Stock Rating Upgrades

We’ve been busy this past week here at VectorGrader.com finishing some improvements to the stock rating system that are now live on VectorGrader.com.

The primary change to our stock rating system is the addition of a component that rates a stock relative to other stocks in the same industry. We added this because a considerable number of indicators such as P/B and P/E work better when the ratio is compared to that of other stocks within the same industry. One reason for this is that each industry’s economics are structurally different. Higher growth rates or margins of some industries could justify a higher P/E or P/B.

Not only does comparing stocks relative to their industry perform better, it also does so with a lower risk of underperformance. This is because the signals from industry comparisons will not leave an investor overweight an underperforming industry with a structurally lower P/E or P/B.

We have also improved our algorithm for comparing indicators to their mean. This has created a more even distribution of stocks across the range of possible ratings and makes a stock’s rating more meaningful.

Coming Soon

We are also working on some tools to help with stock selection that should be complete in a week or two.

Macro Rating – A score for a stock’s specific sector, region, size, quality, and momentum profile, based on relative valuations and momentum of those factors.

New Stock Screens – Some stock screens to dig down into a particular style of investing.

Country ETF Strategy – November 2010

This is an update to the country rotation strategy I outlined a while ago with a few changes.

The country rotation strategy ranks stock markets of developed markets and a few major emerging markets by valuation and momentum. When I outlined this strategy a while ago, I used the median P/E, P/B and P/S. From now on, I will use the median earnings yield, and median P/S. P/B and P/S are highly correlated and I don’t think it is necessary to use both.

Low REIT Yields Point to Below Average Returns

Real Estate Investment Trusts have outperformed the S&P 500 by nearly 30% in the last year. This has pushed an already low dividend yield even lower to 4.36%, a level below the yield of any other time except for a few weeks in April of this year, and a nine month period at the peak of the real estate bubble. Coming so soon after a bubble, this is slightly surprising. Valuations after a bubble tend to stay low for a while as the memory of the bubble is still fresh in investors minds.

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With the dividend yield this far from normal, future real returns will probably be low. The primary source of returns from REITs is dividends, so a low yield is a strong indicator that returns will be below average. Unlike stocks, there has been pretty much no growth in fundamental value of REITs in the past. Because they must pay out most of their earnings as dividends, most REITs don’t grow without raising capital. This is reflected in the past dividend growth of the FTSE NAREIT index, which has not changed much from zero over the full business cycle.

In addition to a low return from dividends, it is also possible that we will see a drop in prices if investors demand higher yields. For the dividend yield of REITs to return to its historical average, REIT prices would have to drop 47%. However, with interest rates at extremely low levels, it may be that the dividend yield of REITs will remain low while the Federal Reserve keeps interest rates down. If this is the case, than valuing REITs relative to treasuries should be insightful. When this is done via the yield spread, REITs no longer appear overvalued.

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The yield spread, currently at 1.67%, is higher than the historical average of about 0.9%. The key here, though, is that this is relative to treasuries. If treasuries have very poor returns, than a slightly higher return is still likely to be unsatisfactory.

Disclosure: No positions in REITs