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.

The Trend of the U.S. Stock Market and Sectors Year-to-Date

As of today, the below table illustrates the year-to-date gains and losses for the S&P 500® Index (SPY) and the 9 Sector SPDRs in the S&P 500®. We observe the current and historical performance to see how the U.S. Sectors match up against the S&P 500 Index.

So far, the S&P 500 Index is down -5.68% year-to-date. Only the Consumer Discretionary (XLY) and Health Care (XLV) are barely positive for the year. Energy (XLE) has entered into its own bear market. Materials (XLB) and Utilities (XLU) are in double-digit declines.

year to date S&P 500 and sector returns 2015-09-10_11-31-05


The trouble with a table like the one above is it fails to show us the path the return streams took along the way. To see that. below we observe the actual price trends of each sector. Not necessarily to point out any individual trend, but we can clearly see Energy (XLE) has been a bear market. I also drew a red line marking the 0% year-to-date so point out that much of this year the sectors have oscillated above and below it and most are well below it now.

year to date stock market sector trends 2015-09-10_11-32-40


Speaking of directional price trends is always in the past, never the future. There are no future trends, today. We can only observe past trends. In fact, a trend is today or some time in the past vs. some other time in the past. In this case, we are looking at today vs. the beginning of 2015. It’s an arbitrary time frame, but still interesting to stop and look to see what is going on.

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 as it isn’t a sure thing…

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

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

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

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

The article also said:

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

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

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

Warren Buffett's Berkshire Lost compared to stock index

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

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

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

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

Chart source:

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

Why Index ETFs Over Individual Stocks?

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

Biogen BIIB

Source: Shell Capital Management, LLC created with

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

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

Market Risk, Sector Risk, and Stock Risk

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

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

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

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

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

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

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

iShares Biotech ETF HoldingsSource:

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

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

Source: Shell Capital Management, LLC created with

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

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

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

Source: Shell Capital Management, LLC created with

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


Source: Shell Capital Management, LLC created with

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

iShares Nasdaq Biotech ETF exposure allocation


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

iShares Healthcare Index ETF exposure allocation


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

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

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

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…

My 2 Cents on the Dollar

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

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

Chart created by Shell Capital with:

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

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

Chart created by Shell Capital with:

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

That’s my two cents on the Dollar…

How long are you? Do you know?

Stock Market Year-to-Date and First Quarter

So far, the U.S. stock market isn’t doing so well. And, the gains and losses over the past quarter have been asymmetric. Consumer Discretionary (12.6% of the S&P 500 index) and Healthcare (14.8% of the S&P 500 index)  have barely offset the losses in four other sectors.

Below are the YTD gain and losses for the popular S&P 500 index and each sector in the index.

stock market first quarter performance 2015-04-02_12-38-10


But, that’s just one data point compared to another data point. Such a table would be incomplete without considering the path those gains and losses took to get there.

sector returns 2015 2015-04-02_12-41-15


To see the results of asymmetric exposure and risk management in action across a global universe of markets, visit:

Performance is historical and does not guarantee future results; current performance may be lower or higher. Investment returns/principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Past performance does not guarantee future results.

Absolute Return as an Investment Strategy

Absolute Return Investment Strategy Fund Manager

In “Absolute Return: The Basic Definition”, I explained an absolute return is the return that an asset achieves over a certain period of time. To me, absolute return is also an investment objective.

In “Absolute Return as an Investment Objective” I explained that absolute return is an investment objective is one that does not try to track or beat an arbitrary benchmark or index, but instead seeks to generate real profits over a complete market cycle regardless of market conditions. That is, it is focused on the actual total return the investor wants to achieve and how much risk the investor will willing to take, rather than a focus on what arbitrary market indexes do.

Absolute return as a strategy: absolute return is sometimes used to define an investment strategy. An absolute return strategy is a plan, method, or series of maneuvers aiming to compound capital positively and to avoid big losses to capital in difficult market conditions. Whereas Relative Return strategies typically measure their success in terms of whether they track or outperform a market benchmark or index, absolute return investment strategies aim to achieve positive returns irrespective of whether the prices of stocks, bonds, or commodities rise or fall over the market cycle.

Whether you think of absolute return as an objective or a strategy, it is a skill-based rather than market-based. That is, the absolute return manager creates his or her results through tactical decision-making as opposed to taking what the market is giving. One can employ a wide range of approaches toward an absolute return objective, from price-based trend following to fundamental analysis. In the ASYMMETRY® Managed Accounts, I believe price-based methods are more robust and lead to a higher probability of a positive expectation. Through my historical precedence, testing, and experience, I find that any fundamental type method that is based on something other than price has the capability to stray far enough from price to put the odds against absolute returns. That is, a manager buying what he or she believes is undervalued and selling short what he believes is overvalued can go very wrong if the position is on the wrong side of the trend. But price cannot deviate from itself. Price is the judge and the jury.

Of course, absolute return and the “All Weather” type portfolio sound great and seem to be what most investors want, but it requires incredible skill to execute. Most investors and advisors seem to underestimate the required skills and experience and most absolute return strategies and funds have very limited and unproven track records. There is no guarantee that these strategies and processes will produce the intended results and no guarantee that an absolute return strategy will achieve its investment objective.

For an example of the application of an absolute return objective, strategy, and return-risk profile,  visit

Absolute Return as an Investment Objective

Absolute Return objective fund strategy

In Absolute Return: The Basic Definition, I explained an absolute return is the return that an asset achieves over a certain period of time. To me, absolute return is also an investment objective.

Absolute Return as an investment objective is one that does not try to track or beat an arbitrary benchmark or index, but instead seeks to generate real profits over a complete market cycle regardless of market conditions. That is, an absolute return objective of positive returns on investment over a market cycle of both bull and bear market periods irrespective of the direction of stock, commodity, or bond markets.

Since the U.S. stock market has been generally in a uptrend for 6 years now, other than the -20% decline in the middle of 2011, we’ll now have to expand our time frame for a full market cycle to a longer period. That is, a full market cycle includes both a bull and a bear market.

The investor who has an absolute return objective is concerned about his or her own objectives for total return over a period and tolerance for loss and drawdowns. That is a very different objective than the investor who just wants whatever risk and return a benchmark, allocation, or index provides. Absolute returns require skill and active management of risk and exposure to markets.

Rather than a long article, this is going to be a series of smaller parts, building up to what absolute return really means.

For an example of the application of an absolute return objective, strategy, and return-risk profile,  visit

Asymmetric Sector Exposure in Stock Indexes

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

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

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

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

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

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

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

asymmetric sector exposure  S&P Mid-Cap ETF

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

asymmetric sector exposure S&P small cap

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

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“?

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

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

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

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

                                    —Charles Dow, 1900

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

u.s. dollar longer trend UPP

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

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

chart source for the following charts:

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

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

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

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

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

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

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

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

To see how tactical decisions and understand how markets interacts results in my real performance, visit : ASYMMETRY® Managed Accounts

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

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

Top Traders Unplugged Mike Shell ASYMMETRY Global Tactical Shell Capital Management

As I approach the 10-year milestone of managing ASYMMETRY® Global Tactical as a separately managed account, I wanted to share my recent interview with Top Traders Unplugged. Niels Kaastrup-Larsen is the host of Top Traders Unplugged in Switzerland. Niels has been in the hedge fund industry for more than twenty years, working for some of the largest hedge funds in the world. He asks a lot of outstanding questions about life and how I offer a global tactical strategy that is normally only offered in a hedged fund in a separately managed account. And with experience comes depth of knowledge, so our conversation lasted over two hours and is divided into two episodes.

Click the titles to listen.

Episode 1

Why You Don’t Want Symmetry in Investing | Mike Shell, Shell Capital Management | #71

“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

Episode 2

He Adds Value to His System | Mike Shell, Shell Capital Management | #72

“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

Direct links:

Episode 1


Episode 2



For more information, visit ASYMMETRY® Managed Accounts.

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


Trend Change in Dollar, International Stocks, Gold?

Directional trends tend to persist. When a price is trending, it’s more likely to continue than to reverse. A directional trend is a drift up or down. For example, we can simply define a uptrend by observing a price chart of higher highs and higher lows. A downtrend is an observation of lower highs and lower lows. For a trading system, we need to be more precise in defining a direction with an algorithm (an equation that mathematically answers the question). The concept that directional trends tend to persist is called “momentum“. Momentum is the empirically observed tendency for rising prices to rise further. Momentum in price trends have been exploited for decades by trend following traders and its persistence is now even documented in hundreds of academic research papers. Momentum persists, until it doesn’t, so I can potentially create profits by going with the trend and then capturing a part of it.

But all trends eventually come to an end. We never know in advance when that will be, but we can determine the probability. Sometimes a trend reversal (up or down) is more likely than others. If you believe markets are efficient and instead follow a random walk, you won’t believe that. I believe trends move in one direction, then reverse, then trend again. When I look at the charts below, I see what I defined previously as “a trend”. I have developed equations and methods for defining the trend and also when they may bend at the end. More importantly, I observe them when they do bend. For example, to capture a big move in a trend, say 20% or more, we can’t get out every time it drops -2%, because it may do that many times on its way to that 20%. So, trend following means staying with the trend until it really bends. Counter-trend trading is trying to profit from the bends by identifying the change in the trend. Both are somewhat the opposite, but since my focus is these trends I observe them both.

Inertia is the resistance to change, including a resistance to change in direction. I could say then, that it takes inertia to keep a trend going. If there is enough inertia, the trend will continue. Trends will almost always be interrupted briefly by shorter term trends. For example, if you look at a monthly chart of a market first, then view a weekly chart, then a daily chart, you’ll see different dimensions of the trend and maybe left with a different observation than if you just look at one time frame.

Below I drew a monthly charge going back nearly 12 years. As you can see, the U.S. Dollar ($USD) has been “down” as much as -40% since 2002. It’s lowest point was 2008 and using my definition for trend, it’s been rising since 2008 though with a lot of volatility from 2008 to 2011. We could also say it’s been “non-trending” generally since 2005, since it has oscillated up and own since then without any meaning breakout.

All of charts are courtesy of

Next we observe the weekly price trend. In a weekly chart we see the non-trending period, but ultimately over this time frame the Dollar gained 9%. The Dollar has been at a relatively low price range during this time. For those who want to understand why a trend occurs: A low currency is a reflection of the U.S. debt burden and lack of economic growth. We can only say that in hindsight. Most of the time we don’t actually know why a trend is a trend when it’s trending – and I don’t need to know.

You can probably begin to see how “the trend” is a function of “the time frame”. The most recent trend is observed in a daily chart going back less than a year. Here we see the U.S. Dollar is rising since July. I pointed out in “Interest Rates and Dollar Rising, Commodities Falling” how the Dollar is driving other markets.

The Dollar is now at a point that I mathematically expect to see it may reverse back down some. Though a trend is more likely to persist and resist change (inertia), trends don’t move straight up or down. Instead, they oscillate up and down within their larger trend. If you look at any of the price trend charts above, you’ll see smaller trends within them. It appears the Dollar is now likely to change direction at least briefly, though maybe not very much. As I mentioned in “Interest Rates and Dollar Rising, Commodities Falling”, it seems that rising interest rates are probably driving the Dollar higher. The market seems to be anticipating the Fed doing things to increase interest rates in the future. Let’s look at some other trends that seem to be interacting with the Dollar and interest rates.

The MSCI EAFE Index is an index of developed countries. You can observe the trend below. International stocks tend to decline when the Dollar rises, because this index is foreign country stocks priced in Dollars.

Below is the MSCI Emerging Markets index, which are smaller more emerging countries. MSCI includes countries like Russia, Brazil, and Mexico as “emerging”, but some may be surprised to hear they also consider China an emerging market. The recent rising Dollar (from rising rates) has been partly the driver of falling prices.

Another market that is directly impacted by the trend in the Dollar is commodities. Below we see the S&P/GSCI Commodity Index.

I am sharing observations about global macro trends and trend changes. We previously saw that the Dollar was generally in a downtrend and at a low level for years. When the Dollar is down, commodities priced in Dollars may be up. One commodity that became very popular when it was rising was Gold. When the Dollar was falling and depressed, Gold was rising. Below is a more recent price trend of gold.

I wouldn’t be surprised to see the Dollar trend to reverse back down some in the short-term and that could drive these other markets to reverse their downtrends at least briefly. Only time will tell if it does reverse in the near future and by how much.

In the meantime, let’s watch it all unfold.

Global Market Trends and Returns 3rd Quarter 2014

The end of a quarter is a popular time for investors to review what happened over the past three months. Below we review some three-month price trends to get an idea of the direction and magnitude of return streams for a wide range of world market indexes.

In the chart below, we see the U.S. Dollar ($USD) was in the strongest rising directional trend and increased smoothly. The second most increasing trend in magnitude was U.S. Long Term Treasury Bonds (TLT), though it made its move in just the past two weeks. The popular large company stock index, the Dow Jones Industrial Average ($INDU) and the broad-based bond index Barclay Aggregate Bond Index (AGG) lost a little during the quarter. Small company stocks, the Russell 2000 ($RUT), and the commodities indexes ($USD and GSG) lost over -9%. As I pointed out in “Interest Rates and Dollar Rising, Commodities Falling” interest rates started drifting up, driving up the U.S. Dollar, which then drove down many commodities. The decline in small company stocks is probably more a sign of an aging bull market in stocks.

Charts courtesy of: ©

Looking closer within the U.S. stock market at its individual sectors, the Healthcare and Technology sectors ended the quarter with the largest gains of around 3%. Energy was by far the largest losing sector over the past three-months with a decline of nearly -10%. Other weakness was Industrial and Utilities. That may be suggesting something about the markets anticipation of the economy.

I also include a bar chart below of the sectors for a different visual of the advance and decline within sectors. The trouble with only looking at the quarter end result is that it ignores what happened along the way. For example, in the line charts above we can see how the trends unfold.

I pointed out in “Interest Rates and Dollar Rising, Commodities Falling” that interest rates started drifting up, driving up the U.S. Dollar. When the Dollar and interest rates rise it can directly impact other markets like commodities, international stocks priced in Dollars, and interest rate sensitive markets like real estate and utilities. In the next chart I include the U.S. Dollar again to show its steady increase the past three months. Then we see that commodities like Gold (GLD), interest rate sensitive markets like Utilities (IDU), U.S. Real Estate REITs (IYR), and Mortgage REITs (REM) all declined materially. International stocks in Developed Countries (EFA) and Emerging Markets (EEM) also declined around 5 to 7%. None of these three-month price trends are permanent, but for those of us who tactically rotate between these world markets it is useful to understand how they all interact with each other.

You may notice when I speak of these trends I use past tense. The past tense is a grammatical tense whose principal function is to place an action or situation in past time. When I speak of trends, I’m always speaking of the past trend, never the future. These charts are created by looking back three months. It is not possible to draw a chart of realized trends looking forward three months. If we could do that, we would only need to do it once. If we could know for sure what just one of these trends would do in the future we could leverage a large bet, take the profit, pay the tax, and be done forever. Instead, we only have past price trends to study and draw inference from. Past data is all we have. As it turns out, that’s all I need.


Playing with Relative Strength

I discussed in my interview with Investor’s Business Daily in 2011 titled “How Mike Shell Uses Relative Strength To Trade ETFs” some very basic concepts of how I apply proprietary relative strength systems to ETFs in a tactical ETF managed portfolio. Though we can develop all kinds of sophisticated algorithms to define relative strength, momentum, and directional price trends, at the end of the day the concept is very simple.

Up until now (a signal that something has changed) small company stocks where lagging large company stocks. To illustrate what that looked like, I stopped the relative chart below in Mid-May. You may observe that the blue line (the Russell 2000 index of small company stocks) was lagging and with a higher range of swings (more volatile). The black line is the S&P 500 stock index weighted toward larger stocks.

small company stocks lagging large


Next we update the chart to today’s date. Over the past month, small companies caught up. However, they are now at the prior high, so we’ll find out in the weeks ahead if the relative out-performance continues, or if it finds some resistance and reverses back down.

small cap stocks relative strength to large company stocks

Below I have zeroed out one side to express only the relative change of the small cap index while holding the large cap index steady. Here we see only the relative difference between small and large over the past year.

relative strength of small vs large ETFs

You can probably see how relative strength isn’t just about strength, there is also relative weakness. And, relative change oscillates over time.

Is market timing [short-term trading back and forth among asset classes] really a good idea?

In October 2004, Jason Zweig interviewed Peter Bernstein for MONEY Magazine. The title was Peter Bernstein interview: He may know more about investing than anyone alive. Peter L. Bernstein was an early pioneer of tactical asset allocation thinking. He wrote about valuation-based asset allocation and being tactical in decisions rather than passive. He believed what I believe: we should take more risk when its likely to be rewarded and less risk when it is less likely to be rewarded. He published several books about it.

In the interview, Zweig asked:

“Is market timing [short-term trading back and forth among asset classes] really a good idea?”

Bernstein answered:

“For institutional investors, the policy portfolio [a rigid allocation like 60% stocks, 40% bonds] had become a way of passing the buck and avoiding decisions. The problem was that institutions had settled on a [mostly stock] asset allocation because in the long run, they concluded, that’s the only place to be. And I think the long run ain’t what it used to be. Stocks don’t have to do well in the future because they did well in the past. In fact, the opposite may be more likely.”


Based on the chart below, which shows the Dow Jones Industrial Average (a stock index that cannot not be invested in directly) since that interview in 2004, I’d say Bernstein was right. Over the next decade, the stock index went on to gain 65%, but it dropped nearly that much along the way. That doesn’t seem to be the kind of asymmetry® that investors are looking for. If you look at it close enough, you can probably see why it makes sense to take more risk at some points, less risk at others. Though, it’s probably at the opposite times most investors do. So, most will advise investors not to try to do it. Like most things in life, some do it much better than others and have active track records that reflect it.

stock market index since 2004


My INVESTOR’S BUSINESS DAILY® Interview and Portfolio Management

Portfolio Management is about buying and selling many different positions over time, not just one “pick”. I often say it’s like flipping 10 coins at the same time with each having a different payoff and profit or loss. It could be a completely random process (like flipping a coin), but if we can positively skew the payoffs (asymmetric payoffs) we end up with more profit than loss (asymmetric returns). And, as a portfolio manager I may flip that coin 100 or 500 times a year. The fact is: if the expectation for profit is positive we want to do it as often as possible.

Picking just one position is like flipping the coin just once. Its outcome may have an expected probability and payoff that is positive, but will be determined by how it all unfolds. We can never control the outcome at the point of entry. It’s the exit that always determines the outcome. We can say that same whether we are speaking of stocks, bonds, commodities, and currencies or buying and selling private businesses: if you actually knew for sure the outcome would be positive you would only need to do it once – but you don’t. So deciding what to buy is a small part of my complete portfolio management process. It’s what I do after I’m in a position that makes it “management”. To manage is to direct and control. If all you do is “buy” or “invest” in a position, you have no position “management”.

But when Trang Ho at INVESTOR’S BUSINESS DAILY®recently asked me “What ‘s the one position you would choose over the next several months and why”, I gave her the first position I thought of – and the most recent position I had taken. I primarily get positioned with the current direction of the trend and stay with it until it changes. That may be labeled “trend following”. I define the direction of the trend (up, down, sideways) and then get in that direction until it changes. Trends don’t last forever. There is a point when the probability becomes higher and higher of a reversal. I call that a “counter-trend”. I developed systems that define these directional trends more than a decade ago and have operated them for-profit since. What I can tell you from my experience, expertise, and empirical evidence is that stock market trends, like many other market trends, cycle up and down over time. So, portfolio management is a daily routine of position management that includes predefining risk at the point of entry, taking profits, and knowing when to exit to keep losses small. That exit, not the entry, determines the outcome.

You may consider these things as you read my recent interview in Investors Business Daily titled: Market Strategists: 5 Contrarian ETF Investing Ideas.

Read More At Investor’s Business Daily:

The Dow Jones Industrial Average is a Black Box

The black box:

In science and engineering, a black box is a device, system or object which can be viewed in terms of its input and output but without any knowledge of its internal workings. Its implementation is “opaque” (black). Almost anything might be referred to as a black box: a transistor, an algorithm, or the human brain.


The opposite of a black box is a system where the inner components or logic are available for inspection, which is sometimes known as a clear box, a glass box, or a white box.

Almost all investment programs are actually a black box. That is, the investment manager may allow the investor to see the holdings, but most investment strategies have many parts and parameters that are undisclosed to the public or even its investors. There is strong logic behind not disclosing ones intellectual property beyond the obvious. And, it isn’t just about intellectual property, it may be a fiduciary issue, too. When the public knows what a portfolio manager is going to do in advance, other portfolio managers can front-run the trade. Just ask Russell whose indexes are more transparent and we believe they’ve had issues because of it. I think a portfolio manager has an obligation to avoid that. And,  it just makes sense.

We can say the same for stock indexes like the Dow Jones Industrial Average or other Standard & Poors indexes. By now, it is public knowledge that the committee that oversees the Dow Jones Industrial Average has made 6 significant changes to the 30 stocks that make up the index. The Index Committee dropped Alcoa, Hewlett-Packard, and Bank of America, and added Goldman Sachs, Nike and Visa. Did you know in advance they would do that? We didn’t know until after they announced it. Why? because it’s something a committee decided. As we defined above, what is going on in the human brain is a black box. When people are going to make decisions, we can’t determine for sure in advance what the output will be.

Though we can’t actually invest in an index directly, index investors and traders gain exposure to indexes through index funds like exchange traded funds (ETFs). We say that ETFs allow us to gain exposure to a market, sector, country, etc. in a low-cost, transparent, and efficient format. But, the transparency is in regard to the index holdings and maybe the universe they select from, but not necessarily how they decide to add and delete holdings (causing the index ETF we may own to buy and sell the underlying stocks, bonds, etc.).

Is that process a black box? Yes, it is.

We know only parts of the input, we know the output, but we don’t actually know in advance the inner workings of the decision. An index like the Dow Jones Industrial Average is a system that can be understood in terms of its input and output, but not necessarily any knowledge of its internal workings. In the recent case of the Dow Jones Industrial Average, the changes will take effect with the close of trading on Sept. 20th. According to the Wall Street Journal, it was explained in a statement:

“we were prompted by the low stock price of the three companies slated for removal and the Index Committee’s desire to diversify the sector and industry group representation of the index,” S&P Dow Jones Indices LLC, the company that oversees the Dow”

Only the “low price” part of that is rules-based. The Index Committee made the decisions to reflect their desire. That doesn’t seem different from an “Investment” Committee that makes such decisions for a fund or other investment program. It isn’t.

What do you really know about indexes? We know the Dow is a price-weighted index, meaning the bigger the stock price, the larger the position for the stock, and vice versa. That is different from indexes such as the Standard & Poor’s 500, which are weighted by components’ market capitalization. But, we don’t know enough about how the Index Committee makes its decisions to have known in advance what stocks they will change. If we did know that, we could buy the new stocks and sell the outgoing stocks in advance of their announcement. That’s one reason they don’t publish it. However, the black box index goes beyond that. They couldn’t publish it before they decide the changes – they didn’t know either what the output would be until the committee members gave their input. Though many indexes may appear more quantitative (systematic decisions based on predefined rules) they are just as qualitative based on judgement and opinion (an Index Committee makes the decisions, so you don’t actually know what they’ll decide – it isn’t so “rules-based”). My point is: we couldn’t have known the outcome in advance because there was an internal meeting involved to decide.

But an index fund investor doesn’t really need to know this information in advance. Neither does an investor in any investment program. That’s why they are an “investor”. If they are a “portfolio manager” or “trader” they can do it themselves and make their own decisions deciding every little detail. When we choose to invest in any fund, index or not, we necessarily leave part of the process to the deemed expert. In the case of the index, the expert is the index provider like S&P Dow Jones Indices.

The Dow Jones Industrial Average index is totally transparent in regard to its holdings, but a black box in regard to how the additions and deletions are decided.

Stay tuned: I’ll get into this more next week…

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To learn more about the Dow Jones Industrial Average, visit its learning center which shows the Ins & Outs of the Dow since 1896 and read Dow Jones Industrial Average Historical Components.

Are Leveraged ETFs Driving Market Volatility?

Believe it or not, there are some people involved in the investment industry who are against Exchange Traded Funds (ETFs). ETFs provide transparent exposure to a wide range of global markets at a low cost. ETFs have allowed us to gain access to return streams many didn’t have access to just a decade ago. For example, if you want to trade Silver, you can now get that exposure with an ETF (SLV). Previously, you would have to buy actual silver bars and deal with them. Or, trade silver actual futures or options. There is nothing wrong with trading the options and futures, but it sure is simpler to get exposure to that return stream with an ETF in many types of accounts. I monitor 25 different countries in my universe that we can access through ETFs. When I started developing my quantitative trend systems in 2001 to 2003 I decided to apply them to sector and country ETFs instead of futures as most others did at the time. ETFs have changed the way we get exposure and it’s a good thing.

Since the May 2010 Flash Crash (when the Dow Jones Industrial Average dropped -9% intraday for those who may have forgotten).  It was the biggest one-day point decline, 998.5 points, on an intraday basis in Dow Jones Industrial Average history. Some thought it could have be caused by ETFs: Leveraged ETFs, the Flash Crash, and 1987, for example.

It seems ETFs and especially leveraged or “geared” ETFs are an ongoing debate about their potential impacts on the market price and volume – especially at the end of the trading day.

Dave Nadig and S.M. Brorup at explored it again recently in Geared ETFs Drive The Market. Or Not.  One conclusion:

“In the end, even with $3 billion in levered and inverse financials, the daily rebalance trade is still likely “just” a few hundred million on a big day. That gets spread across hundreds of financial stocks in the large- and small-cap indexes.”

The bottom line is it doesn’t seem the amount of money invested in these leveraged or inverse ETFs is large enough relative to the total amount of money in the market to make a significant impact. However, market prices are driven by the most basic economics: supply and demand. Any trading activity has the potential to move a price, but we haven’t yet seen any empirical evidence to say leveraged ETFs are the cause of the big price swings we see more of since 2008. Instead, you may consider that investors and traders are just more responsive to changing prices – good or bad.

There are some things we just don’t know for sure, until we do. In the mean time, I consider the possibilities, give them some deep thought, factor it in, so I am prepared for whatever happens next. All things are always uncertain: enjoy it.