Just in case you were wondering, these are the types of companies that a high relative strength strategy won’t own on a trip to the basement. Fortune has a nice slideshow on the biggest disasters. Yes, these are blue chip companies, but they’ve been lousy performers for much of the decade. Maybe they will come back; maybe they won’t. A disciplined relative strength strategy might own these companies at some point during their ascent, but as they weaken in price and their relative strength ranking drops, they will get kicked out of the portfolio. A trend-following strategy will not identify the top or the bottom and will miss the turns, but will try to own assets for part of the ride up and to avoid them during most of the ride down.
The Biggest Losers
February 3, 2010
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Posted by Mike Moody
How To Create Good Portfolio Performance
February 3, 2010Clay Allen of Market Dynamics has a fantastic, fantastic essay on the process needed to generate good performance in a portfolio. The process is incredibly simple, but most often ignored.
Surprisingly, the key to good performance is the ability to identify those stocks that are detracting from the performance of the portfolio. Most portfolio managers spend most of their time and effort trying to find the next big winner in the stock market but good portfolio performance depends more on finding and eliminating the bad stocks from the portfolio.
Why is the process ignored? Because most investors do not want to take a loss! This aspect of investor behavior is so ingrained that academics writing about behavioral finance have given the tendency a name, the disposition effect. (If you google for it, you will find dozens of articles written about it.) No doubt the disposition effect costs amateur investors untold millions in aggregate profits every year.
Mr. Allen’s essay is an eloquent restatement of a fundamental principle: cut your losses and let your winners run. The casting-out process used in our systematic relative strength process does exactly that. Each asset has a stop based on its relative strength rank. If it falters in relative performance, it is kicked out of the portfolio and replaced. Mathematically, this is the correct way to run a portfolio. The recent White Paper on our relative strength testing process shows that even randomly selected high relative strength stocks will outperform over time, as long as the weak stocks are knocked out of the portfolio on a consistent basis. Managing the portfolio properly is as important to the ultimate result as the research to find the strong stocks.
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Posted by Mike Moody
New Definition of Efficient Market
February 3, 2010Apparently, the Chinese market is the only market that is not efficient. Burton ‘Random Walk’ Malkiel is now running a China-focused hedge fund. To clarify, a market is only efficient if Malkiel is not currently managing an active fund in that particular market.
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Posted by Andy Hyer
High RS Diffusion Index
February 3, 2010The chart below measures the percentage of high relative strength stocks that are trading above their 50-day moving average (universe of mid and large cap stocks.) As of 2/2/10.
The 10-day moving average of this indicator is 46% and the one-day reading is 52% after falling to a single-day low of 28% on 1/29/10. This oscillator has shown the tendency to remain overbought for extended periods of time, while oversold measures tend to be much more abrupt.
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Posted by Andy Hyer
How to Find the Winners
February 2, 2010Martjin Cremers, a professor at Yale, and his colleague, Antti Petajisto, authored a paper on the concept of active share. Advisor Perspectives recently interviewed Mr. Cremers to ask about his research. (This link is worth checking out, as it has links to additional articles such as From Yale University: New Research Confirms the Value of Active Management and Compelling Evidence That Active Management Really Works.)
Active share is a holdings-based measure of how different the holdings in an active portfolio are from the benchmark portfolio. As an example, an S&P 500 index fund would have an active share of 0%, since the holdings would be identical to the benchmark. Portfolios with low active shares around 30% are still so close to the benchmark that they are considered closet indexers.
Where Cremers and Petajisto differ from the establishment is that by segmenting managers in this way, they believe they are able to identify a subset of managers-those with high active share-who can outperform the benchmark over time.
That result is probably the most controversial. We find significant evidence, in our view, that a lot of managers actually do have some skill.
What I find refreshing about their approach is their willingness to examine aggregate data more thoroughly. In aggregate, their data also shows that fund managers do not outperform the benchmark. Most studies stop there, pretend not to notice that numerous tested factors show evidence of long-term outperformance, and then advise investors to buy index funds and to forget about active management.
Cremers and Petajisto were not content to take the lazy road. And, in fact, when looked at in more granular fashion, the data tells a different story. Closet indexers do worse than the market, but many managers with high active share show evidence of skill. This is much more in accord with other academic research that shows that broad, robust factors like relative strength and deep value can outperform over time. A manager that pursued such a strategy would have high active share and would have a good chance of long-term outperformance. That’s exactly what our systematic relative strength strategies are designed to do.
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Posted by Mike Moody
Retirement Income
February 2, 2010As baby boomers age, retirement income has become a hot topic. Most of the discussions revolve around determining the best way to structure a retirement portfolio to generate the maximum income from it. I know of no studies that specifically address this issue from a quantitative standpoint, but from a psychological perspective, the idea of dividing assets into buckets has been gaining favor. In this transcript from Consuelo Mack’s Wealthtrack program, several financial experts discuss retirement income ideas and I note that the buckets idea is mentioned frequently.
Although holding up to five years worth of spending in cash is not likely to optimize the overall portfolio return, the idea of buckets is designed to allow investors to hold growth assets with less fear. Spending comes from the liquidity bucket, which given the mind’s natural tendency to segment things, does not seem as connected to the growth part of the portfolio as when the assets are combined in one large portfolio. The investor may have a tendency to leave the growth bucket alone, perhaps using occasional gains to replenish the liquidity bucket.
The additional psychological advantage of separating the liquidity and growth buckets is that investors may not feel pressure to liquidate when the market is weak. If they feel that their spending needs for the immediate future are covered, they may be more willing to let the growth investments fluctuate-and not sell out at inopportune times. If using the bucket approach leads to better investor behavior in the long run, I’m all for it.
Leave a Comment » | Investor Behavior, Retirement/Saving | Permalink
Posted by Mike Moody
Politics 101
February 2, 2010Last week I read something in the WSJ that made my head spin.
A bill was voted down in the Senate which would have created a bipartisan commission whose job would be to tackle the enormous budget deficit the United States is currently running. The key words here are bipartisan commission. This article, taken from the Lawrence Journal, sums up a few of the constraints the commission would have had, which would have kept either party from gaining unchecked authority in balancing the US budget.
The failed bill wasn’t a mandate on how to solve the deficit; it was a bill about setting up a framework of discussion for solving the deficit. There’s a difference between the two, and the bill would have allowed many paths to a solution.
The deficit clearly needs to be addressed before the U.S. ends up with a forced fiscal austerity program like Greece. If you want to get a sense for how rapidly our public debt is growing, here’s a website devoted to tallying our nation’s debt: Debt Clock. (Be sure to hit Refresh a couple times to get a sense of the pace.) It’s scary and breathtaking.
Anyway, back to the bill voted down in the Senate. Apparently, six Senators co-sponsored the writing of the bill, put their name on the bill, and then voted “No” during the roll-call. It might help to repeat the sentence a few times to appreciate the full effect. The behavior of our elected officials is quite discouraging. How can anyone justify even one second of the time these six Senators spent working on this bill, only to vote against it during the roll call? What is the point? I don’t think there is an easy answer to the deficit problem, but it doesn’t seem like voting against your own bill is part of the solution!
To solve a problem, it seems necessary to first identify the problem’s cause. If your books are deeply in the red, you must either cut costs, sell assets, or raise revenues. None of the options is an easy way out; eventually, somebody will have to foot the bill. It’s not going to be a pleasant process for anybody, but maybe things would be more efficient if our government learned to collaborate a little more effectively.
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Posted by JP Lee
Relative Strength Spread
February 2, 2010The chart below is the spread between the relative strength leaders and relative strength laggards (universe of mid and large cap stocks). When the chart is rising, relative strength leaders are performing better than relative strength laggards. As of 2/1/2010:
As with all strategies, certain environments are more favorable than others for relative strength. We’ve seen a little of everything over the last three years. The RS Spread enjoyed a fairly stable trend higher in 2007. From July of 2008 to March of 2009 the RS Spread gyrated between very favorable and very unfavorable environments. From March 2009 to to May 2009 the RS Spread plunged as the laggards rocketed higher. Since then, the RS Spread has languished.
What comes next? The historical precedent is for a period of a declining RS Spread to transition into a much more favorable environment for relative strength. Time will tell how soon this transition takes place.
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Posted by Andy Hyer
Lack of Patience Strikes Again
February 1, 2010From TheStreet.com, another tale of investors who just weren’t patient enough. In this case, though, the culprits were fund companies themselves!
…retail investors aren’t the only ones who make questionable moves at market bottoms. Fund companies recently fired several prominent managers, including David Dreman, former manager of the DWS Dreman High Return Fund(KDHAX Quote); Bill Miller who oversaw part of the Masters Select Equity Fund(MSEFX Quote); and Robert Turner of the Vanguard Growth Equity Fund(VGEQX Quote).
Those managers had suffered periods of poor performance. But after they were fired, their investing styles came roaring back.
In one case, Mr. Dreman had managed the fund successfully for more than 20 years! But a good 20-year track record was apparently no match for a couple of lousy years in the recent past—you’re fired.
Investor behavior is not always good even with professional investors. It’s not surprising that retail investors who might lack reliable information and expertise have problems. It’s a little more suprising to realize that institutional investors also struggle, given that most of them have access to professional consultants. Now it seems that professional investors are subject to the same cognitive biases as all of the rest of us. Getting the most out of your chosen manager usually takes a large dose of patience, especially during the occasional periods of underperformance.
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Posted by Mike Moody
Global Allocation
February 1, 2010Dennis Stattman runs the Blackrock Global Allocation Fund. In this interview with Fortune, he touches on a few interesting topics. We’ve discussed how the market trades on expectations numerous times on this blog, and Mr. Stattman says much the same thing in answer to a question about why he owns so many U.S. stocks:
…you don’t have to have a rip-roaring economy to have a good stock market. What you need is abundant liquidity, corporations that are able to react to the environment, and a belief on the part of investors that things are getting better, not worse. All of those things are in place.
Like many global investors, Mr. Stattman also believes that plenty of investment opportunities can be found overseas:
I do believe the fundamentals for economic growth are superior in developing economies. They have more citizens with unmet needs and the production capacity to shift from exports to domestic consumption.
Blackrock Global Allocation has had exemplary performance, but what I like most about it is how well it meshes with the Arrow DWA Tactical Fund. If you look at this efficient frontier, you can see that the historical combination of the two funds risk/return data has created a higher return and lower volatility than either fund alone. One of our most popular posts ever, it is certainly must reading for any advisor who currently owns Blackrock Global Allocation. This is a good demonstration of the power of combining a value approach with a relative strength approach, something that can often be done very successfully.
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Posted by Mike Moody
Weekly RS Recap
February 1, 2010The table below shows the performance of a universe of mid and large cap U.S. equities, broken down by relative strength decile and quartile and then compared to the universe return. Those at the top of the ranks are those stocks which have the best intermediate-term relative strength. Relative strength strategies buy securities that have strong intermediate-term relative strength and hold them as long as they remain strong.
Last week’s performance (1/25/10 – 1/29/10) is as follows:
It was a rough week for the entire market last week, but the laggards held up a little better than the leaders.
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Posted by Andy Hyer
Red or Blue Portfolio
February 1, 2010Researchers Yosef Bonaparte, Alok Kumar, and Jeremy Page recently released their study, “Political Climate, Optimism, and Investment Decisions” which focused on investor behavior from 1991 to 2002. They found that when an investor’s favored political party held power in Washington, he or she generally increased holdings of risky stocks, shifted from foreign to domestic companies and traded less often. The opposite occurred when the preferred party was out of office. And the patterns held whether an investor was a Republican or a Democrat.
The authors did it by analyzing two sets of data: the information that UBS and the Gallup organization gather each month to calculate the UBS Index of Investor Optimism and the trading histories of more than 60,000 retail investors at a major discount brokerage firm. To preserve confidentiality, the brokerage firm’s name was not disclosed in the study, and the firm did not divulge the identities of the account holders. But the ZIP code of each investor was provided to the researchers. By analyzing presidential election voting patterns county by county, the researchers determined the likely political preferences of these account holders. The results were necessarily imprecise, but statistically significant patterns still emerged.
The details of the study can be found in this New York Times article.
“Though you might think that having money on the line provides a strong-enough incentive to keep political biases from affecting one’s investment decisions, it shouldn’t come as a surprise that it doesn’t,” said Professor Ariely, who is also the author of “Predictably Irrational.” “In politics as in other arenas of life, our beliefs exert a powerful influence on the decisions we make.” [Emphasis Added]
This is just one more excellent reason to allocate systematically based on relative strength. Political biases may quite possibly be doing damage to your investment performance.
Leave a Comment » | Investor Behavior, Tactical Asset Alloc, Thought Process | Permalink
Posted by Andy Hyer
Good Reason To Focus On Price
February 1, 2010In Saturday’s WSJ, Jason Zweig points out an often overlooked fact:
Higher economic growth may not yield higher stock performance. The U.S. expanded faster in the 19th century than in the 20th, but stock returns were no higher. Over the past decade, Asia has had faster economic growth than Latin America, but Latin stocks have performed three times better. Why? Returns depend not only on tomorrow’s growth, but on what investors are willing to pay for that growth today. [Emphasis Added]
The factors that influence what investors are willing to pay change over time. Therefore, the most efficient way to identify the best investment opportunities is often by focusing on price itself.
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Posted by Andy Hyer
