An Intermediate-Term High-Performance System
A system that keeps you invested in the strongest stocks of the S&P100 Index and without any of its weak stocks should enable you to outperform the market by a wide margin. For high performance, you must use the right kind of strength measurement, regularly rank the stocks, and keep the highest-ranked stocks in your portfolio..
Consider that the market appreciates more than 10% a year on average. That is, the market has a long-term upward bias. S&P500 is used by professional analysts and money managers as a proxy for "the market." The S&P100 is made up of the 100 largest and most important stocks in the S&P500. The S&P100 tracks the S&P500 closely but has slightly outperformed it over the years.
Thus, a portfolio consisting of all the stocks in the S&P100 is likely to rise about 10% a year on average. Half the stocks in the portfolio may be rising and half may be falling, but the rising stocks will usually have a slightly greater impact on the portfolio than the declining stocks (otherwise, the index would not rise). If we disregard the impact of weighting factors, we can make a general observation. If the declining stocks generate an average loss of 5% a year over 10 years, then the rising stocks must generate an average gain of 15% a year in order for a portfolio consisting of all the stocks in the S&P100 to gain an average of 10% a year. Similarly, if the declining stocks generate an average loss of 10% a year over 10 years, then the rising stocks must generate an average a gain of 20% a year in order for the portfolio to average a gain of 10% during the same time. Declining stocks cancel out the gains of rising stocks. If a stock rises 35%, the portfolio benefits greatly, unless it contains another stock that declines 35%. If it does, then the portfolio gains nothing. What do you think the performance of the portfolio would be if the portfolio had all the rising stocks but none of the declining stocks?
Assume that we measure the strength of each of the stocks in the S&P100, and then rank all the stocks in the order of their strength. If we were to keep a portfolio invested in the 50 strongest stocks, it should greatly outperform a portfolio invested in all 100 stocks. The weak stocks would not be present in the portfolio to counterbalance the performance of the strong stocks. If we were to screen the 50 strongest stocks and eliminate the weakest 20 of the 50, it is reasonable to assume that performance will be even better for the remaining 30 than for the 50. Why not focus on the top 10? Because we want to keep the turnover rate relatively low. Stocks will not stay among the top ten nearly as long as they will stay in the top 30. How can we use this idea to create a real-world high-performance portfolio?
First, we need a method of measuring strength. Second, we need to have a procedure for adding stocks to and removing stocks from the portfolio. The Relative Strength Index (RSI) is often used by technicians to measure "strength," but it is woefully inadequate for our purposes. Its "snapshot measurements" are too time-constrained to locate stocks that have what we call "persistent internal strength." Stocks with a high RSI are far more likely to be in an unattractive chart pattern context than stocks that rank high with the strength-measuring tool we use. The "Strength" model we use is far more complex. To give you an idea of what you might do yourself, stockdisciplines.com traders use a strength measurement that requires 6 algorithms for the first sort and then 3 more algorithms are applied to the results of the first sort to derive the final scores. The results of the latter are then ranked. This information should help you conceptualize the process.
Value Line and Morningstar do not use this approach, but a similar system is used in the strength rankings in The Valuator. However, if you do not have access to this kind of ranking system, you could try using the RSI over three time periods periods (for example, the standard 14-day measurement and two others of different longer periods) and total or average the results before ranking them. This may not work as well, but it should be far better than using only the 14-day RSI. Unlike the simple 14-day RSI, these measurements really can help a person find stocks that have a much more attractive pattern context. Of course, the universe of stocks being measured will determine the outcome. That is, the strongest stock can only be the strongest stock among those being ranked. Bear in mind that the highest ranked stocks may not be the ones that have appreciated the most in the last 14 days (the latter may have substantial overhead resistance just above current prices).
Create a high-performance diversified portfolio by ranking all the stocks in the S&P100 according to their strength. Then select the highest ranked 20 to 30 stocks for inclusion in the portfolio. Replace any stock that falls out of the top 20 to 30 list. The negative impact of the cost of buying and selling a few stocks occasionally will be minimal in such a portfolio, especially at deep discount commission rates. Also, even if a stock were to decline 20% before it is sold, its impact on the portfolio would be only 1/20 to 1/30 of 20% or about 1% or less. However, this much loss would be an unlikely event because the stock would probably have been sold while it was still among the top 40 stocks. Another strength of the discipline is that the portfolio is always invested in the 20 to 30 strongest stocks and in none of the weakest stocks. Furthermore, losses would usually be minor, having relatively little negative impact on the portfolio. Remember that the ultimate performance of a portfolio is determined by the percentage of time the portfolio is invested in rising stocks. Empty portfolio slots and declining stocks work against top performance.
Dr. Winton Felt maintains a variety of free tutorials, stock alerts, and scanner results at www.stockdisciplines.com has a market review page at www.stockdisciplines.com/market-review has information and illustrations pertaining to pre-surge "setups" at www.stockdisciplines.com/stock-alerts and information and videos about volatility-adjusted stop losses at www.stockdisciplines.com/stop-losses