Combining Sectors and Styles

Style Model Small Value

Sector Model XLU 1.35%

Large Portfolio Date Return Days
ABX 4/11/2013 -18.90% 294
NEM 9/30/2013 -10.38% 122
ISRG 10/21/2013 10.27% 101
EW 10/28/2013 -15.46% 94
JOY 11/18/2013 -6.25% 73
OXY 11/27/2013 -9.43% 64
MUR 12/23/2013 -4.91% 38
SWM 12/31/2013 -9.82% 30
NKE 1/7/2014 -7.31% 23
BTI 1/15/2014 -3.45% 15

(Since 5/31/2011)
S&P Annualized 10.93%
Sector Model Annualized 22.69%
Large Portfolio Annualized 26.93%


From: [url]http://market-mousetrap.blogspot.com/2014/01/1302014-combining-sectors-and-styles.html[/url]

Rotation: selling ISRG; buying MGEE

Yesterday morning I entered limit orders to sell NKE and buy BBOX and then went to work.

I deliberately ignore the market during the day, and limit orders prevent me from chasing a trade.

While I was busy with the real world, NKE gapped down and BBOX gapped up – preventing the exchange. Though disappointing from a tactical perspective, it is extremely encouraging from a strategic one, since these trades were calculated on a very extensive redesign of the full model.

Instead of a one-size-fits-all fundamental screen, I now have a screening process that is adjusted to match a style model that I run in the background. I don’t trade the style model itself, however, because it only outperforms the S&P by 5% per year, which is not enough to make it useful as a standalone model. The reason for the sluggishness is because these are typically broad indexes, and the Mid and Blend options largely overlap with the other styles.

Nevertheless, the style model does tell me when value stocks should outperform growth stocks, or when small caps should outperform large caps. I can adjust my fundamental screens to target these areas. Right now, for instance, the style model is calling for Small Value stocks to outperform. The sector model is calling for Utilities to outperform. In theory, Small Value Utilities should outperform better than Utilities in general.

The full model chooses the best 10% of 98 different industry groups, and within those industries I should look for Small Value stocks.

Large and Small are rather simple. You just sort by market cap.

But what the heck is the difference between Value and Growth?

The key difference is the objective: growth tries to maximize reward and value tries to minimize risk. Growth is a bigger gamble. There may be higher debt loads as the company seeks to expand, for example. Value companies are geared for survival. They may not be after the most aggressive growth, but instead they are trying to be careful with the resources they have.

There are some overlaps: good long term earnings is a sign of both value and growth. And that’s where blended models come into play. Greenblatt’s GARP (growth at reasonable price) approach is one simplified version of a blended model.

In terms of “fear” and “greed”, Growth is the greed trade and Value is the fear trade. A Value investor wants to know how much the company’s assets are worth if it goes out of business tomorrow and has to liquidate everything. A Growth investor would never think in such terms.

Small and Large caps are selected by investors for similar reasons. Small cap stocks have more room to grow, but large cap stocks are less likely to fail.

Small caps and Growth stocks, then, are sought by investors who try to maximize reward.

Large caps and Value stocks, on the other hand, are sought by investors who want to minimize risk.

A small value stock or a large growth stock would both serve as a way of blending reward and risk goals.

The question is which is most indicative of a bull or a bear? Market cap or investment style? In my observation, small caps tend to have higher beta than large caps. And so they will go up more, AND they will go down more, than large caps.

Value and Growth approaches are imprecise and often working on outdated information. Market cap is always known in real time.

For this reason I have estimated the bullish to bearish matrix in the following table (which gives slightly more weight to market cap than investment style):

[ATTACH=CONFIG]22099[/ATTACH]

In the middle are the blended small value and large growth.

As for sectors: Consumer Staples, Healthcare, Utilities, and Financial stocks are defensive, per the work of Sam Stovall and John Murphy.

Those cells marked as “Hold” and “Buy” are the ONLY cells in which the relationship of volume-breadth to price-strength indicates “fair value” to be above the current price.

At the bottom of a bull market, or at the end of a bear, most of those cells should be filled. As the bull reaches its close, the number of cells will dwindle. The small number of listed holds indicates a market that is overbought, while the placement of 4 out of 6 holds in red cells indicates a defensive market.

Currently the best combination is that of “Small Value” and “Utilities.” The best combination is marked as a “Buy” (there will only be one “Buy” at any given time).

The question that comes to mind is – why bother to invest in the red cells at all?

A defensive market is not always a declining market. My models are geared for relative performance, rather than market direction. The red cells usually outperform in declining markets, but there are also such things as “growth recessions” in which monetary policy or sheer momentum can propel a defensive market upward.

In the same way, an optimistic market could still collapse.

Green is generally more profitable than red. But red cells can still make money when investors run for safety. Currently the sector model has been performing quite well in this most recent decline, and is up for the year – even as the broad market is down.

In the end, there are two ways to make money: to go up more than the market, or to go down less than the market. If you can do either of these two things well, you’ll outperform.

Tim