Systematic Relative Strength

A key reason that the markets can be so frustrating to investors is that many of the relationships that investors believe should hold true, in fact, do not. Take the relationship between GDP growth and stock market performance. Many assume that investing in stock markets from economies with high economic growth rates should lead to favorable investment results. As Institutional Investor explains, that has just not been the case:

Many investors in emerging markets believe that identifying the fastest-growing economies is the key to finding higher returns. But while this approach has been effective in fixed-income investing, our research shows that it’s fairly useless for guiding country selection in developing-market equities.

Imagine that it’s the early 1990s and your crystal ball has identified an emerging-markets nation whose economy is on the cusp of growing more than 20-fold over the next two decades. You’d probably think you had found the investment winner of a lifetime. But you’d be wrong. That country was China. Despite compound annual gross domestic product (GDP) growth of 15 percent since 1992, Chinese stocks fell by an annualized 2 percent through December 31, 2013 (see chart below).

Now, what if the same crystal ball also — correctly — predicted that Mexico was headed for low-single-digit GDP growth over that same 20-year period? You’d likely look for better investment opportunities elsewhere. And you’d be wrong again. Mexican stocks have delivered annualized gains of more than 18 percent since 1992, placing them among the period’s best performers, despite 2.4 percent annual GDP growth.

For comparison, the following table shows the country holdings, weight in the index, and GDP growth of the PowerShares DWA Emerging Markets Momentum ETF (PIE). Clearly, we are not weighting the index by GDP growth:

Rather, this index is constructed by using Point & Figure relative strength analysis on a universe of approximately 1,000 emerging markets stocks. From that universe, we select the 100 stocks with the most favorable relative strength characteristics. Again, price is the only input to the rankings.

I often use the following quote, written by one of our analysts, to explain our, admittedly, much more pragmatic approach to investing:

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.

Perhaps some take our “single-factor” approach to investing as overly simplistic, but to us, price encompasses all relevant information for an investor. And the results have been compelling. For example, the three ETFs for which Dorsey Wright is the index provider and have been out for the past 5 years (PDP, PIZ, and PIE), all are the top strategies in their respective categories over the past 5 years.

Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss. This example is presented for illustrative purposes only and does not represent a past recommendation. All holdings for the past 12 months are available upon request. The relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value. See www.powershares.com for a prospectus.