Anatomy of a Bubble

May 26, 2010

One characteristic of bubbles that lends itself to being exploited by trend-following methodologies is that bubbles generally unfold over the span of several years or more. This can be seen in the charts below of bubbles in various stock, currency, and commodity markets. These dynamic moves gain speed and often spike higher in the final year or two of the move before they begin their descent. Trend-following strategies, like relative strength, are designed to start participating early enough in the move that the money made during the ascent more than compensates for the losses experienced during the trend deterioration phase. Once the change in trend has become sufficiently apparent, trend-following strategies exit the trade and begin the search for the next dynamic move.

(Click to Enlarge)

Source: James Montier, GMO Asset Management

The advantage of a global tactical asset allocation strategy is its ability to seek out dynamic trends in a wide variety of asset classes and thereby increasing the probabilities of more consistent returns.

Leave a Comment » | Tactical Asset Alloc | Permalink
Posted by Andy Hyer

$140 Billion Tax Increase is a Done Deal

May 26, 2010

Opportunity cost is just as real as capital loss-it’s just sneakier and harder to see. Laura Rowley’s column on Yahoo! Finance had this gem in an article discussing the low rates available for savers:

“The Fed is determined to keep rates very low, and while it’s painted as fiscal stimulus I think it’s really a stealth bailout of the banks,” says Richard Barrington, a certified financial analyst and expert with the bank comparison site Money-Rates.com. U.S. savers have lost $140 billion in purchasing power to inflation over the 12 months ending in March, according to a Money-Rates study released last month.

“If you tried to raise $140 billion in taxes there would be massive outrage and protests but they’ve taken the equivalent of that out of the pockets of depositors by keeping rates below inflation,” Barrington says. “Depositors are really getting the shaft in this environment and it’s something that’s not really talked about. There’s sympathy for borrowers who are overextended, but they contributed to the financial problem. The sympathy should be with people who did the right thing and saved their money, and are getting teeny tiny interest rates.”

I’ve added the underlining to make the point about opportunity costs; Mr. Barrington is on to something. Savers have had $140 billion in purchasing power evaporate, but because there has been no visible capital loss, it doesn’t necessarily occur to them what has happened. In effect, savers have been taxed $140 billion as their purchasing power has been transferred to someone else.

What can you do about opportunity cost? It helps if you think of things in terms of beanbag economics: if you mush a beanbag down in one spot, it just poofs out somewhere else. What incentive is created by pushing savings rates effectively to zero? It simply causes investors to move their cash elsewhere in the quest for yield or capital gains. The risk level may be different, but money will start to flow nonetheless.

This is the primary attraction of using relative strength for tactical asset allocation. It is able to identify shifts in supply and demand by measuring what assets are strong and what assets are weak. Opportunity cost may be hidden from view, but its effects on the capital markets are laid bare.

Leave a Comment » | Markets, Retirement/Saving, Thought Process | Permalink
Posted by Mike Moody

Hobo Investing

May 26, 2010

Investing, at its core, is a simple process. You need to determine if the train is going north or south, or just sitting on a track siding doing nothing. Once you’ve found a train going north, you need only to hop aboard. If the train starts to go south, you need to jump off.

The concept is simple, but sometimes investors make the execution more complicated. For us, relative strength and trend following provide the tools and methodology to find the northbound trains. The same tools and methodology can be used to tell you when the switch engine has come along and started to move the train south.

The problems happen when investors deviate from the simple goal-directed hobo mentality and get too clever for their own good. Can you imagine how irrational some investor behavior must look to a hobo? Here are the top six dysfunctional hobo sayings:

1. I wanted to go north, so I hopped on an out-of-favor southbound train, hoping it would go north eventually. (value hobo)

2. I got on a northbound train, but it only went north a few miles. A switch engine came along and started to take my boxcar south. How embarrassing! This train owes me. I’m not getting off. (ego-attached hobo)

3. There are so many trains going north. I want to hop on one eventually, but I’m afraid it will go south right after I get on it. (failure to launch hobo)

4. This northbound train is picking up speed. I’d better get off. (premature ejection hobo)

5. I want to go north, but my train pulled on to a siding and stopped. Maybe I’ll just sit here and see what happens. (buy-and-hold hobo)

6. There are so many trains going north without me. Eventually they will all have to go south, and then I’ll have my revenge! (bitter hobo with economics background)

If you want to go north, get on a northbound train. KISS really applies here. On our good days, we all know this, but it’s so easy to forget.

4 Comments | From the MM, Investor Behavior, Just for Fun, Markets, Thought Process | Permalink
Posted by Mike Moody

High RS Diffusion Index

May 26, 2010

The 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 5/25/10.

The 10-day moving average of this indicator is 34% and the one-day reading is 14%. Just one month ago, this diffusion index was in the high 90′s. It has been a rapid move to oversold conditions. Dips in this indicator have often provided good opportunities to add to relative strength strategies.

Leave a Comment » | Markets | Permalink
Posted by Andy Hyer