Systematic Relative Strength

John Kay of the Financial Times has recently written a nice article explaining why the chaos of free markets leads to significantly better results than centrally-planned economies, as has been tried and failed in the Soviet Union, East Germany, Nigeria, and Haiti (and periodically makes inroads in economies found in Great Britain, the United States, and others.)

Kay explains that free markets generate superior results because:

Prices act as signals – the price mechanism is a guide to resource allocation rather than central planning. Markets are a process of discovery – an economy adapts to change through a chaotic process of experimentation. The third element is the capacity of the market to bring about diffusion of political and economic power. This is the most effective way to protect society from rent-seeking – a culture in which the principal route to wealth is not creating wealth, but attaching oneself to wealth created by others…

… Centralized systems experiment too little. They find reasons why new proposals will fail – and mostly they are right. But market economies thrive on a continued supply of unreasonable optimism. And when, occasionally, experiments succeed, they are quickly imitated.

If market economies are better at originating and diffusing new ideas, they are also better at disposing of failed ones. Honest feedback is not welcome in large bureaucracies, as the UK government’s drug advisers can testify. In authoritarian regimes, such reporting can be fatal to the person who delivers it.

Disruptive innovations most often come to market through new entrants. The health of the market economy depends on constant replenishment of ideas, often from unpredicted sources. If you had been planning the future of the computer industry in the 1970s, would you have asked Bill Gates and Paul Allen? If you had been planning the future of European aviation in the 1980s, would you have asked Michael O’Leary or Stelios Haji-Ioannou? If you had been planning the future of retailing in the 1990s would you have asked Jeff Bezos? Of course not: members of the politburo, cabinet or large company board would have consulted grey men in suits like themselves.

I wholeheartedly agree with Kay’s macro-economic analysis.

Furthermore, this line of logic also underpins the process that we employ to manage money. Price (specifically relative price performance) acts as a signal to guide portfolio allocation. We rely on rules-based relative strength models to sort out the winners from the losers from a given investment universe. We buy any security that meets our criteria and sell every security out of the portfolio that fails to maintain strong relative strength. There are no committee meetings where the portfolio managers debate the merits of the stocks before making a decision. There is no emotional attachment to current holdings. Rather, the models, which we have designed, execute a plan that is based on a method with a track record of generating superior investment results over time. A large percentage of our trades turn out to be either losers or just market performers. To the uninitiated, the process can indeed appear to be chaotic. It certainly leads to inferior investment results over certain periods of time (just like free-market economies periodically experience difficulty.) It is only a minority of our trades that turn out to be the big long-term winners. Frequently, the trades that end up generating the biggest gains are trades that made us scratch our heads when they were added to the portfolio.

It turns out that perceived chaos, on both the macro-economic level and on the portfolio management level, leads to very desirable outcomes over time.

—-this article was originally published 11/4/2009. Price acts as a signal in portfolios too.