Wednesday, September 14, 2016

How to Make Momentum Investing Work

Momentum investing is the idea of buying stocks that are strong and not buying (or shorting) stocks that are weak.  Like it's almost opposite cousin, value investing (buying stocks that are undervalued and not buying stocks that are overvalued), momentum investing shows extremely strong long term returns, but also goes through long periods of underperformance.  In a new paper "Two Centuries of Price Return Momentum" by Chris Geczy and Mikhail Samonov, the authors look at momentum going back into the 1800's and find significant periods of time when momentum investing is painful. 

If momentum investing works so well over the long term, why doesn't everyone do it?  The answer is what Cliff Asness refers to as time dilation.  An academic can do research on momentum and find strong long term returns and what look like insignificant period of underperformance or bad performance and not be worried at all.  In the real world, even a short period where something is not working can create tremendous pressure to sell out or change course.  So while momentum is an exploitable market anomaly, in the real world one cannot put all their eggs in the momentum basket.

The key to making momentum "work" is to combine a momentum stock strategy with other types of strategies that have different risk/return characteristics.  Some examples might be intermarket analysis, value investing, or even momentum with volatility filters to limit drawdowns.

Momentum investing is a very powerful anomaly that investors should exploit.  However, historically momentum has had a number of periods or underperformance or bad performance, to mitigate this it should be combined with other, non correlated, methodologies. 

Wednesday, August 3, 2016

Does Long Term Mean Reversion Still Work?

I  just read an article in Institutional Investor about the problems that Grantham, Mayo, Van Otterloo & Co (GMO) are having with their long-term mean reversion strategy:

GMOs Mean Reversion Strategy Is Testing In Today's Markets

Mean reversion works by trying to find times when certain markets are overextended to the upside or the downside. A mean reversion strategy would avoid markets that are overextended to the upside and buy markets that are overextended to the downside. They work because markets are constantly forming bubbles that subsequently burst. While this sounds intriguing, there is a problem. Bubbles can go for a long time before they burst so mean reversion strategies can be on the wrong side of things for a while until they ultimately pay off. 

If individual and institutional investors truly had long-term time horizons, then this wouldn't be a problem, but in real life the hardest thing for any investor to do is watch other people make money while they are not. It appears the stock market is in a bubble [PO1] and possibly has been for a while. However, it keeps going up and any corrections are short lived. At some point it will probably crash, but that could be years away. And that’s GMO’s big problem. GMO’s long-term strategies do not align with their clients’ shorter-term realities.

Is there a Better Mean-Reversion Approach?

Markets have always reverted to their mean, but since mean reversion can take a long time, a better approach could be to align the mean-reversion time frame to the investor’s time frame. That approach could create a better investor experience. Investors might talk about how they have a long time horizon, but when markets are moving against them all of that goes out the window. Mean-reversion strategies can be moved to monthly, weekly, daily, even intraday time frames. Instead of trying to only catch the major market turning points (i.e. bull and bear markets), these types of strategies can look for much shorter-term turning points, from intermediate-term corrections all the way down to intraday reversals. Unlike long-term approaches that would rely on valuation, which wouldn't work for shorter-term models, these approaches could use intermarket analysis, cyclic analysis, or traditional overbought/oversold indicators. 

Intermarket Analysis 

Intermarket analysis involves taking two or more markets that are related to each other and looking for divergences. For example, lets assume stocks and Treasuries move inversely and that bond traders tend to be quicker at predicting turning points than stock traders. An intermarket model could then look to buy stocks when they are going down while Treasuries are moving down at the same time. The model would sell stocks when they are moving up and Treasuries are moving up at the same time. 

Cyclic Analysis

Cyclic analysis would take some measure of market cycles and look to buy into short-term weakness and sell into short-term strength.

Traditional Overbought/Oversold Indicators

Traditional indicators like RSI can also help determine short-term overbought/oversold areas. Traditional RSI measures looked at 14 periods, but there has been some good work by Larry Connors and others looking at shorter-term measures.

Markets are mean reverting by their nature, so any well-thought-out mean-reversion strategy can be successful. Longer-term models are problematic, however, as they don't line up well with investors true time frames. Shorter-term models can still capture the longer-term moves while also lining up better with what investors want. At the end of the day it’s about meeting investors’ comfort zones and expectations. Sometimes traditional approaches do not align with these needs. Since central banks are dominating capital markets, this is one of those times.


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..

Thursday, January 28, 2016

Forward Looking Due Diligence

One important skill we try to teach financial advisors is how to do forward looking due diligence on money managers and investment strategies.  Backward looking due diligence looks at what a manager or strategy did in the past and assumes, usually wrongly, that past performance will persist.  It is the path of least resistance as it is easy to just look at a stream of returns.  Forward looking due diligence tries to figure out whether past performance will actually persist into the future. 

Forward looking due diligence involves answering a couple of key questions:

1. How was the past performance achieved?
2. Why will it persist into the future?
3. And, in the case of a money manager, how will you change your strategy when market dynamics change?

As an example, lets say we are going to do due diligence on a large cap growth money manager and it is March 1, 2000.  If we do backwards looking due diligence all we would do is look at past returns and call it a day.  The manager would have had stellar returns from 1995-2000 and we would make the assumption that they would persist.  Of course we would have been horribly wrong as the manager would have tanked from 2000-2002.  Forward looking due diligence would have sniffed this out by answering the key questions:

1. How was the performance achieved?  You don't need to know the intricacies of the manager's strategy or how they pick stocks.  The answer to this question is simple, large cap growth stocks went up like a rocket ship in the late 1990's.  Since this manager owned large cap growth stocks they rode the market up. 

2. Why will this persist into the future?  Here is the problem.  Growth stocks earned about 30%/year for five years.  That's great but long term returns on stocks are closer to 10%.  Since we know markets mean revert it is safe to assume that not only can't the manager return 30% a year, they also need some losses to get back to more normal average returns.

3. If market dynamics change how will this manager's strategy change?  Here is another problem.  If market mean revert it is safe to assume that at some point we would need to see a bear market.  Since this is a buy and hold money manager they ride the market up, and they ride the market down.

Forward looking due diligence would have failed this money manager on two out of the three questions and it wouldn't take any advanced financial knowledge to figure this out.

Now lets say we are looking at a tactical manager who uses a simple strategy of buying the S&P 500 when it is above its 200 day moving average and selling below.  This strategy would have a very strong backtest most likely showing returns equal to buy and hold with less volatility.  The answers to the three questions would be as follows:

1. How was the performance achieved?  It was achieved because over the intermediate term markets trend.  This is based on psychology and the fact that once the smart money has started to buy or sell something it takes the dumb money a long time to join in.

2. Why will this persist?  Again since this is based on psychology the performance will persist, but we have a small problem here.  Since the manager uses only one methodology there will be times when it cycles in and out of favor, and when it cycles out of favor it can cycle way out of favor.  The performance will persist but it might not be ideal.

3. If market dynamics change how will this manager's strategy change?  This is the make or break question here.  Since we know the strategy will cycle in and out of favor and market dynamics could change to the point were it cycles out of favor more than it cycles in, it is very important to know if the manager is willing to improve their strategy if need be.  If the answer is no then it is time to move on.

Most of the biggest investment mistakes are made because investors only use backward looking due diligence to evaluate opportunities.  Forward looking due diligence can avoid many of these mistakes.

Tactical Diversification

In traditional asset allocation the goal is not to find the "best" asset class, it is to find the best combination of asset classes that gives the client the best chance of achieving the desired result.  Each asset class, be it large cap growth, value, small cap, etc, goes through periods where it appears to be the best.  Imagine you were doing due diligence on a large cap growth manager in March 2000 and looking at how they had done over the past five years.  It would be easy to fool yourself into believing you found the Holy Grail.  The same would go for any asset class, that is why you are better off combining asset classes than you are trying to be in just one. 

The same logic works in Tactical Asset Allocation .  There are a number of tactical methodologies (sets of tactical rules) that work over time.  Things like buying the S&P 500 when it is above the 200 day moving average and selling below or using a 2 period RSI to determine overbought and oversold points will have periods where they will do extremely well.  It is also not a rare occurrence to do a backtest on a set of rules and find that it does extremely well over the entire backtest period.  Tactical methodologies be even more misleading than asset classes as they can go through much longer periods where they are doing well than an asset class can.  However, just like there is no one best asset class, there is no one best tactical methodology.  Every methodology will fall on its face at some point.  Instead of expending effort to find the one methodology that does well in every market, the goal should be to have a mix of different methodologies and expend effort finding the combination that produces the desired results.

Wednesday, January 20, 2016

A Shorter Bear Market?

Nobody can predict the markets but it is useful to look at a number of different possible scenarios to make sure you are prepared when/if it happens.  This recent decline in the market has brought about a possible scenario involving an abbreviated bear market.  We have had three bear markets in history that haven't really lasted that long:

1. 1957 3 Months -20.7%
2. 1962 6 Months -28%
3. 1966 8 Months -22.2%

The sharp decline the market has had since December 2 increases the possibility that we are in another short term bear market.  If this is the case then the lower price target on the S&P 500 would be around 1630-1730 (1737 is the February 2014 low which would be the next major support area if we break the October 2014 lows).  If this scenario actually plays out the market could actually reach new highs by year end.  The Fed will have a lot to say about this, they are probably one and done for now until things stabilize, but things get really interesting if they reverse the December rate hike. 

Another possibility if this is a short term bear market is that we don't reach new highs but we bop around between the new lows and old highs.  For anyone who likes turbulence on a plane this scenario would be lots of fun.

There is still the disaster scenario if the oil continues to decline and China implodes.

Tuttle Tactical Management US Core ETF (TUTT) announced as a 2015 awards finalist

We are pleased that TUTT has been announced as a finalist for best new asset allocation ETF in 2015 by  You can read the announcement Here

Friday, January 8, 2016

A Contrarian Investment Strategy for Any Market

The Holy Grail of investment management is to try to create an investment strategy that can generate returns in any market environment.  Markets either move up, down, or sideways.  It is not hard to devise a method to profit in one of those environments, being able to profit in all three is quite difficult.  This post will present a contrarian investment strategy that can do just that because it doesn't depend on the overall direction of the market, instead it focuses on the predictable emotional responses of human beings who trade in the markets.

Traditional Approaches

The traditional investment approaches all have significant flaws:

1. Buy and hold an S&P 500 Index Fund---In this approach you would just buy a fund that tracks the market (S&P 500) and hold onto it forever.  You would ride the market up and you would ride the market down.  The obvious flaw here is the ride the market down part.  You would have some great gains in a bull market and give them all back, and possibly then some, in a bear market.  All along the way this approach would also be very volatile so you would have to endure a wild ride as you move up and down with the market swings.

2. Asset Allocation/Modern Portfolio Theory--In this approach you would hold a diversified portfolio of assets.  You would have large stocks, small stocks, value, growth, international, and some bonds.  This would probably offer an improvement in volatility over holding an index fund and it could do a little better in a bear market. However, investors would still be subject to large losses as assets that may not be perfectly correlated when markets are rising become correlated when they are falling and there is panic selling. 

3. 60/40 Portfolio---In this approach you would have a static allocation to 60% stocks and 40% bonds.  The idea is that the bonds would provide protection against a market decline.  The problem is that the stocks will have much larger moves than the bonds, so in a bear market the bonds may increase in value but not enough to protect against large losses.  Furthermore, in strong bull markets the bonds will reduce returns.

4. Market Timing--A market timer tries to predict what direction the market is going to go in and position accordingly.  While this sounds good in theory, in practice nobody can accurately predict the market.   You might get lucky sometimes but over the long term this is not a winning investment strategy.

5. Traditional Tactical Asset Allocation--This approach seeks to be in harmony with market trends.  When markets go up you are in stocks and when they start to go down you get out of stocks. Unlike the market timer, the tactical investors isn't trying to predict the market they are reacting to it.  This approach is the closest to being able to work in all markets, it can work well when  markets go up and when markets go down, but it will tend to struggle in sideways markets as there is no real trend to hitch onto. 

None of these approaches work because markets are not random or efficient.  They are not random or efficient because human beings are making the trading decisions that move markets.  Human beings have emotions and there is no way to avoid having their emotions influence their trading decisions.  The two strongest emotions that dictate where stocks will go on a day to day basis are fear and greed. 

When the market is rising greed kicks in.   Maybe some good news came out and the market starts to go up.  Investors see this and get optimistic and start to buy and buy some more.  Then greed kicks in and investors move markets up to a level where people start to worry that prices have moved too far too fast.  Investors who bought also want to take their profits as they start to worry that their profits on paper might disappear.  Fear is starting to kick in.  This causes markets to move back down to some sort of equilibrium that balances out buyers and sellers.  The same process works on the downside.  Maybe some bad news comes out and now the market is declining.  Fear is a more powerful emotion than greed and investors start to sell indiscriminately as they are afraid that the markets will crumble and they will lose a lot of money.  Markets decline to a point where bargain hunters come in, greed is now starting to kick back in.  The bargain buying moves the market back up to some sort of equilibrium.

Greed and fear in the market cause the market to reach levels knows as overbought (moved up too far too fast and due for a retracement) and oversold (moved down to far too fast and due for a retracement).  Regardless of the overall longer term direction of the market these cycles play out on a daily basis with the market moving from equilibrium to overbought, back to equilibrium, to oversold, etc. 

Buy Low, Sell High

We have all heard the adage "Buy Low and Sell High".  It makes perfect sense, if you want to make money consistently then buy a security for a low price and sell it for a higher price, but investors don't do it.  Most investors believe that the most recent past equals the future.  When the market is going up they believe it will continue up and when it is going down they believe it will continue down.  This causes them to buy into rallies and sell into downturns, buying high and selling low.  Because of investors emotions causing the market to move between overbought and oversold, this is the exact opposite of what they should be doing.  A contrarian strategy would be to buy when markets are oversold, buying low, and sell when markets are overbought, selling high.

This is easier said then done.  To make this strategy work you need to be buying when most people are selling and when the talking heads in the media are spreading doom and gloom.  Then you need to sell when most people are buying and the media is telling everyone how wonderful things are.  Going against the herd is not easy, but it is profitable.  Study after study shows that the average investor doesn't make money in the market.  If you want to do well then  you can't do what the average investor does, you have to do the opposite of what they do.

There are a couple of steps necessary to make this approach work:

1. It needs to be quantitative---If you try to be a contrarian without a quantitative approach then your emotions will betray you.  You need to create a system and stick to the system.  A well thought out contrarian approach will be profitable most of the time if you stick to it.

2. You need to have multiple ways to measure if a market is overbought or oversold----There is no one measure that can tell you when a market is overbought or oversold.  There are a number of methods that work very well---RSI, cyclical analysis, intermarket analysis, etc---but they don't work all of the time.  Instead of trying to find the one approach that works best, you should blend multiple approaches.

3. While the overall direction of the market doesn't matter for this strategy you still need to treat uptrending markets differently than downtrending markets.  In a bull market greed is the dominant emotion.   From time to time it gets replaced by fear but it will quickly come back.  So in a bull market, buying the dips is almost a license to print money.  In a bear market fear is the dominant emotion.  It sill makes sense to buy the dips but every once in a while you will buy a dip that keeps on dipping longer than usual.  So, while in a bull market you might want to use leverage to boost returns, in a bear market you may want to keep large amounts of cash and/or Treasuries as a hedge and only buy the dips with part of the portfolio.

This contrarian strategy can work well in any  market environment---up, down, or sideways---because it doesn't rely on the long term direction to make money.  Instead, it relies on investors having predictable emotional responses to the daily moves of the market.

Thursday, January 7, 2016

How Tactial Asset Allocation Can Handle Market Corrections

I have been writing a lot lately about the new market environment and its implications for Tactical Asset Allocation.  Now that it looks like we are back in a market correction this article will go into more detail about how to handle these types of moves.

In the past any type of tactical methodology could successfully  navigate a market correction.  Corrections gave plenty of warning before the majority of the decline and before the majority of the recovery.  In this new market environment, corrections give little, if any warning, making navigating them much harder than ever before.  If practioners implement the following steps then market corrections can be an opportunity rather than something to be dreaded:

1. Use multiple tactical methodologies.  No one methodology works well in every  market environment.  Instead of trying to find the one "best" methodology, multiple, un correlated, methodologies should be combined.

2. Use some sort of optimization and/or regime switching approach to be able to move to the methodologies that are particularly suited to the present market environment.

3. The approach should take volatility into account so that you can increase risk when market volatility is decreasing and reduce risk when it is rising.

4. Emphasize counter trend models over trend following and fundamental.  Counter trend models which seek to buy into short term weakness and sell into short term strength can offer better risk adjusted returns than other types of models.  They also typically do this with much less time in the market than other methodologies.

5. Ladder your counter trend methodologies.  During a correction markets can get very oversold and very overbought.  Counter trend methodologies should be laddered just like a bond portfolio might be laddered so that they scale into and out of markets.

6. Use conditional filters.  Looked at over a large period of time it may seem as if the performance of different methodologies is fairly uniform.  However, when time frames are reduced you may find that a model has much better success with long trades when the underlying security is above a certain moving average, or corporate earnings are increasing, etc.  These types of things can be used to filter trades and reduce risk.

7. Use a short side.  You may not be comfortable being net short the market but using models that have the ability to short can offset the risk of models that may be long during a correction.

8. Incorporate extremely short term momentum models.  Over long periods of time, extremely short term momentum models will not work well.  However, they can navigate a correction very well, getting out near the top and back in near the bottom.  If you apply an optimization or regime switching approach you can be allocated to these models when the environment is conducive and out of them when it is not.

9. Eliminate as much of the rebalance date risk you can.  Because corrections are so sharp and come so quickly rebalancing a portfolio on one fixed date could bring a lot of extra risk.  Instead of rebalancing portfolios on one fixed date they can be tranched.  For example, a strategy that rebalances weekly on Mondays could be changed where 20%  of the portfolio is rebalanced on a daily basis. 

Incorporating these steps will help tactical strategies successfully navigate corrections in this new market environment.

Wednesday, January 6, 2016

Laddering Counter Trend Models

Tactical methodologies generally fall into one of three categories---trend following, counter trend following, or fundamentally based.  In a Trend Aggregation approach no one methodology is better than the other, each has markets it works well in and markets it doesn't, and a diversified tactical portfolio should have dynamic exposure to all three.  However, counter trend strategies will generally provide the best risk vs. return and work well in more market environments than the other two.  A counter trend model will use some sort of metric to determine whether a market is oversold (everyone who has sold is done selling and it is at a level that is likely to draw in bargain hunting buyers) or overbought (everyone who has bought is done buying and it is at a level that will entice people to take profits).  The model would buy what is oversold and sell, or sell short, what is overbought.  Basically acting counter to the trend. 

The one "Achilles Heal" that counter trend models can have is around V shaped corrections.  These are sharp selloffs that come with very little, if any warning, following by sharp reversals.  Because counter trend models buy into weakness they can be hurt when that weakness continues for a while.  In a "normal" market, a counter trend model would buy into a short term low and then sell on a bounce.  In a V shaped correction, the short term low can keep going lower, and lower.  Also, in a "normal" market a counter trend model would sell into a short term high and look to buy back in at a lower price.  In the reversal from a V shaped correction a market can move up quite a bit, leaving the counter trend model behind. 

Just like bond investors ladder bonds to protect from interest rate risk, tactical investors can ladder counter trend models to protect from V shaped correction risk. This is done by using models that have different metrics and time frames.  That way, all  models won't go  from bearish to bullish at the same time, they will tend to leg into markets on the downside.  The same concept works on the upside where models will tend to leg out.  A simple example of this could be combining different period RSI counter trend models.  The RSI is a measure of the magnitude of prices changes in a security.  Typically, high RSI readings can indicate a security is overbought and low readings could indicate that it is oversold.  A 2 day RSI model could be combined with a 3 day model and a 4 day model.  The 2 day model would need weakness over 2 days to get into a market and strength over 2 days to get out.  The 3 day model would need weakness over three days, and the 4 day model would need 4 days.  You could also change the levels that the model needed to hit, some models could need to be very oversold to trigger a buy, while others might just need to be moderately oversold.  Finally, some models could use a moving average filter, while others do not.  For example, an RSI model for the S&P 500 could shut off entirely when the S&P is below its 200 day moving average. 

Instead of using one counter trend model that will be either all in or all out, investors will be better served using multiple models that don't use the same time frames and metrics so they can scale in and out of volatile markets.