Systematic Relative Strength

Theory and reality are not the same thing. One of the pervasive problems of economic modeling and financial market modeling is that it does not account for the really wide range of outcomes that occur but, in theory, shouldn’t.

The Psy-Fi blog had a recent article that archly discusses this problem:

By the late 1980′s there was a growing recognition that the existing understanding of financial systems was flawed. Not only did markets not behave as the economic theories predicted but they often exhibited behaviour that didn’t seem to have any pattern or cause at all.

In response to this a number of economists began looking at some of the research emerging from physics, biology and computer science in the area of complex adaptive systems and this led, in 1987, to a group of economists and scientists getting together at the Santa Fe Institute. The program of work that came out of this seminal event is still unfolding today, but suggests why academics and traders have had such different views on markets: one set lives in the real world, and the other doesn’t.

That’s a good introduction to the problem. Markets don’t behave the way traditional economic theories suggest. A good bit of the problem is in some of the assumptions that theory makes:

To the physicists involved in the original Santa Fe seminars it was obvious that the basis of economic quantification was highly suspect: indeed it was perfectly clear that the assumptions behind the models – stuff like people being perfectly rational – had been introduced to make the maths work, rather than being realistic assumptions.

At the heart of the problem with economics was the focus on equilibrium, the idea that there’s some perfect steady state of the economy in which everything is in balance (see Exit the Walras, Followed by Equilibrium). Essentially equilibrium economics defines the desirable outcome as a static position, then asks what conditions can give rise to this, then assumes that these conditions are present. This is a bit like deciding that riding a bicycle is a good thing, identifying the balance of forces needed to achieve this successfully and then declaring that this balance is the natural order of things.

And then ignoring what happens if you try to go cycling in a typhoon.

Beyond the problem with faulty assumptions, physicists were no strangers to the observer problem in science. They quickly recognized something that the economists did not. Economic systems themselves are reflexive; the actions of the participants can change the course of events:

Equilibrium economics is designed to ignore psychology, because it assumes that a person never changes their mind: they’ve already considered all possible outcomes and rejected all but the most economically rational. In the new economics we can’t assume this: we must work on the basis that if the world changes then a person’s expectations also change. This is a reflexive world, not a static one.

Suddenly, human behaviour matters in economic models in a way it never did before. Psychology, having been banished out of the front door, has crept in the back and has started cooking itself a three course dinner with all the trimmings.

The outcome of the Santa Fe meeting was a focus on non-equilibrium approaches to economics. In fact non-equilibrium economics doesn’t claim that equilibrium conditions don’t occur, only that they’re not guaranteed. The reason for this is human behaviour: we’re not external to the economic machinery, we’re part of it, and our expectations about the future have a critical impact on how it develops. All of which means that the future is not predictable and models that assume it is so are just wrong.

The reality is that people are reflexive and markets are adaptive. One begets the other and in a world where traders are forever trying to anticipate what other traders are going to do the last thing markets will ever be, in the short-term, is efficient and in equilibrium. But, of course, the trick to riding a bike is not falling off, no matter what the weather throws at you.

Source: Elite Bicycles

If the future is not predictable because equilibrium will change each time expectations change, it is essential to have a model that adapts to markets. Relative strength provides just such an adaptive framework. As expectations change, different stocks or asset classes become strong or weak. Relative strength drives the portfolio toward the strongest areas, where the most positive changes in expectations are occurring. Unlike classical models of market or economic behavior, relative strength models do not make any assumptions about potential returns, about correlations between different assets, or about volatility of different assets. Indeed, in the real world these things change all the time-as the expectations of participants change. Behavior that economic models find aberrational, like periods of stability interrupted by intense bouts of volatility, are, in fact, the norm.

The problem with Modern Portfolio Theory and strategic asset allocation is that they are based on the optimization of equilibrium models. If equilibrium is not guaranteed, you can assume the model will fail every time equilibrium conditions don’t exist—which is much of the time. (The fact that these models have failed bear market stress tests repeatedly somehow has not convinced their supporters that they are fatally flawed. Imagine if NASA had insisted on repeatedly using O-rings that cracked in cold weather like the ones that brought down the Challenger. )

Tactical asset allocation driven by relative strength can sometimes be buffeted by rapidly changing expectations, but the underlying drive is always toward adapting to the current environment. Since we cannot predict what will happen going forward, a systematic relative strength process seems like a more robust solution to the asset allocation problem.

Commentary is flying this morning on the news of the S&P downgrade of US government debt. I had to chuckle at one comment from a Wall Street Journal story that I saw by way of Yahoo. Here is the quote that made me laugh:

“Double-A-plus is the new triple-A,” said Abdullah Karatash, head of U.S. fixed-income credit trading at Natixis in New York. “Treasurys will remain the world’s gold standard. What has the market spooked is not the downgrade per se, but the weak underlying macroeconomic fundamentals and the ongoing mess in Europe.”

I put the funny part in bold. Now, Mr. Karatash is arguably correct that US debt is still in better shape than debt from many other countries, but it does point out a lack of imagination or a lack of knowledge about alternative assets.

When our Global Macro strategy looks across a broad universe of assets including equities, fixed income, commodities, currencies, real estate, and inverse funds, one area that ranks highly is precious metals, which we group into the commodity category.

It seems as if precious metals have responded to sovereign credit concerns already, by outperforming most of them. Below, for example, is a 2-year chart of a gold ETF compared to an ETF for the US 7-10 year Treasury. You can see that the phenomenon is not just a recent one.

(Click to enlarge.) Source: Yahoo! Finance

Apparently gold is the gold standard. Rather than argue about whether S&P is right about the downgrade and which political party is responsible for overspending, wouldn’t it just make more sense to respond tactically by positioning part of your portfolio in the assets that are the strongest?

To obtain a fact sheet and prospectus for the Arrow DWA Tactical Fund (DWTFX) or the Arrow DWA Balanced Fund (DWAFX), click here.

To receive a brochure for our Systematic RS portfolios, please click here. Click here for disclosures from Dorsey Wright Money Management. Past performance is no guarantee of future results.

The Wall Street Journal carried a denial from Italy this morning:

Economy Minister Giulio Tremonti convened a meeting of top Italian officials, who later released a statement noting that Italy has been hit by “tensions stemming from international uncertainty.” It added, “The Italian finance and banking system is solid.”

Of course, in the usual topsy-turvy world of politics, a denial is often a form of confirmation. Portugal, Ireland, and Greece all made official statements of denial before eventually taking bailouts as well.

What may be more telling is the price action—that’s the story behind the story. Judging from the price action in Italy and Spain, they may be the next to have problems. The same Wall Street Journal article included a nice graphic showing stock and bond market performance of the two countries.

If you have a choice between believing the market or believing the finance minister, I’d go with the market every time. You may still be wrong occasionally, but the odds are in your favor.

If you’re an investor, you can try to keep up with the news and all of the subsequent revisions or you can just watch how the market is handicapping things. Since relative strength models run on relative price performance, they use the market data exclusively. It allows the portfolio to adapt as market expectations change-or don’t change, as the case may be. That’s why tactical asset allocation makes sense.

Of course, in many cases, the day-to-day news is just noise and the underlying trend persists.

Source: Yahoo! Finance

This chart is pretty clear, I think. Let’s put it in the form of an easy multiple choice question. Which is more reliable: a) your own two eyes, or b) a politician? If what you can see—the price action—is ultimately more reliable that what is said, why are you listening to the news?

A recent report by a major firm, covered in Bloomberg, indicates that the home ownership rate is declining:

The U.S. homeownership rate has fallen below 60 percent when delinquent borrowers are excluded, a sign of the country’s move toward a “rentership society,” Morgan Stanley said in a report today.

The national rate, which stood at 66.4 percent at March 31, would be 59.7 percent without an estimated 7.5 million delinquent homeowners who may be forced into renting, according to Morgan Stanley analysts led by Oliver Chang. The lowest U.S. homeownership rate on record was 62.9 percent in 1965, the first year the Census Bureau began reporting the data.

The homeownership rate reached an all-time high of 69.2 percent in 2004 as relaxed lending standards fueled home sales and President George W. Bush promoted an “ownership society.” Mortgage delinquencies, foreclosures and tighter credit for housing loans are reducing property buying, Chang said.

“Taken together they are forcibly moving the country away from being an ownership society,” Chang, based in San Francisco, said in an e-mail. “This change is only beginning, and is moving the country towards becoming a rentership society.”

The analyst discussed the investment implications of the change:

The shift provides opportunities for builders of multifamily homes and investors in single-family houses leased to renters, Chang said in a phone interview. The U.S. apartment vacancy rate fell to 6 percent in the second quarter, the lowest in more than three years, research firm Reis Inc. said July 7.

Here’s the part I find interesting: the market figured this out long ago, as you can see from the two-year chart below comparing REZ to the S&P 500.

Click to enlarge. Source: Yahoo! Finance

Based on price action, you can see how much stronger residential REITs have been than the general market. Of course, no one ever knows how long a trend will continue, but this particular trend has already lasted long enough to be quite exploitable by typical relative strength methodologies. As usual, price responds more quickly than the analytic community.

Disclosure: Dorsey, Wright Money Management owns various REIT equities and ETFs across many different account classes.

Research Affliliates’ Rob Arnott was the subject of a recent article on Marketwatch, ably written by Jonathan Burton. He discusses what he believes is the actual debt situation—we have much more than most people realize—and discusses investment strategies to cope with the debt hurricane going forward. You can read the whole article for his take, but his short list is as follows:

1) Dump traditional asset allocation.

2) Buy inflation-linked bonds.

3) Stock up on commodities.

4) Embrace emerging markets.

5) Reach for high-yield bonds.

Other heavyweights like Bill Gross of PIMCO have talked before about the problems with the traditional 60/40 policy portfolio. What these market mavens are getting at, I think, is that your portfolio construction process needs to be more flexible to deal with risks and opportunities. I agree with this, whether you are constructing your own portfolio pieces or using an all-in-one tactical solution like the Arrow DWA funds (DWAFX, DWTFX) that incorporate a wide variety of global asset classes. The markets are global and your portfolio construction process needs to reflect that.

To obtain a fact sheet and prospectus for the Arrow DWA Tactical Fund (DWTFX) or the Arrow DWA Balanced Fund (DWAFX), click here.

Commodity prices have been in decline lately. Inflation is off the table. The inflation trade’s sudden disappearance apparently caught a few Wall Street firms off guard as well. However, an Advisor One article suggests that advisors not be so quick to dismiss inflation as a possibility.

PIMCO’s Mihir Worah says that it’s time to wake up and understand the new dynamics affecting inflation in 2011 and beyond, which he explained in a commentary piece for the fund group on Monday. Overall, he expects inflation to average between 3% and 5% a year worldwide.

Worah (left) says “the goldilocks days of the ’90s,” when countries could have both strong economic growth and low inflation at the same time “are gone.” While in the ‘90s and afterward, emerging markets could export disinflation to developed markets, the situation today is “turning around” as emerging markets go through “a particularly commodity and energy intensive phase of growth,” the portfolio manager explains.

“Inflationary pressure from commodities will be even higher within emerging markets … [since] commodities are such a large part of their consumption basket – for example, nearly 60% in India, compared to about 25% in the U.S.,” he wrote in an opinion piece released by PIMCO on June 27.

“Rising commodity prices along with reflationary policies from many developed-market central banks should result in modestly higher inflation going forward,” Worah added. “We expect developed market inflation to average about 3% and developing market inflation to average about 5% over the secular horizon.”

If Mr. Worah is correct, it’s going to be important to figure out ways to deal with secular inflation in client portfolios. Many advisors working today simply do not remember the 1970s, when the US had its last bout of secular inflation. Investors have the tendency to extrapolate what has been happening lately far into the future—and that rarely works. Often, price changes carry within them the seeds of their own destruction. For example, rising oil prices often lead to slower economic growth, which then leads to weaker oil prices due to falling demand.

Because price levels are so dynamic, I think it is important to allow the portfolio to adapt tactically to the changes in the markets. Relative strength is one very good way to accomplish that. Incorporating inflation-sensitive assets into the investment universe and then having a disciplined process to manage them tactically could be important to investment results if a secular inflation forecast proves correct.

Bill Gross of PIMCO can’t say anything these days without creating a big stir in the market—and having his every thought criticized. He probably liked it better twenty years ago when he didn’t have the financial paparazzi trailing him around. That being said, he’s an interesting thinker. Advisor Perspectives carried his most recent letter on financial repression and summarized it as follows:

If the government is going to artificially repress yield, then focus on the parts of a bond that are less repressed! Rather than outright default, many countries attempt rather successfully to keep nominal interest rates lower than would otherwise prevail. Over the long term, this “financial repression” results in a transfer of wealth from savers to borrowers. Investors shouldn’t give their money away, and at the moment, the duration component of a bond portfolio comes close to doing just that – because it doesn’t yield enough relative to inflation.

USA Today had a nice piece on government accounting today. Although it is little known to the public, corporations are required to use accrual accounting, while government entities are allowed to use cash accounting. The difference is profound:

Corporations would be required to count these new liabilities when they are taken on — and report a big loss to shareholders. Unlike businesses, however, Congress postpones recording spending commitments until it writes a check.

Unlike a corporation, Congress (and also smaller government entities like states, counties, and cities) is allowed to make a promise to pay out something, but is not required to reserve for that event. It is akin to an insurance company collecting your policy premiums but not setting anything aside to pay the eventual claims. According to the article, USA Today has calculated federal finances based on standard accounting rules since 2004 using information from the Medicare and Social Security annual reports and the audited financial report of the federal government.

Once standard corporate accounting rules are used, here’s the real picture:

The $61.6 trillion in unfunded obligations amounts to $527,000 per household. That’s more than five times what Americans have borrowed for everything else — mortgages, car loans and other debt.

Ken Rogoff and Carmen Reinhart have discussed debt levels in relation to economies and point out that debt-induced sclerosis—very slow economic growth—results when the debt becomes too unwieldly to service. Based on historical precedent, they point out that very slow growth tends to occur when debt grows to about 90 % of GDP. If eventual liabilities are taken into account, given the US GDP for the last fiscal year was about $14.66 trillion, we are already over 400%.

This is scary stuff. Most households in this country could not readily service a $527,000 loan. Resolution can come in a variety of ways, however: outright default, debt restructuring, repudiation of some of the future promises made, dollar devaluation, inflation, austerity, and so on. Even just muddling along will work for some amount of time—probably. As Mr. Rogoff points out, the timing of a crisis is inexact:

It’s very hard to call the timing of a crisis. You can see that an economy is vulnerable, and maybe even fairly reliably say you’ll have a crisis in 5 to10 years, but until it’s upon you, it’s hard to narrow the window down with any precision. Many of the people who say they predicted the crisis in a precise way had actually been predicting a crisis for years. There’s irreducible uncertainty coming from fragile confidence and political factors. The analogy is someone who’s vulnerable to a heart attack. You can go to the doctor and they can see your cholesterol is high and you have a number of risk factors, but you might go on for 20 years without anything happening. Or it might be 20 hours.

Each of the different scenarios for resolution will create very different investment outcomes. The best way, I think, to deal with the $61 trillion dollar hole, was expressed very eloquently by Andy in an earlier article:

Investing is always disconcerting because of the real and perceived risks to the capital markets and to the global economy. Professor Rogoff’s point about timing a financial crisis based on known fundamental data is an important one. Risks may be in place to cause a crisis, but if the likely window of time for those risks to actually result in crisis range from the next couple months to the next several decades the investor is left with the decision of how to incorporate those known risks into an investment plan. It is one thing to be aware of great fundamental risks and it is another to be able to translate that knowledge into profitable investment returns.

Again, we see why pragmatists gravitate to tactical asset allocation. The tactical asset allocator accepts the reality that timing market moves based on fundamental data is nearly impossible. Therefore, the tactical asset allocator embraces the concept of reacting to trends in a disciplined fashion. It is the next best thing to having a crystal ball.