That thing you do

  By Guest Blogger Doug Rowat

We’re often asked how we make our investment decisions. Some advisors guard their methods like they’re the KFC recipe, which brings to mind the old trope: ‘I’d tell you, but then I’d have to kill you.’

We’re not nearly as secretive. I’ve mentioned in the past some of the indicators that inform our decisions (corporate profitability, labour market strength, yield curve, etc.), but one of our key active management tools is relative-strength analysis.

So, allow me to get technical for a moment.

Relative strength is a price momentum strategy that compares index or security performance and looks for continuation of outperformance (or underperformance) or, alternatively, violations of relative-performance trendlines. In other words, relative strength often seeks to identify either a continuing trend or an inflection point. A broken trendline, for instance, may indicate an index now ready to outperform (or underperform) for an extended period. One of the tenets of relative-strength analysis is that momentum persists, so when momentum changes, the new trend will potentially last. And, conversely, if there’s no sign of changing momentum then it’s best to favour the outperforming index. In other words, if it ain’t broke, don’t fix it.

As an example, our EAFE (Europe, Australasia and Far East) equity exposure currently remains lower than our US equity exposure. Why? Because the relative-strength trend remains firmly in favour of the US market. Relative-strength charts are plotted by dividing one index level into another. Below is the S&P 500 versus the MSCI EAFE Index over the past 20 years. The US market remains in a clear leadership position. Is further US outperformance a certainty? Of course not, but the positive trend certainly supports our higher US weighting.

S&P 500 vs MCSI EAFE: no sign of waning US outperformance

Source: Bloomberg

Because relative-strength analysis (and active management in general) is not infallible, we still maintain EAFE exposure. To exit EAFE entirely would reduce diversification and therefore increase risk. The purpose of relative-strength analysis is not to make massive shifts away from the areas that we don’t favour (or towards the areas that we do), but rather only to slightly tilt portfolios in the desired directions. After all, we could be wrong.

Unfortunately, retail investors usually don’t tilt slightly. Their portfolio management style is more all-or-none. For example, a common retail investor mistake is to take an entire portfolio and move it to cash—a massive gamble almost always based on fear, not fundamentals. After the short-term volatility of Q4 2018, for instance, several of our clients wanted to do exactly this—sell everything and sit in cash. But the error of such an impulse is highlighted by the double-digit equity-market gains that we’ve now seen throughout the first half of 2019. Sadly, we had one client who we simply couldn’t convince to remain invested after Q4. As the market subsequently heated up, rather than admit his mistake, swallow his pride and turn control back to us, which was, after all, what he was paying us for, he simply transferred out. One mistaken emotional decision made worse by another.

Incidentally, the chart below illustrates how wrong investors usually are with their decisions to raise cash, especially at the extremes. The chart compares US money market fund levels (cash) and US equities over the ‘tech wreck’ and financial-crisis bear markets. Notice how the highest cash levels coincide with the market bottoms. Theoretically, investors should be fully invested at such moments.

ICI Monet Market Funds Assets (white line) vs S&P 500 (orange): erroneously, investors often hold the highest levels of cash at market bottoms

Source: Bloomberg

Relative-strength analysis helps determine the market’s most likely outperformers and underperformers, but its use should only result in minor portfolio adjustments. Relative strength can justify favouring a particular market, but it can’t justify holding that market exclusive of all others. Relative strength is a useful tool, but it’s not perfect. So, the key is to wager small, never go all-in. All-in bets not only create risk, but they’re usually driven by emotion, which only increases the odds of failure. Abandoning equities entirely during periods of volatility to sit in cash, for instance, is usually done out of fear and is highly likely to cripple performance.

Also remember that cash earns you nothing. Inflation will beat you every time. Sitting on your big cash nest-egg, keeping it warm and cozy, might make you feel better, but sitting on eggs doesn’t make you an investor, it makes you a chicken.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.