4/20/2007

Three concepts


Studies after studies have shown some concepts in the stock market have an edge over the random walk hypothesis. Out of the many anomalies I have studied and tested, I have based my trading on few key concepts with statistically proven edge.
All my trading is based on three core concepts.
  1. Earnings
  2. Momentum
  3. Neglect


Earnings

Earnings based strategies can have many flavors. At the heart of earnings strategies are concept like PEAD Post Earning Announcement Drift, earning momentum, and earnings overreactions. PEAD or Post Earnings Announcement drift is a phenomenon in which stocks showing surprisingly good earnings or bad earnings show drift in either direction post earnings and this last after the one day earning effect. The Earnings Breakout and Earning Surprise strategies I trade are based on this phenomenon.

Earnings momentum based strategies look for momentum. history of rising earnings growth over several quarters. Such stocks with earnings momentum have propensity to rally for long duration till their earnings momentum lasts. Long term winners (3-5 year time frame) always show earning momentum. The IBD EPS rating is basically a Earning Momentum based rating. It uses a weighted average of EPS growth for 3-5 years plus recent years and quarters to rank stocks. Stocks rated high on EPS ratings have a track record of good earnings growth. You will often see price persistence in such stocks. The IBD 200 strategy is based on Earnings Momentum. It also has price momentum built in to it as it selects top 200 stocks with Earnings plus Price Momentum.

Earnings overreactions lead to long term trends. When stocks establish a long term track record of earnings growth or below par earning growth, investors tend to overreact, assuming such trend will continue. At some stage prices move ahead of the earnings trend and that leads to price reversal. That is why shorting a stocks after it had a long history of earning growth and when it misses for first time often is very profitable strategy. Similarly most contrarian strategies are based on buying stocks when earnings are bad in the hope that they will mean revert. Value investors often use this as one of their strategies.

Momentum

Stocks that have outperformed over the past 3-18 months continue to outperform over the next 3-18 months, and same for underperformance. There are various explanations for this phenomenon and one of the explanation is momentum effect is linked to liquidity. With momentum persisting on previously illiquid stocks more than on liquid stocks. But it is just one of the explanation for the phenomenon and even liquid stocks show momentum.

The 100% plus "Double Trouble" strategy is basically based on this concept. The unique twist is in determining the point for calculating the 100% move. It also eliminates from the trading universe non trending stocks and considerably narrows down the trading universe to only stock with strong momentum. Breakout strategies work on such stocks, they may not work on other stocks. Hence buying a 4% plus breakout.

The momentum effect also shows that in the short time frame of 2-3 weeks there is strong tendency to mean revert. Hence one selects trades based on a 65 day weakness or some prior weakness before a breakout. If you are primarily a short term swing trader a 2 week weakness and a max holding period of two weeks on 100% plus wil significantly improve profits. Also anticipatory or anti trend entries using price channels or Bollinger Bands or other short cycle identification methods can help improve your returns on 100% plus if you are trading primarily the 5 to 10 days horizon.

The 100% plus strategy also has other unique twist of using absolute value rather than relative value for momentum . with an absolute cut off of 100, when no stock matches the criteria, there are no opportunities. While in relative method, you will take say the top 10% even in weak markets. So in bear market like in 2001 or 2002, the 100% plus universe was often below 100 levels.

Now if you want to use same momentum concept on large cap stocks or high liquidity stocks you can set your cut offs at 20 to 50%. So if you want to trade Dow Jones component, you can use entry after 20% plus move. If you want to limit your trading universe to S&P, you can use 50% plus cut off.

The Episodic Pivot method is also based on momentum effect. The primary hypothesis in it is that short term above average momentum often leads to start of a long term momentum cycle. By entering at such juncture, you get to enter at beginning of big move. Now if you add a catalyst study to it then returns improve.


Neglect


Studies of the best and worst performers over the preceding five and three year periods shows that the best performers over the previous 3-5 years period subsequently underperformed, while the poor performers from the prior 3-5 period produced significantly greater returns than the index. So there is long term mean reversion.

There are many possible strategies one can design based on this observation. Value investing is primarily based on such effect. The "Virgin" and "Neglect" strategy I trade is based on this concept. In " Virgin" one is looking for an ultimate in neglect, where a stock has never had a significant rally post its IPO. In my neglect strategy I look for prior 2-5 year growth (it should be negative or sideways), to select stocks and enter once they rally 30 % plus from 260 days low and meet liquidity criteria.

All the three concepts basically allow you to select a vehicle with high probability of going up. By entering them at beginning of major moves, you are likely to find a good amount of stocks early in their price appreciation cycle.

This conceptual understanding and background is essential to trade any of these methods. That is why theories like MACD, price channels , support resistance, etc, should be based on specific behavior of such stocks. A indicator which does not work on specific set of stocks works on certain set off stocks if the selection methodology was different. The overall conceptual understanding also helps to narrow trades when faced with several breakout. Why chose stocks with lowest float in IBD 200 or Episodic Pivot or Earnings breakout is because they are indicator of neglect. My past studies also show that low priced and low float stocks in IBD 200 outperform the high priced and high float by almost 3:1.

The reason to trade a mix of such methods is to ensure you get stocks at different stages in their life cycle. The Episodic Pivot, Earnings Breakout and Virgin/ Neglect strategies get you stocks in early stage of price appreciation cycle. The IBD 200 and Double Trouble primarily gets you in to the "sweet part" of the trend, once momentum in either earnings or price is well established.

If conceptual foundation is strong, you have more confidence in your method and tactical adjustments like entry, exit, risk management become easier. Concept is key. Rest is detail.

Related Post
Concept is key not tools


Are you serious about your trading?

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