Guru Grades

Robert Drach, Trading with 95% Confidence (Last Updated 8/23/08)

A reader asked about Robert Drach's "Basic Timing" Model Portfolio, which presents several hundred trades commencing 5/5/95. The objective of the portfolio is to demonstrate that market timing can beat the S&P 500 index, not to present an optimum trading strategy. The self-assessment of this portfolio as of 5/1/08 reports 370 closed positions with a 90.8% win rate. The average closed position yields a 9.19% gain over 202 days for an annualized return of 15.5%. The cumulative portfolio gain is 201%, compared to 199% for the DJIA and 170% for the S&P 500 index. These cumulative returns "...are reflective as to capital capture and market price of current holdings... They do not include cash dividends, interest earned on cash balances, transaction costs, or anything else." Robert Drach is publisher of the "Drach Weekly Research Report" (no web site). As explained in an article by Jon Markman, "he scales into stocks only when he believes there is a 95% likelihood of a successful result. ...He focuses on buying only from a master list of 80 large stocks [with decent earnings predictability] that hasn't changed much over the years." Do Robert Drach's results demonstrate market timing ability? We can answer this question approximately by measuring the correlation of his cash position (from his Cash Balance Ledger) with future stock market returns. Using this cash data and contemporaneous S&P 500 index data for the period 5/5/95-5/2/08, we estimate that:

For a precise analysis of stock picking versus market timing, we should work with asset class (stocks, cash) weights rather than dollar amounts. However, the effort to reconstruct and mark to market this portfolio over a 12-year period is very large, so we use cash balance as a rough indicator of cash allocation percentage. Also, in comparing changing allocations to future stock returns, we should arguably use future returns for the stocks in the portfolio rather than the S&P 500 index. However, available discussion in the media of Mr. Drach's timing method indicates that he times based on the condition of the overall stock market, and there should be substantial co-movement of his master list of stocks and the S&P 500 index.

The following chart overlays the portfolio cash position and the S&P 500 index for the entire sample period. It is difficult to infer market timing from this chart.The portfolio held little cash during the 2000-2002 bear market and the late 2007-early 2008 downturn, but some spikes (dips) in cash appear to coincide with interim market peaks (valleys).

For more meaningful inference, we compare the changing portfolio cash position to S&P 500 index returns over several past and future intervals.

The next chart shows how the model portfolio cash position relates to future and past S&P 500 index returns for intervals of 10, 21 and 63 trading days. If trades are effective in timing the market, cash balance should have a negative correlation with future returns. In other words, cash should be low (high) when the market is about to rise (fall). In fact, correlations between the cash balance and future returns are near zero for all three intervals, indicating that Robert Drach's timing model is not anticipating stock market movements. In contrast, the cash balance relates positively to past returns. The more the market has gone up, the more the portfolio moves to cash.

These results suggest more a never-lost-money-selling-at-a-profit approach than effective market timing.

Is there a big-picture way to summarize results?

The final chart shows the annual return on the S&P 500 index and the average daily cash balance in Robert Drach's model portfolio for 1995-2008. Calculations for 1995 and 2008 are for partial years based on the 5/5/95 start date for the portfolio and 5/2/08 end date of this analysis. Performance is mixed, with the low average cash balances of 2000-2002 and 2008 to date standing out as poor market timing. Holding losers until they become winners may explain these periods. When the market goes down, he buys and his cash balance goes low. If the market falls further and stays down, he has no winners to sell and his cash balance stays stuck on low.

A policy of holding stocks until they show a gain, as implied by the preceding chart, seems to be at least part of the reason that Mr. Drach has such a high win rate on closed trades in this portfolio. In contrast, of his 27 Current Open Positions, with buy dates extending back as far as August 2000, 22 (81%) are showing losses as of 5/1/08. Some of the losses are very large (such as Bear Stearns and Ambac Financial).

While Robert Drach's annualized return based on the average return and duration of closed trades is 15.5%, this return on invested capital does not include: (1) the relatively low return on capital not invested (cash); and, (2) the negative aggregate return on the 27 open portfolio positions, of which 22 are in the red. The annual compound rate of return for the total portfolio for 5/5/95-5/1/08 is 9.6% (assuming the dividends and return on cash offset trading friction).

An investor may be able to replicate the model portfolio's return, with lower tax obligations, by buying and holding a style-matched (conservative, large-capitalization, value) fund.

In summary, the results for Robert Drach's model portfolio probably derive not from effective market timing but instead from the performance of conservative, large-capitalization value stocks over the past 12 years.

To corroborate the above conclusion we collected media reports on Robert Drach's outlook for the overall stock market, as summarized below. The result is a 53% accuracy rate, a little above average compared to other experts, but the sample is small and bunched (and therefore not included in the Guru Grades snapshot).

See Guru Grades for links to assessments of the outputs of other stock market experts.