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

At times, it seems as if the number of ETFs available to U.S. investors will soon exceed the number of stars in the sky. That might be overstating things a bit, but the pace of expansion in the ETF industry has truly been impressive over the last several years. With multiple products seemingly debuting every week and very few shutting down (despite countless predictions to the contrary), the size of the ETF lineup has effectively doubled in a relatively short period of time. And there’s no indication that the product development front is going to be slowing down any time soon; issuers continue to file for both innovative and duplicative products, producing a pipeline full of hundreds of funds that could debut at some point in the next several months.

The proliferation of ETFs, ETNs, and other exchange-traded cousins of these vehicles is, in many ways, a very positive development for investors. There are now ETPs for just about every investment objective, ranging from the very broad and very straightforward to the hyper-targeted and rather complex. And many of the more recent additions to the ETF lineup have further “democratized” the business of investing, delivering cheap and easy access to sophisticated strategies that would otherwise be time consuming and expensive to implement.

My emphasis added.  Up to this point, I wholeheartedly agree–the expansion of the ETF universe has been extremely beneficial to investors.  It has also played right into our hands here at Dorsey Wright because it has provided a very tax-efficient means of getting exposure to relative strength (See PDP, PIE, and PIZ).  Furthermore, the expansion of the ETF universe has enabled us to provide innovative global tactical asset allocation strategies (See DWAFX and DWTFX) where we can efficiently get exposure to a wide variety of global asset classes.

However, ETFdb then states the following:

But the growth spurt for the industry has also made it increasingly difficult to navigate. Moreover, the tremendous variance in level of sophistication and risk tolerance among ETFs can set the stage for confusion and potentially lead to a less-than-ideal experience with ETFs.

That last part is only true if there is no framework for efficiently and thoroughly evaluating each of the ETFs.  Without such a framework then, yes, I can certainly understand why some find it “increasingly difficult to navigate.”  However, within the context of a relative strength model, more choices are potentially a good thing.  The more options for finding uncorrelated returns, the more likely it is that a global tactical asset allocation strategy can generate favorable returns in a variety of market environments.  Furthermore, relative strength models evaluate each member of the universe in a systematic fashion and only allocate if dictated by the relative strength rank–a true meritocracy!

Source: Wikipedia

See www.powershares.com and www.arrowfunds.com.

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.

Practitioners know that the optimal asset allocation can only be known in retrospect. If your time horizon is 20 years, you’ll have to wait 20 years before you find out what asset allocation you should have had during this period to have earned the best risk-adjusted return.

This is the point so often missed by the modern portfolio theory crowd. Using historical data to come up with the optimal mix tells you nothing about how that mix may perform in the future.  Thus, the argument for trend following.

HT: Abnormal Returns

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.

“There’s a big shift in terms of how plan sponsors are defining risk,” said Michael Thomas, chief investment officer for the institutional business in the Americas at Russell. “During the last 10 years, our industry has developed an unhealthy obsession with tracking error, but managing tracking error isn’t managing risk.”

He’s right—tracking error is not the same thing as risk.  Nor is volatility the same thing as risk, I might add.  Volatility management is just another unhealthy obsession.  Besides, the source of all of the evil volatility is readily apparent.

So far, most of the target volatility asset allocation strategies focus on equity exposure, which is, “by far, the biggest contributor of [portfolio] volatility,” Russell’s Mr. Thomas said.

Equity exposure = volatility.  To reduce it, just add some Treasury bills or bonds to the portfolio.  Duh.  That seems like a simpler solution if you really are concerned about reducing volatility.

I don’t think that investors are going to be any more successful targeting volatility than they are trying to target returns. We have no idea year to year what returns are going to be, even though we know exactly what they have been historically.  We can’t forecast it or target it–we just put up with whatever returns we get.  I don’t think volatility is going to be any more tractable.

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.

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.

For much of the past decade, it was presumed that the debt of developed economies was risk-free. This is why a full $38 trillion, or more than 51%, of the world’s total outstanding marketable safe assets is investment-grade sovereign securities — that is, government bonds.

However, the financial crisis has shown the folly of this presumption. While 68% of advanced economies carried a AAA rating five years ago, the proportion had dropped to 52% by the end of last year, as countries like the United States, France, and Spain all lost their coveted AAA status. And the same trend can be seen in the movement of sovereign bond yields in advanced economies. Prior to 2008, the yields moved in harmony. After 2008, individual countries started peeling away. Greece was the first to depart, followed by Portugal, and then Spain, Italy, and Belgium. All told, $15 trillion in investment-grade sovereign debt has been downgraded.

Why is this happening? Quite simply, countries are far too leveraged. The debt-to-GDP ratio of the euro area went from 66% in 2008 to 85% last year. The United States’ went from 64% to 93%. And Japan went from an already-high 188% to an even higher 220%. While the total general government gross debt of advanced economies amounts to more than $47 trillion today — this includes both investment-grade and non-investment-grade sovereign bonds — the IMF projects this figure will rise to $58 trillion by 2016, an increase of 38%.

In an era of rising debt-to-GDP ratios of developed governments, labels such as “safe” and “risky” are likely to be fluid.  It’s entirely possible that asset classes previously considered risky will be the ones that ultimately prove to be the safest from the perspective of preserving purchasing power.  Asset allocations that remain flexible enough to respond to unfolding developments are the ones most likely to succeed going forward.  

Please click here to view a 13 minute video about this portfolio.

To receive the brochure for our Global Macro strategy, click here.  For information about the Arrow DWA Tactical Fund (DWTFX), click here.

Click here and here for disclosures.  Past performance is no guarantee of future returns.