There's No Edge In Stock Picking

Those that subscribe to the efficient market hypothesis believe that there’s no edge or advantage when it comes to picking stocks. Thus, stock-picking is a binary event and boils down to a 50/50 probability or simply chance. Everything that can be possibly known about a stock is known, and all the available information, technical analysis, and fundamental analysis is priced into the underlying stock price. The efficient market theory may be the Achilles heel of professional money managers’ performance and their inability to outperform their benchmarks. A staggering 92% of actively managed funds do not outperform their benchmark hence the massive inflows into passive index investing and ETFs.

Furthermore, when looking at The Russell 3000 Index over a 26-year timeframe (1983 to 2006) which comprises the largest 3000 U.S. companies, 39% of stocks were unprofitable investments, 64% of stocks underperformed the Russell 3000 and 25% of stocks were responsible for all the market’s gains. Taken together, only 36% of stocks outperformed the Russell 3000 index. If the efficient market theory is correct, is stock picking a useless endeavor? If stock-picking boils down to chance, is there a strategy that places the statistical odds of success in one’s favor?

Efficient Market Hypothesis

Markets aren’t always functioning efficiently. Markets can be irrational and become overbought or oversold. Outside of these extremes, however, markets are efficient, and over the long-term the vast majority of actively managed funds are unsuccessful at beating their benchmarks. Everything that can possibly be known about a stock is known, and there’s no edge in stock picking. As of Q1 2019, for the ninth consecutive year, the majority (64.5%) of large-cap funds lagged the S&P 500 last year. The longer the timeframe, the weaker the performance, after 10 years, 85% of large-cap funds underperformed the S&P 500, and after 15 years, nearly 92% are underperforming the index (Figures 1 and 2). These dismal results hold true across large-cap, mid-cap, and small-cap funds. Even if these actively managed funds happen to outperform their index, it’s due to chance, and this margin of outperformance is primarily negated by hefty management fees, rendering stock-picking useless. To further emphasize this point, for the Russell 3000, 39% of stocks were unprofitable investments, 64% of stocks underperformed the index, and 25% of stocks were responsible for all the market’s gains. Taken together, only 36% of stocks outperformed the Russell 3000 index.

Stock Picking

Stock Picking

Figures 1 and 2 – Time based underperformance of actively managed funds relative to the S&P 500 (Active Fund Managers Trail S&P 500)

Stock Picking

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Figures 3 and 4 – Data summarizing the performance of individual stocks relative to the Russell 3000 index. Highlighting the fact that only 36% of stocks had a higher return than the index and 25% of stocks accounted for all of the market’s gains. (The_Capitalism_Distribution)

Even Distribution of Returns

If the fact that 92% of actively managed funds do not outperform their index and that only 25% of stocks accounted for all the market’s gains wasn’t compelling enough, the distribution of returns also supports the efficient market hypothesis. The S&P 500 moves in a standard distribution over time, the number of daily moves is evenly distributed. There’s an equal and even number of days where the market moved up 0.6% as it moved down 0.6% (Figure 5). The market has fluctuated between a 2% loss and a 2% gain 94% of the time. Markets move in a standard distribution over time; there is no pattern or predicable cycles over the long-term which renders stock picking to random chance or a 50/50 probability. Interestingly, the market does move up over time due to positive skew in these data attributable to the fact that indexes are capitalization-weighted. This means that successful companies receive larger weightings in the index. Conversely, unsuccessful companies receive smaller weightings and are inevitably removed from the index. This disproportionally favors successful, growing companies hence the fact that only 25% of companies account for all the market gains.

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Figure 5 – Standard distribution of daily market moves of the S&P 500 for 65 years

Options Provide Statistical Edge

The only way to consistently and reliably profit from this even distribution and market behavior is via options trading. Options trading allows one to profit without predicting which way the stock will move. Options trading isn’t about whether or not the stock will move up or down; it’s about the probability of the stock not moving up or down more than a specified amount. Options allow your portfolio to generate smooth and consistent income month after month without predicting which way the stock market will move. Options are betting on where stocks won’t go, not where they will go. Running an option-based portfolio offers a superior risk profile relative to a stock-based portfolio while providing a statistical edge to optimize favorable trade outcomes. Options trading is a long-term game that requires discipline, patience, time, maximizing the number of trade occurrences and continuing to trade through all market conditions. Put simply; an options-based approach provides a margin of safety with a decreased risk profile while providing high-probability win rates.

Life Insurance Parallels

Insurance companies sell policies based on risk factors, then price these policies to their advantage. Insurance companies are betting on probabilities and sell overpriced policies above their expected losses. The insurer agrees to pay out a specific amount of money for a specific loss (i.e. death). In return, the insurance company is paid monthly premiums based on this risk-based revenue model. Insurance companies sell policies with a premium cost level that maximizes a statistical edge to the insurance company’s benefit. The goal is to collect premiums over the course of the policy and never payout on the policies they sell. So, the probability of paying out on the policy is very low while the premiums received, over the policy lifespan will exceed your total benefit. In terms of life insurance, it’s the probability that you won’t die before your predicted lifespan so the insurance won’t have to pay. In order to spread the potential payout risk, the insurance company will sell as many policies as possible to collect as much premium income as possible.

Options trading is much like insurance. I receive premium payments (policy payments) in exchange for selling options (insurance). I sell these options with a statistical edge (underwriting) and a high-probability of winning the trade (insurance won’t have to pay). Occasionally, options move against you (death occurred) and you’re assigned stock (insurance is paid out) however in order to spread the risk of being assigned shares, options (insurance) are sold across a diversity of tickers that include both stocks and ETFs with varying expiration dates and optimal sector exposure. Additionally, risk is mitigated by appropriate capital allocation, position-sizing, and holding cash reserves in the portfolio.

Results

Sticking to a set of fundamentals, this approach can provide long-term, high-probability win rates to generate consistent income while circumventing drastic market moves. Over the previous 11 months through both bull and bear markets, the win rate percentage was 84% (231/262). Over the previous 11 months, the options-based portfolio outperformed the S&P 500 over the same period by producing a 0.9% return against 0.4% for the S&P 500 (Figures 6-8).

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Figure 6 – Options based portfolio return (0.90%) in comparison to the S&P 500 return (0.43%)

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Figure 7 – Comprehensive options metrics over the previous 11 months

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Figure 8 – Dot plot summarizing ~260 trades over the previous 11 month period

Conclusion

Markets are efficient, and over the long-term the vast majority of actively managed funds are unsuccessful at beating their benchmarks. A staggering 92% of actively managed funds do not outperform their benchmark. Furthermore, when looking at The Russell 3000 Index over a 26-year timeframe (1983 to 2006) which comprises the largest 3000 U.S. companies, 39% of stocks were unprofitable investments, 64% of stocks underperformed the Russell 3000 and 25% of stocks were responsible for all the market’s gains. Taken together, only 36% of stocks outperformed the Russell 3000 index. Everything that can possibly be known about a stock is known, and there’s no edge in stock picking, hence the efficient market hypothesis. The only way to profit from this even distribution and market behavior is via options trading. Options trading allow one to profit without predicting which way the stock will move. Options allow your portfolio to generate smooth and consistent income month after month without predicting which way the stock market will move. Options are betting on where stocks won’t go, not where they will go and provide a statistical advantage.

An options-based portfolio has allowed me to do something 92% of actively managed funds haven’t been able to accomplish and that outperforms the broader index consistently despite the volatility and the month of August negatively impacting my portfolio in a disproportional manner. Selling options with a favorable risk profile and a high probability of success is the key. Options fundamentals provide long-term durable high-probability win rates to generate consistent income while mitigating drastic market moves. I’ve demonstrated an 84% options win rate over the previous 11 months through both bull and bear markets while outperforming the S&P 500 over the same period by a wide margin producing a 0.9% return against a 0.3% for the S&P 500 with a lower risk profile. Taken together, options trading is a long game that requires discipline, patience, time, maximizing the number of trade occurrences and continuing to trade through all market conditions with the probability of success in your favor.

Noah Kiedrowski
INO.com Contributor

Disclosure: The author holds shares in AAL, BAC, C, CVS, GPS, GE, HLF, KSS, SLB, TRIP, URBN, USO, WBA, and X. However, he may engage in options trading in any of the underlying securities. The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses. The author is the founder of www.stockoptionsdad.com where options are a bet on where stocks won’t go, not where they will. Where high probability options trading for consistent income and risk mitigation thrives in both bull and bear markets. For more engaging, short duration options based content, visit stockoptionsdad’s YouTube channel.

Stress Test Success and Rising Interest Rates

For traders and investors, the political climate has been unlike anything we have ever seen in recent times!

There are plenty of opportunities if you know where to look. I will help to bridge the gap between Washington and Wall Street, finding you the best stock plays being driven by politics.

  • The Federal Reserve increased its short-term interest rate by a quarter of a percentage point and stated that economic growth has been “rising at a solid rate.”
  • The Federal Reserve indicated that two more rate hikes are likely in 2018 followed by three in 2019
  • A consortium of domestic banks passed the Federal Reserve’s stress test that was more rigorous than last year’s criteria
  • The banks are well capitalized and positioned to withstand severe economic conditions under high unemployment, housing depreciation, and credit defaults
  • Banks are in a position to release largess to shareholders via an increase in dividend payouts, share buybacks, and more unobstructed risk appropriate growth
  • Wells Fargo (WFC), Citigroup (C), Bank of America (BAC) and J.P. Morgan Chase (JPM) received approval for their capital return plans while Goldman Sachs (GS) and Morgan Stanley (MS) received conditional approval

Rising Interest Rates:

Back in March, the Federal Reserve expected the economy to continue to strengthen and inflation to rise shortly. The economic strength coupled with inflation telegraphed an environment that was ripe for more interest rate increases over the near term. This economic backdrop has gained momentum, and the Federal Reserve recently increased interest rates by a quarter percentage point and indicated that two more increases are highly likely in 2018 for a total of four this year. The consensus from the committee was perceived as very bullish on the domestic front and that the Federal Reserve will continue on its path of rising interest rates along with higher inflation expectations. In March, the committee stated that “tax changes enacted late last year and the recent federal budget agreement, taken together, were expected to provide a significant boost to output over the next few years” and more recently economic growth has been “rising at a solid rate,” unemployment has “declined” and household spending “has picked up.” The committee sees economic growth hitting 2.8 percent for the full year followed by 2.4 percent in 2019. The committee also indicated it continues to expect three more rate hikes in 2019. "The committee expects that further gradual increases in the target range for the federal funds rate will be consistent with the sustained expansion of economic activity, strong labor market conditions and inflation near the committee's symmetric 2 percent objective over the medium term." Provided this backdrop of positive economic commentary, financials such as Goldman Sachs (GS), J.P. Morgan Chase (JPM), Citigroup (C) and Bank of America (BAC) are poised to benefit as a result. Continue reading "Stress Test Success and Rising Interest Rates"

Tariffs Inducing Market Headwinds and Risks

For traders and investors, the political climate has been unlike anything we have ever seen in recent times!

There are plenty of opportunities if you know where to look. I will help to bridge the gap between Washington and Wall Street, finding you the best stock plays being driven by politics.

  • Trump has been in a back and forth tariff battle with the Chinese for months and now has indicated that the EU may be subject to tariffs
  • This is creating a tit for tat trade war between the world’s two largest economies, the United States and China
  • As these trade war exchanges between the U.S. and China, in particular, unfold, world markets have experienced increased volatility
  • Multinational companies are starting to voice concern that these trade fears are becoming the most significant risk to their respective businesses
  • Multinationals just as 3M (MMM), DowDuPont (DWDP), United Technologies (UTX), General Electric (GE), Boeing (BA) and Caterpillar (CAT) have been under weakness as the tough trade rhetoric continues

Trade War Rhetoric Heats Up

Reports indicated that the Trump administration planned to block many Chinese companies from investing in domestic technology and block additional technology exports to China. It was reported that the administration was drafting rules that would apply to companies with at least 25% Chinese ownership from buying companies involved in "significant industrial technology." Despite these reports, Peter Navarro, a top trade advisor, said the market was overreacting to fears the administration would restrict foreign investment as part of its trade actions against China and other countries. "There are no plans to impose investment restrictions on any countries that are interfering in any way with our country. This is not the plan," he said. He insisted that markets were taking the wrong message from the reports, stating, "I would say more broadly I think today's market reaction is a very large overreaction," Navarro said. "What we have here with Trump trade policy is a tremendous success for this country and this market. It's very bullish." Going further, Treasury Secretary Steve Mnuchin stated that all of President Trump’s advisors were unanimous on the Chinese investment restrictions and that any mixed messages were unfortunate. Hence, part of the uncertainty that corporations and foreign governments are voicing concern. Continue reading "Tariffs Inducing Market Headwinds and Risks"

Make money like Goldman Sachs (new video)

Goldman Sachs (NYSE_GS) declared record earnings of $3.4 billion for the three months prior to June, only months after it accepted government assistance. My gut reaction is how can an institution that so embodies Wall Street be making so much money as if the credit crisis never happened.

In today's short video I'm going to be analyzing the stock of a Wall Street juggernaut known as Goldman Sachs. The video shows you how you could have used MarketClub's "Trade Triangle" technology to make a ton of money just like Goldman Sachs.

I'd love to hear what you think about the Sachs bounce back or your thoughts on where this stock is headed in the future. Please watch the video with my compliments.

All the best,

Adam Hewison
President, INO.com
Co-creator, MarketClub

Finding Big Trades with MarketClub's Trade Triangle Technology (New Video)

In today's video, I will be using MarketClub's "Trade Triangle" technology to discover stocks that are potentially getting ready for big moves on the upside.

I will show you a quick and easy way to replicate these moves using using MarketClub's tools for the trader. With just a few clicks of the mouse, you too will be able to spot these trades.

You can use MarketClub's "Trade Triangle" signals for Stocks, Futures, Precious Metals, forex, ETFs and Mutual Funds. To the best of my knowledge there is no easier, faster way to find winning trades.

The video is free to watch and there is no need to register. I would love to get your feedback about this video on our blog.

My personal guarantee.

All the best,

Adam Hewison
President, INO.com
Co-creator, MarketClub