What This Strategy Aims To Do
This model aims to serve investors who wish to pursue the aggressive end of the reward-risk spectrum and do so in a way that is sensible and consistent with sound financial theory.
Why It’s Worth Considering
Advisors and gurus often focus on the more conservative side of the scale, and that’s fine given that this is consistent with the needs of many, maybe most, who seek financial advice. It’s important, however, that recognition and respect be accorded to the needs of aggressive investors, who need at least as much guidance lest they slip from sensible risk-taking into recklessness.
The name of this Model, “Swinging for the Fences,” evokes the image of the baseball batter who swings as hard as he can hoping to hit a home run. Such batters tend to strike out a lot, but when they connect, they score!
So if we’re swinging for the fences, why water down our strategy with considerations of reasonableness, etc. Shouldn’t those who invest this way just flail away and hope for something spectacular?
The answer takes us back to the baseball analogy. Imagine Batter A who does just that, flails away. He does not study the pitchers he faces or considers the types of pitches that may be thrown given game conditions. He might even close his eyes while swinging. Compare him with Batter B who trains proper muscles in the weight room, studies pitcher tendencies and learns to anticipate what kinds of pitches he may face in a given set of circumstances. If you were a team owner, which Batter would you be more willing to sign to a long-term mega-dollar contract?
It’s the same in investing. While nothing can ever be guaranteed, understanding the situation and doing one’s homework can tilt the probabilities in one’s favor. This model aims to help aggressive equity investors do just that.
How We Do It
Generally speaking, we work with a Momentum-oriented ranking system, in other words, a ranking system that measures share returns achieved over a specific period of time. The stronger the observed momentum, the more investment merit the stock is deemed to have. The portfolio is comprised of the 20 top-ranked momentum stocks in the S&P 500 universe.
Is that all there is? What happened to notions of thoughtfulness?
Actually, there’s quite a bit here. But it’s subtle, like the difference between a fastball and a slider that, to a trained batter, are vastly different pitches but which may seem indistinguishable to the typical spectator.
First to consider is the validity of any use of momentum — given what we all know about past performance not being predictive of the future. Despite casual guru rhetoric that seems to echo that seemingly anti-momentum stance, academicians have found support for use of momentum and a legitimate investment factor.
Here’s how it works. We cannot infer from the fact that stock A outperformed the market by five percentage points in the second quarter that it will do likewise in the third quarter. That is an example of illogical thought that makes gurus shun momentum, and rightly so. But let’s back up a moment. Why did A outperform the market as it did? Was it a random inexplicable event? We say “no.” We believe the stock performed as it did because of certain fundamental and sentiment-related reasons, relating, say, to investment-community expectations regarding future earrings progress. If these expectations persist into the third quarter, there is a good reason to expect the stock to similarly outperform the market during that period as well.
Some who later look back at the third quarter will observe the similar level of relative performance, but attribute it to coincidence saying the second-quarter performance could not possibly have “caused” the third quarter performance. That would be a correct answer — but to the wrong question. The right question is this: Did the factors that caused the stock to perform as it did in the second quarter persist into the third quarter? Based on our observations of the so-called momentum, we can infer that the answer is likely to be “yes.”
Momentum is really just a form of verbal shorthand. What we are really measuring is persistence, the persistence of factors that have bullish (or bearish if we’re dealing with negative momentum) implications for the stock. When technical analysts speak of trends (“The trends your friend,” they like to say), they are recognizing something most or all of us know from observing life but may not have thought to articulate in this manner: Change can be revolutionary or evolutionary (sudden or gradual) but is more often than not evolutionary. Applying that to the kinds of factors that typically catalyze different levels of stock performance, this means that we can draw probabilistic inferences from observed momentum. It would not be unreasonable to suggest that momentum is innocent until proven guilty; i.e. can be presumed sustainable until we see evidence suggesting a change.
A successful momentum strategy has several components.
First, it has to recognize when bona fide momentum exists. Is momentum to be measured over the course of a day? An hour? A year? Academicians have found that it takes more time than many in today’s world of hyper-speedy data transmission for genuine momentum to manifest. (This is why we are not day traders.) Hence our ranking system uses a meaningful time frame.
Second, it has to consider behavioral tendencies in response to factors that lead to share momentum. This is why our ranking system does not work with a period that extends up to the minute. We allow for a period of information digestion. It’s also why, before we sort stocks based on our ranking system, we first disqualify all whose momentum ranks were in the top 5% of our universe, thus incorporating the need to recognize, and avoid, situations where it’s likely that investor shave most recently over-reacted to whatever bullish considerations have been present.
Finally, we work only with S&P 500 constituents. As we have explained in connection with other models, this alone contains a lot of information about company stability, quality and the intensity of study to which they are subjected. This is no small matter; testing has shown that the application of our model to a micro-cap universe produced disastrous results. We must limit at-bats to batters who most likely have studied pitchers’ tendencies, game situations, and who keep their eyes open in the batter’s box. It also helps if the pitcher is most likely to deliver hittable pitches (i.e. we work with companies more likely to be characterized by the relatively stable tendencies a successful momentum strategy requires).
The model is refreshed weekly and stocks whose ratings fall to a lower threshold we established are sold.
Is It Suitable For You?
This Model is suitable only for aggressive investors or for the most aggressive portion of a larger portfolio. And due to heavy trading activity, it is suitable only for those who have very low-cost trading arrangements.
Investing In This Model
This model has a high turnover. This is typical of rule-based models that depend on data to keep positions aligned with strategy. Also, this strategy’s orientation toward Momentum is likely to make higher than would be the case for many other data-driven strategies. Due to the turnover, commissions could play a major factor in the returns.
It is also preferable to follow this model in a tax-deferred account to avoid paying short term capital gains taxes. However, due to the turnover and relatively high number of positions, contributing a small amount each month an be very inefficient depending on your broker.