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Consolidation expected

By Colin Twiggs
July 25th, 2014 10:30 a.m. AEST (8:30 p:m EDT)

Advice herein is provided for the general information of readers and does not have regard to any particular person's investment objectives, financial situation or needs. Accordingly, no reader should act on the basis of any information contained herein without first having consulted a suitably qualified financial advisor.


Summary:

  • S&P 500 retreats below 1985.
  • VIX continues to indicate a bull market.
  • ASX 200 breaks resistance.

The S&P 500 retreated below its new support level at 1985, indicating a false break. Consolidation between 1950 and 1985 is likely — below the psychological barrier at 2000. Respect of support at 1950 would confirm. Declining 21-Day Twiggs Money Flow continues to signal mild, medium-term selling pressure. Further resistance is likely at the 2000 level — and at 4000 on the Nasdaq 100. Breakout would offer a long-term target of 2250*.

S&P 500

* Target calculation: 1500 + ( 1500 - 750 ) = 2250

CBOE Volatility Index (VIX) recovered to above 12, but low levels continue to indicate a bull market.

S&P 500 VIX

Dow Jones Euro Stoxx 50 is consolidating above medium-term support at 3150. Breach would signal a test of the primary level at 3000. Descent of 13-week Twiggs Money Flow warns of modest long-term selling pressure. Recovery above 3250 is less likely at present, but would suggest a target of 3450*.

Dow Jones Euro Stoxx 50

* Target calculation: 3300 + ( 3300 - 3150 ) = 3450

China's Shanghai Composite Index broke resistance at 2100 and is headed for a test of 2150. Breakout would suggest a primary up-trend, but I would wait for confirmation at 2250. Rising 13-week Twiggs Money Flow indicates medium-term buying pressure. Reversal below 2050 is unlikely at present but would warn of another test of primary support at 1990/2000.

Shanghai Composite

* Target calculation: 2000 - ( 2150 - 2000 ) = 1850

The ASX 200 broke clear of resistance at 5540/5560 on strong results from BHP. Expect retracement to test the new support level, but Friday's long tail and rising 21-day Twiggs Money Flow indicate short-term buying pressure. Respect of support would indicate a long-term advance to 5800*. Reversal below 5540 is unlikely, but would warn of a correction.

ASX 200

* Target calculation: 5400 + ( 5400 - 5000 ) = 5800

Diversification — the only 'free lunch' in investing

Diversification is often referred to as "the only free lunch in investing" because it affords investors the opportunity to reduce investment risk without reducing returns. Most investments involve a trade-off between risk and return, with higher returns requiring investors to expose themselves to greater risk. But effective diversification allows investors to reduce risk, by spreading their investments, while maintaining higher levels of return.

What is effective diversification?

Not all diversification is effective. Many investors buy a wide range of stocks in the belief that this will protect them from risk. The benefits of such diversification are marginal if the stocks are all listed on the same exchange and selected using the same method. The entire portfolio is likely to rise and fall in unison — as in the well-known adage "a rising tide lifts all boats." The key is to select stocks or investments that have low correlation.

What is correlation?

Correlation is the degree to which separate investments rise and fall together. Correlation measures the tendency of investments to advance or decline independently of each other. The correlation coefficient, identified by the symbol r, expresses the level of dependency between two variables (stocks in our case). Values for the correlation coefficient range from 1.0, for stocks that a perfectly correlated, to -1.0 for stocks that move inversely to each other.

Only two shares of the same stock, like BHP Billiton, are likely to have a correlation as high as 1.0. But stocks from the same sector are likely to share high values. And stocks from the same market are also likely to share a reasonable degree of correlation in larger time frames (i.e. the primary cycle).

You are also unlikely to find stocks that are the perfect inverse of each other — a coefficient of -1.0 — other than if you go long and short the same stock.

We are not necessarily looking for stocks with negative correlation, however, but investments with low correlation — a coefficient as close to zero as possible. As you can imagine, going long and short the same stock would protect you from any variation in prices, but would not deliver much in the way of return. If we had a spread of investments with close to zero correlation (i.e low dependency) their price movements will tend to offset each other, providing a smoother portfolio return.

3 Ways to achieve diversification

We are likely to find investments with low correlation using three different techniques:

  • Diversification by asset class;
  • Diversification by geographic location; and
  • Diversification by strategy.

Asset class

There are a number of asset classes available to investors. Asset classes as diverse as stocks, real estate and fine art, however, are all subject the vagaries of the economic cycle and tend to rise and fall together.

Bonds tend to have low correlation to stocks. We need to make a distinction here between government bonds with low risk premiums, which fluctuate largely with the interest rate cycle and tend to be counter-cyclical (i.e negatively correlated) to stocks, and corporate bonds which are subject to far higher risk premiums that may expand and contract in line with the stock market cycle. Credit spreads tend to be low when the stock market is bullish and widen sharply during a contraction.

There are other asset classes such as insurance funds, where risks such as weather events tend to have low correlation to the economic cycle, but investors need a fair degree of expertise to assess the risks associated with these investments.

Geographic location

Australian investors tend to be highly concentrated in the Australian market, with only about 15% of assets invested offshore, both directly and indirectly through managed funds. Most major stock markets tend to rise and fall together, but diversification, especially to US markets, affords investors the opportunity to diversify into sectors not available on the local exchange.

By strategy

Diversification by strategy is often overlooked. If an investor, for example, diversifies their stock portfolio across several value-based fund managers they are likely to find that their investments rise and fall in unison. Even though the managers may hold a wide spread of stocks, they are all selected using a similar process and will tend to behave in a similar manner.

By spreading investments across several strategies, the investor is likely to achieve more effective diversification and more stable returns. Diversification between value-based strategies and our own momentum strategy is an obvious example. Recent research shows ASX 200 Prime Momentum has a low correlation of 0.3368 with the popular Perpetual Industrial Share Fund [PER0011AU] and moderate correlation of 0.4263 with Colonial First State Australian Share - Core [FSF0238AU].

Diversification is not the only "free lunch" available to investors — effective tax planning also enables investors to enhance returns without increasing risk — but it is important and should not be neglected. It is a complex area and we recommend that you consult your financial adviser before taking any action.

That's all for today. Take care.



The best argument for mutual funds is that they offer safety and diversification. But they don't necessarily offer safety and diversification.

~ Ron Chernow

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