Click here to listen to the story of how Tom came to embrace Point & Figure Charting.
With approaches to investing such as is described in the following excerpt from a post on Musing On Markets blog (written by a professor at NYU), is it any wonder that factor-based investing (aka “Smart Beta”) is taking off?
Assume that you value a stock at $20 and it is trading at $30. What would you do? If you are a value-based investor, the answer is easy, right? Don’t buy the stock, or perhaps, sell it short! Now let’s say it is three months later. You value the same stock again at $20 but it is now trading at $50. What would you do now? Rationally, the choice is simple, but psychologically, your decision just got more difficult for two reasons. The first stems from second guessing. Even if you believe that markets are not always rational, you worry that the market knows something that you don’t. The second is envy. Watching other people make money, even if their methods are haphazard and their reasoning suspect, is difficult. You are being tested as an investor, and there are three paths that you can take.
- Keep the faith that your estimate of value is correct, that the market is wrong and that the market will correct its mistakes within your time horizon. That may be what every value investing bible suggests, but your righteousness comes with no guarantees of profits.
- Abandon your belief in value and play the pricing game openly, either because your faith was never strong in the first place or because you are being judged (by your bosses, clients and peers) on your success as a trader, not an investor.
- Preserve the value illusion and look for “intrinsic” ways to justify the price, using one of at least three methods. The first is to tweak your value metrics, until you get the answer you want. Thus, if the stock looks expensive, based on PE ratios, you try EV/EBITDA multiples and if it still looks expensive, you move on to revenue multiples. As I argued in my post on the pricing of social media companies, you will eventually find a metric that will make your stock look cheap. The second is to claim to do a discounted cash flow valuation, paying no heed to internal consistency or valuation first principles, making it a DCF more in name than in spirit. The third is to use buzzwords, with sufficient power to explain away the difference between the price and the value.
The level of subjective decision-making described above is a recipe for ulcers, unhappy clients, and likely a short career in this industry. Such an investor follows a different discipline (I use that term loosely in this context) every day. Every change in investment philosophy is largely based on changes in feelings.
One of the major reasons why there has never been a better time to be an advisor in this industry than today is because of the ability to access disciplined investment strategies (aka “Smart Beta”) in rules-based indexes where the risk of the manager not following the discipline is largely removed. Books, such as What Works on Wall Street by Jim O’Shaughnessy, clearly point out that there are a number of return factors that have been able to generate excess return over time. In my opinion, one of the biggest reasons that “actively managed strategies” have had such a poor track record, in aggregate, over time is because the investment committee of these strategies sits around and goes through some variation of steps 1-3 shown above on a regular basis. In other words, there is no discipline!
Consider the following exchange between Tom Dorsey and IndexUniverse from last year on the topic of the future of the ETF industry. Tom was asked to explain his statement that the future of the ETF market is “ETF Alchemy.”
Dorsey: Think about this for a second: If I take H2 and I add O, what do I get?
Dorsey: Yes, water. Each one of those two elements is separate. But when I combine the two, I come up with a substance—water—that you can’t live without. Each one separately is not as good as the two combined. And the concept here is, What’s out there in terms of ETFs I can combine together to make a better product?
Take for instance the Standard & Poor’s Low Volatility Index—and if you add that to PDP, which is our Technical Leaders Index, and combine the two, it’s like taking two glasses of water and pouring them into one bigger glass of water, 50-50. I end up with a better product than either one of them separately.
You’ll find this as we go along: the ability to combine different ETFs to create a better unit where the whole is better than the sum of its parts.
A little later in the interview, Tom Dorsey spoke to just how important the ETF has been to the industry:
Dorsey: Yes, and I can’t tell you how many seminars I have taught to professionals on ETFs and the eyes that widen and the lives that change once they understand it and understand how to use it; it tells me we’re on the right path and this is the exact right product.
Like I’ve said to you before, it’s probably the most important product ever created in my 39 years in this business. And I believe back then when I talked to you that we’re in the first foot of a 26-mile marathon.
With some reasonable amount of due diligence, advisors today can identify a handful of investment factors that have historically provided excess return. The advisor can then combine these strategies—now plentifully available in ETF format—for a client in a way that provides diversified and disciplined exposure to winning return factors at a reasonable cost.
Dorsey Wright is the index provider for PDP. For more information, please see www.powershares.com. A momentum strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value. Past performance is no guarantee of future returns. Potential for profits is accompanied by possibility of loss.
Posted by: Andy Hyer
The WSJ this morning on how to win your NCAA Office Pool:
Pick the favorites. This is the only foolproof way to guarantee you won’t embarrass yourself.
For all of the attention paid to underdogs—is there any other reason you know Florida Gulf Coast University exists?—the better team still wins most round-of-64 games. Over the last 10 seasons, the average number of double-digit seeds beating favorites was six per tournament. Meanwhile, a bracket with favorites winning every game last year would have placed in the 91st percentile of entries to ESPN’s contest, a company spokeswoman said. In other words, your bracket can only be so contrary until it’s cuckoo.
Part of the fun of NCAA Office Pools is bragging rights of picking the underdogs (even if it’s a statistical unlikelihood). However, this same principle applies to investing. When it comes to the financial markets, rather than shoot for bragging rights, go for the money!
Posted by: Andy Hyer
I love this image from Carl Richards of Behavior Gap:
Experience teaches us that the image above is true. Anyone can get it right in the short run. We’ve all seen it. The gambler at the slot machines who walks out with a few thousand dollars, the sports fan who successfully bets on his home team over the higher ranked opponent, the investor who makes some money buying stock in a company recommended by his brother-in-law. Yet, will any of the previous approaches end well in the long run? Not likely.
Relative strength happens to be our discipline of choice. It has been extensively tested. It is logical. It has been effective over time. There are other disciplines that have also been effective over time. There are many approaches that fall in the category of undisciplined. One example: the quant manager who incorporates many different return factors into an ever-changing investment model. A tweak here. A tweak there…
When building allocations meant to last and designed to make a meaningful difference for a client over time, advisors and their clients would be well served to build allocations around effective disciplines and leave the rest by the wayside.
A relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value. Past performance is no guarantee of future returns. Potential for profits is accompanied by possibility of loss.
Posted by: Andy Hyer
Everyone in the financial services industry has seen awesome-looking backtests for various return factors or trading methods, but most people don’t even know what survivorship bias is. When I see one of those amazing backtests and I ask how they removed the survivorship bias, the usual answer is “Huh?”
A recent post by Cesar Alvarez at Alvarez Quant Trading shows just how enormous survivorship bias can be for a trend following system. Most people with amazing backtests, when pushed, will concede there might be “some” effect from survivorship. None of them ever think it will be this large!
Here, Mr. Alvarez describes the bias and shows the results:
Pre-inclusion bias is using today’s index constituents as your trading universe and assuming these stocks were always in the index during your testing period. For example if one were testing back to 2004, GOOG did not enter the S&P500 index until early 2006 at a price of $390. But your testing could potentially trade GOOG during the huge rise from $100 to $300.
- It is the first trading day of the month
- Stock is member of the S&P500 (on trading date vs as of today)
- S&P500 closes above its 200 day moving average (with and without this rule)
- Rank stocks by their six month returns
- Buy the 10 best performing stocks at the close
(click on image to enlarge to full size)
Mind-boggling, isn’t it? The fantastic system that showed 30%+ returns now shows returns of less than 8%!! (The test period, by the way, was 2004-2013.)
Unfortunately, this is the way much backtesting is done. It’s much more trouble to acquire a database that has all of the delisted securities and all of the historical index constituents. That’s expensive and time-consuming, but it’s the only way to get accurate results. (Needless to say, that’s how our testing is done. You can link to one of our white papers that additionally includes Monte Carlo testing to make the results even more robust.) By the way, the pre-inclusion bias also shows very clearly how the index providers actually manage these indexes!
Mr. Alvarez concludes:
People often write about systems they have developed using the current Nasdaq 100 or S&P 500 stocks and have tested back for 5 to 10 years. Looking at this table shows that one should completely ignore those results.
When looking at backtested results, it often pays to be skeptical and to ask some questions about survivorship bias.
Posted by: Mike Moody
Morgan Housel at Motley Fool has a wonderful article on how investors can learn from failure. He sets the tone with a few different quotes and anecdotes that point out that a lot of being a success is just avoiding really dumb mistakes.
At a conference years ago, a young teen asked Charlie Munger how to succeed in life. “Don’t do cocaine, don’t race trains to the track, and avoid all AIDS situations,” Munger said. Which is to say: Success is less about making great decisions and more about avoiding really bad ones.
People focus on role models; it is more effective to find antimodels—people you don’t want to resemble when you grow up. Nassim Taleb
I’ve added the emphasis, but Mr. Housel makes a good point. Learning from failure is equally important as learning from success. In fact, he argues it may be more important.
If it were up to me, I would replace every book called How to Invest Like Warren Buffett with a one called How to Not Invest Like Lehman Brothers, Long-Term Capital Management, and Jesse Livermore. There are so many lessons to learn from these failed investors about situations most of us will face, like how quickly debt can ruin you. I’m a fan of learning from Buffett, but the truth is most of us can’t devote as much time to investing as he can. The biggest risk you face as an investor isn’t that you’ll fail to be Warren Buffett; it’s that you’ll end up as Lehman Brothers.
But there’s no rule that says you have to learn by failing yourself. It is far better to learn vicariously from other people’s mistakes than suffer through them on your own.
That’s his thesis in a nutshell. He offers three tidbits from his study of investing failures. I’ve quoted him in full here because I think his context is important (and the writing is really good).
1. The overwhelming majority of financial problems are caused by debt, impatience, and insecurity. People want to fit in and impress other people, and they want it right now. So they borrow money to live a lifestyle they can’t afford. Then they hit the inevitable speed bump, and they find themselves over their heads and out of control. That simple story sums up most financial problems in the world. Stop trying to impress people who don’t care about you anyways, spend less than you earn, and invest the rest for the long run. You’ll beat 99% of people financially.
2. Complexity kills. You can make a lot of money in finance, so the industry attracted some really brilliant people. Those brilliant people naturally tried to make finance more like their native fields of physics, math, and engineering, so finance has grown exponentially more complex in the last two decades. For most, that’s been a disservice. I think the evidence is overwhelming that simple investments like index funds and common stocks will demolish complicated ones like derivatives and leveraged ETFs. There are two big stories in the news this morning: One is about how the University of California system is losing more than $100 million on a complicated interest rate swap trade. The other is about how Warren Buffett quintupled his money buying a farm in Nebraska. Simple investments usually win.
3. So does panic. In his book Deep Survival, Laurence Gonzalez chronicles how some people managed to survive plane crashes, getting stranded on boats, and being stuck in blizzards while their peers perished. The common denominator is simple: The survivors didn’t panic. It’s the same in investing. I’ve seen people make a lifetime of good financial decisions only to blow it all during a market panic like we saw in 2008. Any financial decision you make with an elevated heart rate is probably going to be one you’ll regret. Napoleon’s definition of a military genius was “the man who can do the average thing when all those around him are going crazy.” It’s the same in investing.
I think these are really good points. It’s true that uncontrolled leverage accompanies most real blowups. Having patience in the investing process is indeed necessary; we’ve written about that a lot here too. The panic, impatience, and insecurity he references are really all behavioral issues—and it just points out that having your head on straight is incredibly important to investment success. How successful you are in your profession or how much higher math you know is immaterial. As Adam Smith (George Goodman) wrote, “If you don’t know who you are, the stock market is an expensive place to find out.”
Mr. Housel’s point on complexity could be a book in itself. Successful investing just entails owning productive assets—the equity and debt of successful enterprises—acquired at a reasonable price. Whether you own the equity directly, like Warren Buffett and his farm, or in security form is immaterial. An enterprise can be a company—or even a country—but it’s got to be successful.
Complexity doesn’t help with this evaluation. In fact, complexity often obscures the whole point of the exercise.
This is actually one place where I think relative strength can be very helpful in the investment process. Relative strength is incredibly simple and relative strength is a pretty good signaling mechanism for what is successful. Importantly, it’s also adaptive: when something is no longer successful, relative strength can signal that too. Sears was once the king of retailing. Upstart princes like K-Mart in its day, and Wal-Mart and Costco later, put an end to its dominance. Once, homes were lit with candles and heated with fuel oil. Now, electricity is much more common—but tomorrow it may be something different. No asset is forever, not even Warren Buffett’s farmland. When the soil is depleted, that farm will become a lead anchor too. Systematic application of relative strength, whether it’s being used within an asset class or across asset classes, can be a very useful tool to assess long-term success of an enterprise.
Most investing problems boil down to behavioral issues. Impatience and panic are a couple of the most costly. Avoiding complexity is a different dimension that Mr. Housel brings up, and one that I think should be included in the discussion. There are plenty of millionaires that have been created through owning businesses, securities, or real estate. I can’t think of many interest rate swap millionaires (unless you count the people selling them). Staying calm and keeping things simple might be the way to go. And if the positive prescription doesn’t do it for you, the best way to be a good investor may be to avoid being a terrible investor!
Posted by: Mike Moody
That’s the title of a Marketwatch article by mutual fund columnist Chuck Jaffe. I have to admit that usually I like his columns. But columns like this make me nuts! (See also The $ Value of Patience for an earlier rant on a similar topic.)
Here’s the thesis in a nutshell:
…safe driving comes down to a mix of equipment and personnel.
The same can be said for mutual funds and exchange-traded funds, and while there is growing consensus that ETFs are the better vehicle, there’s growing evidence that the people using them may not be so skilled behind the wheel.
The article goes on to point out that newsletters with model portfolios of mutual funds and ETFs have disparate results.
Over the last 12 months, the average model portfolio of traditional funds—as tracked by Hulbert Financial Digest—was up 20.9%, a full three points better than the average ETF portfolio put together by the same advisers and newsletter editors. The discrepancy narrows to two full percentage points over the last decade, and Hulbert noted he was only looking at advisers who run portfolios on both sides of the aisle.
Hulbert posited that if you give one manager both vehicles, the advantages of the better structure should show up in performance.
Hulbert—who noted that the performance differences are “persistent” — speculated “that ETFs’ advantages are encouraging counterproductive behavior.” Effectively, he bought into Bogle’s argument and suggested that if you give an investor a trading vehicle, they will trade it more often.
Does it make any sense to blame the vehicle for the poor driving? (Not to mention that DALBAR data make it abundantly clear that mutual fund drivers frequently put themselves in the ditch.) Would it make sense to run a headline like “The Growing Case Against Stocks” because stocks can be traded?
Mutual funds, ETFs, and other investment products exist to fulfill specific needs. Obviously not every product is right for every investor, but there are thousands of good products that will help investors meet their goals. When that doesn’t happen, it’s usually investor behavior that’s to blame. (And you’re not under any obligation to invest in a particular product. If you don’t understand it, or you get the sinking feeling that your advisor doesn’t either, you should probably run the other way.)
Investors engage in counterproductive behavior all the time, period. It’s not a matter of encouraging it or not. It happens in every investment vehicle and the problem is almost always the driver. In fact, advisors that can help manage counterproductive investor behavior are worth their weight in gold. We’re not going to solve problems involving investor behavior by blaming the product.
A certain amount of common sense has to be applied to investing, just like it does in any other sphere of life. I know that people try to sue McDonald’s for “making” them fat or put a cup of coffee between their legs and then sue the drive-thru that served it when they get burned, but whose responsibility is that really? We all know the answer to that.
Posted by: Mike Moody
Buying pullbacks is a time-tested way to boost returns. From time to time, we’ve discussed the utility in buying pullbacks in the market. Buying the dips—instead of panicking and selling—is essentially doing the opposite of how most investors conduct their affairs. In the past, much of that discussion has involved identification of market pullbacks using various oversold indicators. (See, for example, Lowest Average Cost Wins.) In a recent article in Financial Planning, Craig Israelsen proposes another good method for buying pullbacks.
The gist of his method is as follows:
Selling a stock or fund that has been performing well is tough. The temptation to ride the rocket just a little longer is very strong. So let’s focus on the other element: Buy low.
I propose a disciplined investment approach that measures performance against an annual account value target. If the goal is not met, the account is supplemented with additional investment dollars to bring it up to the goal. (For this exercise, I capped supplemental investment at $5,000, in acknowledgement that investors don’t have endlessly deep pockets.)
Very simply, the clients will “buy low” in years when the account value is below the target. If, however, the target goal is met at year’s end, the clients get to do a fist pump and treat themselves to a fancy dinner or other reward.
One benefit of this suggested strategy is that it is based on a specific performance benchmark rather than on an arbitrary market index (such as the S&P 500) that may not reflect the attributes of the portfolio being used by the investor.
In the article, he benchmarks a diversified portfolio against an 8% target and shows how it would have performed over a 15-year contribution period. In years when the portfolio return exceeds 8%, no additional contributions are made. In years when the portfolio return falls short of 8%, new money is added. As he points out:
It’s worth noting that the added value produced by this buy-low strategy did not rely on clever market timing in advance of a big run-up in the performance of the portfolio. It simply engages a dollar cost averaging protocol – but only on the downside, which is where the real value of dollar cost averaging resides.
Very smart! (I added the bold.) It’s a form of dollar-cost averaging, but only kicks in when you can buy “shares” of your portfolio below trend. He used an 8% target for purposes of the article, but an investor could use any reasonable number. In fact, there might be substantial value in using a higher number like 15%. (You could also use a different time frame, like monthly, if that fit the client’s contribution schedule better.) Obviously you wouldn’t expect a 15% portfolio return every year, but it would get clients in the habit of making contributions to their account in most years. Great years like 2013 would result in the fancy dinner reward, while lousy market years would result in maximum contributions—hopefully near relative lows where they would do the most good.
This is an immensely practical method for getting clients to contribute toward some kind of goal return—and his 15-year test shows good results. In six of the 15 years, portfolio results were below the yardstick and additional contributions were made totalling $13,802. Making those additional investments added an extra $12,501 to what the balance would have been otherwise, resulting in a 7.7% boost in the portfolio total. Looked at another way, over time you ended up with nearly a 100% return on the extra money added in poor years.
Of course, Israelsen points out that although his proposed method is extremely simple, client psychology may still make it challenging to implement. Clients are naturally resistant to committing money to an underperforming market or during a period of time when there is significant uncertainty. Still, this is one of the better proposals I have seen on how to motivate clients to save, to invest at reasonable times, and to focus on a return goal rather than on how they might be doing relative to “the market.” You might consider adding this method to your repertoire.
Posted by: Mike Moody
Almost all of the performance from a relative strength or momentum model comes from the upper end of the ranks. We run different models all the time to test different theories or to see how existing decision rules work on different groups of securities. Sometimes we are surprised by the results, sometimes we aren’t. But the more we run these tests, the more some clear patterns emerge.
One of these patterns we see constantly is all of the outperformance in a strategy coming from the very top of the ranks. People are often surprised at how quickly any performance advantage disappears as you move down the ranking scale. That is one of the things that makes implementing a relative strength strategy so difficult. You have to be absolutely relentless in pushing the portfolio toward the strength because there is often zero outperformance in aggregate from the stuff that isn’t at the top of the ranks. If you are the type of person that would rather “wait for a bounce” or “wait until I’m back to breakeven,” then you might as well just equal-weight the universe and call it a day.
Below is a chart from a sector rotation model I was looking at earlier this week. This model uses the S&P 500 GICS sub-sectors and the ranks were done using a point & figure matrix (ie, running each sub-sector against every other sub-sector) and the portfolio was rebalanced monthly. You can see the top quintile (ranks 80-100) performs quite well. After that, good luck. The “Univ” line is a monthly equal-weighted portfolio of all the GICS sub-sectors. The next quintile (ranks 60-80) barely beats the universe return and probably adds no value after you are done with trading costs, taxes, etc… Keep in mind that these sectors are still well within the top half of the ranks and they still add minimal value. The other three quintiles are underperformers. They are all clustered together well below the universe return.
(Click on image to enlarge)
The overall performance numbers aren’t as good, but you get the exact same pattern of results if you use a 12-Month Trailing Return to rank the sub-sectors instead of a point & figure matrix:
(click on image to enlarge)
Same deal if you use a 6-Month Trailing Return:
(click on image to enlarge)
This is a constant theme we see. The very best sectors, stocks, markets, and so on drive almost all of the outperformance. If you miss a few of the best ones it is very difficult to outperform. If you are unwilling to constantly cut the losers and buy the winners because of some emotional hangup, it is extremely difficult to outperform. The basket of securities in a momentum strategy that delivers the outperformance is often smaller than you think, so it is crucial to keep the portfolio focused on the top-ranked securities.
Posted by: John Lewis
As sector ETFs have proliferated, more and more investors have been attracted to sector rotation and tactical asset allocation strategies using ETFs, whether self-managed or implemented by an advisor. Mark Hulbert commented on sector rotation strategies in a recent article on Marketwatch that highlighted newsletters using Fidelity sector funds. All of the newsletters had good returns, but there was one surprising twist:
…you might think that these advisers each recommended more or less the same basket of funds. But you would be wrong. In fact, more often than not, each of these advisers has tended to recommend funds that are not recommended by any other of the top five sector strategies.
That’s amazing, since there are only 44 actively managed Fidelity sector funds and these advisers’ model portfolios hold an average of between five and 10 funds each.
This suggests that there is more than one way of playing the sector rotation game, which is good news. If there were only one profitable sector strategy, it would quickly become so overused as to stop working.
This is even true among those advisers who recommend sectors based on their relative strength or momentum. Because there are so many ways of defining these characteristics, two different sector momentum strategies will often end up recommending two different Fidelity sector funds.
Another way of appreciating the divergent recommendations of these top performing advisers is this: Of the 44 actively managed sector funds that Fidelity currently offers, no fewer than 22 are recommended by at least one of these top five advisers. That’s one of every two, on average, which hardly seems very selective on the advisers’ part.
Amazing, isn’t it? It just shows that there are many ways to skin a cat.
Even with a very limited menu of Fidelity sector funds, there was surprisingly little overlap. Imagine how little overlap there would be within the ETF universe, which is much, much larger! In short, you can safely pursue a sector rotation strategy (and, by extension, tactical asset allocation) with little concern that everyone else will be plowing into the same ETFs.
Posted by: Mike Moody
“The 1%” phrase has been used a lot to decry income inequality, but I’m using it here in an entirely different context. I’m thinking about the 1% in relation to a recent article by Motley Fool’s Morgan Housel. Here’s an excerpt from his article:
Building wealth over a lifetime doesn’t require a lifetime of superior skill. It requires pretty mediocre skills — basic arithmetic and a grasp of investing fundamentals — practiced consistently throughout your entire lifetime, especially during times of mania and panic. Most of what matters as a long-term investor is how you behave during the 1% of the time everyone else is losing their cool.
That puts a little different spin on it. Maybe your behavior during 1% of the time is how you get to be part of the 1%. (The bold in Mr. Housel’s quotation above is mine.)
In his article, Housel demonstrates how consistency—in this case, dollar-cost averaging—beats a couple of risk avoiders who try to miss recessions. We’ve harped on having some kind of systematic investment process here, so consistency is certainly a big part of success.
But also consider what might happen if you can capitalize on those periods of panic and add to your holdings. Imagine that kind of program practiced consistently over a lifetime! Warren Buffett’s article in the New York Times, “Buy American. I Am.” from October 2008 comes to mind. Here is a brief excerpt of Mr. Buffett’s thinking during the financial crisis:
THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.
So … I’ve been buying American stocks.
If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.
A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.
Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.
Gee, I wonder how that worked out for him? It’s no mystery why Warren Buffett has $60 billion—he is as skilled a psychological arbitrageur as there is and he has been at it for a very long time.
As Mr. Housel points out, even with mediocre investing skills, just consistency can go a long way toward building wealth—and the ability to be greedy when others are fearful has the potential to compound success.
Posted by: Mike Moody
The Dorsey, Wright Technical Leaders Index is composed of a basket of 100 mid and large cap securities that have strong relative strength (momentum) characteristics. Each quarter we reconstitute the index by selling stocks that have underperformed and by adding new securities that score better in our ranking system. We began calculating the index in real-time at the end of 2006. Over the last seven years there have been quite a few deletions and additions as the index has adapted to some very dynamic market conditions.
Any relative strength or momentum-based investment strategy is a trend following strategy. Trend following has worked for many years in financial markets (although not every year). These systems are characterized by a several common attributes: 1) Losing trades are cut quickly and winners are allowed to run, 2) there are generally a lot of small losing trades, and 3) all of the money is made by the large outliers on the upside. When we look at the underlying trades inside of the index over the years we find exactly that pattern of results. There is a lot going on behind the scenes at each rebalance that is designed to eliminate losing positions quickly and maintain large allocations to the true winners that drive the returns.
We pulled constituent level data for the DWATL Index going back to the 12/31/2006 rebalance. For each security we calculated the return relative to the S&P 500 and how many consecutive quarters it was held in the index. (Note: stocks can be added, removed, and re-added to the index so any individual stock might have several entries in our data.) The table below shows summary statistics for all the trades inside of the index over the last seven years:
The data shows our underlying strategy is doing exactly what a trend following system is designed to accomplish. Stocks that aren’t held very long (1 to 2 quarters), on average, are underperforming trades. But when we are able to find a security that can be held for several quarters, those trades are outperformers on average. The whole goal of a relative strength process is to ruthlessly cut out losing positions and to replace them with positions that have better ranks. Any investor makes tons of mistakes, but the system we use to reconstitute the DWATL Index is very good at identifying our mistakes and taking care of them. At the same time, the process is also good at identifying winning positions and allowing them to remain in the index.
Here is the same data from the table shown graphically:
You can easily see the upward tilt to the data showing how relative performance on a trade-level basis improves with the time held in the index. For the last seven years, each additional consecutive quarter we have been able to keep a security in the Index has led to an average relative performance improvement of about 920 basis points. That should give you a pretty good idea about what drives the returns: the big multi-year winners.
We often speak to the overall performance of the Index, but we sometimes forget what is going on behind the scenes to generate that return. The process that is used to constitute the index has all of the characteristics of a trend following system. Underperforming positions are quickly removed and the big winning trades are allowed to remain in the index as long as they continue to outperform. It’s a lot like fishing: you just keep throwing the small ones back until you catch a large one. Sometimes it takes a couple of tries to get a keeper, but if you got a big fish on the first try all the time it would be called “catching” not “fishing.” I believe part of what has made this index so successful over the years is there is zero human bias that enters the reconstitution process. When a security needs to go, it goes. If it starts to perform well again, it comes back. It has no good or bad memories. There are just numbers.
The performance numbers are pure price return, not inclusive of fees, dividends, or other expenses. Past performance is no guarantee of future returns. Potential for profit is accompanied by potential for loss. A list of all holdings for the trailing 12 months is available upon request.
Posted by: John Lewis
Marshall Jaffe, in a recent article for ThinkAdvisor, made an outstanding observation:
In a world where almost nothing can be predicted with any accuracy, investor behavior is one of the rare exceptions. You can take it to the bank that investors will continue to be driven by impatience, social conformity, conventional wisdom, fear, greed and a confusion of volatility with risk. By standing apart and being driven solely by the facts, the value investor can take advantage of the opportunities caused by those behaviors—and be in the optimal position to create and preserve wealth.
His article was focused on value investing, but I think it is equally applicable to relative strength investing. In fact, maybe even more so, as value investors often differ about what they consider a good value, while relative strength is just a mathematical calculation with little room for interpretation.
Mr. Jaffe’s main point—that investors are driven by all sorts of irrational and incorrect cognitive forces—is quite valid. Dozens of studies point it out and there is a shocking lack of studies (i.e., none!) that show the average investor to be a patient, independent thinker devoid of fear and greed.
What’s the best way to take advantage of this observation about investor behavior? I think salvation may lie in using a systematic investment process. If you start with an investment methodology likely to outperform over time, like relative strength or value, and construct a rules-based systematic process to follow for entry and exit, you’ve got a decent chance to avoid some of the cognitive errors that will assail everyone else.
Of course, you will construct your rules during a period of calm and contemplation—but that’s never when rules are difficult to apply! The real test is sticking to your rules during the periods of fear and greed that occur routinely in financial markets. Devising the rules may be relatively simple, but following them in trying circumstances never is! As with most things, the harder it is to do, the bigger the potential payoff usually is.
Posted by: Mike Moody
According to a recent Gallup Poll, most Americans don’t think much of the stock market as a way to build wealth. I find that quite distressing, and not just because stocks are my business. Stocks are equity—and equity is ownership. If things are being done right, the owner should end up making more than the employee as the business grows. I’ve reproduced a table from Gallup’s article below.
Source: Gallup (click on image to enlarge)
You can see that only 37% felt that the stock market was a good way to build wealth—and only 50% among investors with more than $100,000 in assets.
Perhaps investors will reconsider after reading an article from the Wall Street Journal, here republished on Yahoo! Finance. In the article, they asked 40 prominent people about the best financial advice they’d ever received. (Obviously you should read the whole thing!) Two of the comments that struck me most are below:
Charles Schwab, chairman of Charles Schwab Corp.
A friend said to me, Chuck, you’re better off being an owner. Go out and start your own business.
Richard Sylla, professor of the history of financial institutions and markets at New York University
The best financial advice I ever received was advice that I also provided, both to myself and to Edith, my wife. It was more than 40 years ago when I was a young professor of economics and she was a young professor of the history of science. I based the advice on what were then relatively new developments in modern finance theory and empirical findings that supported the theory.
The advice was to stash every penny of our university retirement contributions in the stock market.
As new professors we were offered a retirement plan with TIAA-CREF in which our own pretax contributions would be matched by the university. Contributions were made with before-tax dollars, and they would accumulate untaxed until retirement, when they could be withdrawn with ordinary income taxes due on the withdrawals.
We could put all of the contributions into fixed income or all of it into equities, or something in between. Conventional wisdom said to do 50-50, or if one could not stomach the ups and downs of the stock market, to put 100% into bonds, with their “guaranteed return.”
Only a fool would opt for 100% stocks and be at the mercies of fickle Wall Street. What made the decision to be a fool easy was that in those paternalistic days the university and TIAA-CREF told us that we couldn’t touch the money until we retired, presumably about four decades later when we hit 65.
Aware of modern finance theory’s findings that long-term returns on stocks should be higher than returns on fixed-income investments because stocks were riskier—people had to be compensated to bear greater risk—I concluded that the foolishly sensible thing to do was to put all the money that couldn’t be touched for 40 years into equities.
At the time (the early 1970s) the Dow was under 1000. Now it is around 16000. I’m now a well-compensated professor, but when I retire in a couple of years and have to take minimum required distributions from my retirement accounts, I’m pretty sure my income will be higher than it is now. Edith retired recently, and that is what she has discovered.
Not everyone has the means to start their own business, but they can participate in thousands of existing great businesses through the stock market! Richard Sylla’s story is fascinating in that he put 100% of his retirement assets into stocks and has seen them grow 16-fold! I’m sure he had to deal with plenty of volatility along the way, but it is remarkable how effective equity can be in creating wealth. His wife discovered that her income in retirement—taking the required minimum distribution!—was greater than when she was working! (The italics in the quote above are mine.)
Equity is ownership, and ownership of productive assets is the way to wealth.
Posted by: Mike Moody
Interesting view of valuations from Philosophical Economics:
The only way that you can know what the future valuation of stocks will be–so as to estimate future returns–is to apply some conception of what’s fair, appropriate, reasonable, normal. But the range of what can be rationalized as fair, appropriate, reasonable, normal is extremely wide, too wide to be useful, and far too wide to provide reliable pushback against a supply-driven market advance.
Say what you will about trend following, but at least the price is not up for debate!
HT: Abnormal Returns
Posted by: Andy Hyer
From our analysts in the 12/19/13 Dorsey Wright Daily Equity Report:
The market cares about what it wants, when it wants, and for this reason we find that listening to the market and following its trends is a better approach than trying to adapt an economic premise to a market prayer.
Without an understanding of this reality, the markets can much more frustrating (and less profitable) than they need to be.
Posted by: Andy Hyer
One of the ongoing difficulties for investors is finding some kind of simple method for investing. Relative strength is just such a simple method. Even simple methods, however, have to be applied!
Tadas Viskanta from Abnormal Returns writes:
…having a plan, even a sub-optimal one, that you can stick to is preferable to having no plan at all. The ongoing challenge for advisors and investors alike is to find a plan that they will not abandon at the first sign of trouble.
That’s an important point. If you can’t follow a method because it is too complex and if you bail in panic during the first downturn, you’re not going to succeed with any method.
Abnormal Returns revisited this theme recently, in connection with a discussion about systems versus optimization. Mr. Viskanta pulled a quote from Scott Adams:
Optimizing is often the strategy of people who have specific goals and feel the need to do everything in their power to achieve them. Simplifying is generally the strategy of people who view the world in terms of systems. The best systems are simple, and for good reason. Complicated systems have more opportunities for failure. Human nature is such that we’re good at following simple systems and not so good at following complicated systems.
This has a great deal of applicability to the investing process. Simple systems are generally more robust than complex systems, and relative strength is about as simple as you can get. Relative strength is not an optimized system—like most simple systems, it will make plenty of mistakes but its simplicity makes it robust. (I would note that Modern Portfolio Theory relies on mean variance optimization to construct the “ideal” portfolio. Optimized systems are both complicated and fragile.)
In practice, complicated systems tend to blow up. Robust systems are generally more resilient to failure, but will certainly struggle from time to time.
Human nature, I think, makes it difficult to follow any system, whether simple or complex, so discipline is also required. Investors will improve their chances for success with a simple, robust methodology and the discipline to stick with it.
Posted by: Mike Moody
Lots of economists have talked about the deleveraging of the consumer and how it has slowed down the economy. Consumers are reducing their debt loads, perhaps because they are uncertain about the future. When consumers feel more confident, they often borrow to buy consumer goods, homes, or to invest in businesses.
Even more important than the debt itself is usually the ability of the consumer to service the debt. The ability to borrow is often fuel for a bull market—at the least, those two data series often move in tandem.
Did you realize that consumer debt service is now as low as before the huge bull market starting in the 1980s? This chart, from the Fed, is the household financial obligations ratio. It’s a ratio of financial obligations to disposable personal income. Financial obligations consist of payments on mortgage debt, consumer debt, auto leases, rental housing, plus homeowner’s insurance and property taxes.
(click on image to enlarge)
Periods when the consumer was adding leverage, from 1982-1987, from 1994-2000, and from 2003-2007 were outstanding for the stock market.
Right now, with debt service at a relatively low level, the consumer has the capacity to take on more debt. That’s a lot of fuel for a new bull market. We will have to see going forward whether the consumer has the confidence or propensity to take on more debt. If re-leveraging does start to happen, the stock market could be much better than most expect.
HT: The Bonddad Blog
Posted by: Mike Moody
“I can’t buy now—the stock market is at all-time highs.” I’ve heard that, or some version of it, from multiple clients in the last few weeks. I understand where clients are coming from. Their past experience involves waiting too long to buy and then getting walloped. That’s because clients often wait for the bubble phase to invest. Not only is the stock market at all-time highs, but valuations tend to be stretched as well.
Here’s the thing: buying at all-time highs really doesn’t contain much information about whether you are making an investing mistake or not.
For proof, I will turn to a nice piece in Advisor Perspectives penned by Alliance Bernstein. Here’s what they have to say:
With the US stock market repeatedly reaching all-time highs in recent weeks, many investors are becoming leery of investing in stocks. Focusing on the market’s level is a mistake, in our view. It’s market valuation, not level, that matters.
Since 1900, the S&P 500 Index has been close to (within 5%) of its prior peak almost half the time. There’s a simple reason for this. The stock market goes up over time, along with the economy and corporate earnings.
Fear of investing at market peaks is understandable. In the short term, there’s always the risk that other investors will decide to take gains, or that geopolitical, economic or company-specific news will trigger a market pullback.
But for longer-term investors, market level has no predictive power. Market valuation—not market level—is what historically has mattered to future returns.
They have a nice graphic to show that investing near the high—or not near the high—is inconsequential. They show that future returns are much more correlated to valuation.
Source: Advisor Perspective (click on image to enlarge)
I’m no fundamental analyst, but commentators from Warren Buffett to Ed Yardeni to Howard Marks have suggested that valuations are reasonable, although slightly higher than average. There’s obviously no guarantee that stocks will go up, but you are probably not tap dancing on a landmine. Or let’s put it this way: if the stock market goes down from here, it won’t be because we are at all-time highs. The trend is your friend until it ends.
Posted by: Mike Moody
…talk about the best advice they have even gotten in a short piece from Fortune. I think it clarifies the difference between a blind value investor and an investor who is looking for good companies (not coincidentally, many of those good companies have good relative strength). Warren Buffett and Charlie Munger have made a fortune implementing this advice.
Buffett: I had been oriented toward cheap securities. Charlie said that was the wrong way to look at it. I had learned it from Ben Graham, a hero of mine. [Charlie] said that the way to make really big money over time is to invest in a good business and stick to it and then maybe add more good businesses to it. That was a big, big, big change for me. I didn’t make it immediately and would lapse back. But it had a huge effect on my results. He was dead right.
Munger: I have a habit in life. I observe what works and what doesn’t and why.
I highlighted the fun parts. Buffett started out as a Ben Graham value investor. Then Charlie wised him up.
Valuation has its place, obviously. All things being equal, it’s better to buy cheaply than to pay up. But Charlie Munger had observed that good businesses tended to keep on going. The same thing is typically true of strong stocks—and most often those are the stocks of strong businesses.
Buy strong businesses and stick with them as long as they remain strong.
Posted by: Mike Moody
Another prominent bear throws in the towel. Last week, hedge fund manager Hugh Hendry said the following:
I can no longer say I am bearish. When markets become parabolic, the people who exist within them are trend followers, because the guys who are qualitative have got taken out,
I have been prepared to underperform for the fun of being proved right when markets crash. But that could be in three-and-a-half-years’ time.
I cannot look at myself in the mirror; everything I have believed in I have had to reject. This environment only makes sense through the prism of trends.
I may be providing a public utility here, as the last bear to capitulate. You are well within your rights to say ‘sell’. The S&P 500 is up 30% over the past year: I wish I had thought this last year.
Crashing is the least of my concerns. I can deal with that, but I cannot risk my reputation because we are in this virtuous loop where the market is trending.
Whether Hendry is correct in his theory that there is a disconnect between the fundamentals and the technicals or whether he is just not looking at the right fundamentals is up for debate. Pragmatists, like us, are more comfortable simply following the trends.
Posted by: Andy Hyer
Fans of the free lunch will disappointed to find out that option income isn’t really income—it’s just part of the total return stream of an option income strategy. There’s nothing wrong with option income, but a buy-write strategy is just a way to slightly reduce the volatility of an equity portfolio by trading away some of the potential upside. I get concerned when I see articles promoting it as a way to generate extra income, especially when the trade-off is not fully explained.
According to a recent story in the Wall Street Journal, investors are increasingly turning to option income.
So far this year more than $3.4 billion in options contracts have changed hands on U.S. exchanges, according to the Options Industry Council in Chicago. That’s almost as much as 2008′s full-year volume and is on pace to be the second-best year in options trading history. The all-time record came in 2011 with $4.6 billion in contracts changing hands.
A buy-write strategy to generate option income might make sense if it is part of a total-return strategy. All too often, investors have the wrong idea.
How big of a dent can it make on a portfolio’s long-term prospects? A lot, says Philip Guziec, a Morningstar analyst who studies various options strategies. He recently looked at six years worth of performance data through April 2010 using the CBOE S&P 500 BuyWrite Index, which follows a strategy of selling call options on the S&P 500 Index every month and reinvesting premiums.
During that period, a covered-call strategy where premiums were reinvested would have increased the portfolio’s return by around 19%. By contrast, spending each month’s options payments resulted in reducing the options portfolio’s value by more than 50%, according to Mr. Guziec.
“Too many people sell covered calls to generate extra income to live on, not realizing how severely that type of a strategy can eat into a portfolio’s upside over time,” he says.
Many investors would be shocked to learn that their portfolio could take a 50% haircut in only six years if they spent the option income! As always, the bottom line is total return.
Posted by: Mike Moody
The main thing that should matter to a long-term investor is real return. Real return is return after inflation is factored in. When your real return is positive, you are actually increasing your purchasing power— and purchasing goods and services is the point of having a medium of exchange (money) in the first place.
The Dow Jones industrial average broke through 16,000 on Monday for the first time on record — well, at least in nominal terms. If you adjust for inflation, technically the highest level was on Jan. 14, 2000.
Adjusting for price changes, the Dow’s high today was still about 1.3 percent below its close on Jan. 14, 2000 (and about 1.6 percent below its intraday high from that date).
There’s a handy graphic as well, of the Dow Jones Industrial Average adjusted for inflation.
(click on image to enlarge)
This chart, I think, is a good reminder that buy-and-hold (known in our office as “sit-and-take-it”) is not always a good idea. In most market environments there are asset classes that are providing real return, but that asset class is not always the broad stock market. There is value in tactical asset allocation, market segmentation, strategy diversification, and other ways to expose yourself to assets that are appreciating fast enough to augment your purchasing power.
I’ve read a number of pieces recently that contend that “risk-adjusted” returns are the most important investment outcome. Really? This would be awesome if I could buy a risk-adjusted basket of groceries at my local supermarket, but strangely, they seem to prefer the actual dollars. Your client could have wonderful risk-adjusted returns rolling Treasury bills, but would then also get to have a lovely risk-adjusted retirement in a mud hut. If those dollars are growing more slowly than inflation, you’re just moving in reverse.
Real returns are where it’s at.
Posted by: Mike Moody
I’m still getting back into the swing of things after having the flu most of last week. In the midst of my stock market reading, I was struck by an article over the weekend from Abnormal Returns, a blog you should be reading, if you aren’t already. The editor had a selection of the blog posts that were most heavily trafficked from the prior week. Without further ado:
- Chilling signs of a market top. (The Reformed Broker)
- Ray Dalio thinks you shouldn’t bother trying to generate alpha. (The Tell)
- Ten laws of stock market bubbles. (Doug Kass)
- How to teach yourself to focus. (The Kirk Report)
- Are we in a bubble? (Crossing Wall Street)
- Josh Brown, “If the entities in control of trillions of dollars all want asset prices to be higher at the same time, what the hell else should you be positioning for?” (The Reformed Broker)
- Guess what stock has added the most points to the S&P 500 this year? (Businessweek)
- Everything you need to know about stock market crashes. (The Reformed Broker)
- Jim O’Neil is swapping BRICs for MINTs. (Bloomberg)
- How to survive a market crash. (Your Wealth Effect)
I count five of the top ten on the topic of market tops/bubbles/crashes!
Markets tend to top out when investors are feeling euphoric, not when they are tremendously concerned about the downside. In my opinion, investors are still quite nervous—and fairly far from euphoric right now.
Posted by: Mike Moody
Have you ever been to a football game and never seen a punt? Yeah, me neither. You would probably think that coach was crazy. I would have thought so too, but the numbers say otherwise.
It seems like most of the comparisons between advanced statistical metrics in sports and investing have revolved around baseball. This is the first example I have seen of a football coach really thinking outside of the box to give his team a statistical advantage every game. Sure, football coaches have used statistics to game plan and find tendencies, but what this coach is doing goes way beyond that.
How does this relate to investing? This coach has found an edge and relentless exploits the edge no matter what the cost. He knows that statistically he is better off never giving the ball to the other team. He never punts the ball to them. When he kicks off, it is always an onside kick. If the other team wants the ball they have to earn it. He readily admits they only have a 50% fourth down conversion rate so it isn’t like this is some sort of offensive juggernaut that can never be stopped. This coach is wrong a lot. He no doubt looks like a fool quite often. But he has done the math and knows his methods give him a clear statistical advantage to win games over time. It might not work on any given play, series, quarter, or half. Winning investment strategies don’t work every day, week, quarter, or even every year. But over time they do, and the only thing preventing you from realizing those gains buckling under the pressure and failing to execute the strategy. The edges are small, but they add up over time.
Posted by: John Lewis