Trading System by Andrew Gibbs - Member of Larry Williams Hall of Fame

[sinner]

My final 2c on this, because I'm tired of saying the same crap over and over:

* OP wants you to think his trading method is robust, but has provided no actual proof. Anything presented as proof I have highlighted why it's misleading from multiple angles and OP has made 0 effort to address any of these concerns realistically.

* OP wants you to think simply applying a fundamental screen is some form of recipe for success, even though the fundamental screens have all underperformed the market cap benchmark since 2009 lows and OP hasn't bothered to demonstrate that his technical overlay adds even 0.01% of alpha to these screens which are generally designed for low turnover institutional portfolio.

* OP wants you to use a paid-for black box, with no guarantees on business or data longevity, as your source for the fundamental screens. He hasn't exactly made it clear if he has any commercial arrangement with the providers of the magic black box. If you have ever bothered to read the work of Seth Klarman one of the greatest value investors of all time (especially his opinion on what differentiates an investor from a speculator) then this sort of hand-waving will raise red flags for you. The difference between "trading sardines" and "eating sardines".

* OP has a trading business, and has a vested interest in convincing you that he is smart, capable and you will make money together by combining his "high churn" technical overlay with simple low turnover portfolios, without providing any actual evidence thereof. My feeling is that his intelligence and capability are entirely focused on his own pockets, not yours.

* So far every single issue I have raised on this thread, OP has claimed to know about, but conveniently forgot to mention it until someone else called it out.

I'll leave you guys to exercise your faculty of critical thinking and decide what the go is here.

 

[Gringotts Bank]

Sinner, while you're there, do you know any good info on rotational trading in blue chip stocks/ETFs?

 

[Kaizen]

Sinner, while you're there, do you know any good info on rotational trading in blue chip stocks/ETFs?

Simple:
1. Rank each stock in your universe (AS300 or whole market) I find whole market better as trends are normally outside the ASX300
2. Filter for liquidity
3. By the top 5 by your momentum measure.
4. Rotate each two weeks or month to the new top 5. Hold any that are still in the top 5 sell and replace any that are not.

The only tricky part is #3.
I use long term momentum (i.e 252 days) I also punish for volatility because we want nice smooth trend not stocks that have gone up over night.

Have a cut off so you rotate to cash when there are not stocks greater than you minimum momentum measure. This way you rotate to cash in bear markets.

 

[Gringotts Bank]

Simple:
1. Rank each stock in your universe (AS300 or whole market) I find whole market better as trends are normally outside the ASX300
2. Filter for liquidity
3. By the top 5 by your momentum measure.
4. Rotate each two weeks or month to the new top 5. Hold any that are still in the top 5 sell and replace any that are not.

The only tricky part is #3.
I use long term momentum (i.e 252 days) I also punish for volatility because we want nice smooth trend not stocks that have gone up over night.

Have a cut off so you rotate to cash when there are not stocks greater than you minimum momentum measure. This way you rotate to cash in bear markets.

Thanks Kaizen.

I should start a new thread. Can someone transfer to thread "rotational trading systems" so it doesn't sidetrack this thread. Thanks.

 

[zipzap]

Sometimes you can lead a horse to water...

 

[smallcapinvestor]

Sometimes you can lead a horse to water...

Andrew,

I think that discerning and capital-flush investor with a critical eye will indeed look into you, your services and out-of-sample performance in addition to any backtest. I would not waste another moment trying to convice a two-bit heckler who likely lost money by following a free 'hot pick' newsletter service that merely wants to get revenge on every quant and strategist alive. The other alternative is that they have their own agenda and are simply putting others down so they seem good by comparison... a dangerous game to play.

Keep up the good work and thanks for creating low correlation trading products when compared to the average equity fund. I look forward to learning more about what you do. There is a lot of angry alpha males in the investment community who lost a lot of money and are trying to strut around showing off their peacock feathers to convince themselves and others that the market is rigged, they didn't lose their money making bad decisions and they are still a smart and discliplined investor.

 

[nulla nulla]

Andrew,

I think that discerning and capital-flush investor with a critical eye will indeed look into you, your services and out-of-sample performance in addition to any backtest. I would not waste another moment trying to convice a two-bit heckler who likely lost money by following a free 'hot pick' newsletter service that merely wants to get revenge on every quant and strategist alive. The other alternative is that they have their own agenda and are simply putting others down so they seem good by comparison... a dangerous game to play.

Keep up the good work and thanks for creating low correlation trading products when compared to the average equity fund. I look forward to learning more about what you do. There is a lot of angry alpha males in the investment community who lost a lot of money and are trying to strut around showing off their peacock feathers to convince themselves and others that the market is rigged, they didn't lose their money making bad decisions and they are still a smart and discliplined investor.

This post would have more credibility if it came from a long term member with an established reputation rather than being the first post of someone that joined the forum in the last 5 hours.

 

[smallcapinvestor]

This post would have more credibility if it came from a long term member with an established reputation rather than being the first post of someone that joined the forum in the last 5 hours.

If you want to take this to American forums where I have been a long-term member and you are not, I can do that too. But then again, nothing you say, regardless of backing, will be taken seriously until you wait for a few years to build your a forum track record. Or we could skip this high-school bullying and discuss strategy and content and keep it analytical and based on evidence.

 

[Porper]

This post would have more credibility if it came from a long term member with an established reputation rather than being the first post of someone that joined the forum in the last 5 hours.

Seconded. Is it just me or are we starting to get a lot of these "new guru's" joining the forum?

Hopefully members will have more sense than to believe a single word from these people without actual proof that a system works. You'll never see it though. Getting mates to join the forum or creating multiple accounts just doesn't hack it I'm afraid. Very transparent.

 

[tech/a]

Well Andrew I don't know why you bother.
Like you I don't mind informed and constructive
Exchanges,but when it becomes a personal vendetta
To discredit----then your just wasting your time.

Best of luck going forward.

 

[Joe Blow]

Folks, I think this thread could have been a lot more constructive, and it's a shame. These sort of discussions are the type that this community is good at, and are what ASF is all about.

I'm all for robust, passionate debate. It keeps things interesting and injects new ideas and perspectives into the discussion, but please lets keep things both civil and constructive. Discuss and criticise ideas and methodologies, not each other.

There is some good discussion and a lot of useful content in this thread, and I'm sure I'm not the only one who would like to see it continue.

 

[nulla nulla]

If you want to take this to American forums where I have been a long-term member and you are not, I can do that too. But then again, nothing you say, regardless of backing, will be taken seriously until you wait for a few years to build your a forum track record. Or we could skip this high-school bullying and discuss strategy and content and keep it analytical and based on evidence.

Belittling me for stating the obvious only serves to diminish the credibility of your earlier post further.
At no stage have I demeaned the posts of zipzap, quite the opposite in fact. zipzap has very kindly provided me with a sample of data for specific shares for a predetermined period for my assessment. This information is presently being assessed and I will likely post the outcome of my analysis in this thread when I have finished.
Further, I look forward to when zipzap posts his "Stock selection" criteria. The system outlined to date is very "scatterguned" and I'm sure the positive expectancy would be increased through a process of eliminating crappy stocks. This is not an endorsement of his stategy, I can already see some shortcommings but I am not convinced either way at this point. As always do your own research and good luck .

 

[sinner]

Well Andrew I don't know why you bother.
Like you I don't mind informed and constructive
Exchanges,but when it becomes a personal vendetta
To discredit----then your just wasting your time.

Best of luck going forward.

What a joke tech/a, you constantly lambast people on here for using technical indicators in the way OP has proposed claiming they are useless, and in any gfiven thread you can be absolutely counted on to derail any FA discussion whatsoever. Yet when the famous OP comes along proposing to combine these methods in a proprietary and unproven fashion, he is suddenly a benevolent genius reaching down to us idiot folk trying to explain something we would never understand.

Apparently I'm a two-bit, newsletter following, heckling, alpha male market loser out for revenge. At this point, I really hope the likes of you lot sign up with OP and all the services he's spruiking. Last time I waste my time on this stupid ****ing forum.

ENJOY!

 

[zipzap]

I guess when you are new to a forum you have to go through the "initiation" ceremony where everyone is very skeptical and thinks the only reason for posting is for the benefit of the poster.... in this case I have been transparent all the way through, both of my own interests and with disclosing system logic.

What a shame one of these guys is a fellow kiwi, in terms of the comment about, how you'll never see any evidence or proof these things work, if you guys weren't heckling every step of the way you'd already have it.. as it stands I am still getting there. You are getting good quality content and trading ideas just by reading this thread, but you can't see past the "commercial Interest" of the poster so automatically think there is something fishy going on.... When I see a lot of other stuff out there I can hardly blame you.. but let me just make this clear:

• My business depends on me making my clients money
• My reputation depends on providing good quality content, here or anywhere else
• I will be providing solid evidence of every strategy I post in this thread or anywhere else and I am quite comfortable with what I have posted so far.
• I challenge anyone else who has a problem to post something that is more innovative and profitable than what I am showing you here (in another thread and obviously I am setting the bar quite low so it should be easy) and also show backtested results ..then I can do some heckling of my own.

In terms of smallcapinvestors contribution, I drew his attention to the thread as I want to use some content he has published elsewhere and he posted of his own accord and I for one appreciate it and you will likely appreciate it to once you see the content. Thanks also to Tech/a and to the other people who have offered support, posting here does take time away from other activities. Guys like Tech/a keep me posting. There is more to come, as I will be posting some content that is not my own I am getting the necessary permissions so I should have that in place tomorrow morning and if I get a chance I'll start posting more over the weekend.

Please refrain from any additional comments until further posts where I get a chance to finally explain how to backtest and build a portfolio using fundamental data...

and then once we have the stock basket history for the portfolio we can test the technical system through history and see if it adds an value (alpha)

So guys.. be nice, be patient, give me a chance to actually post the information everyone has been patiently waiting for ....

ZZ...

p.s. Sinner, I just saw your last post.. you and me both feel like bashing their head against the wall, for opposite reasons.

 

[waza1960]

Last time I waste my time on this stupid ****ing forum.

Hopefully not Sinner I for one really appreciate your posts.
Nothing like a scientific and evidence based approach I say

 

[Porper]

Sometimes you can lead a horse to water...

I thought I recognised your name. You were an adviser for Tricom (options) a few years ago.

I used your service for a few weeks.

 

[tech/a]

What a joke tech/a, you constantly lambast people on here for using technical indicators in the way OP has proposed claiming they are useless, and in any gfiven thread you can be absolutely counted on to derail any FA discussion whatsoever. Yet when the famous OP comes along proposing to combine these methods in a proprietary and unproven fashion, he is suddenly a benevolent genius reaching down to us idiot folk trying to explain something we would never understand.

Apparently I'm a two-bit, newsletter following, heckling, alpha male market loser out for revenge. At this point, I really hope the likes of you lot sign up with OP and all the services he's spruiking. Last time I waste my time on this stupid ****ing forum.
ENJOY!

Your a smart guy.
Your also more capable of having an intelligent discussion which is of value to everyone--than you currently display here---.

To correct you on my stand with Indicators and Oscillators.
Used for discretionary trading I feel they are next to pointless.
Used in a properly tested System they have value but I don't use them to any large degree.

My stance on F/A is simple.
Its simply a calculated opinion which will be proven correct or incorrect just as T/A.
My main beef with most exponents of F/A is their lack of risk management.
Fine in a Bull market crap in a flat or bearish market.

As for the stuff in Blue---that's left field and in your mind only from what I see.

 

[zipzap]

So… I’ve made a few mistakes with this thread which I’ve been called on, so I am going to try to rectify some of them here. In what follows we are going to take an idea and create and backtest the idea to create a fully mechanical trading system based on fundamental analysis. Then as part 2, I am going to run the technical model we have discussed throughout to see if it improves performance.

What follows is a process for creating a fundamental trading system. Much of the work has been put together by Kurtis Hemmerling and he has kindly allowed me to utilise the content. Remember for my own trading as I’ve mentioned earlier I simply follow portfolios put together by people like Kurtis and then apply my trading systems.. This is simple and easy and takes advantage of the skills from people with more expert knowledge than me. However for people who wish to understand how to build a fundamental trading system I hope that what follows is fairly helpful, it also enables us to have a historical record of portfolio constituents we can apply the technical system to.

Before I go further it is important to note that there is no need to apply a technical model to what follows..that is what I like to do, but it is not necessary and it may even turn out not even more profitable, that is a question that can be answered afterwards with additional testing.

So here goes…

(Reference: How to Build a Strategic Model Portfolio – by Kurtis Hemmerling):

To build a sound investment system that generates reliable returns, you first need a thesis or a concept of why and how you will be able to do achieve bigger returns than the broad market. These investment ideas do not need to be new creations from your head - there is already decade’s worth of academic research that you can draw inspiration from. Sinner also kindly been pointed out some resources you could use earlier as well. But, there is plenty of stuff out there so you do need to dig through these papers and abstracts to discover what has already been researched and tested. As you carefully read through the research, try to think about why these rules may translate into market out-performance or a reduction in risk.

Often, the academic will come right out and tell you the rationale in the article summary, but you need to meditate on the line of reasoning to determine whether you comprehend and agree.

Finding the Idea

One comprehensive resource is called Social Science Research Network (SSRN.com). Here you will find hundreds of thousands of papers – many of which relate to market-timing, momentum, capital structure, technical analysis, dividend yields, payout ratios, valuation techniques and much more. It can be a bit overwhelming at first. Start by picking a topic that fits with your investing style and that you already have a little knowledge and experience with. If you are a long-term investor, you may want to start with value premiums and dividends. Or you might simply type in ‘long-term investing’ in the search bar and sort through the results. This process will take some time.

Below are a few papers you may find interesting:

• Adaptive Market Timing with ETFs, 2010, Glenn
• Best Ideas, 2010, Cohen, Polk and Silli
• Enhancing the Investment Performance of Yield-Based Strategies, 2012, Gray and Vogel
• Filter Rules: Follow the Trend, or Take the Contrarian Approach?, 2010, Kozyra and Lento
• How Active is Your Fund Manager? A New Measure That Predicts Performance, 2009, Cremers and Petajisto
• How to Identify and Predict Bull and Bear Markets?, 2010, Kole and Van Dijk
• Insider Trading and Share Repurchase: Do Insiders and Firms Trade in the Same Direction?, 2011, Bonaime and Ryngaet
• Investing in Stock Market Anomalies, 2011, Bali, Brown and Demirtas Is Portfolio Theory Harming Your Portfolio?, 2011, Scott Vincent
• Long-Term Volatility Forecasting, 2012, Reitter
• Market Timing & Trading Strategies Using Asset Rotation, 2010, Schizas and Thomakos
• Market Timing with Moving Averages, 2012, University of Adelaide Business School
• Optimal Portfolio Strategy to Control Maximum Drawdown – The Case of Risk Based Dynamic Asset Allocation, 2012, Yang and Zhong
• Portfolio Diversification Dynamics as a Measure of Market Sentiment, 2012, Roger
• Rebalancing and the Value Effect, 2012, Chaves and Arnott
• Relative Strength Strategies for Investing, 2010, Faber
• Revisiting the Fisher and Statman Study on Market Timing, 2011, Pfau
• Size, Value, and Momentum in International Stock Returns, 2011, Fama and French
• The High Dividend Yield Return Advantage: An Examination of Empirical Data Associating Investment in High Dividend Yield Securities with Attractive Returns Over Long Measurement Periods, 2007, Tweedy, Browne Company LLC
• Timing and Volatility Quantitative Model, 2009, Baryshevsky
• Where the Black Swans Hide & the 10 Best Days Myth, 2011, Faber

There are thousands more of such gems to be found at SSRN.com and these are just a select few to get you started. The important point here is that you need to have a solid concept of what you want to achieve and a rough idea of how to do so before you start hammering out trading rules. Some questions you may want to ask yourself are these:

• Are you looking to lower downside risk in bad markets? Have you considered market-timing? If bear markets produce high price correlation, how can you use this to your advantage?
• Are you looking to lower day to day portfolio price volatility?
• Do you want to ‘beat-the-market’ in that you want stock picks that have larger returns on average?
• Are you looking to compound dividend returns? What role does payout ratio, yield and capital structure play?
• Do you prefer to follow trends or buck them? With the crowd or contrarian?
• How active of an investor are you willing to be?
• What is your preference for market capitalization?
• Are you aware of such effects (more pronounced on smallcaps) such as Post-Earnings-Announcement-Drift, upward EPS revisions, analyst upgrades, momentum, value and short interest?

Once you have your investment idea that harmonizes well with your objectives, goals and level of risk - you can proceed to the next step where we expand a concept into a strategy.

From Concept to Crude Strategy

Over the course of this post, we will be building an investment strategy based on the Tweedy Browne paper of high yield and low payout ratio…which is in turn based on a Credit Suisse report. As well, we will include some complimentary ideas from the Gray and Vogel paper, Enhancing the Investment Performance of Yield-Based Strategies. The underlying concept in these papers is that stocks with higher yields and lower payout ratios, by their very nature, have deep value which investors may not be pricing efficiently. Consider…
A stock offers a 6% dividend yield. But does this stock have good value or not? One cannot tell simply by the dividend yield. On one hand, the company might not evening be generating profit and the dividend comes from cash reserves. This would not be of good value to the shareholder. On the other hand, a company might have so much profit that they pay only 10% of their earnings back to shareholders as a dividend. If the 10% profit represents a 6% dividend yield – this stock has screaming hot value. Of course, this is an extreme example not likely to be found in the market.
Our initial concept will be to trade stocks with higher yields with limits on the payout ratios as it suggests value – which in turn can lead to a rapid share price increase should sentiment improve. After reading the various academic papers, it is good to make a list of concepts that you feel comfortable with. Your system is liable to evolve and change during this process but you need a starting point.
Here is list of some crude investing concepts:
1. High yield
2. Lower payout ratio
3. Low debt and/or paying down on debt
4. Relative strength holdings

Initial Testing

Initially we will utilise a stock screener for testing before moving onto creating a ranking system and portfolio simulation.The stock screener excels at broad strategy testing, its strong point is to test ideas against thousands of stocks. For example, the stock screener can test all value stocks against all growth stocks in seconds with two massive portfolios containing thousands of stocks each. As we progress a portfolio simulation can then be used as the second step where we take the tested strategy and create a portfolio that holds dozens of stocks with real world constraints that mimic the actual brokerage account.

The stock screener layout looks like the picture below. The rules tab is where you enter buying criteria that must be met in order for a stock to be purchased.

The SCREENER layout looks like the picture below. The RULES tab is where you enter buying criteria that must be met in order for a stock to be purchased.



Using the FRank Function

This is where reading the FACTORS and FUNCTIONS really pays off. In our investment strategy we want high-yield stocks. How will we determine what is high yield and what is not since every market is different? Picking an arbitrary number (e.g. four percent) is weak since what is low during one period of time might be high in another. Thankfully, we have a flexible set of instructions that allows us to screen for the highest relative dividend yield.
• Under FUNCTIONS – RANKING & SORTING we find a valuable tool called FRANK (as in Function: Rank). FRANK allows us to sort stocks based on whatever factor we choose and return stocks in a certain percentile range.

We want the top 30% yielding stocks in the S&P 500. While the YIELD rule will return stocks that are above a specified yield, the FRANK function will return the highest yielding stocks regardless of the actual dividend number. The rule we are using looks like this:
• Frank (“Yield”)>70

Creating a Benchmark

Before we test our first rule, we need an appropriate benchmark. Our system is based on the S&P 500 index, therefore, we should use that as our benchmark. Yet, the S&P 500 is a market-cap weighted index and we are using an equal-weighting methodology (where every stock is held at the same weight regardless of how big or small it is). Hence, we will use an equal-weighting of the S&P 500 as our benchmark. Our slippage will be 0% as we are merely testing the validity of our strategy at this point – later we will factor in trading costs and real-world constraints. We will rebalance every four weeks and start the test in January 1999.



The redline is our equal-weight strategy of the S&P 500 with an annualized return of 8.39% (you can also select the “S&P 500 equal-weight index” as the benchmark but it does not include dividends). The blue line underneath is the market-cap weighted S&P 500 index that is the most widely publicized.

The next step is to run our high-yield ranking rule across the index and keep the best 30% of the yielding stocks. Remember that our screener includes all dividend payments – which is vital for a test such as this.



While our total return improves slightly, our drawdown increases somewhat. We might question our initial test results since not all S&P 500 stocks offer dividends. Although we know this is not true, what if the S&P 500 only had 150 dividend stocks? Our rule that keeps the highest-yielding 30% of the index would, in that case, return the entire set of dividend yielding stocks. Our strategy is to find the highest- yielding stocks of ones that pay dividends. This is a different screen altogether and it requires that we modify our universe of stocks.
But before we create an entire universe of S&P 500 dividend stocks when we can simply add a rule that states the yield on our screened stocks must be greater than 0? Wouldn’t that fix the situation? No because one is an ‘after-market’ rule modifying our universe and the other is a changed universe at the source. Consider how it is different…
• In one scenario you have a universe of S&P 500 stocks that pay dividends only. You have modified the universe at the source so only dividend-paying companies are present. Next, you add a ranking rule in the screener to choose the lowest 10% dividend payers. You will get stocks with small yields such as 0.1%, 0.2% and 0.3%.

• In the next scenario you have all S&P 500 stocks in your universe. Your first rule is to have a yield greater than 0. Your second rule is to rank the entire universe of stocks and keep the bottom 10% yields. What will happen? The first rule eliminates the 100 stocks that don’t pay dividends but the second rule ranks the entire S&P 500 universe and finds that the lowest yielding stocks do not pay dividends at all. Thus, the two rules conflict and absolutely nothing turns up on your screen.
It is best to change your universe of stocks at the source since that is what ranking rules evaluate. There is a work-around but it is better to change it at the source so you do not need to worry about it later.

Creating a Custom Universe

What we have done is create a custom universe then added a single rule that states the following:
• Yield>0

We then run a test just to see how many stocks are currently paying a dividend the answer is 405. We select “S&P 500 Yielding Stocks” as the descriptive name for the new universe. What we have accomplished is the creation of a new equity index where the constituents must be a member of the S&P 500 index plus paying a dividend.



Now we return to the SCREENER and re-run the test with this new stock universe that only holds dividend yielding stock in the S&P 500 index. We backtest the ‘top 30% dividend yield’ rule to see what effect this has on my risk and return.



The return improves slightly along with a few other risk/performance statistics although the maximum drawdown during 2008/2009 increases yet again.

Adding In the Other Rules

The next step is to build the rest of my investing rules which includes payout ratio, relative strength and debt ratios.

After some deliberation, it was decided to use an absolute rule for payout ratio. The reasoning? We do not want a company that pays out more than 100% of its profit in the form of a dividend as this is not sustainable. But we neither want to overly restrict my universe of stocks (feel free to modify at will). So the basic payout ratio rule will stipulate that dividends must be less than profit earned.

• PayRatioTTM<100

The next rule either requires there to be low debt or a reduction of net debt. How can you create a rule that allows either one condition or the other?

Creating a Forked Rule

You need to program the system to accept either condition A or condition B – yet you do not have a preference for which one. First, we need to define each rule clearly.

Our first condition is for a low debt-to-equity ratio. We create a simple rule just like our other FRank rules that will limit the debt-to-equity ratio to the bottom 50% of our universe (based on the most recent quarter):

• FRank("DbtLT2EqQ")<50

Our second condition is trickier since we have to dig into the BALANCE SHEETS as we will be comparing quarterly data to determine a change in ratios.

To create this formula, we will use the long-term debt to equity ratio from one year ago (quarterly) and divide this by the long-term debt to equity ratio of the most recent quarter. In this instance, the bigger the number translates into more debt reduction. So the rule will look like this:

• FRank("(DbtLT(4,QTR)/EqTot(4,QTR))/(DbtLT(0,QTR)/EqTot(0,QTR))")>50

I know it looks scary but if you break it down it is simple. This is a ranking rule so we begin with FRank. Next, we take the LT Debt from the same quarter last year (It is number 4 if you count backwards from the most recent quarter being 0) and divide this by the total equity in the same quarter. You divide this by the same formula – only this time you use the most recent quarter (0). Put brackets around the whole string and make it return the highest 50% (which actually means the largest debt reduction).

All you need now is to place an OR operator between the two screening rules and the system will either take the best 50% as regards low debt-to-equity or the best 50% as to reduction of debt-to-equity.

Relative Strength Testing

Our relative strength rule is simple. This rule requires the 52 week performance of our stock to exceed the S&P 500. Better performing stocks have a tendency to do over the following year. This is called momentum much literature has already been written on the subject.

The 4 Rule Investment System

The 4 rules to my investment strategy looks like this:



To Be continued...

 

[zipzap]

Previous Post Continued - Part 2 (Reference - How to Build a Strategic Portfolio Model - By Kurtis Hemmerling)

Next, we need to historically backtest the strategy. As I do so, I notice that this system is overly restrictive during 1999 and 2000. This could be from my look-back rules or from some other cause. For the sake of this tutorial (and not to make it overly complicated), I will start my backtest in 2001. To do so, I need to re-test the benchmark (equal-weighted S&P 500). I run this manually because I want both an equal-weighted index but also dividends for a comparable total return.

The updated benchmark test since 2001 is below.



Heading back to our simple 4 rule system, we achieve the following results:



Our annual return is 2% higher than an equal-weighting S&P 500 strategy and our drawdown is less. You can also turn the rules on and off – one at a time – to see the individual performance of each rule and then the combined performance of synergy.

As we do so, it shows the relative strength is actually harming returns and being overly restrictive on our stock selection. Why might this be the case? Relative strength looks at price performance of our stock and compares it to the market. However, our high-yield dividend stocks contain a large amount of the returns in dividend payments which is not reflected by a strong price performance. Thus, relative strength might be more meaningful in non-dividend stocks than income stocks. Just think of a quick example…

Stock ABC pays dividends while stock XYZ does not. Stock ABC has a 10% dividend yield. Share prices have stayed flat all last year and the previous 3 years. Stock XYZ has risen 5% every year for the past 3 years. Stock XYZ appears to be the better stock. But wait – stock ABC has returned 10% annually while stock XYZ has only been able to accomplish half that much. In fact, the higher the dividend yield the less meaningful relative strength becomes.

The rule is removed and the strategy is re-run.



This seems to make more sense. What further improvements can we make on this S&P 500 dividend system?
After looking over the strategy it can be discerned that this strategy could woefully pick up stocks where the equity was negative, thus throwing off my formulas. Hence, the addition of this one extra rule to prevent any miscalculations is required. You can add it to your screen or directly to your universe.

• EqTot(4,QTR)>0 and EqTot(0,QTR)>0

It simply states that the equity in the same quarter last year and the most recent quarter must both be positive. Its performance effects are negligible at this point but its safety net is priceless.

Moving onto where we were earlier, Ranking system. Ranking systems that let you grade stocks based on a theme. A ranking system is a group of rules built around a theme. A value ranking system might include price-to-book, price-to-assets, price-to-earnings, and price-to-dividends. All the stocks in our universe are graded by these factors and you can select the top scoring stocks to hold in your value portfolio. Ranking systems can be applied to any other strategy you have or it can be used by itself. I prefer to use it to enhance an existing strategy.

Our 3 buy rules recommend anywhere between 25 and 50 stocks. We will build our own ranking system later, but for now, let’s utilize a basic ranking systems to pick the ‘best 10’ stocks. After testing out various ranking systems, including one that uses market-timing, we settled on one called BASIC: QUALITY. Holding the ‘best 10’ stocks according to this ranking system (in addition to our 4 investing rules), we get the following results:



From our preliminary testing we conclude that we have a good core strategy to build upon. The question is…where to from here? At this point we should do one of three things:
• Use the Advanced Backtest
• Build a custom ranking system
• Create a real-world simulation

Advanced Backtest

I do not wish to spend a lot of time on the advanced backtest other than to say that it is a useful statistical tool to check for strategy robustness. Why is this useful? Perhaps you have an investment strategy that works well starting in March 2009. But is your gain due to superior strategy or lucky timing? In our strategy, we re-balance every 4 weeks. What if we started investing on week 2 instead of week 1? Or week 3? How different might the results be?

The advanced backtest gives us a few stats to mull over.

• Every 4 weeks this strategy earns 1.24% vs the market return of 0.26%.
• In up-markets it averages 3.87% which is similar to the market gain of 3.33%.
• But in down-markets, this strategy only loses 2.62% every 4 weeks on average while the market on average dumps over 4.26%.

Our strategy gains from a reduced downside in bad markets but it does not out-perform in bull markets.

Ranking System

Creating a ranking system can be an in-depth process. There are layers of complexity and depth in a relative ranking system. For the sake of this post we have built a simple ranking system based on our three rules:

• Yield – higher is better – compare vs. Universe
• PayRatioTTM – lower is better – compare vs. Universe
• Long-term debt to Equity – lower is better – compare vs. Universe

Back-testing our ranking system in our S&P 500 dividend universe yields the following results.



After testing my ranking system I am shown the following results:


To be continued next post

 

[zipzap]

Part 3 - How to Build a Strategic Model Portfolio - By Kurtis Hemmerling



What have we accomplished here? We now have a set of relative ranking rules that can be used on any system or strategy – past, present or future. As an example, if you run a test using no other strategy other than ‘the best 10 stocks’ as determined by this ranking system. The chart below shows the back-tested performance using only my 4-rule ranking system on the entire S&P 500 index while rebalancing every 4 weeks.



Now this ranking system may not be suitable for any and all strategies as it is tailored toward dividend stocks. As well, this simple ranking system will no doubt need added layers of complexity and optimization. Remember to include either in the screener rules or in the universe rules a requirement for equity being above 0 in both the most recent quarter and the same quarter last year

(EqTot(4,QTR)>0 and EqTot(0,QTR)>0).

But you can likely see the power of first proving our investment ideas through the SCREENER and then building it into a ranking system to have a powerful and flexible tool to be re-used in many different applications.

Now that we have proven our concept, developed sound investing rules and even have a new ranking system at our disposal - how do we create a portfolio that e-mails us recommendations of when to buy and sell the various holdings? For this step we need to learn how to create a SIMULATION and a PORTFOLIO. Don’t be alarmed – you have already performed 75% of the leg work by creating the strategy in the SCREENER.

Simulation Testing and Optimization

Creating a simulation allows us to simulate what trading this system would look like in a real portfolio with cash. This is as close to the real thing as it gets. And once we have the simulation settings just right
– we simply click one button and it becomes an automatic and hands-free system that e-mails us rebalance notices.

How do we create a simulation?

I will walk you through each screen – one at a time. Your GENERAL screen will look like this:



You need to name the system and choose how much starting capital you want to invest with and an appropriate benchmark. Next, you can enter in the commission for each trade and how much price slippage you expect. The bigger the stock the less price slippage you will experience and these are some of the most widely followed companies – so I expect little slippage. Because I am using Foliofn as my brokerage, I do not pay a commission for each trade ($29 per month flat-fee if using ‘window trading’ which is available twice daily).
Our initial setting is for a re-balance every four weeks, but as I will show you later, you can increase your rebalance to weekly and still manage your annual turnover. Thus, you will have a more responsive system while keeping not over-trading.

The next tab, POSITION SIZING, looks like this:



Here is where we decide how big our optimal portfolio size will be. We can also decide how far to let stocks go before we rebalance. If our constraints are 30% from ideal size, we will not rebalance a stock that trades at $10 per share unless it moves above $13 per share. Personally, I am not a fan of micro- managing our positions so I will leave this number at 30%.

Our next tab is UNIVERSE & RANKING. We already have a custom made universe, so go ahead and select that one. I will use the BASIC: QUALITY ranking system.



We will ignore the STOP LOSS rules. Empirical evidence suggests that using a STOP LOSS does not improve performance or lower risk after fees. If you find that it works for you – go ahead. I don’t and won’t. We want to focus on our BUY and SELL rules. First we open the BUY tab. Here we have 2 buy rules pre- loaded.

• The first rule ensures that our portfolio will not become more than 30% weighted in any one industry.
• The second rule dictates that we can only buy up to 5% of the daily volume. This is good risk management.

Next, simply cut and paste the 3 rules from the SCREENER.

To Be Continued