XBI: #BTFD

If you want to skip the entertainment below and get straight to the punchline: XBI has been in a steady uptrend and recently experienced a pullback. It looks like the drop has stabilized so I’m going to jump in and try to ride it back higher.

However, if you want to read on for what too often passes for trade analysis, feel free to keep going…

Obligatory Macro Environment Analysis

Trade war jitters are yet again on the table as the most likely cause cause of the pullback. Of course, maybe you just had a bunch of people decide to take profits, which lead to a cascade of sell orders from algorithms and monkeys. Honestly who knows but we just experienced a risk-off period that created a buying opportunity for us.

Chart Analysis of Questionable Value

I could draw a bunch of random lines on the chart to pretend like they show support and resistance levels. News flash: they don’t. But the chart below clearly shows the classic technical pattern called Satan’s Snowball setting up. It’s one of the lesser-known chart patterns.

2018.08.01 XBI - BTFD

Obligatory comment on what’s driving sector support

XBI should stay fairly insulated from all the nonsense and noise coming out of Washington. XBI is US-focused and represents a lottery ticket for a lot of investors. The only thing XBI has to contend with is if people think the multiples they’re paying are ridiculous or we hit a risk-off period and drug pipelines and massive acquisitions at giant multiples are abandoned. But hey, that’s next year’s worry. Not this week’s, which is where we’re playing with this trade.

Core Trading

Never let a trade turn into an investment.

Trading has many truisms that are based on behavioral biases and shortcomings. One of the common ones for both traders and investors is the tendency to enter a position then hold onto it as it drops in value instead of sticking with a predefined stop loss or exit plan. A trader will do some mental accounting that moves the position from the trade bucket into the investment bucket. Amateurs aren’t the only ones guilty of this: hedge funds have special rules built into their agreements that allow the hedge fund manager to put an investment into a “side pocket” that restricts investor liquidity. Professionals and amateurs alike will hold onto the trade until it comes back to breakeven. Unfortunately those trades too often turn into dead money.

Core Trading

The easiest way to avoid letting a trade turn into an investment is to use a trading system that can still profit when prices temporarily decline. The best part about core trading is the emotional component: everyone is happy when prices go up but with core trading you won’t mind nearly as much when prices go down because core trading has a well-defined process to buy more.

I’m going to assume a $10,000 position size for each ETF you target just to make the math simple.

The rules are simple:

  1. Find an ETF that is diversified, hopefully not in a valuation bubble, pays a dividend, and won’t go to zero.
  2. Wait for a short-term pullback. Doesn’t matter how you define it – use RSI, Bollinger Bands, Stochastics, whatever. It’s only a guide.
  3. Buy $3,500 worth of the ETF. If it goes up 3 percent from entry, sell it for a $105 profit.
  4. If price drops 5 percent from the entry price, buy another $2,000. If price goes up 5 percent from here, sell this $2,000 tranche for a $100 profit.
  5. If price drops 10 percent from the original entry price, buy another $2,000. If price goes up 5 percent from here, sell this $2,000 tranche for a $100 profit.
  6. If price drops 20 percent from the original entry price, buy another $1,000. If price goes up 10 percent from here, sell this $1,000 tranche for a $100 profit.
  7. If price drops 30 percent from the original entry price, buy another $1,000. If price goes up 10 percent from here, sell this $1,000 tranche for a $100 profit.
  8. If price drops 50 percent from the original entry price, buy another $500. If price goes up 20 percent from here, sell this $500 for a $100 profit.
  9. If price drops below 50 percent then just sit tight. We’re probably in a recession or you bought a single-country emerging markets ETF. Hopefully the dividend stays relatively intact and you can sit back and collect it.
  10. Repeat all of the above steps as prices bounce around between the various levels.
  11. Once price increases 3 percent from the initial entry then start looking for the next ETF that has experienced a pullback.

Do you see the common theme with this core trading strategy? You’re trying to net $100 on every trade. You’re not trying to hit a home run and double your money. You’re just trying to grind out some profits as prices do what they always do: go up and down.

The other neat component to this particular flavor of core trading is that it puts the most money to work in the 0 to 10 percent pullback range. The vast majority of time ETFs will bounce off their peaks and fall back 0 to 10 percent. Every now and then they’ll drop more than 10 percent. The frequency of drops below 10 percent becomes increasingly uncommon and it is extremely rare for stocks to tank more than 50 percent (it’s only happened 3 times for the S&P 500 in the past 100 years). So the idea is that most of your money will have been put to work in the price ranges that are the most likely for stocks to experience. However, dry powder is still available if prices keep going down so you can keep grinding out those $100 profits even if prices are 50 percent below where you first bought in.

Core Trading: the Agony & Ecstasy

As long as you’ve picked an ETF that is diversified, pays a dividend, and doesn’t go to zero, the worst-case scenario is that a global recession hits and prices tank 50+ percent. At the 50 percent mark you’re sitting on a 42 percent loss and the position is only worth $5,753. However, you’re probably collecting a handsome dividend at this point since dividends typically don’t fall as aggressively as prices. And as long as there is an attractive dividend then there will be a price floor for the position.

Core trading will outperform buy & holders in a falling market because you load up on the way down instead of being 100 percent invested at the beginning but will likely lose to a trend trader if the drop is more than 50 percent. It will lose to a buy & holder and a trend trader in a strong bull market as you’ll only be partially invested. But in a choppy market it will eviscerate the trend trader and handily beat out the buy & holder.

But the best part of core trading is that it changes your mind set: you’ll no longer wake up, check the futures market, and feel your heart sink when you see the red numbers. You’ll think “it only needs to drop another X percent before I buy my next tranche.” You won’t get rich fast, but it’s pretty amazing what you’ll end up with once you learn to consistently grind out profits in the market.

VNQ – Add Another Leg

Back in early March I published a post that detailed Signalee’s Core Positions. The two areas I detailed were real estate and South Korea. South Korea has bounced around until it dropped 10 percent in mid-June but VNQ has steadily trended upward. Both of them at the time represented good value and paid a decent dividend. Since then, war tensions on the Korean peninsula have abated but the stronger dollar impacted the value of South Korea equities, which had a stronger effect than the threat of war on ultimate prices. In each case, only a partial position was initiated because one of the main ideas of trading is to limit risk until the signs point to you being right. One of the easiest ways to limit risk is to use a partial position to start a trade and then slowly add to it as it goes in your favor.

Since South Korea has dropped, we’ll use the immortal words on a handwritten note tacked to John Tudor Jones’s wall:

Losers average losers.

JTJ

While fortunes have been made doubling down on a losing position, more have been lost. So I’m focusing on VNQ for today’s post about adding another leg to the trade.

2018.07.23 VNQ

VNQ initially sold off because investors felt the pace of interest rate hikes would be faster than the economic expansion that would allow landlords to hike rents. Historically, real estate has generated positive real returns in a rising interest rate environment simply because a rising interest rate environment has a growing economy supporting it. The ups and downs of a REIT’s stock price is largely determined by which will go up faster: interest rates or rental demand.

With the burgeoning trade war it appears that investors think the pace of rate hikes will slow while demand for real estate will remain robust. It could also be a safe haven play for yield. It could also be investors getting over their fears that Amazon was going to cause a retail apocalypse and destroy demand for retail space.

I don’t know – I could be completely wrong on all of the above. I also have no idea whether the current dynamic that is playing out will continue and we’ll see further price appreciation in VNQ.

But if I knew for certain then I wouldn’t leg into a trade as it moved in my favor. I’d leverage myself to the hilt and put it all in now. This is simply the nature of the game: do your best to understand the fundamental or psychological drivers that are moving markets. Recognize that even if you’re right about the fundamentals, if enough people disagree with you then you can still lose money if you don’t manage the downside. So use the full risk management toolbox available to a trader and leg in while using any long-term moving average of your choice for the exit.

For today, that means adding another leg to VNQ.

IWF: #STFR

And one day later: #STFR. Quick hits are the best hits.

2018.07.06 IWF - STFR

I don’t put a lot of faith in support and resistance because the entire history of the stock market is one of breaking support resistance levels. However, it typically takes more time for price to grind through new highs instead of returning back to where new highs are a possibility.

So I made a quick buck and am hunting for the next trade.

IWF: #btfd

If you want to skip the entertainment below and get straight to the punchline: IWF has shown strength over the past X months and recently experienced a pullback. It looks like the drop has stabilized so I’m going to jump in and try to ride it back higher.

However, if you want to read on for what too often passes for trade analysis, feel free to keep going.

Obligatory Macro Environment Analysis

Trade war jitters probably caused the pullback. I’m thinking interest rate hikes might be another likely culprit. Of course, maybe you just had a bunch of people decide to take profits, which lead to a cascade of sell orders from algorithms and monkeys. Honestly who knows but we just experienced a risk-off period that created a buying opportunity for us.

Chart Analysis of Questionable Value

I could draw a bunch of random lines on the chart to pretend like they show support and resistance levels. News flash: they don’t. The classical interpretation or the price action on the chart is a rising wedge. Some technicians would have you wait until price breaks the upper line that represents overhead resistance, some would have you wait until price breaks the upper line and then “retests it,” while others would have you enter off support of the lower line. I’m a short-term mean-reversion trader so I’m doing the latter.

Just so we’re clear: I’m not actually using that “rising wedge” to guide my trade because you could also interpret the price action as a tiny dwarf wielding a really long whip that’s about to be cracked. I’m not sure what you do with that information, but there it is.

2018.07.05 IWF - BTFD

Since the randomly drawn lines above are not predictive we always use the pioneering work done by the Franciscan friar William of Ockham (of Occam’s Razor fame) to double check our assumption. It’s a 4 step process:

  1. Pour yourself a shot of your favorite liquor.
  2. Take the shot.
  3. Now squint at the chart for no more than 2 seconds. A real technical analysis pro will use his peripheral vision while squinting.
  4. Answer one question: did the blurry, squiggly line you thought you saw go from the bottom left of the chart to the top right?

If you answered “yes” to the fourth step above then you’re in luck! The trade has been confirmed. If you’re somehow not sure, then repeat steps 1 through 4 above until you have your answer.

Obligatory comment on what’s driving sector support

A lot of movement in markets is random noise. Narratives happen that get overblown, which leads to a sell-off. At some point that narrative goes quiet or gets replaced. Since the trade war rhetoric has simmered down and news is out that Europe is actively seeking a way to diffuse it the next narrative is likely to be the old narrative: the US economy is still growing, unemployment is really low, and inflation is still contained. So go buy growth.

on the need to do something

So much of investing is the avoidance of doing dumb stuff. If you’re not sure what “dumb stuff” entails in investing then let me provide you a very incomplete list:

  1. Selling a broad index fund after if dropped 20+ percent and going to cash.
  2. Putting more than 5 percent of your portfolio into a single stock.
  3. Frequently trading in and out of a stock based on its gyrations without a well-defined trading strategy.
  4. Buying individual stocks without reading 10Ks, 10Qs, or knowing how to perform at least a simple valuation based on fundamentals.
  5. Being sold an investment product instead of proactively researching the investment on your own.
  6. Paying a front-end sales load for a mutual fund.
  7. Buying most IPOs on the first day of public trading.
  8. Trading volatility or other structured products with too much leverage.

The one thing the above have in common is that they all reflect the need of an investor to “do something” to try to get better returns. The reality is that all of these actions are hazardous to an investor’s wealth.

There’s one simple trick to avoid all the bad behavior that hurts an investor: dry powder.

Dry powder can come in two forms:

  1. Periodic savings from your paycheck.
  2. Keeping a portion of your portfolio in cash until you find the “right” opportunity.

Every investor has heard about the benefits of dollar cost averaging. They’re not exaggerated and I won’t rehash them here. It’s one of the few free lunches in investing and the best use of the periodic savings from your paycheck.

But you probably didn’t come here to be told to dollar cost average your paycheck into a low-cost, tax-efficient portfolio. You came here to know what to do with the portion of your portfolio you’re now keeping in cash as dry powder so you can do potentially dumb stuff while keeping the bulk of your assets in a responsible, diversified portfolio.

Some solid options if you have the need to do something besides have patience while invested in diversified portfolios over long periods of time:

  1. Trade around a core position: every time one of your core diversified holdings drops by some threshold, whether it’s 10, 20, or 30 percent, use your cash to buy some more and then hold on until it appreciates back to the previous price level. Sell, then repeat.
  2. Trade around a core position but sell long-dated put options. Same as the above, but instead of buying the underlying asset you sell an at-the-money put option with a maturity date of 6 months from sale. Hold onto it until 90 percent of the time value (theta) disappears or it gets assigned to you. If it gets assigned to you then hold onto the underlying until it appreciates back to the original strike price. This strategy has the added benefits of some downside protection, timing the sale of insurance when it’s dear, and a dash of sophistication and sexiness because it involves options (even though it’s a dead-simple strategy).
  3. Speculate on companies you think will do really well, allocating no more than half a percent of your overall portfolio to any single position. There are lots of ways to do this – I don’t recommend it for most people but if you keep your position size very small for each stock you probably won’t do too much damage (plus it’s fun to say you bought shares of Tesla 8 years ago!).
  4. Use an active trading strategy, making sure you placed your stop loss where you’re only risking 0.25% of your portfolio on any single trade at least until you’ve mastered the art of trading. For most people this will be a waste of time and money, but at worse it’s a slow bleed with plenty of action.

The last two options typically lead investors astray; however, if you use the recommended position sizing you won’t do too much damage to your terminal wealth.

What’s your edge?

The best part about financial markets is the mythos that the amateur can compete or even outcompete the professional.

How many other ultra-competitive activities does that hold true? Would you step onto the field against an NFL team? Would you wager millions of dollars playing against a chess or golf pro?

Arrayed against you is an army of PhD-wielding mathematicians, economists, and artificial intelligence researchers, backed by another army of programmers that turn the first group’s insights and data into algorithms that get the best executions and take advantage of fleeting market opportunities in fractions of a second.

So why do you think you can outcompete a finance professional? And I mean a real one – a buy-side hedge fund like AQR or Renaissance Technologies or institutional asset managers like Blackrock or Goldman Sachs, not your typical “financial advisor” who is scrabbling for a ten or fifty thousand dollar 401k rollover.

How do you compete?

As an individual trader you have 3 edges:

  1. Smaller pools of capital: you can have tens of millions of dollars and still be a very small fish that with a little care doesn’t have to worry about moving most markets with your order flow. You can get in and out of investments faster than any institutional investor. While they may be faster than you on the execution of any single trade, you’ll almost always be faster when it comes to large-scale portfolio repositioning.
  2. Patient capital: if you trail your index by five years it’s not like you’ll have the capital you’re trading with yanked away from you; however, if an institutional investor trails their index by five years, whoever owns that capital might transfer it to another financial institution to manage. This allows you to be patient and let your investment or trading thesis play out without worrying about career suicide. Most portfolio managers can’t afford to do this.
  3. You don’t have to do something that appears complex or fancy to justify your fees to your clients. You can invest in simple index funds and beat 80%+ of active portfolio managers.

How does Signalee apply these edges?

  1. Signalee doesn’t have the infrastructure or knowledge to compete with high-frequency traders so we only play in areas where speed of execution doesn’t much matter.
  2. We ignore the traditional concept of risk that substitutes volatility for the permanent loss of capital.
  3. We use a trading strategy that accomplishes our goals – not someone else’s.

For the average investor, focusing on things they can control like investment expenses (including taxes), diversification, and their savings rate, if they’re still in the accumulation phase, is a much better use of their time than trying to find an edge in the market when the playing field is crowded with more capable competitors.