Relative Strength Newsletter - 4th Quarter 2021

Relative Strength Recap

The fourth quarter and 2021 are now officially in the books. After a rocky end to the third quarter, US equities quickly rebounded in October. Aided by generally strong earnings reports, the S&P 500 and Nasdaq each gained around 7% for the month, with the Dow posting a gain of nearly 6%.

US equities’ strength carried through into November with the S&P 500 reaching new all-time highs. However, the emergence of the omicron COVID-19 variant and concerns about the efficacy of existing vaccines sent stock prices and bond yields tumbling post-Thanksgiving.

While the emergence of the omicron variant pushed stocks lower, it took a larger toll on oil prices, which declined more than 10% the day after Thanksgiving, the largest one-day decline since April 2020, leading to a loss of more than 20% for the month.

In remarks the following week, Fed Chair Powell struck a more hawkish tone further unnerving equity investors. Powell said that it was no longer appropriate to call inflation “transitory” and, citing the strength of the US economy, said that a faster tapering of asset purchases was under consideration, The S&P 500 finished the month down slightly, posting a loss of -0.83%. Small-cap stocks were hit harder as the Russell 2000 lost nearly 4.3%.

Fears about the omicron COVID-19 variant subsided as data indicated that, while more infectious, the illness caused by omicron was less severe than other variants, and the S&P 500 ended December with a gain of more than 4% for the month.

Crude oil also rebounded as worries about omicron eased, gaining nearly 14% in December to finish 2021 up more than 55%, its best year since 2009.

The S&P 500 ended 2021 with a gain of just under 27%, its second-best annual return since 2013. Meanwhile, the Nasdaq and the Dow gained around 21% and 19%, respectively. This marked just the sixth year in which the S&P 500 outperformed both of the other major US benchmarks.

While 2021 was undoubtedly a positive year for US equities, rising interest rates were a headwind for bonds. The Bloomberg Barclays US Aggregate Bond Index was down about 1.7% in 2021, its worst year since 2013.

As we begin 2022, we continue to monitor closely for any shifts in the market landscape. Domestic equities and commodities remain first and second, respectively, in the relative strength asset class rankings of our Dynamic Level Investing (DALI) tool. DALI provides us with a heat map of where relative strength (and weakness) resides across and within asset classes. From a sector perspective, relative strength resides with technology and financials; the technology sector regained the top spot in the DALI sector rankings late in the year, finishing 2021 in the same position in which it began.

Thought Process

The Sector Selection vs. Market Timing study can be a useful tool to help one stay the course in a turbulent market, as well as explaining intra-market dispersion and the value of relative strength strategies in general. Over the period of our study, from 1993 through 2021, there were five years in which the S&P 500 posted a negative return for the year, but only in two years – 2002 & 2008 – in which all of the Dow Jones sector indices finished the year in the red. During the most recent negative year for the S&P, 2018, three of the DJ sector indices - healthcare, consumer services, and utilities – finished the year in the green.

Dispersion refers to the performance difference between the best and worst-performing assets and quantifies the opportunity available to tactical strategies. Relative strength-based strategies tend to offer excess return over their benchmarks more readily when the dispersion between the best and worst performers is very wide. The reason for this is straightforward - the more divergence that exists between the best and worst performers, the more potential value that can be added by owning good performing assets and avoiding the bad performers. When there is more dispersion, there is more potential for a tactical decision to produce a meaningful result. On the other hand, such strategies will tend to become muted when the dispersion is narrow. Taken to an extreme, if all investment possibilities were up the same amount each month and each year, tactical asset allocation would have no opportunity to add value via rotation. From 1993 through 2021, the calendar year dispersion between the best- and worst-performing broad DJ sector indices have ranged from a low of just over 25% in 2012 to a high of nearly 97% in 1999, with an average of just under 43%. In most years the sector dispersion has been greater than the total return of the S&P 500, meaning that there was potentially more to be gained from sector allocation than from deciding between the S&P and cash, as our study further illustrates.

Our study tracks the return of four hypothetical investors over 29 years, from 1993 through 2021, the first investor who we’ll dub, "Mr. Buy and Hold” simply buys the S&P 500 Index and rides it up and down, making no movements at all in the portfolio. "Mr. Perfect Market Timer", our second investor, is assumed to be clairvoyant and is only invested during months in which the S&P 500 Index is up. In 2008, for example, this investor would have only been invested in April, May, August, and December, as those were the only positive months that year. In our view, this is about as "perfect" as any "market timer" could ever hope to be, and thus we feel this quantifies well as the best-case scenario for market timing. Our last two investors are both sector investors, one of whom, "Ms. Perfect Sector", has the ability to know each and every year what the best performing sector will be for that year, and invests 100% of her portfolio in just that one sector. The fourth investor, "Mr. Worst Sector", is an unfortunate fellow, who perhaps just follows a favorite magazine cover and is on the wrong side of things every year. He manages to invest only in the single worst-performing sector.

As you might imagine, each of the investors has seen dramatically different results over the years from their initial investments of $10,000 back in 1993. At the end of 2021, Mr. Buy and Hold had a portfolio value of about $193,000 while Mr. Perfect Market Timer had a portfolio value of nearly $15 million. Ms. Perfect Sector saw her portfolio swell to $34.7 million, all while poor Mr. Worst Sector's portfolio was worth only $441! Yes, you read that right - $441 from the starting point of $10,000.

So, it's easy, right? All you have to do is invest in the best-performing sector each year and simply walk away. Unfortunately, it is not that easy, nor are we advocating that you try to pick the best performing sector and put all your eggs in one basket; rather, this is simply a powerful illustration of just how important incorporating a sector rotation plan can be into your overall portfolio strategy. It can also be an eye-opener for clients in that the magnitude of buying the best sectors is even greater than that of being able to perfectly time the overall market.

Tumlin Levin Sumner Wealth Management of Raymond James

Please be aware that the content of this newsletter is based on the opinion of Dorsey, Wright research and may differ from the research provided by your financial advisor. This market theme letter was written by Dorsey, Wright & Associates and is provided courtesy of your advisor.

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.

Stocks offer growth potential but are subject to market fluctuations. Dividends are not guaranteed; companies can reduce or eliminate their dividend at any time. There are special risks associated with an investment in real estate, including credit risk, interest rate fluctuations and the impact of varied economic conditions.

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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.