Wednesday, June 29, 2016

Global Markets Going Nowhere

Thanks to Sarhan Capital for pointing this out, off the lows of the other day here is how far some markets are off their highs and the levels they are trading at:

The S&P was down 6.7% from highs and was trading where it was in Sept 2014.
The Dow...down 7.5% and Sept 2014.
Nasdaq...down 12.6% and Sept 2014.
Nasdaq 100...down 11.8% and Nov 2014.
Transports...down 24.5% and Nov 2013.
Russell 2000...down 16.2% and Oct 2013.
NYSE...down 11.9% and July kidding.
XLF (Financial SPDR)...down 43% and trading where it was in 1999. Yes...financials and yes 1999! 
How about foreign markets?
German Dax...down 25.6% and Jan 2014.
FTSE...down 18.7% and March 98...again...not kidding. We were surprised about this.
Shanghai...down a whopping 54%...and Feb 07.
Nikkei...down an unreal 61.8%/all time high in 1989 at 38,957. How's that money printing working for you?
Hang Seng...38.5% and Jan 07

Wednesday, May 11, 2016

Changing the Structure of Tactical Return Generation

Tactical equity strategies that seek to outperform the market will typically try to accomplish this goal by limiting downside capture during bear markets.   By their nature, tactical strategies don't expect to get 100% upside capture during a bull market (unless they are using a decent amount of leverage) so the only way to outperform the market is through limiting downside capture.  If this can be done consistently then the tactical strategy won't outperform the market on a year by year basis, but it should outperform handily over a full market cycle. 

Since by their nature tactical strategies will have significant periods when they are out of the market, they will miss some upside.  The tradeoff is that they should also miss a lot of downside and a lot of volatility.   If the investor can take a long term view , instead of comparing the tactical strategy to the market every month, quarter, or year then they will experience very attractive returns vs. conventional investment strategies.  However, this is often easier said than done as bull markets are much more prevalent than bear markets and it is hard for investors to ignore the noise without making comparisons to the market.  Traditional tactical strategies are much better than modern portfolio theory and buy and hold but not quite optimal from an investors standpoint.

To be truly tactical a strategy must have times when it is out of the market or underinvested in the market.  These will usually be times of great risk, however during some of these times the market will still rally.  Since most tactical strategies take an intermediate to longer term view of markets, the times they are out or underinvested can be over a month, a quarter, or even a year.  The longer they are out of the market or underinvested the greater chance of missing out on upside capture.  A solution to this issue is to shrink time frames from rebalancing monthly or weekly, to rebalancing daily or even intraday.  So instead of being out of the market or underinvested for a month or longer, a strategy using daily and intraday time frames might be out for a day.  So instead of losing upside capture for a month, quarter, or year, such a strategy would lose upside capture for a day.  This can completely change the definition of a market cycle, instead of having to wait years to outperform the market the market cycle can be compressed into a month.  Instead of corrections lasting weeks, a correction in this case is a down day.  Instead of bear markets lasting a year or more, a bear market in this case could last a week.  Compressing the time frames in this manner allows the tactical strategy to outperform the market on a monthly basis and creates return streams that are much more palatable to ordinary investors.

Monday, May 9, 2016

What World War Z Can Teach Us About Investing

In the movie World War Z a virus starts turning people into Zombies and they threaten to take over the world.  The main character, played by Brad Pitt, is tasked with finding out what happened and how to cure it.  On this mission he hears that Israel was the only country not overrun by the zombies because they built a massive wall before the outbreak.  When he travels to Israel to find out how they predicted what was going to happen they tell him about the 10th man doctrine.  This is a committee of 9 people and a 10th man.  If all 9 people agree on something, it is the 10th man's responsibility to disagree, not matter how far fetched his findings might be, and prepare for that eventuality.   When the Israelis first heard word of zombies all 9 people agreed that it was nothing, the 10th man then had to disagree and build a wall just in case there was a zombie apocalypse. 

What does this have to do with investing?  Everything.  In investing the path of least resistance is to conform to what everyone else is thinking, that way if you are wrong everybody else is wrong at the same time.  It is also easier to believe the most recent past will equal the future.  So if we are in a bull market the consensus is that the bull market will continue, if we are in a bear market then the consensus is that the bear market will continue.  The 10th man doctrine would force you to look beyond the consensus at other possible scenarios and prepare for them. 

Since we have been in a bull market for 7 years one likely scenario is that it will keep going.  If you listen to CNBC that is probably the consensus, so you must be prepared for it.  However, what if it doesn't keep going?  Other likely scenarios are a bear market or the market we have seen since August, with large corrections followed by large rallies without really going anywhere, continuing.  Since you can't predict markets your portfolio has to be prepared for either of these eventualities as well. 

Friday, March 25, 2016

The Current Market Environment and Implications for Tactical Asset Allocation Part III

As I write this the market has gone through what looks like another V shaped correction.  After a few of these types of moves in succession we can no longer call it a fluke, it may not be the new normal but we have to expect that these types of moves will be more common in the future.  Buy and hold and asset allocation don't handle these types of moves well.  They experience all the downside and then ride the market back up, ultimately not going anywhere but having a wild roller coaster ride with all of the emotional minefields that causes.   Asset allocation strategies also have asset classes that move down more than US stocks, magnifying losses.  Traditional tactical strategies don't offer much of a solution to these types of environments.  They can lower the losses on the downside, and if a correction turns into a bear market they come out like heroes.  But, if the correction quickly reverses tactical strategies will take a while to get back in and experience the gains.  These types of strategies look to latch onto trends that last weeks or months, but in this new environment trends are now lasting hours to a couple of days.  By the time a traditional tactical strategy reacts the trend has already changed.  

Investing in the market involves risk and reward.  A good investment strategy has the proper balance between the two---the less risk and more reward the better.  To improve an investment strategy you can increase reward while keeping risk constant, lower risk while keeping reward constant, or any combination that increases the ratio.  Buy and hold and asset allocation will always have a terrible risk reward ratio, there are large potential rewards but the risk is huge.  Traditional tactical strategies have much better risk/reward ratios but if this choppy market environment persists and we don't see a bear market soon it will be difficult for investors to see that.  Similar to this concept is the idea that every investment strategy has its Achilles Heal, the market environment that it just won't perform well in.  Another key then to improving an investment strategy is to make its Achilles Heal as insignificant as possible.  This is impossible in buy and hold and asset allocation as these types of strategies will always ride a market down, reducing the Achilles Heal would involve turning these into tactical strategies.  Traditional tactical will not perform well in choppy markets, this is not significant if markets are trending most of the time, but in this environment all we have seen are choppy markets for two years, making the Achilles Heal much more significant.  The key to improving tactical strategies is in reducing this Achilles Heal and making it much less significant.  The key to this is understanding that time frames have changed and tactical strategies have to be even more responsive to market shifts than ever before.

In the past, running a tactical strategy could be simple, you could just apply a 200 day moving average to the S&P 500 on a monthly basis and rotate in and out at the end of the month.  You would never get out at the top or in at the bottom but trend changes gave enough warning that you didn't need to.  Today, trend changes can happen in an instant, giving no warning at all.  There is still a place for looking at multi month momentum but it can no longer be the centerpiece of an investment strategy.  Markets are too choppy month to month.  There is one place however where momentum still exists, that is intraday.  In this new environment, what happens day to day is much more important than ever, the market can go up or down massive amounts in the space of a couple of days and the shift can happen intraday.   The key to improving the performance of a tactical strategy in choppy markets then is to combine strategies that have much shorter holding periods, from a couple of hours to a couple of days, with traditional longer term strategies.  These strategies can take advantage of the momentum that is still present during a trading day or overnight, without experiencing the gut wrenching ups and downs of a longer term approach.  A market that ultimately goes nowhere has enough of these short term movements that a tactical strategy using short term strategies can make money regardless of how choppy the market is.  Applied appropriately these types of strategies can shift the Achilles Heal of a tactical strategy from a choppy market that lasts over a couple of weeks or months to a choppy market that lasts for a day.  So instead of having problems navigating a market that can move up or down 10% or more over a couple of weeks, which is easy to navigate using short term strategies, the problem shifts to choppy markets intraday that might move up and down 1-2%.  This makes the Achilles Heal of a tactical strategy much smaller while at the same time reducing risk and increasing potential returns. 

Tuesday, March 8, 2016

An Example of Forward Looking Due Diligence in System Development

When most investors do due diligence they look at past returns and expect them to persist into the future.  Unfortunately, they rarely do.  Forward looking due diligence takes past returns with a grain of salt, the goal is to determine where the returns came from and how likely they are to persist.  Forward looking due diligence can be done on money managers, investment strategies, and tactical methodologies.

We recently developed a model for the SPDR S&P 500 ETF (SPY).  The model can either be long SPY, short SPY, or in cash.  From 3/7/2011 to 3/7/2016 it makes $142.6 on one share of SPY, not including any dividends.  For comparison to buy and hold SPY opened at $132.86 on March 7, 2011 and closed at $200.59 on March 7, 2016, so buy and hold would have only made $67.73.  So far so good, our strategy  more than doubles buy and hold over this period.  If we look at the annual returns of our strategy it would have also made money ever year with a low of $3.75 in 2014 and a high of $55.28 in 2015.  Still so far so good.  However, over the past 12 months the strategy made $81.14 and it made $28.24 in February, $14.18 in December, and $14.66 in September.  Those are the best, third best, and fourth best months for the strategy over 5 years, and they all happened within the last 12 months.  On the one hand this tells me that the strategy will do its best in a troubled market.  One the other hand I am worried about whether returns like this can persist.

Backward looking due diligence would place a lot of money into this strategy expecting these recent returns to persist.  In fact our optimization program wants to allocate 50% or more to this model.  Forward looking due diligence is much more cautious.  Yes the strategy has done exceptionally lately, and yes we are likely to stay in a market environment that is conducive to this strategy.  However, the strategy has done so well that the returns actually border on ridiculous, they could persist but they could also revert back to the mean.  Looking at the monthly returns the strategy is up 6 months in a row (March is currently down).  It has only done that once before.  This could be the best model we have ever developed but we have decided to limit exposure to 12.5% until we have a bad month or any type of drawdown. 

Monday, February 29, 2016

Using Intra-Day Models to Improve Tactical Asset Allocation

Just about any form of tactical asset allocation (TAA) will work extremely well in a straight up market and a straight down market.  However, many methodologies will struggle in a choppy market that either has no real trend or that moves so quickly that a TAA strategy just doesn't have time to adjust.  In the past I have written about a number of different ways to improve the way TAA strategies navigate choppy markets, this post will talk about adding intra day models. 

The main reason that TAA works so well is that markets are not random.  For the random walk theory to be valid the day to day movements in the stock market would have to be like a coin flip, where what the market does today has no bearing on what it will do tomorrow.  Markets don't work that way.  They move back and forth between trend following environments, where an increase today is likely to be followed by an increase tomorrow, or mean reverting environments, where an increase today is likely to be followed by an increase tomorrow.  However, in a choppy market the day to day movements do start to become more random in nature and each day becomes less motivated by what happened previously.  At the same time choppy markets tend to be more volatile and the spread between the open price of the market and the close tends to widen out. 

Just like markets tend to trend over longer term time frames, they also tend to trend during the day.  Ghao, Han, Li, and Zhou wrote an interesting paper in 2015 showing that the first half an hour return in the market tend to predict that last half an hour return.

This means that a momentum model can be constructed for intra day trading just like a momentum model can be constructed for longer time periods.  This offers a number of important advantages:

1. In a choppy market there is no real momentum over longer time periods but this should not impact momentum intra day.

2. In a choppy market the risk of holding positions overnight increases, intra day models close out all positions at the end of the day and start fresh the next day.

3. In a choppy market most TAA models would be out of stocks entirely and would not be able to participate in gains on up days.  Intra day models can participate in up days.

Intra day models can substantially improve TAA strategies by allowing them to do better in choppy markets and participate in intra day gains when  they normally would not be positioned in stocks.

Thursday, February 4, 2016

Why We Use Counter Trend Models

Counter trend models seek to buy into market weakness and sell into market strength.  They expect that markets overreact and will be mean reverting in nature.  When the market rallies they expect that the market will go to far and that some of that rally will eventually be retraced.  When markets decline they expect that market will overreact and some of the decline will eventually be retraced.   Because these models go counter to the trend I sometimes get questions from clients who wonder why we are buying when the market is going down and why we are selling when the market is going up. 

Counter trend models shouldn't be looked at in a vacuum, they are part of a diversified tactical portfolio.  Imagine a world where traditional asset allocation actually worked like it was supposed to and you had a diversified portfolio of all different kinds of stocks and bonds.  Lets assume you also had an allocation to an alternative asset class like managed futures.  In 2008 your stocks would have declined, your bonds probably would have held steady, and your managed futures would have gone up a lot.  You may not have understood why managed futures went up, typically these strategies are a black box, but you wouldn't have questioned it.  Then in 2009 your stocks would have gone up and your managed futures might have gone down.  Now you would start to question why you have an allocation to managed futures, conveniently forgetting that they saved your butt in 2008.  Of course this isn't the right way to think, you can't take one asset class out of a diversified portfolio and look at it under a microscope, you need to look at it as part of an overall portfolio and as a diversifier. 

So why do people sometimes have trouble wrapping their head around a counter trend methodology?  I believe that in our minds we are all trend followers, we believe the most recent past will equal the future.  So if the market is up big one day we think it will continue to go up, and if it is down big one day we think it will continue to go down.  We then have trouble understanding why you would sell into a rally and buy into a decline.  However, the data supports the fact that markets really are mean reverting.  CSS Analytics did an interesting study on the frequency of daily runs by decade:

They basically looked at each decade from 1950 to 2009 to see how long market runs were.  What they found was that in the 50's one day market runs, meaning the market went up or down and then reversed the next day, happened only 40% of the time.  Meaning that if the market went up or down today it had a 60% chance that the next day would be in the same direction.  Fast forward to the 2000's and one day market runs happened 53% of the time, meaning if the market went up or down today you have a 53% chance the next day will reverse. 

I found similar study on the woodshedder blog.  They tested a daily follow through strategy vs. a daily mean reversion strategy.  The daily follow through strategy would buy when the market was up and sell short when the market was down.  The daily mean reversion strategy would do the opposite.  what they found was the daily follow through strategy was only profitable 34% of the time and would have lost money.  The daily mean reversion strategy was profitable 64% of the time and would have made money.  The results are below:

So the disconnect is simple, in our minds we are trend followers and in reality markets are mean reverting.  When counter trend methodologies are doing well there is no problem but when we hit a period where counter trend methodologies struggle then we get the disconnect. 

In a tactical portfolio counter trend methodologies are a powerful diversifier to trend following methodologies.  They tend to do best in market periods when trend following methodologies do their worst and they can profit in bear markets without having to go short.  Where they struggle is in market corrections where weakness continues for a long period without enough strength to sell into.  There are a number of things you can do to minimize the impact of this in the overall portfolio..