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A Boring 2015 Outlook – It’s All About Earnings!

Following is a slightly revised article first published on TheStreet on 12/12/2014.

The S&P 500 decidedly broke out resistance level in November and is continuing its upward trend. As of December 14, the S&P 500 is up over 12% year-to-date. Guess what? As the 2014 third quarter earnings report season comes to an end, the S&P 500 trailing 12-month earnings growth is exactly at 12%!

The U.S. stock market is boring since it simply follows the earnings growth rate, but there is a lot of excitement in Asia. Fueled by the Shanghai-Hong Kong exchange connect this year, after a lackluster year in 2013, the China Shanghai Stock Exchange A Share Index has rocketed 43% higher year-to-date. India BSE SENSEX Index also has a great run, rising 30% so far this year.

GOLDILOCKS ECONOMY IN US

The U.S. economy is slowly hitting on all cylinders, and is expected to continue its stable upswing in 2015. Here are some indicators that illustrate why:

  • The Index of Consumer Sentiment from University of Michigan rose above its long term average of 80;
  • Weekly Initial Unemployment Claims are near 40-year lows;
  • Housing Starts are improving;
  • ISM Manufacturing PMI Composite Index is staying well above 50 level;
  • Low inflation expectations from falling oil prices and record expansion in solar utility industry.

Corporate earnings growth, the most reliable market gauge in the U.S., is forecasting 10% growth in 2015.

WHAT MATTERS IN MATURE BULL MARKET – EARNINGS

Investors should focus on companies that can increase the most earnings per share efficiently while maintaining low valuation and not be afraid to increase cash allocation. With the U.S. dollar strengthening, lower energy prices and higher consumer spending, the best bets would be on growth at reasonable priced stocks from consumer discretionary and information technology sectors. With 10,000 baby boomers turning 65 and eligible for Medicare per day and the costly implementation of Obamacare, demands and innovations in the healthcare sector will create tremendous investment opportunities.

In the large cap growth space, our Focus Growth computer model’s current favorable stock is Western Digital (NASDAQ: WDC) with a 5.8% allocation. WDC’s 1 year EPS growth rate is 64% and the dividend increased by 46% over one year ago, with P/E/G of only 0.76.

NO BEAR MARKET IN US

To quote Sir John Templeton, “Bull markets are born in pessimism, grow on skepticism, mature on optimism and die on euphoria.”

Investor sentiment indicators, such as the AAII Investor Sentiment Survey, continue to show a narrow bull-bear spread, indicating that general investors are still skeptical about this five and a half-year-old bull market. Investors and traders continue to embrace momentum trades, creating volatile yet profitable market condition. Bears will probably come out of hibernation when broad-based investors turn to buy-and-hope strategies again and become euphoric about the stock market.

Until then, as Warren Buffett said, “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”

Disclaimer

Investing in the financial markets involves risk, including the risk of principal loss. Don’t invest with money you can’t afford to lose. Information in this report is in no way intended as personalized investment advice and should not be interpreted as such.

Proven Stock Investment Methods

Here we collect powerful techniques for anyone interesting in systematic and emotionless stock investment portfolios through number crunching.

Classic Papers

Just copy and paste to Google search box to locate the paper.

  • A Conversation with Benjamin Graham, Financial Analysts Journal, 1976.
  • Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis, S. Basu, The Journal of Finance, 1977.
  • The Relationship Between Return and Market Value of Common Stocks, Rolf W. Banz, Journal of Financial Economics, 1981.
  • The Cross-Section of Expected Stocks Returns, Eugene F. Fama and Kenneth R. French, The Journal of Finance, 1992.
  • Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers, Joseph D. Piotroski, Journal of Accounting Research, 2000.

Books

Click the image to go to Amazon to review the book.

How Often to Rebalance Stock Portfolio?

In James P. O’Shaughnessy’s book, he rebalanced 50-stocks portfolios annually for tax and transaction cost reasons. Since IRA accounts are tax deferred or tax free (Roth IRA), and transaction commissions have come down significantly for the past 10 years, it is important to examine how rebalance frequency affects performance.

To study the rebalance period, portfolio123.com is used to run a simulation with the following

  • ranking factors:
    • 34.2% – Price to Cash Flow Per Share Ratio, Quarterly
    • 34.2% – Price to Sales Ratio, Quarterly
    • 5.1% – Short Interest, Percent of Shares Outstanding (%)
    • 26.4% – close(0)/((close(120)+close(121)+close(122)+close(123)+close(124)+close(125)+close(126)+close(127)+close(128)+close(129)+close(130)+close(131)+close(132)+close(133)+close(134)+close(135)+close(136)+close(137)+close(138)+close(139)+close(140))/20)
  • parameters:
    • $0.005/share commission cost
    • 0.2% slippage
    • 25% stop loss
    • minimum $3 stocks
    • minimum market cap $50 million
    • average 20 day trading amount above $200,000

The returns of a diversified 50-stock portfolio with different rebalance periods from 2001/03 – 2008/03 are in the table below:

Rebalance Period Total Return Annualized Return Maximum Drawdown
Daily 977.7% 40.9% -30.4%
1 Week 958% 40.5% -28.9%
2 Weeks 853.2% 38.4% -30.8%
3 Weeks 897.1% 39.3% -33.1%
4 Weeks 790.7% 37.1% -31.4%
8 Weeks 722.2% 35.5% -33.4%
3 Months 587.4% 32% -33.2%
6 Months 559% 31.2% -30.7%
1 Year 315% 22.8% -33.1%

There is clear performance and drawdown advantage by rebalancing portfolios on at least weekly basis, by constantly keeping the best 50 stocks in the portfolio.

Individual investors building own portfolio can take advantage of it. Institutions with large amount of money to invest will not be able to take advantage of it, because slippage degrades performance quickly.

How to Pick Stocks?

In James P. O’Shaughnessy’s book, he shows a systematic approach to build a 50-stock portfolio based on multifactor ranking. With the advance of internet and online brokers, now the historical data and back testing tools are at affordable price for individual investors.

Multifactor stock ranking systems are superior than stock selection systems using subjective judgment or lagging technical indicators, such as chart reading, trend lines, Eliott waves, Fibonacci retracements, or moving average, etc. But multifactor stock ranking system is probably the most complicated one to master.

AAII offers a low-cost system with complete database, but requires customization to do ranking back testing. Zacks and valuengine offer similar tools. Portfolio123 offers customized ranking capability as well as a powerful back testing simulator.  With these types of tools, individual investors are at tremendous advantage over mutual funds because of market inefficiency. Good investment opportunities can be bought well before institutions spend m(b)illions of dollars piling them up.

Some web sites, such as https://www.nasdaq.com/reference/guru.stm and https://www.magicformulainvesting.com/ offer free ranking system but lack customized ranking and back testing capabilities.

To show the power of multifactor ranking, portfolio123.com is used to run a 40-stock portfolio simulation from 2001 to 2002 with the following

  • ranking factors:
    • 34.2% – Price to Cash Flow Per Share Ratio, Quarterly
    • 34.2% – Price to Sales Ratio, Quarterly
    • 5.1% – Short Interest, Percent of Shares Outstanding (%)
    • 26.4% – close(0)/((close(120)+close(121)+close(122)+close(123)+close(124)+close(125)+close(126)+close(127)+close(128)+close(129)+close(130)+close(131)+close(132)+close(133)+close(134)+close(135)+close(136)+close(137)+close(138)+close(139)+close(140))/20)
  • parameters:
    • $0.005/share commission cost
    • 0.2% slippage
    • 25% stop loss
    • minimum $3 stocks
    • minimum market cap $50 million
    • average 20 day trading amount above $200,000

The ranking system is a typical value style ranking system because it ranks stocks by low price to cash flow and low price to sales.

As we can see the performance graph of the simulation below, the ranking system was doing very well during the very bad bear market period.

With different ranking systems to find different types of top-ranked stocks, one would be able to build a diversified stock portfolio.

What is the Difference Between Stocks and Funds?

The main difference between a portfolio consisting of funds and stocks is performance potential. Let’s use 2007 as an example.

  • Only 10 stocks had over 100% gain in S&P 500 index in 2007.
  • None of stocks in Dow Jones 30 index had over 100% gain in 2007.
  • There were 4628 stocks with market cap over $100M as of 12/31/2007. 209 of them had over 100% return in 2007. A portfolio of 50 stocks selected carefully could easily contain some of 209 winners.
  • For mid sized funds buying stocks with minimum $1 billion market cap limitation, there were only 2136 stocks to select from in 2007. 91 of them had over 100% return in 2007. A portfolio of 50 stocks had less chance to contain some of 91 winners.
  • For large funds buying stocks with minimum $10 billion market cap limitation, there were only 572 stocks to select from in 2007. 30 of them had over 100% return in 2007. Most of the stocks in a portfolio of 50 stocks were guaranteed not to be in the 30 winners.

To make up the difference in performance potential, many trading techniques have been devised to capture the up trend of funds while avoiding the down trend of funds.

Following summarizes other differences between funds and stocks.

Pros of Funds:

  • Require very low amount of capital to start with some diversification.
  • Low cost way to buy and sell a basket of investment vehicles, such as a basket of home builders.
  • Can purchase investment vehicles other than stocks, such as real estates, bonds, gold, silver, oil, foreign currencies, international stocks, etc.
  • Able to short without unlimited loss or margin issue through inverse funds.

Cons of Funds:

  • Too many to choose from. Over 20000 mutual funds and over 800 ETFs are available in US.
  • Holdings of mutual funds are not transparent. Prone to end-of-quarter/year window dressing.
  • Cannot customize by excluding certain stocks in the holding of funds.
  • May not be aware many funds include same popular stocks, increasing risk of over concentration.
  • Over-diversification – due to funds size limitation, many mutual funds either simply buy and hold stocks of mega cap or buy hundreds of stocks like an index, offering little upside potential.
  • High management effort to properly time buy and sell a portfolio of different funds.

Pros of Stocks:

  • Complete transparency of portfolio holding. Stop loss can be applied on any individual stocks as bad news happen.
  • Offer better performance potential by picking the best individual companies regardless their size.
  • Able to liquidate completely on any dramatic event when market is open.

Cons of Stocks:

  • Very high management effort to establish and maintain a well diversified portfolio with 50 stocks or more. There are more than 8000 stocks in US exchanges to select from.
  • Even trading commissions has come down a lot, it is still cost prohibitive to build a diversified portfolio with 50 stocks or more for account size less than $100,000.
  • More items to report on schedule D for taxable accounts.
  • Unable to take advantage of tax-deferred variable annuity or life insurance.
  • Difficult to buy certain asset classes, such as real estates and international.