Systematic Relative Strength

Jeffrey Kleintop of LPL Financial has an interesting rebuttal to the argument that the market is overvalued:

At any given time, there are always some bubbly valuations among industries and stocks that are hot. But overall, the S&P 500 PE is currently a bit over 16 on current fiscal year estimates, slightly above the long-term average, but only half of what it was in late March 2000. Looking at valuations, compared to 14 years ago, the party in the stock market may not be just getting started — but it is not yet close to being over.

The whole article is worth the read.

Here is what John Lewis, our Senior Portfolio Manager, had to say about valuations in our quarterly letter to clients:

A lot of the volatility and rotation we have seen this year can be attributed to this current bull market turning 5 years old. The stock market has had tremendous gains since the bear market lows in 2009, and that has finally led to serious talk about stretched equity valuations. Some of the good momentum areas like solar stocks and biotechnology certainly fall into this theme, and were sold off during the last couple of weeks of the quarter as these concerns came to the forefront. These concerns surface as any bull market matures, and the truly strong stocks often perform very well long after the serious valuation discussions begin. As valuations become stretched, markets tend to focus more on growth opportunities. That is a positive for our strategies. Relative strength is very good at picking out high growth stocks. Yes, the overall market or certain pockets of the market may be pricey, but that doesn’t mean there aren’t well managed companies capitalizing on current trends that will continue to perform. That is often a great environment for our strategies.

The debate about valuation will rage on, but for momentum investors, having slightly stretched valuations may just be the environment where we can really shine.

PowerShares makes the case for increasing exposure to Europe generally and to PIZ in particular:

The DWA Developed Markets Technical Leaders Index has produced a strong track record of outperformance relative to major market cap-weighted European equity market indices and the MSCI EAFE. The Euro Stoxx 50, FTSE Developed Europe, and iShares MSCI EMU are benchmarks for European equity performance based on ETF volumes and flows, while the MSCI EAFE is regarded as an institutional benchmark for Developed World equity investment excluding the U.S. The tabel below highlights the ouperformance of the DWA Technical Leaders Index. The Index has produced a higher annualized return compared to its peers over the past five years outright and also on a risk adjusted basis given its higher Sharpe Ratio.

PIZ currently has 75% exposure to Europe:

Read the whole report here.

A 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 no guarantee of future returns. Potential for profits is accompanied by possibility of loss. Dorsey Wright & Associates is the index provider for The PowerShares DWA Developed Markets Momentum ETF (PIZ).

Good discussion here about sector relative strength by our analysts, Susan Morrison and Jay Gragnani. Their discussion made me think of this study, published in the NYT:

The soccer field has turned out to be a popular laboratory among economists, with penalty kicks a particular favorite.

Awarded after certain kinds of fouls, or sometimes to decide a championship match, a penalty kick pits one player against the goalkeeper. (Mano a pie instead of mano a mano, though, since the goalie is allowed to use his hands.)

Standing just 36 feet away, the kicker sends the ball hurtling at the goal at 60 to 80 m.p.h., giving the goalie just 0.2 to 0.3 second to respond. Given the speed, the goalkeeper has to decide what to do even before observing the direction of the kick. Stopping a penalty kick is considered one of the most difficult challenges in sports. Not surprisingly, 80 percent of all penalty kicks score.

For their study, Mr. Azar, along with Michael Bar-Eli, a sports psychologist; Ilana Ritov, a psychologist; and two graduate students, scanned the top leagues in the world, collecting data on 311 penalty kicks. Then they computed the probability of stopping different kicks (to the left, the right or center) with different actions (jumping left, right, or staying put) to see which one “maximizes his chance of stopping the ball.”

According to their calculations, staying in the center gives the goalkeeper the best shot at halting a penalty kick — 33.3 percent, instead of 14.2 percent on the left and 12.6 percent on the right.

Yet when the group analyzed how the goalkeepers had actually reacted to these penalty kicks, they discovered the goalies remained in the center just 6.3 percent of the time.

The reason, Mr. Azar contends, is rooted in how the players feel after failing to block the ball.

Source: New York Times

When it comes to soccer and investing, when choosing what to do, sometimes the best thing is nothing.

March 1st is the seventh anniversary of our Technical Leaders Index launching on the NYSE. The last seven years have seen some crazy markets! Through it all we have been really happy at how the index has adapted to the different market environments we have had.

We often get caught up in the day-to-day gyrations of the market and we forget to take a step back and look at what a strategy is designed to accomplish. The Technical Leaders Index is designed to keep the index invested in high momentum stocks. It is a process that is supposed to cut the underperforming stocks out and ride the winners as long as they continue to outperform. That is how most successful momentum and trend-following strategies work.

With that in mind, I thought it would be interesting to show everyone what would be coming out of the index and what would be going in if we rebalanced it today. Remember, the process is designed to cut out the stocks that aren’t performing well and to buy stocks that are performing better than what we are selling. Here are the stocks we would be selling (I have taken the names off the charts for compliance reasons, but the actual names of the stocks don’t really matter anyways):

(Click To Enlarge)

And here is what we would be buying:

(Click To Enlarge)

Pretty remarkable difference, right? The performance over the last few months is quite different for the two groups of stocks. Over time that is what the Technical Leaders process does. It constantly replaces weak stocks with stronger ones.

The WSJ reports on the resurgent demand for European equities:

U.S. fund managers are rediscovering their passion for Europe—and not just as a vacation destination.

Since the start of the year, American investors have ramped up their bets on European stocks, spurred on by a brightening economic outlook and low interest rates.

The continent’s stock markets became a favored destination last year as the region emerged from a bruising recession. This year, with U.S. stock indexes treading water after a rip-roaring 2013, interest in European stocks has grown further, fund managers say.

Investors have sent $24.3 billion into European equity funds this year through Feb. 19, according to fund tracker EPFR Global. U.S. stock funds have seen $5 billion in outflows.

In the exchange-traded-fund world, three of the top four stock-based funds in terms of investor inflows in 2014 are the Vanguard FTSE Europe, the iShares MSCI EMU and the Vanguard FTSE Developed Markets ETFs—all of which have heavy exposure to Europe. The three have seen a combined $4.23 billion in new money this year, while $19.1 billion has flowed out of the largest U.S. stock ETF, the SPDR S&P 500 fund.

My emphasis added. All three of the ETFs referenced above are cap-weighted ETFs. To those three, I have added the PowerShares DWA Developed Markets Momentum ETF (PIZ), which had better performance in 2013 and is also ahead of those three so far in 2014:

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Source: Dorsey Wright; YTD performance through 2/21/14; Performance does not included dividends or any transaction costs

While PIZ is not exclusively focused on Europe, it is certainly heavily weighted to that region:

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Source: PowerShares

PIZ has had inflows of $360 million over the past year and now has $671 million in assets.

Past performance is no guarantee of future returns. Dorsey Wright is the index provider for PIZ. Dorsey Wright also currently owns EZU. All past holdings for the trailing 12 months is available upon request.

Each quarter, the PowerShares DWA Momentum Indexes are reconstituted. These indexes are designed to evaluate their respective investment universes (U.S Mid and Large-Cap equities, U.S. Small-Cap equities, Developed International Market equities, and Emerging Market equities) and build an index of stocks with superior relative strength characteristics. This quarter’s allocations are shown below.

PDP

DWAS

PIZ

PIE

Source: PowerShares, MSCI, and Standard & Poor’s

While capitalization-weighted indices will tend to have relatively stable sector/country allocations from one quarter to the next, our momentum indices can are designed to adapt to leadership changes. The charts below show allocations to two sectors/countries from each of our indices to give you a sense for some of the key areas of leadership and weakness.

PDP

DWAS

PIZ

PIE

The PowerShares DWA Momentum ETFs finished 2013 with $2.8 billion in assets. 2013 performance is shown below:

The performance numbers are pure price return, not inclusive of fees, dividends, or other expenses. Past performance is no guarantee of future returns. Potential for profit is accompanied by potential for loss. A list of all holdings for the trailing 12 months is available upon request.

See www.powershares.com for more information. The Dorsey Wright SmallCap Momentum Index is calculated by Dow Jones, the marketing name and a licensed trademark of CME Group Index Services LLC (“CME Indexes”). “Dow Jones Indexes” is a service mark of Dow Jones Trademark Holdings LLC (“Dow Jones”). Products based on the Dorsey Wright SmallCap Momentum IndexSM, are not sponsored, endorsed, sold or promoted by CME Indexes, Dow Jones and their respective affiliates make no representation regarding the advisability of investing in such product(s).

ETF Trends says PDP might be A Right Place, Right Time Momentum ETF:

Recent data (and the Federal Reserve’s tapering announcement) indicate the U.S. economy is improving and the current economic expansion is maturing.

Assuming that the recovery is moving into late cycle stages, investors may want to consider momentum-based strategies.

“When positioning portfolios for mid to late cycle economic activity, the momentum factor historically had a stronger track record of performance than either small cap or value in generating return,” according to PowerShares, the fourth-largest U.S. ETF sponsor. “It appears that the maturity of the economic cycle may benefit companies which are showing price strength and are able to leverage economic conditions present in a mature economic expansion.”

Past performance is no guarantee of future returns. See www.powershares.com for more information.

Tom Lydon reports on some of the economic challenges facing Indonesia:

Indonesia exchange traded funds have been among the worst performers in the emerging market category as both external and internal factors weigh on the economy, and some observers believe it could get worse next year.

The iShares MSCI Indonesia ETF (NYSEArca: EIDO) has declined 25.5% this year and Market Vectors Indonesia Index ETF (NYSEArca: IDX) is down 24.7% year-to-date.

Within Indonesia, flip-flopping public policies, corruption charges, widening disparity between the rich and poor, and surging inflation are pressuring the economy, writes Arno Maierbrugger for Investvine.

Moreover, the government implemented a protectionist policy, requiring foreign investors to reduce their stakes in mining operations within 10 years and capping foreign exposure in financial institutions.

The country’s growing current account deficit, depreciating currency and high external debt have also weighed on the market. The rupiah currency depreciated 20% since the start of 2013 and touched a 5-year low against the U.S. dollar as capital flight from Asia gained momentum on speculation of an end to easy money.

The depreciating rupiah has exacerbated losses in Indonesia investments, along with rupiah-denominated securities in the Indonesia ETFs. Foreign-currency denominated securities take a hit if their currency depreciates since the investment would be worth less when converted in to U.S. dollars.

We have also seen a large drop in exposure to Indonesia in the PowerShares DWA Emerging Markets Momentum ETF (PIE). Indonesian exposure is shown below:

PIE, which is rebalanced quarterly, went from over 15% exposure to Indonesia in Q3 2013 to 0.95% exposure in Q4 2013 and now has 0% exposure in Q1 2014.

Meanwhile, overweights for PIE are now South Africa, Taiwan, Thailand, Malaysia, Turkey, and the Philippines.

Source: PowerShares and MSCI, as of 1/1/14

A list of all holdings for the trailing 12 months is available upon request. Past performance is no guarantee of future returns. See www.powershares.com for more information.

A noteworthy overweight in the PowerShares DWA Developed Markets Momentum ETF (PIZ) is the United Kingdom:

Source: PowerShares

For some insight into why the United Kingdom may be so strong, consider this post by The Capital Spectator:

‘Tis the season for predictions and all the usual caveats apply. But amid the din of forecasts as the year winds down is one outlook that’s worth a closer a look for what it says about the UK, the Eurozone, and the price tag for embracing a deeply flawed monetary policy inside a misguided currency union.

“The UK is forecast to be the second most successful of the Western economies after the US,” advises the Centre for Economics and Business Research (CEBR) in a new report published today. “Positive demographics with continuing immigration, rather less exposure to the problems of the Eurozone than other European economies combine with relatively low taxes by European standards to encourage faster growth than in most Western economies.” As it travels along the road to recovery, Britain will edge out France to become the fifth-largest economy on the planet in five years, pushing aside Germany to become Europe’s leading economy by 2030, CEBR projects. It seems that the sun is no longer setting on the British Empire in macro terms.

A lot can change between now and five years, to say nothing of what will unfold over the next three decades. But CEBR’s forecast certainly sounds plausible based on what we know about Britain’s economy this year. If you’ve been following the macro news for the UK, you know that it’s been posting encouraging numbers for months. There’s a fierce debate about why Britain’s economy is recovering. There’s also plenty of skepticism about whether the rebound is sustainable or even healthy—some analysts say that it’s overly reliant on a housing boom, for instance.

But there’s no denying that the UK’s generating numbers that stand in sharp relief with the Eurozone—particularly for the Eurozone ex-Germany. If you consider the upbeat economic numbers of late for the US and Japan, Europe’s troubles stand out even more. What explains the difference? Surely monetary policy is a big part of the answer, as Ambrose Evans-Pritchard of The Telegraph explains:

The crippled eurozone alone has chosen to stagger on defiantly without monetary crutches. The result has been a double-dip recession of nine quarters, the longest since the Second World War. The austerity regime has been self-defeating even on its own crude terms. Debt ratios have ratcheted up even faster.

It doesn’t help that the euro has been imposed in a region that falls short of Robert Mundell’s standards for defining an optimal currency area. But the euro isn’t going away, at least not for the immediate future. So, what could change? Perhaps the European Central Bank will embrace monetary stimulus in a more aggressive form in 2014, although it’s clear that policy choices to date have been far too modest to make a dent in the lingering troubles that continue to afflict France, Italy and Spain.

In absolute terms, Britain’s ascendancy of late can be attributed to internal economic momentum, supported by the simple fact that the UK still has its own currency and therefore has dodged the macro headwinds that weigh on countries tethered to the euro. In relative terms vis-à-vis the Eurozone, however, Britain’s strength speaks volumes about the self-inflicted problems on the Continent.

“The UK’s rebound is not because fiscal cuts have been milder than in Europe,” observes Evans-Pritchard. “The squeeze has been roughly comparable over the past three years. The difference is monetary policy. Kudos to the Bank of England, rising to a historic challenge once again.”

Developed International Markets have been among the standouts in 2013 and the PowerShares DWA Developed Markets Momentum Portfolio (PIZ) has been particularly strong-outperforming its benchmark by 16%. Out of a universe of approximately 1000 stocks, this index is designed to select the 100 stocks with the best momentum characteristics (rebalanced quarterly).

Through 12/18/2013, PIZ is +29.79% YTD, while its benchmark, the MSCI EAFE Index (EFA) is +13.79%. Top holdings of PIZ are shown below:

Galaxy Entertainment Group Ltd (Hong Kong)

Galaxy Entertainment Group Limited, through its subsidiary, operates casino, hotel and other entertainment facilities in Macau. The company also manufactures sells and distributes construction materials.

Ezion Holdings Ltd (Singapore)

Ezion Holdings Limited, an investment holding company, develops, owns, and charters offshore assets; and provides offshore marine logistics and support services to the offshore oil and gas industries. It owns multi-purpose self-propelled jack-up rigs, which are used in well-servicing, commissioning, maintenance, and decommissioning of offshore platforms.

SJM Holdings Ltd (Hong Kong)

SJM Holdings Limited is the holding company of Sociedade de Jogos de Macau S.A. (“SJM”), one of the six companies authorised to operate casino games of fortune and other games of chance in casinos, under the terms of a concession granted by the government of the Macau Special Administrative Region in March 2002. SJM is the only casino gaming concessionaire with its roots in Macau, and is the largest in terms of gaming revenue and number of casinos.

Sports Direct International PLC (United Kingdom)

Sports Direct is the UK’s leading sports retailer by revenue and operating profit, and the owner of a significant number of internationally recognized sports and leisure brands. They operate about 400 sports stores in the UK.

Valeant Pharmaceuticals International (Canada)

Valeant Pharmaceuticals International, Inc., a specialty pharmaceutical company, develops, manufactures, and markets pharmaceutical products and medical devices in the areas of neurology, dermatology, and branded generics.

More information about PIZ can be found here. Performance shown above is price return only and does not includes any transaction charges. A list of all holdings for the trailing 12 months is available upon request. Past performance is no guarantee of future returns.