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You can see spike up in long exposure to equities over the last month.  Our own sentiment survey (the full results of the most recent survey can be seen here), and the most recent AAII survey both show retail investors have become more bearish over the last month.  These two surveys don’t measure actual exposure like the BofA survey does, but I think it is safe to assume that retail investors are not increasing equity exposure while they are becoming more bearish on stocks.

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In our survey we ask financial professionals whether their clients are becoming more fearful.  As equities rallied, their clients became less worried about a downturn.  But as the S&P 500 corrected over the last month their clients became more worried about getting caught in a downdraft.

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The AAII poll asks individual investors directly whether they are bullish or bearish.  This chart was taken from Bespoke and clearly shows individual investors became more bearish very quickly during the decline.

Only time will tell which group is correct.  However, I think it is a positive sign for equity markets that there are large pools of money ready to move into stocks during very small corrections.  It is also a positive sign that not everyone is buying the dips!  When everyone is excited to buy dips you are often closer to a top than a bottom.

This index has spent the last six months above 50 percent, but has dipped back to the middle of the distribution.  The 10-day moving average of this indicator is 65% and the one-day reading is 77%.  Dips in this indicator have often provided good opportunities to add to relative strength strategies.

Two years ago I was at the Milken Global Conference in Los Angeles when Mike Milken, during an on-stage panel with Nobel-winning economists, asked the assembled augusts what they had been wrong about. The world had come unglued, economists were flailing, and it was clear that their models were wrong: Mike wanted to know what they had learned about themselves and their theories that had guided so many countries to the current disaster.

Their answer: Nothing. Well, not quite nothing, but close enough. No one would admit to having been shown wrong about anything. Instead, they mostly argued that if people had paid more attention to them — like literally, each of them individually — the credit crisis might not have happened. But what were they actually, you know, shown wrong about? Nothing. Nada.

It was a remarkable concession. Then again, I suppose it’s unsurprising from a discipline whose theorizing has long shown itself to be impregnable to assaults from data, the real world, or any other such irritating intrusions.

Are you really surprised?  I guess it doesn’t matter if you specialize in macroeconomics or finance—no one wants to be confused with the facts.  Fifty years after Markowitz, we’ve shown very little creativity in developing new theories about how financial markets work or how to think about portfolio construction.  Instead, we have ever more complicated versions of the original theories, painstakingly adjusted for all of the “anomalies.”  Finance theorists do not seem to notice that the anomalies now outnumber the things that appear to work.

Maybe investors should spend more time watching how the markets actually behave, instead of worrying about what some theory predicts will happen.

A couple weeks ago, Huffington Post blogger Dan Mirvish noted a funny trend: when Anne Hathaway was in the news, Warren Buffett’s Berkshire Hathaway’s shares went up. He pointed to six dates going back to 2008 to show the correlation. Mirvish then suggested a mechanism to explain the trend: “automated, robotic trading programming are picking up the same chatter on the Internet about ‘Hathaway’ as the IMDb’s StarMeter, and they’re applying it to the stock market.”

The idea seems ridiculous. But the more I thought about the strange behavior of algorithmic trading systems and the news that Twitter sentiment analysis could be used by stock market analysts and the fact that many computer programs are simply looking for tradeable correlations, I really started to wonder if Mirvish’s theory was plausible.

I called up John Bates, a former Cambridge computer scientist whose company Progress Software works with hedge funds and others to help them find new algorithmic strategies. I asked, “Is this at all possible?” And I was surprised that he answered, roughly, “Maybe?”

One more thing for Warren Buffett to worry about!

Source: The Atlantic

A fundamental justification for asset allocation is the notion that different asset classes offer returns that are not perfectly correlated, hence diversification reduces the overall risk in terms of the variability of returns for a given level of expected return.  Therefore, having a mixture of asset classes is more likely to meet the investor’s wishes in terms of the amount of volatility and possible returns.  Asset classes such as stocks, bonds, real estate, commodities, and currencies are typically employed to construct an asset allocation.

However, many financial advisors stop there.  Many think of US stocks as one asset class, bonds as one asset class, real estate as one asset class and so on.  Such thinking leaves a lot on the table. What if US stocks can be broken down into several viable asset classes?  Does this not have the potential to further improve the benefits of asset allocation?  For example, this must-read white paper by AQR Capital makes it clear that value and relative strength are two complementary strategies.  Remember that both strategies profiled in that white paper select securities from the same universe of U.S. stocks.

Anyone who goes to our website sees the following:

High relative strength stocks have historically provided high returns, but they often do not correlate very well with the broad market.  For that reason, high relative strength stocks frequently appear to act like a separate asset class.  From an asset allocation perspective, there is significant value in a high-return asset class that is uncorrelated with most other stocks and bonds.  Non-correlated performance can help smooth out the returns in a diversified portfolio.

To demonstrate this point, consider the R-squared of our Systematic Relative Strength Aggressive portfolio (which invests in U.S. stocks) to the S&P 500.

Remember that the R-squared statistic gives the variation in one variable explained by another.  It is computed by squaring the correlation coefficient between the dependent variable and independent variable (S&P 500 in this case).  As shown in the table, 60% of the variation in our Systematic RS Aggressive portfolio can be attributed to the S&P 500 (therefore, 40% of it is not). This means that even though we are fishing from the same pond (although this portfolio can also invest in mid-cap US stocks) the variation of the performance is quite different from that of the S&P 500.  In fact, this portfolio has a lower R-squared to the S&P 500 than the Russell 2000 (small cap US stocks), MSCI EAFE (developed international stocks), MSCI Emerging Markets, and the Dow Jones Real Estate Index!  This is not a typical result—where the S&P 500 is more correlated to foreign markets than it is to another portfolio composed entirely of domestic securities!  A more typical result may be found when looking at the five most popular equity funds, where their R-squared averages 0.96, according to Morningstar.

How can this happen?  Well, relative strength identifies those securities that have strong intermediate-term relative strength out of a universe of securities.  Often, those securities with the best relative strength are not the stocks that have the biggest influence on the movement of the S&P 500.

All financial advisors are in the asset allocation business.  Some do it well.  Some do it poorly.  I would suggest that including relative strength strategies in your asset allocations has the potential to be very helpful from a performance and diversification perspective.

Click here to receive the brochure on our Systematic Relative strength portfolios.  Click here for disclosures.

We’ve written on this before.  Don’t Trust Your Instincts was one of our most popular recent articles.  Another article I saw on Trader’s Narrative speaks to the importance of controlling emotions because the cost is staggering:

Not surprisingly, the urge to trade increases with market volatility. But surprisingly it arrives immediately after the volatile period has ended. And that can cost clients dearly in performance: up to 4% a year.

This is the behavior gap that DALBAR finds when they look at investor performance in mutual funds.  It’s also the behavior gap that the BCT study found for investors that were working with advisors.  Trader’s Narrative has a really smart graphic that points directly to the truth: advisors are just as susceptible to emotions as clients.

You may claim that the fault lies in the inability of clients to follow the guidance of advisors. But that doesn’t really explain what’s going on here. Consider, for example, an indicator that tracks the sentiment of financial advisors, the Rydex SGI Advisor Confidence Index:

As you can see, in its relatively short lifespan it exhibits the same tendency to swing from ebullient cheerfulness to despondency that we see in the weekly AAII retail investor’s sentiment metric. If you look closely there may be a few divergences here and there but overall, financial advisors are not really immune to the same emotional forces that buffet their clients.

The first reaction of every advisor is to look at this data and say, “Boy, those other advisors are really dumb!”  But as Pogo said, “We have met the enemy, and he is us.”  We are all susceptible to the same emotions—it all boils down to what rules we have in place to civilize ourselves.

Source: www.lakeworthmedia.com

One of the reasons that a Systematic Relative Strength process is so important to us is that it provides an unemotional framework for action.  A systematic process needs to answer what to buy or sell, when to buy or sell, and how much to buy or sell.  The rules need to be robust and tested over a wide variety of market conditions over an extended period of time.  Very importantly, we believe the rules need to be adaptive, for two reasons: 1) eventually you will face conditions different from any in the past, and 2) if you are not confident in the ability to adapt, you will emotionally short-circuit and circumvent the rules at the worst possible time.  Finally, discipline is essential.  Rules aren’t going to help you much if you can’t or won’t follow them.

If you are a financial advisor, you should read this article. 

It discusses the inadequacy of typical retirement calculators, the often false belief that retirement will be less expensive than working, the rule of thumb that you should own more bonds as you age, the idea that moving to a low-cost area for retirement will save you money, and the dangerous idea that your entitlements from Uncle Sam are safe.  There are serious unintended consequences to each of these beliefs that are discussed by some of the retirees interviewed for the article. 

There is no magic bullet for retirement.  The only way you can really protect yourself is to save with a margin of safety and to use multi-asset portfolios (broad diversification!) as part of your retirement allocation.

Taxable bond funds continued to attract the most new money last week and have had inflows of over $30 billion for the year.