Investing Lessons From Last Year’s Winners

At the end of the year, many investors look backwards, wishing they had invested in the previous year’s biggest winners. This behavior isn’t unique to investors. Many individuals take time as the new year approaches to consider their mistakes of the past year. This can be an important exercise, if you learn lessons from a review of the past. For investors, it seems few learn lessons because they repeat the process year after year, almost always looking in the rear view mirror at the stock or ETF they didn’t buy.

We want to take some time to do things differently. We will look at the biggest winners of 2016 and then consider how we can potentially find the ETFs likely to be among the biggest winners of 2017.

In a recent article, Bloomberg provided a list of biggest winners and losers among global stock markets. The chart below shows gains and losses priced in US dollars which is our focus. For local investors, the Venezuela stock market was the biggest winner with a gain of more than 114% but US-based investors would lose much of that to currency depreciation. In dollar terms, Brazil was last year’s biggest gainer.

12

This chart is from Bloomberg which has an audience of professionals all around the world. Many of the stock markets shown above are not accessible to individual investors in the US. It would be almost impossible for an individual to buy Kazakhstan and short Nigeria, for example. But, there are ETFs available in some cases even though the ETFs may not exactly track the indexes shown above.

iShares MSCI Brazil Capped (NYSE: EWZ) closely tracks the Ibovespa Index shown in the chart. Last year, EWZ gained about 64%, in line with the index. Exposure to Peru, the third best performing country on the list is also available through an ETF, iShares MSCI All Peru Capped (NYSE: EPU), EPU also gained about 64% last year, outperforming the S&P BVL Peru General TRPEN Index .

On the downside, there is an ETF offering exposure to Italian stocks (the FTSE MIB Index), iShares MSCI Italy Capped (NYSE: EWI). The Italian index was the biggest loser in 2016. Here the correlation is less precise with EWI down just 8.4% while the MIB dropped more than 13%. There is also an ETF with exposure to Portugal, shown in the chart as the PSI 20 Index. Global X MSCI Portugal ETF (NYSE: PGAL) lost about 4% in 2016, much less than the index’s 16% loss. In smaller stock markets, we often see ETFs fail to match their indexes on the up side or down side. Generally, the trend will be in the same direction and in this example, both PGAL and the PSI 20 were both down.

The question we face as investors is how can we spot a potential winner like Brazil, and EWZ, in advance. While we won’t always be able to catch big winners, the indicator known as relative strength (RS) could help. Notice that this is RS, not the more popular RSI or Relative Strength Index.

Below is a chart of EWZ with RS shown below the price action. This is a traditional measure of RS which gives each stock a percentile score, similar to the method used by Investor’s Business Daily and investors.com. Buy signals are generated when RS moves above 70 and sell signals are given when RS breaks below 70. The solid horizontal line in the RS portion of the chart represents the buy and sell threshold.

13

In EWZ there were two separate trades. This strategy would have captured a total return of 27% between the two trades, a nice gain but less than half the gain of the index.

The next chart shows a different RS indicator, one that you can maintain without a subscription to an expensive data service. This indicator, which we describe below, gave just two signals last year, one buy and one sell. The result was a 92% gain, even better than the performance of the Brazil Ibovespa Index.

14

RS also provided timely buy and sell signals in EPU, in this case capturing nearly all of the annual gain in the ETF.

15

RS can also help us avoid the biggest losers. The next chart shows EWI, the ETF tracking Italian stocks. You’ll notice EWI was on an RS sell signal for most of the year, indicating we should avoid owning that ETF.

16

To calculate the indicator shown in the charts, the most recent closing price is divided by the 52-week high of the ETF. This calculation can be done for any ETF or stock. In the chart above, the indicator is shown as the green line. The red line is a 26-week moving average of the indicator. A buy signal is given when the indicator is above the moving average. Sell signals are given when the indicator falls below the moving average. This is a simple tool that delivered market-beating performance. However, this indicator does not appear to be available at popular charting web sites.

To find candidates based on this indicator, we can use a screener such as the one at FinViz.com which is available for free. This screener allows us to limit a search to ETFs. The specific criteria we used were:

  • Average volume of at least 200,000 shares per day. When investing in foreign stock markets, liquidity can be very important. Trading hours in foreign markets may have little, if any overlap, with the trading hours of US markets. Because of this, ETFs for foreign markets can trade with significant risk premiums on volatile days as the ETF providers seek to limit their risk to adverse market moves. Trading only the most liquid ETFs can limit the trading costs associated with this risk premium.
  • Price within 10% of the 52-week high. This is one of the criteria in the FinViz.com screener. This indicates that the ETF has high RS and studies have consistently demonstrated that stocks or indexes with high RS tend to outperform the market over the next few months.

This simple screen highlighted some of the potential winners for 2017.

Among country funds, Russia, a market which delivered the fourth best return in 2016 according to the Bloomberg chart shown above, is still a strong market. iShares MSCI Russia Capped (NYSE: ERUS) is the country ETF at the top of the screen. WisdomTree Japan Hedged Equity ETF (NYSE: DXJ) is also a highly ranked country ETF. These trades might not sound promising based on fundamentals, demographics or geopolitical concerns. But, RS looks only at the price action and ignores all of those other factors.

For sectors, bank stocks and semiconductors are heading into 2017 with the highest RS readings. ETFs to consider for these sectors include SPDR S&P Regional Banking ETF (NYSE: KRE) and VanEck Vectors Semiconductor ETF (NYSE: SMH).

RS also points to small cap value as a promising investment for the next year. iShares Russell 2000 Value (NYSE: IWN) is an ETF that offers exposure to this segment of the market.

RS is a time-tested strategy that has worked well in the past. Right now, it is telling us to consider investments in Russia, Italy, banks, semiconductors and small cap value which have the potential to be among the biggest winners in the next twelve months.