Mixing Value and Momentum

The real money in the stock market is made at the two extremes – value and momentum. The unquestionable success of those two approaches has had many capital alchemists pondering if there is something in the middle that could consistently outperform by a wide margin at the expense of lower drawdown. This quest for perfection has given birth to concepts like “Growth at Reasonable Value” and the introduction of P/S to many Momentum approaches.

Earlier this week, Josh Brown wrote a post, featuring James O’Shaughnessy and what he calls the best performing market approach for the past 50 years. This approach combines value and momentum. O’Shaughnessy ranks all stocks based on 4-5 major value criteria (P/S, P/B, P/E…) and creates a cumulative value score for each stock. Then he takes 10% of the stocks with the highest value score and picks the 25 of them with the highest trailing 6 month momentum.

A prudent question here would be, how come this approach has not been arbitraged over time. Usually when a method is insanely successful, it attracts attention and capital, which diminishes its success. If everyone knows that stocks with low P/S outperform, everyone will buy such stocks and as a result this advantage should evaporate over time. This is not the case when momentum is involved. Any market approach that integrates some form of momentum in its ranking, cannot be arbitraged. Relative strength approaches involve buying stocks with the highest performance over certain period of time (for example 3mo, 6mo, 12 mo or a combination of those). The best performing stocks attract the most capital, which makes those stocks even better performing. The whole process continues to feed on itself until the trend is violated due to profit taking.

There is one more important point that I want to make regarding momentum approaches. Relative strength is based on performance, which means that stocks that went up 200% in the past 6mo will be ranked higher than stocks that went up 20%. Such an approach could do a disservice to the market alchemist as a stock that is just breaking out from a multi-year or 6 month range will have very low 6 mo performance and therefore low RS score. Essentially, blindly using RS to rank will lead to missing stocks with high probability of outperforming.

There is no one perfect momentum approach that will let you capture all big winners. A RS approach will help you capture the meatiest part of a trend. You will be able to catch stocks that go up 300% a year, when they are up only 100% (for example, you will notice a stock that is going from $20 to $80 when it is trading at $40). The new high approach will help you spot stocks as they are breaking out to uncharted territory from long bases.

Going back to mixing value and momentum, I ran a quick simplified screen, applying a  minimum criteria for P/S<2 and P/B<2 and ranked the resulting universe of stocks based on 6mo RS:

Is Shanghai Composite the Most Overlooked Leading Technical Indicator?

There is a 13 hours time difference between Shanghai and NYC. The Chinese wake up when New York goes to bed. You could say that the Chinese live in the future in some way. What I am more interested in is the price action of the Shanghai Composite, which has been named the ultimate leading indicator by not one or two prominent investors.

We all know that Shanghai Composite reached a major lower high and lower low in January 2008, months before the U.S. markets had their worst performance in decades. Then in the end of 2008, Shanghai Composite bottomed several months before the U.S. stock market did. This relation stays strong, even today. Every time there has been a major divergence between $SPX and Shanghai Composite this year, investors who stuck with the Chinese index were on the winning side. Shanghai has been leading at major turning points.

Let’s take a look at some of the clues this year:

– In April, the Shanghai Composite makes lower high and lower low about a week before $SPY basically tops for the year;

– In the end of July, $SPY attacks the high for the year and multiple stocks are breaking out to new all-time highs. Meanwhile, Shanghai Composite reverses and makes a lower low. Two week later, $SPY is down 20%;

– While $SPY was trading in range between mid August and September, the Shanghai Composite broke down to new YTD low. A few weeks later, $SPY retested and broke below its August low, shedding 10% in 10 trading days;

– And the most recent example: $SPY rallies 8% in a week, reaching its 200dma while the Shanghai Composite makes new 2 year low. Over the past 3 days, $SPY dropped 3.5%.

Personally I have no reasonable explanation why this has been the case. Yes, China is the second largest economy in the world and accounts for almost a quarter of the world growth. Yes, China is a major buyer of commodities, manufacturing center and export monster, but why Shanghai has been leading so often at major turning points is beyond my comprehension at this point.

It is easier to find reasonable explanations to odd events after the fact and make them look obvious in hindsight, but there is a difference between correlation and causation. I’ve always kept an eye on Shanghai Composite, but I never considered it a serious leading indicator. I will pay more attention to it from here on, fully realizing that when everyone starts to pay attention to one indicator, it miraculously stops working.

My Top 11 Posts of 2011. What Are Yours?

Hopefully this initiative catches on and other bloggers also post a summary of what they believe was their best work in 2011. It is not an easy task to choose your best, but here is my selection:

1. 20 Truths About the Stock Market

When you calculate the time you need to drive from point A to point B, you should always take traffic into account.  Traffic is like the stock market. You might pretend that it doesn’t matter, but it will impact you anyway. It doesn’t matter how smart you are, how ingenious your idea is or how cheap your stock is – if the market does not agree with you, you will not get paid. Period.

2. The Market Blinked First

The stock market is bipolar creature, driven by sentiment and irrational expectations. One day, it is an ingenious forward looking mechanism that anticipates and discounts future events beautifully. Another day, it is a stubborn schizophrenic that can’t see further than its nose. It is what it is. You either adopt or leave the scene.

3. Social Media and the Creation of Better Traders

Social media overcomes the geographic limits of time and space and the psychological and cultural limits of perceived status, and opens a whole new world of collaboration. Some people say that social media is noise for the real traders, who have to rely only on themselves to be successful, but as with all tools – something can be very dangerous in one’s hands and extremetly useful in another’s. You just have to learn how to use it.

4. How Expectations Turn into Reality

Investors often act on expectations of how certain events and processes will affect prices. Those events might not change the underlying fundamentals at all, but they can change expectations. When expectations change, prices change. When prices change, expectations change. Yes, some catalysts can start a process of self-reinforcing feedback loop. It works in both directions – up and down.

5. There is a Difference Between What People Say and What People Think

Market sentiment is reflective. It mirrors short-term price action and recent performance. For example, people who have had a number of consecutive successful long trades are likely to be much more optimistic about the markets in general than people who have been on the sidelines.

6. What To Do When the Market Is In A Correction Mode

Watch and wait for that fat pitch to come. It always does. If you are a swing trader, I guarantee you that the market will provide at least one great opportunity every week. How do you recognize it in advance? You don’t.

7. Why Everyone Should Learn How to Trade

Learning how to trade/invest is difficult, but so is everything else. Every discipline has its learning curve. Lawyers go to school for 8 years, before they are considered ready to prove themselves. I haven’t heard of someone, who considers himself a good doctor after reading a few posts on the Internet. If you try a surgical operation after reading a book or watching a Youtube video, I can tell you that most likely you will be unsuccessful.

8. Why Momentum Investing Is A Contrarian Approach

Very few are able to ride the majority of a trend. The common scenario is that there are different owners at the different stages of a trend and what is buy signal for one might be a sell signal for another.

9. Who Is A Better Investor – The “Yes” Man or The “No” Man

So how to find the balance between the Yes man in you, who wants to experience the beauty of the world around him and the No Man, who needs to focus in order to achieve something of significance. Well, you have to learn to distinguish your life as a trader from your life as a human being.

10.  Having a Plan About Your Plan

In the VC industry, experienced investors often claim that ideas themselves are worthless without proper execution. The same is true for the stock market. Having a well thought out equity selection approach is a necessary, but insufficient condition for achieving consistent profitability. Finding new trading ideas is not enough. There is no purpose of having four-five stocks in your watch list if you don’t have a clear plan how to profit from them.

11. Hope is Not a Strategy

It is very dangerous to own momentum stocks on the other side of the mountain. When the trends is over and a stock is trading below its declining 50dma, you are playing with fire when you go long.