view tactical asset allocation–looking at it from a risk budget point of view. The general concept is to own risk assets in good markets and safe assets in bad markets.

It turns out that systematic application of relative strength accomplishes this very well. The good folks at Arrow Funds recently asked us to take a look at how the beta in a tactically managed portfolio changed over time. When we examined that issue, it showed that as markets became risky, relative strength reduced the beta of the portfolio by moving toward low volatility (strong) assets. When markets were strong, allocating with relative strength pushed up the beta in the portfolio, thus taking good advantage of the market strength.

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Using relative strength to do tactical asset allocation, the investor was not only able to earn an acceptable rate of return over time, but was able to have some risk mitigation going on the side. That’s a pretty tasty combination in today’s markets.

This article from the New York Times is pretty much in keeping with the current zeitgeist. It discusses the financial crisis and points out how inter-connected financial markets are these days.

As we all now know, mortgage woes were contained — to planet Earth. And so it may be with overleveraged nations in Europe.

Simply put, contagion is a fact of life in our interconnected global economy and financial markets. And that means investors must strap in for more gyrations in the stock and bond markets as the great and painful deleveraging that began in 2007 continues around the world.

However, this article, like most of its brethren, looks only at the negative aspect of financial contagion. In fact, contagion is just as likely to happen when things get rolling to the upside again.

Right now it is easy to be focused on gloom and doom, but market cycles don’t press on the downside forever. One can certainly make the case that the market would have gone down by now if it really and truly deserved to. Keep in mind that the stock market is typically a leading indicator. We’ve already had a nice rally from March 2009 until now.

What happens if the market stubbornly refuses to go down from here, and continues to make upside progress? Suddenly all the benefits of a positive feeback cycle are being discussed: corporate earnings rise, corporate dividends increase, national tax receipts begin to surge, and hiring starts once again. It’s quite likely that because global markets are so inter-connected that improvements in psychology and corporate results will move around the globe too. The global village may mean that your investment policy needs to be more flexible and to include more asset classes, but it doesn’t mean that we’re going to be mired in the muck forever.

The risks to committing new capital to investments right now may seem abnormally frightening. However, how often is it that we really feel extremely confident that now is a great time to commit new money to an investment? Aren’t there always risks lurking in the shadows? Consider the comments of Neels van Shaik on this topic (via Prieur du Plessis’ blog.)

Commentators and investment pundits have flooded the media with articles and information regarding the state of the world economy and the uncertainty the world faces regarding government debt, geopolitical instability, consumer deleveraging, and the rest of the jargon that goes with it. This is held forward as a key reason why you have to be cautious to commit new capital to the market.

Although all these concerns are valid, you will very seldom, if ever, find a period where global macro forces are in such a state of equilibrium that capital commitments to stocks can be done with any degree of certainty. We can let our minds drift back to the late 1940’s, when Europe was completely broken after World War II and capital was scarce. Looking at the world and the future at that point in time could not have inspired too much hope for investors.

Another example is the seventies which saw one of the worst periods for stock investments. Between 1970 and 1978 the S&P500; delivered a cumulative capital return of 7% and adjusted for inflation a complete annihilation of capital. By the end of 1978 any investor in stocks could have been excused for not having too much optimism on the outlook for stock returns, given the returns over the preceding eight years.

The world has become a very small place and investors and consumers are even more bombarded now with information on financial markets on a daily basis. I am not sure that all this information necessarily adds value to investment decisions though.

Investors must consider the historical pattern of bleak economic environments giving way to periods of economic abundance. Sure, some investments go bust. That is why you don’t put all of your eggs in one basket and why it makes sense to adhere to dynamic approaches that seek to identify and invest in winners and seek to keep losses to manageable levels. Once an investor has given adequate thought to asset allocation and understands the role of each piece of the overall portfolio, it is time to move forward.

Bloomberg carried an excellent story about Ken Rogoff and his view of how the sovereign debt problems will ultimately be worked out. As you read it, you have to keep in mind that Mr. Rogoff was the former chief economist of the International Monetary Fund and thus has had a front-row seat to numerous sovereign defaults in the past. In addition, he and Carmen Reinhart wrote what is certainly the most data-heavy treatment of the last 800 years of financial crises and their aftermath, This Time is Different.

Rogoff was speaking at a conference in Tokyo and painted a bleak picture for sovereign debt.

Following banking crises, “we usually see a bunch of sovereign defaults, say in a few years,” Rogoff, a former chief economist at the International Monetary Fund, said at a forum in Tokyo yesterday. “I predict we will again.”

The U.S. is likely to tighten monetary policy before cutting government spending, sending “shockwaves” through financial markets, Rogoff said in an interview after the speech. Fiscal policy won’t be curbed until soaring bond yields trigger “very painful” tax increases and spending cuts, he said.

On the other hand, he suggests that a little inflation might not be so bad given the alternatives.

“Most countries have reached a point where it would be much wiser to phase out fiscal stimulus,” said Rogoff, who co- wrote a history of financial crises published in 2009. It would be better “to keep monetary policy soft and start gradually tightening fiscal policy even if it meant some inflation.”

It’s hard to know how U.S. policymakers will handle the situation, but it is clear that this business cycle is perhaps unusual because of the large buildup of debt in the system. In situations like that, often things happen in an unforeseen way. In the battle for investment survival, now more than ever, it may be important to be able to tactically allocate around the globe.

It’s no secret that we prefer tactical asset allocation as a way to deal with the vagaries of financial markets. A very nice piece from Doug Short, entitled “Diversification Works…Until It Doesn’t” illustrates why we are leery of sit-and-take-it investing.

Markets are always changing. Sometimes taking risk is rewarded and sometimes it is punished. During the last bear cycle, bonds were the “safe” assets. Given the large buildup of public indebtedness, can anyone assume that bonds will be the safe asset the next time around? I’m not willing to make that leap of faith. That’s one of the nice things about tactical asset allocation: you don’t have to make assumptions; you can just roll with the changes. Let supply and demand determine what is strong and what is weak.