model portfolio performance update

Timing of recent moves to trim the portfolio Beta down to ~0.0x was fortuitous insofar as the market moved downward almost immediately thereafter. The model is now up ~15% since inception vs. ~0% for the benchmark Vanguard Total World Stock fund (ticker: VT).

Essentially, the portfolio is now 66% long of low beta stocks diversified across economic sectors and national geographies, except for my own esoteric bias against banks and gold miners, and 33% short of the S&P 500 (i.e. Large-cap, U.S. stocks).

Since I think the economy has reached an intermediate term headwind, I don't expect to go net long again anytime this year. The market will probably have a few huge up days here and there as the Fed makes announcements concerning liquidity supports, but overall I think the downside risk is too much for being long anytime soon. I wish I saw it differently, and was correct in seeing it that way, but that's not the case and only time will tell. It's frightening to see the recent flight to treasuries and away from stocks and high-yield bonds; reminds me of darker days. At the least, it doesn't portend good things for folks seeking work. If only this were to prove true, the import-substitution effect and associated multiplier would be a huge game changer and brighten the future of profits and jobs (ht: andrew).

Theory of Runs

A trading book I was reading a few weeks ago had a chapter on Martingales and Anti-Martingales. I already knew the pitfalls of a Martingale strategy based on an unfortunate occurrence in Vegas a few years ago when I had but 15 minutes before needing to catch a cab to catch a red eye back to home. I sat down at a $10 black jack table with a couple friends and proceeded to double my bet every time I lost hoping the ever present risk of a run of bad hands wouldn't be realized. I was $800 lighter in the pocket when I caught that cab.

Anyhow, when reading of the Anti-Martingales strategy whereby one increases their bet after a win and decreases the bet after a loss, I was reminded of the book Bringing Down the House wherein this type of strategy was used for risk management purposes. So the combination of these two experiences created a desire to back-test the strategy against historical stock market data (SURPRISE!).

Using Dow Jones Index data from yahoo! finance going back to 1929, I ran the following test:

1. If the prior day was a down day, then don't invest.
2. If the prior day was an up day, then invest 100%.
3. If the prior two days were up, then invest 200%.
4. If the prior three or more days were up, then invest 300%.

Historically speaking, this strategy would have needed to use margin (i.e. borrowed money) to purchase stocks equal to 200% or 300% of ones bankroll or 'stake'. However, today such leverage can be effectuated via ETFs such as UPRO and SDS.

The results of the test are displayed in the charts above. Some interesting take-aways:

1. The Anti-martingales strategy produced higher returns than the Buy&Hold strategy whilst its Beta (relative to the Buy&Hold strategy) typically ranged over time from 0.5x to 1.0x, thus producing a considerable amount of Alpha when measured over the entire 80 years.
2. There were a couple time periods, such as the 1930s and 2000s, when the Anti-martingales strategy would have cost someone ~90% of their stake.
3. All the outperformance of the Anti-martingales strategy came from the period 1940-1974. From 1974 to 2000ish, the returns of Anti-martingales essentially matched those of the Buy&Hold strategy.
4. Around 1974, the average 'run' of either positive or negative days in the market experienced a sudden drop from ~2.3 days down to ~1.9 days. Although I'm not sure why the average 'run' suddenly decreased then (widespread use of computers for trading?), the fact that it did obviously impacted the performance of the Anti-martingales strategy.

Conclusion: I wouldn't try this Anti-martingales strategy since it hasn't worked since 1974. However, the last time this strategy experienced a 90% decline (1930s), it really outperformed over the subsequent 35 years. Perhaps since this strategy experienced a 90% decline in the 2000s it could be poised for some outperformance.

market timing (part 1.2)

Since I basically changed the model portfolio to be market-neutral last week based on the most recent retail and employment stats, I thought it worthwhile to update my prior post on market timing based on retail sales. Last week, I did what no trader should do, which is to take action based on quantitative data before back-testing the decision. In other words, my prior back-testing was based on a rule whereby the trailing-2-month average retail sales were compared to the trailing-12-month average retail sales. So, just to get squared away, this week I've back-tested what it would looks like if one were to have traded based on the criteria I implicitly cited last week, which was:

1. If the year-over-year retail sales growth has weakened for two consecutive months, then sell.
2. If the year-over-year retail sales growth has strengthened for two consecutive months, then buy.
3. Otherwise, hold your position (either in or out of the market as the case may be) the same as the previous month.

The results are shown in the chart above, and the story is essentially the same as it was. Lower variability of returns (standard deviation), much lower Beta, and positive Alpha, which you'll recall is simply the amount of 'excess' return after adjusting for what you 'should' have received after adjusting for the lower Beta of the market-timing strategy. As you can see, this is a long-term strategy that will under-perform in bull markets and outperform in bear markets, but over the entire cycle does fairly well after accounting for the lower volatility risk.

Note: retail sales data is only available in electronic format back to 1994.

Quote for the Week: "Anger is an acid that can do more harm to the vessel in which it is stored than to anything on which it is poured." - Mark Twain

happy fathers day!

I attended this class back in October, the week before my second son was born, and won a door prize for being the expectant father with the nearest due date. It's a great, informative, positive program that I'd recommend to any expectant fathers you may know. I've since been back a couple times as a 'veteran' together with my son to share my own experience with the new 'recruits'. Anyhow, the program hosted a big event today in honor of fathers day and I thought I'd share a couple poinant quotes:

"Slow down and live today like you're dying. Because you are. You just don't know the rate at which you're dying or the expiration date."

Advice to your child when they stop thinking you know everything: "The older you get, the smarter I'll get".

Quotes from Reminiscences of a Stock Operator

REMINISCENCES OF A STOCK OPERATOR by Edwin LeFevre The Sun Dial Press,Inc. Garden City, New York Copyright 1923, by George H. Doran Company

"The public ought always to keep in mind the elementals of stock trading. When a stock is going up no elaborate explanation is needed as to why it is going up. It takes continuous buying to make a stock keep on going up. As long as it does so, with only small and natural reactions from time to time, it is a pretty safe proposition to trail along with it. But if after a long steady rise a stock turns and gradually begins to go down, with only occasional small rallies, it is obvious that the line of least resistance has changed from upward to downward. Such being the case why should any one ask for explanations? There are probably very good reasons why it should go down, but these reasons are known only to a few people who either keep those reasons to themselves, or else actually tell the public that the stock is cheap. The nature of the game as it is played is such that the public should realise that the truth cannot be told by the few who know."

"Speculation in stocks will never disappear. It isn't desirable that it should. It cannot be checked by warnings as to its dangers. You cannot prevent people from guessing wrong no matter how able or how experienced they may be. Carefully laid plans will miscarry because the unexpected and even the unexpectable will happen. Disaster may come from a convulsion of nature or from the weather, from your own greed or from some man's vanity; from fear or from uncontrolled hope."

"On the other hand there is profit in studying the human factors the ease with which human beings believe what it pleases them to believe; and how they allow themselves - indeed, urge themselves -to be influenced by their cupidity or by the dollar-cost of the average man's carelessness. Fear and hope remain the same; therefore the study of the psychology of speculators is as valuable as it ever was. Weapons change, but strategy remains strategy, on the New York Stock Exchange as on the battlefield. I think the clearest summing up of the whole thing was expressed by Thomas F. Woodlock when he declared: "The principles of successful stock speculation are based on the supposition that people will continue in the future to make the mistakes that they have made in the past.""

houston, we have a problem

Yesterday, I received an email from my friend and first boss post college, to which I replied:

"i've been thinking hard lately about taking my model portfolio beta down from ~0.50 to 0.25 by allocating 10% to 2x inverse S&P. but the gubmint releases retail sales tomorrow at 8:30am, which if they come in near expected 0.4% month over month growth (seasonally adjusted), will still show a decent y/y figure (which is my personal favorite indicator). overall, i think i'd rather leave something on the table than get trigger happy - so will likely wait for more confirmation. when i think about potential future scenarios, i just don't see the S&P going back to 666 simply b/c i don't see liquidity getting squeezed like it was back then. also, i think the FED can buy a lot of treasuries to finance govt spending via seniorage without creating inflation pressures, especially if the proposed higher banking reserve ratios keep a permanent lid on lending / velocity of money."

The retail sales figures released this morning were not good. Down 1.2% (month/month), rather than the consensus estimate of up 0.4%. More importantly in my view, this marks the second month in a row where the year/year increase has weakened (see chart above - click it twice).

So what do I do? I go look at other indicators to confirm and I find that the employment sitch isn't any better. Everyone was talking last week about how something like 90% of the new jobs were due to census hiring. Furthermore, calculated risk shows that temp hiring (which tends to lead payrolls) has pulled back. As icing on the cake, the small business hiring that usually isn't picked up by government payroll stats during economic recoveries (which tends to cause people to call them 'jobless' when they really aren't) apparently isn't there.

Separately, and perhaps most ominous, the TED spread has begun to widen. This is particularly worrisome to me because of all the zombie commercial real estate loans out there for which the only sustenance is low LIBOR. This is b/c their interest expense charged to borrowers is most often a spread over LIBOR, which if it's low, can be covered by cash flow generated by the property.

I think the writing is on the wall now. No use in waiting for the trumpets to sound. Trade early or not at all. [feel free to insert your own favorite cliche here]. I'm going to offset the model portfolio's exposure to the stock market by allocating ~33% to the Proshares ETF that is short the S&P 500 (ticker: SH). That will take the beta down to ~0.0x [33%*(-1.0) + (1-33%)*0.5 = 0.0]. I chose the ETF that's 1x inverse of the S&P 500, rather than the version that's 2x inverse b/c I don't like leverage (long or short).

I stand by my views expressed in the email to my friend, but I think we now have confirmation. I don't think the S&P will return to 666, but rather will swing back and forth between 800-1,200 for a few years until P/E ratios (i.e. valuations) bottom out and we begin with a new secular bull market. In the meantime, I think it's worth trying to avoid some of the downswings. At the very least, decreased exposure now will reduce volatility in my account and thereby help preserve clear judgement.

My only hesitation is that I don't know anyone who is bullish on the market right now, but I'm just going to chalk that up to being a function of my friend selection. Nevertheless, when you're a contrarian investor at heart (it's intuitively appealing), it's always bothersome to find someone who agrees with you. I take solace from the fact that wall street sell-side shops are still ostensibly bullish. In any case, I want to make decisions based on intermediate-term drivers like economic stats, without regard to short-term drivers like sentiment. [UPDATE: I hope these guys are both representative of the market consensus and overly optimistic]

P.S. Looking to the bright side, if you choose not to reduce your exposure to stocks at this time and this downswing I've described actually plays out, it will provide a nice chance to convert regular IRA accounts over to Roth IRAs while minimizing the amount of income taxes triggered (which are based on the value of your account at the time of conversion).