November 18, 2006

AJO strategy

Last week, the Financial Times ran the following news comment : “Aronson+Johnson+Ortiz, a Philadelphia fund manager, has for years tracked a simple strategy: buy the cheapest 10 percent (as measured by the multiple of price over earnings) of the 2000 largest stocks in the market, and sell short the most expensive 10 percent. Over time this strategy does well. Since the exercise started in 1962, it gained about 1200 percent (8.4 percent annually).

“This strategy is highly unlikely to lose money. It has only done so when the market is truly out of whack, with the most expensive stocks carried forward by their own momentum.

“A fall in the AJO strategy indicates a major sell-off is in the making. Ahead of the bursting of the internet bubble in early 2000, it dropped 53 percent – an early warning of the juddering halt that lay ahead. Since February 2000, it has gained 380 percent, while the S&P 500 has been flat.

“So it should cause concern that the AJO strategy is now falling, for the first time since 2000. It fell ahead of May's correction, and rose thereafter as the rally gained strength, before falling again. By the end of October, it was more than 10 percent below its peak set early last year. The dearest stocks are once more strongly outperforming the cheapest.

“This is unhealthy. It suggests a correction may be coming sooner rather than later.”