Seeking Alpha

One Way To Beat The Market

by: Invest With An Edge

By Jerry Wagner

Reading Edward Thorp's 1967 book "Beat the Market" in the summer of 1968 changed my life. I had picked the book up as a summer read while home from college. I was intrigued. Years before, I had read a Life magazine account of how Professor Thorp had created the system to beat the dealer at the game of blackjack, or twenty-one.

The method outlined by Thorp in "Beat the Market" used arbitrage (simultaneously buying one asset while selling short another to realize the difference) with stock warrants (rights often issued with stock to make it more attractive to investors by giving the opportunity to gain more shares at a later time at a fixed price).

It turned out that these warrants were often overpriced, and if one sold them short while buying the underlying stock, you could create a "can't lose" trade that made money whether stocks advanced or declined. Included in the index was a valuation formula that allowed you to calculate what the warrant should actually be selling for at current market conditions.

Since I had just completed my first computer programming course, this was a perfect vehicle to practice my newly acquired skill. Merging computer analytics and the stock market just seemed like a natural fit to me. The rest, so they say, is history. So far, I have spent almost 50 years of my life working on the task.

Of course, the original allure was beating the market. Like in gambling, where the conventional wisdom had been no one could beat the casinos, the accepted academic dogma at that time - and for most of the time since - had been that stock price fluctuations were random, and once you adjusted returns for risk, you could not expect to outperform.

Professor Thorp, for most of his career, was a little-known giant in the stock market. Yet, today he is known as the "father of quantitative investing."

I learned at least three lessons from him. He was the first to "Invest with an Edge." He has always believed that each investment made should be anchored by an identifiable edge.

Secondly, all of Thorp's investments were quantifiably derived and managed. They relied solely upon statistics. This meant that they were always objective. It also meant that they were always rules-based, disciplined, and uninfluenced by emotion or opinion.

Finally, Dr. Thorp made me truly aware of risk. Specifically, he made it clear that one had to focus on the risk of an investment, just like the returns.

In 1981, I founded my registered investment advisory firm, Flexible Plan Investments, Ltd., largely focused on these principles. As a result of what I learned from Dr. Edward Thorp, my company has always sought to deliver dynamic, risk-managed strategies to investors.

What does it mean to "beat the market"? I imagine that most people would say that if you have spent the last five years outperforming some index, like the S&P 500, you have been beating the market. However, if you focus on risk as much as return, that simple comparison might not be enough for you to truly qualify as a "market beater."

As was clear from Dr. Thorp's work, risk is important to the discussion. For most investors, beating the market has usually been accompanied by taking more risk than the market. When you adjust the returns for the amount of risk, one often finds that the perceived advantage disappears.

As a general rule, holding just a few stocks, for example, almost always means more risk is being taken. It usually takes at least 14 different issues to constitute enough diversification to get close to the risk level of, say, the S&P 500 - and that's if the 14 issues represent at least the 11 different major sectors of the S&P. Usually, the more focused the portfolio, the less diversified and the more risk.

In addition, market-watchers generally would not award "market beater" status to an investor that simply beat the market when it was going up. Performance over a complete market cycle is the real test. There is no truer test of the actual risk being taken by a portfolio than its performance during a market downturn.

Many market commentators strangely focus on the S&P 500 as a benchmark for portfolio performance and whether you are beating the market. I say "strangely" because I know very few investors that can truly live with the risk actually exhibited by the S&P. It lost more than 50% during both of the last two bear markets. In my experience, few investors can stick with an investment that falls only 20%! (Of course, the popular NASDAQ 100 cannot even keep up with the S&P when the market falls, as it lost more than 70% in both of those declines.)

This is especially relevant in today's market environment. Stocks, as measured by the S&P 500, have been advancing without a 20% correction since March 9, 2009. That is the second-longest bull rally in the S&P 500's history. In fact, we have not even had a 5% correction in that Index for over a year. That's the seventh-longest such period in that history.

Yet, many investors believe they have beaten the market with their current one-, three-, or five-year performance. The real test of that claim is yet to come.

Everyone is aware of the great gains in the current rally for tech stocks. However, did you know that the S&P 500 Technology Sector Index last hit an all-time high early in 2000? Last week, 17 years later, the Index finally topped the high-water mark it set in 2000.

It's a great lesson. From 1997 to 2000, investors were beating the S&P 500 with tech stocks. Their portfolios soared and were referred to as "market beaters." Yet, 17 years later, these same investors are just now getting back to breakeven. That's a 17-year rate of return of… zero!

Why did it take 17 years? As Dr. Thorp would say, "It's just math. It's quantitative." Stocks in the S&P Technology Sector Index lost 80% of their value from 2000 to 2003. When you lose 80% of your value, a portfolio must increase 400% to return to breakeven. Even with the best stocks of the Technology sector, it took 17 years to accomplish that feat.

It will probably happen again. The problem is, no one knows when.

This uncertainty is always there for an investor in any asset class. All experience bear markets. No one can precisely pick the tops and the bottoms that will occur in any one of them.

To deal with that uncertainty, we have adopted an approach that consists of strategies with the following characteristics:

  • They are actively risk-managed.
  • Each has a quantifiable, identifiable edge.
  • Each is implemented in a disciplined, rules-based, computer-driven manner.

After all, history teaches us that one way to beat the market is simply not to lose what the market loses when the market inevitably declines.

Market update

Domestic stock and bond indexes, in general, fell in value last week. Commodities and international stocks gained.

Prior to a dicey Thursday, the S&P 500 hit a new all-time high twice, and the NASDAQ accomplished the feat three times last week. The S&P has now hit new highs 29 times this year, and the NASDAQ has done it 44 times!

The S&P has now closed higher each month this year (nine straight up months, in fact). It has been 264 days since the Index has fallen even 3%. The stairstep pattern continues.

The lack of volatility has been quite amazing. The VIX (fear index) has been in single digits only 26 times since 1990 - and 17 of those occasions occurred this year! That's about two-thirds of the total.

Intraday last week, the VIX hit a new all-time low of under 9%. Of course, the commentators are concerned, but they got hyper when we first breached 20%, then 15%, and finally 10%. However, the last two times we were close to 9% on the VIX (1993 and 2006), the market immediately (in 2006) or after a year of sideways action (in 2003) continued climbing for almost another year.

In tests we have done with the S&P 500, we have found that the danger isn't highest when volatility is low. Instead, it is during high readings that most of the damage occurs.

Earnings continue to surprise to the upside at a 63.3% rate. Revenues are also surprising to the upside-at a 63% rate. Company-generated future-earnings guidance has been the most positive since the first quarter of 2011.

In contrast, economic reports have maintained their underperformance versus analyst expectations. Fortunately, the indicator readings are already solidly high, so it does not appear that any concern is warranted from a week in which 14 reports surprised negatively, seven positively, and three in line.

From a contrary point of view, sentiment continues to be poor, and that is good. With new market highs, it seems reasonable that individual investors are less bearish, but why are they also less bullish? I don't know, but normally that leads to higher prices, not lower.

Technically speaking, stocks are overbought - a little bit on the S&P 500, but a lot on the NASDAQ. This may lead to some short-term weakness, especially since the number of new highs of individual stocks has not moved to new heights along with the averages.

Political seasonality, however, is not as big a concern on our 100-year-old-plus-based Index. It forecasts higher prices until the last week of the month, though August has normally been a turnaround month and can often end up negative. This is generally worse than normal in the first year of a presidential term. It is especially bad in years that end in a "7" for some reason.

Jay on the Markets

P.S. Dr. Thorp has a new book out, "A Man for All Markets." It's his autobiography and is a fascinating read.

Disclosure: No communication by Dynamic Performance Publishing or our employees to you should be deemed as personalized investment advice. Any investment recommended in this newsletter should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company. Dynamic Performance Publishing, its affiliates, and clients may hold positions in the recommended securities. Results are not indicative of holdings for clients of Flexible Plan Investments. Forwarding, copying, or otherwise duplicating this information for the use by anyone other than the intended recipient is expressly forbidden. These results are not representative of those achieved by clients of Flexible Plan Investments, Ltd. (FPI) due to differences in security selection, timing of trades, transaction fees, and FPI's management fees.