Relative Strength Is Everywhere

March 15, 2010

CXO Advisory recently published another study on momentum (otherwise known as relative strength) and style rotation. Not surprisingly, their conclusion was:

In summary, a simple style momentum strategy implemented with ETFs may perform well compared to the overall stock market and individual style ETFs.

Since we have been using style funds in some of our relative strength strategies for years, we could have told you the same thing, but it is always nice to have some validation by a completely independent party.

Relative strength is an incredibly adaptable method. We’ve demonstrated in our own white papers that it works nicely with stocks and asset classes. It works for industry rotation and style rotation. There is lots of third-party validation as well, whether from CXO Advisory here, other practitioners, or academics.

One of the things I particularly like about relative strength is that it can deal with a disparate basket of assets, which is considerably more difficult with other proven return factors like deep value. Value is not too tricky when comparing two similar assets, like two stocks. If you want to get more sophisticated, you can even build a complicated model to determine if stocks are cheaper than bonds. But how easy is it to determine whether crude oil, Apple Computer, or emerging market debt is cheapest? The assets and the metrics typically used to value them are not universal. With relative strength-no problem. It’s not difficult to determine which is the strongest asset and it can be done on an apples-to-apples basis.

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Posted by Mike Moody

Mohammed El-Erian: Don’t Look Back

March 15, 2010

Mohammed El-Erian of Pimco had a recent commentary, posted here at Advisor Perspectives, on the sovereign debt explosion. He talked about different ways in which it could be resolved-some good, some not so good.

One of the points he makes is particularly relevant to investors watching the process unfold and trying to make investment decisions prospectively:

We should expect (rather than be surprised by) damaging recognition lags in both the public and private sectors. Playbooks are not readily available when it comes to new systemic themes. This leads many to revert to backward-looking analytical models, the thrust of which is essentially to assume away the relevance of the new systemic phenomena.

There is always a tendency to rely on what has worked in the past. Often that makes sense; there is usually some commonality of conditions. Yet the exclusive reliance on past paradigms can get you into trouble, especially if you don’t notice that linkages and relationships are subtly different than in previous episodes.

Relative strength, because of its insistence on what is, is often a very fruitful way of looking at a situation with fresh eyes. We know that debt-driven financial crises have occurred before and will again. What we don’t know is how, in subtle ways, they will play out slightly differently than in the past. Relative strength can keep us focused on the here and now-this is what the market thinks right now-which can keep us from adopting backward-looking analytical models that may fail going forward.

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Posted by Mike Moody

Yes Man

March 15, 2010

Although Jim Carrey was in a comedy with this title, the reference here is decidedly darker. A new study reported in Fortune and co-authored by Sendhil Mullainathan, a Harvard professor and MacArthur Foundation genius grant recipient, suggests that most financial advisors are enablers and tend to go along with their clients’ wishes, even when the clients are way off base.

Most planners, his report finds, reinforce our bad investment behaviors instead of fixing them.

The implication of the Mullainathan study is that advisors are incompetent or unethical, but I don’t think that’s the case at all. The problem is that advisors have learned through experience that investors won’t accept good advice-so they tell investors what they want to hear in order to keep the client. The problem is not an easy one to solve and here’s why:

Finally, the yes-man problem can’t just be pinned on advisers. A 2007 survey from the Employee Benefit Research Institute found that two-thirds of the people interested in meeting with a financial planner were likely to implement advice only if it conformed to their own ideas.

Investors are afflicted with an overconfidence bias-they think they know what they are doing-so they tend only to listen to advice they already agree with. The advisor is often put into the position of sussing out what the client’s biases are and then trying to approximate good advice, but only being able to go as far as the client will accept. No doubt this leads to a lot of advisor stress and investor underperformance.

We’ve always tried to be upfront with our opinions, even if the (often ill-informed) client doesn’t agree. Sometimes we get a frustrated client, but more often than not they rise to the occasion and listen. Smart clients are willing to question their assumptions, examine the relevant data, and consider a different point of view-and those are the clients we want anyway.

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Posted by Mike Moody

Will We Get a Hollywood Ending?

March 15, 2010

Everyone has seen some version-action movie or cartoon-of the canoe headed toward the waterfall. Sometimes the protagonist is aware of impending doom; sometimes it catches them by surprise. Lots of times, at least in the movies, there is a Hollywood ending whereby the hero is miraculously saved from going over the falls, or even more miraculously, goes over the falls and survives.

The global debt situation is like that now for the four large countries remaining with AAA credit ratings. Those four countries are the U.S., U.K., France, and Germany, and according to the Wall Street Journal

The credit-rating company repeated that there was no immediate risk of a downgrade of the big triple-A-rated countries, although the slight risk they could fail to get their finances under control, and thus be downgraded, has increased. Moody’s concluded that “on balance, we believe that the ratings of all large triple-A governments remain well positioned—although their ‘distance-to-downgrade’ has in all cases substantially diminished.”

As far as I can tell, “distance-to-downgrade’ is a polite way of informing these countries that if they listen carefully, they will be able to hear a waterfall in the background.

One of the interesting things about currencies is that all of the movement is relative to other currencies. You may be in bad fiscal shape, but you might still have a strong currency if your neighbor’s condition is even worse.

The dollar was having a tough time of it against the Euro until it came out that several members of the EU had very large and in some cases, undisclosed, debt problems. Now the Euro is floundering. The recent strength in the dollar has allowed dollar-denominated assets, like U.S. stocks, to improve in performance versus international stocks. In a purely domestic portfolio, you would probably never notice this, but its effect is very apparent in a global macro-type account.

It’s not clear how things will shake out. Will our policy makers rescue us before we go over the falls, or at least protect our currency better than the other governments? Or will we all go over the falls together? One thing that does seem certain is that the global enonomy is more linked than ever before, and that investors will have to account for this in their investment portfolios.

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Posted by Mike Moody

Weekly RS Recap

March 15, 2010

The 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 (3/8/10 – 3/12/10) is as follows:

The top quartile performed roughly in line with the universe last week, while the best performance came from the laggards.

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Posted by Andy Hyer