Systematic Relative Strength

John Lewis, one of the other portfolio managers here, brought this Reuters article to my attention. The main topic is how bond shops are paying less attention to rating agencies and doing more credit research on their own. But right at the end of the article is a great quote about price action:

Some investors say credit default swap prices — the cost of insuring debt against default — are a much better measure of risk than credit ratings.

Data from Markit showed the 5-year CDS rate for Irish debt, for example, had shot up more than 220 points to more than 940 in the week ending July 8 — the week before Moody’s slashed the country’s credit rating to junk status, warning the debt-laden country would likely need a second bailout.

“Our approach seems to have quite a high correlation to 5-year CDS index which is a decent measure of value in bond markets and a much greater correlation than rating agencies have. In general markets tend to move ahead of rating agencies,” BlackRock’s Ewen Cameron Watt said.

I put the good parts in bold. Price is just the intersection of supply and demand, and when lots of self-interested parties are trying to figure out the clearing price, it tends to be a pretty good indicator of things to come. Relative strength is a pure reflection of price performance.

At the recent Morningstar conference in Chicago, momentum (otherwise known as relative strength) was one of the discussion topics. Shannon Zimmerman did a great interview of Tom Hancock of GMO, who discussed why momentum is so resilient:

Zimmerman: …Tell us a little bit about why something that is as simple as a price-momentum strategy hasn’t been arbitraged away?

Hancock: I think the main reason for that is it’s just a very painful strategy to run, and the bulk of assets in this world are managed indirectly-people like me or organizations like ours managing money for clients-and when you’re using a price-momentum strategy you’re basically buying stocks that go up, and hoping they go up some more, but if they don’t, they go down, you sell them and buy the other ones that went up instead.

So, the situation in which you lose is you’ve just bought stuff that’s gone up, then it goes down, and then you sell it, and that just makes you look like an idiot, right? It’s a very uncomfortable thing to do, and frankly, for most professional investors, it’s a very unintuitive thing to do, because most of us are kind of naturally born and bred contrarians.

We’ve made this point many times in the past. The arbitrage is less with the strategy than with human nature. Most investors can’t capture the excess returns because they aren’t willing to deal with the difficult inflection points. More than that, though, is the fact that most humans are too emotional to do it well:

Zimmerman: …I think you made the point in the panel discussion, too, that it’s a strategy that needs to be ruthlessly applied and very consistently applied.

Hancock: That’s right. You have to be willing to do the uncomfortable thing of, essentially, in some cases, buying high and selling low. If you buy a momentum stock that went up and then sell it when you are down. And momentum investing got a bad name in the tech bubble, I think, not because it was wrong to buy tech stocks in 1999, but the people who are momentum investors but didn’t admit to it, didn’t sell them after the market turned. They rode it down not just in 2000, but in 2001 and 2002. You really have to be strict about your sell discipline, which is why I think a quantitative application of investing is a good, effective technique.

Discipline is hard to come by in the first place; it is doubly hard when you are trying to be disciplined about a strategy that can sometimes be very difficult, like relative strength. Mr. Hancock makes very, very good points and I think this speaks to why there are very few disciplined relative strength managers on most wirehouse platforms. There are tons of value managers, but very few managers using relative strength in a disciplined fashion.

Keep in mind that the excess returns are often found on the road less traveled.