Signalee’s Core Positions

There’s not a lot out there right now that’s enticing from a long-term returns perspective. The US stock market is priced to perfection and bonds are almost guaranteed to only beat inflation by 1 percent or less for the next 10 years. As a result, alternatives are often touted as a way to generate non-correlated returns that will help dampen the overall portfolio volatility in the current low-return regime. Larry Swedroe suggested the AQR Style Premia Alternative Fund, LENDX, which does alternative lending to small businesses along with consumer and student loans, SRRIX, a reinsurance fund, and AVRPX, which is a fund that sells volatility insurance across stocks, bonds, currencies and commodities.

I have a few objections to those potential sources of alternative returns:

  • “Alternative Lending” is often predatory and focuses on high-risk borrowers, so hard pass.
  • Given the likely increase in global warming related natural disasters it’s hard to get excited about taking on catastrophe risk.
  • Since we have historically low volatility it’s not really a great time to pile into premium selling.
  • AQR’s Style Premia Alternative fund isn’t exploiting any inefficiencies that the market doesn’t already know about and has likely priced accordingly.

So what opportunities are left for a non-institutional trader? Signalee is currently focusing on the following:

South Korea

Emerging markets are the “cheapest” asset class if you look at research from GMO, Research Affiliates, and StarCapital (which you should!). But stop to think about which emerging markets you actually want to own. A lot of them are focused on resource extraction; a lot of them are terribly corrupt with significant rule of law issues; and a number of them have gone too far down the socialist continuum to where taxes and government are too much of a burden on local business [Note: before you misread this comment, I’m a big fan of social safety nets provided by the government. Capitalism is the best system for resource allocation and improving lives but only if you have a prudent government as a counterbalance to its worst excesses.]

While emerging markets are the cheapest, you have to be selective about which emerging markets you own. For Signalee, that means South Korea as the risk of war is overblown.

 

US Real Estate

US real estate might seem like an odd core position to include in a rising interest rate environment. And for the YTD period an owner of VNQ would be sitting on an ~10 percent loss without any opportunities to trade around it to reduce the total loss. But two factors argue for its inclusion:

  • An improving economic situation typically causes rents to rise enough to offset the pressure from increasing interest rates.
  • A simple estimate for long-term real estate returns is simply to take the dividend yield and add the rate of inflation (this assumes GDP is positive over the long-term). So the real return of real estate is the dividend yield. For VNQ that yield is currently 4.4 percent, which is better than most alternative options.

The only caveat to REIT holdings is that too severe of a depression can cause massive losses in a core position given its inherent leverage. As long as you maintain dry powder to trade around the ups and downs then it’s less of a problem.

 

Never go all in

The above two positions are not a complete portfolio. Since it’s not a complete portfolio a trader should never go all in on just the above. The two positions I’ve listed represent good opportunities for long-term value and even better opportunities to trade around. So always keep some dry powder for when the short-term price movements put the odds of trading in your favor.

South Korea (EWY)

The next position trade for Signalee is the iShares South Korea ETF (EWY). It has about $4.2B of assets with an average trading spread of 0.01% and daily volume in excess of $200 million. So it’s easy to get into and out of. Furthermore, its price to earnings ratio is only 13x, it has a distribution yield just shy of 3 percent (so we get paid to wait for price to go up or down), and it primarily holds technology, financial, and consumer cyclical stocks.

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The only downside is its 20 percent concentration in Samsung Electronics. Not a dealbreaker as Samsung is a global juggernaut with a diverse product set, but Signalee typically tries to avoid concentrated positions.

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Position Trading
One of the main tenants of position trading is to buy the dip (#BTFD). EWY, like the rest of the market, got caught up in the sharp selloff that occurred at the beginning of February. Since position trading relies on volatility, this was a relief as markets that go straight up for long stretches of time are infuriating for us. As prices stabilized and returned to its prior uptrend, we’re starting a position under the assumption that it’ll continue to grind higher.

If we’re wrong and price drops down to $64, then depending on the economic backdrop and other fundamental trading factors, we’ll re-evaluate the trading position and determine whether to add to EWY or sell it entirely. I realize this seems vague and unhelpful, but traders who rely purely on price stops for exits often miss out on profitable opportunities when they blindly sell.

Why is South Korea cheap?
The most obvious reason why South Korea is trading at a discounted valuation to peers is because of the constant threat of war from its neighbor to the north. Even ignoring the nuclear threat, a massed artillery barrage into the heart of Seoul is always a hair trigger away.

The less obvious reasons why South Korea trades at a discount is because of the conglomerate structure of many of its companies, the clubby nature of the families that own and run them, and all the corporate governance issues that go along with a clubby structure.

However, the reason this will likely be a good position trade for Signalee is that South Korea is a profit-seeking culture with an Ease of Business rank of #4. Its business landscape is diversified and doesn’t rely on natural resource extraction. Lastly, the threat of war is overblown. The North Korean regime wants to survive and stay in power. If it attacks South Korea in such a way that threatens its total destruction then the US would be forced to respond in a way that eliminates the North Korean regime.

In the meantime, the threat of war creates volatility and depressed valuations, which is where we come in to grind out some profits.

Oh, Breakout!

Most of the ideas featured on Signalee are short-term mean reversion trades based on position trading. For good reason: the opportunities happen fairly frequently throughout the year. However, every now and then markets go straight up without pulling back (like now!). If a trader only uses one strategy then they’re stuck on the sidelines while all their trader-friends make money. Worse, they have to listen to their colleague boast about how much money he’s making on the leftover bitcoin he bought three years ago to buy drugs online and then forgot about until just a month ago.

Commodities: the next major trend

Everywhere you look in the world today asset classes are hitting new highs, all the major economies are all growing, and hot money is chasing asset prices higher and higher. Only one asset class is late to the party: commodities. Commodities slumped in 2014 and fell like a stone through 2015 before bottoming and rebounding at the beginning of 2016.

The massive decline was sparked by the Saudi-led price war in energy. Their goal was to bankrupt as many shale oil drillers as possible in the US in an effort to cripple our domestic energy industry. The long-term thinking was that investors would hesitate to commit to marginal shale projects if they knew the Saudis would pump up supplies and depress prices to the point where the marginal projects were unprofitable. Since energy is a major component of the manufacture of industrial metals and a lot of agriculture inputs, the entire commodity space tanked.

The two limiting factors on the Saudis’ success was the need to finance their own socialist welfare state as well as improvements in US shale drilling technology that lowered the breakeven price point. Combine that with a global economy that is experiencing synchronized growth for the first time since the start of the 2007 financial crisis, and commodity prices are finally on a tear.

But is it sustainable?

The hard part about making macro bets is being right (thank you John Madden). It’s incredibly hard to identify the conditions, in real-time, that’ll lead to a big sustained price move in an asset’s price. So this is why we use core position trading.

The chart below shows DJP breaking out of its two-year base. I don’t know if the breakout will hold – that’s always the risk of any new trade.

But to mitigate that risk I’m using position trading. By only risking a third of my total potential position size, then I mitigate the losses if the trade immediately moves against me. Additionally, with the remaining two-thirds of the position as dry powder I can trade around the inevitable short-term ups and downs.