This article was sent to us by Donald W. Dony of www.technicalspeculator.com. What it suggests is that the general trend of the global stockmarkets is far more important than the fundamentals of any particular stock sector.
Therefore, technical analysis or simple charting (ie, what's the shape of the chart look like, bullish or bearish, trending or not) is the dominant factor in determining the movements of stocks. Ultimately, this is because the direction of most, if not all major global stockmarkets are now highly correlated whereas 10 years ago (pre-internet days) most investors didn't have good access to global stockmarket information.
Introduction
The stock selection process and structuring of most mutual funds and portfolios date back to principals that were developed 40 – 60 years ago.
Though many of these time-tested methods are still noteworthy, their efficiency can often be debated. This is largely due to the equity markets having changed tremendously over the past few decades. For example –
- There is now a trillion-dollar derivatives market on currencies, bonds, equity indexes and many stocks throughout the world
- There are multi-billion dollar hedge funds moving in and out of the markets at a rapid pace
- There is computerized program trading of stock indexes and the remarkably growth and tight connection of global stock markets.
This linking was felt in March 2007 with the abrupt decline of the Chinese Shanghai Composite. This event sent negative shock waves around the world to stock indexes immediately, an action that would have been unheard off just twenty years ago. Markets corresponded far closer to their own fundamentals and were not as influence by the trading direction of foreign markets.
Due to all of these changes to the investing environment, I decided to explore some new concepts in portfolio design that take into consideration and advantage the current financial arena. The goal was to establish a portfolio structure that was easy to manage, provided good diversification and safety and above all, offer consistent returns higher than the market.
A New Portfolio Concept Was Developed
In 2003, I developed a portfolio structure that I felt could accomplish the desired goals. Now that the portfolios have had four years of testing, the results have been very encouraging.
The average annual return for the C$ portfolio has ranged from 23.84% to 49.59% with an average of 32.84%. For the U.S.-dollar portfolio, the returns have ranged from 21.90% to 31.19% with an average annual return of 23.97%. This has been achieved with no options or leveraging or short-term trading but utilizing only eight securities in each portfolio and whenever possible using exchange traded funds (ETFs)
This article is the first of several reports that outlines the investment approach that I have been using since 2003. I will go over the basic structure and principals of these new concepts in portfolio design which will include the topics of top-down market direction, relative strength for investment selection, the important use of support levels and exchange traded funds.
Concept #1; Top-down
The vast majority of mutual funds use a bottom-up approach to stock selection usually a 3 step process -
- The picking of the individual company is of primary importance
- Followed by the sector, and finally
- The trading direction of the overall market.
The long-standing belief is that fundamentally strong stocks will rise up, regardless of overall market and sector conditions, and ultimately 'beat the tape' (out perform the main stockmarket indexes). But according to a recent Standard and Poor's report, over 85% of all mutual funds can not out perform the market indexes over a long period of time.
The approach that I use in my portfolios is the opposite.
This is called a top-down selection process. This is where the market direction is the key first step followed by sector selection and finally the stock. This process can now be made one step easier and more efficient thanks to exchange traded funds (ETFs).
Market data over the past 20 years has told me that the trading direction of about 60%-70% of most stocks trend in the same direction as their sector. Though some stocks, within a sector, do clearly move in their path, the majority are being swept along in the same direction as their sector.
In fact, most stocks will turn up or down on the same day as their group regardless of the individual fundamentals of the equity. And most sectors will also trend in the same direction as the overall stock market. If you look at the TSX Composite or the S&P 500 over the past five years, whenever these two indexes are trending up or down, the vast majority of the individual sectors within those indexes are marching to the same direction within five months of the TSX's low in October 2002. Only one group, the Healthcare sector remained out of step with the index. The same percentage of correlation in trading direction within the sectors applies to the S&P 500.
The top-down investment approach can also be taken one step further.
The direction of global markets will dictate the trading direction of the individual stock markets. The best gauge of global equity markets is the Dow Jones World Stock Index. This measure of world markets contains 3,000 companies from 120 countries.
In Chart 1 (below), we see the tight correlation between this index plus the TSX and the S&P 500. All of the major peaks and troughs of the DJ World Stock Index match the highs and lows of the TSX and the S&P 500 over the past three years. This information illustrates the fact that the trading direction of global stock markets will be the same as individual markets. Though the fundamentals are different, the trading pattern is not.
Summary
The trading direction of global markets has a direct impact on the trend of market indexes.
This is largely due to the instant transfer of information and continued globalization of economies. Individual stock markets seldom track in a course that is counter to the overall path of the 'herd' in today's financial arena. These composites, in turn, have a powerful pull on individual sectors and stock groups. Though the examples are for the U.S. and Canadian equity markets, the same pattern applies to the FTSE and all European stock markets.
Therefore, in stock selection, considerations to the trading direction of the equity's sector and index can provide key information about its future trend that a balance sheet can not.
Donald W. Dony, FCSI, MFTA
www.technicalspeculator.com
