Systematic Relative Strength

Lots of retail investors apparently do not believe in the U.S. economy. Mutual fund data indicates they have been heavy sellers of domestic equities. However, corporate profits have been extremely strong. One reason is incredible employee productivity. From an article in Bloomberg Businessweek:

The 6.8 million Americans out of work for 27 weeks or longer — a record 46 percent of all the unemployed — are providing U.S. companies with an eager, skilled and cheap labor pool. This is allowing businesses to retool their workforces, boosting efficiency and profits following the deepest recession since the 1930s, and contributing to a 61 percent rise in the Standard & Poor’s 500 Index since March 2009.

“Companies are getting higher-productivity employees for the same or lower wage rate they were paying a marginal employee,” said James Paulsen, who helps oversee about $375 billion as chief investment strategist at Wells Capital Management in Minneapolis. “Not only are employees higher skilled, you have a better skill match. You have a more productive and more adaptive labor force.”

Maybe the stock market knows something after all.

Retail investors are known to focus on short-term performance. They seem to do very little due diligence about the underlying investment strategy or the underlying return factor. According to a recent Vanguard study, that could be to their detriment:

A common misconception among investors is that owning only highly rated funds (or avoiding poorly rated funds) will surely provide higher returns. However, Vanguard found the opposite when we analyzed Morningstar’s mutual fund ratings and compared them against the rated funds’ subsequent performance. The recent Vanguard research paper Mutual Fund Ratings and Future Performance showed that, on average, just 39% of five-star funds outperformed their benchmark indexes in the three years following the initial rating, while 46% of one-star funds outperformed their benchmark during the same period. In addition, the highest-rated funds were found to post the lowest average returns versus their respective benchmarks.

The emphasis is mine. Vanguard indicates that you have a higher probability of outperformance if you buy a one-star fund as opposed to a five-star fund! Clearly, simple rating systems are not a complete selection system. You need to understand the underlying investment premise of the fund-and to understand that performance is cyclical. Buying a good strategy during a dull period is often the winning lottery ticket.

Relative strength might be in just such a period right now. Mid-2008 to mid-2009 was miserable for relative strength. Over the past twelve months, according to a top-quartile versus bottom-quartile spread chart, relative strength has been pretty dull. Even so, all five of our Systematic RS strategies have managed to outperform their respective benchmarks. I guess you never know, but I’m thinking it might be a harbinger of things to come and might be a good time to add relative strength into the asset mix if it is not there already.

To receive the brochure for our Global Macro strategy, click here. For information about the Arrow DWA Tactical Fund (DWTFX) or Arrow DWA Balanced Fund (DWAFX), click here.

Click here and here for disclosures. Past performance is no guarantee of future returns.