Guru Grading

CXO Advisory does some terrific statistical work, including their Guru Grades. But one guru was notably absent. Until Friday that is.

A reader requested a review of the performance of recommendations made by Lenny Dykstra in his articles at TheStreet.com. The publication has engaged Lenny Dykstra for two stints, the first covering 9/6/05-8/14/06 and the second covering 2/7/07-11/7/07. In these articles, he generally recommends buying deep-in-the-money call options four to six months from expiration for specific "undervalued" stocks, with a good-until-canceled sell order targeting a modest gain of about 10%. He employs this "going deep" options strategy for leverage with minimal time-value erosion. Can Lenny Dykstra systematically find undervalued stocks? Does his options strategy work?

OK, for the record, I was not that reader.

Results suggest that Lenny Dykstra may have some ability to identify intermediate-term value but enter positions too quickly. Note that his return profile does not include trading costs. Also, this profile is probably sensitive to market conditions. For example, the profile might look quite different during a bear market.

I think that sums it up perfectly. He buys battered big name stocks. And over the course of time, it maybe does work in the same way a "Dogs of The Dow" strategy works. That's what CXO's work seems to suggest.

Of course Lenny flips them immediately and rides the losers. So the reality is quite different.

And CXO also uncovers many same flaws that we have noted here.

Regarding return on investment, the calculations offered by Lenny Dykstra have some shortcomings:

1. Some of the calculations are for closed positions only, even though the
strategy has the potential (if not the tendency) to develop a bow wave of
unsuccessful positions. These calculations have a look-ahead bias that essentially assumes open positions will perform similarly to closed positions. The shorter the sample period (this nine-month sample is pretty short with respect to the potential life of unsuccessful positions), the greater the risk in the look-ahead bias.
2. The calculations inconsistently address the cash position that a
trader would have to maintain to assure the ability to implement new
recommendations, including those for averaging down after short-term setbacks. A complete trading strategy would specify a closed system, defining the necessary cash position and including the return on cash in the overall return on investment.
3. The strategy is likely sensitive to broad market conditions
(trend and volatility). It might "crash" under very unfavorable market
conditions (a substantial market decline persisting for several months) not encountered during the nine-month test. Since Lenny Dykstra's tendency is to average down rather than exit after setbacks, such a crash could produce large losses for the strategy.

Is Lenny a High Beta player in disguise?

Just had a thought for a later post.

Developing.......