Get Darwinian on Your Portfolio!

Of all the many battles on Wall
Street, the one that strikes us as peculiarly absurd is the recent sniping
between Economists and Technicians. Each of these specialties digests
different data, and operates over widely diverse time frames. Dismissing each other’s
work as if neither discipline has any value strikes us as exceptionally foolish.

Resolving the dispute is a relatively
simple matter of carefully considering timelines and expectations. Technicians tend
to respond to shorter term market moves (like today’s!), while Economists ply
their trade over much longer time frames. By combining these two dissimilar
disciplines, we can develop a view towards both the immediate and distant
futures.

Despite the Red on today’s
screens, the Technicals favor an upside bias over the next month. We are in the
seasonally best period for equities, Indices are near new highs, and despite
recent sector rotation, Momentum remains strong. However, the Macro-analysis
suggests an eventual slowing of the
economy is more than likely. Housing Sales are softening, the Yield Curve is
Inverted, and the Consumer is slowly tiring. Inflation, at both the retail and
wholesale level — core and non-core alike, — is still rearing its ugly head.

In between these two time
periods, we see numerous technical warning signs: Low volume on Up days versus
heavier volume when the market is down; An increasingly narrow advance, with less
issues participating in the gains, and a small number of 52 week high list
despite the indices being at or near multi year highs – all suggest that a high
degree of caution is warranted for equity investors.

What’s an investor to do?

Darwin’s answer is to Cull the Herd. Now
is the time to get Darwinian on your portfolio. The weak, the sick, the lame,
the infirm – they will only hinder your portfolio’s ability to survive. Your
holdings must evolve, your stock selections must prove their adaptability. Its
a case of relative strength – which is essentially the Technician’s version of Survival of the Fittest.

Any stock you own which has failed to participate in the recent
rallies should be aggressively sold.
This is both a defensive
maneuver, as much as it is a way to raise cash for the inevitable buying
opportunity – whenever it may show. My guess (and its only a guess) is
September/October.

As this "long in the
tooth" cyclical Bull market continues to age gracelessly, your best bet is
aggressively shoot those cattle who cannot keep up with the herd. The market is
a cattle drive, and for the good of the herd, you must get rid of those who
fail to keep up.

Adapt. Evolve. Cull.

If
you have a philosophical problem with a Darwinian
approach, then consider this a dose of Intelligent
Design
for your portfolio.

What's been said:

Discussions found on the web:
  1. At These Levels commented on Feb 28

    The Perennial Dilemma

    Barry Ritholz weighs in on the perennial dilemma of those that have appreciation for market timing and macro indicators at the same time, yours truly included.

  2. TonytheTiger commented on Feb 28

    Interesting, even as a short term option trader I notice call options on the Nas are not worth buying. With these short erratic moves it makes for an uncomfortable trading environment. I’m on the sidelines for now, and have been for awhile.

  3. Mike commented on Feb 28

    I’m an QQQQ options trader too. I sold off the last of
    my calls yesterday.

    Now I’m hoping for a stready climb up so it’ll drive
    down the price of September puts 🙂

  4. angryinch commented on Feb 28

    What’s it gonna take for your pal Cody to ever look at a chart? Jeez. Everything rides on funnymentals with him. Has no clue about entry and exit points.

    Yesterday he was pounding the bull drum for DY (Dycom) which had earnings scheduled today. So I took a look at the chart. Gosh almighty. The stock was rising but all the technicals were headed south in a big, old-fashioned kind of way. Momentum tapped out in early Jan. A slam-dunk short if there ever was one. Now down 20% from Friday’s high. I give up on this guy. He’ll never learn.

  5. Barry Ritholtz commented on Feb 28

    You are waiting for Darwin’s revenge!

  6. Brendan commented on Feb 28

    Barry, how does this Darwinian thesis apply to the chunk of my net worth tied up in mutual funds? Should I cull the funds that aren’t beating the benchmarks, or is that putting too much emphasis on short-term performance? (After all, chasing performance in funds is generally regarded as a bad idea. But so is sticking with a turkey.)

  7. GRL commented on Feb 28

    I would like to offer a slightly different approach, based on my understanding of professor Siegal’s “Stocks for the Long Run,” and “The Future for Investors,” two excellent books people should read.

    Yes, cull the herd, but use the fundamental criteria of valuation, business and balance sheet strength and stability, and dividend yield as your criteria, not technical strength. Keep those stocks which, regardless of near term technical performance, have (a) a low valuation as measured by P/E, price to cash flow or whatever, (b) a solid balance sheet and a stable and under-appreciated business model which will not be destroyed the minute someone comes out with The Next Big Thing or The Same Thing You Make For Ten Cents a Ton Cheaper (this requirement eliminates 90% of all tech stocks), and (c) a high dividend yield, which both demonstrates “survival of the fittest” under criteria (a) and (b) and provides both a cushion and a means of dollar cost averaging un the event of a market down-draft (my cutoff for any stock, no matter how good it is under (a) and (b) is a dividend yield of 3-1/2 to 4 percent).

    For me this works better than trying to use technical analysis to, in effect, time the market. I adopted it because I lost a lot of money in 2000-2002, and I got tired of waking up every third morning to discover that a stock I owned missed an earnings estimate and therefore lost half its value (bet there a lot of goog owners who didn’t feel too good today — goog passes criterion (b) above but fails under (a) and(c), so I don’t own it.).

    Besides, I can understand technical analysis and chart patterns only in hindsight, and only after someone explains them to me.

    Of course, professor Siegel like index funds, which I feel are a loser’s game in this market environment (valuation too high, dividend yield too low).

  8. Barry Ritholtz commented on Feb 28

    I beleive that stocks are essentially commodities, in that they are valued on the basis of supply and demand.

    Thats what makes them rise and fall.

    If fundamental analysis is the basis fo that demand, its fine with me — but I can also use relative strength to determine what a lot of fundie homework has determined.

    Its especially important to “Cull” this late in the cycle, as the market narrows and less and less stocks participate.

  9. TonytheTiger commented on Feb 28

    “I beleive that stocks are essentially commodities, in that they are valued on the basis of supply and demand”

    I agree in part. The difference being that stocks react more on demand.

  10. TonytheTiger commented on Feb 28

    The Dow broke resistance, but has retreated back to safe territory. The SP made an attempt and failed.

    This seems like a typical “prairie dog” move….didn’t like the air up there. Not a good sign (short term) at all.

  11. GRL commented on Feb 28

    I beleive that stocks are essentially commodities, in that they are valued on the basis of supply and demand.

    That’s the whole point of technical analysis, which I guess makes you a “technician.” (As demonstrated by the existence of this excellent blog, you are obviously much more than that, so save the response “but I’m more than just that.”) If being a technician works for you, great. It did not work for me in 2000-2002, and I do not believe it will work for me now, if only because I have a day job and can’t sit in front of a CRT all day to monitor my stocks. (I have a very good friend who does that quite well, but I just can’t do it.)

    I am not saying technical analysis is wrong, only that I cannot, for the life of me, understand it in a way that is in any way helpful to me on a “going forward” basis. I can’t tell you how many stocks I’ve owned that looked great technically one day, but then were “broken” the very next day because of an earnings miss, or the CEO saying something, or whatever, and before I could do anything, they lost half their value. It simply does not work for me.

    I am saying that stocks are shares in a business, and if you buy them you own a part of the business of which they are a share. If that is a commodity, it is a commodity in the same way anything that can be bought or sold is a commodity. It does not follow automatically that all commodities are “fungible.” I would argue that, like art, businesses are not fungible (although shares of the same class in a given business are).

    So, the question we all face is: how do we cope with a market where valuations are stretched to say the least, the economy is uncertain (to put it kindly), and share prices are not always guaranteed to go up.

    You have your way, which works for you.

    I have my way, which works for me, and which I offer as an alternative to those who, like me, have neither the time nor the ability to follow, and trade in response to, technical analysis, or the second by second motions of stocks, or the daily (or even hourly) news flow.

  12. GRL commented on Feb 28

    One other comment: Given my approach, I can honestly say, without being short, that I am pleased the market is down today.

  13. B commented on Feb 28

    The Dow hasn’t really broken anything. And neither has anything broken down. The market internals are very bullish. Certain measurements show “top” bullish.

    That said, I keep expecting the market to go down and those internals to deteriorate. Ain’t happening. The bulls are very much in control for the time being. They’ve jettisoned all but the market leaders on this last rally but, that said, the market could go higher. And, if we get a blow off, much higher.

    Now, the BKX, Dow, NAS, R2K, SPX and Transports are all bouncing on four, five or even eight year resistence trendlines all at the same time. The BKX and Transports are sitting right on eight year resistance lines. These lines have held as major tops repeatedly in the past. So, if we break above these lines, there is free roaming until the SPX, God’s Index, hits its next Fib level way higher than here. Doesn’t mean that it would go there but traders, technicians and nearly all program trading will view that as the next resistance. So, the bulls could roam quite higher. I don’t think they can gain the mojo to do so but it is a possibility. I think the top is in and these ridiculous gyrations of 100 Dow points here and there are noise.

    So, even though the CNBCers keep quacking about new highs, in reality we’ve made marginally higher highs in the last few months as the indices push up against the trendlines that are rising as time passes allowing for minor advances in higher highs. The bulls haven’t busted through anything. That ain’t gonna last forever. It’s either clearly bust out or break down if you look at charts ALONE. And since the majority of trading is program trading, you should look at long term chart patterns because those are the rules program trading uses. Not three day, three week or three month patters but long cycle patterns. Years or longer. Not as a buy signal but as another tool in the tool kit.

  14. TonytheTiger commented on Feb 28

    GRL,

    A good example of different types of traders/investors.
    B wrote:The Dow hasn’t really broken anything. And neither has anything broken down. The market internals are very bullish. Certain measurements show “top” bullish.

    That statement doesn’t apply to me as a short term trader. Not to say B is incorrect, but he apparently has a different approach than me. What the market had done in the past several sessions is very significant to me as far as an entry.

    I don’t care if the market is bullish or bearish at this point. I will not enter if, or until both the Dow and SP break the previous high, with volume and at least 2 to one on the a/d. Still, I would be very vigilant and nimble.

    That has worked for me as a full time trader. However, B may be very successful, but with a different approach.

  15. B commented on Feb 28

    I trade intraday or swings when those opportunities develop. I’ve got a model that’s about 80% accurate or put a more appropriate way, allows me to rack up 80% profits against losses of 20% short term if I take the rules and don’t bend them. It’s all in your head. Or my head. Today was a good day. I’ve got a midterm model that’s about 90% accurate and I’ve got a long term adaptive mechanical model which has nailed every major bear market including 1929 without curve fitting. That’s because it breathes with the market and changes with market conditions. It gets a few false signals every few years but hell I can get right back in if I get jerked out.

    I’ve got thousands of man hours in work and more than that in market experience. A hobby, passion or obsession. One of the above. I’m not sure. But born out of being screwed constantly buy certified financial planners and advisors who can’t pick their arse from a hole in the ground. Who know shit about markets, intermarket analysis, investing, risk management, cycles or anything else. If I sound bitter, I am dammit. Those jerkoffs have cost me enough losses to buy a Ferrari. Or a few of them.

    I don’t mind if we do this up down up down up down charade forever. The average true range is increasing on the daily activity so there is more money in short term action. ATR increases near a multi-year high are not pleasant sorts of behavior for the long term investor from a historical perspective.

  16. B commented on Feb 28

    Btw, not investment advise but for those home gamers, a good fund to use which follows the advise Barry is giving about culling losers is the Brandywine fund or the Turner Midcap Growth Fund. There was some comingling there at one time so they have a similar philosophy.

    That philosophy is constant pruning of their portfolio to maintain stocks with very high relative strength. They buy anything. Oil, commodity stocks, tech, banks, whatever. It’s all about relative strength. Or to use a dirty word, momentum. They are very disciplined and merciless about chucking losers. They don’t give poor management or poor pricing action a second chance. You screw up and you are out. Now, that said, they are awful funds to hold in a declining market. So, good to hold in bull markets and bad to hold in bear markets. They get crushed in bear markets so I say it enough that the one person who goes out and buys these things on a whim and loses their life savings……………..Gotta go. Got a meeting.

    NOT advice. Just an opinion.

  17. muckdog commented on Feb 28

    Good column, BR. Of course, Darwin was anti-Darwinism later in his life. How should I implement that in my portfolio?

  18. Paul Hickey commented on Mar 1

    Shouldn’t investors always be getting “Darwinian on their portfolios”. If someone isn’t always monitoring their portfolio they shouldn’t be managing their money at all.

  19. Bynocerus commented on Mar 1

    “Of course, Darwin was anti-Darwinism later in his life. How should I implement that in my portfolio?”

    Not to go off on a tangent here , but considering that Charles Darwin penned “The Descent of Man and Selection in Relation to Sex” in his ’60’s, I’m not sure how he was anti-Darwinism [sic] later in life.

    And, considering that evolution by common descent is the bedrock of modern biology, I’m not sure how your comment is relevant to anything. Even if creationist were able to resurrect Mr. Darwin GI Joe style and convince him that he was wrong, 99.9% of all biologist wouldn’t give a flying eff.

    Sheesh.

    Back on topic, I noticed that only 8% of stocks on yhe NYSE made new highs when the NYSE made a new high the other day, and only 8.5% of NASDAQ stocks made a new high along with the Nas last month. Talk about a narrowing rally. What did Desmond say the reading was in 00? 6% or something like that. Inching ever closer to Mr. Correction

  20. Dave commented on Mar 1

    Interesting discussion, but a simple momentum approach using no-load mutual funds has trounced the market since 1999. Simply sum the nominal 3Mth, 6Mth, and 1Yr returns within the mutual fund universe, pick the top no-load funds based on this momentum score within sectors (Small Growth, Small Value, Mid/Large Growth, Mid/Large Value, Foreign), and replace a fund when it drops out of the top quartile of its sector. Easily implementable through one of many discount fund supermarkets such as Brown & Co. Only have to trade once per month. This strategy nimbly and continually transitions portfolio from laggards to leaders and has beaten the market by 9 pecentage points per year since 1999, through bull and bear markets (outperformed for yrs ’05 and back by: 5.7%, 4.7, 15.0, 6.7, 15.8, 7.0, 7.1). During this 7 years, Wilshire 5000 returned 2.9%, and this program 11.9%.

  21. John Navin commented on Mar 2

    “Get Darwinian on their portfolios” has that Quentin Tarantino ring to it, doesn’t it? “I’m gonna get Medieval on you” is the line from Pulp Fiction. Same poetic sense.

    Darwin was talking about adaptability, not strength. What’s the line about the race not always going to the swiftest?

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