Stock Market Peak? A Tale of Two Markets

May 15, 2014 By Mike Shell in Actively Manage Risk, Adapting to Change, Empirical Observation, Global Directional Trends, Global Macro, Market Breadth Tags: Dow Jones Industrial, Russell 2000 Index Leave a comment

One of the early warning signs that a bull market in stocks is nearing its end is increasing selectivity. As more investors begin to believe a peak may be near based on statistical analysis or valuation, they may get positioned more defensively. Eventually we observe some stocks participating in a rising trend as others trend down early. Over the past several weeks we have observed a material divergence between large company stocks like those in the Dow Jones Industrial Average (DIA) vs. small company stocks like those in the Russell 2000 Index (IWM). As you can see below, the Russell 2000 index has declined nearly 9% while the Dow Jones Industrial has gained about 2%. Since the Dow Jones Industrial is more popularly quoted in the media, most investors probably believed “the market was still rising”. But unless you only have positions in the largest company stocks, you’re noticing that isn’t the case in terms of the broad market. Small company stocks tend to lead on the downside, so we shouldn’t be surprised if we see the larger companies follow them down at some point. You can probably see how this basic observation leads to further study of market breadth: looking at what percent of stocks are rising vs. falling.

Is this the “tail” of two markets?

Data: http://www.stockcharts.com

Of course, the direction of the overall market is interesting to monitor, but it only matters what positions we have at risk.

Fun with Weather Graphs: A Quant View of Knoxville Relative to Tampa

May 13, 2014 By Mike Shell in Adapting to Change, Critical Thinking, Data Driven Rearch, Empirical Observation, Quantitative Evidence-Based Rearch Tags: Florida, Knoxville, Tampa, Tennessee Leave a comment

I recently compared the climate differences between two places I call home: Knoxville, Tennessee and Tampa, Florida. They have very different climates, Knoxville is in the Tennessee mountains, the Tampa Bay/Clearwater/St. Pete area is home of the best beaches in America. Some of us consider the two the best of both worlds. What you believe depends on your own experience. Knoxville is one of the gateways to the Great Smoky Mountains National Park, the most visited national park in America. It had about 10 million visitors in 2013, which was double the Grand Canyon, the second most visited. The two cities have very different climates in the summer and winter months. We think of Tampa, Florida as hot and sunny. Knoxville is cooler in the summer, chilly in the winter. But that’s just my opinion and description. If we really want to understand the absolute level of temperature, humidity, and sunshine, and relative differences we can apply some quantitative methods and draw some visual graphs between them. Here you will see how I see and understand how I make decisions and draw distinctions. For those who otherwise have difficultly understanding data and graphs, you may find it more interesting to apply the same concepts to the weather. I’ll share with you my study of Knoxville vs. Tampa weather which I think is a good example of applying historical data to understand what to expect. To do this weather comparison, I used this tool with data from the NOAA Comparative Climate Data.

Summer in Knoxville, Winter in Tampa?

Initially, we can compare the average temperature between Knoxville and Tampa to get a quick visual. We can see some positive asymmetry between the winter and summer months. The average temperature in January is in the 60’s in Tampa and only the 30’s in Knoxville: a 30 degree spread. Yet, the average summer months is only a 10 degree spread. I call that positive asymmetry, because we don’t want it too hot in the summer and we don’t want it too cool in the winter. Tampa has the better tradeoff. But, the flaw of averages is that the actual high and low range can be much wider than we realize, so can gain a better understanding by looking specifically at the highs and lows.

AVERAGE TEMP

Although Knoxville is in the south, it still gets cold in the winter months. If we wanted a “winter home” to avoid those cold winter months, we would first focus on the average low temperature. That is, “how cold does it get”? Comparing the lows allows us to understand how cold it gets. As we see in the chart below, January and February are the coldest months in Knoxville when the low is around freezing. On the other hand, in Tampa the average low is above 50. 50 is chilly, not really cold. Notice the other extreme on the chart is the peak, when the average low in Tampa is over 70 during starting in June through September. We could say that that weather in Knoxville is more volatile throughout the year since it has a wider range of temperatures. We can see the visually by how quickly the data spreads out or how steep it is between the summer months and colder months. Clearly, the average lows of Tampa are more comfortable if you enjoy the outdoors.

AVERAGE LOW

What about summer?

We know that the further south we go, the hotter the summers we can expect. To see that visually, we can graph the average high temperatures. In Tampa, the average high is above 70 year around. The cold months in Knoxville have an average high around or below 50. When we consider the average low in Knoxville is in the 30’s and average high is the 50’s, that’s a material difference from an average low in Tampa in the 50’s and average high in the comfortable 70’s. In fact, you may observe the average low in Tampa is the average high in Knoxville.

But what about too much heat? While the average high in Knoxville is in July and just short of 90, Tampa stays as hot as Knoxville hottest month from May up to October. For some, Tampa may be too hot in the summer. But humidity has a lot of do with how hot it feels, we’ll get to that.

AVERAGE HIGH

What about extreme cold?

When we analyze data, we want to look at it in different ways to carve out the things we want (warm weather) and carve away the things we don’t (cold and hot weather). Below we graph for a visual to see the average days below freezing (32F). Clearly, Knoxville experiences some freezing days that are rare in Tampa, Florida. Some of you are probably laughing at my calling below 32F “extreme cold”, thinking it should be instead below zero. What you consider extreme depends on your own judgment and experience.

AVERAGE DAYS BELOW 32F

What about extreme heat?

When we state an extreme, we have to define what we mean by extreme quantitatively. I used 90F to define an extremely hot day. As we see below, while Knoxville has many more days below freezing in the winter, Tampa has many more days of extreme heat in the summer. We are starting to discover when we want to be in Knoxville, Tennessee and when we may want to be in Tampa, Florida. As with investment management, timing is everything.

AVERAGE DAYS ABOVE 90F

What about Precipitation?

It doesn’t matter if the weather feels great if it’s raining all the time. Tampa experiences a lot of rainfall in inches starting in May through September. Knoxville rainfall is actually a little less in the summer months. So, we could describe Tampa as hot wet summers and Knoxville as warm dry summers.

AVERAGE PRECIPITATION

A little rain is one thing and may not be significant. What if we define a “significant rain” as greater than 0.10 inches? The stand out is that Tampa has “significant rain” in the summer months and little in the winter.

AVERAGE DAYS OF PRECIPITATION LESS GREATER THAN 0.10 INCHES

What about Humidity?

If you’ve ever experienced a place like Vail, Colorado in the winter were you can sit outside for lunch in the snow without a coat on when it’s 32F, you’ll have a unique understanding of humidity. We can say the same for south Florida in July. Humidity is the amount of water vapor in the air. Humidity may take more explanation to better understand. According to Wikipedia:

Higher humidity reduces the effectiveness of sweating in cooling the body by reducing the rate of evaporation of moisture from the skin. This effect is calculated in a heat index table or humidex, used during summer weather.

There are three main measurements of humidity: absolute, relative and specific. Absolute humidity is the water content of air. Relative humidity, expressed as a percent, measures the current absolute humidity relative to the maximum for that temperature. Specific humidity is a ratio of the water vapor content of the mixture to the total air content on a mass basis.

Relative humidity is an important metric used in weather forecasts and reports, as it is an indicator of the likelihood of precipitation, dew, or fog. In hot summer weather, a rise in relative humidity increases the apparent temperature to humans (and other animals) by hindering the evaporation of perspiration from the skin. For example, according to the Heat Index, a relative humidity of 75% at 80.0°F (26.7°C) would feel like 83.6°F ±1.3 °F (28.7°C ±0.7 °C) at ~44% relative humidity.

The temperature alone isn’t the full measure of how hot and uncomfortable the climate can be. We can break down humidity into morning and afternoon. Morning humidity in Knoxville is highest in the winter months, which leads to a cold, wet feeling winter. Morning humidity in Tampa is highest in the summer, making hot feel even hotter.

AVERAGE MORNING HUMIDITY

As we see below, afternoon humidity is much higher in Knoxville during the summer months.Tampa stays above 82% humidity on average. By now you have probably began to spot directional trends in the data as well as mean reversion. For example, in the chart below the red line (Knoxville) trends upward sharply from March to August. Then it reverses back down to retrace about half the prior gain. I see the same patterns and trends in global markets, though they are more difficult based more on social science than the science of climate and seasons. Yet, there are seasonal patters in global markets, too, such as “sell in May and go away” and “January Effect”. But unlike weather changes, they seasonal changes in the stock market aren’t as sure as the transition from summer to fall to winter to spring to summer again in Tennessee.

AVERAGE AFTERNOON HUMIDITY

Tampa has a Breeze

Below we see the average wind speed. Tampa has a breeze to help cool us down compared to Knoxville.

What about Sunshine?

Warm dry weather is nice, but what about sunshine? Below we see why they say “Sunny Florida”. You may notice that Tampa is more sunny in the winter months then even the summer months. Knoxville has a greater possibility of sunshine March through October with a sharp downtrend on both ends.

AVERAGE SUNSHINE POSSIBLE

What about Cloudy Days?

If you live in the north, you are familiar not only with cold wet winters, but cloudy grey skies. The outliear that stands out on this graph is that Knoxville is cloudy half of the days of each month in the winter. Tampa, on the other hand, has few cloudy days throughout the year, but its highest is the July. You may have noticed some climate patterns between Tampa and Knoxville are negatively correlated. That is, Knoxville tends to be cloudy in January and least cloudy in July and Tampa is nearly the opposite.

AVERAGE DAYS CLOUDY

In the late 1990’s I remember listening to Steven Covey audiobook of “7 Habits of Highly Effective People” when he would say: “proactive people carry weather with them”. That is an example of Projection makes perception: seek not to change the weather, but to change your mind about the weather. That may work for some of us for many years, but eventually we may instead decide to “rotate instead of allocate”. That is, we may decide a warm sunny place like Tampa, Florida is a great place when its cold, wet, and cloudy in a place like Knoxville. Though, Knoxville may be better to spend the summer months with its more mild summer than the hot humid wet Tampa summer.

You can “carry weather with you” by perceiving it how you want, or you can carry (rotate) yourself to the weather you prefer. You can probably see how this quantitative data study helps visualize the absolute climate ranges and relative differences to make the decision with a greater understanding of what to expect.

Fact, Fiction and Momentum Investing

May 9, 2014 By Mike Shell in Asymmetric Hedging, Asymmetric Risk, Market efficiency, Momentum Relative Strength, Trend Following Tags: Fact, Fiction and Momentum Investing 1 Comment

Abstract

It’s been over 20 years since the academic discovery of momentum investing (Jegadeesh and Titman (1993), Asness (1994)), yet much confusion and debate remains regarding its efficacy and its use as a practical investment tool. In some cases “confusion and debate” is us attempting to be polite, as it is near impossible for informed practitioners and academics to still believe some of the myths uttered about momentum — but that impossibility is often belied by real world statements. In this article, we aim to clear up much of the confusion by documenting what we know about momentum and disproving many of the often-repeated myths. We highlight ten myths about momentum and refute them, using results from widely circulated academic papers and analysis from the simplest and best publicly available data.

Read the full paper: Fact Fiction and Momentum Investing

Source: Israel, Ronen and Frazzini, Andrea and Moskowitz, Tobias J. and Asness, Clifford S., Fact, Fiction and Momentum Investing (May 9, 2014). Can be found at SSRN: Fact, Fiction and Momentum Investing

Asymmetric Risks of Momentum Strategies

May 5, 2014 By Mike Shell in Asymmetric Investment Returns, Asymmetric Risk, Interesting Research Papers, Momentum Relative Strength, Risk Asymmetry Tags: Asymmetric Risks of Momentum Strategies, risk asymmetry Leave a comment

Asymmetric Risks of Momentum Strategies is another attempt to explain the excess returns of momentum using the Capital Asset Pricing Model. The paper discusses a theory of risk asymmetry in momentum risk/reward, but not how to gain an edge from it.

Abstract:

I provide a novel risk-based explanation for the profitability of global momentum strategies. I show that the performance of past winners and losers is asymmetric in states of the global market upturns and downturns. Winners have higher downside market betas and lower upside market betas than losers, and hence their risks are more asymmetric. The winner-minus-loser (WML) momentum portfolios are subject to the downside market risk, but serve as a hedge against the upside market risk. The high return of the WML portfolios is a compensation for their high risk asymmetry. After controlling for this risk asymmetry, the momentum portfolios do not yield significant abnormal returns, and the momentum factor becomes insignificant in the cross-section. The two-beta CAPM with downside risk explains the cross-section of returns to global momentum portfolios well.

Read the full paper: Asymmetric Risks of Momentum Strategies

Source:Dobrynskaya, Victoria, Asymmetric Risks of Momentum Strategies (March 2014). Available at SSRN: http://ssrn.com/abstract=2399359 or http://dx.doi.org/10.2139/ssrn.2399359

Leading stocks are lagging

April 4, 2014 By Mike Shell in Global Directional Trends, Managed Volatility Leave a comment

As another example of the observation I pointed out in Adapting to Change… and Volatility, below are today’s stock index price changes.

Below are the price changes for the top 10 highest ranked stocks. Clearly, leading stocks are dropping more. And, such an increase in volatility is more common now days.

5th Year Anniversary of the Bull Market

March 14, 2014 By Mike Shell in Critical Thinking, Crowd Psychology, Independent Thinking, Investor Behavior Modification, Investor Sentiment Leave a comment

This week marked the 5th anniversary since the March 9, 2009 low in stock market. While much of the talk and writing about it seems to be focused mainly on the upside gains since the low point, it is more important to view it within the context of the big picture.

If you knew on March 9, 2009 that was the low point and could handle the 5 – 10% daily swings that were occurring during that time, then you could have made a lot of money. But, the fact is, many people have emotional reactions after a -10% decline over any period, even more it happens in a day or a week. But even if you don’t, in order to have made a lot of money you would have needed to have exited prior to the large loss before then. You needed cash to invest at the low. I heard some are bragging about their gains since the low, but they left out how much they had lost over the full cycle. It doesn’t mean anything to earn 100% over one period if you lose -50% the next period that wipes it out.

It doesn’t actually matter how much the stock index gained from its low point. What matters is its trend over a full market cycle. People sometimes have trouble seeing and understanding the bigger picture, which is one reason they get caught in traps in the short run.

Below is the price trend of the S&P 500 stock index over the most recent full market cycle. I define a full market cycle as a complete cycle from a peak to low to a new peak. That is, it includes both a “bull market” and a “bear market”. To get an accurate picture, I have used the SPDRs S&P 500 ETF and a total return chart, so it does include dividends. After more than 7 years, the stock index has only gained 35%. Yet, it declined -56% along the way. That isn’t the kind of asymmetry® investors seem to want. If you think about risk reward, 20% is great upside if the downside is only -10%; that is positive asymmetry®. We want to imbalance risk and reward, more of one, less the other.

If you look closely, it took 5 years after the October 2007 peak to get back to break even. Though it has taken a long time to recover from the cascade decline, the recovery was impressive in terms of its gains, but extremely volatile for investors to endure.

When looking at a period of over 7 years, the swings don’t seem so significant. To put them into context, there were about 9 declines around 10% or more with the one in 2011 about -20%. This has kept many investors from buying and holding stocks.

If you are good at visual intuition, you may notice the price swings on the left of the chart are much wider than those more recently. This is a visualization of higher volatility as the trend was down and continued volatility caused by indecision between buying pressure and selling pressure.

After prices have trended down, such as the 2008 and 2009 period, the range of prices is wide and investors who held on too long panic, yet buyers aren’t willing to buy at their price.

After a price trend has been drifting up for several years and investors hear about how much it has gained, they become more and more complacent and more optimistic. They do this near a peak.

You can probably see how most investors who lost a lot of money before are likely to do it again. Unless something like the observations I have shared here helps to change their behavior, they are likely to do the same thing they did before.

Intention = Result: Everybody gets what they want out of the market

March 10, 2014 By Mike Shell in Great Quotes Leave a comment

“Win or lose, everybody gets what they want out of the market. Some people seem to like to lose, so they win by losing money” – Ed Seykota

Source: Schwager, Jack D. (Editor), Market Wizards, HarperCollins (1989), page 172, ISBN 0-88730-610-1, Read it here

Projection makes perception

March 10, 2014 By Mike Shell in Great Quotes Leave a comment

The world you see is what you gave it, nothing more than that. But though it is no more than that, it is not less.… It is the witness to your state of mind, the outside picture of an inward condition.… Therefore, seek not to change the world, but choose to change your mind about the world.

– A Course in Miracles (T-21.in.1:2,3,5,7).

Is market timing [short-term trading back and forth among asset classes] really a good idea?

March 7, 2014 By Mike Shell in Global Macro, Global Tactical Rotation, Great Quotes, Tactical Asset Allocation, Tactical ETF Portfolio Management, Trend Following Leave a comment

In October 2004, Jason Zweig interviewed Peter Bernstein for MONEY Magazine. The title was Peter Bernstein interview: He may know more about investing than anyone alive. Peter L. Bernstein was an early pioneer of tactical asset allocation thinking. He wrote about valuation-based asset allocation and being tactical in decisions rather than passive. He believed what I believe: we should take more risk when its likely to be rewarded and less risk when it is less likely to be rewarded. He published several books about it.

In the interview, Zweig asked:

“Is market timing [short-term trading back and forth among asset classes] really a good idea?”

Bernstein answered:

“For institutional investors, the policy portfolio [a rigid allocation like 60% stocks, 40% bonds] had become a way of passing the buck and avoiding decisions. The problem was that institutions had settled on a [mostly stock] asset allocation because in the long run, they concluded, that’s the only place to be. And I think the long run ain’t what it used to be. Stocks don’t have to do well in the future because they did well in the past. In fact, the opposite may be more likely.”

Source: http://money.cnn.com/2004/10/11/markets/benstein_bonus_0411/

Based on the chart below, which shows the Dow Jones Industrial Average (a stock index that cannot not be invested in directly) since that interview in 2004, I’d say Bernstein was right. Over the next decade, the stock index went on to gain 65%, but it dropped nearly that much along the way. That doesn’t seem to be the kind of asymmetry® that investors are looking for. If you look at it close enough, you can probably see why it makes sense to take more risk at some points, less risk at others. Though, it’s probably at the opposite times most investors do. So, most will advise investors not to try to do it. Like most things in life, some do it much better than others and have active track records that reflect it.

source: https://stockcharts.com/freecharts/perf.php?$indu

The new normal is a roller coaster of one bubble bursting after another.

March 4, 2014 By Mike Shell in Actively Manage Risk, Global Directional Trends 1 Comment

Neural networks are computer systems inspired by an animals’ central nervous system that is capable of machine learning and pattern recognition. Neural networks can be very powerful systems for identifying and classification of things. If we are developing neural networks to categorize and recognize patters we necessarily have to teach it what a pattern looks like. A simple way to understand is to think of letters in the alphabet. The first letter of my last name can appear very different, depending on what font we use.

You can probably see how a program designed to recognize the pattern to classify a letter would necessarily need several variations – a range of possibilities. In other words, if it required perfection and we defined the perfect “S” as the first one, it would miss the other two.

I use this as an example for common errors in identifying and classifying chart patterns. Not all price trends unfold the exact same way, so there is some subjectivity about identifying and classifying them. If we required them to be too exact, we miss those that aren’t. But patterns don’t always play out as expected, either. Just because the stock market index broke out to a new high doesn’t mean it must continue its inertia in that direction. It’s probabilistic, never a sure thing. We the people have trouble with that – people hate uncertainty, even though that’s all we ever have.

Now that we’ve added some tolerance to our thinking for a moment, let’s take a look at an interesting chart someone passed along in my inbox recently. Below is the S&P 500 stock index from the HS Dent Foundation. Harry Dent probably needs no introduction. As you can see, he has labeled the chart to classify the peaks and troughs with A, B, C, D, and E. At this point, the price trend is at the “E” stage. He draws a dotted line that shows the trend eventually reversing down from a higher high at “E” to a lower low, which I guess will be labeled “F”. That’s why they call it a megaphone. What happens after “E” is not yet known, but you can probably see the line of thinking.

The article someone passed along is an interview with Dent. Below is the part that referenced the chart:

HD: Investors must realize that there is a new normal. Stocks will not be growing at 12%/year. Bonds will not yield 5–6%. The new normal is not even the expectation of 4% on stocks and 2% on bonds that people like Bill Gross from PIMCO suggest. The new normal is a roller coaster of one bubble bursting after another.

Investors have to get away from the traditional concepts of diversification and asset allocation for the next decade or so. When bubbles burst, everything goes down. In 2008, real estate, oil, commodities, gold and silver crashed. The U.S., European and emerging markets crashed.

With each bubble, the market has gone to a slightly new high and to a slightly new low when the bubble bursts. We call it a megaphone pattern.

“The new normal is a roller coaster of one bubble bursting after another” isn’t as much a prediction as it is a reality, as evidenced by the actual history of the chart. The problem is, it seems, according to Dent the peak at “E” was supposed to play out in 2013. So, many people now criticize his forecast.

Someone asked what I thought about it, so I’ll share two things.

1. He was wrong in his precise prediction that this top would be 2013. We can only say that because 2013 has passed. The problem with predictions and forecasts such as this is that no one really knows for sure what’s going to happen next, much less the precise date. Even if it were probabilistic based on sound logic and math, which implies there is some chance it may be wrong.

2. What I like about the chart is that it can be useful as a reminder to actively manage risk. What if it does play out that way? Because of #1, it may not be wise to exit to 100% cash and wait for it to happen – it may not. Instead, you may use it as a motivation to know what you’ll do if that does play out. If you do nothing at all, how will a -70% decline in stocks impact you? Will you have time to wait for the 233% gain required to recover the loss? When would that be? If you wish to instead avoid such a decline, how will you do that? Such declines don’t go straight down quickly, but usually more of series of advances and declines making it very difficult to navigate. For example, -10%, +8, -15%, +9, -20%, +17%, etc. Every time it moves up, people get excited and wished they’d picked the bottom. If they get in, and it reverses back down, they are in a loss trap again. When they are down even more, they panic out, it reverses back up, they wish they were in. If they are a new portfolio manager with no prior experience in such a period, they’ll have investors feedback coming in with the wrong sentiment at the wrong time. If you are unsure about what I mean by people oscillating between the fear of missing out and the fear of losing money, you’ll understand after you experience it if this chart plays out.

I’m sure he provides all kinds of fundamental and economic reasons for why a new low for stocks could be reached in the years ahead. Those things can have the power to convince you if it will happen, nor not. What you believe is always true for you. Let it serve as a reality check for the current stage U.S. stocks may be in if you find yourself feeling giddy like the crowd. My focus is on a range of possibilities and being prepared with systems designed from experience to deal with them, not just hypotheticals and back-tests.

It doesn’t matter if it will happen, it only matters if it does. And if it does, how we respond to it is what creates our own outcomes. The thing about patterns is they don’t have to be perfect… just because one person expects it to be Arial doesn’t mean it won’t be Century Gothic.

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Global Macro: Russia was already a bear market

March 4, 2014 By Mike Shell in Asymmetric Observation, Global Directional Trends, Global Macro Leave a comment

On Monday, the Russia stock market, as measured by the MSCI Russia Capped Index, declined over -8% with the headlines filled with news about their military actions. Based on that index of stocks, the Russian stock market was already in a bear market. Big down days often occur when selling pressure is already present. That’s how good price trend systems can avoid waterfall declines. Selling pressure causes prices to fall and falling prices lead to “serial correlation”. That is, prices decline because people are selling because prices are falling. There isn’t a requirement for a fundamental or economic reason. The reason is behavior: people who experience the decline you see in the chart below get to a point that they “tap out”. They tap out just because they are losing money and they have reached their “Uncle!” point. On Monday, the decline didn’t just stop at -4% because people wanted to cut their losses and that selling pressure pushes the price even lower.

Global Macro: Heavy Losses in Russia

March 3, 2014 By Mike Shell in Global Directional Trends, Global Macro Tags: Egypt, Global Macro Trends, Russia Leave a comment

Looking around the globe, the downward drift seems to be in Russia today. Egypt is a close second.

data source: http://www.etf.com

Adapting to Change… and Volatility

March 3, 2014 By Mike Shell in Adapting to Change, Managed Momentum, Momentum Relative Strength Tags: IBD 50, momentum stocks, Relative Strength Leave a comment

High relative strength stocks have always had the potential to gap down just as they may gap up. High momentum is sometimes joined by high volatility. I have observed several changes in trend behavior and volatility since the 2007 to 2009 bear market. One of them has been an increased level of individual volatility, especially on top ranked momentum stocks. Volatility is how much or how quickly the range of prices spread out and volatility is non-directional. A stock that loses -10% in a week may be considered volatile, but so is one that gains 10%. It’s the downside volatility we are concerned about. When stocks tend to gap down more, it makes it difficult to extract more profits than losses. I could show some sophisticated quantitative studies illustrating what I mean, but instead I’ll just show a very simple observation.

As you can see below, the popular stock indexes are down this morning an average of -.67%.

Below are the top 10 stocks of the IBD 50, a proprietary list of the 50 top-ranked companies published every Monday in Investor’s Business Daily. Companies are ranked based on superior earnings, strong price performance, and leadership within their respective industries. These top 10 stocks are down an average of -1.71% with two of the stocks down over -6% and the one that gained over 3% isn’t enough to help While strong momentum stocks have always had times when volatility cuts the other way, we’ve seen it more the last several years.

One of the greatest gifts

March 1, 2014 By Mike Shell in Great Quotes Leave a comment

One of the greatest gifts? Drive.

Outcome bias

February 24, 2014 By Mike Shell in Definitions Leave a comment

The outcome bias is an error made in evaluating the quality of a decision when the outcome of that decision is already known. Outcome bias is the tendency to judge a decision based on the outcome, rather than on the quality of the decision (using information known) at the time it was made.

How do I qualify?

February 22, 2014 By Mike Shell in Asymmetric Observation Leave a comment

Someone passed along one of those passionate political videos with a thought-provoking title, so I watched. It started out with

You want to see something really disturbing? Go to any search engine and type in “how do I qualify” and see what comes up.

I was a surprised by what he said I would find, so I stopped and did just that.

What do you think of when you ponder “How do I qualify”? For college? for a certain job? for a home loan? for medical school? business school? law school? the military? for a private investment program?

According to the Yahoo! search engine, below are the top things Americans want to know when searching “How do I qualify”.

Source: https://www.yahoo.com/

Wow… that is a shocker. I would have lost that bet.

Maybe they’re right. Some of us must be out of touch with the world as it really is.

Academic: not of practical relevance; of only theoretical interest.

February 21, 2014 By Mike Shell in Critical Thinking, Independent Thinking, Playing with Words Leave a comment

Professors at colleges and universities are often called “Academics”. Much of their job is to write and publish “academic research papers”. It is no wonder you can find such a paper on most any topic. Investment management is a popular topic and it seems we see observe more and more such papers being cited and talked about.

Someone was telling me a story recently about the unethical use of the power of persuasion and influence. It reminded me how academic research is sometimes used to mislead people. For example, I read a book a few years ago that was supposedly in pursuit of finding alpha, but the entire book cited hundreds of academic studies promoting a passive asset allocation strategy. Yet, there wasn’t a single mention of the word “momentum” in the book, even thought there are over 300 academic papers that discovered alpha applying simple momentum/relative strength strategies. Momentum has even dis-proven the “Efficient Market Hypothesis”, but promoters of EMH call it an “anomaly” they can’t explain. I found the book misleading because of its title and content was conflicted – and it left out the one thing that even academics have found alpha.

I am often asked for my opinion about some of their research. I spend every day working on my edge. In addition to constant exploring and proprietary studies, I monitor and read many of the academic papers being published on topics I have interest and expertise, such as trend following, behavior finance (investor/trading psychology), volatility trading, global macro trading. I especially read studies about constructing trades with options and applying momentum. While some of these papers are worth reading and some even excellent, most of them seem to lack real world experience for application.

We have to consider that many of the people writing an academic paper don’t have any meaningful actual experience doing what they are writing about, so the studies are theoretical, conceptual, notional, philosophical, hypothetical, speculative, conjectural, and suppositional.

You may find it interesting that I found all those synonyms by looking up “academic” on Wikipedia. I thought it was interesting that their second definition of “academic” is “not of practical relevance; of only theoretical interest.”

As we think independently and critically about the world and our quests, we may keep this in mind as we read and cite academic research. That is in fact a function of being a good scholar and researcher, whether you do it for profit, or not. You may consider that it’s what you may be wrong about, or what you are missing, that should be your primary concern.

Trajectory and Directional Price Trends

February 20, 2014 By Mike Shell in Global Directional Trends Leave a comment

Thinking about the meaning of trajectory and how it relates to directional price trends.

A trajectory is the path followed by a projectile flying or an object moving under the action of given forces. For example, the curved path along which something (such as a bullet or rocket) moves through the air. In thinking of directional price trends, you may consider how the beginning of the trajectory is steep sloping as it gains velocity and then it loses momentum and begins to level off and eventually drifts downward (if it doesn’t hit something along the way).

Oh seven, eight, and nine: Remembering the Last Bear Market

February 19, 2014 By Mike Shell in Critical Thinking, Global Directional Trends, Independent Thinking Leave a comment

I’ve been working on a report for our clients about the current conditions of global markets and how we’ll know when it changes from positive to negative. I’m calling it something like “What a Market Top Looks Like”. It’s actually a working document; something I’ve added to since 2001. I haven’t sent a piece like this to our clients since late summer of 2007 when I believed global markets were getting closer to a significant peak.

The current bull market in U.S. stocks is now about 58 months old. As I explained in The REAL Length of the Average Bull Market, bull markets have averaged about 39 months and bear markets about 17 months. A full market cycle (average bull + bear) is 56 months. The current bull market, then, is longer than the historical average full market cycle. Probably driven by the Fed’s QE experiment, the advancing part of this cycle is 20 months longer than average. So, it seems to make sense to start watching for signs the topping process has started and remind our investors what that looks like and how we deal with it. Most people will become more and more complacent the higher and longer it goes – I’ll do just the opposite.

As I’ve been thinking about this lately, it occurred to me that, if anything, most thoughts seem more focused on the “bear market” period than they are what a market topping process looks like. Clearly, what is today known as the “Global Financial Crisis” or “Great Recession” will be forever imprinted in people’s memory – especially those who held on to losing stocks and bonds to large losses.

Someone was recently telling me of a strategy that “made money in 08”, but when I looked at it, they left out that it had declined -20% just before 2008. For many investors, that -20% may be just enough to cause them to exit the strategy, so it wouldn’t have mattered what it “did” the next year. Losses as large as -20% turn $1,000,000 into $800,000 or $10 million into $8 million. Whether it’s rational or not, investors start to perceive such losses as permanent. The more they think about it the more they may start to experience disappointment from the dreams of what they could have done with all that money they once had – but is lost. But, while our money is invested in a market and exposed the possibility of a loss – a gain is the markets money until we take it.

When people talk about the last bear market, they call it “2008”. They remember “2008” or “08” pronounced “oh – eight”. When we talk to investors about our investment programs they say “How did it do in 08?”. But, the trend wasn’t just 2008.

Below is a total return price chart of the S&P 500 stock index during the calendar year 2008. It declined -38.49% during the calendar year 2008. However, at one point it was down -48%.

That was just the calendar year 2008. The stock market decline actually started October 10, 2007. Below is a chart of that date through year-end 2007. The S&P 500 stock index had already declined -10% at one point and the -6.18% adds to the total decline.

You may start to notice how different the result can seem depending on when you look at it. As it turned out, 2008 was just the middle of the bear market. As we saw in the first chart, October 2008 was the first low. It seems people may call the bear market “Oh eight” because 2009 ended “up”, but the bear market actually continued into 2009. In fact, 2009 was some of the steepest part of the waterfall. Below is the bear market continuation into 2009, an additional -25% decline.

The full bear market was 2007, 2008, and 2009. It was a -56% decline in total.

You can probably see how studying trends closely, we begin to realize that arbitrary time frames, like a calendar year, can be misleading about the bigger picture.

But, what may be more useful today is a strong understanding of the price trends leading up to all the historical bear markets.

Why Investors Fail

February 8, 2014 By Mike Shell in Actively Manage Risk, Critical Thinking, Great Quotes, Independent Thinking 1 Comment

People believe they know things they don’t and focus their energy trying to know the unknowable, rather than focusing on those things we can know and can control. The problem starts with one of the most read and respected investment books.

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.

-Benjamin Graham, “The Intelligent Investor”, 4 ed., 2003, Chapter 1, page 18.

The trouble with that statement is that it promises the impossible. That is, I believe all operations are speculative and we do best by treating them as such.

First, let’s define the terms, according to Merriam-Webster.

A promise is:

“a statement telling someone that you will definitely do something or that something will definitely happen in the future.”

Analysis is:

“detailed examination of the elements or structure of something, typically as a basis for discussion or interpretation.”

Speculative is:

“engaged in, expressing, or based on conjecture rather than knowledge. (of an investment) involving a high risk of loss.”

So, to be sure we understand the meaning, let’s read it again and then interpret what it means using these definitions.

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

In other words, it suggests if you do a thorough examination of the operation, you will gain “safety of principal and an adequate return” and that will definitely happen in the future.

If you have ever wondered why so many don’t do well at investment management, this is one reason. They believe they can do thorough analysis up front that that will assure the outcome and protect against loss.

It doesn’t actually work that way.

We never know for sure in advance. And, if we focus on the things that do matter, we don’t need to know what will “definitely happen in the future”. The exit, not the entry, determines the outcome. The trouble with much of the value investing philosophy, whether buying private companies or exchange traded securities, is the assumption that you can determine what will happen next. But when you are so confident in that, you end up caught in a loss trap when you are wrong with no way out. Instead, the outcome is completely determined by our exit: how we get out of it.

So, I treat all operations as “speculative”. All operations have a high risk of loss.

And, all things are “conjecture”.

Conjecture:

“an opinion or conclusion formed on the basis of incomplete information.”

That is, we always have incomplete information. We never know it all. To me, it makes a lot more sense to focus on the direction prices are trending and know I’ll create my results by my exit, not my entry. I focus my energy on defining the direction and when it’s going in the wrong one… so I can exit.

Dow is down 6.7%: Extreme Fear is Now Driving Stocks

February 3, 2014 By Mike Shell in Actively Manage Risk, Adapting to Change, Investor Sentiment Leave a comment

During holiday parties it seemed everyone was talking about how much the Dow Jones Industrial Average was “up” for the year. So, it is no surprise that the Dow is down -6.7% since the beginning of the new year.

And, now that Dow is down -6.7%, investor sentiment measured by the Fear & Greed Index has shifted from greed as the return driver to Extreme Fear. Investor’s tend to get overly aggressive after prices advance and then afraid after prices fall. For example, a wealth manager told me in December that a client of his wanted to “shift to a more aggressive model’ because stocks had gone up so much. People tend to extrapolate the recent past, expecting it will continue into the future.

Source: http://money.cnn.com/data/fear-and-greed/

Though there seems to be signs the topping process may be underway, the stock market often trends the opposite of what investor’s expect, so I wouldn’t be surprised to see a reversal.

Is the Bull Topping Process Starting?

February 3, 2014 By Mike Shell in Actively Manage Risk, Adapting to Change, Asymmetric Observation, Global Directional Trends Leave a comment

There are several things that unfold as a market begins the topping process. While large cap indexes may continue to make new highs, the market becomes more and more selective. We’ll see that in breadth indicators like bullish percent indexes, Advance Decline Lines, etc. As the market finds fewer and fewer stocks attractive, it becomes more selective, so fewer stocks remain in positive trends.

The current bull market in stocks is about 58 months old. As I explained in The REAL Length of the Average Bull Market the bull markets have averaged about 39 months and bear markets about 17 months. A full market cycle (average bull + bear) is 56 months. The current bull market, then, is longer than the historical average full market cycle. So, it makes a lot of sense to start watching for signs the topping process has started. It’s important to understand a bull markets end with a process of churning up and down and with fewer stocks participating in the last stage of advances.

Below is an example of fewer stocks participating. The S&P 500 Bullish Percent Index shows a composite of the 500 stocks in the S&P 500 index that are in a positive trend. The lower highs made over the past year is beginning to show fewer of those stocks are making buy signals as the S&P 500 index has made new highs. It appears the selectivity is in its early stage as the percent of stocks on a buy signal is still around 70%, but it’s falling. This is just one example of the kind of things I observe when watching for a topping process.

Source: https://stockcharts.com/def/servlet/SC.pnf?c=$BPSPX,P

Below I list a table of several other bullish percent’s for stock indexes. Using Point & Figure terminology, they are either a Bull Top (the chart is falling (in a column of Os) but above 70%) or Bear Confirmed (chart is falling (column of O’s) below 70% and has generated a P&F sell signal). I wouldn’t be surprised to see these get a lot lower in the months ahead. However, what makes it difficult for most people is the process is made up of advances and declines, not usually just a straight down move. The whipsaws up and down is what causes the most trouble.

Index	Bullish%	Status	Status Change
Russell 2000	64.03%	Bear Alert	30-Aug-13
Dow Industrials	63.33%	Bear Confirmed	31-Jan-14
NASDAQ 100	65.00%	Bear Confirmed	29-Jan-14
NYSE	61.55%	Bear Confirmed	27-Jan-14
Optionable Stocks	67.60%	Bear Confirmed	31-Jan-14
S&P SmallCap 600	67.55%	Bear Confirmed	31-Jan-14
AMEX	63.31%	Bull Confirmed	2-Jan-13
NASDAQ Composite	62.68%	Bull Confirmed	2-Jan-13
Wilshire 5000	66.29%	Bull Confirmed	2-Aug-13
S&P 100	70.71%	Bull Top	13-Dec-13
S&P 500	68.41%	Bull Top	24-Jan-14
S&P Composite 1500	70.30%	Bull Top	28-Jan-14
S&P MidCap 400	72.64%	Bull Top	27-Jan-14

“The whole problem…

February 2, 2014 By Mike Shell in Critical Thinking, Great Quotes, Independent Thinking, Investor Behavior Modification Leave a comment

“The whole problem with the world is that fools and fanatics are always so certain of themselves, but wiser people so full of doubts.”

—Bertrand Russell (British mathematician and philosopher, 1872-1970)

Ways you sabotage yourself

January 23, 2014 By Mike Shell in Interesting Research Papers, Investor Behavior Modification Leave a comment

Investors’ hate being wrong, so they’ll hold on to losing positions and get caught in a loss trap. They will favor information that supports what they already believe, even when new information proves it wrong. If you spend time reading about the market, you may notice you are mostly looking for evidence that supports what you already believe rather than data that may cause you to stop and reverse.

Skilled and experienced investment managers eventually figure out that the challenge isn’t the market- it’s us. We create our results, not the market.

When we realize that mistakes are biases and illusions, not being wrong on a position and taking a loss to keep them small, that’s what creates an edge.

Trang Ho of Investor’s Business Daily wrote an outstanding article worth reading on the subject. It’s about self-sabotage: Stock Market Traps: 5 Ways Your Brain Can Sabotage Your Investing

2013 Asset Allocation Returns

January 22, 2014 By Mike Shell in Empirical Observation Leave a comment

2013 was a big year for U.S. stocks and a losing year for other markets like bonds and emerging market countries. Though many people like to talk about how much the Dow Jones Industrial Average or the S&P 500 stock index gained, in reality few people actually invest all of their capital in U.S. stocks. That is probably more true the more money an investor has. If they want to have it all in stocks, it’s probably after a big year, not before it.

The true way to determine what return investors’ as a group earned in funds or ETFs is to create an asset-weighted composite of all the funds available. Such a composite would weight each fund based on how much money is actually invested in it, so if 50% were in bond funds that lost -2% and 50% was in stock funds that gained 20%, the composite would show an asset-weighted return of (50% x -2% = -1%) + (50% x 20% = 10%) = 9%. You can probably see how arbitrary it is to speak of calendar year returns, but the actual return investors earn is dependent on how much capital was invested in the funds and their gain or loss.

I don’t know of a data source that does that for all available funds, but below is a table from Morningstar that presents a category returns of mutual funds in their “allocation” category. I highlighted the 1 year return which approximates the calendar year 2013 and horizontally I highlighted two categories that are likely most represent investors’ allocation. The “Moderate Allocation” is like a 60/40 balance of 60% stocks and 40% bonds, which is popular. The “World Allocation” includes global allocation funds which have been some of the best performing funds long term. The Moderate Allocation category gained over 13% and the World Allocation gained about 8%. And, like the stock indexes, most of these mutual funds are fully exposed to loss at all times.

Source: Morningstar

The Fed: What Happened Next…

January 17, 2014 By Mike Shell in Adapting to Change, Global Directional Trends, Independent Thinking Leave a comment

A month ago in “The Fed: What’s going to happen next? I suggested that you might consider that it doesn’t matter what the Fed does – it only matters how the drivers of price react to it. I went on to explain that we don’t need to know what the Fed would do but instead how the market responds to it. And, the market may not respond the way you expect. Trying to figure out what to do next based on what you think the Fed is going to do is a tough way to make portfolio management decisions. Prior to the announcement, it seemed the worry about it was based on what they would do, but all that really matters is how the price trends evolve of the positions you hold.

Most market participants didn’t seem to expect a taper. And, if a taper were announced, most seemed to expect stock prices would decline. After all, this Quantitative Easing program has been going off and on for several years now and when they’ve stopped it, stock indexes quickly dropped 10 – 20%. You may recall those declines in 2010, 2011, and 2012. Based on that historical precedent, it seemed to suggest stocks could be expected to fall when the Fed finally begins to unwind it’s massive bond-buying program to stimulate the economy. And, at some point it could even be a very significant decline since it appears this QE program has been a driver of stock prices since the 2009 low.

Later that day, the Fed announced that it would indeed begin to “taper” its bond-buying program. Although, The Federal Reserve’s $10 billion taper announcement doesn’t seem a significant cut in the central bank’s massive bond-purchasing plan. It’s still a taper and a taper is what those who talk on TV and write about it seemed to be afraid of. In fact, I mentioned in Fear is beginning to drive stock trends that investor sentiment measures shifted to fear and prices had dropped about -3% leading up to the Fed announcement. It seemed the market had anticipated some negative news and their fear “priced it in”.

Yet, the stock market index actually rose on the announcement instead of down. Maybe they overreacted leading up to the news and prices drifted back up.

In the chart below, we show a chart of global market prices since the taper announcement. Clearly, most global markets actually drifted up including the S&P 500 stock index ($SPX), U.S. Dollar ($USD), Developed Country International stocks (EFA), and even Long Term U.S. Treasuries (TLT).

Commodities like the GSCI Commodities Index (GSG) and Gold (GLD) immediately declined, since commodities and gold typically trend inversely to the U.S. Dollar. And, Emerging Markets countries (EEM) have trended down – maybe because many of them are commodity producers.

Things don’t always turn out the way you expect, so having strong expectations about what’s going to happen next can make portfolio management very difficult. In fact, having strong expectations that reach the point of convictions lead to overconfidence and ego issues that causes one to stay with their losing positions. When you stay with losing positions, hoping they’ll turn around and prove your right, you get caught in a loss trap. That’s how you lose a lot of money.

I find an edge in going with the flow, the current trend, what is actually happening. It seems if we do that, we can never be wrong for too long. It’s OK to be wrong; it’s staying on the wrong side of the trend that becomes a problem. And doing that starts with too much beliefs and expectations about what’s going to happen next and being unable to reverse it.

Flow… just go with it.

When we know in advance what we’ll do next, we don’t have to try to predict in advance what’s going to happen next.

The Fed: What’s going to happen next?

December 18, 2013 By Mike Shell in Actively Manage Risk, Adapting to Change Leave a comment

Today the Federal Reserve meets and investors are talking about it even more than normal because the market wants to know what’s going to happen next. If the Fed will continue the same “Quantitative Easing” government bond-buying program, or will they taper it. Make no mistake about it, the Fed’s manipulation to the economy and capital markets is a serious matter and we’ll only know its true impact years from now. But in regard to its expectation of a positive near term impact on the economy it seems the bigger issue is whether or not the QE continues to work or run out of gas.

Investors, however, are mostly concerned about the capital markets impact: how their decision will drive the directional price of currency, bonds, stocks, and commodities. To that, you may consider that it doesn’t matter what the Fed does – it only matters how the drivers of price react to it. That is, if you are sitting around trying to figure out what’s going to happen next, you may consider that you don’t need to know what the Fed will do but instead how the market (people who buy and sell) responds to it. Will the participants in global markets respond with enough magnitude to shift prices in one direction or another? And, in what direction will they respond? If the Fed tapers, the direction will depend on if there is more buying demand than selling pressure to move the price up. Or, will they perceive it as negative? That is the trouble with trying to figure out what’s going to happen next and basing your exposure to risk on that guess. If you don’t have tomorrow’s newspaper today – you really don’t know. Since tomorrow isn’t yet here it doesn’t yet exist, so it is unknowable. If you guess it right, it doesn’t mean you have special powers. If you guess it wrong, that doesn’t mean anything either.

I don’t worry about what the Fed does or how currency, bonds, stocks, and commodity trends will react to it. I already know what I’ll do next regardless of what shifts the price from one direction to another. People often worry about things and experience what they fear the most even when it doesn’t happen. They worry because they are uncomfortable with uncertainty. Many things are unknowable and uncontrollable, so those things are surely uncertain. All we can do is control how we respond to it. I don’t wait until some news event to figure out what to do next. I always know at what price I’ll buy and sell. It isn’t determined by news, but instead based on the directional price trends of the world markets I trade.

Fear is beginning to drive stock trends

December 14, 2013 By Mike Shell in Investor Behavior Modification, Investor Sentiment Leave a comment

Since I pointed out that “Investors are Complacent” on November 27th, the S&P 500 index of large company stocks has declined -1.4% and the Russell 2000 small company stock index more than -2%. Both are small declines so far, but it was enough to shift the return driver from Extreme Greed in early November to Fear as of the close on Friday.

S&P 500 and Russell 2000 decline

Fear is now driving stock prices. Although, it isn’t yet at an extreme level, I like to point out these oscillations of fear and greed investor behavior because investors feelings are often the wrong feeling at the wrong time. That is, after prices have gone up investors get more greedy and optimistic. Then, after prices decline just a little they become fearful of losing more money. I believe some investors are more oriented toward either fear or greed, but many actually suffer an emotional roller coaster: they oscillate between the fear of missing out and the fear of losing money. That is a real problem when they feel the wrong feeling at the wrong time.

source: http://money.cnn.com/data/fear-and-greed/?iid=EL

Such investor behavior is also a significant driver of price trends. For example, a waterfall price decline occurs from “Serial Correlation”. That is, waterfall declines happen because prices go down, then down some more, as more and more investors sell because they are losing money. Panic selling is serial correlation: selling occurs because prices are falling. For example, investors lose 20% and then begin to exit their positions to avoid further loss. That leads to other investors losing 25% as selling pressure drove prices down more and they exit their positions to avoid further loss. The nice thing is we all get to decide how much we are willing to lose. You can’t lose 50% without allowing it. This can also be an advantage for robust trend systems designed to profit from directional drifts up and down.

Now that Fear has become the return driver, we shouldn’t be surprised to see prices move back up. However, the investor sentiment hasn’t yet reached Extreme Fear, so all the sellers who want to sell may not have yet sold. The simple Fear and Greed Index dial I use here isn’t a timing signal. Instead, I use it to point out how sentiment shifts from Fear to Greed via a website everyone can see. I actually use other indicators to measure sentiment and counter-trend points. But you can use the Fear and Greed Index to discover how your own feelings may oscillate between emotions.

From this point, Fear can continue and reach a more Extreme Fear level and prices can keep going much lower. However, if the sellers that wanted to sell have sold and prices have declined low enough to bring in new buying demand prices will move back up.

Madoff wasn’t a hedge fund

December 14, 2013 By Mike Shell in Critical Thinking, Hedge Funds, Hiring a Portfolio Manager, Independent Thinking Leave a comment

Bernie Madoff is back in the news lately as it’s now been 5 years since he was arrested for the largest Ponzi Scheme. For some reason, the name is commonly linked to “hedge funds”. Yet, the Bernie Madoff scam wasn’t a hedge fund, his company was a registered and regulated brokerage firm called Bernard L. Madoff Investment Securities. Madoff founded the Wall Street brokerage firm Bernard L. Madoff Investment Securities LLC in 1960. Some large hedge funds lost money because they had invested in Madoff’s managed account. They had Madoff managing some of their funds money. But Madoff Investment Securities LLC wasn’t a hedge fund.

If you had an account managed by Bernie Madoff at Madoff Investment Securities LLC you would have had an account owned and titled in your own name. You would have gotten trade confirmations from Madoff Investment Securities LLC when he bought or sold. You don’t get that in a fund. You don’t know when a fund buys or sells. His investment program, then, offered the appearance of transparency – you could see what he was doing at any time.

As it turned out, the appearance of transparency enabled the thief to defrauded customers of approximately $20 billion over several decades. You see, Madoff’s investment program was a fraud, and the reason he was able to do it is that:

1. He was the portfolio manager: he made the trading decisions.
2. He owned the broker that executed the trades (as it turned out, they were fake; he didn’t do trades).
3. He owned the custodian: the custodian and broker was the same company.

Since Madoff Investment Securities LLC was the portfolio manager, broker, and the custodian, that allowed him to pretend to do trades and print trade confirmations and statements with fake information on them. Madoff Investment Securities LLC was regulated and registered as a brokerage firm, just like Wells Fargo Advisors, Edward Jones, Schwab, Morgan Stanley, and other brokers. You can probably see how the real issue was that his program was a fraud and he was able to do it because he controlled the trading decisions, trade confirms, account statements, and custody, because his company did it all. What if he had been required to custody an another company independent of his? he would have had to convince the other company to participate in his scheme which would likely have gotten him busted sooner. Most investment companies aren’t a fraud, so they would likely report him. Madoff was large and respected – but don’t think that made it any safer.

Whether you invest in a separately managed account or a private investment partnership, require that they use multiple service providers that are independent of each other instead of all one company. For example, your portfolio manager is an asset management firm, the broker is a different company that executes the trades and the custodian is a separate company that holds the securities and handles the cash in and out. Then, require it be audited by even another independent company. For example, if you enter into an investment management agreement with ABC Capital Management, LLC that firm is the portfolio manager and the agreement gives it authority to buy and sell in your account. Your account should then be held at a financial institution registered as a broker or bank like Folio Institutional, Trust Company of America, or JP Morgan. You deposit money to that financial institution that holds your money and they send you statements. ABC Capital Management, LLC is just trading the account independently and shouldn’t have custody of the money. If the investment program is a “hedge fund” instead of a separately managed account then it’s typically structured as a private investment partnership, say: ABC Fund, LP. A private fund is operated like a business – the business is trading for profit. You review a Private Placement Memorandum that explains every detail of ABC Fund, LP. When you invest, you sign a “Subscription Agreement” instead of an investment management agreement. You wire the deposit to the bank account of ABC Fund, LP and that money is then wired to the funds brokerage account. It’s best to require the fund to have a “third party administrator” who acts as the funds controller and accountant. That third party administrator is who accounts for your investment and sends you statements showing the value of your investment. You can probably see why you want the administrator to be a third party – independent from the fund manager. Then, the fund is audited annually to verify the administrators accounting is accurate. When ABC Fund, LP is a private investment partnership, it should be operated like any other major business with multiple investors. It has a bank account that sends/receives wires, a custodian that holds securities, a broker that executes trades, a third party administrator that does the accounting and creates profit and loss statements, and an independent accountant that audits all of it. Those should be separate companies independent of each other, not one.

Unfortunately, most of the smaller scams we hear about are even worse than the Madoff scheme. The investors write a check to “John A. Doe” which isn’t even a company at all. I don’t think any legitimate investment program has you writing a check to the individual portfolio manager. Deposits should be made to an independent bank or custodian and statements should come from that custodian. In fact, it’s even better to wire the funds rather than write a check. But “You can’t fix stupid”. There will always be Madoff-like scams and people stupid enough to write them a check. If you simply require that all the service providers be separate companies you won’t be one of them.

Investors are Complacent

November 27, 2013 By Mike Shell in Actively Manage Risk, Adapting to Change, Counter trend, Dynamic Hedging, Global Directional Trends, Investor Sentiment, Quantitative Evidence-Based Rearch, Volatility Trading Tags: Investor Sentiment, VIX, Volatility Index Leave a comment

Implied volatility, the amount of “insurance premium” implied by the price of options, continues to suggest that investors are becoming very complacent. When the VIX is high or rising, it says the market expects the S&P to move up or down more. When the VIX is low or declining, it says the market expects the S&P 500 will not move up or down as much in the future. That is, the “insurance premium” priced into options on the S&P 500 stocks is low. That isn’t necessarily directional – it is an indication of the expected range, not necessarily direction. However, what I know about directional price trends is that after a price has been trending directionally for some time, as the S&P 500 stock index has, investors become more and more complacent as they expect that trend to continue. The mind naturally wants to extrapolate the recent past into the future and it keeps doing it until it changes. When we see that in the stock market, it usually occurs as a directional trend is peaking. Investors are caught off guard as they expected a tight range. If the range in prices widens, they probably widen even more because they are – and it wasn’t expected. Interestingly, people actually expect inertia and that is one of the very reasons momentum persists as it does. Yet, momentum may eventually move prices to a point (up or down) that it may move too far and actually reverse the other way.

If we believe the market is right, we would believe the current level accurately reflects the correct expecation for volatility the next 30 days. That is, we would expect today’s implied volatility of about 12 – 13% will match the actual historical volatility 30 days from now. In other words, 30 days from now the historical (backward looking) volatility is match the current implied volatility of 12.6%. If we believe the current volatility implied by option premiums is inaccurate, then we have a position trade opportunity. For example, we may believe that volatility gets to extremes, high or low, and then reverses. That belief may be based on empirical observation and quantitatively studying the historical data to determine that volatility is mean reverting – it may oscillate in a range but also swing from between one extreme to another. If we believe that volatility may reach extremes and then reverse, we may believe the market’s implied volatility is inaccurate at times and aim to exploit it through counter-trend systems. For example, in my world, volatility may oscillate in a range much of the time much like other markets, except it doesn’t necessarily have a bias up or down like stocks. There are times when I want to be short volatility (earning premium from selling insurance) and long volatility (paying premium to buy insurance). I may even do both at the same time, but across different time frames.

The point is, the market’s expectation about the future may be right most of the time and accurately reflect today what will be later. But, what if it’s wrong? If we identify periods when it may be more likely wrong, such as become too complacent, then it sets up a position opportunity to take advantage of an eventual reversal.

Of course, if you believe the market is always priced accurately, then you would never take an option position at all. You would instead believe that options are priced right and if you believe they are, you believe there is no advantage in being long or short them. I believe the market may have it right most of the time, but at points it doesn’t, so convergence trades applying complex trade structures with options to exploit the positive asymmetry between the probability and payoff offers the potential for an edge with positive expectation.

Fear and Greed

November 26, 2013 By Mike Shell in Definitions, Investor Behavior Modification, Investor Sentiment Leave a comment

What emotion is driving the market now? Extreme Greed

November 7, 2013 By Mike Shell in Counter trend, Global Directional Trends 2 Comments

Today I observe the Fear and Greed Index below is at an “Extreme Greed” level.

source: http://money.cnn.com/data/fear-and-greed/

Investors tend to get optimistic (and 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. 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 readings get to an extreme it often reverses trend afterward.

For example, the last time I pointed out an extreme measure was August 27, 2013 in “Investor Sentiment Reaches Extreme Fear” when the Fear/Greed dial suggested “Extreme Fear” was the return driver. I said when we see these extremes in fear it happens after prices have fallen. Prices can keep falling after it gets to such an extreme, but we often see the directional price trend reverse back up after an extreme fear measure. What I think is useful about observing extremes in sentiment are to understand how investors behave at certain points in a market cycle. If you find you have problems with this behavior, you may use it to modify your behavior.

Below is a chart of the S&P 500 stock index and I have marked August 27^th which was the date I observed the “Extreme Fear” reading. As you can see, indeed that was a short-term low and prices climbed a wall of worry since then.

source: http://www.stockcharts.com

Today, the investor sentiment is “Extreme Greed” as the driver of prices, so we’ll see in the coming months how that plays out.

Getting Technical about Supply and Demand

October 24, 2013 By Mike Shell in Asymmetric Observation, Global Directional Trends Leave a comment

I will first warn that for most investors, zooming in and watching it too closely will more likely lead to a bad outcome. I’ve observed over the years that one of the most common problems of poor investor decisions is watching it too closely – as if it changes the outcome. They end up experiencing every move and reacting to them emotionally. They oscillate between the fear of missing out and the fear of losing money. Since most markets like the stock market can easily swing 5% or more up or down 3 or 4 times a year, they ride an emotional roller coaster. Ultimately, most investors should focus on the primary trend, which I define as a period of 3 – 12 months or more, and that necessarily means accepting some swings.

With that said, I wanted to share a very simple illustration of how I observe the battle of buying and selling pressure (supply and demand) play out visually using charts. We can consider this a continuation of my last post. I have communication with a very wide range of investors, traders, and portfolio managers. Let’s first define those titles. An investor is someone who invests in something; it could be a position they’ll hold for income like commercial real estate or it may be an investment program that is traded on their behalf. An investor is probably looking at 5, 10, or 20-year time frames. A portfolio manager is a person who makes buy and sell decisions within a fund or investment program. A portfolio managers’ time frame depends on their strategy. A portfolio manager can also be seen as a trader, because a trader makes trades, but my traders execute my decisions by executing the trades for me. Then, a trader trying to get the very best price at that moment is focused on tick-by-tick price trends; seconds, not days.

It’s fascinating how different the views of all of these people can be, whether it’s a market maker trading options, a veteran long-term trend follower whose been doing it for decades, or an individual investor who spends some time in the evening reading the headlines. How well their activities help them depends on their true level of expertise and experience – and it takes a lot more of it than people think.

I find that those of us with a very strong understand of how supply and demand is reflected in price action have a better sense of the current conditions and understanding of the market state. Those without it seem to be sitting around trying to figure out what’s going on and what to do next. Sitting around trying to figure out what’s going on and what to do next is like someone handing you the keys to a yacht on the Tennessee River and asking you to take it to the Gulf Coast of Florida and on to the Bahamas. If you are a skilled Captain with a plan of how you’ll time getting through the locks and where you’ll stay overnight, it will be the trip of a lifetime. If not, then I guess you’ll spend a lot of time sitting around trying to figure out what’s going on and what to do next and that’s going to be a gut-wrenching few weeks. And, it could be very costly.

You can probably see my line of thinking as I show you this simple illustration of supply and demand playing out in price action. It gives us a glimpse of how we view what is going on. In the image, you can see the “Candlestick Formation” of a price action of a single day. We borrowed this image from our friends at www.stockcharts.com and if you click that link later it will take you directly to their “Introduction to Candlesticks”. The thin lines are the “shadow” and the larger box is the “Real Body”. If the color is white or green, it closed higher than it opened. Take a close look at the high, close, open, and low of the day to see how they are marked on the “candle”.

I am going to point out a very simple explanation of what this means. To understand what it means, thinking about what it represents. We see the opening price is marked, then the high of the day, then the low it traded that day, and then the price it closed. That is the full range of the days price action. If we looked at the chart in seconds, weeks, or months, it would be the range over that time frame.

Below is the last 10 days of the S&P 500 stock index price action represented by the SPDR^® S&P 500^® ETF, which is a fund that, before expenses, generally corresponds to the price and yield performance of the S&P 500® Index. That is, the ETF is tradeable while the index itself is not.

Source: https://stockcharts.com/h-sc/ui

As you can see in the chart, these are candlesticks and they have real body’s and the thin line shadows. Yesterday is the last candlestick – the one with a red body with more line below the body than the top. candlesticks with long lower shadows and short upper shadows indicate that sellers dominated during the first part of the session, driving prices lower. You can see some other days with upper and lower shadows (the thin line) that are about the same, so buyers and sellers moved the price high and low and then settled about where it opened. Sometimes we see candlesticks with a longer upper shadow and shorter lower which indicates that buyers dominated during the first part of the day, driving prices higher. You can probably begin to see how a deep understanding price action can help us define the current trend direction and identify reversals. It gets far more involved when we start thinking about how the days interact with each other and requires more than reading a book and looking at charts a few years to gain some skill at using it to understand what is going on, but this may give you something to ponder. Of course, creating information is one thing, the ability to make it useful is another. But the basics really isn’t that complicated though people often get too caught up in requiring patterns and outcomes to be perfect.

At the end of the day, you can probably see how this tells us want actually happened that day…

A gap down from here would confirm a short term S&P 500 trend reversal

October 23, 2013 By Mike Shell in Actively Manage Risk, Adapting to Change, Global Directional Trends Leave a comment

I actually wrote this at 1pm but wanted to wait to publish it after the close to see if the pattern I observed at 1pm would be intact at the close. It wasn’t, but I decided to publish this anyway and add an additional point: there is real information in price action and it doesn’t have to be perfect, especially if there is additional confirming information. These candlestick patterns mark potential trend reversals, but require confirmation before action anyway. Even though the close wasn’t exactly a Shooting Star, I still believe the price action suggests the same potential outcome if it is confirmed by lower prices.

Technical analysis of price trends include chart pattern recognition to determine what is likely to happen to a price trend over time. The most useful patterns are reversal patterns. Price data viewed on a chart is a visual representation of supply (selling pressure) and demand (buying pressure). Like other things, the direction of price is ultimately determined by supply of it and demand for it. When there is a greater demand for something its price will rise if supply stays the same. When demand declines, its price will fall. Buying pressure, then, is ultimately the primary driver of prices to the upside and selling pressure is what drives price down. A person with expertise and experience in price trend pattern recognition can study the charts pattern and gain an understanding of what is going on: buying or selling pressure. We can use that to define the direction of the trend and also identify probable reversals in the current trend. That is, determine the most probable price movements based on an examination of past price movements. Of course, price trends are always in the past. The only data of any kind we can ever study is past data; never future data that doesn’t yet exist.

I’m not a big supporter of most chart patterns as many of them aren’t testable quantitatively to determine their actual probability and expectation. However, as discretionary traders who do successfully trade patterns will argue: some patters are obvious enough in their message that when we’ve seen them play out 10,000 times before we realize we have a high probability outcome. But, note that it is still a probability, which implies likelihood; never a sure thing. Today I noticed a pattern for the popular S&P 500 stock index that, based on my two decades of empirical observation, I can say often precedes a reversal. But, it isn’t just the pattern itself that I note, but also some additional confirmation by a overbought reading in the Relative Strength Index (RSI). However, this pattern does require additional confirmation in the days ahead.

A Shooting Star is a candlestick pattern that identifies a potential trend reversal, but requires confirmation before action. It is a bearish reversal pattern that forms after an upward price trend. It occurs after the price gaps up at the open (like it did today) and then continues to move up, but then closes lower than the high of the day. I am writing this at 1pm, so it hasn’t yet closed, but I suspect this pattern is still telling. You can see what it’s supposed to look like up close in the picture above. The formation doesn’t have to be perfect or exact. A confirmation means to establish the correctness of something. Confirmation is required to validate that this pattern is a bearish reversal. The confirmation would be a gap down in price in the coming days. Until then, it is only a warning sign; a shot across the bow.

As you can see in the S&P 500 stock index price chart below, the price has been directionally trending up. It has moved about as much as it has moved in prior advances. I included the RSI indicator, which is a statistical measure that suggests the price is “overbought”. RSI is the “Relative Strength Index” that measures the speed and change of price movements. Over short time frames, like 28 days, price trends tend to exhibit mean reversion. That is, while price trends tend to continue their current trend over periods of 3- 12 months, they tend to oscillate up and down over short-term periods like a month. That is the price trend tends to peak out when the RSI reading is over 70 and bottom out when it’s closer to 30. Of course, we mainly want to follow the primary trend and looking at the chart below, that would require living with the swings of 5 -10%. If we are unwilling to deal with that, we would have to accept missing some of the gains that is required when we reduce exposure to miss some of the decline.

Source: https://stockcharts.com/h-sc/ui?s=spy

I don’t necessarily make my portfolio management decisions with these patters, but instead wanted to share this observation for those interested in understanding what I see when I observe trends unfold like this one. If nothing else, I wouldn’t be surprised to see at least a minor reversal in the price in the near future. When it does that, it may only be a 5% decline and then reverse back up to new highs again. Or, it could go on to make a lower low and be the start of a bear market. You can probably see how this is a daily and dynamic process that evolves over time requiring constant adapting to new information and changes in the current state.

Some may try to tell you that the analysis or price trends don’t work. They may say that because they themselves lack expertise or experience with it, or haven’t been successful at it. But rest assured; some of the most profitable hedge funds apply directional trend systems including pattern recognition, and trend following, all of which can be called technical or statistical analysis of price trends. If they don’t know that, they simply haven’t really studied the most successful funds in history.

In my experience I have found that those who aren’t successful applying quantitative, statistical, or chart pattern methods are people who require complete perfection. They are looking for the 100% accurate switch that doesn’t exist in anything. If it doesn’t work this time, or next, they move on rather than understanding that probability is an estimation of likelihood of occurrence of an event, not a certain outcome. Determining the probabilities and expectation is, by definition, the mathematics of an edge. Those without an edge don’t get that, and that’s why they have no edge.

What in the World is Really Going on, Part 2: Kicking the Can Down the Road

October 19, 2013 By Mike Shell in Adapting to Change, Asymmetric Observation Leave a comment

Jim Rogers says it best.

Playing with Words: Education, Knowledge, Skill, Experience, and Expert

October 18, 2013 By Mike Shell in Critical Thinking 1 Comment

The first step to understand something and to draw distinctions between them is to define the words we use. This isn’t always and easy task since many words don’t have a clear definition that everyone agrees on. In fact, I write my own definitions for many of the specialized topics I speak of and list them in the “definitions” pages of this website. I find that thinking deeply about the meaning of a word is useful. That is especially true for me, since I develop and operate quantitative decision making systems and program them to automatically generate the answer. Once I’ve done that, I can operate it across global markets and an unlimited number of securities and do it with a level of precision and consistency not found in humans. When I say “quantitative systematic decisions” that are processed by a computer algorithm, I think many people envision a computer doing everything on its own. That’s because most people don’t develop a program, they use one someone else developed. I’m writing this using Microsoft Word, but I am an operator of Word, but not a developer. It was just there. I don’t think about or understand what went on behind the scenes to create it. What you may not consider is that a human has to tell the computer program what it will do. I create the algorithm, which is a series of processes: if this input, then that output. You can probably see how that series can be a mile long if we’ve thought about possibilities everyday for a decade. To do that requires me to think very deeply about every single detail because software doesn’t know what to do until I tell it. The only way it will fail is if we leave something out and it has no way to move forward – no answer for the input. This gives me a unique advantage from the start: I have probably thought far more deeply about everything I do than those who spend every day trying to figure out what to do next because I am putting my thinking into more than just a trading plan, I’m putting it into a trading system. A computer needs very precise instructions to operate. A human with a “rules-based” plan has a lot of room for error because it doesn’t have to be so precise – they can make it up as they go and do one thing today and another tomorrow.

You can probably see where I am coming from when I do the “play with words”. In this case, we don’t need perfect definitions everyone agrees with to get the point.

What is education? Wikipedia defines education as:

Education in its general sense is a form of learning in which the knowledge, skills, and habits of a group of people are transferred from one generation to the next through teaching, training, or research. Education frequently takes place under the guidance of others, but may also be autodidactic. Any experience that has a formative effect on the way one thinks, feels, or acts may be considered educational.

What is knowledge? Wikipedia defines knowledge as:

Knowledge is a familiarity with someone or something, which can include facts, information, descriptions, or skills acquired through experience or education. It can refer to the theoretical or practical understanding of a subject. It can be implicit (as with practical skill or expertise) or explicit (as with the theoretical understanding of a subject); it can be more or less formal or systematic.^[1] In philosophy, the study of knowledge is called epistemology; the philosopher Plato famously defined knowledge as “justified true belief.” However, no single agreed upon definition of knowledge exists, though there are numerous theories to explain it. Knowledge acquisition involves complex cognitive processes: perception, communication, association and reasoning; while knowledge is also said to be related to the capacity of acknowledgment in human beings.

What is skill? Wikipedia defines skill as:

A skill is the learned ability to carry out a task with pre-determined results often within a given amount of time, energy, or both^.In other words the abilities that one possesses. Skills can often be divided into domain-general and domain-specific skills. For example, in the domain of work, some general skills would include time management, teamwork and leadership, self motivation and others, whereas domain-specific skills would be useful only for a certain job. Skill usually requires certain environmental stimuli and situations to assess the level of skill being shown and used.

Since we are speaking of skill, let’s also define luck: Luck or chance is an event which occurs beyond one’s control, without regard to one’s will, intention, or desired result. Luck can be good or bad. If skill is what we intentionally do and some degree of control in the outcome from our actions, luck is the part beyond our control. A good rule of thumb is: if you can’t lose on purpose, it’s luck. For example, a roulette table is luck. You can’t win or lose on purpose. Poker is skill-based games were we can apply probability and money management toward a better outcome. If you want to lose, you can.

What is experience? Wikipedia defines experience:

Experience comprises knowledge of or skill of some thing or some event gained through involvement in or exposure to that thing or event. The history of the word experience aligns it closely with the concept of experiment. For example, the word experience could be used in a statement like: “I have experience in fishing”.

The concept of experience generally refers to know-how or procedural knowledge, rather than propositional knowledge: on-the-job training rather than book-learning. Philosophers dub knowledge based on experience “empirical knowledge” or “a posteriori knowledge”.

A person with considerable experience in a specific field can gain a reputation as an expert.

What is an expert? Wikipedia defines an expert:

An expert is someone widely recognized as a reliable source of technique or skill whose faculty for judging or deciding rightly, justly, or wisely is accorded authority and status by their peers or the public in a specific well-distinguished domain. An expert, more generally, is a person with extensive knowledge or ability based on research, experience, or occupation and in a particular area of study. Experts are called in for advice on their respective subject, but they do not always agree on the particulars of a field of study. An expert can be, by virtue of credential, training, education, profession, publication or experience, believed to have special knowledge of a subject beyond that of the average person, sufficient that others may officially (and legally) rely upon the individual’s opinion. Historically, an expert was referred to as a sage (Sophos). The individual was usually a profound thinker distinguished for wisdom and sound judgment.

Experts have a prolonged or intense experience through practice and education in a particular field. In specific fields, the definition of expert is well established by consensus and therefore it is not necessary for an individual to have a professional or academic qualification for them to be accepted as an expert. In this respect, a shepherd with 50 years of experience tending flocks would be widely recognized as having complete expertise in the use and training of sheep dogs and the care of sheep. Another example from computer science is that an expert system may be taught by a human and thereafter considered an expert, often outperforming human beings at particular tasks. In law, an expert witness must be recognized by argument and authority.

Research in this area attempts to understand the relation between expert knowledge and exceptional performance in terms of cognitive structures and processes. The fundamental research endeavor is to describe what it is that experts know and how they use their knowledge to achieve performance that most people assume requires extreme or extraordinary ability. Studies have investigated the factors that enable experts to be fast and accurate

We can now draw a few distinctions here. A person with education is one who has been taught by others or learned from others. Any experience that changes the way one thinks, feels, or acts may be considered educational. You can have an education in investment, trading, and finance, but that may indicate you have gained some knowledge, but not necessarily skill or experience. Knowledge is when we actually understand something and are familiar with it. It seems one way to gain new knowledge is through education – learning from others, researching, etc. Experience comes from the word experiment, so it is knowledge of or skill of some thing gained through involvement in and exposure to that thing. We have experienced it before, or not. Experience can have a wide range of magnitude. Many investors and traders may believe looking at charts for a few hours over a few years makes them experienced. But imagine the difference if they’ve been doing it for several hours a day for two decades. The more experience we have, the more we get in the zone. Experience creates the flow zone: when we have done something so many times we don’t have to think about doing it, we just do. Like driving a car. We don’t think of putting on the brake, but a new driver does. Someone who has an excellent driving record for many years is an expert. Experts have a prolonged or intense experience through practice and education in a particular field. There are different degrees of expert. A professional race car driver is a different level of expert than a person who has just been driving to work every day for years. In racing, you have to be very good to become a professional. In the asset management industry, that isn’t necessarily the case. Investment advisers who work with individual investors often don’t show their potential clients their actual past performance history since they’ve been a professional. They can instead show potential clients performance of something that they didn’t actually invest in when it had good results or even make up past performance with hypothetical and back-tests. A race car driver can’t do that.

I point out these words and draw some distinctions because I am amazed on the magnitude of overconfidence people have when it comes to portfolio management decision-making. For example, I say that I consider an “expert” portfolio manager one who has spent all of his or her time making tactical trading decisions daily for more than a decade and has an excellent actual performance history doing it. This expert has examined well over 10,000 charts with knowledge of how markets interact and how price trends begin and end. An expert portfolio manager developed computer programs designed to define global market trends, separate them out, and enter and exit them while controlling risk systematically. The expert has been operating those systems with discipline for more than a decade and the outcome from that is his or her good track record.

If we define it that way, then we can get an idea where we fit in regard to education, knowledge, skill, expertise, and experience.

What is “News”?

October 16, 2013 By Mike Shell in Critical Thinking, Definitions Tags: Financial News Leave a comment

News is Information not previously known to someone. New information, newly received information, or noteworthy information, especially about recent or important events.

For example:

“I’ve got some good news for you”

“This was hardly news to her”

What in the World is Really Going on

October 14, 2013 By Mike Shell in Asymmetric Observation, Global Directional Trends Leave a comment

I find that people don’t know what in the world is really going on or understand the big picture beyond what has happened most recently. They don’t really understand the aggressive Fed policies the past five years or the long-term debt cycle of the United States. If you really want to understand what is really going on in the big picture, I encourage you to watch this 30-minute video How The Economic Machine Works by Ray Dalio. After you watch it, you’ll understand how debt cycles work, how the Fed operates, and the current cycle the U.S. is in today. That is, you’ll begin to understand what in the world is going on in a way that only a few people do. It’s the kind of information and understanding you’ve previously never had access to.

And, you won’t be so surprised by what happens next…

“A stock operator…

October 12, 2013 By Mike Shell in Great Quotes Leave a comment

“A stock operator has to fight a lot expensive enemies within himself”.

– Reminiscences of a Stock Operator

Cut short your losses, let your winners run on.

October 2, 2013 By Mike Shell in Actively Manage Risk, Adapting to Change, Trend Following Tags: Golden Rule Leave a comment

– David Ricardo 1772 – 1823

Those words, today known as “The Golden Rule of Trading”, were printed in The great metropolis, Volume 2 By James Grant in 1838. To be sure what he specifically meant:

Source: The great metropolis, Volume 2 (Google eBook)

“Do not regret …

October 2, 2013 By Mike Shell in Great Quotes Leave a comment

source: unknown.

(if you know the source, contact us).

Impossibilities in the World

October 1, 2013 By Mike Shell in Adapting to Change, Great Quotes Leave a comment

Who would believe the government of world’s greatest country, the United States of America, would shut down? And, since it did today, who would expect the Dow Jones Industrial Average would be up 65 points at noon? Portfolio management requires preparation and dealing with unlikely events – those that may even seem impossible. And then, accepting the things we cannot change. With that in mind:

Impossibilities in the World

No matter how smart you are…

1) You can’t count your hair.

2) You can’t wash your eyes with soap.

3) You can’t breathe when your tongue is out.

Put your tongue back in your mouth, silly!

It’s a Beautiful Morning even when it’s not…

My INVESTOR’S BUSINESS DAILY® Interview and Portfolio Management

September 30, 2013 By Mike Shell in Actively Manage Risk, Adapting to Change, Asymmetric Investment Returns, Asymmetric Payoff, Counter trend, Dynamic Hedging, Global Directional Trends, Tactical ETF Portfolio Management Tags: Coin flipping, Exchange-traded fund, Portfolio manager Leave a comment

Portfolio Management is about buying and selling many different positions over time, not just one “pick”. I often say it’s like flipping 10 coins at the same time with each having a different payoff and profit or loss. It could be a completely random process (like flipping a coin), but if we can positively skew the payoffs (asymmetric payoffs) we end up with more profit than loss (asymmetric returns). And, as a portfolio manager I may flip that coin 100 or 500 times a year. The fact is: if the expectation for profit is positive we want to do it as often as possible.

Picking just one position is like flipping the coin just once. Its outcome may have an expected probability and payoff that is positive, but will be determined by how it all unfolds. We can never control the outcome at the point of entry. It’s the exit that always determines the outcome. We can say that same whether we are speaking of stocks, bonds, commodities, and currencies or buying and selling private businesses: if you actually knew for sure the outcome would be positive you would only need to do it once – but you don’t. So deciding what to buy is a small part of my complete portfolio management process. It’s what I do after I’m in a position that makes it “management”. To manage is to direct and control. If all you do is “buy” or “invest” in a position, you have no position “management”.

But when Trang Ho at INVESTOR’S BUSINESS DAILY^®recently asked me “What ‘s the one position you would choose over the next several months and why”, I gave her the first position I thought of – and the most recent position I had taken. I primarily get positioned with the current direction of the trend and stay with it until it changes. That may be labeled “trend following”. I define the direction of the trend (up, down, sideways) and then get in that direction until it changes. Trends don’t last forever. There is a point when the probability becomes higher and higher of a reversal. I call that a “counter-trend”. I developed systems that define these directional trends more than a decade ago and have operated them for-profit since. What I can tell you from my experience, expertise, and empirical evidence is that stock market trends, like many other market trends, cycle up and down over time. So, portfolio management is a daily routine of position management that includes predefining risk at the point of entry, taking profits, and knowing when to exit to keep losses small. That exit, not the entry, determines the outcome.

You may consider these things as you read my recent interview in Investors Business Daily titled: Market Strategists: 5 Contrarian ETF Investing Ideas.

Asymmetric Payoff: The Price of College Sports

September 28, 2013 By Mike Shell in Asymmetric Observation, Asymmetric Payoff Leave a comment

Not all asymmetric payoffs are fair. As the college football season gets into full speed, college sports gets some unwanted publicity. It was sickening to hear Arian Foster say:

“I called my coach and I said, ‘Coach, we don’t have no food. We don’t have no money. We’re hungry. Either you give us some food, or I’m gonna go do something stupid.’ He came down and he brought like 50 tacos for like four or five of us. Which is an NCAA violation. [laughs] But then, I walk up to the facility and I see my coach pull up in a brand new Lexus.” — Arian Foster

It’s sickening not so much because the coach broke the rules by feeding a player, but instead that someone who works as hard as a student athlete is sitting there hungry in the United States of America. And, while the college sports “industry” earns billions of dollars in profits. You surely don’t have to be a hardcore Libertarian to see the problem with that. It’s no surprise that many college athletes don’t have financial support from their family. It’s time for universities to focus on how to at least be sure student athletes have food and decent living conditions. I think they earn it.

The conversation will get started when the documentary Schooled: The Price of College Sports premieres Wednesday October 16th 8PM on EPIX:

“The EPIX Original Documentary Schooled: The Price of College Sports is a comprehensive look at the business, history and culture of big-time college football and basketball in America. It is an adaptation of “The Cartel” by Pulitzer Prize Winning civil rights scholar Taylor Branch, and his October 2011 article in The Atlantic, “The Shame of College Sports.” Schooled presents a hard-hitting examination of the NCAA’s treatment of its athletes and amateurism in collegiate athletics; weaving interviews, archival and verité footage to tell a story of how college sports became a billion dollar industry built on the backs of athletes who are deprived of numerous rights.”

Game Changing Asymmetry

September 26, 2013 By Mike Shell in Adapting to Change, Asymmetric Observation Tags: America's Cup, asymmetry, Larry Ellison, Oracle Corporation Leave a comment

Source: ORACLE^® Team USA

If things actually worked they way we are taught in school, all you need to do it get a “college degree” and you’ll be successful.

The reality is, learning the essentials like reading, writing, and arithmetic are basic requirements like eating, sleeping, and you know what.

To be great at something, we have to do a lot more than the basics.

You may consider that many of the greatest game-changers in America didn’t need anyone to tell them what to do next. They instead charted their own course and it was one that didn’t exist before.

Our society wants us to fit into the middle of the bell curve like the average person, but for some of us it’s a lot more fun to be an outlier,

Congratulations! To Larry Ellison and his ORACLE^® Team USA for completing an improbable comeback to win Race 19 to successfully defend the 34th America’s Cup on Wednesday in San Francisco.

It’s a fine example of a game-changing asymmetry.

Before the huge win, Larry Ellison, who is co-founder and CEO of ORACLE^®, was criticized for skipping a keynote address at a company conference to instead watch the comeback of his regatta team. It was a once in a lifetime moment only a few will ever experience by a man who has earned his freedom.

It’s a fine example of knowing when to get off the treadmill…

And, if you know the story, this unlikely outcome came from an unlikely team to start with. The combination of a billionaire CEO and a car radiator mechanic. The story is in The Billionaire and the Mechanic by Julian Guthrie . (I’ve been listening to the Audible version). It’s about how an unlikely duo won the sport’s oldest trophy – before this one. From Amazon:

“The America’s Cup, first awarded in 1851, is the oldest trophy in international sports, and one of the most hotly contested. In 2000, Larry Ellison, co-founder and billionaire CEO of Oracle Corporation, decided to run for the coveted prize and found an unlikely partner in Norbert Bajurin, a car radiator mechanic who had recently been named Commodore of the blue collar Golden Gate Yacht Club.

Julian Guthrie’s The Billionaire and the Mechanic tells the incredible story of the partnership between Larry and Norbert, their unsuccessful runs for the Cup in 2003 and 2007, and their victory in 2010. With unparalleled access to Ellison and his team, Guthrie takes readers inside the design and building process of these astonishing boats, and the management of the passionate athletes who race them. She traces the bitter rivalries between Oracle and their competitors, including Swiss billionaire Ernesto Bertarelli’s Team Alinghi, and throws readers into exhilarating races from Australia and New Zealand to Valencia, Spain.

With new television coverage and huge media, the America’s Cup is poised to be bigger than ever, and The Billionaire and the Mechanic is a must-read for anyone interested in the race or this remarkable story.”

Do you choose the blue pill or the red pill?

September 23, 2013 By Mike Shell in Actively Manage Risk, Adapting to Change, Asymmetric Observation, Critical Thinking, Global Directional Trends, Independent Thinking, Investor Behavior Modification Tags: Asymmetric Investment Returns, Asymmetric return, critical thinking Leave a comment

The “red pill” and “blue pill” refer to a choice between the willingness to learn a potentially unsettling or life-changing truth by taking the red pill or remaining in contented ignorance with the blue pill. It refers to a scene in the 1999 film The Matrix.

I have been talking to a financial planner recently who is struggling between the red pill and the blue pill.

On the one hand, the poor performance of stock and bond indexes over the past decade or so, particularly the losses in bear markets, led him to study long-term market cycles.

An understanding that markets don’t always go up over long periods is the reality of the red pill.

On the other hand, much of the investment industry still believes in getting “market returns” and that a simple plan of “asset allocation” and occasional re-balancing is prudent enough, so a financial planner can choose to keep his practice simple by continuing that plan.

Some investment advisers even consider re-balancing and an occasional change “tactical”.

It isn’t.

The blue pill and the red pill are opposites, representing the choice between the blissful ignorance of illusion (blue) and embracing the painful truth of reality (red).

On the one hand, after understanding the trends of global markets based on simply looking at their history, he realizes the probable outcome of stocks and bonds based on trends I discuss in The S&P 500 Stock Index at Inflection Points and 133 Years of Long Term Interest Rates. Though price trends can continue far more than you expect, the stock and bond markets are at a point where their trends could reverse. The financial planner realizes if he takes the red pill of reality, he’ll have to embrace these facts and do something rather than sit there. He’ll have to change his long-held beliefs that markets are efficient and the best you can do is allocate to them. He’ll have to do extra assignments and homework to find alternative investment managers whose track record suggests they may have the experience and expertise to operate through challenging market conditions.

On the other hand, changing one’s beliefs and taking a different approach can be extra work and have risks. If he continues the static asset allocation to stocks and bonds he’s always done, he says he won’t be doing something so different from the majority of advisers. He knows his career and his life will be easier. When the markets go up, his clients make market returns (minus his fees). When the markets go down, other people are losing money too, and he certainly can’t control what the market does, so: it’s the market. I can see how this is an enticing business model, especially for a busy person who has a life outside the office. That’s probably why it’s so popular.

A similar theme of duality happens in the movie The Matrix.

Morpheus offers Neo either a blue pill (to forget about The Matrix and continue to live in the world of illusion) or a red pill (to enter the sometimes painful world of reality).

Duality is something consisting of two parts: a thing that has two states that may be complementary or opposed to each other. We all get to choose what we believe and our choices shape the world we individually live in.

I can’t say that I can totally relate to the financial adviser because it is my nature to be more tactical and active in decision-making. I believe we should actively pursue what we want. And, I believe what we want from the markets is in there, I just have to extract it from the parts we don’t want. I once explained my investment strategy to a lifelong friend and he replied “you have always been tactical” and reminded me of my background. Though it’s different from me, I can truly appreciate the struggle advisers and investors face choosing between the red or blue pill. Investors and advisers like “market returns” when they are positive, which is what we experience most of the time. It’s when those markets decline that they don’t want what the market dishes out. The markets don’t spend as much time in declines. I pointed out in The Real Length of the Average Bull Market the average upward trend for stocks (bull market) lasts 39 months while the average decline ( bear market) is about 17 months. Investors eventually forget and become complacent about the time they need a reminder. Though the stock markets trend up about 3 times longer than they trend down, it’s the magnitude of the losses that cause long-term investors a problem. For example, the bull market from 2003 through October 2007 gained over 105% but the -56% decline afterward wiped out those gains. You can see that picture in The S&P 500 Stock Index at Inflection Points.

The risk for the financial adviser who has historically focused on “market returns” is that a new strategy for them that applies some type of active risk management is likely to be uncorrelated and maybe even disconnected at times from “market returns”. For example, I discussed that in Understanding Hedge Fund Index Performance. Investors who are used to “market returns” but need a more absolute return strategy with risk management may require behavior modification. If they want an investment program that compounds capital positively by avoiding large losses and capturing some gains along the way they have to be able to stick with it. That requires the adviser to spend more time educating his or her investors about the reality of the red pill. Kind of like I am doing now. Some people have more difficulty doing something different, so they need more help. Others are better able to see the big picture. Some financial advisers would rather deal with explaining the losses when markets decline. For them, it can be as simple as forwarding clients some articles about the market going down with a message something like “We’re all in this together – let’s just hunker down”. That doesn’t require a great deal of independent thinking or doing.

While most individual investors probably do lose money when the stock and bond markets do, that isn’t necessarily the case for those who direct and control downside risk.

It isn’t enough to have a good investment program with a strong performance history.

Just as important is the ability to help investors modify their beliefs and behavior.

That’s the reality of the red pill.

By definition, active is more work than passive. Investors and advisers alike get to choose which pill they take: the blissful ignorance of illusion (blue) and embracing the painful truth of reality (red).

I believe in individual liberty and personal responsibility, so the choice is your own.

My thoughts on the subject are directional – I am the red pill.

Morpheus: “You have to understand, most of these people are not ready to be unplugged. And many of them are so inured, so hopelessly dependent on the system, that they will fight to protect it.”

“Unfortunately, no one can be told what the Matrix is.

You have to see it for yourself.”

Like The Matrix, this is going to be a sequel.

To be continued…

The Dow Jones Industrial Average is a Black Box

September 18, 2013 By Mike Shell in Asymmetric Observation, Critical Thinking, Tactical ETF Portfolio Management Tags: black box index, Dow Jones Industrial Average, Exchange-traded fund, Standard & Poor, Stock index 1 Comment

The black box:

In science and engineering, a black box is a device, system or object which can be viewed in terms of its input and output but without any knowledge of its internal workings. Its implementation is “opaque” (black). Almost anything might be referred to as a black box: a transistor, an algorithm, or the human brain.

The opposite of a black box is a system where the inner components or logic are available for inspection, which is sometimes known as a clear box, a glass box, or a white box.

Almost all investment programs are actually a black box. That is, the investment manager may allow the investor to see the holdings, but most investment strategies have many parts and parameters that are undisclosed to the public or even its investors. There is strong logic behind not disclosing ones intellectual property beyond the obvious. And, it isn’t just about intellectual property, it may be a fiduciary issue, too. When the public knows what a portfolio manager is going to do in advance, other portfolio managers can front-run the trade. Just ask Russell whose indexes are more transparent and we believe they’ve had issues because of it. I think a portfolio manager has an obligation to avoid that. And, it just makes sense.

We can say the same for stock indexes like the Dow Jones Industrial Average or other Standard & Poors indexes. By now, it is public knowledge that the committee that oversees the Dow Jones Industrial Average has made 6 significant changes to the 30 stocks that make up the index. The Index Committee dropped Alcoa, Hewlett-Packard, and Bank of America, and added Goldman Sachs, Nike and Visa. Did you know in advance they would do that? We didn’t know until after they announced it. Why? because it’s something a committee decided. As we defined above, what is going on in the human brain is a black box. When people are going to make decisions, we can’t determine for sure in advance what the output will be.

Though we can’t actually invest in an index directly, index investors and traders gain exposure to indexes through index funds like exchange traded funds (ETFs). We say that ETFs allow us to gain exposure to a market, sector, country, etc. in a low-cost, transparent, and efficient format. But, the transparency is in regard to the index holdings and maybe the universe they select from, but not necessarily how they decide to add and delete holdings (causing the index ETF we may own to buy and sell the underlying stocks, bonds, etc.).

Is that process a black box? Yes, it is.

We know only parts of the input, we know the output, but we don’t actually know in advance the inner workings of the decision. An index like the Dow Jones Industrial Average is a system that can be understood in terms of its input and output, but not necessarily any knowledge of its internal workings. In the recent case of the Dow Jones Industrial Average, the changes will take effect with the close of trading on Sept. 20th. According to the Wall Street Journal, it was explained in a statement:

“we were prompted by the low stock price of the three companies slated for removal and the Index Committee’s desire to diversify the sector and industry group representation of the index,” S&P Dow Jones Indices LLC, the company that oversees the Dow”

Only the “low price” part of that is rules-based. The Index Committee made the decisions to reflect their desire. That doesn’t seem different from an “Investment” Committee that makes such decisions for a fund or other investment program. It isn’t.

What do you really know about indexes? We know the Dow is a price-weighted index, meaning the bigger the stock price, the larger the position for the stock, and vice versa. That is different from indexes such as the Standard & Poor’s 500, which are weighted by components’ market capitalization. But, we don’t know enough about how the Index Committee makes its decisions to have known in advance what stocks they will change. If we did know that, we could buy the new stocks and sell the outgoing stocks in advance of their announcement. That’s one reason they don’t publish it. However, the black box index goes beyond that. They couldn’t publish it before they decide the changes – they didn’t know either what the output would be until the committee members gave their input. Though many indexes may appear more quantitative (systematic decisions based on predefined rules) they are just as qualitative based on judgement and opinion (an Index Committee makes the decisions, so you don’t actually know what they’ll decide – it isn’t so “rules-based”). My point is: we couldn’t have known the outcome in advance because there was an internal meeting involved to decide.

But an index fund investor doesn’t really need to know this information in advance. Neither does an investor in any investment program. That’s why they are an “investor”. If they are a “portfolio manager” or “trader” they can do it themselves and make their own decisions deciding every little detail. When we choose to invest in any fund, index or not, we necessarily leave part of the process to the deemed expert. In the case of the index, the expert is the index provider like S&P Dow Jones Indices.

The Dow Jones Industrial Average index is totally transparent in regard to its holdings, but a black box in regard to how the additions and deletions are decided.

Stay tuned: I’ll get into this more next week…

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To learn more about the Dow Jones Industrial Average, visit its learning center which shows the Ins & Outs of the Dow since 1896 and read Dow Jones Industrial Average Historical Components.

Understanding Hedge Fund Index Performance

September 17, 2013 By Mike Shell in Asymmetric Investment Returns, Asymmetric Observation, Hedge Funds, Investor Behavior Modification 1 Comment

I am often fascinated by investor perception and behavior. I notice it everywhere and study it always. What a person believes makes their world what it is and how they see things. It can also explain their own poor results. You see, if the majority of individual investors and professional investors actually have poor performance over long periods (as evidenced by Dalbar and SPIVA®) they necessarily must be doing and believing the wrong things.

I just came across something that said “Why are hedge fund indexes performing so poorly?”. My first thought was “Are they?”. There are a few different hedge fund indexes, but I use the Barclay Hedge Fund Indices because it can include more than 1,000 funds each month across a wide range of strategies.

The Barclay Hedge Fund Index is a measure of the average return of all hedge funds (excepting Funds of Funds) in the Barclay database. The index is simply the arithmetic average of the net returns of all the funds that have reported that month.

As you can see below, the Barclay Hedge Fund Index, which is the average return of all hedge funds in the Barclay database, has gained 5.22% year to date through August. Is 5.22% a “poor” return when the risk free rate on short-term T-Bills, money markets, and CD’s are near zero? I don’t think so. But, if you compare it to the highest returning index you can find maybe you’ll perceive it as “poor”. For example, the stock market indexes are so far “up” double digits this year, but they can reverse back down and end the year in the red. Stock indexes are long-only exposure to stocks so their results reflect a risk premium earned for owning stocks with no risk management to limit the downside. I don’t know anyone who thinks the stock indexes have created the kind of risk adjusted return they want after declining more than -50% twice the past several years. If they want to compare “hedge funds” to a long-only stock index they should consider focusing on hedge funds that focus on stocks.

As you can see below, the hedge fund index includes a wide range of alpha strategies. The Equity Short Bias is one of only two that are down year to date and that is expected: they are short stocks and stocks have gained this year, so these strategist that short stocks have lost money. Emerging Markets is the other that is down, which is not terribly surprising since most emerging markets are down. They have still managed risk: through August the Emerging Markets Hedge Fund Index is down -1.73% while the iShares MSCI Emerging Markets ETF is down -13.17%. I’m sure any of those hedge fund managers who are down don’t think that’s “good”, but its just a short period of time.

Source: http://www.barclayhedge.com/

Investment managers are to compare their performance to something to illustrate the general market and economic conditions over a period. Since my investment programs don’t intend to benchmark any indexes, we often use the Barclay Hedge Fund Index as a comparison of this “alpha index” to our programs.

In the chart below, we have compared over a full market cycle the Barclay Hedge Fund Index, Dow Jones Global Moderate (a monthly rebalanced index of an allocation across 14 global indexes that are 60% global stocks, 40% global bonds), and the S&P 500 stock index The blue line is the Barclay Hedge Fund Index. Keep in mind that the hedge fund index is net of hedge fund fees while the S&P 500 stock index and Dow Jones Global Moderate does not reflect any fees. If an investor used an adviser, they would pay a management fee, index fund fees, and trading cost, so the net return would be less. Recently, it has “lagged” the other two, but over the full cycle, its risk/reward profile is significantly superior. Though they all ended with about the same total return, the Barclay Hedge Fund Index declined -24% peak to trough during the 2007 – 2009 bear market. That -24% is compared to -38% for the Dow Jones Global Balanced 60/40 index and -55% for the S&P 500 total return (including dividends). That is the advantage of “active risk management” many hedge funds attempt to apply. Look closely at the chart below and decide which experience you would have rather had. And then, consider that it’s important to view the full picture over a full market cycle rather than focus on short-term periods.

As to why the Barclay Hedge Fund Index has lagged stocks lately?

They are supposed to. Hedge funds as a group, as measured by a composite index, are investing and trading long and short multiple strategies across multiple markets: bonds, stocks, currency, commodities, and alternatives like volatility, real estate, etc.

You may also consider that hedge funds are generally risk managers (though not all have that objective). If you look at the end of the last bull market in stocks (late 2007) the hedge fund index lagged 100% stock indexes then, too. You may consider that risk managers are actively managing risk and they could be right in doing it now considering the stage in the cycle. It’s probabilistic, never a sure thing. It worked the last time. Some hedge fund strategies begin to reduce their exposure to high risk markets like stocks after they have moved up to avoid even the early stage of the decline. By doing that, they “miss out” on both the final gains but also the initial decline after a peak. Others wait until stocks actually reverse their trend, which means they’ll participate in some of the initial decline when it happens.

You may also consider that people bragging about the gains to long-only stock indexes that have no downside protection may be another sentiment indicator. Historically, it seems that about they time they get to bragging and become complacent the trend turns against them…

Note: you cannot invest directly in any of these indexes.

The REAL Length of the Average Bull Market

September 16, 2013 By Mike Shell in Critical Thinking, Global Directional Trends Tags: average length of bear markets, average length of bull markets 6 Comments

How long is the average bull market and bear market?

With the current bull market in stocks at its 54^th month, I’ve been hearing several different statistics thrown around lately about the “average” length of historical bear markets. To calculate how long the average uptrend lasts, we have to decide what index represents that stock market and use its most relevant data.

I was telling someone recently what I believe is the correct method to calculate the average bull market cycle. The average bull market lasts about 39 months.

Someone had used the S&P 500 data from Shiller’s database which goes back to 1871 to conclude the average bull market is 50 months. I note two issues with the way they calculated their average.

While that data can be useful for some purposes, we have to understand how the data was compiled and its details. For example, the S&P 500 has been widely regarded as the best gauge of the large cap U.S. equities market, but it was first published in 1957. You may wonder how the Shiller data goes back another 86 years before the index was first published. Other indexes were used and the short story is those indexes used far fewer than 500 stocks, were focused on a few industries, and monthly data wasn’t always available. For example, in Standard Statistics Co. is the predecessor of today’s Standard & Poor’s Corp. In 1926 they developed a 90-stock index that by the 1950s had evolved into the S&P 500. Many people speak of these indexes, but it seems few actually know much about them. You may consider if that index prior to 1957 data is actually relevant enough to understand modern bull and bear markets. If you want, you can visit the data website to fully understand how it was created.

Second, like many others do, they defined bear markets as a 20% decline from a prior peak lasting at least 3 months. They defined bull markets as an advance of 50% or more from the low of a bear market over 6 months or longer. From those definitions and parameters, they conclude the average bull market is 50 months.

I develop and operate quantitative portfolio management systems that I apply to price data to identify potentially profitable price trends and manage risk. In other words, I prefer to have exposure to rising trends and avoid (or short) falling trends. I can tell you from my expertise that one great thing about my process is that it required me to precisely define every single detail. The data, definitions, and parameters that create the decision-making algorithm – which is the process that tells me what to do next. That may give you some idea of how I observe things like this.

I found a similar study by JP Morgan that states the average bull market is a whopping 68 months long going back to 1946. The fine print at the bottom of the chart states they defined a bear market as “a peak-to-trough decline in the S&P 500 Index (price only) of 20% or more. The bull run data reflect the market expansion from the bear market low to the subsequent market peak.” That explains why their bull markets appear so long.

Source: JP Morgan

While defining bull and bear markets with percentages is popular, it seems to leave out the reality of bull and bear market cycles: a full market cycle. A full market cycle includes both a bull and a bear market period, together. These cycles last about 56 months and some believe it is tied to the business cycle and others believe it may be more connected to politics. A data-driven researcher doesn’t need theory to explain what causes it – it is what it is.

I believe the table below from Ron Griess more accurately represents the average bull market by considering the full market cycle rather than defining them by percentages. The time frame is in weeks, so it shows the average bull market cycle is 155 weeks or about 39 months. The average bear market is about 17 months, which actually matches the most recent bear market from October 2007 to March 2009 (17 months). A full market cycle is 56 months.

source: www.thechartstore.com

Whatever we believe is always true for us. Whether you believe the average bull market lasts 39 months, 50 months, or 68 months, it seems the current one is likely late in its stage at 54 months as of September 2013.

As the bull market is aging learn about a strategy designed for it visit ASYMMETRY® www.Shell-Capital.com

Our beliefs create our world

September 15, 2013 By Mike Shell in Great Quotes Leave a comment

“You experience what you believe unless you believe you won’t, in which case you don’t, which means you did.”

– Harry Palmer

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