There are an infinite number of strategies that an investor or buy side analyst can use to deliver alpha. While I'm an advocate of value investing, there are also technical investors, growth investors, GARP investors … if you can dream it, there's probably an investing strategy that matches it.
Of course, some people can dream up strategies that would make the average person go, “Huh?” These people have taken data mining to an extreme and can come across like the village idiot rambling on about aliens and probes.
Then again, some of those crazy investing philosophies have just enough truth to have become part of Wall Street folklore. While I don’t recommend bringing folklore up in your next interview, it's good to have an understanding of the all the strategies out there, no matter how crazy they might sound.
Besides, some of these are kind of funny. Without further ado, I present some of Wall Street's most famous (or is that infamous?) folk stories:
- The Hemline Index
- “Sell in May and Go Away”
- Sunspots and the Market
- Darts vs. Pros
- Dogs of the Dow
- Super Bowl Indicator
The Hemline Index
The Hemline Index has been part of Wall Street's folklore for a long time, ever since it was first presented by economist George Taylor in 1926.
The Hemline Index is based on the idea that the hemlines (the bottom of the dress for all the fashion-challenged men out there) on women's dresses rise and fall along with stock prices and the economy. When times are good, women are willing to wear shorter dresses and be more daring to celebrate the good times. But when times are bad, women wear longer dresses to reflect the somber mood of the economy and the market.
Does it work? Well, it certainly works as an urban legend given this tale has been around for nearly a century. From a behavioral perspective, it makes sense that women would be willing to be more daring and wear shorter skirts when everyone is feeling good about the economy.
Empirical evidence is not so convincing, though, with some studies showing at best a small correlation between the economy and hemlines. Certainly not enough to generate alpha and make a lot of money, which is what you're trying to do.
The Verdict: So how can you take advantage of the Hemline Index? For the women out there, keep an eye on the fashion trends of your friends and play the role of the contrarian investor. Since trees don't grow to the sky and economies and markets tend to mean-revert, try shifting some of your portfolio out of equities and into safer bonds when you discover that all of your friends are wearing short skirts. The good times aren't likely to last forever.
For the guys, well … here's to hoping for a good economy!
“Sell in May and Go Away”
If you've spent 5 minutes in the finance industry, then you've heard this little rhyme. The idea behind this tale is that stock returns are lower during the summer months. It's been around so long and repeated so often that it's become either a cliché or a proverb, I can't tell which.
While there are many ideas about the logic behind this theme, the data suggest there is a bit of truth to this rhyme.
The one wrinkle with this theme is that average returns from May to October are not negative, just lower than average. So you can't short the market in May and go long again in November and make money from the trade. The hit rate is sub-par as well, certainly not enough to be a profitable trading strategy.
The Verdict: Leave the rhyming to Dr. Seuss and stick to investing.
Sunspots and the Stock Market
At first glance, this bit of folklore really does seem like it was contrived by the village idiot. Amazingly, there is quite a bit of research out there on sunspots and the economy.
First, sunspots are magnetic disturbances caused by discharges of solar radiation from the surface of the sun. Frankly, I have no idea what means, but I do understand that sun spot activity seems to ebb and flow in approximately 11-year cycles.
Proponents of the sunspot effect on the market say that the stock markets and the economy have some correlation to the sunspot cycle - i.e., markets and economies tend to peak when sun spot activity peaks.
But is it correlation or causation?
The Verdict: Given that the economy and stock markets moves across time in cycles and so do sunspot cycles, I'd venture to guess any correlation is spurious. In fact, its possible to interpret the correlation such that the economic cycle causes sunspot cycles. Not likely, but possible. So unless you look to alignment of the stars and Jupiter’s alignment with Pluto to assist in your investment process, chalk this one up as a correlation vs. causation problem and get back to your financial models.
Dart vs. Pros
The Dart Board is a favorite of the Efficient Market Hypothesis (EMH) supporters. Since we all know the markets are efficient [wink, nod] and always reflect all known information, a portfolio of random stocks should perform equally to a portfolio picked by investment professionals.
To test out this bit of folklore, The Wall Street Journal started publishing a listing of stocks picked by pros and compared it to a portfolio of stocks picked by WSJ staffers tossing darts at the stock tables. Remember stock tables in newspapers? No? [Sigh.]
In 1998, the WSJ presented the results of its first 100 dartboard contests. The results? The investment pros won 61 of the 100 contests and had a higher average return.
A clear nail in the coffin of the EMH? Not quite. There are a lot of issues with comparing the two portfolios, including whether the simple announcement of the pros picks caused naïve investors to bid up the stocks of the pros. So I'll give the EMH backers a pass on this one.
The Verdict: I'll be honest, there have been times when the market has gone against me and I wonder in those dark days whether or not a dart board would be better at picking stocks. But then I re-affirm my value investing roots and get back to work. If you truly believe the dart board is the way to go, it's time give up the idea of a buy side career and just become a finance professor instead.
Dogs of the Dow
I think we should change the name of this little jingle to go full alliteration (“Everybody knows you never go full ...”) and call this the Dividend Dogs of the Dow because the strategy involves buying the 10 highest dividend yield stocks of the 30-name Dow Jones Industrials Average index.
This strategy was popularized in the early 1990s and became all the rage for a while afterward. After a string of poor returns, though, the philosophy started to drift away.
The idea behind buying the highest dividend yielding stocks is actually based in value investing since higher yielding stocks are “cheaper” than lower yielding stocks. Unfortunately, buying just 10 stocks from the rather narrowly defined DJIA can leave you with a fairly non-diversified portfolio and potentially massive unintended sector bets (who wants to only own bank stocks during a financial crisis?).
Further, using dividend yield as a value metric has severe shortcomings. For example, it’s possible for a company to pay a dividend greater than its current earnings and inflate its dividend yield. This means the company has to borrow to pay a dividend, which is basically a Ponzi scheme if they continue that strategy indefinitely. Somebody will be left holding the bag, and simply saying it won't be you is not a career-enhancing move. “Let the devil take the hindmost” is not a profitable long-term investing strategy.
The Verdict: The valuation-based methodology behind the Dogs of the Dow makes intuitive sense, but there are better metrics to use. Price/earnings ratios are better than dividend yields, but they have their shortcomings as well. Enron proved that the E in P/E can be manipulated quite easily by self-absorbed management teams. It’s best to stick with cash flow yields as cash flow is harder to manipulate. Empirical studies generally support this assertion.
The Super Bowl Indicator
Should you be rooting for the Green Bay Packers or the New England Patriots? Well, if you believe in the Super Bowl Indicator you’d better put on your cheesehead hat and root for the Packers since the market does better when an NFC team wins.
Or does it?
Over time, the market has done better when an NFC team wins. However, since the end of the TMT bubble that trend has started to reverse and we’ve seen the market do better when an AFC team wins.
So who do I root for??? Tell me!!
The Verdict: This is probably an even more flagrant example of data mining than the sunspot index. Stick with real analysis and leave the sports superstitions to the playing fields.
But I've Got this Great Strategy …
When you are trying to break into a career in investing, be it the sell side or the buy side, it's best to have some understanding of your philosophical leanings toward investing. That way you can seek firms that think like you and can help you become a better analyst.
Whatever you do, don't become dogmatic in your investing philosophy before you've ever worked in the real world. Just remember that if you run around telling potential employers that you have a fool-proof strategy based on sunspot activity, you'll be bounced out of the building quicker than you can say “magnetic disturbances.”