Systematic Relative Strength

Central bank balance sheets are being rapidly expanded all over the world. Jim Bianco has a nice piece at The Big Picture, replete with amazing graphics. For the record, I’ve known Jim for 20 years and he does some of the most intriguing fixed income research you will ever see. He writes:

The degree to which central banks around the world are printing money is unprecedented.

He proceeds to show the balance sheets for each of the large central banks, converted back into dollars. Your eyes will bug out when you see the original article. For the sake of brevity, all I show here is his graphic of the composite of eight large central banks.

Source: Bianco Research/The Big Picture (click on image for a sharper version)

Jim points out that:

The combined size of these eight central banks’ balance sheets has almost tripled in the last six years from $5.42 trillion to more than $15 trillion and is still on the rise!

I have no idea if this is a good or bad thing. How you interpret it probably depends on which group of economists you put your faith in. My guess—and this is only a guess—is that huge increases in the money supply will eventually result in some inflation. Commodities generally respond fairly well to inflation, while fixed income may be gasping for air. (This sort of fits the ”retail investor is always wrong” template, given the huge amounts poured into bonds over the last couple of years.) Inflation might be a good thing from the Federal government’s point of view, as it will make paying off debt a lot less expensive in real terms. It might not be so good for investors, depending on how their portfolio is constructed.

The one thing I don’t have to guess at is that quantitative easing, whether it continues to accelerate to ever-giddier heights or starts to wind down, will lead to trends of some kind. When that happens, relative strength will be a useful guide to sort out where the investment opportunities lie.

Now that we seem to be through the recession and investor sentiment is beginning to improve to the point that maybe Recession 2.0 is not on the immediate horizon, investors are faced with trying to figure out what to do next. The Freakonomics blog has a useful thought about what they call the “cleansing effect” of recessions:

In the past, when I’ve tried to schedule our window cleaners they have always been able to come within two days. Despite the still-slow economy, the first available appointment this time is not for three weeks.

“Why?” I ask. The owner says that during the worst of the recession his firm had enough clients to survive, but barely; smaller, less efficient companies died off. Now that demand for cleaning has increased, his own customers are coming back; and the customers of the now-defunct companies are hiring him too, so he’s swamped with business. Recessions kill off inefficient firms; but at least in this case, those that survive come out stronger than before.

Relative strength is a good tool for sorting out the winners from the losers. Companies that have been hit hard from the lingering recession often show weak relative strength, while companies that have managed to power through tough times and grow despite it are often leaders.

Sometimes we focus so much on our own situation that we forget there is a whole wide world out there-and lots of investment opportunities. A chart that was eye-opening for me appeared recently on Dr. Ed’s Blog, written by the estimable Wall Street economist Ed Yardeni. Check it out:

Source: Ed Yardeni (click on image to expand)

Ok, so the developed world isn’t really boosting oil demand. There could be a lot of reasons for that besides a lack of economic growth: conservation, increased efficiency, substitution of other energy sources, etc. But emerging markets—wow! The financial crisis was barely a blip in oil demand.

Money will go wherever it is treated best-and it tends to seek out growth. Markets are global and your portfolio should be too.

TFC Financial Management makes an argument for divergent market performance:

The global financial markets today appear to be divided into three distinct economic modes: 1) Europe with its sovereign debt crisis seemingly headed into recession; 2) the emerging countries and Asia, most apparently back on a moderate growth track; and 3) the U.S. entering a surprisingly improved economic recovery which seems to have caught the “experts” unaware. What may be unfolding is a global picture of divergent investment market scenarios, not the free market convergence which investors have come to accept as gospel these past 15-20 years.

As a general rule, the larger the dispersion in returns in a given investment universe, the better the environment for relative strength strategies.

HT: Real Clear Markets

Low volatility funds have been hot lately. They are easy to market right now. Low volatility sounds appealing and they have performed well. According to the Wall Street Journal:

…it’s not difficult to see why investors might prefer a low-volatility strategy. It certainly paid off last year: The S&P 500 Low Volatility Index returned 10.9% in 2011, more than eight percentage points higher than the Standard & Poor’s 500-stock index.

But there is a caveat:

If the market continues to rally this year, low-volatility strategies could underperform.

Since 2008, the S&P 500 Low Volatility Index has underperformed during years when the Chicago Board Options Exchange Market Volatility Index, or VIX—which tracks investor expectations for market volatility—dropped, while outperforming when the VIX rose. (One exception: In 2007, the VIX rose, but the Low Volatility Index underperformed.)

Low volatility funds tend to lag when markets get hot. Investors, wrapped in their current bearish gloom, aren’t worrying about that right now. But flat market years like 2011 are often followed by above-average years.

One way to use low volatility funds in your portfolio without perhaps taking the full brunt of underperformance is to pair the low volatility return factor with relative strength. Examine, if you will, an efficient frontier constructed from SPLV and PDP. Relative strength often outperforms when markets trend. It’s a nice efficient frontier and might smooth out your core equity exposure over time.

Source: Dorsey Wright Money Management (click on chart to expand)

For the time periods when hypothetical returns were used, the returns are that of the PowerShares Dorsey Wright Technical Leaders Index and of the S&P 500 Low Volatility Index. The hypothetical returns have been developed and tested by the Manager (Dorsey Wright in the case of PDP and Standard & Poors in the case of SPLV), but have not been verified by any third party and are unaudited. The performance information is based on data supplied by the Dorsey Wright or from statistical services, reports, or other sources which Dorsey Wright believes are reliable. The performance of the Indexes, prior to the inception of actual management, was achieved by means of retroactive application of a model designed with hindsight. For the hypothetical portfolios, returns do not represent actual trading or reflect the impact that material economic and market factors might have had on the Manager’s decision-making under actual circumstances. Actual performance of PDP began March 1, 2007 and actual performance of SPLV began May 5, 2011. See PowerShares.com for more information.

This is the title of a new report from McKinsey & Company on global debt. So far, things are playing out pretty much like Ken Rogoff and Carmen Reinhart suggested they would. To wit:

…major economies have only just begun deleveraging. In only three of the largest mature economies—the United States, Australia, and South Korea—has the ratio of total debt relative to GDP fallen. The private sector leads in debt reduction, and government debt has continued to rise, due to recession. However, history shows that, under the right conditions, private-sector deleveraging leads to renewed economic growth and then public-sector debt reduction.

In many countries, debt is still growing. In a few, debt has gone down in the private sector (corporations and individuals), mostly offset by rising debt in the government sector. The good news is that the public sector debt may start to drop when the economy begins to grow.

The Economist has some nice graphics from the McKinsey study. It’s very interactive and allows you to see what happened around the world over time. And they make a good point about debt and wealth:

Wealth ebbs away a lot faster than debt. Our interactive guide shows levels of debt as a % of GDP for a selection of rich countries and emerging markets. With a few exceptions, such as Germany and Japan, most rich countries saw a huge rise in debt levels in the years running up to the crisis. Unwinding these dues will take a lot longer. In many rich countries the process of debt reduction hasn’t even started.

I added the bold. It will take some spending restraint and renewed economic growth to start to pare the debt burdens. By the way, this is true on an individual level as well as a national level! When asset values implode, the debt remains.

It’s too early to tell if the US market has turned the corner and will pay more attention to growth than debt going forward. There are still a lot of things up in the air in Europe and in domestic politics. Once again, relative strength may be the best option for sorting out what assets are going to perform over time.