It would be easy to look at the disconnect between the S&P 500 and its components and see it is a sign of trouble ahead. But there is another explanation as to why the market has been relatively stable: Stocks have become increasingly less likely to move in the same direction as the S&P 500. There’s a measure for this—implied correlation. Implied correlation measures how much options traders expect any given individual stock to trade in lock-step with the benchmark.
In bad times, implied correlation surges higher, approaching 100%, as it did during the financial crisis, when it didn’t matter what you owned, everything was falling. When implied correlation falls, it means that investors are more inclined to trade each stock according to its own merits. And wouldn’t you know? Last week, implied correlation fell below 43% for the first time since 2008.
Posted by: Andy Hyer
Barron’s points out that investors who focus solely on yield may be more susceptible to value traps:
Owning an investment for its dividend doesn’t relieve you of the other, hidden exposures of the asset. Value, growth, quality, junk, etc.: You’ve made a choice whether you realize it or not.
Pankaj Patel, quantitative strategist at ISI Group, highlighted one risk for clients this week:”Dividend yield as a factor is susceptible to value traps. To use dividend yield as a factor for stock selection it needs to be combined with other factors.”
We have found that combining yield with relative strength has been effective at leading us to those stocks that not only have high dividend yields, but are also technically strong. Click here to read more about why we use rankings based on total return (price + yield) to identify holdings for the First Trust DWA Relative Strength Dividend UITs.
Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss. See http://www.ftportfolios.com for more information.
Posted by: Andy Hyer
From Barron’s, an interesting insight into the alternative space:
Investor interest in hedge-fund strategies has never been higher—but it’s the mutual-fund industry that seems to be benefiting.
Financial advisors and institutions are increasingly turning to alternative strategies to manage portfolio risk, though the flood of money into that area tapered off a bit last year, according to an about-to-be-released survey of financial advisors and institutional managers conducted by Morningstar and Barron’s. Many of them are finding the best vehicle for those strategies to be mutual funds.
Very intriguing, no? There are quite a few ways now, through ETFs or mutual funds, to get exposure to alternatives. We’ve discussed the Arrow DWA Tactical Fund (DWTFX) as a hedge fund alternative in the past as well. Tactical asset allocation is one way to go, but there are also multi-strategy hedge fund trackers, macro fund trackers, and absolute-return fund trackers, to say nothing of managed futures.
Each of these options has a different set of trade-offs in terms of potential return and volatility. For example, the chart below shows the Arrow DWA Tactical Fund, the IQ Hedge Macro Tracker, the IQ Hedge Multi-Strategy Tracker, and the Goldman Sachs Absolute Return Fund for the maximum period of time that all of the funds have overlapped.
(click on image to enlarge)
You can see that each of these funds moves differently. For example, the Arrow DWA Tactical Fund, which is definitely directional, has a very different profile than the Goldman Sachs Absolute Return Fund, which presumably is not (as) directional.
Very few of these options were even available to retail investors ten years ago. Now they are numerous, giving individuals the opportunity to diversify like never before. With proper due diligence, it’s quite possible you will find an alternative strategy that can improve your overall portfolio.
Posted by: Mike Moody
Ray Dalio of Bridgewater Associates is an interesting and pragmatic economic thinker. He had a recent interview with Barron’s, in which he described the deleveraging process in the US as “beautiful.” Here’s a snippet:
A beautiful deleveraging balances the three options. In other words, there is a certain amount of austerity, there is a certain amount of debt restructuring, and there is a certain amount of printing of money. When done in the right mix, it isn’t dramatic. It doesn’t produce too much deflation or too much depression. There is slow growth, but it is positive slow growth. At the same time, ratios of debt-to-incomes go down. That’s a beautiful deleveraging.
We’re in a phase now in the U.S. which is very much like the 1933-37 period, in which there is positive growth around a slow-growth trend. The Federal Reserve will do another quantitative easing if the economy turns down again, for the purpose of alleviating debt and putting money into the hands of people.
We will also need fiscal stimulation by the government, which of course, is very classic. Governments have to spend more when sales and tax revenue go down and as unemployment and other social benefits kick in and there is a redistribution of wealth. That’s why there is going to be more taxation on the wealthy and more social tension. A deleveraging is not an easy time. But when you are approaching balance again, that’s a good thing.
What makes all the difference between the ugly and the beautiful?
The key is to keep nominal interest rates below the nominal growth rate in the economy, without printing so much money that they cause an inflationary spiral. The way to do that is to be printing money at the same time there is austerity and debt restructurings going on.
It’s interesting that he seems pretty satisfied with the process the US has taken so far, in the sense that we may avoid significant inflation or deflation. The deleveraging process won’t be easy socially or economically, but it’s certainly preferable to a Japan-type scenario. His opinion is interesting to me because so many other commentators are falling into the doomsday camp, although half are expecting Japan-style deflation and the other half are counting on Weimar-style inflation.
I suppose it is human nature to worry about the worst thing that can happen, but Mr. Dalio suggests a middle path might be the most realistic.
Posted by: Mike Moody
Some time after 2008, Lou Harvey, the founder of DALBAR, did an interview with Barron’s. He discussed what had been learned in the 2008 bear market. It’s worth thinking about, especially his advice on what seemed to work. I’ve got some nice excerpts, but you can read the whole interview here.
In your study you point out that in spite of the “catastrophic” losses in 2008 “belief in modern portfolio theory has inexplicably remained strong.” MPT is grounded in the belief that asset classes are “predictably uncorrelated.” Because MPT is no longer good for all seasons you relegate it to one of several things investors need to consider.
Modern portfolio theory was pioneered by Harry Markowitz in a 1952 paper published in the Journal of Finance. It posited the construction of an “efficient frontier” of optimal portfolios offering the maximum possible expected return for a given level of risk. MPT is a principle-based investment strategy whose basic idea is that better returns can be produced if a portfolio’s holdings are diversified among different asset classes. The idea: to take advantage of the varying directions as each asset class fluctuates.
Nothing’s wrong with MPT. It’s how people use it. What is needed is a back-up plan to protect investors when the theory fails. And it will most likely happen again.
The pushback to our latest report has been strong. Who are we to criticize MPT, devised by a Nobel Prize winner? But this is our research and we stand by what we’ve found. I have lots of scars on my back to prove it. And I’m sure that after talking to you I’m going to get more. Investment results in 2008 showed clearly that correlation of asset classes varied unpredictably and with no warning. This brings into question the very basis for MPT and its ability to forecast an efficient frontier. MPT simply cannot be used in isolation. Instead it should be thought of as only one reference point for modeling the behavior of a potential portfolio. It is only one dimension of a more comprehensive investment-management process.
What’s the most important finding in your recent research?
For me the biggest recent issue stems from the 2008 market meltdown that defied many of the core beliefs in the financial community—the core belief that asset classes are not correlated. When stocks go down, bonds go up. So might real estate. By holding a little bit in each basket, the investor will make steadier returns and avoid losses. We found out that all of the methods based on modern portfolio theory worked within a certain range. Outside of that range, they all failed.
I added the bold. I’m not sure that a theory can be said to have worked if it fails repeatedly under extreme conditions, so I differ with Mr. Harvey on that. As another pundit said recently, it’s like having a seatbelt that only fails when you have a crash. Of more practical interest is his observation of what did work for investors.
We surveyed investors who outperformed in the crisis and tried to glean from them points to ensure success.
One I particularly like is to take your portfolio out and parse it out into smaller, purpose-driven components, and treat each component separately. Money you can’t afford to lose should not be put into the stock market, but rather in something else that guarantees repayment. It could be an annuity. It could be high-quality bonds. The approach functions on the different ways investors look at their holdings. You look differently at money you have set aside for a gay old time on the Riviera than you do at the money you use for breakfast tomorrow. Each basket should define the risk one should take in the market.
DALBAR’s always done interesting work and their research on investor returns versus NAV returns is now legendary. Here, Mr. Harvey suggests that investors who outperformed in the crisis were those who divided their money into buckets of differing volatilities. This is a psychological trick gleaned from behavioral finance—just a different way of looking at the same allocation. We’ve written about this before, but his observation suggests that it works in practice, not just in theory.
Best practices seem to suggest a belief in supply and demand rather than modern portfolio theory, and ratify the idea of using volatility buckets for clients.
Posted by: Mike Moody
In this Barron’s article from 2010, battle lines over fiscal policy are discussed:
Dylan Grice, part of the provocative strategy team at Societe Generale, sees the world split between the cognitive dissonance expressed by President Obama. On one side is what Grice terms the “Keynesian/Krugmanist” faction decrying any withdrawal of fiscal stimulus while conditions remain parlous.
On the other are those worried about government debt, represented by Axel Weber, “the hard-money Bundesbank president who voted against the [European Central Bank's] bond purchase and has been most vocal on the need for fiscal prudence,” Grice writes in his “Popular Delusions” letter.
The fear of both is that the wrong fiscal policy is chosen and we either drown in debt or deflate in a slow growth environment. Some commentators are quoted on what might happen if the economy stagnates:
Yet even while the benchmark 10-year Treasury note yields remains solidly under 3%, at 2.91%, Gluskin-Sheff’s David Rosenberg points to the extraordinarily wide gap of nearly 1% between the 10- and 30-year maturities. Even at a sticker-shock 3.87% yield, he sees scope for further declines in the long bond’s yield.
Based on a new report from the Cleveland Fed, Rosenberg reckons the 10-year yield could “ultimately grind down” to 1.90% with inflation basically nil. Given its historical spread over inflation, the 30-year bond yield could get down to 2.30% –40% less than the current yield.
While fears of a double-dip recession in 2010 were high, the economy continued to grow slowly. Near the end of 2011, the economy actually seemed to accelerate a bit, to the point where some pundits are now worried about inflation again. And what happened to bond yields?
Source: WSJ (click to enlarge image to full size)
Oh, yeah. They went to around 2% anyway. Although we’ve had slow, steady economic growth, bond yields have just continued to fall—making both groups of forecasters notable in getting it wrong, or right for the wrong reasons.
No one’s fears were ever realized. The economy has not imploded nor have we yet drowned in debt. Maybe one or both of these things will eventually come to pass, but forecasters aren’t likely to get that right either!
Investors could have let either bad scenario freeze their investment policy, worried that outcomes A or B would have a negative effect on the market. Instead, we got outcome C and, by the way, the S&P 500 has gone up more than 30%. Ignore the hopes and fears of forecasters and stick to what market prices are telling you. Relative strength is almost always your most reliable guide.
Posted by: Mike Moody
Missing the forest for the trees is, of course, a well-known and common problem. Less well-known perhaps is the opposite problem: missing the trees for the forest.
Barron’s takes on this issue when it points out that excessive worry about the market and the economy (forest) can prevent you from noticing the plethora of good stocks around (trees). Even if the economy is crummy and returns from the market are not enticing, there may be plenty of opportunity.
…why do investors accept a return that is guaranteed to lose out to inflation for the safety of principal on U.S. government debt when they could garner payouts from blue-chip companies that ought to keep pace or exceed inflation and presumably provide capital growth?
The fact is that macroeconomic data and policies to influence the economy are having little impact on what’s really important to equity investors, corporate performance. Yet rarely has there been more attention focused on macroeconomic data and policy decisions.
Clearly, the solution is to focus with blinders on what really matters to equity investors — earnings and dividends, and the price they pay to participate in those sums.
The reason for this, writes David P. Goldman, former head of credit research at Bank of America, is there are two U.S. economies. “One is dead in the water and the other is doing reasonably well,” according to a special study he’s published.
There is no single, aggregate economy. Las Vegas housing or Italy’s economy are apt to remain in the toilet while large U.S. corporations that populate the Standard & Poor’s 500 are doing quite well, he observes.
Corporate performance has been exceptional—I added the bold type above. Barron’s point is especially relevant to those firms (like Dorsey, Wright) that run relatively concentrated portfolios. It takes finding only a few big winners and letting them run to boost returns across the entire portfolio. The general background is always relevant, but it is in the specific and concrete implementation that money is made.
The big picture is important, but make sure you are not missing the trees for the forest.
Posted by: Mike Moody
Our PowerShares DWA Emerging Markets Technical Leaders fund (PIE) received some nice coverage from Barron’s this week. The cover story is “Emerging Markets” and they had the following to say about PIE:
Of course, anyone looking to pare risk can buy an exchange-traded fund that tracks the MSCI index. The cheapest option is the Vanguard MSCI Emerging Markets fund. But the best-performing is PowerShares DWA Emerging Markets Technical Leaders fund, which is up 12.7% over the last 12 months and has fallen only 4.1% since Jan. 1. PowerShares owns just 100 stocks, but they are spread out across the Dorsey Wright Emerging Markets Technical Leaders Index, from Russia to Peru. That shows high conviction in markets as turbulent as these.
See www.powershares.com for more information about PIE.
Posted by: Andy Hyer
Markets are undergoing a lot of changes in traditional relationships right now. For example, Barron’s reports that corporates are the new Treasurys:
U.S. government debt is priced in the credit-default swap (CDS) market as having a higher-default risk than 22% of investment-grade corporate bonds. This means the CDS market, which influences the prices of corporate bonds, stocks, and the implied volatility of equity options, perceives Treasuries to be riskier than bonds issued by companies including Coca-Cola (ticker: KO), Oracle (ORCL) and Texas Instruments (TXN).
“This suggests corporates are the new sovereigns,” Thomas Lee, J.P. Morgan’s equity strategist, advised clients in a research note late last week, referring to corporate debt.
The phenomenon is also evident in Europe. J.P. Morgan’s Lee notes that 100% of corporate-debt issuers in Spain, Greece, and Portugal trade inside their government CDS spreads, while 60% of Italian corporate bonds trade inside that government’s spreads.
Historically, sovereign debt –bonds issued by governments – were considered low risk because governments can raise taxes or print money to pay their bills. During the credit crisis of 2007, governments all over the world printed money, and slashed interest rates to rescue the financial system, and are now saddled with massive debts. Now, some corporations might be financially healthier than governments.
There are also sharp changes in historical relationships going on in the commodity world, according to Reuters:
According to fund flows research company EPFR Global, commodity sector funds that invest in physical products, futures or the equities of commodity companies such as miners, attracted $1.465 billion in net inflows globally in the first two weeks of July.
The push into commodities in July reverses a trend in the second quarter, when investors pulled a net $3.9 billion out of commodities, according to Barclays Capital.
The move explains a divergence of stocks and commodities, with correlation dropping from more than 80 percent positive to around 40 percent negative over the past two weeks.
“Commodities could be seen in some ways as the least-worst option, given what is happening with other markets,” said Amrita Sen, an oil analyst at Barclays Capital who looks closely at fund allocations into commodities. “Some investors have not liquidated positions in commodities, while they have exited some other asset classes such as equities.”
All of the machinations with the debt ceiling and the associated market dislocations have posed a number of important questions for investors.
Q1) What happens to traditional asset allocations when traditional relationships break down?
Q2) How can we tell if the dislocations are a result of temporary factors or represent a permanent paradigm shift?
No one has all of the answers, least of all me, but a couple of things occur to me.
A1) The same thing that always happens when these ephemeral relationships change—your allocation doesn’t behave anything like you thought it would. Although the current uncertainties have highlighted the issues above, this kind of thing happens all the time. In the current investment hierarchy, debt is seen as safer than equity because it is higher up in the capital structure—but that’s only true for a corporate balance sheet. Sovereign debt always depends on the willingness of the sovereign to repay it. Anyone who is old enough to be familiar with the term “Brady Bonds” knows what I am talking about. If 100% of the corporate debt issuers in Spain trade inside the government debt spread, it’s not inconceivable for the same thing to happen in the US. In other words, there’s no a priori reason for government debt to be safer than other debt.
What about commodities then? Strategic asset allocation usually treats them like poor cousins, giving them a small seat at the children’s table. What if they really are the “least worst option” and deserve a major slice of the portfolio due to their performance? After all, commodities are at least tangible and do not rely on the willingness of a sovereign to be worth something. What if the correct safety hierarchy is a) high-grade corporate debt, b) equity in companies with growing revenues, earnings, and dividends, c) commodities, and d) sovereign debt, especially in countries with a ton of obligations and a sketchy political process?
A2) We can’t. That’s one of the issues with a paradigm shift—at the beginning, you can’t tell if it is temporary or permanent. Around 1900, it looked like the US might supplant the UK as the world’s industrial power. That turned out to be lasting. Around 1990, it looked like Japan might supplant the US as the world’s industrial power. That turned out to be temporary. Around 2010, it looked like China might supplant the US as the world’s industrial power—and we have no idea right now if that is a temporary conceit or will become a permanent feature of the landscape.
Constantly changing relationships along with an inability to distinguish between a temporary and a permanent state of affairs, to me, argues strongly in favor of tactical asset allocation. It simply makes sense to go where the returns are (or where the values exist, depending on your orientation). Money always goes where it is treated best, and if you wish to win the battle for investment survival, you would be well-advised to do the same thing.
Posted by: Mike Moody
The always-terrific Barron’s has a nice interview with Dennis Stattman, head of the Blackrock Global Allocation Fund, one of our value-oriented competitors in the global asset allocation arena. He’s done a terrific job for many years, and his value-oriented approach turns out to be a very good complement to our relative strength approach. (For full articles on this topic, see Global is the New Core and The “All-in-One Fund” With a Twist.) For me, the highlight of the interview was this exchange about the role of global go-anywhere funds:
Barron’s: There’s been a lot more money flowing into asset-allocation funds that can invest in many different styles, including the fund you run. What’s your take on this trend?
It isn’t surprising that the category is growing in popularity. It reflects the frankly dismal job that the most popular category, equity-only mutual funds, have done, as shown by the dismal results they have delivered to investors over long periods of time. They just haven’t provided a good risk-return trade-off. Furthermore, the idea that somebody can buy six different U.S. stock funds and somehow achieve useful diversification just isn’t an effective idea. It never was a good idea, and now it has been proved wrong. So having the ability to go anywhere is what, ideally, a fund manager should have. But there are very, very few individuals or teams who have the experience and who are equipped to do this.
I wholeheartedly concur with his remark on style-box diversification being completely inadequate, but I think the problem is not with equity-only mutual funds, but rather reflects the issue of poor portfolio construction. Too often portfolio construction has focused on assets (as in asset allocation) on not on diversification by strategy. Value and relative strength work well together because they are essentially strategic opposites: relative strength is trend following, and value is mean-reverting. It’s not too surprising that their excess returns are uncorrelated, but that makes them a wonderful blend for a client portfolio.
Lots of clients own Blackrock Global Allocation, but how many of them know how much their portfolio can potentially be improved with the addition of our Global Macro strategy?
To obtain a fact sheet and prospectus for the Arrow DWA Tactical Fund (DWTFX) or the Arrow DWA Balanced Fund (DWAFX), click here.
Posted by: Mike Moody
From Barron’s today:
Morgan Stanley analysts checked out some mid-tier department stores and found that the prices of cotton goods like towels, denim, dress shirts and and sheets were up 20% on average.
Who is paying for Mr. Bernanke’s dress shirts when he testifies on Capital Hill? 20% is not a moderate price increase—it’s a big one. If inflation ramps up, investors may find they need a flexible strategy that may preserve purchasing power even in a difficult environment. How many investors even think explicitly about purchasing power?
Posted by: Mike Moody
Barron’s points out that CALPERS, the state pension system could have done better last year owning SPY. CALPERS made 12.5% last year. The state teacher retirement system, CALSTRS, did slightly better, earning 12.7%. But SPY returned more than 14.4%.
This neglects the fact that SPY is all equity and CALPERS is a balanced fund. The S&P balanced ETF that Barron’s mentioned, AOR, returned 11.1%.
I have a modest proposal. Maybe CALPERS should just put their $228 billion into the Arrow DWA Balanced Fund (DWAFX). It has bonds for stability, domestic and international equities for growth, and alternatives for diversification. And the return last year was 16.08%, beating CALPERS, CALSTRS, SPY, and AOR.
Is anyone is Sacramento listening? Heck, we could make do with even $5 billion. We can dream, can’t we?
Click to enlarge. Source: Yahoo! Finance
Posted by: Mike Moody
Michael Santoli highlights the similarities between 2004 and 2010 in his Barron’s column over the weekend:
The year 2004 has served as a useful, if imperfect, touchstone here for at least a year. Some parallels are eerie, some are mere diverting coincidence. As 2004 opened, the Standard & Poor’s 500 index had rallied ferociously off a March bear-market low and sat at 1112; this year it began at 1115, having surged even further from its March 2009 bear-market trough.
In ’04, it knocked around a narrow path until a late-year rally carried it above 1200 to 1211. This year the ride was similar, if more dramatic, rallying into April and then dropping quickly by 17%, before the late-year rally carried it back above 1200, to a current 1243.
In both years, the consensus entering the year was that Treasury yields should rise and the market would remain volatile. In both years, the 10-year Treasury yield, while jumpy, hardly budged from start to finish, and market volatility plummeted all year, reflecting the numbing effects of heavy liquidity.
Then, as now, the market was up respectably, yet finished at a valuation lower than where it started, with corporate earnings advancing far more than share prices did, even as profit growth was about to decelerate sharply.
And the psychology on Wall Street now is pretty close to where it was a few years ago—mostly bullish, with a growing collective belief that things have turned for the better, after months of mass frustration over the unsatisfying pace of economic recovery.
My boldface emphasis added. If the psychology of market participants today is similar to that seen at the end of 2004, it could bode well for relative strength strategies in 2011 as investors increasingly gain confidence in market leadership. As shown in the chart below, 2005 was a very good year for relative strength strategies with our High RS Index gaining 16% while the S&P 500 was up only 3%.
(Click to Enlarge)
“High RS Index” is a proprietary Dorsey, Wright Index composed of stocks that meet a high level of relative strength. The volatility of this index may be different than any product managed by Dorsey, Wright. The “High RS Index” does not represent the results of actual trading. Clients may have investment results different than the results portrayed in this index. Past performance is no guarantee of future results.
Posted by: Andy Hyer
Kate Welling is a terrific financial journalist and has had a sterling reputation for years, on her own and at Barron’s. In my opinion, she has just burnished it with this tremendous interview with former Federal Reserve and current Nomura economist Richard Koo. Koo’s book, The Holy Grail of Macro Economics, Lessons from Japan’s Great Recession, discusses how a balance sheet recession is different from a typical cyclical recession. It’s a long article, but you’ve got to read the whole thing to really understand his thesis. This is a five-star article, in my opinion.
Koo’s argument is that in a balance sheet recession, businesses and consumers direct their free cash flow toward paying down debt and saving, rather than on maximizing profits. Koo’s thesis has visceral appeal: we’ve all seen this happening on a micro level within our own circles of acquaintances. During the deleveraging process, the typical rules of macroeconomics and monetary policy do not apply. For example, cutting interest rates should, in theory, stimulate loan demand and thus stimulate the economy. But even with U.S. interest rates near zero, there is no loan demand. Why? Koo’s contention is that, although it may be partly because of a lack of creditworthy borrowers, it’s largely because people are busy rebuilding their balance sheets–they are not interested in borrowing money at any price, even a low one. Koo’s interview is the first discussion I’ve seen by an economist that explains this phenomenon very well–because it also happened in Japan after their asset bubble burst in 1989.
Here’s where it gets interesting: there could be lots of unintended consequences in the market if policy levers do not operate as expected. Assuming that action x will lead to outcome y in the way we are used to expecting may not be applicable. Basing investment decisions on such assumptions could be very dicey. Using relative strength to power a trend-following process may be very useful, since trend following does not require any assumptions about policy outcomes. Global currency relationships may also become prominent as different countries respond to their situations in various ways. We’ve already seen this to some degree with the Euro/Dollar cross during the Greek situation. With policy responses in flux and with unpredictable outcomes potentially in store, a systematic global tactical asset allocation process may be the best defense for investors.
Posted by: Mike Moody
No, this isn’t the price level on some new-fangled unweighted index. It’s the number of views we’ve had of our blog over the past year or so. In the meantime, we have garnered positive reviews from Barron’s and numerous referrals from other respected websites like Abnormal Returns and World Beta. We appreciate that you and thousands of other investors have made our blog into one of your financial sites of choice and one of the thought leaders in relative strength investing. We will try to continue to provide you with original content, articles, and news pertaining to relative strength and global trends, and to continue to give you our unique spin on the relative strength style of investing.
When I wrote a similar post, DWA 25,000, I mentioned that we wanted to deliver even more value down the road in the form of audiovisual presentations. We’ve done that with new podcasts and on-screen presentations. Check them out! Another valuable and educational feature has been our white papers on important topics like asset class rotation. In everything we do, our intent is to inform, entertain, and provoke thought and discussion. We think we are succeeding, but if you have constructive feedback, we’d love to hear from you. Success is never final and we’re always looking for ways to improve.
Posted by: Mike Moody
Our blog received a nice recommendation from Michael Santoli in his May 3rd Barron’s article, The Provisional Pullback:
MOST OF US, IN THIS ONLINE AGE, are hummingbirds of media consumption, flitting from flower to flower for the promise of a little nourishment, expending much energy to travel not very far. So it’s no surprise that the requests come constantly for recommendations for sites worth reading on market-relevant matters. The quick and easy answer is that everything is worth reading if one approaches it in the proper context, but time constraints require shortcuts and edited research itineraries.
An excellent gateway to the daily bounty (or burden) of economic and financial writing is www.RealClearMarkets.com. There’s a barely perceptible pessimistic bias in the arrayed daily links, but on the whole it’s a fine way to get current on the chatter animating the market.
Passionate, cogent and opinionated periodic commentary on financial and related policy matters can be found at www.StumblingOnTruth.com, a blog by Cliff Asness, who runs the quantitative asset manager AQR Capital Management. If there is a cleverer phrasemaker or clearer thinker among finance Ph.D.s than Asness, he or she is a stranger to my Web browser. Be sure to check out his latest riff on the Goldman/credit crisis inquest, “Keep the Casinos Open.”
For worthwhile color commentary on the day-to-day market action, featuring links to more eclectic research as well, close market watchers should check out http://systematicrelativestrength.com, run by the folks at the technical-analysis firm Dorsey Wright & Associates, and www.tradersnarrative.com.
Finally, the quarterly letters of Jeremy Grantham of asset manager GMO are a fun and thought-provoking read. The latest, at www.gmo.com, is noteworthy mainly for a non-consensus view of what would be the gravest long-term risk to markets and the economy. Grantham makes the case that a halting, uncertain economic recovery that would embolden the Federal Reserve to keep monetary policy hyper-easy could produce another bubble in risk assets, driving stocks toward the old highs and then ultimately collapsing, at a time when governments would lack the wherewithal to mute the effects.
For balance, note that Laszlo Birinyi of Birinyi Associates offers a dismissive take on Grantham’s thinking in his own highly readable and caustically contrary monthly newsletter (offered by subscription only, but alluded to on his firm’s blog, www.tickersense.typepad.com).
Posted by: Andy Hyer
“I don’t want to spend my time dealing with jet charters, dog-walking or bill paying. I want instead to concentrate on asset allocation and manager selection — that is more than a full-time job,” he says. “To say I can do more than that is not being honest about my capabilities.”
Barron’s notes that Pfeifler currently has $4.8 billion in assets under management.
It is so easy for financial advisors to fall into the trap of being a jack of all trades, master of none. Yet, the best in the industry find out where they excel and outsource the rest.
Posted by: Andy Hyer
“We think asset allocation, certainly over the next five to 10 years, begs for a tactical component that is very hard for many investors to deal with because they aren’t structured to think about macro things like equity exposure…” Ah, yes. Now everyone is singing the praises of tactical asset allocation. The quotation above is from a major article in Barron’s over the weekend, which is an interview with Mark Taborsky, the head of asset allocation at PIMCO. (subscription required) If you don’t get Barron’s, at the very least you might want to borrow a friend’s copy and take a look at the interview.
Tactical asset allocation is gaining notice because it is a very useful way to navigate what markets are actually doing, instead of what they should be doing in theory. Taborsky says, “The majority of people who use the modern-portfolio-theory approach — and it has been with us for more than 50 years — recognize that it has many shortcomings. Anyone who has done it more than a year recognizes how far off their estimates of expected returns are by asset class and how far off their expectations of volatilities and correlations are. It is a very elegant approach, but it doesn’t really work that well.” It’s refreshing to hear someone else make these points for a change!
Mr. Taborsky sums up the shortcomings of traditional strategic asset allocation very concisely: ”The traditional approach to asset allocation relies on looking back in history to what asset classes returned. There is a huge reliance on mean reversion. There is a huge reliance on historic volatilities and correlations.” The problem with reliance on historical norms is that when there is a regime change, and the norms change, you are completely at sea. PIMCO believes that we have had a regime change, which they call the “new normal.” If they are correct, strategic asset allocation could have a rough go of it for a while.
Tactical asset allocation seems to be the only logical way to respond systematically to the constantly changing relationships between asset classes. Our Systematic RS Global Macro strategy (in separate account form or in mutual fund form in the Arrow DWA Tactical Fund) is designed to handle the rotation among asset classes for investors. Given the fear that retail investors still harbor, it might be just the thing to consider when moving cash from the sidelines back into the markets.
Posted by: Mike Moody
Barron’s has a nice interview with Cliff Asness and David Kabriller of AQR Capital (click here to read.) Subscription required. One noteworthy exchange:
Why do you think momentum investing works?
Asness: No one has nailed down why. We have a lot of theories. When I say “we,” I don’t just mean AQR. I mean the academic community and the practitioner community. Underreaction is probably our universally favorite story. Good news comes out. There is a phenomenon in behavioral finance called anchoring and adjustment, where people go, “Oh, that’s great news,” and they move halfway but they don’t move all the way to incorporate the great news. So if you buy what’s gone up, there’s a little more to go. I won’t pretend I have told you all the different theories.
Posted by: Andy Hyer
A very interesting article by Randall Forsyth in Barron’s discusses the problem conservative investors are having right now. Economists are worried about inflation down the road if the government chooses to monetize its debt. But the current problem for investors is deflation.
Deflation has driven interest rates on cash to near zero. Interest income is $50 billion lower than a year ago. The recession has caused corporations—many of them financials—to cut dividends as well. I was surprised to learn that overall dividend income is down 25% from a year ago. And it is projected to get worse.
This can’t have a positive effect on consumer spending. And when consumer incomes drop, tax revenues also drop, which puts more pressure on the national deficit.
Investors are also in a bind. The best yields are available, as always, on the riskiest paper. Most of the time, if CDs and Treasurys have reasonable yields, the “widows and orphans” investors ignore high-yield debt. But under the current circumstances, I suppose there is a risk of investors stretching out their risk parameters to reach for yield. Given that bond mutual fund sales have recently been running at five times the level of stock fund sales, I’ve got to wonder whether all of that cash is ending up in an appropriate place on the risk spectrum.
Posted by: Mike Moody
Barron’s recently ran an article on large college endowment returns (see the table below). Most of the schools use a 6/30 fiscal year and are reporting losses on the order of -25 to -30%. Most of these funds use some type of strategic asset allocation, and in recent years they have had large allocations to private equity and hedge funds.
click to enlarge
Our own Arrow DWA Balanced Fund (DWAFX), rather than strategic allocation, uses tactical allocation to domestic equities, international equities, fixed income, and alternatives. We do not have access to some of the asset classes of the large endowments like private equity and hedge funds, which were believed to be high return–low volatility opportunities. Despite the lack of access, the trailing one-year return for DWAFX compares favorably with the major endowments. Perhaps there is something to tactical asset allocation after all!
Posted by: Mike Moody