Pattern Recognition: Is the S&P 500 Forming a Head and Shoulders Bottom?

I don’t always share when I observe stock market patterns unfold, but when I do, it’s usually to inform (or aggravate) my friends who don’t understand (or want to understand) technical analysis.

Long before I started developing computerized trading systems based on quantitative signals I learned and applied chart patterns and trend lines to determine if a trend was up, down, or sideways. Said another way, up until 15 years ago I identified the direction of price trends visually looking at a price trend on a chart. I later defined up, down, and sideways with mathematical equations that help to systematize the process of trend identification. I believe my starting out learning trends by hand and visual representation helped me to develop better quantitative trend systems. The two go hand in hand.

We can define the direction of a trend with an equation as simple as momentum. For example, I have 14 different definitions of momentum and equations that define it. A simple one is X period rate of change. If it’s positive, the trend is up. If it’s negative, the trend is down. The factor that determines the trend direction is the time frame. Many academic types like using simple time series momentum methods like this because it’s easy to backtest. Pattern recognition is more difficult, so fewer have developed systems to automate pattern recognition and make it testable.

Chart patterns have historically been more visual. Chartists or technical analysts look at the chart of a price trend to determine if there is a pattern. The pattern we are looking for tells the story of supply and demand. The chart of a price trend shows us what has been going on with the battle between supply and demand from buyers and sellers. We may get an idea of who may be winning the battle and position our capital in that direction. For example, when prices are rising the buyers are in control and when prices all falling selling pressure is dominant. So, pattern recognition is just another form of trend following. Instead of using X-day breakouts, moving average, or channel breakouts, it’s using a pattern that is believed to tell the story of price action. We don’t make decisions based on a pattern, but the underlying asymmetry between buyers and sellers that caused the pattern and the direction of the price trend.

Simple > Complex

To me, it’s a much more simple way to determine if buyers or sellers are in control of the price trend than trying to find a fundamental narrative. There are so many different reasons for buying demand and selling pressure we could never really know why one is dominating the other. The news attempts to explain it, but the truth is, investors could be buying or selling based on perceived fundamentals, trend lines, moving averages, stop losses, buy stops, fear of missing out, fear of losing money, or tax reasons. Rather than trying to figure out what the majority is thinking, the pattern of the price trend tells the net result of all the buying and selling. It fits the idea of simple beats complex and if we simply stay with the direction of the trend we can’t be too wrong for too long. Someone making decisions based on things other than the price trend itself has the potential to stray far away from the reality of the price.

To me, chart patterns are really just a little more elaborate versions of trend lines. A trend line is just a line marking a chart such as how I marked the higher highs and higher lows yesterday in Divergence in the Advance-Decline Line May be Bullish. 

I observed today the S&P 500 seems to be forming a head and shoulders bottom pattern. The head and shoulders pattern happens when a market trend is in the process of reversal either from a bullish or bearish trend.  There are two kinds of head and shoulders.

  • A head and shoulders top is a pattern that forms after an uptrend. After it is completed, it signals a reversal of the trend from up to down.
  • A head and shoulders bottom is an inverse of the head and shoulders top. The head and shoulders bottom forms after a downtrend and signals a change of trend from down to up.

Below is the chart of a theoretical index used to represent an idealized head and shoulders. It includes both head and shoulders tops and head and shoulders bottoms. Stockcharts offers this index for educational purposes to see what idealized head and shoulders look like. You may notice each top and bottom are a little different – they aren’t perfect.

head and shoulders pattern recognition

I put the green box around a head and shoulders bottom. You can see why when you look at the S&P 500 stock index chart below.

head and shoulders bottom patterns recognition

An inverse head and shoulders pattern is simply a downtrend caused by selling pressure, interrupted by a brief reversal (left shoulder), a selling climax (head), an interruption again (right shoulder), then it would move on to new highs. Moving on to new highs will determine if it is completed as a reversal bottom, or not. To reverse the downtrend, selling pressure must be exhausted as buying demand becomes dominant.

Many patterns like the head and shoulders rely on volume as confirmation, so chartists can make it as complicated as they want, or keep it simple by looking at the pattern. For my purpose, I’m going to keep it simple and say we’ll know if this is indeed a head and shoulders bottom reversal pattern if it follows through on the upside. If it does, we would expect the price trend of this index to at least reach its old highs. If the price doesn’t hold and it doesn’t follow through to the upside, it’s probably going to at least test the prior low again.

Either way, patterns are never completely accurate. It’s probabilistic, never a sure thing. The head and shoulders is simply a pattern formation commonly seen after a downtrend that, if completed, may signal the end of the downtrend and reversal into a new uptrend. It’s based on the visual representation of the battle between supply (selling pressure) and demand (buying interest). For example, when the head and shoulders bottom completes the low point in the (inverse) head, it marks the point when those who wanted to sell have sold. So, the right (inverse) shoulder signals selling has dried up and buyers are taking over. It is completely normal to observe profit-taking after an advance, so the last few days is normal even if this is a reversal up. You can probably see how volume gets involved to confirm the pattern. In the case recently, the volume was high at the lows signaling selling pressure. The volume is declining on the right shoulder. The good news is, the volume didn’t expand on these recent down days.

Let’s see how it all unfolds.

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

The observations shared on this website are for general information only and are not specific advice, research, or buy or sell 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. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

 

Observations of the stock market downtrend

Observations of the stock market downtrend

In the last observation I shared about the stock market, “The stock market trends up with momentum,” we saw the stock market reverse back up with strong momentum. The S&P 500 stock index had declined about -7% from its high, then reversed back up 3%. I discussed how investor behavior and sentiment drives market prices. Many investor sentiment measures signaled investor fear seemed to be in control, driving down prices. Volatility had spiked and then started to settle back down. Many individual stocks in the S&P 500 had declined enough to signal shorter-term downtrends, but then they reversed up. I closed by saying:

In summary, today was a strong upward momentum day for the stock market and most stocks participated in the uptrend. After sharp declines like we’ve seen this month, the stock market sometimes reverses up like this into an uptrend only to reverse back down to test the low. After the test, we then find out if it breaks down or breaks out.

One day doesn’t make a trend, but for those who are in risk taker mode with stocks, so far, so good.

The part I bolded with italics has turned out to be the situation this time.

Below is a year to date price trend of the S&P 500 stock index. As of today, my observation “the stock market sometimes reverses up like this into an uptrend only to reverse back down to test the low” is what we are seeing now.

stock market trend

I’ve always believed investment management is about probability and possibilities, it’s never a sure thing. The only certainty is uncertainty, so all we can do is stack the odds in our favor. As I said before, “After the test, we then find out if it breaks down or breaks out.” 

The positive news is, investor sentiment measures are reaching levels that often precede short-term trend reversals back up.

The bad news is if the current trend becomes a bigger downtrend these indicators will just stay at extremes as long as they want. We have to actively manage our exposure to loss if we want to avoid large losses, like those -20% or more that are harder to overcome.

Down -10% is one thing, down -20% is another. Any investor should be willing to bear -10% because they will see them many times over the years. Only the most passive buy and hold investors are willing to bear the big losses, which I define as -20% or more.

Nevertheless, I see some good news and bad, so here it is. I’ll share my observations of the weight of the evidence by looking at relatively simple market indicators. I don’t necessarily make my tactical decisions based on this, but it is instead “market analysis” to get an idea of what is going on. Observations like this are intended to view the conditions of the markets.

Fear is the dominant driver. 

The Fear & Greed Index tracks seven indicators of investor sentiment. When I included it a week ago, it was at 15, which is still in the “Extreme Fear” zone. The theory is, the weighting of these seven indicators of investor sentiment signals when fear or greed is driving the market. Clearly, fear is the dominant driver right now.

fear greed index investor sentiment behavioral finance

At this point, we can see investor sentiment by this measure has now reached the low level of its historical range. In this chart, we can see how investor sentiment oscillates between fear and greed over time in cycles much like the stock market cycles up and down.

fear and greed back test over time investor sentiment indicator

I believe investor behavior is both a driver of price trends, but investors also respond to price trends.

  • After prices rise, investors get more optimistic as they extrapolate the recent gains into the future expecting the gains to continue.
  • After prices fall, investors fear losing more money as they extrapolate the recent losses into the future expecting them to get worse.

Investor sentiment and price trends can overreact to the upside and downside and the herd of investors seems to get it wrong when they reach an extreme. We observe when these kinds of indicators reach extremes, these cycles are more likely to reverse. It is never a sure thing, but the probabilities increase the possibility of a reversal. But, since there is always a chance of a trend continuing longer in time and more in magnitude, it is certainly uncertain. Since there is always a chance of a bad outcome, I  have my limits on our exposure to risk with predetermined exits or a hedge.

Speaking of a hedge. 

I started pointing out my observation several weeks ago of a potential volatility expansion. If you want to read about it, most of the past few weeks observations have included comments about the VIX volatility index. Over the past few days, we’ve observed a continuation in the volatility expansion.

vix hedge volatility expansion asymmetric hedge asymmetry

Implied volatility has expanded nearly 100% over in the past 30 days.

vix volatility expansion trading

As a tactical portfolio manager, my first focus is risk management. When I believe I have defined my risk of loss, I become willing to shift from risk manager to risk taker. I share that because I want to point out the potential for hedging with volatility. Rather than a detailed exhaustive rigorous 50-page paper, I’m going to keep it succinct.

My day job isn’t to write or talk about the markets. I’m a professional portfolio manager, so my priority is to make trading and investment decisions as a tactical investment manager. I’m a risk manager and risk taker. If I never take any risk, I wouldn’t have any to manage. The observations I share here are just educational, for those who want to follow along and get an idea of how I see things. I hope you find it helpful or at least interesting. It’s always fun when it starts new conversations.

To keep the concept of hedging short and to the point for my purpose today, I’ll just share a simple chart of the price trend of the stock index and the volatility index over the past 30 days. The stock index has declined -8.3% as the implied volatility index expanded over 95%. You can probably see the potential for a hedge. However, it isn’t so simple, because these are just indexes and we can’t buy or sell the VIX index.

vix volatility as a hedge stock market risk management

The purpose of a hedge is to shift the risk of loss from one thing to another. The surest way to reduce the possibility of loss is to simply sell to reduce exposure in the thing that is the risk. That’s what I do most of the time. For example, when I observed a potential volatility expansion, I reduced my exposure to positions that had the possibility of loss due to increased volatility. Once prices fall and volatility contracts, maybe we increase exposure again to shift back to risk-taking. If we take no risk at all, we would have no potential for a capital gain. So, tactical portfolio management is about increasing and decreasing exposure to the possibility of gain and loss. If we do it well, we create the kind of asymmetric risk/reward I aim for.

So, any hedging we may do is really just shifting from one risk to another, hoping to offset the original risk. Keep in mind, as I see it, a risk is the possibility of loss. I’ll share more on hedging soon. I have some observations about hedging and hedge systems you may find interesting.

Most stocks are participating in the downtrend. Below is an updated chart of the percent of the stocks in the S&P 500 that are above their 50-day moving average. If you want to know more about what it is, read the last observations. The simple observation here is that most stocks are declining.

stock market breadth risk indicator

Much like how we saw investor sentiment cycle and swing up and down, we also see this breadth indicator oscillate from higher risk levels to lower risk levels.

  • After most stocks are already in uptrends, I believe the risk is higher that we’ll see it reverse.
  • After most stocks have already declined into downtrends, it increases the possibility that selling pressure may be getting closer to exhaustion.

The good news is, at some point selling pressure does get exhausted as those who want to sell have sold and prices reach a low enough level to bring in new buying demand.

That’s what stock investors are waiting for now.

These are my observations. I don’t have a crystal ball, nor does anyone. I just predetermine my risk levels in advance and monitor, direct, and control risk through my exits/hedging how much I’m willing to risk, or not. We’ll just have to see how it all unfolds in the days and weeks ahead.

Only time will tell if this is the early stage of a bigger deeper downtrend or just another correction within the primary trend.

I hope you find my observations interesting and informative.

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

The observations shared on this website are for general information only and are not specific advice, research, or buy or sell 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. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

Observations of the stock market decline and volatility expansion

Observations of the stock market decline and volatility expansion

On September 25th I shared in VIX level shows market’s expectation of future volatility when I pointed out a low level of expected volatility as implied by the VIX index.

I said:

The current level of the VIX index has settled down to a lower historical level suggesting the market expects the future range of the price of the S&P 500 to be lower. Below is the current level relative to the past year.

I went on to explain my historical observations of volatility cycles driven by investor behavior:

The VIX Index is intended to provide a real-time measure of how much the market expects the S&P 500 Index to fluctuate over the next 30 days. The VIX Index reflects the actual order flow of traders

Since investors tend to extrapolate the recent past into the future, they usually expect recent calm markets to continue and violent swings to persist.

After the stock market declines and volatility expands, investors extrapolate that recent experience into the future and expect volatility to continue. Sometimes it does continue, but this time it gradually declined as the price trend became calmer.

When markets have been calm, traders and investors expect volatility to remain low. Before February, the VIX implied volatility had correctly predicted low realized volatility for months. But, both realized and expected volatility was so low that many investors were shocked when stock prices fell sharply, and volatility expanded.

When the market expects volatility to be low in the next 30 days, I know it could be right for some time. But, when it gets to its historically lowest levels, it raises situational awareness that a countertrend could be near. It’s just a warning shot across the bow suggesting we hedge what we want to hedge and be sure our risk levels are appropriate.

I shared the chart below, showing implied volatility at the low end of the cycle over the past year:

Since that date, we’ve indeed witnessed a volatility expansion of more than 90% in the VIX index and a decline in the S&P 500 stock index over -6%.  Implied volatility has expanded and stocks declined. As implied volatility is now starting to contract, below we can see the recent expansion as it trended from 12 to 24. Today its back to its long-term average of 20.

Stock market indexes, both U. S. and international, have declined 6 – 7% from their highs.

At this point, this has been a normal short-term cycle swing in an ongoing uptrend that is frequently referred to as a “correction.”

To be sure, we can see by looking at the % drawdowns in the primary uptrend that started in March 2009.

Markets cycle up and down, even within overall primary uptrends. As we see over a nine-year period, the current decline is about average and half as deep as the largest declines since 2009.

You can probably see what I meant by situational awareness of the markets cycles, trends, and volatility levels.

It isn’t enough to just say it or write about it. My being aware of the situation helps me to do what I said, which is worth repeating:

But, when it gets to its historically lowest levels, it raises situational awareness that a countertrend could be near. It’s just a warning shot across the bow suggesting we hedge what we want to hedge and be sure our risk levels are appropriate.

As far as the stock market condition, I like to see what is going on inside. Just as volatility swings up and down in cycles, so do price trends. As I’ve pointed out before, I observe prices swinging up and down often driven by investor behavior. For example, many investors seem to oscillate between the fear of missing out and the fear of losing money.

“The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own.” – Warren Buffett

One visual way to observe the current stage is the breadth of the stock market as I shared last week in The Stock Market Trend. Below is the percent of stocks in the S&P 500 index trending above their 50 day moving averages often used as a short-term trend indicator. This is a monthly chart since 2009 so we can see how it oscillates up and down since the bull market started. At this point, the number of stocks falling into short-term downtrends is about what we’ve seen before.

stock market breadth asymmetric risk

The risk is: this continues to be an aged old bull market, so anything is possible. That is why my focus every day is situational awareness. But, there is always a risk of a -10% or more decline in the stock market, regardless of its age or stage.

The good news is, we’ve now experienced some volatility expansion, stocks have now pivoted down to the lower end of their cycles, so maybe volatility will contract and stock prices resume their uptrend.

We’ll see.

All that is left to do is observe, be prepared, and respond tactically as it all unfolds.

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

The observations shared on this website are for general information only and are not specific advice, research, or buy or sell 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. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

The Stock Market Trend

The stock market declined with heavy selling pressure on a major stock market anniversary that I haven’t heard anyone mention.

October 10, 2018, is the 10-year anniversary of the waterfall decline of 2008.

Below is the S&P 500 stock index from October 9, 2007 to October 10, 2008. I remember it very well. It was the first part of the waterfall decline up to this day 10 years ago.

stock market decline 2008

But, as a reminder, while this bear market is often called the “2008 Financial Crisis” and misquoted as being only about the year 2008, it actually continued through March 9, 2009.

average length of bear market crash 2008.jpg

With stock indexes only about -5% or so off their all-time highs, we are far from that today.  But, the stock market decline today was impressive in magnitude and broad across all sectors.

stock market sector ETF October 10 2018

The breadth of the decline was unmistakable by the 50% decline in the % of stocks in the S&P 500 trading above their 50 day moving average. The percentage of stocks trading above the moving average is a breadth indicator that measures internal strength or weakness in the stocks in the index and the index itself. We say that breadth is strong when the majority of stocks in an index are trading above their moving average. Since the 50-day moving average is used to measure the short-medium term trend, it reveals that only 24% of the 500 stocks in the S&P 500 index are above their short-term trend.

percent of stocks above 50 day moving average SPX SPY.jpg

I colored the top red and the bottom green because the extreme highs and extreme lows can signal overbought and oversold levels.

The indicator is an oscillator that cycles between 0% and 100%.

After most stocks have trended up, we say an uptrend has broad participation, which is positive. However, markets cycle and oscillate up and down, so once most stocks have already been in uptrends at some point they reverse back down.

After most stocks have trended down, we say a downtrend becomes washed out. As selling eventually gets exhausted because those who want to sell have already sold.

Next, we observe the % of stocks in the S&P 500 index that are trending above their 200 day, which a longer term trend signal. 19% of the stocks declined below their 200 day moving average today leaving about half of the stocks still in a longer-term uptrend.

SPX BREADTH PERCENT OF STOCKS ABOVE 200 DAY MOVING AVERAGE

Since we are talking about moving averages and the S&P 500, below is the index itself with the 50 and 200 day moving average. Notice the 50 day moving average has been too tight to contain the uptrend. In other words, entering and exiting it would lead to many buys and sells and whipsaws like in June. The 200 day has better contained the trend since April, but notice if it were used as an exit it would have resulted in selling at the low. This observation is just using these moving averages as a very simple way to define uptrend vs. downtrend, it is not a complete trading system. Such measures are never perfect, and they don’t have to be.

stock market SPX 200 day moving average trend following

Today’s decline was impressive because the stock indexes declined over -3% in a single day. One day doesn’t make a trend, but it was enough to erase most of the year to date gains for the stock index.

stock market year to date 2018 trend following momentum

 

The Dow Jones Industrial Average of 30 of America’s largest companies declined even more than the S&P 500. There was even more weakness in small companies, momentum stocks, and an ETF tracking the top-ranked growth and momentum stocks by Investor’s Business Daily declined nearly -6%. As a proxy for leading growth and momentum stocks, this is an indication the leaders declined the most today.

stock market momentum ETF trend following asymmetric

You can probably see why I believe it’s essential to actively manage risk by knowing in advance when to exit a loser to cut losses short as well as understanding the market risk level. For those of us who weren’t fully exposed to the decline who have the capital to eventually buy at lower prices, we get to take advantage of a falling trend.

Over the past week, I shared observations of volatility expansion as the implied volatility index has been trending up. Below is its year to date trend.

VIX VOLATILITY EXPANSION

Here it is over the past week since I mentioned it. I included the S&P 500 stock index to illustrate as the stock market declined about -5% the past week, implied volatility expanded 98%.

SPY SPX VIX ASYMMETRIC RISK REWARD

We’ll see in the days and weeks ahead if this is the beginning of a more significant downtrend that becomes a waterfall decline or if it was enough to exhaust the selling pressure of those who wanted to sell.

 

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

The observations shared on this website are for general information only and are not specific advice, research, or buy or sell 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. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

 

The volatility expansion continues like tropical storm Michael that could become a hurricane

The volatility expansion observation I shared last week has continued.

If you haven’t followed along, I suggest reading VIX level shows the market’s expectation of future volatility and Here comes the volatility expansion to see where I am coming from.

Implied volatility as measured by the CBOE Volatility Index $VIX has gained about 45% in the past three trading sessions, so volatility is expanding.

VIX $VIX VOLATILITY EXPANSION VOL TRADING ASYMMETRIC.jpg

I discussed what a rising VIX and volatility expansion means in the prior observations.

Rising implied volatility means rising expectations for future volatility as implied by options prices. Ultimately, Implied volatility is determined by the price of options contracts.

In other words, implied volatility is driven by supply and demand and order flow.

An increase in options buying increases the price of options which results in higher implied volatility.

The net selling of options decreases the price of options which results in lower implied volatility.

Volatility isn’t directional.

Volatility is a measure of movement and how wide prices spread out, which says nothing about the direction of the price trend. Prices can be trending up sharply and volatility measures could expand.

Here are some examples:

Trending up with volatility expansion: a price trend that gains 10% a day for several days is a directional uptrend, but it’s also volatile. We would say the trend is up, but it’s also a volatility expansion as the price range is expanding.

Non-trending with volatility expansion: a price trend that cycles up and down around 5% a day for a long time with no clear direction up or down is a non-trending condition, but it’s also volatile. We would say it is non-trending, but it’s also a volatility expansion.

Trending down with volatility expansion: a price trend that declines 10% a day for several days is clearly a downtrend, with volatility. We could say the trend is down with expanding volatility.

Most of the time, the risk is asymmetric since we tend to see increased volatility when we see falling prices. As prices fall, more investors and traders respond to the simple fact the prices are falling and they are losing money. This serial correlation with falling prices can lead more prices falling even more as investors sell because prices are falling.

However, occasionally we may observe prices trending down with volatility contraction. A falling price trend with contracting volatility is necessarily going to be a slower downtrend with less directional movement. Instead of 5% or 10% declines, it may be 1 or 2% declines. A downtrend without volatility expansion would be observed as a slower decline that would necessarily take longer for a large loss to develop. For example, a -30% loss would happen much faster with -10% down periods than it would at a rate of -1%. You can probably see how volatility expansions in downtrends get the attention of someone who wants to manage their drawdown.

I’ll share some more detailed ways to observe volatility to decide if volatility is expanding or contracting.

At the top of the chart is the S&P 500 stock index. The bands around the stock index are 2 times the stock index average true range over the past 20 days. The dotted line in the center of the bands is the 10-day moving average. Price trends move in cycles, so they oscillate up and down over time. When we apply bands around the price trend is gives us a visual representation of a “normal” range of prices around the trend. We observe the price trend tends to oscillate or cycle up and down within certain parameters – the range. When this range spreads out, I call it volatility expansion. When the range contracts, it’s volatility contraction. Volatility itself also tends to cycle between expansion and contraction. We can see that here.

volatility expansion stock market VIX ATR

Below the price trend chart with bands of the average true range (ATR) I included a chart of ATR, standard deviation, and the VIX. Both standard deviation and average true range are actual, historical, and realized volatility. These indicators are measuring how the price of the index has actually expanded or contracted. As I pointed out before, the VIX is a measure of options prices on the stocks in this index, so it’s driven by expectations of future volatility over the next 30 days determined by the price of options. ATR and standard deviation are the actual range of movement of the index.

I started with the year-to-date time frame to show how the price trend spread out as it started swinging up and down at the beginning of the year and has since trended up with lower volatility; smaller cycles, smaller swings.

Just as we observe market price trends tend to cycle and swing up and down over time, so does volatility. p

  • Price trends may reach an extremely high or low point, then reverse in the other direction.
  • Volatility may reach an extremely high or low point, then reverse in the other direction.

When we see volatility reach an extreme low/high point, we can expect to see it drift the other way eventually. Investors and traders who only believe trends in price and volatility only go one way are those who get surprised and caught in a loss trap.

Now, let’s zoom in for a closer look with just a three-month time frame to observe what has been going on more recently.

I highlighted in green the recent volatility expansion I pointed out last week. Notice the forward-looking VIX index at the bottom turned up sharper and has trended up higher than its last cycle high last month. However, realized historical volatility as measured by standard deviation and the average true range of index prices has also trended up, but on a lag relative to the forward-looking VIX.

Volatility expansion stock market risk management vix asymmetric risk reward

So, you can probably see why I’m calling it a volatility expansion. It is drifting up, though it could certainly trend up a lot more, or it could reverse back down. For now, the rising prices in options suggest there is demand for protection and it is probably in response to something the market believes may lead to increase risk or volatility. It could be something seasonal like earnings season or it could be as simple as the month of October is historically one of the most volatile months.

Speaking of October…

October is a typical month to see hurricanes in the Gulf and Atlantic, too. Right now, we have Michael (no relation) coming up through the Gulf of Mexico. As of this morning, Michael was just a named storm, but its expected to expand into a Category 2 or 3 hurricane by the time it reaches the Florida panhandle to our favorite places like Sandestin, Miramar Beach, Destin, and the 30A area like Rosemary Beach and Alys Beach. The intensity, speed, and how wide the storm spreads out to reach higher categories is a lot like volatility expansion in market price trends. Most people prefer to experience calm and quiet. We would prefer to see the storm contract and slow down its speed.

Although the tropical storm monitors have ways of measuring the probability of speed, expansion, etc. we are always dealing with the certainty of uncertainty. Hurricanes can shift and drift in different directions, speed up or slow down, and expand or contract. How we respond is a matter of situational awareness of measuring the cone of uncertainty as best we can. Some of us do it better than others. Some of us prepare more timely and respond better than others.

Right now we have some volatility expansion and we are positioned as such. The implied volatility index suggests the market believes we’ll see some price swings (up and down) this month.

We’ll see how it all plays out.

Semper Gumby (Always Flexible).

Let’s hope Michael doesn’t give me a bad name.

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.

 

 

 

 

 

 

Here comes the volatility expansion

Nine days ago in VIX level shows market’s expectation of future volatility I shared an observation that the implied volatility VIX, a measure of expected future volatility that is implied by option prices, had reached an extremely low point. I explained what that means and how I use it:

When the market expects volatility to be low in the next 30 days, I know it could be right for some time.

But, when it gets to its historically lowest levels, it raises situational awareness that a countertrend could be near.

Today we have some volatility expansion.

The VIX Volatility Index has gained 35%. It implies the market now expects higher volatility. Specifically, the market expects the range of prices to spread out over 15% instead of 12%.

VIX $VIX Volatility Expansion asymmetry asymmetric convexity divergence

The popular stock indexes are down over -1% for the first time in a while.

stock market asymmetry asymmetric risk

As I said nine days ago, it should be no surprise to see some volatility expansion. Volatility is mean reverting, which means it tends to oscillate in a high and low range and reverse back to an average after its reaches those cycle highs and lows.

Implied volatility had reached its historical low end, so it’s expanding back out. Stock prices are also spreading out and declining so we shouldn’t be surprised to see more movement in prices in the coming weeks.

At around the same time volatility was contracting and calm, my momentum indicators were signaling stock indexes and many individual stocks were reaching short-term extreme levels that often preceded a short-term decline. These systems prompt me tactically reduce exposure to stocks to dynamically manage our risk.

Only time will tell how it all plays out. We’ll see how it unfolds from here.

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

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. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. 

Stanley Druckenmiller on his use of Technical Analysis and Instinct

Stanley Druckenmiller has a 30-year track record that is considered “unrivaled” by many. From 1988 to 2000, Druckenmiller was a portfolio manager for George Soros as the lead portfolio manager for Quantum Fund. He founded Duquesne Capital to manage a hedge fund in 1981 and closed the fund in August 2010.

Kiril Sokoloff of Real Vision interviewed him recently and shared parts of the interview on YouTube.

I watched the full 90-minute interview and noted some observations I’ll share.

Speaking of dealing with “algo trading” and “the machines,” Kiril Sokoloff asks Stan Druckenmiller:

“Let’s talk about the algos. We haven’t seen the algos sell, we’ve only seen them buy. We saw a little bit of it in February when there was some concentrated selling. We saw it in China in 2015, which was scary. Most people weren’t focused on that but I was and I think you were, too.

They (algos/machines) are programmed to sell when the market is down -2%. The machines are running and can’t be stopped and a huge amount of trading and money is managed that way. We’ve been operating in a bull market and a strong economy.

What happens when it’s a bear market and a bad economy, will things get out of hand?”

So, knowing that and knowing we’re at risk of that any moment… what are you watching for? …. how are you protecting yourself? What are you watching for? 

Stanley Druckenmiller answers:

“I’m going to trust my instincts and technical analysis to pick up this stuff up. 

But what I will say… the minute the risk reward gets a little dodgy I get more cautious than I probably would have been without this in the background.”

What was most fascinating about the rare interview of Stanley Druckenmiller is that some of us have figured out a successful tactical trading global macro strategy using the common elements of price trends, relative strength, risk management, and momentum combined with a dose of instinct all applied to global markets.

You can see for yourself at:

This wasn’t the first time Stan Druckenmiller spoke of his use of technical analysis and charts. In Part IV “Fund Managers and Timers” of The New Market Wizards in 1992, Jack Schwager included an interview with Stanley Druckenmiller titled “THE ART OF TOP-DOWN INVESTING.”

When asked what methods he used, he spoke of earnings, and then:

“Another discipline I learned that helped me determine whether a stock would go up or down is technical analysis. Drelles was very technically oriented, and I was probably more receptive to technical analysis than anyone else in the department. Even though Drelles was the boss, a lot of people thought he was a kook because of all the chart books he kept. However, I found that technical analysis could be very effective.”

Then, he was asked about his experiences during the 1987 stock market crash:

Jack Schwager: What determined the timing of your shift from bullish to bearish?

Stanley Druckenmiller: It was a combination of a number of factors. Valuations had gotten extremely overdone: The dividend yield was down to 2.6 percent and the price/book value ratio was at an all-time high. Also, the Fed had been tightening for a period of time. Finally, my technical analysis showed that the breadth wasn’t there—that is, the market’s strength was primarily concentrated in the high capitalization stocks, with the broad spectrum of issues lagging well behind. This factor made the rally look like a blow-off.

Jack Schwager: How can you use valuation for timing? Hadn’t the market been overdone in terms of valuation for some time before you reversed from short to long?

Stanley Druckenmiller: I never use valuation to time the market. I use liquidity considerations and technical analysis for timing. Valuation only tells me how far the market can go once a catalyst enters the picture to change the market direction.

Jack Schwager: The catalyst being what?

Stanley Druckenmiller: The catalyst is liquidity, and hopefully my technical analysis will pick it up.

Well, that sounds familiar.

What is most fascinating to me is that I’ve come to the same conclusions through my own experience over more than two decades without knowing Stanley Druckenmiller or others similar to him beforehand. I have to admit that I didn’t remember having so much in common with his strategy because I read The New Markets Wizards so long ago.

Some of us have discovered very similar beliefs and strategies through independent thinking and our own experiences. When I discover that others have found success I see the common characteristics and that confirms what drives an edge.

 

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.

The Trend in Interest Rates and the Impact on the Economy and Stock Market

The Federal Reserve raised interest rates and raised expectations for a fourth rate hike in December. The Fed unanimously agreed to raise the federal funds rate a quarter percentage point, to a range of 2% to 2.25%.

But, what does that mean?

The Federal Funds Rate is the interest rate at which depository institutions like banks and credit unions lend their reserve balances to other banks and credit unions overnight, on an uncollateralized basis. The U.S. Target Federal Funds Rate is at 2.00%, compared to the previous market day and 1.00% last year. This is lower than the long-term average of 2.61%.

The interest rate the borrowing bank pays to the lending bank to borrow the funds is negotiated between the two banks. The weighted average of this rate across all such transactions is the Effective Federal Funds Rate. The Effective Federal Funds Rate is at 1.91%, compared to 1.91% last month and 1.16% last year. This is lower than the long-term average of 4.83%.

Below we chart the trend of the Federal Funds Rate and the Effective Federal Funds Rate over the past 5 years. The trend in interest rates is clear.

Federal Funds Rate Interest Rates Effective Target

Why do we care about rising interest rates?

The Federal Funds Rate drives interest rates for mortgages, consumer loans, and credit cards. For example, loans based on the prime rate will be adjusted to reflect the trend in the Federal Funds Rate.

The rising trend in interest rates impacts many things beyond consumer credit cards. Ultimately, when the cost of borrowing increases it can impact real estate, homebuilders, and home construction as I pointed out in Rising Interest Rate Impact on Real Estate and Home Construction.

We haven’t seen the Federal Funds Rate this high in over 10 years.

Federal Funds Interest rate last 10 years

The Federal Funds Rate was much higher at around 4.5% at the peak of the stock market in October 2007. The Fed quickly and sharply lowered interest rates in response to the economic recession in 2008. The U.S. Fed kept a zero interest rate policy like Japan from December 2008 through December 2015.

federal funds rate since october 2007 bull market peak

Many investors wonder how the change in the directional trend of interest rates impacts the stock market. It is no surprise that mutual fund companies who want investors to keep their money invested in their funds that stay fully invested all the time will present data showing rising interest rates don’t impact stocks.

The Fed has been steadily raising rates to keep the U.S. from growing so fast that inflation gets out of hand. Increasing the cost of borrowing will likely slow down spending at some point for both consumers and capital spending of businesses.

The Federal Funds Rate seems to trend follow the stock market. Looking at a chart from the stock market peak in January 2000, we see the Fed Funds Rate was 6%. The Fed lowered the rate to around 2% during the -50% stock market decline and economic recession. I marked the recession in gray.

FED FUNDS RATE TREND FOLLOWING STOCKS ECONOMIC RECESSION

The Fed naturally increases and decreases the Fed Funds Rate in response to changing conditions.

After an economic expansion and the stock market appears highly valued, the Fed begins to raise interest rates to prevent inflation.

After the stock market declines and an economic recession, the Fed begins to lower interest rates to help stimulate recovery. In the chart above, we can see the zero interest rate policy after the crash of 2008 -2009 is abnormal.

Below is the trend Federal Funds Rate going back to the 1950’s. The interest rate has been much higher in the past, but not kept so low.

federal fed funds rate long term history trend following

Now that interest rates are trending up again it’s going to be interesting to observe how it impacts the economy and the stock market.

Many investment advisors and fund companies will probably try to use the data to show a silver lining. If your money is invested buy and hold into funds that are fully exposed to market risks all the time, those funds incentive is to keep you invested in them regardless of the level of risk.

I don’t believe market returns give us what we want over a full market cycle. After the stock indexes have gained for 10 years without a -20% or more bear market, many investors have probably become complacent with their exposures to market risks. That is especially true with one the longest bull market in history and the second highest valuation.

Along with long uptrends, we can experience devastating downtrends that result in large losses. That’s what we’ve experienced the past 25 years. The giant uptrend 1995 – 1999 was reversed from 2000 -2003. The uptrend 2003 to 2007 was reversed 2008 – 2009 and didn’t recover its 2007 high until 2013.

Rather than full exposure to market risk and reward all the time, I believe we must manage risk to increase and decrease exposure to the possibility of gain and loss.

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

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.

VIX level shows market’s expectation of future volatility

Volatility is a measure of the frequency and magnitude of price swings up and down in a market or stock over a period of time.

  • Lower volatility is when prices are calmer and don’t swing up and down as much.
  • Higher volatility is when price movement spreads out, and prices swing up and down in a wider range.

We can measure volatility using two general methods:

  • Realized Volatility: based on actual historical price data. For example, we can see realized volatility by looking at historical standard deviation or average true range.
  • Implied Volatility: is a measure of expected future volatility that is implied by option prices. For example, the VIX Index is a measure of expected future volatility.

The VIX Index measures the market’s expected future volatility based on options of the stocks in the S&P 500® Index. The VIX Index estimates expected volatility by aggregating the weighted prices of S&P 500 Index put and call options over a range of strike prices.

The last observation I shared of the trend and level of VIX was VIX Trends Up 9th Biggest 1-day Move. I pointed out the VIX level had been very low, and it was an observation of complacency. The VIX spiked up nearly 300% – a volatility expansion. Actually, we could call it a volatility explosion.

The current level of the VIX index has settled down to a lower historical level suggesting the market expects the future range of the price of the S&P 500 to be lower. Below is the current level relative to the past year.

Looking at the current level of 12 compared to history going back to its inception in 1993, we observe its level is indeed near its lowest historical low.

The VIX Index is intended to provide a real-time measure of how much the market expects the S&P 500 Index to fluctuate over the next 30 days. The VIX Index reflects the actual order flow of traders.

Since investors tend to extrapolate the recent past into the future, they usually expect recent calm markets to continue and violent swings to persist.

After the stock market declines and volatility expands, investors extrapolate that recent experience into the future and expect volatility to continue. Sometimes it does continue, but this time it gradually declined as the price trend became calmer.

When markets have been calm, traders and investors expect volatility to remain low. Before February, the VIX implied volatility had correctly predicted low realized volatility for months. But, both realized and expected volatility was so low that many investors were shocked when stock prices fell sharply, and volatility expanded.

When the market expects volatility to be low in the next 30 days, I know it could be right for some time. But, when it gets to its historically lowest levels, it raises situational awareness that a countertrend could be near. It’s just a warning shot across the bow suggesting we hedge what we want to hedge and be sure our risk levels are appropriate.

 

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

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

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

 

What trends are driving emerging markets into a bear market?

In Emerging Markets Reached a Bear Market Level we noted the emerging markets index has declined -20%, which is considered to be in bear market territory. The emerging markets index includes 24 countries classified as emerging countries.

To see the country exposure, we examine the iShares MSCI Emerging Markets ETF holdings. China is about 31%, South Korea is about 15%, Taiwan is over 12%, so the top three countries make up 58% of the country exposure. Add India at 10% and the top four countries is a dominant 68% of the exposure. Clearly, we’d expect the drift of these top holdings to dominate the trend.

what countries are emering markets ETF ETFs

Below we see the 2018 price trends of the emerging markets ETF and the top four countries that make up 68% of the emerging markets index ETF exposure. We see that South Korea and China are the primary downtrends that are trending close to the emerging markets index ETF. Taiwan and India have stronger relative momentum.

emerging markets $EEM china $FXI india south korea 2018 trend

To get a better understanding of what is driving the downtrend, we draw the % off high charts to see the drawdowns. From this observation, we can see what is really driving the trend. Of the top four countries in the index, the negative momentum of China and South Korea are driving the trend down. China is down -24% over the past year as South Korea is down -17%.

emerging market ETF trends

Taiwan and India have stronger relative momentum since they have trended up more recently since July. Prior to July, they were trending closer to China and South Korea.

You can probably see why I include the individual countries in my global universe rather than just the broad emerging markets index ETF that includes 24 countries. I want to find potentially profitable price trends, so I increase my opportunity to find them when I give myself more options.

There are 24 countries represented in the MSCI Emerging Markets Index and we’ve looked at the top 4 because they are given 68% of the exposure. That leaves only 32% in the other 20 countries. So, in regard to understanding what is driving the MSCI Emerging Markets Index, viewing the trend of the top holdings is enough to get an idea of the countries driving returns. But, in wanting to go find potentially profitable price trends, I research all the countries trends.

What about the rest of the emerging markets countries? 

Looking at the other 20 countries classified as emerging markets, I’ll divide them into groups. First, we’ll look at the other countries that are down -10% or more year-to-date. Then, I’ll draw a chart of those that are down this year,  but not as much. We’ll end with the few that are positive in 2018.

Emerging markets countries down the most year-to-date include Turkey, South Africa, Indonesia, Brazil, Philippines, Chile, Poland, and Peru. Priced in U.S. dollars, these countries are down between -14% and -52%. Turkey is down the most.

emerging markets countries down 2018 $EEM

Looking at their % off high shows us the drawdown over the past year, which is a different perspective. If you had held one of these ETFs, this is the amount it would be down from its highest price over the past year.

Emerging markets countries down the most 2018

Clearly, these emerging countries are in downtrends and a bear market if we define a bear market as a -20% decline. Keep in mind, these ETFs are foreign stocks priced in U.S. dollars, so to U.S. investors, this is what the trends of these countries look like.

Next, we observe emerging markets countries that are down less than -10% in 2018. Russia, Columbia, Thailand, and Malasia are down between -3% and 8% so far. Their trends are generally down: lower highs and lower lows.

emering markets year to date 2018

We can see the downtrends in a different perspective when we view their drawdowns as a % off high over the past year.

emering market countries percent off high asymmetric risk reward

I saved the best for last. The strongest trending top momentum emerging markets countries so far in 2018 are Mexico, Taiwan, Saudi Arabia, and Qatar. Saudi Arabia was previously classified as a smaller frontier market, but, this summer MSCI announced it will include the MSCI Saudi Arabia Index in the MSCI Emerging Markets Index.

top momentum emerging markets countires 2018

Hearing names like Mexico, Taiwan, Saudi Arabia, and Qatar may highlight home country bias for some investors. Home country bias is the tendency for investors to favor companies from their own countries over those from other countries or regions.

I don’t have a home country bias. I am open to finding potentially profitable price trends in any country around the world. We encourage investors to be open to global trends and not limit their choices, but if our clients don’t want exposure to any specific country, we are able to exclude it in our ASYMMETRY® Managed Portfolios.

While the United States is the single largest economy in the world, according to JP Morgan it accounts for only a small fraction of global GDP and just over 35% of the world’s capital markets. Yet, studies show that U.S. investors have nearly 75% of their investments in U.S.-based assets. As we’ve shown here, there has been a good reason to avoid emerging countries for now, but as we explain in Emerging Markets Reached a Bear Market Level there are times when these countries present strong relative momentum over U.S. stocks.

This is why I tactically shift between global markets based on their directional price trends rather than a fixed buy and hold global asset allocation.

 

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.

 

 

 

 

 

 

The U.S. stock market was strong in August, but…

August was a strong month for the U.S. stock market, but the broad S&P 500 stock index and leading sectors have reached short-term overbought extremes that often indicate short-term elevated risk.

My focus is to position capital in the primary direction of trends across different time frames, but trends can reach short-term extremes within the primary trend. We can focus only on the bigger trend, or we can try to take advantage of the short-term moves.

To understand where I am coming from for this observation, let’s define trend and extreme.

Trend is a direction that a price is moving, developing, evolving, or changing. A trend is a directional drift, one way or another. When we speak of price trends, the directional drift of a price trend can be up, down, or sideways. When I say a price is trending, it’s drifting up or down. I call sideways oscillation non-trending.

Extreme is reaching a high or the highest degree; very great, furthest from the center or a given point.

Tactical traders can be either directional traders or non-directional. For example, all investors are necessarily directional: they invest in a thing and want its price to go up.

A tactical trader can be directional: buying a stock, bond, commodity, or currency, hoping it will go up with them or they can sell it short hoping it will trend directionally down. They are directional traders, so they necessarily need to define the direction of the trend. Which way is it drifting?

However, not all traders are directional. Volatility traders who trade volatility through listed options or futures are trading movement itself, so when we trade volatility we aren’t concerned at all with the direction of the trend – we just want movement. Volatility traders may have no bias at all regarding the direction, we focus on volatility expansion or volatility contraction.

Trend Following is a directional strategy that requires the portfolio manager to determine the direction of the trend and enters that trend expecting inertia and momentum to continue in that direction. There are more than 300 published academic studies alone that prove that the most recent 3 to 12-month price momentum tends to continue rather than reverse. That doesn’t include the vast research and testing conducted by actual trading firms and hedge fund managers (like mine) that are not published to the public. These methods rely on directional trends to exploit for profit.

Countertrend is another directional strategy that requires the portfolio manager to determine the directional trend. However, my counter-trend system is designed to identify trends that are more likely to reverse and change direction than to continue. It may seem this strategy is the opposite of trend following, and in some ways it is, but countertrend systems are based on different time frames when executed correctly.

For example, a trend-following strategy that has been profitable has necessarily identified existing trends that have continued and trend following profits from the magnitude of those gains.

A counter trend can also be profitable and even combined with a trend following system. A counter trend system identifies reversals when the trend has changed or likely to change. The time frame, then, is different.

For example, while research shows that directional momentum over the recent 3 – 12 months tends to continue for another 12 months or longer, we also observe that trends have lasted 4-5 years tend to reverse and change trend.

You may notice stock market uptrends (bull markets) last about 4-5 years before they reverse into a downtrend (bear market). You may also notice investors and their advisers have a tendency to buy funds with the highest 5-year returns, only to catch the end of the excellent performance. You can probably see how they are “trend following” but using the wrong time frame. We find that trends actually reverse around the time those performance tables look appealing to investors. Counter trend systems aim to get positioned for big reversals in trend to profit from their directional change. Skilled counter trend portfolio managers develop and operate countertrend systems that are proven and quantified to identify and profit from such changes in trend.

We also observe short-term countertrends within the 30-day time frame.  Sometimes short-term extremes result in at least a temporary countertrend move in the opposite direction. These are shorter trend countertrends within an overall primary trend. Of course, countertrend reversals can also become longer trend changes, too.

Back to August, it was a strong month for U.S. stocks, but the broad indexes and leading sectors have reached higher risk levels in the short term.

sector rotation august 2018 stock market returnThe Technology sector reached a short-term overbought extreme in June and again in July and declined about -4% before resuming an uptrend.

The Consumer Discretionary sector where Amazon (AMZN) has a 25.5% weighting reached an overbought extreme in June and declined about -4% before resuming an uptrend.

The Healthcare sector has also shown strong momentum in its trend. It also reached a short-term overbought level, but only declined about -3%. However, by my measure, the Healthcare sector is more overbought than others.

These shorter trend trends are partly driven by investor sentiment. So, investor sentiment measures can be useful secondary confirming indicators to understand the condition of trends. At this point, most investor sentiment readings are only modestly elevated to levels that suggest greed is driving the market trend. Price could keep trending until enthusiasm is exhausted and sellers become dominant.

This is a very short-term observation of current trends. It’s just a near-term insight that we shouldn’t be surprised to see stocks decline at least a few percents in the weeks ahead.

And… it’s September… for those who follow seasonality, September has historically been one of the weakest months for stocks. I don’t make decisions based on seasonality. If stocks decline this month, the cause will be what I highlighted, not because which month it happens to be.

The bottom line is the broad stock indexes are trending up and led by a few strong sectors, but they’ve reached levels that my countertrend momentum systems suggest the risk of at least a temporary decline is elevated.

 

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.

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.

Front-running S&P 500 Resistance

The S&P 500 stock index closed just -1% from its all-time high it reached on January 26, 2018, and hasn’t been that high since. It’s been in a drawdown that was as much as -10% and it has taken six months to get back near its high point to break even.

SPY SPX $SPX $SPY S&P 500 STOCK INDEX

Before the madness begins saying “The S&P 500 is at resistance,” I want to point out an observation of the truth. It is one thing to draw a trend line on an index to indicate its direction, quite another to speak of “support” and “resistance” at those levels.

Is the S&P 500 at resistance? 

Depending on which stock charting service or data provider you use, it may appear the S&P 500 ETF (SPY) closed at its prior high. Many market technicians would draw a line like I did below in green and say “the S&P 500 is at resistance.”

S&P 500 stock index at resitance SPY SPX

In technical analysis applied to stock market trends, support and resistance is a concept that the movement of the price of a security will tend to stop and reverse at certain predetermined price levels.

Support is when a price trends down and stalls at a prior low. The reasoning is that investors and traders who didn’t buy the low before (or wish they’d bought more) may have buying interest at that prior low price if it reaches it again.

Resistance is when a price trends up and stalls at a prior high. The reasoning is that investors and traders who didn’t sell the high before (or wish they’d sold short to profit from a price decline) may have the desire to sell at that prior high price if it reaches it again.

Whether everyone trades this way or not, enough may that it becomes a self-fulling prophecy. I believe it works this way on stocks and other securities or markets driven by supply and demand, but an index of stocks?

To assume a market or stock will have support or resistance at some price level (or a derivative of price like a moving average) that hasn’t been reached yet is just a predictive assumption. Support and resistance don’t exist unless it is, which is only known after the fact.

One of the most fascinating logical inconsistencies I see by some technical analysts is the assumption that “support” from buying interest and “resistance” from selling pressure “is” there, already exists, before a price is even reached. Like “SPY will have resistance at $292.” We simply don’t know until the price does indeed reverse after that point is reached.

But, it gets worse.

To believe an index of 500 stocks is hindered by selling pressure at a certain price requires one to believe the price trend is controlled by the index instead of the 500 stocks in it.

Think about that for a moment. Let it sink in. 

  • Do you believe trading the stock index drives the 500 stocks inside the index?

or

  • Do you believe the 500 stocks in the index drive the price of the index?

What you believe is true for you. But, to believe an index of 500 stocks is hindered by selling pressure or buying interest at a certain price requires you believe the price trend is controlled by the index instead of the 500 stocks in it. That’s a significant belief.

To complicate it more. If we want to know the truth, we have to look a little closer.

Is the S&P 500 at resistance? 

As I said, it depends on which stock charting service or data provider we use and how we calculate the data to draw the chart. Recall in the prior chart, I used the SPDRs S&P 500 ETF (SPY) which shows the ETF closed near its prior high. I used Stockcharts.com as the data provider to draw the chart. I’ve been a subscriber of their charting program for 14 years so I can tell you the chart is based on Total Return as the default. That means it includes dividends. But, when we draw the same chart using the S&P 500 index ($SPX) it’s based on the price trend. Below is what a difference that makes. The index isn’t yet at the prior high, the SPY ETF is because the charting service includes dividends.

SPY SPX TOTAL RETURN RESISTANCE

Here is another charting service where I’m showing the S&P 500 ETF (SPY) price return, total return, and the S&P 500 stock index. Only one is at the January high.

spy spx S&P 500 resistance

So, we don’t know if the S&P 500 is at resistance and we won’t know if there exists any “resistance” there at all unless the price does pause and reverse down. It so happens, it just may pause and reverse at this point. Not because more tactical traders are looking at the total return chart of SPY or because the index or ETF drives the 500 stocks in it, but because momentum measures indicate its potentially reaching an “overbought” level. So, a pause or reversal, at least some, temporarily, would be reasonable.

Some may call this charting, others call it technical analysis, statistical analysis, or quantitative analysis. We could even say there is some behavioral finance included since it involves investor behavior and biases like anchoring. Whatever we choose to call it, it’s a visual representation of supply and demand and like most things, it’s based on what we believe to be true.

I’ve been applying charting, pattern recognition, technical analysis, statistical analysis, and quantitative analysis for over twenty years. Before I started developing computerized programs based on quantitative trend systems that apply evidence-based scientific methods, I was able to trade successfully using visual charts. I believe all of it has its usefulness. I’m neither anti-quant or anti-charting. I use both, but for different reasons. I can argue for and against both because neither is perfect. But, combining the skills together has made all the difference for me.

Is the S&P 500 at resistance? 

We’ll see…

 

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.

Earnings season is tricky for momentum growth stocks

Momentum stocks are stocks that show high upside momentum in their price trend. Momentum stocks are trending not only regarding their absolute price gains but also relative strength vs. other stocks or the stock market index.

Momentum stocks are usually high growth stocks. Since momentum stocks are the strongest trending stocks, their trends are often driven by growth in sales and earnings. Growth stocks are companies that are growing earnings at a rate significantly above average. Growth stocks have high increases in earnings per share quarter over quarter, year over year, and may not pay dividends since these companies usually reinvest their strong earnings to accelerate growth.

Now that we have defined what I mean by “momentum stocks,” we can take a look at some examples of momentum stocks and their characteristics like how their prices trend.

Grubhub Inc. ($GRUB) is an online and mobile food-ordering company that connects diners with local restaurants. GrubHub is a great example today of a high momentum growth stock.  GrubHub stock has gained 24% today after smashing Wall Street’s expectations. Earnings grew 92% to 50 cents a share, marking the fifth quarter in a row of accelerating EPS growth. Revenue soared 51% to $239.7 million, a quarterly best.

Grubhub $GRUB GRUB

Before today, GrubHub stock was in a positive trend that developed a flat base since April (highlighted on the chart). GRUB had already gained 60% year to date, but after such as explosive uptrend in momentum, it trended sideways for a while.

It is earnings season, which can be tricky for the highest momentum stocks. Once a stock has already made a big move, it could already have a lot of good news expectations priced in. That concerns some momentum stock traders. In fact, I know some momentum stock traders who exit their stocks before their quarterly earnings announcements. If they had exited GrubHub, they would have missed today’s continuation of its momentum. However, they would avoid the downside of those that trend in the other direction.

I’ve been trading momentum stocks for over two decades. Over the years I’ve observed different regimes of how they act regarding trend strength and volatility. There are periods of volatility expansion and contraction and other periods when momentum is much stronger.

Volatility is how quickly and how far the price spreads out. When price trends are volatile, it’s harder to stick with them because they can move against us. We like upside volatility, but smart investors are loss averse enough to dislike downside volatility that leads to drawdowns. To understand why the smart money is loss averse, read: “Asymmetry of Loss: Why Manage Risk?“.

Strong upward trending stocks are sometimes accompanied by volatility. That’s to be expected because momentum is a kind of volatility expansion. Upward momentum, the kind we like, is an upward expansion in the range of the price – volatility.

That’s good vol.

But, strong trending momentum stocks necessarily may include some bad volatility, too. Bad volatility is the kind investors don’t like – it’s when the price drops, especially if it’s a sharp decline.

I mentioned GrubHub had gained 60% YTD. I like to point out, observe, and understand asymmetries. The asymmetry is the good and the bad, the positive and the negative, I prefer to skew them positively. What I call the Asymmetry® Ratio is a chart of the upside total return vs. the chart of the downside % off high. To achieve the gain for GrubHub, investors would have had to endure its price declines to get it. For GrubHub, the stock has declined -10% to -15% many times over the past year. It has spent much of the time off its high. To have realized all of the gains, investors had to be willing to experience the drawdowns.

grubhub stock GRUB

I point this out because yesterday I wrote “Asymmetry of Loss: Why Manage Risk?” where I discussed the mathematical basis behind the need for me to actively manage the downside risk. To achieve the significant gain, we often have to endure at least some of the drawdowns along the way. The trick is how much, and for me, that depends on many system factors.

Earnings season, when companies are reporting their quarterly earnings, is especially tricky for high momentum stocks because stocks that may be “priced for perfection” may be even more volatile than normal. Accelerating profit growth is attractive to investment managers and institutional investors because increasing profit growth means a company is doing something right and delivering exceptional value to customers. I’m more focused on the direction of the price trend – I like positive momentum. But, earnings are a driver of the price trend for stocks.

Earnings can trend in the other direction, too, or things can happen to cause concern. This information is released in quarterly reports.

Another example of a momentum stock is NetFlix. By my measures, GrubHub is a leading stock in its sector and NetFlix (NFLX) is the leader in its industry group, too, based on its positive momentum and earnings growth. As we see in the chart below, NFLX has gained 88% year to date. That’s astonishing momentum considering the broad stock market measured by the S&P 500 has gained around 5%, and its Consumer Services Sector ETF has gained 11%.

NetFlix NFLX $NFLX

However, NetFlix stock regularly declines as much as -15% as a regular part of its trend. It has fallen over -10% five times in the past year on its way to making huge gains. The latest reason for the decline was information that was released during its quarterly earnings announcement. The stock dropped sharply afterward.

netflix stock risk downside loss

But, as we see in the chart, it’s still within its normal decline that has happened five times the past year.

While some of my other momentum stock trader friends may exit their stocks during the earnings season, I instead focus more on the price trend itself. I predefine my risk in every position, so I determine how much I’ll allow a stock to trend to the downside before I exit. When a stock trends down too far, it’s no longer in a positive trend with the side of momentum we want. To cut losses short, I exit before the damage gets too large.

How much is too much? 

A hint is in the above charts.

If we want to experience a positive trend of a momentum stock, we necessarily have to give it enough room to let it do what it does. When it trends beyond that, it’s time to exit and move on. We can always re-enter it again it if trends back to the right side.

Sure, earnings season can be tricky, but for me, it’s designed into my system. I’m looking for positive Asymmetry® – an asymmetric risk/reward. What we’ve seen above are stocks that may decline as much as -15% as a normal part of their trend when they fall, but have gained over 50% over the same period.

You can probably see how I may be able to create a potentially positive asymmetric risk/reward payoff from such a trend.

 

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.

 

 

 

 

 

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.

Does Your Firm Use Active ETFs?

Christi Shell was recently asked by ETF.com “Does your firm use active ETFs”.

Christi Shell Capital Management

Her answer from the interview:

Our portfolio manager, Mike Shell, doesn’t currently include active ETFs in our universe of tradeable ETFs, but that doesn’t mean he’d never include them. He tactically shifts between ETFs, based on investor behavioral measures and supply/demand. So our portfolio management style itself is the active management; we are, essentially, actively managing beta.

We use ETFs to gain specific exposure to a return stream such as a sector, country, commodity or currency. With an index ETF, we pretty much know what we’re going to get inside the ETF. (Of course, indexes are reconstituted by a committee of people, so we don’t know in advance what they’ll do. However, an index follows some general rules systematically.)

Therefore, if we discover an ETF we believe has a strategy and return stream that we want access to, then we would add it, whether it’s active or not.

Christi Shell is Managing Director and Certified Wealth Strategist® at Shell Capital Management LLC. Christi has 27 years in financial services ranging from bank management to wealth management giving her a unique skill set and experience to help clients get what they want.

Source: http://www.etf.com/publications/etfr/does-your-firm-use-active-etfs

Global Stock and Bond Market Trends 2Q 2018

Yesterday we shared the 2nd Quarter 2018 Global Investment Markets Review, which used a broad range of indexes on performance tables to present the year-to-date progress of world markets. The issue with a table that simply shows a return number on it is it doesn’t properly present the path it took to get there. In the real world, investors and portfolio managers have to live with the path of the trend and we can see that only in the price trend itself. So, today we’ll look at the price trends of stocks, bonds, commodities, real estate, sectors, and other alternatives like volatility. I don’t just look for potentially profitable price trends in stocks and bonds, I scan the world.

How is the market doing this year? Which market?

First, a quick glance at global markets including commodities, stock indexes, volatility, ranked by year-to-date momentum. We wee the CBOE Volatility Index $VIX has gained the most. One clear theme about 2018 is that volatility has increased and this includes implied or expected volatility. Overall, we see some asymmetry since the markets in the green are more positive than the markets in the red. The popular S&P 500 stock index most investors point to is in the middle with only a 2% gain for the year. Commodities like Cocoa, Lumber, Orange Juice, and Crude Oil are leaders while sugar, live cattle, and soybeans are the laggards. Most investors probably don’t have exposure to these markets, unless they get it through a commodities ETF.

 

Most investors probably limit themselves to the broad asset classes, since that’s what most financial advisors do. So, we’ll start there. Below are the trends of broad market ETFs like the S&P 500, Aggregate Bond, Long-Term Treasury. For the year, Emerging Markets has the weakest trend – down nearly -6%. Developed Markets countries are the second weakest. The rising U.S. Dollar is helping to put pressure on International stocks. The leader this year is Commodities, as we also saw above. The Commodity index has gained 8% YTD.

What about alternative investments? We’ll use liquid alternative investments as an example since these are publicly available ETFs. I’ve included markets like Real Estate, Private Equity, Mortgage REITs, and the Energy MLP. Not a lot of progress from buying and holding these alternative investments. This is why I prefer to shift between markets trying to keep capital only in those markets trending up and out of those trending down.

liquid alternative investments

The Volatility VXX ETF/ETN that is similar to the VIX index has gained so much early in the year I left it off the following chart because it distorted the trends of the other markets. It’s one of the most complex securities to trade, but we can see it spike up to 90% when global markets fell in February.

VIX VXX

Looking at the price trend alone isn’t enough. It would be incomplete without also considering their drawdowns. That is, how much the market declined off its prior high over the period. Analyzing the drawdown is essential because investors have to live with the inevitable periods their holdings decline in value. It’s when we observe these decline we realize the need for actively managing risk. For me, actively managing risk means I have a predetermined exit point at all times in my positions. I know when I’ll exit a loser before it becomes a significant loss. Many say they do it, I’ve actually done it for two decades.

The alternative investments are in drawdowns YTD and Energy MLP, and Mortgage REIT is down over -10% from their prior highs. The Energy MLP is actually down -51% from its 2014 high, which I don’t show here.

alternative investment drawdowns risk management

Next, we go back to the global asset class ETFs to see their drawdowns year-to-date. We don’t just experience the gains, we also have to be willing to live with their declines along the way. It isn’t enough to provide an excellent investment management program, we also have to offer one that fits with investors objectives for risk and return. The most notable declines have been in Emerging Market and developed international countries. However, all of these assets are down off their prior highs.

GLOBAL ASSET CLASS RISK MANAGEMENT TREND FOLLOWING 2018

Clearly, markets don’t always go up. The trends so far in the first six months of 2018 haven’t offered many opportunities for global asset allocation to make upward progress.

This is why I rotate, rather than allocate, to shift between markets rather than allocate to them. We also trade in more markets than we covered here, like leading individual stocks. The magnitude of these drawdowns also shows why I believe it is essential to direct and control risk and drawdown.

 

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 it a stock pickers market?

Is it a stock pickers market?

Sometimes the stock market is trending so strongly that the rising tide lifts all boats. No matter what stocks or stock fund you invest in, it goes up. That was the case much of 2017.

Then, there are periods when we see more divergence.

When we observe more divergence, it means stocks, sectors, size, or style has become uncorrelated and are trending apart from each other.

I pointed out in Sector Trends are Driving Equity Returns; there is a notable divergence in sector performance, and that is driving divergence in size and style. Growth stocks have been outperformance value, and it’s driven by strong momentum in Technology and Consumer Discretionary sectors.

When specific sectors are showing stronger relative momentum, we can either focus more on those sectors rather than broad stock index exposure. Or, we can look inside the industry to find the leading individual stocks.

For example, Consumer Discretionary includes industries like automobiles and components, consumer durables, apparel, hotels, restaurants, leisure, media, and retailing are primarily represented in this group. The Index includes Amazon, Home Depot, Walt Disney, and Comcast. Consumer Discretionary is the momentum leader having trended up 9.7% so far this year as the S&P 500 has only gained just under 1%.

momentum sectors

If we take a look inside the sector, we see the leaders are diverging farther away from the sector ETF and far beyond the stock market index.

momentum stocks consumer discretionary sector NFLX AMZN AAPL

In fact, all the sectors 80 stock holdings are positive in 2018.

The Consumer Discretionary sector is about 13% of the S&P 500. As you can see, if these top four or five sectors in the S&P 500 aren’t trending up it is a drag on the broad stock index.

ETF Sector Allocation exposure S&P 500

So, Is it a stock pickers market? 

When we see more divergence, it seems to be a better market for “stock pickers” to separate the winners from the losers.

Another way to measure participation in the market is through quantitative breadth indicators. Breadth indicators are a measure of trend direction “participation” of the stocks. For example, the percent of the S&P 500 stocks above or below a moving average is an indication of the momentum of participation.

Below is the percent of stocks above their 50 day moving average tells us how many stocks are trending above their moving average (an uptrend). Right now, the participation is symmetrical; 52% of the stocks in the S&P 500 are in a positive trend as defined by the 50 day moving average. We can also see where that level stands relative to the stock market lows in February and April and the all-time high in January when over 85% of stocks were in an uptrend. By this measure, only half are trending up on a shorter term basis.

SPX SPY PERCENT OF STOCKS ABOVE 50 DAY MOVING AVERAGE 1 YEAR

The 200-day moving average looks back nearly a year to define the direction of a trend, so it takes a greater move in momentum to get the price above or below it. At this point, the participation is symmetrical; 55% of stocks are above their 200-day moving average and by this time frame, it hasn’t recovered as well from the lows. The percent of stocks above their 200-day moving average is materially below the 85% of stocks that were participating in the uptrend last year. That is, 30% fewer stocks are in longer trend uptrends.

SPY SPX PERCENT OF STOCKS ABOVE 200 DAY MOVING AVERGAGE 1 YEAR

In the above charts, I only showed a one-year look back of the trend. Next, we’ll take a step back to view the current level relative to the past three years.

The percent of stocks above their 50 day moving average is still at the upper range of the past three years. The significant stock market declines in August-September 2015 and December-January hammered the stocks down to a very washed out point. During those market declines, the participation was very asymmetric: 90% of the stocks were in downtrends and only about 10% remained in shorter-term uptrends.

SPX SPY PERCENT OF STOCKS ABOVE 50 DAY MOVING AVERAGE 3 YEARS

The percent of stocks above their 200 day moving average also shows a much more asymmetrical situation during the declines in 2015 and 2016 when the stock index dropped around -15% or more. Only 20% of stocks remained in a positive trend.

SPX PERCENT OF STOCKS ABOVE 200 DAY MOVING AVERAGE 3 YEARS

Is it a stock pickers market?

Only about half of the stocks in the index are in uptrends, so the other half isn’t. So, if we avoid the half that are in downtrends and only maintains exposure to stocks in uptrends and the trends continue, we can create alpha.

But, keep in mind, that doesn’t necessarily mean we should have any exposure at all in the S&P 500 stock index because happens to have the highest sector exposure in the leading sectors.

But, for those who want to engage in “stock picking”, the timing has a higher probability now to diverge from the stock index than last year because so fewer stocks are in uptrends and more are in downtrends.

For individual stocks traders willing to look inside the box, this is a good thing.

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.

Commodities are trending with better momentum than stocks

Commodities are trending with better momentum than stocks

Commodities are trending with better momentum than stocks over the past year.

A commodity is a raw material or primary agricultural product that can be bought and sold, such as copper or coffee. A commodity is a basic good used in commerce that are usually used as inputs in the production of other goods or services.

Soft commodities are goods that are grown, such as wheat, or rice.

Hard commodities are mined. Examples include gold, helium, and oil.

Energy commodities include electricity, gas, coal, and oil. Electricity has the particular characteristic that it is usually uneconomical to store, and must, therefore, be consumed as soon as it is processed.

The Commodity Trend

At first glance, we see in the chart commodities ETF Invesco DB Commodity Index Tracking ETF has trended meaningfully above the popular S&P 500 index of U. S. stocks. The relative outperformance is clear over this one-year time frame. Commodities, as measured by this ETF, are in an absolute positive trend and registering relative momentum.

Commodity ETF trend following commodites natural resources $GNR $GSG $DBC

Examining a price trend is incomplete without also considering its downside. On the downside, I look at the % off high drawdowns over the period. We see that commodities were more volatile than stocks before 2018 with four dips around -4%. Since the stock market -10% decline that started in February, commodities declined, too, but not as much as U. S. stocks.

asymmetry ratio commodity drawdown

Looking back at the trend chart, I added a simple trend line to show that communities are trending directionally better than the popular U. S. stock index. So, my quantitative Global Tactical Rotation®  system that ranks an unconstrained global universe of markets including bonds, stocks, commodities, currencies, and other alternatives like real estate signaled this trend has been generating asymmetric risk/return.

commodity ETF trend commodities

What is the that Invesco DB Commodity Index Tracking ETF? (the bold emphasis is mine)

The Invesco DB Commodity Index Tracking Fund seeks to track changes, whether positive or negative, in the level of the DBIQ Optimum Yield Diversified Commodity Index Excess Return™ (DBIQ Opt Yield Diversified Comm Index ER) plus the interest income from the Fund’s holdings of primarily US Treasury securities and money market income less the Fund’s expenses. The Fund is designed for investors who want a cost-effective and convenient way to invest in commodity futures. The Index is a rules-based index composed of futures contracts on 14 of the most heavily traded and important physical commodities in the world. The Fund and the Index are rebalanced and reconstituted annually in November.

This Fund is not suitable for all investors due to the speculative nature of an investment based upon the Fund’s trading which takes place in very volatile markets. Because an investment in futures contracts is volatile, such frequency in the movement in market prices of the underlying futures contracts could cause large losses. Please see “Risk and Other Information” and the Prospectus for additional risk disclosures. Source: Invesco

The challenge for some investors, however, is that Invesco DB Commodity Index Tracking ETF generates a K-1 tax form for tax reporting. That isn’t a terrible issue, but it means instead of receiving the typical 1099 investors receive a K-1. Some investors aren’t familiar with a K-1, and they can obtain them later than a 1099.

Then, there may be other investors who simply prefer not to own futures for the reason in the second paragraph of the above discription: “Because an investment in futures contracts is volatile, such frequency in the movement in market prices of the underlying futures contracts could cause large losses.” In reality, all investments have risk and stocks can have just as much risk of “large losses” as commodity futures, but it’s a matter of investor preference and perception.

Since we have a wide range of investor types who invest in my ASYMMETRY® Investment Program I could gain my exposure to commodities in other ways. For example, the SPDR® S&P® Global Natural Resources ETF often has a similar return stream as ETFs like DBC that track a commodity futures index, except is actually invests in individual stocks instead.

Key features of the SPDR® S&P® Global Natural Resources ETF

  • The SPDR® S&P® Global Natural Resources ETF seeks to provide investment results that, before fees and expenses, correspond generally to the total return performance of the S&P® Global Natural Resources Index (the “Index”)

  • Seeks to provide exposure to a number of the largest market cap securities in three natural resources sectors – agriculture, energy, and metals and mining

  • Maximum weight of each sub-index is capped at one-third of the total weight of the Index

Below we see the price trend of this ETF of global natural resources stocks has been highly correlated to an ETF of commodities futures.

global natural resources ETF replacement for commodity ETF no K1

In fact, as we step the time frame out to the common inspection date of each ETF in 2011, the SPDR® S&P® Global Natural Resources ETF has actually outperformed Invesco DB Commodity Index Tracking ETF overall in terms of relative momentum.

commodity ETF global natural resources trend following no K1

The bottom line is, commodities “stuff” is trending up over the past two years and when the price of “stuff” is rising, that is called “inflation”.  Commodities and global natural resources have been in a downtrend for so long it shouldn’t be a surprise to see this trend reverse up. Only time will tell if it will continue, but if we want exposure to it, we can predefine our risk by deciding at what price I would exit if it doesn’t, and let the trend unfold.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.Buying and Selling ETFsETFs are flexible and easy to trade. Investors buy and sell them like stocks, typically through a brokerage account. Investors 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.

ETFs are subject to risk similar to those of stocks including those regarding short-selling and margin account maintenance. Ordinary brokerage commissions apply. In general, ETFs can be expected to move up or down in value with the value of the applicable index. Although ETF shares may be bought and sold on the exchange through any brokerage account, ETF shares are not individually redeemable from the Fund. Investors may acquire ETFs and tender them for redemption through the Fund in Creation Unit Aggregations only. Please see the prospectus for more details. After-tax returns are calculated based on NAV using the historical highest individual federal marginal income tax rates and do not reflect the impact of state and local taxes. Actual after-tax returns depend on the investor’s tax situation and may differ from those shown. The after-tax returns shown are not relevant to investors who hold their fund shares through tax-deferred arrangements such as 401(k) plans or individual retirement accounts. Performance of an index is not illustrative of any particular investment. It is not possible to invest directly in an index. As with all stocks, you may be required to deposit more money or securities into your margin account if the equity, including the amount attributable to your ETF shares, declines. Unless otherwise noted all information contained herein is that of the SPDR S&P Global Natural Resources ETF. S&P – In net total return indices, the dividends are reinvested after the deduction of withholding tax. Tax rates are applied at the country level or at the index level.

 

 

Sector Trends are Driving Equity Returns

Sector Trends are Driving Equity Returns

In Growth Stocks have Stronger Momentum than Value in 2018 I explained the divergence between the return of the two styles of Growth and Value. I suggest the real return driver between size and style is primarily the index or ETF sector exposure. To be sure, we’ll take a look inside.

As I said before, the reason I care about such divergence is when return streams spread out and become distinctive, we have more opportunity to carve out the parts we want from the piece I don’t. When a difference between price trends is present, it provides more opportunity to capture the positive trend and avoid the negative trend if it continues.

Continuing with the prior observation, I am going to use the same Morningstar size and style ETFs.

Recall the year-to-date price trends are distinctive. Large, mid, and small growth is notably exhibiting positive momentum over large, mid, and small value.

growth stock momentum over value morningtar small mid large cap

To understand how these factors interact, let’s look at their sector exposure. But first, let’s determine the sector relative momentum leaders and laggards for 2018.

The leaders are Consumer Discretionary (stocks like Netflix $NFLX and Amazon $AMZN), Information Technology (Nvidia $NVDA and Google $GOOG). In third place is Energy and then Healthcare. The laggards are Consumer Staples, Industrials, Materials, and Utilities, which are actually down for the year. Clearly, exposure to Consumer Discretionary and Information Technolgy and avoiding most of the rest would lead to more positive asymmetry.

sector trend returns 2018

Below we see strongest momentum Large Growth is heavily weighted (41%) in Technology. The second highest sector weight is Consumer Discretionary, and then Healthcare is third. Large-Cap Growth is the leader just because it has the most exposure in the top sectors.

iShares Morningstar Large-Cap Growth ETF

On the other hand, Large Value, which is down -3% YTD, has its main exposure in the lagging Financial and Consumer Staples sectors.

iShares Morningstar Large-Cap Value ETF

Dropping down to the Mid-Cap Growth style and size, similar to Large-Cap Growth, we see Information Technology and Healthcare are half of the ETFs exposure.

iShares Morningstar Mid-Cap Growth ETF

We are starting to see a trend here. Much like Large-Cap Value, the Mid-Cap Value has top holdings in Financials, Consumer Discretionary, and Utilities sectors.

 

iShares Morningstar Mid-Cap Value ETF

Can you guess the top sectors of Small-Cap Growth? Like both Large and Mid Growth, Small-Cap Growth top sector exposures are Information Technology, Healthcare, and Consumer Discretionary.

iShares Morningstar Small-Cap Growth ETF

And to no surprise, the Financial sector 26% of Small-Cap Value.

iShares Morningstar Small-Cap Value ETF

So, Information Technology, Healthcare, and most Consumer Discretionary tend to be more growth-oriented sectors. Financials, Consumer Staples, Utilities, Real Estate, that is, the higher yielding dividend paying types, tend to be classified as Value. Each sector has both Growth and Value stocks within them, but on average, some sectors tend to include more Growth stocks or more Value stocks.

Value stocks are generally defined as shares of undervalued companies with lower prospects for growth.

A growth stock has higher earnings per share and often trade at a higher multiple since the expectation of future earnings is high. Growth stocks usually don’t pay a dividend, as the company would prefer to reinvest retained earnings back into the company to grow.

The Information Technology sector includes companies that are engaged in the creation, storage, and exchange of digital information. The Information Technology sector offers potential exposure to growth with the emergence of cloud computing, mobile computing, and big data.

Another Growth sector is Consumer Discretionary sector manufactures things or provides services that people want but don’t necessarily need, such as high-definition televisions, new cars, and family vacations. Consumer Discretionary sector performance is closely tied to the strength of the overall economy. Consumer Discretionary tends to perform well at the beginning of a recovery when interest rates are low but can lag during economic slowdowns

The Health Care sector is a Growth sector involved in the production and delivery of medicine and health care-related goods and services. Healthcare companies typically have more stable demand, so they are less sensitive to the economic cycle, though it tends to perform best in the later stages of the economic cycle.

It turns out, the three primary Growth sectors that tend to best strongest at the late stage of an economic cycle have been the recent leaders.

Consumer Staples sector consists of companies that provide goods and services that people use on a daily basis, like food, clothing, or other personal products.

The Financial sector is businesses such as banking and brokerage, mortgage finance, and insurance which are sensitive to changes in the economy and interest rates. They tent to perform best at the beginning of a business cycle.

This is why I prefer to focus my U. S. equity exposure on sectors and maybe the strongest momentum stocks within those sectors. Many traditional asset allocations use style and size to get their exposure to the stock market, but as a tactical portfolio manager, I prefer to get more specific into the trending sectors and their individual stocks.

 

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.

 

 

 

 

 

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.

 

 

When I apply different trend systems to ETFs

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

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

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

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

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

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

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

 

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

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

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

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

 

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

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

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

 

 

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.

February Global Market Trends

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

stock market decline drawdown februrary 2018

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

global market returns february 2018 loss drawdown

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

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

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

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

stock market decline februrary 2018

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

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

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

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

I said this recently on Twitter:

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

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

Majority of Investors Avoided Taking Action in Recent Market Correction

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

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

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

 

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

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

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

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.

Asymmetry in the Business Cycle

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

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

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

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

The problem is the MAGNITUDE, not length.

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

long-summer-short-winters-economic-expansion

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

strength-of-economic-expansions

 

 

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.

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

 

 

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 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 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.

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.

 

 

Gold Isn’t Always A Hedge or Safe Haven: Gold Stock Trends Have Been Even Worse

For several years we often heard investors suggesting to “buy gold”. We could throw in Silver here, too. They provide many theories about how gold bullion or gold stocks are a “safe haven”. I’ve written about the same assumption in Why Dividend Stocks are Not Always a Safe Haven.

In fact, the Market Vectors Gold Miners ETF website specifically says about the gold stock sector:

“A sector that has historically provided a hedge against extreme volatility in the general financial markets”.

Source: http://www.vaneck.com/gdx/

When investors have expectations about an outcome, or expect some cause and effect relationship, they expose themselves in the possibility of a loss trap. I will suggest the only true “safe haven” is cash. 

Below is a 4 year chart of two gold stock ETFs relative to the Gold ETF. First, let’s examine the index ETFs we are looking at. Of course, the nice thing about ETFs in general is they are liquid (traded like a stock) and transparent (we know what they hold).

GLD: SPDR Gold “Shares offer investors an innovative, relatively cost efficient and secure way to access the gold market. SPDR Gold Shares are intended to offer investors a means of participating in the gold bullion market without the necessity of taking physical delivery of gold, and to buy and sell that interest through the trading of a security on a regulated stock exchange.”

GDX: Market Vectors Gold Miners ETF: “The investment seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the NYSE Arca Gold Miners Index. The fund normally invests at least 80% of its total assets in securities that comprise the Gold Miners Index. The Gold Miners Index is a modified market-capitalization weighted index primarily comprised of publicly traded companies involved in the mining for gold and silver.”

GDXJ: Market Vectors Junior Gold Miners ETF seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the Market Vectors Global Junior Gold Miners Index. The Index is intended to track the overall performance of the gold mining industry, which may include micro- and small capitalization companies.

Gold stocks vs Gold

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

Clearly, gold has not been a “safe haven” or “provided a hedge against extreme volatility in the general financial markets”. It has instead demonstrated its own extreme volatility within an extreme downward price trend.

Further, gold mining stocks have significantly lagged the gold bullion index itself.

These ETFs have allowed for the trading of gold and gold stocks, SPDR Gold explains it well:

“SPDR Gold Shares represent fractional, undivided beneficial ownership interests in the Trust, the sole assets of which are gold bullion, and, from time to time, cash. SPDR Gold Shares are intended to lower a large number of the barriers preventing investors from using gold as an asset allocation and trading tool. These barriers have included the logistics of buying, storing and insuring gold.”

However, this is a reminder that markets do not always play out as expected. The expectation of a “safe haven” or “hedge against extreme volatility” is not a sure thing. Markets may end up much worst that you imagined they could.  As many global and U.S. markets have been declining, you can probably see why I think it’s important to manage, direct, limit, and control exposure to loss. Though, not everyone does it well. It isn’t a sure thing…

______

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. Please click the links provide for specific risk information about the ETFs mentioned. Please visit this link for important disclosures, terms, and conditions.

Bonds Aren’t Providing a Crutch for Stock Market Losses

In Allocation to Stocks and Bonds is Unlikely to Give us What We Want and What You Need to Know About Long Term Bond Trends I suggested that bonds may not provide a crutch in the next bear market.

It seems we are already observing that. So far this year, bond indexes have declined along with other markets like stocks and commodities.

Below is a chart of 4 different bond index ETFs year-to-date. I use actual ETFs since they are tradable and present real-world price trends (though none of this is a suggestion to buy or sell). I drew the chart as “% off high” to show the drawdown – how much they have declined off their previous highest price.

Bond ETF market returns 2015

The long-term U.S. Treasury bonds are down the most, but even the others have declined over -3%. That’s certainly not a large loss over a 9 month period, but bond investors typically expect safety and stability. Asset allocation investors expect bonds to help offset their losses in other market allocations like stocks, commodities, or REITs.

Keep in mind: the Fed hasn’t even started to increase interest rates yet. If you are an asset allocation investor, you have to consider:

What may happen if interest rates do start to increase sharply and that drives down bond prices?

What if both stocks and bonds fall in the next bear market?

Bonds haven’t provided much of a crutch this year for fixed asset allocators…

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.

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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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.

What You Need to Know About Long Term Bond Trends

There is a lot of talk about interest rates and bonds these days – for good reason. You see, interest rates have been in a downtrend for decades (as you’ll see later). When interest rates are falling, the price of bonds go up. I wrote in “Why So Stock Market Focused?” that you would have actually been better off investing in bonds the past 15 years over the S&P 500 stock index.

However, the risk for bond investors who have a fixed bond allocation is that interest rates eventually trend up for a long time and their bonds fall.

This year we see the impact of rising rates and the impact of falling bond prices in the chart below of the 20+ year Treasury bond. It’s down -15% off its high and since the yield is only around 2.5% the interest only adds about 1% over this period for a total return of -14.1%. Up until now, this long term Treasury index has been a good crutch for a global allocation portfolio. Now it’s more like a broken leg.

But, that’s not my main point today. Let’s look at the bigger picture. Below is the yield (interest rate) on the 10-Year U.S. government bond. Notice that the interest rate was as high as 9.5% in 1990 and has declined to as low as 1.5%. Just recently, it’s risen to 2.62%. If you were going to buy a bond for future interest income payments, would you rather invest in one at 9.5% or 1.5%? If you were going to lend money to someone, which rate would you prefer to receive? What is a “good deal” for you, the lender?

I like trends and being positioned in their direction since trends are more likely to continue than reverse, but they usually do eventually reverse when inertia comes along (like the Fed). If you care about managing downside risk you have to wonder: How much could this trend reverse and what could its impact be on fixed bond holdings? Well, we see below that the yield has declined about -70%. If we want to manage risk, we have to at least expect it could swing the other way.

One more observation. Germany is one of the largest countries in the world. Since April, the 10-year German bond interest rate has reversed up very sharp. What if U.S bonds did the same?

As I detailed in “Allocation to Stocks and Bonds is Unlikely to Give us What We Want” bonds are often considered a crutch for a global asset allocation portfolio. If you care about managing risk, you may consider that negative correlations don’t last forever. All trends change, eventually. You may also consider your risk of any fixed positions you have. I prefer to actively manage risk and shift between global markets based on their directional trends rather than a fixed allocation to them.

The good news is: by my measures, many bond markets have declined in the short term to a point they should at least reserve back up at least temporarily. What happens after that will determine if the longer trend continues or begins to reverse. The point is to avoid complacency and know in advance at what point you’ll exit to cut losses short…

As they say: “Past performance is no guarantee of the future“.

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

On Actively Managing Risk… and Persistence

Don't beg anyone to get on the ark just keep building and let everyone know the rain is coming

Source: https://image-store.slidesharecdn.com/c3d3d5ae-e2eb-4e80-9d4c-88e2344b5572-original.jpeg

I just keep doing what I do…

Why So Stock Market Focused?

Most investors and their advisors seem to speak mostly about the stock market. When they mention “the market” and I ask “what market?” they always reply “the stock market”.

Why so stock market centric?

It must be that it gets the most media attention or stocks seem more exciting?. After all, other markets like bonds may seem boring and few know much about the many commodities markets or the foreign exchange markets. There are many different markets and two sides to them all.

If it’s risk-adjusted returns you want, you may be surprised to find where you should have invested your money the past 15 years. To make the point, below is a comparison of the total return of the Vanguard S&P 500 stock index (the orange line) compared to the Vanguard Bond Index (the blue line). Yes, you are seeing that correctly. Using these simple index funds as a proxy, bonds have achieved the same total return as stocks, but with significantly less volatility and drawdowns. This is why we never look at just “average” return data without considering the path it took to get there. A total return percentage gain chart like this one presents a far more telling story. Take a close look at the path they took.

stocks vs. bonds

Created with http://www.ycharts.com

I showed the chart to one investment advisor who commented “It looks like the stock market is catching up”. If that’s what you think of when you view the chart, you may have a bias blind spot: ignoring the vast difference in the risk between the two markets.

Looking at the total return over the period identifies the obvious difference in the path the two return streams took to achieve their results, but below we see the true risk difference. Drawdowns are declines from a higher value to a low value and a visual representation of how long it took to recover the lose of capital. When we observe a drawdown chart like the one below, it’s like a lake. These charts together also help illustrate the flaw of averages. The average return of the stock and bond index have ended at about the same level and have the same average return, but the bond index achieved it with much less drawdown. You wouldn’t know that if you only looked at average returns. If you tried to walk across the stock market lake, you may have drowned if you couldn’t handle swimming in 40′ of water for so long. If that one didn’t get you, the 55′ may have. The stock index declined about -40% from 2000 – 2002 and took years to recover before it declined -55%.

stock and bond market risk historical drawdowns

Created with http://www.ycharts.com

You have to be wondering: why didn’t you just invest in bonds 15 years ago? Maybe you were focused on the prior period huge average returns in stocks?

Before I continue, let me place a very bold disclaimer here: PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. Another way that is stated is that PAST PERFORMANCE IS NO ASSURANCE OF FUTURE RESULTS. One more version is PAST PERFORMANCE MAY NOT BE AN INDICATION OF FUTURE RESULTS. If you remember, the 1990’s were a roaring bull market in stocks. People focus on the past expecting it to continue. That’s probably why you never thought to invest in bonds instead of stocks.

Some of the largest and most successful hedge funds in the world have done that very thing over this period and longer. But, they didn’t just invest in bonds. They leveraged bonds. We’ve seen in this example that a bond index fund has achieved just as much total return as stocks. If you are a stock market centric investor: one that likes the stock market and makes it your focus, then you necessarily had to be willing to endure those -40% to -55% declines and wait many years to recover from the losses. If you are really willing to accept such risk, imagine if you had used margin to leverage bonds. The bond index rarely declined -10% or more. It was generally a falling interest rate period, so bonds gained value. If you were willing to accept -40% to -55% declines in stocks, you could have instead leveraged the bonds 400% or 500%. If you had done that, your return would be 4 or 5 times more with a downside more equal to that of stocks.

Why so stock centric?

Of course, at this stage, the PAST PERFORMANCE IS HIGHLY UNLIKELY TO REPEAT INTO THE FUTURE. Just as the roaring stocks of the 1990’s didn’t repeat. To see why, read Stage and Valuation of the U.S. Stock Market and Bonds: The Final Bubble Frontier?.

From my observations of investors performance and their advisors, most people seem to have poor results the past decade or so, even after this recent bull market. An investment management consultant told me recently that investors and their advisors who are aware of the current stage of stocks and bonds feel there is no place to turn. I believe it’s a very important time to prepare to row, not sail. For me, that means focus on actively managing risk and look for potentially profitable trends across a very global universe of markets; currency, bonds, stocks, commodities, and alternatives like volatility, inverse, etc . That’s my focus in ASYMMETRY® | Managed Accounts.

The Volatility Index (VIX) is Getting Interesting Again

In the last observation I shared on the CBOE Volatlity index (the VIX) I had been pointing out last year the VIX was at a low level and then later started trending up. At that time, many volatility traders seemed to think it was going to stay low and keep going lower – I disagreed. Since then, the VIX has remained at a higher average than it had been – up until now. You can read that in VIX® gained 140%: Investors were too complacent.

Here it is again, closing at 12.45 yesterday, a relatively low level for expected volatility of the S&P 500 stocks. Investors get complacent after trends drift up, so they don’t price in so much fear in options. Below we observe a monthly view to see the bigger picture. The VIX is getting down to levels near the end of the last bull market (2007). It could go lower, but if you look closely, you’ll get my drift.

Chart created by Shell Capital with: http://www.stockcharts.com

Next, we zoom in to the weekly chart to get a loser look.

Chart created by Shell Capital with: http://www.stockcharts.com

Finally, the daily chart zooms in even more.

Chart created by Shell Capital with: http://www.stockcharts.com

The observation?

Options traders have priced in low implied volatility – they expect volatility to be low over the next month. That is happening as headlines are talking about stock indexes hitting all time highs. I think it’s a sign of complacency. That’s often when things change at some point.

It also means that options premiums are generally a good deal (though that is best determined on an individual security basis). Rather than selling premium, it may be a better time to buy it.

Let’s see what happens from here…

My 2 Cents on the Dollar

The U.S. Dollar ($USD) has gained about 20% in less than a year. We observe it first in the weekly below. The U.S. Dollar is a significant driver of returns of other markets. For example, when the U.S. Dollar is rising, commodities like gold, oil, and foreign currencies like the Euro are usually falling. A rising U.S. Dollar also impacts international stocks priced in U.S. Dollar. When the U.S. Dollar trends up, many international markets priced in U.S. Dollars may trend down (reflecting the exchange rate). The U.S. Dollar may be trending up in anticipation of rising interest rates.

dollar trend weekly 2015-04-23_16-04-40

Chart created by Shell Capital with: http://www.stockcharts.com

Now, let’s observe a shorter time frame- the daily chart. Here we see an impressive uptrend and since March a non-trending indecisive period. Many trend followers and global macro traders are likely “long the U.S. Dollar” by being long and short other markets like commodities, international stocks, or currencies.

dollar trend daily 2015-04-23_16-05-04

Chart created by Shell Capital with: http://www.stockcharts.com

This is a good example of understanding what drives returns and risk/reward. I consider how long the U.S. Dollar I am and how that may impact my positions if this uptrend were to reverse. It’s a good time to pay attention to it to see if it breaks back out to the upside to resume the uptrend, or if it instead breaks down to end it. Such a continuation or reversal often occurs from a point like the blue areas I highlighted above.

That’s my two cents on the Dollar…

How long are you? Do you know?

Asymmetric Nature of Losses and Loss Aversion

Loss Aversion:

“In prospect theory, loss aversion refers to the tendency for people to strongly prefer avoiding losses than acquiring gains. Some studies suggest that losses are as much as twice as psychologically powerful as gains. Loss aversion was first convincingly demonstrated by Amos Tversky and Daniel Kahneman.”

For most people, losing $100 is not the same as not winning $100. From a rational point of view are the two things the same or different?

Most economists say the two are the same. They are symmetrical. But I think that ignores some key issues.

If we have only $10 to eat on today and that’s all we have, if we lose it, we’ll be in trouble: hungry.

But if we have $10 to eat on and flip a coin in a bet and double it to $20, we may just eat a little better. We’ll still eat. The base rate: survival.

They say rationally the two are the same, but that isn’t true. They aren’t the same. The loss makes us worse off than we started and it may be totally rational to feel worse when we go backward than we feel good about getting better off. I don’t like to go backward, I prefer to move forward to stay the same.

Prospect Theory, which found people experience a loss more than 2 X greater than an equal gain, discovered the experience of losses are asymmetric.

Actually, the math agrees.

You see, losing 50% requires a 100% gain to get it back. Losing it all is even worse. Losses are indeed asymmetric and exponential on the downside so it may be completely rational and logical to feel the pain of losses asymmetrically. Experience the feeling of loss aversions seems to be the reason a few of us manage investment risk and generate a smoother return stream rather than blow up.

To see what the actual application of asymmetry to portfolio management looks like, see: Shell Capital Management, LLC.

 

asymmetry impact of loss

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

In recent conversations with investment advisors, I notice their sentiment has shifted from “cautious and concerned” about world equity markets to “why have they underperformed”. Prior to 2013, most investors and investment advisors were concerned about another 2007 to 2009 level bear market. Now, it seems that caution has faded. Today, many of them seem to be focused on the strong trend of U.S. stocks since mid-2013 and comparing everything else to it.

Prior to October 2007, International stocks were in significantly stronger positive directional trends than U.S. Stocks. I’ll compare the S&P 500 stock index (SPY) to Developed International Countries (EFA). We can visually observe a material change between these markets before 2008 and after, but especially after 2013. That one large divergence since 2013 has changed sentiment.

The MSCI EAFE Index is recognized as the pre-eminent benchmark in the United States to measure international equity performance. It comprises the MSCI country indices that represent developed markets outside of North America: Europe, Australasia and the Far East. For a “real life” example of its price trend, I use the iShares MSCI EAFE ETF (EFA). Below are the country holdings, to get an idea of what is considered “developed markets”.

iShares MSCI EAFE ETF Developed Markets exposure 2015-04-05_17-14-43

Source: https://www.ishares.com/us/products/239623/EFA

Below are the price trends of the popular S&P 500 U.S. stock index and the MSCI Developed Countries Index over the past 10 years. Many investors may have forgotten how strong international markets were prior to 2008. Starting around 2012, the U.S. stock market continued to trend up stronger than international stocks. It’s a tale of two markets, pre-2008 and post-2008.

Developed Markets International stocks trend 2015-04-05_17-22-22

No analysis of a trend % change is complete without also examining its drawdowns along the way. A drawdown measures a drop from peak to bottom in the value of a market or portfolio (before a new peak is achieved). The chart below shows these indexes % off their prior highs to understand their historical losses over the period. For example, these indexes declined -55% or more. The International stock index nearly declined -65%. The S&P 500 U.S. stock index didn’t recover from its decline that started in October 2007 until mid-2012, 5 years later. The MSCI Developed Countries index is still in a drawdown! As you can see, EFA is -24% off it’s high reached in 2007. Including these international countries in a global portfolio is important as such exposure has historically provided greater potential for profits than just U.S. stocks, but more recently they have been a drag.

international markets drawdown 2015-04-05_17-30-00The International stock markets are divided broadly into Developed Markets we just reviewed and Emerging Countries. The iShares MSCI Emerging Markets ETF (EEM) tracks this index. To get an idea of which countries are considered “Emerging Markets’, you can see the actual exposure below.

emerging countries markets 2015-04-05_17-13-31

https://www.ishares.com/us/products/239637/EEM?referrer=tickerSearch

The Emerging Countries index has reached the same % change over the past decade, but they have clearly taken very different paths to get there. Prior to the “global crisis” that started late 2007, many investors may have forgotten that Emerging Markets countries like China and Brazil were in very strong uptrends. I remember this very well; as a global tactical trader I had exposure to these countries which lead to even stronger profits than U.S. markets during that period. Since 2009, however, Emerging Markets recovered sharply but as with U.S. stocks: they have trended up with great volatility. Since Emerging Markets peaked around 2011 they have traded in a range since. However, keep in mind, these are 10-year charts, so those swings up and down are 3 to 6 months. We’ll call that “choppy”. Or, 4 years of a non-trending and volatile state.

Emerging Markets trend 10 years 2015-04-05_17-21-06

Once again, no analysis of a trend % change is complete without also examining its drawdowns along the way. A drawdown measures a drop from peak to bottom in the value of a market or portfolio (before a new peak is achieved). The chart below shows these indexes % off their prior highs to understand their historical losses over the period. For example, these indexes declined -55% or more. The Emerging Market stock index declined -65%. The S&P 500 U.S. stock index didn’t recover from its decline that started in October 2007 until mid-2012, 5 years later. The MSCI Emerging Countries index is still in a drawdown! As you can see, EFA is -26% off it’s high reached in 2007. As I mentioned before, it recovered sharply up to 2011 but has been unable to move higher in 4 years. Including these Emerging Markets countries in a global portfolio is important as such exposure has historically provided greater potential for profits than just U.S. stocks, but more recently they have been a drag.

emerging markets drawdown 2015-04-05_17-52-19

Wondering why the tale of two markets before and after 2008? The are many reasons and return drivers. One of them can be seen visually in the trend of the U.S. Dollar. Below is a 10-year price chart of the U.S. Dollar index. Prior to 2008, the U.S. Dollar was falling, so foreign currencies were rising as were foreign stocks priced in Dollars. As with most world markets, even the U.S. Dollar was very volatile from 2008 through 2011. After 2011 it drifted in a tighter range through last year and has since increased sharply.

Dollar impact on international stocks 2015-04-05_18-05-02

The funny thing is, I’ve noticed there are a lot of inflows into currency-hedged ETFs recently. Investors seem to do the wrong thing at the wrong time. For example, they’ll want to hedge their currency risk after it already happened, not before… It’s just like with options hedging: Investors want protection after a loss, not before it happens. Or, people will buy that 20 KW generator for their home after they lose power a few days, not before, and may not need it again for 5 years after they’ve stopped servicing it. So, it doesn’t start when they need it again.

You can probably see why I think it’s an advantage to understand how world markets interact with each other and it’s an edge for me.

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Asymmetric Sector Exposure in Stock Indexes

When you look at the table below and see the sector exposure percents, what do you observe? Do these allocations make sense?

asymmetric sector ETF expsoure S&P 500 2015-03-24_16-39-11

That is the sector exposure of the S&P 500 stock index: I used the iShares S&P 500 ETF for a real-world proxy. The source of each image is the index website on iShares, which you can see by clicking on the name of the index ETF.

  • Asymmetric is an imbalance. That is, more of one thing, less of another.
  • A sector is a specific industry, like Energy (Exxon Mobil) or Telecom (Verizon).
  • Exposure is the amount of the position size or allocation.

Most of the sector exposure in the S&P 500 large company stock index is Technology, Financials, Healthcare, and Consumer Discretionary. Consumer Staples, Energy, Materials, Utilities, and Telecommunications have less than 10% exposure each. Exposure to Materials, Utilities, and Telecommunications are almost non-existent. Combined, those three sectors are less than 10% of the index. Industrial has 10% exposure by itself.  But this index is 500 large companies, what about mid size and small companies?

asymmetric sector expsoure S&P 500 2015-03-24_16-39-11

Below is the iShares Core S&P Mid-Cap ETF. Most of the sector exposure in the S&P Mid size stock index is Technology, Financials, Industrial. Healthcare, and Consumer Discretionary. Consumer Staples, Energy, Materials, Utilities, and Telecommunications have less than 10% exposure each. Exposure to Materials, Utilities, and Telecommunications are almost non-existent.

asymmetric sector exposure  S&P Mid-Cap ETF

We see this same asymmetric sector exposure theme repeat in the iShares S&P Small Cap index. Half of the sectors are make up most of the exposure, the other very little.

asymmetric sector exposure S&P small cap

This is just another asymmetric observation… the next time you hear someone speak of the return of a stock index, consider they are really speaking about the return profile of certain sectors. And, these sector weightings may change over time.

Trends, Countertrends, in the U.S. Dollar, Gold, Currencies

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

Trends trend to continue and are even more likely to continue than to reverse, because of inertia. Inertia is the resistance to change, including a resistance to change in direction. It’s an important physics concept to understand to understand price trends because inertia relates to momentum and velocity. A directional price trend that continues, or doesn’t change or reverse, has inertia. To understand directional price trends, we necessarily need to understand how a trend in motion is affected by external forces. For example, if a price trend is up and continues even with negative external news, in inertia or momentum is even more significant. Inertia is the amount of resistance to change in velocity. We can say that a directional price trend will continue moving at its current velocity until some force causes its speed or direction to change. A directional trend follower, then, wants keep exposure to that trend until its speed or direction does change. When a change happens, we call it a countertrend. A countertrend is a move against the prior or prevailing trend. A countertrend strategy tries to profit from a trend reversal in a directional trend that has moved to such a magnitude it comes more likely to reverse, at least briefly, than to continent. Even the best long-term trends have smaller reversals along the way, so countertrend systems try to profit from the shorter time frame oscillations.

“The one fact pertaining to all conditions is that they will change.”

                                    —Charles Dow, 1900

One significant global macro trend I noticed that did show some “change” yesterday is the U.S. Dollar. The U.S. Dollar has been in a smooth drift up for nearly a year. I use the PowerShares DB US Dollar Index Bullish (UUP). Below, I start with a weekly chart showing a few years so you can see it was non-trending up until last summer. Clearly, the U.S. Dollar has been trending strongly since.

u.s. dollar longer trend UPP

Next, we zoom in for a closer look. The the PowerShares DB US Dollar Index Bullish (UUP) was down about -2% yesterday after the Fed Decision. Notice that I included a 50 day moving average, just to smooth out the price data to help illustrate its path. One day isn’t nearly enough to change a trend, but that one day red bar is greater in magnitude and had heavy volume. On the one hand, it could be the emotional reaction to non trend following traders. On the other, we’ll see over time if that markets a real change that becomes a reversal of this fine trend. The U.S. Dollar may move right back up and resume it’s trend…

U.S. Dollar Trend 2015-03-19_08-21-35

chart source for the following charts: http://www.stockcharts.com

I am using actual ETFs only to illustrate their trends. One unique note about  PowerShares DB US Dollar Index Bullish Fund (Symbol: UUP) is the tax implications for currency limited partnership ETFs are subject to a 60 percent/40 percent blend, regardless of how long the shares are held. They also report on a K-1 instead of a 1099.

Why does the direction of the U.S. Dollar matter? It drives other markets. Understanding how global markets interact is an edge in global tactical trading. Below is a chart of Gold. I used the SPDR Gold Trust ETF as a proxy. Gold tends to trade the opposite of the U.S. Dollar.

gold trend 2015-03-19_08-22-41

When the U.S. Dollar is trending up, it also has an inverse correlation to foreign currencies priced in dollars. Below is the CurrencyShares Euro ETF.

Euro currency trend 2015-03-19_08-23-03

Foreign currencies can have some risk. In January, the Swiss Franc gaped up sharply, but has since drifted back to where it was. Maybe that was an over-reaction? Markets aren’t so efficient. Below is a chart of the CurrencyShares Swiss Franc to illustrate its trend and countertrend moves.

swiss franc trend 2015-03-19_08-23-23

None of this is a suggestion to buy or sell any of these, just an observation about directional trends, how they interact with each other, and countertrend moves (whether short term or long term). Clearly, there are trends…

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