Rugged individualism

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

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

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

 

The Starting Point Matters

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

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

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

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

Bond Return Rising Rates

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

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

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

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

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

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

Time frames can be arbitrary and meaningless, or very useful in defining direction

I sometimes find myself having odd conversations about arbitrary time frames. Most people pick a time frame arbitrarily, so it doesn’t’ really make sense if they don’t know what they are doing. For example, if we want to know the direction of a trend, we need to be able to determine a time frame the defines the direction. Some time frame needs to identify it as up, down, or sideways if you want to know its direction.

As I was looking at some data, I thought this would make a great observations of what I mean. It doesn’t matter what this is, just focus the fact that it’s the same exact data over the same time period (May to November), but a different time frame.

Below is a daily time frame of the data. Notice, it’s hard to see much of a trend, except their appears more activity prior to August. See a directional trend? Not really.

DAILY ASYMMETRIC RETURNS 2

Next, we observe the same data, but on a weekly time frame. Starting to see a little direction. A little more so than daily. The more recent period seems down a little relative to the prior period.

Weekly asymmetric returns

Finally, we observe the same data, but on a monthly time frame. Yes, the directional trend is now clearly down…

monthly asymmetry

Same exact data over the same exact time frame, very different observations of its direction.

Time frames can fool you and some can be completely useless. Or, they can define the direction with more clarity.

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: http://money.cnn.com/data/fear-and-greed/

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

Source: http://money.cnn.com/data/fear-and-greed/

The four most dangerous words…

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

To quote from fellow Tennessean, Sir John Templeton:

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

Sir John Templeton

Sir John Templeton

source: http://www.templeton.org

The markets always go back up?

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

I replied: “Tell that to the Japanese”.

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

Long Term Japan Stock Market Index NIKKEI

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

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

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)

Actively Managing Investment Risk

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

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

With global markets in downtrends, this is a great time to listen to my interview with Michael Covel on February 19, 2015. I talked about my concepts of actively directing and controlling risk in advance. It’s now available on Youtube:

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

Steve Jobs

Steve Jobs

What is the Phillips Curve?

There’s a lot of talk about the “Philips Curve” in regard to the Fed decision. What is the “Philips Curve”?

First, keep in mind it is an economic theory. A theory an is idea that is suggested or presented as possibly true but that is not known or proven to be true. A theory is a general belief about something works.

Investopedia explains the “Philips Curve”:

“An economic concept developed by A. W. Phillips stating that inflation and unemployment have a stable and inverse relationship. According to the Phillips curve, the lower an economy’s rate of unemployment, the more rapidly wages paid to labor increase in that economy.

The theory states that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment. However, the original concept has been somewhat disproven empirically due to the occurrence of stagflation in the 1970s, when there were high levels of both inflation and unemployment.”

Source: Investopedia

Another great explanation from Khan Academy if you have 9 minutes to watch:

Back Testing

The glossary on Stockcharts.com explains it well:

“Back Testing: A strategy that is optimized on historical data, then applied to current data to see if the results are similar. Rarely done properly and usually resorts to a form of curve fitting.”

Yep, that is what it is…

Back testing can be useful to quantify a complete system, but back testing has many weaknesses and is very rarely applied and used correctly. To be sure, just look at the actual performance post back test of those who advertise back tested performance.

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

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

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

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

Source: http://www.vaneck.com/gdx/

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

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

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

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

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

Gold stocks vs Gold

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

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

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

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

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

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

______

For informational and educational purposes only, not a recommendation to buy or sell and security, fund, or strategy. Past performance and does not guarantee future results. Please click the links provide for specific risk information about the ETFs mentioned. Please visit this link for important disclosures, terms, and conditions.

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

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

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

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

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…

Bonds Aren’t Providing a Crutch for Stock Market Losses

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

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

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

Bond ETF market returns 2015

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

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

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

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

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

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

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

Source: https://www.pinterest.com/explore/chinese-proverbs/

The Trend of the U.S. Stock Market

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

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

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

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

S&P 500 stock trend

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

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

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

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

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

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

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

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

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

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

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

______

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

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

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

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

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

The article also said:

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

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

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

Warren Buffett's Berkshire Lost compared to stock index

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

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

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

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

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

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

Stock Market Decline is Broad

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

Vanguard ETFs small mid large micro cap

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

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

Small and Micro caps lead down

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

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

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

stock market returns august 2015

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

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

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

What’s Going to Happen Next for the Stock Market? Preparing for the Next Big Move

If you or anyone you know (friends, clients) are concerned about what’s going to happen next in the markets, now is a good time to discover, my separately managed account – ASYMMETRY® Global Tactical. It is currently positioned to adapt to whatever happens next.

The U.S. stock market is a very aged and overvalued bull market. Based on my extensive studies of  100 years of market cycles, this appears to be the early stage of a very different regime. Indexes will swing up and down along the way, which are the most difficult for investors to handle. They many fear losing money when they are down, then they fear missing out if they are in cash during a 10% or 20% move. It is no simple ON/OFF switch.

I’ve operated tactically through this many times before.

I know how to deal with it – it’s what I do.

I also know how to help investors and advisors get through it if they are so inclined -without making costly mistakes.

So, now is a great time to discover ASYMMETRY® Global Tactical.

Here is the fact sheet and website:

http://www.asymmetrymanagedaccounts.com/global-tactical/

You can contact us on that page. We work with advisors and investors all over the U.S.

Using the Month of September to Understand Probability and Expectation

probabilty-coin-flip

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

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

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

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

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

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

First, let’s define probability.

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

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

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

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

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

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

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

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

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

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

Expectation

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

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

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

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

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

Enter your email address to follow this blog and receive notifications of new posts by email.

Connect with me on Linkedin and Follow me on Twitter

Low Volatility Downside was the Same

In Low Volatility and Managed Volatility Smart Beta is Really Just a Shift in Sector Allocation I ended with:

“Though the widening range of prices up and down gets our attention, it isn’t really volatility that investors want to manage so much as it is the downside loss of capital.

As a follow-up, below we observe the  PowerShares S&P 500® Low Volatility Portfolio declined in value about -12% from its high just as the SPDRs S&P 500® did. So, the lower volatility weighting didn’t help this time as the “downside loss of capital ” was the same.

SPLV PowerShares S&P 500® Low Volatility Portfolio

Source: http://www.ycharts.com

Dauntless Courage and Confidence to Get it Done

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

Two observations from the video below:

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

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

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

Press play to watch this:

He has it…

U.S. Sector Observation

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

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

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

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

sector rotation returns ETF

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

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

ETF sector rotation

Source: http://www.stockcharts.com

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

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

Global Markets Year to Date

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

stock index return year to date

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

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

stock index drawdown chart

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

sectors year to date

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

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

bonds commodities year to date

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

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

international emerging markets year to date

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

global stock markets year to data

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

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

world markets year to date

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

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

Why Index ETFs Over Individual Stocks?

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

Biogen BIIB

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

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

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

Market Risk, Sector Risk, and Stock Risk

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

SPDR Biotech vs CELG AMGN BIIB GILD REGN

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

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

iShares Nasdaq Biotech ETF exposure allocation

Source: www.ishares.com

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

iShares Healthcare Index ETF exposure allocation

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

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

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

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

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

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

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

In Southern American English, Wikipedia says:

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

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

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

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

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

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

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

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

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

Uncharted Territory from the Fed Buying Stocks

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

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

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

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

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

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

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

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

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

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

 

Low Volatility and Managed Volatility Smart Beta is Really Just a Shift in Sector Allocation

There is a lot of talk now days about “Smart Beta”. Smart beta refers to an investment style where the manager passively follows an index designed to take advantage of perceived systematic biases or inefficiencies in the market. Smart beta defines a set of investment strategies that emphasize the use of alternative index construction rules to traditional market capitalization based indices.

Low volatility or managed volatility, for example, is considered a version of “smart beta” because its weights the stocks (and therefore sector exposure) differently:

The PowerShares S&P 500® Low Volatility Portfolio (Fund) is based on the S&P 500®Low Volatility Index (Index). The Fund will invest at least 90% of its total assets in common stocks that comprise the Index. The Index is compiled, maintained and calculated by Standard & Poor’s and consists of the 100 stocks from the S&P 500® Index with the lowest realized volatility over the past 12 months. Volatility is a statistical measurement of the magnitude of up and down asset price fluctuations over time. The Fund and the Index are rebalanced and reconstituted quarterly in February, May, August and November.

I bolded the main difference between this index ETF and the traditional capitalization-weighted S&P 500. The S&P 500 everyone knows about weights is 500 stocks holdings based on market capitalization, so the largest stocks are the largest positions in the index.

The Low Volatility Portfolio is really a play on sector allocation. Because it creates its position size based on each stocks past 12 months volatility, it’s weighting will simply depend on what was less volatile the past year. And, it will look back to rebalance and reconstitute quarterly in February, May, August and November. So, you may consider what it really does is shifts the position size and sector weighting.

Below is the index sector allocation for the S&P 500 like what is used for SPDR® S&P 500® ETF so we can see which sectors have the largest position size.

S&P 500 SPY sector weighting

Source: https://www.spdrs.com/product/fund.seam?ticker=spy

Now we observe the sector allocation of the PowerShares S&P 500 Low Volatility Portfolio. Notice is is heavily weighted in Financials (36%) and Consumer Staples (21%). That’s simply because those sectors stocks have demonstrated less realized volatility as measured by standard deviation over the past 12 months.

PowerShares S&P 500 Low Volatility Portfolio SPLV

Source: https://www.invesco.com/portal/site/us/financial-professional/etfs/product-detail?productId=SPLV

Now, let’s observe the difference in return streams. Below is a relative strength comparison of the two since inception of  PowerShares S&P 500® Low Volatility Portfolio in May 2011. As you see, the low volatility index did have a smaller drawdown in 2011, but overall they’ve tracked the same most of the time. The real difference was the lower drawdown from the sector weighting helped reduce the loss in 2011 and that helped smooth out the returns for a few years. Since 2013 U.S. stock volatility declined, so that explains why the two indexes have trended more closely since.

S&P 500 low volatility vs capitalization

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

Over the past year, there is a little more divergence at times as we see below.

S&P 500 Low Volatility

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

You may consider that past realized volatility may not repeat into the future. In fact, it could reverse. But the real difference between these is the trailing realized volatility weighting changes the sector weighting. The sectors are the driver. Which sectors have the lowest 12 month historical volatility will determine the exposure to a volatility weighted index or fund. The risk to volatility weighting is the volatility of markets sometimes reach its lowest point at its peak in price as investors become more and more complacent and less indecisive, which is what causes a wider range in prices. I explained this in This is When MPT and VaR Get Asset Allocation and Risk Measurement Wrong.

Though the widening range of prices up and down gets our attention, it isn’t really volatility that investors want to manage so much as it is the downside loss of capital. I really manage volatility by actively increasing and decreasing exposure to loss.

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

Source:  http://www.project-syndicate.org/commentary/will-computer-algorithms-replace-humans-in-financial-markets-by-robert-j–shiller-2015-07#hmXdmoDjMyvHOw9U.99

Fear is Driving Stock Trend…

Fear is now driving the stock market. As prices fall, investor sentiment indicators suggest that fear increases as prices fall. When sentiment gets to an extreme it often reverses, or it can become contagion and drive prices even lower as people sell their positions. Now that most sentiment gauges are at short term “Extreme Fear” readings, don’t be surprised to see prices trend back up. If they don’t, then it could be the early stages of a larger decline as fear and greed can always get even more extreme.

A simple gauge for investor sentiment is the CNN Money Fear & Greed Index.

Fear and Greed Index

Source: http://money.cnn.com/data/fear-and-greed/

It’s always a good time to manage, direct, and control risk. I do that by predefining my exits and knowing how much potential loss that represents in each position and across the portfolio.

Give me liberty, or give me death!

Give me liberty of give me death

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

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

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

Global Stock Market Trends

Stock Market Decline 2015-06-29

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

Stock Market Sectors 2015-06-29

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

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

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

Source: http://www.etf.com

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

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

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

Much of the world is in great debt…

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

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

 

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

 

 

Why Dividend Stocks are Not Always a Safe Haven

We often hear that high dividend stocks are a “safe haven” in market downtrends. The theory is the yield paid from dividend stocks offset losses in their price. Another theory is that money rotates out of risky assets into those perceived to be less risky: stocks that pay high dividends tend to be older cash rich companies that pay out their cash as dividends. In theory, that sounds “safer”.

I like to point out logical inconsistencies: when beliefs contradict reality.

The above may be true in some cases and it sounds like a good story. In reality, everything changes. The universe is transient, in a constant state of flux. This impermanence, that things are constantly changing and evolving, is one of the few things we can be sure about. It’s a mistake to base too much of an investment strategy on something that has to continue to stay the same. It’s an edge to be adaptive in response to directional trends.

Below is the year-to-date chart iShares Select Dividend ETF that seeks to track the investment results of an index composed of relatively high dividend paying U.S. equities. Notice that I included both the price change by itself (blue) and the total return that includes price plus dividends (orange). The “help” from the dividend over the past six months has helped a little. The price is down -3% but factoring in the dividend leaves the index down -2.33% for the year. The 0.7% is the dividend yield so far.

What has probably gotten investors attention, however, isn’t that their dividend stocks are down over -2% for the year, but that they are down over -4% off their high. That doesn’t sound like a lot: unless you are a conservative investor expecting a “safe haven” from high dividend yielding stocks…

In contrast, the Dow Jones Industrial Average is up about 1% over the same period  – counting dividends. You may be wondering what is causing this divergence? Below is the sector holdings for the iShares Select Dividend ETF.

The position size matters and makes all the difference. Notice in the table above the Utilities, Consumer Staples, and Energy Sectors are the top holdings of the index. As you see below, the Utilities sector is down nearly -9% year-to-date, Energy and Staples are down over -1%. They are the three worst performing sectors…

Source: Created by ASYMMETRY® Observations with www.stockcharts.com 

Wondering what may be driving it? For the Utility sector it’s probably interest rates. You can read about that in What You Need to Know About Long Term Bond Trends. I prefer to rotate between sectors based on their directional price trends rather than just allocate to them with false hope they may do something they may not. 

What You Need to Know About Long Term Bond Trends

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

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

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

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

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

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

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

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

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

A Random Walker on Stock and Bond Valuation

Burton Malkiel is a passive buy and hold investor who believes markets are random. To believe markets are random is to believe there are no directional trends, or high or low valuations. He is the author of “A Random Walk Down Wall Street“.  But in today’s Wall Street Journal even the ” Random Walker” sees that stock valuations are high and future expected returns low, but believes if there is a bubble it’s in bonds.

By

BURTON G. MALKIEL

June 1, 2015 6:58 p.m. ET

“Stock valuations are well above their average valuation metrics of the past, and future returns are likely to be below historical averages. But even as Ms. Yellen talks of gradually ending the Fed’s near-zero interest rate policy, interest rates remain well below historical norms. If there is a market bubble today, it is in the bond market and the Fed is complicit in the “overvaluation.”

Source: http://www.wsj.com/articles/janet-yellen-is-no-stock-market-sage-1433199503

When someone invests in bonds for the long term they mainly intend to earn interest. So, bond investors want to buy bonds when yields are high. In the chart below, I show the iShares iBoxx $ Investment Grade Corporate Bond index ETF that seeks to track the investment results of an index composed of U.S. dollar-denominated, investment grade corporate bonds. The blue line is its price trend, the orange line is the index yield. We observe the highest yield was around 5.33% during a spike in 2008 when the price declined. Fixed income has interest-rate risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Since 2008, interest rates and the yield of this bond index has declined. Clearly, the rate of “fixed income” from bonds depends on when you buy them. Today, the yield is only 2.8%, so for “long term allocations” bonds aren’t nearly as attractive as they where.

bond yield valuation bubble
Another observation is the iShares 20+ Year Treasury Bond ETF, which seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities greater than twenty years. So, this index is long term government bonds. Below we see its yield was 4.75% a decade ago and is now only 2.27%. Buying it to get a 4.75% yield is a very different expected return than 2.27%.

Long term treasury yield valuation spreads asymmetry

However, that doesn’t mean we can’t tactically rotate between these bond markets trying to capture price trends rather than allocate to them.

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

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

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

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

Seasonal Sell in May and Go Away Strategy

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Global Allocation Balanced Fund Drawdowns

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

Bond market risk drawdowns

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

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

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

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

On Actively Managing Risk… and Persistence

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

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

I just keep doing what I do…

Adapting to change is a great quote, but not by Darwin…

adapt to change

“It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is the most adaptable to change.

In the struggle for survival, the fittest win out at the expense of their rivals because they succeed in adapting themselves best to their environment.”

– great quote, but was NOT Charles Darwin

In 1963 Leon C. Megginson delivered a speech that contained a passage presenting his interpretation of Charles Darwin’s ideas. Megginson did not claim that he was quoting the words of Darwin. Nevertheless, over time, in a multistep process this passage has been simplified, shortened, altered, and reassigned directly to Darwin.

Source: http://quoteinvestigator.com/2014/05/04/adapt/

This is a great example of asymmetric information.

Where is the Inflation?

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

Current US Inflation Rates: 2005-2015

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

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

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

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

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

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

How does monetary policy influence inflation and employment? and bond prices…

Straight from the Federal Reserve website titled How does monetary policy influence inflation and employment?

In the short run, monetary policy influences inflation and the economy-wide demand for goods and services–and, therefore, the demand for the employees who produce those goods and services–primarily through its influence on the financial conditions facing households and firms. During normal times, the Federal Reserve has primarily influenced overall financial conditions by adjusting the federal funds rate–the rate that banks charge each other for short-term loans. Movements in the federal funds rate are passed on to other short-term interest rates that influence borrowing costs for firms and households. Movements in short-term interest rates also influence long-term interest rates–such as corporate bond rates and residential mortgage rates–because those rates reflect, among other factors, the current and expected future values of short-term rates. In addition, shifts in long-term interest rates affect other asset prices, most notably equity prices and the foreign exchange value of the dollar. For example, all else being equal, lower interest rates tend to raise equity prices as investors discount the future cash flows associated with equity investments at a lower rate.

In turn, these changes in financial conditions affect economic activity. For example, when short- and long-term interest rates go down, it becomes cheaper to borrow, so households are more willing to buy goods and services and firms are in a better position to purchase items to expand their businesses, such as property and equipment. Firms respond to these increases in total (household and business) spending by hiring more workers and boosting production. As a result of these factors, household wealth increases, which spurs even more spending. These linkages from monetary policy to production and employment don’t show up immediately and are influenced by a range of factors, which makes it difficult to gauge precisely the effect of monetary policy on the economy.

Monetary policy also has an important influence on inflation. When the federal funds rate is reduced, the resulting stronger demand for goods and services tends to push wages and other costs higher, reflecting the greater demand for workers and materials that are necessary for production. In addition, policy actions can influence expectations about how the economy will perform in the future, including expectations for prices and wages, and those expectations can themselves directly influence current inflation.

In 2008, with short-term interest rates essentially at zero and thus unable to fall much further, the Federal Reserve undertook nontraditional monetary policy measures to provide additional support to the economy. Between late 2008 and October 2014, the Federal Reserve purchased longer-term mortgage-backed securities and notes issued by certain government-sponsored enterprises, as well as longer-term Treasury bonds and notes. The primary purpose of these purchases was to help to lower the level of longer-term interest rates, thereby improving financial conditions. Thus, this nontraditional monetary policy measure operated through the same broad channels as traditional policy, despite the differences in implementation of the policy.

Up until now, the Long Term Treasury bond has typically gained in price on days the U.S. stock market is down. The recent price action may be a sign of changing inter-market dynamics between the Long Term Treasury and U.S. Stocks now that the Fed isn’t buying these bonds as they have for several years. As you can see in the chart below, the iShares Barclays 20+ Year Treasury Bond Index was down -1.7% today as stocks were also down. It’s also in a shorter term downtrend since January. This could be a sign that may not offer the “crutch” for falling stocks they have in the past. In the next bear market, bonds may go down too.

TLT long term treasury

Created with http://www.stockcharts.com

 

 

 

%d bloggers like this: