Feelin’ healthy

Lost amid the percolating anticipation investors have placed in the market’s advance is the quiet rehabilitation of health care stocks. Gold and oil stocks are under increasing pressure to bust loose, a trader’s dream – but investors should take a good look at the reassuring trends in a defensive sector that has its own building steam. U.S. health care stocks have been trending positively with the rest of the market since the March market bottom, despite the polarizing political debate about health care insurance in America. Only the financial sector, itself coming off life-support, has performed better than healthcare stocks over the past three months. The health sector promises leverage with its stable of biotech and pharmaceutical stocks, yet generally offers investors defensive cover in the event of a market reversal. Obamacare or not, the stock market is grabbing on to some traditional health care anchors.

During the bear market of last year the S&P Healthcare Index showed its relative price performance over the broad market through the last half of 2008 until the market bottomed in March of this year. When the financials took the market in a tailspin, health care stocks sank with the rest of the market – just not so badly. That is the desired outcome for a defensive sector: relative price performance. But now pharmaceutical stocks, north and south of the border, are showing a performance premium in a bull market. Almost all of the big cap pharma names are in Stock Trends Bullish trends and outpacing the S&P 500 over the recent summer months. Even with its massive acquisition of Schering-Plough Corp. (NYSE:SGP) in the works, Merck & Co. (NYSE:MRK) is up 18% since early June; and Pfizer Inc. (NYSE:PFE) is up 13%, a tidy vote of market confidence that was good cover for the company’s recently announced details of its $2.3-billion settlement of criminal charges. Investors can feel good about pharma’s solid footing in the current market environment.

The Health Care Select Sector SPDR (NYSE:XLV) represents the 13.4% weighting of health care stocks in the S&P 500 and is the most actively traded exchange traded fund in the sector. The next most transacted health care portfolio is the Pharmaceutical HOLDRs (PPH-N), which generally has less than 10% of the number of transactions XLV logs in every week. There are other funds specialized in biotech, medical devices, and healthy services, as well as leveraged Rydex health care ETFs, but XLV is the liquid center of investors’ broad exposure to the group. However, four key big cap pharma stocks account for 34% of the weighting of the fund – Johnson & Johnson (NYSE:JNJ), Pfizer, Merck, and Wyeth (NYSE:WYE). Wyeth is the best performer of the group – hitting new 52-week highs at the end of August – but all of these important stocks are currently in bullish trends, with both JNJ and MRK poised to rally off trend line support.

Stock Trends Bullish since early July, XLV has been quietly advancing along its price channel, making new 2009 highs during the summer as the U.S. health care political debate heated up. The ETF’s price pattern could see the sector add another 10% in the third quarter, especially as Congress works toward clearing uncertainty about health care insurance reform. The bullish trend of the sector indicates that investors are betting on calmer heads prevailing, and are looking for further upside if the broad market continues to advance. If a market correction is instead forthcoming, health care stocks should still be a good play.

Position sizing - fixed investments

Most novice investors, and many experienced ones, do not develop a sophisticated money management trading plan. Last week this column highlighted the importance of an exit strategy, of limiting losses in individual trades, as a trading practice that improves investment returns over the long-term. But there is another question that should be asked when developing a trading strategy: how much should be invested in each position? Many investors know that they will not be so fortunate to have maximized investment in winning positions, and minimized investment in losing positions. Few will ever be so charmed. However, investors can attempt to optimize their money management so that they can most benefit from their trading strategy. Adjusting the amount invested in each position, within the limits of available capital, can affect your portfolio returns.

The Stock Trends TSX Portfolio trading strategy, a model portfolio that has been active for over 15 years, operates on a fixed investment premise. All 440 positions taken were bought for the same transaction cost ($10,000). Whether a large cap stock valued at $25, or a small cap stock trading at $2.50, all trades were limited to the same dollar value exposure. The implication of these equal investments is greater risk (and profits) on lower priced stocks. How would the overall investment return of this portfolio record change if the invested amount for each trade was variable, instead of fixed? This is the kind of question active investors should ask of their own money management.

If the trading history of the Stock Trends TSX trading strategy is replicated with either random or variable investment costs on individual positions, the investment returns of the portfolio change. A random quantity of shares (between 200 and 2,000, for example) invested shows us that portfolio returns can be considerably different. Although the average amount invested in this example remains close to the $10,000 invested in the actual model portfolio, a random sequence of shares invested (correspondingly changing the invested amount to random costs) produces a range of portfolio returns that differ considerably from the actual results.

While the fixed investment strategy of the Stock Trends TSX Portfolio has produced an annualized 39% return on average investment, the random invested amounts for the same trading record results in a range of annual returns from a low of 23% to as high as 59%. Remember, the individual trades only differ by the amount invested - prices and order of trades remain the same – and so does the individual percentage return on each trade. Only the dollar value of the gains and losses varies. Where increased invested capital in winning trades and decreased invested capital in losing trades more favourably reflect the best outcomes, the portfolio returns improve.

The reason for these variable results becomes more apparent when the trading record of the portfolio is adjusted instead to be a fixed number of shares. If we again keep the average amount invested over the 400 positions close to $10,000, but always trade the same number of shares – say 1,000, for example - the return over the entire period is comparable to the actual portfolio result, again about 39% annualized return on average invested capital. However, dropping the number of shares traded to 500, thereby halving the average amount invested on individual trades, reduces annualized portfolio returns to 32%. Doubling the average amount invested by buying 2,000 shares in each position, though, increases annual return over the period to 43%. Notably, annual returns maximized at 46% regardless of how high the average invested amount is adjusted to.

The result of the fixed number of shares example occurs because the varying amount invested is in relation to the price of the stock. Although the example of the random investments highlights that overall portfolio returns can be optimized if the trader is somehow weighted heavily in winning trades, this is an unlikely probability. An investor would have to know in advance which trades were going to be the big winners and increase the invested capital. More reasonable expectations are needed. In reality, we are never certain which stocks are going to be the best performers.

Varying investment amounts can improve portfolio returns based on the price of stocks, but only to a certain level. For that reason, Stock Trends maintains that it is best to use a fixed investment rule. However, that may not be the best case scenario for all strategies, and investors can look at their own trading records to see how their results would change with different money management rules. Position sizing is an under-appreciated aspect of trading.

A detailed trading record of the Stock Trends TSX Portfolio is found at http://www.stocktrends.ca/stonline/stp-tsx1.php