Systematic Relative Strength

Morgan Housel has a fun article at Motley Fool with a possible explanation for why investors are so clueless. His argument, essentially, is that investors confuse the stock market with the economy. If the economy is bad, they assume the stock market must be bad too. Although it’s certainly true that many investors are confused about the linkage between the stock market and the economy, I don’t know if that’s the real explanation or not—but it’s plausible. Maybe I’ve just given up hope that we’ll ever understand investor irrationality! To me, the most staggering part of his article is where he quotes an investor study from Franklin:

Take an annual survey by Franklin Templeton Investments. Near the start of each year, it asks 1,000 investors whether the S&P; 500 went up or down in the previous year.

Now, we live in the age of CNBC and Yahoo! Finance and iPhone apps, where no one lacks the data to know a simple statistic like whether the market went up or down.

Yet year after year, the survey shows that swarms of investors are utterly clueless:

• In 2010, 66% of investors said the S&P; 500 fell in 2009. Yet it was actually up 26.5%.

• In 2011, about half of investors said the market fell in 2010. Yet it was actually up 15%.

• In 2012, 53% of investors said the market fell in 2011. Yet it was up 2%.

• Just recently, 31% of investors said the market fell last year. Yet it was up 16%.

Mind-boggling, isn’t it? During a strong three-year run in the market (2009-2011), more than half of the investors they polled thought it was going down! Last year, the idea that the market might be going up began to sink in. Given that the economy was actually growing slowly during much of that time, perhaps investors are imagining market performance is related to their own economic confidence or linked to their own desire to invest. Whatever the linkage, it’s pretty clear they weren’t basing it on market data.

The more data-centric your investing approach is, the more likely it is that you’ll get somewhere close to reality. If you are looking at relative strength data, it’s easier to see where the strongest trending markets have been—and also to see what’s been sinking. A systematic investment process might be your best insurance policy.