Stock Exchange: Can Model-Based Trading Beat The Market?

The Stock Exchange is all about trading. Each week we do the following:

  • Discuss an important issue for traders;
  • Highlight several technical trading methods, including current ideas;
  • Feature advice from top traders and writers; and,
  • Provide a few (minority) reactions from fundamental analysts.

We also have some fun. We welcome comments, links, and ideas to help us improve this resource for traders. If you have some ideas, please join in!

Review

Our previous Stock Exchange discussed different methods for selecting stocks. Considering the many thousands of publicly traded securities, most traders have a preferred process to sift through the universe. If you missed it, a glance at your news will show that the key points remain relevant.

This Week: Can Model-Based Trading Beat The Market?

The advantages of model-based trading seem clear. For example, models are much more disciplined in their decisions than are humans. For example, we’ve written about this previously by describing the importance of disciplined entry and exit points for your trades, as well as using disciplined position sizing. Further, model-based trading eliminates emotion. For example, according to Dr. Brett Steenbarger, evidence shows that emotions can really screw up your trades (especially if you are a newbe), but they can also be used to help increase your focus if you know what you’re doing. And on that note, we’ve written previously about the importance of making sure your trading process fits your style.

And considering the wide accessibility of model resources (such as data and modeling applications as simple as Microsoft Excel), many of the things human traders seek can be accomplished easily with models. Further still, there should be plenty of incentive to build such models considering the profits that are available.

Please note: This week’s Stock Exchange is being edited by our frequent guest: Blue Harbinger. Blue Harbinger is a source for independent investment ideas focused on value and income opportunities. Please also note: this week our models have no new specific stock picks to share. Instead, we review our model scorecard.

Our Model Scorecard:

Not surprisingly, our models based on momentum (i.e. Felix and Athena) have been working the best lately, while our models based on mean reversion and dip buying (Holmes and RoadRunner) have performed less well. We say “not surprisingly” because momentum stocks (MTUM) have been performing very well recently (relative to the S&P 500) as shown in the following chart.

For more perspective on the recent strength of momentum, James Picerno provides a lot of details in this recent article: Momentum Continues To Lead US Equity Factor Strategies.

However, despite the strong performance by momentum, our other models have held their own. For example, over the last four months, our results (including commissions and fees) are approximately even for Holmes and RoadRunner and up approximately 20% for Felix and Athena. And if you had an equal weighted portfolio of these four models you’d have roughly doubled the S&P 500’s return during the time period. Obviously, short-term success of an approach varies a great deal. And in a few months, the results could be just the opposite (i.e. momentum could underperform). However, one strength of Holmes and RoadRunner is that they outperform over the long run with a low correlation to the market. This is important for volatility reduction purposes (i.e. risk management).

And for a little more color on momentum, here are the previous “Stock Exchange” series write-ups on a couple of Felix’s previous recommendations that have been doing quite well (Felix is our momentum model with an average holding period of 66 weeks):

Hertz (HTZ): Felix’s pick from the week of June 29th

Urban Outfitters (URBN): Felix’s pick from the week of July 20th

And if you are curious, here is a current list of some of the most attractive Russell 1000 stocks according to Felix:

Please note, the above list is very different than the list we’ve been showing readers in previous “Stock Exchange” articles. Also, as a reminder, readers are welcome to send us specific stock ideas that they’d like us to run through our various models, and we’ll happily share the results as we are able.

Conclusion:

At the moment, our models are doing well. And ultimately, extending our longer-term track record of success is most important. We cannot share all of our model picks in this forum, however we believe sharing our approach is interesting and worth discussion. We’re also able to share more information with a few of you that are interested in investing in our models. And also worth mentioning, we’re doing a webinar next Thursday covering our current market views. We hope you enjoy and evaluate our approach and ideas.

Stock Exchange Character Guide

Background on the Stock Exchange

Each week, Felix and Oscar host a poker game for some of their friends. Since they are all traders, they love to discuss their best current ideas before the game starts. They like to call this their “Stock Exchange.” (Check it out http://dashofinsight.com/background-stock-exchange/  for more background). Their methods are excellent, as you know if you have been following the series. Since the time frames and risk profiles differ, so do the stock ideas. You get to be a fly on the wall from my report. I am usually the only human present and the only one using any fundamental analysis.

The result? Several expert ideas each week from traders, and a brief comment on the fundamentals from the human investor. The models are named to make it easy to remember their trading personalities.

Getting Updates

We have a (free) service for subscribers of our Felix/Oscar update list. You can suggest three favorite stocks and sectors. Sign up with email to “etf at newarc dot com”. We keep a running list of all securities our readers recommend. The “favorite fifteen” are top ranking positions according to each respective model. Within that list, green is a “buy,” yellow a “hold,” and red a “sell.” Suggestions and comments are welcome. Please remember that these are responses to reader requests, not necessarily stocks and sectors that we own. Sign up now to vote your favorite stock or sector onto the list!

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