Bad Vibrations

September 28, 2011

Economists are beginning to think that the recent market decline may presage a recession.  Most are not convinced, but many are on the cusp.  Ed Yardeni has a troubling chart today on unemployment.  He writes:

One of my favorite monthly indicators of the labor market is especially disturbing. In its monthly survey of consumer confidence, the Conference Board asks their respondents whether jobs are available, plentiful, or hard to get. The percentage saying that “jobs are hard to get” (JHTG) is highly correlated with the unemployment rate. In August, it increased to 50% from 44.8% in July. Its most recent low was 42.4% during April 2011. So the labor market has actually been deteriorating every month for the past three months, according to this measure. It gets worse: The latest reading is the highest since May 1983. And that’s after the White House spent $880 billion aimed at creating 3.7 million jobs over the past two and a half years. We certainly didn’t get our money’s worth.

The chart that goes along with it is below.

Source: Dr. Ed’s Blog  (click on chart to enlarge)

The question before investors is always how to respond to perceived bad news.  It’s a complicated problem because it is never clear how much bad news is already baked into the market.  One of the typical problems retail investors have is bailing out of markets rife with bad news, having the bad news come out, and then watching the market go up as the market decides the bad news wasn’t quite as bad as it could have been!  Sometimes you can make an educated guess when sentiment is at an extreme level, but it’s never precise.

So, simply responding to bad news won’t get you anywhere.

Relative strength is often a productive way to approach this problem.  Relative strength lets the market separate the winners from the losers.  When the economy weakens or strengthens, companies are affected differentially.  New orders may decline at a factory, but the profit margins may increase due to higher productivity with fewer employees or from increased automation.  The market is usually pretty good at figuring out where the offsets are—and also where they aren’t.

The point of the game is to adapt.  If the securities or asset classes you hold are performing poorly, ditch them.  If the replacements perform poorly, ditch them too.  Most money is lost stubbornly holding a position while waiting for the market to confirm your personal opinion.  When it works, the iconoclasts receive acclaim and media adoration, which might be part of the reason stubbornness is seductive.  (That, and not having to admit you were wrong.)  But there aren’t enough roses in the world to put on the gravestones of stubborn traders whose opinion didn’t quite work out.  Adapt or die.

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Goodbye, Old Theory

September 28, 2011

This is the title of of Bob Veres’ piece in Financial Planning about some of the problems with Modern Portfolio Theory.  He points out some of the salient problems that have come to light involving mean variance optimization and correlation.  A few interesting excerpts:

Recently, we’ve seen data showing the efficient frontier is kind of a silly idea. If you draw one for every decade, using retrospective return and volatility numbers, you get a whole bunch of fishhook graphs in different parts of the risk/return space, with different shapes and slopes. Invest precisely along last decade’s frontier and you’re likely nowhere near the one that fits the current decade.

Why would modern portfolio theory inputs use single numbers for all the correlations when they clearly move around, and converge when markets do what they did in 2008?

…our investing world has developed a lot of strange taboos. “In the investment markets, we are learning that when volatility rises, it tends to stay high-what they call volatility clustering,” he says. “If portfolios are entering a period of high volatility, one might respond by taking some risk off the table.” In the enterprise risk management world, that is common sense. In the investment world, such behavior is labeled market timing.

You’ll benefit from reading the whole article.  Bob Veres highlights some of the critical issues, such as the need for MPT to evolve from its original form as new data arises.  He points out:

…modern portfolio theory is not very different in the way we apply it than it was when Dwight Eisenhower occupied the White House.

We’ve learned a lot since then about correlation stability, volatility clustering, and tactical asset allocation.  The future of investment management is exciting, but we need to move beyond the 1950s and incorporate everything we have learned since then.  I suspect that tactical asset allocation and systematic use of relative strength and value as factor returns will play a big part going forward.

Goodbye (and good riddance)


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Ritholz: Take The Loss

September 28, 2011

Barry Ritholz has a really smart piece —Take The Loss–with important implications (in the event that you want to succeed over time!) for individuals, investors, businesses, and nations.  Here is a teaser:

There will be losses. How you handle them determines your fortune, your fate and your future.

If you want to understand the sell discipline of relative strength models, you’ll benefit from reading Relative Strength and Asset Class Rotation by John Lewis.  Dig deep and read the appendix so that you can understand the pros and cons of altering the relative strength sensitivity.

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High RS Diffusion Index

September 28, 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 9/27/11.

The 10-day moving average of this indicator is 54% and the one-day reading is 58% — well above the washed out levels reached in mid-August.

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