We Beat the Nasdaq 4-to-1 With Just Five Stocks

By Michael Salvatore, Editor, TradeSmith Daily

In This Digest:

Efficient markets be damned…
A simple buy-and-hold strategy that 4X’s the Nasdaq’s seven-year return…
Add this one move for even better performance…
The rare earths trade is white-hot, and Louis Navellier called it right…

For generations, investors have been taught that beating the market is impossible…

That’s thanks to a theory you’ve likely heard of called the “efficient markets hypothesis (EMH).”

Plainly stated, the EMH states that financial assets are automatically, efficiently priced by all market participants at every instant new information is available.

You can’t beat the instant pricing of information because new information is essentially random, unable to be predicted… And therefore prices themselves are essentially random, unable to be predicted.

This is all true.

But where it goes wrong is how it’s been applied in modern portfolios.

Modern proponents of EMH say that because of the theory, there is no exploitable edge anywhere in markets. Rational investors shouldn’t do anything more than own a market benchmark and call it a day.

Doing anything else would be too risky, even foolish. Prices are random, remember? Who would take such an important bet on a truly random outcome?

But as we’ll show you today, this is a gross misinterpretation of the theory.

One that’s largely made a bunch of fund managers rich and caused countless investors to miss out on returns that don’t just beat the benchmarks, but downright embarrass them.

We don’t say that lightly.

In fact, we’ve found a way to apply one of the core mathematical concepts of EMH to a simple five-stock portfolio strategy that downright embarrasses the best-performing market benchmark of all time.

Where holding the benchmark turns $10,000 into over $34,000 from 2018 through today, this simple buy-and-hold strategy instead turns that same position into more than $110,000.

If you took a few minutes per month to refresh the portfolio of five stocks, you can tack on another $30,000 to that result.

The great irony of this is that we used a core mathematical aspect of the EMH, called Mean Variance Optimization, to produce these results.

You read that correctly. We used part of the math behind EMH to disprove its modern usage… and create a simple system that helps you beat the market by orders of magnitude with just five stocks.

We’ll get into all the details today, including the current five stocks this approach recommends holding.

But first, a bit of background to understand how this concept came to be.

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Efficient markets theory dates way back to the late 1800s…

A French stockbroker, Jules Regnault, first proposed that asset prices are random and therefore unpredictable in his so-called “random walk” theory of finance. That was published in 1863 in his book Calcul des chances et philosophie de la bourse – or “Calculation of the Chance and Philosophy of the Stock Market.”

From there, early-20th-century French mathematician Louis Bachelier took the foundations of Regnault’s random walk and applied it to his own Bachelier model, which went on to inform the Black-Scholes model, which is the modern-day foundation for options pricing.

The base concepts of random walk spent the next 65 years passing through the hands of genius mathematicians and economists like Benoit Mandelbrot, Friedrich August von Hayek, and Paul Samuelson – the latter of whom first brought EMH to the modern financial world in the 1960s.

The broad assumptions made from Samuelson’s work were what went on to inspire the shallow applications of EMH today… Even as he himself warned that drawing applicable conclusions from random walk theory is unsupported by empirical mathematics.

Long story short, belief in EMH is a big reason we have benchmarked ETFs today that simply track the market, and why the ETF industry is approaching $14 trillion in size.

EMH has enabled an entire industry of passive fund managers who are just that… getting rich on fees and sitting on their hands.

It’s allowed entire generations of money managers of all stripes to convince people to pay them to settle for average returns.

But through all of this history of EMH lies the idea of Mean Variance Optimization (MVO).

MVO is a core mathematical concept used to adjust how much risk one is willing to accept for a certain reward.

Under the EMH regime, this tool was primarily used to minimize risk while holding a market-based portfolio.

But our research team here at TradeSmith has tweaked this invaluable mathematical formula into something that allows for more risk in exchange for tremendously larger rewards…

Watch how we applied it to the Nasdaq 100…

In terms of market benchmark returns, nothing beats tech. From its inception in 1995, the Nasdaq 100 Index has returned more than 18,000%, more than five times its closest competitor, the S&P 500:

Even over the last seven years, a more relevant timeframe for what we’ll talk about today, the Nasdaq 100 has returned 228% against the S&P 500’s 122%:

We discussed tech’s dominance a couple weeks back, when we used a combination of fundamental and technical factors to produce a five-stock portfolio that beats the Technology Select Sector SPDR ETF (XLK) over the long haul.

I was pretty proud of that work.

Then I took the idea to our research team and got utterly schooled…

Our researchers applied a special algorithmic MVO model that optimized risk-and-reward conditions in the Nasdaq 100 to find the real top 5 stocks to hold. Unlike my model, it didn’t have to look outside the index to find them.

As with all the early-stage research I share in these pages, you have to realize that this is all subject to change and a work in progress. But with the results I’m about to show you, I cannot imagine the methodology will change much.

Look at the chart of the backtest below. The blue line is the result of buying $10,000 of the Invesco QQQ Trust (QQQ), which tracks the Nasdaq 100, on the first trading day of 2018.

The orange line is the result of buying the top 5 stocks as determined by our MVO model on that date and holding them through to today.

The difference is striking, with the top 5% of the Nasdaq 100 outperforming the benchmark 4-to-1:

This study essentially quantifies the “winners keep winning” theory of financial markets.

But as we’ve been discussing lately, our company is highly interested in the idea of monthly rotation strategies that keep your holdings fresh and ensure you’re always in the best stocks possible.

And not for no good reason. These strategies ideally take just a few minutes of work per month and tend to make a positive impact on your results.

We applied this approach to our MVO model on the Nasdaq 100 benchmark. Importantly, this strategy involves rebalancing the portfolio for equal weighting at the start of each month.

And the results are even better.

Just five stocks… five minutes of work a month… and admittedly a heavy Dramamine habit to deal with that volatility…

Turns a 240% buy-and-hold return into more than 1,300% over the same length of time:

It’s a fascinating time to talk about this strategy, because the portfolio just got a new entrant in Advanced Micro Devices (AMD). Here are the current five holdings along with the month they were added to the portfolio:

Make special note that this algorithm identified The Trade Desk (TTD) as a buy in 2018 and has held it ever since. Same with Nvidia (NVDA) in October 2019… Tesla (TSLA) in May 2020… and Strategy (MSTR) in March of last year – around the time bitcoin started charging higher.

If you want to follow this strategy, you simply want to buy these five stocks in equal measure and be prepared to adjust your position sizes at the start of August. If there are new entrants, you simply close the exiting stock and reallocate into the new one.

We’re still working on where to apply this into TradeSmith’s software. But the goal is, as soon as we’re able, to provide this to our subscribers as an easy-to-follow tool not just for the Nasdaq 100, but the S&P 500, Dow Jones Industrial Average, and other benchmarks too.

So stay tuned right here for the latest on this project. And if you’re a paying subscriber, keep a close eye on Mike Burnick’s Inside TradeSmith dispatches for news on this and any other new features coming to our platform.

While we love this strategy, it’s hardly the only way to trade…

The strategy above, pulling from a pool of the Nasdaq 100, naturally only holds large-cap stocks.

Large caps have done great lately, but haven’t always.

And in such a diversified type of strategy, it’s possible to miss out on big emerging themes that are more tradable over a period of months or weeks.

A perfect example is what our friend Louis Navellier has been talking about with AI and rare earth minerals…

I interviewed Louis over the weekend about this topic and a patchwork of others relating to the U.S. economy and the new tax legislation.

But what Louis had to say about the rare earths trade in the U.S. should have any investor at full attention.

The Trump administration is working right now to secure essential mineral imports that will power the next generation of AI applications.

Once you see what’s possible when the best and brightest U.S. tech firms secure rare earth mineral supply, large language models and chatbots will seem like outdated relics.

And the companies involved in this exciting, little-understood area of the commodities sector are set to benefit handsomely from all this.

Where NVDA is the picks-and-shovels play of the generative AI era, these stocks – at a tiny fraction of NVDA’s size – are that same kind of play for the future of robotics.

We Beat the Nasdaq 4-to-1 With Just Five Stocks