Friday, February 17, 2006

Potentially Explosive Research: Spec vs. Non Spec Stocks

The best market indicators, I've found, are the ones that are the least picked over. I can pretty much assure you that if an indicator can be readily created in a charting application, it is of limited predictive value. Been there, done that.

Good indicators, on the other hand, are conceptually grounded and are not easily replicated. The Demand/Supply Index on my Trading Psychology Weblog is an example. It is a straightforward measure of momentum, but is so broad--covering every operating company stock on the major exchanges-- and is so calculation intensive (requiring prices and volatility estimates at two different time frames for each issue) that it's unlikely to appear any time soon on the indicator menu of a trading app.

The indicator I'm working on now has considerable promise for these reasons. I divide a very large stock universe into two components: speculative and non-speculative. Spec stocks tend to be more volatile in their price behavior, younger as firms, more volatile in their earnings, more likely to trade at high price earnings ratios, less likely to pay dividends, and less likely to have a large percentage of their shares owned by institutions. Non-Spec stocks are less volatile, more established as companies, more stable in their earnings, more likely to trade at lower price earnings ratios, more likely to pay dividends, and more likely to have significant institutional coverage. As a whole, Spec stocks show better growth than Non-Spec stocks, but this may be a function of survivor bias. There are plenty of Spec stocks that show earnings declines, and plenty of Non-Spec stocks that show steady earnings gains.

In my first analysis, I created a synthetic market index consisting of half Spec stocks and half Non-Spec stocks. I then looked at occasions when price change in this index is narrow on the day (up or down less than .30%). Since April, 2003 (N = 715), we had 151 narrow days in the index. When the Spec issues were strong on those narrow days (N = 75), the next two days in the synthetic index were up by an average of .33% (47 up, 28 down). When the Non-Spec issues were strong on those narrow days (N = 76), the synthetic index over the next two days was up by an average of .03% (35 up, 41 down).

What this means is that both Spec and Non-Spec stocks (the synthetic index as a whole) perform better when relative strength is on the side of the Spec stocks. This makes sense: when sentiment is favorable in the market, traders will prefer Speculative issues. When sentiment is cautious, traders will lean toward safer, Non-Spec stocks.

There is much research to follow from this, including--of course--predicting the major market averages from the baskets of Spec and Non-Spec issues and creating a Spec Index indicator to track daily speculative sentiment in the market. I have a feeling this one is a winner.


Zak99 said...

Love this idea...this sounds like one of your best research projects to date...please keep us all informed!!


Brett Steenbarger, Ph.D. said...

Thanks, Brian; it does, indeed, look promising. Yet another interesting idea that I hope to pursue is lead-lag relationships among international equity markets. For example, if we are thinking of Speculative vs. Non-Speculative investments, some countries are clearly more Spec than others. Might those lead the major world markets?

Interestingly, this would suggest that the U.S. is a Non-Spec investment and that the markets of developing nations might lead U.S. indices. If the investment climate is favorable for such riskier Spec positions, all markets should benefit.

This theory, however, is unlikely to become popular in the States, where the current political fashion--it seems--is to resist following the lead of other countries. I doubt that the financial markets are as unilateral... :-)