DWA Technical Leaders Index Trade Profiles

January 6, 2014

The Dorsey, Wright Technical Leaders Index is composed of a basket of 100 mid and large cap securities that have strong relative strength (momentum) characteristics.  Each quarter we reconstitute the index by selling stocks that have underperformed and by adding new securities that score better in our ranking system.  We began calculating the index in real-time at the end of 2006.  Over the last seven years there have been quite a few deletions and additions as the index has adapted to some very dynamic market conditions.

Any relative strength or momentum-based investment strategy is a trend following strategy.  Trend following has worked for many years in financial markets (although not every year).  These systems are characterized by a several common attributes: 1) Losing trades are cut quickly and winners are allowed to run, 2) there are generally a lot of small losing trades, and 3) all of the money is made by the large outliers on the upside.  When we look at the underlying trades inside of the index over the years we find exactly that pattern of results.  There is a lot going on behind the scenes at each rebalance that is designed to eliminate losing positions quickly and maintain large allocations to the true winners that drive the returns.

We pulled constituent level data for the DWATL Index going back to the 12/31/2006 rebalance.  For each security we calculated the return relative to the S&P 500 and how many consecutive quarters it was held in the index.  (Note: stocks can be added, removed, and re-added to the index so any individual stock might have several entries in our data.)  The table below shows summary statistics for all the trades inside of the index over the last seven years:


The data shows our underlying strategy is doing exactly what a trend following system is designed to accomplish.  Stocks that aren’t held very long (1 to 2 quarters), on average, are underperforming trades.  But when we are able to find a security that can be held for several quarters, those trades are outperformers on average.  The whole goal of a relative strength process is to ruthlessly cut out losing positions and to replace them with positions that have better ranks.  Any investor makes tons of mistakes, but the system we use to reconstitute the DWATL Index is very good at identifying our mistakes and taking care of them.  At the same time, the process is also good at identifying winning positions and allowing them to remain in the index.

Here is the same data from the table shown graphically:


You can easily see the upward tilt to the data showing how relative performance on a trade-level basis improves with the time held in the index.  For the last seven years, each additional consecutive quarter we have been able to keep a security in the Index has led to an average relative performance improvement of about 920 basis points.  That should give you a pretty good idea about what drives the returns: the big multi-year winners.

We often speak to the overall performance of the Index, but we sometimes forget what is going on behind the scenes to generate that return.  The process that is used to constitute the index has all of the characteristics of a trend following system.  Underperforming positions are quickly removed and the big winning trades are allowed to remain in the index as long as they continue to outperform.  It’s a lot like fishing: you just keep throwing the small ones back until you catch a large one.  Sometimes it takes a couple of tries to get a keeper, but if you got a big fish on the first try all the time it would be called “catching” not “fishing.”  I believe part of what has made this index so successful over the years is there is zero human bias that enters the reconstitution process.  When a security needs to go, it goes.  If it starts to perform well again, it comes back.  It has no good or bad memories.  There are just numbers.

The performance numbers are pure price return, not inclusive of fees, dividends, or other expenses.  Past performance is no guarantee of future returns.  Potential for profit is accompanied by potential for loss.  A list of all holdings for the trailing 12 months is available upon request.

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Dumb Talk About Smart Beta?

October 7, 2013

John Rekenthaler at Morningstar, who usually has some pretty smart stuff to say, took on the topic of smart beta in a recent article.  Specifically, he examined a variety of smart beta factors with an eye to determining which ones were real and might persist.  He also thought some factors might be fool’s gold.

Here’s what he had to say about value:

The value premium has long been known and continues to persist.

And here’s what he had to say about relative strength (momentum):

I have trouble seeing how momentum can succeed now that its existence is well documented.

The italics are mine.  I didn’t take logic in college, but it seems disingenuous to argue that one factor will continue to work after it is well-known, while becoming well-known will cause the other factor to fail!  (If you are biased in favor of value, just say so, but don’t use the same argument to reach two opposite conclusions.)

There are a variety of explanations about why momentum works, but just because academics can’t agree on which one is correct doesn’t mean it won’t continue to work.  It is certainly possible that any anomaly could be arbitraged away, but Robert Levy’s relative strength work has been known since the 1960s and our 2005 paper in Technical Analysis of Stocks & Commodities showed it continued to work just fine just the way he published it.  Academics under the spell of efficient markets trashed his work at the time too, but 40 years of subsequent returns shows the professors got it wrong.

However, I do have a background in psychology and I can hazard a guess as to why both the value and momentum factors will continue to persistthey are both uncomfortable to implement.  It is very uncomfortable to buy deep value.  There is a terrific fear that you are buying a value trap and that the impairment that created the value will continue or get worse.  It also goes against human nature to buy momentum stocks after they have already outperformed significantly.  There is a great fear that the stock will top and collapse right after you add it to your portfolio.  Investors and clients are quite resistant to buying stocks after they have already doubled, for example, because there is a possibility of looking really dumb.

Here’s the reason I think both factors are psychological in origin: it is absurdly easy to screen for either value or momentum.  Any idiot can implement either strategy with any free screener on the web.  Pick your value metric or your momentum lookback period and away you go.  In fact, this is pretty much exactly what James O’Shaughnessy did in What Works on Wall Street.  Both factors worked well—and continue to work despite plenty of publicity.  So the barrier is not that there is some secret formula, it’s just that investors are unwilling to implement either strategy in a systematic way–because of the psychological discomfort.

If I were to make an argument—the behavioral finance version—about which smart beta factor could potentially be arbitraged away over time, I would have to guess low volatility.  If you ask clients whether they would prefer to buy stocks that a) had already dropped 50%, b) had already gone up 50%, or c) had low volatility, I think most of them would go with “c!”  (Although I think it’s also possible that aversion to leverage will keep this factor going.)

Value and momentum also happen to work very well together.  Value is a mean reversion factor, while momentum is a trend continuation factor.  As AQR has shown, the excess returns of these two factors (unsurprisingly, once you understand how they are philosophical opposites) are uncorrelated.  Combining them may have the potential to smooth out an equity return stream a little bit.  Regardless, two good return factors are better than one!

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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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Ritholtz on Prediction

July 12, 2013

In Financial Advisor, Barry Ritholtz of The Big Picture blog gets asked about his market outlook.  He answers with his view on prediction, which I would very much endorse.

Let’s start out with a basic question: What’s your outlook on the markets and the economy?

Let me begin with an answer you will hate: My opinion as to the future state of the economy or where the market might be going will be of no value to your readers. Indeed, as my blog readers will tell you, I doubt anyone’s perspectives on these issues are of any value whatsoever.

Here’s why: First, we have learned that you Humans are not very good at making these sorts of predictions about the future. The data overwhelmingly shows that you are, as a species, quite awful at it.

Second, given the plethora of conflicting conjectures in the financial firmament, how can any reader determine which author to believe and which to ignore? You can find an opinion to confirm any prior view, which is a typical way many investors make erroneous decisions. (Hey, that agrees with my perspective, I’ll read THAT!)

And third, relevant to the above, studies have shown that the most confident, specific and detailed forecasts about the future are: a) most likely to be believed by readers and TV viewers; and b) least likely to be correct. (So you have that going for you, which is nice.)

Last, across the spectrum of possible opinions, forecasts and outlooks, someone is going to be correct—how can you ever tell if it was the result of repeatable skill or merely random chance?

Kudos to Mr. Ritholtz for telling it like it is.

There is no way to know what is going to happen in the future.  Prediction is neither useful or necessary.

Later in the article, Mr. Ritholtz makes the point that most investors do not know even what is going on right now.  That is where relative strength can be a useful technique.  Relative strength can identify what is strong, and trend following is a practical way to implement it, by owning what is strong as long as it remains strong.  Long-term mean reversion methodologies will work too, of course.  In other words, you don’t need to predict the future as long as you can assume that trends and reversion to the mean will continue to occur as they always have.

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Recession Watch 2013

June 28, 2013

Every time the market corrects, pundits start looking for a recession.  It’s not a crazy idea, since the S&P 500 is a leading indicator of the economy.  Recessions are typically led by market corrections, but market corrections have also forecast ten of the last two recessions.  The stock market alone is not a reliable indicator.

Those voting against the recession idea often cite the steep yield curve as a sign the economy is strong.  (See, for example, here and here.)  Recessions typically are preceded by an inverted yield curve, where short-term yields are higher than long-term yields, and we are far from that right now.

Those voting in favor of the recession point out a variety of weakening data series that often forecast recessions, especially new order indexes, credit spreads, and oil prices.  (See, for example, here, here, here, and here.)  Earnings and revenues are decelerating and that causes economists to fear for the future.  Many indicators of this type are not actually negative yet, but the fear is that they will become so.

The truth is that no one knows what will happen.

You are right to be skeptical of economic forecasts.  Most economists did not see the 2008 housing bust and recession coming—and on the other side of the coin, a few economists are still stubbornly clinging to their 2011 recession calls.  The market corrected sharply, the economy slowed, but a recession was ultimately avoided as the economy picked back up.

Part of the rationale for the way we do tactical asset allocation is that we do not have to forecast—we change when the relative strength of asset classes or sectors changes.  The biggest problem with forecasting is that people tend to have an opinion, which they proceed to back up by only looking at confirming evidence.  Both bulls and bears can always point to signs of improvement or signs of deterioration.  Trend following avoids that whole problem and just goes with the flow.  As market expectations change, holdings in a relative strength portfolio change right along with them.  Trend following is never ideal, but it’s mostly in the ballpark most of the time—and it’s way less stressful than worrying about the economy constantly.

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The Stock Market – Economy Disconnect

June 13, 2013

One of the most difficult things for investors to understand is the stock market – economy disconnect.  New investors almost always assume that if the economy is doing well, the stock market will perform well also.  In fact, it is usually the other way around!

Liz Ann Sonders, the market strategist at Charles Schwab & Co., has an interesting piece on this apparent disconnect.  She writes:

Remember, the stock market (as measured by the S&P 500) is one of 10 sub-indexes in the Conference Board’s Index of Leading Indicators. Many investors assume it’s the opposite—that economic growth is a leading indicator of the stock market. For a compelling visual of the relationship, see the following pair of charts, which I’ll explain below.

The most compelling part of her article follow, in the form of her charts that show the GDP growth rate and peaks and troughs in the stock market.

Source: Charles Schwab & Co.  (click on images to enlarge)

More often than not, poor economic growth corresponds with a trough in the market.  Super-heated economic growth is usually a sign that someone is about to take away the punch bowl.

In truth, there is really no disconnect if you accept that the stock market usually leads the economy.  As Ms. Sonders points out, the S&P 500 is part of the Index of Leading Indicators.  A lot of investors have trouble wrapping their heads around that concept—and it continues to cost them money.

The contrast to economic forecasting (i.e., guessing) is trend following.  The trend follower is usually fairly safe in believing that if the market is continuing up that is economy is probably ok for the time being.  When the trend becomes uncertain or tilts down, it might be time to look for clues that the economy is softening.  You’re not going to be right all the time either way, but at least you’ve got the odds on your side if you let the market lead.

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From the Archives: Trend Following Beats Market Timing

May 30, 2013

Mark Hulbert has been tracking advisory newsletters for more than 20 years.  Lots of these newsletters do active market timing, so in a recent column, he asked an obvious question:

The first question: How many stock market timers, of the several hundred monitored by the Hulbert Financial Digest, called the bottom of the bear market a year ago?

And a follow-up: Of those that did, how many also called the top of the bull market in March 2000 — or, for that matter, the major market turning points in October 2002 and October 2007?

If you are relying on some type of market timing to get you out of the way of bear markets and to get you into bull markets, this is exactly what you want to know.  Although there are pundits who claim to have called the bottom to the day, Mr. Hulbert allowed a far more generous window for labeling a market timing call as correct.

… my analysis actually relied on a far more relaxed definition: Instead of moving 100% from cash to stocks in the case of a bottom, or 100% the other way in the case of a top, I allowed exposure changes of just ten percentage points to qualify.

Furthermore, rather than requiring the change in exposure to occur on the exact day of the market’s top or bottom, I looked at a month-long trading window that began before the market’s juncture and extending a couple of weeks thereafter.

That’s a pretty liberal definition: the market timer gets a four-week window and only has to change allocations by 10% to be considered to have “called” the turn.  And here’s the bottom line:

Even with these relaxed criteria, however, none of the market timers that the Hulbert Financial Digest has tracked over the last decade were able to call the market tops and bottoms since March 2000.

Yep, zero.  [The bold and underline is from me.]  It’s not that advisors aren’t trying; it’s just that no one can do it successfully, even with a one-month window and a very modest change in allocations.  Obviously, there is lots of hindsight bias going on where advisors claim to have detected market turning points, but when Mr. Hulbert goes back to look at the actual newsletters, not one got it right!  You can safely assume anyone who claims to be able to time the market is lying.  At the very least, the burden on proof is on them.

We don’t bother trying to figure out what the market will do going forward.  We simply follow trends as they present themselves.  We use relative strength in a systematic way to identify the trends we want to follow: the strongest ones.  We stay with the trend as long as it continues, whether that is for a short time or an extended period.  When a trend weakens, as evidenced by its relative strength ranking, we knock that asset out of the portfolio and replace it with a stronger asset.  The two white papers we have produced (Relative Strength and Asset Class Rotation and Bringing Real World Testing to Relative Strength)  show quite clearly that it is possible to have very favorable investment results over time without any recourse to market timing at all.  Discipline and patience are needed, of course, but you don’t have to have a crystal ball.

—-this article originally appeared 3/17/2010.  It is especially apropos now that many market pundits are busy predicting a top.  It’s certainly possible they are right—but probably equally likely is the proposition that they are just guessing.  Over the long run there is weak evidence that market timing is effective.

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From the Archives: Two Approaches to Motivating Clients

June 28, 2012

Ken Haman, a managing director at the Advisor Institute at AllianceBernstein responds to the following question posed by an advisor and published in Investment News:

Q: I’ve had some frustrating conversations with clients recently—trying to get them back in the market. Very few are taking my advice, even though they seem to know that staying on the sidelines is a mistake. What’s going on, and how can I get them “unstuck”?

A: Problems like this have to do with how people make decisions. Behavioral finance uses the term “inappropriate extrapolation”–and insights about it can help you understand your clients and respond to them more effectively.

To make any decision, human beings create a mental picture of the future. That’s what “expectations” are–the ability to take information from the past and present, and project it into the future. Unlike most animals, human beings can project far into the future; as a result, we are able to “plan ahead.” Unfortunately, we usually don’t create these future images terribly well. Instead of making a thoughtful assessment of what’s likely to happen in the future, we typically picture the future as just a continuation of the recent past.

Essentially, you want to learn how to install a positive picture of the future that the client feels is likely to happen in reality. Start by explaining the mechanisms of the market and illustrating visually how those mechanisms work. Many investors have only the vaguest understanding of the cause-effect dynamics in the markets. Instead of making thoughtful, well-informed decisions, they react to their perception of patterns and trends. Market “mechanisms” are those cause-effect relationships that equip financial professionals to invest rationally instead of speculating randomly.

By looking at how market mechanisms operated in both the recent and more distant past, you teach your clients how to think more strategically about the markets. This allows them to build a more vivid mental picture of market behaviors in the future. Make sure you explain market mechanisms visually as well as verbally: use charts and graphs that show market behaviors over time. Whenever possible, connect your investment recommendations to a clear explanation of the mechanism that is involved.

Second, provide an adequate level of detail about the mechanisms you explain. There’s a commonly held myth that clients aren’t interested in hearing about the markets. So, many financial advisors gloss over important information and rush to their proposal without creating a case the client understands. But clients are interested in understanding the mechanisms that drive their investment results–as long as your explanation is clearly illustrated and easy to understand.

Finally, you have to deliver your message with personal conviction–that you fully believe the future will look the way you anticipate. Your clients need to borrow your conviction and clarity about the future. That’s how they’ll build their sense of confidence in the decisions you’re asking them to make. Take a stand on what you believe about the future, and add the courage of your own convictions to the clarity of your explanation.

There is also an alternative approach of just being frank with the client and telling them that you don’t know exactly what the future holds, nor does anyone else.  However, you adhere to a systematic relative strength process that gives you great flexibility to allocate to a wide range of asset classes depending on how the future unfolds.  At times, the approach can be allocated very conservatively and at times it can be allocated quite aggressively.  My experience has been that clients appreciate the honesty and are willing to embrace a trend-following approach that deals very effectively with not being able to see into the future.

—-this article originally appeared 1/12/2010.  More than two years later, many clients are still on the sidelines.    Many of them definitely do engage in inappropriate extrapolation!  An advisor’s first duty is to be honest, but you’ve got to do it in a way that is motivating and not paralyzing.

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The Market Doesn’t Follow Orders

June 25, 2012

That’s the title of a wonderful piece from Jonathan Hoenig writing for Smart Money.  It’s an excellent reminder that the market is always the final arbiter.

Think of our job not as proclaiming how the markets will act, but observing how they are acting now, and attempting to position our own portfolios to hop along the trend.

So rather than command the markets to act as we think they should, investors should instead rely on the price action to observe how they’re performing and position him/herself accordingly. Because we’re not all-knowing: not you or I or Ben Bernanke, Bill Gross, Barton Biggs or anyone else. The market doesn’t know, care or consider anything we say or do.

That humility offers a more honest and realistic context by which to evaluate our next move.

In truth, the only way to make money is to follow the price trend.  Relative strength is a good way to identify the strongest trends.

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