How To Lose All Your Money….Or At Least More Than You Should

Today was the most watched Fed Day in years…and that’s saying a lot since every Fed Day seems to be the most important ever. US rates tanked across the board while other markets mostly flew higher only to close lower.

In our model portfolio we gained a whopping 8 basis points. That is 0.08% for the day. It obviously would have been nice to have gotten everything right and make more but the flip side is that we REALLY don’t want to get everything wrong and lose a lot.

One of our goals over the years has been to get the portfolio to where no one event, at least not a normally scheduled event, poses much risk to us. If a nuke lands in a major city we could take a big hit. If an alien lands in DC who knows what would happen. But if the Fed has a scheduled meeting we should not be overly exposed to anything that has much of a chance of happening.

One way we are able to do this is by diversifying across asset classes. In fact one of the best things about macro trading is that you are kind of supposed to go across asset classed looking for great risk/reward situations. Being long and short across assets is one way to minimize event risk. Another way is to have trades on with different primary drivers such as growth, inflation, relative value, events, etc. Basically bet on a diverse set of risks across a diverse set of assets.

Why stop there however when you can then focus on price correlations, structuring your trades, sizing your trades, and the placing of stops?

All of this to say that if you want to eventually lose all of your money then make sure that you don’t do any of the above. Make sure that your entire portfolio is based on being completely right on one thing. To make it even more fun ensure that the one thing has a small chance of happening. Why bet it all on a Fed outcome when you can go all in, even levered, on a bet that the USD will collapse and our entire system will go back to the stone ages.

While some of that was said in jest….at least kind of, the reality is that many long term portfolios are setup to only do well in one economic condition and even more “trader” portfolios are betting on one or two outcomes on different events.  If you want to improve your risk adjusted, as well as your absolute, returns then pay attention to this stuff, think about it, study it, etc. and see what you can do to improve your risk and diversification processes.

Happy Trading,

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Optimists Survive By Eating Bears

Today (9/10/15) David Tepper came on CNBC for an hour. The whole discussion is worth watching but one thing he said is missed time and time again by many investors.

“I’m not real comfortable being short stocks because there’s a bias for stocks to go up over time”-Tepper

Tepper has been putting up 25-30% returns for over 20-Years with billions under management. He is one of the best traders in history, great at sizing up risk reward, security selection, and timing….and yet he says “I’m not real comfortable being short stocks because there’s a bias for stocks to go up over time.”

One of the sub-segments of the investment/econ space that I enjoy are the “end of the world as we know it” genre. They are mainly published at market bottoms while the super bullish books are published at market tops (remember Dow 40,000?) but we also see a lot of them mid cycle as well. For whatever reason doom and gloom sells very well. The short argument always sounds like the intelligent argument. To make it worse there is always a lot of data that shows real reasons to be worried. Look at any of the books in the picture below and they are filled with data and charts showing impending doom. If you look at the publishing dates however they either missed the crash or just got the entire thesis wrong. (BTW I recently moved and have not unfinished packing or I could have shown a stack four feet high of end of the world books. For whatever reason I cannot resist the urge when I am in a used bookstore).

The end of the world

The end of the world

What the perma-bears get wrong is that over time civilization has indeed improved its lot in life. Yes, there are downturns but more often than not stocks go UP and not down. If someone as smart as Tepper is wary of shorting then what does that say about what you should be doing?

Looking at US assets over time using data from the Credit Suisse Global Investment Returns Yearbook we can see that stocks go up….a lot….over time. Even after taking into account inflation you would have 1,396 times your money from 1900-2014. Bonds and bills are less explosive but even there they go up over time.

Cumulative Real Returns USA

Cumulative Real Returns USA

Over the past 115 years you would have been fighting a 6.5% annual upwards drift by shorting stocks. That means that you are fighting a 0.54% hurdle each month. And of course that doesn’t even include any borrowing costs, commissions, or taxes.

Annualized Real Returns USA

Annualized Real Returns USA

Now all of this is not to say that we don’t short because we do. We have had success going long and short across asset classes to include stocks. What I am saying is that you need to have a really good reason to fight long term trends in markets. If you can’t figure out why you have an edge on any given trade then you are probably better off not doing it. Oh and in case you are wondering “stocks are overvalued” or “Because the Fed” are not sufficient answers.

If you want more info on the long term bias of stocks to go higher, or just want to get a lot smarter, pick up a copy of the book “Triumph of the Optimists” by Dimson, Marsh, and Staunton.

Happy Trading,

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Cult of the Guru and Independent Thought

You wont believe who said this….but more on that later.

Depression Not Recession

Depression Not Recession

To say that I read a lot of outside research from the sell side, buy side, independent shops, blogs, tweets, and whatever else I can find would be an understatement. I read about one actual book a week along with a gazillion pages and articles of research. I basically get paid to think, read, look at and model data, and……think some more.

That last part is of course key because it is what brings together everything else I do. Sadly I have found that far too many people, and in this case investors/traders, fail to do this. Too many people find a guru or two or three and then attempt to just follow what the guru does, or at least what the investor thinks the guru does. If you actually get to sit in the office with Buffett or Soros or someone similar day after day then maybe this strategy would work–although it probably won’t–but barring that it definitely will not.

We, and by we I hope I mean me and anyone reading this, study great investors to learn the how of what they do and not just what they are doing. I scour 13F’s as much as the next guy…..OK maybe a lot more, but the point remains that if you are not also thinking about both what the famed investor is thinking and whether any of this is applicable to your portfolio. then it is all for naught.

For example look at Warren B. Most people who claim to be following his methodology buy and hold stocks and claim that they are never going to sell. While this may or may not be a successful strategy–for most it ends up being mediocre–it is NOT where Warren B has actually generated most of his outperformance. It is also NOT what he has said to do.

We could go on for a few days on this topic, but the short version is that Warren B says that the ideal stock–sorry, in B terms, it is a company–is one that he never has to sell. Living in reality however WB has regularly bought and sold stocks. In addition he has done more than his share of workouts–in Graham/Dodd speak a workout is what most now refer to as Merger Arbitrage–not exactly a buy and hold forever deal. On top of all this he trades derivatives in massive size, has traded commodities more than once, and finally, at least for now, he gets investment deals that no regular person has a chance of getting into. How many of you did Goldman call up in the 2008 crisis? I was sitting by my phone, but it never rang.

All of this is not to rail on an aspiring Baby Buffett, in fact everyone should read all the Berkshire letters, the Buffett Partnership letters (his Hedge Fund), “How to Trade Like Warren B” by Altucher, “Buffett” by Lowenstein, and all of the academic studies and other books written on the guy. You will learn many things but two stand out. 1-Warren B is a great businessman but a lot of your beliefs about him are probably wrong and 2-You should now have learned enough to adapt parts of his philosophy to your own personality and become your own investor. Notice that I did not say “you can now follow Warren B’s every word and outperform.” The reality is that you can’t. You have to learn from but not worship the great investors.

In the end after you read or listen to anything from anyone but especially supposed “experts” you need to think for yourself.  Failing to do so not only guarantees that over time you underperform but likely makes you drastically underperform.

I love writing this letter and putting my thoughts down on paper. I run a model portfolio to keep me accountable for my official “trade ideas,” but I would hope that anyone reading it would think, read, think some more, and then make a decision about whether what I am saying makes sense to them as well as their portfolios before possibly doing anything.

Why am I all anti-guru all of the sudden? First of all, I have always been anti-guru worship. Second of all, I have had 4 conversations in the past few days regarding the comments of one of my guru heroes. Being unsolicited conversations I thought now a good time to explain my anti-hero worship and blind following.

Professionally my two gurus are undoubtedly Stanley Druckenmiller and Ray Dalio. They are amazing at what they do based on any measure. They make money in most up and down markets, have made more than just about anyone, are both macro, both wicked smart, etc. etc. Basically my goal is to emulate them……but in my own way.

If you are familiar with them, you have already recognized that while they are both macro, they go about things very differently and seem to have different strengths. Where Dalio is king of detailed economic research, Druckenmiller is king of risk taking and risk management.

Both are very much worth studying but guess what?…….They have both been wrong before and will be wrong again.  This is why it is critical that you think for yourself. Everyone, even the best, are wrong on a regular basis.

All this brings us to the next point: A few days ago Dalio came out saying that he expects more QE sooner rather than later. He then clarified what the news reported by writing on LinkedIn his views. Here is the link and it is worth reading for yourself.

The Dangerous Long Bias and the End of the Supercycle

He could be right, and he brings a well thought out case for why he thinks that more QE is on the way. However, I have read it a few times now and disagree with him. I went into why I disagree in the letter this week but let me show you how a guru cannot only be wrong but drastically so.

In my visits to the library in order to read old Barrons (it is both very enjoyable and very enlightening) I came across this article a few months ago (see graphic below). It was published October 12th 1992 by a young Ray Dalio who was then managing $1.5 billion instead of the $150+ billion he is now managing. If you look at the title and then at the date you might be literally laughing out loud. The 1990’s were a lot of things but a depression is not one of them.

Ray Dalio Depression Not Recession

Ray Dalio Depression Not Recession-Barrons October 12, 1992

In the article Dalio goes into why he thought that we were in the early stages of a new depression. Among other things he pointed to was that the Fed had already drastically cut rates and yet the overall economy remained weak.

As you can see in the chart below of the 10-2 yield spread, this piece, and Dalio’s view, came out right at peak Fed ineffectiveness. What I mean by this is basically right around the time that this piece was published, the Fed stimulus started to work, and we left the recession which means that not only was he wrong but he was wrong at exactly the wrong time.

10-2 Yield Spread 1988-1995

10-2 Treasury Yield Spread 1988-1995

As we now know the economy not only did not go into a depression but was actually in the middle of the best 20 year period in the US stock market history. Of course Dalio being a master of the craft must have figured this out since as you can see in the performance table below he proceeded to make a little bit in 1992 and kill it in 1993 (see table in the graphic below).

Bridgewater Pure Alpha Fund Returns

Bridgewater Pure Alpha Fund Returns-Source ValueWalk

Hopefully you see the value in independent thought. Here is a true master, or wizard if you prefer, calling for a depression in something as public as Barrons. He was not only wrong but drastically wrong. If you had blindly followed it, you would have missed some of the best years in market history.

Blindly following a guru, even a guru as good as Dalio, is a sure way to the poor house.  Please think for yourself in all things. Read research (shameless plug: this letter is a great place to find some) but in the end make sure that you agree with any trade idea you find here or anywhere else and that it fits with your current portfolio. Doing anything else is just a way to lose money in the long term.

As a not so side note you should always be thinking things through and making your own decisions. Doing anything else deprives you of learning…..and that sounds like something out of “Principles” by Dalio.

Happy Trading,

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Some Thoughts On Market Timing Part-1

This is the first in a series on what timing is, what it isn’t, and some right ways to do it. 

In recent days I have been experimenting with one of our proprietary indicators to expand its use. I named this indicator a “Risk Index” with the idea being when the indicator is high the risk are low and when the indicator is low the risks are high. As you can see in the chart below a higher percentage reading indicates a more favorable market and a lower reading indicates a less favorable market.

US Equity Risk Index

US Equity Risk Index

Our risk index is simply the percentage of out timing models that are bullish or bearish each week. For US equities we run 10 different models that look at trend, valuation, interest rates, inflation, sentiment, breadth, and intermarket relationships. I estimate that 53% of the individual components in the 10 models are equity trend based. There are a few reasons for this but the most important gets at the heart of timing. We use timing tools to help us first lower risk and in a distant second to increase returns. It turns out that trend following indicators while not a “Holy Grail” do a great job at keeping you in the big moves and minimizing your downside.

Our models come from many places. If you are familiar with Nelson Freeburg, Marty Zweig, and Ned Davis you would recognize a few of the models and would be able to see the inspiration in the other models.* Five of the 10 are straight from their material and the other five while homegrown take inspiration from their work. All the models have been backtested and while most of them slightly improve returns they all drastically improve drawdowns which is our primary goal.

So if each of these models is solid in its own right why would we take a consensus approach? There are several reasons but the two that stand out are that you never know when the market is going to change and invalidate a model. Now we can stand a prolonged period of under-performance but we cant handle a catastrophe.  If a model underperforms for a long enough period of time we would take it out if we could see that something had changed. As an example I once created a breadth based system that I was able to backtest and it generated low 20% returns with the worst drawdown being just over -7%. Well I got to use it for about a year before decimalization came and within weeks the results when to hell. I suspected something was off but it took a few more months to confirm it. I still update it and monitor it as it displays a certain segment of market behavior but its risk/reward is no longer favorable.

Of course most of the models in the risk index are based on weekly data and are longer term in nature. Still the risk is very real that something changes and some of them cease to be useful. By taking a consensus approach any downturn based on a degrading model can be minimized.

We are not going to get into the specifics of each model but instead how almost any model, in this case a consensus model, can be used. Don’t worry because in a future post we will go over how to build a simple but effective long term timing model.

So we have a US Equity model that is based on the buy/sell signals of 10 separate timing models. How can we use it? We could backtest it and see what readings give the best risk/reward and trade it that way but what inspired this post was the idea that we would just invest X% of a portfolio depending on the reading. If the model said that 50% of the models were on buy signals we would invest 50% of the portfolio and change it each time the buy signals percentage changed.  If that went well, it did, and sufficiently cut risk, it did, we could then experiment with different levels of leverage.

We did this with the data we had on hand and got the following results. Trading SPY-SP500 ETF, and using the total return series so that includes dividends, we got the following results. Buy and hold did fine on the upside but had a -50.77% drawdown. Timing trailed a bit on the upside but only suffered a -13.67% max drawdown. Finally by using a full 2X leverage we were able to cut buy and hold risk in half and increase returns by 1.89 times. In case you are wondering by using only 1.2X leverage you beat buy and hold by a few bucks but your max drawdown is still under -15%.

Risk Index SPY Returns and Drawdowns

Risk Index SPY Returns and Drawdowns

Looking at a chart of the equity curves for each of the strategies you can see how timing plus leverage killed buy and hold. Of course while max drawdown was far less the intermittent drawdowns were sometimes larger. Take 2011 for example when the market corrected just enough to turn the model down to 10% bullish only to rocket higher. That is the main risk to any system as you can get whipsawed in and out during a longer term trend. Of course anytime you are using leverage you can expect to have higher volatility at times as you are seeking higher returns.

Risk Index Equity Curves

Risk Index Equity Curves

Looking at the individual drawdown charts shows just how risky buy and hold is as the SPy-SP500 ETF was down over -50%. This of course requires a 100% return just to get back to breakeven.

Buy and Hold Drawdowns

Buy and Hold Drawdowns

Looking at the drawdowns for the timing without leverage equity curve you can see that while it has a lot of little drawdowns it has only had three double digit drawdowns since early 2008 with the worst one being -13.67%. It may have lagged in total return but not by much and as such would have been a lot easier to handle. Of course as we discussed one would only need 1.2X leverage to achieve equal returns with buy and hold with less than 1/3 the risk.

Timing Drawdowns

Timing Drawdowns

Finally we have the drawdown chart of the timing strategy but using 2X leverage. As you can see the worst drawdown was half of that of buy and hold. Of course the next two worst drawdowns also hit -20% in contrast to buy and hold which only had one more -20% drawdown. Still the overall risk has been cut in half and the returns almost doubled.

Timing Plus Leverage Drawdowns

Timing Plus Leverage Drawdowns


Why do we only have the risk index back to 4/11/08? We are working on extending it back a few decades but as we were building these we had some data limitations on two of our homegrown models. When we finish building them out we will share the results with our subscribers as well as the blog.  For now however we think that capturing most of the carnage of 2008 along with the correction of 2011 does a decent job of what can be accomplished with a good timing model and a few different ways to use it.

One aspect of this model that we like is that is gives a specific allocation percentage instead of just a buy/sell signal. This will be the purpose of a future post but if you go back and read all the Marty Zweig stuff, and Zweig was a timer if there ever was one, he never said to go all in or all out.

“How should you, the reader of this book, react to the constantly changing circumstances? Basically, I think you should shun the idea of buy-and-hold. I consider it a fallacious strategy. In the coming decade we are likely to see more bear markets and deeper ones. To lower risk, there will be periods when you should peel back your investments, in the stock and bond markets. It’s a matter of degree. You don’t have to go 100% to cash but you should cut back as risk rises and invest as risk recedes. I believe my market-timing methods in this book will help you do just that.”Marty Zweig from “Winning On Wall Street”

If you go read Howard Marks book “The Most Important Thing” you will find variations of the same concept. If you are a traditional value guy/gal your heart just skipped a beat as I said Howard Marks in the same post as “market timing”. The reality is that all active management has the same goal-minimize risk and maximize reward. Marks in his excellent book talks about assessing the range of future outcomes and  discusses risk throughout both his book and other writings. Despite different approaches both Marks and Zweig have the same goal. be aggressive when their indicators-be they book values or how much the ZUPI moved-say to be aggressive and back off when things look risky.

Happy Trading,

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*I can’t write this and not give credit where credit is due. Nelson Freeburg the late publisher of Formula Research was a fantastic guy and his publication as well as correspondence has had a great influence on me. In fact while the idea of combining timing models together was not new, the way in which he did it elevated my thinking to a new level in his January 15, 1998 issue “The Power of a Composite Stock Market Model”. The components of my risk index are very different but if you read that report you can not help but see similarities.  Aside from that report however he put out more interesting and functional models than anyone I know of. If you can get a hold of any, or all, of them you will be better for it.






Are You A Contrarian Or An Idiot?

Are you a contrarian or are you an idiot? Most that claim to be the former are actually the latter.

I’m not sure why so many think that being a contrarian means that you have to fight every trend all of the time but the reality is that a successful contrarian picks their spots.  This is because most of the time the prevailing trend is the correct one and even if it is not it usually outlasts your ability to fight it. The end result is that you lose most, or all, of your money by fighting it. I don’t know about you but this has never made much sense to me.  On the other hand always going with the trend, while ensuring that you are in major moves, also means that you miss a lot of fantastic risk reward situations. Of course I have never claimed to be a contrarian or a trend follower, instead I just try and find trades with good risk and reward characteristics.

Part of my process at The Macro Trader includes a series of questions as well as a model that I have to go through before I can put on a trade. The first question is “What is the trend?” The reason being that unless my reason to go against the trend is very strong…….I should not be putting it on. Another way of saying this is I believe in going with the trend except for when I totally do not. Medium term counter trend trading, being a contrarian, is only really appropriate when you truly have a variant view on what the market should be doing and NOT when you have one or two data points that are contra to what the market is already doing.

One classic example is when you see a stock that is trading at what you think is a clearly unsustainable valuation. Is the P/E ratio really your only reason to want to short the stock? If so you might want to revisit history as it is replete with overvalued companies that got far more overvalued, or that grew our of their overvaluation and never crashed. Using this example you would want to find reasons why this valuations were not just high but unsustainable because sales were declining, debt costs were overwhelming, the sector was falling apart, and the stock was making a topping pattern.  When the weight of the evidence is pointing to a change in trend both fundamentally and technically then it might be a great time to go against it, not when you see one data point that seems out of whack.

Another example, and one more specific and current, is that of the yield curve. If you look at the 5-30 curve in the chart below you can see that it has been consolidating for the past two and a half months. The stubborn contrarian would say that it has bottomed and they would want to buy it as they now expect the curve to steepen.

Yield Curve 5-30 .4

Is the stubborn contrarian asking the right question here? For that matter is the stubborn contrarian asking any question here? Technically this chart shows that the 5-30 curve is in a downtrend and while it has consolidated a bit it has yet to make a higher high. Nothing in the chart is indicating the trend has changed but instead that the trend has slowed down and consolidated.

Instead we would hope that you ask yourself what is your fundamental view of the direction of the curve? Is the Fed going to hike rates in the coming months or not? What is going to happen to the 5-Yr and what is going to happen to the 30-Yr? What is consensus on this trade? How right or wrong is consensus? What is the risk/reward in either direction? And other questions like this. If you then find that your view is far enough away from consensus and that the risk/reward is good enough maybe you do go long a steepener on a breakout of the consolidation. If on the other hand you find that your view is barely out of consensus you might want to rethink your idea as more often than not the prevailing trend is correct.

Another way of looking at this that is purely technical could be to define what constitutes a change in trend. Maybe a breakout above the downward trendline as well as above the consolidation would constitute a change in trend using your rules. If so, a break in the chart below might be sufficient for you to go against the previous trend. If on the other hand you claim to only trade when the technicals match up with your fundamental view then you better actually think that the yield curve is going to be steeper in medium term than it currently is.

Yield Curve 5-30 .5

Notice how so far we have not made a judgement call on what our view of the yield curve is. Instead we have simply tried to walk you through the thought process of going against this downtrend. As discretionary global macro traders we require a strong reason as well as a good chart to get us into any trade. When it comes to going against the prevailing trend we require a lot more as we are saying that we are smarter than the market and by extension the majority of its participants.

All of this has been a long winded way of saying that going against the trend for the sake of being different is stupid. Make sure that you are being objective and that your contrarian view is both your actual view and that it is differentiated enough that it makes sense to go against the prevailing trend. Doing otherwise makes you not so much a contrarian but an idiot.

Happy Trading,

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