Systematic Relative Strength

It’s true that there are periods of time when markets are trendless, but those periods usually don’t last for long. We use relative strength to follow trends because of its remarkable adaptability, but we still need a trend to follow. If you ever worry about trends going away, you should read Howard Marks’s recent commentary on the credit cycle. Mr. Marks is chairman of Oaktree Capital in Los Angeles and is well-known for lucid commentary:

Then, in “You Can’t Predict. You Can Prepare.” I described this expand-and-contract process in detail, along with its ramifications:

· The economy moves into a period of prosperity.

· Providers of capital thrive, increasing their capital base.

· Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk.

· Risk averseness disappears.

· Financial institutions move to expand their businesses – that is, to provide more capital.

· They compete for share by lowering demanded returns (e.g., cutting interest rates), lowering credit standards, providing more capital for a given transaction, and easing covenants.

When this point is reached, the up-leg described above is reversed.

· Losses cause lenders to become discouraged and shy away.

· Risk averseness rises, and with it, interest rates, credit restrictions and covenant requirements.

· Less capital is made available – and at the trough of the cycle, only to the most qualified of borrowers, if anyone.

· Companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies.

· This process contributes to and reinforces the economic contraction.

Of course, at the extreme the process is ready to be reversed again. Because the competition to make loans or investments is low, high returns can be demanded along with high creditworthiness. Contrarians who commit capital at this point have a shot at high returns, and those tempting potential returns begin to draw in capital. In this way, a recovery begins to be fueled. . . .

Prosperity brings expanded lending, which leads to unwise lending, which produces large losses, which makes lenders stop lending, which ends prosperity, and on and on.

And around and around it goes. Human nature doesn’t change much from cycle to cycle, which is one reason why we aren’t too worried about running out of trends to follow.