SECTOR ROTATION TOOLS

SECTOR ROTATION TOOLS

Sector Analysis with Bullish Percent Indexes

The same Bullish Percent concept that is applied to the NYSE, OTC, Mutual Fund, and International markets can be applied to sectors within the market. In fact, on our web site we have cre- ated Bullish Percent Indexes for every viable stock exchange in the world from Malaysia to Portugal. This application expands our ability to separately evaluate the pieces of the puzzle. The puzzle is the whole market, made up of many sectors. We look at these sectors as the pieces of the puzzle. Sector analysis is proba- bly the most important consideration when investing. Sectors are like the schools of fish you might have seen on the Discovery Channel. These schools dart quickly in one direction or the other, but what is amazing is how a whole school of fish moves per- fectly together on each turn, as if some sixth sense tells each indi- vidual fish what the group is about to do. Sector rotation tends to behave the same way. Economic stimuli that would have an effect on a particular sector tend to affect all the stocks underlying the sector causing them to move in unison. Sector analysis is one of the most important yet least analyzed parts of the market. We place tremendous emphasis on sector rotation in our daily work. I have said in previous chapters that about 75 percent of the risk in a stock is associated with the market and sector, and only 25 per- cent is stock-specific risk. Stocks don’t just jump about with no

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rhyme or reason. Moves tend to be orchestrated like the Boston Philharmonic.

Another analogy keeps coming to mind. I picture a herd of wildebeest romping across the African plains. They move in uni- son, first in one direction, then another. A few of the herd get out of sync, but the majority tend to move together. Sectors operate the same way. Wall Street tends to follow the actions of the herd. First the sector’s supply demand relationship changes and more informed buyers begin to cause the stocks in that particular sec- tor to rise. As the sector moves up, other institutions are alerted that the move is on, and they climb on board. Eventually, the mainstream financial media catch wind of a sector move under- way and begin to write articles about how the industry has made a turnaround and should have clear sailing ahead. This draws in the individual investors just in time to catch the top. By the time the articles appear in magazines about how great the industry is, almost everyone is in who wants to be in leaving little available demand to force the industry up much further. The last group in is the unsuspecting public, who use newspapers and magazines as their primary source of stock market research. Time magazine has a cover story about XYZ Company rated “Company of the Year.” Mr. Jones, who sees this major statement on the cover of this mainstream magazine, calls his broker and buys the stock, virtually drying up the last available demand for the sector. Ev- eryone is now in who wants to be in. The magazine cover sig- naled maximum saturation of positive information about this company. At this point, all it takes is the slightest selling pres- sure to start the downturn because there are no buyers left. With little demand left, it only takes a small amount of supply to turn the situation around. Once the public is in, virtually no one is left to do the buying. Remember that prices move as a direct result of supply-and-demand imbalances. If there are no more buyers left to cast their vote, supply, by definition, must take the upper hand. The sector then begins to lose sponsorship and moves to an oversold condition where everyone who wants to be out of the sector is out, and the whole process starts anew. It’s actually beautiful how these natural rhythms evolve. When you think of the seasons changing, or the produce in the supermarket coming in and out of season, think of sector rotation as I do.

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I mentioned magazine covers. Watch them carefully. The next time you are in the airport, look at the magazine rack and see if you can find a widely read magazine that makes a major state- ment on its cover about some sector of the market—something like “The Banking Industry Is in Trouble.” If you find one, buy the magazine and keep it. Actually, just keep the cover. Nor- mally, the trend in that sector will continue to move for a couple of months in the direction the cover suggests, as the last Joneses buy their shares. Give that sector eight months, and you will find its behavior has a high probability of being opposite of that sug- gested on the magazine cover. The reason for this is that the cov- ers stirs Mr. Jones and Ms. Smith into action and while all the Joneses and Smiths are busy reacting, the sector moves in the forecasted direction. Once these investors are in and the door slams behind them, there is no more buying or selling pressure (whichever the cover suggests) left to sponsor the sector. The forces of supply and demand slowly begin to change, optimism turns to pessimism or visa versa, and the sector takes the oppo- site tack. Try it—you will be amazed. It’s simply human nature.

To put some quantitative research on why sector rotation is so important in stock selection, I want to discuss an interesting study we did at Dorsey, Wright & Associates (DWA). In this study, we had four hypothetical investors invest $10,000 starting in 1990; each had a different set of investment rules. The first in- vestor used a buy-and-hold strategy. The second timed the mar- ket. The third and fourth investors both used sector timing. The study looks at each one of the theories from 1990 to 2005.

Mr. Buy and Hold started with $10,000 and just bought the S&P 500 and held that original investment through thick and thin; his account grew to $35,322. That is certainly not a bad re- turn, about 8.2 percent annualized and the portfolio hit its peek in 1999 and still hasn’t recovered to those levels yet, six years later. He did what we call “ride them up and ride them down.” The next investor, the market timer did even better though. For the purposes of the study, Mr. Market Timer was omnipotent enough to know every month when the S&P 500 was up and stayed invested for those months; and when the S&P 500 was going to show a loss for that month, he was not invested. Keep in mind we know no one has this ability in the real world. Using

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these rules, Mr. Market Timer turned his $10,000 into $440,290! The third investor was Mr. Good Sector Timer. Like, Mr. Market Timer, Mr. Good Sector Timer was omnipotent about the fate of sectors in the marketplace. Every year he consulted the crystal ball and knew exactly what sector was going to be the best per- former for the coming year. By putting his money into the best performing sector each year, his account swelled from the origi- nal $10,000 to $3,656,168 by the end of 2005. This was spectacu- lar performance to say the least. Finally, the last investor was Mr. Poor Sector Timer. This poor soul didn’t have fate on his side and invested in the worst performing sector each year. His portfolio had dwindled to $260 by the end of 15 years. You can graphically see these results in Figure 8.1.

While all these investors are fictitious and certainly no one would ever be able to have the 100 percent accuracy that Mr. Market Timer and Mr. Good Sector Timer had, the study points out that market and sector timing are extremely important in in- vesting. Being able to identify strong sectors and weak sectors can enable one to gain an advantage over just buying and holding

Figure 8.1 Buy and Hold versus Market Timing versus Sector Timing.

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without regard for sector rotation. One doesn’t even have to be close to getting every sector move correct to outperform the buy- and-hold theory.

When evaluating sectors, you must be a contrarian. You must find the courage to buy stocks in sectors that are out of favor. You must avoid the crowd. This is extremely difficult as it goes against human nature. We tend to gravitate to the crowd. You go to your neighborhood supermarket, it’s payday and you are sure the store will be crowded. When you arrive at the store, you see that a major incident of sorts has captured everyone’s attention. There is a major crowd around this incident. Do you go with the crowd to see what is happening or do you take advantage of an empty store while the other shoppers are crowded around the in- cident outside? The sector Bullish Percent indexes force you to go into the store and shop while you can with no interference. You will be able to have your pick of the best produce, best meats, not wait in line at the deli, and have first choice in the marked-down meat section. On top of that, you will be able to check out with no line and all because you went against the crowd.

That contrary view of things is exactly what Earnest Staby was talking about in the mid-1940s. As mentioned earlier, trend charts always look most bullish at market tops and most bearish at market bottoms. The Bullish Percent Indexes force you to be more negative at tops and more positive at bottoms. Once you see more than 70 percent of the stocks underlying the market or a sec- tor go on buy signals, you are in a condition where just about ev- eryone is in who wants to be in. When translated into supply and demand, it simply suggests that the availability of demand has been spent. If this is the case, then an investor should be less en- thusiastic about buying stock in the market or that sector when the index is at 70 percent or higher. When the index is near the 30 percent level or lower, it’s time to put your buy list together.

When I was a stockbroker, I went with the crowd. It was eas- ier to do business that way. Even though I was at a major broker- age firm with highly paid fundamental analysts who were literally hit or miss (you never knew which), my primary source of research was the Wall Street Journal and Barron’s weekly fi- nancial newspaper. When those didn’t yield enough ideas, I lis- tened to the broker next to me pitching a stock. All of us got

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ideas the same way, and as you may have already guessed, the pro- cess was lackluster at best. Our training back then was basically in sales and not much else. It really hasn’t changed much since then either. Now the emphasis for many stockbrokers is on rais- ing money and giving it to a “professional manager” to manage, knowing full well that over 75 percent of all managers and mu- tual funds never outperform the broad averages. The broker’s place in this equation is to manage the manager and manage the customer relation for a fee. He primarily performs a middleman function. For the most part, computers perform this function as they do in most any other business. Somehow I seriously doubt this type of fee for the middleman function will rise in the future. What is a broker to do, though? Most brokers have no plan of ac- tion one way or the other. Don’t get me wrong, there are many craftsmen out there indeed; and many of them subscribe to the Point and Figure method of managing accounts. These people bring major value to the table. The investor’s job is to find a bro- ker who has a solid game plan that includes not only buy strate- gies but also sell strategies. I assure you, you will not find one by going to a branch office of any firm and asking for the broker of the day. Good stockbrokers who have all the skills to manage the money themselves are a rare breed these days. When you find one, stick with that broker. If you need one, just e-mail us (DWA@dorseywright.com), and we can supply the name of a craftsman who lives near your area. Most of our clients under- stand the concepts in this book and use them in their daily mar- ket operations. There are still no guarantees but I assure you, I would want a broker who at least had the principles of this book firmly in mind. This is his operating system, just like Windows XP. There is no question about it; wealth is still created in the stock market. But as we also found out in 2000 to 2002 the mar- ket is the fastest place to lose wealth if your portfolio is not man- aged properly. The year 2000 was a real eye-opener for most investors. Recently, I had a Sunday morning call at my home from an independent broker in New Jersey who decided he would be better off having the Money Management arm of DWA handle a number of his accounts. The market had just taken the wind out his sails. Not only had it taken a strong understanding of Point and Figure Technical Analysis to negotiate that market

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from 2000 to 2002, it also took a good understanding of how to use the options product to help manage the volatility and risk of the markets.

We run Bullish Percent calculations on numerous sectors as well as international sectors. International sector rotation is be- coming increasingly more important as we shift to a total global society. In Chapter 6, we discussed the NYSE Bullish Percent Index in detail. The same principles apply here. You might think these concepts are universally known, but they aren’t. It’s still a lost art. There use to be a TV show called The Street. I was totally surprised that on the show they shouted over the broker’s inter- com, “The Point and Figure Charts are now updated.” It really floored me when I heard this. How did Hollywood ever learn about the Point and Figure concept and feel it was important enough to create an audio that all the viewers of the program could hear? I was so surprised because very few individuals or professionals understand these concepts. After reading this book, you will join a very elite group of investors I often call the SEAL Team 1 of Wall Street. You would be hard-pressed to find a broker, outside our client list, who understands this philosophy and has reached what we would call craftsman status. The reason is sim- ple, it takes some education and dedication to understand it, and most investors and professionals are not interested in going that extra mile to become a true craftsman. A good friend of mine, Dave Winder is a Master Plumber. He told me it takes four years to become a craftsman plumber. Why would the business of in- vesting take any less time? Those of you who are reading this book are a rare breed indeed. You are learning a lost art.

Everything you learned in Chapter 6 on the Bullish Percent Index applies here, so I’m not going to rehash the discussion. If you find you do not understand this concept thoroughly, go back to Chapter 6 and reread it. Sectors employ the same concept, but the number of stocks in the sector universe is smaller than that of the New York Stock Exchange (NYSE) or Nasdaq universe. Be- cause of the smaller number of stocks in sector Bullish Percents, they tend to move faster than the NYSE Bullish Percent. To con- struct a statistically valid Bullish Percent, a sector should have a minimum of 100 stocks. If you have less than 100 stocks, then one stock’s buy or sell signal could move the Bullish Percent more

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than 6 percent. The best way to get a handle on using this concept as well as other indicators for sectors is to take an example and go through it. Let’s take a look at a sector Bullish Percent chart and outline on the chart where the pertinent changes took place.

Electric Utility Bullish Percent

In Figure 8.2, you can see the Electric Utility Bullish Percent. Many people would regard this as a sleepy sector, not worthy of consideration because “it doesn’t move enough.” That really is not the case at all. This sector, like others, has provided good op- portunities over the years. In 1994, the Electric Utility Bullish Percent chart fell to 24 percent. This is down into the “Green Zone,” “Promised Land,” or “oversold” territory. The fall to 24 percent had come after the Electric Utility Sector Bullish Percent reached as high as 94 percent in February 1993 and then reversed down in December 1993. The reversal down in December 1993 into O’s suggested that you bring the defensive team on the field with respect to electric utilities. In your portfolio, you would have wanted to examine the electric utility stocks you owned on a fundamental and technical basis. If the individual stock had de- teriorated on either account, then action was warranted. Remem- ber that a reversal down from above 70 percent puts the sector on defense and suggests high risk. If you owned electric utility stocks in December 1993, you had a high-risk position in your portfolio. To mitigate that risk, you would have several choices. You could set a stop-loss point at which you were not willing to give back any more. You could have taken partial profits off the table thus reducing your exposure to the sector. You could have bought protective puts on your electric utility positions giving you the right to sell that stock at a specific price at a specific time in the future. Again, the whole point would be to reduce risk in an otherwise high-risk sector. You will read in the Fixed Income Indicator chapter that at the same time the Electric Utility Bull- ish Percent was reversing down, the fixed income indicators were also giving major sell signals in November 1993. Do you see how this is all coming together, and the pieces of the puzzle begin to fall into place? Well, the Electric Utility Bullish Percent fell all

Figure 8.2 Electric Utilities Bullish Percent chart.

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the way down to 24 percent by September 1994. Sometimes, sec- tors fall in a straight line and other times they move down like a staircase with each rally producing lower highs and each sell-off producing lower bottoms. From the February 1993 high in the PHLX Utility Index (UTY) to the September 1994 low, the UTY was down 27.5 percent. That’s a utility index, mind you, down 27.5 percent!

Now continuing forward in time, in January 1995, the Electric Utility Bullish Percent chart reversed up to X’s meaning we bring the offensive team back on the field with respect to the sector. As well, the bond market indicators were beginning to give buy sig- nal, the first since the November 1993 sell signal. This informa- tion would have suggested you evaluate your fundamental inventory of electric utility stocks and find those stocks con- trolled by demand to initiate new positions in. You could have also bought calls on the PHLX Utility Index (UTY) or purchased a utility ETF allowing you to buy a school of utility fish instead of owning just one fish. Just as there are numerous ways to be defen- sive, there are numerous ways to be offensive, too. Another sim- ple strategy you might consider when a sector reverses up from a low level is to buy not just one name within that sector, but two. This can be advantageous for a couple of reasons: First, when a sector is reversing up from an oversold condition and has some other factors going for it, we overweight that sector. Let’s say typ- ically you take a 5 percent position in a sector. If the sector Rela- tive Strength (RS) is strong and things are lining up well for the sector, then you might take an 8 percent position. By purchasing two names in the sector, it allows us some extra flexibility when we feel the indicators warrant scaling back in the sector. Second, it seems like Murphy is always hanging around the corner. The electric utility stock you choose to buy would be the one with some type of noose around its neck that doesn’t allow that stock to rally while the rest in the group take off like a rocket. Think about Microsoft (MSFT) in the software sector. From April 2003 to April 2006, the general markets were in a rising trend with the S&P 500 up 54.5 percent during that time. Individual sectors were also doing well. The DWA Software (DWASOFT) sector made a nice recovery from its 2000 to 2002 decline of about 56 percent, to rally 118 percent during the next three years. If the

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software sector was up 118 percent, it would make sense that the largest software company in the world with sound fundamental numbers would participate. However, Microsoft was only up 10.8 percent. Of course utilizing peer RS can help you avoid this situa- tion but sometime having two individual picks within a sector can help smooth out any mistakes along the way.

Just as the move down in 1993 for electric utilities was very sharp and steep, the upmove for electric utilities in 1995 was powerful. The sector Bullish Percent rallied from 30 percent on the reversal up into X’s straight up to 80 percent. During this time frame (January 1995 to March 1996), the PHLX Utility Index (UTY) was up 21.7 percent. This was a good move for a “slow” sector like electric utilities, and that return doesn’t include any dividends.

Let’s continue to look at the Electric Utility Bullish Percent chart for the year 1998. In March 1998, the sector Bullish Percent was at 90 percent, near those 1993 highs of 94 percent. Now look at that chart again and say out loud whether you think this is a high-risk or low-risk time to buy electric utility stocks. It’s a high- risk time. With a reading above 70 percent on a Bullish Percent chart, it tells us that most of the people who want to be in the sec- tor are already in. The availability of demand to continue to push the sector higher is extremely limited. In May, the sector Bullish Percent reverses down to O’s and falls to 66 percent by September. Then in October 1998, the electric utility sector reverses up to X’s at 72 percent. The sector is back in X’s, but the field position is 72 percent. What would you do? Would you go out and enthusiasti- cally buy electric utility stocks the way you would when the sec- tor is reversing up from below 30 percent? You probably would not. In fact, I’m sure after reading this book you definitely would not. A sector Bullish Percent may be in a column of X’s, but the field position may not be good; have patience, it will come back to a better level. They all do. Or, if you have to have a presence in that sector, take just partial positions, not full positions. By Janu- ary 1999, the Electric Utility Bullish Percent was back into a col- umn of O’s at 72 percent. It resulted in a drop to 28 percent.

The Electric Utility Bullish Percent is no different than any of the DWA sector Bullish Percents, from small sectors like precious metals to large macro sectors like energy or technology. After you

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finish reading this case study on the Electric Utility Bullish Per- cent, go to our web site (www.dorseywright.com) and get another sector Bullish Percent chart and do this exact same exercise. The more charts you look at and analyze, the higher your confidence level will get in this methodology. Now, let’s pick up again with the Electric Utility Bullish Percent chart in Figure 8.2 with the end of the year 1999. During the year 1999, the Electric Utility Bullish Percent fell from 70 percent down to the 28 percent level. That move from October 1998 to the December 1999 lows saw the PHLX Utility Index (UTY), fall 28 percent. In January 2000, the Electric Utility Bullish Percent was reversing up to X’s at 34 percent, great field position. Like the NYSE Bullish Percent, often times a sector will retest its lows after reversing up from such a low level. The electric utility sector made a higher bottom in March 2000, and in April 2000, was back in X’s at 38 percent. Think about this a second. The electric utility sector was revers- ing up to X’s right when technology sectors were giving RS sell signals. The sector was the best performing in 2000, up over 40 percent while the Nasdaq Composite was down almost 40 per- cent for the year. When one door closes, another window opens, but we have to keep our eyes open to those new opportunities. I love good peaches in the summer. But come fall, you can rarely find a peach and when you do it is hard as a brick. In the fall, I start buying apples that are at their peak, crisp and juicy just like I like them. Sectors rotate in and out of season just like the pro- duce in the supermarket does. Successful portfolio management means that you are in tune with these rotations by watching the Bullish Percent charts. Embrace sector rotation in your portfolio, don’t try to fight it. In the year 2000, the electric utility sector was the best performing group, up about 40 percent in the face of a Nasdaq Composite down 50 percent from its highs.

By the end of 2000, the Electric Utility Bullish Percent had moved back into the Red Zone above 70 percent and then re- versed down into a column of O’s. As you are already catching on, this suggests to us high risk in the group. By looking at the his- tory of the Electric Utility Bullish Percent chart you will see that the move in this sector has generally run out of steam when the sector Bullish Percent gets into the upper 70 percent range or be- yond. At these levels a prudent thing to do would be to begin scal-

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ing out of Utility positions and take partial profits off the table. Set stop-loss points so you make sure those hard-earned profits don’t turn into losses.

Let’s follow on to the top in September of 2000 and subse- quent reversal down to 18 percent by 2002. These were tough times in the market. The average stock was getting hit pretty hard. In fact, most investors lost large chunks of their retirement portfolios and still to this date in 2006 have not made it up. The “buy and hold” type clients are down in equity over the last eight years. We are nearing a lost decade for many investors.

But let’s get back to the bottom in the Electric Utility Bullish Percent in 2002. This was a major bottom and like it often hap- pens, the index reverses up; profit taking sets in as most investors simply can’t believe the sector is actually rising. The next rever- sal up gets the attention of the institutions and the move is on. The index ratcheted itself up from 18 percent to a top of 92 per- cent in 2004. This was the highest level for the Electric Utility Bullish Percent in 12 years, since hitting that level in early 1992. During the rise in the Electric Utility Bullish Percent from 2002 to 2004, Greenspan was lowering interest rates like there was no tomorrow. Housing markets were rocking and everyone thought they had found a “free lunch.” Actually there was for a while. The real rate of interest rates, taking the interest rate and sub- tracting inflation was below 0 percent.

All things must come to an end and it was clearly signaled by this Bullish Percent index in May 2004, with a reversal down into O’s at 86 percent. Looking back now, I wish I had sold my condo- miniums in Florida on this date. There is an old real estate adage: “You can buy more real estate in a day than you can sell in a life- time.” I’m finding that out to be true. I’m starting to see the wis- dom of the “rent it all and own nothing” camp. In retrospect, it signaled that rates were about to go on the rise. On June 29, 2004, Fed Chairman Greenspan began raising rates and raised them 15 times. Today, May 2006, the Fed is still raising rates. The Electric Utility Bullish Percent is in O’s and has been since October of 2005. This is very interesting how this market is playing out. Here’s my guess. The new Fed Chairman Bernake continues rais- ing short-term rates until the Electric Utility Bullish Percent drops below 30 percent and reverses up. Once this happens, the

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Fed will be finished raising rates and the market will be ready for a sustained move on the upside. Depending on when you read this, you might already know how it played out. It’s like a great mystery, like the game Clue. The murderer turned out to be Colonel Mustard in the Library with the Candlestick. In reality, I never predict, it’s only for fun. When the indicators change, I change. Never anticipate the anticipators.

Sector Bell Curve

The Sector Bell Curve is one tool we use to get a good perspective of the overall market’s relative position on a Normal Distribu- tion. You probably know this as a bell curve. There are basically just two things we know from the study of economics or statis- tics that we can apply to the stock market. First, supply and de- mand governs all price change. Embrace it! When there is more demand than supply, the price will rise and conversely when there is more supply than demand, prices will fall. We depict the supply and demand in the marketplace by recording the price (the net of all supply and demand) of a stock in a logical, sensible, and organized manner, the Point and Figure chart. Second, we have the statistical concept of the bell curve with an overbought, over- sold, and normal level.

One way we use the bell curve concept is to take the differ- ent sector Bullish Percent charts we follow and plot them on a bell curve. This is a concept you will never learn in a university. For that matter, you will never learn any of the concepts in this book at a university. Now read carefully: Every sector will al- ways trade between 0 percent and 100 percent because every stock in the sector can either be on a buy signal (100 percent), on a sell signal (0 percent), or some combination thereof. Typically, we publish the sector Bullish Percent readings in a vertical for- mat with the Y-axis on the left going from 0 percent to 100 per- cent like that of the Electric Utility Bullish Percent in Figure 8.2. With the Sector Bell Curve, we take the vertical axis and make it the horizontal axis. Then, the first four letters of each sector Bullish Percent (for ease of identity) are plotted on the curve (Fig- ure 8.3). If the sector abbreviation is in upper case, then the sec-

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Figure 8.3 April 2002 Sector Bell Curve.

tor Bullish Percent chart in question is in X’s on its own Bullish Percent Index, and moving to the right of the curve. Lower case letters indicate the sector Bullish Percent is in O’s and moving to the left of the curve. Plotting each of the sectors on a bell curve in this fashion gives us a composite picture of the risk in the market. Sometimes, as in April 2002, the curve will get very skewed to the right-hand side indicating an overbought market. To start off the year in 2005, the bell curve of the 40 DWA sectors was also quite overbought and skewed to the right-hand side. We all know how the market of 2002 played out and even in 2005, while the major indices closed up for the year, those gains came after the bell curve had corrected back to a more neutral time. When you see a bell curve like that pictured in Figure 8.3, it usu- ally suggests a “bad moon rising.”

Sometimes, like December 1994, October 2002, or March 2003, the bell curve will get very skewed to the left-hand side in- dicating an oversold market (Figure 8.4). Pictures like this don’t happen very often, only once every couple of years on average. Most of the time, a correction will take the bell curve from an overbought position down to what I call a Normal Market were most of the sectors are huddled around the middle of the curve. This is what happened from May 2006 to June 2006. This market is still in the process of resolving itself and so far the NYSE Bull- ish Percent remains in O’s so we’ll have to see how far down it goes. This last strong decline has taken the NYSEBP from 68 per- cent to 43.5 percent at this writing.

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Figure 8.4 Oversold Bell Curves: October 2002 and March 2003.

The Sector Bell Curve of February 2000 was interesting and unusual. In the February 9, 2000, curve, there are some sectors, mostly NYSE denominated, on the oversold, left-hand side of the curve (Figure 8.5). On that same curve, we see that on the right- hand side, it is populated by technology stocks, mostly OTC or Nasdaq denominated. In general, if you limit yourself to buying

Figure 8.5 February 2000 Sector Bell Curve.

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in sectors that are bullish and around 50 percent or lower, it would have forced you to buy when the risk is low and be more defensive when the risk is high. In this case, it was clear the risk was in the OTC/Nasdaq issues, not the NYSE issues, which is two-thirds small cap. By July 2001, the move was on. The Nasdaq technology issues were slammed and the small-cap issues that had already experienced their bear market in 1998 were ready to rock. In fact, I was a regular on FOX News Cavuto on Business during this time. Neil Cavuto, who I think is the best on the air today, asked me a pointed question: “Tom, all I hear from in- vestors is how they are losing money in the market when more than 50 percent of the stocks that trade are up not down.” This is what the bell curve was telling us at the time. Buy NYSE and avoid technology which was then primarily populated with Nas- daq issues. My answer to him was that the small-cap stocks have already taken the baton in this relay race and the leadership had changed. Indexes like the Dow Jones and Nasdaq were definitely declining because they are capitalization weighted. The stocks that underlie these indexes were rising. What an interesting time in the market this was. We saw it coming because we subscribe to the Yogi Berra School of Investing where he once said: “You can observe a lot just by watching.” We watch a lot. So by regularly viewing the Sector Bell Curve you will see an excellent composite picture of risk in the market. There are many people who think the Point and Figure method of analysis is only a trend-following system. It isn’t. This Bullish Percent concept developed in 1955 forces an investor to do things that are unnatural. It forces him to buy when things look the worse and sell or defend the portfolio when things look the best. The financial media has a vested inter- est in keeping viewer so they typically present only one side of the market, the good side.

Favored Sector Status

Now, let’s bring another piece of the puzzle into the equation— Relative Strength (RS). As you read in Chapters 4 and 5, RS is an integral part of our work. Starting in the mid-1990s, we began to take a much closer look at incorporating a RS overlay to the Bull- ish Percent work and here’s the reason. We might have two Bullish

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Percent charts that looked almost identical. Both had corrected from overbought territory above the 70 percent mark down to oversold territory below the 30 percent level and reversed up to X’s. Positions were taken in both sectors and one vastly outper- formed the other. A look at the bell curve of October 2002 in Fig- ure 8.4 shows that restaurants (REST), retail (RETA), software (SOFT), and telecom (TELE) all were down into oversold territory and by the end of October 2002, all four of these sectors were in X’s with great field position. A look at performance 15 months later at the end of 2003 shows that all four sectors performed well, but software and telecom returns nearly doubled those returns of REST and RETA (Figure 8.6). From a portfolio management per- spective, how could we better ascertain the potential magnitude of movement from sectors? We’ve found RS to be an invaluable tool and specifically the Favored Status ranking.

The concept behind the Favored Status ranking is to marry RS readings with the Bullish Percent concept we know works so well. We began keeping the charts that comprise Favored Status in 1997, so these charts are not very long, but we have certainly seen their value in the last 10 years time and time again. Let’s think back for a second about an individual stock evaluation. If I

Figure 8.6 Favored versus UnFavored Sector Return Comparison.

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were thinking about buying a stock some of the basic things I would want to see is that first the stock was trading in a positive trend or on I-95 North. Next, I would want to see that the stock had good RS versus the market long term and short term. It would make sense then that if these are general attributes of a stock I would want to buy that before I invested in a particular sector of the market, I would want to focus on those sectors where more stocks were moving to positive trends and showing good RS versus the market. This is the genesis of the indicators we use to determine Favored Status ranking. Each ranking alone is a valuable tool but the Favored Status ranking really gives life to these individual indicators. The four criteria we use to assign a Favored Status ranking for sectors is as follows:

1. Sector Relative Strength
2. Percent Positive Trend
3. Percent Relative Strength in X’s
4. Percent Relative Strength on buy signals

   Let’s now take a more detailed look at each of the four criteria

used to determine Favored Status ranking.

Sector Relative Strength

In Chapter 5, you learned about sector RS. Specifically, for each DWA sector an equal weighted index is created. Just like a stock, a daily RS calculation is performed and then plotted on a Point and Figure chart. To quickly review, the daily RS calculation is the price of the index divided by the S&P 500 Equal Weighted Index and then multiplied by 100 to provide a reading. The reading is then plotted on a Point and Figure chart. When the sector RS chart is in X’s, we can assume that group has a higher probability of outperforming the market than underperforming the market and vice versa. We will be well rewarded for focusing our invest- ments in those sectors whose RS charts are in X’s. If you’re not completely comfortable with the RS concepts, go back to Chap- ters 4 and 5. Before you can fully grasp how we apply RS to sec- tors, you need to be comfortable with how individual equity RS is

268 Learn the Point and Figure Methodology

calculated. It’s like learning anything else, you probably won’t get it all on the first reading. Utilize the exercises, review the con- cepts, pull up some examples on your own at our web site. This will take you miles into your journey of becoming a craftsman.

Percent Positive Trend Chart

The Percent Positive Trend (PT) chart measures the percent of stocks within a particular market or sector trading above their Bullish Support Lines. So let’s say there are 100 stocks in a sector and 50 of them are trading above their Bullish Support Lines. This would give us a reading of 50 percent. If this number is increas- ing, it tells us more stocks in the sector or market are turning to positive trend charts and supporting higher prices. Conversely, if we see a net 6 percent change of stocks that were in positive trends now in negative trends, it speaks volumes about the change in trend for the sector to negative. It is this battle between the two trends that eventually causes one or the other to win the match and reverse. It is the reversal that warrants our attention.

As outlined earlier, whenever we initiate a new position, we try to stack as many odds as possible in our favor and one of the primary things we look at is “What is the overall trend of the stock?” We want to focus our buying on those stocks trading above their Bullish Support Line. In the aggregate, we want to focus on those areas of the market that are showing more and more stocks moving to a positive trend or trading above their Bullish Support Line. We can easily see whether this is happening by looking to the PT chart of an overall market or a sector. Like any other Bullish Percent chart, if this chart is in X’s we say it is positive and if this chart is in O’s, we say it is negative.

Percent Relative Strength in X’s

Another important attribute we want to see in any stock we pur- chase is that the RS chart is in a column of X’s, showing the stock is currently outperforming the market. Taking the same logic of the PT charts, we want to focus on those areas of the market that are showing more and more stocks in a column of X’s on their RS

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charts. Within each industry group, we calculate the number of stocks whose individual RS charts are outperforming the market on a shorter term basis. Though RS signals on average last two years or more, a change in columns on the RS chart can last sev- eral months, we find it very useful to evaluate stocks based on their RS chart’s most recent column. If the RS chart is in X’s the stock is outperforming on a nearer term basis; if it is in O’s, it is underperforming the market on a nearer term basis.

This RSX percentage is also plotted on a grid from 0 percent to 100 percent, like the PT indexes, and when this indicator is in X’s and moving higher, it suggests that area of the market or sec- tor is performing better than the market on a shorter term basis. We refer to these charts in-house as RSX charts because we use the prefix RSX before the market or sector symbol to call up the chart on our web site. For example, RSXTELE is the percent of stocks in the telecommunications sector that have their RS charts in a column of X’s. When evaluating the RSX chart, be- cause it can move the fastest of all the Favored Status indicators, we look at the signal on the chart. We place the most emphasis not on what column the chart is in but rather is it on a buy or a sell signal, a Double Top or a Double Bottom.

Percent Relative Strength on Buy Signals

The Point and Figure RS buy and sell signals are long term in na- ture, lasting on average two years. Within a market or an industry group, we calculate the percentage of stocks whose RS charts are on buy signals. This percentage is then plotted on a grid from 0 percent to 100 percent. When it is in a column of X’s and rising, it means more stocks underlying that sector are getting stronger versus the market on a long-term basis. This indicator is much slower moving than the Percent RS in X’s and the Percent Posi- tive Trend. When changes in the Percent RS on buy signals (RSP charts) do occur, however, they are important. For instance, the RSPOTC chart reversed down in April 2000, and this was yet an- other sign that this area of the market was in for a rough ride. Not surprisingly, the RSP charts for the telecommunications, soft- ware, Internet, and other technology sectors were also reversing down into O’s in the spring of 2000. When you think about what

270 Learn the Point and Figure Methodology

this is telling you it is quite astonishing. When a sector’s RSP chart reverses for instance into a column of X’s that is telling us that 6 percent of the stocks in that sector have gone from a RS sell signal to a RS buy signal and the tide has shifted from these stocks underperforming the market to these stocks outperform- ing the market. Since the average RS signal last about two years, reversals on these charts are major statements about a sector’s likely future performance.

Let’s quickly summarize again the indicators that go into de- termining a sector’s Favored Status. The following are the four in- dicators we use to evaluate sectors on an RS basis:

1. Sector RS Chart: Look at the Column.
2. Sector Percent Positive RS (RSP) Chart: Look at the Column. 3. Sector Percent RS Chart in X’s (RSX) Chart: Look at the Sig-

nal (Buy or Sell).
4. Sector Percent Positive Trend (PT) Chart: Look at the Column.

For each sector, we evaluate each of these indicators and give the sector a 0 to 4 score. If all four of the indicators were positive, the sector would get a score of 4. If none of the indicators were positive, that is, all of the charts were in O’s or on a sell signal in the case of the RSX chart, then the Favored Status score would be 0. When the majority of these indicators are positive, that sector should be a market leader and it is where we would concentrate most of our new money going into the market. Once the sector no longer has the majority of indicators in its favor, then we must begin to think about defensive strategies. New positions in sec- tors where the majority of indicators are not positive suggest we should expect trading rallies only, not market leadership quali- ties. Once we have established the score, we then assign the sec- tor a Favored Status according to the following template:

Favored Sector: 3 or 4 indicators positive
Average Sector: 2 of the indicators positive Unfavored Sector: 0 or 1 of the indicators positive

I think the concept of Favored Sector will come alive with an actual example. We’ll use the software sector from October 2002

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that we discussed at the beginning of this chapter to start with. Let’s take a look at the four charts that make Favored Sector sta- tus in Figure 8.7 and just count off what is positive. The first chart is the DWA Software Index RS chart (DWASOFT). Notice that this chart is in a column of X’s so that is one positive. Next, we can take a look at the Percent Positive RS for Software (RSP- SOFT). This chart has also just recently reversed up to X’s so we have another positive for the group and we’re up to 2 positive scores for the sector. Moving on, the Percent of RS charts in X’s for software (RSXSOFT) is on a buy signal. Remember for this chart we look to see whether it has exceeded a previous column of X’s or not. In this case, the last signal was in fact a buy so we have another positive for the group. Our Favored Sector score is now up to 3 for the sector. The final chart to evaluate is the Per- cent Positive Trend for Software (PTSOFT). This chart is also in X’s so we add another positive to the score and we can say that the software sector has 4 out of 4 of its Favored Sector Status indi- cators positive and thus it is a Favored Sector.

What this tells us is that the software sector has a higher probability of being an outperforming sector of the market than a sector with an Unfavored Sector status, like the retail sector. From the same time, October 2002, here’s how the Favored Sector Status charts for the retail sector stacked up:

If we count up the score for the retail sector, we come up with only 1 out of 4 positive and that makes the retail sector an Unfa- vored group. In October 2002, both the retail and the software sec- tors were reversing up to X’s on their Bullish Percent charts but a further investigation into the groups, another overlay of analysis if you will, and we see that software is a Favored Sector with strong RS and retail is an Unfavored Sector with weak relative strength. Which are you going to overweight? The Favored Sector of course. And, it pays off. For the next 15 months, the retail sector is up 34 percent while the software sector is up 82 percent.

272

Figure 8.7 Favored Sector Status Evaluation for Software in October 2002.

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I learn best by actually doing so let’s take a minute here and look at three sectors and you write down what the Favored Sector score for each sector is:

The first sector in the exercise is the telephone (TELE) sector. This sector only has a score of 1 as the only indicator positive is the RSP chart. With a score of just 1 we would consider the tele- phone sector to be Unfavored. Do you know when this reading is from? April 2000. Had you been utilizing this methodology in 2000, you would have known to underweight this sector or elimi- nate it entirely from your portfolio. Let’s look at the next two sec- tors as they are taken from the same time, April 2003. You should have come up with a score of 3 for the oil sector as its Sector RS chart, RSP chart, and PT chart are all considered positive. This would make the oil sector Favored. The drug sector is an entirely different picture. The score for this sector is only 1 as the RSP chart is the only indicator positive. Thus, the drug sector is an Unfavored group. So how did they perform? Over the next 18 months, the S&P 500 Equal Weighted Index, our benchmark, was up 47 percent. The oil sector did in fact perform better, up 66 per- cent while the drug sector was the underperformer, only 23 per- cent. I hope that you are seeing all types of applications for this type of analysis in your investing. It doesn’t matter whether you are a short-term trader or a long-term investor, we all want to be in the right places at the right time and that means sector rota- tion is a key component of your analysis.

We knew intuitively at DWA that the Favored Status work added a tremendously important tool to our analysis but we wanted to put some actual numbers to this work so the DWA Money Management team went to work on a comprehensive analysis of the Favored Status tool they helped develop and bring

274 Learn the Point and Figure Methodology

to life. The results were quite astounding and confirmed some- thing we had already seen work so many times for us in the past. In the study, each of the 40 DWA sectors were considered

from early 2003 to mid-2006. (A previous study was down from 1997 to 2003 and the results were similar.) Each day the sector is assigned a Favored Sector status reading. For the purposes of this study, those sectors whose status is Average remained classified at the previous classification rating it held. For example, if a group was Favored and then dropped to Average status, we consid- ered it to still be Favored. In order for that group to fall to an Un- favored status, the sector score would have to be 0 or 1. To remove the effects of the market, all of the returns are calculated relative to a benchmark, the Value Line Arithmetic average that is also an equal weighted index like the DWA sectors index used for perfor- mance figures. On average, Favored sectors outperformed Unfa- vored Sectors by 5.9 percent per trade. As we have previously discussed, the performance of your outliers can really affect port- folio returns. In our study, the top 10 percent of all trades in Fa- vored Sectors shows the spread over Unfavored Sectors to widen to 14.1 percent and the bottom 10 percent of all trades shows an Unfavored Sector lagging by an average of 6.4 percent. Another important part of the study was to look at the length of the signal because the Favored Status indicators are designed to be more of an intermediate to longer-term measure of RS. The average length of time a sector remains either Favored or Unfavored is about six to seven months with 10 percent of all observations lasting a year or more. Doing studies such as this show us that a systematic, disciplined application of the Point and Figure tools to investing help improve your investment results. Will this mean that every time you buy a Favored Sector you will have a winning trade? No. But more often than not, you will find that the Favored Sector is one of the large outsized winners.

Summary

At this point in the book, I imagine your mind is racing with ideas of how this methodology can be incorporated into your cur- rent investment process. As we have pointed out before, this

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methodology is an operating system similar to Windows XP that allows your computer to run programs. The great thing about the methodology is that once you have the operating system, the choice of which programs and what you want to accomplish on the computer is up to you. Throughout this chapter, I hope that you’ve learned the processes can be applied to a variety of differ- ent investment styles from trader to long-term buy and holder to increase your odds of success and that’s all we can ask of our- selves in the market—stack as many odds in our favor as possible and then manage the position.