Disconnecting from Fundamentals

January 7, 2013

Mohamed El-Erian laments the impact that central banks are having on the markets:

But, critically for both economic prospects and investors, greater relative stability does not guarantee absolute stability. There is a limit to how far central banks can divorce prices from fundamentals. Moreover, as illustrated in the minutes of the latest Fed meeting, there is already discomfort among some policy makers due to the costs and risks of unconventional policies. Also, at some point, and it is hard to tell when exactly, the private sector will increasingly refuse to engage in situations deemed excessively artificial and overly rigged.

This is particularly relevant for asset classes (such as high yield corporate bonds, equities and certain highly leveraged products) outside the direct influence of central banks – an influence that is applied through direct market purchases and forward-looking policy guidance. With the weaker central bank impact, prices need to have greater consistency with the realities of balance sheets and income statements.

In such a world, investors should expect security and sector selections to get repeatedly overwhelmed by macro correlations. Since a growing number of asset classes are now exposed in a material fashion to the belief that central banks will deliver macroeconomic as well as market outcomes, investors have assumed considerable macro-driven correlations across their holdings. Moreover, with seemingly endless liquidity injections, the scaling of such exposure can easily disconnect from the extent to which prices deviate from fundamentals.

The topic of prices deviating from fundamentals is not new.  How much of that deviation between price and fundamentals is a result of investor behavior, central bank policy, or any number of other factors is up for debate.  While there may be a lot of truth to what El-Erian says about the impact of central bank’s policies, it becomes very difficult for an investor to know what actions to take based on those arguments.  What is the correct measure of fundamental value?  If a client places trades based on the expectation that the market will eventually reflect fundamental value, how long should they expect to wait?  Days?  Months? Years?  Decades?  Just how far can prices deviate from fundamental value?

Our approach to investing doesn’t get caught up in normative debates.  Rather, all of our trend-following models focus on one core piece of information that reflects supply and demand– and that is price.   Anything that can possibly affect the price – fundamentally, politically, psychologically, or otherwise – is actually reflected in the price.  Furthermore, relative strength has the advantage of being able to rank trends by their strength.

We are likely to be debating the merits of current central bank policy for many years to come.  In time, conclusions will be able to be drawn about their wisdom.  However, relative strength offers pragmatists a robust and adaptive strategy to employ today.

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Extolling the Power of Compound Interest

January 7, 2013

Carl Richard’s latest sketch simply and effectively conveys the nature of compound interest:

You’ve probably heard that starting early is one of the best investing decisions you can make. That’s because investing done right is short-term boring but long-term exciting.

The reason? The reality of compound interest. Let me explain.

Many people talk about the power of compound interest. Albert Einstein is rumored to have called it the most powerful force in the universe.

Now, I suspect he probably didn’t really say that, but whether he did or not, it’s a point that we often miss in the discussion about compound interest. Despite it being one of the most powerful forces in the universe, it’s not one of the most exciting – at least in the short term. Nothing really great happens until after years and years of discipline and patience.

Take this silly (but true!) story that’s often told to demonstrate how powerful compound interest is: If you start with one penny and double it every day for 30 days, you’ll end up with $5,368,709.12.

I should add a disclaimer here that if anyone offers you an investment that will double in value every day, you should run as fast as you can in the other direction. But let’s get back to the main point. Sure, compound interest has a powerful outcome, but it takes an awfully long time to become fun and exciting.

Now take a look at our penny example again. One penny doubled is 2 cents. Two cents turns to $0.04, $0.04 to $0.08, $0.08 to $0.16, $0.16 to $0.32, $0.32 to $0.64, and $0.64 to $1.28. Nothing very exciting there.

But when you stick with it, it’s that last few times when the figure doubles that it gets very, very exciting. You’re looking at $1,342,177.28 becoming $2,684,354.56, and $2,684,354.56 doubling to $5,368,709.12.

That’s the case with our investments, too. It’s not very exciting at the beginning, but compounding becomes a powerful force after years of patience and discipline.

In case you want to see the penny example in spreadsheet form:


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Weekly RS Recap

January 7, 2013

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 (12/31/12 – 1/4/13) is as follows:

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