Dorsey Wright Managed Accounts

January 27, 2014


Our Systematic Relative Strength portfolios are available as managed accounts at a large and growing number of firms.

  • Wells Fargo Advisors (Global Macro available on the Masters/DMA Platforms)
  • Morgan Stanley (IMS Platform)
  • TD Ameritrade Institutional
  • UBS Financial Services (Aggressive and Core are available on the MAC Platform)
  • RBC Wealth Management (MAP Platform)
  • Raymond James (Outside Manager Platform)
  • Stifel Nicolaus
  • Kovack Securities
  • Deutsche Bank
  • Charles Schwab Institutional
  • Sterne Agee
  • Scott & Stringfellow
  • Envestnet
  • Placemark
  • Scottrade Institutional
  • Janney Montgomery Scott
  • Robert W. Baird
  • Wedbush Morgan
  • Prospera
  • Oppenheimer (Star Platform)
  • SunTrust
  • Lockwood

Different Portfolios for Different Objectives: Descriptions of our seven managed accounts strategies are shown below.  All managed accounts use relative strength as the primary investment selection factor.

Aggressive:  This Mid and Large Cap U.S. equity strategy seeks to achieve long-term capital appreciation.  It invests in securities that demonstrate powerful relative strength characteristics and requires that the securities maintain strong relative strength in order to remain in the portfolio.

Core:  This Mid and Large Cap U.S. equity strategy seeks to achieve long-term capital appreciation.  This portfolio invests in securities that demonstrate powerful relative strength characteristics and requires that the securities maintain strong relative strength in order to remain in the portfolio.  This strategy tends to have lower turnover and higher tax efficiency than our Aggressive strategy.

Growth:  This Mid and Large Cap U.S. equity strategy seeks to achieve long-term capital appreciation with some degree of risk mitigation.  This portfolio invests in securities that demonstrate powerful relative strength characteristics and requires that the securities maintain strong relative strength in order to remain in the portfolio.  This portfolio also has an equity exposure overlay that, when activated, allows the account to hold up to 50% cash if necessary.

International: This All-Cap International equity strategy seeks to achieve long-term capital appreciation through a portfolio of international companies in both developed and emerging markets.  This portfolio invests in those securities with powerful relative strength characteristics and requires that the securities maintain strong relative strength in order to remain in the portfolio.  Exposure to international markets is achieved through American Depository Receipts (ADRs).

Global Macro: This global tactical asset allocation strategy seeks to achieve meaningful risk diversification and investment returns.  The strategy invests across multiple asset classes: Domestic Equities (long & inverse), International Equities (long & inverse), Fixed Income, Real Estate, Currencies, and Commodities.  Exposure to each of these areas is achieved through exchange-traded funds (ETFs).

Balanced: This strategy includes equities from our Core strategy (see above) and high-quality U.S. fixed income in approximately a 60% equity / 40% fixed income mix.  This strategy seeks to provide long-term capital appreciation and income with moderate volatility.

Tactical Fixed Income: This strategy seeks to provide current income and strong risk-adjusted fixed income returns.   The strategy invests across multiple sectors of the fixed income market:  U.S. government bonds, investment grade corporate bonds, high yield bonds, Treasury inflation protected securities (TIPS), convertible bonds, and international bonds.  Exposure to each of these areas is achieved through exchange-traded funds (ETFs).


To receive fact sheets for any of the strategies above, please e-mail Andy Hyer at or call 626-535-0630.  Past performance is no guarantee of future returns.  An investor should carefully review our brochure and consult with their financial advisor before making any investments.

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Equity as the Way to Wealth

January 3, 2014

According to a recent Gallup Poll, most Americans don’t think much of the stock market as a way to build wealth.  I find that quite distressing, and not just because stocks are my business.  Stocks are equity—and equity is ownership.  If things are being done right, the owner should end up making more than the employee as the business grows.  I’ve reproduced a table from Gallup’s article below.

Source: Gallup  (click on image to enlarge)

You can see that only 37% felt that the stock market was a good way to build wealth—and only 50% among investors with more than $100,000 in assets.

Perhaps investors will reconsider after reading an article from the Wall Street Journal, here republished on Yahoo! Finance.  In the article, they asked 40 prominent people about the best financial advice they’d ever received.  (Obviously you should read the whole thing!)  Two of the comments that struck me most are below:

Charles Schwab, chairman of Charles Schwab Corp.

A friend said to me, Chuck, you’re better off being an owner. Go out and start your own business.

Richard Sylla, professor of the history of financial institutions and markets at New York University

The best financial advice I ever received was advice that I also provided, both to myself and to Edith, my wife. It was more than 40 years ago when I was a young professor of economics and she was a young professor of the history of science. I based the advice on what were then relatively new developments in modern finance theory and empirical findings that supported the theory.

The advice was to stash every penny of our university retirement contributions in the stock market.

As new professors we were offered a retirement plan with TIAA-CREF in which our own pretax contributions would be matched by the university. Contributions were made with before-tax dollars, and they would accumulate untaxed until retirement, when they could be withdrawn with ordinary income taxes due on the withdrawals.

We could put all of the contributions into fixed income or all of it into equities, or something in between. Conventional wisdom said to do 50-50, or if one could not stomach the ups and downs of the stock market, to put 100% into bonds, with their “guaranteed return.”

Only a fool would opt for 100% stocks and be at the mercies of fickle Wall Street. What made the decision to be a fool easy was that in those paternalistic days the university and TIAA-CREF told us that we couldn’t touch the money until we retired, presumably about four decades later when we hit 65.

Aware of modern finance theory’s findings that long-term returns on stocks should be higher than returns on fixed-income investments because stocks were riskier—people had to be compensated to bear greater risk—I concluded that the foolishly sensible thing to do was to put all the money that couldn’t be touched for 40 years into equities.

At the time (the early 1970s) the Dow was under 1000. Now it is around 16000. I’m now a well-compensated professor, but when I retire in a couple of years and have to take minimum required distributions from my retirement accounts, I’m pretty sure my income will be higher than it is now. Edith retired recently, and that is what she has discovered.

Not everyone has the means to start their own business, but they can participate in thousands of existing great businesses through the stock market!  Richard Sylla’s story is fascinating in that he put 100% of his retirement assets into stocks and has seen them grow 16-fold!  I’m sure he had to deal with plenty of volatility along the way, but it is remarkable how effective equity can be in creating wealth.  His wife discovered that her income in retirement—taking the required minimum distribution!—was greater than when she was working!  (The italics in the quote above are mine.)

Equity is ownership, and ownership of productive assets is the way to wealth.

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Stock Market Sentiment Review

November 19, 2013

I’m still getting back into the swing of things after having the flu most of last week.  In the midst of my stock market reading, I was struck by an article over the weekend from Abnormal Returns, a blog you should be reading, if you aren’t already.  The editor had a selection of the blog posts that were most heavily trafficked from the prior week.  Without further ado:

  • Chilling signs of a market top.  (The Reformed Broker)
  • Ray Dalio thinks you shouldn’t bother trying to generate alpha.  (The Tell)
  • Ten laws of stock market bubbles.  (Doug Kass)
  • How to teach yourself to focus.  (The Kirk Report)
  • Are we in a bubble?  (Crossing Wall Street)
  • Josh Brown, “If the entities in control of trillions of dollars all want asset prices to be higher at the same time, what the hell else should you be positioning for?”  (The Reformed Broker)
  • Guess what stock has added the most points to the S&P 500 this year? (Businessweek)
  • Everything you need to know about stock market crashes.  (The Reformed Broker)
  • Jim O’Neil is swapping BRICs for MINTs.  (Bloomberg)
  • How to survive a market crash.  (Your Wealth Effect)


I count five of the top ten on the topic of market tops/bubbles/crashes!

Markets tend to top out when investors are feeling euphoric, not when they are tremendously concerned about the downside.  In my opinion, investors are still quite nervous—and fairly far from euphoric right now.

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The Top Ten Ways to Sabotage Your Portfolio

November 4, 2013

Good portfolio management is difficult, while poor portfolio management is almost effortless!  In the spirit of David Letterman’s Top Ten list, here is my contribution to the genre of things to avoid, with a special nod to our brand of investing.  I made a version of this presentation originally at a 1996 Dorsey Wright Broker Institute.



1. BE ARROGANT.  Assume your competition is lazy and stupid.  Don’t do your homework  and don’t bother with a game plan.  Panic if things don’t go well.

2. WHEN A SECTOR OR THE MARKET REVERSES UP, WAIT UNTIL YOU FEEL COMFORTABLE TO BUY.  This is an ideal method for catching stocks 10 points higher.

3. BE AFRAID TO BUY STRONG STOCKS.  This way you can avoid the big long-term relative strength winners.

4. SELL A STOCK ONLY BECAUSE IT HAS GONE UP.  This is an excellent way to cut your profits short.  (If you can’t stand prosperity, trim if you must, but don’t sell it all.)


6. TRY TO BOTTOMFISH A STOCK IN A DOWNTREND.  Instead, jump off a building and try to stop 5 floors before you hit the ground.  Ouch.

7. BUY A STOCK ONLY BECAUSE IT’S A GOOD VALUE.  There are two problems with this.  1) It can stay a good value by not moving for the next decade, or worse 2) it can become an even better value by dropping another 10 points.

8. HOLD ON TO LOSING STOCKS AND HOPE THEY COME BACK.  An outstanding way to let your losses run.  Combined with cutting your profits short, over time you can construct a diversified portfolio of losers and register it with the Kennel Club.

9. PURSUE PERFECTION.  There are two diseases.  1) Hunting for the perfect method.  Trying a new “system” each week will not get you to your goal.  It requires remaining focused on one method,  maintaining consistency and discipline, and making incremental improvements.  2) Waiting for the perfect trade.  The sector is right, the market is supporting higher prices, the chart is good—try to buy it a point cheaper and miss it entirely.  Doh.  Better to be approximately right than precisely wrong.

10. MAKE INVESTMENT DECISIONS BASED ON A MAGAZINE COVER, MEDIA ARTICLES, OR PUNDITS.  Take investment advice from a journalist or a hedge fund manager talking his book!  Get fully engaged with your emotions of fear and greed!  This is the method of choice for those interested in the fastest route to the poorhouse.

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Stocks for the Long Run

September 20, 2013

Unlike certain authors, I am not promoting some agenda about where stocks will be at some future date!  Instead, I am just including a couple of excerpts from a paper by luminaries David Blanchett, Michael Finke, and Wade Pfau that suggests that stocks are the right investment for the long run—based on historical research.  Their findings are actually fairly broad and call market efficiency into question.

We find strong historical evidence to support the notion that a higher allocation to equities is optimal for investors with longer time horizons, and that the time diversification effect is relatively consistent across countries and that it persists for different levels of risk aversion.

When they examine optimal equity weightings in a portfolio by time horizon, the findings are rather striking.  Here’s a reproduction of one of their figures from the paper:

Source: SSRN/Blanchett, Finke, Pfau  (click to enlarge)

They describe the findings very simply:

Figure 1 also demonstrates how to interpret the results we include later in Tables 2 and 3. In Figure 1 we note an intercept (α) of 45.02% (which we will assume is 45% for simplicity purposes) and a slope (β) of .0299 (which for simplicity purposes we will assume is .03). Therefore the optimal historical allocation to equities for an investor with a 5 year holding period would be 60% stocks, which would be determined by: 45% + 5(3%) = 60%.

In other words, if your holding period is 15-20 years or longer, the optimal portfolio is 100% stocks!

Reality, of course, can be different from statistical probability, but their point is that it makes sense to own a greater percentage of stocks the longer your time horizon is.  The equity risk premium—the little extra boost in returns you tend to get from owning stocks—is both persistent and decently high, enough to make owning stocks a good long-term bet.

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Buy and Hold

September 9, 2013

John Rekenthaler at Morningstar launched into a spirited defense of buy and hold investing over the weekend.  His argument is essentially that since markets have bounced back since 2009, buy and hold is alive and well, and any arguments to the contrary are flawed.  Here’s an excerpt:

There never was any logic behind the “buy-and-hold is dead” argument. Might it have lucked into being useful? Not a chance. Coming off the 2008 downturn, the U.S. stock market has roared to perhaps its best four and a half years in history. It has shone in absolute terms, posting a cumulative gain of 125% since spring 2009. It has been fabulous in real terms, with inflation being almost nonexistent during that time period. It’s been terrific in relative terms, crushing bonds, cash, alternatives, and commodities, and by a more modest amount, beating most international-stock markets as well. This is The Golden Age. We have lived The Golden Age, all the while thinking it was lead.

Critics will respond that mine is a bull-market argument. That’s backward. “Buy-and-hold is dead” is the strategy that owes its existence to market results. It only appears after huge bear markets, and it only looks good after such markets. It is the oddity, while buy-and-hold is the norm.

Generally, I think Morningstar is right about a lot of things—and Rekenthaler is even right about some of the points he makes in this article.  But in broad brush, buy and hold has a lot of problems, and always has.

Here’s where Rekenthaler is indisputably correct:

  • “Buy and hold is dead” arguments always pop up in bear markets.  (By the way, that says nothing about the accuracy of the argument.)  It’s just the time that anti buy-and-holders can pitch their arguments when someone might listen.  In the same fashion, buy and hold arguments are typically made after a big recovery or in the midst of a bull market—also when people are most likely to listen.  Everyone has an axe to grind.
  • Buy and hold has looked good in the past, compared to forecasters.  As he points out in the article, it is entirely possible to get the economic forecast correct and get the stock market part completely wrong.
  • The 2008 market crash gave the S&P 500 its largest calendar year loss in 77 years.  No doubt.

The truth about buy and hold, I think, is considerably more nuanced.  Here are some things to consider.

  • The argument for buy and hold rests on hindsight bias.  Historical returns in the US markets have been among the strongest in history over very long time periods.  That’s why US investors think buy and hold works.  If buy and hold truly works, what about Germany, Argentina, or Japan at various time periods?  The Nikkei peaked in 1989.  Almost 25 years later, the market is still down significantly.  Is the argument, then, that only the US is special?  Is Mr. Rekenthaler willing to guarantee that US returns will always be positive over some time frame?  I didn’t think so.  If not, then buy and hold is not a slam dunk either.
  • Individual investors have time frames.  We only live so long.  A buy and hold retiree in 1929 or 1974 might be dead before they got their money back.  Same for a Japanese retiree in 1989.  Plenty of other equity markets around the world, due to wars or political crises, have gone to zero.  Zero.  That makes buy and hold a difficult proposition—it’s a little tough mathematically to bounce back from zero.  (In fact, the US and the UK are the only two markets that haven’t gone to zero at some point in the last 200 years.)  And plenty of individual stocks go to zero.  Does buy and hold really make sense with stocks?
  • Rejecting buy and hold does not have the logical consequence of missing returns in the market since 2009.  For example, a trend follower would be happily long the stock market as it rose to new highs.
  • Individual investors, maddeningly, have very individual tolerances for volatility in their portfolios.  Some investors panic too often, some too late, and a very few not at all.  How that works out is completely path dependent—in other words, the quality of our decision all depends on what happens subsequently in the market.  And no one knows what the market will do going forward.  You don’t know the consequences of your decision until some later date.
  • In our lifetimes, Japan.  It’s funny how buy and hold proponents either never mention Japan or try to explain it away.  “We are not Japan.”  Easy to say, but just exactly how is human nature different because there is an ocean in between?  Just how is it that we are superior?  (Because in 1989, if you go back that far, there was much hand-wringing and discussions of how the Japanese economy was superior!)

Every strategy, including buy and hold, has risks and opportunity costs.  Every transaction is a risk, as well as an implicit bet on what will happen in the future.  The outcome of that bet is not known until later.  Every transaction, you make your bet and you take your chances.  You can’t just assume buy and hold is going to work forever, nor can you assume it will stop working.  Arguments about any strategy being correct because it worked over x timeframe is just a good example of hindsight bias.  Buy and hold doesn’t promise good returns, just market returns.  Going forward, you just don’t know—nobody knows.  Yes, ambiguity is uncomfortable, but that’s the way it is.

That’s the true state of knowledge in financial markets: no one knows what will happen going forward, whether they pretend to know or not. 

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The Emotional Roller Coaster

June 6, 2013

From Josh Brown at The Reformed Broker, a nice picture of investor emotions as they ride the market roller coaster.  All credit to Blackrock, who came up with this funny/sad/true graphic.

Blackrock’s emotional roller coaster

(click on image to enlarge)

One of the important roles of a financial advisor, I think, is to keep clients from jumping out of the roller coaster when it is particularly scary.  At an amusement park, when people are faced with tangible physical harm, jumping does not seem like a very good idea to them—but investors are tempted to jump out of the market roller coaster all the time.

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Flawless Stock Market Forecasting

May 28, 2013

One way to improve your stock market forecasts is to revise them!  Bespoke has a nice piece where they show graphically how Wall Street strategists just change their forecast when the market moves past them.  Whether the market goes up or down here is immaterial—the forecast will be changed to accommodate the market.  Investors might give credence to some of these forecasts if they didn’t know they were a moving target.  Who knew stock market forecasting was so easy?

Source: Bespoke    (click on image to enlarge)

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From the Archives: Psychology That Drives Bull Markets

May 2, 2013

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.

—-this article originally appeared 3/3/2010.  Thinking about this paradox is one of the things that led us to start our own sentiment survey focusing on client investment behavior.  Even now, many years into the bull market, clients are still behaving fairly cautiously, indicating they do not yet fully believe the bull argument.

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Financial Repression Primer

May 1, 2013

Research Affliliates published a very nice primer on financial repression on Advisor Perspectives.  It’s well worth reading to get the lay of the land.  Here’s how they define financial repression:

Financial repression refers to a set of governmental policies that keep real interest rates low or negative and regulate or manipulate a captive audience into investing in government debt. This results in cheap funding and will be a prime tool used by governments in highly indebted developed market economies to improve their balance sheets over the coming decades.

When you hear talk about “the new normal,” this is one of the features.  Most of us have not had to deal with financial repression during our investment careers.  In fact, for advisors in the 1970s and early 1980s, the problem was that interest rates were too high, not too low!

There are disparate views on the endgame from financial repression.  Some are expecting Japanese-style deflation, while others are looking for Weimar Republic inflation.  Maybe we will just muddle through.  In truth, there are many possible outcomes depending on the myriad of policy decisions that will be made in coming years.

In our view, guessing at the outcome of the political and economic process is hazardous.  We think it makes much more sense to be alert to the possibilities embedded in tactical asset allocation.  That allows you to pursue returns wherever they can be found at the time, without having to have a strong opinion on the eventual outcome.  Relative strength can often be a very useful guide in that process.

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From the Archives: The 80/20 Rule in Action

January 17, 2013

According to a fascinating study discussed in Time Magazine based on 27 million hands of Texas Hold’em, it turns out that the more hands poker players win, the more money they lose!  What’s going on here?

I suspect it has to do with investor preferences–gamblers often think the same way.  Most people like to have a high percentage of winning trades; they are less happy with a lower percentage of winning trades, even if the occasional winner is a big one.  In other words, investors will often prefer a system with 65% winning trades over a system with 45% winning trades, even if the latter method results in much greater overall profits.

People overweigh their frequent small gains vis-à-vis occasional large losses,” Siler says.

In fact, you are generally best off if you cut your losses and let your winners run.  This is the way that systematic trend following tends to work.  Often this results in a few large trades (the 20% in the 80/20 rule) making up a large part of your profits.  Poker players and amateur investors obviously tend to work the other way, preferring lots of small profits–which all tend to be wiped away by a few large losses.  Taking lots of small profits is the psychological path of least resistance, but the easy way is the wrong way in this case.

—-this article was originally published 2/10/2010.  Investors still have irrational preferences about making money.  They usually want profits—but apparently only if they are in a certain distribution!  Real life doesn’t work that way.  Making money is a fairly messy process.  Only a few names turn out to be big winners, so you’ve got to give them a chance to run.

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Not Investing?

August 3, 2012

After poor stock market performance over the past few years, many investors are holding on to cash. A survey by BlackRock ranks the reasons why people aren’t investing, and the results may be different from what you had expected.

  Uncertainty about where to invest (37%)

  Belief that it’s a poor investing environment (26%)

  Fear of investing/losing money (23%)

  Previous portfolio losses (8%)

  Not applicable, have not pulled back on investment activity (6%)

Investors are not completely closed off to the idea of investing, but instead don’t know where they should put their money.  One of the chief benefits of employing a relative strength strategy is that it provides the framework for allocating assets–thereby removing the biggest stumbling block to getting investors in the game.

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Small-Cap Relative Strength Performance

July 25, 2012

We’ve just released a small-cap ETF with PowerShares (DWAS), which is the first U.S. relative strength small-cap ETF. We’ve done our own testing, of course, but it might also be instructive to take a look at other small-cap relative strength returns. Once again, we used the Ken French data library to calculate annualized returns and standard deviation. The construction of their relative strength index is explained here. The difference this time around is that we used small-cap stocks instead of large-cap stocks. Generally speaking, a small-cap stock is one whose price times number of outstanding shares (market capitalization) is between $300 million and $2 billion. However, the Ken French data used also includes micro-cap stocks which have an even smaller market capitalization (typically between $50-$300 million). Market cap is above $10 billion for large-cap stocks.

In the past, small-cap stocks have yielded high returns. They often perform well because companies in early stages of development have large growth potential. However, the potential of high earnings also comes with high risk. Small-cap companies face limited reserves, which make them more vulnerable than larger ones. Furthermore, in order to grow, they need to be able to replicate their business model on a bigger scale.

This is the sort of tradeoff investors must think about when choosing how to structure their portfolio.  Typical factor models suggest that there are excess returns to be had in areas like value, relative strength, and small-cap, often at the cost of a little extra volatility. If you’re willing to take on more risk for the chance of higher returns, a portfolio that combines relative strength with small-cap stocks might be a good place to look!

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Stellar Performance—Out of the Limelight

June 4, 2012

Ron Lieber of the NYT explains his surprise that some of the biggest winners over the last 30 years are not the companies that get all the hype:

This week, I asked Wilshire Associates to look back 30 years to the beginning of the big bull run in stocks and figure out which of the companies in its index of more than 5,000 American enterprises had performed best over that stretch.

My guess is that you haven’t heard of half of the Top 10.

Back in 1982, would you have staked your claim on Danaher, the conglomerate that comes in at No. 3? Or might you have waited a few more years, until it was loaded up with debt courtesy of Michael Milken, the onetime junk bond king?

What about Apco Oil & Gas at No. 4? Or Precision Castparts at No. 7? Or maybe the high-tech balloons made by Raven Industries at No. 8 would have been more your taste. Ever heard of HollyFrontier at No. 10?

You get the idea. To have earned the 21 to 26 percent annualized returns (including reinvested dividends) that these companies delivered to investors over the last 30 years, you would have had to pick them out, invest enough to move the needle in your portfolio and then be smart enough to hang on.

Let’s start with selecting the stocks. The top-performing stock on the Wilshire list is Home Depot. Was anyone pointing at that company back in the early 1980s and insisting that it was going to the moon?

“Oh no,” said Arthur Blank, one of Home Depot’s founders, when I asked him this week. “We had no idea that was going to happen. When we went public in 1981, we only had eight stores.”

Indeed, the best investments are often the ones that few people have heard of, and sometimes the companies like it that way.

One of the benefits of building portfolios based on relative strength ranks is that the amount of hype that a company receives has no impact on whether or not the company is included in the portfolio.  Certainly, some on that list have received considerable amounts of attention, like Apple, but I think Lieber is right that many of the other names are off the radar of many investors.  A relative strength ranking system is a true meritocracy where securities are added and removed from portfolios based on one essential criteria—performance of that security relative to all other securities in the investment universe.

Dorsey Wright currently owns a number of the securities listed above.  A list of all holdings for the trailing 12 months is available upon request.

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One Good Data Point

May 30, 2012

This just in.  We are now back at 5/25 levels for the S&P 500.  From Tobias Levkovich at Citigroup, as reported by Business Insider:

Last Friday our panic-euphoria model, one of our proprietary sentiment models went into panic, that gives us a very high probability, almost 90 percent probability that markets are up in 6 months, and 96 percent probability that they’re are up in 12 months.

I have no idea how they come up with those probabilities, but it would be nice if it’s true.  More generally, other analysts have also found a correlation between very negative investor sentiment and higher markets 6-12 months later.

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From the Archives: Is Modern Portfolio Theory Obsolete?

May 29, 2012

It all depends on who you ask.  Apologists for MPT will say that diversification worked, but that it just didn’t work very well last go round.  That’s a judgment call, I suppose.  Correlations between assets are notoriously unstable and nearly went to 1.0 during the last decline, but not quite.  So I guess you could say that diversification “worked,” although it certainly didn’t deliver the kind of results that investors were expecting.

Now even Ibbotson Associates is saying that certain aspects of modern portfolio theory are flawed, in particular using standard deviation as a measurement of risk.  In a recent Morningstar interview, Peng Chen, the president of Ibbotsen Associates, addresses the problem.

It’s one thing to say modern portfolio theory, the principle, remained to work. It’s another thing to examine the measures. So when we started looking at the measures, we realized, and this has been documented by many academics and practitioners, we also realized that one of the traditional measures in modern portfolio theory, in particular on the risk side, standard deviation, does not work very well to measure and present the tail risks in the return distribution.

Meaning that, when you have really, really bad market outcomes, modern portfolio theory purely using standard deviation underestimates the probability and severity of those tail risks, especially in short frequency time periods, such as monthly or quarterly.

Leaving aside the issue of how the theory could work if the components do not, this is a pretty surprising admission.  Ibbotson is finally getting around to dealing with the “fat tails” problem.  It’s a known problem but it makes the math much less tractable.  Essentially, however, Mr. Chen is arguing that market risk is actually much higher than modern portfolio theory would have you believe.

In my view, the debate about modern portfolio theory is pretty much done.  Stick a fork in it.  Rather than grasping about for a new theory, why not look at tactical asset allocation, which has been in plain view the entire time?

Tactical asset allocation, when executed systematically, can generate good returns and acceptable volatility without regard to any of the tenets of modern portfolio theory.  It does not require standard deviation as the measure of risk, and it makes no assumptions regarding the correlations between assets.  Instead it makes realistic assumptions: some assets will perform better than others, and you ought to consider owning the good assets and ditching the bad ones.  It’s the ultimate pragmatic solution.

—-this article originally appeared 1/21/2010.  As we gain distance from the 2008 meltdown, investors are beginning to forget how badly their optimized portfolios performed and are beginning to climb back on the MPT bandwagon.  Combining uncorrelated strategies always makes for a better portfolio, but the problem of understated risk remains.  The tails are still fat.  Let’s hope that we don’t get another chance to experience fat tails with the Eurozone crisis.  Tactical asset allocation, I think, may still be the most viable solution to the problem.

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Two Rides the Public Missed…

May 7, 2012

Mark Twain once said, “A cat who sits on a hot stove will never sit on a hot stove again. But, he won’t sit on a cold stove, either.”  Surely, that applies to investors who have gone through a severe bear market, like 1973-74 or 2008.

Source: The Leuthold Group

Without an investment process that systematically allocates to where the action is, investors may be psychologically incapable of making much money for years to come.

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Relative Strength and Market Volatility

September 30, 2011

Markets have been extremely volatile over the last couple of months.  Volatile markets are very difficult to navigate.  It is very easy to make mistakes, and when a mistake is made it is magnified by the volatility.  From a relative strength standpoint, there are things you can do to help ease the pain of all of these large, unpredictable market moves.  But judging by all the client calls we have taken over the years–almost always when volatility was high–the steps needed to make a relative strength model perform well are most definitely not what most investors would think!

Before we look at relative strength specifically, let’s take a step back and look at different investment strategies on a very broad basis.  There are really two types of strategies: trend continuation and mean reversion.  A trend continuation strategy buys a security and assumes it will keep moving in the same direction.  A mean reversion (or value) strategy buys a security and assumes it will reverse course and come closer to a more “normal” state.  Both strategies work over time if implemented correctly, but volatility affects them in different ways.  Mean reversion strategies tend to thrive in high volatility markets, as those types of markets create larger mispricings for value investors to exploit.

When we construct systematic relative strength models, we have always preferred to use longer-term rather than shorter-term signals.   This decision was made entirely on the basis of data—by testing many models over a lot of different types of markets.  Judging by all the questions we get during periods of high volatility, I would guess that using a longer-term signal when the market is volatile strikes most investors as counter-intuitive.  In my years at Dorsey Wright, I can’t remember talking to a single client or advisor that told me when markets get really volatile they look to slow things down!

During volatile markets, generally we hear the opposite view–everyone wants to speed up their process.  Speeding up the process can take many forms.  It might mean using a smaller box size on a point and figure chart, or using a 3-month look back instead of a 12-month look back when formulating your rankings.  It might be as simple as rebalancing the portfolio more often, or tightening your stops.  Whatever the case, most investors are of the opinion that being more proactive in these types of markets makes performance better.

Their gut response, however, is contradicted by the data.  As I mentioned before, our testing has shown that slowing down the process actually works better in volatile markets.  And we aren’t the only ones who have found that to be the case!  GMO published a whitepaper in March 2010 that discussed momentum investing (the paper can be found here).  Figure 17 on page 11 specifically addresses what happens to relative strength models during different states of market volatility.

(Click Image To Enlarge.  Source: GMO Whitepaper, Sept. 2010)

The chart clearly shows how shortening your look back period decreases performance in volatile markets.  The 6-12 month time horizon has historically been the optimal time frame for formulating a momentum model.  But when the market gets very volatile, the best returns come from moving all the way out to 12 months, not shortening your window to make your model more sensitive.

Psychologically, it is extremely difficult to lengthen your time horizon in volatile markets.  Every instinct you have will tell you to respond more quickly in order to get out of what isn’t working and into something better.  But the data says you shouldn’t shorten your window, and conceptually this makes sense.  Volatile markets tend to be better for mean reversion strategies.  But for a relative strength strategy, volatile markets also create many whipsaws.  When thinking about how volatility interacts with relative strength, it makes sense to lengthen your time horizon.  Hopping on every short term trend is problematic if the trends are constantly reversing!  All the volatility creates noise, and the only way to cancel out the noise is to use more (not less) data.  You can’t react to all the short-term swings because the mean reversion is so violent in volatile markets.  It doesn’t make any sense to get on trends more rapidly when you are going through a period that is not optimal for a trend following strategy.

We use a data-driven process to construct models.  We have found that using a relatively longer time horizon, while uncomfortable, ultimately leads to better performance over time.  Outside studies show the same thing.  If the data showed that reacting more quickly to short-term swings in volatile markets was superior we would advocate doing exactly that!

As is often the case in the investing world, this seems to be another situation where doing the most uncomfortable thing actually leads to better performance over time.  Good investing is an uphill run against human nature.  Of course, it stands to reason that that’s the way things usually are.  If it were comfortable, everyone would do it and investors would find their excess return quickly arbitraged away.

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