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)

The 10-day moving average of this indicator is 54% and the one-day reading is 40%.

At times, it seems as if the number of ETFs available to U.S. investors will soon exceed the number of stars in the sky. That might be overstating things a bit, but the pace of expansion in the ETF industry has truly been impressive over the last several years. With multiple products seemingly debuting every week and very few shutting down (despite countless predictions to the contrary), the size of the ETF lineup has effectively doubled in a relatively short period of time. And there’s no indication that the product development front is going to be slowing down any time soon; issuers continue to file for both innovative and duplicative products, producing a pipeline full of hundreds of funds that could debut at some point in the next several months.

The proliferation of ETFs, ETNs, and other exchange-traded cousins of these vehicles is, in many ways, a very positive development for investors. There are now ETPs for just about every investment objective, ranging from the very broad and very straightforward to the hyper-targeted and rather complex. And many of the more recent additions to the ETF lineup have further “democratized” the business of investing, delivering cheap and easy access to sophisticated strategies that would otherwise be time consuming and expensive to implement.

My emphasis added.  Up to this point, I wholeheartedly agree–the expansion of the ETF universe has been extremely beneficial to investors.  It has also played right into our hands here at Dorsey Wright because it has provided a very tax-efficient means of getting exposure to relative strength (See PDP, PIE, and PIZ).  Furthermore, the expansion of the ETF universe has enabled us to provide innovative global tactical asset allocation strategies (See DWAFX and DWTFX) where we can efficiently get exposure to a wide variety of global asset classes.

However, ETFdb then states the following:

But the growth spurt for the industry has also made it increasingly difficult to navigate. Moreover, the tremendous variance in level of sophistication and risk tolerance among ETFs can set the stage for confusion and potentially lead to a less-than-ideal experience with ETFs.

That last part is only true if there is no framework for efficiently and thoroughly evaluating each of the ETFs.  Without such a framework then, yes, I can certainly understand why some find it “increasingly difficult to navigate.”  However, within the context of a relative strength model, more choices are potentially a good thing.  The more options for finding uncorrelated returns, the more likely it is that a global tactical asset allocation strategy can generate favorable returns in a variety of market environments.  Furthermore, relative strength models evaluate each member of the universe in a systematic fashion and only allocate if dictated by the relative strength rank–a true meritocracy!

Source: Wikipedia

See www.powershares.com and www.arrowfunds.com.

 ¹PowerShares DB Gold, ²iShares MSCI Emerging Markets ETF, ³iShares DJ U.S. Real Estate Index, ⁴iShares S&P Europe 350 Index, ⁵Green Haven Continuous Commodity Index, ⁶iBoxx High Yield Corporate Bond Fund, ⁷JP Morgan Emerging Markets Bond Fund, ⁸PowerShares DB US Dollar Index, ⁹iBoxx Investment Grade Corporate Bond Fund, ¹⁰PowerShares DB Oil, ¹¹iShares Barclays 20+ Year Treasury Bond

Last week’s performance (5/7/12 – 5/11/12) is as follows:

High RS Stocks underperformed the universe last week, as did the laggards.  It was the stocks in the middle of the ranks that actually held up the best.