Sell Everything and Buy Stocks Part 2

Unlike the thousands upon thousands of potential investors whom forced themselves to click on the “Scary Parallel” chart overlaying the 1929 & current Dow Jones Industrial Average, the concept seems like fear mucking propaganda produced to push people out of the market. Reformed Broker said it best last week with a post titled “The Chart that won’t Die,” explaining why such a chart is illogical and flawed.

What we won’t ignore is the stock markets unprecedented stretch to all time highs this week. But while everyone else is evaluating the valuations of the stock market itself, we’re looking at things a bit differently – and analyzing how far the thing needing diversification from (stocks) has out run the diversifier (alternatives)…  We’re interested in analyzing how the S&P 500 is performing relative to managed futures.

Now, this is somewhat of a strange comparison – as managed futures as a whole is non-correlated to the S&P, meaning we shouldn’t expect managed futures to be running up to new highs right alongside S&P; but how far the non crisis period investment runs ahead of the crisis period investment is a bit telling in our opinion – especially when looked at over the past 20 years where three distinct cycles appear.

Stocks and Managed Futures(Disclaimer: Past performance is not necessarily indicative of future results.
The graph above depicts the total return of each asset class since 1993, with the listed ‘amounts’ the difference between such total returns as of the dates listed.)

We’re well into the third cycle of the past 20 years now – and the amount of over-performance of the S&P 500 over managed futures has set a new record, surpassing the old record back in August 2000, to stand at 281% (that’s the difference between the total returns since January 1993, with stocks currently standing at +449% and managed futures at +167%).

The million dollar question is whether this outperformance will last, or whether we’ll see stocks come down to managed futures and managed futures come up to stocks as they did in 2001/2002 and 2007/2008 {past performance is not necessarily indicative of future results}.  We can see that stocks overshot the downside a bit, actually falling below managed futures total return a short 5 years ago, and maybe that means they’ll overshoot on the top side as well.

We half-jokingly said to sell everything else and buy stocks in a newsletter back in late 2012 (and we actually should have – with stocks up 46.7% since then), and this move to new all time highs (again) feels a lot like that period where things are getting a bit stretched and a reversion to the mean is overdue. The cool thing is – that doesn’t necessarily mean a sell off for stocks (although that is definitely on the table as we saw at the beginning of February); a contraction in the outperformance of stocks over managed futures could just as easily be managed futures going up more than stocks for a while, as it could be managed futures going up while stocks go down as has happened in the past crisis periods.

We would be remiss if we didn’t mention the total return comparison above ignores risk… A switch to an ‘underwater equity curve’ which shows the amount of loss each asset class experiences before going back into positive territory; highlights how that big outperformance comes with much, much higher risk in terms of the max amount of pain investors must endure.

Underwater Equity Curve(Disclaimer: Past performance is not necessarily indicative of future results)

Why you Should be Afraid of the V-Shaped Reversal

If you’ve ever wondered what people are talking about when they talk about a V-shaped recovery to a recession, or a V-shaped rally in markets… just take a peek at the price action in stock indices, Crude Oil, Wheat, and to a lesser extent New Zealand and Aussie Dollars. 

SP RussellCrude and WheatNZD AUD
(Disclaimer: Past performance is not necessarily indicative of future results)
All Charts Courtesy: Finviz.com

These types of sharp reversals are kryptonite to your run of the mill systematic trading strategy which uses price momentum such as the big down moves on the left side of the “V” in all of these charts to get into new trades. From there – the trade is simple. If prices keep going down – the trade is likely to be a winner. If there is a reversal, it is likely to be a loser. But here’s some additional detail to consider – if it is a sharp reversal, the trade is likely to be a bigger than usual loser.

One of the long standing “knocks” on systematic trend following strategies is that they often give back open trade profits. But that complaint is usually framed in terms of a profitable trade, something like “you made 10% as the market had an outlier move, then ended up only making 5% as the market slowly retraced and the program waited to get out until the trend as confirmed over”.

The ‘V-shaped’ reversal brings what we call “full stop outs” into play, because of the speed at which the reversion to the mean happened. A typical systematic managed futures program may risk around 0.75% of the account equity on any one trade, yet few trades actually end up losing that much. This is because a typical trend following trade is comprised of both the risk from the entry price and the risk from the market price, meaning most models only need a small amount of time in the desired direction for the moving average of prices to come down/up, thereby reducing the amount of loss (from the entry point).

Here’s a graphical look at the risk over time (as measured from the entry price) for a fictitious trade using a basic trend following model. You can see that the greatest risk to a typical trend following type trade (the bulk of managed futures trades) is right at the outset, where the position is at risk of a sharp reversal and what we call a “full stop out”.

Risk from Entry Price

PS – It’s hard to talk about “V” in our office without the tech guys reminiscing about what they call one of the greatest sci-fi miniseries ever.

PPS – We prefer this shape in coffee much better:

Coffee
(Disclaimer: Past performance is not necessarily indicative of future results)
All Charts Courtesy: Finviz.com

A Different Kind of History Lesson (the VIX)

Happy Martin Luther King Jr. day to you all. It’s a great day to remember one of our nation’s heroes, but for many in the alternative investment space – this three day “market” weekend (stock and bond markets are closed today) brings back memories of a nasty little volatility spike back in 2008. Now, we all think back on 2008 and the huge volatility surrounding the financial crisis and Lehman bankruptcy and what not that fall (Aug. through Nov.)… but the first big warning shot across the bow was actually on MLK weekend (Jan 20th, 2008). The calls and emails started coming in on Sunday night – as the US stock index futures started opening up 4% to 5% lower based on Asian markets having sold off around 5%. A little trip in  the wayback machine brings us this from Barry Ritholtz’s early blogging efforts:

Holy Snikes! Dow Jones Industrial Average futures contract are off 520 points at 11,586; Nasdaq futures were at 1773.25, down 76.25. Standard & Poor’s 500 futures recently were at 1265, down 60.3. Let me hasten to remind you that this is “contained.” Imagine how much worse it would be like if it were not.

It was a move completely out of left field, even though the VIX had been moving up steadily since 2007 and some recession warnings had been starting to surface. Hardest hit were the option selling managers – who take in the insurance premiums against just this sort of thing happening – then are forced to pay out when it does happen. One rather painful example was Ascendant Asset Advisor’s Strategic 1 options program, which up until that fateful night could seemingly do no wrong (reminding us of the famed option turkey).

AscendantSource: Ascendant Options (Disclaimer: Past performance is not necessarily indicative of future results) So here we are 6 years later (has it really been 6 years!! wow, time flies), and the complacency in the market is starting to look a lot like it did back then – with option selling managers again leading the top performing lists and seemingly unable to do any wrong. Will this down trend in volatility, and particularly the VIX – continue? Or are we likely to start getting texts and emails and Ritholtz “look out below” warnings one Sunday night soon.  If you’re a betting man or woman – well there’s an investment for you to place just that bet on whether a spike is coming – they are option selling managers, and they’ve been right a lot more than they’ve been wrong over the past two years… but can it continue. Stay tuned…

Vix 2007-Present(Disclaimer: Past performance is not necessarily indicative of future results) Source: Yahoo Finance For those of you not technically in the alternatives world via managed accounts, but instead doing more staid investments (heavy sarcasm) in things like the inverse volatility ETN – XIV,  your equity curve is starting to look a whole lot like the fattened up turkey before his fateful day. Although – maybe it will add another 337% over the next two years, and the two after that, and so on. It only takes 10 years at that rate to turn $10,000 into $16 million – or $1 million into $16 Billion.  Of course – the market could see some volatility like it did six years ago, or even like it did in 2011 – where your $10k could be worth $1,600, or even $160.

XIV ETN(Disclaimer: Past performance is not necessarily indicative of future results) Source: Yahoo Finance

It’s Final: 2013 Asset Class Scoreboard

Not that anyone didn’t already know – but U.S. Stocks did really, really well last year, leading the race for top asset class basically wire to wire on the way to +30% returns for the S&P 500 to lead our 2013 Asset Class Scoreboard… read ‘em and weep below:

Revised 2013 Asset Class Scoreboard(Disclaimer: Past performance is not necessarily indicative of future results)

Revised Chart Asset Class Scoreboard(Disclaimer: past performance is not necessarily indicative of future results.)
Source: All ETF performance data from Morningstar.com
Sources: Managed Futures = Newedge CTA Index, Cash = 13 week T-Bill rate,
Bonds = Vanguard Total Bond Market ETF (BND), Hedge Funds= DJCS Broad Hedge Fund Index;
Commodities = iShares GSCI ETF (GSG); Real Estate = iShares DJ Real Estate ETF (IYR);
World Stocks = iShares MSCI ACWI ex US Index Fund ETF (ACWX); US Stocks =US Stocks = SPDR S&P 500 ETF (SPY)

Managed Futures secured its spot in 5th place, holding its head above the breakeven point, while Bonds and Commodities were all lower on the year (note, we use the iShares Real Estate ETF for that asset class, which tracks the stock prices of real estate companies, which was down – while average US home prices were showing up according to the Associated Press).  Also, how often do you see stocks and bonds about 34% apart?!

As for managed futures – sneaking above the breakeven mark was a moral victory – and not bad when held alongside other diversifiers such as bonds and commodities; but they need to shine in 2014 (like more than 10% shine…) to get some respect back.  We’ll be looking at just what conditions are needed in our coming newsletter – 2014 Managed Futures Outlook – so make sure to sign up to receive our newsletter if you haven’t already.

Chart of the Week: Stop being Average

We couldn’t help but notice something significant missing from Bob Doll’s chart which is making the rounds. No, not that Bob Dole – the one from Nuveen Investments. We stumbled across the below chart that’s up on Business Insider and the Reformed Broker Blog to name a few, and it looks at the 20 Year annualized returns by asset classes dating from 1992-2011 as well as what the “average investor” has made. Ignore for a second that this data is 2 years stale… it has a bigger problem in our view – managed futures wasn’t included.

Average Investor Returns(Disclaimer: Past performance is not necessarily indicative of future results)

Where does the other alternative investment rank? A few clicks in excel and voila – the adjusted chart:

20 Annualized ReturnsSource: Barclayhedge’s BTOP 50 Index
(Disclaimer: Past performance is not necessarily indicative of future results)

Now – the point of this chart (and likely why it doesn’t matter that it’s two years old) is not to show how well REITs did, or how weird it is that REIT’s did that much better than the median home price – but rather to show the quite disturbing plight of the “average investor”, who despite the best intentions ranks at the very bottom of this list. We could likely recreate this list with the average hedge fund investor versus the various hedge fund category returns – the average managed futures investors versus the various managed futures strategy types… and so on – and get the same result.

Why? Why does the average investor end up doing so poorly? Their emotions – and specifically the emotions of fear, greed, and utter panic, are the likely reasons behind this discrepancy. People like going with a winner, and our innate fight or flee instinct tells us to get rid of or avoid losers. But these instincts can be an investor’s worst enemy, when it is more often than not the better choice to invest today in what didn’t work yesterday, and stop (or lower) your investment today in what did work yesterday.

It doesn’t make any sense to our hardwired brains – and perhaps the reason there is such a thing as market cycles and reversions to the mean is exactly because we are all wired in this way.  So next time you’re looking at the new fund which has been up for three straight years with low drawdowns and high returns, or the next time you’re ready to ditch the well thought out, well executed investment thesis which hasn’t been performing of late (ah hmm…managed futures), take a look at the chart above and ask yourself whether the in at the top, out at the bottom investment method is the reason the average investor underperforms the very things they are investing in.

Mark Twain Warns about Investing in Stocks in January

Ok, we may have taken a little bit (a substantial amount) of liberty with that headline, but the statement isn’t completely false. Here’s the rest of what the great American Writer supposedly had to say.

“October. This is one of the peculiarly dangerous months to speculate in stocks in. The others are July, January, September, April, November, May, March, June, December, August, and February.” – Mark Twain

It’s one heck of a quote (we meant to write about it back in October but forgot), and got us to thinking about all the rest of those silly market sayings such as ‘Sell in May and Go Away’, ‘the January Effect’, and the currently in vogue ‘Santa Claus Rally’, per Forbes.

“Historically, December is a bullish month. In the last 100 years the Dow Jones Industrial Average has closed the month of December higher than its level at the start of the month on 65% of all occasions.  In the past twenty years the S&P 500 has done so 17 times…[tending to move] upward… late in the month. This buying spurt is known as the Santa Claus rally. Despite the name this market phenomenon is no myth…”

However, not all market journalists and analysts believe in the Santa Claus Rally like some of us, particularly Market Watch writer Mark Hulbert.

“Consider the stock market’s gain from Dec. 1 through its highest close during the month. On average, the Dow Jones Industrial AverageDJIA -0.06%   is 3.1% higher at that point than where it stood at the beginning of the month, according to a Hulbert Financial Digest study of the Dow since its creation in 1896.”

In fact, though, a 3.1% rally is below average. It turns out that eight other months — from March to July to October — have stronger rallies than December when their performance is measured the same way. The average Dow rally in all non-December months is 3.4%. So the market’s rally potential prior to Christmas is below average.”

There seems to be some debate however as to when exactly Santa Clause comes to Town. For you true believers out there, Jeff Hirsch editor in chief of Stock Trader’s Almanac says, the Santa Claus Rally only comes at the days following Christmas.

“As Hirsch conveys, since 1950, the S&P 500 has averaged 1.5% gains for that 7-day window. “Not a big gain, but a nice little positive,” is how he describes it. “There’s this general buying bias by the pros at the end of the year after tax-loss selling.”

What about after Santa’s sleigh is back in the barn (or does he store it in a hanger?), and the so called January Effect begins? A Seeking Alpha article does a sufficient job explaining our next trading myth.

“The empirical work of Jay R. Ritter finds th
at the ratio of stock purchases to sales by individual investors displays a seasonal pattern, with individuals having a below-normal buy/sell ratio in late December and above-normal ration in early January. Small stocks are typically sold by individual investors in December -often to realize capital losses- and then bought back in January. Jay R. Ritter documented that small-cap securities often have had higher rates of return than large-cap stocks in the January months in the 20th Century. As a result, theoretically, buying and selling behavior of individual investors at the turn of the year creates a great arbitrage opportunity to profit.”

So has this been the case the past 20 years or so? Seeking Alpha “Plays the January Effect,” and puts the numbers to the test.

“So I dissect the performance of the small-cap Russell 2000 Index (RUT) versus the large-cap Russell 1000 Index (RUI) through all Januaries between 1993 and 2000, to see that most of the “January Effect” actually occurred within the first month of the year.”

January Effect(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: Seeking Alpha

Turns out of the past 20 years, only 10 out of 21 Januarys (47%) saw the January Effect come to fruition – just enough to question whether this theory is in fact a theory, or just a trading aphorism that people follow because it sounds cool.  Pair that with questionable accuracy and timing on the ‘Santa Claus Rally’, and these aren’t exactly investments you want as a core philosophy.  We’ll stick to low cost dividend paying index funds and a healthy dose of managed futures diversification, over ‘catchy saying market timing’ –  thank you.

 

YTD Asset Class Scoreboard

Quick… without looking – what asset class has done the best this year out of Managed Futures, Bonds, or Real Estate?  Would you believe managed futures?  We didn’t ourselves til we ran the data (and noted that real estate is a single ETF tracking real estate, not the equity in your actual home). But anyway, for all the negativity surrounding the asset class, it’s holding in there rather well, thank you.

The real story, of course, continues to be U.S. Stocks meteoric rise, posting another up month (their 9th out of 11) to sit at +26% YTD. Wow – maybe we should have listened to our sarcastic newsletter titled “Sell Everything and Buy stocks“ last year.

Asset Class Performance(Disclaimer: Past performance is not necessarily indicative of future results)

Asset Class Chart(Disclaimer: past performance is not necessarily indicative of future results.)
Sources: Managed Futures = Newedge CTA Index, Cash = 13 week T-Bill rate,
Bonds = Vanguard Total Bond Market ETF (BND), Hedge Funds= DJCS Broad Hedge Fund Index;
Commodities = iShares GSCI ETF (GSG); Real Estate = iShares DJ Real Estate ETF (IYR);
World Stocks = iShares MSCI ACWI ex US Index Fund ETF (ACWX); US Stocks = S&P 500