Dogging the DOW, Debunking Myths

October 29, 2017 11:03 AM
Many traders avoid the 30 Dow components based on long held market assumptions. But are they missing out on opportunities?

Buying the Strongest
Most of us have figured out that a high-quality antique or painting is more likely to appreciate in value than a bargain. Buying a Da Vinci oil is going to be a better investment than buying a portfolio of Da Vinci ink sketches. The high-end appreciates faster (and is more volatile) than the low-end.

If we buy the strongest of the Dow components rather than the weakest, we get returns that are much more attractive, and slightly better than either the full Dow or the S&P. “Going top shelf,” (below) shows two sets of results for buying the top Dow stocks. On the chart on the left rebalancing is done yearly, the chart on the right shows rebalancing done monthly. The yearly rebalancing shows more volatility and a flattening of returns during the past three years. Using a faster, monthly rebalancing, returns far exceed both DIA and SPY, but with a slightly larger drawdown during the financial crisis of 2008.

These results shouldn’t be a surprise. Stocks that are performing well most often, continue to perform well. The idea that a price is technically overbought and should be sold, is nonsense. Look at Apple, Amazon (AMZN) or Tesla (TSLA).The biggest winners defy fundamental analysis, except in retrospect.

 

 

Myth 3: You Can’t Arbitrage the Dow
A relative-value arbitrage takes advantage of divergence in prices of two related markets. Given two stocks in the same industry, one stock is relatively strong and the other is relatively weak. This often happens when, for example, one retail company releases a good earnings report a week before a competitor. The stock of the first company jumps while the other lags, for lack of news. A typical arbitrage is to sell the first and buy the second; assuming that the earnings announcement of the second will also be good and it will close the gap. But the companies in the Dow are not in the same business, so they have no reason to move together. They would only be similar in that they reflect the price reaction to the general economy.

Given a ranking of stocks by historic performance, if we believe that the stocks that are outperforming can’t be sustained, then we can sell the best and buy the worst. But then we would always lose money because the top stocks would continue to outperform and the bottom stocks would likely continue to have the same problems that pushed them to those levels. The worst stocks might not even be moving, so they wouldn’t provide much of an arbitrage, only a waste of resources.

We are then left with the conclusion that the best performing stocks are most likely to continue to outperform. That means the worst performers are not doing as well. We’ll base our strategy on buying the 10 best Dow stocks, evaluated using a 23-day (about one month) rolling linear regression of returns. We’ll rebalance every two weeks.

Reducing Risk Using Volatility
Having settled on the stock selection, we now want to reduce the drawdowns. We’ve already changed the rebalance period from monthly to every two weeks, which makes us more responsive to change. We still evaluate the price performance using 23 days. If we plot the daily returns of our strategy (not the prices), we can get the 20-day annualized volatility, the rolling standard deviation of the daily returns times the square root of 252 (see “A better way,” above).

We take risk seriously, and the simplest way to reduce risk and avoid unnecessary losses is to deleverage when risk gets extreme. In this case, we define that level at 90. Then whenever we are rebalancing (every two weeks), we reduce our position by 50% if the annualized volatility is greater than 90. When volatility drops below 90, we reset our full position on a rebalance day.

Hedging at the Same Time
We can do more. Because we have 50% of our investment available above our volatility threshold, we can now go short the 10 worst performers in the Dow at the same time we reduce long positions. We don’t know that these worst performers will move in the opposite direction, but we do know that they will underperform. In fact, the combination of reducing position size using volatility, and hedging at the same time using available funds, gives enhanced performance (see “Improving our model,” below).

The final method has a return of 15.7%, a volatility of 24.28%, and a return-to-risk ratio of 0.646. That’s twice the return with a ratio about 50% better. It doesn’t eliminate the drawdown during the 2008 financial crisis, but it shows good overall stability.

There is Always a Better Way
Investors need to consider alternatives, always seeking better returns at lower risk. This article was intended to point out three simple, but sound, concepts: Buying strength is better than buying weakness, reducing volatility during periods of extreme risk is a sound principle and identifying strength and weakness can be used to profit and reduce risk using arbitrage.

A strategic or tactical approach to investing doesn’t need to be complicated to be good and it doesn’t need to use obscure markets or chase the latest fad. Active management can generate the same returns as passive investing with half the risk. It’s your money.

Page 2 of 2
About the Author