In last month's (Day 8 of the 12 Days of Christmas) blog post, we highlighted a key relative strength chart comparing US Equities SPX to Fixed Income AGG to show how such a comparison can add value to a portfolio over time. While US Equities and Fixed Income are the two most common asset classes, found in virtually all investors' portfolios, we would be remiss not to consider the rest of the investable asset classes. The Dynamic Asset Level Investing Tool (DALI), allows us to compare areas from every asset class to one another to provide an objective ranking from strongest to weakest. DALI serves as our primary asset allocation tool, and it is built using a three step process, outlined below:
Step One: Define the Inventory
Dorsey Wright, our primary technical analysis provider, separates the investable landscape into six major asset classes: US Equities, International Equities, Commodities, Fixed Income, Foreign Currencies and Cash. The process begins with the construction of asset class “teams” that are comprised of ETFs specific to a certain asset class. US size and style funds help build out the US Equity “team,” while various commodity sectors like precious metals and energy make up the Commodity “team”.
Step Two: Relative Strength Analysis
Every day the members of each team play against each member of the other teams, with net victories tallied in an effort to rank each asset class team by order of overall strength. This means we create a relative strength chart comparing every member of “team US equities” to “team Commodities” and “team Fixed Income” and “team Cash” etc.
Step Three: Rank Each Asset Class
After each member of each team has had a chance to compete in a relative strength comparison versus all others, Dorsey Wright then tallies the total number of relative strength buy signals that each team was able to generate. The asset class with the greatest number of buy signals, representing the greatest magnitude of outperformance compared to the others, ranks in the top spot. The top ranked asset classes are those we want to emphasize within our current allocation.
The rankings and guidance that DALI provides serves as our starting point for a top-down investment process, as it helps to drive the allocation to each of the asset classes. The goal is to overweight the highest ranked asset classes, which offer the most buy signals and thus the greatest leadership, to the greatest extent possible. Looking at how DALI has guided assets in recent decades, notice that it has successfully forced an overweight to US Equities throughout two of the strongest bull markets in history (the 1990s and 2010's). Furthermore, using DALI as our investment compass will allow us to adapt in such a way that the brunt of bear markets in any major asset class are negotiated adequately.
Our process need not be "right" about all things, but it needs to be right about the things that matter over time, and this is primarily being on the proper side of major performance trends. If our process can't accomplish that in a repeatable manner, our clients are probably better off following the strategic allocation mantra of owning a little of everything and hoping for the best.
While no single asset class is the right investment for all of our client assets at all times, the #1 ranked asset class in DALI is shown to produce substantially better outcomes than the bottom ranked asset class. A process that allows us to allocate more of our client assets to the top-ranked asset, and less to the bottom ranked asset, can have a meaningful impact over time. In 2017, the improvement out of International Equities combined with historically low volatility helped Equities, whether Domestic or International, outperform all other asset classes. In most years the market presents a stable leadership option, and in others it involves us in the process of finding one. Over time the performance advantage of that top-ranked asset class is an important reality, and an important part of any discussion with clients regarding why we employ a top-down tactical investment process that is grounded in relative strength analysis.
As always, please call with comments or questions.
Until next time, cheers!