Absolute Return: an investment objective and strategy

Absolute returns investment strategy fund

Absolute Return in its basic definition is the return that an asset achieves over a certain period of time. This measure looks at the appreciation or depreciation (expressed as a dollar amount or a percentage). For example, a $50 stock drifts to $100 is a 100% absolute return. If that same stock drifts back from $100 to $50, its absolute return is -50%.

Absolute Return as an investment objective is one that does not try to track or beat an arbitrary benchmark or index, but instead seeks to generate real profits over a complete market cycle regardless of market conditions. That is, an absolute return objective of positive returns on investment over a market cycle of both bull and bear market periods irrespective of the direction of stock, commodity, or bond markets. Since the U.S. stock market has been generally in a uptrend for 6 years now, other than the -20% decline in the middle of 2011, we’ll now have to expand our time frame for a full market cycle to a longer period. That is, a full market cycle includes both a bull and a bear market.

The investor who has an absolute return objective is concerned about his or her own objectives for total return over a period and tolerance for loss and drawdowns. That is a very different objective than the investor who just wants whatever risk and return a benchmark, allocation, or index provides. Absolute returns require skill and active management of risk and exposure to markets.

Absolute return as a strategy: absolute return is sometimes used to define an investment strategy. An absolute return strategy is a plan, method, or series of maneuvers aiming to compound capital positively and to avoid big losses to capital in difficult market conditions. Whereas Relative Return strategies typically measure their success in terms of whether they track or outperform a market benchmark or index, absolute return investment strategies aim to achieve positive returns irrespective of whether the prices of stocks, bonds, or commodities rise or fall over the market cycle.

Absolute Return Investment Manager

Whether you think of absolute return as an objective or a strategy, it is a skill-based rather than market-based. That is, the absolute return manager creates his or her results through tactical decision-making as opposed to taking what the market is giving. One can employ a wide range of approaches toward an absolute return objective, from price-based trend following to fundamental analysis. In the ASYMMETRY® Managed Accounts, I believe price-based methods are more robust and lead to a higher probability of a positive expectation. Through my historical precedence, testing, and experience, I find that any fundamental type method that is based on something other than price has the capability to stray far enough from price to put the odds against absolute returns. That is, a manager buying what he or she believes is undervalued and selling short what he believes is overvalued can go very wrong if the position is on the wrong side of the trend. But price cannot deviate from itself. Price is the judge and the jury.

To create absolute returns, I necessarily focus on absolute price direction. Not relative strength, which is a rate of change relative to another moving trend. And, I focus on actual risk, not some average risk or an equation that oversimplifies risk like standard deviation.

Of course, absolute return and the “All Weather” type portfolio sound great and seem to be what most investors want, but it requires incredible skill to execute. Most investors and advisors seem to underestimate the required skills and experience and most absolute return strategies and funds have very limited and unproven track records. There is no guarantee that these strategies and processes will produce the intended results and no guarantee that an absolute return strategy will achieve its investment objective.

For an example of the application of an absolute return objective, strategy, and return-risk profile, visit http://www.asymmetrymanagedaccounts.com/

A One-Chart Preview of Today’s Fed Decision: This is what economists are expecting

I can’t image what it must be like sitting around watching and reading the news trying to figure out what the Fed is going to do next. Even if they could know, they still don’t know how the markets will react. New information may under-react to the news or overreact. Who believed there would be no inflation? bonds would have gained so much? the U.S. dollar would be so strong? Gold and oil would be so low? Expectations like that are a tough way to manage a portfolio. I instead predefine my risk and identify the actual direction and go with it. Others believe it comes down to a single word…

Bloomberg says: Here’s a One-Chart Preview of Today’s Fed Decision: This is what economists are expecting

By far the biggest question is whether the Fed will drop the word “patient” from its statement. If it does drop the word, it creates the possibility of a June rate hike, and it will mark the first time since the financial crisis that the Fed is offering no specific forward guidance as to when rate hikes will come.

About 90 percent of economists surveyed by Bloomberg expect the Federal Reserve to drop the word “patience” in today’s announcement.

fed decision interest rates

source:http://www.bloomberg.com/news/articles/2015-03-18/here-s-a-one-chart-preview-of-today-s-fed-decision

Diversification Alone is No Longer Sufficient to Temper Risk…

That was the lesson you learned the last time stocks became overvalued and the stock market entered into a bear market.

In a Kiplinger article by Fred W. Frailey interviewed Mohamed El-Erian, the PIMCO’s boss, (PIMCO is one of the largest mutual fund companies in the world) he says “he tells how to reduce risk and reap rewards in a fast-changing world.” This article “Shaking up the Investment Mix” was written in March 2009, which turned out the be “the low” of the global market collapse.

It is useful to revisit such writing and thoughts, especially since the U.S. stock market has since been overall rising for 5 years and 10 months. It’s one of the longest uptrends recorded and the S&P 500 stock index is well in “overvalued” territory at 27 times EPS. At the same time, bonds have also been rising in value, which could change quickly when rates eventually rise. At this stage of a trend, asset allocation investors could need a reminder. I can’t think of a better one that this:

Why are you telling investors they need to diversify differently these days?

The traditional approach to diversification, which served us very well, went like this: Adopt a diversified portfolio, be disciplined about rebalancing the asset mix, own very well-defined types of asset classes and favor the home team because the minute you invest outside the U.S., you take on additional risk. A typical mix would then be 60% stocks and 40% bonds, and most of the stocks would be part of Standard & Poor’s 500-stock index.

This approach is fatigued for several reasons. First of all, diversification alone is no longer sufficient to temper risk. In the past year, we saw virtually every asset class hammered. You need something more to manage risk well.

But, you know, they say a picture is worth a thousand words.

Since we are talking about downside risk, something that is commonly hidden when only “average returns” are presented, below is a drawdown chart. I created the drawdown chart using YCharts which uses total return data and the “% off high”. The decline you see from late 2007 to 2010 is a dradown: it’s when the investment value is under water. Think of this like a lake. You can see how the average of the data wouldn’t properly inform you of what happens in between.

First, I show PIMCO’s own allocation fund: PALCX: Allianz Global Allocation Fund. I include an actively managed asset allocation that is very large and popular with $55 billion invested in it: MALOX: BlackRock Global Allocation. Since there are many who instead believe in passive indexing and allocation, I have also included DGSIX: DFA Global Allocation 60/40 and VBINX: Vanguard Balanced Fund. As you can see, they have all done about the same thing. They declined about -30% to -40% from October 2007 to March 2009. They also declined up to -15% in 2011.

Vanguard DFA BlackRock PIMCO Asset Allcation

Charts are courtesy of http://ycharts.com/ drawn by Mike Shell

Going forward, the next bear market may be very different. Historically, investors consider bond holdings to be a buffer or an anchor to a portfolio. When stock prices fall, bonds haven’t been falling nearly as much. To be sure, I show below a “drawdown chart” for the famous actively managed bond fund PIMCO Total Return and for the passive crowd I have included the Vanguard Total Bond Market fund. Keep in mind, about 40% of the allocation of the funds above are invested in bonds. As you see, bonds dropped about -5% to -7% in the past 10 years.

PIMCO Total Return Bond Vanguard Total Bond

Charts are courtesy of http://ycharts.com/ drawn by Mike Shell

You may have noticed the end of the chart is a drop of nearly -2%. Based on the past 10 years, that’s just a minor decline. The trouble going forward is that interest rates have been in an overall downtrend for 30 years, so bond values have been rising. If you rely on bonds being a crutch, as on diversification alone, I agree with Mohamed El-Erian the Chief of the worlds largest bond manager:

“…diversification alone is no longer sufficient to temper risk. In the past year, we saw virtually every asset class hammered. You need something more to manage risk well.”

But, don’t wait until AFTER markets have fallen to believe it.

Instead, I apply active risk management and directional trend systems to a global universe of exchange traded securities (like ETFs). To see what that looks like, click: ASYMMETRY® Managed Accounts

Sectors Showing Some Divergence…

So far, U.S. sector directional price trends are showing some divergence in 2015.

Rather than all things rising, such divergence may give hints to new return drivers unfolding as well as opportunity for directional trend systems to create some asymmetry by avoiding the trends I don’t want and get exposure to those I do.

Sector ETF Divergence 2015-03-04_11-24-54

For more information about ASYMMETRY®, visit: http://www.asymmetrymanagedaccounts.com/global-tactical/

 

Chart source: http://www.finviz.com/groups.ashx

 

 

Small vs. Large Stocks: A Tale of Two Markets (Continued)

A quick follow up to my recent comments about the down trend in smaller company stocks in Playing with Relative Strength and Stock Market Peak? A Tale of Two Markets below is a chart and a few observations:

Rusell 2000 Small Caps vs S&P 500 large caps

Source: Bloomberg/KCG

A few observations of the trend direction, momentum, and relative strength.

  • The S&P 500 index (the orange line) of large company stocks has been  in a rising trend of higher highs and higher lows (though that will not continue forever).
  • The white line is the Russell 2000 small company index has been in a downtrend of lower highs and lower lows, though just recently you may observe in the price chart that it is at least slightly higher than its August high. But it remains below the prior two peaks over the past year. From the time frame in the chart, we could also consider it a “non-trending” and volatile period, but its the lower highs make it a downtrend.
  • The green chart at the bottom shows the relative strength between S&P 500 index of large company stocks and the Russell 2000 small company index. Clearly, it hasn’t taken all year to figure out which was trending up and the stronger trend.
  • Such periods take different tactical trading skills to be able to shift profitability. When markets get choppy, you find out who really knows what they’re doing and has an edge. I shared this changing trend back in May in Stock Market Peak? A Tale of Two Markets.

If you are unsure about the relevance of the big picture regarding these things, read Playing with Relative Strength and Stock Market Trend: reverse back down or continuation? and Stock Market Peak? A Tale of Two Markets.

 

Stock Market Trend: reverse back down or continuation?

I normally don’t comment here on my daily observations of very short-term directional trends, though as a fund manager I’m monitoring them every day. The current bull market in stocks is aged, it’s lasted much longer than normal, and it’s been largely driven by actions of the Fed. I can say the same for the upward trend in bond prices. As the Fed has kept interest rates low, that’s kept bond prices higher.

Some day all of that will end.

But that’s the big picture. We may be witnessing the peaking process now, but it may take months for it all to play out. The only thing for certain is that we will only know after it has happened. Until then, we can only assess the probabilities. Some of us have been, and will be, much better at identifying the trend changes early than others.

With that said, I thought I would share my observations of the very short-term directional trends in the stock market since I’ve had several inquiring about it.

First, the large company stock index, the S&P 500, is now at a point where it likely stalls for maybe a few days before it either continues to trend up or it reverses back down. In “Today Was the Kind of Panic Selling I Was Looking For” I pointed out that the magnitude of selling that day may be enough panic selling to put in at least a short-term low. In other words, prices may have fallen down enough to bring in some buying interest. As we can see in the chart below, that was the case: the day I wrote that was the low point in October so far. We’ve since seen a few positive days in the stock index.

stock index 2014-10-22_15-06-14

All charts in this article are courtesy of http://www.stockcharts.com and created by Mike Shell

Larger declines don’t trend straight down. Instead, large declines move down maybe -10%, then go up 5%, then they go down another -10%, and then back up 7%, etc. That’s what makes tactical trading very challenging and it’s what causes most tactical traders to create poor results. Only the most experienced and skilled tactical decision makers know this. Today there are many more people trying to make tactical decisions to manage risk and capture profits, so they’ll figure this out the hard way. There isn’t a perfect ON/OFF switch, it instead requires assessing the probabilities, trends, and controlling risk.

Right now, the index above is at the point, statistically, that it will either stall for maybe a few days before it either continues to trend up or it reverses back down. As it all unfolds over time, my observations and understanding of the “current trend” will evolve based on the price action. If it consolidates by moving up and down a little for a few days and then drifts back up sharply one day, it is likely to continue up and may eventually make a new high. If it reversed down sharply from here, it will likely decline to at least the price low of last week. If it does drift back to last weeks low, it will be at another big crossroads. It may reverse up again, or it may trend down. Either way, if it does decline below low of last week, I think we’ll probably see even lower prices in the weeks and months ahead.

Though I wouldn’t be surprised if the stock index does make a new high in the coming months, one of my empirical observations that I think is most concerning about the stage of the general direction of the stock market is that small company stocks are already in a downtrend. Below is a chart of the Russell 2000 Small Cap Stock Index over the same time frame as the S&P 500 Large Cap Stock Index above. Clearly, smaller companies have already made a lower low and lower highs. That’s a downtrend.

small company stocks 2014 bear market

Smaller company stocks usually lead in the early stage of bear markets. There is a basic economic explanation for why that may be. In the early stage of an economic expansion when the economy is growing strong, it makes sense that smaller companies realize it first. The new business growth probably impacts them in a more quickly and noticeable way. When things slow down, they may also be the first to notice the decline in their earnings and income. I’m not saying that economic growth is the only direct driver of price trends, it isn’t, but price trends unfold the same way. As stocks become full valued at the end of a bull market, skilled investors begin to sell them or stop investing their cash in those same stocks. Smaller companies tend to be the first. That isn’t always the case, but you can see in the chart below, it was so during the early states of the stock market peak in 2007 as prices drifted down into mid 2008. Below is a comparison of the two indexes above. The blue line is the small stock index. In October 2007, it didn’t exceed its prior high in June. Instead, it started drifting down into a series of lower lows and lower highs. It did that as the S&P 500 stock index did make a prior high.

small stocks fall first in bear market

But as you see, both indexes eventually trended down together.

As a reminder to those who may have forgotten, I drew the chart below to show how both of these indexes eventually went on to lower lows and lower highs all the way down to losses greater than -50%. I’m not suggesting that will happen again (though it could) but instead I am pointing out how these things look in the early stages of their decline.

2008 bear market

If you don’t have a real track record evidencing your own skill and experience dealing with these things, right now is a great time to get in touch. By “real”, I’m talking about an actual performance history, not a model, hypothetical, or backtest. I’m not going to be telling you how I’m trading on this website. The only people who will experience that are our investors.

 

 

Playing with Relative Strength

I discussed in my interview with Investor’s Business Daily in 2011 titled “How Mike Shell Uses Relative Strength To Trade ETFs” some very basic concepts of how I apply proprietary relative strength systems to ETFs in a tactical ETF managed portfolio. Though we can develop all kinds of sophisticated algorithms to define relative strength, momentum, and directional price trends, at the end of the day the concept is very simple.

Up until now (a signal that something has changed) small company stocks where lagging large company stocks. To illustrate what that looked like, I stopped the relative chart below in Mid-May. You may observe that the blue line (the Russell 2000 index of small company stocks) was lagging and with a higher range of swings (more volatile). The black line is the S&P 500 stock index weighted toward larger stocks.

small company stocks lagging large

Source: http://www.stockcharts.com

Next we update the chart to today’s date. Over the past month, small companies caught up. However, they are now at the prior high, so we’ll find out in the weeks ahead if the relative out-performance continues, or if it finds some resistance and reverses back down.

small cap stocks relative strength to large company stocks

Below I have zeroed out one side to express only the relative change of the small cap index while holding the large cap index steady. Here we see only the relative difference between small and large over the past year.

relative strength of small vs large ETFs

You can probably see how relative strength isn’t just about strength, there is also relative weakness. And, relative change oscillates over time.