Trading: the Cloud 7 strategy based on the O’Shaughnessy method
The Cloud 7 strategy is based on the O’Shaughnessy method. We can draw on this man’s hard work for our investment success. For decades he has analyzed various strategies on the stock market and price developments.
There are hardly any other activities that can bring out so directly personal strengths and, above all, weaknesses as much as stock trading. It is a continuous struggle against oneself. Success depends on whether or not a person is able to comply with the rules. This is the principle behind the Cloud 7 strategy.
Even if you had the exact parameters of the author to the decimal point, most likely, after a few years you would have different results. And this is not because of the rules, but because of the fact that most likely they are not fully respected. This method only works if you have confidence in the plan, even in difficult times. The following contribution is by Traders’.
The O’Shaughnessy method
James O’Shaughnessy is one of the titans of Wall Street and is on a par with Warren Buffett and Peter Lynch. After a long time working for the analysis company Bear Stearns, he became independent at the end of 2007. At the time, O’Shaughnessy had long become an investment legend after writing the 1996 bestseller “What works on Wall Street”.
O’Shaughnessy had been analyzing stock market data such as prices and ratios for over 30 years and applying them to the 15 most common investment strategies. From the knowledge gained from all this, he then developed his own strategy. It’s something to be proud of: on average, the strategy got a respectable 17.1% a year, from 1954 to 1996. The S&P 500, however, only managed to reach 11.5% annually, with a similar risk, let me be clear! We want to show you the five criteria used by O’Shaughnessy in the stock selection.
1. Market capitalisation must exceed 150 million.
This limit ensures that only stocks that are sufficiently liquid and can be traded on a permanent basis are selected. Why use mini stocks, if there are not enough buyers, if you want to sell?
2. Earnings per share must have risen steadily over the last five years.
This criterion ensures that the company has a sustainable business model and is profitable. O’Shaughnessy found that a steady increase in profits (over five years) is much more important than percentage growth in profits.
The increase in profits makes a company’s stocks more attractive, as the price/earnings ratio (P/E) is therefore lower and the stock is much cheaper. And this consequently drives prices.
3. Does the company pay a high dividend?
Of course, this can only happen if the profits are correspondingly high. O’Shaughnessy also noted that the shares paying the highest dividends are those that experienced the highest accelerations in the first three years after a crash.
4. Does the company have a low price/sales ratio?
The price/sales ratio is significantly more eloquent than the frequently used P/E ratio. Because sales are much more difficult to manipulate than profits which can be relatively simple yet legal to change through asset depreciation or valuation and similar balance sheet tricks. Turnover, on the other hand, is what really comes to money, everything else follows as a result: costs, depreciation and things like that.
5. Does the stock price have a high relative strength?
This is the following consideration: equities that have performed significantly better than the general market in the past have accumulated relative strength. The historical review shows that these winning stocks are likely to continue to perform better than average.
Optimized O’Shaughnessy Strategy
The author has refined and optimized the O’Shaughnessy strategy through intensive work. Instead of the S&P 500 he uses HDAX. He draws on his 110 stocks regularly following all O’Shaughnessy criteria. Only the best seven arrive at the depot. The following criteria for the Cloud 7 strategy have been revised:
- The P/S ratio up to 1.5 is too high. The lower the PSR, the better.
- As an investor, the O’Shaughnessy method doesn’t tell you if you’re coming in at the right time. It could happen that the stock is trapped in a long-running lateral trend.
- According to O’Shaughnessy, loss-making phases are ignored, even if the stock has lost more than 50% of its value. This is too risky.
- If the stock is too far away from the recommended stop, only half of the positional size is invested, thus minimizing the risk.
The perfect combination: O’Shaughnessy and Ichimoku
The Ichimoku method is not very common. In the author’s opinion, however, the method has proven its worth in equity markets as well as commodity markets and foreign exchange. With this method you can immediately see at what stage of the market the investment is currently positioned and then automatically receive the correct signals of buying and selling. The Ichimoku strategy is also called cloud indicator because the different parameters in the chart look like a cloud. So in combination we have a powerful tool: the adapted O’Shaughnessy method filters the fundamentally better stocks and the Ichimoku indicator tests them for trend strength, entry point and price gains.
Here’s how cloud 7 works
Once all company data for the previous fiscal year is known, a ranking is created:
- Does the value have a low PSR?
- Did profits increase in the last fiscal year?
- Has the stock consistently outperformed the market (ideally over the years)?
Then, the best candidates are screened for the strength of the trend thanks to the Ichimoku strategy. Only the seven best stocks according to this analysis end up in the largest selection. A purchase signal is generated whenever the price significantly exceeds the top edge of the cloud. If the stock is already above the cloud at the time of purchase, it will be purchased automatically. In addition, the Chikou Span must leave the cloud significantly upward. The stop is manually placed under the cloud. A sales signal triggers when the price breaks the lower edge of the cloud and the Chikou Span also leaves it. If no sales signal is generated, the ideal case occurs and the value can remain on deposit for one year. Figure 1 shows the performance of Cloud 7 compared to HDAX. During the 2008 financial crisis, when Lehman’s bankruptcy pushed prices down enormously, the H-DAX slipped from 3641 to 2466 points – a drop of more than 30%. At the same time, cloud strategy 7 lost only 6%.
Rheinmetall meets all the author’s O’Shaughnessy criteria. In addition, the price significantly broke the cloud at the end of July 2016, as well as the Chikou Span. A 64.66 position was opened which was held until recently. In mid-May 2018, only Chikou Span came out of the cloud and in mid-June finally also out of the course. Deutsche Post also met the regulated O’Shaughnessy criteria, when a purchase at 32.77 was made at the beginning of June 2017. The entry signal was the course breakout and the Chikou Span from the cloud. The sale took place on February 1, 2018: after the end of 2017 first the Chikou Span came out of the cloud and then on the day of sale also from the course itself.
A strategy is as good as its implementation. In a nutshell: Cloud 7 follows certain rules that determine when the stock is purchased and when it is sold. In short, success depends on whether the rules are respected or not. If you have the discipline to obey the rules, then you will find this strategy beneficial.