Systematic Relative Strength

By now, it’s pretty apparent that the Euro is eventually going to be toast, just like the ERM imploded before it.  (Perhaps it was never logical to assume that one currency and one central bank would be able to satisfy many different cultures and political regimes?)  Of course there is a lot of hand-wringing going on about all of the bad things that will happen, but no one is talking about the offsetting good things that will happen.

We’ve written before about beanbag economics, the essence of which is that when you smush in one part of a beanbag, it just poofs out somewhere else.  Relative strength is a simple and effective way to see where trends are underway.

Consider a typical bad news lead in this Reuters article:

Worries about a run on Greek banks has rattled Athens this week, after savers withdrew at least 700 million euros on Monday alone…

That sounds quite scary.  However, buried deep in the article, at the very end, is the beanbag economics section:

Deposits shifted around Europe dramatically last year, analysis of data from more than 120 listed European banks show.

More than 120 billion euros was taken from two banks in Belgium alone, including an exodus of customer deposits from Dexia (DEXI.BR) which had to be bailed out and restructured. KBC (KBC.BR) also saw a big outflow.

Some 90 billion euros was taken from France’s banks, including around 30 billion each from Credit Agricole (CAGR.PA) and BNP Paribas (BNPP.PA). French banks were hit last year by their heavy exposure to Greece and concerns about their liquidity that forced them to accelerate plans to shrink.

Worries the euro zone crisis would spread also saw about 30 billion euros in deposits leave Italian banks, although inflows to BBVA (BBVA.MC) helped limit the net outflow from Spain.

Cash flooded into Britain; more than 140 billion euros was deposited in four big banks alone. The UK benefits from its position outside the euro zone and its Asia-focused banks HSBC (HSBA.L) and Standard Chartered (STAN.L) are seen as particular safe-havens.

Other banks to see big inflows included Barclays (BARC.L), Germany’s Deutsche Bank (DBKGn.DE), Switzerland’s Credit Suisse (CSGN.VX) and UBS (UBSN.VX) and Russia’s Sberbank (SBER.MM) and VTB (VTBR.MM).

Banks that were in trouble had deposits leave, but they didn’t vanish into thin air.  Other banks saw massive inflows at their expense.  And—think about it—the Greek and French banks had the money in the first place because depositors saw them as relatively more attractive than European stocks or their mattresses, or whatever, at the time.  Times have now changed and the flow of money is being directed somewhere else.  It’s not the end of the world when some asset class implodes, unless, of course, you have 100% of your assets in it.  That implosion works to the benefit of another asset class somewhere else.

There are always relative winners and losers; things are rarely completely one-sided.  This is the primary attraction of using relative strength for tactical asset allocation.  It is able to identify shifts in supply and demand by measuring what assets are strong and what assets are weak.   Markets all over the world operate and interact in this same way.

Beanbag Economist: Someone has to get those asset flows!

Source: www.indyagenda.com

Warren Buffett reiterated at his recent “Woodstock for Capitalists,” otherwise known as Berkshire Hathaway’s annual meeting, that he much preferred productive assets to gold.  Charlie Munger agreed.  For the record, I’ve got nothing against productive assets.  They produce earnings and sometimes dividends and that’s nice.  However, a global tactical asset allocator should not be too eager to count out gold.

Gold has had good relative strength for much of the last decade—and as a result it has dramatically outperformed Warren Buffett.  Bespoke took up this exact issue and had this to say:

Given the fact that BRK/A does not pay a dividend, no matter how much a holder ‘fondles’ or looks at their holdings, one share of BRK/A stock purchased twelve years ago is still one share today.  Sure, you can sell it for more now than you bought it then, but the same is true of gold.  In fact, your gain on gold is considerably more than your gain would be on BRK/A.  Looking at the performance of the two assets since the start of 2000 shows that the value of gold has increased considerably more than the value of Berkshire Hathaway.  In fact, with a gain of 466% since the start of 2000, gold’s gain has been nearly four times the return of BKR/A (466% vs 120%).

Their nifty graphic follows:

Source: Bespoke   (click on image to enlarge)

Relative strength has no axe to grind.  One of the great benefits of using relative strength to drive tactical asset allocation is that it is objective and adaptive.  Relative strength does not have a philosophical bias in favor of, or against, gold.  If relative strength is high, perhaps it should be included in the portfolio.  If relative strength is low, it’s out—period.

The point of investing is not to serve our biases, but to own the best-performing assets that we can identify.

Global investing is becoming extremely important, as so much dynamic growth is located overseas.  In the last decade, it seems like China has grown tremendously.  In fact, if you listen to Congress, they see China as a threat to take American jobs.  Maybe this article from the Wall Street Journal will surprise you like it did me.  It’s a genius way to look at real wages.

Comparing wages across countries can be difficult, but one economist has come up with a way to track people doing identical jobs to make an identical product all across the world: McDonald’s employees.

Just comparing how much money workers make across countries is too simplistic. A better guide can come from taking a wage rate and dividing it by a good, which allows economists to see how much of that product an hour of work buys — a so-called real wage.

In order to calculate a real wage across countries Orley C. Ashenfelter of Princeton University found an excellent example using McDonald’s employees. In his paper published by the National Bureau of Economic Research, Ashenfelter notes that McDonald’s workers across the globe by design are asked to perform the same tasks to build the same product: a Big Mac. By calculating how many hours of work it takes an employee to earn enough to afford a Big Mac, he can show how wages change across countries.

You’ve got to admit that’s pretty clever.  (But Mr. Ashenfelter has been pretty clever in other areas as well.)  The graphic that goes along with it is the surprise.

McWages

Source: Wall Street Journal

Western Europe, the US, and Canada are all high wage areas.  China is significantly cheaper—but look at Latin America and India.  They are another magnitude lower in wage rates than China.  Usually other factors, including political stability and the rule of law, come into play before a company decides to locate jobs offshore.  This suggests that other low-wage areas could boom if they develop political structures that are conducive to business.  Maybe China will export jobs to India!

“Real wage rates seem to have been remarkably similar across countries before the industrial revolution,” Ashenfelter says. Since then “real wage rates have diverged across countries, with catch up taking place in different countries at different points in time.”

How can any individual investor keep up with all of this information?  No one person is going to be able to synthesize information about so many central banks, political administrations, and legal systems.  But guess what—asset prices do that all the time.  If prices in Mexico or Columbia or India start to rise, maybe the market is expecting some positive changes.  If the price change persists and results in a high degree of relative strength, that becomes notable.

This is just another way of pointing out that money goes where it is treated best.  Global tactical asset allocation using relative strength is one way to track these changes as they occur—and to create the opportunity to profit from them.

According to the Wall Street Journal, job growth at US multinationals has been surging for the last two years…overseas.

Thirty-five big U.S.-based multinational companies added jobs much faster than other U.S. employers in the past two years, but nearly three-fourths of those jobs were overseas, according to a Wall Street Journal analysis.

Those companies, which include Wal-Mart Stores Inc., WMT +0.12%  International Paper Co., Honeywell International Inc. and United Parcel Service Inc., boosted their employment at home by 3.1%, or 113,000 jobs, between 2009 and 2011, the same rate of increase as the nation’s other employers. But they also added more than 333,000 jobs in their far-flung—and faster-growing— foreign operations.

Economists who study global labor patterns say companies are creating jobs outside the U.S. mostly to pursue sales there, and not to cut costs by shifting work previously performed in the U.S., as has sometimes been the case.

The reason is simple—there is more growth overseas than in the US.  Companies naturally desire to be close to their customers, so they put operations nearby to serve them.  If you decide to distribute Pepsi in Mongolia, that has to be done by Mongolians.  It’s not a matter of evil corporations exporting jobs overseas—there’s just no way for that job to be done in the US.

When I read articles like this, it makes the argument that some type of global macro strategy needs to be part of a core portfolio.  We no longer have the investment luxury of staying completely within our borders, figuring that the best returns available can be captured here.  The world is changing and global is the new core.

Ray Dalio of Bridgewater is an interesting character and an independent thinker.  He’s also been immensely successful as an investor.  If you are interested in economic history and think it might have some relevance to the way things might evolve in the future, you’ll want to read his paper on why countries succeed and fail.

This is also a wake-up call that you need to consider a flexible, global investment policy.  You need to go where the returns are, and that can change from cycle to cycle.

From an interview on Clusterstock:

Everybody is paying higher prices for oil and that obviously impacts consumption everywhere.  It’s not just oil, it’s food and everything else that’s going up.  There’s inflation everywhere, the U.S. lies about it.  I mean, the U.S. government lies about inflation but there’s inflation everywhere. I mean, I don’t know if  you go shopping, but if you do, you know prices are up. The government says they’re not. I don’t know where they shop. Everybody else’s prices are up.

There’s obviously inflation in Mr. Roger’s neighborhood.  Based on the Everyday Price Index, inflation is a lot higher than the reported CPI.  They’re different measures, but depending on what you buy, your personal inflation rate could be a lot different than the government’s.

The market doesn’t seem to be reacting strongly to inflation pressures right now, but there is no telling if that will change in the future.  Some asset classes respond poorly to inflation, but others perform well and can act as inflation hedges.

I don’t get the sense—judging from the public’s heavy bond buying—that inflation is on the radar for most investors.  It’s probably wise to have an investment policy that is flexible enough to include inflation hedges if they are needed.  Or you could just let a manager handle the global tactical allocation strategy for you.  I’m just saying.

Source: CNBC            (click to enlarge)

We’re big advocates of relative-strength weighting.  That’s how our Technical Leaders Index is set up and it’s performed pretty well.  Another common alternative is market capitalization weighting, which is the default method for most of the major indexes.  A less common, but also robust, method is equal-weighting.  With all weighting methods, volatility should be productive if there is some kind of rebalancing going on.  The Technical Leaders Index is reconstituted and rebalanced quarterly to take advantage of relative strength trends, for instance.

Relative strength methodologies are quite volatile and weights rise with the trend.  Cap weighting and equal weighting are typically mean reversion methods and weights rise against the trend.  The Capital Spectator recently carried an article that showed just how productive volatility can really be.  James Picerno, who edits The Capital Spectator, has a Global Market Index, which has as its components all of the major global asset classes.  (You can click on the link in his article to see what they are.  By the way, he has one of the finest blogrolls anywhere–full of great resources.)

In the chart below, the GMI is rebalanced just once a year, to market weights or equal weights, depending on the index.

Source: Capital Spectator  (click on image to enlarge)

For most of the time frame shown, equal weighting outperforms.  Equal weighting is completely naive.  In effect you are saying, “I have no idea what will perform best, so I will just buy equal amounts of everything.”  Fortunately, since—in truth—no one has any idea what will perform best, equal weighting works pretty well.  Market weighting, if you believe the arguments put forward by Rob Arnott, suffers from overvalued assets getting large weights.  In that sense, perhaps equal weighting is the purer approach.

Why are the rebalanced returns higher than the index returns?  In a word, volatility.  Regardless of the weighting method, rebalancing takes advantage of market volatility.  Investors need to reframe the way they think about volatility.  Volatility is not necessarily something negative or something to panic about.  If it is harnessed, volatility can be the engine for higher returns.

Money tends to migrate to where it is treated best.  And when you tax it, it tends to disappear.  This gives rise to the saying “whatever you tax, you get less of.”  In the case of a wealth tax in England, this happened literally.  Last year, the UK increased its tax rate on the highest earners from 40% to 50%.  Can you guess what happened?  From AdvisorOne:

Britain’s Telegraph newspaper reported that the U.K. Treasury–in the first test of the wealth tax policy introduced last year–received 509 million pounds less for January than the same month in 2011. The Treasury had projected that monthly revenues would actually increase by more than 1 billion pounds.

The projection was for significantly increased revenues to the Treasury, but revenues fell instead.  Now, it is doubtful that the money actually disappeared.  More likely than not, it just changed forms, from income to something else that was taxed at a different rate.

Markets all over the world operate and interact in this same way.  I’ve described it before as beanbag economics—when you smush in one part of the beanbag, it just poofs out somewhere else.  Relative strength is a simple and effective way to see where trends are underway.