Saturday, April 30, 2011

Changes to the Strategic Growth Model, continued

This chart shows the Strategic Growth Model portfolio returns for each of the Thrust / Trend Model (TTM) signal periods since the model's inception in 2003, including the four interim losses that exceed -4%. It's an interesting visualization of the data shown in the earlier table.

This picture clearly shows the benefits of putting 100% of funds to work in the best stocks at the right time, and avoiding stocks all together when it's NOT the right time.

It also clearly shows that the model portfolio's biggest interim losses tend to come when market's up trend has been extended for several weeks beyond a fresh BUY signal.

Changes to the Strategic Growth Model, continued

Managing risk vs. reward...

There are two primary success factors required for the model to profitably align the portfolio's capital in accordance with prevailing market conditions... The model must 1) CONSISTENTLY determine the prevailing market conditions (BUY-NEUTRAL-SELL) and 2) allocate the portfolio's capital (long-short-cash) to take best advantage of the potential rewards while managing the risks associated with the various market conditions.

The Strategic Growth Model relies on the Thrust / Trend Model (TTM) by to signal the various market conditions. The TTM is purely mathematical, which is ideal for our purposes because this removes the possibility that the model's allocations will be affected by human emotions, which tend to be wrong at the most inopportune times.

The table shows the model returns for the 31 TTM signal periods (BUY-NEUTRAL-SELL) since inception in 2003. It also shows the maximum interim loss for each signal period. You'll note that in sixteen "BUY" periods, the maximum interim loss exceeded -4.0% only four times and the maximum interim loss for ANY BUY period was -8.8%. This shows that if the model were to invest 100% of its funds in the selected stocks upon receiving a fresh BUY signal, it's infrequent that the portfolio would weather an intermim loss of even -4% before going on to make a new high water mark, and it would be extremely rare that it will ever see an interim loss worse than -9%. This is well within the system's design limits.

Also note that the benchmark S&P 500 index was down during four of the five "SELL" periods, while the model portfolio was able to show gains during three of these periods.

In summary, the Thrust / Trend Model has demonstrated a CONSISTENT ability to keep the model portfolio on the right side of the market at the most critical turning points.

So... if the SGM is using the same stock selection model and the same Thrust / Trend Model as before, what's changed?

What's changed is the model's allocation strategy.

The specific instrument formerly used to hedge our portfolio (TWM) has been shown to put a drag on the portfolio's performance that far exceeds its value as a hedge against risk. There are multiple factors involved including the specific index being used for the hedge (TWM is linked to the Russell 2000 index of small cap stocks) and the "tracking error" associated with a 2x leveraged fund.

During periods of low risk (BUY) the model portfolio will now allocate 100% of its funds to stock positions. During periods of moderate risk (NEUTRAL) the model portfolio will reduce its exposure to stocks and hold 50% of its funds in cash. During period of heightened risk (SELL) it will allocate 50% of funds to a short position in a non-leveraged INVERSE fund and hold the balance in cash. While this allocation strategy introduces a higher amount of weekly volatility, we've already seen that the model's expected maximum interim loss remains well within acceptable limits.

The model portfolio's allocations are now as follows, in accordance with the Thrust/Trend Model's signals:
BUY - 100% long
NEUTRAL - 50% long / 50% cash
SELL - 50% short / 50% cash

Please note that in my managed accounts, I'm currently maintaining a higher cash position than the model portfolio (approximately 50%), and will continue to do so until the Thrust / Trend Model gives us a fresh "BUY" signal.

I'm doing this because of risk vs. reward. The market trend has become quite extended above its trend line since the current BUY signal was triggered in September, 2010. The risk of a "normal" market sell-off giving us a significant interim loss in our portfolio is much greater now than if the TTM had just thrown us a fresh BUY signal. In my judgement, this is not a good point in the cycle to increase our risk exposure.

Changes to the Strategic Growth Model

As you will recall, the Strategic Growth Model (SGM) is designed to maximize returns over the full market cycle (Bull-Bear-Bull or Peak-to-Peak), and is comprised of two main elements... 1) Select stocks that are expected to outperform the market, and 2) Manage risk vs. reward by aligning capital (long vs. short) with prevailing market conditions. Rather than attempt to "predict" where the market may go in the future, the SGM uses a mechanical Thrust/Trend Model (TTM) by to determine prevailing market conditions. It then allocates capital according to the risk vs. reward profile associated with where the market is within the context of its full cycle.

re: #1) Stock Selection... Except for a 12 month period immediately following the historic market decline of 2007-09, the stock selection algorithm has performed exceedingly well since the model's inception in 2003. So the model portfolio will continue to use the same stock selection algorithm as before. The chart's "SGM long portfolio" shows that the stocks selected by the Strategic Growth Model have outperformed the benchmark S&P 500 index by nearly 3:1 for the 12 months ending 4/22.

re: #2) Managing risk vs. reward... We've seen that the stocks greatly outperformed the benchmark index over the past 12 months, yet we know that the hedged portfolio has failed to capture a significant portion of those gains. This isn't acceptable. There needs to be a better way to manage risk without allowing the hedge to put such a drag on the portfolio's peformance. This is where the improvements are focused.

More on this soon...

Returns for week ending 4/29/11

Past week:
Model portfolio - hypothetical return: -0.5%

Value of $10,000 invested in model portfolio at inception in 2003: $62,688

NOTE: For the first time, the holdings for next week show the "new and improved" Strategic Growth Model.

Monday, April 25, 2011

The new and improved Strategic Growth Model

This chart shows the hypothetical performance of the new and improved Strategic Growth Model portfolio, since inception in May 2003 through April 22, 2011, including its performance during the different phases of the intermediate cycle (BUY-NEUTRAL-SELL).

The "old" model is shown for comparison, as is a 100% hedged model with no market timing, and the benchmark S&P 500 index.

The new model uses the crucial pillars of the retired model... the exact same stock selection criteria and the same timing model. The only change is in the way the timing model drives the portfolio's allocations to stocks, cash and inverse funds in alignment with prevailing market conditions.

The result is a model portfolio that has far greater weekly returns, more than compensating for an increase in its weekly volatility. It is largely uncorrelated with the market, even showing gains during the bear market of 2007-09. As I'll explain in another post, the timing model also greatly assists in managing the risk of a significant interim loss before the portfolio goes on to attain a new high water mark.

Enough for now.

Sunday, April 24, 2011

Note from Steve

While the model portfolio's "full cycle" performance since the market top in October 2007 is impressive (+63% vs -17% for the S&P 500), its performance since the historic market bottom (Spring 2009) has significantly lagged the market, which has been extremely frustrating. In this note, I'll pass along some findings from my recent post performance analysis, and explain some changes I'll be making to the model portolio to hopefully improve its overall performance going forward.

First, I'm reassured from my analysis that the model is again showing that it has the ability to consistently select stocks that will outperform the market. Consider the chart, which shows the "stock only" performance (no hedge) in my ACTUAL trading account for the 12 months ending April 22, 2011. As you can see, the stocks selected for the model portfolio have gained 42.5% while the S&P 500 has gained 11% over the same 12 month period, nearly a 4:1 advantage. These "excess returns" are consistent with the model portfolio's performance since inception in 2003.

The exception was the 12 month period immediately following bottom made in Spring 2009, where the stocks selected by the model significantly underperformed the benchmark index. The model was simply out-of-phase with the market during this period. Why? ...because the model selects growth stocks that are expected to outperform the market in a "normal" rally where money chases growth, whereas the 2009-2010 rally period was led by a bounce-back in large financial stocks that had been severely punished as the financial system unraveled. The model simply isn't designed to select down-trodden stocks... rather it selects high performing growth All-Stars, which happened to underperform the broader market during the 12 month period ending April 2010. This was a highly unusual period following a historic panic fueled decline, and now that money is again chasing growth, our model stocks are out performing the benchmark index.

Going forward you'll see some changes. First, I'm removing the hedge (TWM) from the model portfolio. Even without the hedge the model is uncorrelated with the stock market. e.g. the model has shown to have less than a 30% correlation with the market since inception, which is about as good as it gets. The portfolio's allocations will range from "100% long" to "50% short" depending on market conditions.

To drive the portfolio's long/short allocation, I'll continue to use the same third party timing model I've been using for years... the DecisionPoint Thrust / Trend Model (TTM). Google it if you'd like a detailed description. I've analyzed dozens of market timing algorithms and this is by far the BEST I've ever seen. Importantly, it enabled us to neatly side step the severe market decline in 2008-09 and also correctly got us on the right side of the market in early 2009 as the market began to rise from the ashes.

The TTM gives us three types of intermediate term signals which will drive the allocations:

BUY - 100% long
NEUTRAL - 50% long, 50% cash
SELL - 50% short

Going forward, I'll continue to post the hypothetical "Model Portfolio" stock selections and allocations, and I'll begin posting the ACTUAL weekly performance in my trading account rather than hypothetical model portfolio returns. This will make it easier to track your performance against what is actually achievable rather than what is theoretically achievable. You should be seeing less tracking error as a result.

Enough for now.

Saturday, April 23, 2011

Returns for week ending 4/22/11

Model portfolio, hypothetical returns for past…
1 week: +1.5%

Value of $10,000 invested at inception in 2003: $63,007

Monday, April 18, 2011

Returns for week ending 4/15/11

Model portfolio, hypothetical returns for past…
1 week: +1.0%

Value of $10,000 invested at inception in 2003: $62,101

Sunday, April 10, 2011

Returns for week ending 4/8/11

Model portfolio, hypothetical returns for past…
1 week: -0.4%

Value of $10,000 invested at inception in 2003: $61,525


Saturday, April 2, 2011

Returns for week ending 4/1/11

Model portfolio, hypothetical returns for past…
1 week: +2.5%

Value of $10,000 invested at inception in 2003: $61,763