Welcome to the 3rd installment of our “Nerdvember” series.  We kicked off the month with an update on the state of the market.  Last week, we discussed how the stock market crashes and why investors need to be extremely careful investing in “safe” investments that are interest-rate sensitive, such as bonds, or investments that invest your money in bonds (target date funds, asset allocation funds, etc.).  This week, I’m going to honor a request we received from a client and share a little about how we determine which investments to pick and wrap things up with a quick update on the market today.

As the saying goes, “There are many ways to skin a cat.”  Somewhat gruesome, but I’m sure there are even more ways to screen for and pick investments in a retirement portfolio.  If we start way up at a 30,000 foot level, one can implement a Bottom-Up or a Top-Down approach to investment selection.  At our office, we use the latter approach most often, but we use both because no one strategy works best, all the time.

  • Bottom-Up: Screening for individual securities using any number of parameters to find the best candidates for your portfolio.
  • Top-Down: Comparing different geographical markets against one another, then drilling down into the strongest asset classes, then widdling down to the strongest sectors within the strongest asset classes, then the strongest industry groups, and finally into the individual positions within those industry groups.

We’ll focus on the second (Top-Down) approach today, just because it’s more interesting to learn (not to mention, more fun to teach)!

Two of the ways we scan the market for investments to buy is through the use of a fantastic, but relatively new tool called a Relative Rotation Graph (or RRG for short).  Invented by my friend, Julius de Kempenaer, a buy-side quantitative technical analyst from the Netherlands, he brought the tool to Bloomberg in 2011 and it’s been gaining popularity ever since.

Many studies have proven that rotation in the market exists and that the market is not purely random.  While markets may adapt over time, human psychology hasn’t, and won’t.  Investors will always suffer from the same behavioral biases that result in decisions that make the markets non-random.  Further studies have gone on to show that investments with momentum that have outperformed in the recent past have a tendency to outperform over a future limited timeframe.

What Julius discovered was a way to visualize rotation and relative strength in the market through a combination of these historical studies (using relative strength) and plotting it on a chart using proprietary indicators he created for momentum, velocity, and the rotation you see on the RRG below.

  • Northwest Quadrant = Improving vs. the benchmark
  • Northeast Quadrant = Leading the benchmark
  • Southeast Quadrant = Weakening vs. the benchmark

Southwest Quadrant = Lagging the benchmark

In the RRG above, you can see all the sectors in the U.S. stock market vs. the S&P500, which is the benchmark in this case.  The S&P500 is at the middle (zero) of the graph and all the sectors are plotted around it.  Do you notice anything about the rotation of the graph (if it’s not animated, click the image above)?

That’s right… it’s rotating clockwise.  In fact, research has been done that suggests that, when an investment is in the lagging quadrant, there is a very high probability that it eventually moves to improving, then leading, and so on.  So in short, the RRG has become a useful power tool in our shed of indicators used to screen for new buying opportunities.

Another way we like to screen for new investments is by ranking asset classes, sectors, industry groups, ETFs and stocks by any number of relative strength metrics.  We use an absolute ranking system, a proprietary rate-of-change (ROC) system with a volume filter, as well as a Point & Figure (PnF) ranking system that eliminates time and only compares on price to the market and/or the investment’s peers.

Here’s my proprietary ROC relative strength ranking on an inventory of fixed income (bond) investments.  I’ve broken them down by decile with the ones at the top being the strongest.  I’ve also circled a money market (cash) proxy, which is useful because it tells us which investments (in the bond market, in this case) are outpacing cash – or said another way, which (bond) investments are worse than simply having the bond sleeve of our retirement portfolio invested in a low-risk money market account.  As you can see in the ranking below, only one short-term Municipal Bonds and one High Yield bond ETF are outpacing money market in this particular screen:

Again, there are many ways to screen for investments and the additional filters (for trend, volume, etc.) that can be added to the above-mentioned strategies are well beyond the scope of this article.  But hopefully you learned a little bit about how to buy the strongest investments in the strongest sectors in the strongest asset classes in the strongest countries at any given time!

I just wanted to wrap up with a quick update on the state of the market.  I’m writing this article on Thursday just before noon, so by the time this goes out, the chart will be a tad bit old, but intra-day price action is just noise anyway.  It’s the longer-term trends we’re more concerned with.

Below is a chart of the S&P500 and the red lines are “floors” of support based on prior lows earlier in the year.  The reason these are important is because they represent “mental anchors” at which open stop loss orders are placed, which can trigger additional selling and downside pressure.  These red lines are bad – and we want for the market to hold above these levels.

The blue lines are “ceilings” of resistance where “supply” exists.  This is where those who own stocks sell their positions on rallies in order to take profits and/or short-sellers who think the market will go down add new/additional positions, which drive prices down.

So if we can get above those blue lines, that would be extremely constructive for the long-term trend of the stock market.  On the other hand, if what ultimately plays out is something like a 2000-02 or 2007-09 market crash, we know that all of those red lines will have to be pierced first, below which we’d want to be extremely conservative.

At this point, we’ve already sold some investments in our clients’ accounts to lighten up our stock exposure.  Raising cash levels gives us the ability to be objective and play both sides.  If the market rebounds, we can re-invest the cash when the trends look strong, even if it’s at higher levels (it doesn’t matter to us).  However, we’re also positioned to continue trimming our weakest performers if the market breaks through those red lines, above.

Again, we’re objective when it comes to which direction the market will go from here.  We don’t know, but we’re watching, waiting, and ready to react to what the weight of the evidence is telling us.  As one of my pilot friends once told me, “I’d rather be on the ground, wishing I were in the air, than in the air, wishing I were on the ground.”

But for now, it’s low and slow…  Stay tuned!

I hope you have a warm relaxing weekend with your families and friends.

Till next time…

Adam