Returns for week ending 1/25/08:

Strategic Growth Model (SGM) portfolio = -1.2%
Value of $10,000 invested at inception: $40,933

SGM is on a SELL signal, holdings next week:
1/2 of funds in RWM
1/2 of funds in CASH

Returns for week ending 1/18/08:

Strategic Growth Model (SGM) portfolio = +2.1%
Value of $10,000 invested at inception: $41,409

SGM is on a SELL signal, holdings next week:
1/2 of funds in RWM
1/2 of funds in CASH

Returns for week ending 1/11/08:

Strategic Growth Model (SGM) portfolio = +1.6%
Value of $10,000 invested at inception: $40,558

SGM is on a SELL signal, holdings next week:
1/2 of funds in RWM
1/2 of funds in CASH

The Real World

While the Efficient Market Hypothesis (EMH) continues to enjoy strong support in academia, I have found that it doesn't hold up in the real world.

In the real world:

- Financial information is neither evenly distributed nor smoothly acted upon. The resulting inefficiencies create trading opportunities. Sales and earnings growth data is an example where the information is not smoothly acted upon by the market. Also price momentum.

- Profit generation processes and forecast techniques tend to be compressed together by the forces of consensus. This results in a "herd mentality" that can take markets to extremes, creating both risks and trading opportunities.

The key success factor is to discover these inefficiencies and use them to develop a "winning edge." Once you have a winning edge, you can develop a profitable trading system around it.

The Alpha Stock Model provides the tradeable edge for the trading system to be outlined here over the next several weeks.

Other things I learned in college...

that later proved to be wrong!

Myth #1: "Fundamental Analysis and Technical Analysis are mutually exclusive approaches to investing and trading."

What I've found: William O'Neil's classic, "How to Make Money in Stocks" shows that Fundamental and Technical Analysis can be used together to indentify likely stock market winners. Some call this hybrid approach "Techno-Fundamentalism."


Myth #2: "Market timing is a fool's game... You can't use market timing strategies to enhance risk adjusted returns."

What I've found: Patterns in human behavior repeatedly drive stock market cycles, which can be exploited to enhance risk adjusted returns over time.


Myth #3: "Beta = Volatility = Risk = Bad"

What I've found: Some types of volatility are good, for example when a stock you own explodes to the upside! The challenge is to harness the volatility and retain your trading gains over a complete market cycle. e.g. peak-to-peak or trough-to-trough measurement.

Ivory Tower Theories

While earning my degree, one of my finance professors required the class to read Burton Malkiel's "A Random Walk Down Wall Street." Malkiel's book preaches Efficient Market Hypothesis (EMH), which has become dogma for many in the financial world. For a time, I became a believer in EMH.

Efficient Market Hypothesis (EMH)

• The stock market is a perfectly competitive market
• All information is known
• Prices reflect all information
• The only way to beat the market is luck
• Luck will run out quickly

A few years later, as I began to make investment decisions, my research revealed some notable exceptions that didn't line up with Malkiel's EMH theories. For example, how do you explain Peter Lynch and Warren Buffett? What secret code had they cracked to beat EMH?

I later came across the "January Effect" and the "Persistence of Performance" mutual fund study (Sheldon Jacobs) which further motivated me to look beyond EMH for some explanations.

“What could be more advantageous in an intellectual contest — whether it be chess, bridge, or stock selection — than to have opponents who have been taught that thinking is a waste of energy?” -Warren Buffett

The Challenge

It is an extreme challenge to consistently beat the market. While there are some notable exceptions, professional fund managers do not have a good track record.

I recently came across these sobering statistics from Lipper Research...

• The average mutual fund returns 2% less than the stock market in general
• 80% of mutual funds under-perform the market in any given year
• From 1984 to 1999, one of the largest bull runs in history, the majority of North American mutual funds failed to outperform the Wilshire 5000 index.
• Most mutual fundsd have Sharpe ratios (a measure of risk adjusted return) of less than 1.0
  

Developing a Trading System

The Alpha Stock Model (ASM-10) is the core of the trading system being tested here. The ASM-10 portfolio is the "alpha engine" that primarily drives the portfolio's returns. After developing the predictive model to identify the next big stock market winners, my attention turned to risk management and how to determine the ideal long-short hedge allocation to be aligned with the market conditions.

The goal of developing a trading system is to consistently (systematically!) beat the market while managing risk. The system is optimized for risk adjusted return. Another goal is to make it easy to fine-tune in accordance with the trader's risk tolerance.

Trading System = Stock Selection + Risk Management + Market Timing

Returns for week ending 1/4/08:

Strategic Growth Model (SGM) portfolio = -2.8%
Value of $10,000 invested at SGM inception in November 2003: $39,939

SGM is on a SELL signal, holdings next week:
1/2 of funds in RWM
1/2 of funds in CASH