Price Don’t Lie

June 7, 2011

There is a good reason that we use price as the input for our systematic relative strength investment process.  For a wonderful current example, take a look at this piece on The Stock Sage, by way of Abnormal Returns.  (Abnormal Returns is an outstanding curated linkfest and always one of the best stops of the day.)  It is a saga of a Chinese stock fraud, complete with balance sheet and income statement.  Here’s the summary and the chart from the article:

Without delving into CSKI’s financial statements in great detail (as I believe it is pointless), it is easy to see that CSKI reported having $48 million of cash on its balance sheet with no long term debt and net working capital of over $60 million as of March 31st, 2011. CSKI currently has roughly 17 million shares outstanding at a current share price of $2.57, rounding up that gives CSKI a market cap of $44 million. That’s right, it’s your lucky day, you can buy CSKI shares at less than its net cash on the balance sheet. Is the market really so inefficient that there are diamonds lying on the ground in plain sight and no one is picking them up?

Of course not, the chart tells the story better than CSKI’s suspect financial statements. The market sniffed out that there was something very wrong with CSKI over a year ago and only recently has the financial media caught on.

Click to enlarge.  Source: Stock Sage

If you are following the trend of relative strength, you will not hold these kinds of stocks all the way into the sewer.  It’s certainly possible you will own it on the way up, but somewhere during the slide to oblivion you’re going to hit a relative strength rank stop and bail out.  That’s the nature of trend following.  Stay with the strong securities—and get out when they weaken.

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Modern Portfolio Theory IS Harming Your Portfolio

June 7, 2011

This title is taken from a long blog post at Value Restoration Project—and no, I didn’t write it.  The author, J.J. Abodeely, is a portfolio manager at Sitka Pacific Capital, and a CFA to boot.  It’s nice to have some brothers-in-arms for a change!  Mr. Abodeely bases a lot of his commentary on a recent article by Scott Vincent, available on the Social Science Research Network.  Here’s the core of his argument:

In the paper Vincent argues that the flawed foundation of Modern Portfolio Theory (MPT) that risk=volatility has allowed MPT advocates to control the language of the debate and set the stage for the obvious conclusion that passive index-based investing is inherently superior. And don’t think for a second that this debate is simply theoretical, academic, or unimportant– the basic tenets of MPT shape the decisions of nearly every institutional money manager, wealth management firm, investment counselor/consultant, and financial planner in profound and often disturbing ways. YOUR money is almost certainly being managed with these ideas at the core. The traditional approach to asset allocation is built on false axioms.

While Vincent’s direct assault seems to be focused on highlighting the mistreatment of active, concentrated equity or fixed income asset managers vs. holding a passive equity or fixed income index, his arguments hold sway over the much larger and dangerous consequences of MPT on asset allocation. My assertion is that most damage to investors portfolios from the traditional approach to investing comes from the foundation of static, backward looking assumptions informing broad asset allocation decisions

I put the good parts in bold—and I think you can make a good case for both of those statements.  Instead of using static, backward-looking assumptions, I think it makes sense to examine tactical asset allocation, where asset weights can vary dynamically based on performance or valuation.   To me, it makes no sense to assume, for example, that bonds are preferable as a client gets older, regardless of the interest rate environment or poor price performance.  If an asset is performing poorly, why would any client be excited about holding it?

Strategic asset allocation is founded on the assumptions of Modern Portfolio Theory, and if the axioms are false, it is not surprising that it has not delivered in the way its apologists suggest it should.  Most distressing to me is the fact that asset allocation models are most sensitive to the inputs for return, and return is the most variable input of the three (returns, correlations, and standard deviation).  By definition, if your asset return assumptions are off, your asset allocation is wrong.  And seriously, if you could actually forecast asset returns accurately, you wouldn’t need asset allocation—you’d just buy the best-performing asset.  The greatest danger in strategic asset allocation, to me, is the assumption that past asset returns will be similar in the future. 

I think that assumption is flat-out wrong, because it flies in the face of the observed life cycles of companies and economies.  When companies are small, they are vulnerable.  Many of them simply don’t make it and go out of business.  Midsize companies that succeed often go through a very dynamic growth phase, where revenues and profits grow at a pace far beyond the growth rate of the underlying economy.  Once companies become very large, it is almost impossible for them to grow at a rapid pace, simply because they are working off such a large base.  It is pretty easy for a 20-store retailer to open ten new locations in a year and have 50% growth.  To get 50% growth at Wal-Mart would require them to open 4,485 new locations in a year, more than 12 per day—and then 18 per day the following year to keep that growth rate up.  That’s substantially more difficult.

Economies are no different.  Developing economies can growth at a fast clip, but not forever.  Once an economy is developed, the growth rate is going to slow down.  Growth can be boosted by productivity enhancements and good incentives, but eventually broad market returns will be connected with revenues and profits in the underlying economy.  In 1800, the US was an emerging market economy and the European economies were the developed markets.  The US has gone through a long period of powerful growth and is now the largest economy in the world.  As the Wal-Mart of world economies, we are not going to have the highest growth rate.  That doesn’t mean we can’t have good stock market returns—and, clearly, plenty of dynamic individual companies will do fantastically well—but emerging markets are likely to have higher growth rates.

As a result, I think it is naive to assume that US returns will necessarily resemble what we’ve seen before.  They will be lower than before if we pass the torch to more rapidly growing emerging economies, and they could be higher if emerging economies sabotage themselves with poor incentives or a lack of political stability.  Money goes where it is treated best and that is always an open question in the future.  Whatever the returns end up to be is a function of how we handle the future, not what has happened in the past.  Asset allocation needs to be forward-looking to be relevant for investors’ performance in the future.

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What’s Hot…and Not

June 7, 2011

How different investments have done over the past 12 months, 6 months, and month.

1PowerShares DB Gold, 2iShares MSCI Emerging Markets ETF, 3iShares DJ U.S. Real Estate Index, 4iShares S&P Europe 350 Index, 5Green Haven Continuous Commodity Index, 6iBoxx High Yield Corporate Bond Fund, 7JP Morgan Emerging Markets Bond Fund, 8PowerShares DB US Dollar Index, 9iBoxx Investment Grade Corporate Bond Fund, 10PowerShares DB Oil, 11iShares Barclays 20+ Year Treasury Bond

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