Are We On The “Edge of The Cliff”

RealVision recently put together a compilation of answers from some of the best minds in finance regarding serious risks investors will face today and in years to come. There’s a lot of complacency and chest bumping from many investors who feel they are invincible to negative market swings. In this video there’s great insight from Kyle Bass, Jim Rogers, Jesse Felder, and many more. If you’re interested in their take on the bond markets, currency markets, equity markets and how they will be affected by central bank policies, this is a gem. Buying the dip and shorting volatility isn’t going to work forever. 2018 may be the start of something…interesting.

The Relentless Rise – October 2017 Newsletter (The Forecast Report)

When you’re dealing with stock market “bubbles” there isn’t much that matters…for a while. Bad news, good news, it doesn’t matter. It’s all bullish, or so it seems. Much of the news as of late has been horrific. Believe it or not, many well-known investors are frustrated by the current state of affairs, but the US markets are painting a different picture with its relentless rise. We have Harvey, Irma, and Maria that have caused massive human suffering, loss, and will cost hundreds of billions of dollars which have been siphoned away from productive infrastructure. We have nothing getting done in Washington as the most recent health care bill was shut down, foreign countries are hacking private servers for sensitive information, a transparent tax bill that, for the most part, is unworkable, the Tom Price shit show, and Trump’s failure in Alabama (Luther loses). The Geopolitical environment is less than stellar as North Korea is becoming more of a problem, Catalonia’s secession from Spain is causing riots and worse, and other European countries are still debating leaving the EU. In addition, Las Vegas was attacked in a mass shooting during a concert that took the lives of 58 innocent people and injured hundreds more. So, what effect did that have on the market? Zero, zilch, nothing, nada.

The S&P 500 has now risen for eight consecutive quarters. It hasn’t seen a 3 percent decline in over 228 trading days (11 months for those counting). This year’s biggest drop in the S&P 500 is the smallest for any year in at least 104 years (that’s as far back as I could pull)! This has pushed investors to be complacent and has created a feeling of invincibility. According to Merrill Lynch, clients have the lowest allocation to cash in at least 13 years. Optimism has steadily increased. Look no further for excessive optimism and machismo than the millennials. According to a survey conducted by AMG Funds, they found that 81 percent of millennial investors (most are too young to have experienced the 2008 stock market bomb) consider themselves “extremely or very knowledgeable” when it comes to their finances, while just 19 percent of experienced investors felt the same way. 10 percent of millennial investors stated that they understand the benefits of diversification (compared to 50% of baby boomers). The majority of the Millennials polled are also piling into some of the most excessively priced ETF’s and cryptocurrencies. There’s no fear. Well, I guess many will learn the lessons of generations past the hard way.

Shaded blue region encapsulates the S&P 500’s relentless rise in 2017

There’s been a lot of financial pundits arguing about the S&P 500’s price to earnings ratio and whether it’s overvalued. Some state it is excessively overvalued and some state it’s high, but not excessively so. The problem with placing your faith in the price to earnings ratio is that it can be manipulated. Yes, the S&P 500 Price to Earnings ratio isn’t incredibly extreme, but there’s a reason for that. Much of the data is hidden due to all the financial engineering that has taken place to inflate earnings and hide the true excessive overvaluation of the market. The suggestion that I received when looking at overvaluation was to take into consideration the Price to Revenue metric, which has been very helpful. You can’t really financially engineer revenue, which makes sense. Grant Williams has a great chart (shown right below) that shows, according to the Price to Revenue metric, that our current market is the MOST expensive ever (by a lot). The chart includes the dot com and housing bubble.

The FED…

Last month the Fed unveiled its balance sheet reduction plan, or in other words Quantitative Tapering plan. To give a simple explanation the Fed is planning to let billions of dollars of maturing bonds roll off its balance sheet without reinvesting the proceeds. Our current quarter will see $10 billion of maturing bonds roll off the Fed’s balance sheet per month. As the quarters go on the amount of maturing bonds that roll off increase. For example, in Q1 of 2018, we will see $20 billion of bonds roll off each month ($60 billion total). In Q2 of 2018 it will increase to $40 billion per month and so on.  In effect, the Quantitative Tapering plan will take increasingly larger amounts of liquidity out of the monetary system as the quarters roll on.  It seems as though the plan could work, right? Oh, but wait. The ECB (European Central Bank) is also planning on reducing its Quantitative Easing program along with the BoJ (Bank of Japan). Even though the Fed stopped their QE program over two years ago, the market has still done well. Why? Because the ECB and BoJ have picked up the slack and then some. The liquidity they have produced is huge and much of that liquidity was invested in the US stock and bond markets because the US has been the best house on a shitty block. So, what happens when global liquidity starts drying up??? Well, if this liquidity has been fueling this relentless rise in the US stock market, which it has, without the liquidity stocks will fall, interest rates will rise, and it will rock the financial markets. So, this is the option the Fed is choosing in the hope that they can bring this market, O’ so gently, back to “normalcy.” But, once the central bankers start to extract this liquidity, no matter how gradual or gentle, you’re still letting air out of a massive bubble in stocks. If history, tells us anything about bubbles there’s no gradual way for it to end. No one knows where the breaking point is of the Fed’s Quantitative Tapering program, but that will be part of the catalyst that will end this bull market along with the ECB and BoJ Quantitative Easing reduction. The next logical question to ask is if the bubble does start to deflate, what will the Fed do??? Well, the last resort when the Fed realizes their Quantitative Tapering doesn’t work is, once again, to create Quantitative Easing Number 4…At that point, the Fed will realize that they are unable to exit from their QE program without inflicting pain on the market. The Fed will be out of “ammunition” and will have to succumb to defeat. This, in turn, will provide the public with the knowledge that the Fed is between a rock and a hard place, is unable to unwind QE, and as a result, the public’s reliance and faith in the Fed evaporates.

Of course, we don’t want this to happen, but the public needs to open their eyes to the fact that this market is being fueled by nothing more than excess liquidity. It’s not increased earnings or profitability of companies. We are seeing market caps skyrocket with no underlying catalyst except new money pouring into the market from excess liquidity. The rise is relentless, but the result of the extraction of this liquidity is going to be really really difficult. You can’t have blind optimism that this bull market is going to keep going forever, but many in the public do. Unfortunately, these poor millennials are going to learn the hard way. It’s hard to blame them. They’re used to low volatility, buying the dips, placing their money in high flyers, and not diversifying. Why would they? It’s worked great so far. This will end and when it does investors need to protect themselves. This is a great time to protect yourself. Low volatility provides some great opportunity to protect your portfolios. This our two cents. Could we be wrong? Hell yes! We have been before, but we don’t plan on getting caught in something that has a high probability of occurring. We can’t know the future, but we can be proactive and plan for it. If you don’t have a plan, you’re going to be reactive. Reactive is never good when your an investor in the market, especially if chaos ensues (see 2008).  Don’t chase prices higher in the hope that a greater fool will buy your positions from you at higher prices. Could we see a slow creep up (or an aggressive push higher) through the end of the year? Absolutely and it wouldn’t surprise us. Will that last through 2018? I think you know where we stand.

We hope everyone stays safe out there and has a wonderful Halloween. I don’t know if any of you dads have the same Modus Operandi, but I can’t wait to raid my kids’ candy stash for a boatload of peanut M&M’s! I figured my one-year-old could do the heavy lifting on helping dear old dad out on his candy addiction 🙂

A quick note, you’ll notice that there are a few links at the bottom of this newsletter. These links lead to some articles that, we thought, were super interesting. Please let us know if you enjoyed them. We plan on keeping them coming along with some other awesome content!

As always, if we can help you or anyone that you know please feel free to give us a call or book a meeting. We always enjoy talking to new folks. Last, please forward this newsletter on to anyone that might find it of interest.

 

The Hardest Part is Taking A Step Back

 

Whether you like Tim Ferriss or not is not important. Tim wrote a really insightful blog post recently about why he is stepping away from investing in startups. What intrigued me was why he did it. As a trader and investor I can empathize with what he is going through. Whether you’re an investor in startups or a trader in the public markets, stress is your enemy, but almost impossible to completely eradicate. Tim has a number of great points in this blog post. I will attempt to provide some of the most relevant to this conversation.

FOMO results in “B” Player Status

As an investor/trader many know that the “Fear of Missing Out” is strong. You hear of all the good trades and none of the bad. You fear that you are missing out on trades or investments that other people are making gobs of money on. The same goes for startup investing. If you are an angel or venture capitalist “FOMO” is just as strong. FOMO creates stress, terrible stress. This stress takes you out of the game and results a “B” investor status. Tim realizes that because of FOMO he is investing in more startups than he should. He’s becoming a “yes” man, which becomes an overwhelming experience. As a trader or investor I compare this issue with not being able to choose the investment or trading strategy that best fits your character. As an trader/investor your goal is to make money. When you see others make money or hear of these terrific trades, you start to wonder if you’re missing out. Should your trading/investing strategy change? It goes back to the phrase, keep it simple stupid. If you try to take advantage of every “opportunity” available you get stuck in the mud. You get buried alive. You get stressed out. You can’t focus. Your mind is too busy. Public markets give the trader/investor opportunities daily. Stay focused on what you’re good at, don’t worry about what others are saying, and maintain your edge. Don’t become a “B” player.

Does a large guaranteed decrease in present quality of life justify a large speculative return?

This is a terrific question for any trader/investor. I guess another way to ask this question is whether you would take the trade if the stress of the trade created insomnia, lethargy, loss of appetite, and/or moodiness, but the potential outcome could change your lifestyle. I would argue that this investor is on the path to destruction if that trade gets placed. I’ve been there. I have taken positions where the stakes were much higher than my comfort level. That level of uncomfort will almost always result in a negative outcome. There are always going to be individuals that are comfortable in that type of scenario and can think logically in unbelievably stressful times, but those are few and far between. Tim makes a terrific point in saying that you should always know your ROI which comes in the form of cash, time, energy, or otherwise. “An investment that produces a massive financial ROI but makes me a complete nervous mess, or causes insomnia and temper tantrums for a long period of time, is NOT a good investment.”

Leverage your strengths instead of fixing your weaknesses.

If this statement doesn’t make you think as a trader/investor you’re missing the point. Tim states, “Don’t push a boulder up a hill just because you can.” It’s absolutely true, but most “investment/trading guru’s” will push their methodology because it may have worked for them or a few others. Here’s the problem: the chance of that specific investment/trading methodology fitting your personality is pretty damn low. Before putting money on the line you should be seeking out your strengths and weaknesses. I have been a trader and investor for over 15 years and many “trading gurus” will tell you that eliminating your weaknesses will create success. This is a bunch of baloney. I know that my strengths are not geared toward short term trading. So, why should I trade short term? What benefit will that provide me, except years of attempting to change core behaviors to fit the mold. Why not understand and leverage my strengths? That is your edge, right? Understanding this concept will increase your quality of life and ROI as an investor.

Know Thyself.

This statement dovetails nicely and is somewhat related to the previous point. Many traders/investors are completely consumed by their profession. They’re usually an all or nothing type of person. It’s difficult to find the shut-off switch. Personally, I have realized that if and when I find it hard to shut down and focus on something other than investing, I need to step back. We all have a tendency to get completely absorbed by something and it’s difficult to pull yourself away. We don’t even realize our stress is through the roof. So, what do we do to combat this “disease”? Stop. Stop trading. Stop investing, until you can take a step back and see how it’s effecting you. I give Tim a lot of credit. He has been an extraordinarily successful Angel investor. He realized that he is an all or nothing guy. He knows, in theory, that he can’t follow through if he tells himself he will only invest in two deals a quarter, which he has tried to do. If he wants to slow down and create a better quality of life, he needs to stop for a breather. He needs to stop investing, so he can reboot. What’s the worst that can happen? Ask yourself that question, and write down the answers.

I was always told, “take your time, the market will always be there when you get back.” It’s calming advice. I believe the hardest part of being a trader/investor is the ability to step back and see the bigger picture. This profession can eat you alive faster than any other profession in the world. I don’t believe that there is another profession in the world where it’s absolutely imperative that you know yourself inside and out in order to be somewhat successful. Make sure investing is creating the lifestyle you always wanted, not the stress that buries you alive. Your quality of life is positively related to your success. So, if you need to take a step back, listen.

Why is Investment Style so Important in Trading?

$LQD daily breakout

Dr. Brett Steenbarger had a phenomenal article that he came out with today regarding trading and investment style and why it’s so important. I’ve been trading since 2001. I took a long haitus from 2006 to 2009 to go to law school. It was a good thing because the markets changed on me and I couldn’t figure out how to change with it. It’s been a constant battle trying to figure out what type of trading style fits my personality. Dr. Steenbarger is adamant that matching your trading style to your personality is the single most important factor in succeeding as a trader. I really couldn’t agree more. When I was a younger trader I learned how to scalp and take very short term trades. This wasn’t necessarily conducive to my personality. Even though I made money scalping, I felt like a nervous wreck every time I stepped in to the pits. This tells me that I wasn’t confident in my overall strategy and that it didn’t fit well with my personality. Over the years my trading and investment style has changed and morphed into a longer term trading strategy. My emotions stay in check and I’m able to plan before placing a trade. When I lack the time to plan a trade I feel that I lose my edge. If you don’t have an edge, there’s no chance you’re making money.  Dr. Steenbarger provides a great outline:

Your style of trading and investing embraces a number of dimensions:

  • How you manage risk and pursue reward;
  • How long you hold positions;
  • How many positions you carry at one time;
  • How many markets you follow closely;
  • How you analyze markets and find opportunity;
  • How you express views in markets

This outline is huge for me. It gives me a framework to understand my own personality and nail down a trading style that fits me.

How do you manage risk and pursue reward?  For example, I manage risk very well. Even if I have a string of losses my risk always stays within my parameters. I’ve been burned too many times by allowing positions to move past my stop.

How long do you hold positions? – I hold positions from a few days to a few months vs. my previous style which was day trading/scalping.

How many positions do you carry at one time? –  If I carry too many positions at one time, I tend to second guess myself. For example, I may hold a long position in AUD/USD and a short position in AUD/JPY. Sometimes opposing positions in the base currency (AUD) makes me feel like I’m opposing my original position and end up getting out of one of the positions too early. Having said that I usually only trade one currency base pair at a time, but allow myself to take other positions in other markets.

How many markets do you follow closely? I try to not to follow too many markets at one time. I usually focus on markets that are setting up to my liking and focus on those markets.

How do you analyze markets and find opportunity? Usually I’ll have an idea based on some research that I’ve done. Once I have the idea I will look at the charts for an entry based on technical analysis. I try to bring both fundamental and technical analysis together. I do believe you should understand what’s actually happening in the markets and why before placing the trade. Fundamentals may give me the framework to work from, but technicals are all the details in between.

How do you express views in markets? – I read ALOT. This research provides me with a hypothesis of a possible trade idea. I then try to think of all the ways the position could go. If the risk outweighs the reward, I take the trade. I express my views by taking positions and putting money on the line. This research provides me with the confidence to take the trade.

I really don’t believe you can take someone else’s trading style, copy it exactly, and believe its going to work for you. I do believe you take can tweak someone’s trading style to fit your personality and become successful. Every great trader/investor that I know has found a way to trade their own way taking their own personality into consideration.