Tom Dorsey is one of the leading technical researchers of our time. He is the president and co-founder of Dorsey, Wright & Associates, a registered investment advisory firm based in Richmond, Va., that specializes in point and figure charting, relative strength and other technical analysis. He has authored several books, including "Point & Figure Charting," "Thriving as a Broker in the 21st Century" and "Tom Dorsey's Trading Tips."
Dorsey recently sat down with ETF.com to discuss markets exhibiting the greatest strength, according to his indicators. He looks back on his top three picks from last quarter, tells us his favorite European equity plays at the moment, and explains why currency-hedging never made sense to him.
ETF.com: The First Trust Dorsey Wright Focus 5 ETF (FV) is the newest ETF to incorporate your model. Tell me about the fund's methodology.
Tom Dorsey: To answer your question directly, what we do in the ETFs that we manage is the same method that we have used for 27 years at Dorsey, Wright and Associates. It's basic fourth-grade arithmetic. We have simply been able to tell the computer to look at the X's and O's—which is very simple for a computer, because it's used to 1's and 0's—in various combinations and permutations and whatnot. We utilize relative strength. Now, relative strength has been changed to the new chic word, "momentum."
It's point and figure relative strength, which is different than any other type of relative strength, because ours is just totally basic arithmetic. We'll take a lineup of stocks. You say, "Tom, I want you to create a matrix"; in other words, compare and contrast each one of these stocks in that lineup that I'm giving you. When you compare and contrast them, I want to accumulate the stock for the company that has the most relative-strength point and figure buy signals against its competition.
In other words, say you gave me 50 names. I'm going to enter them into a 50-man arm wrestling contest, in essence. A relative-strength chart is created by dividing one thing by another. So, if I wanted to look at Coca-Cola and Pepsi Cola, I would simply divide the price of Coca-Cola by the price of Pepsi Cola.
That gives me a number. I then can take that number from that division and plot it on a point and figure chart, which looks like a trend chart but isn't. It's a point and figure relative-strength chart, whose signals can last two to 2 1/2 years. So it's very long term in nature.
Those 50 that you gave me, I'll rank them. No. 1 shows the most buy signals on a point and figure chart, doing that relative-strength fourth-grade division. Then I'll take No. 2 and No. 3, and rank them all the way down to No. 50. No. is the one that has the least strength and was unable to perform any buy signals against all the rest of them.
First Trust has an AlphaDex sector suite of ETFs, and they do a great job themselves within the AlphaDex fundamental construction of their indexes. We take these ETFs of their sectors and organize them on that relative-strength basis. We take the top five out of the group. That is our Focus 5.
ETF.com: When we last interviewed you in early March, your models favored U.S. equities, then developed international markets next. Have there been any changes on that front?
Dorsey: That still holds true. This is long term, what we do. Since October 2011, U.S. equities are the No. 1 asset class you should be in. You should be overweighted, plain and simple. That still is the case; it has not changed one iota.
International equities is ranked No. 2. As you just mentioned, last year our play was developed markets, not emerging markets. That played out extremely well, because you wanted to underweight emerging and definitely overweight developed. Now what you have is a condition in which the emerging markets are beginning to gain strength.
So in that international sleeve of our dynamic asset-level investing concept, you would probably be 50/50 between developed markets and emerging markets, whereas a year ago, you would have probably been 70 percent developed and 30 percent emerging.
ETF.com: Valuations in developed markets have now eclipsed those in emerging markets, causing concern among some investors. Does your model have a "frothiness" component? For example, if a market gets too hot, does it trigger some sort of a signal?
Dorsey: No, it does not. As a matter of fact, for us, when things get too hot, they typically get even hotter. You think back to the hottest sector back in the 1950s was the vending machine sector. Then you look into the '70s, the hottest sector that just kept getting hotter and hotter was gold. In the '80s, oil. I could go on to the dot-com craze and on and on.
Just because something's hot doesn't mean it has to stop. We don't do any fundamental valuation. When the indicators begin to change, what we'll see—like in 2008 with our dynamic asset-level investing—is that the more defensive asset classes begin to move up.
In 2008, what happened was, fixed income and cash began to move up that list and pushed U.S. equities out, and pushed international equities out, and kept pushing them to the point where they were ranked fifth and sixth, where they were so far down the list you couldn't have even put any money into them.
It's not a matter of getting out or getting in, or market timing or not market timing. Our whole concept is that we want to be in the right asset class at the right time. We'realways going to be invested. But asset classes move back and forth just the way you'd do a volume thing where you take your mouse and the volume goes hot or horizontal.
That's what happens with our asset allocation; this volume is continuing to change. It's very long term in nature. Like I said, U.S. equities have been the place to be since October 2011. That hasn't changed. I can't predict when it will change.