It was a nervous week for me. A mid-week crash in the bond market sent me into high-speed selling mode for the two small-cap portfolios I manage. As a student of markets, I always try to learn as well as earn. This past week, I learned more than I earned. That’s trading.
Before delving into the actual trading, allow me to once again cover the study aspects that are basis of my trading.
The small-cap equity market universe is huge, numbering many thousands. But by eliminating stocks that:
(i) Did not trade on NASDAQ or the NYSE
(ii) Were rated ‘sell’ or ‘strong sell’ by analysts
(iii) Market caps that exceeded the approximate range of $150 million to $5 billion
(iv) Lowest average daily volumes,
I was able to reduce my study candidates list to 295 stocks. Of these 295, 189 traded on NASDAQ.
“Study” in my case includes using a proprietary model I use that relatively ranks all 295 companies weekly on the basis of earnings and payout fundamentals as reported to the SEC that week. My premise is that if I invest in shares of best-performing companies, over time my portfolio ought to:
(ii) Outperform the major equity market indexes known as ‘alpha’
Through extensive back-testing I know the model works. By consistently trading the top 20 stocks and rebalancing weekly while disregarding the technical picture, the positive returns for the past 53 weeks were +72.68% vs +26.29% for the Russell 2000 ‘small-cap’ index.
The Russell 2000, I discovered, is a mix of small-cap and mid-cap (with stock components having up to $10 billion in capitalization), but that is another story.
Another discovery is that my model produces a weekly turnover of almost 50%, which means that it’s probably a good idea to also apply a system of technical analysis to assist with timing of the buys and sells. Using a deep discount broker, I’m not concerned with slippage from commission costs.
As I applied this portfolio to real money, I also discovered that two stocks that ranked in the top 7th percentile fundamentally had drawdowns of -26% and -23% in the first couple weeks. So, if managing risk as well as reward is part of your portfolio criteria, then additional protocols are required, such as perhaps:
(i) Trading smaller positions in more stocks
(ii) Limiting sectoral exposure, and
(iii) Using stop orders or drawdown rules.
Simply by increasing the portfolio size from 20 to 30, I discovered the positive returns for the past 53 weeks dropped only from +72.68% to +67.70%, while the drawdowns were significantly less; hence there was a superior risk/reward potential.
Also, I discovered that my biggest position drawdowns were in groups like solar companies, which were located in China and subjected to:
(i) Central bank tightening pressures
(ii) Analyst downgrades based on their belief that operating margins in this group were being squeezed due to competition.
So, despite superlative performance of the operating fundamentals, the stock prices were rocked. That, in itself set up a situation I need to manage because when your turnover is something approaching 50% per week, it’s not a buy-and-hold strategy where positions can be held long enough for recovery of over-sold stocks.
By applying a -5% stop rule to my trading, which I need to program into my system on account of the imbecility of actually showing these orders to brokers, I believe the risk/reward performance would improve somewhat.
Thematic volatility has been another factor to deal with. As soon as I started with these two portfolios – one being mostly China-based companies in the Emerging Markets portfolio (EM) and the other mostly US-based companies in the Advanced Markets portfolio (AM) – I had to face the dour music from:
(i) People’s Bank of China (PBC) new monetary tightening policy
(ii) North Korea and South Korea war threats, which depressed the share prices of the EM portfolio, day after day
From that I learned that I should smooth out the volatility of my two portfolios by combining the list of US and non-US stocks in my study list, now totaling 295, and select only the best of the best. I have yet to do that, but in time I shall.
For now, here is a snapshot of the two portfolios, each of which started with $50,000 two weeks ago.
The net result after some heavy selling on Tuesday and Wednesday on my part, brought on by a free-falling US treasury bond market, which I believed contained elements of a potential October 19, 1987 Black Monday type crash, was that the EM portfolio dipped in Net Liquidation Value to $48,307.83 and the AM portfolio to $51,296.42.
Combined, the NLV is $99,604.25. Based on the concern I had on those two days, I consider myself fortunate. Moreover, these two portfolios now hold cash of $22,808.69 and 26086.72, for a total of $48,895.41 or almost 50%.
I decided not to resort to the use of inverse ETFs to hedge, mostly because these were fast markets when I was selling and with the number of positions I had to reduce or liquidate, I happened to be far too busy entering orders at that time.
This week I am going to discuss my personal views with clients before taking more action. At the end of the day, risk management is Job One, so I believe that all or most will see the wisdom of my combining the two portfolios.
Having expanded my universe to 189 NASDAQ-listed stocks and 106 NYSE-listed stocks, I reviewed the fundamental rankings displayed by my proprietary model. Your model may be different than mine, but in my case I averaged the position ranking of the 295 and discovered the average for the NASDAQ group was 148.7 while for the NYSE group the average was a very close 146.3. Actually, I was surprised at the relatively close fundamental rankings of the stocks on the two exchanges.
However, I also discovered a significant difference in the quality of these issues as the NASDAQ-listed stocks were either the best or the worst of the 295. For example, the NASDAQ listings showed up as the top 5, 10 of the top 15, and 21 of the top 30. But they were also the bottom 6, 9 of the bottom 10, 15 of the bottom 17, and 20 of the bottom 23. I’ve not had a chance to run the price performance over the past year for these stocks, but I’ll try to do that next week.
Trading small caps takes time to study plus inexhaustible patience and an acceptance of the drawdowns that go hand in hand with volatile market conditions – the same conditions that can lead to extreme profitability.
This is a process.
Next week, I’ll present the text pertaining to small-cap and micro-cap growth stocks from my book Lessons from the Trader Wizard.