Systematic Relative Strength

The Wall Street Journal had an article on forecasting a while back, partly highlighting how bad forecasts typically were. When I re-read it, one of the things that struck me was the following quote:

Sometimes forecasting isn’t even about the future, some researchers say. The true goals of some predictions, says Kesten Green, a forecasting researcher at Monash University in Melbourne, Australia, include lighting a fire under the sales force or alarming the public into some sort of action.

That’s very true in the public policy arena when someone has an axe to grind. In the financial markets, it seems like the forecasts are often designed just to get attention. If your goal is “hey, look at me,” it’s understandable why some of the forecasts are so extreme. The more in tune with public sentiment and the crazier the forecast is, the more attention it gets.

With public confidence in the financial market very low right now, no one wants to hear about a Dow 36,000 forecast—but a Dow 6,000 forecast will have lots of eager listeners. Is that really forecasting or is it just pandering?

You can always make an articulate case for whatever you want, if you selectively choose data and interpret it liberally. That doesn’t make it correct. While it is sometimes interesting to contemplate what might happen, no one really knows. And often, worrying about what might happen keeps investors from acting in the here and now.

We think the market is so incredibly complex that it is not possible to make consistently accurate forecasts. As a result, we rely on an adaptive process that modifies portfolio holdings as conditions evolve. That way the portfolio is based on what is actually happening, as opposed to what may or may not happen in the future.

The term stagflation is a holdover from the 1970s, a period of sluggish economic growth and relatively high inflation. With falling inflation and strong economic growth over the past couple of decades, stagflation has been forgotten. My memory of stagflation was roused when I read an article in Bloomberg with these items scattered throughout the story:

The cost of living in the U.S. rose more than forecast in August as consumers paid more for food, energy and housing.

The consumer-price index increased 0.4 percent after a 0.5 percent gain in July, figures from the Labor Department showed today in Washington.

The rise in commodity prices earlier this year prompted some companies such as Lowe’s Cos. to pass on the higher costs at a time when Americans’ wages are stagnating. Federal Reserve Chairman Ben S. Bernanke last week said inflation was likely to moderate as some price increases prove “transitory.”

“There has been more momentum in underlying inflation than many had expected,” Jeremy Lawson, a senior U.S. economist at BNP Paribas in New York.

Applications for U.S. unemployment benefits unexpectedly rose last week to the highest level since the end of June, underscoring a struggling labor market, the Labor Department also said. Jobless claims climbed by 11,000 to 428,000 in the week ended Sept. 10 that included the Labor Day holiday.

The Federal Reserve Bank of New York reported manufacturing in the region contracted at a faster pace in September. The Federal Reserve Bank of New York’s general economic index dropped to minus 8.8, the weakest reading since November, from minus 7.7 in August.

Hmm…inflation higher than forecasted, growth lousy. That’s the general recipe for stagflation, which we might end up hearing about again. From Wikipedia:

In economics, stagflation is a situation in which the inflation rate is high and the economic growth rate is low. It raises a dilemma for economic policy since actions designed to lower inflation may worsen economic growth and vice versa. The portmanteaustagflation is generally attributed to British politicianIain Macleod, who coined the phrase in his speech to Parliament in 1965.^[1][2][3][4]

The concept is notable because, in Keynesian macroeconomic theory which was dominant between the end of WWII and the late-1970’s, inflation and recession were regarded as mutually exclusive, the relationship between the two being described by the Phillips curve. In addition because stagflation has generally proven to be difficult and, in human terms as well as budget deficits, very costly to eradicate once it starts.

Stagflation is a problem to deal with using typical Keynesian economic tools because it’s not theoretically supposed to exist in the first place. You should take some comfort in knowing that relative strength leaders began to outperform relative strength laggards in the 1970s about five years before the bull market began in earnest in 1982. Stagflation creates winners and losers too—and relative strength is designed to find the winners.

Source: boardmark.com

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 (9/9/11 – 9/16/11) is as follows:

The market had big gains last week–led by performance from the relative strength laggards.