I am reminded of  a line from the film Crocodile Dundee, when a street hoodlum pulls a switchblade against our hero, Paul Hogan.  “You call that a knife?” says Hogan incredulously, withdrawing a bowie blade from the back of his boot.  “Now this,” he says with a sly grin, “is a knife.”

One of the biggest challenges for an investor is to be able to make the best use of limited resources.  After all, the value of every investment portfolio is finite.  How can you be sure that you are allocating your finite resources to those securities that represent the “best” investment opportunities and not just “good” or “acceptable” investment opportunities?

The elegance of systematic relative strength models is that all securities in the investment universe are evaluated relative to every other security in the investment universe.  With this knowledge you can be sure that each of the final holdings has superior relative strength characteristics and, therefore, gives you the best probabilities of successful investment results.

HT: Dan Ariely, Predictably Irrational

The public’s distaste for equities is palpable and understandable. Negative returns for 10 years in stocks while “riskless” treasuries have soared, and right after one of the best 6 months treasuries have had in the decade, is more than enough to convince folks that stocks are just not where you want to invest long term.

Then there is the really long term. Long term treasuries as measured by the Barclay’s Capital Long Term Treasury Bond total return index have beaten equities as measured by the S&P 500 year to date, and in the 1-, 3-, 5-, 10-, 15-, and 20-year time frames. It’s a tie at 25 years. Over 20 years of consistently superior returns over stocks in an asset guaranteed by the U.S. government seems to be sufficient to drive a stake through the heart of the idea that you want stocks for the long term. Gentlemen and ladies both prefer bonds. Who doesn’t?

It is almost a tautology in capital markets that the best investments are those with the worst previous returns, where expectations are low, demand is down, and prospects appear at best highly uncertain. In 1980 bonds had been through a 30 year bear market relative to stocks, inflation was soaring, yields were at historic highs, yet expected to go higher, and a long bull market in bonds was at hand. The idea that U.S. interest rates would be at all time lows 30 years later would have been dismissed as ludicrous. The situation is now reversed, with stocks having underperformed bonds for decades.

The point here is simple: U.S. large capitalization stocks represent a once in a lifetime opportunity in my opinion to buy the best quality companies in the world at bargain prices. The last time they were this cheap relative to bonds was 1951. I was 1 year old then, but did not have then sufficient sentience or capital to invest. I do now, and if you are reading this, so do you.

His whole article is well worth the read.  If Bill Miller is right, does your investment strategy allow for the flexibility to capitalize on the type of move in large cap stocks that he foresees?

Every time that there seems to be an unusually large degree of uncertainty about the direction of the economy or stock market, the natural reaction for many is to seek “expert” opinion.  Richard Ferri’s recent article in Forbes should make you think twice before getting too excited about what the “experts” think is in store for the economy or stock market in the months and years to come.

Truth be told, market predictions aren’t about the markets; they’re about marketing. By predicting markets, the gurus provide the illusion of skill and knowledge, and that brings attention to whatever service they’re selling. This is especially true if a guru makes an outrageous market prediction that actually comes true. People tend to remember the one big call and overlook a guru’s dismal long-term track record.  Is there hope of finding a guru that actually has market timing skill? Sure there is. Anything’s possible. It’s possible that some guru someplace has forecasting powers, just like it’s possible that space aliens will send giant cockroaches to eat the Earth. It’s just not probable.

A behavioral economist could very easily explain why my plea to pay no attention to investment gurus will fall on deaf ears (it’s emotionally satisfying for an investor to rely on expert opinion so that it is no longer their fault if things don’t work out).  Another explanation, could simply be that many are unaware of the poor track record of forecasters.

For those of us who employ trend-following strategies, the name of the game is to always maintain the flexibility to adapt to new trends.  Furthermore, the question isn’t whether “it” is going to go up or down because there are generally some asset classes going up, some stagnating, and some going down.  Trend followers focus not on forecasting, but on execution.  A behavioral economist would probably also point out that one reason someone like us may prefer to rely on systematic trend-following models is because that it is also emotionally satisfying (I can attest to the fact that it is much less stressful to manage money by strict adherence to models than by my current judgement/emotions). If reliance on guru opinion and reliance on systematic trend-following models are BOTH emotionally satisfying ways of dealing with uncertainty, doesn’t it make sense to choose the one that gives you the best probability of investment success? To help you evaluate the probabilities and performance associated with trend-following models, click here to read the white paper Relative Strength and Asset Class Rotation, written by one of our portfolio managers, John Lewis.

From Newsweek comes evidence that conditions for a recovery are being put in place without any help from the government:

This do-it-yourself stimulus has already started. Corporate America’s balance sheet has never looked better, and consumers are paying down debt and bolstering savings. The challenge is a reluctance to spend. To try to jump-start consumption, companies are enacting mini stimulus programs of their own. In years past, teen-oriented retailer American Eagle has given away free T shirts and movie tickets to potential shoppers as part of a back-to-school promotion. This year it’s offering a free smart phone to shoppers who try on a pair of jeans (and sign up for a plan). Chrysler just kicked off a round of promotions that includes zero-interest financing and an offer to cover the first two installment payments. With banks reluctant to lend to small businesses, warehouse giant Sam’s Club has started a program with an approved Small Business Administration lender, Superior Financial Group. Sam’s Club will essentially subsidize a chunk of the loan process to enable its members to borrow up to $25,000—with the hopes they’ll spend the proceeds in the retailer’s wide aisles.

Innovative retailers like American Eagle, Chrysler, and Wal-Mart will figure out ways to improve their sales.  Other companies will too.  There are always trends because there are always corporate winners and losers–and often a recession strengthens the winners and makes them stand out relative to their competition.  An investment policy that makes systematic use of relative strength is well-positioned to be able to separate the winners and the losers.

For example, a recent article discussed a very topical issue: how to determine if your slumping fund or advisor has permanently lost their touch.  Clients grapple with this issue all the time and, most frequently, get it wrong.  Studies show that both retail and institutional investors tend to terminate advisors after a period of poor performance and to hire advisors after a period of good performance.  Most often, this period tends to be temporary and the studies have demonstrated that investors cost themselves an enormous amount of money by doing so.

On the other hand, no client wants to be permanently stuck with a lousy manager.  So how can you differentiate?

There are a couple of different conditions in which Morningstar suggests you not act too impetuously.

1. Funds that don’t follow the crowd often have very different performance profiles than the broad market.  Their ranking can zig when the market zags.  (Our Systematic portfolios tend to visit both the top and bottom deciles with regularity.) 

2. Sometimes an anomalous time period can make a fund look worse than it is.  Relying on the ranking of a value fund at the end of a growth cycle, or vice versa, would probably be a significant mistake.

In both cases, the fund’s peer ranking can suffer, but as Morningstar points out, the ranking often comes roaring back.  The rankings are exceptionally fluid because the returns are often tightly clustered.  For example:

…most category rankings are based on a tightly constrained range. In the large-value category, a 10-year annualized gain of 1.6% lands a fund in the group’s worst third, but a 3.1% gain puts it in the top third. Neither is good on an absolute basis. It is easy to see how a good month or two is all it would take to vault a fund from the group’s basement to its penthouse, and vice versa.

I’ve added the emphasis because I don’t think the fluidity in ranking is generally understood by the investing public.  If a good month or two can swing your 10-year ranking significantly, it seems to me that it is much more important to understand the manager’s process than it is to worry about the temporary ranking.  Rankings can be unstable; process is permanent.

After performing a simple study, CXO Advisory concludes:

In summary, simple sector ETF momentum strategies have generally outperformed the broad stock market over the past decade for reasonably low trading frictions.

But wait, there’s more:

Including ETFs representing other asset classes (such as bonds, commodities, equity styles and international stocks) may enhance results.

That is essentially the recipe for our Global Macro separate account and the two Arrow Funds we sub-advise.  Our own white paper on asset class rotation found the same thing.  Relative strength just tries to go where the returns are.  The evidence shows that often those returns persist.

When the stock market rises, you feel increasingly optimistic about your financial future.  However, when it falls you start to get nervous and have even had knots in your stomach at times.  Perhaps, you have even considered leaving the stock market for good in order to just invest your money in certificates of deposit where at least you know that you will get your money back with some modest return.

Some variation of the thought process described above is commonplace among those who see retirement on the horizon.  Any time the financial markets experience turmoil, it is natural for investors to ask themselves why they voluntarily signed up for this!  During such periods of introspection, it is a must to ponder the reasons for investing in the first place.  Despite the ever-present risk of loss that exists in the financial markets, the financial markets also present one of the best available means of accumulating wealth.  It is also at times of market turmoil that the consequences of “dialing down the risk” must be considered.

The table below highlights the differences in annual distributions for 6 different investors who each arrive at age 55 with $1 million in savings. It makes many simplifications and does not consider inflation, additional savings, alternative methods of distribution, and other factors.  However, its purpose is to highlight the impact that the rate of return earned on the $1 million over the 15 years from age 55 to 70 of the hypothetical investor have on the annual distributions from age 70 through 95. It assumes that the entire value of the portfolio is removed from the markets when the investor turns 70 years old and then simply divides the value of the portfolio by 25 in order to get the annual distribution amount.

(Click to Enlarge)

Molly Mattress decides that she doesn’t need the stress of investing.  She is simply going to hide her money under her mattress and enjoy her life without having to worry if her money will be there in the future or not.  While it is true that the risk of short-term loss is no longer an issue for Molly, she also is left with only $40,000 per year from age 70 until age 95.  Cindy CD at least earns interest on her money (2.78% is the current average interest rate on 5-year certificates of deposits, according to www.bankrate.com.)  By taking this action, Cindy is able to bump up her annual distribution to $60,352 per year.  On the other end of the spectrum is Venturesome Vic who earns an annualized return of 10% on his money for 15 years and is then able to enjoy distributions of $167,090.  Cautious Kate, Average Alex, and Optimistic Oscar fall in between those extremes.

Does this focus on the amount of the annual distributions change anything?  It should.  After all, it is easy to focus on the here and now and focus on avoiding short-term losses.  However, permanent reductions in risk tolerance when an investor is still potentially decades away from “pushing up daisies” may result in a very modest and potentially unpleasant standard of living during the retirement years.

Source: www.calwatchdog.com

Families are banking more money than they are borrowing for the first time in more than 20 years, a Bank of England report shows.

The austerity, which is also being seen in government budgets, is coming from the same two sources as in the U.S.:

Peter Spencer, the chief economic adviser to the Ernst & Young ITEM Club, said: “People are reducing their borrowings. It’s the combined effect of some families not being able to get credit and other families choosing to pay their debts off.”

In other words, some of the austerity is voluntary and some is involuntary.  The net result is that savings rates are rising in the U.K., as they are here:

Overall savings, including pensions and investments, rose last year from 2 per cent of household income to 7 per cent as families prepared for leaner times, according to the Office for National Statistics. This year, the savings ratio has risen further, to 8 per cent, a level not achieved since 1998.

Consumer behavior, given similar incentives, tends to be quite similar.  Investor behavior is no different around the globe.  When the economic and political climate seem uncertain, as they are now, investors tend to be risk averse.  When investors feel more confident, they are more likely to embrace risk in the quest for higher returns.  (Return factors like relative strength tend to work across markets and asset classes because behavior really isn’t so different, despite location and circumstance.)  I suspect we will see this same behavior in every country that is currently feeling a fiscal squeeze.

Source: Sizzling Europe

Although the immediate macro-economic effect of increased savings may be slower growth, the long-term impact is a rising store of cash to fuel the next market boom.  Money goes where it is treated well–and that asset doesn’t have to be domestic equities.  Even in a difficult overall environment for financial assets, there are always big winners.  Relative strength can help identify those winners around the globe, wherever they are.

CXO Advisory shared the results of a paper that looked at the reversion of stock markets to a valuation benchmark based on a world stock market index.  In other words, when the market is over-valued does it make sense to wait around for it to correct back to the mean?  Or should we just go with the flow, keeping in mind Keynes’ maxim, “In the long run, we are all dead”?

CXO concluded:

…evidence indicates that speed of reversion of stock markets to a valuation benchmark is not reliable over an investing lifetime.

They reached this conclusion because, working with a huge 109-year data sample, the study showed that correcting divergences took a long, long time:

On average over the entire sample period, stock markets eliminate half of a divergence from the valuation benchmark in about 13.8 years…

The 95% confidence interval for correcting half the divergence was a span from 10 to 21 years.  Yikes!  When something gets out of synch, it can stay that way for a long time.  An investor probably will not have the luxury of waiting around for the market to go where it is theoretically supposed to.  In this context, following the current trends in markets to extract returns today may be a more realistic option than waiting around for markets to behave themselves tomorrow–or 15 years from now.

—-Lewis Carroll, Alice in Wonderland

This is the beginning of an article from The Economist entitled “Something Doesn’t Fit.”  The piece goes on to discuss something that is happening now in the capital markets, but according to handbooks on strategic asset allocation, isn’t supposed to happen.  Both gold and Treasury bonds are doing well.  Market lore says gold is supposed to do well during times of inflation and Treasury bonds are supposed to do well during deflationary periods.  As The Economist points out:

There is something remarkable about this combination. You would expect the performance of gold and Treasury bonds to be inversely correlated. When gold was at its real all-time high in 1980, the ten-year Treasury-bond yield was 10.8%. Fixed-income investors had suffered years of negative real returns in the 1970s.

Adding other assets to the mix does not solve the dilemma. David Ranson of Wainwright Economics, a consultancy, has examined how gold and corporate-bond spreads have worked as a guide to asset allocation since 1978. The gold price is an indicator of inflationary pressures. Bond spreads are an indicator of growth: investors are happy to take the risk of owning corporate bonds, and spreads come down, when the economy, and thus business revenues, are strengthening. Over the year to end-May gold was up by 25% while corporate-bond spreads narrowed sharply. History suggests that such a combination should be bad news for government bonds.

One of the more striking things about financial markets is their repeated ability to do impossible things; impossible at least in the finance textbooks.  It turns out that a lot of the things history suggests just don’t pan out.

This is one of the reasons that a trend-following approach based on relative strength can be so helpful.  Trend following does not make any a priori assumptions about how the world works or about how things are correlated.  It just goes with the flow.  A trend follower has no difficulty reconciling gold and Treasury prices going up at the same time.  What is, is. 

Models that are based on historical correlations are prone to break when (not if) the correlations go haywire.  Relative strength models are designed to be adaptive.  This is one of the primary reasons we choose to have all of our investment processes driven by relative strength.

As relative strength flows from one asset class to another, an adaptive simply model changes the holdings.  The changes in relative strength between asset classes are generally somewhat durable.  The flow in relative strength, after all, usually has a rational cause.  In the case of the recent conundrum, The Economist suspects a couple of possible causes: 

So what explains the current situation? Both gold and Treasury bonds could be classed as “safe haven” assets that investors buy when they are risk-averse.

So the safe haven trade is one possibility.  The next possibility is very different:

Martin Barnes of Bank Credit Analyst, a research firm, points out that the direction of official policy (low rates, quantitative easing, big deficits) looks inflationary but the economic fundamentals (a big output gap, sluggish credit growth) look deflationary. Faced with this dichotomy, investors who buy both Treasury bonds and gold are not displaying cognitive dissonance. They are just hedging their bets.

In the absence of being able to figure out what will happen next, perhaps investors are just hedging their bets–otherwise known as “having no clue.”

From a fundamental point of view, these choices are quite different.  From the point of view of a relative strength investor, the explanation is less important than what is actually happening.  Impossible things will contine to happen, but relative strength will just continue to adapt.