I’m sorry.
I have to do a quick bit of shameless self-promotion. That’s the way it goes sometimes. Once upon a time I had some shame. But then we started this newsletter. I don’t know where all my shame went. If you’ve seen it, let me know. Mrs. Draconian is wondering what happened to the quiet, decent man that she married. In his place is a shameless huckster, crazy-eyed and poorly shaven.
But!
There’s something in it for you guys today. Free stuff — which I’ll get to in a minute.
Big Announcement
Because of reader demand, the book is now available in print!
You can order it today from Amazon.com.
It’s only $9.99. If this book doesn’t make or save you nine dollars and ninety-nine cents over the next decade, well, more shame on me.
I had to use a different cover for this book because of some stupid technical issues. It came out OK, though.
Here’s how to get a free copy.
I have a little stack of copies directly from the publisher and I’m giving them all away. Here’s how to get one:
Go to Amazon and write a review.
Click here and then just scroll down to where it says “Create your own review.”
Then just email me at Feedback@TheDraconian.com and let me know that it’s up. I’ll mail you a book. We’re on the honor system here.
Am I above bribing people for reviews? No. I am not above bribing people for reviews. I hope you all aren’t above being bribed for two minutes of your time.
Here’s the kicker: you don’t even have to write a positive review. If you want to give me 1 star and tell me that the book sucks, I have no problem with that. You get a free book. If you thought it rocked and you gave it 5 stars, I’m fine with that too. Free book! If you started to read it but fell asleep… free book! (So long as you share your experience)
Heck, you don’t even have to write a very detailed review. Write about how much you love or hate this weekly newsletter. Anything will work. You don’t even have to post your real name in Amazon’s review system.
Thanks, guys. Seriously.
Thanks for reading every week and thanks for supporting The Grand Publishing Experiment.
The 10 Commandments of Technical Analysis – Part 2
Click here to read the first five commandments in case you missed it last week.
5. Oscillation
This is where it gets a little bit more complicated. We talked last week about how assets tend to trade inside a range. As it happens, there are ways that you can quantify that range. You can measure whether the current price is at a relative extreme.
I don’t want to take you guys too far out in the weeds with these indicators. The calculations can get highly technical. But they’re really cool and the basics are simple to understand.
Bollinger Bands are one of the easiest to use. They’re not technically an oscillator, but they are a way of mapping the back-and-forth movement of the market. The concept is simple. To draw some bands, all you have to do is plot a moving average — 20 days is very popular – and then draw a line two standard deviations above the average and another line two standard deviations below that moving average.
Here’s an example:
Bollinger Bands don’t generate very good buy/sell signals on their own. Other oscillators are much more reliable. But if you use Bollinger Bands in conjunction with other indicators, they do an incredibly good job of telling an investor when prices are relatively too high or low. In my own practice, I’ll use Bollinger bands to confirm the signals I get from other indicators.
Relative Strength is a personal favorite of mine. I’ve talked about it in this newsletter before. It’s one of the indicators I use to tell me when something is overbought or oversold.
I won’t trade entirely around it, but RSI is often the final trigger to get me to make a trade I’ve been watching and waiting on. I’m sort of a freak. I like to buy things that everybody hates and is desperate to sell. And I like to sell things that everybody loves and can’t get enough of. For contrarians and counter-cyclical consumers like me, oscillators such as the Relative Strength Index are a trusty tool to keep in your belt.
Here’s an example:
You can see that the RSI told you things were getting a little frothy back in late July. Maybe that was a good time to take some profits off the table. In mid-August, you can see that the market was pretty oversold. Maybe that was a time to scale back in for a little bounce.
Now, keep in mind that just because an asset is oversold doesn’t mean you want to buy it. And just because it’s overbought doesn’t mean you should sell. Markets do crazy things for crazy reasons, but sometimes they do very sensible things. Sometimes things are cheap and oversold for a reason. So be careful here.
Stochastics are kind of similar to RSI. The theory with stochastics is that prices tend to close near the highs in bull markets and near the lows in bear markets. When bull markets are getting tired, prices tend to close further away from their highs. And when bear markets are getting ready to reverse, prices tend to close further away from their lows. In other words, momentum is the first thing to change in a trend.
Here’s an example, with the oscillator below the chart:
If you’re really good at reading stochastics, you can use them to forecast reversals. In a simpler sense, they can also be used to identify places where the market is overbought or oversold.
The above gold chart is a good one because it demonstrates a couple of important points. The first is that just because a market has moved a long way in one direction doesn’t mean it can’t keep moving further in that direction. The oscillator was flashing “overbought” as early as July 11th. Yet the rally kept exploding for another month. The oscillator stayed high.
It also illustrates the important technical principle of divergence. Even though the gold price was going way up, the oscillator was slowing moving the other direction. That’s how you know when to buckle up for a reversal.
As always, these oscillators are best used in conjunction with one another and other technical and fundamental indicators.
6. Volume
I probably should have listed this as number one or two. Volume is a tremendously important principle in technical analysis. It’s one of the major pillars. It’s involved in almost every aspect of technical study.
However, I don’t spend much time studying volume. That’s just me. Because of all the automated, algorithmic, and high-frequency trading that takes place in the market, volume levels and patterns are completely different than they used to be for most of history. The staggering majority of all the trades transacted in a given day are so short-term in nature that they’re not useful. Most of what happens within the course of the day is noise, at least as it pertains to anyone with an investment horizon beyond next Tuesday.
I think of volume as an exclamation point, a bit of punctuation that modifies the sentence that came before it. If there’s a sell-off in the markets and the daily volume is very high, I interpret that as: today was a SELL-OFF! Volume amplifies the move of the day. If it’s a day in the market where the Dow goes up 200 points, but the volume is very light, I’ll read that as a general lack of conviction.
Volume also goes with the trend. In bear markets, most of the heavy volume comes on down days. In bull markets, the volume comes when the market rises. One of the reasons why I’ve been a little skeptical that this whole bear market that started in 2007 is over is because the volume profile has been pretty concerning. If the market starts making new and consistent lows on light volume, technical analysis tells us that that may be a sign that the primary trend is coming to an end. It may mean that sellers have finally exhausted themselves.
I should also mention that our firm has always had a very difficult time designing trading systems based around volume. Again, this is just our experience. We’ve found it to be a rather weak indicator, especially when designing strictly quantitative systems. Volume tells us very little about the future on its own.
7. Breadth
Market breadth is exactly what it sounds like. It measures the breadth of the market’s move up or down.
In its most simplistic form, you can calculate it by relating the number of stocks that rose to those that fell. If more companies go up than go down, breadth is said to be positive. If more companies go down than up, breadth is negative. Bull markets tend to feature lots of days where the market goes up but also a large percentage of individual companies go up. The opposite is true in bear markets. Remember that day in early August when the market crashed? It was a historically bad day, but to make matters worse, every single one of the 500 in the S&P went down. That’s the kind of thing an investor will see only a handful of times in his entire career.
You can fine tune breadth through technical analysis to make it a more useful indicator. This is what the Advance/Decline Line does. It measures market breadth over time. To calculate it, all you do is subtract the number of declining stocks from those advanced. Then add that to yesterday’s value. You can plot those points over time to identify trends in breadth, though this line has less and less meaning the further out on the timeline you extend it. Personally, I prefer to just monitor day-to-day levels in market breadth.
The McClellan oscillator fixes a lot of what’s wrong the the A/D line. I won’t go into the details of the calculation because it’s kinda complicated. Basically, it turns market breadth into a ratio that’s more useful to track over time.
Here’s a really nice chart:
I look for two things in the McClellan Oscilator. The first are sharp spikes up or down. These are “breadth reversals,” surges in the opposite direction of the trend. Often, these spikes will foretell extended advances or declines in the market. These moves are extra interesting if they also go against the direction of the market. For example, if market is going down but breadth has been improving, I might buckle up for a sharp little rally as the market catches up with the divergence in breadth.
The other thing I look at is the amount of time the oscillator spends above or below zero. By simply studying a price chart of the S&P in the first half of this year, one might have felt reasonably good about the health of the market. Stocks obviously took a hit after the Japanese earthquake, but they rebounded and kept testing new highs all the way into June. If you peeked under the surface, what you saw was a rather bad environment for breadth. Look how much more time this oscillator spent in the red in 2011. That’s more supportive of a bearish trend.
8. Patterns
Patterns exist. They exist in nature and they exist in the markets. Some patterns are easy to spot, while others are difficult. Some have meaning, others are arbitrary.
This is where technical analysis gets a little out of hand. There are something like eleven hojillion different patterns. I only know the really popular ones.
I’ll share a few of those with you now. We’ll use pictures.
Head & Shoulders Top (bottom)
This is the granddaddy of all chart patterns. It’s a rock solid pattern and its track record is quite good.
That picture says it all, and the most important thing to watch is the neckline. If that level of support is violated it means that the trend is probably over. This is a longer term pattern, and you tend to see it near the end of long, large trends in one direction.
I wish that picture included volume. Most technical analysis rookies ignore volume in head & shoulders patterns but volume is the critical element that makes this such a reliable tool. In the classic pattern, volume will be very high on the left shoulder, still kinda high at the head, but very low on the right shoulder. If you see relatively low volume on that third peak and the market heading towards that neckline, be prepared to run for the hills. Tighten up your stops.
Pennants
Pennants are pretty cool. Look for markets that are making lower highs but also higher lows. It’s a pattern that really stands out and usually it will break out dramatically in one direction or the other.
The trend is set depending on which direction the breakout goes.
Double Tops (and bottoms)
These are pretty self explanatory. Look for a market that tries and fails (usually dramatically) to break that first top. It’s another reversal indicator. It’s a sign that buyers are giving up on the market. The opposite is true for double bottoms. Those look like a big “W.”
9. Use multiple indicators together.
All of these tools have flaws. You can’t rely on just one of them. Investing with technical analysis is like building a house. You can’t build a house with just a hammer. But if you also use a saw and a screwdriver, you’ll get somewhere. Not every tool is required for every job. Some jobs require using multiple tools at the same time. The point is that the more proficient you are at using all of these tools, the nicer your house is going to turn out.
Use these technical tools with fundamental analysis, too. This can give you very powerful results, but for some reason, most analysts tend entrench themselves in only one school of thought.
If you see what looks like a head-and-shoulders top forming, check the relative strength. Is it overbought? Are the fundamentals of the asset kinda negative? Is the asset trading near the top of a short-term range? Has market breadth been getting worse? If you know how to do all of this stuff, you can really tilt the probabilities in your favor.
Obviously, you want your investment portfolio to be diversified. But you want your decision-making process to be diversified as well.
Here’s a pretty cool chart that a reader sent me. Last week it might have looked like total gibberish to you. But today I’ll bet you can make some sense of it.
This is a really good chart. You’ll have to click on it to make it bigger and see everything that’s going on. He’s looking at a lot of different things in conjunction. He’s looking at relative strength. He’s plotted out trendines. He’s identified various range channels and areas where there is support or resistance. He pointed out a recent head & shoulders top — with decreasing volume! He’s even looking at Fibonaccis.
10. History repeats itself.
I think this is why people use technical analysis. I’ve yet to meet a serious investor that believes the movement from day to day is random. So many of the things that have happened before happen again. The details aren’t always exactly the same, but people that are skilled at interpreting history are able to look through that and see the bigger picture.
I think this is why technical analysis works. Ultimately, these markets are driven by the actions and emotions of humans. It’s this same dynamic that powers all the major trends and inflection points in history. I don’t know why history tends to repeat itself. I don’t know what it is about all these humans that make them do the same things over and over again. I’m sure there are hordes of scientists trying to figure it out.
All I know is that they do.
Technical analysis is really just a way of codifying that principle and applying it to the investment markets. It’s a way of identifying patterns of behavior that investors have exhibited many times throughout history.
If you accept the premise that history repeats itself, then you’re implicitly accepting the premise that by studying history, you can divine a little bit about the future. If it happened this way once, then maybe it’ll happen this way again.
Now, I can hear you saying, “Hold on a sec there Mr. Nostradamus. It’s impossible to predict the future!”
This is both true and false. Consider some of these predictions:
- The 2012 presidential election will be an ugly fight.
- The Kansas City Chiefs won’t win the Super Bowl.
- The U.S. population will grow.
Keep in mind that those are technically predictions. Those events have not happened yet. But everybody knows that they will. So you can see that it is possible to predict the future.
The catch is that the more precise you try to get, the smaller the odds that your prediction will materialize. It’s easy to make those above three predictions about next year. They are virtual certainties. But it’s basically impossible to predict who wins the presidential election and by what margin, or what teams will make the Super Bowl, or exactly how many new American births there will be next year. I could make those forecasts, but the probability that they occur is very, very small. Predicting the future is all about probabilities.
Keep this in mind when performing technical analysis. These historical patterns can help you determine some broad generalities. But if you’re looking for exact moves on exact days, you’re bound to be disappointed. It doesn’t work that way. That’s the biggest thing that everybody gets wrong about technical analysis. It is not an exact science. Not even close.
The best that technical analysis can do is help you identify the places where the odds are tilted in your favor. Most of the time, the advantage will be slight, but if you do it enough and over a long enough timeline, all you really need is a slight advantage to make some significant money.
To succeed as an investor you have to truly understand risk and divorce yourself from the destructive human emotions of greed and fear.
Technical Analysis
I had a really good question come in over the weekend from a reader. He asked about technical analysis and whether investors actually use this stuff.
Technical analysis is a way of valuing an asset. It focuses entirely on price action. The core curriculum of this school of investment thought is that price is the most efficient way of measuring the relationship between the supply and demand for a particular asset. The idea is that every external factor and every piece of fundamental data gets discounted into one price. Technical analysts look for patterns in the movement of this price, and from it, they draw conclusions about what future price action may look like.
There are a million guides out there on technical analysis. I’m not going to recreate them. I’m not going to assemble anything that Edwards & Magee haven’t already in their classic, Technical Analysis of Stock Trends. But this week I can give you a brief overview of what it’s all about, and more importantly, why people use it.
My dad was actually one of the early pioneers of technical analysis. I remember when I was a kid he used to lug around this big black chart book. I have vivid memories of vacations up at Lake Tahoe or Disneyland. He’d go out in the morning, call the office, and get all the price quotes or buy a Wall Street Journal. Then we’d sit down at the motel coffee table together and I’d read off the Open/High/Low/Close prices while he’d plot them in his book. It must have been an actionable practice, because sometimes we’d play Chinese Checkers after he finished charting and sometimes he’d have to go back out and make more phone calls. And it must have worked because that’s what paid for our stay at the Motel 6.
Technical analysis is basically religion. You believe in it or you don’t. The atheists won’t practice this stuff and no amount of convincing will change their mind. Technical analysis is nothing more than witchcraft to hardcore fundamental analysts. That’s OK. Everybody’s different.
But also like religion, there are varying degrees of faith within the segment of the population that does believe. There are extremists, and like any extremist, those that are slavishly devoted to technical analysis live lives that rational individuals have a hard time understanding. These folks also aren’t much fun at cocktail parties. They’re a little scary. And judgmental.
Most believers are somewhere in the middle. Some go to church every single Sunday and would never, ever buy a stock under its 200-day moving average. That’s perfectly sensible, and for these individuals, very comfortable. I’m a huge advocate for investors to find what feels right and roll with it. Others pick and choose the bits of the faith that are most interesting to them. Maybe they’ll only attend Easter or Midnight Mass and only occasionally short into a head-and-shoulders top. They’ll take the Lord’s name in vain and sometimes they’ll ignore the trendline. These folks are OK, too.
The thing that’s most important to understand about technical analysis is that:
- It is not The Answer.
- It is a spectrum of belief.
There’s a cliche in the investment world, “fundamental analysis tells you what to buy and technical analysis tells you when to buy it.”
I’ve always liked that. It’s not always or entirely correct, but I like that it weaves the two disciplines together in a manner that’s productive and actionable.
I do pretty much the same thing in my own investing. At the back of my mind I always have a list of assets I’d like to own. That list has been assembled almost entirely by fundamental factors. While I may like the assets, I may think like the prices are wrong. Technical analysis helps me figure out the prices at which I should be more active about owning. I feel like it helps me stack the deck in helping me find entry points with more favorable risk/reward characteristics. I’m patient about buying stocks and would rather do it when it’s trading down around key support levels.
What follows is a jargon-free guide on the foundation principles.
Keep in mind, though, that all this stuff ultimately comes down to faith. We each have varying levels of faith, and if there’s one lesson I learned from being raised Catholic, it’s that one’s faith is constantly tested.
The Ten Commandments of Technical Analysis
1. Trends
This is probably the most important concept from Technical Analysis. It’s the First Amendment. It’s Econ 101. It’s the basic tenet from which much of everything else flows.
Prices move in trends. They just do. There are a billion reasons why and they all work together to generate some type of trend. People have written huge books explaining them, but to my knowledge, there’s no single reason that explains why prices tend to move the way that they do. Trends are really easy to spot in hindsight, but they’re a little more difficult to identify in the moment.
Sometimes different flavors of trend may run counter to each other. For example, the stock market is currently in a secular bear trend. But the cyclical trend is bullish. And the very recent trend is bearish.
What it all means is subject to interpretation. Not all of the answers here are black and white. Some are more skilled at deciphering this than others.
Louise Yamada, one of my investment heroes and the High Priestess of Technical Analysis, probably knows what that chart means. She’s not the only one, but the reason why I listen to her specifically is that she allows for a range of outcomes. She might feel very confident and speak very authoritatively about the market moving in a particular direction, but she is neither surprised nor bent out of shape when it doesn’t. She understands that these concepts are guides, not rules.
Even if you don’t trade with the trend, it’s important to at least understand what the trend is. Markets behave in different ways when they’re trending in different directions, and understanding that can help you regardless of what strategy you employ or how you execute it.
2. Moving Averages
These are a way of quantifying the trend. They’re nothing more complicated than an average price for the last X number of days. Around here, we’re big fans of the 200 day moving average. 200 days is actually a rather arbitrary number. The point is that it’s a longer-term moving average. If you want to use a 193 day moving average, you have my blessing.
What we do is look at how current prices relate to the long term average price. If current prices are higher, that’s a sign that the trend is up. If they’re lower, it means the trend is down.
Here’s a 5-year chart of the S&P with a 200-day moving average. You can see that staying out of the market when it’s under the green line has saved you a lot of heartburn.
Watching something like the 200-day moving average certainly isn’t a risk management panacea. But it can help you identify environments where you may want to think twice about being long or short. It’s tough to fight the trend.
More advanced technical analysts will look at how different moving averages play off of each other. They might watch how the 50 day moving average moves about the 200 day. When one crosses the other, it’s an event that may have meaning. Some investors use those events as a buy or sell signal.
3. Support & Resistance
This is one of the most useful concepts that investors can monitor. It’s another thing that investors can easily spot on a chart and it’s easy to implement into actual trading. Support & resistance are the levels that act as roadblocks to the trend. Markets either punch through these roadblocks or bounce off of them.
That’s a 2-year chart of the S&P 500. You can see that the market tried really, really hard to get through 1350, but it just couldn’t do it. There’s probably a reason why, but within the framework of technical analysis, we don’t really care. We just care that it couldn’t. That was a meaningful event. Same thing with all that support down around 1050. Who knows why the market kept rallying off that level, but it did.
In this basic technical analysis study, one might conclude that it’s a good idea to buy around 1050 and sell around 1350.
This is where I use technical analysis in conjunction with my other research. If I have a fundamentally constructive view about the market, but lack conviction, I won’t do anything until the market gets down around that support level. I’ll re-check to see if my fundamental thesis is still sound, and then I’ll make a move. I might still be wrong on the investment, but the probabilities are more in my favor when I’m buying closer to support than resistance.
Markets are naturally drawn to levels of support & resistance. Right now, the market seems to have short-term support between 1125 and 1150. If the market breaks through there, that green line will start acting as a big magnet. The market will probably want to go down and retest that support.
4. Ranges
Basically what we’ve done with support & resistance is define a range. Markets trade in ranges.
Sometimes they trade in ranges between trendlines. Sometimes they trade between moving averages. And sometimes they trade between fixed price levels.
The thing about stocks (or any asset) is that they are valued based on a very long term stream of future cash flows. From a fundamental perspective, the present value of a company like Apple is calculated by discounting the expected streams of income it will generate in the future. As you can imagine, this is a very difficult, very imprecise way to come up with an exact price. ”Probability spheres” get involved and so do varying “discount rates”. Valuation can get a little woolly.
What we’re really left with in the present is a range of sensible values. And over the short run, a specific stock or the broader market will trade inside this range. Technical analysis just tells us how to measure it.
Again, technical analysts look at ranges to identify locations at which to buy or sell. They’re not a guarantee of a winning decision. But they help investors spot the points where the odds are tilted a little more in your favor.
5. Breakouts
When a market moves below or above support or resistance, you have what’s called “breakout.” Usually, it means that the market will keep right on moving in that direction.
Here’s a chart of a few breakouts in the VIX (volatility index):
I don’t ever trade off breakouts. But some people do. I just use them as an indicator to tell me when the game has changed and when I should re-evaluate my investment thesis. I use them in conjunction with other indicators and fundamental data points.
In the case of that VIX chart, the breakout above those old highs should have been a warning signal. Technical analysis was telling you that a major environmental shift was happening underfoot. On TV and from the fundamental camp, pretty much all you saw was shock and confusion.
In times of crisis and volatility, I frequently see investors turn to technical analysis for answers.
I think it’s the same mechanism that drives us back into church when we feel particularly adrift or afraid in our lives.
6. Oscillation
This is where it gets a little bit more complicated. We talked last week about how assets tend to trade inside a range. As it happens, there are ways that you can quantify that range. You can measure whether the current price is at a relative extreme.
I don’t want to take you guys too far out in the weeds with these indicators. The calculations can get highly technical. But they’re really cool and the basics are simple to understand.
Bollinger Bands are one of the easiest to use. They’re not technically an oscillator, but they are a way of mapping the back-and-forth movement of the market. The concept is simple. To draw some bands, all you have to do is plot a moving average — 20 days is very popular – and then draw a line two standard deviations above the average and another line two standard deviations below that moving average.
Here’s an example:
Bollinger Bands don’t generate very good buy/sell signals on their own. Other oscillators are much more reliable. But if you use Bollinger Bands in conjunction with other indicators, they do an incredibly good job of telling an investor when prices are relatively too high or low. In my own practice, I’ll use Bollinger bands to confirm the signals I get from other indicators.
Relative Strength is a personal favorite of mine. I’ve talked about it in this newsletter before. It’s one of the indicators I use to tell me when something is overbought or oversold.
I won’t trade entirely around it, but RSI is often the final trigger to get me to make a trade I’ve been watching and waiting on. I’m sort of a freak. I like to buy things that everybody hates and is desperate to sell. And I like to sell things that everybody loves and can’t get enough of. For contrarians and counter-cyclical consumers like me, oscillators such as the Relative Strength Index are a trusty tool to keep in your belt.
Here’s an example:
You can see that the RSI told you things were getting a little frothy back in late July. Maybe that was a good time to take some profits off the table. In mid-August, you can see that the market was pretty oversold. Maybe that was a time to scale back in for a little bounce.
Now, keep in mind that just because an asset is oversold doesn’t mean you want to buy it. And just because it’soverbought doesn’t mean you should sell. Markets do crazy things for crazy reasons, but sometimes they do very sensible things. Sometimes things are cheap and oversold for a reason. So be careful here.
Stochastics are kind of similar to RSI. The theory with stochastics is that prices tend to close near the highs in bull markets and near the lows in bear markets. When bull markets are getting tired, prices tend to close further away from their highs. And when bear markets are getting ready to reverse, prices tend to close further away from their lows. In other words, momentum is the first thing to change in a trend.
Here’s an example, with the oscillator below the chart:
If you’re really good at reading stochastics, you can use them to forecast reversals. In a simpler sense, they can also be used to identify places where the market is overbought or oversold.
The above gold chart is a good one because it demonstrates a couple of important points. The first is that just because a market has moved a long way in one direction doesn’t mean it can’t keep moving further in that direction. The oscillator was flashing “overbought” as early as July 11th. Yet the rally kept exploding for another month. The oscillator stayed high.
It also illustrates the important technical principle of divergence. Even though the gold price was going way up, the oscillator was slowing moving the other direction. That’s how you know when to buckle up for a reversal.
As always, these oscillators are best used in conjunction with one another and other technical and fundamental indicators.
7. Volume
I probably should have listed this as number one or two. Volume is a tremendously important principle in technical analysis. It’s one of the major pillars. It’s involved in almost every aspect of technical study.
However, I don’t spend much time studying volume. That’s just me. Because of all the automated, algorithmic, and high-frequency trading that takes place in the market, volume levels and patterns are completely different than they used to be for most of history. The staggering majority of all the trades transacted in a given day are so short-term in nature that they’re not useful. Most of what happens within the course of the day is noise, at least as it pertains to anyone with an investment horizon beyond next Tuesday.
I think of volume as an exclamation point, a bit of punctuation that modifies the sentence that came before it. If there’s a sell-off in the markets and the daily volume is very high, I interpret that as: today was a SELL-OFF! Volume amplifies the move of the day. If it’s a day in the market where the Dow goes up 200 points, but the volume is very light, I’ll read that as a general lack of conviction.
Volume also goes with the trend. In bear markets, most of the heavy volume comes on down days. In bull markets, the volume comes when the market rises. One of the reasons why I’ve been a little skeptical that this whole bear market that started in 2007 is over is because the volume profile has been pretty concerning. If the market starts making new and consistent lows on light volume, technical analysis tells us that that may be a sign that the primary trend is coming to an end. It may mean that sellers have finally exhausted themselves.
I should also mention that our firm has always had a very difficult time designing trading systems based around volume. Again, this is just our experience. We’ve found it to be a rather weak indicator, especially when designing strictly quantitative systems. Volume tells us very little about the future on its own.
8. Breadth
Market breadth is exactly what it sounds like. It measures the breadth of the market’s move up or down.
In its most simplistic form, you can calculate it by relating the number of stocks that rose to those that fell. If more companies go up than go down, breadth is said to be positive. If more companies go down than up, breadth is negative. Bull markets tend to feature lots of days where the market goes up but also a large percentage of individual companies go up. The opposite is true in bear markets. Remember that day in early August when the market crashed? It was a historically bad day, but to make matters worse, every single one of the 500 in the S&P went down. That’s the kind of thing an investor will see only a handful of times in his entire career.
You can fine tune breadth through technical analysis to make it a more useful indicator. This is what the Advance/Decline Line does. It measures market breadth over time. To calculate it, all you do is subtract the number of declining stocks from those advanced. Then add that to yesterday’s value. You can plot those points over time to identify trends in breadth, though this line has less and less meaning the further out on the timeline you extend it. Personally, I prefer to just monitor day-to-day levels in market breadth.
The McClellan oscillator fixes a lot of what’s wrong the the A/D line. I won’t go into the details of the calculation because it’s kinda complicated. Basically, it turns market breadth into a ratio that’s more useful to track over time.
Here’s a really nice chart:
I look for two things in the McClellan Oscilator. The first are sharp spikes up or down. These are “breadth reversals,” surges in the opposite direction of the trend. Often, these spikes will foretell extended advances or declines in the market. These moves are extra interesting if they also go against the direction of the market. For example, if market is going down but breadth has been improving, I might buckle up for a sharp little rally as the market catches up with the divergence in breadth.
The other thing I look at is the amount of time the oscillator spends above or below zero. By simply studying a price chart of the S&P in the first half of this year, one might have felt reasonably good about the health of the market. Stocks obviously took a hit after the Japanese earthquake, but they rebounded and kept testing new highs all the way into June. If you peeked under the surface, what you saw was a rather bad environment for breadth. Look how much more time this oscillator spent in the red in 2011. That’s more supportive of a bearish trend.
9. Patterns
Patterns exist. They exist in nature and they exist in the markets. Some patterns are easy to spot, while others are difficult. Some have meaning, others are arbitrary.
This is where technical analysis gets a little out of hand. There are something like eleven hojillion different patterns. I only know the really popular ones.
I’ll share a few of those with you now. We’ll use pictures.
Head & Shoulders Top (bottom)
This is the granddaddy of all chart patterns. It’s a rock solid pattern and its track record is quite good.
That picture says it all, and the most important thing to watch is the neckline. If that level of support is violated it means that the trend is probably over. This is a longer term pattern, and you tend to see it near the end of long, large trends in one direction.
I wish that picture included volume. Most technical analysis rookies ignore volume in head & shoulders patterns but volume is the critical element that makes this such a reliable tool. In the classic pattern, volume will be very high on the left shoulder, still kinda high at the head, but very low on the right shoulder. If you see relatively low volume on that third peak and the market heading towards that neckline, be prepared to run for the hills. Tighten up your stops.
Pennants
Pennants are pretty cool. Look for markets that are making lower highs but also higher lows. It’s a pattern that really stands out and usually it will break out dramatically in one direction or the other.
The trend is set depending on which direction the breakout goes.
Double Tops (and bottoms)
These are pretty self explanatory. Look for a market that tries and fails (usually dramatically) to break that first top. It’s another reversal indicator. It’s a sign that buyers are giving up on the market. The opposite is true for double bottoms. Those look like a big “W.”
10. Use multiple indicators together.
All of these tools have flaws. You can’t rely on just one of them. Investing with technical analysis is like building a house. You can’t build a house with just a hammer. But if you also use a saw and a screwdriver, you’ll get somewhere. Not every tool is required for every job. Some jobs require using multiple tools at the same time. The point is that the more proficient you are at using all of these tools, the nicer your house is going to turn out.
Use these technical tools with fundamental analysis, too. This can give you very powerful results, but for some reason, most analysts tend entrench themselves in only one school of thought.
If you see what looks like a head-and-shoulders top forming, check the relative strength. Is it overbought? Are the fundamentals of the asset kinda negative? Is the asset trading near the top of a short-term range? Has market breadth been getting worse? If you know how to do all of this stuff, you can really tilt the probabilities in your favor.
Obviously, you want your investment portfolio to be diversified. But you want your decision-making process to be diversified as well.
Here’s a pretty cool chart that a reader sent me. Last week it might have looked like total gibberish to you. But today I’ll bet you can make some sense of it.
This is a really good chart. You’ll have to click on it to make it bigger and see everything that’s going on. He’s looking at a lot of different things in conjunction. He’s looking at relative strength. He’s plotted out trendines. He’s identified various range channels and areas where there is support or resistance. He pointed out a recent head & shoulders top – with decreasing volume! He’s even looking at Fibonaccis.
Conclusion: History repeats itself.
I think this is why people use technical analysis. I’ve yet to meet a serious investor that believes the movement from day to day is random. So many of the things that have happened before happen again. The details aren’t always exactly the same, but people that are skilled at interpreting history are able to look through that and see the bigger picture.
I think this is why technical analysis works. Ultimately, these markets are driven by the actions and emotions ofhumans. It’s this same dynamic that powers all the major trends and inflection points in history. I don’t know why history tends to repeat itself. I don’t know what it is about all these humans that make them do the same things over and over again. I’m sure there are hordes of scientists trying to figure it out.
All I know is that they do.
Technical analysis is really just a way of codifying that principle and applying it to the investment markets. It’s a way of identifying patterns of behavior that investors have exhibited many times throughout history.
If you accept the premise that history repeats itself, then you’re implicitly accepting the premise that by studying history, you can divine a little bit about the future. If it happened this way once, then maybe it’ll happen this way again.
Now, I can hear you saying, “Hold on a sec there Mr. Nostradamus. It’s impossible to predict the future!”
This is both true and false. Consider some of these predictions:
- The 2012 presidential election will be an ugly fight.
- The Kansas City Chiefs won’t win the Super Bowl.
- The U.S. population will grow.
Keep in mind that those are technically predictions. Those events have not happened yet. But everybody knows that they will. So you can see that it is possible to predict the future.
The catch is that the more precise you try to get, the smaller the odds that your prediction will materialize. It’s easy to make those above three predictions about next year. They are virtual certainties. But it’s basically impossible to predict who wins the presidential election and by what margin, or what teams will make the Super Bowl, or exactly how many new American births there will be next year. I could make those forecasts, but the probability that they occur is very, very small. Predicting the future is all about probabilities.
Keep this in mind when performing technical analysis. These historical patterns can help you determine some broad generalities. But if you’re looking for exact moves on exact days, you’re bound to be disappointed. It doesn’t work that way. That’s the biggest thing that everybody gets wrong about technical analysis. It is not an exact science. Not even close.
The best that technical analysis can do is help you identify the places where the odds are tilted in your favor. Most of the time, the advantage will be slight, but if you do it enough and over a long enough timeline, all you really need is a slight advantage to make some significant money.
This weekend was the 10th anniversary of 9/11. I didn’t really watch any of the stuff on television about it, at least nothing that didn’t air before a football game. There were a lot of really nice tributes around the NFL on Sunday.
I didn’t realize it at the time, but I guess I got a jump on the 10-year anniversary of 9/11. I wrote a short piece on that back in May.
That newsletter didn’t get the most pageviews, but the response I got from that was astonishing. It received by far the most feedback I’ve ever had on an article. People called in about it, emailed about it, and even talked to me about it in person. I guess it struck a nerve or something, though really, it was 9/11 that struck the nerve. I just spoke honestly about it.
Anyway, if you’re still in a retrospective mood, go back and read it.
I’m one of those writers who will read my work over and over and over until it’s ready for publication. Once I hit the “send” button, that’s pretty much the last I ever see of it. I’m already off to the next project.
But I did go back and read that 9/11 piece. It is really good. I have no idea what came over me that week. I must have been temporarily possessed by some sort of writerly spirit with actual talent. Or maybe I just got lucky like that joke about the thousand monkeys with typewriters.
In any case, today is not the week for quality. No magic monkeys today. But I can’t over-emphasize how important today’s topic is. I wish I could do it justice.
This is really, really important stuff. The markets are at a crucial inflection point.
Listening to the markets
We’ll start with stocks because that’s the easiest and that’s what you hear about on the nightly news.
The stock market has no clue what’s going on. It has no idea where it wants to go because it has no idea what the future may look like. Seriously. I heard yet another beautiful metaphor from Mohammed El-Erian the other day. He described the stock market as being in the back seat of the car, asking “are we there yet? Are we there yet?” Meanwhile, the policy-making parents up in the front seat are lost and trying to navigate without a map.
The future might be OK, in which case stocks may represent a reasonable value at these levels. If corporate earnings hold up then the foundation is in place for a rally. There are still greedy hands in this market.
But corporate earnings may not hold up. We may, for one out of a thousand reasons, slide into recession or close enough to it. Earnings may go down 20-40% as they pretty much always do during recessions. If that’s the case, stocks are almost assuredly too expensive right here. The S&P may need to trade under 1000 to justify the fundamentals of a lower earnings plateau. Everybody’s talking about a new normal of permanently lower GDP growth. But nobody’s talking about a world where corporate earnings pull back and don’t grow as much as they once did.
The stock market is acting like a crazy person right now. And this is what it’s telling us. Psychologically, investors are all over the map. One day they’re manic. The next day they’re depressed.
I wish we could just give the stock market some lithium and let it stabilize. The best we can do in the meantime is try to understand why it’s acting the way that it is. Then we can build our own plan to cope individually.
The bond market
How about the bond market? What’s that telling us right now?
First, let’s do a little thought experiment. Let’s rewind the clock back to mid-2009. We all just lived through the economic apocalypse. Some of us are in better shape than others. But things are starting to improve. We’re even getting annoyed with the phrase “green shoots.”
Imagine if back then I told you that we hadn’t seen the low in the 10-year Treasury yield.
Remember, Treasuries are a safe haven and yields go down when things get messy in the world. So what would you say if I told you back in mid-2009 that we would later see Treasury yields drop below the levels we all just witnessed in the middle of the crisis? Imagine if I told you that yields would eventually make a new all-time low.
My guess is that a few of you would call me crazy. Who is this wild man from the future and how can he be serious about these ridiculous prophesies?!? Others of you would probably react with shock and fear, wondering what new global catastrophe could possibly materialize to stoke such historic demand for safe assets. You might wonder if a bank much bigger than Lehman would have failed in a much more disorganized manner. Some of you might pause for a moment in thoughtful reflection, look up, and say, “oh God — we become Japan, don’t we?” How bad must it get?
Well, we’re here.
The yield on the 10-year note made a new all-time low last week.
Never before in history have so many people wanted to own Treasury bonds so badly. Price-wise, these things are more expensive than they’ve ever been.
What’s interesting is that when you look around today, you don’t see a world that’s in total chaos. I mean, you do. Kind of.
You see things spiraling out of control in Euroland as all these disparate countries and cultures try and wrangle the problem of major debt hangover. You see a U.S. government that is almost unfathomably dysfunctional, more broadly reviled than any of us have seen in our lifetime. You see the ugliest job market that all of us (and most of our parents) have ever known.
But you don’t see a world that’s completely melting down. There are lots of problems, sure, but the economy is hanging in there and nobody really feels like this is a moment of acute pain. We’re all just sort of slogging along, gritting our teeth and hoping that it doesn’t get too much worse, even though that’s exactly what we were doing last summer and, well, it did get worse from there.
Whether these epic low yields are indicative of worse things come, I can’t say. I wish some crazy man from the future would show up and tell me what yields would be in 2013. Then I’d have an idea what this specific moment may indicate.
The best I can do in the meantime is listen to what the markets are telling me. This is much more than the news headlines. The bond market is telling you that investors really, really want to own assets that aren’t going to go poof. They want them and they don’t care about what the price is. The bond market is telling me that people are willing to accept a very tiny rate of return, only a fraction of a percent after inflation, in exchange for zero risk of default.
The options market
When I look at the options market, I see amazing skews.
I see a lot of volume in the $2 Bank of America puts. Back in when Citigroup was in the low-teens, when it was looking really bad but not yet in the middle of the crisis, Kyle and I were laughing that there was activity in the $1 puts. Surely Citigroup wouldn’t go to a buck! But it did. I don’t think it’ll happen in Bank of America’s case, but you have to understand that the options market is telling us there is a non-zero chance that BAC goes bankrupt. Think of what the rest of the world would look like should that happen, or get close to happening. How bad must it really be if they require another bailout?
The volatility index — aka the VIX — isn’t as great a predictor of the future as it is oracle of the present. Right now it’s telling me that investors are afraid. Like, big time. Last week I saw a little headline that said the volatility index has spent more time above 30 this year than it did in 2009. Naturally, that inspired me to pull out some charts.
Here’s a question that’ll rock your world. See if you can get it right.
September 15th, 2008 was the day that Lehman Brothers filed for bankruptcy. It was a Monday. It’s regarded in the industry as one of the ugliest, scariest days in the history of the markets. Lehman was the proverbial shit and Paulson saying “no” to a bailout was the fan. The Dow fell over 500 points that day. A lot of people who had jobs Sunday night didn’t on Monday morning. Wall Street was in utter disarray.
Take a guess where the VIX closed that day.
Go ahead.
50?
60?
Try 31.
At that point, it was a breakout high for the year, too, and the highest level anyone had seen since the dark days of the tech-bubble washout. All the CNBC anchors were like, “Holy cow! Are you guys watching the VIX???” In 2008 the VIX would go on to touch an impossible high of 89.53 a few weeks after Lehman blew up.
We’re at 34 right now. It got up to 48 right after the AAA debt downgrade.
That should give you some context about what’s going on. Right now, there is historic volatility and fear in the market. Unless you watch the markets all day like I do, you probably don’t feel like a new page of history is being written right in front of our eyes.
If you’re messing around in the market today, just understand that you’re playing with fire. Playing with fire is OK if you’re a professional and wearing the proper gear. But amateurs need to be cautious. Investing today is like investing the day after Lehman went down, thinking that the worst was surely behind us. The worst may indeed be behind us — I certainly hope it is. But the Dow closed at 10,917 on the day that Lehman failed. (Which is funny because the Dow closed at 10,992 last Friday).
Six months after Lehman went down, the Dow closed at 6440.
The options market is telling you that we are all standing in a legitimate minefield. We could certainly make it out OK, but people are paying exorbitant premiums to insure against getting blown up. Before dancing in the minefield, every investor really needs to take a hard look at the risk/reward profile of the market right here. What’s your upside? What might be your downside?
Don’t make the mistake of thinking that this will all play out quickly, either. That may be one of the myriad reasons why the details of the next crisis won’t resemble those of the last.
Think Positive
I want to end this on a somewhat optimistic note. I think everybody that knows me in person will attest that I’m actually a really positive, optimistic guy.
When I look around, I do see a corporate America that is strong. It’s shockingly strong. I see a lot of solid balance sheets, defensible business models, and healthy cash flow. Life sucks for most local and small businesses, but big business is doing just fine. They’re ready to ride out whatever may come down the pike. And they will, too. Companies like Apple, Intel, and Johnson & Johnson have an almost embarrassing amount of cash on hand. I saw the other day that Oracle is sitting on $30 billion in cash. That’s triple what they held in 2009. (Note: I don’t actually own any of these stocks.)
These types of companies will lead us through whatever lies ahead. Investing in a mix of them, high-quality bonds, cash, and a sprinkling of real estate, commodities, and alternative strategies, is probably the way to do it. But every investor is different and that’s why you keep a financial advisor on the payroll.
Don’t get me wrong, if we slip into outright recession, these businesses will suffer somewhat. But to study these firms’ balance sheets, you’d think they were gearing up for another apocalypse.
If that just sent a chill up your spine, I understand.
Because that might be what the rest of the markets are telling us too.
This week will be a short issue. Monday was a holiday and then I got sick.
Since last Thursday’s newsletter — which seemed to have touched a nerve with a lot of local readers — the markets have made another dramatic move. Sharply lower, and then a little higher. I saw a little headline on CNBC that said the Dow has been up or down more than 100 points 17 times in the last 22 sessions. Crazy.
Welcome to life north of 30 on the VIX.
The good news is that the VIX continues to make lower highs. The bad news is that it can’t seem to get under 30. It’s funny, one of our predictions at the beginning of the year was that something would make the VIX spike above 30. I was wrong about the cause, so let’s not get too excited about my oracular skills. But I’m not sure the cause even matters much. When you’re dealing with a market that’s psychologically dysfunctional (as well as technically and mechanically unstable), the details of fundamental catalysts stop mattering. These conditions all existed at the beginning of the year and it’s one of the reasons why I was somewhat cautious about 2011.
The news headlines this week suggest increasing concern about Europe. But if you’ve been paying attention, you’ll remember that was the story last year.
What’s different this time? Fundamentally, nothing has really changed. The mid- to long-term economic outlook of the U.S. isn’t all that different right now than it was at the beginning of the year. Nobody is surprised by that. But what has changed is the psychology. It’s that dynamic of sentiment that constantly oscillates between total complacency and sheer panic. There isn’t a middle ground.
When will that change? I wrote about this two weeks ago. It changes when investors aren’t strong-armed into buying risk assets.
In other words: not any time soon.
A Field Guide to Surviving Volatility
Today I want to cut straight to the “useful” part of our threefold objective. Here’s a brief guide on some things you can do that will make the bumpy ride in the markets a little less bumpy. It’s not comprehensive, and most of it is fairly obvious. But you may be surprised at how rarely investors actually employ these techniques.
1. Buy insurance.
The most straightforward way to guard yourself against the nasty effects of volatility is to purchase direct insurance against it. You can do this in the options market. You can buy put options for the stocks that you own or you can pick up some general market puts. You can buy call options on something like the VIX.
All these things go up in value when the market goes down. The trouble is that they cost money. There’s no such thing as free insurance.
There are a variety of ways that you can structure your hedges. Experienced investors can build spreads or write some options in conjunction with purchasing others. You can also vary your strike price or the amount of the position you want to hedge. Like any other insurance policy, you can customize the policy to be as comprehensive and expensive as you want. You can also make it basic and cheap.
The most important rule to follow is that you want to buy assets like this when times are not turbulent. You buy your insurance policy before the hurricane season starts. You don’t buy it when the storm is barreling down the coast and everybody is busy nailing their windows shut. At that point, insurance policies are way too expensive, and that’s assuming you can find somebody who’s willing to insure you in the first place.
Dr. Evil might be your last… option!.. at that point, and you just know he’s going to screw you on the price.
2. Hold cash.
This is the most obvious way to mitigate the effects of volatility. It’s also the easiest way. For investors that don’t have much experience in the options market, this is probably the preferred path.
I know that cash doesn’t pay anything. But guess what. Risk management costs money! At least with cash, you’re only dealing with an opportunity loss. You’re dealing with the risk of not being invested rather than forking physical dollars over for a policy that may or may not pay out.
Holding cash is a more difficult thing to do than you’d think. There are a lot of investors out there who are fundamentally incapable of sitting still. If they’ve got cash, they want it to be invested somewhere, “working” on their behalf. There are other investors (like retirees or pension fund managers) who need their investments to generate income. There was a time when cash used to generate a little bit of income. Those were the good ol’ days before the world changed. Now cash pays you nothing. Literally: nothing. A lot of investors tell me that they can’t afford to keep any cash. This is really disturbing. It’s disturbing that we live in an environment where savers are punished so harshly and it’s also disturbing that so many investors are so desperate for income.
Anyway, the point is that if you’ve got a lot of cash in your portfolio, I guarantee that you’ll sleep much more soundly when the volatility hits.
You’ll also be in a position to capitalize on opportunity if that’s your thing. The relative value of cash goes up when everything else goes down. It’s nice having cash when the markets are falling apart. I know it’s tough to buy when everybody is panicking, but that’s usually the best time to do it. There is value in fading the crowds.
Think about the guy who parked his $100k in the bank back in 2006 rather than use it as a down payment on a house. Think about how much nicer a house he can buy today. That cash “investment” worked out rather well. It might be tough for him to pull the trigger because the housing market is so ugly right now. But the point is that his purchasing power increased substantially relative to a weakening investment market.
Cash is the ultimate hedge against deflation and deflationary environments.
3. Own things that go up in value when it gets volatile.
The most obvious asset here is U.S. Treasuries. When it gets scary out there, money always flies out of risky assets and into the global safe haven that is the U.S. Government Bond market. Yields here are pretty depressing though. 2.01% for a 10-year? Blech.
The kicker, though, is that if the S&P gets spooked and drops another 15%, you could see that yield fall towards 1.5%. That’s good. That means your bonds went up in value while everything else in your portfolio probably went down. There’s a name for that: True Diversification.
I don’t completely buy into the argument that the U.S. is turning into Japan. But there are enough similarities that it’s a line of discussion that warrants serious attention. The economic events, housing bubbles, systemic de-leveraging, banking crises, and policy response are eerily similar. Japanese bonds were pretty awesome to own for entire decade, just as U.S. bonds have been.
But yields can only fall so low.
So who knows how long Treasuries will protect you from volatility. I mean, they always will protect you from volatility in the sense that that’s where investors have always fled when they demand a safe haven. The problem is that Treasuries may not do it quite as well as they did in the past and they won’t be as profitable a long-term investment as they once were. If you’re using them for tactical flexibility, that’s probably OK. Regardless of what the current yield is, Treasuries are always going to rally on a day where the market crashes.
Anyway, the time to buy Treasuries for portfolio protection purposes is before the shakeup actually happens. Selling your stocks and buying Treasuries during a day like August 8th (where the Dow dropped 624 points) is pretty silly. You were too late at that point. Yet this is what everybody is always doing.
4. Trade sizing.
Here’s where it gets a little more sophisticated. One of the risk management tools that the pros use is to vary the size of their trades depending on the level of volatility in the market. This is particularly useful because this is a strategy that you can employ during periods of volatility.
All you have to do beforehand is derive some kind of formula for how large to size your trades. Here’s a quick ‘n dirty example that I came up with, based on a somewhat-standard version that the industry uses:
Trade Size (# of shares) = P * [Portfolio Size / Asset Volatility] / Share Price
Where P is a constant that determines the baseline percentage the trade should represent for of the total portfolio.
Experienced fund managers will notice right away that that formula keeps trade size proportional to the portfolio size. It scales dynamically. It also keeps trade size inversely proportional to volatility. In technical terms, that’s what we in the business call “a double bingo.”
In layman’s terms, all that formula says is that when it gets more volatile, you trade smaller. But it’s remarkable how few people actually do this. It’s one thing to make a big buy and load up fully long when the VIX is under 20 and the market doesn’t move around very much from day to day. Ordinarily, the risk associated with that is tolerable. But when you’re trying to trade in an environment where the Dow can move several hundred points in a manner of minutes, you need to size your trades accordingly.
When volatility is low it may take weeks or months before the market moves enough to hit your profit target. But when it’s volatile that can happen very quickly. In hours or days, even. Let’s say you were looking for a 1-2% move in an asset over the course of two weeks. That might require a full load in a low volatility environment. In a high volatility environment, you could see a 3-5% move over the same time period. The solution is to put on a position that’s 1/3 the size. That way if the asset does move 3-5% the way you expect it to, your actual return (or loss) is back in line with your original 1-2% target.
Your timeline and portfolio risk/return characteristics all stay intact. They’re not disrupted by the volatility.
Here’s another way to think about it. Imagine you’re playing golf and are teeing up at a 160yd Par 3. It’s a nice day with blue skies and no wind. You reach in your bag for your 5-iron, hit it square, and land right in the middle of the green. Your buddies are impressed.
Now let’s say you come back the next day. You get to that same hole only this time there’s a 40mph tailwind. You’re free to go ahead and hit that 5-iron again, but with the wind, it’s a sure bet you’ll fly the green. Your buddies will laugh at you. So you have to club down and pull out a 9-iron. No matter what you do, it’s going to be a much more difficult shot in the volatile, uncertain environment. But if you play it as though it was a calm, normal day, you’re turning it into an impossible shot.
When volatility is high, trade smaller. Use the hard guidance of a mathematical formula or apply a looser, more intuitive adjustment the way you do with your golf game. Find what feels right and do it.
It’s a mystery to me why people trade volatile environments the same way they do halcyon ones. Investors keep reaching for that 5-iron even when it’s super windy.
Go, and be prudent
As I said, this is not a comprehensive guide. Risk management is topic that is broad and deep, and the scary thing is that it’s still evolving. We’re all still learning about how to properly manage risk. It’s a lot more complicated than you might think. It’s a much more subtle art than all those quants with their fancy schmancy VaR formulas thought. Too much reliance on fancy mathematical modeling was what sank AIG, you know. Well. And greed, of course.
Anyway, these four techniques should get you started.
I apologize for the timing of this guide. This would have been a much more useful article for you guys back in March. So I promise that when things settle down and the market falls asleep again, I’ll dust this newsletter off and revise it.
Nobody will listen, of course. That’s the real irony. When the market is sleepy and going up up up, all anybody wants to talk about are what assets to buy and what will go up the most. When the market is chaotic and dropping hundreds of points in a manner of minutes, all anybody wants to talk about is how they can protect themselves from additional losses.
The Draconian advocates questioning the crowds. When the market is complacent, exploit the complacency and buy inexpensive insurance. Take profits and get some cash on the ready. Buy a few of those nasty Treasury bonds that everybody hates when stocks are strong. Work out a strategy for how you’ll react if it all hits the fan.
When it does hit the fan — and in this negative real rate environment, it really is a question of “when” and not “if” — you’ll stay clean.
I grew up in the Sierras. I was born here in Reno but spent a large portion of my youth up in the mountains, particularly Lake Tahoe. If you’ve never vacationed at Tahoe before, you should. It is a place of staggering beauty. But you’ll notice that as you spend more time up here, it begins to shape the type of person you are. I believe we are all products of our geography.
My family has this old 14′ Sunfish. It came from the Sears Catalog. That’s how old it is. Every summer we’d haul it up to our cabin at the Lake and we’d sail it on any morning when there was a breeze. The cool thing about those Sunfishes is that it doesn’t take much wind to scoot them around.
Mornings on Tahoe are always calm. Always. But afternoons are a different story. Sometimes they’re peaceful, with clear, quiet skies and no trace of wind. These are great afternoons for a nap on the beach. But sometimes they are tempestuous. The wind can really blow here in the Sierras, and when it starts whipping across the lake it can kick up some serious whitecaps.
This photo stolen from an old friend who's a ridiculously talented photographer. Hope you don't mind, E.
The thing about Tahoe that nobody in the world appreciates except the people who live here, is that Tahoe is an extremely dangerous lake. It’s dangerous because it’s deceptive. Conditions can change in a matter of minutes and those of us who live here always keep a careful eye on the environmental clues.
When you’re sailing a boat with a 2ft. draft on a lake that can go from glass-flat to 4ft. waves in about thirty minutes, you become rather sensitive to changes in condition. A small boat on big waves in a cold, deep lake is recipe for disaster. My step-dad is one of the chief honchos for the Lake Tahoe flotilla of the U.S. Coast Guard Auxiliary. He can tell you stories that will chill your blood.
With that old Sunfish it’s mandatory to stay on guard. You always keep one eye across the lake to the west, for signs of whitecaps further out. You always keep a finger in the air for changes in the wind’s speed or direction. And you never stray too far from the shore in case you get stuck. It’s a constant dance of risk and reward. I think that’s part of what makes sailing fun and rewarding in the first place.
The market sends us clues too. It lets us know when something’s not right. Sometimes it’s subtle, like that condition I wrote about earlier in the year about how down-days were trading at significantly higher volume than up-days. And sometimes the clues are painfully obvious, like the 15% crash we had at the beginning of August. The point is that you have to listen and the problem is that, like Tahoe, the newbies haven’t figured out how to read the environment or don’t take it seriously.
This economic storm is not over. The wind stopped blowing for a little bit. But the breeze is picking up. Further out the lake is changing from pale blue to dark. There are whitecaps out there. Maybe that tricky Tahoe zephyr calms down or maybe it pulls those waves closer in. I’m not taking any chances. I’m tacking back towards shore.
Investors need to be prepared. As we move through the rest of the summer I want to spend more time discussing this week to week. There are many ways to brace yourself for the turbulence ahead, and so long as you be prudent and take it seriously, it’s easy to sail through it without capsizing.
This reminds me of something I should have talked about back in July.
Investors Hotline and the (Government) Bankruptcy Survival Panels
I’ve been meaning to mention this for some time now, but it’s been a little crazy in the markets. In any case, a few months ago my old buddy Joe Bradley called me up and asked if I’d give an interview for a special project he was working on. Joe runs Investor’s Hotline, and for over three decades he’s been talking to some of the biggest names in finance and economics. He’s interviewed Sir John Templeton, Peter Lynch, and Ronald Reagan.
I told Joe, “of course!” not really knowing what to expect.
I’ll let him explain what it’s all about:
After 35 years of publishing Investor’s Hotline, I’ve been called out of retirement twice. Both occasions have been characterized by overwhelming financial crisis—the first was August 2008, just prior to the Meltdown, and now we have another pending financial tsunami. What lessons can we as investors draw from the last meltdown? How can we protect the value of our portfolios from the ravages of inflation, deflation, taxation and possibly even some other indirect form of government plunder?
Thus, in this environment of risk and uncertainty, the Bankruptcy Survival Panels were born. In a series of discussions with esteemed experts, I posed the most important questions running though the mind of any seasoned investor who has worked hard to build a retirement nest egg. We’re responsible people who are not relying on government to take care of us in our senior years. For me, those conversations solidified some of my views on what lies ahead and on what I need to do to be prepared. They also opened my mind to some alternatives I had not considered before.
You can read a lot more about it right here. It’s called “Be Prepared for the Financial Tsunami Ahead.”
My interview was only a small section of the larger project. We chatted about the role of commodities and CTAs in investors’ portfolios.
If you’re going to buy it, honestly, don’t buy it to listen to me ramble. Buy it to hear Niels Jensen, or Harry Dent, or Whitney Tilson. My name doesn’t belong anywhere alongside those guys. In fact, Tilson, with his value-focused mindset and willingness to flagrantly fly against conventional wisdom, is one of my investment heroes. He’s one of the handful investors that pretty much every industry insider I know pays close attention to. Every major league hedge fund manager watches what Tilson is buying and selling.
The whole package runs about 4 hours. It costs $400, but Joe set it up so that readers of The Draconian can get it for a discounted price of $259. You’ll get digital downloads and he’ll also send you 4 audio CDs in the mail.
Click here to hear some samples and access the special offer Draconian readers.
It’s a good panel of interviews. Legally, I am required to point out that the only perspectives I officially endorse are my own and that my own views are not necessarily those of Jones & Company and Draco Capital Management. The views discussed by the participants on Investor’s Hotline are theirs and theirs alone. (There, lawyers. Happy now?)
Anyway, perspectives like this are a great place to start to help you prepare for the rocky waters ahead.
Market Recap
The market has clearly begun its process of backing and filling. In fact, that process could now even be over with.
I think it’s highly likely that the market will either re-test or break those lows if the economic picture changes from “lackluster” to “concerning.” If the economy holds it together, the market will begin a slow journey higher as those fundamentals come back into play. Remember, stocks are the only game in town.
Stocks may be the only game in town, but if you’ve been following along for the last few years, you’ll notice that I have a really hard time getting excited about them. Just because they’re the only option that investors have to earn a decent yield doesn’t mean that everyone should buy them. Personally, I don’t think the current yield of the market justifies the risk.
The dividend yield of the S&P 500 is just barely off a 100-year low and I’m not enthusiastic about the possibility ahead for robust earnings growth and sustained multiple expansion. The real total return of the S&P 500 might be somewhere around 3-4% for the next decade. In this world, that’s actually pretty good. But that’s not very good when it’s subject to cyclical 20-50% drawdowns and the risk of a technically-driven mini-crash on any given day. For that, I need to get more like 8-9%/year and the market isn’t going to do that until it’s got a foundation for long-term economic prosperity and a sensible earnings multiple.
Don’t worry, that day will come, but I don’t see it arriving until much later this decade. Let’s say… 2018 +/- 2 years.
In the meantime, you’re going to have to do two things:
- You’re going to have to be really careful. You’re going to have to pay more attention to managing risk than you’ve ever paid before and it’ll be difficult because the low-risk investments these days carry depressingly low yields. But don’t get greedy.
- When you do go shopping for opportunity, you’re going to need to do it tactically. You’re going to have to pick your entry points and you’re going to have to pick your specific assets. Gone are the days of buying the market and hanging out while it steadily appreciates.
I know you guys are all tired of hearing it, but passive strategies are dead. Investors need to be active and they need to work it a little more than they used to during the Long Boom. Most importantly, they need to make peace with the fact that their returns will be lower and the general level of risk is higher.
Active strategies are the place to be.
Get active
Here’s an example of the kind of active strategy I’m talking about. Back in February I wrote an article about a medium-term bond & dividend strategy. You can go back and read it for yourself right here.
At the time, the 10-year yield was 3.6%. Stocks were at levels that I thought were kinda overvalued, but more importantly, weren’t pricing in a lot of the risks that I thought might materialize.
The strategy basically boiled down to “sell all your stocks, park your money in middle-of-the-curve Treasuries, wait for the shakeup, and the switch from Treasuries back to dividend stocks.”
If you’ve followed the action in stocks and bonds during the last month, you’ll notice that strategy played out rather well. In fact, it was a home run.
But I can’t take too much credit for that because I had no idea that the shakeup would happen so quickly or so dramatically. I think it was a solid strategy but luck made it look about as wizardly as it could possibly look.
Don’t ever lose an appreciation for how big a role luck plays when it comes to investing. Do not mistake skill for luck. Don’t do it. Never, ever, ever. The moment you start believing that returns from luck are returns from skill, you’ve compromised your objectivity and you’ve sown the seeds for ego to someday lead you astray.
There are legitimately skilled people in this industry, but the uncomfortable secret is that there are far fewer of them running around than you might think. Most people in this industry are just really good at telling stories. Most of them are just really good at convincing you that their good fortune is actually skill.
What’s funny is that I got a bunch of push-back on that article. Most of it came from people who hated Treasuries, who either pooh-poohed a 3.6% yield or didn’t think they had any room to rally. As the market showed us in August, there’s a lot of room to rally under a 3.6% yield! The 10-year touched 2% and currently sits at 2.2%. This has been a heck of a summer for people who owned government bonds.
In that article, I listed a whole bunch of dividend stocks as an example to look at once the big sell-off happened. The yields on these stocks are all much higher now, too. These companies aren’t ones that I specifically endorse or own, but I think they represent the type of companies that defensive investors are looking for. They’re a template to start from. Your financial advisor is the guy who can help you figure out exactly what’s right for you.
The other type of push-back came from people who just didn’t want to sell their stocks and buy them back later. I’ve never really understood this. People get emotionally attached to the stuff in their portfolio. Emotion is so damaging in so many ways when it comes to investing, and it keeps people clinging to stocks that are expensive with unfavorable risk/return profiles. I suppose some of it is a little bit of greed, too. Nobody wants to be left on the sidelines if the market rallies. But I’d rather sell into greed, and it’s a much easier thing to do than buying during environments of fear.
That’s just me. I enjoy the calm. I’m the guy who heads for shore when I see the whitecaps further out.
Not everybody does that. Some people enjoy riding through those waves. Some are very good at it.
Which type are you?
- There are whitecaps ahead in the markets. We’re headed for a rocky patch in the economy and the market will be reacting accordingly. If you don’t know how to navigate the big waves, then be defensive and make a line for the shore.
- In the short-run, the market is currently backing and filling. There is now substantial support in the 1100-1200 range on the S&P. One of the first lessons they teach you at technical analysis school is that support is always tested, and re-tested. If that support around 1100 breaks, it could get ugly.
- Otherwise, things are fine! Stocks are the only game in town and so long as the economic fundamentals hold it together and the machines don’t take over the market again, stocks should be all right.
- For more information on how to prepare your portfolio for the stormy years ahead, check out Joe’s interview panel over at Investors Hotline. You can download a summary of it right here, and readers of The Draconian get a $140 discount off the retail price. This is the special link to click on.
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*If you’re a hardcore film geek like me, you may recognize “Whitecaps” was the title of the finale of season 4 of The Sopranos. It’s widely regarded as one of the best episodes of one of the best shows ever on television. ”Whitecaps” is the name of the beach house that Tony buys for Carmela, the final desperate gesture to hold the family together before their marriage completely disintegrates in the following season. The economic symbolism should be obvious.
