Systematic Relative Strength

The final University of Michigan Consumer Sentiment Index came in at 75.0 for January.  That’s a sharp improvement from where it was last summer and fall, but it’s still in the lower part of the range over the past 30 years.  Check out the fantastic graphic from Calculated Risk:

Source: Calculated Risk  (click on chart to expand)

Maybe the world isn’t ending after all.  One never knows exactly how investors will respond to economic data, but movement from low levels to consumer sentiment to high levels of consumer sentiment is usually associated with decent equity markets.  The best entries tend to occur when sentiment is very poor—i.e., investors are perhaps overly pessimistic.

Bill Miller at Legg Mason Value Trust had one of the longest mutual fund outperformance streaks in history, 15 years through 2005.  His record may end up like Joe DiMaggio’s longstanding consecutive game hits record—never equalled and rarely even approached.  Yet even superstar fund managers may occasionally have feet of clay.  According to a Bloomberg article, his fund has had a rough time with Eastman Kodak:

Legg Mason Capital Management Value Trust (LMVTX), run by Miller since 1982, disclosed in a semi-annual report last week that the fund sold 18.2 million Kodak shares late last year and during this year’s first quarter for about $3.89 each on average. The fund realized a $551 million loss through the divestiture, according to the report.

Miller, 61, began loading up on Kodak shares in 2000 and, by the end of 2005, his firm owned as much as 25 percent of the Rochester, New York, company. Value Trust, one of several Legg Mason funds and accounts to hold Kodak stock, kept the bulk of its stake for more than a decade, only to sell after the film company had lost more than 90 percent of its market value.

Someone took the Kodachrome away

Source: www.photographymonthly.com

One of the challenges that value investors must take on is the value trap.  A value trap is a stock that looks cheap, but turns out to be cheap for a reason.  EK didn’t necessarily hold Bill Miller back; he had quite a number of years of market outperformance with Kodak included in the portfolio.  Other selections did pan out and more than offset the problem stocks.  The problem with value traps is psychological.  The Bloomberg article goes on:

“Part of it was just this mentality that this was just a temporary setback and Kodak would be able to get quickly back on track,” said Bridget Hughes, an analyst at Morningstar Inc., a Chicago-based stock and fund research firm. “It was not only a mistake, it was also causing a lot of client angst.”

I put the psychological problem in bold.  It drives clients crazy to see a big loser in the portfolio quarter after quarter, year after year. Even when buying cheap stocks is obviously part of the investment philosophy and when patience is required to get good returns, clients sometimes struggle with it.

Portfolio management using a systematic relative strength process has different strengths and weaknesses.  Clients are less likely to see a big loser sitting in the portfolio quarter after quarter, but are more likely to see more numerous transactions that result in small or moderate losses.   I suspect clients are no happier about a string of small losses, but they often seem to be able to let it go.  On the plus side, when using relative strength, most of the big winners will be retained in the portfolio for an extended time.

No investment approach is perfect, and every investment methodology will have its fair share of mistakes.  Still, clients choose to stick with some investment managers and bail on others, even when their long-run performance is comparable.  The client’s choice is often made primarily on the basis of emotion—sometimes just how they feel about how things are going.  All other things being equal, why would you elect to have your big losers show up on client statements for an extended period of time?

—-this article was originally published 6/30/2011.  Today EK filed for bankruptcy.  Someone finally took their Kodachrome away.  Kodak has had persistently poor relative strength for years.  Relative strength has its issues, but getting stuck in value traps is not one of them!

The cat, having sat upon a hot stove lid, will not sit upon a hot stove lid again. But he won’t sit upon a cold stove lid, either.—-Mark Twain

When you get burned, it’s important to learn your lesson.  As Mark Twain’s witticism suggests, it’s also important not to learn the wrong thing!  I was thinking about this in reference to James Surowiecki’s recent column in The New Yorker.  He notes:

It isn’t just that volatility costs ordinary investors money. It also makes them  more likely to give up on the stock market entirely: over the past three years,  investors have pulled almost two hundred and fifty billion dollars out of equity  funds, even though stock prices have almost doubled since the lowest point of  the crash. And, while some of that money has gone into exchange-traded funds,  most of it has just left the market. This flight from stocks is probably not a good thing for people’s retirement  accounts—after all, in a capitalist country owning some capital is usually a  smart way to make money. But it may well be a good thing for investors’ psychological well-being. In effect, they’ve decided that, in a market as  volatile as this one, the only way to win the game is simply not to play.

Even though stock prices have almost doubled.  Wow.

The problem here is pretty obvious.  Most investors don’t really want to earn good returns over time–they want to earn good returns all the time.  That’s not going to happen.  Investors are not winning by not playing.  They are just admitting defeat.  Winning the game takes a completely different mindset.

Further evidence that money goes where it is treated best comes from the Wall Street Journal:

…Vietnamese see golf rather differently: as a way to hold on to their money after years of booms and busts.

With property prices sliding and the local stock market in free fall, some people here are investing in golf club memberships in a last-ditch bid to protect their savings from being ravaged by soaring inflation and a fading currency.

Prices for club memberships around Hanoi have risen from around $6,000 in 2004 to roughly $30,000 now, with some of the plushest, complete with swimming pools, villas and tennis courts, reaching $130,000. That’s not as expensive as top clubs in Japan or Singapore, but it is still a large slice of change in a country where the average income is around $1,200 a year.

“Buying a membership is better than putting cash in the bank, better than putting it in the stock market, and better than putting it into gold,” said Do Dinh Thuy, a 48-year-old management consultant, amid the steady thwack of balls being driven out onto a local range here in Hanoi’s suburbs. He recently bought a third membership, “and that one’s not for playing—it’s for investment.”

When nothing else is working and you can’t get capital out of the country, apparently even golf memberships can be viewed as a store of value.  Supply and demand is an amazing thing.  It seems the value of golf memberships is soaring because the Communist Party leaders are restricting new courses in the name of national interest.

It turns out that one of the best predictors of future success is the ability to manage “hot” emotional states and to learn self-control.  Stanford psychologist Walter Mischel concocted an experiment involving 4-year olds and marshmallows to test self-control back in the 1960s, and only understood its significance much later.  (The experiment has been repeated more recently by others.  Here, for example, is a video of Columbian psychologist Joachim de Posada replicating the results.  Watch only if your tolerance for adorable 4-year olds trying to resist a marshmallow is extremely high!)   As Jonah Lehrer writes in The New Yorker:

For decades, psychologists have focussed on raw intelligence as the most important variable when it comes to predicting success in life. Mischel argues that intelligence is largely at the mercy of self-control: even the smartest kids still need to do their homework.

This is very true in financial markets.  Temperament trumps brains when it comes to making money over the long run.  You can have a great plan, but if you do not have the discipline to execute it, the plan is useless.

News flow in financial markets—much of it alarming, since scary new always gets better ratings–gives investors a multitude of opportunities to behave badly.  The best strategy?  Distract yourself.

At the time, psychologists assumed that children’s ability to wait depended on how badly they wanted the marshmallow. But it soon became obvious that every child craved the extra treat. What, then, determined self-control? Mischel’s conclusion, based on hundreds of hours of observation, was that the crucial skill was the “strategic allocation of attention.” Instead of getting obsessed with the marshmallow—the “hot stimulus”—the patient children distracted themselves by covering their eyes, pretending to play hide-and-seek underneath the desk, or singing songs from “Sesame Street.” Their desire wasn’t defeated—it was merely forgotten. “If you’re thinking about the marshmallow and how delicious it is, then you’re going to eat it,” Mischel says. “The key is to avoid thinking about it in the first place.”

According to Mischel, this view of will power also helps explain why the marshmallow task is such a powerfully predictive test. “If you can deal with hot emotions, then you can study for the S.A.T. instead of watching television,” Mischel says. “And you can save more money for retirement. It’s not just about marshmallows.”

As Mr. Mischel points out, it’s not just about marshmallows.  When clients ask me what to do in volatile markets, I only half-jokingly suggest that they read the sports pages.  Focusing on the business news is just going to make you more likely to react.  The more impulsive you are, the more likely you are to make a poor decision.

Self-control is very important when using return factors, none of which offer smooth sailing.  Whether you are implementing relative strength or deep value or whatever, the market is going to gyrate and test you—basically do everything possible to get you to abandon your plan.  A systematic, rules-based approach can be very helpful in this regard.  If you have chosen a successful long-term strategy, more than anything else, your results are going to be dictated by how well you can follow it over the long run.

Hands Off!

Source: www.instructables.com

By way of Michael Covel’s blog came an excellent reminder from Nassim Taleb:

Complex systems that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting no visible risks. In fact, they tend to be too calm and exhibit minimal variability as silent risks accumulate beneath the surface. Although the stated intention of political leaders and economic policymakers is to stabilize the system by inhibiting fluctuations, the result tends to be the opposite. These artificially constrained systems become prone to “Black Swans” — that is, they become extremely vulnerable to large-scale events that lie far from the statistical norm and were largely unpredictable to a given set of observers.

Such environments eventually experience massive blowups, catching everyone off-guard and undoing years of stability or, in some cases, ending up far worse than they were in their initial volatile state. Indeed, the longer it takes for the blowup to occur, the worse the resulting harm in both economic and political systems.

Seeking to restrict variability seems to be good policy (who does not prefer stability to chaos?), so it is with very good intentions that policymakers unwittingly increase the risk of major blowups. And it is the same mis-perception of the properties of natural systems that led to both the economic crisis of 2007-8 and the current turmoil in the Arab world. The policy implications are identical: to make systems robust, all risks must be visible and out in the open — fluctuat nec mergitur (it fluctuates but does not sink) goes the Latin saying.

In financial markets, there are all kinds of ways to constrain volatility, almost all of them unhealthy.  In fact, investors are so concerned with volatility and will do so much to avoid it that they unintentionally court disaster.  Bernie Madoff was able to hoodwink legions of investors because he purported to reduce volatility.  A lightning strike in Yellowstone National Park turned into a firestorm because the system had been artificially constrained by decades of putting out forest fires immediately—when the National Park Service decided on a new policy of letting fires burn out naturally, they forgot about all of the excess fuel that had built up over the years of artificial constraints.  In a noble, misguided attempt to preserve the scenic forest, much of it was destroyed in a single burn.

Investors are notorious for wanting the returns of good investment factors, while wishing to diminish the volatility.  This is a really good way to be involved in a massive blowup somewhere down the road.  Just because the risk is not immediately visible does not mean it has been eliminated.  This is probably not a road you want to go down.

I became infamous at a certain Morgan Stanley investment conference a couple of years ago when I compared volatility to baby poop, admittedly not a typical investment topic.  When you have a baby, you have to deal with baby poop.  It’s just part of the process.  As a parent, you are so pleased with the infant that you don’t see it as a big problem.  No one tries to optimize for a baby that doesn’t poop.  You just deal with things the way they are.

Similarly, investors are wasting their time trying to optimize return factors to reduce volatility.  Volatility is just a feature of the return factor—in fact, consider that the existence of the volatility may be part of the reason that return factors remain exploitable for generations.

Relative strength has been a reliable return factor for a long time, but it is also accompanied by significant volatility.  (The same thing is true of deep value, by the way.)  To my way of thinking, the fact that the volatility is out in the open is important.  Lots of investors are dissuaded from using it, which leaves the factor return intact.  It also makes the return factor robust, since hidden risks are not building up silently.  What you see is what you get.