Relative strength versus standard asset allocation
In a standard asset allocation model you would own all of these asset classes regardless of whether the asset was going up or down in value. Modern portfolio theory and its application to traditional asset allocation does not recognize cash as a viable asset class. By diversifying across many asset classes we are supposed to gain some measure of safety as well as consistency of return. In many cases this does not prove to be true. All asset classes can fall at the same time and going to cash to preserve capital is not an option. This was the primary reason that so many portfolios lost money in recent periods of market turmoil. We think that there is a better way to grow your assets and protect those hard won gains. Using relative strength analysis assist in identifying leading and laggard asset classes.
Traditional asset allocation models do not recognize cash or money market accounts as an asset class. Portfolio managers are penalized by analysts whenever they hold cash in excess of minimal amounts. The objective for managers is to lose less than the market benchmark they are charged with tracking.
Ten week relative strength calculations are mathematical - - not subjective.
In the spring and autum of 2008, virtually all asset classes were declining in value. Modern Portfolio Theory argued that portfolio declines were normal and no strategy change should be implemented. Investing in a variety of asset classes would create a portfolio of low or negatively correlated assets and the overall impact on a person's portfolio would be minimized. In October of 2008, all assets became positively correlated and declined together -- EXCEPT CASH!
The annual study of the investing public conducted by Dalbar® provides significant insight to what should be learned from the 2008 market melt down. Study results are challenging the traditional use of Modern Portfolio Theory. "Investment results in 2008 showed clearly that correlation of asset classes varied unpredictably and with no warning. This brings into question the very basis for MPT and its ability to forecast an efficient frontier. MPT simply cannot be used in isolation. Instead it should be thought of as only one reference point for modeling the behavior of a potential portfolio. It is only one dimension of a more comprehensive investment-management process."
Pay attention to "modeling the behavior of a potential portfolio." That is the big problem. CORRECTLY forecasting the expected return and volatility of the investments you are considering is a very difficult task. For the 5,000 +/- US stocks, one needs to forecast approximately 12,000 data points. That is room for error!
Relative strength calculations in the spring and summer of 2008, if cash was included as an asset class, indicated multiple times that equities and fixed income assets were to be avoided. If your portfolio was adjusted to reflect changes in relative strength, replacing other assets with cash, the resulting capital preservation created more wealth for reinvestment in the spring of 2009 when cash receded into the background of other asset classes that were then more attractive.
Ranking by relative strength
Instead of owning all of these asset classes at the same time in the hope that some of them will be going up, rank them by relative strength and only own the ones that are the strongest, the ones that are headed up. Continue to track them all, but only add them to the portfolio as they overtake weaker asset classes.
Imagine your portfolio conducts a nightly arm wrestling match between five major investment asset classes. You concentrate your portfolio in the best two classes with one additional condition. The only asset classes you hold in your portfolio must also produce results better than holding cash. If your assests are in persistent downtrends, they are destroying your wealth and should be removed from your portfolio and patiently waiting for a better market environment.
“…the key to good performance is the ability to identify those stocks that are detracting from the performance of the portfolio. Most portfolio managers spend most of their time and effort trying to find the next big winner in the stock market but good portfolio performance depends more on finding and eliminating the bad stocks from the portfolio.”
Segregating exchange traded funds (ETF) into asset classes and regularly ranking by relative strength creates a "big picture" of the global investment marketplace. Afterwards, you can "drill down" into the results to identify asset classes and/or investments that you want either in or out of your portfolio.
Investors often make poor investment decisions because of emotional attachment to a company, its product or worse, the price they paid for the investment. Including a relative strength analysis adds an objective, mathematical factor to your decision process.
Things change... (see here)
As the economy changes, rankings will change also. Changing market strength allows you to adapt your investment choices avoiding weaker assets and concentrating on the strength exhibited in the markets at any given time. Whether domestic or international, fixed income or equities, commodities, currencies or cash, follow the strength where ever it goes.
Consider this. In most parts of the country, seasonal changes in climate create a need to change what we wear. We don warmer clothes in the the winter than in the summer. It is obvious and most of us would not go throughout the year with only a wardrobe of shorts and T-shirts.
Asset prices are affected by economic seasons. Periods of growth are intermixed with recessions. Companies experience times of profit interspersed with losses. Inflation has been prevalent for most of our lives but deflation has returned from the '30s. Selecting one investment allocation to prosper or survive in all economic weather conditions seems no more logical than having only shorts and T-shirts to wear.
Stock and bond markets are auction markets. Everyday around the world, buyers and sellers are swapping positions for reasons that are completely unkown to you, me and the press. At the end of the day, concerned parties try to find justification for the day's activity whether up or down. It is always, after the fact rationalization.
What is important to your financial health and well being is ultimately one thing - what is the price of the assets in your portfolio. Even if the fundamentals are "good" from analysts, you cannot retire on fundamentals. You can only convert based on price.
"Value investors" include many famous people such as Warren Buffet, Peter Lynch and John Templeton. However, you cannot retire on "value." You can only retire on the price you can get for the investments you own and can convert to cash. Value can be significantly disconnected from price at a time when you need cash. Generally attributed to conflicts of interest, analysts at major brokerage firms have a strong orientation towards "value" as illustrated with Starbucks (SBUX) from 2007 to early 2009. Starbucks stock reached $40 in November 2007 and fell to $7.50 in December 2008 while Wall Street rated the company a Fundamental 4 or 5 Stars. In April 2009 with the stock price recovering to $15, Wall Street downgraded the company to a Fundamental 1 Star. Shortly thereafter, price trends indicated ownership could again be considered for a portfolio.
If you owned SBUX in your portfolio at the 2007 high and held it for whatever reason (you spend $5/day there or it had good "fundamentals" or you worked there), your portfolio position declined 80% at its low! Even twenty seven months later at $23, you are still down by 40%! Successful portfolio decisons do not ignore price. Price is the arbiter to override emotions in investment decisions.
Perhaps, it is time to examine your portfolio holdings for market strength and direction.
Are there one or two positions in your account causing some concern?
Should you continue to hold them?
Would you improve your return or reduce your risk exposure by selling?
Just send this email!