Memorial Day 2018

Memorial Day is the Federal holiday to honor over 1 million who DIED serving in the U.S. military.

At 3 p.m., local time across the Nation, Americans will pause for the annual Moment of Remembrance to reflect on the sacrifice of America’s fallen warriors and the freedoms that unite Americans.

Semper Fidelis 

Is the economy, stupid?

Many investment professionals admit they are unable to “time the market.”

What is “market timing,” anyway? Wikipedia says:

Market timing is the strategy of making buy or sell decisions of financial assets (often stocks) by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis.

One reason they “can’t time the market” is they are looking at the wrong things. The first step in any endeavor to discover what may be true is to determine what isn’t. The first step in any endeavor to discover what may work is to determine what doesn’t.

For example, someone recently said:

“A bear market is always preceded by an economic recession.”

That is far from the truth…

The gray in the chart is recessions. These recessions were declared long after the fact and the new recovering expansion was declared after the fact.

The most recent recession:

“On December 1, 2008, the National Bureau of Economic Research (NBER) declared that the United States entered a recession in December 2007, citing employment and production figures as well as the third quarter decline in GDP.”

So, the economist didn’t declare the recession until December 1, 2008, though the recession started a year earlier.

In the meantime, the S&P 500 stock market index declined -48% as they waited.

While the recession officially lasted from December 2007 to June 2009, it took several years for the economy to recover to pre-crisis levels of employment and output.

The stock market was below it’s October 2007 high for nearly six years.

Economists declared the recession had ended in June 2009, only in hindsight do we know the stock market had bottomed on March 9, 2009. The chart below shows the 40% gain from the stock market low to the time they declared the recession over. But, they didn’t announce the recession ended in June 2009 until over a year later in September 2010.

Don’t forget for years afterward the fear the economy will enter a double-dip recession.

If you do believe some of us can predict a coming stock market decline or recession, it doesn’t seem it’s going to be based on the economy. Waiting for economics and economic indicators to put a time stamp on it doesn’t seem to have enough predictive ability to “time the market” to avoid a crash.

I suggest the directional price trend of the stock market itself is a better indicator of the economy, not the other way around. Then, some other signals begin to warn in advance like a shot across the bow.

But, for me, it’s my risk management systems and drawdown controls that make all the difference.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

Global Market Trends

Looking at broad indexes for global macro trends, global stocks are flat for the year, bonds are down as much as 6%, commodities are recently trending up.

At this point, U.S. stocks continue to look like a normal “correction” within ongoing higher highs and higher lows (a bull market). In this case, a correction is just a countertrend of “mean reversion” that has “corrected” the prior upside overreaction.

What would change the trend? changing from a normal “correction” within ongoing higher highs and higher lows (a bull market) to lower lows and lower highs. In that scenario, it would be a change in the dominant trend.

Only time will tell how it all plays out.

 

Mike Shell is the founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

The is no guarantee that any strategy will meet its objective.  Past performance is no guarantee of future results. The observations shared are for general information only and are not intended to provide specific advice or recommendations for any individual.

Is this correction and volatility normal?

With perfect hindsight, we now all know that January 26th was the recent price peak in the U.S. stock market. Since then, the S&P 500 has declined about -10% and the Dow Jones Industrial Average about -12%. For simplicity, I’m going to focus on U.S. stock market here.

I wasn’t surprised to see the decline and am not surprised to see “more volatility,” because it would be getting back to “normal.”

But I see recent price action has sure gotten the attention of many on social media. Some even seem dazed and confused.

I’m not surprised about that, either.

On January 11, before stock market declined prices started swinging up and down (volatility), I shared an observation with my friends on Twitter and a warning:

On January 24th, I again warned of complacency. The message was clear:

At this point, this is a normal and expected “correction” of what was an upside overreaction in the prior months. The stock index has declined about -10%, regained some of the loss in March and more recently retested the February 8th low. As long as the lows hold, I consider this a normal correction.

stock market spx

Sure, the decline was sharp and fast, but that’s no surprise for me after such an upside move. I said it was “expected” because, as I pointed out above, 2017 was very abnormal because it lacked the typical -5% to -10% declines we normally see over most 12 month periods in the stock indexes.

Another way I define a “normal correction” is a simple trend line drawn under the price over the past 12 months. Without adding a lot of complicated looking indicators to express it, below we see the stock index has just “reverted to its trend.” The peak in December and January was an abnormal overreaction on the upside, which I pointed out as it was happening. The recent -10% decline has simply put the trend back in a more normal range.

stock market normal correction trend

What is normal, typical, or expected? 

I’m observing a lot of commentaries as if this correction and volatility isn’t normal.  The fact is, many people often include their emotions and feelings along with price action.

Investors perceive what they believe is driving a price trend and what they believe is always true for them.

The February decline was commonly blamed on “the machines,” which got a little silly.

This time, it’s geopolitics.

I believe it’s just the market, doing what it does, and there are so many drivers at the same time I don’t bother to attempt such a narrative. My narrative is simple; the force of sellers took control and outweighed the enthusiasm of buyers.  It is just the market, doing what it does.

I’ve been seeing and experiencing these trends so closely for so long and I remember the regime shifts. I want to share with you my observations of what have been “normal” corrections in terms of drawdowns. A drawdown is the % decline from a prior price high to its low. I show only the period of the past 9 years, which is one of the longest bull markets in history (without a -20% decline).

stock market historical bear market length drawdowns

As you can see, since April 2009, we’ve seen four declines of -15% or more and it took them several months to recover.

These declines of -15% or more are why many people have been unable to hold on to the stock market since the March 2009 low with any meaningful allocation to stocks. When prices fall -10%, investor sentiment shifts from greed to extreme fear. Some of them may even begin to tap out by selling their stock holdings for fear of more losses.

To be sure, here is an investor sentiment indicator at the February 8, 2018 low.

Investor sentiment Februrary 8 2018

In fact, investment managers like me who have dynamic risk management systems may even sell to reduce exposure to loss as an intentional drawdown control. But this time, as I pointed out, the stock market was already at risk of a reversal before this decline. So, a robust risk management system may have reduced exposure before the decline, not after.

We find that declines over -10% get more attention, especially when they get down to -15%. Those can also be more hostile conditions for trend systems, too, as risk management systems cause us to exit and later re-enter.

The point is, over the past 9 years a -15% decline has been a “normal” occurrence and there are many -5% (or more) declines too.

It is only at a -10%, so far, and that’s not unusual.

I intentionally used the last 9 years. Not to show an arbitrary 9 year period, but instead to intentionally leave off March 2009. I did that because the first three months of 2009 was a -24% decline, a continuation of the 2008 waterfall decline. The stock market was still in the bear market that began October 2007. So, this wouldn’t be complete without a reminder of what that period looked like before I go on to show the pre-2008 period.

All bear markets do necessarily begin with declines of  -10%, -15%, -20% . They are actually made of many swings up and down along the way. We often hear people speak of the last bear market as “2008” as though the only loss was the -37% decline in the S&P 500 in 2008.

That is far from reality.

The decline was -56%.

2008 stock market drawdown length of bear market

The drawdowns we’ve seen since 2008 are more than twice what we saw in the bull market from 2003 to 2008 after the “tech wreck.” Below we see the typical decline then was closer to -5% with only a few getting into the -7% or more range. 2004 to 2008 bull market low volatility

Clearly, it was a lot easier to hold a larger allocation of stocks, then.

What is normal and what has changed?

The last 9 years has been more hostile for passive asset allocation investors to hold on to their stock positions because the declines were -15% or so and take months to recover. It’s also been more challenging for active risk managers since a drawdown control system necessarily reduces exposure as prices fall with the intent to control drawdown.

But, to define what is normal today, a -10% to -15% decline is within a normal corrective drawdown.

The recent past matters simply because that’s what investors and traders anchor to. Most people put more emphasis on the recent past. Our experience and how much we’ve studied and observed the trends determine how much we can recall easily. I’ve been an investment manager most of my life, over two decades now. For me, it hasn’t been a hobby or part-time venture, it’s what I do and who I am. So, my memory of these trends and intuitions about what is normal, or not, is what it is.

If you are wondering, here are the drawdowns for the S&P 500 going back about 70 years. I highlighted the -15% declines or more, which obviously gets investors attention.

stock market bear market length and dradowns

Clearly, there are a lot of -15% or greater declines. In fact, there are several -30% and three in the -45% or larger drawdowns.

Knowing this, it’s why I say:

We believe world markets require active risk management to avoid large losses and directional trend systems to position capital in profitable price trends.

And, I also say:

It doesn’t matter how much the return is if the downside risk is so high you tap out before it’s achieved.

But at this point, you can probably see that the current -10% decline is so far within a “normal correction.”

Though, as I shared in The enthusiasm to sell overwhelmed the desire to buy March 19, 2018, I expect to see more swings (volatility) than last year, and that would be “normal” too.

I define this as a non-trending market. When I factor in how the range of price movement has spread out more than double what it was, I call it a non-trending volatile condition.

Markets decline to a low enough point to attract buying demand. Only time will tell how it all plays out from here.

If you enjoyed this, I encourage you to read “What About the Stock Market Has Changed? A Look at Ten Years of Volatility” 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

 

What’s going to happen next? continued

The stock market is getting a lot of attention this past week since the global stock market indexes were down as much as -4% for the MSCI EAFE Developed Countries index to the most significant decliner in the U.S. was the NASDAQ (represented below by PowerShares QQQ), which declined over -7%.

I said in What’s going to happen next? on Friday, the most important factor is the stock index is near its prior low in February when it declined -10% sharply. To reemphasize the rest of what I said:

“By my measures, it’s also reached the point of short-term oversold and at the lower price range that I consider is within a “normal” correction.

I know many traders and investors were expecting to see a retest of that low and now they have it. So, I expect to see buying interest next week. If not, look out below… who knows how low it will need to go to attract buying demand.”

As expected, so far today stocks have indeed found some buying demand at the prior low as we see in the chart below. As I suggested, this second low could bring in buyers who were waiting for this retest of the low in February.

Only time will tell how much buying enthusiasm we see from here. It could be enough to eventually drive prices to new highs, and this -10% correction forms a “W” pattern and the correction quickly forgotten.

Or, the buying interest we see now may not be enough to continue a sustainable upward trend.

Ultimately, the price trend of our individual positions is the final arbiter. My decisions are made based on what the price trend is actually doing.

But, I have other quantitative and technical measures that can be a useful guide to update expectations as trends unfold. I look at these trends because I enjoy it and share my observations, so you get a glimpse of how I see trends unfold over time.

This could change any moment, but at this point, I see today’s gains are relatively broad as all the U.S. sectors are positive with Financials, Consumer Discretion, and Technology leading the way. Past performance does not guarantee future results, but Sector strength in the more cyclical Financials, Consumer Discretionary, and Technology leading the way is a good sign.

Getting more technical and quantitative,  I want to update the breadth indicators I shared at the lows on February 9th in Stock Market Analysis of the S&P 500 

At the lows, in February I pointed out the % of stocks in the S&P 500 had shifted from what I consider the “Higher Risk Zone” to the “Lower Risk Zone.” Though that could have been the early stage of a bear market because it could have got much worse, but those stocks instead reversed up from that point. Last weeks downtrend pushed them even deeper in what I consider the “Lower Risk Zone.”

S&P 500 STOCKS BULLISH PERCENT ABOVE MOVING AVERAGE

As we see in the chart above, half of the 500 stocks in the S&P 500 stock index are trending below their own 200 day moving average and half are trending above it. I used the Point & Figure method to clearly express the % of stocks in the S&P 500 that are above their 200 day moving average.

If you think about how long 200 trading days is, it’s about 10 months. If a price is trading above its moving average, it’s considered to be in a positive trend, if it’s trending below the average it is trending down. My trend signals are generated from more robust proprietary systems, so I do not trade using this moving average, but it can be a simple guide to illustrate a trend.

To be precise, at the February low 56% of the 500 stocks were trading in a positive trend after they had reached what I consider a “Higher Risk Zone” in January when most of the stocks, 82%, were in a positive trend. After many stocks trended down, they reversed up to the point that 71% were above their 200-day average during the countertrend. Now that prices have fallen again, even more stocks are in a downtrend.

It may seem a contradiction for this to be potentially bullish because it shows half the stocks have been trending down (and it is), but I’ve been observing this indicator for two decades and what I see in the most simple terms is:

  • When most stocks had already trended up as they had in January when 82% were in positive trends, we are likely to see a countertrend and mean reversion at some point.
  • When most stocks have already trended down to negative trends, we are likely to see a countertrend and mean reversion.

Guess what mean reversion is?

About halfway…

For those who aren’t as mathematically inclined, that would be the 50-yard line. The 50% on the chart above…

Now, keep in mind, it’s only at 51% down from 82% in January. It could go to 5 or 10%, which would take a significant decline from here. But, so far, the ball is on the 50. Which end zone it reaches next will depend on who is stronger; the buyers or the sellers.

If you want more detail and to better understand where I am coming from, revisit what I wrote in February: Stock Market Analysis of the S&P 500.

Risk management is the common characteristic among all the best traders/investors who have lasted over the many significant up and down market cycles of the past decades. I decided I was going to be one of them over two decades ago. No matter how you choose what and when to buy, it is essential to control the size of your potential loss. If you want to learn what I mean by that, read the previous ten or twenty observations I’ve shared here. This is not individual investment advice. The only individuals who get our advice are clients who have an investment management agreement with us. If you have any questions, contact us.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The is no guarantee that any strategy will meet its objective.  Past performance is no guarantee of future results. The observations shared are for general information only and are not intended to provide specific advice or recommendations for any individual.

 

What’s going to happen next?

S&P 500 has declined to the 200-day moving average. I don’t trade the moving average, but include it as a reference for the chart. More importantly, the stock index is also near its low in February.

By my measures, it’s also reached the point of short-term oversold and at the lower price range that I consider is within a “normal” correction.

I know many traders and investors were expecting to see a retest of that low and now they have it. So, I expect to see buying interest next week. If not, look out below… who knows how low it will need to go to attract buying demand.

 

Mike Shell is the founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right.

The is no guarantee that any strategy will meet its objective.  Past performance is no guarantee of future results. The observations shared are for general information only and are not intended to provide specific advice or recommendations for any individual.

Apparently there was more enthusiasm to sell

The U. S. stock market as measured by the S&P 500 declined -2.57%.

The shorter-term investor sentiment measures suggest fear is driving the stock market. That may be a positive signal since investor sentiment gets it wrong at extremes.

I don’t have anything more to share beyond what I wrote earlier this week, which I have reprinted below:

My systems define this as a non-trending market. When I factor in how the range of price movement has spread out more than double what it was, I call it a non-trending volatile condition. It is useful for me to identify the market regime because different trend systems have different results based on the situation. For example, non-trending volatile market conditions can be hostile situations for both passive and trend following strategies. However, countertrend systems like the swings of a non-trending volatile market.

Trend following systems thrive in markets that are trending and smooth. When a market is trending and smooth, the trend following system can earn gains without having to deal with significant adverse price action. When a market trend shifts to non-trending and volatile, the trend following signals can result in whipsaws. A whipsaw is when the price was moving in one direction (and the trend follower buys) but then quickly reverses in the opposite direction (and maybe the trend follower exits with a loss). Even if the trend following system doesn’t enter and exit with a loss, in a non-trending volatile market the trend follower has to deal with the same hostile conditions as a passive investor as the market swings up and down.

My U. S. equity exposure since early February has come from my shorter term countertrend systems. My focus and the focus of my systems isn’t to predict the direction of markets but instead to identify when a market is undergoing a regime change or shifts to a distinct environment. I don’t analyze the markets to try to predict what it will do next. I look at what the market is actually doing and react to it.

 

Mike Shell is the founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter @MikeWShell

The is no guarantee that any strategy will meet its objective.  Past performance is no guarantee of future results.

 

 

The enthusiasm to sell overwhelmed the desire to buy March 19, 2018

The enthusiasm to sell overwhelmed the desire to buy. The S&P 500 stock index closed down -1.42% today. Stocks trended down most of the day and at 2:35pm it was down -2%. As you can see on the chart, it reversed up in the last 90 minutes and closed with positive directional movement. It almost closed above its Volume Weighted Average Price (VWAP).

There are many notable economic reports out this week, so maybe investors are concerned about to the jobs report and the Fed FOMC Meeting. The options market has priced in a 94% chance of a rate hike, so it shouldn’t be a surprise. But, this week is the first FOMC meeting for the new Chairman Powell.

Implied volatility in recent weeks is one of many signals that suggest a volatility regime change. The CBOE Volatility Index® (VIX® Index®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. The VIX® doesn’t seem to want to go back to those prior low levels, so the expectation is higher volatlity.

At this point, the decline today was nothing too abnormal. The stock index is -3.% off it’s high a few weeks ago and -5.4% off its all-time high. However, as you can see below it is within a normal trading range. Speaking of trading range, notice the bands of realized volatility I added to the chart are drifting sideways rather than trending up or down. I see higher lows, but equal highs in the most recent trend and lower highs looking back to January. The VIX is expected volatility, the blue bands are realized volatility.

My systems define this as a non-trending market. When I factor in how the range of price movement has spread out more than double what it was, I call it a non-trending volatile condition. It is useful for me to identify the market regime because different trend systems have different results based on the situation. For example, non-trending volatile market conditions can be hostile situations for both passive and trend following strategies. However, countertrend systems like the swings of a non-trending volatile market.

Trend following systems thrive in markets that are trending and smooth. When a market is trending and smooth, the trend following system can earn gains without having to deal with significant adverse price action. When a market trend shifts to non-trending and volatile, the trend following signals can result in whipsaws. A whipsaw is when the price was moving in one direction (and the trend follower buys) but then quickly reverses in the opposite direction (and maybe the trend follower exits with a loss). Even if the trend following system doesn’t enter and exit with a loss, in a non-trending volatile market the trend follower has to deal with the same hostile conditions as a passive investor as the market swings up and down.

My U. S. equity exposure since early February has come from my shorter term countertrend systems. My focus and the focus of my systems isn’t to predict the direction of markets but instead to identify when a market is undergoing a regime change or shifts to a distinct environment. I don’t analyze the markets to try to predict what it will do next. I look at what the market is actually doing and react to it.

 

Mike Shell is the founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter @MikeWShell

The is no guarantee that any strategy will meet its objective.  Past performance is no guarantee of future results.

 

When I apply different trend systems to ETFs

In my portfolio management, I primarily want to identify trends and get positioned with that trend. As long as there is uncertainty, we’ll see trends. Investor sentiment and expectations underreact to information causing the price to adjust gradually and that’s what produces a trend. The trend following systems I wrote about in My Introduction to Trend Following are designed to buy an asset when its price trend goes up, and sell when its trend goes down, expecting price movements to continue.

We also see the overreaction of investor sentiment and their expectations. After price keeps rising, investors may become overly enthusiastic, which causes prices to overreact and move up to an extreme that matches their sentiment. We saw that the last part of 2017 and it continued in January. We say these markets have become “overbought” and mathematical indicators can signal a countertrend.

We also sometimes see investor sentiment and their expectations plunge as they panic when prices are falling. We say these markets have become “oversold” and mathematical indicators can signal a countertrend. Looking back over the past two months, we may have seen an overreaction on the upside, then an overreaction on the downside. I say that because the stock market very quickly dropped -10%, then recovered most of it a few weeks later.

Someone asked recently “Do you invest and trade in all ETFs and stocks using the same trend system?” The answer is “not necessarily.” As I described above, trend following and countertrend systems are very different. Trend following systems can be multiple time frames, but usually longer trends of at least several months to years. Countertrend moves are normally shorter term as a market may get overbought or oversold, but it doesn’t usually stay that way a long time. For example, the S&P 500 was overbought the last few months of 2017 and that was an anomaly. It was one of the most overbought periods we’ve seen in the stock indexes. So, it was no surprise to see a fast -10% decline.

My point is, different trend systems can be applied to markets. Both trend following and countertrend are trend systems, they just intend to capitalize on a different trend in behavior – overreaction or underreaction.

When I apply my countertrend systems to markets, a great illustration is the high dividend yield market. A great example is the Global X SuperDividend® ETF $SDIV which invests in 100 of the highest dividend yielding equity securities in the world.

Below is a price chart in blue and it’s dividend yield in orange over the past five years. As you can see, the price trend and dividend yield have an inverse correlation. As the price goes up, the dividend yield from that starting point goes down. That is, if we invest in it at higher prices, the dividend yield would have been lower. But, as the price goes down, the dividend yield from that starting point goes up. If we invest in it at lower prices, our future income from dividend yield is higher.

 

For example, I highlighted in green the price was at its low when the yield was also at its highest at 8%. Investors who bought at the lower price earn the higher yield going forward (assuming the stocks in the index continue paying their dividend yields). If we invested in it in 2014 the yield was 6%. High yielding stocks are not without risks. High yielding stocks are often speculative, high-risk investments. These companies can be paying out more than they can support and may reduce their dividends or stop paying dividends at any time, which could have a material adverse effect on the stock price of these companies and the ETFs performance. You can probably see how an ETF that includes 100 of these stocks may be more attractive to gain exposure rather than risking a few individually.

This is an example of when we may use a countertrend system. As I am more inclined to invest in positive trends, this is an example of a situation I may be more willing to buy low. But, I always focus on Total Return. All of my systems include Total Return data that includes the dividend yield, not just the price trend. So as I explain this, keep in mind we still apply my risk management and trend systems but we consider and account for the high yield that makes up its total return.

Below is a chart of the Global X SuperDividend® ETF $SDIV from the low point in 2016 (I highlighted in green above). I charted both the price trend by itself as well as the Total Return which includes dividends. Had someone invested in it at the low, we saw above their yield would be 8% and the impact is evident in the difference. With the dividend yield included, the return was 36% and 18% without it. In other words, the dividend was half the return over this period. The higher the dividend yield at the point of entry, the more it can have an impact on Total Return.

As a special note for our investment management clients who are invested in ASYMMETRY® Global Tactical. We do not reinvest dividends. Instead, we want the cash dividends to go into the cash portion of our portfolio. Since we usually have some positions that generate a monthly yield, it provides the cash balance we need to cover any slippage between trades, investment management costs, as well as provide cash for other investments. I mention this, because any position we hold like this with a high yield may not appear to have as large of a percentage gain since it only represents the price return, not the total return. That is simply because we are using the cash instead of reinvesting the dividends.

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

 

 

My Introduction to Trend Following

I have noticed more investors are talking about “trend following” these days and more traders and advisors are calling themselves trend followers. As a professional portfolio manager who has been applying trend systems to global markets for two decades, one of the most common questions I get asked is “how did you get started?” Specifically, how my investment strategy, risk management, and trend systems evolved over time. I’ll explain it here, so you know where I am coming from.

Why do you think we learn math by hand before using a machine? We learn to do the math manually because it teaches us the basics before we use a computer. We learn to ask the right questions, turn problems into math formulas, then do the calculations. By working it out manually by hand, we get a feel for the math, an instinct for it. I learned trend following the same way.

What is trend following?

Trend following or trend trading is a trading strategy according to which one should buy an asset when its price trend goes up, and sell when its trend goes down, expecting price movements to continue.”

My first introduction to the term “trend following” was John Murphy‘s Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications published by New York Institute of Finance in 1999. It was the first book I read clearly dedicated to charting price trends and technical analysis.

In the early 1990’s the first book I read on investment and trading was How to Make Money in Stocks: A Winning System in Good Times and Bad by William J. O’Neil. He described a systematic quantitative approach to screen for stocks with high relative price strength, high earnings growth, and then determine the entry and exit viewing a price chart. O’Neil’s research discovered the best stocks display seven common traits just before they make their biggest gains.  O’Neil calls his strategy the CAN SLIM® Investment System. The CAN SLIM® system for deciding what to buy is based on things like strong earnings growth, which is believed to be the primary driver of a stocks price trend. Once he has screened for this criteria, O’Neil applies trend following to stocks because he requires them to be in a positive trend.

After researching and applying his investment system for years in the late 1990’s, I wanted to create my own system that fit me.  My first interest was to become more advanced in the understanding and identifying directional price trends. Naturally, that was the beginning of my extensive research that began with studying every book I could find on technical analysis and doing every training program I could do.

I went on to read over 500 books covering a broad range of portfolio management topics including trading, technical analysis, and maths like probability and statistics. I wanted to understand how markets interact with each other, what typically drives trends, and what trends look like. Studying price trends naturally led me to investigate investor sentiment, trading psychology, and investor psychology. I have always had a strong interest in math and I think in terms of systems and algorithms, so fifteen years ago I shifted from looking at charts visually to testing and developing trading systems based on price trends.

By 2006, I had already begun testing and developing quantitative computerized trading systems, but I was still also working on the craft of charting and CAN SLIM®. In 2006, I flew out to Santa Monica, CA to attend the first CAN SLIM® Masters Program training with O’Neil and his portfolio managers and passed the exam for the CAN SLIM® Masters certification. I also had become skilled at all kinds of charting including bar charts, point & figure charting, and candlestick charting. I believe becoming a craftsman at all of these different methods provided me with unique skills to understand price trends, how markets interact, and developing computerized trading systems.

I have spent over two decades fully immersed in learning about methods of identifying trends and systems and how to trade them across multiple time frames and multiple markets. My own experience started with basic charting, evolved with more technical analysis tools, then I developed computerized trading systems based on the knowledge and skills I cultivated. Reading books (or writing them) only discovers knowledge. The only way to develop skill is through the intentional practice of actually doing it.

Before I share one of the first things I read on trend following, I want to explain there is more than one way to execute a trend system.  Whether you are an investor who invests in an investment program or a trader who makes the portfolio management decisions in an investment program, you have to choose which fits you and your own beliefs. I can only tell you what I believe. What you believe is true, for you. As I have been successful doing what I do, I can only tell you that the key to success if finding what fits you. Reading information like this is intended to help you decide what you believe and what you don’t believe.

I see tactical traders applying two main methods for trend following. Some of them say they are “rules-based” others say they are “systematic”, but we don’t often see them say they are “discretionary” even if they are. Here is how I see it.

Discretionary trend following trading and investment decisions can include a wide range of operations, but I’m specifically talking about a discretionary trend follower. A discretionary trend follower is someone who looks at a chart, sees the signal, sees that it looks right, and pulls the trigger. The discretionary trend follower may be rules-based and may have a systematic process, but the discretionary trend follower is ultimately making the decision to buy or sell.

Systematic trend following trading and investment decisions apply a set of rules and procedures for trading and investment decisions. To me, a trend follower can be systematic but also be discretionary. A systematic “discretionary” trend follower may be still discretionary but has rules and a process. For example, they look at a chart, see the signal, see that it looks right, and pulls the trigger. Or, a trend follower can be systematic and automated by a computerized trading system that generates the signals. However, when the professional investment industry says “systematic trading” or “systematic trend following” we usually mean more automated and mechanical.

Automated Systematic trend following is necessarily systematic because it’s when we use a computer program to generate the signals automatically. But, a fully systematic trend follower who is automated has a program that not only generates a trend following signal but also generates trade instructions to the broker. A fully mechanical and automated trend following system is computerized to the point that it enters the trades.

I explained these operational methods so you will know where I am coming from as you read about trend following in a technical analysis book. Which of these you believe in is up to you. I believe that either discretionary trend following or systematic with automation can both work. It’s just a matter of which method fits you. There are potential advantages and disadvantages of both and depending on your personal preference, you’ll see them that way. If you are an investor in an investment program, you need to invest with a portfolio manager that fits your preference. If you are a trend following trader, you may lean toward one or the other.

Some traders simply like looking at charts and making their decision that way. They need to see the signal and see that it looks right according to their rules to get the confidence to execute. Others may not be so skilled at seeing the signal on a chart, or maybe they don’t want to spend their time doing it so we can program a computerized system. It seems many new systematic traders weren’t good at discretionary decisions using charts, so their backtesting makes them feel more confident. Only time will tell if these newer systematic traders will be able to follow their automated systems when they invariably don’t perform as they hoped all the time.

Ultimately, it comes down to beliefs and confidence. If you aren’t confident in your ability to see the signal and execute from a chart consistently, then an automated system may help. Some trend followers gain more confidence seeing the signal and pulling the trigger. Those same trend followers would likely have difficulty executing system generated trades.

I often hear things like “our systematic model removes the emotion”, which is far from the truth. Anyone who believes an automated system will remove their emotional issues will eventually experience a whole new set of emotions they may not have felt yet. But, some have a real problem with pulling the trigger, so an automated system may help if they have someone else execute the trades. For example, a professional money management firm like mine has professional traders who execute our trades. But, this still doesn’t assure anyone the trend follower will be able to follow the system through different market conditions.

If someone lacks the self-discipline required to pull the trigger, execute the trades, and follow whatever systems they follow, no method or automation will help. If a trader or investor lacks self-discipline, that issue has to be resolved another way before they’ll find success.

I know at least 100 or so professional investment managers who have been tactical trading including trend following for a decade or a few decades. I’ve seen a range of experiences and outcomes. I can tell you that it isn’t easy. The only people who will say it is are those who aren’t actually doing it. Developing an edge either personally as a discretionary trader or through an automated trading system requires a tremendous amount of knowledge, skills, and self-discipline. Few have it, but some of us do. I believe in human performance because I’ve experienced it first hand. It’s like hockey or Indy racing. Anyone can attempt it, but only the most dedicated will achieve long-term success. Rest assured, discretionary or systematic, it’s still a human endeavor as long as it’s their money.

By now, you may be wondering what I believe and what I do. I do a combination of these. I am Man + Machine. I started charting over two decades ago and applied what I knew to developing computerized systems fifteen years ago. I still enjoy drawing charts like I share here on ASYMMETRY® Observations to see how trends are unfolding. I have several systems that are fully automated that trade all kinds of markets. I’ve learned a lot from just operating them for so long. But ultimately, I use my systems to inform decisions and generate signals and I have the necessary discipline to pull the trigger by sending instructions to my professional traders who execute my trades. That’s what works for me. What works for others may be different. I know where I am sitting right now and it’s where I want to be.

Without further ado, I present one of the first things I read on trend following published in 1999. As you will see, trend following and technical analysis are related. Trend following uses technical indicators like trend lines, moving averages, directional movement, and momentum to generate signals for following trends.

John Murphy is a well-known technical analyst whose books I have read for over two decades. His first book I read was Technical Analysis of the Futures Markets published in 1986 which was charting applied to commodities futures. One of my first introductions to the “trend following” strategy was John Murphy’s Technical Analysis of the Financial Markets published in 1999. I share the following with permission from John Murphy. He starts with the philosophy or rationale of technical analysis, which has an objective of following trends in hopes they will continue. The rest of the book describes many ways to actually identify trends.

Except from Technical Analysis of the Financial Markets:

_______________________

There are three premises on which the technical approach is based:

  • Market action discounts everything.
  • Prices move in trends.
  • History repeats itself.

The statement “market action discounts everything” forms what is probably the cornerstone of technical analysis. Unless the full significance of this first premise is fully understood and accepted, nothing else that follows makes much sense. The technician believes that anything that can possibly affect the price— fundamentally, politically, psychologically, or otherwise— is actually reflected in the price of that market. It follows, therefore, that a study of price action is all that is required.

All the technician is really claiming is that price action should reflect shifts in supply and demand. If demand exceeds supply, prices should rise. If supply exceeds demand, prices should fall.

The technician then turns this statement around to arrive at the conclusion that if prices are rising, for whatever the specific reasons, demand must exceed supply and the fundamentals must be bullish. If prices fall, the fundamentals must be bearish.

Most technicians would probably agree that it is the underlying forces of supply and demand, the economic fundamentals of a market, that cause bull and bear markets. The charts do not in themselves cause markets to move up or down. They simply reflect the bullish or bearish psychology of the marketplace.

As a rule, chartists do not concern themselves with the reasons why prices rise or fall. Very often, in the early stages of a price trend or at critical turning points, no one seems to know exactly why a market is performing a certain way.

While the technical approach may sometimes seem overly simplistic in its claims, the logic behind this first premise— that markets discount everything— becomes more compelling the more market experience one gains.

It follows then that if everything that affects market price is ultimately reflected in market price, then the study of that market price is all that is necessary.

By studying price charts and a host of supporting technical indicators, the chartist in effect lets the market tell him or her which way it is most likely to go. The chartist does not necessarily try to outsmart or outguess the market.

All of the technical tools discussed later on are simply techniques used to aid the chartist in the process of studying market action.

The chartist knows there are reasons why markets go up or down. He or she just doesn’t believe that knowing what those reasons are is necessary in the forecasting process.

Prices Move in Trends

The concept of trend is absolutely essential to the technical approach. Here again, unless one accepts the premise that markets do in fact trend, there’s no point in reading any further.

The whole purpose of charting the price action of a market is to identify trends in early stages of their development for the purpose of trading in the direction of those trends. In fact, most of the techniques used in this approach are trend following in nature, meaning that their intent is to identify and follow existing trends.

There is a corollary to the premise that prices move in trends— a trend in motion is more likely to continue than to reverse. This corollary is, of course, an adaptation of Newton’s first law of motion. Another way to state this corollary is that a trend in motion will continue in the same direction until it reverses.

This is another one of those technical claims that seems almost circular. But the entire trend following approach is predicated on riding an existing trend until it shows signs of reversing.

__________________________

He explained the philosophy or rationale of technical analysis, which has an objective of following trends in hopes they will continue. The rest of the book describes many ways to actually identify trends. As I see it, trend following uses technical indicators to generate signals for following trends.

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

Asymmetric force was with the buyers

In Asymmetric force direction and size determines a trend, I explained how the net force of all the forces acting on a trend is the force that determines the direction. The force must be asymmetric as to direction and size to change the price and drive a directional trend.

The asymmetric force was with buyers as they dominated the directional trend on Friday.

Friday’s gain helped to push the stock market to a strong week and every sector gained.

The S&P 500 stock index is about -3% from it’s January high and closed slightly above the prior high last week. I consider this a short-term uptrend that will resume it’s longer-term uptrend if it can break into a new high above the January peak.

After declining sharply -10% to -12%, global equity markets are recovering. The good news for U.S. stocks is the Russell 2000 small company index is closest to its prior high. Small company leadership is considered bullish because it suggests equity investors are taking a risk on the smaller more nimble stocks.

As you can see in the chart, the Dow Jones Industrial Average and International Developed Countries (MSCI EAFE Europe, Australasia and Far East) are lagging so far off their lows but still recovering.

So far, so good, but only time will tell if these markets can exceed their old highs and breakout into new highs, or if they discover some resistance force at those levels and reverse back down. As we discussed in Asymmetric force direction and size determines a trend it’s going to depend on the direction and size of the buyers vs. sellers.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

Asymmetric force direction and size determines trend

In physical science, force is used to describe the motion of a push or pull. Newton’s first law of motion – sometimes referred to as the law of inertia. Newton’s first law of motion is stated as:

“An object at rest stays at rest and an object in motion stays in motion with the same speed and in the same direction unless acted upon by an unbalanced force.” —Newton’s First Law of Motion

Unbalanced force? well well, there’s another asymmetry.

A push or pull is a force. To define a force, we must know its direction and size. It works similar to supply and demand on market prices. If there is enough size in a direction, a price will move in that direction. If there isn’t enough price size in a direction, the price will stay the same.

There are two kinds of forces:

Symmetrical (balanced) forces are equal in size, but opposite in direction. Symmetric forces are balanced, so they lack the direction and size to cause a change a motion. The push and pull are equal and offsets each other. Applying the concept of force to price trends in the market, when balanced forces act on a market price at rest, the market price will not move. When buying enthusiasm and selling pressure are the same, the price will stay the same.

Asymmetrical (unbalanced) forces are not equal and are opposite in direction, so they cause a change in the motion. The size of one directional force is greater than the other, so it’s going to trend in that direction. Some examples of these unbalanced forces can be observed in physical science.

More than one force can be acting at the same time, so the forces are combined into the net force. The net force is the combination of all the forces acting on a trend. The net force determines the direction. If forces are trending in opposite directions, then the net force is the difference between the forces, and it will trend in the direction of the larger force. You can probably see how that is visible in a chart of a price trend.

If buyers are willing to buy more than sellers are willing to sell, the buying pressure is a force that forces up the price until it gets high enough to push sellers to sell.

If sellers are ready to sell more than buyers are willing to buy, the selling pressure is a force that pulls down the price until it gets low enough to pull in buyers to buy.

So, Newton’s first law of motion and inertia is related to Economics 101: When the size of the force of buyers or sellers is larger in one direction, the price will trend. We can observe who is more dominant by simply looking at a price trend chart or quantifying it in a trading system.

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

Investment results are probabilistic, never a sure thing. Past performance is no guarantee of future results.

 

 

Betting on price momentum

“Don’t fight the tape.”

“Make the trend your friend.”

“Cut your losses and let your winners run.”

“These Wall Street maxims all mean the same thing—bet on price momentum. Of all the beliefs on Wall Street, price momentum makes efficient market theorists howl the loudest. The defining principle of their theory is that you cannot use past prices to predict future prices. A stock may triple in a year, but according to efficient market theory, that will not affect next year. Efficient market theorists also hate price momentum because it is independent of all accounting variables. If buying winning stocks works, then stock prices have “memories” and carry useful information about the future direction of a stock.”

James O’Shaughnessy, What Works on Wall Street: A Guide to the Best-Performing Investment Strategies of All Time 1st Edition (1996) 

 

Investment management can take many years of cycles and regimes to understand an edge.

It takes at minimum a full market cycle including both bull/bear markets to declare an edge in an investment management track record.

But we also have different regimes. For example, each bull market can be different as they are driven by unique return drivers. Some are more inflationary from real economic expansion driving up prices. Others are driven by external manipulation, like the Fed intervention.

I’ve been managing ASYMMETRY® Global Tactical for fourteen years. It’s an unconstrained, flexible, adaptable, go-anywhere global tactical program without the limitations of a fixed benchmark. I pursue absolute returns applying dynamic risk management and unconstrained tactical trading decisions across a broad universe of global currency, bonds, stocks, and commodities.

So, I can tell you the bull market 2003-07 was a regime of rising commodities, foreign currency, and international producers of commodities. In this bull market, U.S. equities have dominated. We can see that in the chart below. If your exposure up until 2008 was only U.S. stocks, you would be disappointed as Emerging Markets countries like China and Brazil were much stronger as was commodities. We can also see how those markets have lagged since the low in 2009.

Everything is impermanent, nothing lasts forever, so this too shall change eventually.  Those who believe the next decade will be like the past do not understand the starting point matters, the return drivers, and how markets interact with each other. Past performance is never a guarantee of future results.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

Investment results are probabilistic, never a sure thing. Past performance is no guarantee of future results.

 

Stock pickers market? Sector rotation with stocks for asymmetric reward to risk

After yesterdays 1.1% gain for the S&P 500, it is back in positive territory for the year. It’s been a very volatile start for 2018 with an abnormally strong trend in U.S. stocks late 2017 continued in January only to be wiped out in February. Below is a visual representation, showing the period November 2017 to the low last month. I point that out to show how quickly a trend can change and prior gains of 12% in just a three-month time frame and be erased in a -10% decline over 9 days. Most of the decline was in two days over that period.

With that said, as the broad stock market is lagging in its third month of the year so far, two sectors are leading. Consumer Discretionary (XLY)  and Technology (XLK). At Shell Capital, we monitor global market trends at the broad market level like the S&P 500 which is diversified across 500 stocks that are a part of 10 sectors. These sectors are tradable via ETFs. We can quickly get broad exposure to the overall stock market, or we can get more granular and get exposure to a sector in a low-cost structure with Sector ETFs.  I also monitor the individual stocks inside the sector ETF. When the overall market is in a positive trend, most of the stocks in a sector should be trending up. But, when the overall market has struggled to trend up, like this year-to-date, fewer stocks are trending up inside a sector.

The popular narrative becomes “it’s a stock pickers market.”

I don’t say that myself, I just observe when it is “a stock pickers market” naturally through my daily quantitative research. Here are some examples of my observation.

I pointed out yesterday in Buying demand dominated selling pressure in the stock market that only 32% of the 500 stocks in the S&P 500 are above their 50-day moving average. After yesterdays stock market gain, the participation increased to 40%. The 50-day moving average is a short-term trend indicator, so if 60% of the stocks are below that trend line, we can infer “most stocks are in short-term downtrends.” As of yesterdays close, only 203 (40%) of the S&P 500 are above their 50-day moving average, which means 297 are below it. You can probably see if the price trend continues up, we should see more and more stocks participate in the trend. In fact, if we don’t see more stocks participate, it necessarily means only a few stocks are driving the broad index trend up. I would consider that “a stock pickers market.” Of course, the trick is to see this in advance, or early enough in the stage to capitalize on it. We don’t have to know in advance what’s going to happen next, and we don’t, we just need to observe it soon enough to capture some positive asymmetry (P>L).

I like a visual representation, so here is the chart of the S&P 500 Percent of Stocks Above 50 Day Moving Average. I colored the top part of the chart red and labeled it “Higher Risk Zone” and the lower part green with the label “Lower Risk Zone”. The observation is when 80% of stocks are already trending positive that momentum is a good thing, but as a skilled risk manager, I begin to prepare for change. After most stocks are already trending up, the stock market has been trending up, so a skilled risk manager prepares for a countertrend reversal that is inevitable at some point. As I shared in my observation near the low, Stock Market Analysis of the S&P 500  when nearly all the stocks were already in negative trends as a skilled risk-taker, I look for that to reverse, too.

 

This is only a small glimpse at what I look at for illustration purposes to make the point how I can quantify a “stock pickers market.” After 83% of stocks were already in downtrends I shifted from a risk manager stance to risk-taker mode looking. That is, shifting from a reversal down in January after prices had already trended up to an extreme, to preparing for the decline to end after the stock index quickly dropped -10% and my many indicators were signaling me when and where to pay attention. I shared this to represent that I was not surprised to see certain stocks lead a trend direction when so many had shifted from positive trends to negative trends in a short-term time frame.

This leads me to my main point, which is very simple. A simple way to observe a “stock pickers market” is to see that certain stocks are leading the trend. Because so may stocks were in short-term downtrends, it isn’t a surprise to see a few strong relative strength leaders inside a sector. For example, in the Sector ETF performance table below, two leading sectors are Consumer Discretionary (XLY)  and Technology (XLK). They are up about 6-7% as the broad stock index is up 1.77%. Let’s see what is driving their stronger relative momentum.

Looking inside the Sector for the Leading Stocks 

Reviewing the holdings of the Consumer Discretionary $XLY ETF,  Amazon.com Inc $AMZN is 20.69% of the Consumer Discretionary Sector and has gained +30.28% for the year. A 20% weighting of a stock that has gained 30% results in a 6% contribution to the portfolio return. That is, this one large position has contributed 100% of the sectors return year-to-date. There are 84 stocks in the ETF. This doesn’t mean the other 83 stocks are flat with no price change. Instead, some of them were also positive for the year and some are negative. So far this year, they have offset each other. Some stocks in the sector have gained more than Amazon, but it makes the simple example because it’s exposure is the largest at 20%. Netflix $NFLX, for example, is the sector ETFs biggest gainer up 64%, but it’s 4.63% of the portfolio. However, because it’s gain is so strong this year its contribution at the portfolio level is still significant at 3% of the 5.66% YTD gain in the sector ETF. That is an extreme example. Why is it extreme? Let’s look at price charts of the year-to-date price trend, then the drawdown, which expresses the ASYMMETRY® ratio. The ASYMMETRY® ratio is a ratio between profit and loss, upside vs. downside, or drawdown vs. total return.

First, we observe the price trend for 2018 of the Consumer Discretionary Sector ETF $XLY, Netflix $NFLX, and Amazon $AMZN. The divergence is clear. But, you may notice they all had a drawdown a few weeks ago. All to often I see the upside presented, but not enough about the path we would have to endure to achieve it. To get a complete picture of asymmetric reward to risk, we want to see the drawdown, too, so we understand the ASYMMETRY® ratio.

Those are some big impressive short-term gains in those stocks. Clearly, this past performance may not be an indication of future results.  Too bad we can’t just know for sure in advance which is going to trend up with such velocity.  We can’t catch every trend, but if we look in the right way we may find some. In order to take a position in them, we’d have to be willing to experience some downside risk, too. As a portfolio manager, I decide how much my risk is in my positions and at the portfolio level by predefining when I’ll exit a losing position. But, to understand how much downside is possible in stocks like this and the sector ETF, I can examine the historical drawdown. We’ve seen a drawdown in the stock market already this year. Below we see the Consumer Sector ETF drawdown was about -8% a few weeks ago. Amazon wasn’t more, even though it’s gain is much more than the sector. That’s what I’m calling positive asymmetry and good looking asymmetric reward to risk in regard to the trend dynamics. Netflix declined -13%, but its gain is much higher. This is what leading stocks are supposed to look like. They have their risk and they could decline a lot more than the market if investors lose their enthusiasm for them, but we can manage that risk with our exit and drawdown controls.

I often say that it doesn’t matter how much the return is if the risk and volatility are so high you tap out before it is achieved. To better understand that, I want to show two more charts of these stocks. Below is what the YTD price change looked like at the February low. If investors watch their holdings closely and have emotional reactions, you can see how this would be viewed as “I was up 45% and now only 30%.” Many investors (and professional advisors) have difficulty holding on to strong trends when they experience every move.

One more chart to illustrate how it doesn’t matter how much the return is if the risk and volatility are so high you tap out before it is achieved. I don’t believe we can just buy and hold and reach our objective of asymmetric reward to risk. I believe risk must be managed, directed and controlled. To make the point, below are the historical drawdowns that have been -60% to -90% in these three. It doesn’t matter how much the return is if the risk and volatility are so high you tap out before it is achieved! To extract positive asymmetric reward to risk, we must necessarily do something different than buy and hold.

This may make you wonder: Why buy a sector ETF if you can buy the strongest stocks?

The divergence isn’t normally this wide. In a trending market, more of the other stocks would normally be participating in a trend. This is why I first explained that in an upward trending market we normally see the majority of stocks eventually trending together. When that is true, the sector ETF provides good exposure and limits the selection risk of just one or two stocks. Make no mistake, individual stocks are riskier. Individual stocks are more subject to negative news like disappointing earnings reports, negative product outlook, or key executives leaving the company, etc. So, individual stocks are more volatile and subject to trend in much wider swings both up and down. But for me, I apply the same risk management systems to predefine my risk at the point of entry drawdown controls as the trend unfolds in the stock, up or down.

Yes, it’s been a “stock pickers market” so far and that trend may continue. It just means that fewer stocks are leading the way for now and in a healthy trend more stocks will participate if the short-term uptrend continues to make higher highs and higher lows. As a tactical portfolio manager, my focus is on what seems to offer the positive ASYMMETRY® of a positive asymmetric reward to risk.

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

Investment results are probabilistic, never a sure thing. Past performance is no guarantee of future results.

Buying demand dominated selling pressure in the stock market

Past performance is no guarantee of future results and that was the case today. After last weeks Selling pressure overwhelms buying demand for stocks for the third day in a row the enthusiasm to buy overwhelmed the desire to sell. Market prices are driven by simple Economics 101: when buying enthusiasm overwhelms sellers, prices rise. The S&P 500 gained 1.16% today and seems to have found some buying support at the prior range I highlighted in green.

stock market florida investment advisor

Sector breadth was strong with Utilities, Real Estate, and Financials leading the way.

Sector rotation trend following

We don’t just invest and trade in U.S. stocks and sectors, I look for trends globally across the world. Though the Global ETF Trends monitor below shows many international countries were in the green, the good ole USA was one of the biggest gainers today.

global tactical asset allocation trend following global tactical rotation

Back to the U.S. stock market, in the chart below, I added Kelner Channels to illustrate a few things.

Keltner Channels are volatility-based envelopes set above and below an exponential moving average. This indicator is similar to Bollinger Bands, which use the standard deviation to set the bands. Instead of using the standard deviation, Keltner Channels use the Average True Range (ATR) to set channel distance.

Kelner Channels show the range of volatility has spread out and got wider since the stock market price trend trended above the upper channel in January, suggesting its uptrend was abnormal.  Since then, the trend reversed down and again traded outside the range of the Kelner Channel on the downside. It’s a good example of how the market can overreact on both the upside and downside.

stock market trading range ATR

In the chart above, I also include the Relative Strength Index, which is on its 50-yard line. You can see how it was reading “overbought” in January (and had been for months), then after that extreme it became oversold. This kind of price action presented us with an opportunity to turn on the swing trading systems. My countertrend systems signaled short-term entries in several stocks and ETFs very near the low prices.

I pointed out in Stock Market Analysis of the S&P 500 on February 9th near the lows the breadth of the stock market was oversold at a lower risk. Market analysis is best used as a weight of the evidence. You can probably see how these different indicators signaled a countertrend move was possible and this time that has happened so far. I say this time because it’s always probabilistic, never a sure thing. If the stock market were going to trend down -50% over a two year period it would start off this way being “oversold” and look “washed out”, only to get worse as it swings up and down on it’s way to a lower low. During times like this, a skilled swing trader or countertrend systems can help to generate profits as price trends swing up and down.

Below is an updated chart of the percent of stocks in the S&P 500 that are trading above their 50-day moving average. 12% more stocks are trading above their 50-day moving average after today, bringing it to 32%. I point this out because it gives us an idea of how many stocks are still left to trend back up. That is, based on this breadth indicator, there is room for stocks to keep trending up if buyers continue their enthusiasm. This is the opposite of the condition in the last months of 2017 and January when 80% or more stocks were already in positive trends. To revisit this concept I encourage you to read Stock Market Analysis of the S&P 500. 

SPX S&P 500 stocks above the 50 day moving average SPY

The bottom line is, the supply and demand for the stock market seems to be shifting back in control of buyers for now. Only time will tell if it continues in the days and weeks ahead. This is just a quick market analysis to look at what is going on, not investment advice. Our investment management and advice are only offered through an investment management agreement. If you want investment management or advice, contact us.

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

Investment results are probabilistic, never a sure thing. Past performance is no guarantee of future results.

Selling pressure overwhelms buying demand for stocks for the third day in a row

Well, I guess by saying on Tuesday I’m planning to write a comment when the stock index closes up or down 1% or more I’ve turned myself into a regular ole Mark Twain.

If you’ve ever read the “about” page, I poke some fun:

Mark Twain’s mother once said:
“I only wish Mark had spent more time making money rather than just writing about it”.

I go on to say:

Today there is no shortage of writings about the capital markets and portfolio management. Many who write about money and the management of it provide no evidence to suggest their beliefs are useful. That is, they do a lot of talking and writing, a lot less doing. We are left to wonder if they have good results. The author of ASYMMETRY® Observations is no Mark Twain.

Ok, so March isn’t getting off to the best start so far. The stock market as measured by the S&P 500 closed down -1.45% today. Below is the intraday chart. This index was down most of the day, but it did trend up off of its low after 2PM.

stock market spx spy march 1 2018

Zooming out to a few months instead of intraday, the SPY didn’t care at all that I drew that black line to show the prior low. It traded right below it. Of course, we don’t own this index at Shell Capital, so I am just sharing this as an observation.

stock market index asymmetry

We can get more granular by looking at the individual sector changes instead of the broader S&P 500 index that includes some of them all. Below, I show that the Utility sector was the only sector in the green (barely), which is no surprise since it has been the laggard for a while.

sector trend rotation march 2018

We can drill down even more into the sectors and see the ETF subsectors. Here we see some shades of green.

sector trend following

Next, we could look at stocks within the sectors, but that’s enough detail for now.

I will add that today was a global market decline as several other countries stock markets participated. Japan declined more while Mexico, Peru, and Egypt gained. The emerging markets index which includes Mexico only declined -0.19% today.

global ETF trend outlook march 2018

Finally, below is the same table of bar charts I used earlier in February Global Market Trends, but this one is only the past three days. The U.S. stock market has declined the past three days, so I wanted to see what other markets have done over the same period. Let’s just say that a diversified portfolio of global asset allocation wouldn’t have helped since many markets are down like commodities and international markets.

global asset allocation trend

If you haven’t read February Global Market Trends I encourage you to. Near the end, I discussed if an investor should pay too much attention to daily market swings. My purpose of writing this is to summarize what happened and that is always necessarily in the past. The future may be different.

How does this affect us at Shell Capital? I predefine my risk by knowing in advance when I’ll exit my positions if they decline. I do it to control my risk in each position and for drawdown control at the portfolio level. So, I respond accordingly.

If this keeps up, it looks like I’ll be eating dinner at my desk every evening, typing away like Mark Twain 🙂

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

Investment results are probabilistic, never a sure thing. Past performance is no guarantee of future results.

February Global Market Trends

After a very positive January for U.S. and international stocks, in February it only took 10 days for the S&P 500 to decline -12% intraday and a -10% drawdown based on closing price.

stock market decline drawdown februrary 2018

Yet, February ended with the S&P 500 only down -3.5% after that -12% intra-month drawdown.  For the month, International (MSCI EAFE) and Emerging Markets declined the most viewing the below board based indexes. The U.S. Dollar gained 1.8%.

global market returns february 2018 loss drawdown

Next, we view February global market returns relative to the S&P 500 stock index by holding it constant. This visual shows us how much markets gained/lost net of the S&P 500, Though in the absolute trend table above I showed bonds declined in absolute return, they gained relative to the S&P 500,

global market trend returns relative to spx spy S&P 500

Of course, one month isn’t a trend. In fact, I’m going to explain how this is an intentional logical inconsistency. Speaking of one time period in isolation, be it a month, year, or series of years is just an arbitrary time frame. What’s worse is viewing just the result over a time frame, like the month of February above, in just a table format.

A return stream is precisely that; a stream. A return stream is a continuous price trend in a continuous specified direction. Continuous is forming an unbroken whole; without interruption. So, I like to view return streams as price trends on a chart so I can see how the trend really unfolded over the period. Observed as a visual price trend, we see both the good and the bad of the price action along the way. You can probably see how it does that better than a simple performance table, monthly return % of the period or the bar chart above.

stock market decline februrary 2018

In the chart above, we see how much the price trends of those markets declined along the way before closing the month yesterday. I wrote about the short-term risk reversal in Stock Market Analysis of the S&P 500 suggesting it may reverse back up at least temporarily and retrace some loss and it did.

Now, what is essential about looking at performance data and trends is what the investor experiences. Investors experience what they choose to experience. For example, suppose and the investor is fully invested in the stock market, they could experience the month one of three ways.

  • If the investor only looks at his or her month-end statement, they would experience either the month end “-3.5%”.
  • If the investor watches their account or market indexes closely every day, they experienced every daily move and the full -12% decline and then some recovery.
  • Some may not pay any attention at all either because they are disinterested or they have an investment manager they trust to manage their risk-taking and risk management for them.

Investors and traders get to choose what time frame they watch things. I’ve always observed that “watching it too closely” can lead to emotional mistakes for many. For me, I’m paying attention and may zoom in and pay more attention when trends get more volatile or seem to reach an extreme. But, I’m a tactical portfolio manager, it’s what I do. I can view short term or long term trends alike with self-discipline. I have an edge that has been quantified by a long track record of 14 years in the current portfolio I manage.

I said this recently on Twitter:

If the investor doesn’t like to see such losses like those experienced in many markets in February, they may choose to instead not be fully invested in stocks all the time. That’s what I do. I’m not invested in any specific market all the time. My exposure to risk and return increases and decreases over time based on trends and my risk systems. I intentionally increase and decrease my exposure to the possibility of loss and gain. I’m also unconstrained so I can do it across any global market like bonds, currency, stocks, commodities, or alternatives like REITs, inverse (shorting), or volatility.

According to the American Association of Individual Investors, the decline was so quick most individual investors didn’t seem to respond:

Majority of Investors Avoided Taking Action in Recent Market Correction

“This week’s Sentiment Survey special question asked AAII members what portfolio action, if any, they took in response to the recent market correction. The majority of respondents (62%) said they didn’t make any change or only made a small change. Many of these respondents described themselves as being focused on the long term, viewing this month’s correction as being only temporary in nature or not severe enough to warrant any action. A few of these respondents described the correction as lasting too short of a time for them to take advantage of it. Nearly 33% respondents said they took advantage of the decline to buy stocks or funds. Some said they took advantage of the reduced prices to either add to current positions or buy new holdings. Just 7% of respondents said they sold stocks during the correction. A small number of respondents said they sold some positions and then bought new positions.”

I say investors should find and do what helps them, not make it worse. Know yourself, know your risk, and know your risk tolerance. That’s what we do.

So, that is what happened during the month of February, and a little asymmetric observation to go with it.

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

Investment results are probabilistic, never a sure thing. Past performance is no guarantee of future results.

Selling pressure overcomes buying demand for second day in U.S. stock market

When popular market indexes gain or lose 1% or more in a day, we’ll try to take the time to comment on it here. Go figure I said that yesterday, now I’m writing about it two days in a row.

Much like yesterday in Stock market indexes lost some buying enthusiasm for the day the S&P 500 stock index closed down 1.01% today. The SPY traded most of the day above yesterdays close, then broke below that level after 3PM. Like yesterday, the last trades were downside volume, which is selling pressure.

But, the above chart is the intraday price trend of what happened in a single day, today. We aren’t making decisions for such a short time frame. I only show the day to discuss today’s action. So far, it isn’t anything too unusual, but that could change.

What’s more important is a bigger picture. The chart below is still only two months, so not the big picture, but since the stock indexes are in a correction the last several weeks, I’m zooming in to see the detail. Two down days of -1% or more is evidence of some selling pressure and distribution, but so far it isn’t a change or trend direction. If the trend declines below the prior low, which I marked with the black line, then I wouldn’t be surprised to see if fall further. In other words, it should get some buying demand (support) at that level. If it doesn’t, we may see further downside. The reversal back up from the February 9th low could be coming to an end and set the stage for a retest of the low. Only time will tell. We’ll see. I don’t have a position in this, but the S&P 500 is a widely followed index we use as a market proxy.

I predefine my risk by knowing in advance when I’ll exit my positions if they decline. I do it to control my risk in each position and for drawdown control at the portfolio level.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

Investment results are probabilistic, never a sure thing. Past performance is no guarantee of future results.

 

 

The most important rule of trading is to play great defense, not great offense.

It is fascinating to read Market Wizards: Interviews With Top Traders published in 1989 again and see how much the portfolio management strategy of another ole boy from Tennessee is nearly identical to my own. I read the book the first time in the early 1990’s so it may have had an impact on me as a young tactical trader as I evolved over time.

“The most important rule of trading is to play great defense, not great offense. Every day I assume every position I have is wrong. I know where my stop risk points are going to be. I do that so I can define my maximum possible drawdown. Hopefully, I spend the rest of the day enjoying positions that are going in my direction. If they are going against me, then I have a game plan for getting out.”

Paul Tudor Jones in Market Wizards: Interviews With Top Traders (p. 123). Wiley. Kindle Edition. Schwager, Jack D..

 

Stock market indexes lost some buying enthusiasm for the day

Buying enthusiasm reversed from positive to selling pressure today after the first hour. I observed notable selling volume at the close, which was the opposite of what I pointed out last Thursday.The S&P 500 Stock Index was down -1.27% for the day.

 

I’ll also share that volume increased sharply during the -10% decline in the S&P 500 Stock Index earlier this month. No surprise, it was selling pressure after many months of buying enthusiasm, just an observation…

 

So far, the S&P 500 Stock Index has regained approximately half of its -10% loss earlier this month and is now up 2.64% for the year.

Since I pointed out that the stocks inside the S&P 500 has dropped to a much lower risk zone in Stock Market Analysis of the S&P 500, the % of stocks in the index above their 50 day moving average increased from only 14% in a positive trend to 55%. Today, 18% fewer stocks are above their 50-day moving averages.

S&P 500 percent of stocks above 50 day moving average Feb 2018

None of this is yet suggesting a change of trend, but when stock popular stock indexes gain or lose more than 1% or so my plan is to update it here.

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

Investment results are probabilistic, never a sure thing. Past performance is no guarantee of future results.

Stock Market Analysis of the S&P 500

There are many parts to a complete risk management system. One part is monitoring and measuring the risk of the overall markets. Market risk analysis may involve observing risk gauges like price momentum, market breadth, investor sentiment, P/E valuation, and fund flows.

Stock market breadth is useful for market analysis to better understand internal conditions. For trading decisions, I focus individual trends. As I shared last week, when breadth reaches such extremes (high or low) it may point attention in the right direction.

I start with a Point & Figure chart of the % of stocks in the S&P 500 index that are trading above their 50-day moving averages. Only 14% of the 500 stocks were trending above their 50 day moving average, signaling the internal trend weakness of the stocks inside an index.

S&P 500 % OF STOCKS ABOVE 50 DAY MOVING AVERAGE

I color the high zone as “Higher Risk” because, after 84% of stocks in the S&P 500 stock market index are already above their 50 day moving average nearly all of them are already trending up – think “upside exhaustion”, eventually it will reverse. It was a “warning shot across the bow”.

I color the low area as “Lower Risk” because, after 86% of stocks in the S&P 500 stock market index are already below their 50 day moving average nearly all of them have already trended down – think “downside washout”, eventually it will reverse. But, 50 day is a short-term trend, so…

Since the 50 day moving average just signals a short-term trend, let’s also consider the % of stocks above and below the longer term 200-day moving average. With a longer time frame, we’ll see more lag.

SPY $SPX #SPX S&P 500 STOCK MARKET % OF STOCKS ABOVE 200 DAY MOVING AVERAGE

As we see above, 82% of S&P 500 stocks were above their 200 day two weeks ago. After the -10% or so S&P 500 decline, only 56% were still trending above. With the lag in the 200 day, we aren’t surprised to see fewer stocks dropped below the 200 day since they had more distance to fall to reach it.

The longer time frame creates more lag in the signal simply because the 200 day is using 400% more data points than the 50 – it’s going to be slower. We call that “lag”.

What do these internal breadth indicators suggest? It’s a measure of trend direction “participation” of the stocks in the S&P 500. As we saw, the 50 SMA is washed out, but since 50 SMA is short-term, it could stay that way if prices keep falling. The 200 SMA is more important.

What do these internal breadth indicators suggest?

It’s a measure of trend direction “participation” of the stocks in the S&P 500 index. The % of stocks above the 200 SMA dropped to where they did in the recent past and reversed up… but… I’ve been observing breadth for nearly 3 decades, so I’ve seen how low it “can” go.

As I lengthen the time on the chart, I show you the “real” lower risk zone is in the teens like the 50, for the 200. Only time will tell if it stops here, as it has the past two years, or goes lower.

S&P 500 $SPX $SPX Bulllish percent of stocks above 200 day moving average

The bottom line is, market breadth is “washed out” in the short-term and about halfway there on a longer term view – if it is to go lower. So, while this is evidence enough to expect to see at least a short-term reversal back up, there is also plenty of room to see the S&P 500 stock index drop another -10% or more as only half of the stocks are yet below their 200-day averages. What it does next is simply a matter of buying demand outweighing the desire to sell. 

As I’ve said, there are many parts to a complete risk management system. The above is just an observation and example of “market analysis” using breadth.

Next, let’s take a look at the S&P 500 price trend to explore buying demand vs. selling pressure. 

S&P 500 stock index tapped the 200-day moving average intraday in oversold territory. I highlighted in green it’s a zone of about 8 months of prior trading range. Support occurs after prices fall; buyers may become more inclined to buy and sellers become less inclined to sell. So far, that is what we are observing. The stock index declined about -12% and reached an “oversold” level on the momentum oscillator and is above the 200-day moving average used for standard trend following.

S&P 500 oversold
Looking even closer, I’ll point out the trading volume has been heavier on positive days and relatively lighter on down days. I circled the heaviest volume below. The biggest volume in the S&P 500 SPY ETF wasn’t on the down days, it was on the days it closed positive: last Tuesday and Friday. This is an overly simplistic analysis of the volume and price as I could go into more detail and separate up volume vs. down volume, but my objective is an educational overview of the big picture.
S&P 500 $SPY $SPX trend following asymmetry asymmetric
Finally, I’ll get a little more technical into the details.
In the candlestick chart below, I circled in blue a Doji cross & long shadow in Friday’s trading. Doji is when the open and the close is nearly the same and suggests indecision, a tug-of-war, between buyers and sellers. It’s when the price moves above and below the opening, but closes near the opening price.
$SPY $SPX stock market
The long lower shadow on Friday and short upper shadow indicated that sellers dominated during the first part of Friday, driving prices lower. But then it closed positive. So, it “could” suggest at least some short-term capitulation, especially if today’s gain holds. We’ll see.

Risk management is the common characteristic among all the best traders/investors who have lasted over the many important up and down market cycles of the past decades. I decided I was going to be one of them over two decades ago. No matter how you decide what and when to buy, it is essential to control the size of your potential loss. If you want to learn what I mean by that, read the prior ten or twenty observations I’ve shared here. This is not individual investment advice. If you need individual advice, contact us.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

Investment results are probabilistic, never a sure thing. Past performance is no guarantee of future results.

Asset Class Returns are Driven by Sector Exposure

The popular U. S. stock indexes closed in the red for the year Monday, erasing their big starting gains in January. As I mentioned many times; quick gains can be lost even faster. The financial news has mostly been quoting the Dow Jones Industrial Average because it had gained the most year-to-date. It had gained over 7% in January, but lost that gain, and then some, in two days. After just a few days, the Dow Jones dropped -14% in the futures market and -8% on a closing basis. That was enough to wipe out recent gains and mark the index down nearly -2% for the year.

I discussed the market risk in our portfolio commentary for our investment management clients, and we were positioned for it. I also explained it in In remembrance of euphoria: Whatever happened to Stuart and Mr. P? and In the final stages of a bull market. So, it should have been no surprise.

But, when I looked at the asset class performance table, I saw some interesting divergence. Large Cap Growth is still outperforming Small Value. As most of the U.S. equity asset classes were in the red, Large Growth remained positive on the year. I thought I would share a look as to why.

I am a tactical portfolio manager, so my focus is on finding trends and shifting to the trends I want and avoiding those I don’t. That’s a lot different than “asset allocation.” Financial advisors who create asset allocation models for their investment clients normally allocate into funds in the asset class style box. This is also typical with 401(k) plans. They offer funds that provide broad exposure to an asset class style box, rather than the individual stock market sectors I prefer to focus on. So, we often hear style box asset classes quoted like “Large Growth is beating Small Value” or “Large Caps ard leading Small Caps.”

According to Morningstar:

The Morningstar Style Box is a nine-square grid that provides a graphical representation of the “investment style” of stocks and mutual funds. For stocks and stock funds, it classifies securities according to market capitalization (the vertical axis) and growth and value factors (the horizontal axis).

Below is a recent performance for the equity markets. As you see, U.S. Large Growth was leading with a 2.89% gain year-to-date, Small Value was down -4.83%.  When we observe such a divergence, it makes us curious what is causing it.

 

To understand what is driving the return, we take a look inside to see “what is different.” Below is the sector exposure breakdown of Large-Cap Growth.  We can understand the sector exposure of the iShares Morningstar Large-Cap Growth ETF. Clearly, the big standout is heavy exposure to Information Technology. The other two larger exposures are Consumer Discretionary and Health Care.

Large Growth Stocks Outperform Small

Next, we observe the sector exposure of the Small Value asset class. We can see the sector exposure in the holdings of iShares Morningstar Small-Cap Value ETF.

The Small Value index has 22% exposure to Financials since many financial sector stocks are smaller companies. The other top sector exposures are Industrials, Consumer Discretionary, Real Estate, and Energy.

Small Value Stocks Underperforming Why are

What is different?

Clearly, the single largest difference is that Large Growth is very heavily exposed to the trend in Technology sector. Technology is 50% of Large Growth while it’s only 8% of Small Value. On the other hand, Financials is only 5% of Large Growth but its the largest exposure in Small Value at 22% of the index.

Stock market asset class returns are driven by their sector exposure. Recently, the Tech sector has been one of the mightiest trends, so it’s helped Large Growth also appear more dominant over equity styles that hold less of it. I would preferably look inside and find out what return driver is causing the difference, then get exposure to that trend in momentum.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

Investment results are probabilistic, never a sure thing. Past performance is no guarantee of future results.

In the final stages of a bull market

In the final stages of a bull market, we normally see a parabolic move to the upside, a final blowoff that gets in the last investors. Buying demand is the response of investor euphoria like I pointed out last week.

An indication of a parabolic move is seen in price channels and confirmed with momentum oscillators. Only time will tell if this is it, but in the chart, I highlight the S&P 500 stock index broke out above an upper moving average channel.

spy spx trend

Price trends usually peak with volatile swings up and down before a larger leg down. Some swing tighter than others, but there is normally a period of “indecision” that precedes an intermediate trend change or drawdown. A drawdown is a decline in the value of an investment or market below its all-time high. Below is the period leading up to the -15% drawdown in the stock index late 2015 – 2016. In the green box, I show the price trend entered a period of swings up and down before breaking an upward trend, drifting more sideways, then a-15% decline.

 

spy eem stock market

Next is the swings in the S&P 500 entered into what became a -18% decline in 2011. My point here is that larger legs down don’t necessarily happen all at once, there are indecisive swings that eventually fall apart.

spy 2011 decline

The top in 2007 presented much larger swings and of course ended up declining -56% over nearly two years afterward. I believe these swings up and down before a larger trend unfolds is indecision among traders and investors. Again, my point here is that larger legs down don’t necessarily happen all at once, we instead observe indecisive swings that eventually fall apart.

spy spx 2007 stock market top

Lastly, here is the 1999 – 2000 peak that also presented wings like the previous peaks. The stock market trend broke above a simple channel a few times before entering a -50% bear market.

stock market top 1999

The current trend just recently stretched above the channel and at the same time, was very overbought for months as measured by the momentum oscillators. This happened at the same time bullish investor sentiment measures was reaching record highs and volatility at historical lows. However, as seen in observations above, the U.S. stock market could just now be entering into a phase of swings up and down that could last for months or years, or it could fall apart sooner. Either way, I make this point for situational awareness.

As a portfolio manager, I don’t need to know for sure what’s going to happen next.  I just know what I’ll do next as trends unfold.

Only time will tell if this is the early stages of an end of an aged bull market or just an interruption of a euphoric “melt up”. We don’t need to know when a major top is in. It doesn’t require an ON/OFF switch. When a big bear market does come, it will be made up of many swings up and down along the way over many months. People will crave to be in, out, in out, in, out, as it all unfolds.  Adaptability is essential: the consistent willingness and ability to alter attitudes, thoughts, and behaviors to appropriately respond to actual or anticipated change in the environment.

Clearly, it’s the swings we have to be prepared for… if we want to avoid a loss trap.  In a loss trap, investors get caught in a loss and have a hard time getting out. When they lose more than they can afford or more than their risk tolerance, they are prone to tap out after large declines. To avoid the loss trap, know your risk tolerance and actively manage risk within that tolerance.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

Investment results are probabilistic, never a sure thing. Past performance is no guarantee of future results.

 

In remembrance of euphoria: Whatever happened to Stuart and Mr. P?

I have recently found myself reminiscing about the late 1990’s – specifically the grand euphoric year of 1999. If you aren’t sure why then maybe you aren’t paying attention. Sometimes not paying attention is a good thing if it prevents you from following a herd off a cliff.

The four most expensive words in the English language are “this time it’s different.” – John Templeton

Lately, I’ve been reminiscing about the tech stock bubble, the .com’s, and how the Nasdaq QQQ replaced the Dow Jones Industrial Average as the favorite index by 1999. Then there were all the infamous statements like “you don’t understand the New Economy”. We’ve been talking about the funny commercials from the baby trader to the college-age guy helping the mature executive start trading online, to “Be Bullish”.

Do you remember Stuart and Mr. P? Back in 1999, there were traditional “stockbrokers” who were registered with a brokerage firm, who bought and sold stocks, bonds, and options for individual and institutional clients. If you were a stockbroker back then, like I was, you probably remember it well. Online trading was the beginning of the end for the traditional “stockbroker” firms earning a $200 commission to buy or sell 100 shares. The great thing about the evolution of online trading is it lowered trading costs dramatically. For someone like me who wanted to be a tactical money manager anyway, that was a great thing. I embraced it and went on to start my investment management company. But the point of this observation is the investor sentiment in 1999. The video below is amazing to watch 20 years later. But what fascinates me the most is how it reminds me of today; different subjects, same sentiment.

Watch:

 

That may remind you of some of the things we hear today.

Those type of commercials flooded the financial news and evening news channels in 1999. To be sure, below is a WSJ article printed about the “Let’s Light This Candle” ad on December 7, 1999. I’ll tell ya what… that’s about as close to the top as you can get.

So, I wondered, what happened to Stuart and Mr. P? 

Stuart was helping Mr. P buy Kmart stock online. Kmart was then one of America’s leading discount retailers. The Kmart Corporation was the second largest U.S. discount retailer and major competitor to Walmart. Kmart filed for Chapter 11 bankruptcy protection in January 2002. Just two years after Stuart helped Mr. P buy shares online it filed for the largest ever retail bankruptcyKmart was later bought by Sears, which is now a failing company. At least Mr. P was wise enough to only buy 100 shares, young Stuart wanted him to buy 500 shares! They had no position size method to determine how much to buy based on risk, which would include a predefined exit. It is unlikely Mr. P had a predefined exit in place to exit the stock to cut the loss short. During that time, investors were only thinking about what to buy. They rarely considered how and when to exit a stock with a small loss to avoid a larger loss. After such a strong bull market, who is thinking about the risk of loss?

For those of us who remember, in the late 1990’s most investors weren’t just buying the largest retailers – they were buying technology. In hindsight, that period is now referred to as the “tech boom” or “tech bubble”. That’s because almost everyone wanted to buy tech stocks. Literally, even the most conservative seniors were cashing out bank CD’s to buy tech stock.  And… I’m not even going to get into the .com stocks, most of which no longer exist from that time.

Whether you remember the trend as my friends and I do or not, we can use historical price charts to see what happened. Below is the Technology Select Sector SPDR® ETF  since its inception 12/16/1998 to today. I’m starting with the full history to see the initial gain, before the waterfall decline. The Technology Select Sector SPDR® Fund seeks to:

“Provide precise exposure to companies from technology hardware, storage, and peripherals; software; diversified telecommunication services; communications equipment; semiconductors and semiconductor equipment; internet software and services; IT services; electronic equipment, instruments, and components; and wireless telecommunication services.”

Those were the most popular sectors, aside from the actual Internet stocks.

Below is what happened from December 9, 1999, when WSJ printed the article about the ad because it was so interesting and popular, to now. After nearly 20 years an investor buying the diversified tech sector would have just recently realized a profit, assuming they held on for 19 years.

Here is what that -80% drawdown looked like that lasted 19 years.

“Those who cannot remember the past are condemned to repeat it. “

George Santayana

 

This is a kickoff of a series of articles on this topic I have in queue on current global market conditions. Stay tuned…

Mike Shell is the founder of Shell Capital Management, LLC, a registered investment manager and portfolio manager of ASYMMETRY® Global Tactical.

All Eyes are Now on the Potential Government Shutdown

If the U. S. Government shuts down, it will be the 19th time. Looking at the table below, it doesn’t seem a big deal. The table shows the 18 prior government shutdowns going back to 1976. It lists the start and end date of the shutdown and the gain or loss for the S&P 500 stock index. The average is only a -0.60% loss from beginning to end of the shutdown.

But, here are some considerations: 
1. It is too small of a sample size to draw a statistically significant inference. Basic probability needs 30 data points.
2. It only shows the gain/loss from beginning and end of the shutdown.
3. It doesn’t show what happened before and after those dates. Was there more movement/drawdown before or after?
4. It doesn’t show what happened in between the start and end date so it may have been worse.
5. It doesn’t consider market stage at the time of shutdown. Was it overvalued and overbought? Or was it undervalued and oversold?

The truth is; anything can happen.
We don’t know for sure how it will play out. With such a small sample size of prior events and without factoring in the market conditions at the time, what it did in the past doesn’t provide us with a good expectation.

The current condition: if the government shuts down this time:
1. It will be when the U.S. stock market is at the second most expensive fundamental valuation, ever.
2. When investor and advisor bullish sentiment has reached record highs, at this point a contrary indicator.
3. As recent momentum indicators are at the highest levels ever seen before, at this point a contrary indicator.

My solution? always be prepared that anything can happen.
I know how much risk I’m willing to take given the possible outcomes and define my risk by knowing when I’ll hedge or exit.

 

Mike Shell is the founder of Shell Capital and the Portfolio Manager of ASYMMETRY® Global Tactical.

Counting down to the New Year

Doesn’t it seem the years are flying by?

It’s partially just math. It’s asymmetric!

We perceive that time seems to pass faster as we age because, at four years old, a year was 25% of our life. At 40 a year is only 2.5% of our life. The older we get, we perceive the years go by faster because each year is relatively less of our life.

Maybe we can’t control time, but we can make each year BETTER!

Or… maybe we can control our time?

As we get older, we tend to become more stable, so life can become routine. The more familiar we become with our day-to-day activities, the faster the days seem to pass by.

Want to slow down time? and have more fun?

Change things up! Create new experiences! Do new things!

Industrial Sector Pulling Back as RSI Suggested it Could

In “Resolving Conflicts with Relative Strength” I discussed the conflict between high Relative Strength (a trend that is gaining more than others) and a high RSI (a trend that is considered overbought). I used the Industrial Select Sector SPDR ETF as an example. It has taken about five weeks, but the point can be seen clearly now.

Below is part of what I said on September 27, 2017, and following that I’ll share an update.

When I see the chart below, I think:

“The trend is up, it has moved up fast enough to be overbought in the short term, so it may pull back some and then the trend may resume to the upside”.

That chart was about five weeks ago. Below is an update on the trend in the U.S. Industrial sector. Since the sector got “overbought” based on a RSI reading over 70, the trend continued up (green highlight) and has since trended down about -3%. At this point, it is trading around the same price it was when it first became overbought. Now, it is getting closer to being “oversold” on a short-term basis.

So, as the Industrial sector was one of the strongest sector trends a few weeks ago, it also appeared overbought on a short-term basis. It is now drifting down to what may become a better entry point in what has otherwise been a strong directional trend.

We’ll see how it unfolds.

Black Monday: Huge Losses a Reminder of Risk

30 years ago today, global stock markets collapsed. The U.S. stock market represented by the S&P 500 had gained over 35% year-to-date. Investors were likely optimistic. It only took a single day to erase the gain.

The loss on Black Monday was -31.5%. Notice that a -31.5% decline more than erased a 35%+ gain. In fact, after the index had gained over 35% for the year, it was down nearly -9% after a -31% decline.

 

As I explain in Asymmetric Nature of Losses and Loss Aversion, losses are asymmetric. Losses compound exponentially, which is what makes risk management and the pursue of drawdown control worthwhile.

Below we see it in action. It only took a decline of -31% to erase over 60% of a 100% gain since 1984. The S&P 500 stock index had gained over 100% since 1984. The -31% decline brought the gain all the way down to 37%. Losses are very asymmetric.

Black Monday is talked about as a single one-day event, but really it wasn’t. Several weeks of weakness led up to a big down day. But, it would have taken a rather tight risk management system to have exited.

Looking even closer, the % off high chart shows the stock index was about -7% off its price high for several weeks before the crash. So, a drawdown control and risk management system trading this index would have had to exit because of this trend.

It doesn’t have to happen in a single day to erase a lot of gains.

Let’s remember this one.

And more recently, this one.

Today is a reminder that markets are risky and they necessarily require risk management.

 

 

Asymmetry in Income Taxes

It seems we hear more about “inequity” in recent years, like income inequality. Income inequality refers to the extent to which income is distributed in an uneven manner among a population. That shouldn’t be a surprise since our efforts are asymmetric. We don’t hear much about the asymmetry in the effort. That is, some try harder and work harder than others, and take bigger risks, which leads to the asymmetry in income.

Regardless of the cause, the progressive U.S. tax system aims to balance it out to spread the wealth.

In “A closer look at who does (and doesn’t) pay U.S. income tax” Pew Research finds that:

…taxpayers with incomes of $200,000 or more paid well over half (58.8%) of federal income taxes, though they accounted for only 4.5% of all returns filed (6.8% of all taxable returns).

By contrast, taxpayers with incomes below $30,000 filed nearly 44% of all returns but paid just 1.4% of all federal income tax – in fact, two-thirds of the nearly 66 million returns filed by people in that lowest income tier owed no tax at all.

Read the full story at: “A closer look at who does (and doesn’t) pay U.S. income tax

What do wealthy people do differently?

This morning a financial planner who knows we are the investment manager to wealthy families asked me a great question:

“What do wealthy people do differently?”

I thought I would just sit here and write it out. These are my own observations over a few decades.

First, let’s define “wealthy”.

I’m going to define “wealthy” as someone who has already achieved “freedom”. Notice I said “freedom”, not just “financial freedom”. I’ve asked thousands of people over the past two decades “what is important about money to you?”. Ultimately, the question leads to one single word: “freedom”. So, there doesn’t seem to be a need to add “financial” in front of “freedom”. But, that isn’t to say you can’t have plenty of money without much freedom. You could say “Some people have far more money than they ever need but they still don’t enjoy their freedom because they keep working for more”. You may consider that person is still getting what they want. Some people just want to produce, and they never stop. They are still free. They have the freedom to keep doing what they love doing. In fact, some wealthy people are driven to create more wealth for a charity. No matter what our goals are in life, traveling, relaxing, time with family and friends, helping others, having enough capital to do what we want seems essential.

Having enough money to do what we want, when we want, seems to be the primary goal of most of us.

So, I define “wealthy” as someone who has already achieved “freedom”, regardless how he or she chooses to enjoy his or her freedom.

What do these people do differently than those who haven’t accumulated enough capital to say they are “wealthy”?

1. They save and invest money. The first thing that I have observed is that they simply save part of their income and invest it.

a. Save: They save it because they don’t spend more than they should. They save a large amount of themselves to use later. Even if they earn $X a year, they don’t the most they can for their home or carts. For example, a person earning $1 million a year may live in a $1 million neighborhood and a neighbor who earns $200,000 a year. Who do you think will be “wealthy”? One is stretched, the other is saving.

b. Invest: People who achieve “freedom” and the “wealthy” status don’t stop and just saving money in a bank account, they invest it. Wealthy people take the time to invest their money. Most of them invest with an investment manager who is fully committed to investment management.

2. Wealthy people care about their money. I know a lot of wealthy people, and I know just as many who aren’t. Those who are wealthy save and invest money, those who don’t spend it. As investment management clients, wealthy families are the first to complete forms, etc. as needed because they care about their money. They also appreciate investment managers who are on top of things as they would be.

3. Wealthy people are focused on that ONE thing they do best. Just like the book The ONE Thing: The Surprisingly Simple Truth Behind Extraordinary Results says: they are focused. If they are a Physician, they focus on being a great Physician. If they own a company, they focus on their business. If they are a country music artist, they focus on being the best they can be. If they are an engineer, that’s their focus. They do what they do best and they find other people to do the things they don’t want to do like lawn maintenance or whatever. If you want to earn more money to save and invest, focus on what earns you the most and pay others for the things you aren’t so great at or don’t want to do.

4. They take some risks and manage their risk. To achieve wealth, we have to be both risk-takers and risk managers. If we take no risks in life, we’ll have no chance of reward. Not graduating from college has some risks, but so does attending. Who we marry, how we title our assets, how we insure our assets, and how we manage our assets all have risks and the potential for reward. Wealthy people tend to take risks in that one thing they are best at. They go “all in”. But wealthy people also direct and control their risks. They try to take good risks that are worth taking. It doesn’t matter how much wealth we accumulate if we aren’t able to keep it. For example, many people can remember how much wealth they created on paper up to 2000 only to see it cut in half. They did it again up to 2007 through 2009, and it took years to break even. Wealthy people know to realize a real profit, you have to take a profit. To avoid a large loss, we have to cut losses off at some point. Proper planning and risk management are essential.

5. Everything is relative, but yet it isn’t to them. I know business owners as well as Physicians who I consider wealthy as well as musicians, and athletes. But, you don’t have to earn $500,000 a year all your life to become wealthy. You don’t have to earn it all in a short time, either. I know people who have a total $500,000 invested who are wealthy. They have “enough”, for them. Depending on the lifestyle, others may not become wealthy until they have over $5 million if they spend a few hundred thousand a year traveling, etc. I also know families with several hundred million. Everything is relative, but wealthy people don’t compare their wealth and assets to others. They aren’t “keeping up with the Joneses”. People who do that often have large debts because they buy things they can’t afford with money they don’t have. Or, they save and invest less.  Wealthy people don’t buy a new car or house because their friend does, or compare their investment account to others. Wealthy people may be more introverted when it comes to personal finance – their focus is on their own family needs.

What do the wealthy do differently? They discover how much capital they need to enable the freedom to do what they want when they want, whatever that may be. Income alone, or the neighborhood we live in, or the cars we drive, or memberships don’t signal that we are wealthy. Some wealthy people are still operating their business, practice,  or “working”. A distinction is that they want to and they could choose to do something else with their time if they want. Wealthy families have saved and invested enough money to have achieved freedom. To do that, they focus on the thing they do best. They delegate the other stuff to someone else. They care about accumulating and managing their money and managing their risks. They appreciate investment managers and wealth managers who help them do it.

Resolving Conflicts with Relative Strength

In “Relative Strength can be a source of conflict for Tactical Traders” I explained how two different momentum indicators are in conflict with each other and can lead to conflict in tactical trading decisions. Tactical traders may use many different indicators and methods to determine whether to enter, hold, or exit a position. If we look at two conflicting indicators like this, we have to avoid becoming conflicted ourselves.

To avoid the conflicts, define clearly what they are and how to use them. To do that, I’m going to mix up a bowl of Physics and Psychology.

The indicators essentially represent the same thing. They apply a different algorithm, but both are momentum measures that determine the speed of change in price movements. A key difference is that the basic Relative Strength I used is a simple price change over a period. That simple Relative Strength algorithm simply compares the price change over a period to determine which trends are stronger and which are weaker. Tactical Traders using this method of Relative Strength expect the stronger trends will continue to be stronger and the weaker trends will continue to be weaker. A trend in motion is expected to continue in that direction until some inertia comes along and changes it. You may recognize this from Physics:

Newton’s first law of motion states that “An object at rest stays at rest and an object in motion stays in motion with the same speed and in the same direction unless acted upon by an unbalanced force.” Objects tend to “keep on doing what they’re doing.” In fact, it is the natural tendency of objects to resist changes in their state of motion. This tendency to resist changes in their state of motion is described as inertia.

Inertia: the resistance an object has to a change in its state of motion.

We can say the same about investor behavior and beliefs when we look at confirmation bias.

Confirmation bias is the tendency to search for, interpret, favor, and recall information in a way that confirms one’s preexisting beliefs or hypotheses.

That psychological bias is similar to the physics law of motion;

“Objects tend to keep on doing what they’re doing. In fact, it is the natural tendency of objects to resist changes in their state of motion.”

Investor and trader behavior and Confirmation Bias seems to agree with the first law of motion.

You can probably see how we may develop our beliefs because of our environment. If we observe over time the natural tendency of objects to resist changes in their state of motion then we may expect a trend to continue.

It gets more interesting. According to The Physics Classroom:

Newton’s conception of inertia stood in direct opposition to more popular conceptions about motion. The dominant thought prior to Newton’s day was that it was the natural tendency of objects to come to a rest position. Moving objects, so it was believed, would eventually stop moving; a force was necessary to keep an object moving. But if left to itself, a moving object would eventually come to rest and an object at rest would stay at rest; thus, the idea that dominated people’s thinking for nearly 2000 years prior to Newton was that it was the natural tendency of all objects to assume a rest position.

So, up until Newton’s first law of motion, people believed trends would eventually end instead of continue. In that same way, some people look for and expect recent price trends to change rather than continue.

We have discovered two different beliefs.

  • A trend in motion will stay in motion with the same speed and direction (unless acted upon by an unbalanced force).
  • A trend will eventually stop moving (a force is necessary to keep an object moving).

A Tactical Trader using Relative Strength based on the rate of change assumes that trend speed and direction will continue into the future. This is more in agreement with Newton’s first law.

A Tactical Trader using the Relative Strength Indicator, an oscillator,  assumes that trend speed and direction will oscillate between a range. If it reaches “oversold” it may reverse back up and if it reaches “overbought” it may reverse back down. This is more like the Physics beliefs prior to Newton’s first law when they expected a trend or motion to change.

To avoid conflicts between these two concepts and indicators, I define them separately as Trend Following and Countertrend.

Trend Following systems are methods that aim to buy securities that are rising and sell securities that are declining. Trend following is directional – it focuses on the direction of prices. Not all measures of Relative Strength are directional, but the one I used is. I simply ranked the sectors based on their price change over 3 months. That is an absolute ranking, but also a relative ranking. I may require the price change to be positive to enter a position. Some Relative Strength methods are only relative, so they don’t require a positive trend. They may enter the sectors that have the better price change over the period even if it’s negative.

Countertrend systems aim to bet against the recent price trend for the purpose of pursuing a capital gain or for hedging. In a strongly rising market, a countertrend strategy may believe the price is more likely to reverse. For example, the RSI is “overbought.” In a  declining market, a countertrend strategy may indicate the trend is likely to reverse back up. For example, RSI is “oversold.” The risk is, an oversold market can keep trending lower and an overbought market may keep trending up!

I believe there are directional trends that are more likely to continue than to reverse – so I apply Trend Following to them. That necessarily means I believe investors may underreact to new information causing the price trend to drift gradually over time to match supply and demand.

I also believe that trends can reach an extreme, especially in the short run, by overreacting to information or extremes in sentiments like fear and greed. Because I have observed trends reaching an extreme, I may apply overbought and oversold methods for countertrend trading.

When I see the chart below, I think:

“The trend is up, it has moved up fast enough to be overbought in the short term, so it may pull back some and then the trend may resume to the upside”.

I combine the two, rather than them necessarily being in conflict with each other. I believe the high RSI number is confirming the strong trend, but I also believe it suggests it may not be the best entry point if you care about entering a position that may decline a few percent after you enter it.

So, I believe both of these systems can be applied at different times depending on the market state of the trend type. When a price trend is oscillating up and down over time but not necessarily making a major new high or low, a Countertrend method may capture profits from those swings. When a trend is moving up or down for a prolonged period that same Countertrend system may catch some of the profits and miss some as well. That is because it expects the trend to reverse at certain points and it doesn’t. However, a Trend Following system may better capture the overall trend when it keeps trending. But, none of them are perfect. If a Trend Following system captures the bigger trend it also means it will likely participate in a drawdown when the trend does end. If the Trend Following algorithm is loose enough to ride the trend without whipsaws, it will also be loose enough to lose some gains when the trend does change to the other direction.

If Tactical Traders and investors have useful definitions like these and can apply these different methods to different types of markets, with the right mindset and expectations we can avoid the conflicts.

Relative Strength can be a source of conflict for Tactical Traders

Relative Strength can be a source of conflict for Tactical Traders. I was talking to another tactical trader who manages a hedge fund. He said:

“Industrials are a leading sector, but it’s overbought”.

Relative Strength is a simple measurement to determine which stock, sector, or market has trended up the most over a period of time.  For example, when we rank U.S. sectors over a period of 3 months to see which sectors have been trending the strongest, we see sectors like Financials, Energy, Materials, and Industrials have been the leaders over the past three months. Of course, past performance doesn’t necessarily indicate it will continue into the future. As with any trend indicator, Relative Strength is always looking at the past, never the unknowable future.

To see a different visual, below is how those same sectors appear in a line chart over the past 3 months. We observe that most of the sectors have trended in a wide range over the past few months.

 

When ranked by Relative Strength, the Industrial Sector is a leader compared to other sectors and its directional trend can also be seen in its price chart.

No, wait.

Now that I’ve pulled the chart up: The Industrial sector is overbought right now based on the Relative Strength Index. I highlighted the indicator over 70 with the red line.

So, one “Relative Strength” indicator says it’s in a strong relative trend, the other suggests its “overbought”.

These two indicators sound the same, but they are different, but also the same. It depends on what you think it represents. Both of them actually represent the same thing, but the expectation from them is the opposite.

Relative Strength as I used above, is just a simple comparison of the price trends over the past 3 months, or whatever time frame you want to use.

The Relative Strength Index is a momentum oscillator that measures the speed and change of price movements. That doesn’t sound much different than Relative Strength. The equation is different. The way it is used is different. RSI oscillates between zero and 100. The default time frame is only 14 days. Without writing a book on it, I’ll share that RSI is intended to capture the shorter term swings in a price trend. Since it’s using 14 days, it’s assuming a cycle of 28 days.

When the RSI exceeds 70 it’s considered “overbought” because, mathematically, it has moved a little too far, too fast. When it gets “overbought” it’s expected to either drift sideways for some time or reverse back down. We may indeed observe the price trend stalling at overbought levels. The trouble is, it isn’t perfect. A strong trending price with a lot of inertia can continue trending up and just get more and more overbought. I find that investors who pay a lot of attention to it are concerned their profit will be erased, so they are looking to take profits when it appears overbought.

When the RSI declines below 30 it’s considered “oversold” because, mathematically, it has moved down a little too far, too fast. When it gets “oversold” it’s expected to either drift sideways for some time or reverse back up. We may indeed observe the price trend stalling at oversold levels. The trouble is, a waterfall declining price trend with a lot of inertia like panic can continue trending down and just get more and more oversold. Buying oversold markets, sectors, or stocks can lead to profits, but it’s like catching a falling knife. When I buy oversold markets, I focus on the high dividend yield positions whos yield gets higher as the price falls.

Tactical traders use many different indicators and methods to determine whether to enter, hold, or exit a position. If we look at two conflicting indicators like this, we have to avoid becoming conflicted ourselves. Many tactical traders may experience Confirmation Bias, looking for an indicator that agrees with what they already believe.

So, let’s look at that chart again. On the one hand, it’s trending up! On the other hand, it’s overbought! Will the trend continue or will it reverse down?

We don’t know, but different tactical traders use different methods to enter, hold, and exit positions. I know tactical traders who use only Relative Strength. I know others who mainly use RSI. They are buying and selling each other’s positions and both of them could be profitable overall. If you don’t like to enter a position that may decline in the weeks ahead you may want to avoid high RSI “overbought” markets if you believe they may decline in the short term. If you are a trend following purist who loves to buy new breakouts you’ll ignore the RSI and instead realize a high RSI indicators a strong trend and go for it. Said another way: do you fear missing a trend or fear losing money short term.

It’s easy to say “Don’t get conflicted and biased!” but another to shed more light on the conflict.

Tomorrow I’m going to share with you how I see it.

Stay tuned.

Read Part 2: Resolving Conflicts with Relative Strength

FANG Stocks were the Leaders but now the Laggards

The so-called “FANG” stocks are Facebook (FB), Amazon (AMZN), Netflix (NFLX), and Google (GOOG). These are some of the most talked about stocks in the market the last several years.

If you notice, every bull market has some catchy phrase or acronym the media likes to focus on.

The Nifty 50 was a group of 50 stocks that were most favored by institutional investors in the 1960s and 1970s. Companies in this group were usually characterized by consistent earnings growth and high P/E ratios. Examples of nifty-50 stocks were companies like IBM,  Coca-Cola, and General Electric. The list also included companies that have been had challenges the past decade, like Xerox and Polaroid.

The FANG stocks are popular for good reason. They are some of the best companies in the world. I say that based on the things or services they provide, but also their earnings growth. Earnings growth is the key driver of a stock price. For example, the Investors’ Business Daily shows a EPS Rating of 98, which means NFLX EPS growth rate is above 98% of other stocks. The RS rating is relative strength and means the stock has outperformance 93% of other stocks.

However, in recent months these stocks have shifted from market leaders to laggards. As the overall market has been flat recently, these stocks have declined -5% or so.

We’ll see if they continue to drift down or reverse back up.

Even Hurricane Irma Hasn’t Shaken Recent Investor Greed

It has been over a week since Hurricane Irma came smashing through South Florida. Hurricane Irma was an extremely powerful and catastrophic Cape Verde type hurricane, the strongest observed in the Atlantic since Dean in 2007. I saved the radar image below on my phone. The yellow star is my home in Tampa Bay. Of course, we evacuated northwest to the spend a few days in Rosemary Beach in the panhandle. As Irma shifted more into the gulf, we drove on to Knoxville days in advance of her. Better safe than sorry.  We returned several days after she passed and fortunately, our neighbors were safe and our homes weren’t damaged in our area. However, many still were without power for a week. Our area is a new development, so our power lines are underground. We weren’t just lucky – we were better prepared. I’m not a fan of relying on luck to survive.

Hurricane Irma Maria

Hurricane Irma was a Category 5 Hurricane as she approached Florida. Irma was only two weeks after Hurricane Harvey caused severe damage to the Houston, Texas area.

This has been a very volatile hurricane season.

But, we can’t say the same about stock market volatility.

Amazingly, the U.S. stock market has remained resilient. In fact, the range of how much the prices have spread out has gotten tighter lately and the declines are smaller. We can see this in the chart below that shows % off highs of the S&P 500 stock index.

low volatility

This is also reflected in the investor sentiment, which has once again become extended to the point of “Extreme Greed” on the Fear & Greed Index. This index uses several indicators to estimate investor fear and greed.

Fear and Greed Index Investor Sentiment

Calm and quiet periods are nice, but eventually, an inertia comes along and changes that trend. You would think two destructive hurricanes in two weeks would be that inertia, but investors in stocks aren’t shaken just yet.

In fact, below I drew a chart of world market returns since Irma struck the United States. Generally, most of the markets are flat. Initially, most markets declined, but overall “safe assets” like U.S. Treasuries, Gold, and Real Estate Investment Trusts actually declined around -2% since Irma.

market returns since irma

Cash has been as good as anything since that period – and with no risk.

We shouldn’t be surprised to see a meaningful decline at some point and prices trending in a wider range.

We’ll see.

VIX Trends Up 9th Biggest 1-day Move

About a week after a hedge fund manager who is popular with the media but has a poor track record of managing risk said “please stop talking about the low VIX”, it gains 44.4% in a single day – its 9th biggest 1-day move. He was suggesting the low VIX wasn’t an indication of high risk. If you have followed my observations, you know that I disagree. I’m one who has been talking about the low VIX and suggesting it is one of many indications of complacency among investors. That is, investors hear “all time new highs” and get overly optimistic instead of reducing their risk or being prepared to manage downside loss.

VIX biggest moves

I point out the hedge fund manager’s comment because I believe a low VIX is an indication of complacency because it measures expected implied volatility for options on the S&P 500 stocks. When implied volatility gets to historical low points, it means options traders aren’t paying high premiums for hedging “protection”. Others can believe what they want to believe. I don’t just point out observations at extremes. I actually do something.

As I pointed out recently in “No Inflection Point Yet, But… ” the VIX was at an extreme low. About a week later this other fund manager implies it may not be meaningful. That’s exactly what we expect to hear when the expected volatility gets to such an extreme low. We expect to see it shift the other direction at some point. I like to follow trends until they reach an extreme – and reverse.

Here is what it looked like.

VIX 9th biggest one day move

More importantly, here is what the stock indexes looked like on Google Finance after the close:

Stock market down Korea

Another observation I shared in “No Inflection Point Yet, But…” is that leading stocks can sometimes be more volatile and yesterday was no exception. While the stock indexes were down around -1.5% some of the most popular stocks were down about twice as much:

FANG stocks downSource: Google Finance

Of course, this is all just one day. We’ll see if it continues into a longer trend.

It’s always a good time to manage risk, but sometimes it’s more obvious than others.

No Inflection Point Yet, But…

It can be interesting to revisit previous observations to see what has changed. The last time I shared an observation about the overall state of the stock market was “Is this the Inflection Point for Stocks?” written on April 28th. I shared a few observations of the actual market trend and then some indicators that may give warning of an inflection point. Understanding the market state is an examination of the weight of the evidence. At that time, the weight of the evidence seemed to suggested defense. We’ll see if that is the case today.

I make it clear to follow the actual trend itself. For me, there is no better indication of what I really believe than my actual positions and exposures to the markets. Writing an observation about the market state is one thing, what we actually do is our reality. I am a portfolio manager, not a market commentator, so I make no bones about it. For a portfolio manager, market and portfolio commentary is not necessary.

On the last day of April, I said:

My first indicator is always the actual price trend itself. If we want to know what is going on, there is no better observation than the actual price trend. The price action tells us what force is in control: supply or demand. And, we can see the potential for the inflection point – when the direction is changing. In the chart below, I highlight a recent point of “resistance”. I call it resistance because the stock index hasn’t broken above the March high and is instead drifting sideways.

What has changed?

Here is what I said at the end of April:

Investors sometimes assume a prior price high will automatically become “resistance” just because it’s the price range they expect to see the price trend stall. Resistance is the price level where selling is expected to be strong enough to prevent the price from rising further. We can see that recently in the chart. As the price advances towards the prior peak, supply may overcome demand and prevent the price from rising above resistance. For example, it may be driven by investors who wished they had sold near the prior peak and had to wait as the price recovered again. They anchor to that prior high. Once it gets back to the prior peak, they exit. Prior highs don’t always become “resistance” as expected. Sometimes demand is strong enough to break through and keep trending up. At this point, we see there has been some resistance at the prior high. I highlighted it in yellow in the chart above. So, we shouldn’t be surprised to see the price decline if this resistance holds for a while. Or, it could be an inflection point.

Below is the chart of what actually happened. The red line marked the potential for resistance I spoke of. The S&P 500 stock index did decline about -2% since then, twice, but overall it has trended up with higher highs and higher lows. That is, it broke above what I said could have become resistance. As I said, that’s the thing about trend concepts like support and resistance – they don’t exist until they do. At this point, the stock index is near its all-time high with no previous high that could act as “resistance”. As we’ll see, such headlines make investors very optimistic as people tend to extrapolate the recent past into the future.

S&P 500 Stock Index Trend

I had also pointed out the directional trend of the small company stock index. I said:

The S&P 500 stock index is mainly large companies. Smaller companies tend to lead larger companies. Their price trends move in a wider range and they sometimes move faster, so they get to a point sooner. That’s why we say small company stocks “lead” large company stocks. In that case, I highlight below that the small company stock index, the S&P 600 Small Cap ETF, reached its prior, but found resistance and reversed down. The soldiers may lead the way for the Generals.

What has changed? 

Below I marked the red line in the same place as the end of April. As you can see, since then, smaller stocks indeed continued to move in a wider range, but though they have been more volatile. they have trended to slightly higher highs. At this point, this index is also at its all-time high, a headline that makes investors optimistic.

Russell 2000 small cap stock trend

This is a good time to remind ourselves of the definition of an inflection point. You see, we want to go with the flow of what is, but, we may also want to apply some situational awareness of the current state so we aren’t surprised when things change.

inflection point

I went on to say:

As I continue sharing some observations, I’m going to get farther away from my main decision maker which is the directional price trend, but you’ll see how these indicators help to quantify the state of the trend and the potential for an inflection point. As we keep going, keep in mind that indicators are a derivative of the price at best or a derivate of something unrelated to the directional price trend. In the case of the VIX® Index index above, it’s a measure of options (a derivative) on the stocks in the S&P 500. When we start looking at things like economic growth and valuations we are necessarily looking at things that are a derivative of price, but not as absolute as the price trend itself. The direction of the price trend is the arbiter.

At the end of April, I pointed out:

It seems that the stock index is stalling at a time when investors are complacent. When investors are complacent or overly optimistic an inflection point is more likely. The CBOE Volatility Index® (VIX® Index)  is very low. The CBOE Volatility Index® (VIX® Index®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. The VIX® historically trends between a long-term range. When the VIX® gets to an extreme, it becomes more likely to eventually reverse. In the chart below I show the price level of the VIX® since its inception in 1993. We can see its long-term average is around 20. I highlighted in red its low range is around 12 and it has historically spiked as high as 25 or 60. This means the traders of options are expecting lower volatility in the weeks ahead at a time when other things seem to suggest otherwise.

 

What has changed?

The CBOE Volatility Index® (VIX® Index) actually spiked up 55% in May but since has declined to its all time low.

VIX spike to manage risk

The VIX® is now at a historically low point, suggesting that investors may be unusually complacent. Such low levels of expected future volatility tend to proceed market tops, declining markets, and rising volatility.

VIX July 2017

When volatility spiked, the stock indexes only dropped -2% to -4%. However, some of the most popular growth stocks in the technology sector declined much more creating a short term trading opportunity for those of us willing to manage our risk.  These have been the leading stocks, so when they decline more than broad market indexes it’s an indication of the overall risk level. Eventually, these short downtrends may continue to deeper drawdowns, so drawdown control is essential.

FANG tech stocks

I also mentioned on April 28th that the following Monday was the beginning of May, a seasonally weak period. Specifically, I said:

I’m not a huge fan of using seasonality as an indicator to enter or exit the stock market, but there is some tendency for certain periods to gain or lose value historically. For example, a common seasonality is “Sell in May and go away”. Depending on the historical time frame you look and which index, some periods show a “summer slump”. One theory is many investors and traders go on vacation in the summer, so volume is light. They return after the summer and take more action.

While I certainly don’t use “Sell in May and go away” as a trading indicator, we usually do see a “summer slump” at some point. We haven’t seen that, yet, so we shouldn’t be surprised if we do.

Aside from the historically low VIX® the other warning sign is the current valuation of the stock indexes. As the stock indexes are gradually making higher highs which seems to be leading to investor complacency, it comes at a time when stocks are “significantly overvalued”, according to my friend Ed Easterling in Crestmont Research Stock PE Report July 2017:

CURRENT STATUS (Second Quarter 2017) In the second quarter, the stock market added 2.9% for a cumulative 8.2% gain in the first half, well more than underlying economic growth. As a result, normalized P/E increased to 29.8—significantly above the level justified by low inflation and low interest rates. The current status remains “significantly overvalued.”

There are no perfect indicators; it’s all about the weight of the evidence. What we do know is this is a very aged old bull market that has now lasted eight years. Historically, bull markets have lasted 4 – 5 years. We also know the most astute fundamental analyst, Crestmont warns that the current status remains “significantly overvalued.” As to be expected, as the primary stock trend continues up, investors are getting more and more complacent expecting the trend to continue. The same investors who got caught in the loss trap last time are likely to get caught again.

Eventually, there will be an inflection point. The higher and more overvalued a market becomes the more significant the inflection point may be.

We’ll see how it all plays out.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC and the portfolio manager of ASYMMETRY® Global Tactical.

 

Is this the Inflection Point for Stocks?

As if the election result wasn’t enough, the U.S. stock market has surprised most people by trending up since last November.

But, it has been stalling since March. The S&P 500 drifted down about -3% into March and April.

The stock market seems to be at an inflection point now.

Understanding the market state is an examination of the weight of the evidence.

The weight of the evidence seems to suggest defense.

My first indicator is always the actual price trend itself. If we want to know what is going on, there is no better observation than the actual price trend. The price action tells us what force is in control: supply or demand. And, we can see the potential for the inflection point – when the direction is changing. In the chart below, I highlight a recent point of “resistance”. I call it resistance because the stock index hasn’t broken above the March high and is instead drifting sideways.

average age of bull market top

Investors sometime assume a prior price high will automatically become “resistance” just because it’s the price range they expect to see the price trend stall. Resistance is the price level where selling is expected to be strong enough to prevent the price from rising further. We can see that recently in the chart. As the price advances towards the prior peak, supply may overcome demand and prevent the price from rising above resistance. For example, it may be driven by investors who wished they had sold near the prior peak and had to wait as the price recovered again. They anchor to that prior high. Once it gets back to the prior peak, they exit. Prior highs don’t always become “resistance” as expected. Sometimes demand is strong enough to break through and keep trending up. At this point, we see there has been some resistance at the prior high. I highlighted it in yellow in the chart above. So, we shouldn’t be surprised to see the price decline if this resistance holds for a while. Or, it could be an inflection point.

The S&P 500 stock index is mainly large companies. Smaller companies tend to lead larger companies. Their price trends move in a wider range and they sometimes move faster, so they get to a point sooner. That’s why we say small company stocks “lead” large company stocks. In that case, I highlight below that the small company stock index, the S&P 600 Small Cap ETF, reached its prior, but found resistance and reversed down. The soldiers may lead the way for the Generals.

Small Cap

It seems that the stock index is stalling at a time when investors are complacent. When investors are complacent or overly optimistic an inflection point is more likely. The CBOE Volatility Index® (VIX® Index)  is very low. The CBOE Volatility Index® (VIX® Index®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. The VIX® historically trends between a long-term range. When the VIX® gets to an extreme, it becomes more likely to eventually reverse. In the chart below I show the price level of the VIX® since its inception in 1993. We can see its long-term average is around 20. I highlighted in red its low range is around 12 and it has historically spiked as high as 25 or 60. This means the traders of options are expecting lower volatility in the weeks ahead at a time when other things seem to suggest otherwise.

As I continue sharing some observations, I’m going to get farther away from my main decision maker which is the directional price trend, but you’ll see how these indicators help to quantify the state of the trend and the potential for an inflection point. As we keep going, keep in mind that indicators are a derivative of the price at best or a derivate of something unrelated to the directional price trend. In the case of the VIX® Index index above, it’s a measure of options (a derivative) on the stocks in the S&P 500. When we start looking at things like economic growth and valuations we are necessarily looking at things that are a derivative of price, but not as absolute as the price trend itself. The direction of the price trend is the arbiter.

Another signal of an inflection point is breadth. That is, what percent of stocks are rising or falling. Since I have mentioned the S&P 500 stock index, I’ll show the S&P 500 Bullish Percent Index below. The Bullish Percent is a breadth indicator based on the number of stocks on Point & Figure buy signals. Developed by Abe Cohen in the mid-1950s, the Bullish Percent Index was originally applied to NYSE stocks. Cohen was the first editor of ChartCraft, which later became Investors Intelligence. BP signals were further refined by Earl Blumenthal in the mid 70’s and Mike Burke in the early 80’s. The S&P 500 Bullish Percent shows a composite of the 500 stocks in the S&P 500 index that are in a positive trend. The S&P 500 Bullish Percent recently reversed to a column of O’s from a high point of 80, which means about 80% of the S&P 500 stocks were in a positive trend and about 8% of them are now in a negative trend. In addition to the direction, the level is important because we consider the level above 70% or 80% to be a higher risk (red zone) and the levels below 30% to be lower risk (green zone). So, more and more stocks within the index are starting to decline. This weak “breadth” or participation could be a signal of a change in trend.

Bullish Percent

I’m not necessarily a big user of economic indicators. I believe the stock indexes are the leading indicator for the economy, so that’s my guide. However, I have a strong sense of situational awareness so I like to understand what in the world is going on. The total return of stocks is a function of three things: earnings growth + dividend yield + P/E ratio expansion or contraction. Since earnings growth has made up nearly 5% of the historical total return of the S&P 500 since 1926, it does matter in the big picture in regard to expected return. Today, we observe the headline in the Wall Street Journal:

GDP Slows to Weakest Growth in Three Years

The U.S. economy’s output grew at the slowest pace in three years during the first quarter, underscoring the challenges facing the Trump administration as it seeks to rev up growth.

The New York Times says:

G.D.P. Report Shows U.S. Economy Off to Slow Start in 2017

■ The economy barely grew, expanding at an annual rate of only 0.7 percent.

■ The growth was a sharp decline from the 2.1 percent annual rate recorded in the final quarter of last year. It was the weakest quarterly showing in three years.

■ Consumption, the component reflecting individual spending, rose by only 0.3 percent, well below the 3.5 percent rate in the previous quarter.

The Takeaway

The first-quarter performance upset expectations for a Trump bump at the start of 2017.

If you want an economic catalyst for why prices could stall or reverse down, there you go. You see, earnings growth of stocks is part of GDP. GDP is the sales of all U.S. companies, private and public. The earnings growth of the S&P 500 is the earnings of those 500 companies. In other words, GDP of the economy is highly connected to EPS of an index of 500 stocks.

This recent stall in the price trend and economic growth along with a dash of complacency comes at a time when stocks are “significantly overvalued”, according to my friend Ed Easterling at Crestmont Research:

“In the first quarter the stock market surged 5.5%, well more than underlying economic growth. As a result, normalized P/E increased to 29.4—significantly above the level justified by low inflation and low interest rates. The current status remains “significantly overvalued.” The level of volatility plunged over the past quarter and is now in the lowest 4% of all periods since 1950. The trend in reported earnings for the S&P 500 Index reflects a repeating pattern of overly-optimistic analysts’ forecasts. Earnings and volatility should be watched closely and investors should heighten their sensitivity to the risks confronting an increasingly vulnerable market.”

Oh, and one more thing: Monday will be May. I’m not a huge fan of using seasonality as an indicator to enter or exit the stock market, but there is some tendency for certain periods to gain or lose value historically. For example, a common seasonality is “Sell in May and go away”. Depending on the historical time frame you look and which index, some periods show a “summer slump”. One theory is many investors and traders go on vacation in the summer, so volume is light. They return after the summer and take more action.

So, maybe this will be a good time to sell in May and go away. Not because it’s May, but instead because the weight of the evidence suggests this could be an inflection point.

We’ll see.

How Future Losses Erase Prior Gains

Someone was talking about how much the stock market is “up”.

However, it’s the exit that determines the outcome.

When someone talks about being “up” that doesn’t mean anything unless they have sold to realize the profit.

If they haven’t sold, it’s the markets money. The market may giveth, but it can also taketh away. Market gains are just market gains. To realize a profit, we have to sell.

Open profits aren’t yet realized.

Open profits may never be realized.

Open profits may be evaporated by later losses.

Closed profits are ours. When we exit and take a profit, we’ve realized the gain and have the cash to show for it.

To be sure, let’s look at the last 20 years. It’s hard to believe that a data point of 1997 is now 20 years ago! It seems like yesterday to me. Talking about 1997 may sound ancient now, but it wasn’t so long ago. The late 1990’s was one of the strongest cyclical bull markets in history. The S&P 5oo stock index gained over 200% in five years! The sharp gains of the late 1990’s inspired even the oldest bank savers to cash in CD’s that were paying 5% to 7% for the chance for high profits.

Only in hindsight do we know what happened next.

The essential concept investors must understand is not only how capital compounds, but also the math of loss.

Losses are asymmetric. In fact, losses are more asymmetric than gains.

That is, losses compound more exponential than gains.

Losses are exponential. As they get larger, it takes more gain to recover the loss to be back to even.

That’s why we don’t have to capture 100% of a gain to result in the same or better return if the downside loss is limited. When we avoid much of the downside, we simply don’t need to risk so much on the upside to compound capital positively. And, if we don’t have large losses on the downside investors are less likely to tap out with losses. Those concepts are essential to understand. It doesn’t matter how much the return is if the downside is so large they tap out before the gain is realized.

In the chart below, we can see how the math works.

A -10% loss takes +11% to recover. A 20% loss takes +25% to recover. Beyond -20%, the losses become more asymmetric and exponential. A -30% loss needs a +43% to get back to even. At -40% you need +67% to regain. That’s why losses in the -50% range as we’ve seen twice over the past 15 years are so devastating to life plans. At -50% you need +100% just to recover the loss and get back to breakeven. If your loss is -60%, it’s +150% to recoup. So when you hear people bragging about the stock market gains since 2009, don’t forget the other side of the story. It’s the other side the makes all the difference. How many years of staying fully invested in risky markets did it take to recover the loss?

Let’s look at how this matches up with real price trends we’ve observed over the past 20 years.

Below we see the late 1990’s gains more than erased by the sharp decline from 2000 to 2002. But keep in mind, while the decline was a sharp one at -50%, the decline was made up of many swings up and down along the way. The swings of lower highs and lower lows swayed many investors back “in” as those swings up along the way made them think the low was in and it was a “buying opportunity”. They did that just in time for the next down move. Avoiding bear markets isn’t as simple as exiting near the peak and reentering near the low. It’s far more complicated. Investors fear missing out during every 10% to 20% upswing, then they fear losing more money after every -10% to -20% downswing. But, the point here is that the large uptrend was erased by the later downtrend. What happens along the way brings additional challenges.

After the low around 2003, a new cyclical bull market began. As we know in hindsight, it lasted until October 2007. In October 2007, investors were pretty optimistic again and maybe a little euphoric. Stocks had gained over 100% from the bear market low and they wanted more stocks. It didn’t take long for a decline large enough that more than erased all the gains they were so excited about.

In fact, not only did that bear market erase the gains of the cyclical bull market that started in 2002, it also erased all of “The Tech Bubble” gains going back to 1995! By 2009 the past fourteen years was at a loss for stock index investors.

Even the largest uptrends have been erased by the later downtrends. This has happened many times in stock market history.

It doesn’t matter how much the stock market had gained. It only mattered if the profits were realized. Otherwise, it was just a rollercoaster.

You can probably see why I say that markets have profit potential, but because they don’t always go up, they require risk management. It’s why I actively manage risk and apply directional trend systems intended to capture profits and avoid significant losses.

Name ONE thing money can’t buy?

money business finance investment

Name ONE thing money can’t buy? asked a friend on Facebook that got responses like happiness, respect, health, love, freedom, and class.

My answer:

Anything.

Money itself can’t buy anything.

Money is a medium of exchange. It is used to facilitate the trade of things between people.

For example, we can trade our time for money or our money for time.

It is people who buys things with it, saves it, or invests it.

Money itself doesn’t buy anything.

It’s what people do with their money that determines its usefulness for them. Perceptions about money are an individual preference based on individual circumstances.

Let’s consider the replies about happiness, respect, health, love, freedom, and class.

Money can’t buy happiness?

Happiness is a mental or emotional state of well-being defined by positive or pleasant emotions ranging from contentment to intense joy.

So, it depends on what makes you happy.

If being at home with the family makes you happy, having more money can facilitate that if you don’t have to leave home for work. If traveling and new experiences make you happy, money can allow you to do it. If playing more golf makes you happy then having an abundance of money allows you the freedom to do the things makes you happy.

But, you have to use your money in a way that makes you happy. Money itself doesn’t do it for you.

Money can’t buy respect?

Respect is a feeling of deep admiration for someone or something elicited by their abilities, qualities, or achievements. Money itself isn’t going to buy us any respect. However, the source of our money and what we do with it may lead to greater respect.

Money itself isn’t going to buy us any respect. However, the source of our money and what we do with it may lead to greater respect. If respect is admiration of abilities, qualities, or achievements, then those things may also lead to more money than less. Money is a medium of exchange, so money is measured and valued to be exchanged for other things.

We have to admit that some of our abilities and achievements can be measured in monetary terms. Professionally, money is the direct exchange from our abilities and achievements. So, someone may not respect us for how much money we have, but they may respect us for what we did to earn it. Money is the measure of whether or not our abilities, qualities, or achievements have paid off. Maybe you know someone who speaks highly of their abilities, qualities, and achievements but never has money, wants to borrow money from you, or is jealous of other people who have money.

Money can’t buy Love?

Can’t buy me love, love
Can’t buy me love

I’ll buy you a diamond ring my friend if it makes you feel alright
I’ll get you anything my friend if it makes you feel alright
Cos I don’t care too much for money, and money can’t buy me love

I’ll give you all I got to give if you say you’ll love me too
I may not have a lot to give but what I got I’ll give to you
I don’t care too much for money, money can’t buy me love
Can’t buy me love, everybody tells me so
Can’t buy me love, no no no, no

Love is or warm personal attachment or an intense feeling of deep affection.

Money doesn’t buy anything itself, so it doesn’t buy love.

But, if you spend your money buying flowers or golf balls to express your affection for another you may discover it leads to greater love.

To be sure, just try it.

If that doesn’t work, buy them some wine.

The reality is, when we spend some money expressing our affection for others we may get some affection in return.

Or, maybe a day hug and kiss will do.

Money can’t buy health?

Health is a state of complete physical, mental, and social well-being and not merely the absence of disease or infirmity.

Since much of health is about staying fit, eating healthy, and a good state of mind, it seems that more money can lead to better health than less. For example, if we have the freedom with our time to get out and walk or train in a gym we may stay more healthy. If we have the money to afford medical care and advanced treatment we may live more healthy. If we don’t have the stress that comes with a lack of money we may have a better overall well-being. But, we have to choose a healthier lifestyle.

We can have less stress and better health without money I suppose, but it seems we need some level of money to achieve good health.

Money can’t buy class?

Classy means elegant, stylish, or having high standards of personal behavior. So, “classy” is certainly relative and dependent.

Class is a tricky one, since “being classy” is very relative and a personal preference.

For example, an aristocratic Southern family may consider going out hunting on horseback to be “classy”. Someone living on a golf course and country club considers their lifestyle to be “classy” and may think horseback riding and hunting is the opposite of “classy”. Those aristocratic Southerners who live on fine farms that ride horses and hunt believe those who live on golf courses are far from “classy”. Someone in New York City may believe walking on concrete to eat in a crowded restaurant in a suit and dress is “classy”.Maybe all of them are “classy”, but in different ways.

Money doesn’t buy anything, so it can’t buy class, either. But, if you want to be classy I suppose you could buy some classes on being classy or money buys the time to spend learning how to be classy if you aren’t already “classy”.  But, class is a relative thing. What is considered classy depends on the person.

My suggestion: be who you really are. Some may consider you classy, others may not. You may not care – if you have enough money!

Money can’t buy freedom?

freedom

Freedom is the power or right to act, speak, or think as one wants without hindrance or restraint.

To better understand who can do that, consider who can’t. Who can’t act, speak, or think as one wants without hindrance or restraint? What may prevent someone from acting, speaking, or thinking as one wants without hindrance or restraint?

You got it.

When you have financial freedom, you not only have the abundance of money to do what you want, when you want, but you also have more freedom to act, speak, or think as one wants without hindrance or restraint.

Money itself can’t buy anything.

It is people who buys things with it, saves it, or invests it.

Money is just the medium of exchange.

What you choose to do with it determines its usefulness, to you.

What you choose to do with money determines if it leads to happiness, respect, health, love, and freedom, for you.

If you have enough money that it allows you the freedom to do what you want, when you want, and with whom you want, you decide what you get in exchange from it.

The reality is, saving and investing money and spending it wisely can lead to greater happiness, freedom, health, respect, and even love if that’s what you want.

March 9th is the Bull Market’s 8-Year Anniversary

I observed many headlines pointing out that March 9th is the 8th anniversary of the current bull market in U.S. stocks.

The rising trend in stocks is becoming one of the longest on record. It is the second longest, ever.

Looking at it another way, March 9, 2009 was the point that stock indexes had fallen over -50% from their prior highs.

Since most of the discussion focuses on the upside over the past 8 years, I’ll instead share the other side so we remember why March 9, 2009 matters.

 ‘Those who cannot remember the past are condemned to repeat it.’

– George Santayana

When investors speak of the last bear market they mostly call it “2008” or “o8”.

However, the end of the last bear market was actually March 9, 2009 and the beginning was October 2007.

Below is a chart of the S&P 500 stock index from October 9, 2007 to March 9, 2009. The price decline was -56%.

No one knew that March 9, 2009 was the lowest it would go. It could have gotten much worse.

Talking only about the gains since the low leaves out the full story.

When we research price trends, we must necessarily consider the full market cycle of both rising and falling trends. For example, below is the price trend since the peak nearly 10 years ago on October 9, 2007.  Even after such a large gain, the Risk-to-Reward Ratio isn’t so good if you had to hold through the big loss to achieve it. That is, investors had to experience -56% on the downside for how much gain?

It isn’t the upside that causes so much trouble, it’s the downside.

That’s why we must manage risk to increase and decrease exposure to the possibility of gain and loss.

On Sheep, Wolves and Sheepdogs

I consider On Sheep, Wolves and Sheepdogs from the book, On Combat, by Lt. Col. Dave Grossman, to be essential. It is absolutely necessary to understand the concepts so that we know who we are, where we fit in, and how we interact with each other. 

on-sheep-wolves-and-sheepdogs

On Sheep, Wolves and Sheepdogs by Lt. Col. Dave Grossman (reprinted with permission)

“Honor never grows old, and honor rejoices the heart of age. It does so because honor is, finally, about defending those noble and worthy things that deserve defending, even if it comes at a high cost. In our time, that may mean social disapproval, public scorn, hardship, persecution, or as always, even death itself. The question remains: What is worth defending? What is worth dying for? What is worth living for?”

– William J. Bennett
In a lecture to the United States Naval Academy
November 24, 1997

One Vietnam veteran, an old retired colonel, once said this to me: “Most of the people in our society are sheep. They are kind, gentle, productive creatures who can only hurt one another by accident.” This is true. Remember, the murder rate is six per 100,000 per year, and the aggravated assault rate is four per 1,000 per year. What this means is that the vast majority of Americans are not inclined to hurt one another.

Some estimates say that two million Americans are victims of violent crimes every year, a tragic, staggering number, perhaps an all-time record rate of violent crime. But there are almost 300 million Americans, which means that the odds of being a victim of violent crime is considerably less than one in a hundred on any given year. Furthermore, since many violent crimes are committed by repeat offenders, the actual number of violent citizens is considerably less than two million.

Thus there is a paradox, and we must grasp both ends of the situation: We may well be in the most violent times in history, but violence is still remarkably rare. This is because most citizens are kind, decent people who are not capable of hurting each other, except by accident or under extreme provocation. They are sheep.

I mean nothing negative by calling them sheep. To me it is like the pretty, blue robin’s egg. Inside it is soft and gooey but someday it will grow into something wonderful. But the egg cannot survive without its hard blue shell. Police officers, soldiers and other warriors are like that shell, and someday the civilization they protect will grow into something wonderful. For now, though, they need warriors to protect them from the predators.

“Then there are the wolves,” the old war veteran said, “and the wolves feed on the sheep without mercy.” Do you believe there are wolves out there who will feed on the flock without mercy? You better believe it. There are evil men in this world and they are capable of evil deeds. The moment you forget that or pretend it is not so, you become a sheep. There is no safety in denial.

“Then there are sheepdogs,” he went on, “and I’m a sheepdog. I live to protect the flock and confront the wolf.” Or, as a sign in one California law enforcement agency put it, “We intimidate those who intimidate others.”

If you have no capacity for violence then you are a healthy productive citizen: a sheep. If you have a capacity for violence and no empathy for your fellow citizens, then you have defined an aggressive sociopath–a wolf. But what if you have a capacity for violence, and a deep love for your fellow citizens? Then you are a sheepdog, a warrior, someone who is walking the hero’s path. Someone who can walk into the heart of darkness, into the universal human phobia, and walk out unscathed.

The gift of aggression

“What goes on around you… compares little with what goes on inside you.”
– Ralph Waldo Emerson

Everyone has been given a gift in life. Some people have a gift for science and some have a flair for art. And warriors have been given the gift of aggression. They would no more misuse this gift than a doctor would misuse his healing arts, but they yearn for the opportunity to use their gift to help others. These people, the ones who have been blessed with the gift of aggression and a love for others, are our sheepdogs. These are our warriors.

One career police officer wrote to me about this after attending one of my Bulletproof Mind training sessions:

“I want to say thank you for finally shedding some light on why it is that I can do what I do. I always knew why I did it. I love my [citizens], even the bad ones, and had a talent that I could return to my community. I just couldn’t put my finger on why I could wade through the chaos, the gore, the sadness, if given a chance try to make it all better, and walk right out the other side.”

Let me expand on this old soldier’s excellent model of the sheep, wolves, and sheepdogs. We know that the sheep live in denial; that is what makes them sheep. They do not want to believe that there is evil in the world. They can accept the fact that fires can happen, which is why they want fire extinguishers, fire sprinklers, fire alarms and fire exits throughout their kids’ schools. But many of them are outraged at the idea of putting an armed police officer in their kid’s school. Our children are dozens of times more likely to be killed, and thousands of times more likely to be seriously injured, by school violence than by school fires, but the sheep’s only response to the possibility of violence is denial. The idea of someone coming to kill or harm their children is just too hard, so they choose the path of denial.

The sheep generally do not like the sheepdog. He looks a lot like the wolf. He has fangs and the capacity for violence. The difference, though, is that the sheepdog must not, cannot and will not ever harm the sheep. Any sheepdog who intentionally harms the lowliest little lamb will be punished and removed. The world cannot work any other way, at least not in a representative democracy or a republic such as ours.

Still, the sheepdog disturbs the sheep. He is a constant reminder that there are wolves in the land. They would prefer that he didn’t tell them where to go, or give them traffic tickets, or stand at the ready in our airports in camouflage fatigues holding an M-16. The sheep would much rather have the sheepdog cash in his fangs, spray paint himself white, and go, “Baa.”

Until the wolf shows up. Then the entire flock tries desperately to hide behind one lonely sheepdog. As Kipling said in his poem about “Tommy” the British soldier:

While it’s Tommy this, an’ Tommy that, an’ “Tommy, fall be’ind,”
But it’s “Please to walk in front, sir,” when there’s trouble in the wind,
There’s trouble in the wind, my boys, there’s trouble in the wind,
O it’s “Please to walk in front, sir,” when there’s trouble in the wind.

The students, the victims, at Columbine High School were big, tough high school students, and under ordinary circumstances they would not have had the time of day for a police officer. They were not bad kids; they just had nothing to say to a cop. When the school was under attack, however, and SWAT teams were clearing the rooms and hallways, the officers had to physically peel those clinging, sobbing kids off of them. This is how the little lambs feel about their sheepdog when the wolf is at the door. Look at what happened after September 11, 2001, when the wolf pounded hard on the door. Remember how America, more than ever before, felt differently about their law enforcement officers and military personnel? Remember how many times you heard the word hero?

Understand that there is nothing morally superior about being a sheepdog; it is just what you choose to be. Also understand that a sheepdog is a funny critter: He is always sniffing around out on the perimeter, checking the breeze, barking at things that go bump in the night, and yearning for a righteous battle. That is, the young sheepdogs yearn for a righteous battle. The old sheepdogs are a little older and wiser, but they move to the sound of the guns when needed right along with the young ones.

Here is how the sheep and the sheepdog think differently. The sheep pretend the wolf will never come, but the sheepdog lives for that day. After the attacks on September 11, 2001, most of the sheep, that is, most citizens in America said, “Thank God I wasn’t on one of those planes.” The sheepdogs, the warriors, said, “Dear God, I wish I could have been on one of those planes. Maybe I could have made a difference.” When you are truly transformed into a warrior and have truly invested yourself into warriorhood, you want to be there. You want to be able to make a difference.

While there is nothing morally superior about the sheepdog, the warrior, he does have one real advantage. Only one. He is able to survive and thrive in an environment that destroys 98 percent of the population.

There was research conducted a few years ago with individuals convicted of violent crimes. These cons were in prison for serious, predatory acts of violence: assaults, murders and killing law enforcement officers. The vast majority said that they specifically targeted victims by body language: slumped walk, passive behavior and lack of awareness. They chose their victims like big cats do in Africa, when they select one out of the herd that is least able to protect itself.

However, when there were cues given by potential victims that indicated they would not go easily, the cons said that they would walk away. If the cons sensed that the target was a “counter-predator,” that is, a sheepdog, they would leave him alone unless there was no other choice but to engage.

One police officer told me that he rode a commuter train to work each day. One day, as was his usual, he was standing in the crowded car, dressed in blue jeans, T-shirt and jacket, holding onto a pole and reading a paperback. At one of the stops, two street toughs boarded, shouting and cursing and doing every obnoxious thing possible to intimidate the other riders. The officer continued to read his book, though he kept a watchful eye on the two punks as they strolled along the aisle making comments to female passengers, and banging shoulders with men as they passed.

As they approached the officer, he lowered his novel and made eye contact with them. “You got a problem, man?” one of the IQ-challenged punks asked. “You think you’re tough, or somethin’?” the other asked, obviously offended that this one was not shirking away from them.

“As a matter of fact, I am tough,” the officer said, calmly and with a steady gaze.

The two looked at him for a long moment, and then without saying a word, turned and moved back down the aisle to continue their taunting of the other passengers, the sheep.

Some people may be destined to be sheep and others might be genetically primed to be wolves or sheepdogs. But I believe that most people can choose which one they want to be, and I’m proud to say that more and more Americans are choosing to become sheepdogs.

Seven months after the attack on September 11, 2001, Todd Beamer was honored in his hometown of Cranbury, New Jersey. Todd, as you recall, was the man on Flight 93 over Pennsylvania who called on his cell phone to alert an operator from United Airlines about the hijacking. When he learned of the other three passenger planes that had been used as weapons, Todd dropped his phone and uttered the words, “Let’s roll,” which authorities believe was a signal to the other passengers to confront the terrorist hijackers. In one hour, a transformation occurred among the passengers–athletes, business people and parents–from sheep to sheepdogs and together they fought the wolves, ultimately saving an unknown number of lives on the ground.

“Do you have any idea how hard it would be to live with yourself after that?” 

“There is no safety for honest men except by believing all possible evil of evil men.”
– Edmund Burke

Reflections on the Revolution in France

Here is the point I like to emphasize, especially to the thousands of police officers and soldiers I speak to each year. In nature the sheep, real sheep, are born as sheep. Sheepdogs are born that way, and so are wolves. They didn’t have a choice. But you are not a critter. As a human being, you can be whatever you want to be. It is a conscious, moral decision.

If you want to be a sheep, then you can be a sheep and that is okay, but you must understand the price you pay. When the wolf comes, you and your loved ones are going to die if there is not a sheepdog there to protect you. If you want to be a wolf, you can be one, but the sheepdogs are going to hunt you down and you will never have rest, safety, trust or love. But if you want to be a sheepdog and walk the warrior’s path, then you must make a conscious and moral decision every day to dedicate, equip and prepare yourself to thrive in that toxic, corrosive moment when the wolf comes knocking at the door.

For example, many officers carry their weapons in church. They are well concealed in ankle holsters, shoulder holsters or inside-the-belt holsters tucked into the small of their backs. Anytime you go to some form of religious service, there is a very good chance that a police officer in your congregation is carrying. You will never know if there is such an individual in your place of worship, until the wolf appears to slaughter you and your loved ones.

I was training a group of police officers in Texas, and during the break, one officer asked his friend if he carried his weapon in church. The other cop replied, “I will never be caught without my gun in church.” I asked why he felt so strongly about this, and he told me about a police officer he knew who was at a church massacre in Ft. Worth, Texas, in 1999. In that incident, a mentally deranged individual came into the church and opened fire, gunning down 14 people. He said that officer believed he could have saved every life that day if he had been carrying his gun. His own son was shot, and all he could do was throw himself on the boy’s body and wait to die. That cop looked me in the eye and said, “Do you have any idea how hard it would be to live with yourself after that?”

Some individuals would be horrified if they knew this police officer was carrying a weapon in church. They might call him paranoid and would probably scorn him. Yet these same individuals would be enraged and would call for “heads to roll” if they found out that the airbags in their cars were defective, or that the fire extinguisher and fire sprinklers in their kids’ school did not work. They can accept the fact that fires and traffic accidents can happen and that there must be safeguards against them. Their only response to the wolf, though, is denial, and all too often their response to the sheepdog is scorn and disdain. But the sheepdog quietly asks himself, “Do you have any idea how hard it would be to live with yourself if your loved ones were attacked and killed, and you had to stand there helplessly because you were unprepared for that day?”

The warrior must cleanse denial from his thinking. Coach Bob Lindsey, a renowned law enforcement trainer, says that warriors must practice “when/then” thinking, not “if/when.” Instead of saying,“If it happens then I will take action,” the warrior says, “When it happens then I will be ready.”

It is denial that turns people into sheep. Sheep are psychologically destroyed by combat because their only defense is denial, which is counterproductive and destructive, resulting in fear, helplessness and horror when the wolf shows up.

Denial kills you twice. It kills you once, at your moment of truth when you are not physically prepared: You didn’t bring your gun; you didn’t train. Your only defense was wishful thinking. Hope is not a strategy. Denial kills you a second time because even if you do physically survive, you are psychologically shattered by fear, helplessness, horror and shame at your moment of truth.

Chuck Yeager, the famous test pilot and first man to fly faster than the speed of sound, says that he knew he could die. There was no denial for him. He did not allow himself the luxury of denial. This acceptance of reality can cause fear, but it is a healthy, controlled fear that will keep you alive:

“I was always afraid of dying. Always. It was my fear that made me learn everything I could about my airplane and my emergency equipment, and kept me flying respectful of my machine and always alert in the cockpit.”

– Brigadier General Chuck Yeager
Yeager, An Autobiography

Gavin de Becker puts it like this in Fear Less, his superb post-9/11 book, which should be required reading for anyone trying to come to terms with our current world situation:

“..denial can be seductive, but it has an insidious side effect. For all the peace of mind deniers think they get by saying it isn’t so, the fall they take when faced with new violence is all the more unsettling. Denial is a save-now-pay-later scheme, a contract written entirely in small print, for in the long run, the denying person knows the truth on some level.”

And so the warrior must strive to confront denial in all aspects of his life, and prepare himself for the day when evil comes.

If you are a warrior who is legally authorized to carry a weapon and you step outside without that weapon, then you become a sheep, pretending that the bad man will not come today. No one can be “on” 24/7 for a lifetime. Everyone needs down time. But if you are authorized to carry a weapon, and you walk outside without it, just take a deep breath, and say this to yourself… “Baa.”

This business of being a sheep or a sheepdog is not a yes-no dichotomy. It is not an all-or-nothing, either-or choice. It is a matter of degrees, a continuum. On one end is an abject, head-in-the-grass sheep and on the other end is the ultimate warrior. Few people exist completely on one end or the other. Most of us live somewhere in between. Since 9-11 almost everyone in America took a step up that continuum, away from denial. The sheep took a few steps toward accepting and appreciating their warriors, and the warriors started taking their job more seriously. The degree to which you move up that continuum, away from sheephood and denial, is the degree to which you and your loved ones will survive, physically and psychologically at your moment of truth.

Source: On Combat The Psychology and Physiology of Deadly Conflict in War and in Peace by Dave Grossman 

You want to be fearful when others are greedy?

“You want to be greedy when others are fearful. You want to be fearful when others are greedy. It’s that simple.… ” – Warren Buffett

Investors are emotional and we can profit from it.

Though investors are emotional, they can also manage their emotions to feel the right feeling at the right time.

Market trends are both the result of investor behavior and driven by it. Anyone who watches “the market” has had feelings of fear and greed at some point. Those who “watch it closely” feel it often.

  • Fear: I am losing money! Is it ever going to stop?
  • Worried: How much more money will I lose?
  • Defeated: I’ve lost so much money I don’t know what I’m going to do.
  • Hope: I hope I make money this time. I hope it keeps going up!
  • Greed: I’m up X%! Up! this, Up! that. I’m up!
  • Euphoric: I’m going to tell everyone how much I’m UP! Up, up, and away!

All of these feelings and reactions drive directional price trends. Emotions also determine investor’s results. Investor behavior determines investor’s results as much as their investment program or the market.

fear-and-greed-index-explaination-cnn

Investor sentiment just reached “Extreme Greed” again. Investor sentiment tends to swing from “Fear” to “Greed” a few times a year, mostly reacting to the price trend. That is, we don’t see the majority of investors getting fearful when others are greedy. Instead, we see them get fearful after prices have fallen and they’ve lost some value. We don’t see investors getting greedy after prices fall, we instead see them get greedy after prices have already gained and they are “up”.

Being “up” in a position doesn’t mean anything if it’s “down” in the next period.

Being “up” in a position is an open profit until it’s closed.

An open profit is just the markets money until it’s realized by selling it.

A realized gain is a profit that has been taken by selling.

The Fear & Greed Index I used above is one that is simple to follow for anyone who wants to give themselves a reality check.

If you find yourself feeling euphoric and talking about how great “the market” or your investments are “doing”, this measure is likely dialed to the right for “Extreme Greed”.

If you find yourself fearful of more losses after losses you may be taking too much risk, but it could also be near a turning point. One the one hand, you don’t want to reach your uncle point and tap-out. So, you predefine your tolerance for loss and match that with an investment program that includes risk management and drawdown control.

You want to avoid doing the wrong things at the wrong time- like the quote said.

Although the Fear & Greed Index equally weights seven different sentiment indicators, the most prominent of them is the CBOE Volatility Index® (VIX® Index®), which is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. When the VIX gets really low like it is now, it suggests that expectations for near-term volatility is very low.  I say “really low” because, as you can see, its current level of 10.74 is about as low as it’s gotten since introduction in 1993. That’s a contrary indicator because it’s at such an extreme. It seems the market is getting complacent and any surprise will shock them.

vix-cboe-volatility-index

What does this mean?

We shouldn’t be surprised to see the recent upward price trend reverse down some, at least temporarily.

And, those who apply the simple sounding strategy of “You want to be greedy when others are fearful. You want to be fearful when others are greedy.” may start to take some profits and preparing to take advantage of, or avoid, a later decline.

It doesn’t mean it will be a large decline, though it could be. For example, the last time I pointed out “Investor Optimism is Reaching Extreme” was December 9th of last year. As you can see below, the stock index dropped only about -2% over the next two weeks. That’s a small drop. Based on history, we expect to see swings of stock index prices of -5% to -10% two or three times a year. When I see such overbought conditions as I see now, I expect that level of normal decline.

decline-since-fear-and-greed-index

The upward trend in U.S. stocks has mostly been uninterrupted since last November. You can probably see how this just adds to the weight of the evidence that we shouldn’t be surprised to see a “normal” drop at some point. As a tactical trader, I prefer to avoid large declines when I can and take advantage of them.

We’ll see how it unfolds this time…

Ps. This is not investment advice and I don’t publish such observations for every swing I see.

Asymmetric Volatility Phenomenon

In Asymmetric Volatility, I used the range of weather temperatures to show that volatility is how far data points are spread out.

While it’s 72 degrees and sunny in Florida it can be below freezing in Boston with snow on the ground.

We observe asymmetric volatility in equity markets, too.

The equity market tends to crash down, but drift up. That is, uptrends tend to drift slower and less steep, and downtrends tend to fall faster and sharper and can become waterfall declines.  We observe fewer geysers than waterfalls.

asymmetric-volatility-phenomenon

The drivers of this market dynamic seem to be mainly based on behavior and a reaction to price trends.

I could add that leverage has an impact, too. As markets have gone up for a while investors are more likely to use leverage to “get more aggressive”. Leverage levels tend to be highest at peaks. But, leverage and volatility feedback tend to be linked to panic selling leading to selling pressure. Prices fall more because they are falling.

I believe that upward price trends are primarily driven by underreaction to information. Even if we all get the same information at the same time, but we respond to it differently and at different times. Some get in the trend sooner, others enter later, some even wait until the end (and use leverage!).

Investors may underreact in downtrends, too. Many investors may not react to a loss of  -5%, but -10% they may start to pay more attention and -20% some may panic. The deeper the fall, the more investors are likely to tap-out. By the time the stock market is down -20%, many may be selling to cut their loss. As selling pressure builds, selling leads to more selling as prices fall. If you are bold and -20% isn’t enough to tap you out, maybe -50% is.

If you are bold and -20% isn’t enough to tap you out, maybe -40% is. Or, -50%. I think everyone has a tap-out point. It could be losing it all.

Here is an example you may remember.

stock-market-crash-2008

As the price trend made lower highs and lower lows, selling pressure continued and it led to a waterfall panic level decline. This kind of decline is what many “risk measurement” systems fail to acknowledge. Actually, they intentionally ignore them.  If you use a risk measurement system that says it has a “95% Confidence Level”, these downtrends are the 5% it ignores.  It acts like they won’t happen. It even does it on purpose.

That’s the very move you want to avoid.

You can probably see why I believe it is necessary to actively manage risk and apply drawdown control.

For the record, the period above wasn’t the full downtrend. I often see that period misquoted as “2008”.

It wasn’t just 2008.

The S&P 500 was just down -37% in the calendar year 2008.

The full decline was actually -55%. It began at the peak in October 2007 and didn’t end until March 2009.

It began at the peak in October 2007 and didn’t end until March 9, 2009.

stock-market-bear

2009 ended positive, so many people don’t include it when they speak of this last bear market. Below is January 1, 2009, to March 9, 2009. It continued to decline nearly -30% in those two months after 2008.

2009-stock-market-decline

Beware of those who understate the historical downside and the potential for downside.

They are the same people who will experience it again.

Asymmetric Volatility

Volatility is how quickly and how far data points spread out.

Asymmetric is not identical on both sides, imbalanced, unequal, lacking symmetry.

This time of year we are reminded of asymmetric volatility in the weather. The wide range in the temperature is highlighted in the morning news.

This morning, it’s 72 degrees and sunny down south and below freezing and snowing up north.

asymmetric-volatility

Source: MyRadar

Some of the news media presents the variation in a way that invites relative thinking. Just like the financial news programs that show what has gained and lost the most today, the weather shows the extreme highs and lows.

Those who watch the financial news may feel like they missed out on the stock or market that gained the most, then be glad they weren’t in one that lost the most. Some feelings may be more asymmetric: they feel one more than the other.

Prospect Theory says most of us feel a loss much greater that we do a gain. It’s another asymmetry: losses hurt more than gains feel good (loss aversion).

If you are up north trying to stay warm, you may wish you were down south sitting on the beach.

If you are down south trying to stay cool, you may wish you were up north playing in the snow!

It really doesn’t matter how extreme the difference is (the volatility). The volatility is what it is. Volatility is just a range.

What matters is what we want to experience.

If we want to experience snow we can fly up north.

If we want to experience sunny warmth we can fly down south.

If we want less volatility, we could live down south in the winter and up north in the summer.

We get to decide what we experience.

Asymmetry in the Business Cycle

The current U.S. economic expansion is now 90 months old.

It is the fourth longest of the 23 expansions since 1900.

The history of the U.S. business cycle is one of long summers and short winters.

The average expansion has lasted 46 months – 3x longer than recessions.

The problem is the MAGNITUDE, not length.

The business cycle, like the stock market, can be asymmetric: it crashes down, but slowly drifts back up. That could be an overreaction on the downside, but an under-reaction on the upside.

long-summer-short-winters-economic-expansion

To be sure, the chart below shows a sharp recession after the 4th Quarter 2007, and though the trend has since been long in length, it has been the slowest growth. Magnitude is more important than length.

strength-of-economic-expansions

 

 

So Goes January, So Goes the Year?

 

Focusing on an arbitrary time frame is called “reference dependence.” It regards the comparative nature of human perception. It also concerns the tendency of people to compare things to some reference point. Perception of an outcome depends on the reference point that a person chooses. The reference point or time frame is arbitrary and is based on random choice or personal whim.

The idea of reference dependence reminds me of when I watched Arkansas play Virginia Tech in the Belk Bowl last week.

After the first quarter, Arkansas was beating Virgina Tech 17-0. If we judged the game at that reference point, the score was so one-sided that it seemed like Arkansas was going to decimate Virginia Tech.

arkansas-virginia-tech-first-halfSource: http://secsports.go.com/scores/football/arkansas-razorbacks

By halftime, the score was 24-0. Arkansas was ahead by three touchdowns and a field goal. The momentum was evident. The game appeared to be a terrible mismatch. If we placed bets, it would have been for Arkansas to win the game. At that point, this outcome was most probable.

When a game is close, fans “watch it closely.” However, when the score broadened to 24- 0, many fans probably stopped paying attention and expected Arkansas to be the winner.

Yet football has four quarters, not just two.

Three touchdowns and a field goal are a tough lead to overcome. It would require Virginia Tech first to play very well with their defense so as to prevent Arkansas from scoring more points against them. Then, they would need their offense to score many touchdowns and field goals just to catch up.

In the third quarter, that’s exactly what they did.

arkansas-virginia-tech-final-score

By the end of the third quarter, Virginia Tech had scored 21 points to make the score 21–24. In the final and fourth quarter, they scored another 14 points to take the lead 35–24. They scored 35 points, and their defense held Arkansas to zero in the second half. It was a high-volatility game – swinging from one extreme in one period to another extreme in the next.

Now, look at it from the perspective of a Virginia Tech fan. By halftime, they were losing 0–24. All hope was gone. They may have stopped watching. If they were at the game, they might have left at halftime.

The end of the game was the only time frame that mattered.

Global markets operate in the same way. Our perception is just the result of our reference point – the time frame we choose. Below is the S&P 500 stock index over 18 months from January 2015 to June 2016. Overall, it was non-trending and volatile.

non-trending-stock-market-period

It wasn’t just U.S. stocks. Developed countries and Emerging Markets countries declined even more as they trended in wider swings.

global-market-trends-returns-asymmetric

 

You can probably see why very few people invest all their money all the time in the stock market. It doesn’t matter how much the return is if the risk is so high that you reach your uncle point before it’s achieved. At some point, investors decide to look, and when they do, their perceptions depend on the reference point they choose. For this reason, global markets require risk management, and investors need behavioral management. If the swings of 10% to 25% observed over the past two years aren’t enough to shake out every investor, the declines of -50% or more that we’ve seen the past fifteen years probably are.

Much like the Belk Bowl, the stock index was down and out for most of the period but ended the year positively in the final quarter.

last-quarter-spy

 

As investors, our most important reference point is, ultimately, our full investment time horizon. For most people, that means their entire lifespan. For those who establish trusts, foundations, or endowments with their money, their reference point goes beyond their own lives. Investment management is different from football in that the score compounds for as long as you have money invested. It is not just one season, or one quarter, or a single game.

The end is the only time frame that matters. Everything in between is just you deciding to compare one reference to another.

I titled this observation, “So Goes January, So Goes the Year.”

You can probably see how arbitrary it is to say that.

By the way, you can see on the chart that the stock market dropped sharply last January, but it ended positively for the year.

“So Goes January, So Goes the Year”?

Not always.

The end is the only time frame that really matters.

Investor Optimism is Reaching Extreme

As it often does, the U.S. stock market trended the complete opposite of what market pundits expected after the election.

Clearly, a Presidential election can be the blame for volatility we saw this year before the election. However, instead of crashing down U.S. stocks regained their previous losses quickly. Along with that, investor sentiment shifted from fearful a month ago to much more optimistic as prices trended up. At this point, investors have probably forgotten how volatile markets were the first part of 2016. Once the losses are regained, they eventually forget the stock indexes were down -12% or more in January and February.

Investors tend to get optimistic (or even greedy) after prices have gone up and then fearful after prices go down.

I am not necessarily a contrarian investor. I mainly want to be positioned in the direction of global markets and stay there until they change. But markets sometimes get to an extreme – increasing the probability of a reversal. At this point, a tactical trader can hedge, reduce exposure, realize profits, or wait until an actual reversal to respond.

My purpose of pointing out these extremes in investor sentiment (fear and greed) is to illustrate how investors’ feelings oscillate between the fear of missing out (if global markets have gone up and they aren’t in them) and the fear of losing money (if they are in global markets and they are falling). Fear and greed is a significant driver of price trends. When stock market investor sentiment reaches an extreme, it often reverses trend afterward.

Indicators suggest that investors are pursuing higher risk strategies and that investor optimism has reached a short-term extreme. I like to use the Fear & Greed Index that is a simple snapshot for anyone to see. Below is the reading as of yesterday as it reached “Extreme Greed.”

cnn-fear-greed-index

We shouldn’t be surprised to see the recent upward price trend reverse down, at least temporarily.

Along with that, we could see investor sentiment reverse from “Extreme Greed” to “Fear” as prices fall.

It’s OK to feel and experience your feelings… if you feel the right feeling at the right time.

Indicators like this can help investors observe how they tend to feel the wrong feeling at the wrong time.

 

To learn more, below are some of my previous observations about sentiment reaching an extreme greed level of optimism.

Investor Optimism Seems Excessive Again

It’s official: extreme greed is driving the stock market

What emotion is driving the market now? Extreme Greed

Many who are self-taught far excel the doctors, masters, and bachelors of the most renowned universities.”

–  Ludwig von Mises (German: [ˈluːtvɪç fɔn ˈmiːzəs]; 29 September 1881 – 10 October 1973) was a theoretical Austrian School economist.

People who are motivated enough to study on their own probably discover more than they could be taught at a university.

many-who-are-self-taught-far-excel-the-doctors-masters-and-bachelors-of-the-most-renowned-universities-ludwig-von-mises

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