Relative Strength Still Off the Radar

May 16, 2012

The Big Picture has a thumbnail summary of the annual Merrill Lynch US Equity and US Quant Strategy pieces, where they interview 100 large institutional managers.  Of particular interest to me was the top ten return factors by popularity.

via The Big Picture  (click on image to enlarge)

You can see that relative strength did not crack the top ten.  On the bigger chart, which you can see in the article, relative strength came in at #11.  Of course, there are many formulations of relative strength, so even that ranking probably covers a lot of different methods.

A number of the popular factors are value-related and some are based on profitability.  All of these factors ultimately interact in complicated ways, but you don’t have to worry about a crowded trade in relative strength.

Value, quality, and risk-related factors are all much more popular than relative strength.

via The Big Picture     (click on image to enlarge)

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The Not-So-Normal Bell Curve

May 16, 2012

Matt Koppenheffer nicely makes the case for holding on to your winners and cutting out your losers (exactly what relative strength is designed to do):

When it comes to investing, there’s no shortage of bad advice floating around out there. Among the worst, though, is the old saw, “You can’t go broke by taking a profit.”

The saying refers to the belief that if you have a stock that’s gone up in value, it’s hard to go wrong selling that stock and “locking in” the gains. But while the saying is technically true — it’s hard to picture a scenario where an investor is suddenly bankrupt after selling a stock at a profit — it’s a dangerous platitude for investors to follow.

There’s a name for that
The practice of selling winning stocks and hanging on to losing ones is a practice that’s familiar to behavioral-finance experts. It’s a behavioral bias known as the disposition effect and has been revealed to be quite harmful for investors. A number of academic papers have shed light on the subject, including Berkeley professor Terrance Odean’s 1998 study that concluded that individual investors’ “preference for selling winners and holding losers … leads, in fact, to lower returns.”

A possible explanation
If the long-term returns from stocks were distributed normally — that is, they formed the familiar bell-shaped curve and most stocks’ returns clustered around the average — selling winners and holding losers might actually work. If the returns from most individual stocks were likely to be right around the average for all stocks, then a big winner would be more likely to stall out after its winning streak than continue climbing. At the other end, it wouldn’t be unreasonable to expect a stock that’s been a big loser to climb back closer to the average.

But that’s not how it works.

I was reminded of this by a recent report by Shankar Vedantam for NPR, called “Put Away the Bell Curve: Most of Us Aren’t Average.  Vedantam reviewed the research and work of Ernest O’Boyle Jr. and Herman Aguinis, who studied the performance of 633,263 people involved in academia, sports, politics, and entertainment.

In short, the pair’s finding was that the performance distribution in these groups wasn’t bell-shaped. Instead, many participants clustered below the mathematical average, while a group of superstars produced results far above the average and pulled the overall average up.

Stock returns have a similar distaste for fitting to a bell curve. Over the past 10 years, 63% of the S&P 500 companies underperformed the average. Meanwhile, a large group of significant outperformers delivered returns that were well above the average.

As compared with the bell curve in the background, the data plotted here is a mess. And it should be. Stock returns are not normally distributed — which is what produces that nice bell-shaped curve. And though stats-stars who are much smarter than me often try to describe stock returns as “lognormal” — a mathematical transformation of the returns that gets them to more closely fit a bell curve — they’re not that, either. Stocks are typified by “fat tails” on either end — that is, more seriously outperforming and underperforming stocks than is easily captured by streamlined mathematical models.

So no matter how you look at stock returns, a surprising number of stocks end up returning far more and far less than the average. Practically, this means that the practice of “locking in gains” and hanging on to losers is a good way to miss out on the market’s huge outperformers, stay stuck with poor performers, and earn lackluster overall returns.

HT: iShares

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Morningstar Fair Value

May 16, 2012

We use relative strength, not fundamentals, but that doesn’t mean we ignore it.  Now that we have powered through another earnings season and we’re having another Greek crisis moment in Europe, it’s interesting to see that the good folks at Morningstar calculate that the market is about as undervalued as it has been all year.  I know it’s trendy to hate stocks and love alternatives, but analysts who follow these companies—and don’t have an axe to grind—don’t think they are expensive.

Stocks still undervalued according to Morningstar

Source: Morningstar  (click on image to enlarge)

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High RS Diffusion Index

May 16, 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 5/15/12.

The 10-day moving average of this indicator is 54% and the one-day reading is 40%.

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