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We’ve gained an outstanding education on relative strength investing from our friends at Dorsey Wright and Associates. Between their Point and Figure Institutes and daily research, they’ve taught us an incredible amount about the markets. One of the biggest tools they provide us with is called DALI, or Dynamic Asset Level Investing. DALI evaluates the supply and demand forces of asset classes, and ranks them from strongest to weakest based on their relative strength. It also takes their absolute trend characteristics into account. We strongly believe that relative and absolute asset class trends should be considered in the tactical asset allocation process.
Measuring Asset Class Relative Strength
When it comes to point and figure relative strength charts, buy signals indicate longer term outperformance. Therefore, these signals serve as our central unit of asset class measurement. Each asset class is given a ranking based on the number of relative strength buy signals it’s able to accumulate. DALI displays this score not only as a numerical ranking, but as a percentage of the total possible signals as well. The asset class with the highest number (or percentage) of buy signals has the best relative strength.
Why Not Stop There?
An issue with only considering relative strength is that sometimes relative outperformance means being down 20% when everybody else is down 25%. This is why DALI pairs relative performance with absolute performance.
Measuring the Absolute Performance of Asset Classes
An additional DALI component looks at each asset class’s cash percentile rank. This is done by creating an inventory of the asset class’s underlying components and including a proxy for cash. Cash’s relative rank among the asset class’s inventory is considered. When cash ranks highly in comparison to the majority of an asset class, that’s a clear red flag. Anything that ranks beneath cash on a relative strength basis has been losing money. This is our absolute benchmark.
DALI also looks at something Dorsey Wright and Associates have deemed the “cash bogey check”. This involves a point and figure relative strength chart of each asset class that measures it against a cash proxy. When the relative strength chart is in X’s, the asset class passes its cash bogey check. That means it has been outperforming cash in the near term. When the relative strength chart is in O’s, the asset class fails its cash bogey check. On these charts, column changes tell us about near term activity, so that asset class has been underperforming cash in the shorter term. In order to generate a column change on these relative strength charts, an asset class must reverse by 10%. Failing a cash bogey check means an asset class has reached correction territory. It may not always mean an end to the trend, but it definitely warrants attention.
How Do We Consider the Relative and Absolute Together?
If an asset class has accumulated a strong percentage of the available relative strength buy signals, and cash ranks poorly against its components, that is a trend we would strongly consider participating in. However, if an asset class has strong relative strength characteristics, but cash is outperforming many of its components, we may want to think twice about our level of participation in that trend.
All of DALI’s pieces work together to provide us with guidance in the tactical asset allocation process. By considering total relative strength buy signals, as well as cash percentile rank and the cash bogey check, we are given a more accurate depiction of where each asset class stands on both a relative and absolute basis.
Further Reading on Asset Allocation Using Relative Strength:
http://dorseywrightmm.com/downloads/hrs_research/SSRN-id1585517.pdf