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12 Days of Christmas – Day 8

12 Days of Christmas – Day 8

| July 10, 2018

Today we present number 8 in the series we began back in December called The 12 Days of Christmas.  As a reminder, this series provided an in-depth discussion of the tools and techniques we are utilizing every day to manage our client advisory accounts.

One of the benefits of our work is that it can help to simplify the complicated.  The Point & Figure methodology is designed to cancel out the market "noise" and help us to objectively see price direction and trends.  Metrics such as Fund Score and Technical Attributes are calculated by aggregating the most pertinent technical data to provide a numerical value.  Even tools like Dynamic Asset Level Investing (DALI) and the Relative Strength (RS) Matrix summarize hundreds (or thousands) of RS relationships to give a clear ranking.  And none of our calculations go beyond arithmetic you learned before 5th grade.  

Another way we try to "keep it simple" is by monitoring a select number of individual relative strength relationships.  Among the key RS charts we keep a watchful eye on is the S&P 500 Index SPX vs iShares US Core Bond ETF AGG chart.  This chart is meant to serve as a generic proxy for measuring the relative strength relationship between the two most commonly used asset classes in investors' portfolios - US stocks (represented by the S&P 500 Index) and Bonds (represented by the iShares US Core Bond ETF).  The reason it has become a meaningful chart over the years is because it has historically provided us with signals that are both timely and valuable.  As a result, it is one that we keep on our radar screen.  

As a quick refresher, when this chart is on a buy signal, it signals towards positive relative strength for US equities.  When on a sell signal, it tells us bonds are in favor.  Below we have compiled some of the biggest talking points about using Relative Strength (and specifically this chart) to drive macro asset class decisions within the portfolio.

1. Relative Strength is not perfect. We will be the first to say it. Relative Strength will never be able to get us in at the bottom and out at the top, but it will allow you to partake in the "meat" of the move. Take the signals surrounding the financial crisis as an example.  We know the market topped in October of 2007 and went on to find a bottom in March of 2009.  The relative strength sell signal, to get out of US equities wasn't until July of 2008 and the buy signal giving us the "green light" to get back in came in June of 2009.  So, while not "perfect," the signals certainly guided investors away from the worst of the decline.  Furthermore, it allowed them to begin participating again soon after the bottom was found, at a time that many investors where still paralyzed by fear.

2. Relative Strength is not fail proof.  Not every signal will lead to outperformance.  However, what we do know is that RS is right more often than it is wrong, and the SPX vs AGG chart is no exception. Looking at the chart above, notice that there have been a total of 5 completed signals over the life of the chart (three buy signals and two sell signals). We have outlined the date ranges for each signal along with the returns for both proxies during each time frame. Notice that four out of the five signals have been "profitable" - meaning the investment with the positive RS outperformed the alternative throughout the life of the signal.  That is a success ratio of 80% in this case. Someone who consults this chart to help in their allocation decisions between equities and bonds could have added a gain in excess of more than 20% over either of the two options alone over the last 14 years!

3. Relative strength is "self-correcting."  It's okay to be wrong, but it's not okay to stay wrong.  While we know a relative strength chart may give us a "false" or "bad" signal every now and again, without follow through, the chart will correct itself.  Generally speaking, we also tend to see the false signals contained to the short term.  Notice that the most recent sell signal lasted 272 days, which is the shortest signal in the history of the chart, with the average length of signals coming in at 1024 days. 

4. It's always about the "weight of the evidence."  If you are a regular reader of our columns, you are no stranger to this phrase.  While these individual relationships can help to simplify our focus, we always try to consider the weight of the evidence when possible.  This means that the SPX vs AGG chart is only one of many charts or indicators we consult. 

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As always, please call with any questions or comments.

Until next time, cheers!