Written by: Amy Kemp, Asset Management Research Specialist, Nasdaq
The ability to efficiently and effectively communicate one’s process to both prospects and clients is arguably the most important piece of an advisor’s skill set. This is something we at Dorsey, Wright & Associates, a Nasdaq Company, can relate to as well, as we are often asked to explain our process and approach to investing.
Providing evidence from third parties can help give credibility to your story. The book, “What Works on Wall Street: The Classic Guide to the Best-Performing Investment Strategies of All Time,” by James O’Shaugnessy, is an excellent such source, especially with regard to relative strength research. While O’Shaugnessy tested and examined many different investment strategies, his findings surrounding relative strength strategies were particularly compelling, and establish evidence for applying it in a systematic fashion, much like we do. There are a few key excerpts from the book we feel can be particularly helpful when the time comes (as it does with every investment philosophy) to defend your process.
Quote #1 – “The only way to beat the market over the long term is to use sensible investment strategies consistently…The lack of discipline devastates long-term performance.”
The ability to make rules-based investment decisions, and to do so in a repeatable fashion, is easier said than done. It becomes far more challenging when the factors that guide your “rules” are ambiguous to begin with. Many fundamental inputs, whether growth or value oriented, can become ambiguous over time. Accounting standards can shift, analysts can focus upon top-line instead of bottom-line numbers, etc. All of us can recall the manner in which “dot-com” companies had their numbers massaged by analysts in an effort to generate a positive opinion as the stocks were rising. When the stocks began to fall, changing that opinion in a timely fashion was hard to do, since the data supporting the “buy” recommendation didn’t change. If an analyst says to “buy” a company that isn’t making money, the simple observation that they are still not making money a year later doesn’t give cause to downgrade the stock. Market psychology can change much faster than company fundamentals, and this is why price inputs are so useful. Price is an objective input, and our relative strength calculations are based solely upon price inputs. There is no “pro-forma” relative strength calculation that might be confused with the GAAP relative strength analysis. Relative strength is calculated simply by dividing the price of one security by another on a daily basis, and that calculation comes to life once we plot it on a Point and Figure (PnF) chart. At any time, a PnF chart is either on a buy signal or a sell signal. There is no gray area, allowing the practice of constructing relative strength-based portfolios to be conducted in both a “sensible” and “consistent” manner.
Quote #2 – “Relative strength is the only growth variable that consistently beats the market…”
Said another way, “Don’t fight the tape.” At Dorsey Wright, we focus on the use of relative strength because we are comfortable with the many ways in which it has been tested and applied as a successful return factor for portfolio managers. While we feel we have advanced the utility of relative strength for the advisor a great deal, using research conducted by the likes of James O’Shaughnessy and others is always helpful in establishing credibility for the process. O’Shaughnessy gained access to the Compustat database and tested everything that had been purported to work (market capitalization, P/E ratios, price-to-book ratios, price-to-cash flow ratios, price-to-sales ratios, dividend yields, earnings per share, profit margins, return on equity, and relative strength) from 1951 to 1996. He tested them independently and in conjunction with other variables. In summary, he found that there was only one factor included in all of the top 10 performing strategies over time, and that factor was relative strength. In addition, he pointed out that the worst strategy he tested was the anti-relative strength strategy of bottom fishing (or buying the stocks with the worst trailing performance).
The relative strength test results above were based upon 6-month momentum, and included a broad data set of 80 years of market data. He simply looked back at the previous 6-months of market data, placed the best 10% of performers in the first “bucket,” the next 10% in the second bucket, and so on. Each bucket became a portfolio and each portfolio was tested for performance over the next year. The next month, new market data was brought in, new buckets were filled, and a new performance test was added to the pile. After 80 years and nearly 1,000 “buckets” of testing, the results were rather clear … stocks that have performed well, tend to continue to perform well for a while. The top-decile bucket produced average annual returns nearly 10% above those of the bottom-decile bucket. This is powerful research and a powerful picture to use in beginning a conversation about why relative strength plays an important role in the process you employ and the products you use.
Quote #3 – “Don’t second guess [good strategies]. Don’t try to outsmart them. Don’t abandon them because they’re experiencing a rough patch. Understand the nature of what you’re using and let it work…it is only by being dispassionate that you can beat the market over time.”
It is important to remember that every investment strategy will have laggard periods where it underperforms, and relative strength is no exception. We know that markets where leadership changes leads to increased turnover and often underperformance for relative strength. We also know that the strategy struggles in markets lacking sufficient dispersion. These are elements that are out of our control, but how we react is very much controllable. The true challenge is finding the discipline to stay the course, something we have espoused for years and will continue to do moving forward.
To learn more about Relative Strength and the Dorsey Wright Relative Strength strategies, download the whitepaper Point & Figure Relative Strength Signals, or contact us here. To learn more the DWA Technical Research platform, click here to take a free 21-day trial.
This article was prepared by Dorsey, Wright & Associates, LLC, a Nasdaq Company. Dorsey Wright is a registered investment advisory firm. The study and conclusions above are the result of a strategy back-test on uninvestable indexes or baskets of stocks. Back-tested results have certain limitations. Such results do not represent the impact of material economic and market factors might have on an investment advisor’s decision making process if the advisor were actually managing client money. Back-testing performance also differs from actual performance because it is achieved through retroactive application of a model investment methodology designed with the benefit of hindsight.
The relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value. Relative Strength is a measure of price momentum based on historical price activity. Relative Strength is not predictive and there is no assurance that forecasts based on relative strength can be relied upon.
Neither the information nor any opinion expressed shall constitute an offer to sell or a solicitation or an offer to buy any securities, commodities or exchange traded products. The information contained herein has been prepared without regard to any particular investor’s investment objectives, financial situation, and needs. Accordingly, investors should not act on any recommendation (express or implied) or information in this material without obtaining specific advice from their financial advisors and should not rely on information herein as the primary basis for their investment decisions. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.
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