Although September is often the worst month of the entire year for the stock market, so far, August was worse. And, The term structure for VIX shows that implied (or expected) volatility was actually higher in August than September. We’ll see how it all unfolds…
Source: http://www.cboeoptionshub.com/wp-content/uploads/2013/09/VIX-VXN1.jpg
From 1928-2012 the S&P 500 was up 39 months and down 46 months. It’s down 55% of the time in September…
Dow Jones Industrial Average 1886-2004 (116 years) 49 years the Dow was down, in 67 years the Dow was up. It’s down 58% of the time in September…
Those are probability statements. First, let’s define probability.
Probability is likelihood. It is a measure or estimation of how likely it is that something will happen or that a statement is true. Probabilities are given a value between 0 (0% chance or will not happen) and 1 (100% chance or will happen). The higher the degree of probability, the more likely the event is to happen, or, in a longer series of samples, the greater the number of times such event is expected to happen.
But that says nothing about how to calculate probability and apply it. One thing to realize about probability it that is the math for dealing with uncertainty. When we don’t know an outcome, it is uncertain. It is probabilistic, not a sure thing.
As I see it, there are two ways to calculate probability: subjective and objective.
Subjective Probability: assigns a likelihood based on opinions and confidence (degree of belief) in those opinions. It may include “expert” knowledge as well as experimental data. For example, the majority of the research and news is based on “expert opinion”. They may state their belief and then assign a probability: “I believe the stock market has a X% chance of going down.” They may go on to add a good sounding story to support their hypothesis. You can probably see how that is subjective.
Objective Probability: assigns a likelihood based on numbers. Objective probability is data-driven. The popular method is frequentist probability: the probability of a random event means the relative frequency of occurrence of an experiment’s outcome when the experiment is repeated. This method believes probability is the relative frequency of outcomes over the long run. We can think of it as the tendency of the outcome. For example, if you flip a fair coin, its probability of landing on head is 50% and tail is 50%. If you flip it 10 times, it could land on head 7 and tail 3. That outcome implies 70%/30%. To prove the coin is “fair” (balanced on both sides), we would need to flip it more times. If we flip it 30 times or more it is likely to get closer and closer to 50%/50%. The more frequency, the closer it gets to its probability. You can probably see why I say this is more objective: it’s based on historical data.
If you are a math person and logical thinker, you probably get this. I have a hunch many people don’t like math, so they’d rather hear a good story. Rather than checking the stats on a game, they’d rather hear some guru opinion about who will win.
Which has more predictive power? An expert opinion or the fact that historically the month of September has been down more often than it’s up? Predictive ability needs to be quantified by math to determine if it exists and opinions are often far too subjective to do that. We can do the math based on historical data and determine if it is probable, or not.
As I said in September is statistically the worst month for the stock market the data shows it is indeed statistically significant and does indeed have predictive ability, but not necessarily enough to act on it. Instead, I suggest it be used to set expectations: the month of September has historically been the worst performance month for the stock indexes. So, we shouldn’t be surprised if it ends in the red. It’s that simple.
Theory-driven researchers want a cause and effect story to go with their beliefs. If they can’t figure out a good reason behind the phenomenon, they may reject it even though the data is what it is. One person commented to me that he didn’t believe the September data has predictive value. But, it does.
I previously stated a few different probabilities about September: what percentage of time the month is down. In September is statistically the worst month for the stock market I didn’t mention the percent of time the month is negative, only that on average it’s down X% since Y. It occurred to me that most people don’t seem to understand probably and more importantly, the more complete equation of expectation.
Expectation
There are many different ways to define expectation. We probably think of it as “what we expect to happen”. In many ways, it’s best not to have expectations about the future. Our expectations may not play out as we’d hoped. If you base your investment decisions on opinion and expectations don’t pan out, you may stick with your opinion anyway and eventually lose money. The expectation I’m talking about is the kind I apply: mathematical expectation.
We have determined above the probability of September based on how many months it’s down or up. However, probability alone isn’t enough information to make a logical decision. First of all, going back to 1950 using the S&P 500 stock index, the month of September is down about 53% of the time and ends the month positive about 47% of the time. That alone isn’t a huge difference, but what makes it more significant is the expectation. When it’s down 53% of the time, it’s down -3.8% and when it’s up 47% of the time it’s up an average of 3.3%. That results in an expected value of -0.50% for the month of September. If we go back further to 1928, which includes the Great Depression, it’s about -1.12%.
The bottom line is the data says “based on historical data, September has been the worst month for the stock market”. We could then say “it can be expected to be”. But as I said before, it may not be! And, another point I have made is the use of multiple time frames for looking at the data, which is a reminder that by intention: probability is not exact. It can’t be, isn’t supposed to be, and doesn’t need to be. Probability and expectation are the maths of uncertainty. We don’t know in advance many outcomes in life, but we can estimate them mathematically and that provides a sound logic for believing.
We’ve made a whole lot of the month of September, but I think it made for a good opportunity to explain probability and expectation that are the essence of portfolio management. It doesn’t matter so much how often you are right or wrong, but instead the magnitude. Asymmetric returns are created by more profit, less loss. And that provides us a mathematical basis for believing a method works, or not. Not knowing the future; it’s the best we have.
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One observation I regularly share is the constant flow of research papers and books about topics I am interested in. Specifically, these topics are listed on the “About” page, but they are primarily those with the potential to create positive asymmetry in the P/L (that is: more profit than loss). The “momentum” subject is a big one for me, since I have operated directional trend systems for more than a decade. Momentum is sometimes called relative strength, or inertia, or trend-following. There are now more than 300 papers I know of documenting evidenced of momentum: whatever trend has been within the last year tends to continue. It’s interesting reading these research papers. They are sometimes written by academics at a University and sometimes by research at an investment company. The funny thing is they are rarely written by an investment manager who has strong performance history actually doing what they write about. I wouldn’t dare write a paper specifically about what I do that works. Nevertheless, these researchers share their opinions and only a few of us know how correct or wrong they may be. You see, a research paper is just a study or opinion, we can never really prove something true since it can some day be proven untrue. Think: swans are white, until you see a black one. As I see it, the only people qualified to say so is if they themselves have good actual performance history doing these things. Experience matters, but research isn’t so much about experience as it is thinking deeply about a subject and offering ones views and findings.
I just got in my inbox a new paper by Ryan Larson Hot Potato: Momentum As An Investment Strategy (August 2013).
He concludes:
So what are investors to do with momentum? Our conclusion is that momentum is inadvisable as a stand-alone strategy due to the risk of precipitous losses. Rather, we suggest that long-term investors seeking to tap more than one source of equity premium choose another, more stable factor for their core investment strategy (value is certainly a strong candidate), and consider adding momentum as a short-term trading strategy when market conditions are favorable.
I agree that momentum (or relative strength) by isn’t best used as a stand alone strategy, but adding some other strategy like “value” to it isn’t the answer. Momentum (or relative strength) needs active risk management.
September is statistically the worst month of the year for the stock market.
Going back to 1928, the S&P 500 has lost -1.12% on average in September. There seems to be plenty of news that could “cause” a decline in stocks this month. On top of the conflict in Syria, the Federal Reserve may taper its bond buying when it meets on the 17th and congress will soon be back to work and deal with the debt ceiling.
There are plenty of things to worry about if that’s what you like to do. I believe people often worry about things that never even happen, so they experience those things either way. I guess I am too focused on what is actually happening in this moment, now, to worry about things that haven’t even happened. And for portfolio management I always know what I’m going to do next, so I’m never trying to figure out what’s going to happen next and what to do next. I’ve been running my systems for a decade.
I noted earlier that Investor Sentiment is Bearish and that Fear is the Current Return Driver for stocks. That fear increased during August as stocks declined. It could be that investors have already anticipated the news? Keep in mind that “news” means “new information”, so none of these things are “news” today. We’ll see how it all unfolds. I believe it’s the uncertainty and change that makes life fun. I enjoy letting things evolve as they will. I know what I can control – and what I can’t.
I don’t worry about the news. I already know in advance at what point I’ll exit or hedge to control my risk or go short if markets decline.
The four charts below show a graphical image showing September as the worst month historically, though it only goes back 23 years from 1980 through 2012. It’s been the best month for gold, so maybe those holding losing gold positions will get some relief. We don’t make our investment decisions based on what month it is, but this does provide probabilities.
The broad global market indexes declined during August. Global stocks, represented by $SPX, EFA, and EEM below, declined -4% or more during the month. The broad bond index (AGG) declined too.
EFA: iShares MSCI EAFE is exposure to Developed markets stocks in Europe, Australia, Asia & the Far East.
EEM: iShares MSCI Emerging Markets is exposure to Emerging markets large- and mid-cap stocks.
AGG: iShares Core Total U.S. Bond Market is exposure to US investment grade bonds
$SPX S&P 500® is widely regarded as the best single gauge of large cap U.S. equities.
There is a clear correlation between the level of education and unemployment. College graduates is 3.8% while those with less than a high school degree is 11.1%!
Another incredible observation of long term interest rates comes from Shiller’s database. The red line is the trend in long term interest rates. Interest rates peaked in 1981. That would have been an incredible time to buy bonds: their yields were 15%. But it was a terrible time to borrow money. Then interest rates declined dramatically- until now. Interest rates have been 2-3% lately, the lowest going back to 1880. At low interest rates, it’s a great time to borrow money, but a very risky time to buy bonds. When interest rates eventually go up, their values will go down. With rates at outlier low rates and the Fed going to need to taper their Quantitative Easing they’ve created to prop up the economy and stock market, the rise in rates in the years ahead could possibly be stunning. So the decline in bond values would be equally stunning. One of my advantages as a global macro manager is an understanding of how world markets interact with each other. The inverse relationship between bond price and interest rates is one of the few inter-market relationships that is a sure thing.
Source: Shiller’s database.
For more views on bonds, read Interest Rates Trend and Interest Rates are Trending Up, Bonds Investors Feeling the Pain
“Computers are useless. They can only give you answers.”
Since May, we observe that global market indexes have diverged. While some markets are still trending up, others are trending down. Prior to 2013, many markets were generally trending together. The current U.S stock bull market is now 52 months old from from its March 2009 bear market low. If history is a guide, it’s closer to the end (read: The S&P 500 Stock Index at Inflection Points). One of the things we see near the end of a major trend change is some world markets start to reverse down. For example, going in to 2008 it was Financials and REITs (real estate). As we see in the chart, U.S. stocks are still trending up for now, but emerging markets and all categories of bonds and Real Estate Investment Trusts (REITs) are weak. Rising interest rates = falling bond prices and falling interest rate sensitive markets like REITs. The diversification of global asset allocation over this period has actually resulted in more downside risk rather than reducing it. Bonds have been in a rising trend for the past 30 years, so when stocks drop -50% exposure to bonds haves helped to offset the losses for asset allocators who mix stocks and bonds. If bonds are changing to a downtrend as it appears they are, bonds may not be a crutch in the next bear market. In fact, they may inflate losses.
If you aren’t familiar with the index symbols for the markets in the table in the top left:
If you have any questions or comments, contact me.
Photo by Christi Shell
As I sit here this morning in my favorite place watching ESPN College Game Day getting ready to spend the Labor Day weekend on the lake, I was thinking…
Over the years, I’ve asked many people what is most important to them. What I’ve learned is that while we all have different ways we like to spend our time, at the end of the day what we really want is freedom. That is, freedom to do what we want, when we want.
I want to share with you my beliefs about freedom and how to earn it.
An employee is hired to operate a system that another created. Their job is to operate the system; maybe it’s an engineer working for a large engineering firm or a physician working for a large medical practice. For that, the employee enjoys having a system they operate, but that they don’t have to create or necessarily keep updated. They enjoy the job stability.
The self-employed person is one who believes they can do it better, so they start their own firm or medical practice and create their own systems to manage the business. But, the self-employed person also operates the system. They are there, running the system they created. And they have to be there, or there is no system.
As they shift more toward freedom, they can become a business owner. The business owner hires all the necessary people to completely run the business. He or she can take nice long vacations without closing the business because employees are running the business. But, they still have to be the business owner and oversee the business as that owner, no matter if they call themselves President, CEO, or Chairman. It’s an active responsibility to oversee the business.
The ultimate freedom is the investor. The investor isn’t a business owner and operator, but instead an investor. The investor is passive in his or her investment. An investor earns profit and loss, like a business owner, but without having to actually do anything other than investing capital. The investor can sail the world on a yacht, see the country in an RV, spend every day at the beach house or mountains with the family, or do whatever he or she wants to do. The investor has full freedom. That’s what I think we all want.
Sometimes people truly love how they earn their capital. Maybe they can do it to the end. But more often than not, the aging process doesn’t allow them to do it to the end, so they’ve got to become an investor at some point.
There are many ways to earn freedom. We don’t have to start and grow a business to end up as an investor. You can be an employee and save and invest into a retirement fund. No matter how you do it, we all want freedom and that necessarily means earning and accumulating a retirement fund large enough that you find your own freedom to do what it is you really want.
I may have a unique perspective on this because I own an investment management business that helps people do that; I’m a trader, and an investor.
Have a great Labor Day weekend! and maybe the best teams win!
The chart below is the S&P 500 Stock Index at Inflection Points showing full market cycles since 1997 (16 years).
A few observations:
• You may agree there is a trend here. Several years of upswings followed by downswings, but no meaningful progress for many years. Unfortunately, many people have needed more than this to get the financial freedom they want.
• 100% uptrends are followed by -50% downtrends that are enough to erase the gains from the uptrend. People get euphoric and complacent after 100% uptrends – just in time to participate in the next big waterfall decline.
• You may consider the point where it is now vs. the last time it reached those points.
• And, if you can avoid most of the downside and capture some of the upside (what I call ASYMMETRY®) you could have earned a different result. To achieve that takes real skill, but there are managers who have experience doing it and have actual audited track records as evidence. It will unlikely be achieved by overconfident people who have no experience, skill, and no actual track record.
Click on the chart for a larger view:
I’m not saying it’s there yet, but if you understand the past no one should be surprised about what can happen next…
“Those who cannot remember the past are condemned to repeat it.”
–George Santayana, – Reason in Common Sense
A performance incentive fee is the key compensation for a hedge fund manager. Many people may not understand the concept of “alignment of interest”. For example, an investor recently told me they only invest in private funds because of alignment of interest. Essentially they want the fund manager to profit when they do. For example, if a $50 million private fund earns a 10% net return, the fund manager would earn $1 million of the profit as a performance incentive. If the fund manager earned a 100% return, his compensation would be $10 million. If the fund manager has a loss he gets no performance incentive fee until the loss is fully recovered and the fund reaches a new high. You can probably see why some money managers focus on growing the fund through the process of trading rather than trying to find more and more new investor money. I know people across various sides of the money management industry – the incentives and motivations are vastly different depending on their business structure and specialization. A wealth manager that measures success by assets under management will focus on gaining new clients. An alternative portfolio manager pursuing asymmetric investment returns may have an incentive to focus more on the profits they generate. That is, if you really believe you’ve got some skill, you’ll want to align your rewards in that direction. At least, that’s what an entrepreneur who sells a business for $100 million may tell you.
And believe it or not, Pensions & Investments Magazine shows these performance incentive fees may indeed matter in Hedge funds charging highest performance fees provide best returns. They say:
A comparison by Preqin of hedge fund net returns categorized by the performance fees they charge shows that funds charging more than 20% in performance fees actually outperform those that charge 20% or less. Funds charging higher fees appear to be producing higher, and more consistent net returns…
And the chart speaks for itself:
Source: Pensions & Investments
We provide investment management for family offices and wealth managers and in fact, one of my operating companies also serves as my own family office. So, we comment about “family office” a lot. People often ask: “What is a family office?”.
The short answer is a family office is a business entity, an operating company, that handles the personal affairs of a person or family. Rather than just paying for personal services like investment management, tax planning, estate planning and management, or house maintenance, etc. from a personal checkbook, a family office is established as a business entity (operating company), like a Limited Liability Company or Limited Partnership and that “business” manages the affairs of the family. It’s mostly useful for families of substantial wealth: maybe $5 million or more of personal assets.
For example, maybe the family owns multiple homes in different locations, a boat kept at a marina out of town, and maybe a plane. To maintain these assets and keep them safe, people must be employed, etc.
A common example of a family forming a family office is selling a business or medical practice. Often the owner of the business had an executive assistant who helped the family handle their personal affairs, too. When the business is sold, they have to decided what to do in their “new” business called “retirement”. The business owner may form a family office to have a formal structure for handling these things. For example, they may hire that executive assistant to keep helping them but focus exclusively on their personal assets. The business owner now has cash from the sale of the business to invest. The family office may hire a “Chief Investment Officer” or outsource an experienced one to manage the new investment capital to provide income to fund their new found lifestyle. As noted in How a Family Office Selects an Investment Manager a family office is usually more concerned about actively managing investment risk to maintain their capital first, then produce income and grow the capital base without large losses along the way. They usually want to keep what they earned as a first priority, so they hire experienced managers with a proven track record of compounding capital positively over time, while controlling downside loss. It’s all about putting the structure in place so the family can enjoy their freedom to do the things they love, by limiting the headache of dealing with the things they don’t.
We work with these issues all the time at Shell Capital. If you have any questions or want to understand how we do it, contact me.
To get an idea of the significance of the decision of U.S. military action in Syria, spend some time at: http://www.woundedwarriorproject.org/ and while you are at it, please express your gratitude by making a donation.
Sometimes we’ve got to do what we’ve got to do, but think of who’s actually doing it and the price they pay.
ZeroHedge points out that CNBC’s Nielsen ratings are at a 20 year low. In fact, they point out:
“CNBC’s Fast Money (-32% Y/Y), Mad Money (-42% Y/Y) and Kudlow (-52% Y/Y) all had all time low ratings in the “all viewers” category in August 2013″
Below is their Nielsen viewership total and prime viewers chart since 1992. You can see how viewership grew sharply during the bull market in stocks of the 1990’s. Viewers seemed to lose interest by around 2005 after the stock market decline from 2000- 2003 had recovered by 2005. No surprise their viewership trended back up and peaked around 2008 – 2009 when global markets dropped -50% or worse and negative news was at an all time high. Since the stock market recovery (driven mostly by the Fed’s Quantitative Easing I will add) their ratings have declined to a 20 year low. Fewer people are watching CNBC than ever.
I have related the swings in viewership to the directional trends and price volatility in the global markets. That may or may not be a driver of their viewership, but there seems at least some correlation. But, it seems that if the financial media like CNBC had strong credibility their viewership would be more consistent.
Either way, after the 1990’s viewers have probably realized that financial media like CNBC is just financial entertainment – much like Sports Center, just a different game. People sit around a table with different views and debate what’s going to happen next and state their opinions. Most of the time you have no empirical evidence if their opinion even means anything – if you don’t know their track record. It sometimes gets outright silly. I’d rather watch Sports Center for fun – money management is a serious matter. It isn’t a game to me.
Finally, the chart below is a fine example of symmetry. Symmetry is balance. I always point out the error in people saying you should “balance your risk and reward“, when in fact we want imbalance. If we want something to trend up over a long time, we want Asymmetry: an imbalance between profits and losses. That is, we want more reward, less risk. Or, more profit, less loss. If your profits and losses are symmetry (balance) over time, you’ll have periods of gains followed by periods of losing those gains with no progress overall. For example, if CNBC were able to keep some viewers while just losing some, their chart would grow from the lower left to the top right with just minor dips along the way. Instead, we see their viewership has oscillated up and down. They have periods of strong viewership followed by periods of weak viewership that erases the prior growth. Over all it’s an symmetrical chart: it moves up and down over 20 years, but ends in the same place.
That may sound familiar as the stock market has done the same thing… and if your portfolio just tracks that market, so does your account. You may be “up” now, but that’s just because the market is “up”. What happens if the market goes down -50% again over the next few years? Will you have symmetry?
Source: Nielsen Media Research
As I said in “Fear is the Current Return Driver“, investor sentiment has turned to “Fear” since the stock and bond markets have declined recently. Investors tend to get optimistic (and greedy) after prices have gone up and then fearful after prices go down. Now, I am not a contrarian investor. I want to be positioned in the direction of global markets and stay there until they change. 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 and investment returns. When stock market investor sentiment readings get to an extreme it often reverses trend afterward. For example, as you can see in the Fear & Greed Index below, the dial is now at “Extreme Fear” as the return driver. 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. With that said, the purpose of this observation of extreme points of sentiment isn’t to be necessarily used as a timing indicator, but instead to recognize how extreme readings of investor sentiment are most often the wrong feeling at the wrong time. It isn’t the best timing indicator because, thought extreme readings often proceed a change in the price trend, these extreme readings can get a LOT more extreme and prices can keep moving far more than expected. So, all countertrend indicators have that risk. It’s like value investing: you think it’s oversold, or undervalued, but it gets a lot more oversold and a lot more undervalued. 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 to modify your behavior.
If you don’t understand this, or have question or comment, contact me directly or reply to this post if you don’t mind others to see your reply.
A picture can sometimes speak a thousand words. The graph below illustrates how investor emotions can oscillate from fear to greed through a full market cycle. The key is to understand how this can be used to know to reduce risk and when to increase it, and the timing is the opposite of what most people feel.
Believe it or not, there are some people involved in the investment industry who are against Exchange Traded Funds (ETFs). ETFs provide transparent exposure to a wide range of global markets at a low cost. ETFs have allowed us to gain access to return streams many didn’t have access to just a decade ago. For example, if you want to trade Silver, you can now get that exposure with an ETF (SLV). Previously, you would have to buy actual silver bars and deal with them. Or, trade silver actual futures or options. There is nothing wrong with trading the options and futures, but it sure is simpler to get exposure to that return stream with an ETF in many types of accounts. I monitor 25 different countries in my universe that we can access through ETFs. When I started developing my quantitative trend systems in 2001 to 2003 I decided to apply them to sector and country ETFs instead of futures as most others did at the time. ETFs have changed the way we get exposure and it’s a good thing.
Since the May 2010 Flash Crash (when the Dow Jones Industrial Average dropped -9% intraday for those who may have forgotten). It was the biggest one-day point decline, 998.5 points, on an intraday basis in Dow Jones Industrial Average history. Some thought it could have be caused by ETFs: Leveraged ETFs, the Flash Crash, and 1987, for example.
It seems ETFs and especially leveraged or “geared” ETFs are an ongoing debate about their potential impacts on the market price and volume – especially at the end of the trading day.
“In the end, even with $3 billion in levered and inverse financials, the daily rebalance trade is still likely “just” a few hundred million on a big day. That gets spread across hundreds of financial stocks in the large- and small-cap indexes.”
The bottom line is it doesn’t seem the amount of money invested in these leveraged or inverse ETFs is large enough relative to the total amount of money in the market to make a significant impact. However, market prices are driven by the most basic economics: supply and demand. Any trading activity has the potential to move a price, but we haven’t yet seen any empirical evidence to say leveraged ETFs are the cause of the big price swings we see more of since 2008. Instead, you may consider that investors and traders are just more responsive to changing prices – good or bad.
There are some things we just don’t know for sure, until we do. In the mean time, I consider the possibilities, give them some deep thought, factor it in, so I am prepared for whatever happens next. All things are always uncertain: enjoy it.
“Here be dragons” means dangerous or unexplored territories, in imitation of the medieval practice of putting dragons, sea serpents and other mythological creatures in uncharted areas of maps.
Most people fully accept paranormal and pseudoscientific claims without critique as they are promoted by the mass media. Here Be Dragons offers a toolbox for recognizing and understanding the dangers of pseudoscience, and appreciation for the reality-based benefits offered by real science. Real science is a process for proving something to have predictive ability through a process of testing.
The video below titled “Here Be Dragons” is an outstanding 40-minute video introduction to critical thinking. Watch it and see how you start to think more critically about what you believe.
I originally wrote this is a few years ago on another forum. It’s a concept that is so important to understand I wanted to share it here. The term “Independent Thinker” comes up in conversations a lot. I’m so often accused of being one. I search for a good definition and bold the parts that resonates the most with me. I find a useful explanation at iPersonic:
Independent Thinkers are analytical and witty persons. They are normally self-confident and do not let themselves get worked up by conflicts and criticism. They are very much aware of their own strengths and have no doubts about their abilities. People of this personality type are often very successful in their career as they have both competence and purposefulness. Independent Thinkers are excellent strategists; logic, systematics and theoretical considerations are their world. They are eager for knowledge and always endeavor to expand and perfect their knowledge in any area which is interesting for them. Abstract thinking comes naturally to them; scientists and computer specialists are often of this type.
Independent Thinkers are specialists in their area. The development of their ideas and visions is important to them; they love being as flexible as possible and, ideally, of being able to work alone because they often find it a strain having to make their complex trains of thought understandable to other people. Independent Thinkers cannot stand routine. Once they consider an idea to be good it is difficult to make them give it up; they pursue the implementation of that idea obstinately and persistently, also in the face of external opposition.
Referencing some of the parts I made bold, I will add a few comments. Independent Thinkers are analytical and self-confident and do not get worked up by conflicts and criticism. Independent Thinkers are open to debate topics they are interested in and are well prepared to compare and contrast beliefs with logic and empirical evidence. By virtue of “independence” the Independent Thinker is able to consider many different views to determine which is based on truth and facts. As an Independent Thinker myself, I can tell you that I have learned as much from people whose views are opposite mine, but not because they influence or control my beliefs but instead because they often confirm them. If you’re on to something, something that has a strong logic and mathematical reasoning behind it, then your next step is to figure out what may be wrong or go wrong rather than learning it the hard way. Outcomes are always uncertain, never a sure bet, so the best we can do is stack the math for dealing with uncertainty in our favor and figuring out in advance what may shift it against us. Once we’ve done this, then we have no reason to worry about things that haven’t even happened. If you want to discover any potential issues with your ideas, you’ll learn more by sharing them with people who are more likely to disagree with you than those who will probably just agree without any critical thinking or testing. But if you find you mostly follow along with what others believe, then you may not be thinking independently. When we speak of “independent”, we necessarily speak of the various things listed by dictionary.com:
1. not influenced or controlled by others in matters of opinion, conduct, etc.; thinking or acting for oneself: an independent thinker.
2. not subject to another’s authority or jurisdiction; autonomous; free: an independent businessman.
3. not influenced by the thought or action of others: independent research.
4. not dependent; not depending or contingent upon something else for existence, operation, etc.
5. not relying on another or others for aid or support.
6. rejecting others’ aid or support; refusing to be under obligation to others.
7. possessing a competency: to be financially independent.
8. sufficient to support a person without his having to work: an independent income.
9. executed or originating outside a given unit, agency, business, etc.; external: an independent inquiry.
10. working for oneself or for a small, privately owned business.
11. expressive of a spirit of independence; self-confident; unconstrained: a free and independent citizen.
12. free from party commitments in voting: the independent voter.
13. Mathematics . (of a quantity or function) not depending upon another for its value.
I’ll leave it for you to decide what independence or independent thinking is not, but to offer a head start in this intellectual exercise I’ll suggest that it isn’t any of the above…
And finally, when I am thinking deeply about a meaning I like to look at other words of similar meaning to get a full picture. in the image below we view “independent” in the Visual Thesaurus, an interesting way to discover connections between words by revealing the way words and meanings relate to each other.
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I think an independent thinker learns what he or she wants to know, while others must be taught. For example, the most intelligent humans are those who didn’t need someone to teach them formally, they are the first to figure things out. Our society often relates the most learned people by what college they attended and how much of it, but what if someone instead read over 500 books on subjects like math, scientific research, psychology, and trading? You may consider that the developers of the best systems and the products we love didn’t necessarily create them at a university or after earning an Ivy league degree. They are instead the ones teaching the world new things that they are able to develop and understand in ways most people can’t. Others go to the classroom hoping to understand some of the basics taught by books and lectures. The greatest things are discovered by deep independent thinking.
Intelligence: has been defined in many different ways including logic, abstract thought, understanding, self-awareness, communication, learning, having emotional knowledge, retaining, planning, and problem solving.
Source: When the student is ready, the master appears. ~Buddhist Proverb
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As I said in “Investor Sentiment is Bearish“, I’ll point out my observations about investor sentiment when it gets to an extreme and asymmetrically skewed to fear or greed. I pointed out the most recent AAII Investor Sentiment reading is bearish. Another simple gauge of investor sentiment is the Fear & Greed Index. As you can see, it hasn’t gotten to the extreme fear point, but fear has recently been the driver for stocks. Its reading was Greed just a month ago. Stock prices fell, investor sentiment shifted to fear. I believe many investors oscillate between the fear of missing out and the fear of losing money and I’ll share the observations as they occur as empirical evidence. When investor fear increases, eventually the last seller has sold and it pendulum swings back the other way.
I will point out observations of investor sentiment when it gets asymmetric: tilted to one extreme or another. In doing so, we’ll see how investors tend to oscillate between the fear of missing out and the fear of losing money. That is, after stock prices go up, they’ll become complacent and overly optimistic. After prices go down, they’ll fear losing more money. Over time, I observe investors oscillating between these two fears. Or, you could call it fear and greed. The problem is, they feel the wrong thing and the wrong time. We’ll observe that through empirical evidence of the investment sentiment polls taken by AAII as it happens over time. Sometimes falling prices warrant some fear, and rising prices are a good thing. The point of our observations about the pendulum of sentiment is to show how they feel the wrong thing and the wrong time and most people don’t actually act on it well.
The AAII Investor Sentiment Survey Results as of 8/21/2013 shows investors are bearish.
This week’s AAII Sentiment Survey results:
Bullish: 29.0%, down 5.5 points
Neutral: 28.2%, down 9.1 points
Bearish: 42.9%, up 14.7 points
Long-term averages:
Bullish: 39.0%
Neutral: 30.5%
Bearish: 30.5%
The AAII Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months; individuals are polled from the ranks of the AAII membership on a weekly basis. Only one vote per member is accepted in each weekly voting period. To learn more, visit: AII Investor Sentiment Survey
A hedge fund is really just a structure for running an investment program. It’s a business structure, usually a Limited Partnership, that operates like a business. It’s a “private investment partnership”. Its business is investing or trading. There are several good reasons for operating an investment program in a private investment partnership structure. For example, a global macro manager may have an edge constructing exposure to markets with options. Rather than risking money buying stock or a currency, we may gain a better risk/reward through a vertical spread. Many strategies are difficult to execute across multiple accounts, so they can’t effectively and efficiently be offered as separately managed accounts, so the LP structure is the better choice. And, even though some strategies can be implemented in a mutual fund, a mutual fund is far more expensive to operate and administer to make them available to the general public. So if a manager aims to only offer a strategy to a fewer number of investors, he ends up managing what is commonly called a “hedge fund”. There are all kinds of strategies operated in that format, so it’s really just industry jargon. The term “hedge fund” is just slang for a “private investment partnership that isn’t offered to everyone”. Beyond that, here is a great primer for hedge funds:
In Interest Rates are Trending Up, Bonds Investors Feeling the Pain we looked at the trend in interest rates and bond prices going back 15 years. For a more macro view of just how low interest rates are historically, below we view rates going back to 1962. It shows how low rates have been, but also gives historical precedent as to how high they could go…
source: dshort.com
At lunch someone asked me “How’s the market doing this month?”
Which market? And, why does a month matter?
He probably meant the “stock market” because that’s what people know about, but there are many different markets and we can get long or short any of them.
source: FINVIZ
There are now more than 300 published papers providing evidence of the persistence of price trends (inertia/momentum). We point out the constant flow of new papers adding to the evidence of relative price strength as a market inefficiency (often called a market anomaly by academics). I call it velocity.
We examine the role of shorting, firm size, and time on the profitability of size, value, and momentum strategies. We find that long positions make up almost all of size, 60% of value, and half of momentum profits. Shorting becomes less important for momentum and more important for value as firm size decreases. The value premium decreases with firm size and is weak among the largest stocks. Momentum profits, however, exhibit no reliable relation with size. These effects are robust over 86 years of US equity data and almost 40 years of data across four international equity markets and five asset classes. Variation over time and across markets of these effects is consistent with random chance. We find little evidence that size, value, and momentum returns are significantly affected by changes in trading costs or institutional and hedge fund ownership over time.
They find the momentum premium exists and is stable across all size groups and the entire 86-year period—it was persistent in all four 20-year periods examined, including the most recent two decades that followed the initial publication of the original momentum studies.
First, we view 15 Year Chart of the 10 Year U.S. Treasury Note Yield (interest rate) (Symbol: $TNX). Keep in mind this chart reflects the rate of change in the interest rate, not the price trend. If we define a downtrend as “lower highs, lower lows” the 15 year trend for interest rates has been down. But since 2012, the trend has sharply turned up – though that isn’t the first time.
Next, we zoom in t0 view the magnitude of the interest rate on the 10 Year U.S. Treasury Note Yield since its low a year ago in August 2012. The interest rate on the 10 year treasury has gained 85%. The current yield is about 2.88%.
Next we look at the long term U.S. Treasury Bond Yield – the 30 year. Long terms rates have been in a downtrend the last 15 years, but have recently trended up sharply.
Understanding the implications of a reversal in the trend of interest rates is critical to a global macro fund manager. A large part of my global tactical decisions is identifying direction trend changes. and understanding how markets interact with each other. For example, we can see below how rising rates significantly impact the price value of bonds.
Below, we observe the total return (price trend + interest) of a wide range of different styles of bond ETFs.
Clearly, they have recently been in a downtrend with U.S. Government bonds down the most at -13.65% over the past year.
Finally, we observe some markets and sectors that are very sensitive to changes in interest rates.
Eventually the Federal Reserve will stop their “Quantitative Easing” program of buying bonds. You know how supply and demand works: when demand dries up, price goes down…
According to a new white paper from The Center for Due Diligence “TACTICAL ASSET ALLOCATION & ERISA PLANS: Best Practices for Finding the Right Strategy for Plan Participants“:
Looking for ways to stabilize returns and manage downside risk, the interest in Tactical Asset Allocation (TAA) strategies has increased. This was initially driven by the 2008 financial crisis, where diversification of asset classes did not provide participants with downside protection. Fueled by concerns over a transitioning monetary policy and asset class repricing, today’s equity market valuations, changing interest rate environment and a better understanding of participant risk tolerance has further increased interest in TAA. This trend could impact the rosy projections for target-date funds and the market share held by the dominant providers.
Given today’s investment dynamics – heightened risk for equities as well as bonds – astute investment advisors are increasingly questioning the prudence of modern portfolio theory. The DOL’s recent Tips for ERISA Plan Fiduciaries may also have sparked the desire for more oversight through custom solutions.
While somewhat limited in application, many proprietary target date fund managers already use a tactical overlay. Until now, there was very little guidance for plan fiduciaries to help them understand the different types of core TAA strategies, let alone evaluate the suitability of a particular strategy for their individual plans.
Separating analytically disciplined TAA strategies from high risk “market timing” type strategies, the CFDD’s exclusive white paper on Tactical Asset Allocation & ERISA Plans will become an invaluable resource for plan sponsors, investment advisors and product manufacturers considering TAA strategies. It will also spearhead the need for tactical transparency and accountability.
TAA contemplates dynamic changes based on current conditions. In addition to requiring special skills and being more complex than traditional approaches, TAA managers may have different goals and trigger methodology. Offered in conjunction with the Wagner Law Group – one of the nation’s most prestigious ERISA law firms – the white paper provides a conceptual overview of legal standards, core fiduciary principles and QDIA applications that will benefit both the experienced and those considering tactical strategies for the first time.
In addition to providing the analytic framework for evaluation, the white paper includes a checklist of best practices and key considerations for plan fiduciaries considering TAA strategies. Moving beyond the marketing hype, the white paper empowers plan fiduciaries with the knowledge to understand/evaluate TAA strategies and ask the right questions. It also paints a realistic picture of the rewards, risks and limitations of these wide ranging strategies.
I read The Little Book of Hedge Funds over a weekend. It’s an easy read and an excellent choice if you want to get a good overall understanding of hedge funds and the general industry of hedge fund management, selection, or absolute return strategies in general. It doesn’t get into detailed strategies, but instead a high level overview of the pursuit of asymmetric returns. My favorite part of the book was Anthony’s section on selection of hedge fund portfolio managers and how he defines “pedigree”. As he puts it (pp. 149-150):
“To make a long story short, the investment research and due diligence process is focused on determining or not a manager can: Generate attractive absolute and relative returns. Manage risk. Produce uncorrelated returns, with relatively attractive liquidity. Evolve as market conditions evolve. Perhaps most important, we have to understand how they will behave when the shit hits the fan in market debacles like LTCM, September 11th, the summer of 2002, 2008, the European financial crisis, and so on.”
He goes on to say he breaks the manager selection process into two categories. The first is Pedigree (pp. 150-151):
Pedigree:
“Pedigree is an all-encompassing term we use to assess whether a manager possesses the right experience and skill to execute a particular strategy in a particular market environment. Typically, an investor should strive to find a manager with many years of real “buy-side experience,” that is, the manager should have actually managed a reasonable amount of capital over a reasonable period of time. The exception to this rule is a new, cutting-edge manager who is implementing strategies that may not have existed three years ago. You would be surprised at how many hedge funds fail the basic “experience” test. For instance, if a manager’s only prior experience is that he was a fixed-income salesman, you could undoubtedly find someone with more relevant experience and skills. For whatever reason, a lot of hedge fund investors tend to be drawn like moths to a flame to big-name sell-side guys who come out and launch a new hedge fund. A general rule of thumb: Avoid these guys like the plague as history has shown that they tend to always fail. After all, managing capital for private investors is completely different from running market making/prop trading outfits. Pedigree also includes a manager’s temperament and qualitative judgment. Is he a loose cannon or thoughtful and deliberative? Has he experienced personal and professional setbacks in his career and how has he responded? Has he treated his investor capital with prudence or has he viewed it as a tool to make a name for himself and get rich quick? Answering these questions takes a lot of work. But, if you want to invest with a hedge fund manager you have to be willing to roll up your sleeves and analyze that manager’s pedigree.”
I thought his explanation of pedigree is outstanding. He points out that pedigree is more about a persons actual experience and skill as evidenced by track record rather than the things we would see on a resume like college alumni, GPA, and places they’ve worked. It shows Anthony Scaramucci is the real deal. That is especially true because Anthony himself is a Harvard MBA graduate and began his career at Goldman Sachs before staring his own firm. Getting in and out of Harvard’s MBA program and landing a job at Goldman is an accomplishment, but says nothing about ability to manage money. A portfolio managers pedigree is about executing with an edge and is evidenced by a track record.
The Little Book of Hedge Funds description from Amazon:
Written to provide novice investors, experienced financiers, and financial institutions with the tools and information needed to invest in hedge funds, this book is a must read for anyone with outstanding questions about this key part of the twenty-first century economy.
“The essence of investment management is the management of risks, not the management of returns.”
– Benjamin Graham
The problem is many portfolio managers believe they manage risk through their investment selection. That is, they believe their rotation from one seemingly risky position to another they believe is less risk is a reduction of risk. But, risk is the exposure to the chance of a loss. The exposure is still there. Only the perception has changed: they just believe their risk is less. For example, for the last thirty years, the primary price trend for bonds has been up because interest rates have been falling. If a portfolio manager shifts from stocks to bonds when stocks are falling, bonds were often rising. It appears that trend may be changing. Portfolio managers who have relied on bonds as their safe haven may rotate out of stocks into bonds and then their bonds lose money too. That’s not risk management.
They don’t know in advance if the position they rotate to will actually result in a lower possibility of loss. Prior to 2008, American International Group (AIG) carried the highest rating for an insurance company. What if you rotated to AIG? Or to any of the other banks. Many investors believed those banks were great values as their prices were falling. They just fell more. It has taken them a long time to recover some of their losses. Just like tech and telecom stocks in 2000.
All risks cannot be hedged away if you pursue a gain. If you leave no chance at all for a potential profit, you earn nothing for that certainty. Risk is exposure to an unknown outcome that could result in a loss. If there is no exposure or uncertainty, there is no risk. The only way to manage risk is to increase and decrease the exposure to loss. That means buying and selling or hedging. When you hear someone speaking otherwise, they are not speaking of active risk management. For example, asset allocation and Modern Portfolio Theory is not active risk management. The exposure to loss remains. They just shift their risk to more things. But they can all fall together, as they do in real bear markets.
It’s required to accomplish what the family office Chief Investment Officer said in “What a family office looks for in a hedge fund portfolio manager” when he said:
“I like analogies. And one of the analogies in 2008 brings to me it’s like a sailor setting his course on a sea. He’s got a great sonar system, he’s got great maps and charts and he’s perhaps got a great GPS so he knows exactly where he is. He knows what’s ahead of him in the ocean but his heads down and he’s not seeing these awesomely black storm clouds building up on the horizon are about to come over top of him. Some of those managers we did not stay with. Managers who saw that, who changed course, trimmed their exposure, or sailed to safer territory. One, they survived; they truly preserved capital in difficult times and my benchmark for preserving capital is you had less than a double-digit loss in 08, you get to claim you preserved capital. I’ve heard people who’ve lost as much as 25% of investor capital argue that they preserved capital… but I don’t believe you can claim that. Understanding how a manager managed and was nimble during a period of time it gives me great comfort, a higher level of comfort, on what a manager may do in the next difficult period. So again it’s a it’s a very qualitative sort of trying to come to an understanding of what happened… and then make our best guess what we anticipate may happen next time.”
I made bold the relevant points.
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A theory is a generalized explanation of how things work. For example, I apply a scientific process for quantitative investment research and that quantitative research can either be data-driven or theory-driven. Theory-driven research starts with a theory about how I something works or if a thing will work (or not). For example, we may theorize that buying a stock, ETF, commodity, or currency that is rising over the past six months may continue to rise and result in higher profits than buying securities that are falling. The is a belief in momentum and intertia. At that point, it’s just a theory – a belief. Theories aren’t necessarily true. But if you believe it, it’s probably true for you. A data-driven approach starts with testing all kinds of systems and methods to determine what works and what doesn’t and it doesn’t start with a theory, but instead a study of the data. Most of testing I’ve done was data-driven because I was trying to create a certain result through the process of buying and selling. I really don’t believe I need a good story to back it: if it works it works and proving that mathematically is good enough. As it turns out, doing original research without the biases of beliefs and theories may have been an edge. Of course, we can confirm, prove, or disprove our theories through data studies. People prefer a good story behind a good system. To have that illusion of some firm foundation behind why something works is probably better than not having one. I digress. I was thinking of that as I read over the below paper on options pricing theory. You see, the theories of how options are priced is a theory- a general explanation of why the premium is what it is. Option pricing is one the most researched theories. I thought the following paper titled “Option Pricing Asymmetry” was interesting. It doesn’t surprise me there is some asymmetry in options pricing.
Option Pricing Asymmetry by Dallas Brozik, Marshall University
Introduction:
“Option pricing is one of the most researched areas of finance. Several different option pricing models have been developed, each with its own strengths and weaknesses. One characteristic of these models is that call options and put options are treated as opposites by the pricing model. While such a result might be intuitively appealing, there is no a priori reason to believe that market participants price these contracts in an identical but opposite manner. Option prices reflect the behavior of the market participants, and if there is a significant difference between the behavior of the buyers/sellers of call options and the buyers/sellers of put options, then any option pricing model will need to reflect this difference in the pricing of the different contracts.”
“The markets for call options and put options may be similar, but they are not identical. The pricing models for calls and puts are not mirror images. This lack of symmetry between call and put pricing implies that hypothesized relationships like put/call parity may be inaccurate and that models based on these hypothesized relationships will need to be revisited. One aspect of the difference appears to be that call and put options do not value time in the same way. In addition to any cost of capital assumed by the underlying pricing model, there is an additional time factor that causes the spread between call and put option prices to increase with time. No mechanism is suggested for this difference, but it is there. This is an area for future research.”
The topic of selecting an investment manager is an important one. Many investors, including professional financial planners and advisors admit they have little skill at selecting asset managers. In fact, some admit they do such a poor job at it they don’t even try. But if you understand the value in alternative investment strategies from private equity to absolute return focused investment programs, then you need to know what to look for in an investment manager. These alternative investment strategies are most often offered privately in a private hedge fund format and sometimes offered as a separate managed account (SMA). Whether you are a private individual investor, an allocator for a family office or institution, or a portfolio manager, the video below is an outstanding example of how a sophisticated investor analyzes a money manager. It’s an interview with the Chief Investment Officer of a family office. He explains why a family who sold a large business may be interested in alternative investments or alternative investment strategies rather than conventional public investments and investment programs like mutual funds. His family office has allocated 80% to alternative investment managers (like hedge funds and the Asymmetry Investment Program™). He offers some insight about:
On how they select hedge funds: (begins around 4:07/9:57)
“We are looking for opportunities with managers were we can get comfortable as to their strategy and what will generate returns for them and what the risks might be? We haven’t been very active with emerging or start-up managers. I think a lot of that has to do with where we are in terms of time.
2008 was an awesome and an awful market experience it’s helpful to look at managers who actually were in existence during that period of time to gain some understanding of how they manage their portfolios are the most difficult. Someone doesn’t have a 08 track record is much harder to get a sense of how they’re going to do a difficult markets. 09 was a pretty easy market to make money if you were long.”
How are you evaluating the 2008 period what are you looking at specifically, the drawdown?
“We obviously start with performance but I also want to see exposure in the portfolio. How did the manager navigate those markets? Did he keep his portfolio fully invested in a market environment for his strategy was not allowing it to make money was actually causing losses? Did he trim exposure? When did he put exposure back into the market place? is something that we look at it. It’s really it’s a number of different factors we try and I can understand how the manager managed during that period of time and try to gain some insight on his style. Conviction doesn’t automatically mean that you stay fully invested at all times. Although we certainly saw a number of managers who waited FAR too long to trim their exposure. So, it’s a combination of all those factors we try and consider. But I would say one of the things that are most important to me is trying to follow a managers gross and net exposures during that period trying to understand. That leads to conversations of what the manager was thinking at the time.”
He goes on to say:
“I like analogies. And one of the analogies in 2008 brings to me it’s like a sailor setting his course on a sea. He’s got a great sonar system, he’s got great maps and charts and he’s perhaps got a great GPS so he knows exactly where he is. He knows what’s ahead of him in the ocean but his heads down and he’s not seeing these awesomely black storm clouds building up on the horizon are about to come over top of him. Some of those managers we did not stay with. Managers who saw that, who changed course, trimmed their exposure, or sailed to safer territory. One, they survived; they truly preserved capital in difficult times and my benchmark for preserving capital is you had less than a double-digit loss in 08, you get to claim you preserved capital. I’ve heard people who’ve lost as much is 25% of investor capital argue that they preserved capital… but I don’t believe you can claim that. Understanding how a manager managed and was nimble during a period of time it gives me great comfort, a higher level of comfort, on what a manager may do in the next difficult period. So again it’s a it’s a very qualitative sort of trying to come to an understanding of what happened… and then make our best guess what we anticipate may happen next time.”
I can tell you he’s spot on. Those whose jobs are that of the asset allocator, who allocates capital to investment programs, often rely too much on Modern Portfolio Theory statistics and not enough on looking very closely under the hood. As a quantitative trading system developer and operator, we are focusing on far different things and I can tell you: it’s the things that matter. It’s critical that the investor or allocator take a close look at the downside: how was their drawdown from peak to trough? What were the actual holdings during that time? Like he said: do they stay in the market even when it’s not working for them? Or, do they reduce their exposure to the possibility of loss (risk management) by selling positions or dynamic hedging?
I very much agree with his comments about experience. Today there are many people selling hypothetical backtests who have no real experience executing during difficult conditions. After such a radical waterfall occurred in 2008 – 2009, more investors and professionals have now figured out the state of the market. In a secular bear market, such waterfalls occur and it can happen again. After the fact, many investment professionals have scrambled to come up with solutions and naturally they’ll be attracted to what actually worked in the past: like some forms of Global Tactical Asset Allocation, Trend Following, and other so-called “alternative” investment strategies like we run. We now have new people interested in active portfolio management that seek an absolute return, rather than a relative return. But like he said: they lack the actual experience. You really don’t know how they’ll react in the heat of the battle. But you can be assured of this: back-testing a system is one thing, and executing is another.
Click below to view:
Family Office Management, Investment Management, Hedge Funds, Absolute Returns, Active Risk Management
After a year hiatus, I am pleased to introduce my new blog. My prior site, Asymmetric Investment Returns, had an average readership of over 4,000 a day. ASYMMETRY® Observations is my observations about alternative investment strategies and global trend observations aimed at creating asymmetric returns; more of the profits we want, less of the downside we prefer to avoid. http://www.AsymmetryObservations.com
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