Our Fidelity Sector Fund Switching Program

Our Fidelity sector fund switching program, which we comment on in every memo, is derived from a concept John Hammerslough brought to my attention in the late 1960's. John used relative strength to buy and sell the Dow Jones Industrials' 30 component stocks, and his strategy outperformed the Dow itself. I therefore decided, back in 1986, to try using it with Fidelity's sector funds. It worked!

John's relative strength analysis uses a combination of three rates-of-change: an eight-week, a sixteen-week, and a thirty-two-week; you then calculate a combined strength rating by taking 50% of the eight-week ROC and a lesser percentage of the other two. (The combination is centered at approximately sixteen weeks). Our Fidelity switching program therefore starts by calculating the strength rating for each of Fidelity's sector funds every week (using Wednesday's closing prices); we then rank them from best to worst in typical relative strength-analysis fashion, and the rankings are published in our memos.

To actually start the switching program, we bought three funds with the highest strength ratings. The important thing, though, is the three sell criteria; when one of the holdings triggers any one of the sell criteria, the holding is sold and the proceeds redeployed into the highest-ranking fund not already owned.

The three sell criteria are:

       1. The fund falls into the bottom half of all funds (because you don't want to hold something that is underperforming the majority of the other funds).

       2. The fund falls below the S&P 500 (because you don't want to hold something that is underperforming the market itself).

       3. The fund falls below the money market rate of return (because you don't want to hold something that is underperforming cash). This criteria has a key added benefit; during a severe decline in the market, there may come a point when less than three funds are outperforming cash, so -- unlike a pure relative strength program -- our switching program can actually go into a defensive mode. (No funds were outperforming cash, for example, as of the Wednesday before the 1987 crash, so the switching program moved to 100% cash at that time.)

The year-by-year tally:

Year Switching Program S & P 500
1992 + 13.9% + 4.5%
1993 + 23.4% + 7.1%
1994   - 3.9% - 1.5%
1995 + 45.2% + 34.1%
1996 + 13.6% + 20.3%
1997 + 24.2% + 31.0%
1998 + 15.9% + 26.7%
1999 + 49.8% + 19.5%
2000 + 33.0% - 10.1%
2001 - 24.3% - 13.0%
2002   - 5.2% - 23.4%
2003   + 8.0% + 26.4%
2004 + 16.0% + 9.0%
2005 + 21.9% + 3.0%
2006 - 17.2% + 13.6%
2007 + 15.6% + 3.5%
2008 - 26.2% - 38.5%
2009 + 33.2% + 23.5%
2010 + 11.4% + 12.8%
2011 - 14.0% 0
2012 + 20.3% + 13.4%
2013 + 39.8% + 29.6%
2014 + 9.5% + 11.4%
2015 - 2.4% - 0.7%
2016 + 24.0% + 9.5%



We've also found, over the years, that the percentage of funds that are outperforming cash is a very good intermediate-term market indicator. When the percentage rises above 66% (into "overbought territory"), then falls back below 66% again, it's a sign that the intermediate trend has turned down. Conversely, when the percentage drops below 33% (into "oversold territory"), then rises back above 33% again, it indicates that the trend has turned back up. (An "overbought" or oversold" reading itself has no predictive value, however; in the past, the percentage has sometimes stayed overbought or oversold for a l-o-n-g time before finally reversing.)

Our Fidelity switching program has proven, over the years, to be a very valuable tool. Our latest weekly Fidelity sector fund strength ratings can be seen here.

Walter Deemer

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