The week in review shows some shifts

Much of the observations I shared last week are continuing to be more apparent this week.  So, in case you missed it, this may be a good time to read them.

Earnings season is tricky for momentum growth stocks

I discussed how earnings season can drive a volatility expansion in stocks, especially high growth momentum stocks. The stock market leaders can become priced for perfection, so we never know how investors will react to their earnings reports. To achieve asymmetric returns from momentum stocks, we need a higher magnitude of positive reactions than adverse reactions over time. On a quarterly basis, it can be tricky. The gains and losses as much as 20% or more in the most leading momentum stocks like Facebook ($FB), Google ($GOOGL), Twitter ($TWTR), Grub ($GRUB), and NetFlix ($NFLX) have since provided a few examples.

Front-running S&P 500 Resistance

In Front-running S&P 500 Resistance I shared an observation that many market technicians incorrectly say support and resistance appear before it actually does. We won’t know if resistance to a price breakout exists until the price actually does pause and reverse. I suggested the S&P 500 may indeed pause and reverse, but not because the index drives the 500 stocks in it, but instead because my momentum indicators suggested the $SPY was reaching a short-term overbought range “So, a pause or reversal, at least some, temporarily, would be reasonable.” As of today, the S&P 500 has paused and reversed a little. We’ll see if it turns down or reserves back up to continue an uptrend.

Asymmetry of Loss: Why Manage Risk?

asymmetry of loss losses asymmetric exponential

In Asymmetry of Loss: Why Manage Risk? I showed a simple table of how losses compound exponentially. When losses become greater than -20%, it becomes more exponential as the gains required to recover the loss are more and more asymmetric.  This simple concept is essential and a cornerstone to understanding portfolio risk management. Buy and hold type passive investors who hold a fixed allocation of stocks and bonds are always fully exposed to market risk. When the market falls and they lose -20%, -30%, -50% or more of their capital, they then face hoping (and needing) the market to go back up 25%, 43%, or 100% or more just to get back to where they were. This can take years of valuable time. Or, it could take a lifetime, or longer. Just because the markets have rebounded after being down for four or five years from their prior highs doesn’t guarantee they will next time. Past performance is no guarantee of future results.

Trend following applied to stocks

In Trend following applied to stocks, the message was short and sweet: gains are produced by being invested in stocks or markets that are trending up and losses are created by stocks trending against us. Investors prefer to be in rising stocks and out of falling stocks. But, as I showed in Earnings season is tricky for momentum growth stocks the trick is giving the big trends enough room to unfold. In fact, applying trend following and momentum methods to stocks is also tricky. It’s a skill that goes beyond just looking at a chart and it’s not just a quantitative model.

Stock market investor optimism rises above the historical average

About two weeks ago,  the measures of investor sentiment showed a lot of optimism about future stocks prices, so we shouldn’t have been surprised to see some stocks fall. When a lot of enthusiasm is already priced in, investors can respond with disappointment when their stocks don’t live up to high expectations.

Much of the momentum and trend following in stocks is driven by an overreaction to the upside that can be accompanied by an overreaction to the downside. A robust portfolio management system factors these things in.

 

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

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

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

Asymmetry of Loss: Why Manage Risk?

“The essence of portfolio management is the management of risks, not the management of returns.” —Benjamin Graham

Why actively manage investment risk?

Why not just buy and hold markets and ride through their large drawdowns?

Losses are asymmetric and loss compounds exponentially.

The larger the loss, the more gain is required to recover the loss to get back to breakeven.

The negative asymmetry of loss starts quickly, losses more than -20% decline start to compound against you exponentially and with a greater magnitude the larger the loss is allowed to grow.

If your investment portfolio experiences a -20% loss, it needs a 25% gain to get back the breakeven value it was before the loss.

asymmetry of loss losses asymmetric exponential

At the -30% loss level, you need a 43% gain to get it back.

Diversification is often used as an attempt to manage risk by allocating capital across different markets and assets.

Diversification and asset allocation alone doesn’t achieve the kind of risk management needed to avoid these large declines in value. Global markets can fall together, providing no protection from loss.

For example, global markets all fell during the last two bear markets 2000-2003 and 2007-2009.

global asset allocation diversification failed 2008

It didn’t matter if you had a global allocation portfolio diversified between U.S. stocks, international stocks, commodities, and real estate REITs.

Diversification can fail when you need it most, so there is a regulatory disclosure required: Diversification does not assure a profit or protect against loss.

This is why active risk management to limit downside loss is essential for investment management.

I actively manage loss by knowing the absolute point I’ll exit each individual position and managing my risk level at the portfolio level.

Active risk management, as I use it, applies tactics and systems to actively and dynamically decrease or increase exposure to the potential for loss.

My risk management systems are asymmetric risk management systems. Asymmetric risk management intends to manage risk with the objective of a positive asymmetric risk/reward.

My asymmetric risk management systems are designed to cut losses short, but also protects and manages positions with a profit.

After markets trend up for a while without any significant interruption, investors may become complacent and forget the large damage losses can cause to their capital and their confidence. When investors lose confidence in the markets, they tap-out when their losses are allowed to grow to large.

I prefer to stop the loss before it gets too large. How much is too large depends on the client, but also the math. As seen here, I have a mathematical basis for believing I should actively manage investment risk.

It’s why I’ve been doing it for two decades. Because I understood the math, I knew I had to do it over twenty years ago and developed the systems and tactics that proved to be robust in the devastating bear markets I’ve executed through since then.

 

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

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

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

Trend following applied to stocks

A stock must be in a positive trend to earn a huge gain…

A stock must be in a downtrend to produce a large loss…

The common factor? the direction of the trend…

That’s what investors like about the concept of trend following.

We want to have capital in trends that are rising and out of trends that are falling.

 

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

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

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

 

 

 

Stock market investor optimism rises above historical average

“Optimism among individual investors about the short-term direction of the stock market rebounded, rising above its historical average.”

AAII Investor Sentiment Survey

The AAII Investor Sentiment Survey is a widely followed measure of the mood of individual investors. The weekly survey results are published in financial publications including Barron’s and Bloomberg and are widely followed by market strategists, investment newsletter writers, and other financial professionals.

It is my observation that investor sentiment is trend following.

Investor sentiment reaches an extreme after a price trend has made a big move.  After the stock market reaches a new high, the media is talking about and writing about the new high, which helps to drive up optimism for higher highs.

When they get high, they believe they are going higher.

At the highest high they are at their high point — euphoria.

No, I’m not talking about cannabis stocks, I’m just talking about the stock market. Cannabis stocks are a whole different kind of high and sentiment.

A few years ago, I would have never dreamed of making a joke of cannabis stocks or writing the word marijuana on a public website. Who had ever thought there would be such a thing? But here I am, laughing out loud (without any help from cannabis).

Back to investor sentiment…

Excessive investor sentiment is trend following – it just follows the price trend.

Investor sentiment can also be a useful contrarian indicator to signal a trend is near its end. As such, it can be helpful to investors who tend to experience emotions after big price moves up or down.

  • Investor sentiment can be a reminder to check yourself before you wreck yourself.
  • Investor sentiment can be a reminder to a portfolio manager like myself to be sure our risk levels are where we want them to be.

Although… rising investor optimism in its early stages can be a driver of future price gains.

Falling optimism and rising pessimism can drive prices down.

So, I believe investor sentiment is both a driver of price trends, but their measures like investor sentiment polls are trend following.

For example, below I charted the S&P 500 stock index along with bullish investor sentiment. We can see the recent spike up to 43% optimistic investors naturally followed the recent rise in the stock price trend. investor sentiment July 2018

However, in January we observed something interesting. Investor sentiment increased sharply above its historical average in December and peaked as the stock market continued to trend up.

Afterward, the stock market dropped sharply and quickly, down around -12% very fast.

Maybe the investor sentiment survey indicated those who wanted to buy stocks had already bought, so there wasn’t a lot of capital left for new buying demand to keep the price momentum going.

The S&P 500 is still about -2.4% from it’s January high, so this has been a non-trending range-bound stock market trend for index investors in 2018. The Dow Jones Industrial Average was last years more gaining index and it is still -6% from its high.

stock market 2018 level and drawdown

The stock index will need some buying enthusiasm to reach its prior high.  We’ll see if the recent increase in optimism above its historical average is enough to drive stocks to new highs, or if it’s a signal of exhaustion.

Only time will tell…

I determine my asymmetric risk/reward by focusing on the individual risk/reward in each of my positions and exposure across the portolio. For me, it’s always been about the individual positions and what they are doing.

 

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

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

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

 

Is the economy, stupid?

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

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

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

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

For example, someone recently said:

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

That is far from the truth…

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

The most recent recession:

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

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

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

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

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

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

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

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

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

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

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

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

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

Global Market Trends

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

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

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

Only time will tell how it all plays out.

 

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

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

What’s going to happen next? continued

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

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

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

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

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

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

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

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

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

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

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

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

S&P 500 STOCKS BULLISH PERCENT ABOVE MOVING AVERAGE

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

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

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

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

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

Guess what mean reversion is?

About halfway…

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

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

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

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

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

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

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

 

What’s going to happen next?

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

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

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

 

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

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

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

Apparently there was more enthusiasm to sell

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

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

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

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

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

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

 

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

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

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

 

 

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

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

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

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

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

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

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

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

 

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

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

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

 

Asymmetric force was with the buyers

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

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

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

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

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

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

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

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

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

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

Asymmetric force direction and size determines trend

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

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

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

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

There are two kinds of forces:

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

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

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

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

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

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

 

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

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

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

 

 

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

 

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

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

Looking inside the Sector for the Leading Stocks 

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

 

In the final stages of a bull market

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

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

spy spx trend

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

 

spy eem stock market

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

spy 2011 decline

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

spy spx 2007 stock market top

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

stock market top 1999

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

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

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

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

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

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

 

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

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

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

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

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

Watch:

 

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

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

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

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

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

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

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

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

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

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

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

George Santayana

 

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

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

All Eyes are Now on the Potential Government Shutdown

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

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

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

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

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

 

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

Black Monday: Huge Losses a Reminder of Risk

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

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

 

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

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

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

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

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

Let’s remember this one.

And more recently, this one.

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

 

 

What do wealthy people do differently?

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

“What do wealthy people do differently?”

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

First, let’s define “wealthy”.

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

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

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

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

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

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

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

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

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

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

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

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

Resolving Conflicts with Relative Strength

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

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

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

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

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

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

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

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

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

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

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

It gets more interesting. According to The Physics Classroom:

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

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

We have discovered two different beliefs.

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

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

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

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

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

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

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

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

When I see the chart below, I think:

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

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

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

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

Relative Strength can be a source of conflict for Tactical Traders

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

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

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

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

 

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

No, wait.

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

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

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

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

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

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

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

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

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

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

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

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

Stay tuned.

Read Part 2: Resolving Conflicts with Relative Strength

VIX Trends Up 9th Biggest 1-day Move

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

VIX biggest moves

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

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

Here is what it looked like.

VIX 9th biggest one day move

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

Stock market down Korea

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

FANG stocks downSource: Google Finance

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

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

Is this the Inflection Point for Stocks?

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

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

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

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

The weight of the evidence seems to suggest defense.

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

average age of bull market top

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

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

Small Cap

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

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

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

Bullish Percent

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

GDP Slows to Weakest Growth in Three Years

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

The New York Times says:

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

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

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

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

The Takeaway

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

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

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

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

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

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

We’ll see.

How Future Losses Erase Prior Gains

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

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

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

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

Open profits aren’t yet realized.

Open profits may never be realized.

Open profits may be evaporated by later losses.

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

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

Only in hindsight do we know what happened next.

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

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

That is, losses compound more exponential than gains.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

– George Santayana

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

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

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

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

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

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

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

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

On Sheep, Wolves and Sheepdogs

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

on-sheep-wolves-and-sheepdogs

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

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

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

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

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

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

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

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

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

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

The gift of aggression

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Reflections on the Revolution in France

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

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

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

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

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

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

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

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

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

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

– Brigadier General Chuck Yeager
Yeager, An Autobiography

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

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

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

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

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

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

Asymmetric Volatility Phenomenon

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

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

We observe asymmetric volatility in equity markets, too.

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

asymmetric-volatility-phenomenon

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

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

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

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

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

Here is an example you may remember.

stock-market-crash-2008

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

That’s the very move you want to avoid.

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

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

It wasn’t just 2008.

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

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

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

stock-market-bear

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

2009-stock-market-decline

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

They are the same people who will experience it again.

Investors feel and do the wrong thing at the wrong time…

Investors feel and do the wrong thing at the wrong time…

Many studies show that investors have poor results over the long haul including both bull and bear markets. For example, DALBAR has been conducting their annual Quantitative Analysis Of Investor Behavior study for 22 years now.

DALBAR’s Quantitative Analysis of Investor Behavior (QAIB) has been measuring the effects of investor decisions to buy, sell and switch into and out of mutual funds over both short and long-term time frames. The results consistently show that the average investor earns less – in many cases, much less – than mutual fund performance reports would suggest.

Their goal of QAIB is to improve investor performance by pointing out the factors that influence behaviors that determine the outcome of investment or savings strategies. They conclude individuals have poor results for two primary reasons:

  1. Lack of capital investment.
  2. Investor Psychology.

If someone doesn’t save and invest some of their money, they’ll never have a chance to have good long-term results. However, they find the biggest reason for poor results by investors who do invest in the markets over time is investor psychology. Investors tend to do the wrong thing at the wrong time, especially at market extremes.

The chart below illustrates how investors tend to let their emotions lead them astray. The typical “bull market” for stocks may last four or five years. After investors keep hearing of rising market prices and headlines of “new highs” they want to invest more and more – they become euphoric. The may get more “aggressive”. However, those gains are in the past. Market trends are a good thing, but they can move to an extreme high (or low) and then reverse. Investors feel euphoria just as the stock market is getting “overvalued” at the end of a market cycle.

Look at that chart: what big trend do you think happens next? 

do-your-emotions-lead-you-astraySource: Investing and Emotions

On the downside, investors panic after large losses. There are many ways that investors get caught in this loss trap. For example, some are told to “stay in the market” so they hold on beyond their uncle point and then tap out. After they sell at much lower prices, they are too afraid to “get back in.”  They are “Panic-Stricken.” They don’t discover the actual risk of their passive asset allocation until it’s too late and their losses are larger than they expected.

Investors need to know their real tolerance for loss before the loss happens. Then, they need to invest in a program that offers a matching level of risk management, so they don’t lose so much they tap out and lock in significant losses. If they reach their uncle point and tap out, they have an even more difficult challenge to get back on track.

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

The chart above shows twenty-one years of the historical return of the S&P 500 stock index. Look at the graph above to see the points this happens. It shows an idealized example of investor emotions as prices trend up and down. As prices trend up, investors initially feel cautious, then hopeful, encouraged, positive, and as prices move higher and higher, they feel confident and thrilled to the point of euphoric. That’s when they want to get “more aggressive” when they should be doing the opposite. The worst investors actually do get more aggressive as they become euphoric at new highs, and then they get caught in those “more aggressive” holdings as the markets decline -20%, -30%, -40%, or more than -50%.

After such investment losses investors first feel surprised, then as their losses mount they feel nervous, then worried, then panic-stricken. But this doesn’t happen so quickly. You see, larger market declines often take a year or two to play out. The most significant declines don’t fall in just a few months then recover. The significant declines we point out above are -50% declines that took 3 – 5 years or more to get back to where they started. So, they are made up of many swings up and down along the way. If you look close at the chart, you’ll see those swings. It’s a long process – not an event. So few investors notice what is happening until it’s well in the past. They are watching the daily moves (the leaf on a tree) rather than the bigger picture (the forest).

So, investors get caught in a loss trap because the swings along the way lead them astray.  Their emotions make them oscillate between the fear missing out and the fear of losing money and that’s why investors have poor results over a full market cycle. A full market cycle includes a major peak like the Euphoric points on the chart and major lows like the Panic-Stricken points. Some investors make their mistakes by getting euphoric at the tops, and others make them by holding on to falling positions too long and then panicking after the losses are too large for them.

At Shell Capital, I manage an investment program that intends to avoid these mistakes. I prefer to avoid the massive losses, so I don’t have panicked investors. And, we don’t have to dig out of large holes. That also necessarily means we don’t want to get euphoric at the tops. I want to do the opposite of what DALBAR finds most people do. To do that, I must necessarily be believing and doing things different than most people – a requirement for good long term results. But, creating exceptional investment performance over an extended period of ten years or more isn’t enough. We also have to help our investor clients avoid the same mistakes most people make. You see, if I am doing things very differently than most people, then I’m also doing it at nearly the opposite of what they feel should be done. Our investors have to be able to deal with that, too.

If you are like-minded, believe what we believe, and want investment managementcontact us. This is not investment advice. If you need individualized advice, please contact us  

 

Source for the chart: BlackRock; Informa Investment Solutions. Emotions are hypothetical and for illustrative purposes only. The S&P 500 Index is an unmanaged index that consists of the common stock of 500 large-capitalization companies, within various industrial sectors, most of which are listed on the New York Stock Exchange. Returns assume reinvestment of dividends. It is not possible to invest directly in an index. Past performance is no guarantee of future results. The information provided is for illustrative purposes only.

Investors Were Indeed Complacent…

A month ago I wrote “What is the VIX Suggesting about Investor Complacency and Future Volatility?” suggesting that options traders are paying low premiums for options because they are not so fearful of future volatility and lower stock prices. I pointed out that:

We could also say “investors are complacent” since they aren’t expecting future volatility to increase or be higher.

These levels of complacency often precede falling stock markets and then rising volatility. When stock prices fall, volatility spikes up as investors suddenly react to their losses in value

We shouldn’t be surprised to see at least some short-term trend reversals; maybe stocks trend down and the VIX® trends up…

A month later, the VIX® has gained 50% and 40% in a single day yesterday as the S&P 500 dropped -2.4%.

vix-september-2016

Ten days ago I also wrote “September Worst Month for Stocks?” pointing out the historic expected return for U.S. stocks in the month of September. I showed a chart that illustrates the mathematical expectation for the expected return for each month based on the past 66 years. Since 1950, the month of September has historically been the worst month for stocks.

You can probably see how the weight of the evidence of multiple factors paints a picture of the current market state. We could add that this is a very, very, aged and overvalued bull market. The normalized P/E is 26.7—well above the level justified by low inflation and interest rates. The current status remains “significantly overvalued.” 

Investors should actively manage their downside risk and prepare for continued swings in market trends. 

If you are like-minded, believe what we believe, and want investment managementcontact us. This is not investment advice. If you need individualized advice please contact us  or your advisor. Please see Terms and Conditions for additional disclosures.

September Worst Month for Stocks?

“October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.” – Mark Twain

I’m not a fan of “seasonality” for use with tactical decisions… but if when it’s considered along with other issues like investor complacency and an overvalued stock market it can be more interesting.

Seasonality is a characteristic in the data experiences regular changes that seem to recur every calendar year. Any change or pattern in a time series that recurs or repeats over a one-year period can be said to be “seasonal”.

I don’t expect these seasonal patterns to always play out. However, the average gain or loss over a 66 year period can be statistically significant. It’s just not a “sure thing” – but nothing ever is. The fact is, the chart below does illustrate the mathematical expectation for the expected return for each month based on the past 66 years. If the average return for a month is down nearly -1%, then that is the expectation. But it’s based on the “average” of the sample size; it says nothing about the probability or magnitude of outliers. The bottom line is: it will not always play out this way because the probability of an event is the measure of the chance that the event will occur.

Since 1950, U.S. stocks are often weak May to October and then a counter-trend rise occurs in July.

Then comes September…

Chart of the Day shows worst calendar month for stock market performance over the past 66 years has been September…

We’ll see…

September Stock Market

Source: http://www.chartoftheday.com/20160831.htm?H

If you are like-minded, believe what we believe, and want investment management,contact us. This is not investment advice. If you need individualized advice please contact us  or your advisor. Please see Terms and Conditions for additional disclosures.

What is the VIX Suggesting about Investor Complacency and Future Volatility?

The CBOE Volatility Index® (VIX® Index®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, theVIX® Index has been considered by many to be the world’s premier barometer of investor sentiment and market volatility.

The VIX® historically trends between a long-term range. An extreme level of the VIX® will likely reverse … eventually. The chart below we show the price level of the VIX® since its inception in 1993. We can visually observe its long-term average is around 20, but (I highlighted in red) its low range is around 12 and it has historically spiked as high as 25 or 60.

VIX Since its introduction in 1993, the VIX Index has been considered by many to be the world's premier barometer of investor sentiment and market volatility

The CBOE Volatility Index®  is an index that cannot be invested in directly, however, there are futures, options, and ETN’s that attempt to track it. Its level is commonly used as a gauge of investor sentiment. An extremely high level of the VIX® means that options traders are paying high premiums for options because they are fearful of future volatility and maybe lower stock prices. Options traders and investors are buying options to hedge their portfolios and their demand drives up the “insurance premium”.

Just the opposite is the driver of an extremely low level of the VIX® like we see today. It means that options traders are paying low premiums for options because they are not so fearful of future volatility and lower stock prices. They are unlikely buying options for hedging and their low demand drives down the “insurance premium”. We could also say “investors are complacent” since they aren’t expecting future volatility to increase or be higher.

These levels of complacency often precede falling stock markets and then rising volatility. When stock prices fall, volatility spikes up as investors suddenly react to their losses in value. Or, in the short term volatility could trend even lower and reach an even more extreme low level for a while. But the VIX® isn’t an index that trends for many years in one direction. Instead, as we see in the above chart, the VIX® oscillates between a low and high range so can expect it to eventually trend the other way.

We shouldn’t be surprised to see at least some short-term trend reversals; maybe stocks trend down and the VIX® trends up…

We’ll see…

There is much more to the VIX® , such as it’s term structure, but the scope of this article is to point out its extreme low level could be an indication of future change.

If you are like-minded, believe what we believe, and want investment management, contact us. This is not investment advice. If you need individualized advice please contact us  or your advisor. Please see Terms and Conditions for additional disclosures.

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

– William J. Bennett

In a lecture to the United States Naval Academy

November 24, 1997

Source: http://www.killology.com/sheep_dog.htm

 

Essence of Portfolio Management

Essence of Portfolio Management

“The essence of investment management is the management of risks, not the management of returns. Well-managed portfolios start with this precept.”

– 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 in risk. But, the 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 would often be rising. It appears that trend may be changing at some point. 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 result in a lower possibility of loss. Before 2008, American International Group (AIG) carried the highest rating for an insurance company. What if they rotated to AIG? Or to any of the other banks? Many investors believed those banks were great values as their prices were falling. They instead fell even 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 profit. If you leave no chance at all for a potential profit, you earn nothing for that certainty. The 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 the possibility of loss. That means buying and selling (or hedging).  When you hear someone speaking otherwise, they are not talking 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. Those markets 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 parts I think are essential.

If you are like-minded and believe what we believe, contact us.

Investor Optimism Seems Excessive Again

When someone asks me why I hold so much cash or against a market decline, it always corresponds to extreme optimism readings in the most basic investor sentiment indicators. Investors have poor long-term results because they feel the wrong feeling at the wrong time. They feel optimistic after price gains just before they decline. They fear more losses after they hold on to losing trends, and their losses get large.

After the stock market declined and then reversed back up to make headlines investor sentiment has reached the level of “Extreme Greed” once again. I don’t use the CNN Fear & Greed Index as a trading signal as my systems focus on other things, but I think it’s a publically available source that is useful to help investors avoid feeling the wrong feeling at the wrong time.  For example, the CNN Fear & Greed Index uses eight indicators of investor sentiment to determine Fear or Greed. The reading oscillates between Extreme Fear, Fear, Neutral, Greed, and Extreme Greed. If you feel optimistic about future prices and the reading is at Extreme Greed, you are probably wrong. If you feel fearful about future prices and the reading is at Extreme Fear, you are probably wrong. You see, most investors feel the wrong feeling at the wrong time.

As you see below, it has reached the “Extreme Greed” point, and that often signals high risk and eventually precedes at least a short-term trend reversal.

CNN Fear Greed Index

Source: CNN Fear & Greed Index

 

Below is a chart of the past 3 or so years of the Fear & Greed reading. As you see, the levels of fear and greed do indeed oscillate from one extreme to the other over time. I think we observe these readings indicate the wrong feeling at the wrong time.

Fear and Greed over time investor sentiment

Source: CNN Fear & Greed Index

The most obvious extreme level is the extremely low level of expected future volatility. Maybe they are right, but when the VIX Volatility Index reaches such as extreme low it often signals at least a short-term stock market peak that reverses down.

VIX Volatility Index.jpg

I like directional trends, but I also believe they sometimes reach extremes at a point and then reverse.

We’ll see how this one unfolds in the weeks and months ahead…

You can probably see why it’s prudent to actively manage risk and hedge at certain extremes.

To learn more, contact us.

Situational Awareness

Chuck Yeager was a famous test pilot and the first man to fly faster than the speed of sound. He understood the risk, so he was prepared.

Chuck Yeager

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

– Brigadier General Chuck Yeager
Yeager, An Autobiography

Image source: http://www.chuckyeager.com/

 

What in the World is Going on?

The trend has changed for U.S. stocks since I shared my last observation. On January 27th I pointed out in The U.S. Stock Market Trend that the directional trend for the popular S&P 500®  U.S. large cap stock index was still up, though it declined more than -10% twice over the past year. At that point, it had made a slightly lower high but held a higher low. Since then,  theS&P 500® declined to a lower low.

First, let’s clearly define a trend in simple terms. A trend is following a general course of direction. Trend is a direction that something is moving, developing, evolving, or changing. A trend is a directional drift, one way or another. I like to call them directional trends. There is an infinite number of trends depending on the time frame. If you watch market movements daily you would probably respond to each day’s gain or loss thinking the trend was up or down based on what it just did that day. The professional traders who execute my trades for me probably consider every second a trend because they want to execute the buy or sell at the best price. As a tactical position trader, I look at multiple time frames from months to years rather than seconds or a single day.  So, trends can be up over one time frame and down over another.

As we observe the direction of  “the trend”, let’s consider the most basic definitions over some specific time frame.

  • Higher highs and higher lows is an uptrend.
  • Lower lows and lower highs is a downtrend.
  • If there is no meaningful price break above or below those prior levels, it’s non-trending.

Below is the past year of the S&P 500® stock index, widely regarded as a representation of large cap stocks. Notice the key pivot points. The top of the price trend is lower highs. The bottom of the range is lower lows. That is a “downtrend” over the past year. It could break above the lower highs and hold above that level and shift to an uptrend, but for now, it is a downtrend. It could also keep swinging up and down within this range as it has the past year, or it could break down below the prior low. At this moment, it’s a downtrend. And, it’s a downtrend occurring after a 7-year uptrend that began March 2009, so we are observing this in the 7th year of a very aged bull market. As I said in The REAL Length of the Average Bull Market, the average bull market lasts around 4 years. This one was helped by unprecedented government intervention and  is nearly double that length.

stock market downtrend

Another interesting observation is the trend of small and mid-size company stocks. In the next chart, we add small and mid-size company stock indexes. As you see, they are both leading on the downside. Small and mid-size company stocks have made even more pronounced lower highs and lower lows. Market trends don’t always play out like a textbook, but this time, it is. For those who want a story behind it, small and mid-size company stocks are expected to fall first and fall more in a declining market because smaller companies are considered riskier. On the other hand, they are expected to trend up faster and stronger since a smaller company should reflect new growth sooner than a larger company. It doesn’t always play out that way, but over the past year, the smaller companies have declined more. Large companies could catch up with them if the declining trend continues.

small and mid cap underperformance relative strength momentum

What about International stocks? Below I included International indexes of developed countries (EFA) with exposure to a broad range of companies in Europe, Australia, Asia, and the Far East. I also added the emerging markets index (EEM) that is exposure to countries considered to be “emerging” like China, Brazil, and India. Just as small U.S. stocks have declined more than mid-sized and mid-sized have declined more than large companies, emerging markets and developed International countries have declined even more than all of them.

global market trends

What in the world is going on?

Well, within U.S. and International stocks, the general trends have been down. This could change at any time, but for now, it is what it is.

You can probably see why I think actively managing risk is so important. 

 

This is not investment advice. If you need individualized advice please contact us or your advisor. Please see Terms and Conditions for additional disclosures. 

Risk comes from not knowing what you are doing so wide diversification is only required when investors are ignorant.”  – Warren Buffett

 

quote-risk-comes-from-not-knowing-what-you-are-doing-so-wide-diversification-is-only-required-warren-buffett-125-94-63

Sourcce: http://www.azquotes.com/quote/1259463

 

 

Extreme Fear is Now Driving Markets

On October 27th I wrote in Fear and Greed is Shifting and Models Don’t Avoid the Feelings that:

The CNN Fear & Greed Index shows investor fear and greed shifted to Extreme Fear a month ago as the popular U.S. stock indexes dropped about -12% or more. Many sectors and other markets were worse. Since then, as prices have been trending back up, Greed is now the driver again. I believe fear and greed both drives market prices but also follows price trends. As prices move lower and lower, investors who are losing money get more and more afraid of losing more. As prices move higher and higher, investors get more and more greedy. If they have reduced exposure to avoid loss, they may fear missing out.

Since global markets declined around August and some markets recovered much of their losses by November, global markets have declined again. Below are charts of U.S. stocks, International stocks, U.S. bonds, and commodities. Even the iShares iBoxx $ Investment Grade Corporate Bond ETF that seeks to track the investment results of an index composed of U.S. investment grade corporate bonds is near -8% from its peak. Small and mid companies U.S. stocks are down more than -20% from their peak. Commodities and emerging countries are down the most.

global markets 2016-01-15_13-59-45.jpg

This all started with investors being optimistic in late October as I mentioned in Fear and Greed is Shifting and Models Don’t Avoid the Feelings. So, it is no surprise that today is just the opposite. As markets have declined investors become more and more fearful. As of now, Extreme Fear is the driver of the market.  Below is the current reading of the CNN Fear & Greed Index.

Fear and Greed Index

Source: CNN Fear & Greed Index 

As you see in the chart below, it’s now getting close to the Extreme Fear levels that often signal at least a short-term low.

Fear and Greed Over Time

Another publicly available measure of investor sentiment is the AAII Investor Sentiment Survey. 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. The most recent weekly survey shows investors are very bearish and again, such pessimism occurs after price declines and at such extremes sometimes precedes a reversal back up.

Survey Results for Week Ending 1/13/2016

AAII Investor Sentiment January 2016

Source: AAII Investor Sentiment Survey

I say again what I said in October: This is the challenge in bear markets. In a bear market, market prices swing up and down along the way. It’s these swings that lead to mistakes. Above was a chart of how the Fear and Greed Index oscillates to high and low points over time. Investors who experience these extremes in emotion have the most trouble and need to modify their behavior so they feel the right feeling at the right time. Or, hire a manager with a real track record who can do it for them and go do something more enjoyable.

The Stock Market Trend: What’s in Your Boat?

The stock market trend as measured by the S&P 500 stock index (the black line) has had a difficult time making any gains in 2015. SPY in the chart below is the SPDR S&P 500 ETF seeks to track the investment results of an index composed of large-capitalization U.S. equities. It’s the stock index most people talk about.

But, what is more interesting is the smaller companies are even worse.

The red line is the iShares Russell 2000 ETF (IWM), which seeks to track the investment results of an index composed of small-capitalization U.S. equities.

The blue line is the iShares Micro-Cap ETF (IWC), which seeks to track the investment results of an index composed of micro-capitalization U.S. equities. This index provides exposure to very small public U.S. companies.

Small Cap Laggards

Clearly, smaller companies are having an even more difficult time attracting enough demand to create a positive trend lately. This may be the result of a very aged bull market in U.S. stocks. It could be the very early stages of a change in the longer term direction.

We’ll see…

I don’t worry about what I can’t control. I instead focus only on what I can control. My focus is on my own individual positions risk/reward. I defined my risk/reward.  If I want to make a profit I have to take some risk. I decide when to take a risk and when to increase and decrease the possibility of a loss.

Successful investment managers focus less on what’s “outside their boat” and focus on what’s “inside their boat.”

The markets always go back up?

Someone recently said: “the markets always go back up!”.

I replied: “Tell that to the Japanese”.

The chart below speaks for itself. Japan was the leading country up until 1990. The NIKKEI 225, the Japanese stock market index, has been in a “Secular Bear Market” for about 25 years now. I believe all markets require active risk management. I suggest avoiding any strategy that requires a market “always go back up” because it is possible that it may not. Or, it may not in your lifetime

Long Term Japan Stock Market Index NIKKEI

Source: http://www.tradingeconomics.com/japan/stock-market

PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS. Investing involves risk a client must be willing to bear.

Actively Managing Investment Risk

The global market declines in early August offered a fine example of the kind of conditions that cause me to exit my long positions and end up in cash. For me, this is a normal part of my process. I predefine my risk in each position, so I know my risk across the portfolio. For example, I know at what point I’ll sell each position if it falls below a certain point in which I would consider it a negative trend. Since I know my exit in advance for each position, I knew in advance how much I would lose in the portfolio if all of those exits were reached due to market price movements trending against me. That allowed me to control how much my portfolio would lose from its prior peak by limiting it to my predefined amount. I have to take ‘some’ risk in order to have a chance for profits. If I took no risk at all, there could be no profit. The key for me is to take my risk when the reward to risk is asymmetric. That is, when the probability for a gain is much higher than the probability for a loss.

The concept seems simple, but actually doing it isn’t. All of it is probabilistic, never a sure thing.  For example, prices sometimes move beyond the exit point, so a risk control system has to account for that possibility.  More importantly, the portfolio manager has to be able to actually do it. I am a trigger puller. To see the results of over 10 years of my actually doing this, you can visit ASYMMETRY® Managed Accounts.

 

 

The Trend of the U.S. Stock Market

When I say “The Trend” that could mean an infinite number of “trends“. The general definition of “trend” is a general tendency or course of events.

But when I speak of “The Trend” I mean a direction that something is moving, developing, evolving, or changing. A trend, to me, is a directional drift, one way or another. When I speak of price trends, I mean the directional drift of a price trend that can be up, down, or sideways.

Many investors are probably wondering about the current trend of the U.S. stock market. So, I will share a quick observation since one of the most popular U.S. stock indexes seems to be right at a potential turning point.

Below is a 6 month price chart of the S&P 500 stock index. The S&P 500® is widely regarded as a gauge of large-cap U.S. equities. Clearly, prior to late August the stock index was drifting sideways. It was oscillating up and down in a range of 3% to 4% swings, but overall it wasn’t making material higher highs or lower lows. That is, until late August when it dropped about -12% below its prior high. Now, we see with today’s action the stock index is attempting reach or breach it’s very recent peak reached on August 27th. If the index moves above this level, we may consider it a short-term uptrend. We can already observe the index has made a higher low.

S&P 500 stock trend

Source: Shell Capital Management, LLC created with http://www.stockcharts.com

You can probably see how the next swing will determine the direction of the trend. If it breaks to the upside, it will be an uptrend as defined by “higher highs and higher lows”. Although, that is a very short-term trend, since it will happen within a more intermediate downtrend.

My point is to observe how trends drift and unfold over time, not to predict which way they will go, but instead to understand and define the direction of “the trend”. And, there are many different time frames we can consider.

If this trend keeps going up, supply and demand will determine for how long and how far. If it keeps drifting up, I would expect it may keep going up until some inertia changes it. Inertia is the resistance to change, including a resistance to change in direction.

But if it instead goes back down to a new low, I bet we’ll see some panic selling driving it even lower.

The real challenge of directional price trends is if this is the early stage of a larger downward trend (like a bear market), there will be many swings along the way. In the last bear market, there were 13 swings that ranged from 10% to 27% as this stock index took about 18 months to decline -56%.

Below is the same stock index charted with a percentage chart to better show the percent changes over the past 6 months. You can probably see how it gives a little different perspective.

S&P 500 stock index percent chart average length of bear markets

Source: Shell Capital Management, LLC created with http://www.stockcharts.com

I don’t necessarily make my tactical decisions based on any of this. I enjoy watching it all unfold and I necessarily need to define the trend and understand it as it all plays out. I want to know what the direction of the trend is based on my time frame, and know when that changes.

I believe world markets require active risk management and defining directional trends. For me, that means predefining my risk in advance in each position and across the portfolio.

______

For informational and educational purposes only, not a recommendation to buy or sell and security, fund, or strategy. Past performance and does not guarantee future results. The S&P 500 index is an unmanaged index and cannot be invested into directly. Please visit this link for important disclosures, terms, and conditions.

Warren Buffett’s Berkshire Hathaway Hasn’t Managed Downside Risk

 shares an interesting observation in Fortune ” Warren Buffett’s Berkshire lost $11 billion in market selloff“. He points out that Buffett’s Berkshire Hathaway (BRK.A or BRK.B) is tracking the U.S. stock indexes on the downside. He says:

“…during the worst of the downturn from mid-July to the end of August. That represents a 10.3% drop. The good news for Buffett: His, and his investment team’s, performance was likely not much worse than everyone else’s. During the same time, the S&P 500 fell 10.1%.”

Comparing performance to others or “benchmark” indexes is a what I call a “relative return” objective. Comparing performance vs. our own risk tolerance and total return objectives is an “absolute return” objective. The two are very different as what I call “relativity” is more concerned about how others are doing comparatively, while “absolute” is more focused on our own situation.

The article also said:

“If you are invested in an index fund, you may have outperformed the Oracle of Omaha, slightly.”

Let’s see just how true that is. Since the topic is how much Warren Buffett’s Berkshire Hathaway has lost during this stock market decline, I’ll share a closer look.

A picture speaks a thousand words. As it turns out, the guru stock picker is actually down -13.4% off it’s high looking back over the past year. That’s about -4% worse than the SPDR® S&P 500® ETF (SPY) that seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the S&P 500® Index. I am using actual securities here to present an investable comparison: SPY vs. BRK.B.

Warren Buffett's Berkshire Lost compared to stock index

As we observe in the chart, Warren Buffett’s Berkshire Hathaway began to decline off it’s high at the end of last year while the S&P 500® Index started last month. I have observed more and more stocks declining over the past several months. At the same time, more and more International markets have entered into their own bear markets. So, it is no surprise to see a focused stock portfolio diverge from a broader stock index.  points out some of the individual stock positions in ” Warren Buffett’s Berkshire lost $11 billion in market selloff

Below is the total return of the two over the past year. We can see the high in Warren Buffett’s Berkshire Hathaway BRK.B was in December 2014.

Warren Buffett's Berkshire Lost compared to stock index total return

I believe world markets require active risk management and defining directional trends. For me, that means predefining my risk in advance in each position and across the portfolio.

Chart source: http://www.ycharts.com

Read the full Fortune article here: ” Warren Buffett’s Berkshire lost $11 billion in market selloff

Stock Market Decline is Broad

We typically expect to see small company stocks decline first and decline the most. The theory is that smaller companies, especially micro companies, are more risky so their value may disappear faster.  Below, we view the recent price trends of four market capitalization indexes: micro, small, mid, and mega. We’ll use the following index ETFs.

Vanguard ETFs small mid large micro cap

Since we are focused on the downside move, we’ll only observe the % off high chart. This shows what percentage the index ETF had declined off its recent highest price (the drawdown). We’ll also observe different look-back periods.

We first look back 3 months, which captures the full extent of the biggest loser: as expected, the micro cap index. The iShares Micro-Cap ETF (IWC: Green Line) seeks to track the investment results of an index composed of micro-capitalization U.S. equities. Over the past 3 months (or anytime frame we look) it is -13% below its prior high. The second largest decline is indeed the small cap index. The Vanguard Small-Cap ETF (VB: Orange Line) seeks to track the performance of the CRSP US Small Cap Index, which measures the investment return of small-capitalization stocks. The small cap index has declined -11.5%. The Vanguard Mega Cap ETF (MGC) seeks to track the performance of a benchmark index that measures the investment return of the largest-capitalization stocks in the United States and has declined -9.65%. The Vanguard Mid-Cap ETF (VO) seeks to track the performance of a benchmark index that measures the investment return of mid-capitalization stocks and has declined -9.41%. So, the smaller stocks have declined a little more than larger stocks.

Small and Micro caps lead down

Source: Shell Capital Management, LLC created with http://www.ycharts.com

Many active or tactical strategies may shift from smaller to large company stocks, hoping they don’t fall as much. For example, in a declining market relative strength strategies would rotate from those that declined the most to those that didn’t. The trouble with that is they may still end up losing capital and may end up positioned in the laggards long after a low is reached. They do that even though we may often observe the smallest company stocks rebound the most off a low. Such a strategy is focused on “relative returns” rather than “absolute returns“. An absolute return strategy will instead exit falling trends early in the decline with the intention of avoiding more loss. We call that “trend following” which has the objective of “cutting your losses short”. Some trend followers may allow more losses than others. You can probably see how there is a big difference between relative strength (focusing on relative trends and relative returns)  and trend following (focusing on actual price trends and absolute returns).

So, what if we look at the these stock market indexes over just the past month instead of the three months above? The losses are the same and they are very correlated. So much for diversification. Diversification across many different stocks, even difference sizes, doesn’t seem to help in declining markets on a short-term basis. These indexes combined represent thousands of stocks; micro, small, medium, and large. All of them declined over -11%, rebounded together, and are trending down together again.

stock market returns august 2015

Source: Shell Capital Management, LLC created with http://www.ycharts.com

If a portfolio manager is trying to “beat the market” index, he or she may focus on relative strength or even relative value (buy the largest loser) as they are hoping for relative returns compared to an index. But a portfolio manager who is focused on absolute returns may pay more attention to the actual downside loss and therefore focuses on the actual direction of the price trend itself. And, a key part is predefining risk with exits.

You can probably see how different investment managers do different things based on our objectives. We have to decide what we want, and focus on tactics for getting that.

Dauntless Courage and Confidence to Get it Done

Know: be aware of through observation, inquiry, or information.

Two observations from the video below:

1. Know where you’ll be when you get where you’re going.

2. Know the parts of the process that is the risk of a bad outcome; then manage it, and accept it…

From that comes dauntless courage and the confidence to get it done.

Press play to watch this:

He has it…

U.S. Sector Observation

I don’t often comment on a day’s price action in the stock market, but thought I would. The U.S. stock market reversed up somewhat today. Market trends swing up and down on their way to a larger trend. Notice at 3pm the stock indexes almost lost all their gain for the day.

stock market 2015-08-27_16-17-41

Source: https://www.google.com/finance

The interesting observation today was the leadership. Energy and Basic Materials have been the biggest losers the past three months and they moved up the most.

sector rotation returns ETF

Source: https://www.google.com/finance

Below are the U.S. sector returns over the past 3 months after todays close. You can see the two biggest losers were today’s winners.

ETF sector rotation

Source: http://www.stockcharts.com

It will be interesting to see if this is an oversold bounce or it reverses to a lower low.

Trends unfold as swings up and down over time. They don’t go straight up or down…

Global Markets Year to Date

This is a quick year to date observation of some global market trends. First, we start with the popular U.S. stock market indexes. The Dow Jones Industrial Average is down -9.6% YTD. S&P 500 is down about -7%. A simple line chart shows a visual representation of the trend and the path it took to get there.

stock index return year to date

Source of Ycharts in this article: Shell Capital Management, LLC drawn with http://www.ycharts.com

I like to look at the asymmetry ratio of the trend, so I observe both the upside total return and the downside drawdown. Below is a chart of the % off the highest price these indexes reached to define the drawdown from its prior peak. This is how much they’ve declined from their highest point so far this year. The Dow Jones Industrial Average is down -12.8% from it’s high, the S&P 500 is down 10.8%.

stock index drawdown chart

Below are the sectors year to date. Healthcare remains the leader and the only one positive at this point.

sectors year to date

Source:Shell Capital Management, LLC  drawn with  http://finviz.com

Looking at a few more broad based alternatives, below is the iShares S&P GSCI Commodity-Indexed Trust (GSG: blue) which seek to track the results of a fully collateralized investment in futures contracts on an index composed of a diversified group of commodities futures. The red line is Gold (GLD) and the orange line is the iShares Core U.S. Aggregate Bond ETF seeks to track the investment results of an index composed of the total U.S. investment-grade bond market. Bonds are flat (including interest), gold is down -3%, and the commodity index is down -24%.

bonds commodities year to date

We are beginning to observe that a fixed asset allocation to these markets, no matter how diversified, may be very negative this year.

What about International stocks? Below we see some material divergence so far between developed International markets (EFA) and emerging markets (EEM). The iShares MSCI EAFE (EFA) seeks to track the investment results of an index composed of large- and mid-capitalization developed market equities, excluding the U.S. and Canada. Those countries index is down -2.9%. The iShares MSCI Emerging Markets (EEM) seeks to track the investment results of an index composed of large- and mid-capitalization emerging market equities. It is down -18.6%.

international emerging markets year to date

What about global stock markets? A few are positive year to date, most are very negative.

global stock markets year to data

Source:Shell Capital Management, LLC  drawn with  http://finviz.com

What about individual commodities, interest rates, and volatility? The VIX was low most of the year, but now that markets have declined the implied volatility of stocks has spiked.

world markets year to date

Source:Shell Capital Management, LLC  drawn with  http://finviz.com

I believe world markets require active risk management and defining directional trends. For me, that means predefining my risk in all of them, not just a fixed allocation.

Why Index ETFs Over Individual Stocks?

A fellow portfolio manager I know was telling me about a sharp price drop in one of his positions that was enough to wipe out the 40% gain he had in the stock. Of course, he had previously told me he had a quick 40% gain in the stock, too. That may have been his signal to sell.  Biogen, Inc (BIIB) recently declined about -30% in about three days. Easy come, easy go. Below is a price chart over the past year.

Biogen BIIB

Source: Shell Capital Management, LLC created with http://www.stockcharts.com

Occasionally investors or advisors will ask: “Why trade index ETFs instead of individual stocks?“. An exchange-traded fund (ETF) is an investment fund traded on stock exchanges, much like stocks. Until ETFs came along the past decade or so, gaining exposure to sectors, countries, bond markets, commodities, and currencies wasn’t so easy. It has taken some time for portfolio managers to adapt to using them, but ETFs are easily tradable on an exchange like stocks. Prior to ETFs, those few of us who applied “Sector Rotation” or “Asset Class Rotation” or any kind of tactical shifts between markets did so with much more expensive mutual funds. ETFs have provided us with low cost, transparent, and tax efficient exposure to a very global universe of stocks, bonds, commodities, currencies, and even alternatives like REITs, private equity, MLP’s, volatility, or inverse (short). Prior to ETFs we would have had to get these exposures with futures or options. I saw the potential of ETFs early, so I developed risk management and trend systems that I’ve applied to ETFs that I would have previously applied to futures.

On the one hand, someone who thinks they are a good stock picker are enticed to want to get more granular into a sector and find what they believe is the “best” stock. In some ways, that seems to make sense if we can weed out the bad ones and only hold the good ones. It really isn’t so simple. I view everything a reward/risk ratio, which I call asymmetric payoffs. There is a tradeoff between the reward/risk of getting more detailed and focused in the exposure vs. having at least some diversification, such as exposure to the whole sector instead of just the stock.

Market Risk, Sector Risk, and Stock Risk

In the big picture, we can break exposures into three simple risks (and those risks can be explored with even more detail). We’ll start with the broad risk and get more detailed. Academic theories break down the risk between “market risk” that can’t be diversified away and “single stock” and sector risk that may be diversified away.

Market Risk: In finance and economics, systematic risk (in economics often called aggregate risk or undiversifiable risk) is vulnerable to events which affect aggregate outcomes such as broad market declines, total economy-wide resource holdings, or aggregate income. Market risk is the risk that comes from the whole market itself. For example, when the stock market index falls -10% most stocks have declined more or less.

Stock and Sector Risk: Unsystematic risk, also known as “specific risk,” “diversifiable risk“, is the type of uncertainty that comes with the company or industry itself. Unsystematic risk can be reduced through diversification. If we hold an index of 50 Biotech stocks in an index ETF its potential and magnitude of a  large gap down in price is less than an individual stock.

You can probably see how holding a single stock like Biogen  has its own individual risks as a single company such as its own earnings reports, results of its drug trials, etc. A biotech stock is especially interesting to use as an example because investing in biotechnology comes with a unique host of risks. In most cases, these companies can live or die based on results of drug trials and the demand for their existing drugs. In fact, the reason Biogen declined so much is they reported disappointing second-quarter results and lowered its guidance for the full year, largely because of lower demand for one of their drugs in the United States and a weaker pricing environment in Europe. That is a risk that is specific to the uncertainty of the company itself. It’s an unsystematic risk and a selection risk that can be reduced through diversification. We don’t have to hold exposure to just one stock.

With index ETFs, we can gain systematic exposure to an industry like biotech or a sector like healthcare or a broader stock market exposure like the S&P 500. The nice thing about an index ETF is we get exposure to a basket of stocks, bond, commodities, or currencies and we know what we’re getting since they disclose their holdings on a daily basis.

ETFs are flexible and easy to trade. We can buy and sell them like stocks, typically through a brokerage account. We can also employ traditional stock trading techniques; including stop orders, limit orders, margin purchases, and short sales using ETFs. They are listed on major US Stock Exchanges.

The iShares Nasdaq Biotechnology ETF objective seeks to track the investment results of an index composed of biotechnology and pharmaceutical equities listed on the NASDAQ. It holds 145 different biotech stocks and is market-cap-weighted, so its exposure is more focused on the larger companies. It therefore has two potential disadvantages: it has less exposure to smaller and possibly faster growing biotech stocks and it only holds those stocks listed on the NASDAQ, so it misses some of the companies that may have moved to the NYSE. According to iShares we can see that Biogen (BIIB) is one of the top 5 holdings in the index ETF.

iShares Biotech ETF HoldingsSource: http://www.ishares.com/us/products/239699/ishares-nasdaq-biotechnology-etf

Below is a price chart of the popular iShares Nasdaq Biotech ETF (IBB: the black line) compared to the individual stock Biogen (BIIB: the blue line). Clearly, the more diversified biotech index has demonstrated a more profitable and smoother trend over the past year. And, notice it didn’t experience the recent -30% drop that wiped out Biogen’s price gain. Though some portfolio managers may perceive we can earn more return with individual stocks, clearly that isn’t always the case. Sometimes getting more granular in exposures can instead lead to worse and more volatile outcomes.

IBB Biotech ETF vs Biogen Stock 2015-07-29_10-34-29

Source: Shell Capital Management, LLC created with http://www.stockcharts.com

The nice thing about index ETFs is we have a wide range of them from which to research and choose to add to our investable universe. For example, when I observe the directional price trend in biotech is strong, I can then look at all of the other biotech index ETFs to determine which would give me the exposure I want to participate in the trend.

Since we’ve observed with Biogen the magnitude of the potential individual risk of a single biotech stock, that also suggests we may not even prefer to have too much overweight in any one stock within an index. Below I have added to the previous chart the SPDR® S&P® Biotech ETF (XBI: the black line) which has about 105 holdings, but the positions are equally-weighted which tilts it toward the smaller companies, not just larger companies.  As you can see by the black line below, over the past year, that equal weighting tilt has resulted in even better relative strength. However, it also had a wider range (volatility) at some points. Though it doesn’t always work out this way, you are probably beginning to see how different exposures create unique return streams and risk/reward profiles.

SPDR Biotech Index ETF XBI IBB and Biogen BIIB 2015-07-29_10-35-46

Source: Shell Capital Management, LLC created with http://www.stockcharts.com

In fact, those who have favored “stock picking” may be fascinated to see the equal-weighted  SPDR® S&P® Biotech ETF (XBI: the black line) has actually performed as good as the best stock of the top 5 largest biotech stocks in the iShares Nasdaq Biotech ETF.

SPDR Biotech vs CELG AMGN BIIB GILD REGN

Source: Shell Capital Management, LLC created with http://www.stockcharts.com

Biotech indexes aren’t just pure biotech industry exposure. They also have exposures to the healthcare sector. For example, iShares Nasdaq Biotech shows about 80% in biotechnology and 20% in sectors categorized in other healthcare industries.

iShares Nasdaq Biotech ETF exposure allocation

Source: www.ishares.com

The brings me to another point I want to make. The broader healthcare sector also includes some biotech. For example, the iShares U.S. Healthcare ETF is one of the most traded and includes 23.22% in biotech.

iShares Healthcare Index ETF exposure allocation

Source: https://www.ishares.com/us/products/239511/IYH?referrer=tickerSearch

It’s always easy to draw charts and look at price trends retroactively in hindsight. If we only knew in advance how trends would play out in the future we could just hold only the very best. In the real world, we can only identify trends based on probability and by definition, that is never a sure thing. Only a very few of us really know what that means and have real experience and a good track record of actually doing it.

I have my own ways I aim to identify potentially profitable directional trends and my methods necessarily needs to have some level of predictive ability or I wouldn’t bother. However, in real world portfolio management, it’s the exit and risk control, not the entry, the ultimately determines the outcome. Since I focus on the exposure to risk at the individual position level and across the portfolio, it doesn’t matter so much to me how I get the exposure. But, by applying my methods to more diversified index ETFs across global markets instead of just U.S. stocks I have fewer individual downside surprises. I believe I take asset management to a new level by dynamically adapting to evolving markets. For example, they say individual selection risk can be diversified away by holding a group of holdings so I can efficiently achieve that through one ETF. However, that still leaves the sector risk of the ETF, so it requires risk management of that ETF position. They say systematic market risk can’t be diversified away, so most investors risk that is left is market risk. I manage both market risk and position risk through my risk control systems and exits. For me, risk tolerance is enforced through my exits and risk control systems.

The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted, and numbers may reflect small variances due to rounding. Standardized performance and performance data current to the most recent month end may be obtained by clicking the “Returns” tab above.

Uncharted Territory from the Fed Buying Stocks

I remember sometime after 2013 I told someone “The Fed is buying stocks and that’s partly why stocks have risen so surprisingly for so long”. He looked puzzled and didn’t seem to agree, or understand.

The U.S. Federal Reserve (the “Fed”) has been applying “quantitative easing” since the 2007 to 2009 “global financial crisis”. Quantitative easing (QE) is a type of monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective. The Fed implements quantitative easing by buying financial assets from banks and other financial institutions. That raises the prices of those financial assets and lowers their interest rate or yield. It also increases the amount of money available in the economy. The magnitude they’ve done this over the past seven years has never been experience before. They are in uncharted territory.

I was reminded of what I said, “the Fed is buying stocks” when I read comments from Bill Gross in “Gross: Fed Slowly Recognizing ZIRP Has Downside Consequences”. He says companies are using easy money to buy their own stock:

Low interest rates have enabled Corporate America to borrow hundreds of billions of dollars “but instead of deploying the funds into the real economy,they have used the proceeds for stock buybacks. Corporate authorizations to buy back their own stock are running at an annual rate of $1.02 trillion so far in 2015, 18 percent above 2007’s record total of $863 billion, Gross said.

You see, if we want to know the truth about market dynamics; we necessarily have to think more deeply about how markets interact. Market dynamics aren’t always simple and obvious. I said, “The Fed is buying stocks” because their actions is driving the behavior of others. By taking actions to increase money supply in the economy and keep extremely low borrowing rates, the Fed has been driving demand for stocks.

But, it isn’t just companies buying their own stock back. It’s also investors buying stocks on margin. Margin is borrowed money that is used to purchase securities. At a brokerage firm it is referred to as “buying on margin”. For example, if we have $1 million in a brokerage account, we could borrow another $1 million “on margin” and invest twice as much. We would pay interest on the “margin loan”, but those rates have been very low for years. Margin interest rates have been 1 – 2%. You can probably see the attraction. If we invested in lower risk bonds earning 5% with $1 million, we would normally earn 5%, or $50,000 annually. If we borrowed another $1 million at 2% interest and invested the full $2 million at 5%, we would earn another 3%, or $30,000. The leverage of margin increased the return to 8%, or $80,000. Of course, when the price falls, the loss is also magnified. When the interest rate goes up, it reduces the profit. But rates have stayed low for so long this has driven margin demand.

While those who have their money sitting in in bank accounts and CDs have been brutally punished by near zero interest rates for many years, aggressive investors have borrowed at those low rates to magnify their return and risk in their investments. The Fed has kept borrowing costs extremely low and that is an incentive for margin.

In the chart below, the blue line is the S&P 500 stock index. The red line is NYSE Margin Debt. You may see the correlation. You may also notice that recessions (the grey area) occur after stock market peaks and high margin debt balances. That’s the downside: margin rates are at new highs, so when stocks do fall those investors will either have to exit their stocks to reduce risk or they’ll be forced to exit due to losses. If they don’t have a predefined exit, their broker has one for them: “a margin call”.

Current Margin Debt Stock MarginSource: http://www.advisorperspectives.com/dshort/charts/markets/nyse-margin-debt.html?NYSE-margin-debt-SPX-since-1995.gif

If you noticed, I said, “They are in uncharted territory”. I am not. I am always in uncharted territory, so I never am. I believe every new moment is unique, so I believe everyone is always in uncharted territory. Because I believe that, I embrace it. I embrace uncertainty and prepare for anything that can happen. It’s like watching a great movie. It would be no fun if we knew the outcome in advance.

 

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