Two Tales Of The Same Indicators

As of late we have been seeing the following chart pop up all over our Twitter feed as well as in our inbox.  You don’t even have to look very closely to see that over the past 20-Years the ISM Manufacturing Index and the year over year change in the SP500 have been highly correlated. This might lead you to believe that we are headed for a doom and gloom bear market and even a recession. After all an ISM reading below 50 indicates a contraction while readings above 50 indicate expansions.  With a reading of 48.2 we are obviously below 50.  So guaranteed recession right? Not so fast.

ISM and SP500 Last 20-Years

ISM and SP500 Last 20-Years

If you look at the above chart again, but closely this time, you can also see that not only does it only cover the time period from 1998-now but that there have been several reading below 50 that did not lead to a recession.  If we instead turn our eyes to the next chart of the 10-Year correlations of the ISM PMI and the SP500 YoY change we can see that it has only been in the past 10 years or so that the relationship was anything near what it is today. In fact right now the correlations are at an all-time high around 80%. Looking at past eras however show that sometimes the relationship has been at 40%, others in the 20% range, and still others displayed a negative correlation. Yes, this means that when the ISM index went negative, sub-50, the SP500 went positive.

ISM-10-Year-Correlations With SP500 YoY Change

ISM-10-Year-Correlations With SP500 YoY Change

If we look at the next chart of the ISM Index and the SP500 YoY, but this time all the way back to the beginning of the ISM data we can see how tenuous this relationship has been over time.  Not only has a sub-50 ISM number not been anything close to an automatic recession but it doesn’t even mean stocks have to go lower.

ISM and SP500 Full History

ISM and SP500 Full History

Now could stocks go lower and could we be in a recession?  Of course they could and of course we could. The point we are trying to make is that there are so many false positives that you can not overweight this indicator to much in your framework. In fact if we look over the history of the ISM, or just the history of the economy, we can see that manufacturing is actually less important to the economy than ever before and that this has been a long term trend as we have transitioned towards a service/knowledge based economy. We don’t make stuff if we can have China make our stuff cheaper.  In fact manufacturing currently only represents 12% of GDP and 8.6% of employment in the United States.  Seen in this light, and combined with the rest of our business cycle work, we do not see an imminent recession in the United States.

At the same time according to JP Morgan manufacturing does account for almost 60% of the profits in SP500 companies.  So while the odds of a recession are relatively low the odds of earnings being low and going lower are fairly high. This would not be the first time that we had a correction or even a bear market amidst an expansion.

Don’t overweight any indicator more than its history and causality deserves. Don’t mistake a mid-cycle correction with a recession or the end of the world.  Do take a holistic approach to the economy and look under as many rocks as you can while also figuring out what really moves what. Finally, at least for now, realize that as important as the stock market and the economy are, in the short run, they are not the same thing.  Trade accordingly.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

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I Have Met The Enemy And It Is Me

A few weeks ago I picked up the book “Superforecasting” by Tetlock and Gardner. It was so good that after I read it I read it again.

In it the authors go over their experiments to find out first if there was such a thing as a superforecaster and second if there were (and there are) what makes them that way and if was teachable.  Lucky for us the results of the experiment, and it is ongoing, is that while some people are more suited to forecasting than others, it is teachable and almost anyone can improve their forecasting skills.

What I was most struck by was how much of forecasting is really knowing and battling the different mental biases we all have to greater or lesser degrees. Computational power, knowing math and probabilities and similar skills, matters and can help a lot but the majority of the book was really dealing with how to think and control your thinking and less on how to do Monte Carlo simulations (actually they just mention them as the book is not math heavy at all and can be read and used by almost anyone who can read).

I liked this because it fits in with something I have been working on for some time. Over the past few years I have been working on a list of biases that I have and a checklist to make sure I am addressing them every time I am looking at putting on a trade. While my questioning is more in depth and specific even just the exercise of asking yourself questions like “Recency bias: Am I over or under weighting recent data relative to older data? If so why?” can go a long ways towards at least lessening the impact, if not doing away with the bias completely.

You can ask yourself similar questions for any other bias or problem that you find yourself struggling with. Anchoring, sunk cost, disposition effect, outcome bias, bandwagoning, etc are but a small list of known biases that have been shown to greatly affect investment results. Go read “Superforecasting”, “Predictably Irrational”, “Nudge”, and anything else by Ariely, Kahneman, Thaler, Maubossin, and other researchers in behavioral science and you will learn how to spot a bias and often how to counteract it.

Of course I understand that none of this, at least to the extent that I am writing about it here, is truly new. Most readers of this site know about investing biases and how they can mess with our results. What I am trying to encourage you to do is to be systematic about it and actually make a checklist to combat any investment return killing bias that you suffer from.

In trading after we get past the CFA/CMT level knowledge base (both great programs but really just the beginning of this game and not the end), broadly speaking, there are only two real advantages in this game. You can have more and better computational/data power and/or you can become a better and more disciplined thinker. While we should strive to get better at both it has been my experience with me and all the investors/traders I interact with that we are our own worst enemies.

I could go on all day but will end with this: make a list of biases, figure out how they affect you, measure them going forward, and then tweak and improve as necessary.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

P.S.-go buy the book “Superforecasting”, I only touched on how it pointed out many biases and how our thinking is usually our worst enemy but the book was packed with info on how to better forecast just about anything and think through problems. In addition it was entertaining and only a few hundred pages.

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The Only Thing I Am Certain Of Is That Certainty Kills

One of the worst things that traders can do is to think they know anything. The more certainty you have the less flexibility you will have in changing your mind.

Of course we do all that we can to skew the odds in our favor. We read, we model, we figure out how to structure the trade, and we look at how it would fit in our portfolio.  We do all this but in the end we have to be ready to cut and run because there is no 100% certainty in this business.

In fact the more certain you are that you are right the worse it can be for you. Want to lose 100% of your money? Go find a stock that you “know” will go up where you “know” that everyone else is wrong and then hold onto it no matter what.

What is fascinating is that it is widely believed that if you buy a few stocks and hold them you will make money the reality is that about 40% of stocks actually lose money over time while 64% of stocks under-perform the indices over time. The belief comes from the fact that the indices go up over time as they dump the losers and add to the winners. The main takeaway is that many stocks-40% of them-have negative lifetime returns.(for more on this search for the paper “capitalism distribution” it is full of interesting and useful data)

Trade certainty gets even harder when it comes to commodities and currencies as there is no reason why any of them “have to” go higher. Look at a 30+ year chart of any of the major currency pairs or commodities. They go up, they go down, and they go back up again. This cycle repeats over and over.

If you can’t be flexible in your thinking then the only thing you can be certain of is that you will eventually lose a lot of money.  If you look at any successful fund manager who has been at it for a long time you will see a lot of flexibility in their approach. Maybe the king of flexibility is Soros.

Go read Alchemy of Finance* and you will see that while he explains all these grand theories on what he thinks is going to happen in the market he is wrong almost every single time. Despite this he made over 120% during his “real time experiment”.

A typical entry in the book would read something like this “I thought the Fed would do this and then the German Bundesbank would do this so I bought Deutchemarks” of course the Deutsche mark would then start to tank and he would sell out, double his size, short the Deutsche mark, and make $200 million.

Despite his belief that such and such was going to happen he was not against changing his mind at all once he realized he was wrong.  He has almost no ego in his trading and in the end just wants to be on the right side of the market. The Soros/Druckenmiller track record is the best 30+ year record I know of so maybe there is something to this whole figure out a view, bet on the view, and then if it isn’t working dump the view approach. Read anything you can about Soros/Druckenmiller and you will find that their true edge was not in their research or political* views but in their ability to change their mind in an instant.

I have been thinking of this more than normal the past nine days as most of our positions, which had been working very well for most of the year, started to go against us. At first you assume its just some normal volatility but then it gets worse and you have to say “I guess I am wrong now” and move on. It is annoying when you have a theme going that you still think makes sense but in the end you have to decide what is more important to you-being right or making money? They are definitely NOT the same thing.

 

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

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*Alchemy of Finance-If you have not read this book change that now. Read it 2-3 or even more times and you will get more from it each time.

*Political views-As far as I can tell Soros and Druckenmiller are on different sides of the political spectrum. But guess what? It doesn’t matter. This is just further evidence that politics have almost nothing to do with making money….unless of course you are a politican.

 

 

One Thing All Investors Can Take From CTA’s and Risk Parity Funds

If you follow the alternative investment landscape at all then you have heard of both risk-parity funds as well as CTA’s-Commodity Trading Advisors.  Regardless of what you think of either strategy there is one thing that most investors should look at adapting to their particular style of trading/investing.

What “thing” am I talking about? Well the one component that most of them use in their trading process is to equalize the risk on each of their positions. Most CTA’s use a volatility based position sizing model of sorts while one of the goals of risk-parity is to bring each asset class up to the same risk level hence the parity in risk-parity.

In the case of a CTA they might use the last 20, 60, or 100 days to measure the volatility of the instrument. They might use standard deviation, average true range, or any number of other volatility based measures. Risk-parity funds tend to look at the long run historical volatility of an asset class. The time frame is of course dependent on their average holding period. Most risk-parity funds are relatively slow moving asset allocation shifts as volatility rises and falls while most CTA’s are medium term trend followers. So while a risk-parity fund might only adjust their allocations once a year a CTA could have 300% turnover in a year.

But while their time frames are different the ultimate goal remains the same. In both cases they are trying to normalize risk in an algorithmic fashion. This does two things. One is obviously to normalize risk across assets. The second is to take the human decision out of the equation.  Both reasons have a lot going for them but I suspect that most investors would benefit from the second reason more than anything else.

In general humans tend to be over or under confident. When it comes to investing it is almost always hubris that hurts but in some cases it is still under confidence.  By being as systematic as possible we can eliminate, or at least reduce, our bad tendencies while accentuating our good tendencies.

As an example I have always been far too risk adverse. I started off as a broker catering to very active traders. In this environment I saw a few people make a ton of money and a ton of people trade their accounts into oblivion. This experience made me very risk adverse and consequently my drawdowns have always been very small. The bad part of very small drawdowns is that it makes it that much harder to have very good upside. I always rationalized that “I will add more to the position later” when in practice that rarely happened. Over time I realized that if I doubled my drawdown size I would be fine and yet my upside would also double. To put this in perspective I have never had a -10% drawdown.

I always paid lip service to position sizing models but usually ended up taking 1/2 and sometimes even 1/3 of the suggested position.  I have a solid risk management process but I was never maximizing my risk taking. Overly cutting off your upside is almost as bad as NOT cutting off your downside as they both lead to far less than optimal outcomes.

I finally decided I was done with that and worked out a position sizing algorithm that in theory I was happy with. I then committed myself to following it….no matter what. I now type in my volatility measurement, buy/short price, stop price, volatility measure and it spits out how big a position to take. My results have not only been far better but also more consistent and all this with drawdowns that are still tolerable. With my revised sizing regime I will eventually have a drawdown larger than -10% but barring some huge gap risk it should never be larger than -20%.

What I have seen across many investors accounts is that equalizing their risk, or at least really understanding how unequal risk is across positions, is a huge benefit to them. Take the traditional 60/40 stock bond portfolio. If you measure your risk you will see that you have far more risk in equities than the 60% would indicate.  If you are really OK with this than fine but most investors….and even most of their advisors don’t even know this.

I could obviously go on and on about this topic and maybe will in a future post. In the meantime I would recommend that you go read up on risk-parity as well as CTA strategies. Whether you like their overall strategy or not is up to you-some people don’t want to lever up bonds to match their equity risk or go long/short soybeans-but they both have some systematic and very useful risk management concepts.

Finally I would say, just like half the industry would say, that the number one thing between many losing or at least under-performing investors/traders is a poor risk management and portfolio construction process. The word “process” sounds so cliche anymore and yet it is a real thing. If you don’t focus on process over outcomes then you will under-perform and likely lose money over time.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

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Global Macro-Generate Superior Returns With Less Risk

We at The Macro Trader are obviously fans of Global Macro as an investment strategy and even philosophy. Fortunately the data backs us up showing that global macro not only generates higher returns but does it with far lower risk than equities.

The chart below shows how you would have done if you had invested $1,000 into the Credit Suisse Macro Hedge Fund Index, SP500, and Barclays Aggregate Bond Index since 1994. As you can see the CS Macro Hedge Fund Index did drastically better than either stocks or bonds. To be more specific the CS Macro Index beat the SP500 by 2.11 times and the AGG Index by 2.75 times.  So that shows the returns but what about the risk taken to achieve these returns?

Global Macro vs SP500 vs Lehman AGG Bond Index

Global Macro vs SP500 vs Lehman AGG Bond Index

We have a few different charts to display the risks taken to generate the returns in each index. First we will show the historical drawdown charts. A drawdown is simply anytime you are not at new highs in your account. If you have $100 and lose $5 you are in a -5% drawdown. The deeper the drawdown the higher the return needed to get back to breakeven and the math, while simple, can be tricky. For instance if you lose -50% many think you need to make 50% to get to breakeven. The reality is that you need 100% to get to breakeven. In our case of being down -5% you only need a 5.26% return to get to breakeven but it gets harder the deeper you get.

Looking at a drawdown chart of the SP500 you can see that not only are stocks usually in a drawdown but over the past 20+ years we have had two massive drawdowns that took years to make up. We know them as the DotCom crash and the GFC-Global Financial Crisis. It took the SP500 57 months to recover from the DotCom crash and 50 months to recover from the GFC.

SP500-Drawdowns

SP500-Drawdowns

At the opposite end of the spectrum we have the drawdowns of the Barclays AGG Fixed Income Index. As you can see the AGG Index has frequent but small drawdowns with the worst one barely dropping below -5%. It only took nine months for the AGG index to fully recover from the worst drawdown and three months to recover from the second deepest drawdown.

Lehman/Barclays AGG Fixed Income Index Drawdowns

Lehman/Barclays AGG Fixed Income Index Drawdowns

Finally we have the CS Global Macro Index drawdowns. As you can see its worst drawdown was a -26.79% and its second worst was -14.94%. It took 19 months to recover from the -26% drawdown and 19 months to recover from the -14.94% drawdown.

Credit Suisse Global Macro Index Drawdowns

Credit Suisse Global Macro Index Drawdowns

Another way to show the depth and length of the drawdowns is to plot both the equity line as well as the new highs line. In each of the next three charts the green line equals the highest the equity line got, notice it never dips down, and the red line is the equity curve which goes both up and down.

Here is the SP500. As you can see while it hit a new high in 2007 it then went back down. In essence it took about 12 years before investors were really making new money. While this is a worse than “normal” period it is also not the first or the second time that the stock market has had a rough decade.

SP500 DD and NH

SP500 DD and NH

Looking at the AGG Fixed Income Index we see that the drawdowns are both shallow and short. If you were in the AGG Index you would not make the most money but you also took very little risk.

Lehman-Barclays AGG Fixed Income Index DD and NH

Lehman-Barclays AGG Fixed Income Index DD and NH

Finally we have the CS Global Macro Index. As you can see the drawdowns while larger than that of the AGG index are far smaller than the SP500 index. It kind of takes the middle route in regards to risk but it drastically outperforms both in regards to return.

Credit Suisse Global Macro Index DD and NH

Credit Suisse Global Macro Index DD and NH

Another way to look at the risk and return is to look at the 12-Month Rolling Returns. At any point in the chart you are looking at the returns you would have gotten if you had invested 12-Months ago.  As you can see the SP500-red line has the highest 12-Month returns but also the lowest 12-Month returns. The AGG Index-green line almost always shows positive returns but it never has a really big year. Finally the CS Macro Index-blue line again comes somewhere in the middle. It is positive almost as often as the bond index but the 12-Month period to 12-Month period returns are less than stocks.

Global Macro-SP500-AGG 12-Month Rolling Returns

Global Macro-SP500-AGG 12-Month Rolling Returns

Basically global macro has lower volatility and more consistent returns than the stock market and almost as consistent returns and far more gains than the bond market.  The main reason that this is possible is that as opposed to either the stock or bond index a global macro fund can go long and short anything and trade derivatives on anything. Most macro managers stick to liquid instruments but that still means you have hundreds if not thousands of tradeable instruments. The flexibility inherent in global macro allows you to always find a bull market somewhere whether that is being long stocks, short stocks, long the Australian Dollar, or short the Australian Dollar. You can bet on US Treasuries against German Bunds or across almost any other market relationship you can think of. Not only is global macro flexible but macro managers are famous for stringent risk management practices. It is almost cliche but in the end risk management is one of the keys to success in any trading approach and one of the most important things that separate macro from long only buy and hold.

What about claims in the press that “hedge funds have under-performed the SP500 since the GFC?” Well that is true but if you are picking only half a cycle than it is probably not a fair comparison. In the chart below you can see what happened to the CS Macro Index and the SP500 from the end of 2008 until the end of August 2015. As you can see the stock market is ahead.

2009-Now

2009-Now

Of course that was just in a bull move when everything was headed up. If instead of the end of 2008 or the end of February 2009 we use 2007 as our starting point we get a drastically different result. In this case the flexibility and risk reduction inherent in the global macro approach shines as the CS Macro Index outperforms the SP500 with both higher returns and far lower risk.

2007-Now

2007-Now

As far back as we have data global macro has outperformed both stocks and bonds across full market cycle. On the other hand long only equities has been profitable but has had some very long and deep periods of negative returns.  We are obviously biased towards global macro. We have a site and run a research service dedicated to it. You could say we drank the kool-aid and live and breathe this stuff. At the same time however many of the most successful money managers in history have been macro managers and the data shows that when done right it can lead to both higher absolute and risk adjusted returns.  So while we are indeed biased we think that the case is fairly strong in our favor.

 

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

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