Caveat Equity Funds

Top down investment approach

Top down investment approach
By T. Relihan

n the investment sphere there are a number of different approaches that fund managers and asset managers use to determine the mix of asset classes that a portfolio should contain in order to perform positively or even outperform their respective markets. Unfortunately even with a wealth of knowledge of the markets and current events, it is still common practice for asset and fund managers to underperform the various markets and benchmarks. It seems as if the problem lies in correctly applying the knowledge, rather than the volume of it.

The Top Down approach to investing has two pillars that supports the philosophy and helps the investor to achieve the returns they are looking for. The two pillars are:

  1. Fundamental analysis
  2. Technical analysis

These two pillars serve as start, end and continuous control points throughout the investment process. They not only help investors to choose one share over another but also what sector within the markets to make these choices in.

What is the “Top down approach”?

The approach can be broadly divided into a “Top down” and a “Combined” component. The approach integrates fundamental and technical analysis. It is only when all these components are incorporated and read together that a larger more holistic picture of the markets can be formed. It is then a more complete picture of the market that will be used to ascertain one of the key principles for investing and trading – the trend.

Shares within the same sector tend to move in unison: usually only a small number of shares in a sector that is outperforming the general market will underperform or lag in comparison with their peers. It is on this basis that renewed value can be placed on an old favourite saying “the trend is your friend” and serves to remind investors to trade with the trend and not against it. Trading with the trend by definition should include trading with the direction of the global, country, sector and share trends. If markets are trending up, you should look for opportunities to go long, or if markets are trending down, then look for opportunities to go short or simply stay out of the markets. Playing counter trend rallies can be exciting and costly rather than exciting and profitable. “Be the cork in the river of life... not the salmon that swims upstream!” (Wayne McDonell, FXbootcamp).

Ideally trades should be in the direction of the primary (long term - years), secondary (medium term - months) and tertiary (short term - week/days) trends.

Fundamental

Understanding Alpha and Beta

The reason the trend is of such fundamental importance in the top down approach is because of two famous Greeks Alpha and Beta. When making trading and investment decisions, it is necessary to understand the distinction between alpha and beta. All shares are driven to a more or lesser extent by the overall market and reigning market conditions. Alpha takes the volatility of a portfolio or fund and compares its risk adjusted performance to a chosen benchmark. Risk adjusted performance is an investment’s return by measuring how much risk is involved in producing that return. Any excess return of the portfolio or fund relative to the return of the chosen benchmark index is known as the alpha. Beta is described as a measure of the systematic risk of a security and maps out the probable correlation between the movements of the security in relation to the movement of the market. The beta for the market is taken as 1.00 and the difference between the beta of the security and that of the market states to what degree a correlation exists between said security and the market. For example, a beta of less than one will imply that the security is less volatile than that of the market movement; i.e. a beta of 0.8 will theoretically be 20% less volatile than the market.

Market composition

If the main components of the major stock exchanges are analysed and broken up into sectors, one will usually find a larger percentage of financial and industrial shares than resource shares. The exception to this is the Canadian and Australian markets as they have a heavily weighted resource component to their respected indexes, like South Africa. Fundamental drivers for the resource and financial and industrial shares are very different and therefore require different fundamental drivers to push the respective shares higher. For this reason it is wise to do separate analyses on these two very different markets.

In the United States of America (USA), the financial and industrial indexes’ primary driver is the Standard & Poors 500 (“S&P 500”), the top 500 companies in the country (ranked by market capitalisation). The resource indexes are driven primarily by the health of the global economy and USD commodity prices. This remains true even if you take the emerging markets’ currency fluctuations into account.

The rotation between the USA bond market and the equity markets (represented by indexes such as the S&P 500 and Dow Jones Industrial) is also an important factor in the Top down approach. If there is a preference for equities, it is a “Risk On “situation and if there is a preference for bonds, it is a “Risk Off” situation. Whenever adverse events influence the markets, investors switch from equities to bonds. When analysing bonds compared to equities, it is clear that an inverse relationship exist between the bond yields and the bond values and a more direct correlation between bond yields and equities;  i.e. bond yields move up or down together with equities.

Fundamental drivers of the Financial and Industrial sector

It is said that a man with money, spends money. The Consumer Confidence Index is a valuable indicator of the public’s feelings regarding their own and the national economic situation. It also provides insight in the current and future spending and saving habits of the public. This is the core driver behind the fundamental drivers of the financial and industrial sector; the increasing or decreasing of the money flow circulating in the economy. More money changing more hands within normal inflationary conditions will always benefit the financial and industrial sectors. For fundamental drivers to be positive for the financial and industrial markets there should be at least some of the following factors in place:

  1. Strong sustainable growth particularly in the consumer sector of the economy.
  2. Low inflation. (High and rising inflation leads to higher interest rates and this is negative for the consumer.)
  3. Low real interest rates. (That is interest rates after a deduction for inflation has been made.)
  4. A strong and stable currency. (Higher import cost leads to higher product cost that leads to higher inflation, which then leads to higher interest rates. This will cause a negative cycle for financial and industrial performance.)
  5. Positive and growing net discretionary consumer income, high and growing company earnings and low PE (The price earnings ratio or PE, is a company’s stock price divided by earnings per share) for companies.

These are some of the more important fundamental economic drivers that will push financial and industrial share prices higher.

Fundamental drivers of the Resource sector

The main driver for resources is the health of the world economy. When economies are performing strongly, there is a demand for resources. This controls commodity prices in a demand and supply manner also known as the building blocks of trade. Within the scope of the world economy, such factors are a general increase or high global GDP growth, existing or increasing demand for resources especially from emerging markets, the limitations on supply versus demand for the resource, the strength of the exporting country’s currency and company earnings.

Looking back to the 2001 and 2002 downturn, it was China’s import demands for its massively developing economy that provided the X-factor that rescued the commodity market. During the ramp up to the 2007-2008 highs, all of the above mentioned factors were evident throughout most of the big and emerging economies and so we saw the exponential growth of resource share values across the globe. Another important driver is the general stock markets. This is especially true with resource heavy indexes as mentioned above. A higher general equity market will result in a general higher value of resource shares.

Technical

The field of technical analysis lends itself to an almost unlimited amount of changes, additions, methods and rules. What tools and methods we have and will have in the future, are limited only by our imagination. If one chooses to follow and apply every tool available, the task of technical analysis becomes cumbersome and unreliable. It is therefore especially important to keep it simple. Using only a few tools and indicators to determine future share movements that have been personally tested to each investor's own personal style is key in effective technical analysis. It must also be kept in mind that it is the “body of evidence” that follows from technical analysis that shows the more probable route the markets will take rather than what a singular oscillator is signalling or telling us.

Some important principles to remember are that markets and shares seldom go straight up and straight down. They tend to spend time at the bottom and top which gives time for price consolidation. It remains important to study patterns before you look at detailed indicators. An example is the triple bottom on the S&P500 in 2003 and again in 2008. Every asset type, market and share has its own unique patterns. One should use and find trends and support and resistance lines to help you with entry and exit points. Be careful of having numerous indicators derived from the same source and last but not least, remember to adopt your trading/investing strategy to the stage of the markets e.g. bull, bear, or range bound.

The investor

The human factor behind markets cannot be ignored. In the end it will always be human actions that determine where markets will go. There seem to be an underlying need within the human spirit to be a hero. It is this underlying need to be a hero that compels us to become bottom and top pickers. It is this hero that makes us trade counter trend, or neglect simple principles such as stop loss points. With it comes the desire to be right, to prove to everybody, or to spot something in the markets first in spite of the all-important “body of evidence”. It is this desire or primal urge that has brought many a highflying investor smashing back to reality and usually a poorer reality. In the highly emotional world of investing and trading, it is the rational minds that will most benefit from the various market signals that can be found.

Putting it all together

Knowing how to read charts, chart patterns, candle sticks or oscillators is not enough to give an investor the edge in the markets. An in-depth comprehension of inter-market analysis and an understanding of the various ways in which markets inter connect as well as the role that the dollar plays within each aspect of the different markets are needed. Only after the fundamental analysis factor is added to the mix will an investor be able to form a complete picture of where the markets could be going next.

There exists an interconnected uniformity between shares in the same sector that will cause them to move together and fall together. It is this uniformity found in the markets that leaves bottom-up analysis wanting. Even though a resource share’s fundamentals are outstanding, if there is no national and more importantly international appetite for this sector, the odds are stacked against you and your fundamentally sound share will be dragged down with its peers in the sector. When applying the “top down approach” to your investment strategy, the starting point is never at home (unless your country of residence has the most powerful financial market indexes in the world i.e. S&P500, Dow Jones Industrial). The start of your analysis will correspond with the top of the financial market pyramid; those markets where financial choices are made trickle down and essentially influence all other markets beneath them. For reasons too numerous to explain in this article, the top or starting point will for the foreseeable future remain the USA markets. From there one will move to other international markets such as the United Kingdom (FTSE100), Hong Kong (Hang-Seng), other resource economies and lastly emerging economies.

If the investor understands what is going on in a particular country, determining the next step in the top down process becomes easier namely sector analysis. It is important to understand what the driving factors behind a sector’s performance are, as they will help you identify what sectors to invest in as well as provide additional proof that your analysis was/is correct regarding a specific sector. The way in which market fundamentals are used to determine what sectors to invest in has already been discussed, but it is those factors that will guide the investor to the most profitable markets, sectors and eventually individual shares. If the above mentioned steps have been successfully completed, the final step of stock selection becomes a much easier task. This is because when a certain sector is outperforming the market, very few of the shares in that sector will be underperforming the market.

These principles necessitate a broader and international approach for equity and bond investments. Understanding what is going on in the world today will help you make better investments tomorrow.