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URL:  http://boards.fool.com/blending-at-a-whole-new-level-26834345.aspx

Subject:  Blending at a Whole New Level Date:  7/22/2008  12:37 AM
Author:  Zeelotes Number:  211385 of 250277

Introduction

Although some may think that moving between blends based on the market's environment is too prone to curve-fitting, in my view the opposite is the case. It only makes sense to me to have the blend match the environment. My greatest concern all along as it relates to curve-fitting was the tendency of most to arrive at a blend using the Solver and all of the screen's history with the thought that what was a perfect match with the past would be a perfect predictor of the future. In my book, that is the premier definition of curve-fitting. Of course, with the work last fall a new standard was set for arriving at a blend. A standard based on using all the history up to the date of the new blend's selection (end of each year) for the next year's investment. Then to take that idea and backtest it going forward from the earliest available data right up to the present to see if it actually worked, not just a hope and a prayer, but a system built on concrete evidence that the method had worked in the past and should continue to work going forward.

It only makes sense that a measure that is the most predictive for bullish periods will not be the measure that is most predictive for bearish periods. How could that not be the case? Obviously, it must be. It is for this reason that I set out on this backtesting journey to determine if it would be possible to find a way of doing this that would have worked in real-time historically.

Determining the Bullish and Bearish Periods

Some may have the thought that this is the most important element in the mix. I don't think so. I've tested exponential moving averages on various indexes and the results are pretty consistent. All outperform a random selection of screens for a blend and most definitely outperform an equal weight of all screens by a huge margin. I've also tested other timing systems and found the results to be consistent. The primary component, therefore, is not the means for identifying the periods, but rather, the consistency in doing so.

So I thought I'd pull out one of my simplest methods for determining bullish and bearish periods. It simply takes the new highs and new lows of the index and subtracts the one from the other and applies a weighted moving average to the result to remove excessive whipsaw. When it is above, say zero, you are bullish, and when below, you are bearish. I've used values I've tuned a bit, but anyone is welcome to get the data from Pinnacle and go through the same process. This results in more trades than with the EMA crossovers, but I prefer it anyway simply because it is something that is tried and true and has a very long history of out-performance. From 1978 the Nasdaq Composite has returned a CAGR of 25.25% during the bullish phases and -8.07% during the bearish compared to a long-term buy and hold of 10.89%. Using this indicator the signal turned to bearish on 10/19/2007 and has remained so till now. Can't hardly beat that, now can you?

Treynor/GSD for the Full History as a Benchmark

As a benchmark I'm using the Treynor/GSD which was selected last November as the absolute best measure when used for the full history -- that is, without dividing up between bullish and bearish periods.

Benchmark  Treynor/GSD
CAGR 31.43%
GSD 16.21
Sharpe 1.57
UI 5.16%
Drawdown -26%

Parameters Used

Begin Date:      1/2/1989
End Date: 11/9/2007
Universe: Value Line
Screens Held: 5
Ranks: 1-4
Total Stocks: 20
Switch: NH-HL
Index: Nasdaq
Smoothing: Yes
Weighted

All Measures Compared

The following table is the fruit of a test where all measures are used for the period up to 7/18/2008. The test compares using Ascending and Descending sort. I'm sorting the results based on the highest return during the bullish period using a descending sort. Here we see that the Sharpe Ratio has finally gotten its revenge since it comes out on top. In fact, Sharpe/GSD descending produces the highest return for the bearish period for the descending sort measures -- some are higher for ascending.

                           ASC      ASC        ASC         ASC       DESC      DESC       DESC        DESC
Screen Bullish Bearish Bull Win % Bear Win % Bullish. Bearish. Bull_Win % Bear_Win %
Sharpe 34.83% 25.83% 59% 74% 54.28% 15.58% 78% 63%
Sortino 35.65% 26.48% 63% 74% 51.49% 22.89% 78% 72%
Ulcer Performance Index 37.76% 31.27% 59% 76% 50.25% 15.31% 80% 65%
CAGR/(UI^x) 36.75% 27.23% 59% 76% 49.91% 15.92% 81% 67%
Alpha 41.04% 27.64% 69% 76% 49.31% 11.57% 63% 69%
Calmar 35.95% 29.16% 65% 78% 48.29% 17.16% 78% 67%
GSD 31.40% 24.70% 67% 76% 47.21% 14.45% 57% 72%
Downside Deviation 30.46% 24.76% 67% 72% 46.93% 15.96% 57% 70%
Jensen 37.30% 27.10% 70% 74% 46.41% 12.74% 59% 69%
Upside Potential Ratio 30.59% 26.29% 67% 76% 45.91% 25.32% 74% 70%
CAGR/(GSD^x) 35.68% 26.65% 59% 72% 45.83% 20.91% 74% 72%
CAGR/(SF^x) 36.05% 26.34% 59% 78% 45.70% 14.84% 81% 65%
Upside Potential 27.89% 21.35% 65% 78% 45.65% 16.40% 57% 69%
Normalized Trough Count 35.04% 30.43% 69% 83% 45.54% 15.68% 57% 72%
Beta 35.00% 25.13% 70% 69% 40.10% 4.57% 61% 69%
Treynor 37.86% 24.50% 69% 74% 39.14% 22.01% 70% 72%
GSD Ratio 37.25% 29.08% 61% 80% 37.77% 29.13% 72% 80%
Ulcer Index 33.74% 27.33% 76% 81% 37.72% 26.70% 63% 76%
Sleep Ratio 31.27% 25.88% 69% 80% 36.99% 24.05% 61% 76%
Sharpe/(GSD^x) 36.16% 25.94% 61% 74% 35.29% 30.44% 74% 83%
CAGR/(UPI^x) 32.24% 23.69% 70% 80% 35.24% 29.58% 63% 78%
Correlation 43.65% 31.38% 70% 78% 32.75% 13.96% 59% 72%
Treynor/(Beta^x) 40.48% 26.46% 65% 78% 32.19% 24.82% 67% 74%
Treynor/(GSD^x) 36.83% 23.76% 61% 74% 30.09% 25.01% 61% 76%

Nothing comes close to the Sharpe for the bullish period whether you use an ascending or descending sort. But for the bearish period you can also see that under ascending sort these three do quite well: Correlation, Ulcer Performance Index, and Normalized Trough Count. I'll be showing the results of these below.

Improved Blends -- Raising the Blend to a Whole New Level

Here is a table showing the results from above which I will follow with some comments and observations:

Begin Date:     1/2/1989                                                                             
End Date: 11/9/2007

Bullish: Sharpe Sharpe Sharpe Sharpe
Desc Desc Desc Desc
Bearish: Sharpe/GSD Correlation Normalized Trough Count Ulcer Performance Index Russell 2000
Desc Asc Asc Asc
CAGR 45.59% 46.10% 46.19% 46.07% 9.19%
GSD 18.44 23.25 18.4 24.44 18.18
Sharpe 2.03 1.7 2.05 1.63 0.34
Ulcer Index 5.10% 7.60% 5.16% 7.87% 13.85%

Bullish:
Reb Win % 78% 78% 78% 78%
Screen Win % 68% 68% 68% 68%
Bearish:
Reb Win % 83% 78% 83% 76%
Screen Win % 71% 70% 76% 73%

Yrs >= Index 89.47% 89.47% 94.74% 94.74%
Yrs >= 0 94.74% 94.74% 94.74% 100.00% 68.42%
Drawdown -23.92% -38.46% -24.91% -38.21% -46.04%
Bullish 54.28% 54.28% 54.28% 54.28% 9.52%
Bearish 30.44% 31.38% 30.43% 31.27% -3.45%

Years ROI ROI ROI ROI ROI
1989
18.08% 23.50% 17.39% 18.73% 14.22%
1990 -0.02% -0.32% -2.42% 10.59% -21.45%
1991 90.80% 117.82% 99.15% 111.33% 43.68%
1992 67.15% 39.42% 46.01% 41.50% 16.36%
1993 45.87% 66.41% 33.70% 56.17% 17.00%
1994 28.07% 45.14% 24.54% 52.97% -3.18%
1995 91.62% 74.60% 90.28% 72.06% 26.21%
1996 39.90% 42.84% 37.09% 37.37% 14.76%
1997 41.36% 47.19% 48.15% 61.50% 20.52%
1998 36.26% 11.03% 37.70% 14.51% -3.45%
1999 144.16% 151.31% 142.16% 135.41% 19.62%
2000 77.02% 51.61% 87.86% 73.27% -4.20%
2001 37.17% 57.99% 49.53% 30.48% 1.03%
2002 35.77% 27.87% 42.84% 7.62% -21.58%
2003 36.15% 29.30% 32.95% 61.92% 45.37%
2004 43.54% 53.87% 46.59% 43.08% 17.00%
2005 56.08% 66.58% 65.94% 57.85% 3.32%
2006 15.58% 3.42% 19.63% 5.91% 17.00%
2007 13.03% 43.13% 14.69% 57.44% -2.75%

Observations and Conclusions

I personally see this as an excellent way to apply all the research at our disposal for blend selection. This increases Sharpe to levels above two while also adding 13 to 15 points of CAGR. That is very impressive IMO. Last fall I didn't think it would be possible by any means to get the Sharpe above 2.0.

I would choose the Sharpe for the bullish periods and the Sharpe/GSD or Normalized Trough Count for the bearish side. Both of these produce a low Ulcer Index which I consider important.

What would my forward expectation be for a blend like this -- I'd be very happy with a CAGR in to the 20-25 range, but not the least bit surprised if it resulted in a 25-35 CAGR over the next twenty years. There is absolutely no question that this method beats out a toss of a coin, or just throwing darts, as the means to select the screens one uses to build a blend. Could it be just a statistical fluke? Sure, but to no more degree than anything and everything else done on this board.

Now for those who just love to have something to torpedo -- have at it! I challenge anyone to come up with a method for building a blend that surpasses what is being shown here. If a challenge can get a passenger rocket built, it certainly ought to be able to get a blend built that is worthy of this board and its long history. :)
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