Market Adjusted Returns

How can you control for market conditions? You do so by calculating market-adjusted returns. As most things in investments, this adjustment is not as straightforward as it sounds. As a measure of underlying market conditions, you can use the S&P500 as your adjustment. Trading in SPY, an ETF that tracks the S&P500, began in 1993, which enables you to use SPY returns for adjustment as follows.

N-day market-adjusted return = N-day return – N-day return for SPY

This adjustment is not perfect. Theoretically, you want to adjust the return for your strategy by the return you would have received if you invested in the average stock that has the same risk. We screened companies using minimum volume and minimum dollar volume criteria (as described in Chapter 3, “The Occurrence of Gaps”) to avoid thinly traded, illiquid stocks. Although we removed extremely small and illiquid companies from the sample, stocks that have a smaller market capitalization than the stocks in the S&P Small-Cap 600 remain in the sample. Thus, the sample contains stocks with a wide range of market capitalizations. Academics will be quick to point out that the risk metrics of a pool of stocks with such a wide range of market capitalization are not identical to those of SPY; thus, the adjustment made in this book for market returns is not perfect.