Century-Old Tic-Tac-Toe Stock Charts Rake in ETF Billions

The Point & Figure methodology

Ex-Nasdaq Official Gets 3½ Year Sentence for Insider Trading
Photographer: Jin Lee/Bloomberg

The Nasdaq Stock Market has always been associated with cutting edge technology, whether it be for the companies it lists or the systems used to match buyers and sellers on the first all-electronic exchange.

Yet interestingly enough, one of the lines of business that Nasdaq OMX Group chose to highlight in its earnings report today has its roots in a technique for analyzing stock prices that was championed by the likes of Charles Dow more than a century ago. During the first quarter, Nasdaq bought Dorsey Wright & Associates LLC, which boasts it is "known on Wall Street as the experts in the Point & Figure methodology."

Point and figure chart for Facebook
Point and figure chart for Facebook

In an era of heat maps, three-dimensional volatility surfaces and countless other highfalutin technical tools, point-and-figure charts appear adorably quaint at first blush. They were originally done with pencil, graph paper and stock prices taken from a newspaper. The charts look like some sort of extreme version of tic-tac-toe, using columns of Xs to represent rising price trends and Os to represent falling prices.

"A rising series of X’s and O’s tells us that demand is getting stronger and supply is getting weaker — that is what we want to see in stocks, ETFs and funds we own," is how Dorsey Wright explains how to use the charts. While P&F chart readers look for about 11 identifiable patterns in the charts, Dorsey Wright says they are just variations of two basic patterns: the "double top" buy signal when a column of X's exceeds a previous column of X's and a "double bottom" sell signal when a column of O's exceeds a previous column of O's.

Dorsey Wright shows when X (and O) marks the spot to sell
Dorsey Wright shows when X (and O) marks the spot to sell

Simple, right? So easy even a 19th century pencil pusher could do it! Well, maybe not quite that simple. Dorsey Wright applies the charts to ratios of various securities to study the relative strength between them and identify those with the best momentum. And it uses computers that calculate point-and-figure trends and automatically rebalance indexes accordingly. As Anthony Effinger and Eric Balchunas wrote in Bloomberg Markets Magazine, if Tom Dorsey and his team got abducted by aliens, the algorithms wouldn't even notice. “Once a quarter, we press a button,’’ Dorsey told the magazine. “We just need someone to press the button.’’

But here's the thing: exchange traded funds based on Dorsey Wright indexes are raking in the cash. In just the first two months the index business was owned by Nasdaq, assets tracking Dorsey Wright grew 37 percent, the company said today.

The 13-month-old First Trust Dorsey Wright Focus 5 ETF (ticker: FV) attracted $1.2 billion in inflows last year and has already topped that amount this year with almost $1.5 billion. The ETF, which tracks an index using the point-and-figure relative-strength approach to identify the five top-ranking ETFs from First Trust, is up 11 percent so far in 2015 and about 23 percent since its inception in March 2014. Its holdings include the First Trust NYSE Arca Biotechnology Index Fund, another health-care fund and ETFs holding Internet and consumer stocks.

 Another ETF tracking a Dorsey index, the $1.9 billion PowerShares DWA Momentum Portfolio (ticker: PDP), is up 7 percent this year and has attraced $218 million. Its top holdings currently are Jazz Pharmaceuticals PLC followed by Apple Inc. and O'Reilly Automotive Inc. A PowerShares ETF using the Dorsey approach to buy small caps (ticker: DWAS) has risen more than 6 percent and attracted $134 million this year.

Those three ETFs have helped push the assets tracking Dorsey Wright indexes to $7 billion, according to Tammy DeRosier, president of the DWA business at Nasdaq. She credits the growth with the importance of sector rotation as the bull market ages, and the ease with which it can now be down with an ETF.

"Stocks and sectors rotate in and out of season just like produce in the supermarket does," DeRosier said in a phone interview. "We are like a chef that's going to the farmer's market and creating that menu, with the freshest and best in season."

Of course, the freshest momentum in the stock market has been known to wilt pretty quickly, and not necessarily at a time that corresponds with a quarterly rebalancing. But at least for the moment, there is a lot of interest in what all those Xs and Os are spelling.

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