Sometimes in order to see something differently, you just have to look at it from a different vantage point. Jonathan Hoenig, writing in Smart Money, makes a very valid point about how investors tend to look at the market.
First, we’re conditioned to want a bargain. If we’re bullish on NTT DoCoMo (DCM: 17.04*, +0.34, +2.03%) trading at $16.75, for some reason we refuse to pay anything more than $16.40, and when it rallies further, we stubbornly sit on our hands and promise to add shares only if the price corrects back to where we originally spotted it. We’re a nation of hagglers: Nobody wants to pay full price.
In other words, investors tend to look at things in terms of high or low. The desire for a bargain has led to various flawed analogies that investors should be delighted to buy stocks “on sale,” as if they were buying toilet paper or vegetables. That may not be the correct frame to use. Toilet paper and vegetables are consumables that fulfill a specific need. Vegetables and toilet paper are not performance-based. A financial asset cannot be consumed to fulfill a specific need-its only value lies in its eventual performance. Hoenig goes on to say:
Regular readers know we never characterize markets as “high” or “low,” but as “strong” or “weak.” And in trending markets, strong securities like the yen or bonds tend to stay strong, or at least stronger than alternatives. On a price basis alone, an all-time-high is a reason to follow a market, not flee it.
Although this is a simple statement, the implications are profound. As soon as markets are framed as strong or weak (rather than high or low), your perspective changes. It is a crucial paradigm shift. As Hoenig points out (and lots of research has confirmed), strong markets tend to stay strong. I think strong and weak is the correct mindset when dealing with financial markets from a performance perspective. Relative strength approaches financial markets from this perspective-measuring strength or weakness objectively and always pushing the portfolio toward strength.
In every other endeavor where performance is important, we gravitate to strength. When a baseball manager fills in a lineup card, he tries to put the best players on the field to win the game. When a corporation needs to win over a big account, they send their best salesperson, not their worst. When we send a relay team to the Olympics, we send the four fastest runners-not slow runners that we hope will improve. As Damon Runyan wrote, “The race is not always to the swift, but if you have to bet, that’s the way to play it.”
Markets are no different. The paradigm shift in thinking about strong and weak assets seems simple but may be a tipping point in terms of finding profitable investment strategies.
