Despite strong U.S. equity market returns in early 2012 that sent the Dow back above 13,000 by the end of February, indications are that many Americans remain investment spectators, reluctant to participate in the equity market rally, a Franklin Templeton global poll has found.

Investor skepticism appears to be tied to the extreme volatility witnessed in 2011, in which the Dow Jones Industrial Average had 104 days of triple-digit swings-representing a significant portion of the 252 total trading days last year. Indeed, when asked about the importance of various market scenarios when deciding to purchase an equity investment, market stability was most frequently identified by U.S. respondents as an important factor.

“The market volatility that has persisted since 2008 is keeping many investors on the sidelines, and their ability to view positive equity market performance constructively has been thwarted by the market ups and downs that are at odds with the stability they are seeking,” John Greer, executive vice president of corporate marketing and advertising at Franklin Templeton Investments, said in a statement. “But the reality is that investors who have been waiting for ‘the right time’ to get back into the equity market have been missing out on the market rally we’ve witnessed over the past few years.”

This is sadly typical of retail investors.  Volatility tends to be greatest at market bottoms, and volatility tends to be what investors most avoid.  As a result, investors often avoid returns as well!

This period strikes me as psychologically reminiscent of the late 1970s, when Business Week famously published a cover announcing the death of equities.  Consider what investors had been through: in the late 1960s, the speculative names had gotten torched.  By 1973-74 even the bluest of the blue chips had gotten ripped.  By the late 1970s, 20% annual corrections were the norm.  The economy was a mess and investors simply opted out.  The Business Week cover just reflected the spirit of the time.

The late 1970s are not so different from now.  The speculative names collapsed in 2000-2002, followed by a bear market in 2008-2009 that got everything.  The last couple of summers have been punctuated by scary 15-20% corrections.  The economy is still a mess.  Psychologically, investors are in the same spot they were when the original cover came out.  Based on fund flows, “anything but stocks” seems to be the battle cry.

Yet, consider how things unfolded subsequently.  Only a few years later both the market and the economy were booming.  (High relative strength stocks began to perform very well several years ahead of the 1982 bottom, by the way.)  The Business Week cover is now famous as a contrary indicator.  It wouldn’t shock me if the current investor disdain for stocks has a similar outcome down the road.

Business Week: the famous "Death of Equities" cover

I was thinking about this in relation to this article about customer service in the retail world from PandoDaily.

There is simply no such thing as a shortcut when it comes to customer service. You can provide an alternate service, if you don’t want to invest in a local call center of friendly competent people armed with helpful databases of customer information. But don’t call this customer service, because it isn’t. To call a person reading from a script a customer-service representative is like calling a middle school play Broadway. You might as well not have an 800 number.

Zappos, GoDaddy, Qualtrics and Braintree have proven that spending money on customer service isn’t throwing money away — it’s investing in the business. Done well, good customer service is the difference between a mediocre business and a great one. You can get shoes anywhere, and Zappos’ site design has never been that amazing; its entire success is wrapped up in treating people well. GoDaddy doesn’t view its call center as a “cost center,” arguing it has actually generated more than $100 million in annual revenues.

If anything, client service is even more important in wealth management because the product itself is intangible.  How can you put a price on financial security and peace of mind?  And, as GoDaddy shows, good client service can generate revenues, not just add to costs.  People come first.

We’ve written before about beanbag economics, the essence of which is that when you smush in one part of a beanbag, it just poofs out somewhere else.  Relative strength is a simple and effective way to see where trends are underway.

Consider a typical bad news lead in this Reuters article:

Worries about a run on Greek banks has rattled Athens this week, after savers withdrew at least 700 million euros on Monday alone…

That sounds quite scary.  However, buried deep in the article, at the very end, is the beanbag economics section:

Deposits shifted around Europe dramatically last year, analysis of data from more than 120 listed European banks show.

More than 120 billion euros was taken from two banks in Belgium alone, including an exodus of customer deposits from Dexia (DEXI.BR) which had to be bailed out and restructured. KBC (KBC.BR) also saw a big outflow.

Some 90 billion euros was taken from France’s banks, including around 30 billion each from Credit Agricole (CAGR.PA) and BNP Paribas (BNPP.PA). French banks were hit last year by their heavy exposure to Greece and concerns about their liquidity that forced them to accelerate plans to shrink.

Worries the euro zone crisis would spread also saw about 30 billion euros in deposits leave Italian banks, although inflows to BBVA (BBVA.MC) helped limit the net outflow from Spain.

Cash flooded into Britain; more than 140 billion euros was deposited in four big banks alone. The UK benefits from its position outside the euro zone and its Asia-focused banks HSBC (HSBA.L) and Standard Chartered (STAN.L) are seen as particular safe-havens.

Other banks to see big inflows included Barclays (BARC.L), Germany’s Deutsche Bank (DBKGn.DE), Switzerland’s Credit Suisse (CSGN.VX) and UBS (UBSN.VX) and Russia’s Sberbank (SBER.MM) and VTB (VTBR.MM).

Banks that were in trouble had deposits leave, but they didn’t vanish into thin air.  Other banks saw massive inflows at their expense.  And—think about it—the Greek and French banks had the money in the first place because depositors saw them as relatively more attractive than European stocks or their mattresses, or whatever, at the time.  Times have now changed and the flow of money is being directed somewhere else.  It’s not the end of the world when some asset class implodes, unless, of course, you have 100% of your assets in it.  That implosion works to the benefit of another asset class somewhere else.

There are always relative winners and losers; things are rarely completely one-sided.  This is the primary attraction of using relative strength for tactical asset allocation.  It is able to identify shifts in supply and demand by measuring what assets are strong and what assets are weak.   Markets all over the world operate and interact in this same way.

Beanbag Economist: Someone has to get those asset flows!

Source: www.indyagenda.com

via The Big Picture  (click on image to enlarge)

You can see that relative strength did not crack the top ten.  On the bigger chart, which you can see in the article, relative strength came in at #11.  Of course, there are many formulations of relative strength, so even that ranking probably covers a lot of different methods.

A number of the popular factors are value-related and some are based on profitability.  All of these factors ultimately interact in complicated ways, but you don’t have to worry about a crowded trade in relative strength.

Value, quality, and risk-related factors are all much more popular than relative strength.

via The Big Picture     (click on image to enlarge)

When it comes to investing, there’s no shortage of bad advice floating around out there. Among the worst, though, is the old saw, “You can’t go broke by taking a profit.”

The saying refers to the belief that if you have a stock that’s gone up in value, it’s hard to go wrong selling that stock and “locking in” the gains. But while the saying is technically true — it’s hard to picture a scenario where an investor is suddenly bankrupt after selling a stock at a profit — it’s a dangerous platitude for investors to follow.

There’s a name for that
The practice of selling winning stocks and hanging on to losing ones is a practice that’s familiar to behavioral-finance experts. It’s a behavioral bias known as the disposition effect and has been revealed to be quite harmful for investors. A number of academic papers have shed light on the subject, including Berkeley professor Terrance Odean’s 1998 study that concluded that individual investors’ “preference for selling winners and holding losers … leads, in fact, to lower returns.”

A possible explanation
If the long-term returns from stocks were distributed normally — that is, they formed the familiar bell-shaped curve and most stocks’ returns clustered around the average — selling winners and holding losers might actually work. If the returns from most individual stocks were likely to be right around the average for all stocks, then a big winner would be more likely to stall out after its winning streak than continue climbing. At the other end, it wouldn’t be unreasonable to expect a stock that’s been a big loser to climb back closer to the average.

But that’s not how it works.

I was reminded of this by a recent report by Shankar Vedantam for NPR, called “Put Away the Bell Curve: Most of Us Aren’t Average.  Vedantam reviewed the research and work of Ernest O’Boyle Jr. and Herman Aguinis, who studied the performance of 633,263 people involved in academia, sports, politics, and entertainment.

In short, the pair’s finding was that the performance distribution in these groups wasn’t bell-shaped. Instead, many participants clustered below the mathematical average, while a group of superstars produced results far above the average and pulled the overall average up.

Stock returns have a similar distaste for fitting to a bell curve. Over the past 10 years, 63% of the S&P 500 companies underperformed the average. Meanwhile, a large group of significant outperformers delivered returns that were well above the average.

As compared with the bell curve in the background, the data plotted here is a mess. And it should be. Stock returns are not normally distributed — which is what produces that nice bell-shaped curve. And though stats-stars who are much smarter than me often try to describe stock returns as “lognormal” — a mathematical transformation of the returns that gets them to more closely fit a bell curve — they’re not that, either. Stocks are typified by “fat tails” on either end — that is, more seriously outperforming and underperforming stocks than is easily captured by streamlined mathematical models.

So no matter how you look at stock returns, a surprising number of stocks end up returning far more and far less than the average. Practically, this means that the practice of “locking in gains” and hanging on to losers is a good way to miss out on the market’s huge outperformers, stay stuck with poor performers, and earn lackluster overall returns.

HT: iShares

Stocks still undervalued according to Morningstar

Source: Morningstar  (click on image to enlarge)

In a nutshell, this is the entire reason for a systematic process.  Yes, I know we’ve featured this quote before, but it’s just so darn good.

Dan Loeb

Source: Business Insider

via Abnormal Returns

Gold has had good relative strength for much of the last decade—and as a result it has dramatically outperformed Warren Buffett.  Bespoke took up this exact issue and had this to say:

Given the fact that BRK/A does not pay a dividend, no matter how much a holder ‘fondles’ or looks at their holdings, one share of BRK/A stock purchased twelve years ago is still one share today.  Sure, you can sell it for more now than you bought it then, but the same is true of gold.  In fact, your gain on gold is considerably more than your gain would be on BRK/A.  Looking at the performance of the two assets since the start of 2000 shows that the value of gold has increased considerably more than the value of Berkshire Hathaway.  In fact, with a gain of 466% since the start of 2000, gold’s gain has been nearly four times the return of BKR/A (466% vs 120%).

Their nifty graphic follows:

Source: Bespoke   (click on image to enlarge)

Relative strength has no axe to grind.  One of the great benefits of using relative strength to drive tactical asset allocation is that it is objective and adaptive.  Relative strength does not have a philosophical bias in favor of, or against, gold.  If relative strength is high, perhaps it should be included in the portfolio.  If relative strength is low, it’s out—period.

The point of investing is not to serve our biases, but to own the best-performing assets that we can identify.

This particular article appeared August 17, 2010.  The market had just gone through a near 20% decline, as well as the flash crash a few months before.  Here is the front end of the article:

Yes, it’s going to get worse, a whole lot worse … Bill Gross warns this is the “New Normal. Forget 10% returns. Think 5%”. … Economist Larry Kotlikoff, author of The Coming Generational Storm, warns: “Let’s get real. The U.S. is bankrupt. Neither spending nor taxing will help the country pay its bills” … Economist Peter Morici warns: “Unemployment is stuck near 10%. Deflation coming. Stock market threatens collapse. The Federal Reserve and Barack Obama are out of bullets. Near zero federal funds rates, central bank purchases, a $1.6 trillion deficit have failed to revive the economy.” … Simon Johnson, co-author of 13 Bankers, warns: “We came close to another Great Depression, next time we may not be so lucky.” Why? Because Wall Street’s already well into the next bubble/bust cycle — the “doom cycle.”

The doom cycle sounds pretty bad and we are warned that things are going to get a whole lot worse.  I’m not exaggerating.  The whole paragraph was in heavy bold type.

Since then, we’ve gone through another 20% correction.  And the market is more than 25% higher.  Yes, higher.

Before you smirk and think you are immune from getting carried away, think again.  We are all susceptible to emotion—it’s just part of our wiring.  And it’s not just on the downside.  It’s equally easy to get carried away with “new era” thinking on the upside.

Sentiment swings, I think, demonstrate one of the very best reasons to use a systematic investment process.  Our happens to be an adaptive one driven by relative strength, but I’m sure other styles could also be successful.  The important thing is to define a profitable process and then stick to it through thick and thin.