Systematic Relative Strength

With interest rates surging in recent days, I think it is interesting to stand back and look at a chart of the 10-Year Treasury Yield from a broader historical perspective. Via Business Insider:

Source: Global Financial Data (click to enlarge)

Business Insider’s take:

So if you believe in the power of mean reversion, then it’s not unreasonable to expect yields to head back up toward 4%.

Although investors have grown accustomed to interest rates primarily moving in one direction (down) over the past 30+ years, history shows a number of periods of extended rising rate environments. Needless to say, it is quite possible that there will be opportunities to add value over a passive approach to fixed income exposure by being tactical in years ahead. In the context of multi-asset class portfolios, that may mean underweighting fixed income altogether. For allocations within fixed income, it may mean being more discriminating when determining what sectors of fixed income to own. I suspect that relative strength may prove to be very valuable in the years ahead as it relates to fixed income exposure.

Financial Times author, Ruchir Sharma, says that money flows into the emerging markets are more discriminate this decade.

As the printing presses continue to hum, however, the question remains: where will the money go? Policy makers cannot assume it will flow to the emerging markets, the way it did in the 2000s. That was an exceptional decade, when all emerging markets boomed, attracting huge new capital flows. Now the blind optimism about growth in many emerging markets has dimmed, as many face serious structural problems.

Brazil, Russia and South Africa may grow more slowly than the global average over the next few years. However, inflows remain high in some of the more reform-oriented emerging economies such as the Philippines, Thailand and Turkey.

Interestingly, countries—Philippines, Thailand, and Turkey—that he labels as “more reform-oriented emerging economies” are all countries where we have overweights in the PowerShares DWA Emerging Markets Technical Leaders ETF (PIE).

As of 4/1/2013.

These overweights and underweights have had a very positive impact on YTD performance:

Source: Yahoo! Finance

Performance numbers listed above are pure price returns, not inclusive of dividends, all fees, or other expenses. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss. See www.powershares.com for more information.

HT: Abnormal Returns

According to Morningstar, The Arrow DWA Tactical Fund (DWTFX) is now outperforming 95% of its peers in the World Allocation category YTD. Through April, the fund is up 9.79%

You can access the fact sheet for the fund by clicking below:

See www.arrowfunds.com for more information. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.

From Eddie Elfenbein comes what I consider to be among the biggest reasons for employing a tactical approach to asset allocation—an approach that seeks to overweight or underweight U.S. equities depending on their relative strength.

I want to revisit the Ibbotson data again to look at the often-cited claim that the stock market has historically returned (capital gains and dividends) 7% per year greater than inflation. This claim has been repeated so much by Jeremy Siegel that some have called it Siegel’s Constant.

Here’s the long-term real return in blue, with a 6.9% trendline in black.

I think this is a dangerous idea for several reason. For one, the long-term real return of stocks is no longer 7%. Thanks to two giant market crashes in less than a decade, the long-term number has fallen to 6.67% (that’s since 1925). Furthermore, much of that gained comes from the post-war boom. Over that last 50 years, that real return has been a much more reasonable 5.45%.

Another problem is that this data series is highly volatile. Too volatile to call the results a constant. There have been long periods when investors haven’t made a dime from the stock market in real terms.

Looking at the data, there seems to be periods of 15 to 20 years when stocks boom, or when they bust. Notice how the blue line runs above or below the black line for long periods at a time. Still, I would say that we don’t have enough data to make the claim that the stock market does this regularly.

During those 15-20 year periods when stocks boom it makes sense to seek to overweight them and during the extended periods when stocks are out of favor it is quite likely that an investors will benefit by seeking to overweight other asset classes. This theory of tactically allocating among different asset classes was put to the test here in a white paper published by John Lewis. It doesn’t work every year, but over time the results speak for themselves.

3/31/2013

The Arrow DWA Balanced Fund (DWAFX)

At the end of March, the fund had approximately 46% in U.S. Equities, 25% in Fixed Income, 17% in International Equities, and 12% in Alternatives. This is little changed from the allocations to the different asset classes as of the end of February. Our biggest overweight continues to be U.S. equities. Within the U.S. equity sleeve, we have exposure to Healthcare, Financial, and Consumer Services sector funds. These three sectors have maintained fairly stable leadership for some time now. We also have exposure to U.S. small and mid-cap value funds. Value has generally had much better relative strength than Growth style funds.

DWAFX gained 2.52% in March and is up 6.34% through 3/31/13. Although our best performing holdings in March came from our exposure to U.S. equities, we also had some strong performance from International equities—Mexico in particular. Fixed income was relatively flat in March. Our exposure to fixed income can range from 25-65 percent of the fund, but for now the exposure is at the lower end of its band.

We believe that a real strength of this strategy is its balance between remaining diversified, while also adapting to market leadership. When an asset class is weak its exposure will tend to be towards the lower end of the exposure constraints, and when an asset class is strong its exposure in the fund will trend toward the upper end of its exposure constraints. Relative strength provides an effective means of determining the appropriate weights of the strategy.

The Arrow DWA Tactical Fund (DWTFX)

At the end of March, the fund had approximately 63% in U.S. Equities, 27% in International Equities, and 9% in Real Estate. As part of our U.S. equity exposure, we own Healthcare, Financial, and Consumer Services sector funds. These three funds have maintained fairly stable market leadership. We also have exposure to U.S. small and mid-cap value funds. Value has generally had much better relative strength than Growth style funds.

DWTFX was up 3.07% in March and has gained 6.98% through 3/31/13. Much of the best performance for the month came from our exposure to domestic equities and real estate, while our exposure to International equities was relatively flat over the course of the month.

This strategy is a go-anywhere strategy with very few constraints in terms of exposure to different asset classes. The strategy can invest in domestic equities, international equities, inverse equities, currencies, commodities, real estate, and fixed income. Market history clearly shows that asset classes go through secular bull and bear markets and we believe this strategy is ideally designed to capitalize on those trends. Additionally, we believe that this strategy can provide important risk diversification for a client’s overall portfolio.

See www.arrowfunds.com for more details.

Brian Westbury and Bob Stein, Chief Economists for First Trust, have an interesting view of what may be in store for inflation in the coming years:

Inflation is tame. For now. The CPI (consumer price inflation) was flat in January and is up only 1.6% from a year ago. The PPI (producer prices) rose a small 0.2% in January and is up just 1.4% from a year ago.

And even though energy prices spiked in February, the year ago comparisons are likely to stay tame. The consensus expects the February CPI to rise 0.6% - the largest in 44 months. Nonetheless, it would still show just 1.9% inflation in the past year, which is still below the Federal Reserve’s target of 2%.

This won’t last. With the Fed loose; we expect consumer prices to rise toward 3% during 2013. Then rise to 4% in 2014 on its way to 5% gains, maybe even higher, in the next few years. In theory, the Fed has said that 6.5% unemployment and 2.5% or greater inflation would force it to tighten policy.

However, we believe the Fed will remain in denial about inflation. Ben Bernanke, Janet Yellen, and Bill Dudley – the power-elite – don’t believe inflation can head higher, so when it does, they will either ignore it or blame it on temporary, one-off shocks as the Fed did in the 1970s.

The first excuse will be that higher inflation is due to commodities, and they are just not that large a part of the economy. Moreover, “core” inflation remains tame.

But when rising housing prices (and rents) push “core” inflation above the 2% target, the Fed will resort to its second excuse: housing prices are just bouncing back to normal…and that this is just a temporary phenomenon.

The third excuse will be that “it is not actual inflation that matters, but what the Fed forecasts future inflation will be” over the next year or two. And, as long as the Fed is forecasting a return to 2% or lower, then there’s nothing to worry about.

If we are right and inflation persists above 2% and continues to rise, that excuse won’t work anymore, either.

Enter excuse number four: this is when the troika of Bernanke, Yellen and Dudley will argue that “it’s OK for inflation to exceed a 2% target because it has to make up for when inflation averaged below target during past years.”

Finally, the Fed will resort to excuse number five, which will blame increasing price pressures, not on loose money, but on things like temporary weakness in the dollar or a temporary increase in velocity or the money multiplier.

The fact that CPI has been so tame over the last couple years of this recovery has surprised many, but Wesbury and Stein may well be correct about inflation (and the Fed’s response to it) going forward. For those approaching asset allocation from a tactical perspective, this doesn’t necessarily have to be a bad thing. In fact, a portfolio that has the ability to make meaningful allocations to commodities and real estate, among other asset classes, may even thrive in that environment.

Morningstar details the risks facing fixed income investors seeking higher yields:

The ability for even very low-rated, highly leveraged companies to get financing has helped many firms stay afloat when they would otherwise have defaulted in a normal year. The high demand for these speculative issues has caused some investors to discard fundamentals in favor of searching for the highest yield without regard for quality. This strategy has worked so far, but at some point demand will soften, poor business fundamentals will catch up with firms, or the Fed will change its policy.

The article also included this chart showing historical drawdowns in high yield bonds:

This is a pretty good argument for being tactical with your fixed income exposure.

To learn about our approach to tactically managing a broad universe of fixed income, including Treasurys, Corporates, High Yield, International, Convertible, and TIPs, click the image below to watch a short video presentation on our Tactical Fixed Income portfolio (financial professionals only).

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