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The Stock Market's On-Base Percentage

08/28/06 12:10:27 PM PST
by Terrence M. Quinn

The key statistic that doubles annual returns!

In his bestseller book Moneyball, author Michael Lewis describes the use of one key statistic by Oakland Athletics general manager Billy Beane to build a consistently winning major league baseball team. The key statistic is known as the on-base percentage (OBP), which measures the probability that a player will not make an out. A player with an OBP of .400 will make an out in six out of 10 plate appearances, but will get a hit or a walk during the other four plate appearances.

The beauty of the OBP stat is that it sets aside all of the other extraneous information and focuses on a player's ability to help his team score runs. There are three outs in an inning. So long as the team at bat has not made three outs, anything is possible. However, once they have made the third out, their turn at bat is over and they cannot score any more runs in that inning. It follows then that the more players a team can get on base, the more runs they will score and the more games they will win. Home runs, batting averages, and runs batted in are all secondary. A walk is as good as a hit and the OBP captures this information.

Oakland's emphasis on the OBP stat has certainly been rewarded by the team's success since Beane became the general manager in 1997. It took a few years to turn things around, but Oakland posted a winning season in 1999. They have had a winning season every year since, one of only four major league teams to do so. Only one team (the New York Yankees) has won more games in the American League than the Oakland Athletics have over the past seven years.

The world of stock investing appears to also have its own key statistic. Emphasizing this key indicator, like the OBP in baseball, can also lead to consistent winning results. The rationale for using this statistic is also pure and logical, and its value may surprise you. The key factor is the relative strength. More specifically, the key is the relative strength for the prior six months. On the surface, the stat can be as useful for the stock market as the OBP is to baseball. As we will see, its appropriate use can lead to returns well above market indexes. Further, just like the OBP has a team contribution quality, the relative strength indicator draws attention to the stock's performance relative to the market and its contribution to the portfolio as a whole.

RELATIVE STRENGTH
The relative strength (RS) tells us simply how a stock has performed relative to the market over a given time frame. Often, the index used in this situation is the Standard & Poor's 500 and the time frame generally is for one year, but neither is mandatory. The Dow Jones Industrial Average (DJIA), the Russell 3000, or some other appropriate benchmark can also be used to measure the overall market. Similarly, you can use whatever time frame you please. The equation for RS is simply:

RS  = (Current Stock Price/ Previous Stock Price)
(Current Index Price/ Previous Index Price)

An RS of greater than 1.0 indicates the stock has outperformed the market, while less than 1.0 indicates below-market performance. Sometimes you will see RS expressed as a percentage or percentile ranking. An RS of 68, for instance, would indicate that the stock has outperformed 68% of the stocks in the index during the time period. Under this format, a rating above 50 indicates the stock has outperformed, and vice versa. By the way, there is another indicator with a similar name known as the relative strength index (RSI). The RSI is different than the RS and be sure you are using the RS to apply any of the concepts discussed here.

WHY THE RS?
The RS for the market is similar to the OBP for baseball in that both cut to the heart of the matter. For the majority of investors, the goal is to consistently outperform the market. If your portfolio is composed of stocks that individually outperform the market, it follows that your portfolio in the aggregate will outperform. A baseball team might have a player leading the league in home runs, but if nobody is able to get on base ahead of him, the team is not likely to win very many games. Similarly, your portfolio may have one or two great stocks, but if most are laggards, your portfolio is likely to lag as well. Can the RS be for the stock market what the OBP is to baseball? We decided to find out.

THE RS STRATEGY
To determine the effectiveness of RS, we need to first clearly state our RS strategy and then back-test the strategy to determine its effectiveness. As indicated, to apply the RS indicator, you need to define the time frame over which you are going to compare the stock performance to the market. Our working expectation was that an RS using a six-month time frame would produce the best results. A shorter time frame would lead to many false alerts. It is hard to expect that how a stock performed over, say, the prior week would be helpful in predicting its performance over a one-year period. At the other end of the spectrum, a time frame of five years is equally likely to be misleading. A six-month time period, it would seem, could well produce the best results.

It is a long-enough period to identify the major trend, but short enough to take advantage of it. As we will touch upon later, the six-month time period proved to be superior to other time frames. We will refer to the relative strength over the prior six-month period as RS-6 and state the initial step in our RS-6 strategy as follows:

Rule 1: Once you have identified your list of possible investment candidates, make your final stock selections based upon their respective RS-6 ratings. Continue to use whatever method you prefer in order to identify possible investment candidates. Then, applying rule 1, you add the RS-6 rating as a final filter.

It would be attractive for many reasons if after making our final selections based upon RS-6 we could then not touch our stock portfolio again for at least 12 months. Once a stock has begun to underperform relative to the market, we will want to identify it and remove it from our portfolio. Here again we want to select an appropriate time frame to update our portfolio. So the next step in our simple strategy is:

Rule 2: Every three months, update your portfolio by eliminating the stocks that are underperforming according to their RS-6 and replace them with stocks with favorable RS-6 ratings.

There you have it with two simple rules. Buy stocks with favorable RS-6 ratings and update your portfolio quarterly. It does not get much simpler than that. Now, we want to see just how effective following these two rules can be.

LET'S SEE HOW WELL IT WORKS
We devised a 10-year study to determine just how valuable the use of the RS-6 statistic might be. Russell maintains and publishes many indexes. Among them are the Russell 1000 Growth Index, the Russell 1000 Value Index, the Russell Mid-Cap Growth Index, the Russell Mid-Cap Value Index, the Russell 2000 Growth Index, and finally, the Russell 2000 Value Index. These six indexes give us complete coverage of the equity markets from small-cap to large-cap stocks and both value and growth stocks.

We used these six indexes as the universe of investment choices in our study. We looked back over the 10-year period beginning in January 1996 and ending in December 2005. As you know, during this period we experienced some of the strongest (late 1990s) and weakest (2000-02) stock markets in recent history. Notwithstanding this volatility, the overall return of the Standard & Poor's 500 during that period was 8.58%, consistent with expected returns for the market over a 10-year period. A 10-year study during this time frame enabled us to test the strategy during different market conditions but with a normal long-term return.

We began by going back to January 1, 1996, to determine the RS-6 for each of the six indexes. We then hypothetically invested in the one index that had the highest ranking at that time and held it throughout the first quarter of 1996.

On April 1, 1996, we then updated the six-month performance for each of the six indexes and purchased (or stayed in) the best-performing index at that time. We continued this process for every quarter through the end of 2005. Throughout the entire 10-year study, the only criteria for selecting among the six indexes was its RS-6. No other criteria entered into the decision. Moreover, we simply updated the portfolio on a quarterly basis, no more or less frequently. The results, therefore, would give us a clear indication of the value of the RS-6 indicator.


FIGURE 1: RESULTS OF RS-6 APPLIED TO THE RUSSELL INDEXES (1996-2005). The annual rate was 21.85%, which is more than twice the 8.58% return on the S&P 500 during the same time period.

THE RESULTS WERE SURPRISING
Quite frankly, our expectation was that the RS-6 strategy would yield, perhaps, moderately positive results. However, the actual results were surprising. Figure 1 summarizes the results.

Adjacent to each quarter over the 10-year period, we have listed the index that was selected using the RS-6 indicator. Under the "Result" column, we entered the return for that index in the quarter expressed to the second decimal place. A reading of 1.06 indicates a 6% gain, whereas a reading of 0.94 indicates a 6% loss. We were then able to calculate the annual return for each calendar year and compare the returns against the S&P 500 for each year over the entire 10-year period.

Use of the RS-6 indicator generated an annual return of 21.85%. This phenomenal rate exceeds by more than two times the 8.58% return on the S&P 500 for the same period. To put this return into even further perspective, of the 2,000 or so mutual funds that had been around 10 years or more by the end of 2005, only three had a better return--and then by less than one percentage point.

Some more observations about the results are worth noting. The RS-6 strategy outperformed the S&P 500 in nine out of the 10 years studied. The only exception was 1996, the first year of the study, which means that the RS-6 has outperformed for nine consecutive years. Another observation is that when both market indexes had three consecutive losing years, the RS-6 strategy only had one losing year, 2002, and even that year the loss was less than 10%.

For sake of space, we did not offer here our analysis using three-, nine-, and 12-month RS indicators. To summarize those results, we found that the six-month RS produced the best results. A three-month, nine-month, and 12-month RS numbers all produced favorable results relative to the market, but the best results were obtained using the RS-6 approach.

SUMMARY
In this article we wanted to share with you an observation about the markets. Specifically, we observed that a portfolio composed of stocks with strong RS-6 ratings, updated quarterly, appeared to have a pretty good chance of outperforming the market. We then devised a straightforward 10-year backtest designed to quantify for us just how valuable the RS-6 indicator might be. Our results were very positive. Not only did the RS-6 outperform the market, it far outpaced the overall market.

Returning to our comparison between the RS-6 indicator and baseball's OBP, we think the two are similar with respect to their applications. Both offer clear and direct indications of future success captured in a single indicator. Not every baseball team has embraced the OBP, nor certainly will every investor use the RS-6 indicator in making their investment decisions. The study we described here suggests that the RS-6 indicator is worthy of your serious consideration.

Whether and to what extent you incorporate this indicator into your stock selection process obviously is entirely up to you. In recent years, other baseball general managers have had to make their own determination about Oakland's use of the OBP. We invite you to weigh the merits of the RS-6 indicator.

SUGGESTED READING
Quinn, Terrence M., and Kristin A. Quinn [1998]. "Zero Cost Averaging," Technical Analysis of STOCKS & COMMODITIES, Volume 16: April.



Terrence M. Quinn

Terrence M. Quinn is a senior vice president and senior investment officer for First Midwest Bank, headquartered in Itasca, IL. He also serves as an adjunct faculty member for Indiana University (Northwest). He can be reached at terry.quinn@firstmidwest.com.

First Midwest Bank has not added any product or service information to TRADERS' RESOURCE.
Title: Senior Investment Officer
Company: First Midwest Bank
E-mail address: terry.quinn@firstmidwest.com

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