A Brief Summary of the Compact Model Portfolio

In the very first post on this blog, I referred to the Compact Model Portfolio, which is a strategy I have researched and traded for a while.

The premise of the strategy is that the stock market is a voting mechanism for trading ideas (not a radical theory, I admit.) However, in this case we specifically assume that the market is able to pick the winning stocks but that it is not very good at trading them. i.e. That we can infer from market activity what the stocks we should own are, but that the market is not sufficiently efficient to eliminate the excess return that accrues to the owner of those stocks. I call this a semi-efficient markets approach.

The strategy is described in detail in the document linked to above and I do trade based upon this strategy. I find it appealing because it is a different way of looking at the market to the paradigm followed by traditional alpha trading. Basically, we examine the dollar volume of each stock in the market and use this to create a ranking based upon the markets' interest in each company. We then cherry pick this ranking for a subset of stocks to hold in a portfolio.

Technically we are assuming that the ordinal ranks are efficiently expressed but that the cardinal ranks are not — that the market can pick the stocks to own but that it doesn't do a good job of trading them.

The purpose of this post is not to recommend this strategy as an investment vehicle for the general public. It is to highlight a different way of looking at things. Quantitative traders can get trapped into thought ruts — particularly if their methodology leads to some success for them. It's to answer the question "what does the market think I should hold?" This way, the analyst has a base portfolio to compare their holdings too that is not wedded to implicit biases and scales in the way the major market indices (as currently composed) are.

This portfolio might also not be a suitable starting point for many investors. Based on it's current composition, the market is currently interested in holding SDS and SKF, which are ultrashort (i.e. two times leveraged) exchange traded funds. As a result of this holding, the index is currently profitable for this year. I recently added a link to the historical holdings of the Compact Model Portfolio. This allows one to follow the market's preferences as they change (it should be noted that the rankings involve a time scale of several months, so members will not change rapidly — they will drift up and down).

UPDATE (14:30 PM EDT): Of course, the on day I post this SKF and SDS are having a terrible day (at the time of writing SKF is down 21% and SDS down 11%). I hope this underscores the point that this post and the data associated with it should not be taken as blind investment calls — you should always verify that an investment is right for you.