Quote of the Week

March 31, 2012

Dan Loeb at the Columbia Student Investment Conference 2012:

Think deeply about process over outcome. If you do something the right way enough times, you’ll win.

HT: Market Folly

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Dorsey, Wright Client Sentiment Survey – 3/30/12

March 30, 2012

Here we have the next round of the Dorsey, Wright Sentiment Survey, the first third-party sentiment poll.  Participate to learn more about our Dorsey, Wright Polo Shirt raffle! Just follow the instructions after taking the poll, and we’ll enter you in the contest.  Thanks to all our participants from last round.

As you know, when individuals self-report, they are always taller and more beautiful than when outside observers report their perceptions!  Instead of asking individual investors to self-report whether they are bullish or bearish, we’d like financial advisors to weigh in and report on the actual behavior of clients.  It’s two simple questions and will take no more than 20 seconds of your time. We’ll construct indicators from the data and report the results regularly on our blog–but we need your help to get a large statistical sample!

Click here to take Dorsey, Wright’s Client Sentiment Survey.

Contribute to the greater good!  It’s painless, we promise.

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Price Signals

March 30, 2012

Shortly after writing my article on the dual nature of prices, I ran across this wonderful article on price signals written by Jonathan Hoenig for Smart Money.

Whether it’s gasoline or groceries, blaming traders because you happen not to care for a market’s prices is like blaming the mailman because you don’t like the mail. They are price messengers, not manipulators.

It’s a nice read and probably especially germane to current bond investors.  And Mr. Hoenig may get the prize for the most bluntly named hedge fund in the industry!

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Sector and Capitalization Performance

March 30, 2012

The chart below shows performance of US sectors and capitalizations over the trailing 12, 6, and 1 month(s).  Performance updated through 3/29/2012.

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The Rise of Tactical Allocation

March 29, 2012

Portfolio construction has typically relied on strategic asset allocation to help control volatility.  The idea is that if you combine assets with low correlations, you can significantly reduce the volatility of your returns.  Lately, however, correlations have become a problem.  Jeff Benjamin, writing in Investment News, discusses the problem:

Asset classes have become so highly correlated over the past few years that many traditional diversification strategies have lost their effectiveness.

For example, take the link between growth and value stocks.

For the decade ended December 2000, the correlation between the Russell 1000 Growth Index and the Russell 1000 Value Index was just 57%. During the decade ended this past December, it jumped to 92%.

For a more extreme case, compare the correlation of the MSCI Emerging Markets Index with the Russell growth index. The former was negatively correlated to the latter by 6% — which was great for those seeking diversification — in the decade through December 2000, but the correlation spiked to 89% in the following decade.

You can see the issue—drastically changing correlations will move your efficient frontier far from where you imagined it was.

Some of the observers Mr. Benjamin quoted were blunt:

“Traditional diversification is like a seat belt that only works when you’re not in a car accident,” said Michael Abelson, senior vice president of investments at Genworth Financial Wealth Management Inc.

“Depending on risk tolerance, we might recommend allocating half a portfolio to a diversified strategic strategy and then 30% to 35% to a tactical strategy and 15% to 20% to alternatives,” Mr. Abelson said.

Besides having a knack for a fine turn of phrase, Mr. Abelson mentions something that we have noticed more and more in recent years.  It used to be the case that tactical allocation was used as a satellite strategy and might get only a 10% slice of a portfolio.  Now, we often see the tactical strategy with a 35-50% weight.  Some advisors are even using the tactical allocation as the core strategy and arranging alternatives and other asset classes as strategic overweights.

With the rise of tactical allocation come new challenges.  Chief among them is how to manage the tactical portion of the portfolio.  All-in/all-out timing decisions are notoriously difficult to get right.  Overweighting and underweighting based on valuation requires sophisticated modeling that must be constantly updated.  In addition, many assets are resistant to traditional valuation methods.

One method that does work over time is tactical asset class rotation using relative strength.  We’ve chosen that path for our Global Macro strategy because it allows a very large and diversified universe to be ranked on the same metric.  That, and because it works.

Click here and here for disclosures.  Past performance is no guarantee of future returns.

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Fund Flows

March 29, 2012

The Investment Company Institute is the national association of U.S.investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs).  Members of ICI manage total assets of $11.82 trillion and serve nearly 90 million shareholders.  Flow estimates are derived from data collected covering more than 95 percent of industry assets and are adjusted to represent industry totals.

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Winners Keep Winning

March 29, 2012

The Final Four has been determined for the NCAA tournament.  (I hope your bracket doesn’t look anything like mine!)  To try to reward the best teams with the easiest path to the Final Four, the tournament committee seeds all 64 (now 68) teams.  The idea is that you will get a high seed if you have been one of the top teams all season.

While there are always upsets, for the most part, the top teams continue to win.  That is, after all, why they are the top teams.

Econompic Data carried an article about the win rates for the top seeds.  Below is their graphic showing the seed level of all of the teams to get to the Final Four since 1997.

Winners Keep Winning

Source: EconompicData   (click to enlarge to full size)

As you can see from the data, more than 80% of the Final Four teams were one of the top four seeds in their division.  In effect, for the most part, the Final Four teams were a subset of the top sixteen teams.  If you start to think of high relative strength securities as top seeds you’ll see where this is going.

Every now and then a dark horse slips in, but most teams have been top teams all year.  Winners keep winning.

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High RS Diffusion Index

March 28, 2012

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 3/20/12.

The 10-day moving average of this indicator is 88% and the one-day reading is 88%.

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Dorsey, Wright Client Sentiment Survey Results – 3/16/12

March 27, 2012

Our latest sentiment survey was open from 3/16/12 to 3/23/12. The Dorsey, Wright Polo Shirt Raffle continues to drive advisor participation, and we greatly appreciate your support! This round, we had 45 advisors participate in the survey. If you believe, as we do, that markets are driven by supply and demand, client behavior is important. We’re not asking what you think of the market—since most of our blog readers are financial advisors, we’re asking instead about the behavior of your clients. Then we’re aggregating responses exclusively for our readership. Your privacy will not be compromised in any way.

After the first 30 or so responses, the established pattern was simply magnified, so we are comfortable about the statistical validity of our sample. Most of the responses were from the U.S., but we also had multiple advisors respond from at least four other countries. Let’s get down to an analysis of the data! Note: You can click on any of the charts to enlarge them.

Question 1. Based on their behavior, are your clients currently more afraid of: a) getting caught in a stock market downdraft, or b) missing a stock market upturn?


Chart 1: Greatest Fear.  From survey to survey, the S&P 500 rallied +2.3%, and all of our client sentiment indicators responded positively.  The greatest fear number fell to its all-time lows, from 83% to 62%.  It’s hard to believe we’ve been running the survey for 2 whole years, and clients still have not even hit the high 50’s.  On the flip side, the opportunity group rose from 17% to 38%.

Chart 2. Greatest Fear Spread.  Another way to look at this data is to examine the spread between the two groups.  The spread fell to its all-time lows this round at 24%.

Question 2. Based on their behavior, how would you rate your clients’ current appetite for risk?

Chart 3: Average Risk Appetite.  The overall risk appetite number rose to just under its all-time highs which were set in April of 2011.  Close, but no cigar.  This round, we saw an average risk appetite of 3.02.  If the market continues to rally, so will the overall risk appetite number.

Chart 4: Risk Appetite Bell Curve. This chart uses a bell curve to break out the percentage of respondents at each risk appetite level.  The bell curve continues its recend trend towards more risk.  This round, over half of all respodents wanted a risk appetite of 3.

Chart 5: Risk Appetite Bell Curve by Group. The next three charts use cross-sectional data. This chart plots the reported client risk appetite separately for the fear of downdraft and for the fear of missing upturn groups.  This chart sorts out as expected, with the upturn group wanting more risk than the downturn group.

Chart 6: Average Risk Appetite by Group.  Historically, this is one of the most volatile indicators in the survey.  This round, the upturn group actually fell, while the dowturn group moved higher.  We’d expect both groups to move higher in a risingmarket, but the upturn group has been known to buck the trend.

Chart 7: Risk Appetite Spread.  This is a spread chart constructed from the data in Chart 6, where the average risk appetite of the downdraft group is subtracted from the average risk appetite of the missing upturn group.  The spread fell this round.

From survey to survey, the market was up +2.3%, and all the indicators performed as expected.  We’re now sitting at the lowest fear levels we’ve ever seen in the history of the survey.  The market has rallied roughly +23% from recent lows in September, and our sentiment indicators are responding to that information.  If the market continues to move higher, we will eventually hit par on the overall fear indicator (50-50 split), which might happen sooner than you expect.

No one can predict the future, as we all know, so instead of prognosticating, we will sit back and enjoy the ride. A rigorously tested, systematic investment process provides a great deal of comfort for clients during these types of fearful, highly uncertain market environments. Until next time, good trading and thank you for participating.

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PDP: Leading the Strategy Indexing Revolution?

March 27, 2012

Strategy indexing is hot, according to John Prestbo of Dow Jones.  In a recent interview carried in Index Universe, he discussed what he meant by strategy index:

[Index Universe editor Olivier] Ludwig: What are we talking about here? Things like what Rob Arnott’s up to, or to those smart-beta indexes that have proliferated in the last 12 months?

Prestbo: That’s exactly what I’m talking about. I group them all together into a broad category called “strategy indexes,” where the index is not tracking a traditional segment of the market so much as it’s tracking a way of approaching the market. A lot of people want to get the best return they can, and they are willing to put in the time and effort to be flexible and manipulate their portfolio among various offerings. They combine the benefits of semi-active investing with the lower costs that come with it. The cost may be higher than the plain-vanilla indexes, but they are lower than an active manager.

I added the italics.  The Technical Leaders indexes must have been far ahead of the wave, since Powershares launched PDP more than five years ago, not in the last 12 months!  Academic factor models, like Carhart’s four-factor model suggest that there is a return premium (above inflation) available from:

  • the market itself
  • small-cap stocks
  • value stocks
  • momentum stocks (relative strength)

There are hundreds of ETFs that can give you market exposure, and many more focusing on small-cap and value stocks.  If you look hard enough, you can probably find even ETFs for small-cap value stocks in almost every market.

To my knowledge, for many years, only the Technical Leaders ETF family focused on relative strength.  PDP was launched in March 2007.  Developed (PIZ) and emerging markets (PIE) were added later, in December 2007.  Russell now has a couple of momentum indexes out, although they are less than 12 months old.

Here’s a quiz for you: Of Carhart’s four factors, which has the largest return premium?  Maybe the graphic below will help you answer the question.

Which factor has the largest return premium?

Source: Mercer Advisors

The best returns belong to the return factor that has been most neglected: relative strength.  It is a source of continuing amazement to everyone in our office that PDP has $500 million in assets, rather than billions like some of its competitors, especially given its performance.  Perhaps value investing sounds more sophisticated and small-cap investing is racier, but historically it’s been relative strength that has provided the biggest raw returns.

Good investing requires education, so maybe PDP is just ahead of the curve.  We’re hoping that, over time, there will be more discussion of relative strength as a return factor and that it will get a more prominent (and well-deserved) place within investor portfolios.

See www.powershares.com for more information about PDP.  Past performance is no guarantee of future returns.  A list of all holdings for the trailing 12 months is available upon request.

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From the Archives: Essence of Relative Strength

March 27, 2012

“I can’t change the direction of the wind, but I can adjust my sails to always reach my destination.” – Jimmy Dean

—-this article originally appeared 12/11/2009.  Who knew the sausage king knew anything about relative strength?

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Relative Strength Spread

March 27, 2012

The chart below is the spread between the relative strength leaders and relative strength laggards (universe of mid and large cap stocks).  When the chart is rising, relative strength leaders are performing better than relative strength laggards.    As of 3/26/2012:

RS leaders and RS laggards have had similar performance over the past couple of years.  History would strongly suggest that we will eventually see RS leaders resume their outperformance.

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The Dual Role of Price in Financial Markets

March 26, 2012

Price has a dual role in financial markets.

  • Price represents the intersection of supply and demand.  It is the point at which buyers and sellers can agree on a value at which to exchange.  Everyone in the financial markets knows this.  Even economists get it.
  • Price also stimulates demand.  This price function is largely overlooked in the financial markets, but is the very reason why investors pile into strong stocks or strong assets.  Relative strength can obviously be a great help in identifying what those strong assets are.  Economists don’t understand how higher prices can drive demand, and just think investors are irrational.

If you are not convinced, here’s an excerpt from a Bloomberg article today:

Hedge funds trailing the Standard & Poor’s 500 (SPX) Index for the last five months are giving up on bearish bets and buying stocks at the fastest rate in two years.

The reason is obvious, and also mentioned in the article:

The benchmark gauge for U.S. equities is on track for the best first-quarter gain since 1998, according to data compiled by Bloomberg.

Yep.  A strong market stimulates demand for equities.  This tends to be true of all financial markets.

This runs counter to the traditional economic theory of supply and demand, where lower prices are expected to stimulate demand.  Traditional economic theory is correct in a special case—only if there is a concrete end use for the product.  For example, if gasoline prices went to $1.25 per gallon, users might be tempted to put tanks in their driveway and fill them up to take advantage of the low price, knowing they will use the gasoline later.  The same thing will be true of canned goods, toothpaste, and toilet paper.  People will buy as much as they can use before it spoils to take advantage of low prices.

Stocks are different.  Financial assets are intangible.  You can’t eat stock certificates or fuel your car with them.  Their end use is performance.  Performance is intangible, but performance depends on rising prices (assuming you are long, anyway).  When prices are rising strongly, it is a market signal that this asset may be useful for performance—and that is what stimulates additional demand.  Relative strength is like a neon sign in this respect.

Hedge funds and institutional investors are particularly subject to performance pressures, so they are very sensitive to market signals.  When markets are trending, they tend to go after the strongest assets first.  This is entirely rational economic behavior when continued poor performance can put you out of business.  Money flows follow performance.

Source: GlassGiant.com

[Endnote:  It is entirely possible, of course, to buy stocks when they are out of favor and make money too.  This is exactly what contrarian, value investors do.  One of the appeals of value investing is that buyers have very little competition when buying out-of-favor assets.  Yet even a value investor needs demand fueled by rising prices to ultimately profit.  It may be true that for every asset there is some “fair” or “intrinsic” value, but it’s probably also true that the asset is correctly priced only twice each cycle—once on the way up, and once on the way down.]

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From the Archives: Ken French Should Check His Website

March 26, 2012

A new paper from Eugene Fama and Ken French is circulating, suggesting that active mutual fund managers don’t add value.  Articles, like the one here at MarketWatch, have been appearing and the typical editorial slant is that you should just buy an index fund.

I have a bone to pick with this article and its conclusions, but certain things are not in dispute.  Fama and French, in their article Luck versus Skill in the Cross Section of Mutual Fund Returns, look at the performance of domestic equity funds from 1984 to 2006.  (You can find a summary of the paper here.)  They discover that the funds, in aggregate, are worse than the market by 80 basis points per year–basically the amount of the fees and expenses.  (After backing out fees and expenses, the funds are 10 basis points per year above the market.)  After that, Fama and French run 10,000 simulations with alpha set to zero to see if the distribution of returns from actual fund managers is any different from the distribution of returns from the random simulations.  They conclude it is not very different and suggest that any fund manager that outperforms is simply lucky.

Let me start my critique by pointing out that, based on their sample and their goofy experimental design, their conclusions are probably correct.  Existing mutual funds in aggregate pretty much own the market portfolio and underperform by the amount of fees and expenses.  There clearly are some above-average mutual fund managers, but as Fama and French point out, it’s difficult to tell statistically from just performance data if they are good or simply lucky.  Within a big sample of funds like they had, after all, a few are bound to have good performance just because the sample is so large.

This is quite a quandary for the individual investor, so let’s think about the realistic scenarios and their outcomes–in other words, let’s take actual investor behavior into account.

Scenario 1.  Buy a mutual fund after its good performance is advertised somewhere and bail out when it has a bad year.  Continue this behavior throughout your investment lifetime.  According to Dalbar’s QAIB and other data, this is what actually happens most of the time.  Not a good outcome–underperformance by a large margin, often 500 basis points or more annually.

Scenario 2.  Buy a decent mutual fund and make the radical decision to leave it alone, come hell or high water.  Do not be tempted by the blandishments of currently hot funds or panicked by underperformance in your fund when it inevitably happens.  Close eyes and hold on for dear life.  Continue your ostrich-with-its-head-in-the-sand routine throughout your investment lifetime.  Your outcome, as Fama and French point out, will probably be market returns less the 80 basis point per year in fees.  Your returns will probably be 400 basis points annually or more better than Scenario 1.

Scenario 3. Throw active management overboard entirely.  Buy an S&P 500 index fund or a total market index fund and proceed as in Scenario 2.  Your outcome might be 60-70 basis points per year better from reduced costs than the investor in Scenario 2.  (Your cost is that you don’t get to brag at cocktail parties on the occasions when your actively managed fund has a good year.)  On the other hand, you are no less likely to succumb to Scenario 1 than an actively managed mutual fund investor.  Unfortunately, index mutual funds tend to show the same pattern of lagging returns due to investor behavior as actively managed funds.

Scenario 4. Visit Ken French’s own website.  Look for factors that are tested and that have outperformed consistently over time.  Hint: relative strength.  (Academics tend to call it ”momentum,” I suspect because it would be very deflating to have to admit that anything related to technical analysis actually works.)  Find a manager that exposes a portfolio to the relative strength factor in a disciplined fashion over time.  Buy it and pretend you are Rip Van Winkle.  Continue this dolt-like behavior for your entire investment lifetime.  Your outcome, according to Ken French’s own website, is likely to be market outperformance on the magnitude of 500 basis points per year or more.  (You can link to an article showing a performance chart back to 1927 here, and the article also includes the link to Ken French’s database at Dartmouth University.)

I prefer Scenario 4, but maybe that’s just me.  Since it is well-known even to Eugene Fama and Ken French that momentum has outperformed over time, what is their study really saying?  It’s saying that essentially no one in the mutual fund industry is employing this approach.  That’s more a problem with the mutual fund industry than it is with anything else.  (Mutual fund firms are businesses and they have their reasons for running the business the way they do.)  One option, I guess, is to throw up your hands and buy an index fund, but maybe it would make more sense to seek out the rare firms that are employing a disciplined relative strength approach and shoot for Scenario 4.

Their flawed experimental design makes no sense to me.  Although I am still 6’5″, I can no longer dunk a basketball like I could in college.  I imagine that if I ran a sample of 10,000 random Americans and measured how close they could get to the rim, very few of them could dunk a basketball either.  If I created a distribution of jumping ability, would I conclude that, because I had a large sample size, the 300 people would could dunk were just lucky?  Since I know that dunking a basketball consistently is possible–just as Fama and French know that consistent outperformance is possible–does that really make any sense?  If I want to increase my odds of finding a portfolio of people who could dunk, wouldn’t it make more sense to expose my portfolio to dunking-related factors–like, say, only recruiting people who were 18 to 25 years old and 6’8″ or taller?  In the same fashion, if I am looking for portfolio outperformance, doesn’t it make a lot more sense to expose my portfolio to factors related to outperformance, like relative strength or deep value, rather than to conclude that managers who add value are just lucky?  No investigation of possible sub-groups that were consistently following relative strength or deep value strategies was done, so it is impossible to tell.  Fama and French are right, I think, in their assertion that plenty of luck is involved in year-to-year performance, but their overall conclusion is questionable.

In short, I think a questionable experimental design and possible sub-groups buried in the aggregate data (see this post for more information on tricks with aggregate data) make their conclusions rather suspect.

—-this article originally appeared 12/3/2009.  It turned out to be one of the blog readers’ favorite rants, so I am reprising it here.  I still think active management can add value over time through disciplined exposure to a reliable return factor.

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Why You Are A Trend Follower, Part…

March 26, 2012

Morgan Housel sheds some light on valuations:

This all raises the question of where valuations are today. When looking at a broad index like the S&P 500, the unfortunate (but honest) answer is no one really knows. Using a straight P/E ratio, the market looks a little cheap historically. Using a metric like the cyclically adjusted P/E ratio that averages 10 years’ of earnings together, it looks a little pricey. Profit margins are near all-time highs and could contract. But interest rates are low, so stocks look attractive when compared with bonds. Equally smart people disagree on what these all actually mean.

Clear as mud?  This is just your daily reminder of why you are a trend follower!

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Weekly RS Recap

March 26, 2012

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 (3/19/12 – 3/23/12) is as follows:

High RS stocks outperformed the universe last week.

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Quote of the Week

March 23, 2012

…the Wall Street consensus has a pretty good record of being completely and utterly wrong.—-James Montier

Mr. Montier is on the asset allocation team at GMO and was writing about analysts’ extrapolations for future profit margins, but I think his words may have more general application.  In truth, we have no better ability to forecast, which is why our investment work relies on the systematic application of relative strength.  Prices are usually more accurate than the consensus forecast.

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Sector and Capitalization Performance

March 23, 2012

The chart below shows performance of US sectors and capitalizations over the trailing 12, 6, and 1 month(s).  Performance updated through 3/22/2012.

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Balanced Funds Make a Comeback

March 22, 2012

According to an article in Smart Money, balanced funds have been attracting client money this year.

So-called balanced funds, which invest in a mixture of stocks and bonds — and occasionally cash, commodities and other asset classes — suddenly are back in style. So far this year, investors added $7.1 billion to these portfolios, according to Lipper, a research firm. That is a huge reversal from last year, when investors yanked $20 billion from these funds.

The turnaround also stands in contrast to pure stock funds, which had inflows of just $56 million this year through March 14. And some investing experts say demand for balanced strategies is likely to rise. “There’s a little ‘Goldilocks’ appeal for investors,” says Russel Kinnel, director of fund research for Morningstar, meaning the funds are “just right” in finding a spot between timid and risky.

Indeed, advisers say they are using the funds to bring clients who are still spooked by last year’s extreme market volatility — but tired of record-low yields in the bond market — back into stocks. The pitch is that these funds offer most of the upside if the market surges but less of the downside if it tanks.

…advisers say balanced funds are often a good fit with younger investors, or those looking for a set-it-and-forget investment. Some also use the funds as core holdings for clients, and supplement them with alternative assets and funds to get even broader diversification.

Advisors are finding that clients are a bit more receptive to the equity story, but far from willing to go “all in.”  We’re seeing some glimmers of that in our own survey of investors’ risk appetite.  Investors are finally peeping out of the foxhole they have been in since 2008 and surveying the environment.  They are beginning to realize that today’s low bond yields will not get them to their goals, but they also seem to want some fixed income as a buffer from market volatility.  A balanced fund is a pretty good compromise.  (You can find more out about balanced funds generally here.)

The Arrow DWA Balanced Fund (DWAFX) that we sub-advise crossed its 5-year anniversary last summer, while outperforming 90% of its peers.  There are dedicated sleeves for fixed income, domestic equities, international equities, and alternative investments.  The alternative sleeve, which is something many balanced funds do not include, can come in pretty handy for inflation protection and always adds an additional layer of diversification.

I’ve included a snip with the asset allocation as of 12/31/2011 and the performance of each strategy sleeve.  Every sleeve has a positive return since inception in 2006, even with the 2008-2009 bear market.  I think it is primarily the hybrid nature of these funds that is making them attractive to clients right now—and DWAFX might be something to consider for clients just easing back to a more normal asset allocation.

Source: Arrow Funds

Click here to visit ArrowFunds.com for a prospectus & disclosures.  Click here for disclosures from Dorsey Wright Money Management.

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From the Archives: Why Systematic Models Are Great

March 22, 2012

James Montier wrote this piece in 2006, but it is so great that I have to bring it up again!  This article is a gem, worth reading over and over again.

What could baseball, wine pricing, medical diagnosis, university admissions, criminal recidivism and I have in common? They are examples of simple quant models consistently outperforming so-called experts. Why should financial markets be any different? So why aren’t there more quant funds? Hubristic self belief, self-serving bias and inertia combine to maintain the status quo.

Montier gives numerous examples of situations in which the models outperform both experts and experts using the models as additional input.  Using your “expert knowledge” just makes it worse most of the time.  In fact, in a study of over 130 papers comparing systematic models with human decision-making, the models won out in 122 events.

So why don’t we see more quant funds in the market? The first reason is overconfidence. We all think we can add something to a quant model. However, the quant model has the advantage of a known error rate, whilst our own error rate remains unknown. Secondly, self-serving bias kicks in, after all what a mess our industry would look if 18 out of every 20 of us were replaced by computers. Thirdly, inertia plays a part. It is hard to imagine a large fund management firm turning around and scrapping most of the process they have used for the last 20 years. Finally, quant is often a much harder sell, terms like ‘black box’ get bandied around, and consultants may question why they are employing you at all, if ‘all’ you do is turn up and crank the handle of the model. It is for reasons like these that quant investing will remain a fringe activity, no matter how successful it may be.

Lack of competition may be the best reason of all to use a systematic approach.  How many investors are willing to go through a thorough and rigorous testing process to build a robust model—and are then willing to stick with the model through thick and thin?  As Montier points out, it may remain a “fringe activity” no matter how successful it is.

—-this article originally appeared 12/22/2009.  This is a powerful, powerful argument in favor of using a systematic model.  Montier’s discussion of why investors resist using models is still very true.

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Fund Flows

March 22, 2012

The Investment Company Institute is the national association ofU.S.investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs).  Members of ICI manage total assets of $11.82 trillion and serve nearly 90 million shareholders.  Flow estimates are derived from data collected covering more than 95 percent of industry assets and are adjusted to represent industry totals.

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High RS Diffusion Index

March 21, 2012

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 3/20/12.

The 10-day moving average of this indicator is 87% and the one-day reading is 91%.

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From the Archives: Sorry, No Correlation

March 21, 2012

How should today’s news, that the nation’s gross domestic product rose at a lower annual rate in the third quarter than previously estimated, factor into your investment decisions?  Bad news for stocks?

Recently, Brandes issued a report, Gross Domestic Product: A Poor Predictor of Stock Market Returns, that points out that stock market performance has not been correlated with GDP performance.  Note this research covers an 80 year period of time.

Exhibit 1 shows the predictive power of changes in GDP (in explaining concurrent equity returns) was not statistically significant.  The coefficient of determination, or the portion of the stock market performance, explained by GDP changes, is only 0.1619, and the regression line is a poor fit.

(Click to Enlarge)

In addition, Exhibit 2 reveals that predictive power for changes in GDP in explaining subsequent equity returns is not statistically significant. The coefficient of determination for this relationship is 0.0225, and again, the fit of the regression line is poor.

(Click to Enlarge)

It may seem logical to you to try to link GDP growth with stock market performance, but the results just don’t back that thesis up.  I believe that these results confirm that investors are best served  by focusing on the price movement of a security/market itself when evaluating the merits of an investment.

—-this article originally appeared 12/22/2009.  It’s a very good reminder to stay focused on the relative strength of the individual security and not on all of the surrounding economic noise.  The fact is that there is no correlation, and where there is some relationship, it is usually the stock market that leads.

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The Coming Mega-Bull Market

March 20, 2012

Fuel for a bull market in the future in continuing to build up.  Scott Grannis, former chief economist at Western Asset Management, recently wrote about how much cash is piling up.  (His blog, Calafia Beach Pundit, is highly recommended for insight into the global economy.)

M2 is growing above its long-term average annual rate of 6%, even though the economy is 12-13% below its long-term trend.  By far the biggest source of growth in M2 is savings deposits. These have increased by over $2 trillion since late 2008, and have grown at a blistering 15.7% annualized pace over the past three months. This is unusually strong growth that can only reflect great fear and caution on the part of investors everywhere, especially when one considers that savings deposits pay virtually no interest.

Mr. Grannis includes some charts that show both the rapid growth of savings deposits and the strong investor preference for bonds over stocks right now.  We regularly detail the ICI numbers here as well, but his charts are a fantastic visual presentation.

Source: Calafia Beach Pundit         (click on images to enlarge)


We all know what happens when a match finds the fuel; what we don’t know is when or how the match will be struck.  Investors have pretty clearly been traumatized by 2008-2009.  I’m not sure what it will take for investor sentiment to become less negative.  It could be a variety of things: better employment data, less consumer leverage, or maybe some time just needs to pass so the memory of 2008 isn’t so sharp.  This process could take weeks, months, or years.

Fuel, on the other hand, is abundant.  Although struggling consumers and corporations are in the process of rebuilding their balance sheets, many successful companies and consumers with positive cash flow are squirreling the money away.  They are perhaps not comfortable investing it yet, but the cash is building up quickly and could create a tsunami when it breaks loose.

At some point, investors will realize that they need equity-like returns to meet their savings and investment goals.  Or perhaps they will simply become disssatisfied with such low returns from money market funds and CDs.  A trickle of money will start to flow from cash and low-yielding bonds into the stock market, which will nudge the market higher.  As the market begins to move up, investors will become more confident and yet more money will flow into stocks.  The next thing you know, we could have another mega-bull market on our hands, although most probably won’t be willing to believe it.  Plentiful fuel and public disbelief is how bull markets start and then extend themselves.

We’ve already had a more than 100% move from the 2009 lows over the last three years.  The retail investor has not participated much so far.  I don’t know how much longer they will be willing to sit on their hands when it is costing them big money, but if I had to guess, “forever” is probably not the right answer.  We may be closer to an inflection point than it seems.

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The Economy Does Not Equal The Stock Market

March 20, 2012

Aussie Trader, Jessica Peletier, succinctly points out the disconnect often seen between an economy and its stock market:

I admit it – I’m jealous.

Right now, I want to be American.  I want to buy cheap houses and eat mega-huge fast food.

But most of all, I want a stock market that goes up.

Ours appears to have forgotten how.   In fact it’s almost as though it’s pulled the doona over its head and decided never to get up again.

If you ask me, that’s kind of bizarre because you’d think the Australian Market has everything to live for.

You see, economically we rock.  We have stable banks, interest rates that actually pay money and a resource sector that has the rest of the world drooling.  And we have jobs for anyone who actually wants to work.

Now compare that to our American friends.  Their banks have a less than sterling reputation, interest rates can barely go any lower, and there’s very few jobs in many areas – in fact whole towns are dying through the extinction of industry.

And yet their market is merrily making higher highs without a care in the world, while ours is languishing like a drunk on Sunday morning.

It simple really – the economy does not equal the stock market.

What does equal the stock market is people’s perception of what might happen in the future, and this goes some way toward explaining what’s going on with the US market.

Even though right now their economy is junk, people are overjoyed that there are green shoots appearing.  People are more optimistic about the future.  It doesn’t matter that right now, things are still rubbish – the fact is there is hope.

If the markets were a reflection of the economy, the US market may have risen marginally to reflect the odd green shoot.  But what’s happened is not marginal, it’s a beautiful big fat money-making up-trend.

This is exactly why it makes sense to go directly to trading price trends!

HT: Abnormal Returns

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