Nasdaq Dorsey Wright’s Senior Portfolio Manager John Lewis on Relative Strength Investing and 2020 Market Trends
Nasdaq Dorsey Wright Senior Portfolio Manager, John Lewis, CMT, provides valuable insights into relative strength investing and some key investment opportunities. Here he answers questions that we field directly from Financial Advisors about what is happening in the markets.
Q: RS Spreads are often used as a way to gauge the overall environment for relative strength investing. Can you provide a summary of how the spreads are behaving in different markets around the world?
JL: All of the RS Spreads (Global, Domestic, Developed, and Emerging) have been rising so far this year. A rising spread indicates a good environment for momentum or RS where the leading stocks are outperforming the laggards. The biggest surprise is the strength of the Emerging Markets spread. While the Global, Domestic, and Developed spreads have remained below their two-year highs, the Emerging Markets spread has broken out to new highs. I think this is significant because the media coverage has been so focused on the problems in Emerging Markets. Between the trade war and now the Corona Virus, there has been no shortage of negative news coming from EM. The momentum indexes have adjusted for this. We have seen a shift out of areas affected by things like the trade war, and in to other areas. Momentum is very dynamic and adaptive so it is not uncommon to see this. A capitalization-weighted index can’t adjust like a momentum index so there is still a huge China weight that has hurt the performance of those benchmarks over the last 12 months or so.
Domestically, we have seen a lot of back-and-forth in the momentum spreads. There were several large momentum sell-offs of momentum stocks in the summer and fall of last year. That led to a downward sloping spread trend, which wasn’t the best environment. Each time we had a laggard rally last year, the trends weren’t sustainable and the spread recovered. It is still too early to tell about this latest spread rally, but we have broken above some minor previous highs from the fall, which is a positive sign.
Q: Can you provide some perspective on how broad based (i.e., market breadth) this bull market is? Are there any noteworthy areas of the market that are not participating in this move?
JL: The current rally has been very broad-based with some notable pockets of weakness. The biggest area of weakness has been Energy. The S&P 500 GICS Energy Sector recently dipped to a 20-year low versus the S&P 500 TR index (relative performance) despite the massive run up we saw in the mid-2000’s when “peak oil” was the theory du jour. Energy has started off this year as huge laggard, and is an underweight in any momentum strategy. Another area that has been weak has been selected retail stocks. Most of the stocks that seem to be affected fall in to the “Death By Amazon” category, and are having trouble keeping up with changing consumer buying habits.
The rest of the market seems very healthy, and the rally has been broad. There are a number of diffusion measures that are still showing strength, or have just recently rolled over. The percentage of stocks above their 200-day moving average, for example, is still at very high levels. When this indicator is in the upper quartile (75% or greater of the stocks above their 200-day moving average), both the market and high momentum stocks tend to perform better than historical averages. The NYSE BP and the NYSE High Low are two examples of indicators that have recently rolled over. However, these two indicators are still at high levels indicating there is still broad-based strength, but that strength is beginning to narrow.
If we do get a market where strength begins to narrow we can get much different results from being invested in the “market” versus high RS stocks. When the market narrows it usually affects the broad market first. When you own the entire market (S&P 500 for example), that narrowing of leadership affects the entire index. When some of these diffusion indicators roll over and begin to decline the indexes often deliver returns below historical averages. That is not always the case for high RS stocks. When the market narrows, high RS stocks can still deliver above average returns. It is not always a bad thing for momentum to have the market narrow! The biggest issues for momentum performance tend to come when the indicators are deeply oversold and reverse up. This usually happens at the bottom of a bear market or large correction. With market averages near all-time highs, we are nowhere near that scenario right now.
Q: It has been stated by others in the industry (see here) that investors who only look at indexes when it comes to international investing may be missing some key opportunities. Can you share your thoughts on how our Systematic RS International Portfolio can be a potential solution for investors looking to broaden their opportunity set when it comes to this asset class?
JL: There is a huge difference between investing in indexes and in individual stocks. Over the last 10 years, the S&P 500 has dramatically outpaced both the MSCI EAFE and MSCI EM indexes. However, there have been plenty of years where a large percentage of the top 100 performing stocks globally have been outside of the U.S. There are plenty of opportunities abroad! Just looking at indexes tends to mask this, and leads people to believe there are fewer opportunities than there are. To be fair, you need a strategy that can capitalize on that and buy some of these smaller, more dynamic companies that have delivered solid returns. Our International strategy invests in companies in all capitalization ranges and is a concentrated portfolio so we can find some of these opportunities that exist abroad and capitalize on them.
Q: One of the key features of the NDW Systematic RS Growth Portfolio is its ability to raise [up to 50%] cash if market conditions warrant. Can you explain how and when this portfolio will raise cash and how and when it will put that cash back to work?
JL: The market is healthy now, but we know it won’t always stay that way. Eventually we will encounter a market that requires us to play defense, and we can do that in our Growth strategy. We run a very simple process to raise cash in that portfolio. It is a trend-following filter, so we are essentially letting the market tell us when we need to get defensive. In normal market conditions, when a stock isn’t performing we sell it and replace it with something stronger. However, when the market is trending down, we sell stocks and don’t replace them. This is a simple way to allow the cash to build up as stocks break down and become weak. When the market begins trending up again, we put that cash back to work in a systematic fashion like we do on the sell side. I think one of the benefits of doing our risk management this way is we are not automatically selling stocks that don’t show weakness. There are times when our market filter indicates a downtrend, but our holdings continue to do well. In those cases, we don’t wind up selling anything. In other cases, we have more things break down and the cash portion grows as we sell more stocks. When we find long-term winners we do everything we can to hold on to them until the demonstrate weakness.
Q: Can you share which sectors of fixed income are performing well and which sectors are currently performing poorly as well as share your thoughts on why the NDW Tactical Fixed Income strategy is a potential solution in this area?
JL: Fixed Income has been interesting over the last 12 months. There weren’t many analysts that predicted the dramatic fall in rates we saw last year. Most of the data we have seen showed just about every analyst forecasting higher rates. Our Fixed Income strategy is a simple, trend-following strategy so we just position the portfolio to take advantage of the direction in rate movements rather than trying to forecast what the economy will do 12-36 months from now. We are aggressively positioned in the strategy right now. Rates have continued to fall, and are near the lows made last summer. We have a lot of long treasury exposure to capitalize on that. The economy and stock market are also strong so we can take advantage of that too. Areas like high yield and convertibles do well in this type of environment so we have exposure there as well. Our strategy is designed to take risk off the table when these aggressive positions reverse, and hold funds in short-term treasuries to preserve capital. Right now we don’t need to do that. Fixed Income is performing well, and there are opportunities to capitalize on both falling rates and a robust economy.
Since 2005, Nasdaq Dorsey Wright’s portfolio management team has managed Dorsey Wright Systematic Relative Strength strategies that are available today as separately and unified managed accounts (SMAs/UMAs). All of our managed accounts use a disciplined approach that seeks to capitalize on long-term trends. Our investment universe and model constraints differ from strategy to strategy, resulting in different risk and return profiles. For more information, contact us here or download a copy of our latest performance brochure here.
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The relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value. Relative Strength is a measure of price momentum based on historical price activity. Relative Strength is not predictive and there is no assurance that forecasts based on relative strength can be relied upon to be successful or outperform any index, asset or strategy.
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 previous performance. Investors should have long-term financial objectives. 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, hypothetical or actual, 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. Advice from a financial professional is strongly advised.