High RS Diffusion Index

March 28, 2017

The chart below measures the percentage of high relative strength stocks (top quartile of our ranks) that are trading above their 50-day moving average (universe of mid and large cap stocks.)  As of 3/27/17.

diffusion 03.28.17

The 10-day moving average of this indicator is 69% and the one-day reading has pulled back to 57%.

The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.  Investors cannot invest directly in an index.  Indexes have no fees.  Past performance is no guarantee of future returns.  Potential for profits is accompanied by possibility of loss.

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Think Global to Avoid Shrinking U.S. Stock Market

March 27, 2017

Ben Carlson, quoting research from Dimson, Marsh and Staunton in their Global Investment Returns Yearbook 2017, has some fascinating stats on worldwide publicly listed companies today versus just 20 years ago.

According to CRSP data, there were more than 9,100 U.S.-listed public companies in 1997. Today, that number is down to slightly more than 5,700. The Wilshire 5000, an index used as a proxy for all U.S. securities with readily available pricing data, holds just over 3,600 stocks as of the start of this year, down from more than 7,500 in 1998. So the number of stocks that trade on the exchanges has basically been cut in half over the past 20 years or so. There are a number of reasons for this change — increased regulations to go public, fewer IPOs, lax anti-trust laws, venture-backed companies staying private longer and a winner-takes-all marketplace in many industries.

Investors are worried that the shrinkage in the number of U.S. companies means that wealth and the markets themselves are becoming more concentrated in fewer and fewer hands. Fewer investment options could make it harder for investors to find adequate investment opportunities. For those investors who share these worries my advice would be to look abroad for more investment opportunities. While U.S.-listed companies have seen their ranks diminish since the 1990s, there are now more public companies than ever worldwide.

According to Dimensional Fund Advisors, the number of companies listed on global stock market exchanges has increased from about 23,000 in 1995 to 33,000 by the end of last year. So while the number of companies in the U.S. has shrunk the number of companies worldwide has exploded.

These are very important trends that have a variety of meaningful implications for investors.  As it relates to international equity exposure, more choices can be a good thing if investors have a logical framework to analyze this broad universe of securities.  We are partial to using relative strength to evaluate any given universe of securities, but perhaps the rationale for doing so is even greater for international equities.  It is one thing for a fundamental analyst to become an expert in U.S.-listed securities.  There is a common currency, one government, one set of regulations, and so on, but when it comes to international equities, an investor is dealing with much, much greater complexity of fundamentals.  However, for a relative strength-driven strategy, it always comes back to price, which makes international investing no more complicated than investing here in the U.S. from a portfolio construction perspective.

John Lewis, our Senior Portfolio Manager, did an interview with HedgeWeek recently in which he delved into more of the reasons why we think there are so many opportunities when it comes to international equities.  That interview focused on why we think ADRs are a great way for US investors to get this exposure.

This trend of more and more securities being listed abroad and fewer here in the U.S. is something that should be a topic of conversation with your clients.  Being able to provide them with some strong options for international equities is another important way that you can help them navigate growing global investment opportunities.

The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.  There are risks inherent in international investments, which may make such investments unsuitable for certain clients. These include, for example, economic, political, currency exchange, rate fluctuations, and limited availability of information on international securities.

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Tom Dorsey and John Lewis on AdvisorShares AlphaCall

March 21, 2017

Click here for a replay of their recent conversation on our International strategy, available as AADR and as an SMA.

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Relative Strength Spread

March 21, 2017

The chart below is the spread between the relative strength leaders and relative strength laggards (top quartile of stocks in our ranks divided by the bottom quartile of stocks in our ranks; universe of U.S. mid and large cap stocks).  When the chart is rising, relative strength leaders are performing better than relative strength laggards.    As of 3/20/17:

rs spread

The RS Spread has declined for most of the past 12 months as the RS laggards have performed better than the RS leaders, but that dynamic appears to be changing.  The RS Spread has now moved above its 50 day moving average, a potentially positive development for relative strength strategies.

The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.  Past performance is not indicative of future results.  Potential for profits is accompanied by possibility of loss.

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Process over Short-Term Outcome

March 20, 2017

Jim O’Shaughnessey, author of What Works on Wall Street, recently wrote about 7 traits that he believes are required for active investors to win in the long run.  I fully agree with all 7, but I found #2 on his list to be particularly compelling:

2. Successful Active Investors Value Process over Outcome.

“If you can’t describe what you are doing as a process, you don’t know what you’re doing.”

~W. Edwards Deming
The vast majority of investors make investment choices based upon the past performance of a manager or investment strategy. So much so that SEC Rule 156 requires all money managers to include the disclosure that “past performance is not indicative of future results.” It’s ubiquitous–and routinely ignored by both managers and their clients. In keeping with human nature, we just can’t help ourselves when confronted with great or lousy recent performance. “What’s his/her track record?” is probably investors’ most frequently asked question when considering a fund or investment strategy. And, as mentioned above, the vast majority of investors are most concerned with how an investment did over the last one- or three-year period.

Yet successful active investors go further and ask “what’s his or her process in making investment decisions?”  Outcomes are important, but it’s much more important to study and understand the underlying process that led to the outcome, be it good or bad. If you only focus on outcomes, you have no idea if the process that generated it is superior or inferior. This leads to performance chasing and relying far too much on recent outcomes to be of any practical use.  Indeed, shorter-term performance can be positively misleading.

Look at a simple and intuitive strategy of buying the 50 stocks with the best annual sales gains. Consider this not in the abstract, but in the context of what had happened in the previous five years:

Year                            Annual Return            S&P 500 return

Year one                      7.90%                          16.48%

Year two                     32.20%                        12.45%

Year three                   -5.95%                         -10.06%

Year four                     107.37%                     23.98%

Year five                     20.37%                        11.06%

Five-year

Average Annual

Return                         27.34%                        10.16%

$10,000 invested in the strategy grew to $33,482, dwarfing the same investment in the S&P 500, which grew to $16,220. The three-year return (which is the metric that almost all investors look at when deciding if they want to invest or not) was even more compelling, with the strategy returning an average annual return of 32.90% compared to just 7.39% for the S&P 500.

Also consider that these returns would not appear in a vacuum—if it was a mutual fund it would probably have a five star Morningstar rating, it would likely be featured in business news stories quite favorably and the long-term “proof” of the last five years would say that this intuitive strategy made a great deal of sense and therefore attract a lot of investors.

Here’s the catch—the returns are for the period from 1964 through 1968, when, much like the late 1990s, speculative stocks soared. Investors without access to the historical results for this investment strategy would not have the perspective that the long term outlook reveals, and thus might have been tempted to invest in this strategy right before it went on to crash and burn. As the data from What Works on Wall Street make plain, over the very long term, this is a horrible strategy that returns less than U.S. T-bills over the long-term.

Had an investor had access to long-term returns, he or she would have seen that buying stocks based just on their annual growth of sales was a horrible way to invest—the strategy returned just 3.88 percent per year between 1964 and 2009! $10,000 invested in the 50 stocks from All Stocks with the best annual sales growth grew to just $57,631 at the end of 2009, whereas the same $10,000 invested in U.S. T-Bills compounded at 5.57 percent per year, turning $10,0000 into $120,778. In contrast, if the investor had simply put the money in an index like the S&P 500, the $10,000 would have earned 9.46 percent per year, with the $10,000 growing to $639,144! What the investor would have missed during the phase of exciting performance for this strategy is that valuation matters, and it matters a lot. What investors missed was that these types of stocks usually are very expensive, and very expensive stocks rarely make good on the promise of their sky-high valuations.

Thus, when evaluating an underlying process, it’s important to decide if it makes sense. The best way to do that is to look at how the process has fared over long periods of time. This allows you to better estimate whether the short-term results are due to luck or skill. We like to look at strategies rolling base rates—this creates a “movie” as opposed to a “snapshot” of how strategies perform in a variety of market environments.

This is a philosophy you’ve repeatedly heard from us as well.  Short-term outcomes are important, but process ultimately determines long-term results.  Among the ways that this can be illustrated is by looking as some of our white papers on relative strength investing.  John Lewis’ white paper, Point and Figure Relative Strength Signals detailed the long-term investment results of a relative strength process that took 1,000 U.S. stocks and categorized them into one of four portfolios based on their PnF relative strength signal (BX-buy signal and in a column of X’s; BO–buy signal and in a column of O’s; SX—sell signal and in a column of X’s; or SO—sell signal and in a column of O’s).  Portfolios were equal-weighted and rebalanced on a monthly basis.  Performance of these four portfolios from 12/31/1989 to 12/31/2015 is shown below.  As detailed in the paper, following a disciplined process of investing in stocks with the highest momentum (BX portfolio) generated significant outperformance over this test period.

base rates

Click here for disclosures

Long-term success with active management comes from doing sufficient due diligence to either design a robust investment process yourself (or to employ one designed by someone else) and then to execute, execute, execute.  If the process is sound, long-term outcomes should take care of themselves.

The performance above is based on total return, inclusive of dividends, but does not include transaction costs.  Past performance is not indicative of future results.  Potential for profits is accompanied by possibility of loss.  The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.  Some performance information presented is the result of back-tested performance.  Back-tested performance is hypothetical and is provided for informational purposes to illustrate the effects of the strategy during a specific period. The hypothetical returns have been developed and tested by DWA, but have not been verified by any third party and are unaudited. Back-testing performance differs from actual performance because it is achieved through retroactive application of a model investment methodology designed with the benefit of hindsight. Model performance data (both backtested and live) does not represent the impact of material economic and market factors might have on an investment advisor’s decision making process if the advisor were actually managing client money.  Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.

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False Sense of Security with Passive?

March 14, 2017

Peter Chiappinelli in Advisor Perspectives sheds some interesting light on the active versus passive debate as it relates to fixed income exposure.  See below for a few excerpts of his recent article.

The trends are clear. 2016 was the year in which the investment community warmly embraced passive portfolios. Our worry, however, is that investors are feeling a false sense of security, particularly with passive bond portfolios–namely those funds and Exchange Traded Funds (ETFs) linked to a common benchmark, the Bloomberg Barclays U.S. Aggregate Bond Index (the Agg). There is nothing passive about this index, and we would argue it is aggressively taking on more risk at the worst possible time. There are three main reasons for our concern: the simple math of bond duration; the changing composition of the index; and the very logical financing behavior of corporate borrowers.

Bond math and duration

Without doing a rehash of intricate bond math, duration is an important calculation of bond risk. Though it has many variants, at its root duration measures the sensitivity of a bond’s price to a shift in yields. For example, a bond (or a bond portfolio) with a duration of 5 years means that for every 1% shift upwards in yields, there is a 5% drop in the price of the bond. Duration is measured in years because it is a function of the timing and magnitude of a bond’s cash flows (coupons and principal repayment): the more distant the cash flows, the higher the sensitivity (i.e., higher risk) to a change in interest rates, all else held equal. The cleanest example of this is the 30-year zero-coupon bond, which pays a single massive cash flow 30 years down the road, and therefore this bond has a duration of exactly 30 years. There are no coupon payments along the way that would dampen its sensitivity to a change in yields. Generally speaking, the smaller the coupon, the higher the duration (and vice versa); the longer the maturity, the higher the duration (and vice versa). That’s just how the math of bond risk works.

Unfortunately for investors in passive bond portfolios or ETFs tied to the Agg, bond math is making this “safer” bond portfolio much riskier than it was even a few years ago. It is now much more sensitive to a possible rise in bond yields (as we saw in November) due simply to a lower “cushion” of coupons. As shown in the chart below, coupons have dropped dramatically since the Financial Crisis of 2008 and the introduction of Quantitative Easing by the Federal Reserve (Fed). For many years leading up to 2008, the Agg happily paid its investors a healthy coupon of over 5%, but today it is a measly 3%, a number that is among some of the lowest ever recorded. This is problem number one.

coupons

Changing composition of the Agg

Problem number two is that the Agg has dramatically changed its stripes since the Financial Crisis. Eight years ago, the largest bond sector was securitized loans (e.g., asset-backed securities, mortgage-backed securities), and most of these types of securities have shorter maturities and duration. Today, longer-dated Treasuries are now the dominant sector of the Agg, while securitized bonds have dropped off significantly. This, again, has shifted both the maturity and duration of the Agg upward.

Click here for the rest of Chiappinelli’s article, but following paragraph is a nice conclusion to his analysis:

The bond math of lower coupons, the changing composition of the Agg, and the issuance of longer-maturity bonds by corporate America all conspired to increase risk, at possibly the worst time. By any reasonable fiduciary standard, this was a time to be reducing duration, yet the Agg, and the passive bond portfolios and ETFs tied to it, has seen a 62% increase in duration over the past 8 years. There is nothing passive about the Agg–it has actually become more aggressive! Be careful.

Contrary to popular belief, passive does not necessarily mean static.  The composition of the Aggregate Bond Index has changed dramatically over time and this has important implications for its investors.  Part of the reason that we introduced our Tactical Fixed Income portfolio (available as a separately managed account) in 2013 is that we thought that we were likely  entering a period of time where active could be increasingly important in the fixed income space.  See below for the FAQ on this strategy:

Why is there a need for Tactical Fixed Income?

Bond buyers face a dilemma. Yields are very, very low. If interest rates stay low this low, bondholders are facing minimal returns, all the while having those returns eaten away by inflation. If interest rates rise, bondholders are facing potentially significant capital losses. Both outcomes, obviously, are problematic. This situation demands a tactical solution that can manage through either outcome.

At Dorsey Wright, we have taken our time-tested relative strength tools and have applied them in a unique way to the fixed income markets. This solution is now available as a separately managed account. We think it will be welcome news for bond holders and prospective bond buyers who are grappling with the current bond market dilemma. Equally important, we think it will be a robust solution in the future across a broad range of possible interest rate environments.

What is the investment universe for the Tactical Fixed Income strategy?

The Tactical Fixed Income strategy can invest in short-term and long-term U.S. Treasurys, inflation-protected bonds, corporate, convertible, high yield, and international bonds. This is a broad universe of fixed income types that have varying yields and volatility characteristics.

How is the risk managed in the Tactical Fixed Income portfolio?

The Tactical Fixed Income model structures the portfolio in a way that balances risk and reward. Certain types of fixed income behave better in “risk-on” environments, while other fixed income categories are more defensive. Our model is built to ensure that the portfolio remains diversified. It’s very important to understand that this is designed as core fixed income exposure. We’re trying to generate good fixed income returns, without creating equity-like volatility.

Our model compares the relative strength of all of the ETFs in the investment universe. Those fixed income sectors exhibiting the strongest trends will be represented in the portfolio.

How does the strategy handle a rising rate environment?

Although the general trend of interest rates has been down over the past three decades, there have been periods where rates have generally risen. The period of mid-2003 to mid-2007 was generally a period of rising interest rates, while the period of mid-2007 to late 2016 was generally been a period of declining interest rates. Sectors like long term government bonds tend to perform much better in a declining interest rate environment while sectors like convertible bonds tend to perform much better during rising rate environments.

Our Tactical Fixed Income strategy is designed to be adaptive and seeks to add value in both environments.

Will the strategy invest in inverse bond ETFs?

We do not use inverse bond ETFs in the portfolio due to the cost of carrying the short positions, which includes the management fees of the ETFs as well as paying out the interest payments while you own these funds. However, a rising rate environment typically is accompanied by a strong economy. We do have ample ability to have exposure to sectors of the fixed income market, like high yield, international, and convertible bonds, that may perform well during these environments.

How has the strategy performed since it was introduced in March 2013?

We have been pleased with the performance of this strategy.  As shown below, it has outperformed the Barclays Aggregate Bond Total Return Index since inception:

TFI performance

As of 2/28/17

To receive the fact sheet for this portfolio please e-mail andyh@dorseymm.com or call 626-535-0630.

Net performance shown is total return net of management fees for all Dorsey, Wright & Associates accounts, managed for each complete quarter for each objective. The advisory fees are described in Part II of the adviser’s Form ADV. All returns since inception of actual Accounts are compared against the Barclays Aggregate Bond Index. A list of all holdings over the past 12 months is available upon request. The performance information is based on data supplied by the Manager or from statistical services, reports, or other sources which the Manager believes are reliable. There are risks inherent in international investments, which may make such investments unsuitable for certain clients. These include, for example, economic, political, currency exchange, rate fluctuations, and limited availability of information on international securities. Past performance does not guarantee future results. In all securities trading, there is a potential for loss as well as profit. It should not be assumed that recommendations made in the future will be profitable or will equal the performance as shown. Investors should have long-term financial objectives when working with Dorsey, Wright & Associates.

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International Climbs the Ranks

March 6, 2017

While the bull market in U.S. equities is capturing plenty of headlines, perhaps less well understood is the strength taking place in International equities. Dorsey Wright’s main asset allocation tool, Dynamic Asset Level Investing (DALI), ranks six asset classes based on their relative strength. As shown below, U.S. equities remain firmly in first place, but International equities currently finds itself in the number two spot.

The whole point of a tool like DALI is to be able to identify asset classes that are in favor as well as asset classes that are out of favor so an investor’s portfolio can be positioned to capitalize on those trends.

dali

Source: Dorsey Wright, 3/2/17

The chart below shows the historical rank of International equities in DALI. As shown below, it wasn’t all that long ago that International equities was ranked dead last. Over the last year, this asset class has made a powerful move higher.

int'l_dali

Source: Dorsey Wright, 3/2/17, based on monthly tally ranks

Chances are good that your clients have a healthy allocation to U.S. equities, but are they currently light on exposure to International equities? If so, we have a suggestion for how you go about getting that exposure for your clients.

On March 31, 2006 we launched our Systematic Relative Strength International Portfolio that was designed to start with an investment universe of ADRs from developed and emerging markets, small, mid, and large cap stocks and then to evaluate that universe based on our relative strength model. Our model seeks to overweight strong sectors and to underweight weak sectors. It also makes its buy and sell decisions by relative strength rank. Stocks are bought from the top quartile of our ranks and they are sold when they fall out of the top half of our ranks. It is a disciplined trend following approach to international equity exposure. The results have been something that we have been very proud of. See below for details:

intl 1

intl 2

As of 2/28/17.

This portfolio is available on a large and growing number of SMA and UMA platforms. To receive the fact sheet for this portfolio, please call 626-535-0630 or e-mail andyh@dorseymm.com.

The performance represented in this brochure is based on monthly performance of the Systematic Relative Strength International Model. Net performance shown is total return net of management fees, commissions, and expenses for all Dorsey, Wright & Associates managed accounts, managed for each complete quarter for each objective, regardless of levels of fixed income and cash in each account. The advisory fees are described in Part 2A of the adviser’s Form ADV. The starting values on 3/31/2006 are assigned an arbitrary value of 100 and statement portfolios are revalued on a trade date basis on the last day of each quarter. All returns since inception of actual Accounts are compared against the NASDAQ Global ex US Index. The NASDAQ Global ex US Index Total Return Index is a stock market index that is designed to measure the equity market performance of global markets outside of the United States and is maintained by Nasdaq. A list of all holdings over the past 12 months is available upon request. The performance information is based on data supplied by the Manager or from statistical services, reports, or other sources which the Manager believes are reliable. There are risks inherent in international investments, which may make such investments unsuitable for certain clients. These include, for example, economic, political, currency exchange, rate fluctuations, and limited availability of information on international securities. Past performance does not guarantee future results. In all securities trading, there is a potential for loss as well as profit. It should not be assumed that recommendations made in the future will be profitable or will equal the performance as shown. Investors should have long-term financial objectives when working with Dorsey, Wright & Associates.

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Relative Strength Spread

March 2, 2017

The chart below is the spread between the relative strength leaders and relative strength laggards (top quartile of stocks in our ranks divided by the bottom quartile of stocks in our ranks; universe of U.S. mid and large cap stocks).  When the chart is rising, relative strength leaders are performing better than relative strength laggards.    As of 3/1/2017:

spread

The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.  Past performance is not indicative of future results.  Potential for profits is accompanied by possibility of loss.

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Ever-Increasing Efficiency

March 1, 2017

For those of you who have been in this business for a decade or longer, how much more efficient is your business today than it was when you began?  I suspect that the answer to that question is “much more efficient.”  Why?  Because those advisors who failed to innovate and streamline their business are likely already on to a different career.  We are all aware of just how much competition there is in this industry and have seen the general trend in lower fees and increased automation.  Yet, in my humble opinion, there is still no better place to be.  In fact, for the advisor who is on the right side of these trends, who continues to find ways to operate more efficiently, and continues to increase their value proposition to their clients, the future is as bright as ever.

While recently reading Martin Ford’s book Rise Of The Robots, I came across the following passage which speaks to the pace of innovation and ever-increasing efficiency in our economy.

In 1988, workers in the US business sector put in a total of 194 billion hours of labor.  A decade and a half later, in 2013, the value of the goods and services produced by American businesses had grown by about $3.5 trillion after adjusting for inflation—a 42 percent increase in output.  The total amount of human labor required to accomplish that was…194 billion hours.  Shawn Sprague, the BLS economist who prepared the report, noted that “this means that there was ultimately no growth at all in the number of hours worked over this 15-year period, despite the fact that the US population gained over 40 million people during that time, and despite the fact that there were thousands of new businesses established during that time.”  (Shawn Sprague, “What Can Labor Productivity Tell Us About the U.S. Economy?,” US Bureau of Labor Statistics, Beyond the Numbers 3, no. 12 (May 2014)

Kind of amazing, isn’t it?  42% more output with the same amount of human labor.  As you look at your business today, what parts need to become more efficient?  Marketing, reporting, compliance, investment management, customer service, client onboarding?  Perhaps, a little of all of the above?  While we don’t profess to be all things to all people here at Dorsey Wright, we can make a major impact on your investment management process.

Let me suggest 3 ways that Dorsey Wright can help your business become more efficient.  This is by no means an exhaustive list, but it does include some which I believe to have the most potential to take your business to the next level.

  1. Become an expert in implementing one or more of the following tools across your client portfolios: Team Builder (to employ a process for defining your investment inventory and then building a diversified allocation while selecting best of class funds), Portfolios (to track your current holdings and to receive alerts when any of those holdings fall below an acceptable technical attribute of fund score), Tactical Tilt (to enable tactical shifts within strategic boundaries), Models (to put to work pre-built sector rotation, fixed income rotation, or country rotation models),  Matrix Plus (to facilitate the automation of buy and sell decisions based on relative strength rank within a customized investment universe).  Each of the above tools are scalable, giving you the opportunity to provide world class investment management in a time-efficient manner.
  2. Leverage the expertise of Dorsey Wright’s Systematic Relative Strength Portfolios.  Perhaps, part of becoming more efficient for your business is to outsource some of the investment management to a 3rd party money manager–especially to one whose investment process is one that you believe in.  Click here to see a list of SMA/UMA platforms where these portfolios are currently available.  E-mail andyh@dorseymm.com to receive the brochure.
  3. Leverage the expertise of Dorsey Wright through the use of ETFs or mutual funds which DWA is involved in managing.  Click here for the list of options.  These products give you turn-key access to relative strength strategies, driven by Dorsey Wright’s global technical research.

I suspect that that success as a financial advisor in the future will require the capability to continually streamline your investment management process in a way that is clearly differentiated from the competition.  Dorsey Wright research tools and managed products can be instrumental and foundational in that effort.

The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.

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