A Streamlined Approach to Identify Market Leadership

Prolog

RADAR monitors the risk cycle which is based on the emotions that drive the market. At the mature part of the emotional cycle investment becomes speculation in which leverage is applied to maximize an opinion. It is at this point that momentum becomes the mantra for all market participants. (This includes sell side analysts who are among the most emotional of market participants)

Initially there is an abundance of euphoria. However history shows us that busts always follow booms. The excesses themselves sow the seeds of their demise.

These cycles are based on the capricious nature of speculators. The leverage that the speculators sought has a destabilizing effect on liquidity. In the end there is an inversion of this emotion as a loss capital parallels a loss of confidence. In the end speculators do not make allowances for what occurs at either end of the emotional cycle and are overwhelmed by abnormal events.

Over time values revert to their mean. That is why the efficient market theory works, or so one would have reason to believe. However in periods less then eighteen 18 months this is not always true. In these shorter periods perception and reality often collide as they have opposite views.

Introduction

There is a widely accepted premise that the stock market leads and the economy follows. Building on this premise, it is reasonable to conclude that market cycles will lead economic cycles.

Understanding how the emotional cycles of “greed and fear” correlate with market cycles is just as important as understanding the relationship between market cycles and economic cycles. This is because these emotions are the common denominators at the start and end of every investment cycle.

Emotion is the underlying cause of Cycle Tops or Bottoms

A thorough understanding of how emotion creates a constantly changing environment will provide that extra edge to make informed investment decisions.

Late in a trend, all styles - fundamental, quant, growth and value - share the momentum characteristics of excess & complacency.

In order to understand “Why” fundamental (and technical analysis) works and “When” it fails, we need to look at this common denominator in every investment cycle. As markets approach important cycle tops or bottoms there is a divergence between perception and reality. This is where participants lose control of their emotions which in turn affects their ability to correctly analyze the risk factor of an investment decision.

At the mature part of the emotional cycle investment becomes speculation in which leverage is applied to maximize an opinion. It is at this point that momentum becomes the mantra for all market participants. (This includes sell side analysts who are among the most emotional of market participants)

These cycles are based on the capricious nature of speculators. The leverage that the speculators sought has a destabilizing effect on liquidity. In the end there is an inversion of this emotion as a loss capital parallels a loss of confidence. In the end speculators do not make allowances for what occurs at either end of the emotional cycle and are overwhelmed by abnormal events.

Excessive optimism (or pessimism) causes an acceleration of the short term price which forces money mangers to jump on the bandwagon (or off) for fear of underperforming their benchmark. During this part of the investment cycle, liquidity becomes an illusion. Volume increases and then disappears as participants finally realize they have misguided perceptions of risk.

Initially there is an abundance of euphoria. However history shows us that busts always follow booms. The excesses themselves sow the seeds of their demise.

What is RADAR?

RADAR has been developed around the theory that market psychology is a key force in the pricing mechanism of the market. RADAR monitors the risk cycle which is based on the emotions that drive the market.

The economic cycle drives the economy but we believe that it is the perception of this cycle that drives the stock market. When there is excessive optimism (pessimism) perception and reality reach unsustainable extremes. Over time values revert to their mean. That is why the efficient market theory works, or so one would have reason to believe. However in periods less then eighteen 18 months this is not always true. In these shorter periods perception and reality often collide as they have opposite views

The key to our work is analysis of risk.

RADAR is a quant product that is a blend of momentum and contrarian styles. The momentum component identifies market leadership and rotation from a top down perspective by identifying how the market is voting at Sector / Industry and stock level. While its contrarian aspect focuses on the extremes in valuations and when there is a discrepancy between perception and reality.

By monitoring of price, volume and volatility RADAR measures these emotions and identify where they are in the current market cycle. This is the key to understanding when to shift from the momentum process into a contrarian (value) mode.

RADAR is a rules based discipline that has two levels. Our top-level view measures investor sentiment and identifies when it is at extremes. This is our first strength as we manage at the extremes by identifying rotation. The second level is a unique view of beta. We have created a forward looking beta model that ranks individual issues as to their future performance vs. a benchmark.

Using RADAR to identify the “risk” component in fundamental valuations

The Buy Side Demand Index (BSDI) is a forward looking indicator that identifies when emotion influences perception and therefore causes a deviation from economic reality. This is when the market is most vulnerable to an external event that causes a price collapse. Greed then turns to fear.

RADAR monitors investor sentiment and identifies when it is at extremes. During buying panics and crashes, market participants act more like speculators than like investors. Their main concern was with changing market conditions in the near term, rather than with changing business conditions in the long term. Their anxiety had more to do with the drop in prices (and the need to stem losses) than with the opportunity to pick up bargains.

RADAR works best at the extremes, which allows it to identify when a fundamental is not being supported by the market and how to adjust for it. It measures the risk factor behind the trend by identifying the probability of the trend continuing or failing.

The need for a supportive tool that saves time

One of RADAR’s primary functions is the “time management of data”. It is not a "timing device". We collaborate with the client’s process by using their watch list to identify those stocks that have the highest probability to out perform on an absolute and relative basis at a specific point in time.

RADAR is part of an assembly line process that enables the user to take several different inputs, mix them together, and by using different tools, generate stock purchase and sale ideas. This complete process (client’s watch list + RADAR) answers the question,

RADAR is a unique tool that alerts you to when the market is recognizing your assumptions and theories.

RADAR defines the characteristics of the current and future investment cycles based on a top down view of global, sector and industry strength. We then query assorted watch lists to identify those companies that align with our model. This is done at each level to define the correct search criteria.

RADAR provides the answer to the question of when. The system is rules-based; specifically tailored to the client’s investments style and needs. By tracking the cycles of investor sentiment we are able to forecasts change in market leadership and direction. The bottom line benefit is better buy and sells indicators.

RADAR answers the questions:

• Is the market vulnerable?
• Is my style poised to outperform?
• Should I aggressively pursue my strategy?
• How am I positioned versus my benchmark?

The benefits to RADAR clients are:

• Effectively forecast market turning points.
• Most effective “at the extremes.”
• Identifies shifts in market leadership.
• Successfully used at all levels of differentiation: stock, industry, sector and asset-class.
• Provides a disciplined approach to identifying securities and sectors poised to out- or under-perform.
• Recognizes when momentum will or will not support various fundamental strategies.

When is RADAR the most useful?

RADAR is most useful when used as a filter. When employed as a filter, RADAR can interface with a variety of external models. Valuation metrics state what should be and will be recognized, while RADAR says what is being recognized. This is our value add. RADAR enhances one’s valuation metrics enabling clients to prepare for the time when the market begins to recognize value.

RADAR is built on the concept of the Time Management of Data. Buy too early and the asset underperforms. Buy too late and the opportunity is missed.

RADAR functions as a backdrop for a variety of fundamentally based products.

Our ability to blend such products results in a degree of customization that most clients are not accustomed to receiving from other research vendors.

RADAR provides an interactive relationship that is specifically tailored to each investor’s investment style and needs. Our backdrop results in more concentrated activity during periods where the probability of a successful outcome to a fundamental style is high.

When RADAR is used as a backdrop to a fundamental strategy an immediate benefit is seen.

This interaction of diverse viewpoints is successful because technical and fundamental approaches are disciplined and rules based. Fundamentals provide you with the best stocks in each sector based on one’s unique analysis. RADAR identifies the “when”.

Valuation model + Simon Economics = 3

RADAR is the result of a time tested process during real market conditions. We reserve the right to continually improve upon the process as we believe in dynamic modeling.

Summary

RADAR is easy to integrate into the investment decision making process. Risk is identified from a top down perspective, while generating ideas from a bottom up perspective. It is able to interact with any market cap, sector or style of investing. We leave you with one question, “Do your current technical tools provide this value add?”

Part 2

The Stock Selection Process:

A universal problem around Wall Street is too much information being delivered to you on a daily basis.

One of the most difficult decisions facing any money manager is when to buy a stock. The original goal of the investment process was and is to identify what companies to buy. Identifying suitable investments using a fundamental model and placing them on a watch list is only part of the solution for higher investment returns. Initially, between 400 and 500 names may appear on the list at any one time. The next hurdle is the purchase decision.

“What should we buy today?” At this point, for you to remain proactive you either a) expand your research to recognize opportunity, or b) you turn a proactive tool into a reactive investment process and are faced with a missed opportunity, or worse, have invested in an under performing asset that fails to perform for a prolonged period of time.

Step 1 - Identify the trend.

The first measure of trend is “price”, but adding “participation” brings depth.

“Participation” of each constituent is identified through their “Score”.

Overall, participation is measured in the “Buy Side Demand Index” (BSDI).

The BSDI measures the trend and the psychology underlying it.

Step 2 - Identify the trend’s exposure.

Observation has taught that a BSDI:

• > 80% is an extended bull market
• < 15% is an extended bear market.

Step 3 - Identify how best to play the trend reversal.

The Score measures the changes occurring within the trend.