Tuesday, August 28, 2007

Seeking Relative Outperformance

A common reader query here at OfTwoMinds is: what can I do to protect myself financially from the coming unraveling? There is no easy answer, of course, for many reasons.

One, I am not qualified nor prepared to offer investment advice of any kind. Two, if I were foolish enough to advise buying XYZ today, tomorrow it would be hit with news which caused it to crash, and three, the only person who can properly assess an investor's risk appetite, financial situation and investing style is the investor himself/herself. There is no shortcut to this financial self-knowledge.

That said, there are some basic strategies which can be useful. One is "relative performance," described here by frequent contributor Harun I.:

It has been my observation that the majority of people make investment decisions based on many things but no weight is given to the most important factor, that being whether the investment is increasing purchasing power. (emphasis added)

In my humble view investment decisions must start with asset-class performance (stocks, bonds, commodities) against an accepted measure of value such as gold, broad market performance, and sector performance. The current mass thinking in the diversification and buy-and-hold theory has one keeping poor performing assets which makes no sense to me. This thinking doesn’t respect differences in time horizon.

If people were willing to shift an hour of their time daily to do proper research then they would find that their investment results would be much different.

So let's take the oil sector and see what we can make of it. We start with a long-term chart of light crude oil with a relative-performance comparative to gold:

Please go to www.oftwominds.com/blog.html to view the charts.

Harun's comment: "Where the red line is rising (1985 and 2000 peaks) oil was outperforming gold. From 2005-mid 2006 oil underperformed gold as noted by the decline of the red line."

Next, let's look at a chart (courtesy of Harun) of an integrated oil/energy company, Exxon Mobil (ticker symbol XOM) plotted with relative-performance comparatives to the S&P 500 and gold:

Harun provided this explanation:

With Gold the denominator, when the red line is rising the numerator, which in this case is XOM, is outperforming Gold. When the red line is declining XOM is underperforming gold. The only significance of the red line being above or below price is the relative value (how much can be purchase with XOM), which is not to be confused with performance.

The same goes for the blue line which measures the performance of XOM relative to the SP 500. When the blue line is rising XOM is outperforming the SP 500, when the blue line is declining XOM is underperforming the SP 500. Once again the amplitude only determine how much of the SP 500 XOM can purchase.

Note that the actual direction of price move is irrelevant. The SP 500 and XOM can both be in decline and the relative strength line will still rise if XOM is falling slower than the SP 500.

What is not shown is the RS line of gold to the SP 500 during this period. But during the bull market from 1982-2000 The SP500 outperformed gold. In other words the SP 500 was increasing in purchasing power (its ability to buy gold and commodities). XOM was outperforming gold too but at a much slower rate than the SP 500. During that period it was better (easier?) to own the index (or a stronger performing stock than XOM).

Harun's summary:

The measure of success of any investment is determined by the simple question, did purchasing power increase, decrease or remain unchanged?

During the 20-year Bull Market, Exxon purchasing power increased because it performed better than gold--but was it the best stock to own?

1988-2000 XOM grew better than gold (red) but underperformed the SP 500 (blue). Remember that the SP 500 outperformed gold during this period so while it didn't kill you to own XOM, implicitly you lost money for 12 years.

2000-2003 XOM underperformed gold and outperformed the SP 500 which was underperforming gold. XOM in this time frame would have been a bad investment.

2003-present is the only time that XOM outperformed both the SP500 and gold, makig it a sensible investment. But it must be noted that XOM cannot purchase as much gold as it did in 2005 even though it is showing a higher nominal price.

So what conclusions can we draw from plotting the relative performance of the broad stock market (S&P 500), gold against a leading oil/energy blue chip company?

Any investment performance must ultimately be measured not just against alternative investments but in terms of purchasing power.

These charts also suggest three other insights.

1. An investment may appear to be "doing OK," i.e. rising in nominal dollars, but meanwhile it is seriously underperforming other asset classes.

2. An asset may outperform for a period of time, and then underperform. "Buy and hold forever" may not be a successful strategy for establishing and maintaining outperformance.

3. Diversification may be a good idea, but diversifying into asset classes which are outperforming other classes and maintaining or growing one's purchasing power is an even better idea.

Thank you, Harun, for sharing your knowledge and insights.

Thank you, Rod C., ($10) for your generous donation to this humble site. I am greatly honored by your support and readership. All contributors are listed below in acknowledgement of my gratitude.

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