Month: October 2016

Active portfolio management is not a new concept but tends to be more mysterious to investors regarding what the wizards do behind the curtain. Even if it is not used exclusively, technical analysis tends to play a greater role in active management as compared to fundamental analysis. Prior blog posts have covered some of the differences between the two. Today we will be running through a rather quick history lesson about technical analysis including the evolution and role of indicators. As the tools of the trade are understood, the fog of mystery should begin to disperse.

Technical analysis did not have one specific starting point. The benefits of plotting prices for the sake of extracting clues of future direction occurred in the 1600’s as lottery prices were plotted in England. Accounts by Joseph de la Vega reported prices in the Dutch markets also in the 1600’s and Homma Munehisa of the rice markets in 17^th century Japan.

bank-england Bank of London

In the U.S., Charles H. Dow created his famous index to visualize the collective changes in a group of industrial companies. In the early 1900’s, traders and authors such as Richard Schabacker, Harold Gartley, William Gann, R.N. Elliot, and Richard Wyckoff developed and published methods to interpret the price action of stocks and commodities. “Technical Analysis of Stock Trends” by Edwards and Magee, is commonly cited as the most comprehensive book on early technical analysis. Most of these works center around identification and interpretation of trends, price patterns, and volume analysis. This was the era in which concepts such as, Head and Shoulders tops and bottoms, double tops and bottoms, triangles, support and resistance, and trend lines were introduced.

Fast forward to the late 1960’s and early 1970’s, which brings us to the early stages of the meat of our topic – indicators. In 1969, Sherman McClellan and his mathematician wife Marian developed the oscillator and summation bearing their last name. Amazingly, the complex math was calculated daily, originally by hand, prior to the aid of computers.

One of my life’s greatest thrills was eating lunch at a Taco Bell with Mr. McClellan many years ago, but that’s a story for another time.

In 1978, J. Welles Wilder Jr. published, “New Concepts in Technical Trading Systems”. Similar to the McClellan indicators, Wilder’s indicators were described to readers exactly how to calculate by hand the formulas behind indicators using daily worksheets. Wilder’s book introduced indicators such as the Relative Strength Index (RSI), Directional Movement (ADX and DMI), Parabolic SAR, Average True Range (ATR), and others. These indicators are early examples of going beyond looking at basic price action. In other words, math formulas were introduced that can create plots on the same page or chart as the price action to serve as a companion to the traditional forms of price and volume analysis.

Example of early charting software displaying candlesticks

As a brief but important aside, 1970 was the beginning of the Market Technicians Association (MTA). This organization was established by a group of professional technical analysts that sought to raise the level of acceptance of the craft to beyond what had been deemed by many as a “voodoo” form of analysis. Many of the MTA members are well-known, having extensive authorship and media appearances regarding chart-based methods. In 1949, the Securities and Exchange Commission displayed a strong bias against chart-based methods when the organization stated “all Wall Street research must be rooted in sound fundamental principles”. Through ongoing efforts by the MTA, in 2005, the Securities and Exchange Commission amended Rule 344. “There are officially two different categories of Wall Street research analysts: a fundamental analyst follows companies and has a CFA diploma; a technical analyst follows stocks and has a CMT diploma”.

In the decades that followed, computers and technology have played significant roles in the expansion of technical analysis and its impact to portfolio management. Already mentioned were trailblazers such as the McClellans and J. Welles Wilder Jr., but many others developed indicators that received notoriety. An indicator by Dick Arms was seen scrolling along the tickers on the financial programs noted as the TRIN or Trading Index, though many call the indicator the Arms Index in honor of the originator. Joe Granville’s On Balance Volume, John Bollinger’s Bollinger Bands, Gerald Appel’s Moving Average Convergence Divergence (MACD), and many others became staples among chartists as early versions of charting software incorporated these tools.

bloomberg-terminals Indicators can fit into various categories and similar to a chef reaching for specific ingredients, can be combined and incorporated with different weightings in order for a portfolio to take on a particular flavor or have a particular personality. Low volatility funds may use specific indicators while aggressive portfolios may choose to use others. In future blogs, we will take a look at these different categories, covering some indicator examples and why a portfolio manager may or may not use them in the recipe.

So why spend time with the history lesson? A building’s foundation must be strong in order for it to stand the tests of time. Before the building blocks form the foundation, architects, engineers, and contractors must understand the nature of the building materials and how they work together for the common goal. If we want to understand how a portfolio is constructed and managed, we have to establish a basis upon why portfolio management has confidence in the methods. From a broader sense, some chart-based analysis used by portfolio managers may be relatively simple but many can be very complex, based on decades of supporting research and development by many wizards of the craft.

Disclosures

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Spectrum Financial, Inc. in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Spectrum Financial, Inc. expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing. For full disclosure please see disclosures page here.

October 2016 Quarterly Newsletter

By Ralph J. Doudera, CEO

On October 21, 2016

In Quarterly Newsletter

General Market Commentary

In spite of election uncertainty, consumer confidence has improved substantially, and in the US, job optimism is hitting a nine-year high. This remains the bedrock of economic growth. While businesses are slow to make decisions pending the election outcome, consumers don’t seem to have a problem. Current market reaction to the outcome of the election seems to prefer a Democratic president. But, if we end up with a Democratic president as well as Democratic majority in the House and Senate, I feel that the market will definitely not react well.

Inflation may begin to rear its ugly head and the Federal Reserve may raise short-term interest rates to combat it.

“The last time we had a series of rate increases was in 2004-06 following the 2002-03 recession/bear market. The Fed raised the Fed Funds Target Rate from 1.0% to 5.25% in 17 steps.

Michael Price OnTrack Report, 2016-20

The stock market initially sold off when the Fed started raising rates, but soon reversed course and moved higher. During the 25-month period shown on these charts, the S&P 500 gained 13.92% — and junk bonds fared even better. Junk bonds did not sell off with stocks when rates started to rise, and the ML Junk Bond Index gained 18.84% during the 25-month period — with much less volatility than the S&P 500.” Michael Price OnTrack Report, 2016-20

Michael Price OnTrack Report, 2016-20

Floating Rate Funds (Senior Loans) vs. High Yield Bonds

A low interest rate environment creates challenging opportunities to seek out alternative investment strategies that produce respectable returns and still limit risk. Most people do not recognize the risk involved in government bonds when interest rates rise, or in high yield bonds when a recession begins.

Senior loans may be a solution to this dilemma. These investments are secured corporate loans made to a company and rank in seniority ahead of other unsecured high yield bonds that the company may own. They offer a floating rate that can take advantage of rising interest rates, which we currently see on the horizon, by increasing the loan terms as interest rates increase.

These investments also offer strong and stable current income in both high and low interest rate environments, superior credit position due to being in a senior position, and lower volatility of price, thanks to removal of most interest rate risk as well as credit risk. For example, the chart below illustrates the return and volatility of the floating rate Credit Suisse Leveraged Loan Index (CSLLLTOT) compared to the iBoxx High Yield Bond Index (IBOXHY) for the past three years. You should note that although performance for the period is similar, floating rate funds are much less volatile. They are also easier to trade.

In addition, since rates can adjust upward in periods of rising interest rates, they may have outperformed other fixed income securities as is shown in the chart below.

There remains, however, a time to leverage these bonds and increase exposure, as well as a time to sell them and go to a safe cash position. These sell signals can be seen on the chart. By monitoring these investment alternatives, we continue to be conservative investors when risk increases, yet we maintain liquidity to go to cash when favorable conditions change.

Low Volatility Strategies

Many people have asked: How has Spectrum produced high returns for strategies that are supposed to have low volatility?

Low volatility does not necessarily mean low performance. Spectrum’s products are designed to take advantage of upward directional moves, and avoid drawdowns by using several integrated strategies. For those of us who took chemistry in school, it comes down to both qualitative and quantitative analysis. What to own and how much to own becomes the question. Since certain strategies primarily hold bonds, and because we have found that all categories of bonds do not move together, we have developed a selection process over the years to phase in and then phase out of bond sectors based on a ranking analysis of various sub-groups. The chart below illustrates performance of various sub-groups, which we monitor, and one can see different directional movements at various times. By rotating in and out of these bond sectors, we attempt to minimize drawdowns and select the groups with the highest relative performance. Finally, we evaluate market conditions to see how much of each bond class to own, and we may use leverage when appropriate.

This blog contains excerpts taken from the October 2016 edition of The Full Spectrum newsletter. To continue reading please download the full copy here: The Full Spectrum: October 2016

Disclosure

Spectrum Financial, Inc. is a Registered Investment Advisor. The Full Spectrum is published quarterly for its investors and account executives. This publication is not intended to offer or solicit investment advice, nor should anyone act upon any suggestions made herein, without individual counseling from your account executive regarding risks involved. There is no guarantee that the recommendations of management will prove to be as profitable in the future, as they have in the past. The information presented in this issue has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. A copy of Spectrum’s current written disclosure statement discussing advisory services and fees is available upon request. All rights reserved, please notify when quoting.