My Thoughts
I think this is a great article and explaination of the market so I have reprinted it here from CNBC in case they remove it from their site. Mr. Markman also has a book, "Online Investing" that can be ordered from Amazon.com.
SuperModels
Ride market tailwinds to short-term profits
Lost the taste for long-term investing? StockScouter can show you how to build monthly portfolios to profit from market trends, whichever way the winds blow.
By Jon D. Markman
Over the past two weeks, I've explained how to use our new StockScouter rating system to choose stocks to hold for six months at a time. But what about the short term?
For investors who prefer to trade stocks fairly frequently, StockScouter assesses three "market preferences" that tend to boost or hinder securities' performances over one- to two-month periods. Studies have shown that stocks with favorable market preferences tend to yield the strongest performance for as long as those preferences are in favor. Think of these as tailwinds, if they are in a stock's favor, or as headwinds if they are not.
The market preferences, recalculated weekly and updated Tuesdays on our Market Trends page, are:- Sector. We have divided our universe of stocks into 12 industrial sectors, such as technology or health care, by their federal identification code. Generally, investors prefer a third or fewer of these sectors at any given time. When they do, we call them "in favor." The rest are either "out of favor" or in a no-man's land we call "neutral." Academic and professional research indicates that as much as 50% of a stock's performance derives from the strength or weakness of its sector.
Market cap. We have divided our universe into four market-capitalization categories: The top 400 stocks by market cap are "large cap"; the next 1,000 are "mid-cap;" the next 2,500 are "small cap;" and the rest, around 2,300 stocks in June 2001, are "micro cap." Generally, investors prefer only one or two groups at a time. Again, the groups investors prefer are considered "in favor." The rest are either "out of favor" or "neutral."
Style. We have divided our universe into two investment styles by price/sales ratio. High-priced stocks are categorized as part of the "growth" style of investing, while low-priced stocks are categorized in the "value" style. Generally, investors prefer one style or the other for periods lasting a year or more. We rate each "in favor," "out of favor" or "neutral."
How to use market preference data
Camelback Research Alliance, the Arizona company that created the StockScouter system for us, says their studies show that the best stocks to own over one-month periods are rated 8, 9 or 10 and are a member of two, but preferably three, categories preferred by the market. In the short term, StockScouter would prefer a stock rated 8 or 9 with three "in favor" tailwinds over a stock rated 10 with just one "in favor" tailwind. When no sectors, market caps or style are rated "in favor," our system prefers stocks with "neutral" tailwinds. At the very least, research suggests that it's best to avoid sectors, market caps or styles with "out of favor" headwinds if you're aiming for a one-month hold. (Note: Stocks are sorted into sector, market cap and style categories monthly to maintain stability, but market preferences are updated weekly to maintain freshness.)
Camelback has tested a 10- and 50-stock portfolio managed according to these rules against data from the past 10 years of market history. In cases where a tie-breaker was required to choose between stocks with identical ratings and market preferences, Camelback researchers programmatically chose ones with the lowest expected risk. No stop losses were used.
Over the past decade, StockScouter's benchmark monthly rebalanced 50-stock portfolio advanced 43% per year, versus a 13.3% annual increase in the Wilshire 5000 Index ($TMW.X). The average six-month return for StockScouter was 19% versus 5.4% for the Wilshire 5000. The standard deviation, or volatility, for the StockScouter system was slightly higher than the Wilshire 5000 at 22% per year versus 13% per year.
To determine whether a system takes on too much risk for each unit of return, academics and professionals calculate a "Sharpe ratio" of return minus the return of a risk-free investment (e.g., a 5% Treasury bond) divided by risk. (The measure is named for Stanford University professor William Sharpe, who shared in the Nobel Prize for Economics in 1990 for his work on measuring risk and return on investments.) Any value over 1.0 is considered very good, and the higher the better. The Sharpe ratio for StockScouter's 50-stock monthly portfolio is 1.46 over the past 10 years; the ratio for the Wilshire 5000 is 0.89.
Additionally, the StockScouter benchmark portfolio beat the Wilshire 5000 in 82% of all months. While the StockScouter-based portfolio performed well when the market performed well, it really shined when the market performed poorly. In the 10 worst months for the Wilshire 5000 Index over the past 10 years, the StockScouter short-term portfolio registered monthly gains seven times.
The beauty of the monthly portfolio methodology is that sectors and capitalizations have come to move in and out of favor very rapidly in the past couple of years. Staying with mostly in-favor groups and avoiding out-of-favor groups should help rational investors sidestep potential trouble. As an example, in March 2000 the 50-stock monthly portfolio consisted of about half large-cap tech stocks, a quarter mid-cap energy stocks and a quarter mid-cap utility stocks. After the late March tech-stock rout that year, however, tech stocks fell out of favor and never regained their tailwind the rest of the year -- even as many investors desperately hoped they would. In April 2000, the monthly portfolio was composed mostly of energy and utility stocks � and Scouter beat the badly slumping market, and especially the Nasdaq Composite ($COMPX). Likewise, the monthly benchmark portfolio has risen in every month of 2001 largely on the basis of a heavy reliance on small- and micro-cap financial, energy and home-building stocks.
A low-maintenance version
You do not need to run a 50-stock portfolio with monthly rebalances to take advantage of the StockScouter system, however. A 10-stock monthly portfolio also works very well, as I'll explain in a few weeks with many examples. Or, if you fancy yourself an investor in large-cap stocks, use the StockScouter feature found in MSN Money's Screener or on the Market Trends page to find only high-rated large-caps. If you prefer stocks favored by corporate insiders, then use the Screener to find high-rated stocks with Ownership grades of "A." If you prefer value stocks, then use the Screener or Market Trends page to find only high-rated value stocks. If you are interested in shorting stocks, then find stocks rated 1 with low Technical or Valuation grades. And so on.
I'll be regularly writing more about actual stocks picked by the Scouter, and publishing several portfolios at a time. In fact, I published my first 10-stock six-month portfolio on Aug. 1. Look for the first two monthly portfolios -- one of 50 stocks, the other a 10-stock subset -- in my Sept. 5 column.
Fine Print
This column is somewhat abbreviated because I'm heading off on vacation -- a week of camping near Yosemite with my family. I will have a lot more to say about monthly Scouter portfolios in the future, including lists of stocks that were chosen by Scouter in the past, and their returns. � Meanwhile, I've been pleasantly surprised to see that portfolios listed in my midyear July 11 column ("All-star portfolios: Still swinging at midseason") have gotten off to a roaring start. The new Mr. P portfolio of beaten-up long-term winners, in particular, was up 13.7% through Aug. 2 (when I left for vacation), versus a 3% gain in the S&P 500 Index. It was powered by a huge move in chipmaker PMC-Sierra (PMCS, news, msgs), up 31% in the period, as well as a 24% surge in Sun Microsystems (SUNW, news, msgs). In fact, all of the stocks in that portfolio were up�. Also winning so far are the Swans, which are largely unknown but strong stocks on the skids. That list was up double the market, 6.2% through Aug. 2, led by Universal Stainless & Alloy Products (USAP, news, msgs), up 20%; and Medical Action Industries (MDCI, news, msgs), up 19%. � And the quirky list of clean balance-sheet companies whose shares are down at least 50% more than the market, my Lauer Lookalikes, was up 10%, led by Benchmark Electronics (BHE, news, msgs), up 24%, and Integrated Silicon Solutions (ISSI, news, msgs), up 19%.
At the time of publication, Jon Markman did not own or control shares in any of the equities mentioned in this column.
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