Quadrix Hits A Rough Patch


The bad news is that the Overall score, the most important metric in our Quadrix rating system, recently stopped working. The good news: Losing streaks are part of all quantitative systems, and the Overall score tends to rebound with a vengeance.

As shown below, the top one-fifth of stocks in the broad Dow Jones U.S. Index based on Overall score have underperformed in six consecutive 12-month periods. The top scorers based on Value, the most important of the six category scores that figure in the Overall score, have underperformed in 19 consecutive periods.

Value scores tend to be streaky. When confidence in the earnings outlook erodes, top Value scorers tend to lag. Relatedly, when stocks with low betas outperform because investors want to avoid risk, stocks with high Value scores tend to underperform.

Over the last five years, beta (an informational variable not used in the calculation of the Overall score) has been the single most effective variable in Quadrix. Beta measures a stock's sensitivity to stock-market movements.

Overall often works even when Value is flailing. In fact, relative returns for stocks with high Overall scores and low betas are positively correlated. However, over the past six months, with investors favoring stability and dividends above all else, high scorers for Momentum, Quality, and Earnings Estimates have also begun to underperform.

When the market rotates back toward higher-beta stocks, we expect growth-oriented scores like Momentum, Quality, and Earnings Estimates to begin working again. And we think Value standouts are due for a big snap-back rally, though timing such rotations is very difficult.

Market comment

The S&P 500 and Nasdaq Composite indexes moved to new highs after a robust employment report. Still, stocks have been moving mostly sideways since late July, while the Dow Transports are still nearly 4% from the April 20 closing high of 8,109.19. Without a new high in the Transports to confirm the Industrials' high, we intend to maintain a somewhat conservative posture.

We will take advantage of buying and selling opportunities on a stock-by-stock basis, and this week's rank changes have increased our stock-market exposure to nearly 81%. But we intend to hold an above-normal cash position unless the Transports can close above 8,109.19. We'd also like to see fresh highs in the Dow Industrials and improved market breadth.

The S&P 1500 Index advance-decline line, a daily running total of advancing minus declining stocks, has dipped slightly since July 26. Considering the advance-decline line's strong advance since June, ringing alarm bells about its recent stall is premature. But we'd like to see a broad move higher along with a breakout in the Transports, because we'd like to see economically sensitive groups join the defensive groups that have led this year.

For new buying, top technology picks include new Focus List additions Alphabet ($808; GOOGL), CDW ($46; CDW), and Lam Research ($89; LRCX). In health care, Laboratory Corp. of America ($140; LH) offers a top year-ahead pick.


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