Asymmetric Volatility Phenomenon

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

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

We observe asymmetric volatility in equity markets, too.

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


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

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

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

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

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

Here is an example you may remember.


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

That’s the very move you want to avoid.

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

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

It wasn’t just 2008.

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

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

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


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


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

They are the same people who will experience it again.

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

– Richard Dennis


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

Systems trading is ultimately discretionary. The manager still has to decide how much risk to accept, which markets to play, and how aggressively to increase and decrease the trading base as a function of equity change. These decisions are quite important – often more important than trade timing.”

Ed Seykota in Market Wizards: Interviews with Top Traders By Jack D. Schwager

Market Wizards Interviews with Top Traders

Essence of Portfolio Management

Essence of Portfolio Management

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

– Benjamin Graham

The problem is many portfolio managers believe they manage risk through their investment selection. That is, they believe their rotation from one seemingly risky position to another they believe is less risk is a reduction in risk. But, the risk is the exposure to the chance of a loss. The exposure is still there. Only the perception has changed: they just believe their risk is less. For example, for the last thirty years, the primary price trend for bonds has been up because interest rates have been falling. If a portfolio manager shifts from stocks to bonds when stocks are falling, bonds would often be rising. It appears that trend may be changing at some point. Portfolio managers who have relied on bonds as their safe haven may rotate out of stocks into bonds and then their bonds lose money too. That’s not risk management.

They don’t know in advance if the position they rotate to will result in a lower possibility of loss. Before 2008, American International Group (AIG) carried the highest rating for an insurance company. What if they rotated to AIG? Or to any of the other banks? Many investors believed those banks were great values as their prices were falling. They instead fell even more. It has taken them a long time to recover some of their losses. Just like tech and telecom stocks in 2000.

All risks cannot be hedged away if you pursue a profit. If you leave no chance at all for a potential profit, you earn nothing for that certainty. The risk is exposure to an unknown outcome that could result in a loss. If there is no exposure or uncertainty, there is no risk. The only way to manage risk is to increase and decrease the exposure to the possibility of loss. That means buying and selling (or hedging).  When you hear someone speaking otherwise, they are not talking of active risk management. For example, asset allocation and Modern Portfolio Theory is not active risk management. The exposure to loss remains. They just shift their risk to more things. Those markets can all fall together, as they do in real bear markets.

It’s required to accomplish what the family office Chief Investment Officer said in “What a family office looks for in a hedge fund portfolio manager” when he said:

“I like analogies. And one of the analogies in 2008 brings to me it’s like a sailor setting his course on a sea. He’s got a great sonar system, he’s got great maps and charts and he’s perhaps got a great GPS so he knows exactly where he is. He knows what’s ahead of him in the ocean but his heads down and he’s not seeing these awesomely black storm clouds building up on the horizon are about to come over top of him. Some of those managers we did not stay with. Managers who saw that, who changed course, trimmed their exposure, or sailed to safer territory. One, they survived; they truly preserved capital in difficult times and my benchmark for preserving capital is you had less than a double-digit loss in 08, you get to claim you preserved capital. I’ve heard people who’ve lost as much as 25% of investor capital argue that they preserved capital… but I don’t believe you can claim that.Understanding how a manager managed and was nimble during a period of time it gives me great comfort, a higher level of comfort, on what a manager may do in the next difficult period. So again it’s a it’s a very qualitative sort of trying to come to an understanding of what happened… and then make our best guess what we anticipate may happen next time.”

I made bold the parts I think are essential.

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

Investor Optimism Seems Excessive Again

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

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

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

CNN Fear Greed Index

Source: CNN Fear & Greed Index


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

Fear and Greed over time investor sentiment

Source: CNN Fear & Greed Index

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

VIX Volatility Index.jpg

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

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

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

To learn more, contact us.

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

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

We see the world not as it is but as we are

The U.S. Stock Market Trend

When we define the direction of a trend, we consider the most basic definitions.

  • 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 a few key points. The top of the price range is just that: a range, with no meaningful breakout. The bottom is the same. The price trend has dropped to around the same level three times and so far, has trended back up. What’s going to happen next? At this point, this stock market index is swinging up and down. It would take a meaningful break below the prior low that holds to make a new “downtrend”. It could just as well trend up. We could put an exit point below those prior lows and let it all unfold.

Stock market trend

Of course, as I’ve mentioned a lot the past several months, other global markets and small company U.S. stocks and mid-cap stocks have been much weaker than large U.S. stocks and certain sectors within the U.S. You can read the details of this in The Stock Market Trend: What’s in Your Boat? As I pointed out then, in the chart below we can see the mid-size and small cap stocks have actually declined much more. But, the capitalization-weighted indexes are driven by their sector exposure.

small cap mid cap stocks

Some U.S. sectors are still holding up and still in uptrends. Below is the Technology sector index, for example. I consider this an uptrend, though volatile. Less volatile trends are easier to hold, more volatile trends are more difficult unless we focus on the directional trend.

Tech Sector Trend

Below is the U.S. Healthcare sector. It’s down, but not out. It’s still so far holding a higher low.

healthcare sector

The really weak markets that have been in more clear downtrends are the commodity related sectors like Energy and Basic Materials.  This could signal the beginning of a larger move down in other sectors if they follow, or not. But if we focus on “what’s in our boat” we are focused only on our own positions.

Energy Sector basic materials

The key to tactical decision-making is sometimes holding exposure to potentially positive trends and giving them room to see how they unfold: up or down. The other key is avoiding the clearest downtrends. Then, there comes a point when those trends change and reverse. Even the downtrends eventually become uptrends. We can be assured after that happens everyone will wish they had some exposure to it!

Never knowing for sure what will happen next it always involves uncertainty and the potential for a loss we must be willing to bear. I think the edge is predefining risk by knowing at what point to exit if the trend has really changed, accepting that, then letting it all unfold.


Extreme Fear is Now Driving Markets

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

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

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

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

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

Fear and Greed Index

Source: CNN Fear & Greed Index 

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

Fear and Greed Over Time

Another publicly available measure of investor sentiment is the AAII Investor Sentiment Survey. The AAII Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months; individuals are polled from the ranks of the AAII membership on a weekly basis. The most recent weekly survey shows investors are very bearish and again, such pessimism occurs after price declines and at such extremes sometimes precedes a reversal back up.

Survey Results for Week Ending 1/13/2016

AAII Investor Sentiment January 2016

Source: AAII Investor Sentiment Survey

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

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


Charles Dow 

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

Fear and Greed is Shifting and Models Don’t Avoid the Feelings

Investors are driven by fear and greed. That same fear and greed drives market prices. It’s Economics 101 “Supply and Demand”. Greed drives demand, fear drives selling pressure. In fact, investors are driven by the fear of losing more money when their account is falling and fear missing out if they have cash when markets go up. Most investors tend to experience a stronger feeling from losing money than they do missing out. Some of the most emotional investors oscillate between the fear of missing out and the fear of losing money. These investors have to modify their behavior to avoid making mistakes. Quantitive rules-based systematic models don’t remove the emotion.

Amateur portfolio managers who lack experience sometimes claim things like: “our quantitive rules-based systematic models removes the emotion”. That couldn’t be further from the truth. Those who believe that will eventually find themselves experiencing feelings from their signals they’ve never felt before. I believe it’s a sign of high expectations and those expectations often lead to even stronger reactions. It seems it’s the portfolio managers with very little actual performance beyond a backtest that make these statements. They must believe a backtested model will act to medicate their feelings, but it doesn’t actually work that way. I believe these are the very people who over optimize a backtest to make it perfectly fit historical data. We call it “curve-fitting” or “over-fitting”, but it’s always “data mining”. When we backtest systems to see how they would have acted in the past, it’s always mining the data retroactively with perfect hindsight. I’ve never had anyone show me a bad backtest. If someone backtests entry and exit signals intended to be sold as a managed portfolio you can probably see how they may be motivated to show the one that is most optimized to past data. But, what if the future is very different? When it doesn’t work out so perfectly, I think they’ll experience the very feelings they wish to avoid. I thought I would point this out, since many global markets have been swinging up and down. I’m guessing some may be feeling their feelings.

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

CNN Fear and Greed IndexSource:

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

Fear and Greed Over time investor sentiment


The four most dangerous words…

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

To quote from fellow Tennessean, Sir John Templeton:

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

Sir John Templeton

Sir John Templeton


The markets always go back up?

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

I replied: “Tell that to the Japanese”.

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

Long Term Japan Stock Market Index NIKKEI


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

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”.


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

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.

The person who says it cannot be done should not interrupt the person doing it.

– Chinese Proverb

The person who says it cannot be done Should not interupt the person doing it


Uncharted Territory from the Fed Buying Stocks

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

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

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

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

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

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

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

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

Current Margin Debt Stock MarginSource:

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


Human judgment, good and bad, will drive investment decisions and financial-market outcomes for the rest of our lives and beyond.


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

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

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:

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

Chart created by Shell Capital with:

Finally, the daily chart zooms in even more.

Chart created by Shell Capital with:

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…

Conflicted News

This is a great example of conflicted news. Which news headline is driving down stock prices today?

Below is a snapshot from Google Finance::

conflicted news 2015-04-17_10-21-43

Trying to make decisions based on news seems a very conflicted way, which is why I instead focus on the absolute direction of price trends.

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 economist 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 backwards than we feel good about getting better off. I don’t like to go backwards, 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:


asymmetry impact of loss

“We like what’s familiar, and we dislike change. So, we push the familiar until it starts working against us big-time—a crisis. Then, MAYBE we can accept change.”

—Kevin Cameron (Journalist, Cycle World April 2013)

Confirmation Bias: The tendency to search for, interpret, focus on and remember information in a way that confirms one’s preconceptions.

“It is impossible to produce a superior performance unless…

Sir John Templeton


A great quote from my fellow Tennessean, Sir John Templeton:

“It is impossible to produce a superior performance unless you do something different from the majority.”

Sir John Templeton

US Government Bonds Rise on Fed Rate Outlook?

I saw the following headline this morning:

US Government Bonds Rise on Fed Rate Outlook

Wall Street Journal –

“U.S. government bonds strengthened on Monday after posing the biggest price rally in more than three months last week, as investors expect the Federal Reserve to take its time in raising interest rates.”

My focus is on directional price trends, not the news. I focus on what is actually happening, not what people think will happen. Below I drew a 3 month price chart of the 20+ Year Treasury Bond ETF (TLT), I highlighted in green the time period since the Fed decision last week. You may agree that most of price action and directional trend changes happened before that date. In fact, the long-term bond index declined nearly 2 months before the decision, increased a few weeks prior, and has since drifted what I call “sideways”.

fed decision impact on bonds
Charts created with

To be sure, in the next chart I included an analog chart including the shorter durations of maturity. iShares 3-7 Year Treasury Bond ETF (IEI) and iShares 7-10 Year Treasury Bond ETF (IEF). Maybe there is some overreaction and under-reaction going on before the big “news”, if anything.

Government bonds Fed decision reaction
Do you still think the Fed news was “new information“?

Fed Decision and Market Reaction: Stocks and Bonds

So, I’m guessing most people would expect if the Fed signaled they are closer to a rate hike the stock and bond markets would fall. Rising interest rates typically drive down stocks along with bonds. Not the case as of 3pm today. Stocks were down about -1% prior to the announcement, reversed, and are now positive 1%. Even bonds are positive. Even the iShares Barclays 20+ Yr Treas.Bond (ETF) is up 1.4% today.

So much for expectations…

Below is snapshot of the headlines and stock price charts from Google Finance:

Fed Decision and Reaction March 18 2015


Diversification Alone is No Longer Sufficient to Temper Risk…

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

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 dradown: 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: MALOX: 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.

Vanguard DFA BlackRock PIMCO Asset Allcation

Charts are courtesy of drawn by Mike Shell

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.

PIMCO Total Return Bond Vanguard Total Bond

Charts are courtesy of drawn by Mike Shell

You may have noticed the end of the chart is a drop of nearly -2%. 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.

Instead, I apply active risk management and directional trend systems to a global universe of exchange traded securities (like ETFs). To see what that looks like, click: ASYMMETRY® Managed Accounts

Illusion of Control


“The illusion of control is the tendency for people to overestimate their ability to control events; for example, it occurs when someone feels a sense of control over outcomes that they demonstrably do not influence.”


Top Traders Unplugged Interview with Mike Shell: Episode 2

Top Traders Unplugged Mike Shell ASYMMETRY Global Tactical Shell Capital Management

“In the second part of our talk with Mike Shell, we delve into the specifics of his program and why most of his clients have 100% of their investments with his firm. He discusses backtesting, risk management, and the differences between purely systematic systems and systems with a discretionary element. Listen in for an inside look at this fascinating firm.” – Niels Kaastrup-Larsen

Listen: Top Traders Unplugged Interview with Mike Shell: Episode 2


Direct links:

Episode 2

For more information, visit ASYMMETRY® Managed Accounts.

Top Traders Unplugged Interview with Mike Shell: Episode 1

“It’s not about trying to make all the trades a winner – it’s about having the average win be much greater than the average loss – and that is asymmetry.” – Mike Shell

Does anyone recognize this guy? this is the first episode of my 2 hour interview with Niels Kaastrup-Larsen in Switzerland on “Top Traders Unplugged” who has been part of the hedge fund industry for more than twenty years, working for some of the largest hedge funds in the world.

For those unsure what a “top trader” means, my 10 year performance is at the bottom of this link:

I encourage you to to listen to the interview as it’s as much about life as trading. You can listen directly on the website or the podcast in iTunes. click: Mike Shell Interview with Top Traders Unplugged

Top Traders Unplugged Mike Shell Capital Management Interview

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

I was talking to an investment analyst at an investment advisory firm about my ASYMMETRY® Managed Account and he asked me what the standard deviation was for the portfolio. I thought I would share with you and explain this is how the industry gets “asset allocation” and risk measurement and management wrong. You see, most people have poor results over a full market cycle that includes both rising and falling price trends, like global bull and bear markets, recessions, and expansions. Quantitative Analysis of Investor Behavior, SPIVA, Morningstar, and many academic papers have provided empirical evidence that most investors (including professionals) have poor results over the long periods. For example, they may earn gains in rising conditions but lose their gains when prices decline. I believe the reason is they get too aggressive at peaks and then sell in panic after losses get too large, rather than properly predefine and manage risk.

You may consider, then, to have good results over a long period, I necessarily have to believe and do things very different than most people.

On the “risk measurement” topic, I thought I would share with you a very important concept that is absolutely essential for truly actively controlling loss. The worst drawdown “is” the only risk metric that really matters. Risk is not the loss itself. Once we have a loss, it’s a loss. It’s beyond the realm of risk. Since risk is the possibility of a loss, then how often it has happened in the past and the magnitude of the historical loss is the mathematical expectation. Beyond that, we must assume it could be even worse some day. For example, if the S&P 500 stock index price decline was -56% from 2007 to 2009, then we should expect -56% is the loss potential (or worse). When something has happened before, it suggests it is possible again, and we may have not yet observed the worst decline in the past that we will see in the future.

The use of standard deviation is one of the very serious flaws of investors attempting to measure, direct, and control risk. The problem with standard deviation is that the equation was intentionally created to simplify data. The way it is used draws a straight line through a group of data points, which necessarily ignores how far the data really spreads out. That is, standard deviation is intended to measure how far the data spreads out, but it actually fails to absolutely highlight the true high point and low point. Instead, it’s more of an average of those points. Yet, it’s the worst-case loss that we really need to focus on. I believe in order to direct and control risk, I must focus on “how bad can it really get”. Not just “on average” how bad it can get. The risk in any investment position is at least how much it has declined in the past. And realizing it could be even worse some day. Standard deviation fails to reflect that in the way it is used.

Consider that as prices trend up for years, investors become more and more complacent. As investors become complacent, they also become less indecisive as they believe the recent past upward trend will continue, making them feel more confident. On the other hand, when investors feel unsure about the future, their fear and indecisiveness is reflected as volatility as the price churns up and down more. We are always unsure about the future, but investors feel more confident the past will continue after trends have been rising and volatility gets lower and lower. That is what a peak of a market looks like. As it turns out, that’s just when asset allocation models like Modern Portfolio Theory (MPT) and portfolio risk measures like Value at Risk (VaR) tell them to invest more in that market – right as it reaches it’s peak. They invest more, complacently, because their allocation model and risk measures tell them to. An example of a period like this was October 2007 as global stock markets had been rising since 2003. At that peak, the standard deviation was low and the historical return was at it highest point, so their expected return was high and their expected risk (improperly measured as historical volatility) was low. Volatility reverses the other way at some point

What happens next is that the market eventually peaks and then begins to decline. At the lowest point of the decline, like March 2009, the global stock markets had declined over -50%. My expertise is directional price trends and volatility, so I can tell you from empirical observation that prices drift up slowly, but crash down quickly. The below chart of the S&P 500 is a fine example of this asymmetric risk.

stock index asymmetric distribution and losses

Source: chart is drawn by Mike Shell using

At the lowest point after prices had fallen over -50%, in March 2009, the standard deviation was dramatically higher than it was in 2007 after prices had been drifting up. At the lowest point, volatility is very high and past return is very low, telling MPT and VaR to invest less in that asset.

In the 2008 – 2009 declining global markets, you may recall some advisors calling it a “6 sigma event”. That’s because the market index losses were much larger than predicted by standard deviation. For example, if an advisors growth allocation had an average return of 10% in 2007 based on its past returns looking back from the peak and a standard deviation of 12% expected volatility, they only expected the portfolio would decline -26% (3 standard deviations) within a 99.7% confidence level – but the allocation actually lost -40 or -50%. Even if that advisor properly informed his or her client the allocation could decline -26% worse case and the client provided informed consent and acceptance of that risk, their loss was likely much greater than their risk tolerance. When the reach their risk tolerance, they “tap out”. Once they tap out, when do they ever get back in? do they feel better after it falls another -20%? or after it rises 20%? There is no good answer. I want to avoid that situation.

You can see in the chart below, 3 standard deviations is supposed to capture 99.7% of all of the data if the data is a normal distribution. The trouble is, market returns are not a normal distribution. Instead, their gains and losses present an asymmetrical return distribution. Market returns experience much larger gains and losses than expected from a normal distribution – the outliers are critical. However, those outliers don’t occur very often: maybe every 4 or 5 years, so people have time to forget about the last one and become complacent.

symmetry normal distribution bell curve black


My friends, this is where traditional asset allocation like Modern Portfolio Theory (MPT) and risk measures like Value at Risk (VaR) get it wrong. And those methods are the most widely believed and used . You can probably see why most investors do poorly and only a very few do well – an anomaly.

I can tell you that I measure risk by how much I can lose and I control my risk by predefining my absolute risk at the point of entry and my exit point evolves as the positions are held. That is an absolute price point, not some equation that intentionally ignores the outlier losses.

As the stock indexes have now been overall trending up for 5 years and 9 months, the trend is aged. In fact, according to my friend Ed Easterling at Crestmont Research, at around 27 times EPS the stock index seems to be in the range of overvalued. In his latest report, he says:

“The stock market surged over the past quarter, adding to gains during 2014 that far exceed underlying economic growth. As a result, normalized P/E increased to 27.2—well above the levels justified by low inflation and interest rates. The current status is approaching “significantly overvalued.”

At the same time, we shouldn’t be surprised to eventually see rising interest rates drive down bond values at some point. It seems from this starting point that simply allocating to stocks and bonds doesn’t have an attractive expected return. I believe a different strategy is needed, especially form this point forward.

In ASYMMETRY® Global Tactical, I actively manage risk and shift between markets to find profitable directional price trends rather than just allocate to them. For more information, visit


Tomorrow’s Newspaper: the Future, Part One

People often ask me questions of the future. I guess they figure I have such a strong track record, I must know something about the future.

I paused my time machine, the rest of the world stopped; I took one step forward to see what happens next.

Here is what I saw:

Tomorrows Newspaper What the Future Looks LIke

Source: The Future: a period that doesn’t yet exist.

If anyone sees anything different please take a picture, come back here, now, and post it in the comments for all of us to see.

Stock Investors Even More Bullish While Japan Falls into Surprise Recession

Following up with Are investors getting overly optimistic again? I pointed out that investor sentiment as measured by the AAII Investor Sentiment Survey had shifted to a point of unusually high bullishness.

After prices trend up, investors get more optimistic as they extrapolate higher prices into the future, assuming that existing trends will continue. Interestingly, they get more bullish as prices are more “overvalued”. As more and more investors become optimistic about stocks in the months ahead, you have to wonder who will continue the buying needed to push stocks higher. A good trend follower knows that trends do indeed often continue, until the demand runs out. Since supply and demand is the driver of all things traded in an auction market, we can observe demand shifts and how it drives prices.

Since I wrote Are investors getting overly optimistic again? less than two weeks ago, the latest AAII Investor Sentiment Survey shows bullishness is even higher.

investor sentiment and asymmetric risk


In the mean time, Fox Business reports this morning “Japan’s economy unexpectedly slipped into recession in the third quarter”. That shouldn’t be a big surprise. If you take a look at the weekly chart of the Japan stock index (priced in Dollars) below, it’s been suggesting something for the past year. I am seeing similar trends (or choppy non-trends) in many global stock markets.

Japan stock market recession

Courtesy of

It will be interesting to watch how it all unfolds.

The Mistake is Not Taking the Loss: Cut Your Losses and Move on

One of the keys to managing investment risk is cutting losers before they become large losses. Many people have difficulty selling at a loss because they believe it’s admitting a mistake. The mistake isn’t taking a loss, the mistake is to NOT take the loss. I cut losses short all the time, that’s why I don’t have large ones. I’ve never taken a loss that was a mistake. I predetermine my risk by determining before I even buy something at what point I’ll get out if I am wrong. If I enter at $50, my methods may determine if it falls to $45 that trend I wanted to get in is no longer in place and I should get out. So when I enter a position in any market, I know how I’ll cut my loss short before I even get in. It’s the exit, not the entry, that determines the outcome. I don’t know in advance which will be a winner or loser or how much it will gain or lose. For me, not taking the loss, would be the mistake.

I thought of this when a self-proclaimed old-timer admitted to me he still holds some of the popular stocks he bought the late 90’s. Many of those stocks are no longer in business, but below we revisit the price trend and total return of some of the largest and most popular stocks promoted in the late 90’s. The black line is Cisco Systems (CSC), Blue is AT&T (T), Red is Pfizer (PFE), and green is Microsoft (MSFT). AT&T’s roots stretch back to 1875, with founder Alexander Graham Bell’s invention of the telephone. Pfizer started in 1849 “With $2,500 borrowed from Charles Pfizer’s father, cousins Charles Pfizer and Charles Erhart, young entrepreneurs from Germany, opened Charles Pfizer & Company as a fine-chemicals business”. At one point during the late 90’s “tech bubble” Microsoft and Cisco Systems were valued more than many countries. But the chart below shows if you did buy and held these stocks nearly 20 years later you would have held losses for many years and many of them are just now showing a profit.

tech bubble leaders 2014-11-15_07-04-53

chart courtesy of

The lesson to cut losses short rather than allow them to become large losses came from a book published in 1923.

“Money does not give a trader more comfort, because, rich or poor, he can make mistakes and it is never comfortable to be wrong. And when a millionaire is right his money is merely one of his several servants. Losing money is the least of my troubles. A loss never bothers me after I take it. I forget it overnight. But being wrong – not taking the loss – that is what does the damage to the pocketbook and to the soul.”

-Reminiscences of a Stock Operator (1923)

If you are unfamiliar with the classic, according to Amazon:

Reminiscences of a Stock Operator is a fictionalized account of the life of the securities trader Jesse Livermore. Despite the book’s age, it continues to offer insights into the art of trading and speculation. In Jack Schwagers Market Wizards, Reminiscences was quoted as a major source of stock trading learning material for experienced and new traders by many of the traders who Schwager interviewed. The book tells the story of Livermore’s progression from day trading in the then so-called “New England bucket shops,” to market speculator, market maker, and market manipulator, and finally to Wall Street where he made and lost his fortune several times over. Along the way, Livermore learns many lessons, which he happily shares with the reader.



Are investors getting overly optimistic again?

Just as I was observing U.S. stocks getting to a point that I would expect to see stock indexes pull back at least a little or drift sideways, I noticed that investor sentiment readings last week were unusually bullish. 49.4% of investors polled by AAII last week believe stocks will rise in the next 6 months. Only 21.1% were bearish, believing stocks would fall.

That’s an unusual asymmetry between the percent of individual investors believing stocks will rise over those who believe they will fall. You can see the historical averages below.

AAII investor sentiment survey


Investors tend to get more bullish about stocks after they have risen recently (and they have). They tend to get more bearish after stocks have fallen and they are losing money – and fear losing more.

It isn’t a perfect indicator, but the majority tends to feel the wrong feelings at the wrong timeThat presents an advantage for those of us who don’t, and are aware of how behavior signals trends, but a challenge for advisers and individual investors as they try to modify their behavior to avoid it.

Markets don’t always react the way investors expect, so I focus on what is actually happening

hedge fund market wizards

I noted the below question and answer between Jack Schwager and Ray Dalio in Jack’s book “Hedge Fund Market Wizards: How Winning Traders Win” (2012). Ray Dalio is the founder of Bridgewater, the largest hedge fund in the world and one of the most successful. I saved it when I read the book as a fine example that markets don’t always react the way people expect, and that is why I focus instead on what is actually happening rather than what could or should happen – but may not. Everything is very transient, coming and going, and it’s funny how some of the same kinds of things happen over and over again. As you read comments below you’ll hear it’s always a similar story, different day. 1982 was the end of a 20 year secular bear market made up of huge swings similar to the past decade and the beginning of the largest bull market on record up to 2000.

Below is Jack Schwager asking a question to Ray Dalio:

Any other early experiences stand out where the market behaved very differently from what you expected?

In 1982, we had worse economic conditions than we do right now. The unemployment rate was over 11 percent. It also seemed clear to me that Latin America was going to default on its debt. Since I knew that the money center banks had large amounts of their capital in Latin American debt, I assumed that a default would be terrible for the stock market. Then boom—in August, Mexico defaulted. The market responded with a big rally. In fact, that was the exact bottom of the stock market and the beginning of an 18-year bull market. That is certainly not what I would have expected to happen. That rally occurred because the Fed eased massively. I learned not to fight the Fed unless I had very good reasons to believe that their moves wouldn’t work. The Fed and other central banks have tremendous power. In both the abandonment of the gold standard in 1971 and in the Mexico default in 1982, I learned that a crisis development that leads to central banks easing and coming to the rescue can swamp the impact of the crisis itself.

Source: Schwager, Jack D. (2012-04-25). Hedge Fund Market Wizards (pp. 54-55). John Wiley and Sons. Kindle Edition.

All of this, everything that is happening and expected to happen, will be reflected in the directional trend and volatility of price. The directional price and range of prices (volatility) will overreact at times and under-react at others, but it will reflect what is actually going on. Because the direction and volatility of price “is” what matters.

Extreme Fear is Now the Return Driver

A professional investment adviser recently passed along some materials and asked for my opinion about a “tactical model” offered by another money manager. I was surprised that they expect great results from their model when it said something like:

“As investors become more risk-averse, the model becomes more defensive and vice versa.”

Let’s consider that for a moment.

As investors become more risk-averse, the model becomes more defensive. When investors become more risk-seeking, the model becomes more offensive.

That surprises me because investor sentiment is usually used as a countertrend indicator, not as a trend following indicator. Investors often get overly optimistic after prices have trended up and investors get more afraid after prices have trended down.

They went on to say they also use economic indicators as their signal to increase and decrease exposure. I am always concerned when I hear of someone using anything other that the direction of the price trend itself. Other indicators like credit spreads or perceived risk premiums are derivatives of price and it’s the directional movement of the price trend itself we really want. If the price gains 5%, we make money. If the price loses 5%, we lose money. If the price does nothing and the ratio or spread you rely on goes up or down, it did nothing for you. If you use something that is a derivative of the price itself, you have the potential to stray far from the price trend itself.

All blow-ups in history started that way.

Investor sentiment is usually wrong. It isn’t something I’d want to follow. If anything, I’d want to do the opposite of investor sentiment when it reaches an extreme. I occasionally point out my observations when investor sentiment reaches an extreme. When I do, I’ll highlight a simple sentiment gauge that is publicly available on the CNN Money website. Now, that gauge doesn’t actually have a signal that says when it has reached an extreme. It’s just a gauge to swings from one extreme to the other and spends a lot of time in between. It isn’t what is telling me to share my observations – it’s not my signal. I have other systems for actually doing that, but my systems often coincide with extreme readings in the Fear and Greed Index.

investor sentiment fear driving stocks

source: Fear and Greed Index


As of Friday, fear is driving stocks. A few weeks ago I pointed out “It’s official: extreme greed is driving the stock market”. Prices had been rising and investors became more and more optimistic. Stocks have now fallen about 3 – 4% and investor sentiment quickly shifted from “Extreme Greed” a few weeks ago to “Extreme Fear” now. The stock market had gone months without a 1% move, so a -2% down day got their attention.

stock market decline investor fear


Investor sentiment isn’t necessarily and indicator I use to increase and decrease exposure, but instead one that is useful to help investors understand problems in their behavior. If you find yourself getting more aggressive after prices have already made a big move, or scared after price declines, you may find it useful to monitor the Fear and Greed Index to help adjust your behavior. That money manager may be one of them.

If anything, you may find increasing and decreasing exposure to risk is best done opposite of sentiment extremes, not along with it. Investor sentiment is usually wrong, not right. Extreme fear occurs at lows, extreme greed at highs.


5th Year Anniversary of the Bull Market

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

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

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

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

S&P 500 full market cycle 2014-03-14_10-34-31

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

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

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

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

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

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

Ways you sabotage yourself

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

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

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

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

Fear is beginning to drive stock trends

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

S&P 500 and Russell 2000 decline

S&P 500 and Russell 2000 decline

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

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

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

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

Do you choose the blue pill or the red pill?


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

On the one hand, the poor performance of stock and bond indexes over the past decade or so, particularly the losses in bear markets, led him to study long-term market cycles. An understanding that markets don’t always go up over long periods is the reality of the red pill.

On the other hand, much of the investment industry still believes in getting “market returns” and that a simple plan of “asset allocation” and occasional re-balancing is prudent enough, so a financial planner can choose to keep his practice simple by continuing that plan. Some investment advisers even consider re-balancing and an occasional change “tactical”. It isn’t.

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

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

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

A similar theme of duality happens in the movie The Matrix. Morpheus offers Neo either a blue pill (to forget about The Matrix and continue to live in the world of illusion) or a red pill (to enter the sometimes painful world of reality). Duality is something consisting of two parts: a thing that has two states that may be complementary or opposed to each other. We all get to choose what we believe and our choices shape the world we individually live in.

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

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

It isn’t enough to have a good investment program with a strong performance history. Just as important is the ability to help investors modify their beliefs and behavior. That is the reality of the red pill. By definition, active is more work that passive. Investors and advisers alike get to choose which pill they take: the blissful ignorance of illusion (blue) and embracing the painful truth of reality (red). I believe in individual liberty and personal responsibility, so the choice is your own. But my thoughts on the subject are directional – I am the red pill.

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

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

To be continued… stay tuned.

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Understanding Hedge Fund Index Performance

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

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

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

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

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

Barclay Hedge Fund Indices


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

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

Hedge Funds vs. Asset Allocation and Stock index

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

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

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

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

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

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