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China’s Market And Policy Timeline

Bloomberg has created an interesting graphic looking at the various market interventions undertaken by the Chinese government. The part to concentrate on is the number of actions taken to stem the decline – none of which seemed to have worked.  My feeling has always been that markets will go int he direction they want to go and any government intervention is simply an attempt for politicians of all stripes to feel as if they are doing something useful rather than just taking up space.

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Drawdowns

I thought will the market currently going to hell in a handcart it would be instructive to generate a few drawdown curves for the main players. Moves such as the one we are undergoing are always instructive, if only for the illustrative effect of seeing how little the media actually knows about market. The issue for me is one of surprise – I am always surprised that others are surprised that the market goes down – to the best of my knowledge the law of gravity as it applies to stocks prices has not been repealed.

I posted the following comment in the Alumni Section of our Mentor Program forum.

I always return to the notion that the market will tell you everything you need to know – you need to know how to listen.

For example, the US has been weak for months, the various new high/new low indices have been faltering and the number of stocks within each index that is above its benchmark moving average has been steadily falling. Put this together with a market that was range bound and all you needed was a catalyst in the form of China to trigger a move. However, you can only see these things if you are watching them as they unfold – this sell off has obviously caught a lot unprepared simply because they either were not listening or didn’t believe that markets could ever go down.

From my perspective it is impossible to have the worlds largest market go sideways for a year and for the worlds second largest market to fall out of bed without there being some form of reaction. The reaction might be a one week wonder or it might see out the year, no one knows and those who say they do are deluded. The central issue is having the ability to be involved for however long it lasts. I find the pain of getting involved in a move and not making as much out of it as I should is much less than not being involved at all.

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As is plainly obvious drawdowns are not new – markets have always been afflicted by these emotional reactions. Sometimes, they are accompanied by a reasonably cohesive narrative such as during the GFC, at other times it is simply the blind reaction of the herd and we look for justification afterwards. Irrespective of the causes, they are inevitable and they are a feature of trading/investing that everyone has to find a way to deal with. The only way I have found to deal with them is to have a fluidity of perception and to  not be wedded to any single view point. I understand that we a little more than a collection of biases and watching and listening to the reactions of people to the slip merely reinforces my opinion that most people have never had a rational thought in their entire lives. This goes doubly for those in the sell side of the industry who are offering all manner of silly platitudes and little homilies as a means of dealing with what is a real event.

The key point in all of this is to trade what you see, not what you think you see or more importantly what you want to see.

History Counts

One of the more frustrating things about trading is that in some ways your returns are bounded by the environment within which you are investing. This is particularly true if you are dim enough to be  a buy and hold investor. The underlying sentiments of markets ebbs and flows and this sentiment infects all aspects of the market. as the old saying goes all ships float on a rising tide, implying that bull markets are good for all stocks and I believe this to be largely true. For aggressive disciplined traders bull markets present a cornucopia of opportunity that is too good to resist. However, flat markets are painful and dull and once again they are especially painful for those who are inactive investors who are merely carried along by what is happening.

I wanted to look at the broad distribution of returns of various periods – this is one of those dodgy back of the envelope things that I like to do. What I did was look at the three metrics as applied to the All Ordinaries, the value of $1 invested for the time period, the maximum drawdown for that period and the annualised return. These are shown below.

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I broke the returns up into decades since this is about the average lifespan of an investor/trader. So for the period 1991 to 2001 if you had invested $1 into the All Ordinaries at the beginning of this period by the end it would have been worth $1.98. During that period you would have had to endure a maximum drawdown in your investment of 22% and your annualised return would average out at 7.1%.

There are a few interesting points to this table –

1. The index only produced double digit average annualised growth once in this survey. For the decade sized samples from 1998 onwards the returns were very modest.

2. A single event such as the GFC can have a devastating impact upon long term investment strategies. If you do not take any prudent measures to avoid or manage them. it should be remembered that we are encountering such events about once every ten year.

3. The best decade was 1997 to 2007. However, if I look at these returns in more detail this decade had four good years that produced most of the returns. If I isolate this period of 05/03 to 09/07 I found that $1 invested at the beginning of this period had grown to $2.09 by 09/07 with an annualised rate of return of 18.9%.

4. When you invest matters.

For the sake of completeness I did look at the returns for simply holding throughout this period and the results were as follows –

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The above table puts into perspective much of the hype you hear from find managers about being in the market for the long haul, good shares always get better, dont miss the good day blah…blah…blah. Very little that is said by the sell side of the industry stands up to scrutiny – what you see here is very modest returns. I feel that the central point is that the majority of returns are made during very select periods of time and outside of those periods traders either need to be very active or simply search further afield for opportunities.

 

Returns

With nothing to do on a Sunday afternoon I thought I would have a bit of a play with excel and look at the returns for ASX Top 20 shares. I have split the returns into 1 year, 5 year and 10 years. I have also looked at the maximum drawdown that occurred during that 10 year period.

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Returns are intriguing little metrics and there are a few things that are quite obvious.

1. Starting date is important – this is why people when quoting their returns will try to generate a start date that is favourable to them. This is why it is so hard to find long term data on fund managers – longer term data tends to blunt the lift given by preferentially selecting a favourable start date.

2. Persistence is interesting – good returns tend to persist and  so do poor returns. This to me is further evidence that you keep shares that are performing and dump those that are not. Unfortunately, most professional money managers have this backwards.

3. The longer term return is probably the closest to the real return – this is simple mean reversion in action.

4. Drawdowns kill – as you would expect from this sort of data the period immediately post the GFC sucked for equities. Whilst some might opt for a buy and hold approach I doubt many could stomach drawdowns in excess of 60% which occurred with a few shares.

5. The performance of the overall market during this period has been very poor with the All Ords struggling to generate 10 annualised growth in excess of  3.4%. It would seem that if you were a fund manager than the best play in the past 5 years would have simply to hunted in the top 20 and leave the rest of the market alone.

Finally a pretty chart.

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A Self Fulfilling Fantasy

I came across this interesting piece on the British Psychological Society website. You can read the article in full at your leisure but I wanted to look at one particular piece of the article. In short the article looks at the gamblers fallacy – that is the notion that after a series of losses that a gambler is due for a win. You will often hear this expression from double digit IQ football commentators who state that a given side having been flogged for weeks on end are due for a win. In the paper being examined two researchers set out to examine how this fallacy functions in real life not just within the somewhat sterile bounds of academia where undergraduates are given five bucks and a beer to be tortured. What they initially found was fascinating.

Although the bets were from unrelated events, from football matches to horse racing, people who had a run of wins had a higher probability of winning their next bet. For example, gamblers who had a run of three wins had a probability of 0.67 of winning their next bet, compared to a probability of 0.45 for those who hadn’t had such a winning streak. The researchers analysed streaks of up to six wins in a row and found that the probability of winning the next bet just went up and up. The effect also held for losing steaks, so that those who lost successive bets were also more likely to lose again. The effect didn’t seem to be due to skill, since a control analysis showed that the average winnings for gamblers who had long streaks of luck were the same, or perhaps even slightly lower, than for those who didn’t have long streaks. The result seems to contract the gambler’s fallacy, and even our reasonable faith that bet outcomes should be independent.

This is an interesting conundrum and the answer was found in looking at the actual bets that were placing and analysing both odds the bets were placed at and the size of the bet.

The answer to the mystery was revealed when Xu and Harvey analysed the odds of the bets placed by gamblers in the middle of a streak, and the amount they staked. Gamblers who won tended to take their next bet on a safer odds than the bet they had just won, with the reverse true for people on losing streaks. This, the researchers suggest, is because they believed in the gambler’s fallacy and so expected their luck to turn. This had the paradoxical effect of creating luck for those who were already winning – because they then made bets they were more likely to win – and rubbing in the bad luck of those who were losing – because they made bets which they were less likely to win and so perpetuated their losing streak.

What interests me about this study is that the gamblers were using a form of risk control during their streaks in effect they were trading their equity curve – a tactic too few traders engage in. They also seemed to be moving away subconsciously from high volatility markets to markets of perceived low volatility.

 

Is The Market Overvalued Part 2

I had not intended for my Is The Market Overvalued? piece to become a two parter but I came across the following chart courtesy of the people at Bespoke, who produce a dazzling array of metrics.

 

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This chart looks at the number of S&P500 stocks which are above their 50 day moving average. The implication of such charts is that when there is a low percentage of stocks above their moving average that the bears are exhausted and the market is ripe for reversal. Conversely, having almost all stocks above their moving average may indicate that the market is overextended.

The notion of looking at panic and euphoria has always interested me and the Bespoke chart is of some academic interest. However, like a lot of things in trading it seems to me that looking at a 50 day moving average really doesn’t convey all that much information. I find narrow time frames far too noisy to be of much benefit in decision making. If you are looking for what could be called global shifts in sentiment then you need to take a more macro view.  The central philosophy of being a portfolio trader is that you are only interested in when to be in the market and when to be out of the market. Everything else is largely an irrelevancy and it is an irrelevancy because time in the market is an irrelevant concept. The notion of time in the market simply doesn’t work as evidenced by the chart below where the effect of being in the market all the time is compared to missing those periods when the market went up 2.5% versus those times when it went down by 2.5%.

 

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I wholly accept that it is impossible to miss all those periods when the market goes down by a given amount. But these periods occur in obvious bear markets so if we can go some way to identifying these periods then we will be ahead of those who simply cling to the mantra of being in the market all the time.

However, back to our metric of the number of stocks above a given moving average. I wanted to take as wider view of the market as possible so the chart below looks at Dow stocks that are above their 200 week moving average and I have plotted this against the Dow. The Dow is a far from perfect sample but it is the only group I have data for.

 

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The take home point for me is in an uptrend it is quite possible to have the majority of stocks above their 200 week moving average and for this mean not much at all. What is important is the trend since this puts the movement of stocks into context. If the broader market is trending up and the majority of stocks are also above their moving average then this does not automatically mean that stocks are going to reverse. To assume show would appear to be a mistake.

The same is largely true for downtrends. However, there does seem to be a slight exception to this rule. On those rare occasions when every single component of an index has tanked it does seem to indicate that the bears are exhausted and that selling pressure may be abating. It does seem that on these occasions that fear is readily supplanted by greed and the index does reverse. The question though is one of both utility and information management. Does this information in isolation provide enough confidence to act or is it merely a form of early warning. I would tend to err on the side of caution and suggest that it is simply a form of early warning – the market is telling you something but I don’t think it is telling you enough to act.

So we are back to the notion of simply using trend to decide when to be in the market and when to be out of the market. The various metrics I have looked at in this unintended two parter are interesting and they do tell a story but it is really only part of a story.

 

Is The Market Overvalued?

This is a question that tends to get posed at boardrooms and dinner parties any time the market has had an extended run. Whenever, someone poses this question to me, my immediate and somewhat flippant answer is don’t know and don’t care. My response is based upon the notion that I feel it is the wrong question because it is based upon the false assumption that markets can in some way be fairly valued. I feel a more telling and pertinent question to ask is the market exhibiting signs of mania?

By mania I mean is the world consumed by what is happening in the market? Does everyone you met from all walks of life talk incessantly about the market? If the market is a topic of conversation everywhere you go then it is a good bet that the market is in the grip of mania. The problem with this is that it is simply an anecdotal observation that may be skewed by any number of factors.

Defining mania in a quantitative sense is very hard since it is a sociological phenomenon and the social sciences are notoriously fuzzy. The notion of measuring mania is a problem I have returned to over and again. And as the years pass I don’t think I am actually any closer to answering my own question. Traditionally when looking at the notion of valuation and the broader market fundamentalists (as least those with a global view) have turned to looking at relative PE ratios. The thinking behind this as a measure is that as markets accelerate and valuations become more out of alignment with whatever the perceived reality is then this will show up in the markets overall PE ratio.

The chart below is of the Schiller PE ratio compared to the S&P500.

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The issue with the sort of data is that it is not a timing tool and therefore it is problematic for those of us who time the market. It also suffers from the problem that the GFC occurred at a time when valuations did not seem to be that divorced from reality. There is a problem for this mechanism and it highlights a problem in general with outlier moves. They may effectively blindside investors because there is no reasonable forewarning and this is one of the problems that seems to have bedeviled markets over the past few decades.

The other tool that I have investigated is margin debt on the NYSE since people when full of misguided conviction will ignore the risks of being over leveraged.

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The use of margin debt as a proxy for mania is an interesting concept and is one that I do think has some merit but only as a background measure. I say it is a tool of qualified use because over the years there has been a structural change in the market that I think skews the picture a little. The emergence of hedge funds that use massive amounts of leverage means that when looking at margin debt we are not actually looking solely at retail margin but also institutional margin. So in effect we are seeing institutional mania.

However, some would argue that we are actually seeing intuitional confidence and I would in part agree with these in the earlier stages of the take up of leverage. But, it assumes that hedge funds are smarter than the average punter and less prone to emotional swings. In my opinion this is not true. All investors are flawed emotionally and prone to the same reckless errors. It is just that hedge funds and the like make their mistakes on a massive scale, which is why they are so dangerous.

One of the errors that creeps into thinking about tools that could be used to identify mania is the belief that they are predictive when in fact they are post- dictive.  They tell us what the peak of mania might have been once we are past it. They are a good rear view mirror tool as are all technical tools. They have a slightly different orientation but they are neither better nor worse than any other tool.

I often state that the single most important rule for trading is knowing when to be in the market. Equally important is when to stay with the market and be a pig. These tools don’t actually do this because they act as in many ways as little more than confirmation bias. If you feel the market is overvalued or in the grip of mania you will look at one of these tools to confirm you view. If you think the market is undervalued you will do the same thing. Confirmation bias is the enemy of traders and sentiment or market valuation tools tend to have a stronger pull than strict trading tools. I have often wondered whether this is because they form part of narrative that traders construct and therefor they strongly support the underlying narrative.

This inevitably raises the question of what do I do. What I do is based upon a few ground rules.

  1. I have no idea where the market is going – never have had, never will have. I was obviously born without the special crystal rubbing, psychic, tarot reading, seeing dead people gene that so many peanuts on Facebook seem to have. Strange how they are all poor.
  2. I am not wedded to any particular mindset – the notion of bull or bear is largely irrelevant in a trading context. I might be a bull this week, a bear next and back to being a bull.
  3. Go as hard as you go for as a long as you can. When you cannot go any longer then the good times are probably over.
  4. Don’t trust yourself – each of us is fallible in ways we never imagine and never take into consideration.
  5. Don’t get killed.

In terms of how I take the temperature of the market I tend to be very simple and use the following two charts. When they are long I am long, when they are short I am out or short.

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