Systematic Relative Strength

In every corner of the world, supply and demand is the essential law of economics that never gets repealed. For proof, consider this quote from a Reuters story:

Somali pirates said on Sunday they would lower some of their ransom demands to get a faster turnover of ships they hijack in the Indian Ocean.

Armed pirate gangs, who have made millions of dollars capturing ships as far south as the Seychelles and eastwards towards India, said they were holding too many vessels and needed a quicker handover to generate more income.

In essence, supply is piling up and the pirates are cutting prices! This demonstrates pretty clearly why price is so important—it is the clearing level for supply and demand.

Source: www.timtim.com

From a story in The Economist, discussing the many problems with the efficient markets hypothesis:

But the efficient-market hypothesis, like a Hollywood monster, has proved very hard to kill off.

The whole article is worth a read, especially the brief discussion of relative strength (known in academic circles as momentum).

This one might even be statistically significant. Apparently the market prefers blondes. CNBC.com reports:

The models’ hair color was gauged from the Sports Illustrated website, dating back to 1964.

The fact that there is such a large return difference between covers featuring blondes and brunettes is obviously coincidental. However, it points to the danger of data-mining and optimization. If you search through enough data to find relationships, you will succeed in your quest—and lots of the relationships will be coincidental. When you do research, you must first start from a logical premise that suggests that two data series are related in a specific way. Otherwise you will find lots of stuff with high statistical significance that will fall apart in real life.

Here is a cool chart from MarketBeat. It’s from an article on Netflix in which they discussed how analysts are still playing catch-up on the stock price target. Currently, the analysts’ consensus price target is $186, but the stock is currently trading at about $210.

Click to enlarge. Source: MarketBeat, FactSet

It’s a tough business, estimating a target price, especially when the darn stock won’t cooperate. It looks like the stock price and the consensus target were pretty aligned in 2009. In 2010, the stock charged higher and the analysts are still trying to make sense of the move. (On the other hand, the 18% of analysts that carried NFLX as a buy in March 2009 are looking pretty good.)

No doubt Netflix will top out at some point in the future-but that price is still to be determined.

Disclosure: Dorsey, Wright Money Management owns NFLX in some account styles.

Every NFL team competes every week with one goal in mind: to get to the Super Bowl. No team wins every year, but every team tries to win every year. Like NFL teams, investment managers are a competitive bunch. Each year, about this time, firms wrap up their year-end performance data. We always look to see how we stack up against our direct competitors-some years great, other years not so well.

Last year, 2010, turned out to be a very good year for relative strength generally, and especially our relative strength process. The grand-daddy of relative strength indexes, the Technical Leaders Index, performed admirably against both the market and other momentum indexes. While that is unlikely to be the case every year, perhaps we should take the opportunity to do a touchdown dance now!

2010 S&P 500 total return +15.06%

AQR Momentum Index +18.60%

Technical Leaders Index +26.59%

There are some differences between the indexes, of course. The S&P 500 is the de-facto market, containing 500 companies weighted by capitalization. The AQR Momentum Index (AMOMX) contains the top third (about 300 companies) of the largest 1000 by market value. It is ranked by 12-month return and is capitalization weighted. The Technical Leaders Index (PDP) contains 100 companies from the Russell 1000, ranked by Dorsey Wright’s proprietary relative strength measure. The 100 stocks are weighted by relative strength also.

Click to enlarge. Source: Yahoo! Finance

Source: Carl Richards, New York Times

I think Carl Richards hits the nail on the head here. Investing for your future is too important to be left to guessing. We think it is far more sensible to harness a proven return factor (like relative strength) in a systematic process. There is enough randomness in the market and in life as it is!

Andrew Barber, quoted in Forbes, had this to say about volatility products:

“I would advise anyone considering buying one of the volatility futures products to dig a small hole in the backyard and set their money on fire instead,” said Andrew Barber, a strategist at investment adviser Waverly Advisors in Corning, N.Y. “The net result is the same.”

Source: Forbes.com

Hilarious. Mr. Barber has a way with words. It’s sexy to talk about hedging your portfolio with VXX or some similar product, but when in contango, the negative roll yield causes terrible performance. And they’ve been in steep contango for a while. Since VIX typically has a strong inverse correlation with the S&P, another option would be just to use an inverse ETF-unleveraged.

On the other hand, there’s a simple way to handle volatility: if you want exposure to the market, suck it up and learn to deal with it.

Dynamic Hedge has a funny article about how messy the investment process is. That’s especially true for investors in separately-managed accounts (SMA). While the SMA has tax advantages over a mutual fund, and sometimes expense and return advantages, the SMA is also inherently messier because clients can see the trades. Often clients interpret a few losses as evidence that a manager is ineptly thrashing around in the market. In fact, as Dynamic Hedge points out, the whole investing process is like a sausage factory. You might like the end result-RS strategies had really, really nice numbers last year-but you might not like to watch the sausage being made. We think that the SMA vehicle is very worthwhile, but you might need to avert your eyes now and then. Give the portfolio manager a break, eh?

Source: Dynamic Hedge

In January, many firms seem compelled to offer a forecast for the coming year. Not us. (By now you should know what I think about predictions!) We just go with the flow and try to turn every year into a good year.

Since I recognize this is not very satisfying, here is my favorite prediction so far, courtesy of Laszlo Birinyi, by way of Investment News. I’m not saying it’s more accurate, just that I like it better!

I say high, you say low
You say why, and I say I don’t know
Oh, no
You say goodbye and I say hello
Hello, hello
I don’t know why you say goodbye
I say hello
Hello, hello
I don’t know why you say goodbye
I say hello
—-John Lennon/Paul McCartney

This is a good reminder not to get locked into a position-when one door closes, another door opens. I have long suspected these lyrics referred to sector rotation in the stock market, but I guess you can never be sure, since John Lennon is no longer around to ask. He was killed thirty years ago yesterday, news that was broken to the American public by Howard Cosell during a Monday Night Football game. Moment of silence, please.