This Week’s Sign of the Apocalypse

July 29, 2011

From Business Insider:

According to the latest daily statement from the U.S. Treasury, the government had an operating cash balance of $73.8 billion at the end of the day yesterday.

Apple’s last earnings report (PDF here) showed that the company had $76.2 billion in cash and marketable securities at the end of June.

In other words, the world’s largest tech company has more cash than the world’s largest sovereign government.

Kind of funny.  Kind of not.

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Dorsey, Wright Client Sentiment Survey – 7/29/11

July 29, 2011

Here we have the next round of the Dorsey, Wright Sentiment Survey, the first third-party sentiment poll.  Participate to learn more about our Dorsey, Wright Polo Shirt raffle! Just follow the instructions after taking the poll, and we’ll enter you in the contest.  Thanks to all our participants from last round.

As you know, when individuals self-report, they are always taller and more beautiful than when outside observers report their perceptions!  Instead of asking individual investors to self-report whether they are bullish or bearish, we’d like financial advisors to weigh in and report on the actual behavior of clients.  It’s two simple questions and will take no more than 20 seconds of your time. We’ll construct indicators from the data and report the results regularly on our blog–but we need your help to get a large statistical sample!

Click here to take Dorsey, Wright’s Client Sentiment Survey.

Contribute to the greater good!  It’s painless, we promise.

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From the Archives: Master of Disaster

July 29, 2011

Ken Rogoff is just a brilliant guy. First of all, he is an International Grandmaster in chess and in the 1970s won the U.S. Under 21 Championship when he was only 16. After getting his Ph.D. in Economics from M.I.T., he served as the chief economist at the International Monetary Fund, where he had to deal with systemic banking failures in a number of nations. He and Carmen Reinhart have written insightfully on the banking crisis in the past. Mr. Rogoff might know more about how to solve banking crises than anyone, and certainly more than Congress or their lobbyists.

His latest piece is important reading. He concludes “within a few years, western governments will have to sharply raise taxes, inflate, partially default, or some combination of all three.” Possibly like the rest of us, he sees little prospect that Congress will ever actually cut spending.

Most western nations, and certainly the U.S., have not been in that position in the recent past. If Mr. Rogoff’s scenario comes to pass, having a Global Macro-type portfolio could be a lifesaver. The only way to protect hard-earned capital might be to have investment access to a wide range of asset classes around the globe.

Click here for disclosures from Dorsey Wright Money Management.

—-this article originally appeared 8/27/2009.  We’re two years down the road now and it looks like all of these things are going to happen, or have already.  As the saying goes, “There’s nothing new under the sun, just history you haven’t read yet.”

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First Principles

July 29, 2011

The first principle is that you must not fool yourself, and you are the easiest person to fool—-Richard Feynman, Nobel Prize in Physics

 

Confirmation bias is a real problem for all sorts of problem solving—political, military, social, and economic.  It refers to the cognitive bias where we look for evidence that confirms our existing opinion, and tend to ignore, dismiss, or refuse to look for evidence that would contradict what we already believe.

Science proceeds along the opposite path, with an attempt to actively seek disconfirming evidence and to keep an open mind about the data.  That process, first of all, requires data.  You can’t improve a process until you measure it.  As the saying goes, “without data, you’re just another dude with an opinion.”

Even when you have data, you’ve got to be open to alternative explanations of your hypothesis.  Experiments have to be designed to tease apart what effects are really operational.  In a laboratory, you can control the inputs to a large extent.  In social science, economics, or financial markets, you’re stuck with messy datasets and often you have only probabilities, not necessarily clear-cut cause-and-effect relationships.  

Correlation is not the same thing as causation, and this is where much junk science founders.  For example, if you know that all heroin addicts drank milk when they were young, this does not mean that milk is a “gateway” drug for heroin.  Although a relationship exists, it is not causal.  You can read absurd claims in the press all the time, where it’s never clear if you’re looking at a cause, an effect, or just a coincidental correlation. 

The main problem with junk science is that it causes people to mistrust real relationships in the data, because they are so used to seeing bogus relationships touted as important.  At that point, arguments often center on idealogy—and the data is ignored.

Here is something that is often lost when arguing about issues: you can’t fake reality.  When asked if he believed in psychological warfare at the chessboard, Bobby Fischer replied “I believe in good moves.”  You can believe whatever you like about a bullet coming toward you—but you’re going to be just as dead as the next guy if it hits you.  In short, trying to understand the underlying reality is important.    

Market prices provide great insight into the underlying reality.  If markets are not doing what you think they should, the market is probably right and you are probably letting confirmation bias fool you.  (Prices reflect the current expectations around a situation—not necessarily the correct expectations.  If circumstances cause expectations to change, you can expect that market prices could have quite an adjustment too.)  With a lot of smart people wagering significant sums of money on outcomes, prices are often our best guide to the probable future.  Prices are going to reflect reality as best it can be determined.  Ignore them at your peril.

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Slouching Towards Debt-lehem…

July 29, 2011

Markets are undergoing a lot of changes in traditional relationships right now.  For example, Barron’s reports that corporates are the new Treasurys:

U.S. government debt is priced in the credit-default swap (CDS) market as having a higher-default risk than 22% of investment-grade corporate bonds. This means the CDS market, which influences the prices of corporate bonds, stocks, and the implied volatility of equity options, perceives Treasuries to be riskier than bonds issued by companies including Coca-Cola (ticker: KO), Oracle (ORCL) and Texas Instruments (TXN).

“This suggests corporates are the new sovereigns,” Thomas Lee, J.P. Morgan’s equity strategist, advised clients in a research note late last week, referring to corporate debt.

The phenomenon is also evident in Europe. J.P. Morgan’s Lee notes that 100% of corporate-debt issuers in Spain, Greece, and Portugal trade inside their government CDS spreads, while 60% of Italian corporate bonds trade inside that government’s spreads.

Historically, sovereign debt –bonds issued by governments – were considered low risk because governments can raise taxes or print money to pay their bills. During the credit crisis of 2007, governments all over the world printed money, and slashed interest rates to rescue the financial system, and are now saddled with massive debts. Now, some corporations might be financially healthier than governments.

There are also sharp changes in historical relationships going on in the commodity world, according to Reuters:

According to fund flows research company EPFR Global, commodity sector funds that invest in physical products, futures or the equities of commodity companies such as miners, attracted $1.465 billion in net inflows globally in the first two weeks of July.

The push into commodities in July reverses a trend in the second quarter, when investors pulled a net $3.9 billion out of commodities, according to Barclays Capital.

The move explains a divergence of stocks and commodities, with correlation dropping from more than 80 percent positive to around 40 percent negative over the past two weeks.

“Commodities could be seen in some ways as the least-worst option, given what is happening with other markets,” said Amrita Sen, an oil analyst at Barclays Capital who looks closely at fund allocations into commodities. “Some investors have not liquidated positions in commodities, while they have exited some other asset classes such as equities.”

All of the machinations with the debt ceiling and the associated market dislocations have posed a number of important questions for investors.

Q1) What happens to traditional asset allocations when traditional relationships break down?

Q2) How can we tell if the dislocations are a result of temporary factors or represent a permanent paradigm shift?

No one has all of the answers, least of all me, but a couple of things occur to me. 

A1) The same thing that always happens when these ephemeral relationships change—your allocation doesn’t behave anything like you thought it would.  Although the current uncertainties have highlighted the issues above, this kind of thing happens all the time.  In the current investment hierarchy, debt is seen as safer than equity because it is higher up in the capital structure—but that’s only true for a corporate balance sheet.  Sovereign debt always depends on the willingness of the sovereign to repay it.  Anyone who is old enough to be familiar with the term “Brady Bonds” knows what I am talking about.  If 100% of the corporate debt issuers in Spain trade inside the government debt spread, it’s not inconceivable for the same thing to happen in the US.  In other words, there’s no a priori reason for government debt to be safer than other debt.

What about commodities then?  Strategic asset allocation usually treats them like poor cousins, giving them a small seat at the children’s table.  What if they really are the “least worst option” and deserve a major slice of the portfolio due to their performance?  After all, commodities are at least tangible and do not rely on the willingness of a sovereign to be worth something.  What if the correct safety hierarchy is a) high-grade corporate debt, b) equity in companies with growing revenues, earnings, and dividends, c) commodities, and d) sovereign debt, especially in countries with a ton of obligations and a sketchy political process?

A2) We can’t.  That’s one of the issues with a paradigm shift—at the beginning, you can’t tell if it is temporary or permanent.  Around 1900, it looked like the US might supplant the UK as the world’s industrial power.  That turned out to be lasting.  Around 1990, it looked like Japan might supplant the US as the world’s industrial power.  That turned out to be temporary.  Around 2010, it looked like China might supplant the US as the world’s industrial power—and we have no idea right now if that is a temporary conceit or will become a permanent feature of the landscape.

Constantly changing relationships along with an inability to distinguish between a temporary and a permanent state of affairs, to me, argues strongly in favor of tactical asset allocation.  It simply makes sense to go where the returns are (or where the values exist, depending on your orientation).  Money always goes where it is treated best, and if you wish to win the battle for investment survival, you would be well-advised to do the same thing.

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Sector and Capitalization Performance

July 29, 2011

The chart below shows performance of US sectors and capitalizations over the trailing 12, 6, and 1 month(s).  Performance updated through 7/28/2011.

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Dare to be Different

July 28, 2011

Advisor Perspectives ran a recent article by Sitka Pacific’s J.J. Abodeely.  There was a fantastic quotation he pulled out from Ben Inker at GMO:

“The good news is that in the investment business there are very few people who do real asset allocation and actually move money around in an aggressive way,” Inker said. “It’s a tough thing to do and survive. The nice thing about it, and the reason why we do it, is because this means it’s an inefficiency that is not going to get arbitraged away anytime soon.”

We’ve written in the past about this exact feature of many winning investment strategies: the arbitrage involved is behavioral, not financial.  Good returns derived from uncomfortable strategies do not get arbitraged away, because very few people will actually do it.  In other words, if you look at your portfolio and get a warm, fuzzy feeling, you’re probably doing it wrong.

Simple examples of this phenomenon abound.  Here’s one: to lose weight 1) eat less and 2) exercise more.  Have I now arbitraged away the entire diet book industry because I just gave you the basic advice for free?  Of course not!  When I searched Amazon for “The * Diet,” I got 65,338 results (!!), ranging from The Warrior Diet to Crazy Sexy Diet to The Juice Lady’s Turbo Diet.  Although I am in awe of publishers’ ingenuity in coming up with great book titles, none of these diets will necessarily work any better than my basic advice.  The reason people struggle to lose weight is not because reasonable advice is not readily available; it’s because the advice is hard to implement.  Eating less and exercising more is simply less comfortable than our default position of eating more and exercising less!

Relative strength is often an uncomfortable strategy whether it is implemented in equities or global asset classes simply because the portfolios can deviate significantly from the market or from traditional notions of asset allocation.  On the plus side, it may give you some comfort to realize that relative strength methods have shown excellent returns for many decades—returns that are not likely to be arbitraged away unless human nature undergoes a substantial change.

Dare to be different

Source: www.samdiener.com

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Nowhere to Hide

July 28, 2011

Security is mostly a superstition.  It does not exist in nature, nor do the children of men as a whole experience it.  Avoiding danger is no safer in the long run than outright exposure.  Life is either a daring adventure, or nothing—-Helen Keller 

This is a candidate for quote of the week!  It’s a good reminder that risk is omnipresent, in life and in financial markets.  It doesn’t matter what you own or don’t own—you’re still exposed somewhere.

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Fund Flows

July 28, 2011

The Investment Company Institute is the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs). Members of ICI manage total assets of $11.82 trillion and serve nearly 90 million shareholders. Flow estimates are derived from data collected covering more than 95 percent of industry assets and are adjusted to represent industry totals.

Domestic equity outflows reached their second-highest levels of the year in the week ending last Thursday.  Taxable bond flows continue to attract new money.  However, there were net outflows total last week in all funds, perhaps signalling that clients are just ready for the sidelines.

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Congress Is Not Alone

July 27, 2011

Apparently Congress is not alone in its profligate ways.  According to US News:

More than 75 percent of advisers surveyed indicated that not saving enough was the major roadblock to their clients’ success. This is important because the amount saved is something that people can control, while investment performance or economic conditions are largely beyond our control.

Close behind, 73 percent of the advisers surveyed indicated that a client living beyond their means was the biggest obstacle to financial success. Again, an area that is within an investor’s control.

This is from a survey of more than 600 advisors done by Principal Financial.  The two biggest barriers to client success were not saving enough and living beyond their means, two factors which are obviously closely related.  If you are living beyond your means, clearly you are not going to be able to save enough.  Americans’ compulsive overspending seems to be mirrored by America’s compulsive overspending.

I guess the good news is that overspending is a behavioral issue under our control.  Willpower is hard.  An automatic investment plan is probably the way to go, especially to get started.  There are lots of good balanced funds around that can serve as a complete investment program.  Of course, I am biased in favor of the Arrow DWA Balanced Fund (DWAFX).

To obtain a fact sheet and prospectus for the Arrow DWA Tactical Fund (DWTFX) or the Arrow DWA Balanced Fund (DWAFX), click here.

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

Living Beyond Their Means

Source: wikimedia.org

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The Great Divide in Economics

July 27, 2011

Kudos to Mark Thoma, a professor of economics at the University of Oregon, for an article suggesting that there needs to be more interaction between researchers and practitioners.  He writes:

When I was trying to figure out if there was a housing bubble or not, the academic economists I had come to trust said no, the fundamentals explain this. Sometimes this was backed by econometric analysis. But many people outside of academics, or at least a few, said there was a bubble. This was often backed by logic, intuition, and simple charts rather than sophisticated econometrics based upon theoretical constructs. For the most part, I dismissed the people I should have listened to, especially if it contradicted what the academics were saying. Most of all, I relied too much on the experts in the academic community instead of listening to all the evidence and then thinking for myself.

One of the reasons I didn’t listen is that until I started blogging, I was pretty arrogant about academic economists. As far as I was concerned, pretty much, academic economists knew more about everything related to economics than anyone else. But one thing I’ve learned from the wide array of voices in the blogosphere is that I was wrong. Academic economists have a lot to learn if they are willing to listen.

If only some Modern Portfolio Theorists were as honest and open-minded as Dr. Thoma!  The best point he makes, I think, is about listening to all of the evidence and then thinking for yourself.  There’s plenty of blame to go the other way too.  Practitioners have sometimes been all too eager to accept and implement academic theories, even when they make very little sense or have been based on incredibly suspect assumptions that do not obtain in the real world.  Other practitioners are arrogant and dismiss the idea that academics know anything at all, something that is also not true. 

There’s always something to learn from people in other fields.  Daniel Kahneman and Amos Tversky were psychologists studying decision-making processes—until someone connected the dots and realized that market participants make decisions with uncertain outcomes all the time.  Many years later, psychologist Daniel Kahneman ended up with a Nobel Prize in Economics.

There is particularly a lot to learn in finance if academics and practitioners would interact more and actually listen to one another.  Both Warren Buffett and George Soros have written about problems they perceive with the Efficient Markets Hypothesis, yet some academics dismiss their billions of dollars extracted from the market as some kind of lucky coin-flipping.  Even a rudimentary knowledge of statistics and the law of large numbers would tell you that someone who has made thousands of trades a year over four decades and has ended up with billions of dollars in profits (like George Soros) is not just lucky!

Good theory-making always derives from observation: examine data to see what is happening and then construct a theory to explain why it is happening the way it is.  If you can figure out why, you can extrapolate and test your hypothesis.  (The budget debate is a great example of bad theories—everyone has an idealogy, but no one is citing past historical examples or data.  Open-minded economists and business people with common sense are more likely to do the right thing than political idealogues.)  More interaction might lead to better theories, and better theories would lead to better policy-making for all of us.

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A Visual Guide to US Debt

July 27, 2011

Worth checking out, just to get a visual sense for the magnitude of US debt, is this article.

Amazing, isn’t it?

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High RS Diffusion Index

July 27, 2011

The chart below measures the percentage of high relative strength stocks that are trading above their 50-day moving average (universe of mid and large cap stocks.)  As of 7/19/11.

The vast majority of high relative strength stocks are now trending higher.  The 10-day moving average of this indicator is 76% and the one-day reading is 72%.

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What’s Hot…and Not

July 26, 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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The Home Rentership Society

July 26, 2011

A recent report by a major firm, covered in Bloomberg, indicates that the home ownership rate is declining:

The U.S. homeownership rate has fallen below 60 percent when delinquent borrowers are excluded, a sign of the country’s move toward a “rentership society,” Morgan Stanley said in a report today.

The national rate, which stood at 66.4 percent at March 31, would be 59.7 percent without an estimated 7.5 million delinquent homeowners who may be forced into renting, according to Morgan Stanley analysts led by Oliver Chang. The lowest U.S. homeownership rate on record was 62.9 percent in 1965, the first year the Census Bureau began reporting the data.

The homeownership rate reached an all-time high of 69.2 percent in 2004 as relaxed lending standards fueled home sales and President George W. Bush promoted an “ownership society.” Mortgage delinquencies, foreclosures and tighter credit for housing loans are reducing property buying, Chang said.

“Taken together they are forcibly moving the country away from being an ownership society,” Chang, based in San Francisco, said in an e-mail. “This change is only beginning, and is moving the country towards becoming a rentership society.”

The analyst discussed the investment implications of the change:

The shift provides opportunities for builders of multifamily homes and investors in single-family houses leased to renters, Chang said in a phone interview. The U.S. apartment vacancy rate fell to 6 percent in the second quarter, the lowest in more than three years, research firm Reis Inc. said July 7.

Here’s the part I find interesting: the market figured this out long ago, as you can see from the two-year chart below comparing REZ to the S&P 500.

REZ vs. S&P 500

Click to enlarge. Source: Yahoo! Finance

Based on price action, you can see how much stronger residential REITs have been than the general market.  Of course, no one ever knows how long a trend will continue, but this particular trend has already lasted long enough to be quite exploitable by typical relative strength methodologies.  As usual, price responds more quickly than the analytic community.

Disclosure: Dorsey, Wright Money Management owns various REIT equities and ETFs across many different account classes.

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Greece = Toast

July 26, 2011

According to a CNBC.com article:

Moody’s downgraded Greece’s bond ratings by a further three notches Monday and warned that it is almost inevitable the country will be considered to be in default following last week’s new bailout package.

The agency said the new EU package of measures implies “substantial” losses for private creditors. As a result, it cut its rating on Greece by three notches to Ca — one above what it considers a default rating.

Greek Bondholders

Source: Clusterstock

This was an inevitable outcome, apparent when the Greek debt crisis first entered consciousness last summer.  Now, it may seem like a year of wrangling was overly painful and completely counterproductive, merely delaying the inevitable, but consider the positive consequences of the foot-dragging:

1) Markets have had an extended period of time to adjust expectations, thus smoothing market action if and when a default occurs, and

2) Debt holders have had an extended period of time to accumulate capital reserves to deal with the losses.

If you are a major European bank that holds a significant amount of Greek bonds, it’s politically and financially complicated to sell your position.  But you can use the year to build a loan loss reserve to cover yourself.  (If the CFO hasn’t done that, they probably deserve to go out of business.)  This doesn’t happen if you just rip off the band-aid immediately.

The final result is still going to be some kind of partial default and subsequent haircut, but the long negotiation process provides cover for financial markets and bag holders.  Investors have time to adjust to new trends or to reconsider their positions.  This is one reason why a systematic relative strength process is often so effective.  Once again, process is much more important than investors typically believe.

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DWTFX Excelling in 2011

July 26, 2011

With a return of 8.06% YTD, 2011 is turning out to be a very good year for the Arrow DWA Tactical Fund (DWTFX).  It has outperformed 92% of its peers YTD, 97% of its peers in June, and 94% over the past year.

Source: Morningstar, as of 7/25/2011

Holdings of this go-anywhere-fund, are shown below:

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

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

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Simple. Boring. Solid Savings Advice.

July 25, 2011

Simple. Boring. Solid savings advice from Carl Richards in What to Do If You Haven’t Saved Anything Yet.

(Even if you are actively saving and investing, the article is good motivation to keep it up.)

Source: Carl Richards

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Dorsey, Wright Client Sentiment Survey Results – 7/15/11

July 25, 2011

Our latest sentiment survey was open from 7/15/11 to 7/22/11. The Dorsey, Wright Polo Shirt Raffle continues to drive advisor participation, and we greatly appreciate your support! This round, we had 97 advisors participate in the survey. If you believe, as we do, that markets are driven by supply and demand, client behavior is important. We’re not asking what you think of the market—since most of our blog readers are financial advisors, we’re asking instead about the behavior of your clients. Then we’re aggregating responses exclusively for our readership. Your privacy will not be compromised in any way.

After the first 30 or so responses, the established pattern was simply magnified, so we are comfortable about the statistical validity of our sample. Most of the responses were from the U.S., but we also had multiple advisors respond from at least four other countries. Let’s get down to an analysis of the data! Note: You can click on any of the charts to enlarge them.

Question 1. Based on their behavior, are your clients currently more afraid of: a) getting caught in a stock market downdraft, or b) missing a stock market upturn?

Chart 1: Greatest Fear. From survey to survey, the S&P fell -1.7%, but client fear levels managed to inch lower.  Usually on any down move, we’ll see an uptick in client fear.  It seems like the rally from two surveys ago (+5%) has left most clients with enough positivity to push fear levels lower.

Chart 2. Greatest Fear Spread. Another way to look at this data is to examine the spread between the two groups. Like the overall fear numbers, the spread nudged lower this round from 63% to 56%.

Question 2. Based on their behavior, how would you rate your clients’ current appetite for risk?

Chart 3: Average Risk Appetite.  Unlike the overall fear numbers, the average risk appetite fell in-line with the market, from 2.68 to 2.42.  If I had to pick just one indicator to gauge client sentiment real-time, it would have to be the overall average risk appetite number.  For some reason, the overall number seems to follow our expectations nearly every survey.  Following an up move, average risk goes up, and vice versa.

Chart 4: Risk Appetite Bell Curve. This chart uses a bell curve to break out the percentage of respondents at each risk appetite level. Fear is slowly moderating, but still in command.  2’s were the most common response this around (49%), trailed by 3’s (37%).

Chart 5: Risk Appetite Bell Curve by Group. The next three charts use cross-sectional data. This chart plots the reported client risk appetite separately for the fear of downdraft and for the fear of missing upturn groups. This chart also sorts out pretty much as expected, with the fear group wanting less risk and the opportunity group wanting more.  Note there are zero responses with a risk appetite of 5.

Chart 6: Average Risk Appetite by Group. A typical result this week (and the exact opposite of last week): investors fearful of a downturn had a lower risk appetite, while investors fearing missing an upturn increased their risk appetite.  The opportunity investors seem ready to add risk despite a minor pullback.

Chart 7: Risk Appetite Spread. This is a spread chart constructed from the data in Chart 6, where the average risk appetite of the downdraft group is subtracted from the average risk appetite of the missing upturn group. The spread shot right back up on the market downswing, after falling last round.

This survey round presents a few anomalies.  First, the overall fear numbers did the opposite of what we would expect in a falling market.  We saw a continued drop in fear levels, despite a market pullback.  I’d guess that move could be explained as a follow-through from the survey before, when we saw fear levels plummet on a +5% market move.  On the other hand, we saw average risk appetite move in-line with the market, falling as the market dropped.  The overall average risk appetite numbers continue to perform the most consistently through the week-to-week market noise.

No one can predict the future, as we all know, so instead of prognosticating, we will sit back and enjoy the ride. A rigorously tested, systematic investment process provides a great deal of comfort for clients during these types of fearful, highly uncertain market environments. Until next time, good trading and thank you for participating.

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How Track Records Are Achieved

July 25, 2011

Investment News on the role of proper due diligence:

Looking at a portfolio manager’s track record is one thing, but understanding how he or she achieved it, and whether it can be repeated, is another story and something that financial advisers should consider when selecting funds for their clients, according to those who study investor behavioral trends.

We agree — which is why we have released two white papers that, we believe, will help anyone become comfortable with relative strength strategies:

Relative Strength and Asset Class Rotation, John Lewis, CMT

Bringing Real-World Testing To Relative Strength, John Lewis, CMT

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US Defaults on Debt!

July 25, 2011

According to John Tamny’s piece at Real Clear Markets, the US has already defaulted on its debt.  He uses Rogoff and Reinhart’s discussion of US finances in the 1930s:

In their 2009 book, This Time Is Different, economists Carmen Reinhart and Kenneth Rogoff singled out Australia, Canada, New Zealand and the United States as countries that have never defaulted, or more specifically, have “never outright failed to meet their external debt repayment obligations or rescheduled on even one occasion.” Of course, as they later acknowledged on the same page, there are other ways to default.

There is traditional default whereby creditors experience a “haircut” or a delay in payments, and then there’s a stealth default. Looked at in terms of stealth defaults, all those countries, including the U.S., have most definitely stiffed creditors over the years.

Reinhart and Rogoff in particular pointed to a U.S. default in the 1930s. As they wrote, “the abrogation of the gold clause in the United States in 1933, which meant that public debts would be repaid in fiat currency rather than gold, constitutes a restricting of nearly all the government’s domestic debt.”

In short, the U.S. defaulted in 1933, and as evidenced by the dollar’s stupendous decline in value from 1/35th of an ounce of gold in 1971 (in private markets a dollar bought roughly 1/45th of an ounce of gold at the time in question) to 1/1550th today, the U.S. has been in default for most of the last 40 years.

You don't have to sit still for a bad haircut!

Source: US Presswire

The important point here is that their are lots of ways to get a haircut.  (I added the bold above.)  It can be explicit, as in “we’re not giving you all of your money back,” or it can be disguised, as in “here’s your dollar back, but it’s only worth 50 cents.”  Just because someone tells you you’re getting your money back doesn’t mean you’re not taking a haircut!

Don’t be naive about financial markets.  You can’t fake reality, and if someone can’t afford to pay you back, you’re going to take a haircut somehow.  This has been obvious in Greece for a while now, apparently to everyone but the European finance ministers.  Greece has had five sovereign defaults in the past—why would they stop now?

Instead of taking a haircut, perhaps you should consider taking your money where it has a chance to appreciate.  Relative strength might help you identify some of the likely candidates.

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Weekly RS Recap

July 25, 2011

The table below shows the performance of a universe of mid and large cap U.S.equities, broken down by relative strength decile and quartile and then compared to the universe return.  Those at the top of the ranks are those stocks which have the best intermediate-term relative strength.  Relative strength strategies buy securities that have strong intermediate-term relative strength and hold them as long as they remain strong.

Last week’s performance (7/18/11 – 7/22/11) is as follows:

It was an up week for all relative strength quartiles last week, but the strongest performance came from the relative strength laggards.

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Winning!

July 22, 2011

There are a few things that are important to understand about winning.  First, it’s better than losing.  And second, it’s not easy.

Embracing volatility

Source: www.perezhilton.com

In financial markets, winning—good performance over time—is also typically accompanied by plenty of volatility.  Most investors try to avoid volatility like the plague, but according to Advisor One, that might not be a good idea, even though it seems like only the mentally unstable would actually embrace volatility.  They write:

…advisors who place too much emphasis on volatility management can inadvertently spook investors into taking overly conservative positions that remove too much risk and diminish long-term return potential.

Rather than burden investors with volatility worries on a tick-by-tick basis, advisors can stimulate more rational, less fear-driven choices by touching upon volatility just annually or semi-annually. Simply put: when it comes to volatility management, focusing on short-term volatility may not be the best solution for clients whose overall objective is long-term growth.

For growth assets, you can’t afford to be allergic to volatility.  It might not be a problem if you are already an adrenaline junkie, but most clients decidedly do not have that orientation.  So how do you keep them from focusing only on the downside?

Riding the return rollercoaster

Source: www.likecool.com

When advisors downplay the relative importance of short-term ups and downs of their account values as compared to long-term results, investor angst over volatility should fade away. When this happens, determining appropriate risk levels becomes easier and long-term goals are more likely to be achieved.

This is good advice from work being done in behavioral finance.  It is certainly a healthy attitude for relative strength investors, who have to deal with significant volatility during trend changes.  A focus on volatility becomes a focus on the short-term—and that can prevent good long-term results.  Winning in the short term can easily be the result of luck.  Winning in the long term is usually a matter of consistency in exploiting a return factor over multiple market cycles and that takes discipline and focus.

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Sector and Capitalization Performance

July 22, 2011

The chart below shows performance of US sectors and capitalizations over the trailing 12, 6, and 1 month(s).  Performance updated through 7/21/2011.

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Fund Flows

July 21, 2011

The Investment Company Institute is the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs). Members of ICI manage total assets of $11.82 trillion and serve nearly 90 million shareholders. Flow estimates are derived from data collected covering more than 95 percent of industry assets and are adjusted to represent industry totals.

Taxable bond funds have now crossed the $100 billion threshold for new money.  Domestic equities continue to bleed assets as investors flee to perceived safety.  Foreign equity and hybrid funds are still holding the middle ground.

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