Dealing With Financial Repression

January 28, 2013

James Montier, the investment strategist at GMO, published a long piece on financial repression in Advisor Perspectives in November 2012.  It’s taken me almost that long to read it—and I’m still not sure I completely understand its implications.  Financial repression itself is pretty easy to understand though.  Along with a humorous description of Fed policy, Montier describes it like this:

Put another way, QE sets the short-term rate to zero, and then tries to persuade everyone to spend rather than save by driving down the rates of return on all other assets (by direct purchase and indirect effects) towards zero, until there is nothing left to hold savings in. Essentially, Bernanke’s first commandment to investors goes something like this: Go forth and speculate. I don’t care what you do as long as you do something irresponsible.

Not all of Bernanke’s predecessors would have necessarily shared his enthusiasm for recklessness. William McChesney Martin was the longest-serving Federal Reserve Governor of all time. He seriously considered training as a Presbyterian minister before deciding that his vocation lay elsewhere, a trait that earned him the beautifully oxymoronic moniker of “the happy puritan.” He is probably most famous for his observation that the central bank’s role was to “take away the punch bowl just when the party is getting started.” In contrast, Bernanke’s Fed is acting like teenage boys on prom night: spiking the punch, handing out free drinks, hoping to get lucky, and encouraging everyone to view the market through beer goggles.

So why is the Fed pursuing this policy? The answer, I think, is that the Fed is worried about the “initial condition” or starting point (if you prefer) of the economy, a position of over-indebtedness. When one starts from this position there are really only four ways out:

i. Growth is obviously the most “popular” but hardest route.

ii. Austerity is pretty much doomed to failure as it tends to lead to falling tax revenues, wider deficits, and public unrest. 2

iii. Abrogation runs the spectrum from default (entirely at the borrower’s discretion) to restructuring (a combination of borrower and lender) right out to the oft-forgotten forgiveness (entirely at the lender’s discretion).

iv. Inflation erodes the real value of the debt and transfers wealth from savers to borrowers. Inflating away debt can be delivered by two different routes: (a) sudden bursts of inflation, which catch participants off guard, or (b) financial repression.

Financial repression can be defined (somewhat loosely, admittedly) as a policy that results in consistent negative real interest rates. Keynes poetically called this the “euthanasia of the rentier.”3  The tools available to engineer this outcome are many and varied, ranging from explicit (or implicit) caps on interest rates to directed lending to the government by captive domestic audiences (think the postal saving system in Japan over the last two decades) to capital controls (favoured by emerging markets in days gone by).

The effects of financial repression are easy to see:  very low yields in debt instruments, and the consequent temptation to reach for yield elsewhere.  Advisors see the effects in clients every day.

If you are feeling jovial, I highly recommend reading Montier’s whole piece as an antidote to your good mood.  His forecast is rather bleak—poor long-term returns in most all asset classes for a long period of time.  My take-away was a little different.

Let’s assume for a moment that Montier is correct and long-term (they use seven years) equity real returns are approximately equivalent to zero.  In fact, that’s pretty much exactly what we’ve seen during the last decade!  The broad market has made very little progress since 1998, a period going on 15 years now.  Buy-and-hold (we prefer the terminology “sit-and-take-it”) clearly didn’t work in that environment, but tactical asset allocation certainly did.  Using relative strength to drive the process, tactical asset allocation steered you toward asset classes, sectors, and individual securities that were strong (for however long) and then pushed you out of them when they became weak.

I have no idea whether Montier’s forecast will pan out or not, but if it does, tactical asset allocation might end up being one of the few ways to survive.  There’s almost always enough fluctuation around the trend—even if the trend is flat—to get a little traction with tactical asset allocation.

Source: Monty Python/Youtube

[In fact, might I suggest the Arrow DWA Balanced Fund and the Arrow DWA Tactical Fund as considerations?  You can find more information at www.arrowfunds.com.]

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Relative Strength: A Solid Investment Method

January 28, 2013

We are fond of relative strength.  It’s a solid investment method that have proven itself over a long period of time.  Sure, it has its challenges and there are certainly periods of time during which it underperforms, but all-in-all it works and it’s been good to us.  It’s always nice, though, when I run across another credible source that sings its praises.  Consider the following excerpt from an article on the Optimal Momentum blog:

Momentum, on the other hand, has always made sense. It is based on the phrase “cut your losses; let your profits run on,” coined by the famed economist David Ricardo in the 1700s. Ricardo became wealthy following his own advice.  [Editor's note: We wrote about this in David Ricardo's Golden Rules.] Many others, such as Livermore, Gartley, Wycoff, Darvas, and Driehaus, have done likewise over the following years. Behavioral finance has given solid reasons why momentum works. The case for momentum is now so strong that two of the fathers of modern finance, Fama and French, call momentum “the premier market anomaly” that is “above suspicion.”

Momentum, on the other hand, is pretty simple. Every approach, including momentum, must determine what assets to use and when to rebalance a portfolio. The single parameter unique to momentum is the look back period for determining an asset’s relative strength. In a 1937, using data from 1920 through 1935, Cowles and Jones found stocks that performed best over the past twelve months continued to perform best afterwards. In 1967, Bob Levy came to the same conclusion using a six-month look back window applied to stocks from 1960 through 1965. In 1993, using data from 1962 through 1989 and rigorous testing methods, Jegadeesh and Titman (J&T) reaffirmed the validity of momentum. They found the same six and twelve months look back periods to be best. Momentum is not only simple, but it has been remarkably consistent over the past seventy-five years.

Momentum, on the other hand, is one of the most robust approaches in terms of its applicability and reliability. Following the 1993 seminal study by J&T, there have been nearly 400 published momentum papers, making it one of the most heavily researched finance topics over the past twenty years. Extensive academic research has shown that price momentum works in virtually all markets and time periods, from Victorian ages up to the present.

Of course, momentum is just the academic term for relative strength.  For more on the history of relative strength—and how it became known as momentum in academia—see CSI Pasadena: Relative Strength Identity Theft.  The bigger point is that relative strength has a lot of backing from both academics and practitioners.  There are more complicated investment methods, but not many that are better than relative strength.

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Weekly RS Recap

January 28, 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 (1/21/13 – 1/25/13) is as follows:

ranks 1.28.13 Weekly RS Recap

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