Systematic Relative Strength

I suspect that many in the free market economy camp would agree with the following analysis by David Merkel of The Aleph Blog:

When you are in the bust phase of the credit cycle, there are no good solutions. Do you try to reflate? You can try to, and you will succeed (sort of), if the Fed Funds rate maintains a respectable positive value that does not kill savers. But you might not succeed, because there is not enough interest margin available to capitalize today. That is where we are today, and so the Fed moves on to QE, where any asset can be financed via the Fed’s fiat.

The best policy focuses on the booms, and seeks to limit excesses. It seeks to deliver pain in the bust phase to those who made bad lending decisions. Had the Fed allowed real pain to be delivered to the banks in the late 80s and early 90s, we wouldn’t be having our current problems. The Fed lowered rates far lower than was needed, and kept them there until a crisis erupted, forcing change.

Had the Treasury and the Fed let Mexico fail in 1994, and let the stupid Americans who had put money into cetes lose money, we would have been better off now. If losses are not delivered to those who deserve them imbalances build up.

The same applies to the 1997 Asian crisis, Russia/LTCM, the popping of the tech bubble, and the response of the Fed flooding the system with liquidity. Too much, and too long — it set us up for the housing/financial bubble of which we are now in the aftermath.

So, when the latest crisis hit in 2008, I took up the lonely position of suggesting failure was the better solution. If the government had to get involved, let it be a DIP lender. If it had to meddle in the creation of credit, create a bunch of new mutual banks.

But as I mentioned in the first paragraph, when the big bust hits, and Fed funds drops to zero, all solutions are pretty useless. At that level, normal monetary policy can no longer cause revaluations of asset prices (and liabilities), allowing the reflation of assets with low ROAs. That is, until QE appears, leading to temporary inflation of assets through sucking in a decent chunk of the safest part of the intermediate fixed-income universe, forcing a temporary increase in risk taking.

There is no question about the fact that government intervention creates moral hazard among market participants. There is also no question about the fact that government intervention has an impact on the boom/bust cycle. However, from an investor’s perspective it makes no sense to look at this issue in normative terms. We have to deal with the market that we are given. It’s impossible to tell to what degree current trends are being driven by the “private economy” or by “government intervention.”

From a trend-following perspective it makes little difference what dynamics combine to produce long-term trends. We have seen times when government intervention has caused problems with trend-following strategies (think financials going from the weakest group in early 2009 to the strongest group), but over time trend-following strategies have shown the ability to excel and even capitalize on government intervention in the private economy. There was certainly plenty of government intervention during the time frame studied in our two white papers (click here and here) which detailed the excellent results achieved by relative strength strategies over time.

It’s best to save normative discussions on government policy for another arena.