Manager Insights: Third Quarter Review

October 10, 2016

The stock market spent the majority of the summer months moving sideways in a tight trading range.  The S&P 500 finished the quarter up almost 4%, and is sitting on a gain of 7.8% so far this year.  International equity markets were a bright spot, and outperformed domestic markets.  Developed markets finished up 6.5% and Emerging markets finished with a gain of 9.2%.  Bonds also finished in positive territory with a 0.5% gain.  Commodities were a weak spot in the third quarter.  After strong gains in the first six months of the year, the S&P GSCI Commodity Index gave back 4.2% over the summer and now sits at a gain of 5.3% for the year.

We continue to see rotation below the surface in a number of different asset classes.  This is nothing new, but we think the rotations we are seeing now have the potential to be very beneficial to our strategies.  In the U.S. equity markets there has been a momentum shift out of areas such as high dividend and low volatility stocks.  The relentless reach for yield drove many investors into stocks instead of bonds, and drove valuations to historically high levels.  The same valuation issues cropped up in low volatility stocks, which have been quite the hot ticket for the last year or so.  These are not the areas that usually lead a robust bull market.  Low Volatility, especially, tends to lead during down markets.  As a result, there was a lot of hand wringing about how solid the market actually was with that kind of leadership.  We felt the leadership we were seeing was more a result of investor’s preference for yield (and the lack of good fixed income options) rather than an indictment on the overall market.

The new leadership that appears to be emerging is what is traditionally considered positive for a strong bull market.  Small capitalization stocks have had spotty performance for a while, but they really picked up steam in the third quarter.  The Russell 2000 Total Return index finished with a gain of 9% moving it well ahead of the S&P 500 for the year.  Technology stocks also dramatically outperformed what could be considered the old leadership (Utilities, Consumer Staples, and Low Volatility) over the summer.  The relative improvement in these higher volatility areas shows investors are gaining more confidence in the market.  Confidence is an incredibly important piece of the puzzle for momentum strategies so we are looking at this new development very favorably.

The appetite for higher volatility investments is also increasing internationally.  As previously mentioned, Emerging markets had a fantastic third quarter.  Latin America has been the biggest driver of that performance so far this year.  For the past couple of years, international markets have not fared as well as our domestic markets.  That appears to be changing, and we are seeing increasing allocations to Emerging markets in those account styles that allocate internationally and globally.  The overall composition of those portfolios has changed dramatically over the course of the year.

As we head in to the final three months of the year it is impossible not to think about the upcoming election.  Frankly, it is nothing short of a circus sideshow at this point.  We fully understand the uncertainty people feel because neither candidate seems like a good choice.  That, however, is politics, and we are investing.  We encourage you not to get caught up in the headlines.  We do expect some volatility around election time, but we don’t think either candidate’s victory means doom or exuberance for the stock market.  It is incredibly difficult to forecast how politics will affect the market, and most so called experts get it wrong.  Keep your politics out of your investing plan and you will be much better off for it in the long run.  Never forget that there is always some reason not to invest, but the reality is that investing in stocks is a tremendous way to build wealth over time.

The final three months of the year should be interesting to say the least.  There are pieces falling in to place that lead us to believe our relative strength strategies can do quite well if these trends are sustainable.  If you have any questions about any of our strategies please give us a call at any time.

This information is from sources believed to be reliable, but no guarantee is made to its accuracy.  This should not be considered a solicitation to buy or sell any security.  Unless otherwise stated, performance numbers are not inclusive of dividends or fees.  Investors cannot invest directly in an Index.  Past performance is not indicative of future results.  Potential for profits is accompanied by possibility of loss.

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Q&A with John Lewis, CMT

August 1, 2016

John Lewis is the Senior Portfolio Manager at Dorsey Wright.  Since joining Dorsey Wright in 2002, Mr. Lewis has developed strategies for the firm’s Systematic series of separate accounts, the Technical Leaders Index methodology, global asset allocation strategies, and multiple series of UITs. His work is technically driven and focuses on relative strength and momentum as the main factors in the investment process.

Q: What is the role that computer programming plays in your portfolio management responsibilities?

A:  Computers play an integral part in designing new strategies and maintaining existing ones.  We have designed a ton of different investment processes over the years and we have done so much testing that we have a pretty good idea of what will and won’t work and how to integrate that into a portfolio.  That knowledge base is really invaluable and is really the most important part of the process.  But we can harness the power of the computer to validate and stress test all of those ideas.  We are able to run tens of thousands of tests if we need to in order to make sure our ideas have merit.  On an ongoing basis, our strategies are designed to be systematic so using a computer to do all of the calculations for us is a huge time saver and allows us to run a large number of strategies with minimal human capital.

Q: How did you develop those computer programming skills?

A:  This story is 100% true.  I was working in San Diego and part of my job function required me to stay later than everyone else to get data loaded into our systems for the next trading.  All of my friends on the floor were leaving early (remember, the market closes at 1:00 on the West Coast) to go to the beach, golfing, or whatever, and it was always difficult for me to cut out a little early.  When faced with such a large problem it often takes drastic measures to solve it.  So I taught myself how to program visual basic and I set up a bunch of Excel macros to run stuff while I was out of the office.  It would up working really well so I just kept going and figuring stuff out along the way.  Computer programming has always been pretty easy for me, and I have had any formal training or anything like that.  The result of that decision to teach myself how to program in order to leave work early was the launching pad to what we are doing today.  However, my golf game is still terrible and my beach body has rapidly become something that shouldn’t be allowed on the beach.

Q: What led to the development of the family of Systematic Relative Strength portfolios (separately managed accounts)?

A: We did a review of our portfolios and tried to figure out what was working and what wasn’t.  As we dug deeper into the data it became clear that relative strength was really driving the performance and not any of the other “stuff” that went into the decision making.  Our testing process actually led us down a totally different path than how most things get tested.  We started with a bunch of inputs and kept whittling down the list.  Instead of finding something that worked and trying to add additional things to the model, we kept asking ourselves if we could accomplish the same goal with fewer things in the model.  The more streamlined you make a model the more robust it should be over time.  There are fewer things to break.  Whenever we talk about the process for our portfolios, people seem to think we aren’t as sophisticated as other managers who use a bunch of different factors and constantly reoptimize them.  But the fact of the matter is that we have computers too and we could do that if we wanted to.  There is a very elegant simplicity to how we set up our models, and sometimes that is actually harder to accomplish than making something that is very complex.

Q: Many in the industry argue for multi-factor investment models.  The family of Systematic Relative Strength portfolios employs just one input—relative strength.  Why?

A: Relative Strength (momentum) is one of the premier investment factors out there.  Our expertise lies in building and implementing investment processes using momentum.  That is really where our edge is so we try to exploit that as best as we can.  Over the years we have gained a lot of experience in using other factors along with momentum so you have probably seen us write about other factors, but they are still centered around relative strength.  Momentum is a great factor, it is very objective, and it lends itself very well to the type of systematic models we are good at building.

Q: Of the 7 strategies in the family of Systematic Relative Strength portfolios, one can’t help but take note of the International portfolio.  Is there anything unique about the way that this strategy is managed that may have contributed to its success?

A:  The International strategy uses a universe of ADR’s.  It is one of our smaller strategies in terms of assets under management, but one of our best performers.  The ADR universe is very unique.  There is a ton of dispersion in that universe meaning there are a lot of stocks that have tremendous performance and others that have dreadful performance.  That is great for any relative strength strategy.  In addition, it is a very flexible strategy so we can swing the allocation between developed and emerging whenever we need to.  The ADR strategy is really unique and now that we have a 10 year live track record under our belt I would not be surprised to see interest in that strategy pick up dramatically in the coming years.

Q: What is the trade-off investors face when they choose between our Aggressive, Core, and Growth portfolios, all of which invest in U.S. mid and large cap equities?

A:  It is a classic risk and return tradeoff.  The Aggressive strategy is the most aggressive application of momentum.  That means it has more turnover, more volatility, and over long periods of time higher potential return.  However, it can go quite a while underperforming the other strategies if we aren’t in a good momentum market.  The difference between Core and Growth really comes down to the cash component.  We can raise cash in the Growth portfolio if necessary.  Obviously, that is very beneficial in down markets, but can result in lagging performance in up markets.  All three of those strategies have done well despite not having a real good momentum environment for a while.

Q: Our most popular separately managed account by assets continues to be our Global Macro portfolio.  Why do you think this portfolio has seen so much demand?

Global Macro is a very flexible global tactical asset allocation strategy.  This appeals to a lot of investors because it is so difficult to determine where the best returns will be in the future.  A strategy like global macro just goes to where the momentum is and can invest in a number of different asset classes.  If equities are doing well, we are overweight there.  If things shift and commodities start doing well the portfolio will shift along with it.  What is also appealing is the disciplined application of the process.  Making global trend predictions is darn near impossible.  We know that so we don’t even try to do it.  We are wrong a lot, but the goal is not to stay wrong.  We don’t paint ourselves into a corner and hold on to a prediction we made.  We just position the portfolio to wherever the strength is and make changes when that strength changes.  That is a very appealing way to capitalize on global trends in a very uncertain environment.

To receive the brochure for our Systematic Relative Strength portfolios, please e-mail or call 626-535-0630.

The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.

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Q1 Manager Insights

April 15, 2016

The year got off to a rocky start.  After the holidays ended and everyone returned to work, the stock market had a sharp selloff that left it in negative territory for January.  The market would eventually bottom out in mid-February and continue to recover through the end of the quarter.  Despite the early selloff, the S&P 500 actually finished up 1.3% for the quarter.  Small cap and International stocks didn’t fare as well as both of those categories finished in negative territory for the first three months of the year.  Fixed Income and interest rate sensitive securities were some of the best performing areas during the first quarter with broad bond market indexes finishing up about 3%.  Commodities also finished the quarter in negative territory, but did stop the relentless slide they had been on since last year.

Looking at the summary numbers for the first quarter might lead you to believe it was a ho-hum first three months of the year, but that was certainly not the case.  We saw a tremendous amount of rotation under the surface that had a big impact on all of our strategies.  In this piece, we normally like to update you on some big picture items that are affecting the markets and economy, but we felt it was more appropriate to go into greater detail about the specifics of the rotation we saw and how it affected our strategies.

The overarching theme for our investing style was that the laggards finally had their day in the sun.  Simply put, the stocks and asset classes that had been leading the market lower since last summer finally stopped going down and actually went up a lot from the lows.  This is known as a laggard rally, and is never a time when we perform well.  These laggard rallies come along every so often so we are used to them by now.  Everyone realizes the leaders can’t lead forever so we view these periods as an opportunity to refresh the portfolios and find new leadership.  More importantly, they don’t cause a change in our strategy, but they do cause trading activity to pick up as the old leadership is removed from the portfolios and our process tries to find the emerging leadership.  So, if you have noticed a lot more trading in your account recently, that is the reason why.

The changes we have made in the portfolios really changed the characteristics of some of the strategies.  One example of this was the weakening U.S. Dollar.  The Dollar had been strong for quite some time, and finally exhibited enough weakness that we needed to remove it from the portfolios.  We saw a weak dollar asset, Gold, added to many of the strategies.  The strong Dollar had caused quite a headwind for assets such as international equities and commodities, which generally do better in a weak dollar environment.  If the dollar continues to weaken, we expect to see more of these types of assets come into the strategies.  That would actually be a welcome change as it would allow our strategies to do what they do best: find bull markets anywhere around the globe (and in places many people are overlooking).

On the individual equity side, it was much the same as the asset class side.  The so-called FANGs (Facebook, Amazon, Netflix, and Google) were stellar performers last year, but had a difficult start to the year.  What really performed well were the things like energy and basic materials that had such dreadful performance last year.  In some of our other writing we touched on these issues during the quarter.  One example of this is when we look at the S&P 500 industry groups.  The worst relative strength groups outperformed the best performing group by more than 12% during the first quarter!  That was completely opposite from last year when just avoiding the worst groups was the key to outperformance.  Whether these groups can continue to perform is anyone’s guess, but often times they have a large rally off the bottom and then settle in as average performers while they work out their issues.

We are 100% sure (which you almost never hear in this business!) that some of the changes we made to the portfolios won’t work out and we will have to continue to search for leadership.  That is totally normal, and we expect that to be the case over the coming months.  If you have any questions, please don’t hesitate to call us.

Performance numbers provided are the performance of indexes that are not available for direct investment and do not include dividends or transaction costs. Past performance is not indicative of future results and there is no assurance that any forecasts mentioned in this report will be attained.  Stocks offer growth potential but are subject to market fluctuations. Dividends are not guaranteed; companies can reduce or eliminate their dividend at any time. There are special risks associated with an investment in real estate, including credit risk, interest rate fluctuations and the impact of varied economic conditions.  Technical analysis is just one form of analysis. You may also want to consider quantitative and fundamental analysis before making any investment decisions.  The information contained herein has been prepared without regard to any particular investor’s investment objectives, financial situation, and needs.  Accordingly, investors should not act on any recommendation (express or implied) or information in this material without obtaining specific advice from their financial advisors and should not rely on information herein as the primary basis for their investment decisions.  Information contained herein is based on data obtained from recognized statistical services, issuer reports or communications, or other sources believed to be reliable (“information providers”).  However, such information has not been verified by Dorsey, Wright & Associates, LLC (DWA) or the information provider and DWA and the information providers make no representations or warranties or take any responsibility as to the accuracy or completeness of any recommendation or information contained herein.  DWA and the information provider accept no liability to the recipient whatsoever whether in contract, in tort, for negligence, or otherwise for any direct, indirect, consequential, or special loss of any kind arising out of the use of this document or its contents or of the recipient relying on any such recommendation or information (except insofar as any statutory liability cannot be excluded).  Any statements nonfactual in nature constitute only current opinions, which are subject to change without notice.  Neither the information nor any opinion expressed shall constitute an offer to sell or a solicitation or an offer to buy any securities, commodities or exchange traded products.  This document does not purport to be complete description of the securities or commodities, markets or developments to which reference is made. Potential for profits is accompanied by possibility of loss.    You should consider this strategy’s investment objectives, risks, charges and expenses before investing.  The examples and information presented do not take into consideration commissions, tax implications, or other transaction costs.  The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy.

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Q4 Manager Insights

January 7, 2016

Despite a decent fourth quarter, global equity markets had a volatile year in 2015.  U.S. and global equities both finished the quarter with solid gains.  After the summer correction in the S&P 500, U.S. stocks snapped back quickly.  This was a surprise to many investors who were looking for the end of one of the longest bull markets on record.  After the snapback, equities treaded water and moved in a very tight trading range to close out the year.  Fixed Income (measured by the Barclay’s Aggregate Index) finished the fourth quarter down slightly, but held on to scrape a 0.55% gain for the year.  Commodities, led by oil, continued their sell off and were the worst performing class of the year.  The trouble in commodities also affected emerging markets, which finished the year down over -14%.

If you were left scratching your head and wondering why it was so difficult to make money in 2015 you are not alone!  According to data from Societe Generale, 2015 was the hardest year to make money in 78 years.  U.S. equities (measured by the S&P 500 Total Return Index) were the best performing major asset class, but only managed to squeak out a gain of 1.38% for the year.  That paltry gain was more than bonds, international equities, and short-term T-bills.  Way back in 1937 (despite what my kids say I was not around to witness that market!) short term treasuries were the best performing major asset class with a gain of only 0.3%.  Even in 2008, bonds were up over 20% so there was somewhere to make money.  This year’s environment was very difficult for hedge funds and for strategies that try to capitalize on major global trends.

Momentum and Relative Strength was a bright spot for the year.  We noticed that more focused (i.e., focused on one specific market) and concentrated (i.e., fewer holdings) strategies performed better.  For example, a concentrated U.S. equity momentum strategy did much better than a strategy with a large number of holdings or a strategy that was invested in multiple asset classes.  It was also advantageous to have a momentum overlay combined with other factors.  Value strategies didn’t fare well in 2015, but value stocks that also had good momentum did very well.  A lot of the momentum outperformance this year came from what momentum strategies avoided rather than what they held.  When we looked at the performance of the S&P 500 industry groups and broke them into quintiles (based on a monthly rebalance), the top four quintiles all had similar performance for the year.  The performance of the bottom quintile, however, was dreadful.  That quintile was made up mainly of Energy and Basic Materials groups.  It is rare to see one group underperform the other four groups by such a large margin (over -13%) for the year.

The Federal Reserve finally took action and raised interest rates by 0.25% during the fourth quarter.  The move was long anticipated, but had been put off due to market volatility and concerns about the health of the global economy.  It is important to keep in mind that even with the hike, rates are still historically low.  We have seen some studies recently that show equities are not as affected as you might think until rates get up around 5%, and we are a long way from that now.  This may be more of a problem for the fixed income markets than equities, but only time will tell.

As the current bull market continues to age we expect a few things to happen we believe will be positive for our strategies.  First, you will begin to hear more cries that the market is “expensive.”  That usually affects valuation based strategies more than relative strength based processes.  Second, the market will continue to narrow.  That is natural and totally expected as the bull market matures.  A narrow market is very positive for our strategies because we can overweight the small pockets of strength that are performing well and avoid the areas that are weak.  As a result, we are encouraging people to take a look at their portfolios and overweight momentum relative to value.  If you have any questions about your allocations or the best way to get exposure to momentum strategies please call us at any time.

Information is from sources believed to be reliable, but no guarantee is made to its accuracy.  This should not be considered a solicitation to buy or sell any security.  Past performance should not be considered indicative of future results. Potential for profits is accompanied by possibility of loss.

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Q3 2015 Manager Insights

October 8, 2015

The third quarter was a difficult one for the stock market as U.S. stocks fell by -6.4% (measured by the S&P 500 Total Return Index).  The decline in equities actually began in May, so the August selloff caused the S&P 500 to fall by more than 10% from its high, which is considered to be a “correction.”  It had been nearly three years since  the market had last entered correction territory, which made it the fifth-longest correction-free streak on record.  Other markets fared even worse than U.S. stocks.  International Developed Markets stocks were down over -10%, and Emerging Markets equities fell nearly -18% during the third quarter.  Commodities were also terrible as Energy prices tumbled.  The one bright spot was Fixed Income, which managed to eke out a small gain of 1.2% (measured by the Barclay’s Aggregate Index).

The main catalyst for the selloff in the third quarter was China.  The Shanghai Composite Index was down more than -25% over the last three months.  The drop in Chinese equities was so severe that the government intervened during the summer and halted trading in some companies, as well as purchasing massive amounts of stock.  The Chinese economy has been slowing, and in August the government devalued the Yuan.  The official reason for the devaluation was to give market forces a bigger role in setting the exchange rate.  Market participants viewed the devaluation as a way for the Chinese government to prop up the ailing industrial sector.  If the government was going to such extreme measures to prop up industry then many people thought they might be in worse shape than we think.

The Federal Reserve was also in focus during the third quarter.  Everyone has been waiting for that first rate hike for what seems like forever.  It seemed like the consensus was that there would be a rate hike during the September meeting.  The Fed, however, decided to leave rates unchanged for the time being.  The issues in China were certainly part of this decision to postpone the rate increase.  Normally, investors are happy with the Fed when they don’t raise rates, but that wasn’t the case this time.  We had another selloff after the lack of a rate increase because people are worried that the global economy might be slowing too much to handle a rate increase.  If that is the case, it will be difficult to use monetary policy to kick start the economy because we are already starting from historically low interest rates.  We also think the disappointment over a lack of a rate increase is because people are simply tired of waiting for it to happen.  The Fed has telegraphed this move so far in advance it is hard to believe anyone will be caught off guard by it.  At this point, it seems like the Fed risks being the parent who constantly threatens punishment, but never follows through with the discipline.  Eventually, the kids stop listening and chaos ensues.  Looking at the big picture, a 0.25% rate increase really isn’t a big deal, and rates will still be historically low.  It seems like raising rates in the near future would signal that the Fed feels the economy is strong enough to handle it and would be welcomed by most investors.

The news hasn’t been all bad though!  High Relative Strength stocks continued to maintain their spread over the broad market on a year to date basis.  Momentum stocks generally performed in-line with the broad market over the summer, which leaves them ahead of the benchmarks for the year.  The biggest area of excess performance this year has come from avoiding the laggard stocks.  Energy and Basic Materials have performed terribly this year, and avoiding those areas has been crucial.  Owning the highest RS stocks has helped, but not as much as avoiding the losers.  That situation isn’t common, but we do see it happen from time to time.

Heading in to the fourth quarter we are optimistic that we are near the bottom of the correction.  Many of our indicators are in oversold territory where historically, we have seen significant rallies develop.  We do anticipate more volatility in the near term, but we believe the environment is setting up nicely for a rally late in the year.

Information is from sources believed to be reliable, but no guarantee is made to its accuracy.  This should not be considered a solicitation to buy or sell any security.  Past performance should not be considered indicative of future results. Potential for profits is accompanied by possibility of loss.

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Q2 Manager Insights

July 8, 2015

Stocks managed small gains in the second quarter of 2015.  The S&P 500 was up slightly, leaving it up about 1.2% so far this year.  Bond yields also rose during the second quarter as investors braced for upcoming rate hikes from the Federal Reserve.  Despite the underperformance of international equities during the second quarter, they remain ahead U.S. equities on a year–to-date basis.

High relative strength equities had much choppier returns during the quarter than the broad market.  After their stellar performance during the first three months of the year we expected there might be some giveback this quarter.  Right out of the gate, high momentum equities began underperforming the broad market, and reached a relative low during the last part of April and beginning of May.  But the second half of the quarter was very good for our strategies.  We made up a lot of the performance lag during the last six weeks of the quarter.  High momentum stocks generally finished slightly behind their benchmarks for the quarter, but that still leaves them well ahead of the broad market for the year.  We were pleased to see the rebound in the types of stocks we buy given the exceptionally strong performance to begin the year.

The circus in Greece dominated the headlines at the end of the second quarter.  There is really no question whether Greece will default on their debts to their creditors – they are going to.  The big question seems to be whether Greece will accept austerity measures that will allow them to borrow even more money, and if not, whether they will abandon the Euro as their currency and return to the Drachma.  To put things in perspective, Greece has spent a good portion of its modern history in some sort of financial crisis so this is really nothing new.  What is new is that Greece doesn’t have its own currency any more so that can not be used as a tool to inflate their way out of debt.  The political and economic ramifications of any scenario in Greece are, quite frankly, impossible to determine.  There is no shortage of opinions being expressed in the media about what should happen, but nobody knows for sure.  We do know, however, that this will play out in the price action of various securities and asset classes around the globe.  It appears U.S. investors have been largely shrugging off the news so far.  If that changes, new trends will emerge and our process is designed to shift the portfolios to those emerging trends.

The economic data received during the second quarter confirmed that the economy is slowing down.  Gross Domestic Product decreased 0.2% during the first three months of the year.  There were some mixed data points that were released later in the quarter so it is really too early to tell if the slowdown in Q1 was the beginning of something bigger or just a small dip within a larger trend.  The economic data did seem to have an effect on Federal Reserve policy.  It appeared as if the Fed was looking to raise rates over the summer (as early as June), but the slowing economy seems to have delayed those plans.  The Fed minutes indicated they would like to begin rate increases some time this year, but the pace of those increases might not be as rapid as people thought.  The Fed has spent an enormous amount of time and energy (and money!) helping the economy limp along, and their statement confirmed they are not about to abandon that policy any time soon.

Overall, we were pleased that our strategies held their own during the quarter after such a strong start to the year.  We believe this leaves us well positioned to capitalize on the second half of the year.  There are definitely some news headlines that will get a lot of attention and add to the volatility over the summer.  However, it is important to remember there have been numerous “problems” that have cropped up during the entire bull run over the last 5 plus years, and nothing has been able to derail this bull market yet.

E-mail to request the brochure for our Systematic Relative Strength portfolios.

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Q1 Manager Insights

April 9, 2015

The stock market chopped its way to a small gain in the first three months of 2015. February was definitely the best month of the first quarter and made up for negative returns in the other two months. That pattern held true for international markets as well. Bonds also turned in a positive performance for the quarter, but, like equities, experienced some volatility along the way.

One of the biggest stories of the first quarter continued to be the decline in oil prices. As the world continues to have an oversupply of oil, it is a double-edged sword as far as the markets are concerned. Obviously, weak oil prices are not good for the Energy sector which has been one of the worst performing areas lately, and we are seeing a major slowdown in capital spending for new and existing energy projects. On the other hand, lower energy prices are very good for consumers. Many of you have probably noticed much lower gasoline prices. I just drove by a gas station with gas under $3.00 per gallon, which is unheard of in our area of Southern California. Lower energy prices give consumers more spending power, and they seem to be taking advantage of it. Our strategies have recognized this and have allocated more toward areas benefitted by increased consumer spending while underweighting energy companies. It will be interesting to see how this dynamic plays out, but for now it appears the consumer is the biggest beneficiary of the oil price decline.

The big news overseas was the European Central Bank announcement of a bond buying program that could top $1 trillion. That sent the euro into a tailspin, but also helped buoy the European equity markets. In contrast to last year when international markets dramatically underperformed U.S. markets, international markets performed much better during the first three months of the year. Most of the performance came from Developed Markets (reflecting the strength in Europe). Emerging Markets performed better than U.S. markets, but didn’t perform as well as Developed Markets.

Investors are also becoming more concerned with when the Federal Reserve is finally going to raise rates. That possibility was once way off in the distance, but now it appears it may come later this year. Even if the Fed does raise rates later this year, interest rates will still be low by historical standards so the move will be mostly symbolic. It will also be symbolic of a move toward a more “normal” market with much less government intervention. This would be a welcome sign for our strategies. Our decision-making process is primarily focused on market price movements. Less government intervention should mean fewer price shocks and less correlation among stocks and sectors than during the risk on, risk off environment of the last few years.

Our relative strength strategies performed well across the board in the first quarter. We track a Relative Strength Spread, which measures the performance of a basket of strong momentum stocks versus a basket of weak momentum stocks. That measure exploded higher during the first quarter. The spread has been moving sideways for a couple of years, so seeing it begin to move upward again is a very good sign. The strong momentum performance was fairly broad- based, and wasn’t the result of a few lucky stocks. We track a number of strategies that mix momentum with value, dividends, or some other factor. In each case, the strategy with the momentum overlay was superior to the other factor by itself this quarter. The momentum move was very broad based and appeared in numerous segments of the market.

As the bull market continues to mature we are expecting the leadership to narrow. Valuations are up and it is getting more difficult to find bargains. When investors can’t find enough value they often turn to companies that can continue to grow earnings despite a slowing economy. This is usually a very healthy period for momentum strategies. We think we are entering that phase of the cycle and are quite optimistic for what that will mean for our strategies for the rest of 2015.

Information is from sources believed to be reliable, but no guarantee is made to its accuracy.  This should not be considered a solicitation to buy or sell any security.  The relative strength (momentum) strategy is not a guarantee.   There may be times when all investments and strategies are unfavorable and depreciate in value.  Past performance should not be considered indicative of future results.  Potential for profits is accompanied by possibility of loss.

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DWA Q3 2014 Update Webinar

July 18, 2014

Click here for our quarterly DWA webinar with Tom Dorsey, Tammy DeRosier, and John Lewis.

DWA Webinar

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Q2 Manager Insights

July 2, 2014

Click here.


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Q1 Manager Insights

April 1, 2014

Click here for our review of the first quarter and for our market outlook.

mgr insights

Relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.  Relative Strength is a measure of price momentum based on historical price activity.  Relative Strength is not predictive and there is no assurance that forecasts based on relative strength can be relied upon.

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The Coming Mega-Bull Market?

March 2, 2014

Investor behavior has a lot to do with how markets behave, and with how investors perform.  To profit from a long mega-bull market, investors have to be willing to buy stocks and hold them through the inevitable ups and downs along the way.  Risk tolerance greatly influences their willing to do that—and risk tolerance is greatly influenced by their past experience.

From an article on risk in The Economist:

People’s financial history has a strong impact on their taste for risk. Looking at surveys of American household finances from 1960 to 2007, Ulrike Malmendier of the University of California at Berkeley and Stefan Nagel, now at the University of Michigan, found that people who experienced high returns on the stockmarket earlier in life were, years later, likelier to report a higher tolerance for risk, to own shares and to invest a bigger slice of their assets in shares.

But exposure to economic turmoil appears to dampen people’s appetite for risk irrespective of their personal financial losses. That is the conclusion of a paper by Samuli Knüpfer of London Business School and two co-authors. In the early 1990s a severe recession caused Finland’s GDP to sink by 10% and unemployment to soar from 3% to 16%. Using detailed data on tax, unemployment and military conscription, the authors were able to analyse the investment choices of those affected by Finland’s “Great Depression”. Controlling for age, education, gender and marital status, they found that those in occupations, industries and regions hit harder by unemployment were less likely to own stocks a decade later. Individuals’ personal misfortunes, however, could explain at most half of the variation in stock ownership, the authors reckon. They attribute the remainder to “changes in beliefs and preferences” that are not easily measured.

The same seems to be true for financial trauma. Luigi Guiso of the Einaudi Institute for Economics and Finance and two co-authors examined the investments of several hundred clients of a large Italian bank in 2007 and again in 2009 (ie, before and after the plunge in global stockmarkets). The authors also asked the clients about their attitudes towards risk and got them to play a game modelled on a television show in which they could either pocket a small but guaranteed prize or gamble on winning a bigger one. Risk aversion, by these measures, rose sharply after the crash, even among investors who had suffered no losses in the stockmarket. The reaction to the financial crisis, the authors conclude, looked less like a proportionate response to the losses suffered and “more like old-fashioned ‘panic’.”

I’ve bolded a couple of sections that I think are particularly interesting.  Investors who came of age in the 1930s tended to have an aversion to stocks also—an aversion that caused them to miss the next mega-bull market in the 1950s.  Today’s investors may be similarly traumatized, having just lived through two bear markets in the last decade or so.

Bull markets climb a wall of worry and today’s prospective investors are plenty worried.  Evidence of this is how quickly risk-averse bond-buying picks up during even small corrections in the stock market.  If history is any guide, investors could be overly cautious for a very long time.

Of course, I don’t know whether we’re going to have a mega-bull market for the next ten or fifteen years or not.  Anything can happen.  But it wouldn’t surprise me if the stock market does very well going forward—and it would surprise me even less if most investors miss out.

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How Not to be a Terrible Investor

February 27, 2014

Morgan Housel at Motley Fool has a wonderful article on how investors can learn from failure.  He sets the tone with a few different quotes and anecdotes that point out that a lot of being a success is just avoiding really dumb mistakes.

At a conference years ago, a young teen asked Charlie Munger how to succeed in life. “Don’t do cocaine, don’t race trains to the track, and avoid all AIDS situations,” Munger said. Which is to say: Success is less about making great decisions and more about avoiding really bad ones.

People focus on role models; it is more effective to find antimodels—people you don’t want to resemble when you grow up.    Nassim Taleb

I’ve added the emphasis, but Mr. Housel makes a good point.  Learning from failure is equally important as learning from success.  In fact, he argues it may be more important.

If it were up to me, I would replace every book called How to Invest Like Warren Buffett with a one called How to Not Invest Like Lehman Brothers, Long-Term Capital Management, and Jesse Livermore. There are so many lessons to learn from these failed investors about situations most of us will face, like how quickly debt can ruin you. I’m a fan of learning from Buffett, but the truth is most of us can’t devote as much time to investing as he can. The biggest risk you face as an investor isn’t that you’ll fail to be Warren Buffett; it’s that you’ll end up as Lehman Brothers.

But there’s no rule that says you have to learn by failing yourself. It is far better to learn vicariously from other people’s mistakes than suffer through them on your own.

That’s his thesis in a nutshell.  He offers three tidbits from his study of investing failures.  I’ve quoted him in full here because I think his context is important (and the writing is really good).

1. The overwhelming majority of financial problems are caused by debt, impatience, and insecurity. People want to fit in and impress other people, and they want it right now. So they borrow money to live a lifestyle they can’t afford. Then they hit the inevitable speed bump, and they find themselves over their heads and out of control. That simple story sums up most financial problems in the world. Stop trying to impress people who don’t care about you anyways, spend less than you earn, and invest the rest for the long run. You’ll beat 99% of people financially.

2. Complexity kills. You can make a lot of money in finance, so the industry attracted some really brilliant people. Those brilliant people naturally tried to make finance more like their native fields of physics, math, and engineering, so finance has grown exponentially more complex in the last two decades. For most, that’s been a disservice. I think the evidence is overwhelming that simple investments like index funds and common stocks will demolish complicated ones like derivatives and leveraged ETFs. There are two big stories in the news this morning: One is about how the University of California system is losing more than $100 million on a complicated interest rate swap trade. The other is about how Warren Buffett quintupled his money buying a farm in Nebraska. Simple investments usually win.

3. So does panic. In his book Deep Survival, Laurence Gonzalez chronicles how some people managed to survive plane crashes, getting stranded on boats, and being stuck in blizzards while their peers perished. The common denominator is simple: The survivors didn’t panic. It’s the same in investing. I’ve seen people make a lifetime of good financial decisions only to blow it all during a market panic like we saw in 2008. Any financial decision you make with an elevated heart rate is probably going to be one you’ll regret. Napoleon’s definition of a military genius was “the man who can do the average thing when all those around him are going crazy.” It’s the same in investing.

I think these are really good points.  It’s true that uncontrolled leverage accompanies most real blowups.  Having patience in the investing process is indeed necessary; we’ve written about that a lot here too.  The panic, impatience, and insecurity he references are really all behavioral issues—and it just points out that having your head on straight is incredibly important to investment success.  How successful you are in your profession or how much higher math you know is immaterial.  As Adam Smith (George Goodman) wrote, “If you don’t know who you are, the stock market is an expensive place to find out.” 

Mr. Housel’s point on complexity could be a book in itself.  Successful investing just entails owning productive assets—the equity and debt of successful enterprises—acquired at a reasonable price.  Whether you own the equity directly, like Warren Buffett and his farm, or in security form is immaterial.  An enterprise can be a company—or even a country—but it’s got to be successful.

Complexity doesn’t help with this evaluation.  In fact, complexity often obscures the whole point of the exercise.

This is actually one place where I think relative strength can be very helpful in the investment process.  Relative strength is incredibly simple and relative strength is a pretty good signaling mechanism for what is successful.  Importantly, it’s also adaptive: when something is no longer successful, relative strength can signal that too.  Sears was once the king of retailing.  Upstart princes like K-Mart in its day, and Wal-Mart and Costco later, put an end to its dominance.  Once, homes were lit with candles and heated with fuel oil.  Now, electricity is much more common—but tomorrow it may be something different.  No asset is forever, not even Warren Buffett’s farmland.  When the soil is depleted, that farm will become a lead anchor too.  Systematic application of relative strength, whether it’s being used within an asset class or across asset classes, can be a very useful tool to assess long-term success of an enterprise.

Most investing problems boil down to behavioral issues.  Impatience and panic are a couple of the most costly.  Avoiding complexity is a different dimension that Mr. Housel brings up, and one that I think should be included in the discussion.  There are plenty of millionaires that have been created through owning businesses, securities, or real estate.  I can’t think of many interest rate swap millionaires (unless you count the people selling them).  Staying calm and keeping things simple might be the way to go.  And if the positive prescription doesn’t do it for you, the best way to be a good investor may be to avoid being a terrible investor!

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The Growing Case Against ETFs

February 21, 2014

That’s the title of a Marketwatch article by mutual fund columnist Chuck Jaffe.  I have to admit that usually I like his columns.  But columns like this make me nuts!  (See also The $ Value of Patience for an earlier rant on a similar topic.)

Here’s the thesis in a nutshell:

…safe driving comes down to a mix of equipment and personnel.

The same can be said for mutual funds and exchange-traded funds, and while there is growing consensus that ETFs are the better vehicle, there’s growing evidence that the people using them may not be so skilled behind the wheel.

The article goes on to point out that newsletters with model portfolios of mutual funds and ETFs have disparate results.

Over the last 12 months, the average model portfolio of traditional funds—as tracked by Hulbert Financial Digest—was up 20.9%, a full three points better than the average ETF portfolio put together by the same advisers and newsletter editors. The discrepancy narrows to two full percentage points over the last decade, and Hulbert noted he was only looking at advisers who run portfolios on both sides of the aisle.

Hulbert posited that if you give one manager both vehicles, the advantages of the better structure should show up in performance.

It didn’t.

Hulbert—who noted that the performance differences are “persistent” — speculated “that ETFs’ advantages are encouraging counterproductive behavior.” Effectively, he bought into Bogle’s argument and suggested that if you give an investor a trading vehicle, they will trade it more often.

Does it make any sense to blame the vehicle for the poor driving?  (Not to mention that DALBAR data make it abundantly clear that mutual fund drivers frequently put themselves in the ditch.)  Would it make sense to run a headline like “The Growing Case Against Stocks” because stocks can be traded?

Mutual funds, ETFs, and other investment products exist to fulfill specific needs.  Obviously not every product is right for every investor, but there are thousands of good products that will help investors meet their goals.  When that doesn’t happen, it’s usually investor behavior that’s to blame.  (And you’re not under any obligation to invest in a particular product.  If you don’t understand it, or you get the sinking feeling that your advisor doesn’t either, you should probably run the other way.)

Investors engage in counterproductive behavior all the time, period.  It’s not a matter of encouraging it or not.  It happens in every investment vehicle and the problem is almost always the driver.  In fact, advisors that can help manage counterproductive investor behavior are worth their weight in gold.   We’re not going to solve problems involving investor behavior by blaming the product.

A certain amount of common sense has to be applied to investing, just like it does in any other sphere of life.  I know that people try to sue McDonald’s for “making” them fat or put a cup of coffee between their legs and then sue the drive-thru that served it when they get burned, but whose responsibility is that really?  We all know the answer to that.

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Is Sector Rotation a Crowded Trade?

January 16, 2014

As sector ETFs have proliferated, more and more investors have been attracted to sector rotation and tactical asset allocation strategies using ETFs, whether self-managed or implemented by an advisor.  Mark Hulbert commented on sector rotation strategies in a recent article on Marketwatch that highlighted newsletters using Fidelity sector funds.  All of the newsletters had good returns, but there was one surprising twist:

…you might think that these advisers each recommended more or less the same basket of funds. But you would be wrong. In fact, more often than not, each of these advisers has tended to recommend funds that are not recommended by any other of the top five sector strategies.

That’s amazing, since there are only 44 actively managed Fidelity sector funds and these advisers’ model portfolios hold an average of between five and 10 funds each.

This suggests that there is more than one way of playing the sector rotation game, which is good news. If there were only one profitable sector strategy, it would quickly become so overused as to stop working.

This is even true among those advisers who recommend sectors based on their relative strength or momentum. Because there are so many ways of defining these characteristics, two different sector momentum strategies will often end up recommending two different Fidelity sector funds.

Another way of appreciating the divergent recommendations of these top performing advisers is this: Of the 44 actively managed sector funds that Fidelity currently offers, no fewer than 22 are recommended by at least one of these top five advisers. That’s one of every two, on average, which hardly seems very selective on the advisers’ part.

Amazing, isn’t it?  It just shows that there are many ways to skin a cat.

Even with a very limited menu of Fidelity sector funds, there was surprisingly little overlap.  Imagine how little overlap there would be within the ETF universe, which is much, much larger!  In short, you can safely pursue a sector rotation strategy (and, by extension, tactical asset allocation) with little concern that everyone else will be plowing into the same ETFs.

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Systematic Relative Strength Portfolios: Q4 Manager Insights

January 7, 2014

Fourth Quarter Review

After a short dip to start the fourth quarter, the stock market moved strongly higher through the end of November.  The marked moved sideways during December, never giving up any substantial ground.  What a remarkable year for the stock market!  Despite some choppiness, every quarter this year has had positive equity returns!

The S&P 500 finished up over 30% for the year.  The last time the S&P accomplished that feat was all the way back in 1997.  That was quite a while ago.  In fact, it was the longest streak without a 30% up year since the drought from 1959 to 1974.  The 10.5% return in the fourth quarter made that possible.

Other asset classes didn’t fare as well as equities in 2013.  Continuing to fear tapering by the Federal Reserve, the bond market was lackluster during the final three months of the year.  Many broad fixed income indexes finished 2013 with losses.  Other asset classes, like commodities, performed poorly as well.  Gold, in particular, had a very difficult year after being a darling of the fear mongers for many years.  Diversification, which provided improved returns over the past few years, was definitely not the way to go in 2013.  It was all about equities.

Economic growth may be starting to pick up.  The final estimate for Q3 GDP growth is now 4.1%.  That’s stronger annual growth than we’ve seen for at least six quarters.  Another positive is the Conference Board’s Leading Economic Index, which is up 3.1% over the past six months.  Industrial capacity utilization is still slack and employment still fairly weak, suggesting that there will be little pressure on consumer prices for now.

Although there was some political wrangling about the government healthcare website, the big story for the market this quarter was the December Fed meeting.  Would the Fed taper or not?  The stock and bond markets both seemed apprehensive that the Fed would decide to reduce bond purchases, especially given the negative market reaction in May.  In the end, the Fed decided to taper slightly—and the stock market vaulted upward.

Part of the explanation may have been that the taper was more modest than expected, but a bigger factor was likely the Federal Reserve making it clear that its low interest rate policy would continue even after employment begins to pick up.  Although a new Fed chair, Janet Yellen, is scheduled to be installed in January, observers don’t expect significant policy changes.  The stock market seems to like quantitative easing and there is no end in sight.

While all of this is good news for equities some people are beginning to wonder if we have reached the end of the bull market.  The S&P 500 closed the year at an all-time high.  It has only done that five times since 1929, so it is a rare event.  The good news is that, according to Standard and Poor’s, equities were up an average of 8.5% in the years following a close at an all-time high.  The base rates were also good with equities being up four out of those five years.

We also aren’t seeing the type of euphoria from retail investors that often accompanies major market tops.  In a recent survey, Blackrock found that affluent investors were holding 48% of their investable assets in cash!  This despite expressing greater confidence about their financial futures.  Their allocation to equities was only 18% in the survey.  During the late 1990’s stock assets were closer to 40%, so despite reaching all-time highs equities are still not universally loved.

We are heading into the part of the cycle that tends to be very good for relative strength.  We believe equities can continue to deliver solid returns, and as the market narrows that should be a major positive for our methodology.  As always, we continue to focus on implementing our process in the most disciplined way possible, and if you have any questions we are always happy to speak with you about them.

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Equity as the Way to Wealth

January 3, 2014

According to a recent Gallup Poll, most Americans don’t think much of the stock market as a way to build wealth.  I find that quite distressing, and not just because stocks are my business.  Stocks are equity—and equity is ownership.  If things are being done right, the owner should end up making more than the employee as the business grows.  I’ve reproduced a table from Gallup’s article below.

Source: Gallup  (click on image to enlarge)

You can see that only 37% felt that the stock market was a good way to build wealth—and only 50% among investors with more than $100,000 in assets.

Perhaps investors will reconsider after reading an article from the Wall Street Journal, here republished on Yahoo! Finance.  In the article, they asked 40 prominent people about the best financial advice they’d ever received.  (Obviously you should read the whole thing!)  Two of the comments that struck me most are below:

Charles Schwab, chairman of Charles Schwab Corp.

A friend said to me, Chuck, you’re better off being an owner. Go out and start your own business.

Richard Sylla, professor of the history of financial institutions and markets at New York University

The best financial advice I ever received was advice that I also provided, both to myself and to Edith, my wife. It was more than 40 years ago when I was a young professor of economics and she was a young professor of the history of science. I based the advice on what were then relatively new developments in modern finance theory and empirical findings that supported the theory.

The advice was to stash every penny of our university retirement contributions in the stock market.

As new professors we were offered a retirement plan with TIAA-CREF in which our own pretax contributions would be matched by the university. Contributions were made with before-tax dollars, and they would accumulate untaxed until retirement, when they could be withdrawn with ordinary income taxes due on the withdrawals.

We could put all of the contributions into fixed income or all of it into equities, or something in between. Conventional wisdom said to do 50-50, or if one could not stomach the ups and downs of the stock market, to put 100% into bonds, with their “guaranteed return.”

Only a fool would opt for 100% stocks and be at the mercies of fickle Wall Street. What made the decision to be a fool easy was that in those paternalistic days the university and TIAA-CREF told us that we couldn’t touch the money until we retired, presumably about four decades later when we hit 65.

Aware of modern finance theory’s findings that long-term returns on stocks should be higher than returns on fixed-income investments because stocks were riskier—people had to be compensated to bear greater risk—I concluded that the foolishly sensible thing to do was to put all the money that couldn’t be touched for 40 years into equities.

At the time (the early 1970s) the Dow was under 1000. Now it is around 16000. I’m now a well-compensated professor, but when I retire in a couple of years and have to take minimum required distributions from my retirement accounts, I’m pretty sure my income will be higher than it is now. Edith retired recently, and that is what she has discovered.

Not everyone has the means to start their own business, but they can participate in thousands of existing great businesses through the stock market!  Richard Sylla’s story is fascinating in that he put 100% of his retirement assets into stocks and has seen them grow 16-fold!  I’m sure he had to deal with plenty of volatility along the way, but it is remarkable how effective equity can be in creating wealth.  His wife discovered that her income in retirement—taking the required minimum distribution!—was greater than when she was working!  (The italics in the quote above are mine.)

Equity is ownership, and ownership of productive assets is the way to wealth.

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Warren Buffett and Charlie Munger’s Best Advice

November 26, 2013

…talk about the best advice they have even gotten in a short piece from Fortune.  I think it clarifies the difference between a blind value investor and an investor who is looking for good companies (not coincidentally, many of those good companies have good relative strength).  Warren Buffett and Charlie Munger have made a fortune implementing this advice.

Buffett: I had been oriented toward cheap securities. Charlie said that was the wrong way to look at it. I had learned it from Ben Graham, a hero of mine. [Charlie] said that the way to make really big money over time is to invest in a good business and stick to it and then maybe add more good businesses to it. That was a big, big, big change for me. I didn’t make it immediately and would lapse back. But it had a huge effect on my results. He was dead right.

Munger: I have a habit in life. I observe what works and what doesn’t and why.

I highlighted the fun parts.  Buffett started out as a Ben Graham value investor.  Then Charlie wised him up.

Valuation has its place, obviously.  All things being equal, it’s better to buy cheaply than to pay up.  But Charlie Munger had observed that good businesses tended to keep on going.  The same thing is typically true of strong stocks—and most often those are the stocks of strong businesses.

Buy strong businesses and stick with them as long as they remain strong.

Source: CNN/Money (click on image to enlarge)

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Podcast: A Profile of our Growth Portfolio

November 25, 2013

A Profile of our Growth Portfolio

Mike Moody and Andy Hyer

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Stock Market Sentiment Review

November 19, 2013

I’m still getting back into the swing of things after having the flu most of last week.  In the midst of my stock market reading, I was struck by an article over the weekend from Abnormal Returns, a blog you should be reading, if you aren’t already.  The editor had a selection of the blog posts that were most heavily trafficked from the prior week.  Without further ado:

  • Chilling signs of a market top.  (The Reformed Broker)
  • Ray Dalio thinks you shouldn’t bother trying to generate alpha.  (The Tell)
  • Ten laws of stock market bubbles.  (Doug Kass)
  • How to teach yourself to focus.  (The Kirk Report)
  • Are we in a bubble?  (Crossing Wall Street)
  • Josh Brown, “If the entities in control of trillions of dollars all want asset prices to be higher at the same time, what the hell else should you be positioning for?”  (The Reformed Broker)
  • Guess what stock has added the most points to the S&P 500 this year? (Businessweek)
  • Everything you need to know about stock market crashes.  (The Reformed Broker)
  • Jim O’Neil is swapping BRICs for MINTs.  (Bloomberg)
  • How to survive a market crash.  (Your Wealth Effect)


I count five of the top ten on the topic of market tops/bubbles/crashes!

Markets tend to top out when investors are feeling euphoric, not when they are tremendously concerned about the downside.  In my opinion, investors are still quite nervous—and fairly far from euphoric right now.

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Q4 Technical Leaders Indexes Webinar

October 17, 2013

Click below to access the Q4 DWA Technical Leaders Indexes Webinar.

TL Webinar

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Long-Only Momentum

October 4, 2013

Gary Antonacci has a very nice article at Optimal Momentum regarding long-only momentum.  Most academic studies look at long-short momentum, while most practitioners (like us) use long-only momentum (also known as relative strength).  Partly this is because it is somewhat impractical to short across hundreds of managed accounts, and partly because clients don’t usually want to have short positions.  The article has another good reason, quoting from an Israel & Moskowitz paper:

Using data over the last 86 years in the U.S. stock market (from 1926 to 2011) and over the last four decades in international stockmarkets and other asset classes (from 1972 to 2011), we find that the importance of shorting is inconsequential for all strategies when looking at raw returns. For an investor who cares only about raw returns, the return premia to size, value, and momentum are dominated by the contribution from long positions.

In other words, most of your return comes from the long positions anyway.

The Israel & Moskowitz paper looks at raw long-only returns from capitalization, value, and momentum.  Perhaps even more importantly, at least for the Modern Portfolio Theory crowd, it looks at CAPM alphas from these same segments on a long-only basis.  The CAPM alpha, in theory, is the amount of excess return available after adjusting for each factor.  Here’s the chart:

Source: Optimal Momentum

(click on image to enlarge)

From the Antonacci article, here’s what you are looking at and the results:

I&M charts and tables show the top 30% of long-only momentum US stocks from 1927 through 2011 based on the past 12-month return skipping the most recent month. They also show the top 30% of value stocks using the standard book-to-market equity ratio, BE/ME, and the smallest 30% of US stocks based on market capitalization.

Long-only momentum produces an annual information ratio almost three times larger than value or size. Long-only versions of size, value, and momentum produce positive alphas, but those of size and value are statistically weak and only exist in the second half of the data. Momentum delivers significant abnormal performance relative to the market and does so consistently across all the data.

Looking at market alphas across decile spreads in the table above, there are no significant abnormal returns for size or value decile spreads over the entire 1926 to 2011 time period. Alphas for momentum decile portfolio spread returns, on the other hand, are statistically and economically large.

Mind-boggling right?  On a long-only basis, momentum smokes both value and capitalization!

Israel & Moskowitz’s article is also quoted in the post, and here is what they say about their results:

Looking at these finer time slices, there is no significant size premium in any sub period after adjusting for the market. The value premium is positive in every sub period but is only statistically significant at the 5% level in one of the four 20-year periods, from 1970 to 1989. The momentum premium, however, is positive and statistically significant in every sub period, producing reliable alphas that range from 8.9 to 10.3% per year over the four sub periods.

Looking across different sized firms, we find that the momentum premium is present and stable across all size groups—there is little evidence that momentum is substantially stronger among small cap stocks over the entire 86-year U.S. sample period. The value premium, on the other hand, is largely concentrated only among small stocks and is insignificant among the largest two quintiles of stocks (largest 40% of NYSE stocks). Our smallest size groupings of stocks contain mostly micro-cap stocks that may be difficult to trade and implement in a real-world portfolio. The smallest two groupings of stocks contain firms that are much smaller than firms in the Russell 2000 universe.

What is this saying?  Well, the value premium doesn’t appear to exist in the biggest NYSE stocks (the stuff your firm’s research covers).  You can find value in micro-caps, but the effect is still not very significant relative to momentum in long-only portfolios.  And momentum works across all cap levels, not just in the small cap area.

All of this is quite important if you are running long-only portfolios for clients, which is what most of the industry does.  Relative strength (momentum) is a practical tool because it appears to generate excess return over many time periods and across all capitalizations.

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Q3 Manager Insights

October 2, 2013

Click below for the Q3 Manager Insights:

Q3 Commentary 10.02.13

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Investment Process versus Investment Performance

September 6, 2013

Marshall Jaffe wrote an excellent article on investment process versus investment performance in the most recent edition of ThinkAdvisor.  I think it is notable for a couple of reasons.  First, it’s pithy and well-written.  But more importantly, he’s very blunt about the problems of focusing only on investment performance for both clients and the industry.  And make no mistake—that’s how the investment industry works in real life, even though it is a demonstrably poor way to do things.  Consider this excerpt:

We see the disclaimer way too often. “Past performance is no guarantee of future results.” It is massively over-used—plastered on countless investment reports, statements and research. It’s not simply meaningless; it’s as if it’s not even there. And that creates a huge problem, because the message itself is really true: Past performance has no predictive value.

Since we are looking for something that does have predictive value—all the research, experience and hard facts say: Look elsewhere.

This is not a controversial finding. There are no fringe groups of investors or scholars penning op-ed pieces in the Wall Street Journal shooting holes in the logic of this reality. Each year there is more data, and each year that data reconfirms that past performance is completely unreliable as an investment tool. Given all that, you would think it would be next to impossible to find any serious investors still using past performance as a guideline. Indeed, that would be a logical conclusion.

But logical conclusions are often wrong when it comes to understanding human behavior. Not only does past performance remain an important issue in the minds of investors, for the vast majority it is the primary issue. In a study I referred to in my August column, 80% of the hiring decisions of large and sophisticated institutional pension plans were the direct result of outstanding past performance, especially recent performance.

The truth hurts!  The bulk of the article discusses why investors focus on performance to their detriment and gives lots of examples of top performers that focus only on process.  There is a reason that top performers focus on process—because results are the byproduct of the process, not an end in themselves.

The reason Nick Saban, our best athletes, leading scientists, creative educators, and successful investors focus on process is because it anchors them in reality and helps them make sensible choices—especially in challenging times. Without that anchor any investor observing the investment world today would be intimidated by its complexity, uncomfortable with its volatility and (after the meltdown in 2008) visibly fearful of its fragility. Of course we all want good returns—but those who use a healthy process realize that performance is not a goal; performance is a result.

Near the end of the article, I think Mr. Jaffe strikes right to the core of the investment problem for both individual investors and institutions.  He frames the right question.  Without the right question, you’re never going to get the right answer!

In an obsessive but fruitless drive for performance too many fund managers compromise the single most important weapon in their arsenal: their investment process.

Now we can see the flaw in the argument that an investor’s basic choice is active or passive. An investor indeed has two choices: whether to be goal oriented or process oriented. In reframing the investment challenge that way, the answer is self-evident and the only decision is whether to favor a mechanical process or a human one.

Reframing the question as “What is your investment process?” sidelines everything else.  (I added the bold.)  In truth, process is what matters most.  Every shred of research points out the primacy of investment process, but it is still hard to get investors to look away from performance, even temporarily.

We focus on relative strength as a return factor—and we use a systematic process to extract whatever return is available—but it really doesn’t matter what return factor you use.  Value investors, growth investors, or firms trying to harvest more exotic return factors must still have the same focus on investment process to be successful.

If you are an advisor, you should be able to clearly explain your investment process to a client.  If you are an investor, you should be asking your advisor to explain their process to you.  If there’s no consistent process, you might want to read Mr. Jaffe’s article again.

HT to Abnormal Returns

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Bucket Portfolio Stress Test

September 4, 2013

I’ve long been a fan of portfolio buckets or sleeves, for two reasons.  The first reason is that it facilitates good diversification, which I define as diversification by volatility, by asset class, and by strategy.  (We happen to like relative strength as one of these primary strategies, but there are several offsetting strategies that might make sense.)  A bucket portfolio makes this kind of diversification easy to implement.

The second benefit is largely psychological—but not to be underestimated.  Investors with bucket portfolios had better performance in real life during the financial crisis because they didn’t panic.  While the lack of panic is a psychological benefit, the performance benefit was very real.

Another champion of bucketed portfolios is Christine Benz at Morningstar.  She recently wrote a series of article in which she stress-tested bucketed portfolios, first through the 2007-2012 period (one big bear market) and then through the 2000-2012 period (two bear markets).  She describes her methodology for rebalancing and the results.

If you have any interest in portfolio construction for actual living, breathing human beings who are prone to all kinds of cognitive biases and emotional volatility, these articles are mandatory reading.  Better yet for fans of portfolio sleeves, the results kept clients afloat.  I’ve included the links below.  (Some may require a free Morningstar registration to read.)

Article:  A Bucket Portfolio Stress Test

Article:  We Put the Bucket System Through Additional Stress Tests

Article:  We Put the Bucket System Through a Longer Stress Test



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Adventures in Fictive Learning

September 3, 2013

What the heck is fictive learning?  Well, I’m glad you asked.  Fictive learning refers to our ability to imagine “what if” situations.  We learn not only from our actual actions, but from our perceptions of what would have happened if we had done something differently.  It turns out that fictive learning has a lot to do with investor behavior too.  Here are a few excerpts about relevant experiments discussed in an article in Wired magazine.

To better understand the source of our compulsive speculation, Read Montague, a neuroscientist now at Virginia Tech, has begun investigating the formation of bubbles from the perspective of the brain. He argues that the urge to speculate is rooted in our mental software. In particular, bubbles seem to depend on a unique human talent called “fictive learning,” which is the ability to  learn from hypothetical scenarios and counterfactual questions. In other words, people don’t just learn from mistakes they’ve actually made, they’re able to learn from mistakes they might have made, if only they’d done something different.

Investors, after all, are constantly engaging in fictive learning, as they compare their actual returns against the returns that might have been, if only they’d sold their shares before the crash or bought Google stock when the company first went public. And so, in 2007, Montague began simulating stock bubbles in a brain scanner, as he attempted to decipher the neuroscience of irrational speculation. His experiment went like this: Each subject was given $100 and some basic information about the “current” state of the stock market. After choosing how much money to invest, the players watched nervously as their investments either rose or fell in value. The game continued for 20 rounds, and the subjects got to keep their earnings. One interesting twist was that instead of using random simulations of the stock market, Montague relied on distillations of data from famous historical markets. Montague had people “play” the Dow of 1929, the Nasdaq of 1998 and the S&P 500 of 1987, so the neural responses of investors reflected real-life bubbles and crashes.

Montague, et. al. immediately discovered a strong neural signal that drove many of the investment decisions. The signal was fictive learning. Take, for example, this situation. A player has decided to wager 10 percent of her total portfolio in the market, which is a rather small bet. Then, she watches as the market rises dramatically in value. At this point, the investor experiences a surge of regret, which is a side-effect of fictive learning. (We are thinking about how much richer we would be if only we’d invested more in the market.) This negative feeling is preceded by a swell of activity in the ventral caudate, a small area in the center of the cortex.  Instead of enjoying our earnings, we are fixated on the profits we missed, which leads us to do something different the next time around.

When markets were booming, as in the Nasdaq bubble of the late 1990s, people perpetually increased their investments. In fact, many of Montague’s subjects eventually put all of their money into the rising market. They had become convinced that the bubble wasn’t a bubble. This boom would be different.

And then, just like that, the bubble burst. The Dow sinks, the Nasdaq collapses, the Nikkei implodes. At this point investors race to dump any assets that are declining in value, as their brain realizes that it made some very expensive mistakes. Our investing decisions are still being driven by regret, but now that feeling is telling us to sell. That’s when we get a financial panic.

Montague has also begun exploring the power of social comparison, or what he calls the “country club  effect,” on the formation of financial bubbles. “This is what happens when you’re sitting around with your friends at the country club, and they’re all talking about how much money they’re making in the market,” Montague told me. “That casual conversation is going to change the way you think about investing.” In a series of ongoing experiments, Montague has studied what happens when people compete against each other in an investment game. While the subjects are making decisions about the stock market, Montague monitors their brain activity in two different fMRI machines. The first thing Montague discovered is that making more money than someone else is extremely pleasurable.  When subjects “win” the investment game, Montague observes a large increase in activity in the striatum, a brain area typically associated with the processing of pleasurable rewards. (Montague refers to this as “cocaine brain,” as the striatum is also associated with the euphoric high of illicit drugs.) Unfortunately, this same urge to outperform others can also lead people to take reckless risks.

More recently, a team of Italian neuroscientists led by Nicola Canessa and Matteo Motterlini have shown that regret is also contagious, so that “observing the regretful outcomes of another’s choices reactivates the regret network.” (In other words, we internalize the errors of others. Or, as Motterlini wrote in an e-mail, “We simply live their emotions like these were our own.”) Furthermore, this empathy impacts our own decisions: The “risk-aptitude” of investors is significantly shaped by how well the risky decisions of a stranger turned out. If you bet the farm on some tech IPO and did well, then I might, too.

If you are an investment advisor, all of this is sounding pretty familiar.  We’ve all seen clients make decisions based on social comparison, regret, or trying to avoid regret.  Sometimes they are simply paralyzed, trapped between wanting to do as well as their brother-in-law and wanting to avoid the regret of losing money if their investment doesn’t work out.

The broader point is that a lot of what drives trends in the market is rooted in human behavior, not valuations and fundamentals.  Human nature is unlikely to change, especially a feature like fictive learning which is actually incredibly helpful in many other contexts.  As a result, markets will continue to trend and reverse, to form bubbles and to have those bubbles implode periodically.

While social science may be helpful in understanding why the market behaves as it does, we still have to figure out a way to navigate it.  As long as markets trend, relative strength trend following should work.  (That’s the method we follow.)  As long as bubbles form and implode, other methods like buying deep value should help mitigate the risk of permanent loss.  Most important, the discipline to execute a systematic investment plan and not get sucked into all of the cognitive biases will be necessary to prosper with whatever investment method you choose.

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