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Wednesday, August 31, 2016

System 12. Portfolio Construction and Rules

The logic behind System 12 strategy is deceptively simple:
a. By using best available stocks scanner, select 12 biggest by market capitalization US companies.
b. Invest into these stocks continuously, while they are in uptrend.
c. Don't invest if they fall in downtrend.
d. Use rules only - to differentiate between b and c above.
e. Don't break the rules.

American MegaDozen.
According to FinViz, these are 12 largest American enterprises:
Since these stocks commonly referred to as 'mega-caps', I call this list Mega Dozen (MD).
This is MD:
This is SD - Second Dozen - next 12 stocks by market cap:
These two lists need to be re-evaluated monthly for any changes and positions need to be revised accordingly. MD stocks are the biggest and the best, but its not written anywhere that they will remain to be so. Some will fall and never come back, but they are always replaced by new 'winners' in stock market, as in life.

S12 Requirements:
Minimum account size to run a System12 portfolio is $40,000, considering initial allocation of 12 equal positions of about $3000 each, with more than Standard Position Size cash reserve for replenishment. Read about 'How to Bet' here (link)
-note- I attempted to do it will less money and found results unsatisfactory. Don't repeat my mistakes - learn from them!
At larger sizes, System 12 becomes increasingly more efficient, as dividends accumulate and costs decrease. All my systems are designed to be run at 10 times of minimum allocation with almost no changes to execution (for my own future use), but S12 really stands apart. This thing can be traded with virtually unlimited amount of money, as MD stocks are some of the most liquid traded securities. A million dollars?  10 million? Just look at a volume figures for these stocks - you can do it on an opening tick and the Market will not even know you are there.

System 12 requires daily monitoring. I found it unnecessary and even counterproductive to watch these stocks intraday. We are not day-trading here, but portfolio needs to be reviewed nightly on closing basis and stops placed or adjusted. This should not take more than 15 minutes.

Personally, I think S12 should be traded in tax-efficient account, like an IRA. First of all, MD is a heavy object and moves slowly. Beneficial effects of this strategy will not be apparent in a period of few months, but over a year or two. It would be nice not to pay any taxes in the interim. Secondly, S12 has extremely efficient re-entry procedure (see 'Trade management'), unfortunately disregarding wash-sales (if investment bought and sold for a loss within 30 days, a loss can't be applied to offset gains for tax purposes). Since typical IRA does not observe wash-sales rules, our lives are made a little easier.

S12 Rules:
1. Take positions only in stocks trading above 200 day simple moving average. Any stock with daily close under 200dma is DISQUALIFIED from System12 and must be sold.
2. Any remaining stocks are AVAILABLE for purchase above 50 day simple moving average.
3. BUY all stocks that are Qualified and Available from MegaDozen (MD) first. If not all MD stocks  can be purchased, then go to Second Dozen (SD) and continue to buy until 12 positions are filled.
-note- an edge of System12 is in largest of mega-caps. The lower you go into SD, the more this edge dissipates. You must consider this very carefully.
4. Sell any position if daily closing price is below 50dma.
5. Use Positioning Period (PP) of 1 week (up to 5 trading days) to enter and exit positions. There will be more about this in a next article on 'Trade Management' (post link).
6. S12 portfolio can not have more than 12 positions. No margin. No leverage.
7. S12 portfolio can be partially or fully in cash for unspecified period of time. No trades beyond MD and SD are permitted.

Accordingly, as of today, S12Portfolio should look like this:

You can poke around fundamentals of these stocks via FinViz (link), but I tell 'ya - this is one helluva portfolio. Conservative and diversified, but definitely skewed towards technology and financials - market leaders of the past few years. Good. Even better, considering that it was picked not by some biased analyst, but by Mr. Market himself. I don't need to have an opinion (AMZN has crazy P/E) or make predictions (I would never have picked FB). A "bloodless verdict of the marketplace" is already reflected in these 12 stocks. Just follow the rules...

...until next week, when I will expand on a topic of "Trade Management", including Positioning Period (PP), 'by-pass' conditions and usage, and rare (but dreadful) Emergency Exit (EE).

.this is a second article in 'System 12' series.
Read Part 1: System 12. American MegaDozen. Introduction.
-reading part 2-
Read Part 3: System 12. Trade Management 
Read Part 4: System 12. Performance and Risk
Read Part 5: System 12. Portfolio Initiation  

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