As a guy who remembers actually reading trading orders over the phone to a broker (and having him repeat it back before it got placed, then it got placed and I would wait for him to call back while the order was sent to the trading pit, carried to the floor trader, the floor trader would bucket the order, then get me a crappy fill and send it all back whence my broker would call me with that condescending yet caring sounding voice that only brokers could pull off and give me the “tough luck” news about my “disappointing” fill while muttering something about “fast markets”), yes, I do occasionally marvel at how far things have come technology wise. 

So though I may be something of an “old dog” when it comes to the markets, I am all for electronic markets – I want my fill as quickly as possible.  But every time I read about how high frequency traders are executing trades – buy and sell – in a fraction of a second, and how high frequency trading often accounts for 70% of the stock market trading volume, I can’t help but to think that there is a terrible “glitch induced” bad thing out there waiting to happen. 

But hey, in the immortal words of Alfred E. Nuemann, “What, me worry?”

But What about the “Average Joe”?

I do worry sometimes about the “Average Joe”, who does not have the ability to be a high frequency trader even if he wanted to be.  Oh sure, he can punch an order into his cell phone with impressive speed, but sorry to inform you Bub, it ain’t quite the same.

Still, the “Average Joe” who is only a part-time investor because he is too busy working for a living – or too busy looking for a job so he can work for a living, as the case may be – simply cannot compete on a technological basis.  That’s the bad news.  The good news is that he doesn’t necessarily have to.  This leads us to:

Jay’s Trading Maxim #7: Rocket science is great but when it comes to investing, it’s not necessarily necessary.

Let’s illustrate this bold (and seemingly outdated) assertion with a simple example. 

The Endless Debate: Large-Cap versus Small-Cap

One of the great never ending investment “debates” involves “large-cap stocks versus small-cap stocks.”  This debate starts when someone asks the question “which is better, investing in large-cap stocks or investing in small-cap stocks?”  And then people who fancy large-cap stocks chime in with their argument favoring such stocks and those who prefer small-cap stocks counter with their own argument.  It’s a lot like people arguing politics.  If one is a left winger then he or she views everything through a given prism and sees a given event in a certain light, whereas if one is a right winger then he or she views everything through an entirely different prism and thus sees the exact same event in a completely different way.

And what typically ensues in both cases – whether arguing investment styles or politics – is a mostly pointless argument based on little more than personal preference.  At this point let’s (mercifully) put aside politics and focus just on stock investment styles.

In reality, the answer to the question “which is better, large-cap or small-cap” is, “it depends.”  On what you might ask.  Well, in this case it appears to depend mostly on which is presently performing the best. 

Jay’s “Rocket Science Free System” (RSFS)

To clarify, I am not offering a system that involves rocket science analytics for free.  Quite the contrary, I am simply going to describe a method that is completely devoid of anything that might resemble “rocket science” – but which still has managed to work pretty darn well.

-For this system we will use the Russell 1000 (ticker RUI) which tracks large-cap stocks and the Russell 2000 (ticker RUT) which tracks – you guessed it – small-cap stocks.  

-After each trading day we will look at the 252 day percentage rates-of-change for both ticker RUI and ticker RUT.  If RUI has outperformed RUT over the past 252 trading days we give our RSFS Model a reading of +1, otherwise the model reads 0.

-If the RSFS reads +1, we want to hold large-cap stocks.  This can be accomplished by buying the ETF ticker symbol SPY, which tracks the S&P 500, which enjoys roughly a 99% correlation with the Russell 1000 (and which trades about 120 times the number of shares traded per day for ticker IWB, an ETF that actually tracks the Russell 1000).

-Now here is the tricky part – if the RSFS reads 0, then exit SPY and simply hold cash.

-One technical note: I use a one day lag – so if on Tuesday’s close the model goes from 0 to +1 then SPY is purchased at the close on the next trading day.  The same applies when the model goes from +1 to 0.  SPY is sold at the close of the following trading day (Sure the high frequency guys would have gotten filled at 8:30:000000000001 Central Time the following morning, but in this case I don't know that that is necessarily an advantage).  

How has all of this worked out?  The results appear below.  For the record, these results are hypothetical results generated using the indexes RUI and RUT themselves and not ticker SPY.  But results generated using SPY would be quite similar and we prefer SPY for actual trading purposes due to the vastly greater liquidity of ticker IWB.

Figure 1 displays the growth of $1,000 invested in RUI when the RSFS Model is +1 (the blue line) versus the growth of $1,000 invested in RUI when the RSFS Model is 0 (the red line).

Figure 1-Growth of $1,000 invested in Ticker RUI when Large-Cap stocks have outperformed over previous 252 trading days (blue line) versus all other days (red line) - 1989-2012

Notice a difference?  For the record, since 12/31/89 through 6/20/12:

-$1,000 invested in RUI when the RSFS Model is +1 grew +487% to $5,876 (no interest, dividends or taxes are included).

-$1,000 invested in RUI when the RSFS Model is 0 declined -32% to $684 (no interest, dividends or taxes are included).

Further if we assume that interest is earned while out of the market at a rate of just 1% per year, then from 12/31/1989 through the present:

-$1,000 grew to $6,650 versus $4,019 using a buy-and-hold approach.

-The worst calendar year for the system was 2001 (-12.1%).

-The worst calendar year for a buy-and-hold apporach was 2008 (-39.6%).

-The system’s worst decline in equity was -22% versus -57% using a buy-and-hold approach.

Summary

So when it comes to stocks, yes it is apparently true - "size matters”.  Also the simple method I have detailed here suggests that it may still be possible for the “Average Joe” to make some money even if he cannot buy and sell huge baskets of stock shares a couple times a second. 

I hate to sound old-fashioned but I can't help but to think that that’s a good thing.

Jay Kaeppel

Staff Writer and Trading Strategist

Optionetics.com ~ Your Options Education Site

NOTES:

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