Process and Spot. Part 3

Last week was part 2 of a 5-part series discussing the critical components of an investment process geared towards earning superior investment returns: Focus Markets, Market Bias, Actionable Price Targets, Position Sizing, and finally, Execute, Monitor and Close the Trade Idea.

I opened this series of commentaries by discussing the secret to pro golf phenomenon Rory McIlroy’s success. In his own words, Rory says that he focuses on two things: “process and spot.” He focuses on the process of making the right swing with long and chip shots and focuses on hitting the right spots on the green with his putting. That same focus on process and spot can make you a successful investor.

In this week’s commentary, I’m going to discuss how to build a Market Bias for each of the Focus Markets that you have curated using the information from the last 2 weeks.

For each of your Focus Markets you need to develop a process for evaluating both the fundamental and technical picture of each market and then turning that evaluation into a bias of LONG, SHORT or NEUTRAL.

A LONG bias indicates that both the fundamental and technical picture are bullish and we believe a particular market will rise in price.

A SHORT bias indicates that that both the fundamental and technical picture are bearish and we believe a particular market will fall in price.

A NEUTRAL bias indicates that the fundamental and technical pictures are not aligned (one is bullish and the other is bearish) and a particular market currently has an unclear direction and should be avoided.

The goal of the market bias, over time, is to capture the majority of the prevailing trend in a Focus Market and, more importantly, “catch the turns” and alert investors when the current trend ends and a new one begins.


Fundamental Analysis

Your process for evaluating the fundamental picture for a each Focus Market will be dependent on that particular market.

However, your fundamental analysis for all Focus Markets should include a thorough geographical understanding.

Here are the top 4 factors you want to monitor:

1. The current economic conditions of the geography where your Focus Market exists.

2. The current monetary policy.

3. The state of interest rates.

4. The local currency.

These 4 factors should be monitored for all of your Focus Markets whether they are mutual funds, stocks or exchange traded funds. All investments exist in a particular geographical area and it’s important to monitor and understand the state of that particular economy.

In addition to those 4 factors, there are a couple of other factors to add to your fundamental analysis depending on each focus market.

If you have an individual stock as a Focus Market, include some type of financial statement analysis or a process for better understanding the idiosyncratic risk of that particular company. You also may want to include some sector-level analysis to better understand the factors that impact the sector that your company operates in.

Again, these analyses are in addition to geographic-specific factors we discussed earlier. Let’s run through 3 examples so that you can see this process in action.

Example 1: One of your Focus Markets is the S&P 500 Index ETF (SPY). The 4 factors that you need to monitor for the SPY are: US monetary policy, economic conditions, the US Dollar, and interest rates on 10-year Treasuries.

US monetary policy can be monitored by reviewing any Fed-related releases such as minutes from Fed meetings and the Beige Book. In order to understand the economic conditions in the US, you should monitor the labor market, housing and consumer-related reports. Next evaluate the US Dollar and interest rates in relation to US equities.

What are these 4 factors telling you about the US economic environment? Is the environment bullish for US equities or bearish? Once you’ve answered that question you’re ready to move on to evaluating the technical picture for SPY.

Example 2: One of your Focus Markets is the Utilities Select Sector SPDR (XLU). You will want to analyze the four factors that we covered in Example 1 to understand the US economy and whether it is bullish or bearish for US equities, in general. Because you're investing in a specific sector, add sector-specific analysis to determine if the current conditions are bullish or bearish for US utility stocks.

For instance, it doesn’t matter what the first 3 factors look like, if US interest rates are rising or are at an elevated level, utilities will have a difficult time performing well. Historically, utilities have a difficult time competing for investors capital in a rising interest rate environment.

Once you have evaluated the 4 factors plus your sector specific factor(s) you can rate the fundamental picture as bullish or bearish for US utility equities. Once you’ve rated the fundamental picture you’re ready to move on to evaluating the technical picture for XLU.

Example 3: One of your Focus Markets is Duke Energy (DUK), an individual US equity in the utility sector. Analyze the 4 factors that we covered in Example 1 to understand the U.S economy as well as any sector-specific factors for the utility sector.

In addition to that analysis, add company specific research to better understand the idiosyncratic risks of Duke Energy. This research should include at least a thorough review of its financial statement as well as a comparison of Duke Energy against other US utility companies like Dominion Resources (D) and Sempra Energy (SRE). Once you’ve rated the fundamental picture for Duke Energy you’re ready to move on to evaluating the technical picture.

I hope you can see how this fundamental process can be applied to any financial instrument trading anywhere in the world.


Technical Analysis

Now that you’ve rated the fundamental picture for your Focus Market, it’s time to determine if the technical picture (price movement) of your Focus Market is bullish or bearish.

There are a million ways to determine the direction of your Focus Market. However, the 2 simplest and most effective are moving averages and trendlines. Whether you choose to use moving averages or trendlines, it's important to be duration agnostic.

Monitor each Focus Market over multiple time frames, not just one. I personally don’t look at any trend less than 1 month in duration and I monitor all of my Focus Markets over 3 time frames: 1-3 months, 3-6 months, and 6 months or more.

Monitor your markets over at least 2 time frames. I prefer trend lines but moving averages are the easiest to implement because any charting service will automatically calculate and populate a chart with a moving average of any duration.

Take a 12-month chart of each Focus Market and populate the chart with 3 different moving averages: 20 day (1 month), 60 day (3 months) and 120 day (6 months). Are the moving averages sloped upward, down or flat-lining?

Now, draw trend lines individually on a 1-month chart, then a 3-month and 6-month chart. Are these trend lines sloped upward, down or flat-lining? Are all 3 time frames congruently bullish or bearish? Are the short-term time frames showing a different technical picture than the long-term? This simple exercise can give you a clear picture as to whether the Focus Market is bullish or bearish in its price action.

As I started this section on technical analysis, there are as many technical indicators and charting methods as there are people on Earth. Technical analysis is one area where you want to keep it simple.

Now that you’ve evaluated the technical picture of each Focus Market, you’re ready to rate the Market Bias for that particular market.

If both pictures are bullish, then the market gets a LONG bias.

If both pictures are bearish, then the market gets a SHORT bias.

If one picture is bullish and the other is bearish, then the market gets a NEUTRAL bias.

Now that we have our Focus Markets and we have a Market Bias for each market, we are ready to determine the actionable price targets for each market.

At some point in the coming weeks, I will discuss how to determine the appropriate entry and exit prices for each Focus Market.