I have outlined before the importance of percentile rank and where we are in relation to history; this time I have updated my market risk system. This is only part of the picture and I use it in conjunction with fundamental analysis to create a framework for investment decisions – however as you will see it is an important part of the process and served to keep me from making rash decisions……
The basis of this theory is to look at some key components that have been indicators of high or low levels of risk for the FTSE-100 in the past; these include
- Simple moving averages
- Exponential moving averages
- Distance from 5 year highs and lows
- Distance from long term trend
- Correlation to mid and small cap indices
I then put all these into percentile rank that allows for easy comparison and the creation of a simple average of them (I considered applying a weighting to each of them but given the effectiveness of the simple average this was unnecessary) that provides a guide line as to the level of risk.
This was pretty accurate but I subsequently found that using a moving average of the average percentile rank (26 week and 104 week) provided indicator as to whether the FTSE-100 was over or undervalued; take a look at the graph below.
What did become obviously apparent was that when the 26 week moving average dipped below the 104 week moving average a lower negative returns followed; and when it recovered back above the 104 week average investors would start to be rewarded.
With this in mind I conducted a test again using the following strategy: –
- When the 26 week moving average falls below the 104 week moving average invest 20% in FTSE 100 TR and 80% in FTSE Index Linked Gilt TR
- When the 26 week moving average climbs above the 104 week moving average invest 80% in FTSE 100 TR and 20% in FTSE Index Linked Gilt TR
I was able to test from November 1998 onward, and for simplicity used indices – specific stock, sector or index selection can improve things even further see Pimp My Portfolio for some further examples – the results were very encouraging and provided returns well in excess of both indices and inflation.
Not only are the returns attractive but so is the risk profile with a maximum drawdown of just over 15% compared to the FTSE-100 that suffered almost 45% losses on two occasions since 1998; take a look at the yearly returns of this portfolio compared to the FTSE-100 to see the value of capital preservation……..
Negative years less than 5% drawdowns
Its interesting to see that these peaks and troughs are confirmed by the fundamental analysis of bellwether shares.
Having a overview of where markets are in relation to history can help achieve a far more satisfactory outcome