Alternative Links: Post Freak Out

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Wall Street slump highlights liquidity crunch in U.S. options market – (Reuters)

Commodity Traders Feel Unusual Pain of a Market Rout – (Wall Street Journal)

How did Managed Futures do while the Dow was Down 1000 – (Attain Alternatives Blog)

3 Effective Ways to Hedge Portfolio Risk – (Equities)

‘Alternative’ Mutual Funds Providing Limited Protection — (Wall Street Journal)

One Millennial’s Letter To CNBC – (Zero Hedge)

Death Cross:

The Death Cross with Michael Covel on Trend Following Radio – (Covel)

The Dangers of the Death Cross Indicator – (Attain Alternatives Blog)

Industry News:

Catalyst Converts Auctos Managed Futures Hedge Fund Into Mutual Fund – (FIN Alternatives)

Todays Moves Across Different Markets

Volatility is in the air. China is in freefall, crude oil is in the 30’s, the euro is up 2% on the day, and the U.S. markets can’t seem to shake the volatility. The chart below does a pretty good job of showing the markets moves in equities, both internationally and domestically.

Stocks Plunge(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: Bloomberg

These are today’s moves:

Money Values:

$182 Billion – The amount the worlds 400 richest have lost from moves in the markets according to Bloomberg

$17,951 – The dollar amount in today’s range in the DAX

$6,687.5 – the dollar amount in the Emini-S&P range Today (113.75* $50 per point)

Percentage Moves:

35.50% — Move up in the VIX Today

5% — The percentage that triggers a limit down move in the Emini S&P before or after day trading. It happened early this morning.

-3.36% — WTI Crude Oil move today

-8.5% —  The down move in the Shanghai Composite Index

-10% — Decline in the CSI 300 Index

 

P.S. – We in the Alternatives space welcome the volatility in the market.

The Dangers of The Death Cross Indicator

Apparently, the major financial media outlets decided they wanted to pretend to care about market indicators this month. We’re not talking Bollinger Bands or a Fibonacci Retracement or a Sharpe Ratio, but the most ominous market indicator out there, The Death Cross. It’s the market indicator that strikes fear into those who just heard that such an indicator exists.

It just so happens that the Dow Jones Index crossed this fear striking indicator this month for the first time since 2011.

Death Cross Bloomberg(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: Bloomberg

Not to worry, stock market bulls – Guru Barry Ritholtz was hot on the job dispelling the idea that this is any reason to fear a market correction or downturn.

“Myths that become Wall Street rules of thumb have existed for as long as there have been trading desks. They are legion, they pop up regularly and most of the time they are terribly wrong. Woe to the unwary trader who relies on the urban legends to inform an outlook.”

What is the Death Cross?

Technically, it is when the average closing price of the past 50 days “crosses” below the average closing price of the past 200 days. When plotting these averages on a chart, as above, you get ‘moving averages’, which tick up and down each day when a new closing price is added to the average, and the price 51 or 201 days ago dropped from the average. The 50 day moving average moving below the 200 day moving average tells us the current environment is weaker than it has been, perhaps signaling a market top. The Golden Cross, conversely, is when the opposite happens, with the 50 day moving average crossing above the 200 day average.

Is the Death Cross a Premonition of Dark days Ahead?

Is this the moment we’ll all look back on as the time this already long in the tooth bull market ended?  Is the Death Cross as deadly as its name suggests?  According to Bespoke Investment Group, via Ritholtz, it turns out that this market idiom isn’t all that accurate of an indicator:

“Looking at the past 100 years, they wrote that “the index has tended to bounce back more often than not.” Shorter term (one to three months), however, these crosses have been followed by modest declines in the index. 

How modest? The average decline is 0.17 percent during the next month and 1.52 percent the next three months. By comparison, Bespoke notes, during the past 100 years the Dow averages a 0.62 percent gain during all one-month periods and a 1.82 percent rise during all three-month periods.” 

So it’s useless?

As a single indicator to dictate your entire asset allocation strategy, yes, it’s useless. As a tool to gauge market strength and inform your stock market exposure, it may have some value. But its real value is likely as a systematic trigger to signal the beginning of a trend, on top of which you layer risk control, position sizing, target returns, and all the rest.

How Trend Followers Use Market Indicators like the Death Cross:

Using different aspects of a market’s price relative to one another is one way to determine the start of a trend. These so called relative price models are less concerned with if a market has broken out of a range and more concerned with whether recent prices are stronger or weaker than past prices. A Simple Moving Average Cross Over method (like the Death and Golden Crosses) is the classic example of this, and it entails buying or selling when two moving averages of differing time periods (such as the 20-day and 100-day moving average, or 50/100, or 50/200) cross over one another. The shorter term moving average is used as the trigger, signaling a buy when it crosses above the longer term average, and a sell when crossing back below the average.  On top of this buy and sell signal, a systematic trader will have a pre-determined percent of equity to risk on the trade, which will equate to an exit point designed to not risk more than that amount.

There’s Death Crosses (and Golden Crosses) weekly…

The thing the press ignores about the Death Cross is that you can apply mathematics to any market, and there are 100s of tradeable markets around the globe, meaning there are Death Crosses, and their opposite, likely any day of the week if looking across markets as varied as Cocoa, Japanese Bonds, Swiss Francs, and Crude Oil.  Ritholtz sort of points this out, saying that using the Dow Jones as the overall market gauge can be dangerous as it isn’t a true presentation of the entire market; and we’ll add that it definitely isn’t a true presentation of all markets.

As proof of concept, we can see that more than half of the sectors in the S&P 500 currently have their 50 day MAs below the 200 day ones, showing there’s more than one way to find a Death Cross out there.

Death Cross S&P500(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: AMP Capital

It’s not where you get in, it’s where you get out:

Which brings us to this chart showing all of the time (shaded blue) the S&P has been in a ‘death cross’, with the 50 day MA below the 200 day MA. Looks to us like about 35% of that chart is shaded blue, if not more. But more telling is where the price is when the blue changes back to white. You can see in periods like 1981 that the Death Cross was a good signal for calling a top (despite failing to call such a top in ’78 and ‘79), but that prices had come all the way back, and even above the prior level, before there was a Golden Cross telling you the trend was over…

That problem, more than anything else, is what makes the Death Cross “terribly wrong” in Ritholtz’s words. The Death Cross is ok at showing you when prices will turn lower, but give absolutely no information as to whether that turn lower will last 1 month or 4 years. It’s useless as a signal without overlaying risk control, position sizing, and a method (different than the Golden Cross) for getting out.

Death Cross S&P 500 all time(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: AMP Capital

So, don’t go mortgaging your house to put on the mother of all short trades on this most recent Death Cross.  But beware tossing it out with the bathwater as well. It has real value to systematic traders, when put to use across multiple markets and overlay other indicators and money management techniques on top of it.   In the end, if you have stock exposure, you should probably, as Ritholtz suggests, just let stocks do what they’ll do, and not jump at reasons like this to lighten up. If you’re worried about the downside, the better approach is to instead look for non-correlated diversification in your portfolio, for when the Death Cross does become the next crisis.

Playing Discretionary Global Macro Trader For a Day

Since this down move started, the first question we get when talking to investors is: “When is crude going to find a bottom in the market?” For that, we’ll refer you to “How to Play a Bounce in Crude Oil (Hint: Not $USO).” Let’s face it, if you’re asking that question, then you want to play global macro discretionary trader for a day. Ignoring the metrics, the Bollinger Bands, the Average True Ranges — what are events telling us? Let’s pretend we’re a discretionary trader…

Before we know where we’re going, we need to know where we’ve been:

We’ll be the first to tell you past performance is not necessarily indicative of future results, but how much has crude moved lower relative to other big down moves? We haven’t seen crude oil below $40 since 2009. But it’s not just the fact that it’s near $40, it’s that it’s in the top 5 down moves of all time.

Worst Crude Declines in History:’85-’86: -63%’90-’91: -51%’96-’98: -53%’08-’09: -68%’14-Today: -59%

— Charlie Bilello, CMT (@MktOutperform) Aug. 12 at 10:26 AM

 

What’s been the impact of the drop?

If you have stock in Exxon or Chevron, things don’t look too optimistic, but for the average consumer, you actually have more spending power than you had last year without really knowing it. Since the oil’s drop, America’s 10 largest oil companies have lost a combined $200 billion in market cap, the Texas oil industry lost 8,300 jobs, and a handful of well publicized “commodity funds” have stopped trading or seen big losses (Andy Hall, Armajaro, etc). On the flip side, the energy department predicts this sort of drop will give U.S. consumers a combined $60 billion more spending power.

How does supply and demand work?

Well, given that our world increasingly runs on energy (from driving to manufacturing to charging iPhones) , and crude oil is responsible for at least 1/3rd of all energy used around the world, understanding the demand is rather intuitive. But OPEC, Shale, Brent, WTI, and the rest confuse the supply side somewhat. CNN Money provides a good explanation of how the global economic supply and demand chain works with crude oil in this video.

What’s with the recent down move?

Nobody knows for sure – the easiest answer is that investors and consumers want to pay less for it today than they did a few weeks ago. More complex answers involve China, the Saudis, improvements in technology, and all the rest. Here are some of the stats and fundamentals we have to digest as a discretionary guy.

U.S. Dollar Strength

Remember that commodities like Gold, Corn, Cotton,  and Oil are all priced in US Dollars – so all else being equal – a rising US Dollar means a falling commodity priced in US Dollars.  That made perfect sense last year as we saw the US Dollar up and Oil down. It’s played out a little less so in 2015, with the USD having mainly been range bound.

USD(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: Finviz

OPEC 3-year-highs Production

OPEC isn’t slowing down production, despite the plunge in price (or maybe they’re doing so on purpose to curse the Shale guys as some conspiracy theorist would have us believe). Just this week, they reported OPEC is at three year production highs. Here’s a table of the OPEC countries and their oil production month to month, via Bloomberg.

OPEC oil productions

China Economic Slow Down

China is certainly dealing with a slowing economy with their markets tumbling, China’s central bank devaluing the Yuan, and China cutting their import of crude oil by 11% since last year. When one of the largest importers of oil cuts their import supply by 11% from a year prior, that’s something to pay attention to.

A Global Take

Speaking of which…oil plays a big role with global economics, not only because countries need it for energy, but also because its people do as well. Here’s a stellar interactive map looking at what percentage of GDP is reliant on crude oil imports or exports, via the Economist.

The Economist Map Crude OilChart Courtesy: The Economist 

As a case study, the crude oil drop has really hit Ecuador’s economy hard, and that’s just one of the many countries whose economic stability is tied to the market.

Where will it go from here?

Will OPEC continue to increase oil production, price be damned? Will more oil rigs come online in the U.S. in anticipation of increased US economic activity? Will the lifting of Iranian sanctions increase production even more? On the flip side, if China cuts imports more, how low could oil go?

The real question for those looking to dig deep into the supply and demand of crude oil is: “What is the lowest it can go?” After all, it can’t go to zero, there will be some economic use for it, thereby giving it a value. But let’s be real, very few investors have the time to research the most recent happenings in the crude market, and by the time it’s being published online, the market has already reacted.  And that’s just the energy market stuff.  Don’t forget how ingrained with the US and world economy Crude is, meaning you’ll have to play world economist as well.

For our money, we’d much rather take emotions (and the hours and hours of work) out of it and rely on professionals approaching the market in a disciplined and systematic way; whether they are the trend following type, which won’t look to play a bounce until and unless the market breaks above recent highs and/or moves above moving averages, or professional commodity traders relying on fundamental data, but doing so in a systematic way where only so much is risked in case the market doesn’t react in the way they expect from the fundamentals.

 

 

This Easy Table will Help you Understand Correlation

The reputation around the alternative space is that Managed Futures is an asset class you need for diversification when the stock market goes into crisis. After all, it was one of the only investment strategies out there that not only showed a positive return, but showed double digit returns (Newedge CTA Index) during the 2007/2008 financial crisis.

But that type of thinking about diversification leads to a dangerous mindset, where investors see Managed Futures as negatively correlated to US stocks (going up while stocks go down, and down while stocks go up). We don’t have a problem with the first part of that, managed futures going up while stocks go down… but the other part isn’t always true. Managed Futures aren’t always down when stock go up.

Statistically – this is because they are NON-correlated versus negative correlated. What’s that mean?  It means that managed futures goes up and down independently of the stock market, at times doing the same thing, at times doing the opposite – to average out as doing something different, and tending to do the exact opposite when there’s a violent or prolonged move down, because that tends to cause a sell off across various markets from Crude Oil to Aussie Dollars.

So, if investors are aware of the managed futures profile during down markets – how familiar are they with the profile during up markets (beyond the small sample size that is the past 4 years), and moderately up markets, and sideways markets?  In our recently updated, “Managed Futures: Performance Profile,” we broke down stock market performance based on 12 month rolling rates of return of the S&P 500 going from 1994-2014, and then created different “buckets” of performance representing seven different market environments – ranging from the very good (rolling 12 month returns of over 30%) to the very bad (rolling 12 month returns of -25% or lower). From there, we simply looked at the rolling 12 month rates of return for managed futures on those dates which fell into each “bucket,” and averaged across all such dates. And because we’re overachievers, we analyzed world stocks, bond, and hedge fund performance in the same manner.

Stock_market_cyclesDisclaimer: Past performance is not necessarily indicative of future results)
Data Span = 1994-2014

Our takeaway from the Whitepaper:

There are a few important takeaways here. For starters, the other so called diversifiers out there-hedge funds and world stocks- aren’t exactly the diversifiers you think. World Stocks, on average, lost more than the S&P 500 during down periods, and, in most instances, underperformed during the good times. Hedge funds posted positive returns on average during the down periods, but when the down periods were really down, the numbers weren’t exactly impressive. For those looking to diversify based on market cycle performance, these may not be the magic bullets you were hoping for.

Managed futures, on the other hand, on average, posted positive returns in each of those stock market cycles- the only asset class outside of bonds to do so. For those into such cycle period performance, the takeaway equation should be:

Managed Futures = Good when stocks are bad + OK when stocks are good.

To learn more about Managed Futures performance, its track record with consistency, and our rankings, download our “Managed Futures Performance Profile.”