A member recently asked me if a screening strategy with fewer criteria performs better than one with many criteria. As irony would have it, a few days later after I was asked this question, Wesley Gray and his colleagues at Alpha Architect published a paper on SSRN comparing several of the value-oriented AAII Stock Screens to a simple valuation model. The study’s results are not an apples-to-apples comparison to the way we track the performance of the screens (I’ll discuss the differences momentarily), but it did find that only our Piotroski High-F Score screen fared as well as a screen that simply seeks non-financial stocks with low ratios of EBITDA (earnings before interest, taxes, depreciation and amortization) to TEV (total enterprise value).

Valuation is among the biggest drivers of stock returns. A strategy solely focused on low valuations will have good returns if it identifies enough stocks.

The challenge with any strategy is making it investable. It is quite common for an analysis of indicators to divide the results into deciles, or 10 evenly split groups ranked from lowest to highest. Even if the universe of stocks studied for the analysis is narrowed in some fashion, each decile may still contain far more stocks than the average individual investor is willing to hold or can cost-effectively hold. (In Gray’s study, the EBITDA/TEV screen identified an average of 96 stocks.) There is also a behavioral aspect to consider: How willing are you to hold stocks that are otherwise unattractive?

This is where adding additional criteria can be beneficial. By adding additional criteria to a screen, the list of passing stocks can be narrowed down to a manageable level. More importantly, undesirable traits can be weeded out. Gray’s ValueShares US Quantitative Value ETF (QVAL) overlays economic moats and financial strength on top of valuation measures. Our Model Shadow Stock Portfolio overlays profitability, domicile and exchange-listing requirements on top of a simple strategy designed to identify small companies trading at very low valuations. I’ll add that all AAII screens use more than a single indicator for identifying stocks.

An element of human interaction is helpful as well. A good screen only knows what it is told to look for. It knows nothing beyond its criteria. As such, a screen can have historical or backtested results and still identify undesirable stocks. After all, companies can experience surprises (both good and bad) that are beyond the scope of the screen. To get around this unsystematic risk, you need to build a large enough portfolio (e.g., 15 or more stocks).

So, what’s the maximum amount of criteria you should use in a stock screen or a stock selection strategy? The answer partially depends on what you count as a being a criterion. Technically, the Piotroski: High F-Score screen only looks for stocks with a minimum F-Score and not excluded by three other restricting criteria. The F-Score itself, however, is based on nine different parameters. Joel Greenblatt’s Magic Formula screens for stocks with return on capital greater than 25% and selects the 30 with the highest earnings yield. This sounds like just two criteria, but return on capital for this screen requires calculating tangible capital from five balance sheet items, and earnings yield is calculated as dividing earnings before interest and taxes by enterprise value (as opposed to merely the inverse of the price-earnings ratio).

The answer further depends on what you want to exclude from your results. Greenblatt’s seemingly simple strategy was initially based on a database of only exchange-listed stocks. This necessitates including a criterion to exclude over-the-counter stocks. Our Model Shadow Stock Portfolio screen has restricting criteria to omit ADRs, financial stocks, Chinese stocks, limited partnerships and stocks with share prices below $4.

There is a point at which a screen will fail to identify a sufficient number of stocks, or no stocks, because it is so restrictive. This can occur when too many criteria are used. A balance can be found by selecting the key traits you want in a stock (e.g., low valuation, earnings growth, price momentum, dividends, etc.) and overlaying additional criteria to omit stocks you want to absolutely avoid (e.g., over-the-counter stocks). Don’t obsess over the amount of criteria used in your screen, but rather focus on the general characteristics you desire in a stock. In other words, there isn’t a magic number of criteria you should target.

I looked at the AAII screens to see if there was any noticeable trend in the number of criteria used, as I sensed that some of you would feel unsatisfied without an actual number. Out of the 10 screens with the best performance from inception, seven used either eight or nine criteria based on what is listed on AAII.com. I view this more as coincidence than anything else, especially given the diversity of how those screens approach stock selection.

As far as the results published in the study mentioned above are concerned, Gray and his colleagues restricted the analysis to stocks with market capitalizations ranking in the largest 60% of all NYSE-listed stocks. When no stocks were identified, the portfolio balance was allocated to a universe of mid- and large-cap stocks. The stock screen results we show on AAII.com do not have market capitalization restrictions, unless specifically part of a given screen. When no stocks are identified, we treat the portfolio balance as being allocated to cash. Furthermore, the Gray study looked at returns for the period of 1963 through 2013, whereas the results on AAII.com are calculated from the beginning of 1998 through the most recently completed calendar month. (The authors do caution in their study about their returns potentially differing drastically from what appears on AAII.com.)

• Constructing Winning Stock Screens – AAII president John Bajkowski explains how to translate investing concepts and strategies into stock screens.
  
• Investing’s Odd Couple: Value and Momentum – A common screening approach is to seek stocks with complementary characteristics. Here’s why seeking value and momentum together may make sense.
  
• Does It Matter How Complex a Screen Is? – Tell us on the AAII.com discussion boards.
  

The U.S. bond market will be closed on Tuesday in observance of Veteran’s Day, but the stock and futures market will operate on normal hours. On behalf of everyone at AAII, thank you to those of you who have served or are currently serving in the military.

Fewer than 20 members of the S&P 500 will report earnings next week. Included in this group will be Dow Jones industrial average components Cisco Systems (CSCO) on Wednesday and Wal-Mart Stores (WMT) on Thursday. Along with Wal-Mart, we will start to see third-quarter reports from several other retailers.

We won’t see any economic reports of note until late in the week. The September Job Openings and Labor Turnover Survey (JOLTS) will be released on Thursday. Friday will feature October retail sales, October import and export prices, the preliminary November University of Michigan consumer sentiment survey and September business inventories.

The Treasury Department will auction $26 billion of three-year notes on Monday, $24 billion of 10-year notes on Wednesday and $16 billion of 30-year bonds on Thursday.

Pessimism among individual investors fell to a nine-year low,while optimism rose to its highest level for 2014 in the latest AAII Sentiment Survey. At the same time, nearly one-third of survey respondents describe their short-term market outlook as “neutral.”

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 3.3 percentage points to 52.7%. This is the largest amount of optimism registered by our survey since December 26, 2013. It is also the fifth consecutive week and the 12th out of the past 13 weeks with bullish sentiment above its historical average of 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 2.7 percentage points to 32.3%. The rise puts neutral sentiment back above its historical average of 30.5% for the first time in five weeks.

Bearish sentiment, expectations that stock prices will fall over the next six months, dropped by 6.0 percentage points to 15.1%. This is the smallest amount of pessimism registered by our survey since July 14, 2005 (14.0%). Bearish sentiment has been lower on only 56 out of the 1,400+ weeks tracked by our survey. The historical average is 30.5%.

The spread between bullish and bearish sentiment (the "bull-bear spread") is now at 37.6 points. The last time we saw a bull-bear spread this wide was January 6, 2011.

Bearish sentiment has plunged by a cumulative 18.6 percentage points since hitting a near-term high of 33.7% in mid-October. Over the same period, bullish sentiment has risen by a cumulative 17.3 percentage points. At current levels, optimism is unusually high and pessimism is unusually low. Historically, such occurrences have been followed by lower-than-average levels of market gains, as I explained in the June 2014 AAII Journal.

Individual investors continue to react positively to the market’s rebound from its mid-October lows. Also contributing to the level of optimism are earnings growth, the Federal Reserve’s ending of its bond purchasing program and sustained economic expansion. Keeping some AAII members cautious are worries that a larger drop in stock prices is forthcoming, a sense that prevailing valuations are still too high, geopolitical events and the pace of economic growth. It is unclear what, if any, impact Tuesday’s elections had on investor sentiment.

This week’s special question asked AAII members what they thought about the Federal Reserve’s decision to conclude its bond purchasing program. Nearly two-thirds of respondents (64%) said it is a good idea or that it was about time to end the program. About 13% of respondents said the Fed should have ended quantitative easing sooner. Approximately 8% thought the conclusion of the bond purchasing program will have little or no impact. A few members said the Fed could always restart the stimulus if economic conditions worsen.

Here is a sampling of the responses:

• “I think it’s an excellent idea. Maybe now there will be some investments for retired people other than just stocks.”
• “It should have been ended a long time ago.”
• “Well-telegraphed and done at the correct time.”
• “I think it was the right thing to do. They can restart if needed, but the economy needs to stand on its own.”
• “I’m glad they followed through as planned.”
• “Amen!!”

Bullish: 52.7%, up 3.3 points
Neutral: 32.3%, up 2.7 points
Bearish: 15.1%, down 6.0 points


Bullish: 39.0%
Neutral: 30.5%
Bearish: 30.5%

Equity allocations among individual investors fell to a 14-month low, according to the October AAII Asset Allocation Survey. Bond allocations rose to levels not seen since last November, while cash allocations rose for the third consecutive month.

Stock and stock fund allocations fell by 2.6 percentage points to 64.1%. This is the smallest equity allocation since August 2014. Even with the decline, stock and stock fund allocations remained above their historical average of 60% for the 19th consecutive month and the 21st out of the past 22 months.

Bond and bond fund allocations increased 0.4 percentage points to 17.2%. This is an 11-month low. It is also the fourth consecutive month with fixed-income allocations above their historical average of 16%.

Cash allocations rose 2.1 percentage points to 18.7%, a five-month high. Even with the increase, October was the 35th consecutive month with cash allocations below their historical average of 24%.

Even though optimism about the short-term direction for stock prices increased in our weekly Sentiment Survey, many AAII members reduced their allocations to individual stocks last month. Differences in the composition of who took the respective surveys and the date at which they took the surveys may explain some of the differences between the results. Nonetheless, the overall decline in equity allocations suggests that some individual investors sought to reduce risk in reaction to the downward volatility that occurred last month.

October’s special question asked AAII members what, if any, changes they made to their small-cap stock allocations given the relative underperformance of small-cap equities this year. Nearly half of all respondents (47%) said they have not made any changes. Some of these AAII members said they don’t own small-cap stocks, while others said they have been maintaining their current allocations. Slightly more than a quarter of all respondents (26%) said they sold all or part of their small-cap holdings. About 21% of respondents said they have either increased their small-cap stock allocations or plan to do so.

Here is a sampling of the responses:

• “None. I generally do not do small-cap.”
• “None. I’m keeping my asset allocation the same.”
• “No changes. I will be likely to buy even more if they continue to drop and the prices become attractive.”
• “I purchased more positions during the mini-correction of October.”
• “Earlier in the year, I lightened up on small caps.”

• Stocks Total: 64.1%, down 2.6 percentage points
• Bonds Total: 17.2%, up 0.5 percentage points
• Cash: 18.7%, up 2.1 percentage points

• Stocks: 30.2%, down 3.7 percentage points
• Stock Funds: 33.9%, up 1.2 percentage points
• Bonds: 3.9%, down 0.2 percentage points
• Bond Funds: 13.3%, up 0.7 percentage points

Take the Asset Allocation Survey.

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