Morningstar Buy Signal for U.S. Stocks?

March 9, 2010

Since 1994, Morningstar has been tracking a strategy of buying the asset classes that had the largest net outflows and then holding the positions for three years before rotating them out.  The essential idea is just to buy an asset class when it is out of favor and hold on to it patiently, long enough to reap the gains.  In effect, this is simply doing the opposite of what most investors do.  The strategy produces better than market returns over both three-year and five-year time horizons.

From 1994 through 2009, the buy-the-unloved strategy produced an annualized 8.1% return, compared with 4.77% for the loved, 6.24% for the S&P 500, 6.96% for the Wilshire 5000, and 5.36% for the MSCI World. This assumes you invest in the unloved categories for three years running and then roll over the oldest group into the new unloved group starting in year four. 

The strategy also produced strong results if you run it on a five-year rotation. In that version, the unloved produced an 8.08% annualized return, compared with 4.25% for the loved, 5.17% for the S&P 500, 5.76% for the Wilshire 5000, and 4.55% for the MSCI World.

While it is no shock that going opposite retail (and institutional pension funds!) investors is profitable, it may be a bigger surprise what the portfolio is buying this year.

Based on the 12-month flows through the end of January, the unloved categories to buy now are large-cap growth, large-cap value, and world stock.

Note: this would be a good time to point out that our Systematic RS Aggressive and Core portfolios fit solidly within the large-cap category!  I will be pleasantly surprised if we begin to see flows into our domestic equity products by far-seeing, patient advisors.  Industry practice is to wait until there is a good marketing window for retail investors–usually after a year or two of strong performance.  There’s nothing wrong with that, but since the timing isn’t optimal, investors have to be prepared to weather a couple of cycles to really get maximum benefit from the strategy.  If I were in advertising, I would advise you to beat the rush and buy domestic large cap stocks today!

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Posted by Mike Moody

Trends Are Everywhere

March 8, 2010

Acorn Investments’ Jason Russell writes:

Trends are everywhere – weather, sports, fashion, food, entertainment, health, science and politics. Some trends are long, some are short. They come and they go as they always have and always will. Life and business both thrive on identifying, following and serving trends. Market prices for metals, currencies, energies or bonds are no different.

This is why we are never very concerned when markets are trendless for a while.  New trends come and go all the time, and our Systematic RS process is designed to identify the strongest trends and to latch on to them.  The trends that continue for a long period of time can be very profitable.

via www.MichaelCovel.com

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Posted by Mike Moody

If You Miss the 10 Best Days

March 5, 2010

We’ve all seen numerous studies that purport to show how passive investing is the way to go because you don’t want to be out of the market for the 10 best days.  No one ever mentions that the “best days” most often occur during the declines!

It turns out that the majority of the best days and the worst days occur near one another, during the declines.  Why?  Because the market is more volatile during declines.  It is true that the market goes down 2-3x as fast as it goes up.  (World Beta has a nice post on this topic of volatility clustering, which is where this handy-dandy table comes from.)

from World Beta

You can see how volatility increases and the number of days with daily moves greater than 2.5% really spikes when the market is in a downward trend.  It would seem to be a very straightforward proposition to improve your returns simply by avoiding the market when it is in a downtrend.

However, not every strategy can be improved by going to cash.  Think about the math: if your investing methodology makes enough extra money on the good days to offset the bad days, or if it can make money during a significant number of the declines, you might be better off just gritting your teeth during the declines and banking the higher returns.  Although the table above suggests it should help, a simple strategy of exiting the market (i.e., going to cash) when it is below its 200-day moving average may not always live up to its theoretical billing.

click to enlarge

Consider the graphs above.  (The first graph uses linear scaling; the second uses logarithmic scaling for the exact same data.)  This test uses Ken French’s database to get a long time horizon and shows the returns of two portfolios constructed with market cap above the NYSE median and in the top 1/3 for relative strength.  In other words, the two portfolios are composed of mid- and large-cap stocks with good relative strength.  The only difference between the two portfolios is that one (red line) goes to cash when it is below its 200-day moving average.  One portfolio (blue line) stays fully invested.  The fully invested portfolio turns $100 into $49,577, while the cash-raising portfolio yields only $26,550.

If you would rather forego the extra money in return for less volatility, go right ahead and make that choice.  But first stack up 93 boxes of  Diamond matches so that you can burn 23,027 $1 bills, one at a time, to represent the difference–and then make your decision.

The drawdowns are less with the 200-day moving average, but it’s not like they are tame–equities will be an inherently volatile asset class as long as human emotions are involved.  There are still a couple of drawdowns that are greater than 20%.  If an investor is willing to sit through that, they might as well go for the gusto.

As surprising as it may seem, the annualized return over a long period of time is significantly higher if you just stay in the market and bite the bullet during train wrecks–and even two severe bear markets in the last decade have not allowed the 200-day moving average timer to catch up.

At the bottom of every bear market, of course, it certainly feels like it would have been a good idea (in hindsight) to have used the 200-day moving average to get out.  In the long run, though, going to cash with a high-performing, high relative strength strategy might be counterproductive.  When we looked at 10-year rolling returns, the fully invested high relative strength model has maintained an edge in returns for the last 30 years running.

click to enlarge

Surprising, isn’t it?  Counterintuitive results like this are one of the reasons that we find testing so critical.  It’s  easy to fall in line with the accepted wisdom, but when it is actually put to the test, the accepted wisdom is often wrong.  (We often find that even when shown the test data, many people refuse, on principle, to believe it!  It is not in their worldview to accept that one of their cherished beliefs could be false.)  Every managed portfolio in our Systematic RS lineup has been subjected to heavy testing, both for returns and–and more importantly–for robustness.  We have a high degree of confidence that these portfolios will do exceedingly well in the long run.

8 Comments | Markets, Relative Strength Research, Thought Process | Permalink
Posted by Mike Moody

If “the Worst” Happens…

March 5, 2010

Fascinating analysis by Gary Alexander of Navellier regarding how the market has reacted to unexpected shocks, such as epidemics, wars, earthquakes, tsunamis, floods, and other tragedies.

There is some cold comfort in knowing that no matter how tragic the world’s events may seem, the market is one thing we don’t need to worry about when sudden tragedy strikes.

No doubt, there are many investors who  dial back their risk or largely avoid risk altogether  (unwisely, it turns out) because of fear of unexpected shocks.

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Posted by Andy Hyer

The Land of the Midnight Sun

March 4, 2010

Norway is now trying to figure out whether they should continue to use active managers or go to passive management.  Their crisis came about in the financial meltdown when their previously successful active managers lost a slug of money.  Now they are wondering whether they should just save the fees and use a passive approach.

I must confess that I’ve never completely understood this argument.  Sure, an active manager can lose when the market goes down–but a passive manager is guaranteed to lose also.  Fees are never pleasant,  but as the old saying goes, “the bitterness of poor service lingers long after the sweetness of low cost is gone.” 

The base question is: are you getting what you pay for?  Clearly, it makes no sense to pay a closet indexer the full fee for active management.  We’ve written about this before, and it’s true that closet indexers are a large part of the industry.  No, you need to find a manager out of the mainstream with a high active share.  It means you won’t track the benchmark very closely at all, but you’ve got a very decent shot at beating the market according to the research.

And despite what John Bogle and other EMH apologists say, there are plenty of strategies that do beat the market.  Mark Hulbert of MarketWatch addressed this recently:

 My three decades of tracking investment advisers has shown that, over long periods of time, about one out of five advisers are able to do better than simply buying and holding an index fund. While that means it isn’t impossible to outperform the market over the long term, the odds are stacked against us.

That 20% number sounds about right to me, and obviously Mr. Hulbert has the data to back it up.  The 80/20 rule holds just about everywhere else; I don’t know why investment management would be any different. 

If, instead of resorting to passive management, you dedicate yourself to finding that superior 20% of the industry, it could be quite rewarding, not to mention a lot less boring than settling for mediocrity.

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Posted by Mike Moody

Investing Lies We Grew Up With

March 3, 2010

This is the title of a nice article by Brett Arends at Marketwatch.  He points out that a lot of our assumptions, especially regarding risk, are open to question. 

Risk is an interesting topic for a lot of reasons, but principally (I think) because people seem to be obsessed with safety.  People gravitate like crazy to anything they perceive to be “safe.”  (Arnold Kling has an interesting meditation on safe assets here.) 

Risk, though, is like matter–it can neither be created nor destroyed.  It just exists.  When you buy a safe investment, like a U.S. Treasury bill, you are not eliminating your risk; you are just switching out of the risk of losing your money into the risk of losing purchasing power.  The risk hasn’t gone away; you have just substituted one risk for another.  Good investing is just making sure you’re getting a reasonable return for the risk you are taking. 

In general, investors–and people generally–are way too risk averse.  They often get snookered in deals that are supposed to be “low risk” mainly because their risk aversion leads them to lunge at anything pretending to be safe.  Psychologists, however, have documented that individuals make more errors from being too conservative than too aggressive.  Investors tend to make that same mistake.  For example, nothing is more revered than a steady-Eddie mutual fund.  Investors scour magazines and databases to find a fund that (paradoxically) is safe and has a big return.  (News flash: if such a fund existed, you wouldn’t have to look very hard.) 

No one goes looking for high-volatility funds on purpose.  Yet, according to an article, Risk Rewards: Roller-Coaster Funds Are Worth the Ride at TheStreet.com:

Funds that post big returns in good years but also lose scads of money in down years still tend to do better over time than funds that post slow, steady returns without ever losing much.

The tendency for volatile investments to best those with steadier returns is even more pronounced over time. When we compared volatile funds with less volatile funds over a decade, those that tended to see big performance swings emerged the clear winners. They made roughly twice as much money over a decade.

That’s a game changer.  Now, clearly, risk aversion at the cost of long-term returns may be appropriate for some investors.  But if blind risk aversion is killing your long-term returns, you might want to re-think.  After all, eating Alpo is not very pleasant and Maalox is pretty cheap.  Maybe instead of worrying exclusively about volatility, we should give some consideration to returns as well.

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Posted by Mike Moody

Psychology That Drives Bull Markets

March 3, 2010

The Leuthold Group’s Doug Ramsey on the psychology that drives bull markets:

Cashing in on bull markets is not a matter of waiting for everything to line up, anyway.  There must be a set of intellectually appealing bear arguments keeping some players on the sidelines…it is these same players who will eventually drive prices even higher when “new” and intellectually appealing bull arguments belatedly appear on the scene.  I have found that some of the best bull market action occurs when the “bull/bear” arguments superficially appear to be in relative balance, confounding many market players.  When the balance tips too heavily to one side or the other, the odds are that most of the related market move is already in the books.

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Posted by Andy Hyer

Forecasting, Schmorecasting…

March 2, 2010

We’ve written about the uselessness of forecasting in the past and even cited James Montier’s wonderful piece, The Seven Sins of Fund Management.  This citation comes from Mebane Faber’s World Beta blog.  Montier writes:

The two most common biases are over-optimism and overconfidence. Overconfidence refers to a situation whereby people are surprised more often than they expect to be. Effectively people are generally much too sure about their ability to predict. This tendency is particularly pronounced amongst experts. That is to say, experts are more overconfident than lay people. This is consistent with the illusion of knowledge driving overconfidence.

Dunning and colleagues have documented that the worst performers are generally the most overconfident. They argue that such individuals suffer a double curse of being unskilled and unaware of it. Dunning et al argue that the skills needed to produce correct responses are virtually identical to those needed to self-evaluate the potential accuracy of responses. Hence the problem.

This is irony in action.  Knowledge drives overconfidence, so people who actually know something about a topic are more prone to think they can forecast, and they probably even sound more believable.  And finally, the worst performers are the most overconfident!

This may be one of the few instances in which ignorance is bliss.  If you have the Zen “beginner’s mind” and don’t make any assumptions about what might happen, you’re going to be better off than if you are knowledgeable and try to guess.

Systematic trend-following eliminates the need to forecast (although apparently not the desire, since we have clients constantly asking us what we think is going to happen).  We use relative strength to drive our trend-following; it is able to pick out the strongest trends, and those are the trends we are interested in following.  We stay with an asset as long as it remains strong.  When it weakens, we kick it out of the portfolio and replace it with something stronger.  This kind of casting-out method allows the portfolio to adapt to the market environment, as it is constantly refreshed with new, strong assets. 

Despite having a logical and simple method that performs well over time and eliminates the need to forecast, soothsayers will probably always be with us–but your best bet is to ignore them.

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Posted by Mike Moody

Rob Arnott and the Key to Better Returns

February 26, 2010

Rob Arnott is a thought leader in tactical asset allocation, currently well-known for his RAFI Fundamental Indexes.  In his recent piece, Lessons from the Naughties, he discusses how investors will need to find return going forward.

The key to better returns will be to respond tactically to the shifting spectrum of opportunity, especially expanding and contracting one’s overall risk budget.

It’s a different way to view tactical asset allocation–looking at it from a risk budget point of view.  The general concept is to own risk assets in good markets and safe assets in bad markets.

It turns out that systematic application of relative strength accomplishes this very well.  The good folks at Arrow Funds recently asked us to take a look at how the beta in a tactically managed portfolio changed over time.  When we examined that issue, it showed that as markets became risky, relative strength reduced the beta of the portfolio by moving toward low volatility (strong) assets.  When markets were strong, allocating with relative strength pushed up the beta in the portfolio, thus taking good advantage of the market strength.

click to enlarge

Using relative strength to do tactical asset allocation, the investor was not only able to earn an acceptable rate of return over time, but was able to have some risk mitigation going on the side.  That’s a pretty tasty combination in today’s markets.

1 Comment | Markets, Tactical Asset Alloc, Thought Process | Permalink
Posted by Mike Moody

The Upside of Financial Contagion

February 26, 2010

This article from the New York Times is pretty much in keeping with the current zeitgeist.  It discusses the financial crisis and points out how inter-connected financial markets are these days.

As we all now know, mortgage woes were contained — to planet Earth. And so it may be with overleveraged nations in Europe.

Simply put, contagion is a fact of life in our interconnected global economy and financial markets. And that means investors must strap in for more gyrations in the stock and bond markets as the great and painful deleveraging that began in 2007 continues around the world.

However, this article, like most of its brethren, looks only at the negative aspect of financial contagion.  In fact, contagion is just as likely to happen when things get rolling to the upside again.

Right now it is easy to be focused on gloom and doom, but market cycles don’t press on the downside forever.  One can certainly make the case that the market would have gone down by now if it really and truly deserved to.  Keep in mind that the stock market is typically a leading indicator.  We’ve already had a nice rally from March 2009 until now. 

What happens if the market stubbornly refuses to go down from here, and continues to make upside progress?  Suddenly all the benefits of a positive feeback cycle are being discussed: corporate earnings rise, corporate dividends increase, national tax receipts begin to surge, and hiring starts once again.  It’s quite likely that because global markets are so inter-connected that improvements in psychology and corporate results will move around the globe too.  The global village may mean that your investment policy needs to be more flexible and to include more asset classes, but it doesn’t mean that we’re going to be mired in the muck forever.

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Posted by Mike Moody

The Price That Must Be Paid

February 26, 2010

Just like there are risks associated with trend-following (lagging at the turns) there are risks associated with forecasting (being too early or just plain wrong.)  As far as forecasters go, Jeremy Grantham has been pretty good.

Jeremy Grantham warned in January 2000 that U.S. equities were “more overpriced than at any time in the last 70 years due to the massive overpricing of technology and especially dot-com stocks.”  By the end of 2002, the Standard & Poor’s 500 Index had fallen 40 percent and technology shares were down 73 percent. The forecast didn’t help his firm, Grantham Mayo Van Otterloo Co., because he’d been bearish since 1997. Assets declined 45 percent in the late 1990s as customers sought out better- performing mutual funds that liked the technology stocks Grantham disdained.

He recommended avoiding Japanese stocks more than two years before they started falling at the end of 1989.

Two of Grantham’s most recent forecasts were right — and timely.  In 2007, he wrote in his newsletter that all asset classes were overvalued and it was time to sell high-risk securities.  In March 2009, when the S&P 500 index bottomed out at 676, Grantham wrote that fair value for the benchmark of the largest U.S. stocks was 900, or 33 percent higher.

Looking back on more than 40 years in the investment business, Grantham summed up his career this way: “We win all the bets but we are horrifically early,” he said. [Bold is my emphasis]

It appears that his firm’s performance has been very good over time, but Grantham’s own assessment of his tendency to be “horrifically early” is just something his investors have to be aware of and accept.  I am always impressed with those managers who are fully aware of the weaknesses of their strategies, but accept them as the price that must be paid in order to acheive excellent long-term results.

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Posted by Andy Hyer

How To Cope With Inflation…Or Not

February 26, 2010

Many investors are worrying about inflation these days. There is certainly a good case that can be made for inflation as an eventual consequence to the vast amounts of debt being issued by many governments.   Matthew Bandyk, writing for U.S. News and World Report, looked at some investment possibilities for hedging against inflation.  His article points out that about half of the economists surveyed believe the Fed will keep inflation under control, while 41% believe that there will be significant inflation.  In other words, inflation does not seem to be a foregone conclusion.

Just in case, Mr. Bandyk looks at three major areas as possible inflation hedges.  These would be investments whose value can resist a weakening dollar or rising consumer-good prices.  He examines TIPS (Treasury inflation-protected securities), gold, and real estate and concludes that no single hedge works for all inflation situations.  We agree and further suggest that rather than focusing on forecasts for a single asset class, investors utilize a strategy that has the ability to shift among a variety of asset classes as dictated by which ones are actually working.

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Posted by Harold Parker

Committing Capital Amid Uncertainty

February 25, 2010

The risks to committing new capital to investments right now may seem abnormally frightening.  However, how often is it that we really feel extremely confident that now is a great time to commit new money to an investment?  Aren’t there always risks lurking in the shadows?  Consider the comments of Neels van Shaik on this topic (via Prieur du Plessis’ blog.)

Commentators and investment pundits have flooded the media with articles and information regarding the state of the world economy and the uncertainty the world faces regarding government debt, geopolitical instability, consumer deleveraging, and the rest of the jargon that goes with it. This is held forward as a key reason why you have to be cautious to commit new capital to the market.

Although all these concerns are valid, you will very seldom, if ever, find a period where global macro forces are in such a state of equilibrium that capital commitments to stocks can be done with any degree of certainty. We can let our minds drift back to the late 1940’s, when Europe was completely broken after World War II and capital was scarce. Looking at the world and the future at that point in time could not have inspired too much hope for investors.

Another example is the seventies which saw one of the worst periods for stock investments. Between 1970 and 1978 the S&P500 delivered a cumulative capital return of 7% and adjusted for inflation a complete annihilation of capital. By the end of 1978 any investor in stocks could have been excused for not having too much optimism on the outlook for stock returns, given the returns over the preceding eight years.

The world has become a very small place and investors and consumers are even more bombarded now with information on financial markets on a daily basis. I am not sure that all this information necessarily adds value to investment decisions though.

Investors must consider the historical pattern of bleak economic environments giving way to periods of economic abundance. Sure, some investments go bust.  That is why you don’t put all of your eggs in one basket and why it makes sense to adhere to dynamic approaches that seek to identify and invest in winners and seek to keep losses to manageable levels.   Once an investor has given adequate thought to asset allocation and understands the role of each piece of the overall portfolio, it is time to move forward.

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Posted by Andy Hyer

Ken Rogoff Sees Sovereign Defaults Ahead

February 23, 2010

Bloomberg carried an excellent story about Ken Rogoff and his view of how the sovereign debt problems will ultimately be worked out.  As you read it, you have to keep in mind that Mr. Rogoff was the former chief economist of the International Monetary Fund and thus has had a front-row seat to numerous sovereign defaults in the past.  In addition, he and Carmen Reinhart wrote what is certainly the most data-heavy treatment of the last 800 years of financial crises and their aftermath, This Time is Different.

Rogoff was speaking at a conference in Tokyo and painted a bleak picture for sovereign debt.

Following banking crises, “we usually see a bunch of sovereign defaults, say in a few years,” Rogoff, a former chief economist at the International Monetary Fund, said at a forum in Tokyo yesterday. “I predict we will again.”

The U.S. is likely to tighten monetary policy before cutting government spending, sending “shockwaves” through financial markets, Rogoff said in an interview after the speech. Fiscal policy won’t be curbed until soaring bond yields trigger “very painful” tax increases and spending cuts, he said.

On the other hand, he suggests that a little inflation might not be so bad given the alternatives.

“Most countries have reached a point where it would be much wiser to phase out fiscal stimulus,” said Rogoff, who co- wrote a history of financial crises published in 2009. It would be better “to keep monetary policy soft and start gradually tightening fiscal policy even if it meant some inflation.”

It’s hard to know how U.S. policymakers will handle the situation, but it is clear that this business cycle is perhaps unusual because of the large buildup of debt in the system.  In situations like that, often things happen in an unforeseen way.  In the battle for investment survival, now more than ever, it may be important to be able to tactically allocate around the globe.

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Posted by Mike Moody

Crowding Out

February 23, 2010

One of the consequences of overspending is the need to borrow lots of money to cover that spending.  The federal government is borrowing, the state and local governments are borrowing, and the consumer is often crowded out.  There’s only so much money to lend and institutions and inviduals would rather loan it to the government, for example, as opposed to small businesses.  In addition, because there is a lot of borrowing and a finite amount of money to lend, interest rates often get pushed up.

An article on CNBC.com discusses the crowding out issue and its effect on interest rates.

Consumers and businesses looking to borrow and investors trying to find a way to navigate a marketplace heading toward higher interest rates will find the conditions daunting, experts say.

“Clearly the government is not the 800-pound gorilla—it’s the 8,000-pound gorilla in the credit markets nowadays,” says Mike Larson, analyst at Weiss Research in Jupiter, Fla. “These numbers are just so mind-boggling. Really what’s going on is you have intractable debt and deficit problems in the country that neither side wants to tackle in a meaningful way, so the market is doing it for them.”

I’ve added the emphasis in the quotation.  It’s a good reminder that markets will not wait around for policy makers to figure out what they want to do.  Markets will begin to trade on expectations of what will happen, whether those expectations turn out to be right or wrong in the long run.  Markets don’t like uncertainty and they will begin to resolve uncertainties on their own by making assumptions about what might happen and pricing things in the market accordingly.

Right now the market is assuming that there is more borrowing going on than lenders are eventually going to be able to supply.  Thus the yield curve is very steep and there is concern that interest rates will push higher.  It could certainly work out differently, but it’s important to keep an eye on the assumptions that markets are making.

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Posted by Mike Moody

Zut Alors!

February 19, 2010

If you need another reason to hate the French, besides envy of their excellent cuisine, it turns out that a bevy of winemakers were fined and given suspended sentences for foisting cheap, lousy wine on American consumers and charging them premium prices for it.

On the other hand, it shows that cognitive biases are everywhere.  Neither the American company the wine was shipped to nor consumers drinking it ever complained! Because the wine was labeled as premium pinot noir, wine enthusiasts apparently thought it tasted great.  In fact, it turns out that wine drinkers think expensive wine tastes better, even when you trick them and give them two glasses of wine from the same bottle.

This behavior is not unknown in the stock market, where cognitive biases run unbridled down Wall Street.  Ten years ago, everyone was in love with General Electic.  It, too, was high-priced and tasted great.  Ten years later, GE is considered cheap swill that leaves a bitter taste in the mouths of investors.

The moral of the story is that you can’t fall in love with your stocks or your wine.  You have to like it on its own merits.  In the case of our Systematic RS accounts, we like a stock only as long as it has high relative strength.  When it becomes weaker and drops in its ranking–indicating that other, stronger stocks are available–we sell it and move on to a better class of grape.  (We’ve been known to break a bottle here and there, but the idea is to adapt as tastes change.)  In this way, we strive to keep our wine cellar stocked with the best vintages all the time.

Leave a Comment » | Investor Behavior, Just for Fun, Markets, Thought Process | Permalink
Posted by Mike Moody

Building a Winning Team

February 19, 2010

Our partners at Arrow Funds have just released their latest newsletter in which they have included a nice analogy on relative strength:

In a sports tournament, a team’s ultimate goal is to win.  Likewise, a relative strength portfolio manager uses a tournament approach to narrow a portfolio to a group of the strongest securities.  In the first round of the tournament, securities are grouped and compared by asset classes.

Relative strength of individual securities can be used to measure within their asset class to identify the top-performing representatives.  In the second round, relative strength is used to compare the strength of each asset class against the asset class universe that was established by the manager.

A portfolio manager uses this process to allocate larger (strong relative strength) and smaller (weak relative strength) positions to these asset classes within the portfolio.  The ultimate goal is to put together a team with exposure to the strongest asset classes and securities.

In sports, a tournament ends with a winning team as the champion.  That champion will remain until the next season’s tournament.  A relative strength tournament in investing also repeats.  However, the manager has the ability to alter the frequency of the tournament based on the time frames being used to measure the securities.

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Posted by Andy Hyer

Diversification versus Tactical Allocation

February 18, 2010

It’s no secret that we prefer tactical asset allocation as a way to deal with the vagaries of financial markets.  A very nice piece from Doug Short, entitled “Diversification Works…Until It Doesn’t” illustrates why we are leery of sit-and-take-it investing.

Markets are always changing.  Sometimes taking risk is rewarded and sometimes it is punished.  During the last bear cycle, bonds were the “safe” assets.  Given the large buildup of public indebtedness, can anyone assume that bonds will be the safe asset the next time around?  I’m not willing to make that leap of faith.  That’s one of the nice things about tactical asset allocation: you don’t have to make assumptions; you can just roll with the changes.  Let supply and demand determine what is strong and what is weak.

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Posted by Mike Moody

Municipal Bonds: Still Low Risk?

February 18, 2010

As discussed in today’s WSJ, it appears that municipal bond holders are going to become increasingly familiar with the term “Chapter 9.”

The seldom-used part of U.S. bankruptcy law gives municipalities protection from creditors while developing a plan to pay off debts. Created in the wake of the Great Depression, Chapter 9 is widely considered a last resort and filings under it are more taboo than other parts of bankruptcy code because of the resulting uncertainty for everyone from municipal employees to bondholders.

The economic slump, however, is forcing debt-laden cities, towns and smaller taxing districts throughout the U.S. to consider using Chapter 9. As their revenue declines faster than expenses, some public entities are scrambling to keep making payments on municipal bonds. And that is causing experts to worry about the safety of securities traditionally considered low risk.

Past assumptions about municipal debt need to be reevaluated:

“People believe that municipal debt is safe based on assumptions that are no longer true,” says Kenneth Buckfire, managing director and chief executive of Miller Buckfire & Co., an investment bank that has worked with corporations on restructurings and now is advising municipalities.

Once again, we can see the merit of allocating among assets based on intermediate-term relative strength as opposed to long-held assumptions.

1 Comment | Tactical Asset Alloc, Thought Process | Permalink
Posted by Andy Hyer

Was It Really a Lost Decade?

February 17, 2010

Index Universe has a provocative article by Rob Arnott and John West of Research Affiliates.  Their contention is that 2000-2009 was not really a lost decade.  Perhaps if your only asset was U.S. equities it would seem that way, but they point out that other, more exotic assets actually had respectable returns.

The table below shows total returns for some of the asset classes they examined.

click to enlarge

What are the commonalities of the best performing assets? 1) Lots of them are highly volatile like emerging markets equities and debt, 2) lots of them are international and thus were a play on the weaker dollar, 3) lots of them were alternative assets like commodities, TIPs, and REITs.

In other words, they were all asset classes that would tend to be marginalized in a traditional strategic asset allocation, where the typical pie would primarily consist of domestic stocks and bonds, with only small allocations to very volatile, international, or alternative assets.

In an interesting way, I think this makes a nice case for tactical asset allocation.  While it is true that most investors–just from a risk and volatility perspective–would be unwilling to have a large allocation to emerging markets for an entire decade, they might find that periodic significant exposure to emerging markets during strong trends would be quite acceptable.  And even assets near the bottom of the return table like U.S. Treasury bills would have been very welcome in a portfolio during parts of 2008, for example.  You can cover the waterfront and just own an equal-weighted piece of everything, but I don’t know if that is the most effective way to do things.

What’s really needed is a systematic method for determining which asset classes to own, and when.  Our Systematic Relative Strength process does this pretty effectively, even for asset classes that might be difficult or impossible to grade from a valuation perspective.  (How do you determine whether the Euro is cheaper than energy stocks, or whether emerging market debt is cheaper than silver or agricultural commodities?)  Once a systematic process is in place, the investor can be slightly more comfortable with perhaps a higher exposure to high volatility or alternative assets, knowing that in a tactical approach the exposures would be adjusted if trends change.

Leave a Comment » | From the MM, Markets, Tactical Asset Alloc, Thought Process | Permalink
Posted by Mike Moody

A not so Happy Valentine’s Day

February 17, 2010

What could be more appropriate on Valentine’s Day than an article about being in the red?  Tom Raum of Associated Press published an alarming article Sunday on why US debt will keep growing even with recovery.  It looks like there are some very difficult choices ahead for voters and their representatives.  Current projections have our national debt exceeding our GDP within the next few years.  In addition, the interest on that debt will be 80% of the federal budget within a decade.

Needless to say, if the government does not act on this problem, the financial markets certainly will at some point.  For example, Reuters recently reported that some of China’s generals have called for using our debt as a weapon against us by having their government sell off U.S. Treasury bonds if we sell arms to Taiwan.

We do not profess to know all that is needed to solve this problem, although obviously we need to throttle back the government gravy train.  As responsible voters, we need to contact our representatives to get them to take the budget problem seriously.  But as investors, we need to have enough flexiblity in our investment policy to position our assets to protect them if our representatives don’t act.

Leave a Comment » | Markets, Non-partisan op-ed, Tactical Asset Alloc, Thought Process | Permalink
Posted by Harold Parker

Getting Off the Sidelines

February 17, 2010

We’re at a strange place in the market cycle.  Depending on the day, investors are either fearful of a further decline or fearful of missing the recovery.  No one can tell if we are in the eye of the storm and about to head into the dreaded double dip or if the nascent economic recovery has legs and is about to surprise on the upside.  Despite the best year of the decade in 2009, it’s safe to say that investor confidence is still very fragile.

Amid that backdrop, investors have responded by clinging to cash.  According to a recent article in Investment News, more than $9 trillion is on the sidelines.  Investors need to figure out some way to get back in the game.

Of course, investor angst is understandable.  Most investors diversified and tried to be patient, the very behavior they had been counseled to follow.  Then 2008 came along and they got whacked when almost every asset class dropped.  In other words, they did what they were told and it turned out disastrously for them.  Now investors don’t know what to do or who to believe. 

It’s not that investors are living in a cave.  They can see the current environment and they understand that there are multiple risks they need coverage against: inflation, deflation, currency depreciation, and so on.  With the yield on cash at essentially zero, they also know they can’t sit in money market funds forever and reach their investment goals. 

Investors recognize that a potentially broader approach to asset classes would be helpful, but they are paralyzed with fear and have no idea how to implement that kind of investment policy.  It’s not so much that they are afraid of the market as they are afraid of jumping in (or out) and getting it wrong.

Our Global Macro portfolio offers a possible solution for some of that $9 trillion sitting on the sidelines.  Investors, I believe, after being beaten half to death by the proponents of sit-and-take-it investing,  are now open to a tactical approach that offers great flexibility of exposure to different asset classes.  They can see with their own eyes that the world has changed.  They are just confused about how to handle the timing of multiple asset class exposures and reluctant to attempt it on their own.  

Their problems can be addressed with something like the Global Macro portfolio because the timing and market exposure is handled for them.  If conditions are harsh, the portfolio could be held in fixed income, inverse funds, and cash.  If risk is being rewarded, aggressive assets such as domestic equities, emerging markets, and real estate might be held.  In an inflationary environment, there might be more exposure to basic materials and commodities.  If the dollar depreciates, the portfolio might be heavily laden with international equities and foreign currencies.  The other significant benefit is that the systematic relative strength process used to run the accounts continues to adapt to new conditions as markets change.  I think investors breathe a little easier when they recognize that there is a specific strategy that is being followed–it won’t be optimal in every environment, but it won’t be driven by fear and greed.

It’s up to each client and each advisor to figure out how to get off the bench and back into the game, but for many clients a global allocation product might smooth the transition back onto the field of play.

Leave a Comment » | Investor Behavior, Markets, Tactical Asset Alloc, Thought Process | Permalink
Posted by Mike Moody

10 Issues That We Don’t Have

February 11, 2010

Brett Steenbarger lists the top ten reason that traders lose their discipline:

Losing discipline is not a trading problem; it is the common result of a number of trading-related problems. Here are the most common sources of loss of discipline, culled from my work with traders:

10- Environmental distractions and boredom cause a lack of focus;

9- Fatigue and mental overload create a loss of concentration;

8-  Overconfidence follows a string of successes;

7- Unwillingness to accept losses, leading to alterations of trade plans after the trade has gone into the red;

6- Loss of confidence in one’s trading plan/strategy because it has not been adequately tested and battle-tested;

5- Personality traits that lead to impulsivity and low frustration tolerance in stressful situations;

4- Situational performance pressures, such as trading slumps and increased personal expenses, that change how traders trade (putting P/L ahead of making good trades);

3- Trading positions that are excessive for the account size, created exaggerated P/L swings and emotional reactions;

2- Not having a clearly defined trading plan/strategy in the first place;

1- Trading a time frame, style, or market that does not match your talents, skills, risk tolerance, and personality.

Emotions are a performance and discipline killer.  The difference in stress levels between managing money based on systematic models and using manager discretion is immense!  You can spend a lifetime trying to make yourself immune to emotions (not going to happen while you are still breathing) or you can rely on systematic models.  Systematic models have the benefit of never getting tired, upset, nervous, or bored.  Furthermore, research in a variety of fields confirms the performance advantage of systematic models.

Leave a Comment » | Investor Behavior, Thought Process | Permalink
Posted by Andy Hyer

Getting Torched By Expert Opinion

February 11, 2010

Barry Ritholtz has posted a 5 minute clip of some of Ben Bernanke’s public comments between 2005-2007 on the housing market and the broader economy.  The point of me posting this is not to say that Bernanke is a complete moron because I have little doubt that he is one of the brightest financial minds in the country.  However, talk about being dead wrong!  If you relied on these opinions in order to make investment decisions, you likely got torched.  If you can’t rely on expert opinion when making investment decisions, then what options do you have?

This highlights the value of trend-following systems.   Trend following requires zero reliance on expert opinion; it simply allows the investor to adapt to whatever trends the market offers, whether or not experts expected things to play out in a given way.  With trend following, you’ll have plenty of losing trades, but you’ll also avoid sitting in losing trades for long periods of time.  Furthermore, systematic trend-following has an excellent track record (see here and here.)  Trend following allows you to cut your losses short and to hold on to your winners.  Frequently, the strongest trends end up being very different from what even the brightest experts predicted.

Leave a Comment » | Tactical Asset Alloc, Thought Process | Permalink
Posted by Andy Hyer

Why We Like Price

February 10, 2010

Relative strength calculations rely on a single input: price.  We like price because it is a known quantity, not an assumption.  In this deconstruction of the Price-to-Earnings Growth (PEG) ratio, the author, Tom Brakke, discusses all of the uncertainties when calculating even a simple ratio like PEG.  And amidst all of the uncertainties he mentions is this:

In looking at that calculation, only one of the three variables has any precision:  We can observe the market price (P) at virtually any time and be assured that we have an accurate number.  The E is a different matter entirely.  Which earnings?  Forward, trailing, smoothed, operating, adjusted, owner?  Why?  How deep into accounting and the theory of finance do you want to go?

For most investors, not very far.  We like our heuristics clean and easy, not hairy.  So, in combining the first two variables we get the P/E ratio, the “multiple” upon which most valuation work rests, despite the questionable assumptions that may be baked in at any time.  The addition of the third element, growth (G), gives us not the epiphany we seek, but even more confusion.

The emphasis is mine.  This isn’t a knock on fundamental analysis.  It can be valuable, but there is an inherent squishiness to it.  The only precision is found in price.  And price is dynamic: it adapts in real time as expectations of the asset change.  (Fundamental data is often available only on a quarterly schedule.)  As a result, systematic models built using relative strength adapt quite nicely as conditions change.

Leave a Comment » | Thought Process | Permalink
Posted by Mike Moody

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