Can You Time the Market Without Crying?

We’ve all seen pictures like this one from Putnam showing how bad of an idea it is to miss the 10 best days in the stock market

Missing the Best DaysChart Courtesy: Putnam

But we read an interesting post on trying to time trading systems (that’s like timing market timing) that seemed to approach this in a bit more logical way. You see – it doesn’t make much sense to talk about missing the 10, or 20, or 40 best single days in the stock market. Most market timers aren’t trying to avoid a single bad day,  and get back in the next day. Most are looking at things like Price to Earnings ratios and the rest are trying to avoid bad periods… not just bad days. Plus, nobody is that unlucky trying to time the market that they miss just the 10 best days over a few decades. On the flip-side, nobody is that lucky that they would magically miss the worst market days over 10 to 20 years, only to get right back in the next day.

It makes much more sense to us to talk about what missing the best streaks of days looks like. The best 10 and 30 days periods, for instance. That would be a lot more interesting; to see how bad/good you would have been if you picked the exact wrong/right time.

Here’s what we found:

(Note: These figures do not represent actual trading, and were not taken from real experiences)

Missing the Best Trading Days

Missing the Worst Trading Days(Disclaimer: Past performance is not necessarily indicative of future results)
(Note: The figures and charts above are an example and do not represent actual trading)

In our opinion, the better argument for not trying to time would go something like this:

Trying to time the market?

  • If you’re incredibly smart, or lucky, or both – missing the worst 10 day streak would save you 549%
  • If you’re incredibly dumb, unlucky, or both – missing the best 10 day streak would cost you 212%
  • If you’re somewhere in between smart and dumb and have average luck – you’ll likely not miss anything… with missing the average 10 day streak resulting in 4%

We’re not sure if this supports timing or not – but it sure seems a better way to talk about it, rather than the more prevalent narrative about the big danger of missing the best 10 days in the stock market – like they come one right after the other or you’re the unluckiest person on the planet.  The whole thing is kind of silly anyway – as it is backwards looking, and would need to be completely thrown out the window if the next 30 years were the negative image of the past 30 years, with stocks returning –70% over the span. If that happens, then timing would do no good, again – it would be better to not be involved at all…

 

 

Performance of 40 Futures Markets Mid-Year

We’ve officially made it half way through the year, meaning those who did well will likely be mentally doubling their first half success in imagining where their year will end, while those who struggled will act like a weekend golfer making the turn – saying ‘ok, let’s turn it around now… let’s get it done on the back nine’.

Without further ado, the front nine scores across 40 different futures markets courtesy of Finviz:

Futures Performance 2014 Q2(Disclaimer: past performance is not necessarily indicative of future results)
Chart Courtesy: Finviz.com

Some of our thoughts:

• 65% of the markets are positive of the year, down from 75% last quarter.

• Corn and Wheat went from number 4 & 8 on the leader board last quarter, to a negative performance on the year thanks to an ongoing multi-month down trend.

• Coffee and Hogs continue to hold their position as the top commodity performers. However, coffee is down considerably (-19%) from its 2014 highs, while hogs have been hitting new highs.

• Nikkei is the only stock futures index that remains negative of the year

• CHF, CAD, USD, and EUR are almost unchanged on the year

• The S&P 500 & the 30 Year Bond’s YTD performance are almost identical.

 

Why Hedge Funds Don’t Care if They’re Underperforming the S&P

With the S&P 500 showing triple digit returns since the financial crisis, we’ve noticed there have been more and more publications denouncing hedge funds as under performing the S&P 500. We even got in on the trend too, but in a slightly different way than most.

The problem with saying hedge funds are underperforming the S&P 500 is that the grand majority of them aren’t even trying to beat the S&P 500 in returns, for any set period. They are trying to deliver better risk adjusted returns than the stock market, but that doesn’t make for as good of a headline. “Hedge funds post .026 better Sharpe ratio over trailing 36 month period” just doesn’t have that ring to it.

The problem is, as more and more hedge fund like products make it into so-called ‘liquid form’ via a mutual fund or ETF or the like; more and more everyday investors will be able to access them, and more and more websites and other portfolio tools which compare performance to stocks by default will be serving up the S&P 500 as the benchmark for the Alternative Funds performance. It turns out more than a few people are picking up on this apples and orange comparison, with Joe Light from the Wall Street Journal weighing in recently with his article “How Do You Measure the New ‘Alternative’ Funds?

“If a fund intentionally hedges its exposure to stocks, it isn’t really fair to say that the fund did well in 2008 or poorly in 2013, says Jonathan Boersma, head of professional standards and a benchmarking expert at the CFA Institute. The problem is that it wasn’t really designed to beat the S&P 500 during up markets in the first place.”

So what should investors in Alternatives benchmark their investments against? Mr. Light has two key factors to look at before attempting to compare a hedge fund to anything.

“The first step: Figure out what you might have invested in instead. Another yardstick: What does the fund manager say his ultimate goal is?”

Once you know what’s under the hood of your hedge fund, and know the ultimate goal, there are many possibilities for a proper benchmark.

1. Measure against 0 

Most hedge funds market themselves as “absolute return” vehicles, being able to make money in many different economic environments; and in the strictest sense of that phrase – the benchmark to use would be the 0% line. A positive gain. This is the sort of benchmarking a lot of investors do unknowingly, saying if the investment is making money (is up >0), it is doing well, and if not – it’s under performing – no matter what the stock or bond markets are doing.

2. Hedge Fund Indices

What about a hedge fund index?  Yes, there are such things, and while they are plagued with complaints of survivorship, backfill, and other biases – they appear to act quite well as a benchmark for alternative investments in… you guessed it – hedge funds. We prefer the DJCS Hedge Index, which just happens to have multiple sub-indexes covering Emerging Markets, Event Driven, Long/Short Equity, Global Macro, and Managed Future; just to name a few.

3.  Managed Futures Indices

You’ll see that managed futures is one of the listed hedge fund indices, and for those in the space we specialize in – it is more than a fair comparison to measure up your alternative investment in the managed futures space to the various managed futures indices. While they differ month to month and have different compositions, we’ve found the average of them to be quite consistent with the actual gains and losses seen in actual managed futures accounts of our clients. It’s also worth noting that there are sub indices here as well – where you can dive down and compare different styles with the short-term trader index, ag index, and trend following sub-index.

4. Commodity Index

It’s hard to get too far down the alternative investment spectrum without running into commodities – and comparing your alternative investment (especially if it is a commodity heavy managed futures investment or energy fund or the like) to one of the original alternative investments makes a lot of sense.  You can get more granular here as well, with indices on energy, agriculture, and so forth – just be careful you’re not looking at an index of energy companies.

Now, comparing an investment to an index which is most similar to the strategy or you investment seems logical enough, but even then your investment is likely to be much more volatile (both on the upside and downside) than the index due to the index gaining the advantage of a smoothing effect by combining many managers. This makes it important to normalize the performance in some manner, which is where risk adjusted ratios come in:

1. Sharpe Ratio 

The most popular risk adjusted ratio is the Sharpe. The Sharpe Ratio measures return over volatility. But as we’ve discussed, the largest issue of using volatility of returns, and more technically the standard deviation of returns, is that using such a calculation assumes a normal distribution of returns.

2. Sortino Ratio 

Then there’s the Sortino ratio, which measures risk over both the upside and downside volatility.

3. Mar and Calmar Ratios

The Mar and Calmar Ratios measures Compound ROR over Max DD.

4. Sterling Ratio

The Sterling ratio is slightly different, which measures Compound ROR overage the average drawdown, instead of max drawdown.

And just how do hedge funds look against the S&P when considering their normalized behavior – their Sharpe ratios? As joked about earlier – when you plot the rolling 3 year Sharpe ratio of Hedge Funds and the S&P 500, there isn’t the same sexy headline of hedge funds underperforming the S&P 500. They’ve been about the same lately, after being handily ahead for the better part of the 2000′s.

3 Year Rolling Sharpe Ratio(Disclaimer: Past performance is not necessarily indicative of future results)
Data: Hedge Fund = DJCS Hedge Fund Index SPY = S&P 500 ETF via Yahoo Finance

 

So the next time there’s an article claiming Hedge Funds (or other Alternative Investments) as underperforming the S&P 500, realize they are telling you that the Filet tastes meatier than the Salmon. The Salmon is half the calories and half the fat content… if it doesn’t taste as meaty – that’s usually on purpose.

The Russell 2000: The Chicken or the Egg?

All eyes in our office tomorrow will be looking at Russell 2000 futures after shooting right up to down trend line today.  While some have been calling for the S&P and Dow to confirm the down move seen in the Russell, there now exists the very real possibility the Russell will rally to make new highs to match those two, instead of the other way around.

The 1130 level (today’s close), 1140 level (the next resistance on the down trend), and the 1150 level (the mid April bounce highs) will all be key levels to watch in the saga which is small cap stocks…

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

Who will catch up to whom?? Stay tuned….

Sell in May, and Look Managed Futures Way?

It’s hard to believe that tomorrow is the first day of May for us Chicagoans, as we’ve only experienced a glimpse of spring after a brutal, brutal winter. But the stock market doesn’t particularly care whether you’re already enjoying Spring temperatures or not – it’s May 1 for the stock market today whether you’re ready for it or not. Which means it’s high time for one of the catchiest stock market sayings out there:

“Sell in May and go away.”

Financial Blogger Zerohedge dug into this theme a little more with a recent post, highlighting the S&P 500’s average returns by month since 1950, and the data definitely supports the theme, with the May through October returns visibly less than Nov. through April.

Zero Hedge S&P Monthly Returns(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: ZeroHedge

But is it really that easy?  Just sell in May? Does it matter if stocks have been going up leading into May, what about if they’re down? What if we’re in the 2nd year of a presidential cycle?  Luckily, there’s firms like J. Lyons Fund Mgmt. working through just these sorts of thought experiments. Their most recent post  shows that this type of environment (moderate gains leading up to May) as resulted in somewhat moderate May-Oct returns, not losses – while the 2nd year of the presidential cycle shows and average May-Oct gain of 0.00%.

Sell in May J Lyons(Disclaimer: Past performance is not necessarily indicative of future results)

J Lyons Presidential Cycle(Disclaimer: Past performance is not necessarily indicative of future results)

Which leads us to our little patch of turf, managed futures. How have managed futures performed in the May-Oct period as compared to stocks, and in May-Oct periods preceded by moderate growth like this?  Glad you asked:

Managed Futures Sell in May_1(Disclaimer: Past performance is not necessarily indicative of future results)
Data Courtesy: Barclayhedge CTA Index

Looks like there is no such phenomenon as ‘Sell in May’ in Managed Futures, with the May through October period in Managed Futures actually outperforming the rest of the year (except when stocks have seen a big 20% or more rally through the preceding April). It’s good to see the average managed futures performance following a Nov. through April period seeing stock market gains of between 0% and 19% (that’s what we just came through) at +5%. We sure could use it, and this mirrors past data we’ve run showing managed futures tend to be a 2nd half performer.

And what about Presidential Cycles? Does being in the 2nd year of a cycle make any difference for managed futures performance? A fun exercise, but there’s not much correlation between managed futures returns and the Presidential Cycle from what we see, although we’re glad to see that +5% number again for the May to October performance in Yr. 2 of the presidential cycle (this year).

Managed Futres Presidential Cycle(Disclaimer: Past performance is not necessarily indicative of future results)
Data Courtesy: Barclayhedge CTA Index

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