If you’re a client, listened to the weekly podcast, or have any type of familiarity with Adaptiv, you have likely heard us talk about a “top down” approach to the markets. And of course, this absolutely flows through to our portfolio management process. In a nutshell, it really boils down to a combination of relative strength and wanting to own “the best of the best of the best”. We feel that these two attributes put our clients in the best positions from a risk/return perspective.

At the “top” of our top-down process, for equities, we like to look at Growth stocks relative to Value stocks. As we know, Growth stocks typically include sectors such as Technology, Consumer Discretionary. And Healthcare. Value, on the other hand, includes sectors like Fianancials and Energy. 

Once we know which direction the largest winds in the market are blowing, we can start to narrow down where we want to allocate our assets. If Growth is outperforming, as mentioned above, we typically want to be in Technology and Consumer Discretionary. Some areas of Healthcare also generally fall into this category. There is no reason to be involved in anything related to the typical Value sectors. Even if they may outperform for a day or maybe a week, here and there, we want to avoid them and stay with the larger trend. 

The next step in the process would be to look at the individual Industries inside these Sectors. For example, industries inside of Technology would include Semiconductors, Software, Internet, etc. And examples of industries inside of Consumer Discretionary would include Retail, Autos, and Gambling. Again, there is no need to have exposure to other areas of the market if we know that Growth, and thus Technology and Discretionary, stocks are outperforming the major indices. Even if a “random” area such as Transportation stocks looks enticing, we want to stay inline with the major themes until we have enough evidence that the overall trends have changed.

And finally, this brings us to individual stock selection. This is where a disciplined top-down approach can really pay dividends. Again, we know that we want to stay within the individual industries that we have identified. And that those industries fall underneath the proper Sectors that we also want to be in sync with. If Semiconductors are outperforming Technology as a whole, it would be imperative to consider having exposure to one (or multiple, depending on your portfolio construction process) Semiconductor stock. Further, if Software is also outperforming, then we would also believe it appropriate to have exposure to at least one stock from this Industry as well. 

From a visual perspective, here’s what this methodology could look like, given the scenario laid above:

The idea with this type of process is for the portfolio manager to continuously be putting himself (and his client’s assets) in the best position to find and capture alpha. We want don’t want to be guessing at what might outperform next. We want to put allocate our capital towards sectors, industries, and individual stocks that are leading now. While some areas may look cheap, or may have been lagging the market and are therefore “due” for some type of reversion to the mean, we do not know when that will happen. For example, how many times over the last 2-3 years have you heard how “cheap” Energy stocks compared to the overall market? I am betting quite a few times. While they may be cheap, according to some fundamental valuation, they’ve been underperforming for a very, very long time. And having any type of exposure to these type of stocks has been a major headwind for any portfolio. The natural market phenomenon of momentum, which has been around since the beginning of time, will allow leaders to lead (and laggards to lag) for much long than most market participants can imagine.

-Ian McMillan, CMT

If you have any questions or want to connect, please feel free to reach out to us at info@adaptiv.com.