Quiet the Noise – Listen to the Data

Below you will find a “temperature reading” on the market and the risk level on the “field.”

Relative Strength Line Up of the Asset Classes:

Q1 2016 Asset Scale Activity:

  • Most activity in the Asset Scale since 2011
  • Domestic Equities/Stocks fell from #1 to #3 and have moved back up for a 2nd place tie with CASH
  • Commodities have moved up from last place to #5, the first move off bottom since June 2012, hence Gold’s impressive Q1 +16% 


4/15/2016 Status:

  • #1 Asset Class:  Bonds/Fixed Income
  • #2 Asset Class:  Stocks/Domestic Equities 
  • Market Status:  BULL MARKET
  • NYSE Bullish Percent (NYSE BP):  OFFENSE @ 61% Reversed up @ 27% on 2/1/2016.  

What Contributed To the Market Performance Last Quarter:

A Dramatic Whipsaw in Equities Adds to Relative Strength Underperformance

The quarter and the year began with the worst 10-day start to a year in the history of the Dow Jones Industrials dating back to 1897. Panic about the slowdown in China and crashing oil prices sent the Dow from above 17,200 to under 16,000.

Dow chart worst start

To say the year got off to a rocky start would be a gross understatement. After the holidays ended and everyone returned to work, the stock market experienced a sharp selloff that left it in negative territory for January. The market would eventually bottom out in mid-February and continue to recover through the end of the quarter. Despite the early selloff, the S&P 500 actually finished up 0.77% for the quarter. Small Cap and International stocks were not immune to the sell-off as well, as both of those categories finished in negative territory for the first three months of the year. While most areas in the equity space rallied near the end of the quarter, it still wasn’t enough to push them out of the red. Fixed Income and interest rate sensitive securities were some of the best performing areas during the first quarter, with broad bond market indexes finishing up about 3%. Commodities, in general, also finished the quarter in negative territory, but put in a solid showing in the second half of the quarter, helping to stop the relentless slide they had been on since last year. All in all, while our allocations played our cards right; overweight bonds and cash underweight stocks and dipping our toe back into the commodity pool, the results were not overwhelming, as one would expect when you’ve followed the rules and the rules were right.

Looking at the summary numbers for the first quarter might have lead you to believe it was a ho-hum first three months of the year, but that was certainly not the case. We saw a tremendous amount of rotation under the surface. The overarching theme for our investing style was that the laggards finally had their day in the sun. Simply put, the stocks and asset classes that had been leading the market lower since last summer finally stopped going down and actually went up a lot from the lows. This is known as a laggard rally. These laggard rallies come along every so often and everyone realizes the leaders can’t lead forever so we view these periods as an opportunity to refresh the portfolios and find new leadership. More importantly, they don’t cause a change in our strategy.  We can look to remove old leadership and our process tries to find the emerging leadership.

This past quarter, we saw a weakening dollar asset, and strength in Gold. For the first time since 2013, we find Gold back in our Models as of February. This position is a prime example of how and when we will lag the market, in the short-run, due to our tactical, NOT timing nature.  

Despite Gold’s (GLD) robust performance in January and YTD given its longer-term weak performance since 2012 and its #6 position on the Asset Scale (having been there for almost 3 straight years), our rules required confirmation that we should own it. Confirmation in your terms means less whipsawing, which is almost always accompanied with short-term underperformance. 

How so?  February 8th, Commodities moved from the last position on the Asset Scale to #5, and on 2/12/16 we took a position in Gold which has been a flat trade thus far for our Models, yet GLD is up 15% YTD.  That is frustrating to all, yes, but in honoring risk, AKA confirmation, we give up short-term performance. Gold will continue to be a safe haven and I suspect will continue add to the bottom line in 2016.  

Why?  The strong dollar had caused quite a headwind for assets such as international equities and commodities, which generally do better in a weak dollar environment. If the dollar continues to weaken, we expect to see more of these types of assets come into our models as their performance improves visa vie other asset classes that have benefited from the strong dollar. That would actually be a welcome change as it would allow our strategies to do what they do best: find bull markets anywhere around the globe (and in places many people are overlooking).

On the individual equity side, it was much the same as the asset class side. The so-called FANG’s (Facebook, Amazon, Netflix, and Google) were stellar performers last year, but had a difficult start to the year. What really performed well were the things like energy and basic materials that had such dreadful performance last year. One example of this is when we look at the S&P 500 industry groups. The worst relative strength groups outperformed the best performing group by more than 12% during the first quarter! That was completely opposite from last year when just avoiding the worst groups was the key to outperformance. Whether these groups can continue to perform is anyone’s guess, but often times they have a large rally off the bottom and then settle in as average performers while they work out their issues.

Every investment strategy, whether it’s value investing, growth investing, or trend following goes through periods of underperformance, and relative strength (RS) is no exception.  Periods where RS lags can be uncomfortable times in the market, and the recent market activity is an unfriendly reminder of this.  The latter part of 2015 into the beginning of 2016 has been a great example of when we typically see these types of market environments. Certainly, one of the times that RS will experience underperformance is off of a market bottom, and another environment would be times of leadership change.

A Relative Strength Market Bottom Study:

At the risk of another lengthy chart-chocked and data filled newsletter, I wanted to share this RS study from Dorsey Wright and Associates. It delves into our last market bottom example of 2009 and attempts to explain WHY we should hold tight with a RS strategy.

Relative Strength Laggard Period Perspective, DW&A 3/31/2016

The 2009 market bottom, and initial rally, was the epitome of an RS laggard period for stocks.  In general, the stocks that performed the worst heading into the market bottom were the stocks that rebounded the quickest off the market bottom. 

In order to get a sense of RS laggard periods over the past eight plus years, we looked at the rolling six month excess returns of the PowerShares DWA Momentum Portfolio PDP versus the S&P 500 Index SPX.  PDP is an ETF based on the DWA Technical Leaders Index which owns 100 of the top RS stocks, and rebalances and reconstitutes quarterly. This ETF provides a good gauge of how a basket of high RS stocks are doing and has a live trading history going back to March 2007. This recent “trend” in underperformance in RS stocks is the worst that we have seen since the late 2008 / early 2009 time period based on rolling six month excess returns. While periods of underperformance like this are not common, they are not unprecedented.  And, as difficult as they feel, periods of underperformance are sometimes the best times to add to these types of strategies because these are often the times when the strategies are adapting to the new leadership trends in the marketplace.  Notice, for instance, coming out of the 2009 time period, PDP displayed positive excess rolling six month returns for nearly two years from November 2009 through August 2011. 

Momentum ETF

The returns used above are not inclusive of dividends or all transaction costs.  Investors cannot invest directly in an index.  Indexes have no fees.  The relative strength strategy is not a guarantee.  There may be times where all investments are unfavorable and depreciate in value.  Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.  

Another strategy is sector rotation.  One way to track RS sector rotation is with the Focus Five Sector Rotation Model, which owns five of the top RS sectors within the First Trust lineup for sectors. This Model was first published in late-October 2009, and a similar analysis based on rolling six-month excess returns versus the S&P 500 Index SPX shows an interesting story, and also shows the recent underperformance we have all been feeling in RS-based strategies. Since the end of October 2009, there were 72 rolling six-month periods examined in the chart below.  Out of these 72 periods, 46 have resulted in positive excess returns over that six-month period.  For instance, the data point on the chart below at 12/31/2014 would represent the excess return over the six-month period of 6/30/2014 thru 12/31/2014.  So, another way of stating the above would be to say that every month money is allocated to this strategy there has been a 64% probably of excess return of the next six months. The reality about RS strategies, though, is that the numbers don’t necessarily work out that cleanly. 

The resulting “trend” in rolling excess returns has been negative, the worst stretch this Model has seen since 2011, and this comes on the heels of a year and a half of positive excess return periods. That is the bad news. The good news is that many of the same reasons for the underperformance in 2011 are the same reasons for underperformance in recent times, and the biggest reason would be turnover.  Since the history of the Model (10/21/2009 – 3/30/2016) there have been nine changes in holdings. Out of those nine changes, five of those changes came in 2011 and four of those came from June 1st thru December 31st. In other words, in the six and half years of live model trades more than half came in 2011. Second only to 2011 is the year of 2016 in terms of model turnover, as 2016 has seen two changes in holdings in just the first three months.  Outside of 2011, this is the only year the Model has actually experienced multiple changes in one year. 

So, while market bottoms can present RS laggard periods (like 2009), market environments that see a lot of turnover also present periods of underperformance.  This occurs as the old leadership rotates out of favor (like Healthcare, for example) and the new leadership trends emerge (like Utilities and Energy).  There is no doubt this recent performance has been uncomfortable, and while not common it is not unprecedented. These bouts of underperformance often present great opportunities as the new leadership trends rise to the top.

Focus Five Model

The returns used above represent model returns and are not inclusive of dividends or all transaction costs.  Investors cannot invest directly in an index, like the S&P 500 Index.  Indexes have no fees.  Model performance data does not represent the impact material economic and market factors might have on an investment advisor’s decision making process if the advisor were actually managing client money. The relative strength strategy is not a guarantee.  There may be times where all investments are unfavorable and depreciate in value.  Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.  

Bottom Line:

Major Index YTD Performance thru 3/31/2016:

Major Index YTD Performance.png

Q2 Outlook – What’s In Store?

Let me be clear:  Abandoning our bias to RS strategies is NOT what’s next.  Its been a busy and an unfruitful year thus far, but history has proven in times like this, that this is precisely the time to stay the course.
Oil/Commodities:  I expect the uptrend in Energy and Commodities to continue. Add to that continued volatility with interest rate uncertainty and an Presidential election underfoot, and you guessed it, a conservative stance will take precedence over any FANG tech stock rally in all of our Models.  I expect May-October, which is seasonably a flat time in the market to be sideways in performance with high volatility. Same unpleasantly as we have seen YTD.  While equities now find themselves back into “overbought” territory, with a #2 position on the Asset Scale, we’re invested but we’re not fully invested just yet. I expect a pull back to occur soon and will use that as a time to re-adjust back to a market weight position in stocks.  
Cash:  Our Cash position has diminished by more than 50% with the rebound in equities and the second place tie on the Asset Scale, but with a continued cautious stance on the wind that this Bull Market “sail” may not have, we are on the sidelines ever so slightly to not only buffer our bond portfolios from rising interest rates, but also to buffer our equity portfolios from the aforementioned current overbought status.
International Equities:  While we are, for the most part, void international equities as they hold the #6 position on the asset scale.  I expect to see some added international exposure this quarter, in a minimal fashion.  As mentioned with a weakening dollar, emerging and developed markets abroad are trending up. And while international markets have offered less diversification from the US Market’s volatility in the last 2 decades, I welcome some international exposure to our heavy US bias we’ve had since last August.  
Fixed Income/Bonds: While the bond story continues to be a precarious one given the rising interest rate environment we find ourselves in, we give thanks to the Fed and Janet Yellen for a dovish/slow and steady stance to the past and pending hikes.  In the meanwhile, much work will continue to go into bond holdings as we continue to manage interest rate risk within an over-weighted segment of all portfolios. Young, old, risk-averse, risk taker — You own bonds given that they are the #1 ranked Asset Class.  Thankfully, our 3 bond models have performed in line and better than expected with returns of +2.87 to +8.4% YTD.
Other:  Dipping our toe back in the Master Limited Partnership (MLP) pool has, too begun, given the uptrend in Energy — but in a very small fashion.  This will add excess yield over our other low yielding bond holdings (and yes more volatility) and more importantly, diversification for our overweight stance in Bond holdings.  MLPs will not behave too similarly to bonds when the FED decides to make another move.  Alternatively, owning bond “substitutes” like MLPs and other low correlated vehicles is a big focus as we enter back into FED decision territory.   AMLP is a small part of our Aggressive Bond Model, but up 8% since we entered the position on 3/28/16.  (No K1s with AMLP you’ll be glad to know…)
What is always paramount to reiterate in this ever changing sea of leadership, asset classes, investment vehicles and volatility is that we remain disciplined to our process for the safety of your hard earned assets.  Thank you for your loyalty and trust in these uncertain times. Remembering that… YES, #wevegotyoumanaged.

Portfolio Changes:

One of my favorite sayings is “Performance measured is performance improved.”  I am constantly tuning our strategies, rules and models and measuring past performance in order to bring optimal risk-adjusted performance to our clients. After almost 3 years of due diligence, I will be increasing the number of Models that Darrin Cohen and his team at Infinite Asset Management (IAM) manages for us, in-house at Folio. 

Currently, IAM manages 7 of our 20 Models. IAM not only adds an extra layer of money management expertise, but also represents a way to diversify our 100% Pure RS strategy.  As you’ve read above, there are benefits to a pure RS strategy, but over a market cycle, opportunities exist for alternate strategies to outperform — and hence, compliment a RS approach.  IAM does employ RS, but also incorporates alternate tactical strategies beyond my expertise.  This is a strategic partnership worth mentioning and that we are excited about.

Furthermore, IAM brings a host of alternative options for our portfolios such as private equity and multi-strategy hedge fund options. 

New additions to the Q1 line-up:

A Utilities Model was added late January to several allocations resulting in YTD performance of +6.68%.  For those clients who don’t own the Utilities Model, never fear, you own RYU, the IShares Utilities ETF within your AV Core Model.  RYU is up nearly 12% since we added it to all portfolios.

Albeit Healthcare is having a bit of a comeback from its Q1 selloff, we cut our allocation to Healthcare in half in account and moved half to the abve mentioned Utilities Model.  Healthcare has moved considerably down the RS performance scale, but we remain in the space, in a limited manner, and in some portfolios we are void.

Resources, Resources, Resources!

Check out our Resources page at Alphavest.com and explore the many ways in which we are empowering investors.

A Snapshot of What’s There:

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