The Falcon has Landed

The FTSE 100 closed up a respectable 1.4% yesterday. The S&P 500 followed with a modest 0.88% gain. It’s the type of move investors find calming at the end of the year. It’s not a side-splitting Santa rally. But it’ll do. Anything to put the year to rest with a gain.

But let’s keep grinding, shall we dear reader? Let’s put our sceptic’s hat on and see how broad the rally is. If it’s just the Fangs and the Bagels — in other words, if just a few stocks are making the index move — that makes the rally suspicious, and dangerous. What gives?

Kindly turn your attention to the chart below. It’s the S&P 100 Bullish Percent Index (BPI). It’s a measure of market breadth on the S&P 100. The chart shows you that the BPI correlates nicely with the performance of the underlying index. It also shows you that the index isn’t wildly ‘overbought’ right now. Allow me to explain…

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The BPI is a combination of technical analysis and charting. Each constituent in the index has a ‘point and figure’ pattern; a system of Xs and Os that tell you in which direction a stock has momentum. The BPI is a little like the relative strength indicator. When it’s over 70, you have a lot of stocks in a bullish trend and it tends to be overbought. When it’s under 30, you have a lot of stocks in a bearish trend and it tends to be oversold.

None of this, of course, has anything to do with the intrinsic value of a security or the present value of future earnings, unless you that everything known about a share is in the chart. But in a market driven by liquidity and momentum, the chart does tell you something useful. It gives you some insight into how long a trend might continue, or how close it is to reversing (or mean reverting, as the case may be).

Changes in a long-term trend are a market timing issue. And a full discussion of the value of market timing is beyond the scope of today’s e-letter. Suffice it to say that Santa rally is clear for take-off. But if the BPI drops below 55, the sky may be full of falling reindeer.

Stop, drop, and roll. Or duck and cover. Put on your antler armour.

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On a more serious note, how useful are benchmarks like the S&P 500 or the FTSE 100? For fund managers, the benchmark is a simple measure of relative performance. You either do better or worse. Everyone accepts the index as a measure of the value of active management (or the benefits of low-cost, passive index tracking).

But the whole idea of indices like the Dow Jones Industrials or the FTSE is that they tell you something useful about the underlying health of the economy and the direction of share prices. If the index isn’t a useful signal, then the index isn’t useful at all.

For British investors, the question is whether the FTSE is a useful benchmark. Does the performance of the index really tell you what’s going on in the British economy? Does it hold your wealth manager truly accountable for his or her performance? MoneyWeek’s Matthew Lynn took up some of these questions in a recent article for the Telegraph. Here’s some of what he said:

‘The FTSE has become completely unfit for purpose. [It] is not in the least representative of the British economy. Where has the growth come from in the last three years? It has come from the start-up boom, with more than half a million new businesses being created every year. It has come from a rapidly developing technology sector, and booming professional services, such as consultancy, engineering design and law. And it has come from the rapid growth of self-employment, especially at the top end of the labour market. None of that, however, is reflected in the FTSE.

‘If you look away from the FTSE, you will find that smaller companies are doing much better, and their indexes reflect that. The performance of the main index dominates the news. It is what you hear quoted on the TV or radio every day. It is the benchmark for investment, and the standard against which portfolios are measured. The risk is that its dire performance creates a misleading impression, deters global investors from the UK, and puts people off saving and investing.

‘It doesn’t have to be like that. It would be perfectly possible to create a new index that reflected the broad make-up of the British economy, with an emphasis on smaller companies, technology, media, and services, which are our real strengths. After all, the FTSE itself only dates back to 1984. We would hardly be losing a long tradition by replacing it.

‘For a new year’s resolution, the media, the markets and the stock exchange should ditch the FTSE and find another index instead.’

Matthew has a point. The FTSE 100 is down 5.96% year-to-date. Yet the French CAC is up 8.46% year-to-date. The German DAX is up 8.56%. The Italian FTSE MBI is up a 11.88%.

Dios mio!

Why is the British index such a laggard? That’s where it gets interesting. And this is where you have three distinct opportunities to improve your investment performance in 2016. Each idea is related to a project we’re working on here at Friars Bridge Court.

The FTSE 100’s performance this year has been decimated by the miners. If you took out Glencore (-69.22% year-to-date) Rio Tinto (-33.45%), and BP (-15.69%), the FTSE would look a lot better. Yet those are the stocks – or at least that’s the sector – that Alex Williams reckons you could do well from at some point next year. Just when that is, well, that’s up for grabs. But look for more on it from Alex in the magazine.

Your second opportunity to improve is in the companies not represented in the blue chip index. The smaller companies Matthew mentions are newer, less-well known, and sometimes much riskier stocks, (although Glencore’s 70% slide is indistinguishable from a similar loss in a gold exploration stock, and you don’t even get the same upside with Glencore).

Your third opportunity to improve your investment performance next year is to ditch the benchmark altogether. Build your own. Build one that better represents the best companies in the British economy. The ones that provide stable dividends, can grow earnings, will thrive with Brexit and have the best chance to survive in a rising interest rate environment. Use that new benchmark as your guide.

If you don’t have time to do all of that, keep reading Capital and Conflict. Charlie Morris is on the case. He floated the idea of building a better index to me a few months ago. At first I was uncertain. But now I’m not so sure he isn’t right.

If you want to do better than the City, or the funds management industry, you need a benchmark that’s not biased in favour the industry. Charlie thinks he can build an index that tells you something useful about the stockmarket and the economy. That would be a valuable improvement on the status quo.

It used to be that the stockmarket was a leading indicator of the economy. That important signal – that corporations were generating more earnings and that those earnings would show up in greater GDP growth – has been corrupted in the age of ZIRP and QE. Rather than bemoan the loss of a useful signal, we’re going to build a new one. Stay tuned.

The Falcon has landed

Finally, if you’re on pins and needles waiting for an exposition of the dangers Britain’s current account deficit holds for sterling, gilts, and stocks, you’ll have to wait one more day. But it will be an excellent Christmas Eve present! A real mental stocking stuffer. And remember, the willingness to delay consumption is the key to building long-term capital and thus, the key to wealth. Patience! And thanks for being patient.

In the meantime, reward yourself for your virtue by watching the spectacular landing by Space-X’s Falcon 9 rocket earlier this week. It went into space, deployed a payload, and then returned to Cape Canaveral in Florida and parked itself on the tarmac. This makes driverless cars look like chump change. It was awesome.

It’s more than awesome though. Listen to the way the crowd in mission control goes nuts when the rocket touches down. How do you explain that reaction? I have an idea.

There is something primal and exhilarating about our drive to explore. It’s in our DNA to fear any change which threatens our survival. But it’s also in our DNA to take risks which give us a chance to improve our lives, or simply to learn more about the world we live in. Or even the worlds we don’t live in yet, but might.

Source: Space-X

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That’s what exploration is about. To launch a rocket, deploy a payload in space, and safely return the launch vehicle to earth for reuse is a massive technological accomplishment. It’s a great symbol for what the next 50 years could be like: an epic era of human innovation, exploration of the frontiers of medicine and energy, and exponential technological change.

Yes, there will be dangers. And yes, we may have to plod through the breakdown of the Warfare/Welfare State at the same time. But it’s going to be an incredibly exciting time to be alive, for you, your kids, and your grandkids.

Until then,

Dan Denning,

For Markets and Money

Editor’s note: Long time Markets and Money readers will remember Dan Denning, who previously wore many hats at Port Phillip Publishing, including company Publisher, and Editor of Markets and Money and Money Morning. Today Dan has moved on to the UK, where he pens Capital and Conflict for our sister company, MoneyWeek Research. The above article is republished from those pages.

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Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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