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Strategies & Market Trends : TA Science Projects & Experimental Indicators -- Ignore unavailable to you. Want to Upgrade?

To: ftth who wrote (113)	5/25/1998 11:16:00 PM
From: ftth	Read Replies (1) \| Respond to of 237

Using the Alpha/volatility ratio: From an interview with Louis Navellier in TASC: -------------------------------- Could you define a high-alpha stock strategy? High-alpha stocks are stocks that demonstrate better monthly returns independent of the stock market. We regress or statistically compare the returns of individual stocks to the returns of the broad market. The returns of the stock that are correlated to the market are referred to as the betaÿ, while the returns of the stock that are independent of the returns of the market are referred to as the alpha. A stock with a positive alpha theoretically is outperforming the market based on its own merits and hopefully will continue to do so. A stock with a negative alpha, however, would be a stock to avoid because it is underperforming the market based on its own merits. So the first step is identifying positive alpha stocks? Right. At our firm, we can test any stock-screening method that's been used on Wall Street. I have two quantitative analysts here who only research what's being applied by Wall Street analysts. We've tested everything imaginable, and nothing we've looked at has been better than screening based on alpha. Another method to measure performance is the relative strength of the stock. How does the relative strength strategy compare with the high-alpha strategy? A lot of people confuse the two, interestingly. Relative strength is simply the stock's performance relative to the overall market. Consider that during a bear market, a stock may be declining slower relative to the overall market. That stock will have a high relative strength but still have negative returns. On the other hand, a stock can only have a positive alpha if the returns from the stock are independent of the overall market movements. Right now, there are examples of stocks with good relative strength but with zero or possibly negative alphas. For example? One stock that comes to mind is Casino America (CSNO). That stock has a good relative strength reading but an alpha near zero. All of its performance is correlated to the market. The key to a stock having a high alpha is for the stock to zig when the market zags. If the stock zigs when the market zigs, then the stock is highly correlated with the market and will have an alpha near zero. I would not expect that stock to necessarily outperform the market. So alpha is the reward part in the risk-and-reward equation. How do you measure risk? We measure a stock's risk by calculating the standard deviationÿ of the monthly returns over the previous 12 months. This measurement indicates the stock's volatility or unsystematic risk. Some stocks deviate 5% a month, while other stocks deviate 30% a month. Does the volatility stay constant? No. The fascinating thing is that risk on Wall Street is not constant. What is low risk today often becomes high risk down the road. For example, the technology stocks are not risky today because they have been badly beaten up. On the other hand, utility stocks are much riskier today than they have been on a historical basis. So risk on Wall Street is always changing. How do you incorporate a stock's volatility into your screening to select the best stocks to own? We measure a stock's alpha and then divide the alpha by the standard deviation of the returns. The stocks on our buy list are sorted by this reward/risk ratio. What's an attractive reading for this ratio? Exceptional stocks will have a ratio of 0.4 or higher. Our buy list will typically include stocks with a reward/risk ratio of 0.3 or higher. How many stocks do you find with these characteristics? When I first started publishing a buy list, I had a universe of more than 360 stocks and I listed about 30 stocks a month. Today, because of our firm's computer power, I have a universe of more than 6,000 stocks and our buy list runs a little over 400 stocks. By looking for stocks with high reward/risk ratios, our buy list has returned over 20% annually. You know what's interesting? I've found that stocks used to stay on my list for about four to five months, which is not the case now. Back then, the inefficiencies we would find in the market would last a while. How long do stocks stay on the buy list today? Today, stocks are only staying on the buy list for about two and a half months. Markets are really much more efficient today. As a consequence, it's more important today to be more nimble in managing money. There's more to your work than looking for high reward/risk ratios. The computer screens I run to generate high-alpha stocks are totally automated. There's no subjective human judgment involved at all. My whole purpose in life is to beat the computer. I try to outsmart the first screen with other fundamental screens.