Can anybody here relate to this feeling? The company fundamentals look great. All the analysts love the stock, but it just keeps going down! Has anybody here bought stock in a good company and felt puzzled when the stock went down?
Basically, there are two types of securities analysis – fundamental analysis and technical analysis. Fundamental analysis is what most of us are familiar with. When you see an analyst on television or read comments from an analyst in a magazine or news story, most often these comments come from fundamental analysts. A fundamental analyst tries to answer the question “What” to buy. She will study the company’s balance sheet, evaluate the management team, try to understand the quality of the company’s earnings. A technical analyst tries to answer the question “When” to buy and just as importantly, “When” to sell. A technical analyst wants to find the trend of a chart – is it trending up or trending down. Is the stock outperforming the broad market? How high, or in some cases, how low can the stock go? Unfortunately, there are very few on Wall Street who effectively combine the fundamentals with the technicals. In a sense, they’re playing the piano with only one hand. While that may be a way to play a simple melody, you can play much better music if you play the piano with both hands. In fact, our game plan is grounded in this philosophy of combining the fundamentals with the technicals, or playing the piano with both hands.
We all understand the basic law of supply and demand; we have all experienced these forces at the supermarket. We know why in the winter tomatoes don’t taste very good, don’t have a very long shelf live, and are expensive. We inherently understand why there are lemonade stands in the summer and hot chocolate stands in the winter. Stocks, sectors and asset classes move in and out of favor just like produce in the supermarket.
The Point & Figure chart is merely a logical, sensible, organized way of recording supply and demand in the marketplace. If we take a look a series of prices for XYZ would you say that this chart is positive or negative? If you are like me, it’s pretty hard to tell from this price listing.
We have taken those prices and plotted into a graph as Charles Dow would have done back in the late 1800’s. Charles Dow was the first one to popularize the methodology. Charles Dow was the founder of the Wall Street Journal and he was a fundamentalist at heart but he also appreciated understanding the supply and demand relationship in anything he was going to buy. By putting the prices into a simple graph, Charles Dow could tell several things about this stock. First, every time it rallied, it rallied a little further than the last telling us that demand was getting stronger. At the same time, each time it pulled back, it did not pull back quite a far as the previous time. That tells us that supply is getting weaker. That is what we want to see in a stock we own – demand getting strong and supply getting weaker. Notice also the formation in blue. Think back to geometry class and what does this look like – a square? A trapezoid? It looks like a triangle pattern. You’ve just read your first Point & Figure chart. There are 11 patterns in all and the bullish triangle is one of them. The Point & Figure chart is merely a logical, sensible, organized way of recording supply and demand in the marketplace. If we take a look at a series of prices for XYZ would you say that this chart is positive or negative? If you’re like me, it’s pretty hard to tell from the list of prices. It’s only when you plot them on a chart does it come to life.
This is a modern day Point & Figure chart of XYZ Stock. The numbers have moved to the vertical axis and the prices have been replaced with X’s and O’s. X’s represent demand O’s represent supply. You’ll notice that from September 2008 to December 2008, the stock was making lower X’s and lower O’s meaning that demand was getting weaker and supply was getting stronger. That started to change in December. Now we see that XYZ is showing demand getting stronger by the X’s going higher and supply getting weaker by the O’s not pulling back as far each time. You’ll also notice two lines – red and blue. The Blue line is called the Bearish Resistance Line or I like to refer to it as I-95 South. As long as the stock is below the blue line, it’s “trend” is negative. Conversely, the red line is the Bullish Support Line or I-95 North. As long as the stock is above the red line, it’s “trend” is positive and I consider it a solid citizen.
Now that you have an understanding of how the Point & Figure chart works, let’s have a little test. Look at this chart and let me know whether supply or demand is in control? If you had this stock in your portfolio, would you want it in there or would you want to sell or hedge it?
The stock had clearly started establishing a series of lower X’s – demand getting weaker; and lower Os – supply getting stronger. The Point & Figure chart was clearly signaling you sell or hedge the stock well before any of the news came out and well before the stock was down into the teens and single digits. We think back to the lack of sell recommendations during the Technology Bubble that burst in 2000-2002 and chastise the fundamental analysts for not having more sell ratings with new regulations designed to do just that but here we stand six years later and find that nothing much as changed according to the New York Time article “Why Analysts Keep Telling Investors to Buy.” I quote from that article, “At the top of the market, they urged investors to buy or hold onto stocks about 95 percent of the time. When stocks stumbled, they stayed optimistic. Even in November, when credit froze, the economy stalled and financial markets tumbled to their lowest levels in a decade, analysts as a group rarely said sell.” In fact, in January 2009 when the market suffered its worst January since 1950, there were a mere 5.9% of stocks possessing a sell rating according to Bloomberg. If the fundamentals in January 2009 don’t warrant sell ratings now, when will they?
But the Point & Figure charts didn’t just point to danger in the previous stock, it also pointed to danger in other stocks...
And forewarned of supply taking control of others...
You’ll notice in these previous charts that they were all financial related issues. When we look at the causes of price movement in any individual stock, the market and the sector together on average cause 80% of the price movement in a stock. That means the company fundamentals usually account for less than 20% of a stock’s price movement. This is the reason a company’s stock price sometimes seems to move independently of the fundamentals!
Most people, however, spend 80% of their time on stock evaluation and only 20% on sector and market evaluation. In other words, they ignore where the greatest amount of risk lies – the market and sector forces. Because most of the risk in any stock is in the market and the sector, I structure my game plan from a top down approach. My success ratio in stock selection is going to be limited until I define risk in the broad market first. Source: “The Latent Statistical Structure of Securities Price Changes” by Benjamin F. King
This is the five-step process I use to manage risk in the market. First, I look at the market to determine whether it is supporting higher prices. If it is, then I move to the sectors and determine which sectors are supporting higher prices. From there, my inventory of stocks is determined by those deemed fundamentally sound in the strong sectors. Then, from that inventory I choose those that are technically sound and controlled by demand. Finally, all the stocks in your portfolio are updated each day so that I see changes in the supply/demand relationship and can notify you to opportunities as well as potential problem areas. We stick to the KISS principle of Keep It Simple Silly! In fact, if you were to visualize my game plan, it would look like the following:
That’s right football. Think about your favorite football team for a moment. If they played offense 100% of the time, they would be marginal at best. It is the same way in the market. If you play offense 100% of the time, as most investors assume you must do, your investing will be marginal at best too. In any football game, there are times when the offensive team will be on the field and times when the defensive team is on the field. The problem that most investors have is knowing which team is on the field.
Knowing when to play offense and when to play defense can make all the difference in meeting your goals – whatever they might be. History continues to repeat itself with steep declines in both the market and individual stocks. The key is where you get on the investment train. If you got on the investment train in 1929, it took you 25 years to get back to even. If you got on the investment train in 1973 it took you 7.6 years to get back to even. It is the same case for individual stocks. Maybe you started investing in 1998 and find yourself right where you started after riding one heck of a roller coaster ride. After the market causality of 2008, how long will it take you to get back to even? 7.6 years? 13 years? 25 years? Can you afford to go through another bear market?
Here is a picture of a great tool from New York Times. Put in what your portfolio was worth, what it is worth today and then pick different returns and inflation rates to see how long it will take to get even. Here we look at a half a million dollar portfolio that lost 38% like the S&P 500 did in 2008. We’ll assume a 3% inflation rate going forward and since a lot of people are scared to invest right now, let’s assume a low return on investment of 4.7%. In that scenario, it’s going to take you 29 years to get back to even. Most people can not afford another Bear Market yet still need to grow their investments to reach their goals in a reasonable amount of time. This is why my investment philosophy includes both an offensive and defensive playbook based upon a three legged stool approach of knowing when to bring the defensive team on the field.
In my three legged stool approach to managing equities in the portfolio there are different components the portfolio can have exposure to. In the first leg, we will look at having equity exposure or not based upon the Point & Figure charts we have briefly looked. For the remaining two legs of the stool, we look at the strength of different things you could be invested in like Domestic Equities, International Equities, Commodities, Foreign Currencies, Fixed Income and cash to determine which two are the strongest. Approaching risk management this way allows the portfolio to fluctuate from being 100% invested down to no exposure to equities. As we learned from 2008, sometimes raising just a little cash means we hit the wall going 45 mph instead of 65 mph but we still end up in the ER. This approach allows me to go from just letting up on the gas to coming to a complete stop and anywhere in between. Let’s take a closer look at how each leg is determined.
At the beginning of the presentation we talked about the fact the Point & Figure methodology is merely a way of measuring the supply and demand in the market place. In the first Leg of our stool, we want to get a composite pictures of whether stocks in general are controlled by supply or demand. You’ll remember from those beginning charts that Demand is represented by a column of X’s and supply is represented by a column of O’s. So in the first column of O’s, supply took the stock down to 26. At that level, the buyers came in and carried the stock up to 29. At the 29 level the buyers dried up and then supply took control and carried the stock to 26 again. Once again at that level the buyers came in and pushed the stock up to 29. However, this time the buyers did not dry up at 29 and instead demand was strong enough to push the stock above the previous X and that gives us a double top buy signal. We call it a double top because there are two columns of X’s. What do you think we would call it if there were three columns of X’s? Conversely, in the chart on the right, at first demand carried it up to 38 and then supply or sellers came in and pushed it back to 35. There, the stock found buyers and pushed the price up to 38. Once again demand waned and supply took control. This time supply was strong enough to carry it not only down to 35 but to 34 and that was a double bottom sell signal. We call it a double bottom because the 35 level of support was tested twice and on the second test of support it was unable to hold. All stocks must be on one of these two patterns. There can be variations, like a triple top or a quadruple bottom, but they all come down to these two patterns and because of this we can easily plot a chart called the NYSE Bullish Percent to ascertain whether demand or the Double Top is control of more stocks or supply and the Double Bottom has the upper hand.
The NYSE Bullish Percent Indicator, whose history goes back to 1955, is merely a measure of the percent of stocks being controlled by demand. At the end of everyday we go through all stocks on the NYSE and put them in two piles – the Double Top or Buy Pile and the Double Bottom or Sell Pile. Once that is completed, then we get a percentage reading of the percent of stocks on a Double Top or controlled by demand and plot that percentage on a grid which goes from 0% to 100%. When this indicator is in X’s it is rising and telling us that stocks are coming from the supply pile into the demand pile. Conversely, if the stock is falling and in O’s then it tells us that more stocks are moving from the buy pile into the sell pile and supply is gaining the upper hand. We look at this chart as one of our main coaches telling us whether the offensive team is on the field or the defensive team is on the field. When the chart is in X’s the offensive team is on the field and we look to wealth accumulation strategies. When the chart is in a column of O’s, the defensive team is on the field and we look to wealth preservation strategies for the portfolio. There are two lines of demarcation letting us know our field position and the types of plays we should run. When this indicator gets down to the 30% level or lower it is in oversold territory and this is when the news media will be particularly negative. But remember, the markets look ahead 6 to 18 months. News headlines tell us what has happened. Conversely, the 70% level or higher is high risk. The availability of demand to push the market higher is severely limited. Typically this indicator gets to these extremes only once every 3 to 4 years. While 2008 was very active on this chart, it was just a reflection of the overall market volatility and on average this chart only changes 2.5 times a year from offensive to defense and vice versa. There is one warning I must give you about this indicator and that is it will not necessarily move like the S&P 500 or the Dow Jones. Both of these indices give more votes to certain stocks either based upon how big the company is, capitalization in the case of the SPX, or price, as is the case with the DJIA. In the NYSE Bullish Percent, all stocks are created equal much like your portfolio is put together. That is why I find it a much better indicator to watch than the often quoted indices. You’ll never see this indicator quoted on CNBC.
The next two legs of our stool are an evaluation of different types of investments. At some times Fixed Income is the place to be, sometimes, it is international equities, other times US stocks, and there are times that commodities or foreign currencies are the place to be. A solid investment strategy will evaluate all of these asset classes to determine what is the strongest and should be represented, and just as importantly, what deserves no representation in your portfolio. And with the advent of the Exchange Traded Fund (ETF) market, all of these asset classes are available to investors similar to buying securities on an exchange. Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations. The yields and market values of fixed income investments will fluctuate so that your investment, if sold prior to maturity, may be worth more or less than its original cost. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline of the value of your investment. Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. Foreign Exchange trade is not suitable for all clients. Commodities and Foreign Currency trading are speculative and volatile and involves a high degree of risk, is only appropriate for the risk capital portion of a portfolio.
Let’s talk a little more football for a second. Who do you think is going to be a better team next year – the Pittsburgh Steelers or the Detroit Lions? In case you don’t keep up with football, the Steelers won the Superbowl and the Detroit Lions were the first team in the NFL to go 0-16 on the year. Of course the Steelers. Why? Because they have put together a strong team. They may not win the Superbowl again next year but I think we can all agree that the Steelers are more likely to than the Detroit Lions. The funny thing is the way investors typically invest. They look to the Detroit Lion stocks and sectors and bet on those in hopes that they have a miraculous turnaround and are dumbfounded when the turnaround doesn’t happen overnight. Rather, we want to focus on the performing teams. Teams that have good strategies, good players, and good coaches. The teams that are performing the best because they are most likely to continue to perform well.
If we apply this thought process – finding the strongest teams or areas - to the markets we’re talking about Relative Strength. Relative strength is merely a ranking system. Think about it like ranking your favorite sports team. Every sport has a ranking system – from golf to tennis to baseball to football to bowling – and they are all based upon the same philosophy. The better a player or team performs, the higher they go in the rankings. When they start to lose, they begin to fall in the rankings. We can affect the same type of ranking system based upon how an asset class performs. The more it outperforms something else, the stronger it is. When it begins to lose that strength, it falls in ranking. The actual relative strength calculation is very simple. We take one asset class like cash and divide by another asset class like US stocks. This number is then multiplied by hundred and then plotted on a Point & Figure chart like those you have just learned about.
The Point & Figure Relative Strength Chart on the right is the result of dividing a money market fund by the S&P 500. When the RS chart is in X’s it tells us that cash is favored over stocks and when the RS chart is in O’s it tells us that money market is out of favor or stocks are favored. The numbers in the chart stand for time. The numbers at the bottom are the years – 1998 thru 2009 and the numbers in the chart are represent the months of the year (1 is for January, 2 is for February and A, B and C are for October, November and December). You can see that this chart doesn’t change that often. It is designed not to catch every wiggle in the market but to rather capture major themes. For instance, this chart moved to favoring cash for the entire year of 2001 and 2002 and moved again to cash in March 2008 – both times were pivotal in protecting your portfolio value. At the same time, knowing when to get back in the market is important too. This RS chart moved you back to stocks in March 2003 and suggested being invested for the next five years. Let’s look at another example.
In this chart we look at cash versus the commodity markets using the Continuous Commodity Index (UV/Y) which is an equal weighted basket of 17 different commodities. The Point & Figure Relative Strength Chart on the right is the result of dividing a money market fund by the Continuous Commodity Index. When the RS chart is in X’s it tells us that cash is favored over commodities and when the RS chart is in O’s it tells us that money market is out of favor or commodities are favored. Again, the numbers in the chart stand for time. The numbers at the bottom are the years – 1998 thru 2009 and the numbers in the chart are represent the months of the year (1 is for January, 2 is for February and A, B and C are for October, November and December). Once again you can see that we are capturing long term trends in the market. This chart was suggesting cash from August 1998 to October 15 th 2002. During that time, Money Market was up 18.41% while Commodities were only up 10.11%. Then from October 15 th 2002 this chart would have suggested your money would be better off in commodities then cash. From October 15 th 2002 to August 15 th 2008, commodities were up 115% while cash only posted a gain of 17%. Then, this chart alerted you to the fact commodities were falling out of favor in August 2008 and from there we saw commodities give back 27% of their gains and money market has been flat. This relative strength ranking system enables us to take the temperature of two markets and compare them to see which is gaining relative performance over the other.
Now take this analysis of cash and US stocks and Commodities a step further and imagine that we are holding an arm wrestling contest. In that contest, each asset class arm wrestles another. At the end of the tournament, we see how many matches each asset class won and then rank them. The two asset classes then have the ability to be favored but the final hurdle is that the asset class must be able to be favored over cash in its relative strength analysis. If it is not, then cash will take its slot. Now we have a game plan for the portfolio that encompasses a broad spectrum of assets, including cash.
In order to be a successful investor, we don’t have to be perfect. What we do need to know is when wealth accumulation is the focus and when wealth preservation are the focus. Will we catch the exact top of the market to get out? No. Will we catch the exact bottom to get back in the market? No. Will there be times the portfolio is down? Absolutely. Will the portfolio be positioned to take advantage of major themes in leadership. Yes. The goal of these strategies is to help us navigate the financial waters – whether the seas are calm or choppy – so that one day we can arrive at our end destination. Those without a strategy for knowing when to be invested and when to wait on the sidelines until we get the ball back have a high probability of finding themselves shipwrecked on a deserted island. The small changes we make during the course are at first imperceptible but down the road as you are making your way toward your destination that same changes can make the difference in hitting your goal and missing.
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Point & Figure Analysis The analysis in this presentation is known as a technical analysis. You may also want to consider quantitative and fundamental analysis before making any investment decisions. Please be aware that Dorsey Wright research can and will differ from the research provided by Wells Fargo Advisors own technical analysts. Wells Fargo Advisors, LLC is a registered broker-dealer and a separate non-bank affiliate of Wells Fargo & Company. CAR 0209-2697 J Duncan Black, M.B.A. Senior Vice President - Investments PIM Portfolio Manager Wells Fargo Advisors 900 Elm Street Manchester, NH 03101 603-644-0646 Securities and Insurance Products: Not Insured by FDIC or any Federal Government Agency May Lose Value Not a Deposit of or Guaranteed by a Bank or Any Bank Affiliate
Market and sector forces together typically cause 80% of the price movement in a stock. That means the company fundamentals usually account for less than 20% of a stock’s price movement. This is the reason a company’s stock price sometimes seems to move independently of the fundamentals!
Source: “The Latent Statistical Structure of Securities Price Changes” Benjamin F. King