Blogs Dashboard

Even bullish investors must be starting to wonder how much longer the stock market can maintain its vigor as oil price rallies alternate with corrections and as observers wonder how the Federal Reserve will resolve the tug-of-war between economic sluggishness, especially in the housing arena, and latent inflationary pressures.

The debate is sure to induce many to approach the topic of diversification more systematically. A traditional hard-times script might call for increasing allocation of funds to equities from sectors perceived to be “defensive,” such as consumer products or health care. But we’ve seen how even those stocks can drop hard if earnings disappoint. Health care, meanwhile, has a set of completely different dynamics, especially with the Democrats having just gained control of Congress.

Another, academically purer approach to diversification is statistically based. It suggests investors supplement consideration of potential returns with serious consideration to the way returns on a particular stocks correlate with those of other shares they may be holding. It’s quite possible that Portfolio A, consisting of two stocks with moderate uncorrelated returns may ultimately outperform Portfolio B, which has two very strong but highly correlated stocks.

We make an effort to cut correlation by seeking stocks with low betas in general (beta is a historical measure of share price return relative to the S&P 500) and low down-betas (the same calculation but confined to months when the market is down) in particular. Specifically, we seek betas below 1.00 and down betas below 0.25. Instead of measuring how each stock in a group correlates with each other stock, we measure how each correlates to a common benchmark.

Within this narrowly constrained universe, we then seek to identify stocks with potentially reasonable returns by confining ourselves to those that appear in at least one of our Reuters Select screens, appear in many screens or in screens that are top ranked for performance, have average analyst-rating scores no higher than 2.25 (1.00=best, 5.00=worst), and experienced an increase in analyst bullishness (reflected in a drop in the average score) in the past 13 weeks.

Here is our list: