, Investing Strategies

How to Crush the S&P 500

June 14, 2016 / by TradeSmith Research Team

The S&P 500 has long been the benchmark Index for measuring the performance of hedge funds and money managers. Many of these professionals resort to extremely risky stocks and strategies to satisfy their clients’ demands to beat the S&P.

But what if you could outperform the S&P by trading the S&P?

I wouldn’t have believed the results of this study if I hadn’t seen them with my own eyes … and double and triple checked the numbers.

The study in question was prompted by one of our subscribers. He posed the question, “How did your Stock State Indicator (SSI) system perform versus a buy and hold strategy on the S&P 500 itself?” In other words, if we had gotten in and out of the S&P 500 on the SSI entry signals and stop loss signals, how would that compare to just a buy and hold strategy for the S&P 500 over the same period of time.

I told this subscriber that the SSI wasn’t developed as a strategy for beating buy and hold on a broad market index. The SSI was developed as a tool to help individual investors maximize their returns in individual stocks … and to help investors hold on to their winners instead of holding on to their losers.

That’s absolutely true … but secretly I was nervous that my SSI system might have underperformed a buy and hold strategy. I was already on the defensive before I had even run the numbers. As it turned out, I had nothing to worry about.

Before I get to the results, let me first make sure that you understand exactly how the SSI entry and exit signals work.

The SSI system is based on our proprietary volatility metric the Volatility Quotient (VQ). The VQ tells us how much we should expect a stock (or index) to move, up or down, just because of noise in the market. In the case of the S&P 500 (as represented by SPY, the ETF that tracks the performance of the S&P 500), the current VQ is 10.6%.

The chart below shows the most recent exit and entry signals on SPY.

Back in August, 2015, SPY moved down off of its high more than 10.6%. That triggered an SSI exit signal (when the black closing price line crossed the red stop loss line). Then in March, 2016, the price moved back up more than 10.6% and the SSI Trend indicator became sufficiently positive (sloping upward) to trigger a new SSI entry signal.

Here’s what these same indicators look like going back nearly 20 years. The SSI system buys SPY at the start of each red stop loss line below and exits at the end of each red stop loss line.

So, how exactly did the SSI system of entries and exits perform against a pure buy and hold strategy on the S&P 500? Take a look:

You don’t need much of an explanation of the above chart to see that the SSI system dramatically outperformed a buy and hold strategy on the S&P 500 itself. For the record though, that’s a 229% gain for the SSI system on SPY vs. a 76% gain for a buy and hold strategy on the S&P 500.

The chart also clearly shows where the meat of the outperformance came from. It came from missing the big drawdowns from 2001 – 2003 and 2008 – 2009. That’s called winning by not losing.

What’s even more impressive is that it took less risk to achieve this dramatic outperformance. Here are the same results but framed in terms of Risk Adjusted Returns. You can understand Risk Adjusted Returns as how many dollars you would have made for every dollar you risked.