We are starting this new discussion to share a powerful investment strategy inspired by What Works on Wall Street by James P. O'Shaughnessy. I highly recommend reading the book to dive into the details of quantitative investing, though we’ll summarize the main rules here for clarity.

This strategy’s simplicity and robustness aren’t widely appreciated, but when we discovered it, we realized its potential as a cornerstone for any investment portfolio. It combines value and momentum, drawing from decades of historical data to beat the market consistently.

The algorithm’s objective is to capitalize on stocks that are undervalued yet showing strong price momentum, using a universe of S&P 500 stocks (or a broader set like O'Shaughnessy's "All Stocks"). All rules are applied annually, with a disciplined rebalancing approach, unless a RISK OFF signal is triggered.

• Market Regime Filter: The S&P 500’s momentum over the last 12 months (252 trading days) is positive, ensuring we’re investing in a bullish environment. If the momentum turns negative, the indicator signals RISK OFF.
• Risk Management (Improvement): When the Market Regime Filter signals RISK OFF, we exit equities and invest in CASH (e.g., money market funds) or medium-term bonds (e.g., 5-10 year Treasuries), depending on which has the higher momentum over the last month (21 trading days). If equities are back in a RISK ON regime, we resume stock investments.
• Liquidity Filter: The stock must be among the 500 most liquid US stocks, determined monthly by the highest 200-day average dollar volume.
• Value Filter: The stock’s Price-to-Sales Ratio (PSR) must be below 1, identifying undervalued companies relative to their sales.
• Momentum Filter: The stock’s Relative Strength must rank among the top performers over the past 12 months, confirming it’s a "winner" with strong upward momentum.
• Stock Selection: Rank all qualifying stocks with PSR < 1 by their momentum, then BUY on the close, in equal weight, the 25 stocks in descending order of momentum.
• Sell Rule: SELL the stock on the close at the end of the year when the portfolio is rebalanced, sticking to a strict annual cycle, unless a RISK OFF signal prompts an earlier exit to CASH or bonds.

Benefits of a PSR & Relative Strength Strategy

This strategy leverages two proven factors: value and momentum. Stocks with a PSR < 1 are often undervalued, providing a margin of safety as they’re bought at a discount to their revenue (Chapter 8, What Works on Wall Street). Meanwhile, Relative Strength captures stocks that have already begun to outperform, capitalizing on the tendency of winners to keep winning (Chapter 15). This combination diversifies a portfolio by blending a value stream with a momentum stream, reducing correlation with pure growth or mean reversion strategies. It exploits market inefficiencies—buying undervalued stocks with strong momentum—and has historically delivered consistent returns, especially in trending markets. Our RISK OFF improvement further enhances the strategy by reducing exposure during bearish markets, preserving capital through CASH or bonds.

Backtest Results and Key Statistics

We backtested this strategy from 1998 to October 2024 to confirm its effectiveness in more recent market conditions. Below are the results of our backtest, which align with O’Shaughnessy’s historical findings:

• Compound Annual Return (CAGR): 17.412%, demonstrating strong long-term growth compared to the S&P 500’s historical average of around 10% over similar periods.
• Sharpe Ratio: 0.524, indicating a reasonable risk-adjusted return, balancing profitability with volatility.
• Drawdown: 56.500%, with the largest drawdown occurring in 2020 due to the COVID-19 crisis. This significant drop was driven by the unprecedented market crash in March 2020, which affected nearly all strategies, especially those with exposure to momentum factors like Relative Strength. However, the strategy recovered steadily as markets rebounded.

• Win Rate: 55%, with an average win of 2.29% and an average loss of -1.606%, leading to a Profit-Loss Ratio of 2.16. This shows the strategy’s ability to generate more substantial gains than losses over time.
• Net Profit: Starting with $1,000,000 in 1998, the strategy grew to $7,898,506.01 by October 2024, yielding a net profit of $7,798,506—a testament to its compounding power.
• Annual Standard Deviation: 0.242, reflecting moderate volatility, which is expected given the momentum component of the strategy.
• Alpha: 0.996, indicating significant outperformance relative to the market benchmark.
• Portfolio Turnover: 0.89%, highlighting the strategy’s low turnover due to annual rebalancing, which helps minimize transaction costs.

These results confirm that the PSR & Relative Strength strategy continues to perform well in modern markets, maintaining its edge as identified by O’Shaughnessy in his 1951-1994 tests. The elevated drawdown in 2020 underscores the importance of staying disciplined during market shocks, as the strategy’s long-term returns remain robust. Our RISK OFF improvement likely mitigated some losses during such periods by shifting to CASH or bonds.

We’ve implemented this improved version of this strategy and we are running it in real time. Follow our X account for updates on the verified track record and performance.

We hope the community can benefit from this PSR & Relative Strength strategy inspired by What Works on Wall Street. Feel free to test it, tweak it, and share your improvements as we work toward a best-in-class approach to value-momentum investing.