You want to be fearful when others are greedy?

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

Investors are emotional and we can profit from it.

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

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

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

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

fear-and-greed-index-explaination-cnn

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

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

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

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

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

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

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

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

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

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

vix-cboe-volatility-index

What does this mean?

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

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

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

decline-since-fear-and-greed-index

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

We’ll see how it unfolds this time…

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

Asymmetric Volatility

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

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

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

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

asymmetric-volatility

Source: MyRadar

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

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

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

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

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

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

What matters is what we want to experience.

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

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

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

We get to decide what we experience.

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

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

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

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

I always say that you could publish trading rules in the newspaper and no one would follow them. The key is consistency and discipline. Almost anybody can make up a list of rules that are 80 percent as good as what we taught people. What they couldn’t do is give them the confidence to stick to those rules even when things are going bad.”

– Richard Dennis

richard-dennis

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.

A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it.”

Max Planck, Nobel Prize-winning physicist

Max Planck

Source: https://en.wikiquote.org/wiki/Max_Planck

 

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.

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/

 

Manage Market Risk

exit stop loss risk management

Market risk cannot be diversified away.

Market risk must be actively managed, directed, and controlled through exits.

The exit, not the entry, always determines the outcome.

It doesn’t matter at what price we buy something if we don’t know in advance what direction it will go (and we never do).

We can only control the outcome by the price we sell.

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. 

What do you think about the election?

flag.jpg

Many people have asked me what I think about the Election.

I don’t think much about it, but when I do…

I believe that we’re going to find who America really is.

If any of us doesn’t like it, we can find another country.

There are many other countries to live in the world depending on what we want.

If someone wants a country that treats people more “equal” and doesn’t reward anyone for doing more, there are countries for that.

If someone wants a country that rewards people based on what they do, there are countries for that.

For example, people who are concerned about America becoming more “Socialist” and less “Capitalist” are looking at citizenship in countries like Singapore.

If we want another country, we can simply search “citizenship in _______”. For example, when I search “citizenship in Singapore” I quickly found the requirements and a link to “Apply for Singapore Citizenship”. Just like America, other countries have rules for legal citizenship:

“A Permanent Resident for at least two years who is employed or married to a Singaporean citizen can register for citizenship. A male Permanent Resident may also apply upon satisfactory completion of full-time National Service, as may children of Singaporean citizens living in Singapore.”

I believe we all get what we want by deciding what we get. If any one of us doesn’t like America, we can go to another country.

We are going to soon find out whom America really is… and we’ll probably find out who we really are, too.

What would Warren Buffett do?

Few investors have gotten as much media attention than Warren Buffett. He is considered to be the most famous investor in the world. Buffett is the chairman, CEO and largest shareholder of Berkshire Hathaway (BRK.A) and is consistently ranked among the world’s wealthiest people. He earned his money investing. Buffett is often referred to as the “Oracle of Omaha”. Plenty has been said about his performance over the decades.

Below is an interesting view of the Total Return (Price + Dividends) of his Berkshire Hathaway (BRK.A). The chart shows the “% off high” to see its drawdowns. A drawdown is how much a price trend declines from a previous high before it recovers the decline. Berkshire Hathaway (BRK.A) has so far declined -17.2% from its high. During the bear market 2007 to 2009 it declined -50%.

Warren Buffett Berkshire Hathaway

Though -10% declines are fairly common for stocks, 2011 was the last year that stocks declined more than -15% within the year. During 2011, Berkshire Hathaway (BRK.A) dropped about -23% before recovering and eventually trending to new highs.

BERKSHIRE Hathaway 2011

Warren Buffett is 85 years old and has been doing this a very long time. He certainly has some tolerance for stock market declines.

What do you think Warren Buffett is doing right now? 

The public, as a whole, buys at the wrong time and sells at the wrong time. The average operator, when he sees two or three points profit, takes it; but, if a stock goes against him two or three points, he holds on waiting for the price to recover, with oftentimes, the result of seeing a loss of two or three points run into a loss of ten points.”

idowcha001p1

Charles Dow 

(November 6, 1851 – December 4, 1902) was an American journalist who co-founded Dow Jones & Company

Rugged individualism

Rugged individualism was the phrase used often by Herbert Hoover during his time as president. It refers to the idea that each individual should be able to help themselves out, and that the government does not need to involve itself in people’s economic lives nor in national economics in general.

Rugged individualism is the belief that all individuals, or nearly all individuals, can succeed on their own and that government help for people should be minimal.

Source: https://en.wikipedia.org/wiki/Rugged_individualism

 

The Starting Point Matters

For long term investors who buy and hold, the risk/reward expectations are sometimes very, very, simple.

If you bought the long term U.S. Treasury index via the iShares 20+ Year Treasury Bond ETF (Symbol: TLT) about 12 years ago your yield is around 5% and the total return has been 100%.

Keep in mind, the total return is price appreciation + interest (or yield).

At this starting point, if you are buying it today, your yield is 2.6%… so the expected future total return from the yield is half.

Bond Return Rising Rates

Clearly, the expected total return for bonds is much lower today than just over 10 years ago.

Since the yield is lower, the risk/reward payoff isn’t as positive. The lower yield limits the upside for price appreciation.

There may be times this long term U.S. Treasury is the place to be and times it isn’t.

But over a longer expectation, it’s much less attractive than it was.

No market or security performs well in all conditions, so traditional allocation often holds positions with a negative risk/return profile.

You can probably see why I think it’s critical to be unconstrained and flexible rather than a fixed allocation that ignores the current condition.

The four most dangerous words…

Every new moment is necessarily unique – we’ve never been “here” before. Probabilities and potential payoffs change based on the stage of the trend or cycle. For example, the current decline in stocks is no surprise, given the stage and magnitude of the prior trends. A few see evidence of the early stages of a bigger move, others believe it’s different this time. We’ll see how it all unfolds. I don’t have to know what’s going to happen next – I am absolutely certain of what I will do given different conditions.

To quote from fellow Tennessean, Sir John Templeton:

“The four most dangerous words in investing are, it’s different this time.”

Sir John Templeton

Sir John Templeton

source: http://www.templeton.org

Each of us tends to think we see things as they are, that we are objective. But this is not the case. We see the world, not as it is, but as we are—or, as we are conditioned to see it. When we open our mouths to describe what we see, we in effect describe ourselves, our perceptions, our paradigms.”

–  The Seven Habits of Highly Effective People: Powerful Lessons in Personal Change by Stephen R. Covey, Quote Page 28 (2004)

Here’s to the crazy ones. The misfits. The rebels. The troublemakers. The round pegs in the square holes. The ones who see things differently. They’re not fond of rules. And they have no respect for the status quo. You can quote them, disagree with them, glorify or vilify them. About the only thing you can’t do is ignore them. Because they change things. They push the human race forward. And while some may see them as the crazy ones, we see genius. Because the people who are crazy enough to think they can change the world, are the ones who do.”

Steve Jobs

Steve Jobs

Using the Month of September to Understand Probability and Expectation

probabilty-coin-flip

September is the month when the U.S. stock market’s three most popular indexes usually perform the poorest. So say the headlines every September.

I first wrote this in September 2013 after many commentators had published information about the seasonality of the month of September. Seasonality is the historical tendency for certain calendar periods to gain or lose value. However, when commentators speak of such probabilities, they rarely provide a clear probability and almost never the full mathematical expectation.  Without the mathematical expectation, probability alone is of little value or no value. I’ll explain why.

For those of us focused on actual directional price trends it may seem a little silly to discuss the historical probability of gain or loss for a single month. However, even though I wouldn’t make decisions based on it, we can use the seasonal theme to explain the critical importance of both probability and mathematical expectation.

“From 1928-2012 the S&P 500 was up 39 months and down 46 months in September. It is down 55% of the time in September…”

“Dow Jones Industrial Average 1886-2004 (116 years) 49 years the Dow was up in September, in 67 years the Dow was down in September. It’s down 58% of the time in September…”

Those are probability statements. But they say nothing about how much it was up or down.

First, let’s define probability.

Probability is likelihood. It is a measure or estimation of how likely it is that something will happen or that a statement is true. Probabilities are given a range of value between 0% chance (it will not happen) and 100% chance (it will happen). There are few things so certain as 0% and 100%, so most probabilities fall in between. The higher the degree of probability, the more likely the event is to happen, or, in a longer series of samples, the greater the number of times such event is expected to happen.

But that says nothing about how to calculate probability and apply it. One thing to realize about probability is that it is the math for dealing with uncertainty. When we don’t know an outcome, it is uncertain. It is probabilistic, not a sure thing. Probability provides us our best estimation of the outcome.

As I see it, there are two ways to calculate probability: subjectively and objectively.

Subjective Probability: assigns a likelihood based on opinions and confidence (degree of belief) in those opinions. It may include “expert” knowledge as well as experimental data. For example, the majority of the research and news is based on “expert opinion”. They may state their belief and then assign a probability: “I believe the stock market has a X% chance of going down.” They may go on to add a good sounding story to support their hypothesis. You may see how that is subjective.

Objective Probability: assigns a likelihood based on numbers. Objective probability is data-driven. The popular method is frequentist probability: the probability of a random event means the relative frequency of occurrence of an experiment’s outcome when the experiment is repeated. This method believes probability is the relative frequency of outcomes over the long run. We can think of it as the historical tendency of the outcome. For example, if we flip a fair coin, its probability of landing on heads is 50% and tails is 50%. If we flip it 10 times, it could land on heads 7 and tails 3. That outcome implies 70%/30%. To prove the coin is “fair” (balanced on both sides), we would need to flip it more times to get a large enough sample size to realize the full probability. If we flip it 30 times or more it is likely to get closer and closer to 50%/50%. The more frequency, the closer it gets to its probability. You may see see why I say this is more objective: it’s based on actual historical data.

If you are a math person and logical thinker, you may get this. I have a hunch many people don’t like math, so they’d rather hear a good story. Rather than checking the stats on a game, they’d rather hear some guru’s opinion about who will win.

Which has more predictive power? An expert opinion or the fact that historically the month of September has been down more often than it’s up? Predictive ability needs to be quantified by math to determine if it exists and opinions are often far too subjective to do that. We can do the math based on historical data and determine if it is probable, or not.

As I said in September is statistically the worst month for the stock market the data shows it is indeed statistically significant and does indeed have predictive ability, but not necessarily enough to act on it. Instead, I suggest it be used to set expectations of what may happen: the month of September has historically been the worst performance month for the stock indexes. So, we shouldn’t be surprised if it ends in the red. It’s that simple.

Theory-driven researchers want a cause and effect story to go with their beliefs. If they can’t figure out a good reason behind the phenomenon, they may reject it even though the data is what it is. One person commented to me that he didn’t believe the September data has predictive value, even though it does, and he provided nothing to disprove it. Probabilities do need to make sense. Correlations can occur randomly, so logical reasoning behind the numbers may be useful. For example, one theory for a losing September is it is the fiscal year end of many mutual funds and fund managers typically sell losing positions before year end to realize losses to offset gains.

I previously stated a few different probabilities about September: what percentage of time the month is down. In September is statistically the worst month for the stock market I didn’t mention the percent of time the month is negative, only that on average it’s down X% since Y. It occurred to me that most people don’t seem to understand probability and more importantly, the more complete equation of expectation.

Expectation

There are many different ways to define expectation. We may initially think of it as “what we expect to happen”. In many ways, it’s best not to have expectations about the future. Our expectations may not play out as we’d hoped. If we base our investment decisions on opinion and expectations don’t pan out, we may stick with our opinion anyway and eventually lose money. The expectation I’m talking about is the kind that I apply: mathematical expectation.

So far, we have determined probability of September based on how many months it’s down or up. However, probability alone isn’t enough information to make a logical decision. First of all, going back to 1950 using the S&P 500 stock index, the month of September is down about 53% of the time and ends the month positive about 47% of the time. That alone isn’t a huge difference, but what makes it more meaningful is the expectation. When it’s down 53% of the time, it’s down -3.8% and when it’s up 47% of the time it’s up an average of 3.3%. That results in an expected value of -0.50% for the month of September. If we go back further to 1928, which includes the Great Depression, it’s about  -1.12%.

The bottom line is the math says “based on historical data, September has been the worst month for the stock market”. We could then say “it can be expected to be”. But as I said before, it may not be! And, another point I have made is the use of multiple time frames for looking at the data, which is a reminder that by intention: probability is not exact. It can’t be, it’s not supposed to be, and doesn’t need to be! Probability and expectation are the maths of uncertainty. We don’t know in advance many outcomes in life, but we can estimate them mathematically and that provides a sound logic and a mathematical basis for believing what we do.

We’ve made a whole lot of the month of September, but I think it made for a good opportunity to explain probability and expectation that are the essence of portfolio management. It doesn’t matter so much how often we are right or wrong, but instead the probability and the magnitude. Asymmetric returns are created by more profit, less loss. Mathematical expectation provides us a mathematical basis for believing a method works, or not. Not knowing the future; it’s the best we have.

Rather than seasonal tendencies, I prefer to focus on the actual direction of global price trends and directly manage the risk in individual my positions.

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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.

The Southern Voice: What You Don’t Know About the South and the Southern Accent

Asymmetric Information is when someone has superior or more knowledge than others about a topic. The Illusion of Asymmetric Insight occurs when people perceive their knowledge of others to surpass other people’s knowledge of themselves. An asymmetric advantage goes beyond a normal advantage of knowledge into the realm of having asymmetric information and knowing things others do not.

Over the past few weeks there has been much in the media about the Confederate Battle flag and misinformation about the South. As it turns out, it seems many people may be more ignorant about these things than they believe they are. So you think the “Southern Accent” is bad English? au contraire.

In Southern American English, Wikipedia says:

“The Southern U.S. dialects make up the largest accent group in the United States”

Wikipedia cites PBS as the source: “Do You Speak American: What Lies Ahead”. Specifically, that article says: 

  • Due to a huge migration to the South and Southwest and the national appeal of country music, Southern speech is now the largest accent group in the United States.
  • The dominant form is what linguists call Inland Southern…

As a Southerner myself, I have always known my Southern dialect is derived from my European ancestors. If you aren’t from the South or weren’t taught its history, you may not realize that. Most of the settlers in Appalachia and the South came from Scotland, Ireland, the British Isles. If you know anything about those areas and their people, you can probably see how they may have been attracted to the mountains of Tennessee, north Georgia, and North Carolina. Its geography is similar to their motherland. Oh, and they made whiskey and moonshine.

Researchers have noted that the dialect retains a lot of vocabulary with roots in Scottish “Elizabethan English” owing to the make-up of the early European settlers to the area.

Source: “The Dialect of the Appalachian People”. Wvculture.org. Retrieved 2012-11-08.

Oh, and they sang fiddle songs like Rocky Top! This is the origin of what has evolved today as “country music”. They blended popular songs, Irish and Celtic fiddle tunes, and various musical traditions from European immigrant communities.

That leads to this very interesting video clip from the History Channel “You Don’t Know Dixie” explaining the many versions of the Southern Accent:

Want to learn more about the South? search for the History Channel show “You Don’t Know Dixie” at your cable provider. I found it on Verizon and recorded it. Or, it’s available at Amazon.

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.

 

Give me liberty, or give me death!

Give me liberty of give me death

A quotation attributed to Patrick Henry from a speech he made to the Virginia Convention in 1775, at St. John’s Church in Richmond, Virginia.

He is credited with having swung the balance in convincing the convention to pass a resolution delivering Virginian troops for the Revolutionary War. Among the delegates to the convention were future U.S. Presidents Thomas Jefferson and George Washington.

Image Source: http://faculty.isi.org/media/images/catalog/originals/Give_me_liberty_or_give_me_death.jpg

Global Stock Market Trends

Stock Market Decline 2015-06-29

Stock markets around the world declined -2% or so arguing over which flag to fly. It was a good day for a cash position, or something other than U.S. and International stocks. Below is a table of U.S. stock sectors.

Stock Market Sectors 2015-06-29

Source: http://www.sectorspdr.com/sectorspdr/tools/sector-tracker

But it wasn’t just U.S. stocks. Equity markets around the globe were down. The graphic below shows much of the world  stock markets down around -4%. Spain and Germany were down the most.

Global Stock Market Trend 2015-06-29_16-02-23

Source: http://www.etf.com

The big news came over the weekend that Greece closed banks to head off chaos as bailout talks break down. Greece owes lenders $242.8 billion Euros in total and $1.7 billion tomorrow. Germany is its largest creditor.

The Greek stock market is closed, but the ETFs are not. The Global X FTSE Greece 20 ETF (GREK) was down nearly -20%. The Global X FTSE Greece 20 ETF tracks the FTSE/ATHEX Custom Capped Index, which is designed to reflect broad based equity market performance in Greece. The index is comprised of the top 20 companies listed on the Athens Exchange by market capitalization.

GREK Greece ETF 2015-06-29_16-33-16

Much of the world is in great debt…

One day isn’t much of a trend, but -2% days like this are notable, so we’ll see if it is the beginning of a trend. The year-to-date total return (including dividends) is negative for both the Dow Jones Industrial Average and the IBoxx $ Invest Grade Corporate Bond ETF.

stock and bond market 2015-06-29_17-14-43

 

The stock market is risky and that includes the loss of capital. Past performance does not guarantee future results.

 

 

Seasonal Alpha? The Real Probability and Expectation of “Sell in May and Go Away”

Here is the trouble with a seasonal strategy. According to Standard & Poors, the S&P 500 has gained 1.05 % in May, though it was a volatile month. So, “sell in May and go away” just missed out for no other reason other than it was May.

The second problem is best explained in the chart below. According to Standard & Poors, since 1946 (68 years) the S&P 500 has actually been positive during the “sell in May and go away” period May – October 64% of the time with an average gain of 1.3%. So, the expectation for the period is actually a positive return of .83% May to October.

Seasonal Sell in May and Go Away Strategy

Another interesting observation in the chart is after a positive “up” May, the May to October period tends to increase 87% of the time an average of 3.5%. So, the expectation is 3.04%. Based on the probability and expectation, we would expect 2% more through October. Of course, the trouble is this stock index is trading at 27 times EPS which is overvalued territory, so this time could instead be the 13% of the time it declines instead, but the probability and expectation is what it is and we want to invest with it, not against it. I would rather focus on the actual direction of trends rather than what month it is.

One month or series of months is an arbitrary time frame, which is why a strategy based on specific time frames like “Sell in May and Go Away” are arbitrary – no matter what story is told to make it sound good.

This May it turned out it most of the other global markets were down materially in May like the Emerging Markets index -4.1%, Commodity Index -2.17%, and even the iShares iBoxx $ Investment Grade Corporate Bond declined -1.12%. So, anyone who was globally positioned across multiple markets during May did experience declines. Those who shifted from the S&P 500 index to bonds at the beginning of May actually lost what the stock index gained…

I prefer to focus on the actual direction of global price trends, no matter when they are. You can see what that looks like here.

Allocation to Stocks and Bonds is Unlikely to Give us What We Want

That was the lesson you learned the last time stocks became overvalued and the stock market entered into a bear market.

I believe holding and re-balancing markets doesn’t give us the risk-adjusted returns we want. In all I do, I believe in challenging that status quo, I believe in thinking and doing things differently. The way I challenge the status quo is a focus on absolute return, limiting downside risk, and doing it tactically across global markets. Why do I do it?

In a Kiplinger article by Fred W. Frailey interviewed Mohamed El-Erian, the PIMCO’s boss, (PIMCO is one of the largest mutual fund companies in the world) he says “he tells how to reduce risk and reap rewards in a fast-changing world.” This article “Shaking up the Investment Mix” was written in March 2009, which turned out the be “the low” of the global market collapse.

It is useful to revisit such writing and thoughts, especially since the U.S. stock market has since been overall rising for 5 years and 10 months. It’s one of the longest uptrends recorded and the S&P 500 stock index is well in “overvalued” territory at 27 times EPS. At the same time, bonds have also been rising in value, which could change quickly when rates eventually rise. At this stage of a trend, asset allocation investors could need a reminder. I can’t think of a better one that this:

Why are you telling investors they need to diversify differently these days?

The traditional approach to diversification, which served us very well, went like this: Adopt a diversified portfolio, be disciplined about rebalancing the asset mix, own very well-defined types of asset classes and favor the home team because the minute you invest outside the U.S., you take on additional risk. A typical mix would then be 60% stocks and 40% bonds, and most of the stocks would be part of Standard & Poor’s 500-stock index.

This approach is fatigued for several reasons. First of all, diversification alone is no longer sufficient to temper risk. In the past year, we saw virtually every asset class hammered. You need something more to manage risk well.

But, you know, they say a picture is worth a thousand words.

Since we are talking about downside risk, something that is commonly hidden when only “average returns” are presented, below is a drawdown chart. I created the drawdown chart using YCharts which uses total return data and the “% off high”. The decline you see from late 2007 to 2010 is a drawdown: it’s when the investment value is under water. Think of this like a lake. You can see how the average of the data wouldn’t properly inform you of what happens in between.

First, I show PIMCO’s own allocation fund: PALCX: Allianz Global Allocation Fund. I include an actively managed asset allocation that is very large and popular with $55 billion invested in it: MCLOX: BlackRock Global Allocation. Since there are many who instead believe in passive indexing and allocation, I have also included DGSIX: DFA Global Allocation 60/40 and VBINX: Vanguard Balanced Fund. As you can see, they have all done about the same thing. They declined about -30% to -40% from October 2007 to March 2009. They also declined up to -15% in 2011.

Global Allocation Balanced Fund Drawdowns

Going forward, the next bear market may be very different. Historically, investors consider bond holdings to be a buffer or an anchor to a portfolio. When stock prices fall, bonds haven’t been falling nearly as much. To be sure, I show below a “drawdown chart” for the famous actively managed bond fund PIMCO Total Return and for the passive crowd I have included the Vanguard Total Bond Market fund. Keep in mind, about 40% of the allocation of the funds above are invested in bonds. As you see, bonds dropped about -5% to -7% in the past 10 years.

Bond market risk drawdowns

You may notice they are recently down -2% from their highs. Based on the past 10 years, that’s just a minor decline. The trouble going forward is that interest rates have been in an overall downtrend for 30 years, so bond values have been rising. If you rely on bonds being a crutch, as on diversification alone, I agree with Mohamed El-Erian the Chief of the worlds largest bond manager:

“…diversification alone is no longer sufficient to temper risk. In the past year, we saw virtually every asset class hammered. You need something more to manage risk well.”

But, don’t wait until AFTER markets have fallen to believe it.

I just don’t believe holding and re-balancing markets is going to give us the risk-adjusted returns we want. In all I do, I believe in challenging that status quo, I believe in thinking and doing things differently. The way I challenge the status quo is a focus on absolute return, limiting downside risk, and doing it tactically across global markets. Want to join us? To see what that looks like, click: ASYMMETRY® Managed Accounts

Where is the Inflation?

In How does monetary policy influence inflation and employment? and bond prices… I pointed out that even the Fed expected their monetary policy to eventually lead to inflation. The problem with economics and economist is they expect a cause and effect, and often their expectations don’t come true. Remember all those newsletters advising to buy gold the last several years? Gold trended up a while, then down. Applying a good trend system to gold may have made money from it, but buying and holding gold is probably a loser. Inflation was supposed to go up and gold was supposed to be a shelter. However, inflation has instead trended down: The U.S. Inflation Calculator  presents it best:

Current US Inflation Rates: 2005-2015

The latest inflation rate for the United States is -0.1% through the 12 months ended March 2015 as published by the US government on April 17, 2015. The next update is scheduled for release on May 22, 2015 at 8:30 a.m. ET. It will offer the rate of inflation over the 12 months ended April 2015.

The chart, graph and table below displays annual US inflation rates for calendar years 2004-2014. Rates of inflation are calculated using the current Consumer Price Index published monthly by the Bureau of Labor Statistics (BLS). For 2015, the most recent monthly data (12-month based) will be used in the chart and graph.

Historical inflation rates are available from 1914-2015. If you would like to calculate accumulated rates between different dates, the US Inflation Calculator will do that quickly.

Inflation Rate 2015-05-04_19-44-49

Source: http://www.usinflationcalculator.com/inflation/current-inflation-rates/

However, as you can see in the chart, like market prices, economic data trends directionally too. This trend of declining inflation may continue or it may reverse.

Recent Observations: Stock Market, Volatility, Absolute Returns

In case you missed them, here is a list of popular observations I’ve shared recently:

This is When MPT and VaR Get Asset Allocation and Risk Measurement Wrong

A Tale of Two Conditions for U.S. and International Stocks: Before and After 2008

Absolute Return: an investment objective and strategy

Asymmetric Nature of Losses and Loss Aversion

Why So Stock Market Focused?

What About the Stock Market Has Changed? A Look at Ten Years of Volatility

Diversification Alone is No Longer Sufficient to Temper Risk…

Top Traders Unplugged Interview with Mike Shell: Episode 1 & 2

Mike Shell Interview 2 with Michael Covel on Trend Following

Asymmetric Sector Exposure in Stock Indexes

What About the Stock Market Has Changed? A Look at Ten Years of Volatility

When asked to sum the Buddha’s teachings up in one phrase, Suzuki Roshi simply said, “Everything changes.”

The universe is transient, in a constant state of flux. This impermanence, that things are constantly changing and evolving, is one of the few things we can be sure about. Whatever it is today, it will evolve and eventually change. I believed this, so I embraced change and uncertainty. That led me to deeply study rates of change, magnitude of change, and probability of change.

So when I speak about volatility, I am necessarily talking about “how much it has changed”. Volatility is the range of change. If there is no volatility, there is no change. If the range is very wide, the range of outcomes is wide.

In statistics, standard deviation is a measure that is used to quantify this amount of range, variation, or dispersion of a set of data. In finance, it’s used to measure the range of prices. Many use it as a risk measure.

As of this month, I have been managing ASYMMETRY® Global Tactical as a separately managed account program for 10 years. Ten years is somewhat an arbitrary time frame, but it’s also a meaningful milestone given the range of change over this period. This past decade has been unique in that it included a range of change few have experienced or observed before. It’s really just change doing what it does.

What has changed over the past 10 years?

In A Tale of Two Conditions for U.S. and International Stocks: Before and After 2008 I pointed out the material change in the directional trends of the U.S. stock market vs. international stocks. Prior to 2008, the international stock market indexes were materially stronger trends than U.S. stocks. Since 2008, the U.S. stock market rate of change has been stronger than the global markets.

Another very significant change has been volatility. The change in volatility is critical to understand as I pointed out in This is When MPT and VaR Get Asset Allocation and Risk Measurement Wrong. Below, I will illustrate visually how volatility has changed and what it means today.

Historical standard deviation is commonly used in investment models as an input for  volatility and is often considered a measure of ‘risk”. In some ways that is true, in other ways I disagree. When prices trade in a wide range up and down, it tends to get attention. Investors start to watch it closely. If a portfolio goes up 10% and then down -10% over a period of time, it gets the investors attention. If that portfolio declines -20%, then gains 10%, then declines -15%, they may have a reaction. We call the actual decline “drawdown”, but the widening range and how fast the values move up and down is called “volatility”.

The chart below is the S&P 500 stock index (blue line) and the historical volatility as measured by standard deviation with a 1 year look-back. As you can see, historical volatility as measured by standard deviation tends to decline after the price trend rises such as 2005 to late 2007 and again starting in 2013 to now. We can also observe it increasing significantly after the stock index declined. Historical volatility stayed very high after 2008 and observing from a 1 year look-back, it remained very high until late 2013. Investors dislike volatility because it’s more difficult to hold on to a trend when its range up and down is high. If investors don’t like volatility, then you can see why they had such a hard time holding stock positions for several years.

Standard Deviation

Clearly, investors who don’t like volatility had a very difficult time holding the stock market up until recently. The past decade has shown us material changes in volatility from the low and decreasing period pre-2008 to the extreme high volatility up until late 2013. Some investors may now even be thinking of getting “more aggressive”, now that the wide price swings have become a distant memory. But you may consider that low volatility is a sign of less indecision. After prices trend up for years, investors become more complacent and therefore volatility declines. Just as we saw in 2007, we shouldn’t be surprised to see volatility very low at the price peak.

You can probably see how this is a real problem. On the one hand, if we want investors to be able to handle the volatility of a investment program, the risk and volatility necessarily needs to be managed so they don’t experience it. An active risk management system with an absolute return objective like I operate wants to have less exposure during highly volatile periods investors prefer to avoid. Yet, you may see how many investors who apply conventional asset allocation and risk measures, like Modern Portfolio Theory and Value at Risk that use standard deviation as an input, are likely to have models that get them more exposure at the peaks and less exposure at the lows. That is, at the peaks their models expected return is at its highest and its expected variance is at its lowest. After a major decline in price just the opposite is true: their expected return based on historical return is at its lowest and expected variation is the highest.

The past 10 years was a very challenging period anyway we slice it. But an investment program like ASYMMETRY® Global Tactical that avoided large drawdowns as well as avoided such radical swings, allowed investors to stick with the program and compound capital positively rather than panic out or deal with large losses and drawdowns.

The Greek philosopher Heraclitus famously said, “No same man could walk through the same river twice, as the man and the river have since changed.” I think we can be sure about only one thing: the next price trend and volatility will be different, so I embrace it and am prepared for however it unfolds.