Use the RCI to Gauge Market Strength

11/17/2011 7:30 am EST

Focus: MARKETS

John Benedict

CEO, J2 Capital Management, Inc.

Using an indicator called the Risk Controlled Index, John Benedict has been able to make real, responsible gains for his clients. In part one of our interview with Benedict, he describes how it identifies market direction.

Kate Stalter: Today on The Daily Guru, we’re talking with John Benedict of J2 Capital Management.

John, one of the reasons that you got my attention to begin with was that I found your blog, which has the somewhat provocative title, The Cynical Advisor. Tell us a little something about what that says about your philosophy, how it relates to your blog title.

John Benedict: Well, I tend to be an opinionated person by nature. Some early feedback I got was: I might want to change it to The Skeptical Advisor, because “cynical” seems a little bit harsh.

I decided to keep it “cynical.” I think in this day and age, being cynical of whether it’s our industry or politics—I think a lot of people are at this stage right now, and I think a lot of people can identify with that.

Kate Stalter: So, what are some of the philosophies or viewpoints that fall under that label?

John Benedict: This is pretty much borne out. I’m a registered investment advisor—an independent advisor, if you will—and I have plenty of experience in the traditional wirehouse/broker-dealer world. Coming up through that world and kind of seeing how that world worked and some of the things that go on, I grew very skeptical of the industry for quite some time.

And when I started to see products that are being manufactured or pushed out, or how certain advisors advise their clients, I wanted to provide a blog that at times could maybe shed a light on some of those things that go on.

Kate Stalter: Let’s talk a little bit about your current philosophy, with regard to your clients.

John Benedict: So, a little quick history, if I can go back. Coming up in the traditional world, we were taught as advisors to not necessarily know too much about the market, and our primary focus is always selling and gaining new assets under management.

So, most advisors that I find out there: Either you’re an asset gatherer or you’re an asset manager. Predominantly what you find are asset gatherers that are out there.

And in taking my clients through the 2000 bear market, where I would rely on the companies that I worked for to give me guidance on what to tell my clients, as their accounts were going down, it was always the same thing. It was: Hold their hands, tell them to stay invested for the long term and not to worry. But I did.

It was very difficult for me to take my work home at the end of the night and watch clients who were either retired or about to retire take significant drawdowns in their portfolio.

So, what occurred to me: There was just no price at which you should ever sell. That’s where the skepticism or the cynicism started: At what point do you need to start to think about getting a client out of the market?

That led me then onto a very long road of searching for the answers myself, becoming more aware and interested in how investments and markets are intertwined and work together in order to help my clients manage risk better.

So, my current philosophy is one that revolves around risk management. When you look at the past decade to 15 years, I think a lot of people are trying to search for that balance between how to make money but also at the same time how to manage and reduce risk.

So, what I’m good at doing for my clients is understanding where the risk is in anything that I’m either recommending, or that I am buying for them in their accounts at this stage.

Kate Stalter: As part of the research that you did, you’ve come up with some proprietary indicators. One that you’ve written about is called RCI. Tell us a little bit about that.

John Benedict: Yes, so this is going back five, six, or seven years, as I started to learn what is called technical analysis—that is looking at certain indicators or charts to kind of give you a snapshot of where maybe investor emotion is.

I thought it was very important for me to put together my own proprietary indicators. Because once again, what I found early on, maybe through trial and error, was: Looking at what other people were doing, there was so much stuff out there, it can get confusing.

So, I made the decision that if I was to do this, it had to be my research that I was using for my clients. Therefore, when something didn’t work or it did work, that I’d be able to have an explanation for what was going on.

This was a long process of trial and error, of putting together, and looking at backtesting. We hired computer programmers to basically take my ideas and historically plot them on a chart, and we developed this indicator over several years.

We’ve been working with it now for probably four-and-a-half to five years, with some very good success. Now, our firm does run several other strategies for our clients, so I do need to point out that I think that when you talk about diversification, we don’t believe it in the traditional sense.

We believe it a little bit different. We believe that clients should have diversification amongst different strategies that are all looking at maybe something different going on in the market. But the RCI indicator is probably the one in our firm that we call our core model that most of our clients are into.

RCI stands for Risk Controlled Index, or Risk Controlled Investment, and it’s a macro indicator that reports back to us what the risk-reward of the current market environment is at any given time. It’s a very slow moving indicator. It’s not one of these that signals every week. In fact, if you look at since 1996, this indicator has maybe produced a sell signal somewhere around eight or nine times since 1996.

So, it’s a very slow moving indicator that allows us to know when it’s possible that we are in a long-term bull market, or when it’s possible that we’re in a long-term bear market.

Kate Stalter: Is this based on a price or volume model, John? What are some of the basic indicators that you did use to build this?

John Benedict: Basically, we have four main categories that we look at in the market:

  • We’re looking at the market’s trend.
  • We’re looking at the momentum that’s on that trend. Is the momentum strong or weak?
  • We’re looking at the technicals that are going on inside.
  • And then we’re looking at market breadth, which is simply the number of stocks participating or not participating in a given move. So, that would be a confirming indicator to all the others.

We’ve developed kind of a, let’s say a Kentucky Fried Chicken original recipe, where we blend these different indicators together to kind of come up and give us a score. It then it produces an oscillator for us that we run nightly, that we take a look at, and that gives us an idea of the risk-reward that’s in the market.

Kate Stalter: Do you use this as an overall market indicator, or for individual stocks or other securities, like ETFs? How does that work?

John Benedict: Well, knowing when the wind is at your back or in your face is very important on either of them. We run all of those. We run ETFs and individual stocks, but if you’re trying to pick individual stocks when our indicator is showing you that you’re in a potential bear market, that’s going to be very difficult.

So, we do lean on this indicator, and we do have other indicators, but this is our longest term indicator that gives us a gauge of the long-term health of the market. Other indicators are more shorter term, but we definitely look at this indicator to help us gauge decisions on when it’s appropriate to take a position or to even add more.

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