Relative Strength Spread

December 31, 2013

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 12/30/2013:

spread 12.31.13

Healthy RS Spread as we head into 2014.

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60/40 Portfolio Subjected To Historical Data

December 30, 2013

Conventional wisdom says you don’t need anything more complicated than a 60/40 portfolio.  From the WSJ:

Investment advisers and managers usually recommend some variant of 60% stocks and 40% bonds (with fewer stocks and more bonds as you get older). The portfolio should be rebalanced at least once a year—selling some of what has done well to buy more of what has done poorly, restoring the target proportions.

The theory is that when stocks do badly bonds will do well, and vice versa. But the theory is flawed.

Historically, this portfolio has only succeeded when stocks, or bonds, or both, have been reasonably valued or cheap. In the past, if you had invested in this portfolio when stocks and bonds were both overvalued, it proved a very poor deal.

Using data on stock and bond returns from New York University’s Stern School of Business and inflation data from the Labor Department, I looked at how such a portfolio performed in the past when measured in real, inflation-adjusted dollars.

It lost a third of its value from 1928 to 1932, and it lost value over two longer periods as well, from 1936 to 1947 and from 1968 to 1982—even before deducting taxes and costs. In reality, most investors would have done very badly indeed.

Another theory that doesn’t hold up when subjected to real data.

So what are your alternatives?  How about expanding the investment universe to include domestic equities, international equities, inverse equities, currencies, commodities, real estate, and fixed income.  John Lewis conducted a rigorous test of this type of Tactical Asset Allocation strategy in this 2012 white paper.  Of particular interest in light of this WSJ article, note the performance of the Tactical Asset Allocation strategy compared to a 60/40 portfolio over time.

From John Lewis’ white paper:

factor summary

Table 2 shows a summary of returns using different lookback periods for various relative strength ranking factors.  Once again, the robust nature of relative strength is shown by the ability of multiple random trials to outperform using a variety of factors.  Some of the intermediate-term factors work better than others, but they all exhibit a significant ability to outperform over time.  At very short lookback periods, such as 1 month, the performance is not as good as at longer periods.  Relative strength models are not designed to catch every small wiggle, and investors need to allow positions to ebb and flow over time.  It is also clear from Table 2 that as you begin to lengthen your lookback period, returns begin to degrade.  While a long-term buy and hold approach to a relative strength strategy is necessary, the investments within the strategy are best rotated on an intermediate-term time horizon.

We have employed this type of tactical approach to portfolio management in The Arrow DWA Tactical Fund (DWTFX) and our Global Macro separately managed account.  DWTFX is +25.70% YTD through 12/27/13 and has outperformed 95 percent of its peers in 2013.

dwtfx

Source: Morningstar

Investors may benefit from looking beyond just domestic equities and domestic fixed income when deciding what strategies they want to employ to get them through the next couple of decades.

Past performance is no guarantee of future returns.  

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More Supporting Data For Momentum

December 30, 2013

The WSJ reports the performance of Sam Eisenstadt’s, former head of research at Value Line, stock-ranking system from 1965-2012.

Though the system is proprietary, its two primary factors are known as “price momentum” and “earnings momentum.” A stock is ranked higher to the extent its performance over the trailing year has been good and its earnings growth has accelerated. Despite the name “Value Line,” the stocks it favors fall closer to the “growth” end of the spectrum.

The system has been phenomenally successful over the past five decades. From 1965 through 2012, according to data on Value Line’s website, Group 1 stocks on average have gained an annualized 12.9%, before dividends. That’s nearly seven percentage points per year better than the S&P 500’s 6.1% annualized return over the same period, and more than 22 percentage points ahead of the minus 9.8% return for Group 5.

Once again, the data confirms the effectiveness of price momentum.

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Weekly RS Recap

December 30, 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 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 (12/23/13 – 12/27/13) is as follows:

ranks 12.30.13

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Sector Performance

December 27, 2013

The chart below shows performance of US sectors and capitalizations over the trailing 12, 6, and 1 month(s).  Performance updated through 12/26/2013.

s_c 12.27.13

Numbers shown are price returns only and are not inclusive of transaction costs.    Source: iShares

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Britain’s Ascendancy

December 26, 2013

A noteworthy overweight in the PowerShares DWA Developed Markets Momentum ETF (PIZ) is the United Kingdom:

piz alloc 12.26.13

Source: PowerShares

For some insight into why the United Kingdom may be so strong, consider this post by The Capital Spectator:

‘Tis the season for predictions and all the usual caveats apply. But amid the din of forecasts as the year winds down is one outlook that’s worth a closer a look for what it says about the UK, the Eurozone, and the price tag for embracing a deeply flawed monetary policy inside a misguided currency union.

“The UK is forecast to be the second most successful of the Western economies after the US,” advises the Centre for Economics and Business Research (CEBR) in a new report published today. “Positive demographics with continuing immigration, rather less exposure to the problems of the Eurozone than other European economies combine with relatively low taxes by European standards to encourage faster growth than in most Western economies.” As it travels along the road to recovery, Britain will edge out France to become the fifth-largest economy on the planet in five years, pushing aside Germany to become Europe’s leading economy by 2030, CEBR projects. It seems that the sun is no longer setting on the British Empire in macro terms.

A lot can change between now and five years, to say nothing of what will unfold over the next three decades. But CEBR’s forecast certainly sounds plausible based on what we know about Britain’s economy this year. If you’ve been following the macro news for the UK, you know that it’s been posting encouraging numbers for months. There’s a fierce debate about why Britain’s economy is recovering. There’s also plenty of skepticism about whether the rebound is sustainable or even healthy—some analysts say that it’s overly reliant on a housing boom, for instance.

But there’s no denying that the UK’s generating numbers that stand in sharp relief with the Eurozone—particularly for the Eurozone ex-Germany. If you consider the upbeat economic numbers of late for the US and Japan, Europe’s troubles stand out even more. What explains the difference? Surely monetary policy is a big part of the answer, as Ambrose Evans-Pritchard of The Telegraph explains:

The crippled eurozone alone has chosen to stagger on defiantly without monetary crutches. The result has been a double-dip recession of nine quarters, the longest since the Second World War. The austerity regime has been self-defeating even on its own crude terms. Debt ratios have ratcheted up even faster.

It doesn’t help that the euro has been imposed in a region that falls short of Robert Mundell’s standards for defining an optimal currency area. But the euro isn’t going away, at least not for the immediate future. So, what could change? Perhaps the European Central Bank will embrace monetary stimulus in a more aggressive form in 2014, although it’s clear that policy choices to date have been far too modest to make a dent in the lingering troubles that continue to afflict France, Italy and Spain.

In absolute terms, Britain’s ascendancy of late can be attributed to internal economic momentum, supported by the simple fact that the UK still has its own currency and therefore has dodged the macro headwinds that weigh on countries tethered to the euro. In relative terms vis-à-vis the Eurozone, however, Britain’s strength speaks volumes about the self-inflicted problems on the Continent.

“The UK’s rebound is not because fiscal cuts have been milder than in Europe,” observes Evans-Pritchard. “The squeeze has been roughly comparable over the past three years. The difference is monetary policy. Kudos to the Bank of England, rising to a historic challenge once again.”

HT: Abnormal Returns

A list of all holdings for the trailing 12 months is available upon request.  See www.powershares.com for more information.

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Fund Flows

December 26, 2013

Mutual fund flow estimates are derived from data collected by The Investment Company Institute covering more than 95 percent of industry assets and are adjusted to represent industry totals.

ici 12.26.13

In case you are wondering how it is possible that the U.S. stock market has been up so much when net new cash flow into domestic equity mutual funds has been rather tepid (+ approximately $21 billion in 2013), see ICI’s FAQ below:

Is cash flow a measure of investors’ total demand for equities?

Mutual fund cash flow does not measure total demand for equities. There is no established correlation between mutual fund flows and stock market activity. Mutual funds own only about 20 percent of the total U.S. equities outstanding. Larger percentages are owned directly by U.S. and foreign individual investors, domestic pension plans, and state government retirement plans. In order to measure total demand, you would need information on the activities of these investors in addition to mutual fund cash flow. Unfortunately, comparable data is not available on non-mutual fund investors.

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Relative Strength Spread

December 24, 2013

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 12/23/2013:

spread 12.24.13

This rising spread continues to reflect a generally favorable environment for relative strength strategies.

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Momentum as a Growth Replacement

December 23, 2013

Let’s say that you have reviewed enough of the body of work on momentum to have concluded that momentum is able to generate excess returns over time and that you want to employ it in your investments.  Now what—where does it fit in an allocation?  As much of the research indicates, momentum is more highly correlated to growth than it is to value.  Therefore, you might think of it in terms of a way to diversify your portfolio from value.

Further insight comes from this study published by RBC Capital Markets in 2011 that points out that since the 1930s, momentum has outperformed value, growth, and the S&P 500.  Value also outperformed the S&P 500, but growth underperformed them all.

RBC Study

Yet, how many allocations remain diversified between growth and value when they might be better off by replacing their growth exposure with momentum?

For example, consider the growth of two sample portfolios from July 1995 – November 2013.  One portfolio is 50% Russell 1000 Growth and 50% Russell 1000 Value.  The other portfolio is 50% Momentum and 50% Russell 1000 Value.

momentum 12.23.13

Source: Russell Investments, Ken French Data Library: Momentum Portfolio is Top Half Market Cap, Top Third Momentum

Over this period of time, the Growth/Value portfolio had an annualized return of 8.84% while the Momentum/Value Portfolio had an annualized return of 11.25%.  It is also noteworthy that the standard deviation was virtually identical for this time frame: 15.85% for the Growth/Value portfolio and 15.84% for the Momentum/Value Portfolio.  For comparison, the S&P 500 had an annualized return of 8.72% and standard deviation of 15.61% over this same time frame.

So where does momentum fit in a portfolio?  Try replacing your growth exposure with momentum and see if your results don’t improve over time.

Dorsey Wright is the index provider for a suite of Momentum ETFs with PowerShares.

Past performance is no guarantee of future returns.  All results above include dividends, but do not include any transaction costs.

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Quote of the Week

December 23, 2013

Mine is not to reason why, mine is just to sell and buy.—-Steve Robbins, DWA Message Board

Steve posted this in response to a thread discussing various monetary and fundamental worries in the current market.  His response indicates his confidence that if a particular market worry manifests itself, it will be reflected in securities prices and can be responded to appropriately at that time.  This is a healthy attitude (I think) because it avoids many of the cognitive biases that harm performance and focuses just on the actual trend in the marketplace.  The trend is your friend, until it ends.  The time to act is when the trend ends—not before, based on your worries.

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The Imprecise Measurement of Valuation

December 23, 2013

Interesting view of valuations from Philosophical Economics:

The only way that you can know what the future valuation of stocks will be–so as to estimate future returns–is to apply some conception of what’s fair, appropriate, reasonable, normal.  But the range of what can be rationalized as fair, appropriate, reasonable, normal is extremely wide, too wide to be useful, and far too wide to provide reliable pushback against a supply-driven market advance.

Say what you will about trend following, but at least the price is not up for debate!

HT: Abnormal Returns

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Weekly RS Recap

December 23, 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 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 (12/16/13 – 12/20/13) is as follows:

perf 12.23.13

For the most part, the best performance came from the top half of the relative strength ranks last week.

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Quote of the Week

December 20, 2013

From our analysts in the 12/19/13 Dorsey Wright Daily Equity Report:

The market cares about what it wants, when it wants, and for this reason we find that listening to the market and following its trends is a better approach than trying to adapt an economic premise to a market prayer.

Without an understanding of this reality, the markets can much more frustrating (and less profitable) than they need to be.

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Developed Int’l Markets (PIZ) Hit Their Stride

December 19, 2013

Developed International Markets have been among the standouts in 2013 and the PowerShares DWA Developed Markets Momentum Portfolio (PIZ) has been particularly strong–outperforming its benchmark by 16%.  Out of a universe of approximately 1000 stocks, this index is designed to select the 100 stocks with the best momentum characteristics (rebalanced quarterly).

PIZ pnf 12.19.13

Through 12/18/2013, PIZ is +29.79% YTD, while its benchmark, the MSCI EAFE Index (EFA) is +13.79%.  Top holdings of PIZ are shown below:

PIZ 12.19.13

Galaxy Entertainment Group Ltd (Hong Kong)

Galaxy Entertainment Group Limited, through its subsidiary, operates casino, hotel and other entertainment facilities in Macau. The company also manufactures sells and distributes construction materials.

Ezion Holdings Ltd (Singapore)

Ezion Holdings Limited, an investment holding company, develops, owns, and charters offshore assets; and provides offshore marine logistics and support services to the offshore oil and gas industries. It owns multi-purpose self-propelled jack-up rigs, which are used in well-servicing, commissioning, maintenance, and decommissioning of offshore platforms.

SJM Holdings Ltd (Hong Kong)

SJM Holdings Limited is the holding company of Sociedade de Jogos de Macau S.A. (“SJM”), one of the six companies authorised to operate casino games of fortune and other games of chance in casinos, under the terms of a concession granted by the government of the Macau Special Administrative Region in March 2002. SJM is the only casino gaming concessionaire with its roots in Macau, and is the largest in terms of gaming revenue and number of casinos.

Sports Direct International PLC (United Kingdom)

Sports Direct is the UK’s leading sports retailer by revenue and operating profit, and the owner of a significant number of internationally recognized sports and leisure brands.  They operate about 400 sports stores in the UK.

Valeant Pharmaceuticals International (Canada)

Valeant Pharmaceuticals International, Inc., a specialty pharmaceutical company, develops, manufactures, and markets pharmaceutical products and medical devices in the areas of neurology, dermatology, and branded generics.

More information about PIZ can be found here.  Performance shown above is price return only and does not includes any transaction charges.  A list of all holdings for the trailing 12 months is available upon request.  Past performance is no guarantee of future returns.

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PowerShares & Dorsey Wright Expand Momentum ETFs

December 19, 2013

Building upon the success of our current line-up of Momentum ETFs, PowerShares announces a new suite of Momentum Sector ETFs and a Nasdaq Momentum ETF:

On December 17th, the Board of Trustees approved name, investment objective, underlying index, and investment policy and strategy changes for the following ETFs. These changes are scheduled to take effect on February 19, 2014:

Momentum

(click to enlarge)

“As with our existing PowerShares DWA Momentum ETF lineup, these portfolios will be based on momentum strategies as measured by Dorsey Wright’s definition of relative strength characteristics,  which can be a powerful tool for stock selection,” said Lorraine Wang, Invesco PowerShares global head of ETF products and research. “The momentum indexes were developed by Dorsey Wright who we believe remains a leader in relative strength investing.”

Very exciting news!  We will be talking much more about these new ETFs in the coming weeks.

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Fund Flows

December 19, 2013

Mutual fund flow estimates are derived from data collected by The Investment Company Institute covering more than 95 percent of industry assets and are adjusted to represent industry totals.

ici 12.19.13

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Relative Strength Spread

December 18, 2013

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 12/17/2013:

spread 12.18.13

The rising RS Spread continues to reflect the generally favorable environment for relative strength strategies.

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The Simplicity of Relative Strength

December 16, 2013

One of the ongoing difficulties for investors is finding some kind of simple method for investing.  Relative strength is just such a simple method.  Even simple methods, however, have to be applied!

Tadas Viskanta from Abnormal Returns writes:

…having a plan, even a sub-optimal one, that you can stick to is preferable to having no plan at all. The ongoing challenge for advisors and investors alike is to find a plan that they will not abandon at the first sign of trouble.

That’s an important point.  If you can’t follow a method because it is too complex and if you bail in panic during the first downturn, you’re not going to succeed with any method.

Abnormal Returns revisited this theme recently, in connection with a discussion about systems versus optimization.  Mr. Viskanta pulled a quote from Scott Adams:

Optimizing is often the strategy of people who have specific goals and feel the need to do everything in their power to achieve them. Simplifying is generally the strategy of people who view the world in terms of systems. The best systems are simple, and for good reason. Complicated systems have more opportunities for failure. Human nature is such that we’re good at following simple systems and not so good at following complicated systems.

This has a great deal of applicability to the investing process.  Simple systems are generally more robust than complex systems, and relative strength is about as simple as you can get.  Relative strength is not an optimized system—like most simple systems, it will make plenty of mistakes but its simplicity makes it robust.  (I would note that Modern Portfolio Theory relies on mean variance optimization to construct the “ideal” portfolio.  Optimized systems are both complicated and fragile.)

In practice, complicated systems tend to blow up.  Robust systems are generally more resilient to failure, but will certainly struggle from time to time.

Human nature, I think, makes it difficult to follow any system, whether simple or complex, so discipline is also required.  Investors will improve their chances for success with a simple, robust methodology and the discipline to stick with it.

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Weekly RS Recap

December 16, 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 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 (12/9/13 – 12/13/13) is as follows:

ranks 12.16.13

High relative strength stocks generally held up better than the universe and than the laggards last week.

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50+ Years of Corporate Profits

December 9, 2013

If you are obsessed with the Fed’s balance sheet, Congress, Nouriel Roubini, or any of the many other doomsayers, you might want to print out this chart of corporate profits to refer to from time to time.  Corporate profits continue to climb.

Since this chart is done on a logarithmic scale, it suggests that corporate profits are rising at a pretty steady constant percentage rate.  I’m sure the composition of corporate profits has changed—which companies are producing them—over time, but American business seems to be remarkably resilient.

Source: St. Louis Fed  (click on image to enlarge)

There have been plenty of periods where corporate profits have declined or been stagnant.  There have been a few periods where corporate profits grew at sustained high rates.  Both have tended to regress toward the mean.  If you take out all of the zigs and zags, you can see that corporate profits have continued to grow at a pretty steady underlying rate.  There’s lots of year-to-year variability, but it’s a somewhat more hopeful view than a constant “sky is falling” outlook.

Keep in mind that when you buy stock, you are buying a share of the corporate profits too.  If corporate profits continue to rise over time, share prices should participate as well.

In the long run, the optimists tend to win.

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Quote of the Week

December 9, 2013

The best investors in the world have more of an edge in psychology than in  finance.—-Morgan Housel, Motley Fool

 

This is so true!  Most investing problems are behavioral, so having an edge in psychology is very meaningful.  You will tend to do well if you are more disciplined (less panicky) and more patient than your competition.  This quote is from a longer article that I saw featured on Business Insider.  You can read the whole list here.

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November Arrow DWA Funds Update

December 6, 2013

11/30/2013

The Arrow DWA Balanced Fund (DWAFX)

At the end of November, the fund had approximately 47% in U.S. Equities, 25% in Fixed Income, 17% in International Equities, and 11% in Alternatives.

U.S. equities pushed to another all-time high in November and remain the dominant asset class from a relative strength perspective.  U.S. equities continue to be our biggest weighting in the fund.  All three of our sector positions (Consumer Services, Health Care, and Financials) outperformed the broad market in November.  We also continued to see strong performance in our style positions (Mid-Cap Value and Small-Cap Value).  Developed International Markets continued their outperformance versus Emerging Markets in November and all five of our international positions are from developed markets.

Our fixed income holdings were essentially flat in November and this asset class remains near the lower end of its exposure constraint.  Our exposure to Alternatives (MLPs and Currencies) was also relatively flat for the month.  Other Alternatives like precious metals (which we do not currently own) had steep losses for the month and remain among the weakest asset classes.

Stable leadership has been a theme in 2013 and relative strength has capitalized.

DWAFX rose 1.48% in November, and is up 14.18% through 11/30/13.

We believe that a real strength of this strategy is its balance between remaining diversified, while also adapting to market leadership.  When an asset class is weak its exposure will tend to be towards the lower end of the exposure constraints, and when an asset class is strong its exposure in the fund will trend toward the upper end of its exposure constraints.  Relative strength provides an effective means of determining the appropriate weights of the strategy.

dwafx 12.06.13

The Arrow DWA Tactical Fund (DWTFX)

At the end of November, the fund had approximately 90% in U.S. equities and 9% in International equities.

According to Morningstar, this fund is outperforming 95% of its peers YTD.  One of the dominant themes in the market in 2013 has been small and mid-cap stocks outperforming large caps.  Approximately half of the holdings of the fund are in either small or mid-caps as a result of their strong relative strength.  We also had strong performance from our sector positions in November (Healthcare, Industrials, and Consumer Services), all of which outpaced the broad market for the month.

Our one position in international stocks is focused on Eurozone stocks.  The position was up in November, but largely lagged U.S. equities.

Part of risk management is being able to capitalize in strong equity markets and this fund has certainly done that this year.

DWTFX was up 2.97% in November, and has gained 23.26% through 11/30/13.

This strategy is a go-anywhere strategy with very few constraints in terms of exposure to different asset classes.  The strategy can invest in domestic equities, international equities, inverse equities, currencies, commodities, real estate, and fixed income.  Market history clearly shows that asset classes go through secular bull and bear markets and we believe this strategy is ideally designed to capitalize on those trends.  Additionally, we believe that this strategy can provide important risk diversification for a client’s overall portfolio.

DWTFX 12.06.13

A list of all holdings for the trailing 12 months is available upon request.

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Real Returns on Bonds

December 6, 2013

First Trust’s Bob Carey had a blog post of couple of months ago that examined the real return on bonds.  (I encourage you to read the whole post because he also had some interesting comments.)  Bonds, I think, are a pretty good diversifier because they can often reduce overall portfolio volatility.  But there’s not much real return—return after inflation—in bonds right now.

Source: First Trust  (click on image to enlarge)

In 2011, in fact, you have evidence of a bond bubble.  Even in the TIPs market, expected real returns were negative for a period of time.  When investors are willing to buy an asset expecting to lose purchasing power, well, that seems a little crazy.  Right now, expected real returns are still quite low.

If inflation drops from here, maybe things will work out.  If the stock market has a significant decline, holding bonds might turn out to be the better alternative.  But if real returns go back to their historic norms, there may be more turmoil ahead in the bond market.  There’s no way to know what will happen going forward, of course, but it’s probably a good idea to know where you stand relative to history.

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Fund Flows

December 6, 2013

Mutual fund flow estimates are derived from data collected by The Investment Company Institute covering more than 95 percent of industry assets and are adjusted to represent industry totals.

ici 12.06.13

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A Tactical Approach to Portfolio Management

December 5, 2013

Click below to hear Tom Dorsey explain “A Tactical Approach to Portfolio Management.”  This webinar includes an introduction to The Arrow DWA Balanced Fund (DWAFX), The Arrow DWA Tactical Fund (DWTFX), and an implementation idea that combines these two funds with our four PowerShares DWA Momentum ETFs.  (Financial Professional only)

DWA_Arrow

See www.arrowfunds.com and www.powershares.com for more information.

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