Previously we have written about our active-beta strategies and how we are applying them to equities and fixed income. We also mentioned how we were working on a solution to systematically take advantage of the carry trade. After a lot of research we have finally devised an acceptable method to capture returns while at the same time minimizing drawdowns.

In the initial stages of research we did a lot of search and came across a few good and several bad ideas. One of the most insightful things we read came from Macro Man . He wrote where he uses a volatility filter to tell him when it is a good time to be involved in the G-10 carry trade. After further research we found it to be true that the best time for the carry trade is when things are fairly stable and volatility is low or declining and the worst time is when it is high or rising. This of course makes sense since the majority of this strategy revolves around trying to capture interest rate differentials from high yielding currencies versus the low yielding currencies. When excessive volatility comes into the market many participants will start to unwind their leveraged positions and in so doing they can wipe out a lot of gains from the carry. Using a volatility filter helps to sort out the high, moderate, and low risk times. For the most part we want to be involved in the moderate and low risk times and step aside in the high risk times.

Of course volatility is not the only risk to the carry trade. Anytime a central bank decides to change rates the carry will change and depending on what they do you can make or lose money. Also if a few large market participants quickly unwind positions you can get hit before the filter is triggered. What we have attempted to do is to simply eliminate a regularly occurring risk and improve our risk-adjusted returns by avoiding that risk.

Some investors new to currency trading might be wondering what is the carry trade? It is when you go long a high yielding currency and go short a low yielding currency. The G-10 carry trade is simply to go long the three highest yielders and go short the three lowest yielding currencies. Right now for instance you would be long the New Zealand Loonie, Australian Dollar, and the Norwegian Krone. You would go long these against the Japanese Yen, US Dollar, and Canadian Dollar. In a currency account you can put these on and then decide how much leverage you want to use. If you are new to currency trading and/or are constrained in your trading instruments you can just buy the DBV-Deutsche Bank G10 Currency Harvest ETF. It does exactly this strategy and applies 2X leverage. Since TheMacroTrader.com trades ETF’s we use the DBV to take advantage of the carry trade.

Happy Trading,

The Macro Trader

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In our December 7^th, 2007 issue we went bullish gold. By way of the ETF GLD we got in at $79.60. Currently it is right around $87. So to help our subscribers and potential subscribers understand our trade process we felt it would be helpful to walk you through this trade.

We look for potential trades fundamentally and trade them technically. As we have mentioned before technical analysis helps us define our risk vs. reward and makes our trading more objective. We like to think we get the best of both worlds.

Fundamentally there are several things that are bullish for gold and precious metals in general.

-Negative real rates. When inflation adjusted rates are negative you want your money in real assets.

-Falling US Dollar. If the US Dollar is declining in value relative to almost anything you want your money in other currencies. While we don’t necessarily think we need to be back on the gold standard, we do see gold as an alternative currency.

-Rising Swiss Franc. Historically when the Swiss Franc is rising it means that investors are putting their money in a safe haven currency. The correlations between gold and the Swiss Franc have held over the long term due to many of the same reasons.

-Rising Inflation. Again if your money is devaluing you want to put it somewhere else.

These are but a few of the reasons that we have been bullish gold. After we have a fundamental reason to go long or go short as the case may be we then look for a catalyst. That catalyst can come in many ways. Sometimes it is an actual economic number, a chart pattern, or any number of things. In this case it was a textbook example of a triangle consolidation.

As we have posted before we are huge proponents of risk management. We have found that for us technical analysis is one of the big pieces of the puzzle. Using charts we are able to define entry and exit points in an objective way. Some may disagree with us but we have found charts to be invaluable. In the case of gold we had wanted to get long for a while but it was overextended. Well patience paid off because it pulled back and consolidated and formed a strong triangle. We placed it in our newsletter and that same week we got in at $79.60. As of tonights close it is at $86.50 and our current stop is at $84.38

Happy Trading,

The Macro Trader

P.S. If you have any questions regarding our newsletter or anything else feel free to e-mail us at Editor@TheMacroTrader.com

Our last post discussed the advantages to using systematic investing processes along side discretionary trading. Here is a great example of this in practice.

In our Junk Bond Model we track several Junk Bond Funds and indexes. We do this so that we aren’t burdened with mutual fund trading restrictions and so that we have a fuller view of the High Yield Bond market. In this example we are using PRHYX the T Rowe Price High Yield Bond Fund. It is actually one of our favorite Junk Bond Funds because among other reasons it tracks the index very well and has a long history.

Looking at the results of the PRHYX its year to date (YTD) performance has been OK. On a total return basis it is up +3.9% this year with a maximum drawdown of -5.69% and a current drawdown of -1.56%. Looking at the results of our Junk Bond Model we have a YTD return of +5.6% with a max drawdown of -.71% and a current drawdown of -.71%.

If you look at the chart below you can see the results of investing $100 in the Junk Model versus $100 in he PRHYX Bond Fund.

Obviously the Junk Bond Model was able to sidestep the huge drop this summer and has avoided most of the current downturn. If you had invested in the Fund you would have taken on almost six times the risk for less return than trading the Junk Model. By the way the main inputs for this model are price action and interest rates.

This is an example of a model we use in our trading. As stated before we do this so that we can have uncorrelated, consistent, outperforming returns over time. We look at several asset classes, across as many countries as we can, using varied trading strategies. We do this because we are looking for the best risk to reward trades on the planet.

Happy Trading,

The Macro Trader

P.S.-If you liked this you will love TheMacroTrader.com Newsletter and will want to add us to your RSS Reader.

UPDATE-So far for the year 2007 our Junk Bond Model is ahead of the SP500 in both absolute and risk adjusted returns.  The SP500 is up 2.87% and the Junk Bond Model has returned 5.86%.  And what about drawdowns?  Well the SP500 has had two drawdowns slightly larger than -8% and few in the -5% range.  The Junk Bond Model’s worst drawdown is still only -.71%.  So yes, long term (and short term as well) adding different asset classes and trading strategies to your overall portfolio does help returns, diversification, and your risk profile.

Here at TheMacroTrader.com we use several different strategies across several asset classes. Why do we do this? For several reasons not the least of which is so that we can find and exploit as many of the best risk to reward situations as possible. If you tie yourself to one strategy or one asset class you are limiting your potential opportunites.

In this article we will focus on using systems. As we have already mentioned we use several systems. Some are purely automatic. If they say buy we will go and buy if they say to sell we will sell. We also have several systems that leave us a lot of discretion as to what we do. We look at many different variables depending on the asset class and time horizon. For instance in some of our short term systems we only use prices of the actual instrument to determine buys and sells. On some of our longer term systems we use economic data such as interest rates, market valuations, technical studies, inflation, competing yields, etc.

Right now we have several systems for domestic and foreign equities, domestic bonds (treasuries, corporates, and junk), precious metals, currencies, commodities, volatility trading, and asset allocation. All of the systems we use have historically beaten their benchmarks with less risk. So over time we can expect to outperform.

As noted earlier we also have systems that leave us with varying amounts of discretion. Some of the systems are only used to alert us of a potential trade. We then go in and look to see if we feel it is worth doing. For instance one of our systems is designed to highlight potential option trades across several different indexes. Its main variable is volatility. While we could possibly use it as a stand alone system at this point in time we think it is better used to highlight potential opportunities.

So how do we use it? We update it every week and most weeks it will show us a few different areas worth looking at. We than go in and research those potential trades to assess the situation. If the right conditions are present and we can see a catalyst we will then go in and put on the trade. If not we will continue monitoring the situation in case it changes. While we only put on about a third of the trades that it presents us we feel it is an invaluable tool because it highlights many situations that we would otherwise miss. To sum it up in one sentence it highlights promising situations. That is but one example of using a systematic process in our trading.

In summary using systematic processes in trading allow us to cover more asset classes and more countries. It allows us to spot more opportunities and to more consistently achieve above average and less correlated returns.

Happy Trading,

The Macro Trader

With Asia at new highs every week it was not a surprise when a client recently came to us asking where might be a good place to invest in Asia. Here are some of the things that we look for in potential investments.

Looking over different countries we give a lot of weight to the interest rate environment. Most of the countries in Asia currently have rising interest rates. China, Hong Kong, and South Korea being notable examples. Singapore on the other hand has had stable and low rates for a while now. Another trend right now worldwide is that almost half of the 45+ countries we track have inverted yield curves. Asia is an exception to that as well with only Indonesia and Hong Kong having inverted rates. Needless to say Singapore does not have inverted rates.

The next big factor that we look at is the stock index trend. We don’t fight the trend. Falling knife syndrome has been known to cause huge losses and we just aren’t into that. Looking at the EWS chart it is in a definite uptrend and while it is not at the start of the trend as long as other conditions are favorable such as monetary trends, valuations, etc. we will look to buy on pullbacks and consolidations.

Another major factor in the fundamentals of a country is if it has surplus or deficits. Twin surpluses are good and twin deficits are bad. Singapore is a twin surplus country. Unfortunately the United States is a twin deficit country.

Valuations come into play especially on a relative basis. We look at P/E, P/S, and P/B ratios. In this case the P/E of the EWS is 16.29 versus the SP500 P/E of 17.67. We like it when the country is valued at or below the SP500.

We also like good news about the country. Not things like “XYZ index next stop 1,000,000 but positive things about its business environment and other positive influences. Here is one such positive for EWS Singapore is ranked the easiest country in the world to start a business.

While we look at several other factors we feel these are the most important. If there is anything that you would like a sample of feel free to e-mail us at Editor@TheMacroTrader.com

Happy Trading,
The Macro Trader