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,

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Trader, Economist, Expert On TV?

You have to decide what your goal is. Do you want to make money, sound smart, get on TV, etc? It sounds simple but the reality is that many investors get it very wrong. They think they are investing to make money but in reality they just try and impose their view on the market. Other people, a prominent gold bug comes to mind, just seem to want to be on TV. I am not even sure they are trying to make capital gains but instead just sell a product. Luckily I don’t think most investors fall into the TV camp….at least I hope not.

Where I see most investors go astray is when they fall into the sound smart/economist camp. Many investors do a lot of research for a view and then get so anchored into that view that they cant envision a different world.  This causes a lot of problems if you are ever wrong…..and everyone is wrong on a regular basis.

One recent case of the “this is what I believe and I am right” disease was peak oil. Everyone thought that we were going to run out of cheap oil and that it would stay above $100 forever. There were dozens of books talking about it, hundreds of websites, and thousands of research pieces written talking about how oil was going higher and never coming down. Here is a sample.

Twilight In The Desert

Twilight In The Desert

Of course as we all know now the only think that was peaking was the actual price of oil. The high price of oil spurred everyone to find new energy and new ways to extract oil. This brought us the surge in solar and wind capacity that is still going today, companies like Tesla, as well as a group of folks collectively referred to as “The Frackers”.  It was a long battle but five years post-financial crisis we finally saw the price of oil fall…and fall hard, going from $100/barrel to just under $40/barrel in about 18-Months.

Crude-20 year chart

Crude-20 year chart

If you held onto the view that oil was going to go higher forever no matter what, even once we started to see overwhelming evidence that fracking was very real and very repeatable, then you have likely lost a lot of money as both oil, natural gas, and all their related stocks have come crashing down.  It is not that the original research wasn’t accurate or that your initial view was bad, but instead that you stayed wedded to the notion that things don’t change and that you have to be right.

This happens time and time again. Think the Dotcom crash when the internet was not only going to change everything but that “the winners of the new world” were going to overtake everything and could never go down. (BTW Google that phrase and read the first result. Classic mania) Other recent examples would be gold or 3D printing stocks.

Ed Seykota has a great quote “Win or lose, everybody gets what they want out of the market” and while it has been beaten to death it is still worth pondering. If you are trying to make money you have to have “strong opinions, weakly held” and not “strong opinions, I can’t be wrong”.  This is why I like to think of myself as a trader economist. Every day, week, month, year I shop around for what makes the most sense given the current environment. What is the same, what is changing, and what looks like it might change are all better uses of your time than complaining that “they just don’t get it” because whether they get it or not if your positions are moving against you, pick your time frame, then you are wrong.

Most your ego from “I am right” to “I like to count my money” and your odds of success in this game will go up exponentially. If you want to be an expert or get on TV on the other hand than good luck with that.

Happy Trading,

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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,

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,

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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,

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