Friday, June 23, 2006


Yesterday’s post discussed how valuation discrepancies in a capitalization-weighted portfolio overweight overvalued stocks and underweight undervalued stocks. Since many investors have a large amount of their money in S&P 500 capitalization-weighted index funds, most investors are subject to this misallocation.

As stated by Rob Arnott in my post from yesterday:

Now if every asset is trading above or below its true fair value, then any index that is capitalization-weighted (price-weighted or valuation-weighted) is automatically going to have us overexposed to every single asset that's trading above its true fair value and underexposed to every single asset that's trading below its true fair value.[i]


There are several ways to overcome this misallocation.

1. Use non-capitalization weighted indices. Arnott suggests indexes based upon non-valuation factors such as book value, cash flow, revenue, ECT. Pick, for example the 500 largest stocks based upon book value or the 500 companies that have the largest work force. Arnott includes studies that demonstrate that indices based upon these non-valuation metrics outperformed the capitalization-weighted S&P 500 index.[ii]

Does it work? You bet. The graph below shows that the thousand largest by capitalization over the past 43 years, the red line, would have taken every dollar you invested and turned it into 70 dollars. Well that's awesome, that's what a quarter-century bull market from '75 to '99 does -- the biggest bull market in US capital markets history.

Taking a dollar to seventy dollars is remarkable. But if you use any of these other measures, any of them, you do roughly twice as well. In fact a little better than twice as well for the average: 160 dollars for every dollar at starting value. It's a huge gap. Look also at what happened after '99. The S&P 500 is still down 10 percent in total return including income. Fundamentally weighted indexes: up 30 percent.

Why does it work? A capitalization-weighed index has a bias toward large stocks that cost more, or have larger market capitalization. Many of these stocks are overvalued and as a result, such a portfolio is over weighted with overvalued stocks. Similarly, these capitalization-weighted indices are under weighted in undervalued stock. If you change the mix to a different measurable selection criterion, you remove this return-killing bias.

2. Value-based investments. John Mauldin, the publisher of the “Thoughts from the Frontline”, proposes value stocks and other instruments to overcome this bias. A value based investing technique seeks out undervalued stocks and holds them until the market recognizes their value. Value investing is a valid and effective methodology in a Bull Market or a neutral market. But in a Bear market, a value investment will still fall with the rest of the market. Not by as much, and there may be some winners in the portfolio. But it is still swimming against the momentum of the market.

3. Relative Strength, Momentum based investing as practiced by the Author. This approach is an absolute return methodology and seeks to NEVER lose money. We follow the market. When it moves up, we buy the strongest moving investments and hold them until they slow. We get out near the top and avoid the steep pullbacks. When the market is in a sideways movement, we hold cash. When the market is in decline, we hold cash and some investments that move inverse to the market. This methodology avoids the entire “Noisy Market”[iii] problem. In fact, we use the “Noise” to our advantage and avoid the downside of inefficient pricing “Noise”.

Today’s post and yesterday’s post discuss a matter that further discredits a “buy and hold” methodology. It is just one more reason to spend more time in the Desert of the Real!