TSX TrendWatch Weekly

Sometimes all it takes is a specific event to provide an opportunity to obtain a (relatively) low risk return on an investment. When the specific date, time and details of the event are know ahead of time, that’s even better. I’ll walk you through one of those scenarios below.  But first, a look at last week.

WEEKLY REVIEW… The S&P/TSX Composite Index advanced another 1.5% last week, resulting in a +29% gain year-to-date. The S&P/TSX Venture Index did much better with a 3.5% gain, netting +76% year-to-date. Risk-takers have been generously rewarded on the S&P/TSX Venture Index this year.

The major US indexes were flat to modestly down last week, as economic indicators and the status of the US dollar swayed sentiment this way and that.

In Canada, nine of the ten sector indexes contune to have positive trend values. Only INFORMATION TECHNOLOGY is on a downward slide, primarily due to RIM’s pathetic performance recently.

MATERIALS  has been the best performing sector year-to-date (+42%) and continues to lead on a trend basis (+2.1%/week). All other leading sectors have trend values that are under 1%/week at the moment. You need to keep in mind, though, that MATERIALS are literally that and consequently the group is quite diverse. Companies with products as varied as pulp & paper, precious metals, fertilizer, basic minerals and even methanol are all included. A close look at the DATA & CHARTS workbook will help stock-pickers find those subgroups that are performing best.

We won’t complain one bit about the fact that 73% of S&P/TSX Composite Index stocks are trending upward. The average trend value is now at  0.9% per week… not bad considering that most banks will only pay you that much in interest payments for an entire year!

We continue to watch for signs of a reversal to the downside (if only a temporary one).  We’ve rarely ever had that index in the 70-90% range for so long.  Then again, we’ve rarely seen the 2008 sustainable levels of damage before either.

Whatever the future may have in store, we’ll be staying almost fully invested… substituting faster gainers for those that top out or start to decline (using our relative trend analysis™ (RTA)  methodology).

MONEY FOR NOTHING…   (well, almost nothing!) As most of you know an investment stategy (any investment strategy!) is better than having no strategy at all. Generally, the implementation of a strategy involves either fundamental analysis or technical analysis.  Some claim to use both, even though there is a theoretical contradiction in doing so, for the following reason…

The fundamental analyst studies the nature of the company in which he or she invests. Things like the growth of revenue and profits, the strength of the management team, demand for the company’s products, etc. are all relevant to projecting where the stock price might go.  The technical analyst assumes that all of those properties are already factored into the stock price, so all of that effort is a waste of time.  Hence, the contradiction in using both approaches. All that matters in technical analysis are recognizable price patterns over time, since everything about the company itself is irrelevant. If some sort of chart pattern has resulted in profits more often than losses in the past, the odds are that there should be more winners than losers going forward. Or, so the argument goes.

But something that doesn’t seem to fit into either category is the event trade. Suppose there is a foreseeable event at a fixed time and place that could influence stock prices one way or the other when the event takes place. If the controller of the event is outside of any company whose stock might be involved in the event, fundamental analysis won’t help. Similarly, isolated events are problematic in a technical analytic framework where patterns over time are involved. The event is essentially an anomaly in a technical pattern.

There are a variety of such event-driven situations, but I’ll just focus on one this week, since it’s timely.

Every quarter Standard & Poors does a review of the constituents of the S&P/TSX Composite Index. Stocks which no longer meet its criteria for inclusion are dropped and if there is a batch of stocks that have jumped over the  threshold for inclusion, due to excellent price performance (or other significant improvements) over the quarter,  they might be added to the index. Over the past year or so there have been more deletions than additions, so the overall number of stocks in the S&P/TSX Composite Index is about 200.  (Remember when the TSE300 always had 300 stocks?  That was a long time ago!)

The significance of this is that a phenomenal amount of money is invested in index ETFs and mutual funds. The managers of these funds must buy and sell stocks so that their funds mimic the index to as much precision as possible.  They can’t arbitrarily add and delete stocks that are not in the index, and they need to have the right number of shares of each stock to reflect the weights of those stocks in the underlying index.

The consequence of this is that when a quarterly revision results in a relatively large number of additions, there will be huge buy orders coming from every fund manager on the day the changes take effect. That drives prices for those new index constituents up.

What’s great about the revision announcements is that the proposed changes are announce at least a week before they actually are implemented.  This is the official “heads up” to index fund managers to flag which stocks they’ll have to be buying (or selling if their are deletions). The last revision was announced September 11 and implemented September 21. The pattern should be similar in December.

Now, you might ask why the index fund managers wouldn’t act before the effective date? But, if they did that they would be implicitly saying that their index is not following the true index for at least a week, and that’s totally contrary to the intent of the fund.  So, they need to buy and sell on the implementation date… which might be December 21 this quarter if the September pattern holds. (Monday mornings seem to be a good time to trigger such changes.)

The individual investor, on the other hand, doesn’t have this constraint. You and I can buy the new candidate stocks ahead of the implementation date and sell them at the end of the first day of trading as part of the revised index.

There are many academic studies that have proven beyond any reasonable doubt that there are statistically significant price jumps on revision day for the new index members. The only controversial point is whether the effect persists beyond that first day.  Some studies say yes; others no.

I’m not saying that the price changes are huge, but they’re typically quite a bit higher than a typical up-day for the stock.  To play this event trade properly, you’d need to buy as many shares as you can afford, or use leverage through options or margin loans. It’s pretty rare that options will be available for a stock that’s not already in the S&P/TSX Composite Index but it does happen occasionally.  So, the other choice is to borrow heavily and pay a few days’ interest on your loan before you sell.

This strategy is not for the risk averse, but the odds of success are high, especially if you sell at the end of the first revision day or shortly thereafter. The amount of leverage you use will determine your profits.

Now it just so happens that we have an index review just around the corner.

What’s great about the revision announcements is that the proposed changes are announce at least a week before they actually are implemented.  This is the official “heads up” to index fund managers to flag which stocks they’ll have to sell and buy.  The last revision was announced September 11 and implemented September 21.  It should be similar in December.

Now, you might ask why the index fund managers wouldn’t act before the effective date, but if they did they would be implicitly saying that their index is not following the true index for at least a week, and that’s totally contrary to the intent of the fund.  So, they need to buy and sell on the implementation date… which might be December 21 this quarter if the September pattern holds. (Monday mornings seem to be a good time to trigger the changes.)

A recent Globe & Mail article cited a CIBC World Markets report on the most likely additions we might see to the S&P/TSX Composite Index when the next quarterly revision is made in December. We’ve added the current trend and consistency values (Tr10/C) from our Premium Service Canadian Equity database. Trend is %/wk and Consistency is % out of 100% as usual.

• Cott Corp (BCB)… 1.3/24 (options available)
• Brookfield Renewable Power Fund (BRC.UN)… n/a
• Centerra Gold (CG)… 4.7/71 (options available)
• Celtic Exploration (CLT)… -0.8/22 (options available)
• Lake Shore Gold Corp (LSG)… 3.5/60
• Runicon Minerals (RMX)… 1.0/28
• Semafo Inc (SMF)… 7.3/77
• Ventana Gold (VEN)… 7.5/68

The only listing that may be deleted is Cardiome Pharma (COM) according to the report. It’s trend/consistency pair is -1.8/41.

Looking at the available information, CG, SMF, VEN and maybe even LSG have the trend/consistency pairs that would make them worthwhile investments (after due diligence to ensure that there aren’t extraneous factors at work).  So, why not consider those with the additional goal of getting that “new entry bump” as a bonus?  You might even want to hold those beyond the implementation date to see if the trend is still intact at the end of the week. If so, hang on longer.

Cott and Celtic have call options to provide some leverage, but it wouldn’t be advisable to hold them after the end of implementation day… if you even want to consider those at all.
Centerra could be the best bet overall with call options available for leverage, plus excellent trend and consistency values.  If you are an options trader, be cautious though about high premium costs due to other investors playing the same game. You could be right about the call, yet not earn the kind of return you’d expect if premiums shrink later on.

So, there’s your first example of an event trade. I’ll talk about others later and revisit this one closer to the time when the “official” additions and deletions are announced by Standard & Poors.