Third Year of an Election Cycle: Volatility Returns to the Market

    by James B. Cloonan

    Third Year Of An Election Cycle: Volatility Returns To The Market Splash image

    Volatility has certainly returned this year.

    The Shadow Stock Portfolio has seen everywhere from a gain of 15% to a gain of only 2% over the past few months. It is now up by 7.5% for the year, compared to 5.1% for the S&P 500 (as represented by the Vanguard 500 Index fund). The complete data is shown in Figure 1.

    I never want to look a gift horse in the mouth, but it is important to keep in mind that the stock market—and the Shadow Stock Portfolio—does contain risk in the form of volatility, and that volatility will result one year in negative returns.

    A look at Table 1 will show that it has been a long time—the year 2000—since the portfolio has had a down year. Although we still have several months to go before year-end, this has not been a typical pre-election year. On the other hand, Congress is back in session, and there may be some more “spending for votes” before the year is over. I also feel the Federal Reserve will be a bit more accommodating and the sub-prime mortgage fiasco will pass by.

    Where It Stands

    Table 2 shows the current holdings of the Model Shadow Stock Portfolio and their status, Table 3 shows the latest portfolio rules and Table 4 summarizes the portfolio activity over the three months ended August 31, 2007.

    Please note that we have raised the acceptable price-to-book-value ratio from 0.80 to 0.85 to accommodate current market conditions. I would have thought that the recent market pullback would have given us more qualifying stocks, but it has not.

    In terms of changes, the Cronus Group (CRNS) was bought out by CRX Acquisition, a holding company, for $16.00 a share. In addition, Bonso Electronics (BNSO) violated its earnings probation and was sold during our activity period in the last week of August. We also added Golfsmith International Holdings (GOLF) and Johnson Outdoors (JOUT) to the portfolio. And, since P&F Industries (PFIN) qualified as a buy and our holding was a bit below average, we used some cash to buy additional shares.

    Figure 1.
    Model Shadow Stock
    Portfolio vs. Benchmarks
    (Through 8/31/07)



    Screening on Your Own

    For those of you who do your own screening using the Shadow Stock Portfolio rules, you may have uncovered International Shipholding (ISH) and NovaStar Financial Inc. (NFI). Why aren’t they in our own Model Shadow Stock Portfolio?

    International Shipholding passed the screens in our own portfolio, but we sold it earlier this year because of negative earnings (this was unfortunate, since it almost doubled), and we don’t buy stocks recently sold.

    NovaStar Financial, on the other hand, is a different story. NovaStar would be a value stock if you could believe the data—which we don’t because the value of outstanding loans is impossible to calculate. Down from $130 to $7.16, it was the classic sub-prime lender.

    Once again there are stocks we could sell under the two-year rule if we needed the money for new purchases. However, there are not many qualifying stocks, so we don’t really need to raise cash.

    As I mentioned earlier, I raised the acceptable price-to-book-value ratio to 0.85 this quarter, and I may raise it to 0.90 next quarter, but I don’t want to go higher than that. I may also raise the market-cap limit, particularly if the market rebound continues.

    Portfolio Turnover

    I was curious about the nature of the portfolio turnover in the Model Shadow Stock Portfolio, so we went back and examined the reasons we had sold holdings over the past four years.

    Here’s what we found out. Out of the last 49 stocks sold:

    • Twenty-four had violated the earnings requirements;
    • Eight had exceeded the value restrictions because they went up too much;
    • Fourteen were bought out at a premium;
    • Three lost their listing (two voluntarily deregistered to avoid the costs of Sarbanes-Oxley regulations and one was permanently delisted by the exchange); and
    • The majority of the sells were at a profit.

    The two stocks that voluntarily withdrew registration have gone up significantly since we sold them. We have kept some stocks that fell into this category if we had assurances that they would continue to act like public companies. However, we have had a tendency to sell them for fear they wouldn’t make data public. We will look more carefully before selling the stock of companies that deregister voluntarily.

    The Election Cycle

    As I have mentioned in previous articles, this third year is usually the best year in the four-year election cycle. In fact, there has not been a negative return in the year before an election since the Great Depression, and the average return for the third year in the election cycle is an impressive 22.6%.

    That 22.6% gain seems far away right now, but it is still possible. At the end of 2006, I suggested that the unusual run-up in the last quarter may have borrowed some steam from 2007.

    In any event, the election year—2008—is a below-average year in the election cycle, but not the worst. The worst year is the first year of the new presidency, which comes in 2009.

    However, all of this is “on average” and there is quite a bit of variation from year-to-year. Like the election itself, it ain’t over until it’s over.

       Table 3. Model Shadow Stock Portfolio Rules

    Purchase and Sales Rules

    Stock purchases must meet these criteria:

    • No bulletin board or pink sheet stocks will be purchased.
    • Price-to-book-value ratio must be less than 0.85. (Figure will change gradually with changes in overall market values.)
    • Market capitalization must be between $17 million and $200 million. (Figure will change gradually with changes in overall market values.)
    • The firm’s last quarter and last 12 months’ earnings from continuing operations must be positive.
    • No financial stocks or limited partnerships will be purchased.
    • No foreign stocks will be purchased because of different accounting and/or withholding tax on dividends.
    • The share price must be greater than $4.
    • In order to reduce trading by avoiding stocks that are forever marginal, any stock that was sold within two years will not be rebought.
    • Note second item under Stock Order Guidance concerning spreads when buying shares.
    • Price-to-sales ratio must be less than 1.2. (Figure may change gradually with changes in overall market values.)

    Stocks are sold if any of the following occur:

    • If last 12 months’ earnings from continuing operations are negative, the stock is put on probation; if a subsequent quarter has negative earnings prior to 12-month earnings from continuing operations becoming positive, the stock is sold.
    • The stock’s price-to-book-value ratio goes above three times the initial criterion.
    • Market capitalization goes above three times the initial maximum criterion.
    • After two years, sell if not qualifying as a buy currently. (But do not sell until there is a qualified stock to buy.) The two years should be measured from the last time the stock qualified, not from when you purchased it.

    Stock Order Guidance

    • These rules are for general guidance. Your own experience, market conditions and the size of the position will impact your own decisions. The results in the model portfolio were obtained while sometimes paying more.
    • If the quoted bid-ask spread is more than 4% (ask price minus bid price, divided by ask price), try to place a limit order between the bid and ask to keep the premium low. If necessary, build a position gradually. With low commissions, it is often better to place partial orders than to try to establish a large position all at once. Be patient.
    • Be careful if the average daily number of shares traded is not four times the amount needed for your position. It may be too difficult to get in and out of the position, but you may be able to grow the position gradually and sell gradually.
    • Market orders are not used. Instead, limit orders are placed between the bid and ask prices unless the difference between the two is 2% or less, in which case purchases are placed at the ask price and sales are placed at the bid price.
    • For NASDAQ stocks, it appears to be better to use day orders. If the order is not filled, it is placed again with a slight adjustment. For NYSE and Amex stocks, good-till-canceled (GTC) orders are used to keep a place in line in the specialists’ books. If the market isn’t close to the desired price, the price is adjusted in a few days with a new GTC order.
    • If price changes cause a stock to become ineligible (due to changes in price-to-book-value ratio or market capitalization) when only part of the order has been filled, stocks already purchased are kept but the balance of the order is canceled.

    Management Rules

    • Equal dollar amounts are invested in each stock initially.
    • Decisions are made only at the end of each quarter. In order to react to the majority of earnings reports as soon as possible, quarterly reviews are made early in February, May, August, and November.
    • Best judgment is used for tenders or mergers, but all criteria must be obeyed.
    • At the end of a quarter, if receipts from stocks sold exceed requirements for new purchases, the excess receipts—up to 5% of the portfolio’s value—are kept in cash until the next quarter. If the excess receipts are greater than 5% of the total portfolio value, the amount above 5% is distributed to smaller holdings that still qualify as buys. Efficient quantities are purchased: If over 10% of the portfolio is in cash, the price-to-book-value ratio can be moved up, but never over 0.90.
    • At the end of a quarter, if receipts from stock sales are insufficient to buy all newly qualifying stocks, purchases are made in order of lowest bid/ask spreads.
    • Note that if you are managing your own portfolio, it should consist of at least 10 stocks. If you are developing the portfolio gradually, you can do it stock by stock, but don’t put more than 10% of your funds in each additional stock. More than 20 stocks is not needed until the portfolio exceeds $1 million.

    Table 4. Third-Quarter 2007 Transactions
    Company (Ticker) Reason
    Cronos Group (CRNS) acquired by CRX Acquisition Ltd.
    Bonso Electronics (BNSO) negative earnings
    Golfsmith Int’l Holdings (GOLF)  
    Johnson Outdoors (JOUT)  
    P&F Industries (PFIN) purchased additional shares with excess cash

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