On February 7, 2017 issue #17 of our research service led with this:
Yesterday, the position was closed at 13h01 US Eastern time ahead of the Fed’s interest rate announcement. The screenshot of the alert sent to subscribers shows the result (and uses Central European Time on the stamp):
A cherry-picked example for sure. But our full 2016 record is available here to download along with the rest of the harvest; and we will be publish quarterly updates.
As of this writing our internal trading account, based entirely on what is published in our research, is up +24.3% since inception in June, 2016. The S&P 500 is up +15.2%.
Yesterday the US central bank raised its base rate – the federal funds rate – to 1% continuing the move away from a ZIRP (zero interest rate policy). While exceptionally low by historical and absolute standards 1% is clearly the start of a larger tightening cycle.
Intuitively one expects more expensive credit to be a negative for equities. So why the rally? It is all about context:
That said, there is perhaps an ‘unknown unknown’ in the current story: will the unwinding of quantitative easing proceed in an orderly manner?
While there have been bouts of QE since 2007-2008 there have also been several taper tantrums. This time the fact, rather than the prospect, of a rate increase has been embraced.
So far, anyway. The past is a guide not a guarantee.
President Truman asked for one-handed economists to avoid hearing “on the one hand…but on the other”. Winston Churchill complained that any meeting with 2 economists provided 2 competing views – unless one of them was John Maynard Keynes in which case you got 3.
And so it is with equity analysts who try at one and the same time to recommend but point out the probable pitfalls of their advice. Consider this graph from a Morgan Stanley research report:
It so happens it is a great piece of research. But one must wonder about the worth of the blue triangle which says a buyer might make 61%. But on the other hand he might lose 75%. And there, in between, is the ‘Lord Keynes’ view that a gain of 10% is most likely.
This is why hedging is attractive: the finest brains of analysts and economists cannot – and as a rule do not – forecast. They assess current conditions.
“There is nothing new except what has been forgotten.”
Marie-Antoinette is not generally considered a great font of portfolio management knowledge. But this quote attributed to her is relevant.
It reminds that there are no mysteries to managing a portfolio which have not already been grappled with and (for the most part) cracked. The usual issue is one of discipline and recall of the rules.
This is a link to an essay written in 2012 by Zeke Ashton of Centaur Capital (see page 21). It’s a cogent and tightly written piece that breaks down the challenge of running a portfolio into 5 elements that must be addressed by the manager:
- Capital flight
It is a useful handbook when building up holdings of long/short pairs. For example, the section on correlation of positions is especially pertinent since related pairs frequently trigger at a similar time. Excessive holdings of what are effectively the same bets is not a great idea.
But all the points are key and must not be forgotten. That’s why it is saved in our library archive. Hopefully it is of use to you!
In the 2017 edition of the Credit Suisse Global Investment Returns Yearbook, published this month, is this terrific illustration of the power and danger of equity investment:
US equity investors have enjoyed 6.4% average returns over the period 1900 to 2016. That has come with a fairly hefty standard deviation of 20%. But compared to other global markets that’s not bad.
On the other hand, the US standard deviation includes a worst year return of -38.4%. But, again, not bad compared to, say, Germany or Japan right after the Second World War.
However, when the years 1929 and 1930 are included the US decline was 80% in real terms, peak to trough. For the UK the worst such range was 1973-1974 when markets fell 71%. More recently, 2008 has been the worst year on record for almost half the markets listed.
Bottom line – it’s not easy to forecast when they will happen but catastrophic declines will punctuate our equity existence. So hedge.
Our latest research was released today at 10h30 GMT! It covers the following:
- A featured pair from the steel and construction sectors
- Signal price slippage – your experience
- Performance update
- Research review: commodities & cointegration
- Status of research pairs
What does a ‘featured pair’ look like? An example excerpt from issue #9 (note, not today’s release) is below:
The full version digs into both halves of the pair, provides a fundamental accounting profile and the backtest out of the ArbMaker cointegration software tool-set. If a signal is subsequently generated for this pair an alert is sent via email and mobile phone alert with complete entry details.
Trials available here.
Research review: Percent accruals (2010)
A subscriber to our premium research newsletter and owner of our software commented that he was surprised by the depth of fundamental analysis we applied to our selections.
This is particularly the case where the anticipated trade horizon demands it. That is, it is frequently a good idea to identify the stronger half of your pair and trade with it rather than against it – especially for longer trade durations. Over time pricing is more likely to reflect fundamentals than not.
This approach is in keeping with the notion of “filters” we have written about several times in our research to clients: the stat tells one story; technical indicators another; sentiment yet another; and the accounting one more (and so on). The sweet-spot where these filters overlap represents a validation of one’s primary methodology.
To underline this point have a read of this older but still valid paper that is accounting-focussed. The core, entirely reasonable notion is that cash trumps accruals – and the large data set presented demonstrates the payoff. The authors are positing that a single indicator allows traders to select both a long and a short and expect a significant reward (in the aggregate) over the following accounting exercise.
These types of indicators are useful secondary triggers that help validate a trade’s thesis. But limitations remain and it would be a misguided trader who sought to apply it (i) in isolation; and (ii) for very short-term trades.
*This is an abridged version of an excerpt from our research service. Try it free.
This week US stock markets hit records. Will the run continue?
Long/short approaches should not care either way – it is generally directional investors and traders who rejoice (and hope). In an ideal world one would have exposure to both strategies. But there are always important provisos to consider for long only strategies.
There is sometimes comfort taken from “momentum” arguments when buying high. Others view purchases made at all-time highs under the assumption that, over the “long term”, the passage of time will forgive paying too much today.
Maybe so, but there is no guarantee of that. A long term investment is sometimes only a euphemism for a short term investment gone bad. Worse, events may subsequently prove the purchase did not fully appreciate the context in which it was made.
We point you to an article here showing how such an attitude unravelled for one set of professional private equity investors caught in a “we must not miss out on this” mindset. It’s about a 10 minute read.
Any investment can tank. Often that may be due to factors beyond one’s control. But succumbing to the temptation of a roaring market without taking everything – most of all price – into account is avoidable!
Better still, hedge.
Some interesting and informative data for long/short traders from a 13 February “Earnings Season Update” report compiled by BoA Merrill Lynch.
With 85% of companies reported:
- 61% have beaten on EPS
- 48% have beaten on sales
- 36% have done both
Those EPS beats are better than post-2000 average of 53% but the sales results are worse than their historical 56% level.
Perhaps most interesting were these 2 graphs:
Health Care and Tech have had most positive surprises with the opposite being the case for Staples, Telecom and Utilities.
Something to bear in mind when considering sentiment.
None the less, we like it very much as a news source and general sounding-off platform. If you care to follow us just go here or click the graphic below.