Friday, October 07, 2011

Dueling Economists on Bloomberg

Earlier this week I caught about ten minutes of dueling economists on Tom Keene's noontime Bloomberg program. One was Andrew Tilton, and the other was Michael Darda. The two were starkly different.

What struck me was that Tilton had this 'head down, read the numbers' sort of attitude, which led him to make assorted ludicrously optimistic statements. Then, again, he works for Goldman, which probably doesn't want to spook markets while their and their customers' money is long.

Darda, on the other hand, made sensible comments about real world economic events. He wasn't totally candid, but at least he gave reasonable weight to qualitative events occurring in Europe and various debt markets.

Sadly, Keene sat there and, as I've learned he often does, played up to both guests as if they offered unalloyed wisdom. I suppose he was practicing the usual on-air media nonsense of never asking tough questions of a guest because they might not return if he did.

Thus, it was a mostly wasted ten minutes of my time.

This Morning's Fake Job Numbers

It's 8:35AM and I've just watched the release of the September Labor Department employment numbers.

Allegedly, consensus was for +60K jobs and 9.1% unemployment.

In reality, jobs rose by 110K with a flat 9.1% unemployment rate. However, we then quickly learned that August jobs were restated upwards, and September jobs were high, by roughly the number of striking Verizon craft workers.

Meaning that August wasn't really flat, and September didn't really add 110K jobs.

What kind of bizarro employment measurement system distorts results over a strike that everyone knows happened?

You wonder why any one month's numbers are useless? This is why.

How The Ford-UAW Agreement Erodes The Union's Basic Functions

Wednesday's Wall Street Journal contained an informative article concerning the UAW's tentative agreement with Ford. It explains,

"Meanwhile, a new buyout program will allow the Dearborn, Mich., auto maker to shed its most expensive workers and add more lower-cost workers to its U.S. assembly lines.

All of the new hires are expected to earn little more than half the roughly $28 an hour wage that veteran auto workers  make. The wage shift is paving the way for the hiring of up to 12,000 U.S. workers through 2015, including 7,000 previously announced jobs."

Signing bonuses and up-front one-time inflation adjustments replace COLAs in the agreement.

When I read those two paragraphs, I was reminded of this post from June of this year which I wrote on my companion political blog discussing a Journal editorial from this summer. In the editorial, a labor lawyer writes about how cheap labor in Southern US states will ruin American productivity and its economy. Thus, he excoriates Boeing for its building a plant in South Carolina, where wages are much less than in its Seattle plants. The author, Thomas Geoghegan, equates labor costs with quality and skill.

How, then are we to interpret the tentative new Ford-UAW agreement?

The agreement forces the union to basically toss its older, allegedly 'skilled' workers to the wolves, in favor of hiring younger, less-skilled, and cheaper, replacements.

Isn't this sort of competition to work for lower wages precisely what Walter Reuther & Co. established their unions to prevent? Now Bob King is turning 80 years of union policy on its head.

Moreover, the fact that the UAW head would accept that paying younger workers half as much as older, to-be-released so-called highly skilled workers is an admission that labor skill, seniority and expense are completely unrelated. Otherwise, the union would insist that Ford would be building lesser-quality cars with its new, younger, cheaper labor force.

And what if you were an older, allegedly-skilled worker who didn't want to lose your job? Could you offer to work for the new, lower-by-half wage? What would that say about the value of your so-called skill? Call it what you will, Bob King's proposed UAW contract with Ford is an admission of downward pressure on the value of auto assembly work and the jobs that come with it..

Curious, isn't it? When global competitive forces and trade finally push US labor unions to the wall, they violate their own stated goals of protecting all of their members, and abandon the older, higher-paid workers, whose jobs would be eliminated, in favor of younger, cheaper workers, in order to keep some jobs onshore.

So much for the myth that wage rates signify quality or skill.

Either in Detroit, or Charleston.

Thursday, October 06, 2011

Apple In The Wake of Steve Jobs' Death

It's tough getting real business news this morning, as the major cable business channels, CNBC and Bloomberg, are devoting so much time to eulogizing Steve Jobs.

Over on CNBC, his royal pompousness, Jim Cramer, actually self-referenced his capacity for being pompous and windbaggish.

Yes, it's sad that Jobs is dead. Yes, he was the Thomas Edison of our era.

No, despite the claim of one Bloomberg guest, Jobs was not our era's Thomas Jefferson nor Ben Franklin. To my knowledge, Jobs carefully eschewed both public office and/or ambassadorships.

Yes, Leo Hindry- why this guy keeps popping up everywhere after destroying his last venture, Global Crossing- was correct to declare that there have been at most four other business inventors of Jobs' calliber in the past few decades, including Watson, Sr., David Packard and Bill Hewlett. No, Hindry said, Mark Zuckerberg is not the next Steve Jobs.

That said, let the dead bury the dead.

The remaining question, which I addressed in this frequently-read post from last December, is how to approach Apple as an investment. Here's what I wrote,

"One, of course, is the firm's clear, successful focus on consistent innovation and evolution of well-received products. Those products have achieved high brand preference status. Additionally, they are typically in price ranges that have made them less vulnerable during the recent US recession and continuing economic weakness. With Steve Jobs' continued leadership, the firm may outperform expectations for a little while longer still.

And, finally, there's something which many investors fail to grasp. That is, even broadly-followed, popular firms can outperform. What is required is unexpected excellent performance. Firms like Microsoft, Dell, Kolhs, in the past, and, currently, Apple, have achieved this. It can never last forever, but it can often outlast ill-informed, generically-based expectations.

What Google does seems to be less unique with time, while Microsoft has been mismanaged for over a decade, with no sign of significant change in that important parameter.

The bottom line for me is that I don't subjectively select equities. But I can and often do interpret why my quantitative approach selects those equities which appear in portfolios. And from post hoc, informal inspection, it's easy for me to see why none of the recent portfolios have held Google or Microsoft, while many have included Apple."
And, soon after, this post concerning his first medical leave,

"Of the three developments, I'd say that Jobs' departure will be the most critical. As expected, it knocked some value off of the equity's price this morning, causing a 3.7% drop by 11AM, as I write this post. As a growth equity, it's understandable that uncertainties over Jobs' future at the company will affect the forward-looking component of its price. So even strong quarterly performance reports will probably be overshadowed by these worries.

I remain comfortable trusting the management that brought Apple to its path of consistently superior performance. If Steve Jobs becomes unavailable in the long term, that will probably affect the company's share price and, thus, it's implied performance for shareholders. It's a self-fulfilling prophecy that could very well remove Apple from my equity selection process' results. So be it."

With Jobs' death, many will question how long they should continue to buy/hold Apple. As I wrote in the above passages, I use quantitative methods. So as long as Apple continues to meet my performance criteria, my portfolios will include the equity.
Many pundits have argued, in the hours since Jobs' death was announced, that Apple's culture and team approach to management is so strong that it will outlive Jobs.
That's doubtful. Maybe for a few months, a year. But with Jobs dead, the remaining Apple executives will eventually evolve to a new team dynamic, since Jobs will not be coming back anymore to get them all back in line.
People have personal goals, individual objectives, visions, etc. And without Jobs' unifying vision, Apple will, must, in time, become different.
But for me, the proof is in the performance. It's as simple as that.
Even with Jobs, it's quite likely that Apple would eventually have fallen victim at least to investors' expectations finally catching up with the firm's fundamental performance. Without him, there's the potential for that, as well as competitive pressure that no longer has Jobs' instincts to counter it.
And the possibility of federal regulatory action which they wouldn't have dared initiate against America's favorite innovator while he lived.
But, dead, his company is fair game.
So, to reiterate, sad though we all are that Steve Jobs died yesterday, decisions regarding owning shares in the company he co-founded should not depend upon that event. They should depend upon the firm's performance going forward.

Equity Market Turbulence & More Comments from Kyle Bass

It's been quite a week for US equity markets. On Tuesday, the S&P had something like a 4 percentage point swing. It had fallen by more than 2% by around 2:30PM, then catapulted back to finish the day up by 2.2%.

My proprietary equity options volatility measure hasn't been in 'long' territory since August 1st. Now intra-day S&P moves are triggering proprietary equity allocation signals to move from 'long' to 'out' or 'short.'

I've written in several prior posts about my expectation that, barring a brisk market rise, that signal would move to 'short' by sometime this quarter. Tuesday's lows on the S&P pushed my equity signal to 'out.'

I constructed this proprietary equity long/short signal back in 2001. It has correctly signaled moves from long to short before the 2001 market decline, as well as the 2008 crisis. It hasn't signaled a false positive in ten years, but it's correctly detected, a priori, both major equity market hurricanes, as well as re-entry points very close to equity index market bottoms in the resulting period of severe decline.

Now, on any given day, the S&P can easily close in territory that moves the signal to 'short' for next month. Specifically, if the S&P return for this month is much worse than -2%, the signal will go 'out/short.'

Thus, I moved the bulk of my funds which were in equities into cash yesterday. Because the signal wasn't 100% solid, but only an intra-day low, I didn't move 100% of the assets.

For what it's worth, more than a few pundits and fund managers appearing on CNBC and Bloomberg have said they are doing the same in the past week.

Meanwhile, yesterday David Faber's noontime program featured a long segment with Kyle Bass at the latter's Texas Barefoot Economics conference. Bass reiterated his remarks from a few weeks ago regarding the hopelessness of the European situation working out with defaults and a damaged Euro.

Bass discussed how ludicrous it is to expect some nations, like Spain and Italy, to be guarantors of bad Greek debt today, then turn around and become receivers of further Euro help tomorrow. Bass referred, again, to his firm's original market research among Germans regarding their attitudes toward bailing out the rest of Europe, and added, this time, a reference to private conversations with senior German government officials. This smacks of the legwork Bass was known for, ex post, in the 2007-2008 mortgage crisis, as displayed on Faber's House of Cards documentary.

I've written posts about the House of Cards program, and Michale Lewis' The Big Short, both of which, in hindsight, spotlighted hedge fund managers who did their spadework to find bad mortgage debt, then bet their ranches against them, and won. Names like Bass, Paulson, Eisman, Burry, Ledley and Hockett.

This time, we're hearing and seeing those types of characters disclosing their current fears in real time on CNBC and Bloomberg. Or, in Bass' case, the same character.

Bear in mind that Tuesday's S&P yo-yo-ing was due to negative, then positive investor reactions to news stories coming out of Europe regarding its debt crisis and the fate of the little bank Dexia, which went insolvent earlier this week.

Then we have another recession, or the extension of the current one, which eased, coming in the US. And what appears to be a lame-duck president.

There's no good economic news anywhere you look. And it's way too early to hope that this is just a 'wall of worry' that equity indices will climb. This time, there are significant global financial and economic problems.

Oh, and Congress is close to passing anti-Chinese yuan policy legislation that will ring in a trade war.

Someone mentioned on CNBC this morning that any corporations which get caught by surprise by a Greek default should fire their senior management, because we've had since April of 2010 to see this coming.

For perspective, I took a look at the S&P levels and volatility since then. Beginning with that first Greek crisis in the markets, the S&P was at roughly 1110 to 1130. My proprietary options volatility signal rose to 'put' levels by early April, and stayed there for the next six months.

In the intervening months, the S&P has climbed as high as 1363 on 29 April 2011. Now it's back to where it was, more or less, at the start of the Greek crisis last year. Holding long equity portfolios generated by my proprietary strategy in the interim would have allowed an investor to realize gains for most of that period. Gains which would be rebalanced as portfolios rolled on and off. A sort of slightly more sophisticated variant of dollar-averaging, if you will.

But now, volatilities, and, thus, risk, in both my proprietary options and equities signaling systems have risen to critical levels amidst equity market levels which aren't providing concomitant returns.

As I write this post at about 1PM on Wednesday afternoon, the day before it will publish, the S&P is at 1131. A slight gain from yesterday. But in times like these, any one day's equity market performance isn't the point. It's the overall trend, or lack of one, coupled with instantaneous and recent volatility that guides my quantitative long/short signals. The qualitative economic and financial information I process provides context.

And now, the context and the signals are flashing to be mostly out of US equities.

Wednesday, October 05, 2011

Regarding GE's China Avionics Deal

The potential for conflict between economic growth of US companies and US employment is perhaps no better exemplified than in the recent reports of GE setting up an avionics venture in China. Especially since GE's underperforming CEO, Jeff Immelt, the man ultimately responsible for this offshore business and job-creating venture, is also chairman of the president's special US job creation council.

Last week, the Wall Street Journal ran this piece about the venture,

"During a factory tour in South Carolina, Jeffrey Immelt smiles and cuts me off after I ask another question about his new venture in China:

"I'm done," says the chief executive of General Electric. "This was reviewed by the Commerce Department and the Defense Department."

If Mr. Immelt's response seems a bit edgy, it's probably because I raised a topic that has much of U.S. business on edge too: How to compete in China without giving away the store. And specific to General Electric: What's to keep GE's new avionics joint venture with China from transferring the best of U.S. technology abroad, empowering a new set of Chinese companies to challenge U.S. aircraft makers?

China watchers are anxious about this venture. Avionics— the "brains" guiding navigation, communications and other operations on an airplane—are at the pinnacle of American know-how, where the U.S. is still highly competitive. It's also technology the Chinese military covets.

GE says it has built protections into the venture, but the debate can get heated.

"To suggest that there are going to be firewalls that will stop this technology from going to the Chinese military is approaching laughable," says Rep. Randy Forbes (R., Va.), who sits on the House Armed Services Committee. "The fact that GE would say that is shocking."

You could substitute many industrial companies for GE in this equation, because over the last 30 years most have struck their own difficult bargains with China's many state-owned companies. China is the world's fastest-growing major market, and in return for access the country frequently demands technology or other know-how. China then absorbs that technology and uses it to battle global competitors, selling products that are often heavily subsidized by China.

That has happened in a range of industries, including autos, electronics and energy. Siemens now competes internationally against Chinese high-speed rail companies that sell products partly based on technology gleaned from an earlier joint venture with the German firm.

The U.S. has restrictions on the export of certain technology that could threaten U.S. security, but it appears less equipped, or less organized, to contend with this broader challenge: what to do about the threat to many business sectors posed by China's state-sponsored industrial juggernaut.

"We've been passive in deciding how to deal with China's aggressive industrial policies," says James Lewis, who worked on technology-transfer issues at the Commerce Department and is now at the Center for Strategic and International Studies.

"U.S. companies are making the right decision from a business point of view, but it might not be the right decision for the country," Mr. Lewis adds.

"It's unclear whether anyone in the U.S. government took a look at the GE deal in terms of U.S. competitiveness—the future of the aviation industry 10 or 20 years out," says an executive who advises companies working in China. He worries that a heavily subsidized Chinese jet program, enhanced with U.S. avionics, could eventually clobber Boeing. "China has an incredible ability to distort markets, and we can't be reacting after the distortion has taken place."

Clyde Prestowitz, a former U.S. trade negotiator who writes on global economics and business, says China is violating World Trade Organization rules that prohibit making technology transfer a condition of market access. "In a normal market the avionics would be done for that plane in the U.S. and we'd sell it to China," he argues.

GE says it wasn't forced to give up its technology for market access. Instead, it sees this joint venture as a valuable piece of an existing global network of joint ventures and supplier relationships between the world's big aviation companies.

"Technology is the heart and soul of our company," says Rick Kennedy, a GE spokesman. "Why would we give away our future?"

In its China project, GE will develop a new generation of its avionics operating system with state-owned Aviation Industry Corp. of China, which supplies China's commercial and military aircraft industries. The business will be based in Shanghai and owned 50-50 by the two firms.

GE says its half of the work load will chiefly be handled out of GE facilities in Florida, Michigan and Britain. And it expects that capturing new business through the joint venture will both boost exports from its U.S. operations and add jobs.

The venture's first big customer: Commercial Aircraft Corp. of China, which is developing the C919 passenger jet to compete with Airbus and Boeing. The joint venture will also sell its avionics to aircraft makers globally. GE's current operating system is already on the Boeing 787.

As for the Chinese military, GE says it has spent nearly three years developing a compliance program that it believes won't let the military near its technology. GE will run the compliance office and will vet all hiring. AVIC is forbidden from sharing information with its military business. And people who leave the venture must wait two years before they can take any Chinese military-related assignment.

Still, China is an authoritarian country with a weak legal system. It is difficult to imagine that any technology deemed worthwhile in the GE/AVIC venture wouldn't somehow find its way onto the next-generation Chinese jet fighter. GE says that its system is specific to commercial use, not military. And if there were evidence that information had gotten to the Chinese generals, the joint venture would be shut down.

Kathleen Palma, who handles trade compliance for GE Aviation, says GE determined that U.S. export licenses weren't required for the technology involved, but the company nonetheless briefed the Commerce Department and the Defense Technology Security Administration several times. She says the U.S. government appeared satisfied. A spokeswoman for DTSA said GE said it was "complying with all applicable laws." A spokesman for the Commerce Department referred questions back to GE.

GE has manufacturing operations elsewhere in China, and it isn't alone in giving a lift to China's commercial jet program. Other U.S. companies have a piece of the action, including Honeywell, Hamilton Sundstrand, Rockwell Collins, Eaton and Parker Aerospace. Airbus has manufacturing operations in China.

What is uncertain is whether these companies will remain part of China's aviation calculus once they are done being useful, and whether Chinese companies will supplant them. That transition has happened in other industries and is a mainstay of China's "indigenous innovation" industrial strategy, which is explicit about "metabolizing" foreign technology and making it China's own.

GE says that if it hadn't linked with AVIC in a joint venture a competitor would have, which is very likely. Mr. Immelt, the CEO, says he'll take responsibility if the venture goes wrong. "It's on me," he says. "It's on me."

But the reality is more complicated. When it comes to China and its ability to shake global industries, the ramifications of GE's decisions—and the decisions of many other American companies—are on everyone."

There are a number of interesting aspects to the GE avionics venture.

First, Immelt claims he is 'responsible' for the venture if it "goes wrong."

"It's on me" he was quoted as saying.

Well, GE's decade of shareholder value destruction has been "on him," too, it would seem, but that hasn't led Immelt to do anything to address the problem, has he? He's still being paid millions each year by the firm's equally-ineffectual board while continuing to run a lackluster, needlessly-diversified conglomerate.

Second, it's pretty clear that the place where most of the jobs will be created by this China-based venture will be....China! So much for Jeff demonstrating to other US executives how to create US jobs.

Third, Clyde Prestowitz' charge that GE's, and other major corporations' being forced by China to surrender technology as a term of operating in the country is a clear violation of international trade laws to which China has agreed to operate. Why isn't GE, the US government, or any other company pursuing these issues through appropriate international venues?

Fourth, if GE is a leader in this business, wouldn't it's refusal to cede its technology to the Chinese leave the latter with second-tier vendors whose new commercial aircraft would be inferior to those of Boeing and Airbus? Thus making GE's decision the very reason it will be problematic?

Fifth, who, with a brain, really believes that if GE ever discovers evidence of its technology inappropriately being transferred to the Chinese military complex, it will ever be able to do anything about it? The technology will be gone. The venture's closure will only hurt GE. And it's not likely the Chinese would let GE remove anything- money, people, equipment- if they didn't choose to. Just imagine the prospect of GE employees and property seized by Chinese, and subjected to interminable holding while the Chinese dared anyone, including the US government, to act to get them back.

Sixth, contrary to GE manager Rick Kennedy's contention that technology is the "heart and soul" of GE, so why would they compromise future returns, the answer is simple. Pressure to meet short term profit goals by a poorly-performing CEO- Immelt.

Seventh, there is clear evidence across several other product markets that the Chinese will take the technology they want, then kick the US venture to the curb and compete with those same companies internationally. Why does GE think it will be any different?

There are so many reasons to doubt the wisdom of this GE venture that its truly shocking that the US government has allowed it to go forward.

I had one thought while reading the Journal account of this disaster in the making. It was the Soviet Union's Nikita Kruschev chortling that Western capitalists would sell (to Communists) the rope with which they would eventually be hung, so hungry for profits, and shortsighted were they.

Sound like Immelt's GE? It does to me.

Tuesday, October 04, 2011

Regarding Amazon's Fire Tablet- And Apple

The big news in online business last week was Amazon's unveiling of its Fire tablet. By now, you've doubtless read plenty of reviews of the product, comparisons with Apple's iPad, heard and seen countless pundits pontificate on the new entry.

Here's my take.

First, as I've always contended, and several pundits reinforced, Amazon will always trail Apple in this product space, by virtue of its entirely outsourcing the design and manufacture. For example, from what I've read, the Fire has no camera and lacks some connectivity options.

Second, the real and most important aspect of the Fire is its $200 price point. While it technically exploits a market segment which Apple doesn't care to currently address, it does begin to exert more downward pressure on pricing and margins in the product/market. In fact, the Wall Street Journal's report on the Fire alleged that Amazon is not only pricing to profit on the downloadable content, but that the $200 list price doesn't even cover the Fire's production costs.

Thus, as I told a friend over lunch last Friday, Amazon is embarking down a very dangerous road- using a sprawling, integrated business model including its entire online general store to subsidize the cost of its latest deliverable tablet. Sooner or later, some aspect of Amazon's business will probably begin to experience pricing problems as the transfer pricing and allocation of overheads begin to distort the prices and margins of products which effectively fund the Fire.

Mixed into that mess is Amazon's tying the Fire to an automatic Premium subscription. So various shipping and other discounts on content are included with the tablet, but it's unclear that buyers of the Fire actually want, prefer or will use much of that content. Or spend more money to buy or rent what isn't free with the Fire.

In contrast, Apple's business model seems simpler and cleaner.

As I also explained to my friend last Friday, this development is why Apple won't be in my equity portfolios forever. Eventually, one or more of three forces tend to drive equities from the buy list: investor expectations adjust to the firm's actual performance, resulting in the equity's price no longer rises so smartly; competitive forces attenuate the firm's revenue and profit growth, and/or; regulatory action puts a stop to the firm's previously-unstoppable growth.

I've seen a succession of former portfolio holdings fall victim to one or more of these forces over time: Kohls, Dell, Microsoft, Home Depot and Wal-Mart.

Now Apple and Amazon seem to be heading in that direction. Both have been recent portfolio members. But now their evolving struggle involving tablets and online-delivered content- music, video and books- is likely to limit margins and pricing power for both.

Thus, Amazon's Fire has accelerated the move of the tablets and their content toward commoditization. Good for consumers, not so great for investors in the providers of these services.
Interestingly, in his weekend Wall Street Journal column, Holman Jenkins, Jr. contended that the real reason for the demise of technology firms Microsoft and HP has been that their product lines are devoid of the social media content which Apple, Amazon, Google, and Facebook have so zealously and successfully pursued. Including, for the first three, developing special-application computers, a/k/a tablets and smartphones, which undercut general-purpose computers and emphasize media consumption.

Certainly, that's one view. But personal computers became commoditized some years ago- well before the rise of Facebook, social media and the general accessibility of media content via cheap, ubiquitous wireless connections.

Still, as I contended in today's companion post, competitive forces tend to affect every product/market, even if at different speeds.

Competition Eventually Visits Every Product/Market

I wrote a post last year involving History Channel programs featuring a pawn broker and two Iowa-based "pickers."

Both History Channel programs have already spawned competitors.

The pickers now have competition on Lifetime. The new series stars two pretty young Southern sisters, Tanya McQueen and Tracy Hutson, who call themselves Picker Sisters. They differentiate themselves by focusing on the storefront gallery they run, and how they envision transforming their derelict picks into trendy furnishings. Their refurbishment guy is often included to discuss how the piece will be treated to arrive at the sisters' desired look.

Unlike the Iowa pickers, Frank and Mike, who seem to mostly just recycle their picks as-is, the sisters' and their program seeks to engage buyers' and viewers' sense of style, fashion and interior decorating.

Pawn Stars has provoked a low-rent version of itself on another network. The name escapes me, but it's pretty much a direct rip-off, but with far less humor, drama and educational value.

But it just goes to show that, even with what you'd think would be fairly innocuous products, like quirky cable television special-interest programs, knockoffs arrive with surprising speed.

Monday, October 03, 2011

Regarding Low Volatility Stock Portfolios

Saturday's edition of the Wall Street Journal contained a long, prominent article extolling the virtues of so-called low-volatility equity portfolios entitled, somewhat immodestly, Beat the Market- With Less Risk.

It's a piece that runs the equivalent of a full Journal page. Suffice to say, the title makes the major claim. Never mind that risk, which is what the piece claims is minimized, isn't the same as volatility, though the latter is what is actually minimized. Here are some of the piece's key passages,

"But what if there were a way to beat the stock market's returns over the long haul with significantly less short-term instability?

More surprising, however, is that the Low-Volatility Index has returned 80% during the past 10 years, compared with the S&P 500's 42.9%, assuming reinvested dividends. Go back 20 years, a period that includes most of the go-go 1990s, and the index has beaten the S&P 500 by about 180 percentage points, according to S&P, which set up the Low Volatility Index in April.

The success of low-volatility investing flies in the face of what most investors consider the central axiom of investing: the greater the risk, the greater the reward.

The low-volatility strategy has some downsides. The biggest: It can underperform badly when the overall market is rising. That is because investors tend to pile into riskier stocks during big rallies. For example, the S&P Low-Volatility Index approach gained only 19.2% in 2009, compared with 26.5% for the S&P 500.

Sometimes the market can rally for long stretches, making the pain of missing out even worse. Low-volatility stocks gained 126% for the eight years leading up to the dot-com peak in March 2000, for example—less than half of the S&P 500's 307% rise.

The upshot: Investors who embrace this strategy should be focused on the long term.

"You need to have an honest conversation with yourself," says Joe Wolfe, director of quantitative research at Northern Trust in Chicago. "You have to be able to live with the results."

Yet even if market sentiment turns to riskier assets, investors aren't likely to lose money, says Pim van Vliet, a senior portfolio manager at Robeco—they will underperform only until the next bout of risk aversion. "If your neighbor earns a lot of money, you may feel poor," Mr. van Vliet says. "But if you look at what you can do with your money, you'll feel rich." "

Let's take the points in order.

It's usually most helpful to describe equity strategy performance in terms of a timeframe, its gross or net basis, and a compounded or arithmetic average annual over the period. Thus, it's not clear just what the average annual differences are between the S&P Low Volatility Index and the S&P500 Index. The claim of performance difference of "180 percentage points" over the past twenty years is even more difficult to assess, as it is a single net figure. I happen to know, though, from some recent work, and Penn's noted finance professor, Jeremy J. Siegel's remark on the exact same phenomenon, that the past 20 years of the S&P500 performance are the same as its long-run average, which is a bit over 11% per year, gross. No dividend reinvestment, which distorts results.

So to suggest that the past two decades are unusual is wrong. But it's hard to know precisely what the claim means, compressing so much information into literally a single net performance number.

All of those performance statistics omit what I have learned, from experience in the industry, is among the most important characteristics which institutional investors use to evaluate equity strategies- the duration and magnitude of so-called drawdowns. These are the periods during which a strategy continues to underperform relative to its benchmark, on a monthly basis.

Simply stating that a low volatility strategy outperforms the S&P by 180 percentage points over 20 years tells us nothing about how consistent that performance was. How badly it trailed the S&P500, cumulatively, at its worst point. This is important information for several reasons.

First, consistency has a value. And inconsistent approach which has a few runs of extreme outperformance isn't as valuable as a more consistent approach which may have a lower average annual return.

Second, inconsistency, or volatility of returns, especially posting negative absolute or relative (to the benchmark) returns, is precisely the sort of performance which leads investors to suspect a strategy no longer works, and abandon it. That's why the exclusive use of backtesting can mislead. Without any live data, including, if appropriate, redemptions, it's impossible to know whether real investors would have calmly absorbed losses and remained invested in a strategy.

The next point, that there is some proven relationship between all returns and risks, is simply false. My own proprietary equity strategy has outperformed the S&P500 by more than two-fold, on a gross basis, over the past twenty years, with considerably lower volatility. I'm not alone in managing to do this. Those equity managers who really find niches of superior performance deliver less volatility, while the mainstream subjective horde of stock pickers and index-shadowers typically do not.

The last general point of the passages concerns the lower returns the low volatility equity portfolio approach earns during periods of rising markets.

The fact is that, over the long term, the S&P500 rises about 2/3 of the time, on a monthly basis. And it earns more in a positive month, in absolute magnitude, than it typically loses in a down month.

Moreover, volatility has risen, and fallen, by my proprietary measure, frequently over the past decades. The article discusses volatility as if it's a contemporary, observable phenomenon. It isn't. Often the specific nature of market volatility- its duration and magnitude- isn't really clear until a good way through a bout of either high or low volatility. On a monthly basis, which is how most portfolio performances are measured, and often investment decisions made, fairly typical market turbulence may be indistinguishable from unusually high volatility for a while.

Thus, between potentially switching in and out of the low volatility approach, and getting timing wrong, and the cost of actively running such an approach, it may not be the panacea which the Journal article suggests.

Moreover, comparing such a strategy to a purely passive S&P500 Index return isn't strictly correct, either. The latter, when used as a primary equity investment vehicle such as the Vanguard S&P500 Index fund, is typically invested monthly for a dollar-averaging effect. That makes the raw S&P 500 return no longer equal what a typical investor is realizing. Thus the need for a more detailed performance comparison than one or two net returns over a long period with no assumptions explicitly stated.

However, as I've explained to inquiring colleagues recently, if you're dollar-averaging a passive S&P index fund already, you can do even a little better with this simple tactic. If the S&P has risen above its long term average rate for the past few prior months, invest less than your average monthly target. If it's been underperforming its long term average for the past few months, invest a little more than your target monthly amount. For investors with a long time horizon, this effectively adds more investments when the S&P is relatively lower, and less when it's higher, thus providing a little more return on the same passive index stream. What's actively managed is the amount of investment each month, not the equities in the fund.

I'm frankly surprised that the Journal ran this article without some sort of rigorous academic test of the implicit hypothesis that a low volatility strategy is superior to the S&P500 Index. And a test involving more than just backtesting.

Call it what you will, a low volatility approach is a cousin of the long-discussed low-beta approach. As the article mentions, then dismisses, if such a simple, long-known effect really exists, you can bet it would have been exploited into triviality long ago.

In summary, I found the Journal's piece on low volatility equity strategies, while interesting, to be far short of conclusive. And entirely lacking in the rigor appropriate to include a section providing detailed advice and options for actively implementing such an approach..