Relative Strength Newsletter - 1st Quarter 2022
Relative Strength Recap
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.
The Relative Strength Seeding Process
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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