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.