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Zacks highlights commentary from People and Picks Member «JohntheWizard».

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Making Money in the Stock Market

When you invest money in stocks, ideally, you would like to see the returns weekly grow with a constant percentage, like compounding savings. Unlike savings, investments carry risks that can be quantified as the drawdowns your investment portfolios suffer with progressing time. A well balanced market-cap weighted portfolio like the S&P500 draws down some -10% during a correction, -50% in a recession and -85% in a depression. It is generally known that even the best dividend stock funds carry more risks in terms of draw downs than the S&P500.

Quantitative back testing of portfolio strategies reveals these risks. Forward testing  reveals trading with foreknowledge and stock market manipulation. For instance, forward testing four-weeks’ estimate revisions of analysts reveals that these revisions maximize your returns only when you would have known those five weeks in advance. Hence, you can safely conclude that this information has been held back from the general public for some five weeks. For the larger stocks that appears to be generally the case.

The question then is how are you going to beat a drawdown risk of some -50% without that foreknowledge and in a world where drawdowns appear to return with increasing periodicity? Risks are always calculated on the basis of historical performance. Life insurance companies calculate their premiums on the basis of life expectancy, which appears to increase with increasing age. Life expectancy is a statistical concept that does not predict anything about the age that a given individual out of the statistical population is going to reach. Similarly, when the S&P500 drew down by -54.7% on March 06, 2009, relative to its latest top on October 12, 2007,  it doesn’t tell you anything about the drawdowns of the individual stocks in this population, nor does it predict anything about the future of this population of 500 stocks. Every one to two weeks we can observe that this portfolio of 500 stocks is rebalanced with a new stock with another one taken out. The selection rules are simple and are based on historical cash flow, balance sheet and income performance. However, satisfying these rules imply that you qualify, but not necessarily that you will become a member.

Successful stock picking is a statistical activity where your chosen population or watch list determines the risk for a certain drawdown based on historical performance. From this watch list you can weekly, monthly or quarterly pick the best dozen to a few thousand stocks, whatever you name as “best”. S&P appears to do that on a weekly basis, and they continuously market-cap weight their portfolios. However strange it may sound, market cap weighting puts your largest investment amount on the largest cap, hence on the stock with the largest drawdown risk in terms of absolute money. A drawdown of -40% of Exxon leads to a much larger financial loss than a -80% drawdown of a small cap in a market cap weighted portfolio. Equal weighting much better balances those risks as it doesn’t favor any stock category.

For instance, for stocks with an average minimum daily Money Flow of $ 0.5 mil, Wall Street’s 500 smallest caps compound 26%/year in equally weighted portfolios of these 500 stocks and 0.1%/year in their market-cap weighted counterparts over the full past 12.5 years. The maximum drawdown of the equally weighted portfolios was -58%, versus -76% for its market-cap weighted version and -55% for the S&P500.  

You can use a simple trading tactics to improve on these drawdowns. That is what is called Tit-For-Tat tactics taken from game theory. When you play on a highly competitive field with many participants, always start with a cooperative approach until the game (the market) turns its back to you. Then you get out until after the market returns what you set as a minimum threshold. That minimum expectation can be found empirically on the basis of optimum historical performance back testing. For these 500 stocks it is found that you should minimally expect -1.8% as a weekly return. You would have been 78% in the money with this threshold. This very simple trading tactics improves your maximum drawdown to -25% while keeping the annually compounded growth rate at 26%/year. To a much lesser degree, it improves the market-cap weighted portfolios, mainly because of the unequal weighting of the parts.

Your weekly stock turnover of this P&P500 is only 3.5% (sell and buy 18 stocks per week plus fully get in and out about nine times per year). The Net Present Value of this P&P500 is about $3.5 mil, assuming a discount rate of 6.5% and stock commission costs of 2%. These 500 stocks by far outperform the 250 Zacks’ Ranked #1 stocks.  In fact, I don’t know any ranking system that beats this one, even if you just start to select the 12 to 40 best ones. The 40 best ones returned over 35%, YTD. Compare that to the 40 best  ZR#1’s. These 40 ZR#1’s did 7%, YTD, the S&P500 7.6%.

What Research Wizard doesn’t give is the stocks with the best drawdowns prior to each week. Hence, RW is not able to select for you each week the stocks with the best measure for the margin of safety. Calculating all these maximum drawdowns each week for all those 14,000 stocks in the Zacks Dbases is only a matter of turning on your laptop, adding a few simple programming lines and let it run. The same holds for building in Tit-For-Tat and ranking the stocks according to trend. Trends of each stock are most objectively calculated by smoothing the 26 periods (weeks) of data prior to any week by a Fourier series expansion and calculate the tangent at the end of each smoothing period. That is just 20 lines of programming of standard mathematical functions, all available in VBA Excel. The larger the tangent, the stronger the trend. The smaller the tangent, the stronger the downwards trend.  

Our own back test results reveal that only a few parameters really matter when you speculate or invest. Investing in larger stocks on the basis of fundamentals gives you on average returns that show that you have been investing after the fact. In other words, the numbers appear to reveal that other parties must have known the data earlier and made their gains before the general public got access to them. Hence, use the fundamentals to consolidate them into sectors and the total market so that you get a pretty good idea of how the activities are running of the various industries from a financial point of view. But be careful to timely use these fundamentals for future investments as past performance doesn’t warrant any future performance.  

One of the most successful watch lists I ever saw was the one that came about in a discussion between Mo, JaiH and myself. This watch list contains the 85 stocks that came out best in terms of maximum drawdowns from both the Internet and Credit crises. YTD, the 12 best out of this pack made 24%. No fundamentals. Seems hard to beat to me.           

The most recent picks by «JohntheWizard» are:
A buy rating on Molson-Coors ([url=]TAP[/url]),
a buy rating on Sherwin-Williams ([url=]SHW[/url]) and
a buy rating on Rock-Tenn Co. ([url=]RKT[/url]).

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