My Rotation Model! - An explanation of this part of my Methodology
Initially written: 02/1974 and Updated: 11/24/10
This is my 4th Article in a series I call: "Why Most Investors and Nearly All Traders Lose Money." It is also expanded in one of the chapters I have in my (un-published) book. The title of my book is: Decoding Wall Street.
"Rotation is simple a part of our life's process that we seldom ever get a handle on. When we do, something always positive occurs." Steve Bauer.
It is one of the Three Pillars of my Methodology of "Investing Wisely." (for and over-view of my Methodology - please see my Personal / Private Blog) http://twitter.com/#!/InvestRotation
The term Rotation Model was introduced to me while in University. Several "old - at the time - investors" hired me to chart for them. It was at that time, and for over a year - I hand charted about 100 Indices and Companies per day for these wealthy people. Coincidently while taking a math class the lights came on, when I was able to calculate how "Rotation" worked. I have enjoyed remarkable success refining this part of my methodology ever since.
If you've spent any time at all following financial markets, you've probably heard the term "sector rotation." It is generally accepted that sectors of business tend to profit more, or perhaps less, in certain stages of an economic cycle. This simple arrangement of stages provides me a very useful road map to "Investing Wisely." I have taken this principle to a more specific level and dropped the word 'sector' and added all Indices, Sectors, Industry Groups and Securities. That's a lot of "Rotation" to follow, but computer models make the job efficient.
A Definition of My Rotation Model:
My Rotation Model is one of my "Three Pillars" of my methodology and an investment strategy involving the movement of money from one sector and/or industry group and/or company in a rotational manner. This work / analytics permitted keeping a focus on where the lowest risk, and the highest return (combination) is currently taking place. It sprouted as a theory from NBER (National Bureau of Economic Research) data on economic cycles, dating back to 1854. It's thanks to this cadre of government and academic economists whom we know the start, end and duration of each business cycle and now for me the same for the stock market cycle.
Years ago, as part of the development of my Methodology, I had a void that just kept haunting me. I could not figure out why some very good companies did not go up, as they should during a bullish move of the stock market. Remarkable, to me, some securities even had disappointing price movement during these bullish time frames. This enigma continues today - what appears to be an excellent investment often disappoints. Fundamentally, and Technically - they met all the standards of this new bee -financial analyst (that was me!). The textbooks and securities' market authors were wrong in theory, and I was disappointed more than just a few times before I caught on. That was over 50 years ago.
I performed a study after study on everything that I could read, and it kept bringing me back to Rotation. That information collectively did not work either. That is, until I broke it down to Sector, Industry Group and Company fundamental valuation modeling combined with my SHB Cycle. (My SHB Cycle is another paper you may want to read).
It was apparent, way back then, and it still is clear that there is a fundamental rotation going on, but the question was - Why, How did it Work? I needed to identify the basics of this process of this rotation, and everything that I read was technical in nature. In the end, the technical analysis portion of My Rotation Model is still quite important, but definitely not the dominant discipline.
I soon found that the fundamental valuation modeling is essential as the starting point but not in the manner you, or I might expect. I mentioned or have implied that after doing hundreds of valuations of companies that I realized that was the key.
I have a proprietary way to screen a large universe of companies, that gives me several very important directions pursue. For example, I always want to know what sectors are currently in favor and those that are out of favor. I often use the bell-curve to explain my work, and it applies to the 15 or sectors and over 200 industry groups that I use for modeling.
Like in the bell-curve there are always companies to buy at one end and always companies to be shorted at the other end, and the rest and majority are in the middle. This is perfect because it enables me to focus on those that are on the Bullish 'end on the left' at times when I am anticipating a Bullish Inflection Point and to focus on those that are on the Bearish 'end on the right' when I am anticipating a Bearish Inflection Point. I hope I am making sense to you, and that you are beginning to understand the principle that - there is a great deal of work / analytics necessary before you make investment decisions. The good news is that - as we cycle from the bullish camp to the bearish camp we have plenty of time to do this work / analytics and be in phase (sync.) with the marketplace.
I have found that few people / investors seem to understand how important that last couple of sentences are!
A Bell Curve Helps Explain Why "My Rotation Model" is so Important:
Notes for the above Bell-Curve: The far left is where the very best (Top) bullish candidates for buying currently reside in a given time frame. The far right is where the very best (Bottom) bears candidates for shorting currently reside in another given time frame. The blue line or Bell-Curve has three important areas of consideration. The Top and between -2 and +2 are where most companies are most of the time. The far Left and the far Right is where rather few companies reside at any given time. The Bullish - Top 5% at or around Bullish Inflection Points and the Bearish - Bottom 5% at or around Bearish Inflection Points.
It is vitally important that you understand that all companies are constantly rotating and cycling into and out of favor over time. That means that at one point of time, say the period of one year or more, there are only about 5% or less of all the companies in a given universe that are "Top, Bullish or perhaps Bearish candidates" for taking investment positions. Therefore, on the above graphic of my Bell Curve, consider the bottom line (axes) also as a time line.
Offering you an analogy or perspective for understanding: Remember in school that in every single class of students there were very few A's and F's, more B's and D's and lots of C's. It's the same with "Investing Wisely." Buy only the "A's" and Short only the "F's" is my advice.
Now I will share just a bit about the necessity of the Technical Analysis side of this research procedure. In a nut-shell, it is all about the trend, momentum, and relative strength of the Indices, Sector, Industry Group and Company. This approach is unique from the textbooks and all the formulas that are being promoted in today's cyber world. Actually, and with regard to My Rotation Modeling - technical analysis is just another conformation or rejection of what I learn from the fundamental valuation studies. Perhaps you would like to know that rejection is rather frequent. If I do not have both (fundamental & technical conformations) clearly pointing in the same direction, I move on until I have a substantial list of companies that have both forms of my analytics going for them. It's a matter of simple having both a belt and suspenders approach to "Investing Wisely."
I mention in other articles, that I have a universe of only about 1,500 companies with special focus on the current companies that have a positive trend, momentum and relative strength. ('Positive' in bullish environments and "Negative" in bearish environments.) If my client allocation model is to own 12 - 15 securities at a given time then I must find my very best one percent (1.0%) of the candidates for buying or candidates for shorting. Again that is in concert with whether I am focused on a bullish cycle or a bearish cycle. So, let's say in my consulting business, that I am asked for my top 50 companies by some research or asset management firm. I am still within the top five percent (5.0%) of my rather conservative universe of quality companies. That's something for all Investors to ponder - before making investment decisions.
Recapping just a bit - the job is huge and with an excellent computer programs I am constantly immersed in My Rotation Modeling. Remember also that while I am looking for the "best of the best," that means that there is a very heavy weighting on risk vs. reward. Risk management is the number consideration for a professional asset manager. So the companies I select are often not the best performers during my holding period. Others, often outperform but the risk at the time of making decisions to invest, they (the big winners) did not meet my risk / reward formula.
This is serious stuff -- exclusively for you folks that are Serious Investors and are truly interested in making money in the Stock Market ...
For Me and perhaps For You -- The Good News -- is ...
I have figured out how to make money through the development of my conservative methodology.
Keep Smiling, have Fun - "Investing Wisely",