If you limit your portfolio to the safest US stocks, there is no edge over passive investing with ETFs
By Jeffrey Cohen, President and Founder, US Advanced Computing Infrastructure, Inc. A consultancy and investment advisory firm.
There is no edge when you remove risky companies in your stock portfolio.
Last night we updated our Chicago Quantum Net Score to reflect market conditions. US stock indices are showing weakness and this is reducing future, expected returns. US Treasury (UST) bonds, notes and bills are also showing weakness through higher yields, which raises risk-free rates of return. The combination reduces the expected gains from investing in US equities.
With rising UST interest rates, US-listed stocks face a higher borrowing cost on their variable-rate debits, which are usually priced with a spread added to a policy or bank-to-bank lending rate. Those spreads were recently 1% to 9% over 3-year Treasury Notes based on diversified US Corporate Bond indices from Bloomberg and ICE.
Our changes to model input parameters were as follows:
Companies may have 5x Debt to Net Income (was 4x)
Minimum volume traded yesterday: 30,000 shares (was 20,000)
Risk-free return is 5.46% (was 6%)
Floor rate of return for each US equity index is 5% (was 6%). This impacted the Russell 2000 since it has a historical negative return.
There are 843 companies that meet these requirements of being profitable and having nominal debt. Their stock variance is low: 3.4 x 10–5, and expected returns are 9.45%. The best 50 stocks have an insignificant 1-tick of benefit, on average. The 50 worst stocks have 40-ticks less benefit than the whole basket, which is also fairly insignificant.
As a result, the best ‘long’ US stock portfolio has 15 stocks, and the top 25 portfolios (with 13 to 22 stocks) all have one-tick of alpha or edge. This is an insignificant edge over holding any of the US Index ETFs we use in our model, which includes $SPY, $QQQ and $IWM. In other words, if we limit our stock picks to profitable firms with un-leveraged debt, we end up with a portfolio (and associated trading costs), that is no better than buying the market.
This is not what we were hoping to find. We were hoping that these lower risk stocks had offsetting correlations and stock price movements that allowed for…