We believe education is the strongest defense against the vagaries of the market. Each quarter we’ll share with you our perspective and some context about the economy and markets. We hope you find our Relative Strength newsletters interesting and informative.
1st Quarter 2022
Well, a lot has happened in the last three months! Does anyone even remember the Winter Olympics? We closed out 2021 near all-time highs for large-Cap U.S. stocks as measured by the S&P 500. Sure, there were concerns about inflation (at least the Fed did, however, stop referring to it as ‘transitory”) and expectations of a rate-rising cycle but the overall mood was relatively optimistic. The economy had significant tailwinds coming out of the pandemic with both corporate and personal balance sheets in very good shape. Inflation was expected to moderate as supply chain issues began to clear and producers would start being able to satisfy record demand. Russia was amassing troops on the Ukrainian border but most believed it was just saber-rattling to induce some additional concessions from the West.
On the surface, things appeared to still favor the Bulls but, looking a bit closer, some areas of the market were decidedly weaker than the S&P500. Small-Cap U.S. and the Dow Jones Transportation average had been stuck in a range since late last Spring. Under the surface there was a rotation out of many speculative names and into more defensive dividend payers. While the S&P500 continued its upward trajectory, the number of stocks reaching new highs was declining. Due to the way the S&P500 is constructed, about 40% of the index’s return is attributable to just a handful of large-Cap technology stocks.
As inflation pressures mounted and Russia began to invade their neighbor, the market finally relented and produced the first significant correction we have seen in nearly two years and the beginning of Covid. The mood of the market turned more negative as the quarter progressed as many financial firms, Raymond James included, reduced their GDP estimates for 2022. The Fed began its tightening cycling to combat inflation. Commentary from various Fed governors became decidedly hawkish, signaling more aggressive rate hikes and balance sheet reductions than many in the bond market were anticipating. This led to a quarter where both bonds and stocks produced negative returns. As the quarter ended and despite some Ukrainian progress on the war front, many of the same concerns remain- inflation, rate hikes and a potentially slowing economy. Our Relative Strength portfolios saw several changes as we adapted to the new trends. We continued to see a shift from growth to value, increasing our commodity exposure and raising a bit of cash.
Although it may not have been top-of-mind for many people this year in light of the ongoing Russia/Ukraine conflict, the College Basketball Tournament generated excitement among many die-hard fans across the country. We would argue that the tournament was a much needed distraction from the tragedy taking place in Europe. While personal college affiliations are of course important, for many people it is the office pools and bracket challenges that drive the interest in this event. In bracket scoring, there is no reward for our favorite team "hanging in there" against a major conference powerhouse, and style points are not awarded in the final tabulation. Participants simply need to pick which teams will win each of the 63 games, which is no easy task – estimates of the odds of picking a perfect bracket (i.e. correctly picking the winner of all 63 games) range from one in 128 billion to one in 9.2 quintillion. Fortunately, the committee brought the tournament into the casual fans' wheelhouse by seeding the teams, helping us all move one step closer to being "bracketologists."
The seeding process of teams began in 1979 as a way for the NCAA to make sure that the strongest teams didn't end up meeting each other too early in the tournament, which would be a threat to TV ratings and the overall fan experience. The seeding also provides the uninitiated a basis for picking winners because while there are few who have likely followed the seasons of all 64 teams from around the country, everyone intuitively understands that picking a number 16 seed (the lowest-ranked teams) to beat a number one seed is not a statistically good bet. A team with a high ranking is, after all, the stronger team based upon qualitative and quantitative evaluation. They often possess more talent and better coaching than the lower-ranked teams, especially when comparing teams with a large gap in seeding. While past performance has certainly not guaranteed future success for all the high-seeded teams, it is certainly a good starting point for the average fan's tournament bracket. With data compiled from CBS Sports and ESPN regarding the success of each of the 16 seeds advancing through the NCAA tournament, updated through the 2021 tournament (there were no results for 2020 as the tournament was canceled that year). The seeding process has largely worked out as the NCAA intended it to. Higher ranked teams typically advance through the early rounds, leading to exciting clashes of talented teams late in the tournament. Top-seeded teams don't always survive the four-round gauntlet that precedes the Final Four, but, historically, these teams win about 80% of the games they play. Meanwhile, the 13 - 16 seeds combine to win just only about 11% of the games they play.
Despite the statistical trends, in many years we see a "Cinderella team" emerge somewhere along the way. Basically, a low-seeded team manages to defy the odds and beat a higher-seeded team. In 2017 11th seed Xavier, defeated a three seed (Florida State) and two seed (Arizona) to make it into the Elite Eight. Over the life of the NCAA tournament, however, two and three seeds still win more than two-thirds of their games, while 11 seeds win only about one-third of theirs. Yet many fans spend as much time evaluating which 11 seed will win their first game as they will analyzing which top-seed is likely to win the whole tournament - which is far more important in terms of bracket scoring. This tendency is similar to a study that we have referenced many times over the years regarding the derivation of risk in a given stock. The study, conducted by Benjamin King, looked at the risk in an individual stock and what caused the price of the stock to move. The study found that 80% of the risk is associated with the sector and overall market, while only 20% was company-specific. The other part of the study found that the average investor spends 80% of their time evaluating the company-specific information, and just 20% of their time evaluating market and sector risk.
When we compare investments in a relative strength matrix, we are simply “seeding” teams, and like the NCAA experts, we are seeding them based upon their success against their peers. The more relative strength buy signals generated by a team/security, the stronger the ranking or the “seeding” of that stock or ETF. Similar to the NCAA tournament, we know that history shows those top seeds perform better as a universe than the lower seeds. There are upsets, of course, but the trend favors the higher seeds and so that is where we focus our investment. While the NCAA committee has its own proprietary ways of ranking teams, the input is based upon head-to-head games earlier in the season and overall recent performance. The manner by which a relative strength matrix ranks stocks, sectors, and even asset classes is not particularly dissimilar. Our relative strength rankings are a way to identify the strongest performance trends within a given universe, using head-to-head comparisons (RS charts) to build a database of information. The matrix process also affords us a lens through which to see negative performance trends begin to improve. We'd offer, however, that top-ranked assets in a matrix are your high-seeds, and thus offer the best probability of repeatable success. While low-ranked assets that are simply improving would be the equivalent of a 12 seed scoring an upset. We would not build a portfolio based upon 12 seeds due to the instability of these trends, however, the RS rankings do offer a logical, organized means for approaching the "upset" selection process.
Tumlin Levin Sumner Wealth Management of Raymond James
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The performance numbers in this article do not reflect transaction costs. Indexes are not available for direct investment. Past performance is not indicative of future results and there is no assurance that any forecasts mentioned in this report will be attained.
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Opinions expressed in the attached article are those of the author and are not necessarily those of Raymond James. All opinions are as of this date and are subject to change without notice. The investment profile examples are hypothetical, and the asset allocations are presented only as examples and are not intended as investment advice. Please consult with your financial advisor if you have questions about these examples and how they relate to your own financial situation. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Past performance may not be indicative of future results. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including diversification and asset allocation. Prior to making an investment decision, please consult with your financial advisor about your individual situation. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise. Investing in commodities is generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising. The companies engaged in the communications and technology industries are subject to fierce competition and their products and services may be subject to rapid obsolescence. The Dow Jones Industrial Average (DJIA), commonly known as “The Dow” is an index representing 30 stock of companies maintained and reviewed by the editors of the Wall Street Journal. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. The NASDAQ composite is an unmanaged index of securities traded on the NASDAQ system.