Supply and
demand key to manager’s decisions
I speak to
many money managers as part of my research endeavours. Most managers practice a
similar style, with a slightly different twist here and there. But once in
awhile, I speak with a manager that truly has an attitude and philosophy that
is in the minority – at least in the mutual fund world. While I don’t buy into
all of the different philosophies I hear, I often find them intriguing. This
week, I’ll give you a glimpse into philosophy of a little-known firm from St.
Catherines Ontario – Crystal Wealth.
I’ve
written many times about the factors that influence long-term stock returns.
Stock valuations, future interest rate changes, and future growth in cash flows
capture most of the market’s long-term returns. But what about the short term?
I must
admit that I agree with those that attribute some of the nutty short-term
movements in stock prices to investor psychology. However, the so-called “smart
money” (i.e. investment bankers, brokerages, pension funds, etc.) isn’t immune
from this phenomenon. We needn’t look any farther back than 1999 for solid
proof. For instance, one tech stock that was in the $60 range fetched bullish
targets from some brokers in the $80 range. Once it broke $80, the brokers’
target would hit $100 – and so on.
While most
money managers are focused on buying today in the hopes of realizing their
target returns over the subsequent three to five years, Crystal aims to exploit
the psychology-driven inefficiencies that are characteristic of daily market
action. Even with the more recent fall in the volatility of stock prices, daily
market movements remain significant.
Clayton
Smith, lead manager of the Crystal Enhanced Index RSP fund, maintains that fear
and greed drive short-term market movements. Hence, he says that market volume
(i.e. the number of shares changing hands) and price changes (i.e. both
direction and magnitude) combine to give him insight into the supply and demand
for stocks – and hence the direction of the market.
His logic
has intuitive appeal since prices do rise when there are more buyers than
sellers, and vice versa. However, in order for this information to be exploited
for profit, investor demand for stocks must have some predictable staying
power.
Smith’s
philosophy is based on the assumption that the supply and demand for stocks is
somewhat persistent. In other words, he believes that strong demand for stocks
(i.e. strong upward movement with lots of shares changing hands) one day will
likely persist long enough for him to jump on the market’s coattails.
Conversely,
he says the same persistence holds on the downside – which, in theory, would
allow him to jump out of the market allowing him to avoid much of the downside.
His
conclusions are the result of proprietary market research and analysis. While
advising individual clients several years ago, Smith says he spent most of his
time on research. The relationship between investor demand and subsequent returns
was an early belief that he began researching using technical analysis.
(Technical
analysis focuses on patterns of market movement that repeat over time.
Fundamental analysis is the more common method of researching companies to find
stocks trading at reasonable values.)
In
practice, Smith makes one decision daily. Based on the market movement and
volume on the previous day, he decides whether or not to be in the market the
following day. Hence, if the market shows strong downward momentum one day, the
Crystal funds will happily sit in cash the next day.
Crystal
Enhanced Index RSP is either in S&P 500 futures contracts or it’s in cash –
and it’s an all or nothing decision. Its use of instruments means the fund is
best suited for a tax-deferred account – i.e. RRSP, RRIF, etc. – given the
taxable income that typically flows from funds using derivatives.
In addition
to a base management fee of 1.75 per cent annually, the fund charges a
performance fee equal to fifteen per cent of the amount by which it outperforms
the S&P 500.
The fund
was launched in the summer of 1999, so its history is brief. However, that’s an
interesting period because it includes nearly a full year of strong index
returns along with a significant market decline and the most significant
terrorist attack in North American history.
During the
nearly three-year period, the Crystal Enhanced Index RSP has the following
stats:
Ÿ
It has
handily beaten the S&P 500 (“the index”) by nearly 9 percentage points
annually, since inception.
Ÿ
It
outperformed the index nearly 60 per cent of the time.
Ÿ
In the
past, it posted a losing month nearly 30 per cent less often than the index;
but when it lost money, it lost about 20 per cent more than the index.
Ÿ
During
losing months for the index, the fund outperformed in about four out of every
five months (80 per cent of the time).
Ÿ
During
up months for the index, the fund outperformed in just three out of every ten
months.
So far,
Smith has been successful and he is so confident in his model that all of the
firm’s employees have all of their investment assets in the fund.
While Smith
expects to move from futures to cash, or vice versa, every few days, the fund’s
return patterns indicate that it has had exposure to the market roughly 70 per
cent of the time. In that context, its positive return of nearly three per cent
annually is a significant accomplishment during a period that was witness to an
annualized loss of more than six per cent for the index.
While those
of us that subscribe to fundamental analysis used to equate technical analysis
with voodoo, the academic world has begun to embrace the potential of technical
indicators. James A. Bennett and Richard W. Sias published an article in the
November/December issue of the Financial Analysts Journal entitled Can Money
Flows Predict Stock Returns? They studied 86 million U.S. stock trades
(rather than the index) but their findings parallel Smith’s beliefs.
In short,
Bennett and Sias noted the following conclusions:
Ÿ
Market
volume and movements are indicative of supply and demand for stocks (i.e. money
flows).
Ÿ
High
money flows in one period were usually followed by strong money flows in
subsequent periods.
Ÿ
Money
flows in one period strongly correlated with higher returns in subsequent
periods.
While I
wouldn’t consider myself a convert just yet, I am intrigued by the performance
of the fund in its brief history and the research supporting its strategy.
Dan Hallett, B.Comm., CFP, CFA is the Senior Investment
Analyst with Sterling Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, Alberta, and Manitoba.