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Volatility and Stuff

With the situation on the Korean Peninsula threatening to give us another 9 years of MASH and with our own politician desperately trying to find relevance on the world stage by injecting themselves into the crisis I thought it might be interesting to see how markets viewed what was going on. Markets traditionally respond to uncertainty with a lift in volatility – this lift reflects not only the uncertainty but also the need to be compensated for the risk associated with this uncertainty. If things are really bad then markets lift volatility across the board. So to see if this was happening I took a small snapshot of major markets, looked at their 30 day historical volatility and then compared that with their long term average volatility.  I have marked those markets that are currently experiencing relatively low volatility in blue. The results of my straw poll can be seen in the table below.

HV Comp

Intriguingly the worlds largest market doesn’t seem to think much of the crisis, nor does gold which is usually seen as a barometer of such things. As to what these means I have no idea and historical precedents are not much help since it offers a slightly different picture. At the outbreak of the original conflict in 1950 volatility went through the roof  but during the Cuban missile Crisis which our idiot politicians are trying to compare it to only had an increase in volatility after the crisis ended and markets were recovering.

So what does it all mean? I have no idea but since it is only observational and not predictive it doesn’t really matter.



S&P 500 Panic Attacks


ETF’s that ate the world

Interesting graphic from the Investment Company Institute showing the flows of cash into index ETF’s and out of actively managed funds.


A Century of Evidence on Trend Following

AQR recently updated its paper A Century of Evidence on Trend Following and whilst the updated hasn’t changed the basic conclusion of earlier versions it is worth unpacking some of the main point of the paper.

The paper in its introduction makes an immensely important point that is lost on most –

As an investment style, trend following has existed for a very long time. Some 200 years ago, the classical economist David Ricardo’s imperative to “cut short your losses” and “let your profits run on” suggests an attention to trends. A century later, the legendary trader Jesse Livermore stated explicitly that the “big money was not in the individual fluctuations but in … sizing up the entire market and its trend.”

The thing I always find fascinating about trading, markets and people is that everyone is trying to reinvent the wheel. I understand this compulsion after all a new wheel sells but the basic technology of trend following and trading in general is as seen above centuries old. Yet these simple ideas somehow go by the wayside. Granted our own psychology gets in the way of following Ricardo’s simple missive of letting our profits run and cutting our losses short as we find being in the action more compelling than actually trading correctly. But even professionals have trouble following this rule as evidenced by the number of institutions who hold stocks as they grind their way into the ground.

In assembling the material for this paper AQR looked at the monthly returns for some 67 markets which were made up of four major asset classes – 29 commodities, 11 equity indices, 15 bond markets and 12 currency pairs. Which is no mean feat when you are going back a century. The results of this analysis can be summed up in few charts. To test the notion of trend following they adopted a simple strategy consisting of a 1- month, 3-month, and 12-month momentum strategy for each market. In this instance momentum does not refer to an indicator but rather price movement.  A long position was taken if the pat return over the look back period was positive, conversely a short position was taken if the return over the look back period was negative.

It’s a simple if it’s going up buy it, if it’s going down sell it strategy.

Position sizing was volatility based and the portfolios were rescaled monthly to make certain that the portfolio hit an annualised volatility target of 10%. Fees and charges were included in the testing.

Take home points

Trend following was profitable in every decade since 1880 as shown in the table below.

Exhibit 1

Trend following beats traditional 60/40 portfolios. The chart below looks at drawdowns during periods of financial stress. As can be seen trend following does very well during these periods. The authors posit that this occurs because of the simple ability of trend following to point themselves in the direction of the prevailing trend as dictated by Livermore’s dictum of deciding what the overall trend is.


Trend following produces outsized gains when markets are moving. In developing a trading system traders often simply look at the overall return of the system and if it is positive then they are happy. However, of equal importance is how those returns are derived. It has been my experience that the majority of returns are generated in a cluster of individual returns, that is the entire portfolio doesn’t do well but rather pockets of the portfolio do extremely well and drag the average up. In trading you want a strategy that produces outliers when the opportunity exists – you have to be a pig when the opportunity to be a pig presents itself.


The chart above illustrates this phenomena – the chart looks a little complex but it is only measuring two things. The performance of the US stock market on the horizontal axis and the performance of the momentum strategy on the vertical axis. The green line curving a path through the dots is known as a smile and it shows that trend following produces its best returns when markets are moving.  This harks back to the earlier point of being able to take advantage of market moves when they occur.

Trading is a simple profession since it can be summed up in three ideas. If it is trending up over the time frame you are trading you buy it.If it trending down over the time frame you are trading you sell it. Dont bet the farm. It is hardly rocket science yet despite this our very nature more often than not defeats us despite the evidence that it shouldn’t.

A Few Charts To Chat About

Every quarter JP Morgan Chase put out what they call a Guide to the Markets. The report itself is largely noise and is the sort of thing that research departments like to show to clients in an attempt to convince them that they are more than the sum of their convictions and misdemeanours. Generally I ignore this sort of thing but there are two charts within the report making the rounds and these deserve comment and the third is one that doesn’t get much attention but which is perhaps the most useful chart in the report.

The first chart I want to look at is the one titled S&P 500 at Inflection Points –


To be honest I have never known what they mean by the term inflection point. Inflection simply means a change in the form of a word although I do think they might be trying to be a little bit clever and use the meaning that is derived from differential calculus which is the point at which a curve changes from being convex to concave and vice versa. So the implication for the average punter seeing this is that the S&P 500 is at a point of instability or change when in fact all you are seeing is a series of straight lines drawn with the benefit of hindsight. I have been receiving these reports for some time and the terminal point of the final line has been creeping up as the market has moved up. Whatever predictive value they think is has is eroded by this simple fact of self correction. The other point that concerns me about this sort of thing is the small call out box in the middle of the chart which offers a series of metrics which are designed to offer a comparison between the present day and two points of previous reversal. Again the implication is to convey the notion that the market is at some sort of tipping point.

One of the things that amazes me most about trading is that the longer I do it the more I admit that I dont know. For a very long time I have been convinced that I have no idea where the price of instrument is going. I certainly know a lot about market dynamics, the history of markets (which is something everyone should study) and about my own reactions to events. But I have sod all idea about where the market is going. Granted I can create a narrative in my own head to justify my own positions but at the end of the day I simply make a bet on the direction of an instrument and I am consciously aware of my own behavioural short comings. Charts such as the one above try to convey a form of pseudo scientific form of prediction that does little more than seek to appeal to the various biases of the reader. Readers viewing this sort of thing will anchor on the two highlighted points and use them as a reference for their decision making when they are probably little more than a Ludic fallacy.


This second chart only tells us one thing – an index go up over time. But even that is not as obvious as it seems. Firstly, the S&P 500 is a relatively new index it certainly was not around in the early 1900’s. So what you are seeing is an artefact, something that is not real. Secondly, the chart doesn’t show the real changes in the index when adjusted for inflation. Accepting that the index did not exist for the majority of the period under investigation and using as much historical data as I could find I have adjusted the index below for inflation. You will also note that even though I have adopted the same log scaling the scaling of the data is different – this is what happens when you are plotting a made up version of the index.


As you can see the almost linear climb of the last few decades is not as pronounced when the data is adjusted. Whilst I dont want to overstate the impact of adjusting the data it is important to understand that the reality of investing over the very long term as opposed to the rosy picture presented by simple price data.

The final chart is actually what I would consider to be the only useful chart in the entire report because it documents the extreme rebound that equity markets are capable of.


As you can see despite some deep falls within the year the index has in the majority of cases managed to finish positive for the year.  However, it doesn’t man that the index has an ever upward trajectory – it can still go nowhere for periods of time which is what catches the buy and hold brigade. They misinterpret this chart as indicating that markets always get better and markets or more correctly indices do climb over time of their upward bias but that doesn’t mean your stock or collection of stocks will follow. The usefulness in this final chart is that it reminds us that markets change and they change over a variety of periods – change offers us the potential for involvement and therefore profit.

Professional Short Seller – Marc Cohodes

In our newest conversation on Bespokecast, we sit down with short seller Marc Cohodes. Marc manages his portfolio from San Francisco, and has had great success with high profile bear cases focused on frauds, fads, and failures in recent years. His investment industry experience dates to the early 1980s, and has helped him hone his process for picking out companies unlikely to succeed. Marc goes into detail on his approach, including how he thinks about finding potential shorts, timing, and risk management. He discusses with us recent successful shorts including Valeant, Concordia, and Home Capital Group, as well as another new bear case he has been building a position in Badger Daylight. You can read more about Badger at Marc’s website discussing the company. Marc is the first short seller we’ve had on Bespokecast, and we learned a ton about his approach to the market. We hope you do too! If you like what you hear today, you can learn more about our firm by visiting our website, Bespoke…

Click here to listen on Overcast

Surplus to requirements

One of the best things about heading away for a few days is not necessarily the break from Melbourne’s winter  but rather the enforced break from trading. Whilst technology now gives us the ability to trade from anywhere there is a stable internet connection I tend to switch off when on holidays and drop into cant be bothered mode. I know for some this is difficult and from my perspective this is either a compulsion or a sign of the rather egotistical belief that the market cannot do without you.

When I come back from holidays I always have an expectation that the world and by definition markets will be vastly different. Sadly this is not the case. The world is pretty much the same and markets have gone on without me as evidenced by the chart of the S&P500 which is pretty much the same as when I left.


Some might find it distressing that the world goes on without them – I find it very comforting…….

General Advice Warning

The Trading Game Pty Ltd (ACN: 099 576 253) is an AFSL holder (Licence no: 468163). This information is correct at the time of publishing and may not be reproduced without formal permission. It is of a general nature and does not take into account your objectives, financial situation or needs. Before acting on any of the information you should consider its appropriateness, having regard to your own objectives, financial situation and needs.