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Marc H. Gerstein ( or if already on Twitter, search for @MHGerstein) is an independent investment analyst/consultant specializing in rules-based equity and ETF investing strategies, with particular emphasis on small-cap equities and leveraged ETFs. Many of is views... More
My company:
Portfolio123 and Ariston Advisors
My blog:
Forbes Low-Priced Stock Report
My book:
Screening The Market
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  • In Defense Of Goldman Sachs

    I voted for Obama. I’m a Democrat. I believe we badly need financial regulatory overhaul. I think there has been much behavior among bankers and on Wall Street that was downright despicable. But the recent declaration of war against Goldman Sachs (NYSE:GS) looks wrong; very, very wrong.


    By now, we know the basics of the case being pursued by the SEC (and possibly by the US Attorney). Goldman marketed a derivative, ABACUS 2007-AC1, the performance of which would be based on the performance of a pool of mortgages. We also know from our 2010 vantage point that in terms of creditworthiness, these mortgages were dreadful. We also know that in 2007, when ABACUS 2007-AC1 was put together, a lot of people  believed sub-prime mortgages were great and that housing could continue to soar. One such team of professional investment geniuses bought ABACUS 2007-AC1 and wound up suffering a fate similar to that of former Dutch investors who ploughed into tulips at the wrong time; they got their heads handed to them.


    At first glance, one would think that for better or worse, Goldman, which brokered the ABACUS 2007-AC1 deal, would be no worse than the old tulip salesmen. But, according to the SEC, there’s a difference. Goldman didn’t disclose that Paulson & Co., a hedge fund that was smart enough to want to bet against subprime mortgages at the top of the market, grew or helped to grow these tulips . . . oops. . . select securities for ABACUS 2007-AC1.


    Let’s look more closely at the SEC’s allegations against Goldman and Fabrice Tourre, the Goldman employee who managed the ABACUS 2007-AC1 deal, as presented in Litigation release No. 21489, posted on the SEC web site:


    “[T]he marketing materials for ABACUS 2007-AC1 — including the term sheet, flip book and offering memorandum for the CDO — all represented that the reference portfolio of RMBS underlying the CDO was selected by ACA Management LLC ("ACA"), a third party with expertise in analyzing credit risk in RMBS. Undisclosed in the marketing materials and unbeknownst to investors, a large hedge fund, Paulson & Co. Inc. ("Paulson"), with economic interests directly adverse to investors in the ABACUS 2007-AC1 CDO played a significant role in the portfolio selection process.

    .  .  .  .


    “Tourre is alleged to have known of Paulson's undisclosed short interest and its role in the collateral selection process. He is also alleged to have misled ACA into believing that Paulson invested approximately $200 million in the equity of ABACUS 2007-AC1 (a long position) and, accordingly, that Paulson's interests in the collateral section process were aligned with ACA's when in reality Paulson's interests were sharply conflicting.”


    So who actually picked the securities, Paulson or ACA? Can we simply rely on Paulson as the architect? That’s hard. Here’s the announcement regarding Abacus 2007-AC1 as published on the ACA web site:


    “Since 2008, ACA Financial Guaranty Corporation has cooperated with a Securities and Exchange Commission (the “SEC”) inquiry focused on a specific collateralized debt obligation (“CDO”) transaction – Abacus 2007-AC1. ACA Management L.L.C., a subsidiary of ACA Financial Guaranty Corporation, acted as the portfolio selection agent in that transaction. On April 16, 2010, the SEC announced a civil action against Goldman Sachs & Co. and one of its employees in connection with this CDO. No ACA entity or individual is accused of any violation by the SEC in this action.” (Emphasis supplied.)


    Does that rule out the notion that Paulson actually picked some or all of the securities? Not necessarily. ACA’s language is vague, probably deliberately so and probably as a result of extensive word-crafting on the part of its legal representatives. But I think we have to at least assume that ACA had some sort of a role. If it didn’t, it would seem logical that the SEC would be charging it with fraud.


    Next, was ACA qualified to serve as “risk management agent”  (whatever the heck that is)? It’s hard for an outsider who just tuned into this as a result of the news to make a definitive conclusion. But it does seem clear ACA is trying to present itself as a qualified party. Here’s the biographic notation from the web site regarding its CEO Raymond J. Brooks (something I’m sure Goldman’s legal defense team already has in its files and is already researching further):


    “A former managing director with Alvarez & Marsal, Brooks has more than fifteen years of experience in risk management, capital markets and portfolio management. Over the course of his career, Brooks founded Pine Creek Healthcare Capital, which was a high yield and distressed healthcare debt manager. He also held positions at Price Waterhouse, Lehman Bros., and Aubrey G. Lanston / Industrial Bank of Japan. He is a former Member of the Chicago Mercantile Exchange and the International Monetary Market. Brooks received an MBA in finance from the University of Chicago’s Graduate School of Business and a B.S. from Saint John’s University.” (Emphasis supplied.)


    OK. So we have to assume that ACA, a firm that publicly conveys the impression it is experienced and proficient in the analysis of risky distressed securities was somehow involved in putting together the Abacus 2007-AC1 portfolio.


    How would you expect such a firm to go about doing its job?


    Might they assess the likelihood of default of each mortgage in the pool? One would expect that.


    Might they assess the likelihood of default by many mortgages in the pool at the same time? One would expect that.


    Might they assess the extent of losses likely to be incurred in the event of default? One would expect that.


    Might they base their analysis on whether someone on the selling side of the Abacus 2007-AC1 transaction is bullish or bearish? You’ve got to be kidding!


    Is the SEC really going to argue that a firm spearheaded by someone who brags about “more than fifteen years of experience in risk management” needed to know if Paulson was bullish, bearish or apathetic in order to make a professionally competent judgment as

    to the quality of the securities in the Abacus 2007-AC1 pool? Is that how ACA has been analyzing distress credits . . . by asking sellers if they’re bullish or bearish?


    Give me a break!


    One of the elements of securities fraud is that the representation or omission be “material” to the victim’s decision  to trade the security. Where is the materiality here? Who cares if Paulson is betting against the derivative? Who cares if Goldman agrees with Paulson and helps him implement his strategy? Neither Paulson nor Goldman were assuming the role of objective analyst. That role was assumed by ACA.


    Now, it is possible that ACA and/or the buyer really did suffer a massive brain-cramp and rely on something absurd like what Paulson thought or did. We all have bad days, sometimes even very bad days.


    But that would not be sufficient to make a case of fraud.


    The victim’s reliance needs to have been “reasonable.” If you buy a 1955 un-remodeled Chevy because the seller tells you it gets 250 miles for each gallon of gasoline, you can’t sue for fraud even though the seller was an impressive liar. Your reliance on such nonsense would not have been reasonable. The institutional-professional buyer of Abacus 2007-AC1 was no better, and if ACA needed to know what Paulson thought, they’d have been even dumber because they were supposed to be the distressed security experts.


    Frankly, I’m baffled as to why the SEC isn’t chasing ACA (I haven’t even considered the ratings agencies, and I won’t because if I did, I may trigger too many browser obscenity filters).


    In any case, much needs to be done in the area of financial reform and there will undoubtedly be vigorous debates along the way. Sadly, as this case moves through the courts and as evidence and legal principles come to be considered by judges and possibly jurors rather than by politicians and journalists, I fear it may cloud, rather than focus, the case for financial reform.

    Disclosure: No position in GS
    Tags: GS
    Apr 30 3:47 PM | Link | 7 Comments
  • Apple: The Second Coming Of AOL?

    As we all know, Apple (NASDAQ:AAPL) remains on an amazing roll. Its products are now beloved by consumers and its stock is beloved by investors. There are detractors (a situation Apple shares with winners in other walks of life, such as the New York Yankees), but their utterances typically attract storms of rhetoric from the company’s many loyal fans. That’s why I suspect I’m about to attract some very hostile comments as I point out some troublesome aspects of Apple’s core product philosophy; a trait that, I believe, revives memories of another once-but-fallen king: America OnLine, or as it’s now known, AOL, Inc. (NYSE:AOL).


    A Case Study In Usability


    When it comes to usability, Apple products are as clear, comfortable, sensible, elegant and magnificent as anything imaginable – if you use them the way Apple product developers assume you will use them. But if you use them in a way Apple didn’t anticipate, its offerings can be as awkward and clunky as anything Microsoft (NASDAQ:MSFT) or anyone else has ever been accused of peddling.


    I’m not a tech person. So I’m not going to get into things like open versus closed architecture or anything like that. Plenty of others can, have, and still are addressing that far better than I can.


    I’m just a middle-aged iPod lover who can’t help but notice Apple’s failure to anticipate what I do with it and how awkward it is for me to do what I do. I’m also an investment analyst with a couple of decades of experience who can’t help but recall how often I’ve seen how tiny, hardly-noticed seldom-discussed, flaws in how a company does business can, in fact, reflect conditions that can, over time, derail corporate progress and eventually send high-flying super-stocks into oblivion, especially when mixed in with hubris and a lack of leadership depth.


    We can easily dispense with the last two topics. Apple has shown itself to have ample leadership depth, as we recall from the way the company flourished back during the time when Steven Jobs was in exile. And of course when it comes to corporate hubris, who could ever imagine Apple in that way. (Wink, wink.)


    Now, please be patient with what follows. So much of the love surrounding Apple stock stems from the supposed usability of its products. It is valuable to consider a close-up case study suggesting a contrary view and what the details of this one might suggest for a big-picture assessment of the investment case. Pretend you’re sitting behind a one-way mirror watching me and my iPod in a focus group (the sort of focus group Apple probably never convened). After that, I’ll explain what this suggest for a big-picture view of Apple.


    That said, here we go . . .


    A One-Person Focus Group


    I love medieval, baroque and classical music and have loaded my iPod accordingly. I also have various other kinds of music.


    I’m in the mood now to listen to a concerto by Corelli. So I turn on my iPod, scroll to composers, and look through the Cs. Guess what: no Corelli.


    That’s odd. I see Carl Philipp Emanuel Bach (not sure why he’s not under B) and a bunch of other completely unrecognizable names. I go to my computer and open iTunes (Did I mess up when loading it?) and sort the 2,548 items in my music “folder” by composer: still no Corelli.


    But I got lucky. Under A, I notice Arcangello Corelli. Cool. I didn’t know his first name was Arcangello.


    I go back to my iPod and check the letter A under composers. Yup, there he is, Arcangello Corelli. Live and learn. I know some first names, Ludwig and Wolfgang for instance. But it looks like I’ll have to go to Wikipedia and look up and memorize some others.


    I also notice one of my favorites under the As, Antonio Vivaldi.


    Oh, wait a minute: right below Antonio Vivaldi, I see a composer named “Antonio Vivaldi (1678-1741).” Huh! Under Antonio Vivaldi, I see 96 “songs” spread among four albums. Under Antonio Vivaldi (1678-1741), there are a couple of dozen songs from what looks to be two albums but they aren’t subdivided so I need to look again more slowly when I have time.


    I’m getting a headache and am starting to shudder when I contemplate looking for a piece by something by Mozart.


    I know this probably isn’t Apple’s fault. They depend on the recording companies to supply data for fields like Composer, Artist, Album, etc. and obviously, the latter aren’t quite so wired into usability of modern electronic products. That will be especially important when I want to find Medieval instrumental or vocal works, for which Apple has no recognizable category.


    So I’ll take matters into my own hands. I’ll organize things the way I want, into folders, oops, I was supposed to say playlists.


    I can do that, sort of.


    It turns out I can’t organize content around a collection of sub-playlists that make sense for me. All playlists must be co-equal. So I can’t have a grand Mozart playlist under which is a sub-playlist for concertos, another for operas, another for symphonies, and another for sonatas. I need four separate and co-equal playlists (ouch; I’m going to wind up with an incredible truckload of playlists when I’m finished) or a more manageable number of incredibly huge playlists. (I looked hard to see about sub-folders; if I’m wrong and they can be done, please tell me so. I can use the help!)


    It gets more cumbersome.


    I don’t just listen to music. I have audio books. I buy mp4 lecture series from the Teaching Company, some dealing with History, some with Philosophy, some with Literature, etc. I like to save and archive some of the many podcasts I listen to as well. I have a great collection of poetry readings.


    A straight alphabetical sort of a hundred or more playlists is going to become a real pain. So I invest some time to create a system of prefixes to help me recognize families of playlists which I can keep together since, it seems, iTines sorts all the lists alphabetically (whether I want to or not). I these could have been grouped together under subfolders,  but what the heck, it is what it is. Some of my prefixes are MC for classical music, MG for general music, MS for sow music (I like that, too), T-HI for Teaching Company History sets, T-LI for Teaching Company Literature courses, PC for Poetry-classical, B for audio books, etc.


    If my focus on a particular audio book or Teaching Company lecture series is ongoing, I add an A prefix to push it up to the top of my incredibly lengthy list of iPod playlists (A-T-HI-Name or A-B-Name).


    Tell me again how easy and intuitive Apple products are! Oh well, too bad (for me) Apple’s product developers failed to anticipate my existence.


    Actually, there’s more. Apple never heard of the Teaching Company, or at least never considered anyone might use an iPod to listen to its courses. So as far as iPod is concerned, a course consisting of 36 lectures is really 36 separate audio books none of which have any relationship to any other. Getting them into the iTunes library and organized into “playlists” is quite a messy process, but I’m not going  to bore you with that. Instead, let’s get end the one-person focus group and consider how this relates to an investment case relating to Apple stock.


    My travails will not throw Apple stock over the edge. Nor do they prevent me from enjoying my iPod. I’m a big boy. I can handle it. I started with pcs back in the DOS era! But they do say something scary about the way Apple thinks, something that reminds me of the old AOL.


    Let’s see the connection.


    Two Product Design Philosophies


    Think of product design (at least insofar as it pertains to the new generation of mass technology) as being divided into two camps.


    The first approach is one that leads users by the hand, guiding them every step of the way. It controls the user experience in order to make it as accessible and as positive as possible. Apple is obviously in this camp. As another example, consider such offerings as Quicken, Turbo Tax, etc. I’ll call this the Guided approach.


    The second approach is one that empowers users to do as much as possible on their own in order to give them as much freedom to decide for themselves what they want to do and how they want to do it. Consider for example, Excel which, out of the box, is, essentially a platform allowing users to do an incredible variety of things; budgeting, taxes or whatever. Apple rivals lean, in varying degrees, this way. I’ll refer to this as the Self-Directed approach.


    If you’d like to directly experience a side-by-side comparison of these philosophies, go to and complete the free registration process. (This is a recently launched individual-investor version of the Portfolio123 screener I use.) Go to the tutorial area, check the PDFs, and start trying to screen for stocks. Pay particular attention to the alternative interfaces we offer: Rules Wizard and Free Form.


    No, this is not a subtle plug for my site (though we would love to attract new users). I can’t think of any application that offers such a thorough and stark side-by-side contrast between the two aforementioned product-development philosophies. It will help you see the Apple-versus-others debates in important new ways.


    On paper, the Guided approach seems great. It also wins flat out when demonstrated at a trade show or in a store. Reviewers, bloggers and consultants love it. Novice and generally less dedicated users also love it. This is why Apple, the bastion of Guided product design, is flourishing so brilliantly right now.


    What about other users. As you can see, for people like me, the Guided approach underlying iTunes and iPod have actually been making things harder for me. (In case you’re wondering why I continue to use iPod, the answer  is inertia. I don’t use iPhone nor will I use iPad. And when my iPod battery dies, who knows which way I’ll turn.)


    I presume Apple would not be happy to hear of my struggles with its product as described above. But when you develop Guided products, it’s not feasible to accommodate every possible thing every possible user might want. There’s way too much variety in the world for that to be feasible.


    Guided products need to be designed with certain kinds of users in mind. That means, by implication, that other kinds of users will not and can not be considered. Some designers cynically ignore users outside their target. Others know they’re there, but are consciously aware that no company can be all things to all people and hope they’re doing the best they can for as many as they can.


    Guided Products Can Be Great


    Sometimes, the Guided approach turns out to be a great business decision.


    Consider Turbo Tax. Aside from professional tax preparers, people do taxes once per year and dread the experience. They have no motive to learn how to build their own tax preparation spreadsheets even if, arguably, a custom developed sheet would be easier to use. It’s worth it to grit one’s teeth and put up with Turbo Tax’s endless interview once per year.


    Consider Quicken. This is a long-term use, and obviously, nobody can create a better budget program for you than you can for yourself with Excel. But for most people, it’s not worth the effort. Hence the success of the Guided-philosophy Quicken product.


    At Portfolio123, we know our core Do-It-Yourself “Free From” interface is a powerhouse that can do things most investors wouldn’t dare imagine they could do with a web-based screener. But we also know that it takes a real commitment to learn how to use it. When we decided to introduce StockScreen123 for individual investors, we knew we’d have to give them a Guided version (the “Rules Wizard”) to help them ease into the process. Readers who have followed my screening articles on Seeking Alpha can’t help but notice the drop-off of late in the number and frequency of submissions. Work in connection with building StockScreen123 has been quite consuming. I point this out as evidence of the fact that I have tremendous respect and admiration for Guided products.


    Now, consider internet. Back in the late 1990s, this was a confusing, and in many cases, scary phenomenon. Getting access was often a challenge in and of itself. (Does anybody besides me remember an access module called Trumpet Winsock?) And once you do get on line, what then? Where do you go and how do you get there and once you get there, how do you go someplace else, and once you get someplace else, how do you get back to where you were if you used to be if you choose to so do? For a large segment of the population, these were complex and exhausting issues.


    Enter, which pretty much waved a magic wand (dial-up access and a walled garden that conveniently bundled browsing, e-mailing, chatting and shopping). It was magnificent. It was a revelation. It made internet easy and accessible for everyone and anyone. It changed the way we live. And it put AOL on top of the world even to the point where it could snap its corporate finger and swallow up a powerful media giant like Time Warner. It looked like another case of the Guided philosophy leading the way to commercial success.


    Limitations On Guided Products


    But there was a difference between AOL and Quicken or TurboTax. Internet is a perennial activity. Even the greenest of novices gets the hang of it eventually. Moreover, comfort grew exponentially as broadband solved access issues, and better linking, bookmarking and tabbed browsing made it much easier to get around. The AOL walled garden, arguably a major factor in helping internet to become a mass phenomenon in the first place, eventually became more trouble than it was worth relative to the Do-It-Yourself approach.


    Novices always struggle with the Do-it-Yourself approach. But how much of a business opportunity do novices really present?


    If, in the late 1990s, something like internet bursts into the world all at once, it looks like the novice market is massive. Everybody is a novice, whether you’re a six-year old, a twenty-something, a forty year old or an older person.


    But that didn’t last. Eventually “everybody” outgrow internet newbie stature. Now, the only novices are those young children that, each year, reach the point where they can start using internet. This is a bona fide market. But it’s dramatically smaller than what the novice market looked to be back when AOL ruled the roost and ultimately, it turned out to be way too small to allow AOL to remain viable in its turn-of-the-century configuration.


    What’s Ahead For Apple?


    Now, let’s turn back to Apple, the new hero for novice users who, on day one, find it a lot easier to point to pictures and move their fingers and let things get done for them automatically then it is to type or scroll to words or numbers. They, and even non-novice but less-committed users, have good reason to love Apple, as we see all the time on the web including, often, in Seeking Alpha.


    But what will happen down the road as all these hand-held intelligent super-gadgets start to become passé?


    What will happen as the increasingly experienced user base wants to do more and more things that didn’t occur to Apple’s design team back on day one?


    What will happen when these several hundred dollar phones or tablets have to be sent back to Apple for who-knows-how-long for battery replacement?


    What happens as the increasingly computer savvy population comes to wonder whether they really are better off paying so much more for an Apple laptop compared to a comparably-powered Wintel machine?


    There will always be a core group of novices for who Apple will continue to be the vendor of choice. But how big will that market be five years from now? AOL and its adherents thought they were looking at a powerful market. It turned out they were in fact looking at a one-time surge that was about to become a slow-growth market from a much smaller base.


    AOL, its fans, and its investors once dismissed such questions as not being worthy of consideration.


    Apple, its fans and its shareholders are equally free to be dismissive or even derisive, as I’m sure some will be once comments start to appear below. But for those who do actually own the stock, it may be a good idea to at least start to wonder about the nature of the market segment served by Apple (those who favor Guided products) and what its prospects are for growth or shrinkage, as time passes. That, and not the here-and-now acclaim Apple is earning, is what will ultimately determine the company’s fate.


    Speaking for myself, I see no immediate danger. If Apple appears in any of my screens, I’m willing to buy it. I don’t marry my stocks. I rerun and rebalance all my models every four weeks. But if someone were to ask me about Apple as a stock that could be put away as a long-term holding, I’d feel compelled to say “no.” In fact, if I were better at technical analysis than I am, I’d be on guard for an opportunity to consider long-dated Puts.

    Disclosure: No Positions in apple
    Tags: AAPL
    Apr 14 2:46 PM | Link | 2 Comments
  • Sometimes, We Have To Just Throw Out The Past

    By now, we've all heard "past performance is no assurance. . . blah, blah, blah" so often, it almost sounds liked a nursery rhyme. But it may be time to stop a moment, think about it, and possibly give the saying a new, broader, spin. Usually, the phrase is meant as a warning that cautions us against assuming the future will be as good as the past. Actually, though, this is a two sided coin. We need to also be careful about assuming the future will be as bad as the past.

    Crises, crises and more crises

    I suspect that years from now, many investors will still be telling stories about what happened, what they did, and what they didn't in the 2000s to those among the new generation who remain courteous enough to pretend to care. But what about the big picture? What will people think of it, if they think of it, a decade or so down the road?

    After all, how often do you think about October 1987 (how many even know the S&P 500 dropped more than 20% in a singe day)? How often do you think about late 1998 (do you recall the dangerous financial unraveling we faced, or do you just remember the early stages of the new-economy tech stock boom)? How often do you think about 1969-1972 (how many even know why I mention it), or 1974-75? For those of you who don't know what CLEC stands for, how often do you think about 2000-02?

    Every time a crisis occurs, people seem to want to connect it with what we think of as the big one, 1929-32 and the rest of that decade. So far, though, none of the subsequent ones have come anywhere close. There's much that has been and still can be said about what made the 1930s so distinct from the crises we've had since then. That's well beyond the scope of this post. The topic for today is how investors should consider crises when evaluating potential strategies. This is a particularly poignant topic for those who have access to backtesting, as do users of Portfolio123 and StockScreen123, and notice how badly results fare once we hit October 2008.

    The Prudence Police

    It's so easy to preach attention to worst-case scenarios. Nobody will ever accuse you of spreading hype or advocating recklessness. And those with 20-20 hindsight can definitely appreciate how well off everyone would have been had they listened to you in the first place (even if you hadn't started to articulate your warnings until well after the fact).

    We definitely don't want to ignore the possibility of more crises down the road. Here are two simple approaches that stand a good chance of protecting you or at least helping you keep losses to tolerable levels.

    Stay in cash

    This is the most extreme perma-bear solution and some will, or already have, adopted it. Most who read this will not want to go that far.

    Engage in some form of market timing

    This sounds exotic to some and like voodoo to others, but actually, it's more do-able than many realize. Something as simple as being bearish if the S&P 500 50-day moving average is below the 200-day moving average can be surprisingly helpful. (This is a nice approach because it's easy and you don't have to figure out why the crisis is here, just let price action tell you it is here.) If you're bearish, go all cash or in the alternative, consider staying in stocks but allocating 10% or so of your portfolio to a short or leveraged short ETF. If you're into options, this would be a cue to sell calls and/or buy puts.

    Strategies For All Seasons

    Few strategists or investors go all cash all the time. Some are willing to engage in market timing. But many others, especially those who have access to backtesting and simulation, work to develop good-for-all-seasons strategies that would be capable of withstanding crises as well as the best of times. Put another way, this is a pursuit of "robustness."

    Do you ever notice, though, how great robust strategies look on paper (That's why we say they're robust!) but how, when the next crisis comes around, they don't deliver? I suspect every investor who, thought at the start of 2008 that he or she was prepared for bad times is shaking his or her head and muttering.

    I believe robustness is a nice quest but like the pot of gold at the end of the rainbow, it's forever elusive. If you think you have a robust model, I suspect that what you really have is a four-letter word: L-U-C-K. Be glad you survived the last crisis or past crises. But don't get complacent about the next one.

    Crises in perspective

    Here's a simple, but quite revealing, screening exercise. It involves back-dating so you’ll probably want to try it on, which is in beta and, hence, free.

    Create a simple two rule screen to look for stocks with market caps of at least $5 billion that declined 20% or more in the past four weeks. Use StockScreen123’s “Free Form” rules interface. You can copy each of these rules into your clipboard and paste them into the screener (create two separate rules):




    Click on Totals. Note the percent of stocks meeting the market cap requirement that pass. As of this writing, it was one out of 775, or 0.13%.

    Change the as-of date and run this same screen as of 7/31/02, when the dot-com explosion was really in full force. I got 101 out of 521, or 19.4%.

    Now set the as-of date to 10/31/08 and run the screen again. I got 443 out of 547, or 80.1%.

    Change the size and percent-decline thresholds. No matter how you slice and dice it, you'll see October 2008 was one heck of a bad month, even by bad-month standards.

    Figure 1 provides a bigger-picture perspective. It's compiled by backtesting the above screen starting on 3/31/01 and rebalancing every four weeks. The graph shows the number of stocks falling 20% or more in the past four weeks as a percent of those that pass the market-cap test.

    Figure 1

    We see that by counting every four weeks from 3/31/01, I was able to capture an even worse period in 2002. we also see that the post 9/11/01 period was quite awful. Notice, though, how October 2008 stands out as being one of a kind, at least since 3/31/01.

    Pause for a moment and think about that: approximately 80% of big (supposedly respectable) stocks dropped 20% or more in a single month! Now do you understand why your strategies didn't work? Nothing worked, except for L-U-C-K. That wasn't a stock market we experienced, where some do well and others don't based on some sort of criteria we can try to discover. That was a widespread dumping of equities as an asset class. If it could be sold, there was an 80% chance it would be dumped.

    Do you really think it's worthwhile to try to build a "robust" model that will outperform the benchmark even in October 2008? Yes, with enough "data mining," you could probably come up with something. But why bother? What chance do you think any such model would have helping you in the future. It might have to be so conservative as to make you wonder why you're even bothering to deal with equities at all. Or it might be an instance of that four-letter L word (which tends to be what happens when you engage in data mining).

    Market timing, as mentioned above, will probably serve you better - seriously. Figure 2 represents a backtest of a strategy of being in the S&P 500 SPDR ETF (NYSEARCA:SPY) when the index's 50-day moving average is above the 200-day average, and being out of the market at other times.

    Figure 2

    Figure 3 offers a different perspective. It plots all rolling four-week declines in the S&P 500 going back to January 30, 1950.

    Figure 3

    Finally, figure 4 shows all rolling four-week S&P 500 percent changes since early-1950.

    Figure 4

    So again, do you really think it's worthwhile to try to come up with a good-for-all-seasons strategy that will protect you from the sort of thing that occurred in October 2008? Is it even possible?

    Ignoring The Prudence Police

    When it comes to formulating a strategy, the prudence police will definitely wag their fingers if you ignore October 2008. FINRA and the SEC would probably do likewise, or worse, if you're a professional and creating a backtest that you want to use as part of your marketing efforts.

    But for your own consideration, when deciding on what kind of an all-in equity strategy (i.e. aside from market timing) you want to create and use, I think the best way to deal with October 2008 is to ignore it. Throw it out. There's noting useful you can learn from it. Ditto for other exceptional crises, such as September 2001, October 1987, etc. (If you're a pro using test results to market, you'll have to show the data, but don't be shy about explaining it.)

    "Respectable" types will talk against market timing and advocate robust modeling. Don't believe it. Market timing can help you. Robust modeling can fool you.

    Disclosure: No positions.
    Mar 29 2:38 PM | Link | Comment!
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