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.

XIV – A Friendly Reminder

This past Tuesday, February 6th, one of the hottest trades for the past two years, the so-called easy money trade, blew up in a most spectacular fashion. After peaking around $145 halfway through January, XIV started to slide until it closed at $99 by the end of the day on Monday, February 5th. The next morning it opened just above $10, fell some more, then was liquidated by Credit Suisse.

If you had initiated the position at the start of 2016, when XIV was trading around $20, then by February 6th you had only lost 75 percent of your position by the end of the day. If you had waited until halfway through 2017 to start playing, then you lost 95 percent.

Kid Dynamite has the best explanation of what happened if you’re curious. Cullen Roche at Pragcap.com has the best quote from the XIV prospectus, which he notes that almost no one reads:

“The long term expected value of your ETNs is zero. If you hold your ETNs as a long term investment, it is likely that you will lose all or a substantial portion of your investment.”

The first thing that line in the prospectus tells you is that XIV is not a long-term investment to just buy and hold. It’s meant to be traded. However, even if you fully understood the product before you traded it there’s only three ways you could have protected yourself from the 90 percent gap down:

1. Buy OTM put options to limit losses. This isn’t a great option because the premium would severely eat into any trading gains to the point where generating positive expected value is questionable.

2. Position sizing: if you’re trading a derivative that has an asymmetric risk-return profile (e.g., the VIX was trading at sub-10 levels but could easily spike up to 30 or more, hence at least a 3 to 1 risk return profile), make sure the position size is small enough that the whole thing can go to zero without blowing up your account.

3. Don’t trade the derivative. Stick to trading assets that generate value by serving a widespread and reasonably useful purpose in society.

XIV is just the latest reminder of one of the truths of trading or investing: there are a lot of relatively easy ways to quickly make a little money but it is extremely hard to quickly make obscene amounts of money. When traders or investors try the latter, they often fail like XIV: in a most spectacular fashion.

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.

 

Bitcoin, the Stock Market, and Other Asset Bubbles

Conventional wisdom: bubbles should only be in champagne and in a bath, not in asset holdings.

My opinion: asset bubbles are awesome* when you own the asset in question. Irrational exuberance represents unearned returns or returns that have been pulled to the present from the future because a herd of investors are overly optimistic about the asset’s prospects. The best thing that can happen to an investor is to have time accelerated for investment purposes.

The asterisk: Asset bubbles are only awesome if you sell the asset and redeploy the proceeds into a different asset that isn’t as bubbly. You’ll look like a sucker in the short-term when all your friends are bragging about the killing they’re making in the bubbilicious asset, but it’ll work out for you over the long-term.

The key is to figure out when things are in a bubble. It’s easy in hindsight, but it’s difficult to do when it’s happening. You have your own emotions working against you: “At this rate, I’ll be rich!” so you don’t want to get off the train, and you also have the additional distraction of the drumbeat of pundits saying “This time it’s different!”

How to spot an asset bubble

Historical data is a good guide to identifying asset bubbles, but that requires access to the data, the time and ability to crunch the numbers, and an understanding of the historical context and macro factors that guide the historical range.

An easier way is to divest the holding, or at the minimum rebalance your portfolio, whenever a given asset hits the upper 3-standard deviation 200-day Bollinger band. Gold at the end of 2011 is a good recent mainstream example where a major asset class tagged its upper 3-standard deviation Bollinger band and then failed from there. Bitcoin of course is another example, but that one sets the new gold standard for irrational exuberance.

The chart below shows how exceptional Bitcoin has been over the past two years. I set it up with two, three, and four-standard deviation 200-day Bollinger bands. The upper 2-standard deviation 200-day Bollinger band is the limit of normal trading for the vast majority of market regimes. Bitcoin broke the mold as it has not only repeatedly tagged its 3-standard deviation 200-day Bollinger band but also tagged its 4-standard deviation 200-day Bollinger band. Bitcoin is the first time in my experience I’ve ever seen an asset do that (short of a takeover offer at a significant premium).

NYXBT

You’ll notice that every time bitcoin tagged its three (and four)-standard deviation Bollinger band it pulled back or consolidated.

Tag!

If you find yourself in the enviable situation where you bought an asset and then held on as it ripped higher before ultimately tagging its 3-standard deviation 200-day upper Bollinger band, you have two prudent options:

    • Sell the position and hunt for the next opportunity. 9 times out of 10 this is the correct response because price usually tanks from here.
    • If you’re a true believer in the asset in question (#HODL), the next best thing is to sell enough to get back your original investment plus 10 or 20 percent (to cover the cost of capital and all that), and then let the remaining portion ride. In this scenario you lock in a profit but still get to participate in any additional upside.

Technically Overbought?

If you look at the chart below, which represents a proxy for the global stock market, price is getting close to the 3-standard deviation 200-day Bollinger band.

ACWI

Just something to think about.

Straight to the Moon!

Price action in the first half of January is one of many reasons why a trader (or investor!) should never have all of their money in a single asset or strategy.

The biggest risk to new traders in these situations is that they try to force a trade or all of a sudden decide they’re breakout traders. Both errors generally end in losses:

  • Forced trades: maybe an ETF pulled back just a little. In normal times a trader wouldn’t think to enter because there’s not enough of an edge. Alternatively the trader might start looking outside their previously defined investment universe. The worst-case scenario is that the trader finds a stock or ETF that has significantly pulled back and he takes the trade. The question that should be asked is if everything is going gangbusters, why is this stock or ETF not joining in? Most likely answer: it’s not going to mean-revert and the trader will suffer a loss.
  • Breakout traders typically experience win/loss ratios of 1:5 or worse. The only way breakout trading works is if you have a bunch of small trades going at the same time and the big winners make up for all of the small losers. A new trader will often make the mistake of using the same position size for a breakout trade as they do for a mean reversion trade. Most typical result: the position doesn’t break out and the trade is closed out for a loss.

So what’s the solution?

This advice might seem strange considering it’s on a website devoted to trading, but my best advice for new traders: wait to allocate a portion of your capital to trading until you have a healthy sized Buy & Rebalance portfolio already established. Trading should just be another part of your portfolio, not the whole kit and caboodle.

And if you already have a diversified portfolio established, when stocks go straight up like they have recently, it’s a great time to rebalance back to your targeted allocation.

Ballistic Missile Inbound!

And 38 minutes later, after all the sound and fury, it largely signifies nothing.

I have to admit, managing money is kind of a dream job. A lot of the time you do nothing besides sit, read, think, and read some more. Maybe go for a walk. If you’re doing the job right, you don’t have to react to every headline in a panic. So I’ve had plenty of time to read and think about the nuclear brinkmanship.

With a little bit of distance from the false alarm out of Hawaii it’s possible to take stock of what didn’t change:

  1. The world’s population continues to increase.
  2. Global demand for goods and services continues to increase.
  3. The United States (including Hawaii!) still exists.
  4. North Korea still exists.
  5. United States citizens continue to have trouble finding North Korea on a map.

All of the above points to capitalism continuing to exist. While consumer confidence in the US and around the world might decrease a little because of the saber rattling, which sometimes leads to reduced spending, which sometimes leads to lower corporate earnings, which sometimes leads to lower equity prices, which sometimes leads to higher prices in other assets, which … you get the point. The future is going to keep occurring and in a fashion that’s rather familiar with what’s been happening during the past century. Problems will continue to arise and need to be solved. There will be entrepreneurs, businesses, and capital available to tackle them (the government might even help too!).

And if the world does stumble into a nuclear holocaust and your account was positioned to profit from the end of the world then how’s your counterparty going to pay you?

What hasn’t changed is our inability to accurately predict which asset class will be the best performer over the next couple of decades. So stay diversified with stuff that produces cash flow, rebalance periodically, stick to your trading plan, and don’t panic.