The Wrong Focus

by Michael Gayed, CFA, Portfolio Manager, Pension Partners

“Don’t dwell on what went wrong. Instead, focus on what to do next. Spend your energies on moving forward toward finding the answer.” – Denis Waitley

What matters more – your indicators, or your opportunity set?

I think this is an incredibly important question to think through.  Visit any website, turn on any financial news channel, and invariably you’ll find someone who references some indicator to support his or her bullish or bearish view.  Many indicators will be shown against some chart, or in the context of  a strategy, to show just how powerful that indicator has been in the past, and what it means in the context of some current market action.

Put simply, this is overly simplistic, and frankly just the wrong way to evaluate a viewpoint or a strategy.  I would bet that any indicator, when backtested, likely has good theoretical results as long as you find the perfect asset class or security that it works with.  The problem is if an  indicator is applied to a strategy, and the strategy is underperforming for a prolonged cycle, that indicator is deemed to be broken.  In reality, your opportunity set determines a strategy’s cycle performance more so than the buy and sell triggers you’re following.

Rather than prove this out in this writing, I highly encourage you to spend the time reading the 2015 Founders Award winning paper I co-authored “Lumber: Worth Its Weight in Gold.”  I’ve presented across the country on its findings, and many are fascinated by the implications.  When Lumber outperforms Gold, generally risk-on conditions present themselves.  When Gold outperforms Lumber, however, the market is more likely than not to enter a risk-off phase.

But the paper is less about the signal, and more about executing on that indicator with six different backtests that have six different investments in the opportunity set.  And each strategy, though strong over a multi-decade period, outperforms and underperforms in different smaller sub periods of several years purely because of the opportunity set the strategy is working with at any moment in time.

The last several years, I would bet that nearly all popular indicators “worked” in the context of the uptrend of US stocks if your opportunity set was US stocks on the upside, and lower volatility US stocks on the downside.  You would have killed it with your indicators.  But if instead you used the exact same indicators and your risk-on opportunity set included emerging markets, you would have had very different results with the exact same indicators. Likely, if managing money for others in that small sample period of a few years, your clients would blame you and your indicators, rather than the cycle favoring or not favoring the method of execution.

So please – do yourself a favor and don’t come to judgments on an indicator working or not working based on results.  Look deeper at the opportunity set and the cycle those securities are in to really have a deeper understanding of why things work when they work, and why they don’t when they don’t.  “Lumber: Worth Its Weight in Gold” makes that abundantly clear.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

Copyright © Pension Partners