Where to put new money?

Based on where the market was trading when I wrote Bitcoin, the Stock Market, and Other Asset Bubbles there weren’t any terribly attractive mainstream asset classes. So I put money to work in some contrarian positions that included EWY and FREL. Since then the market has been a bit more volatile and is off its 2018 peak. We’ve made a little money just because of dollar cost averaging combined with a sideways market, but we’re not exactly crushing it right now.

Volatility! Trade Wars! Trump!

The headlines are creating noise to try to explain what’s going in the market these days. The good news is that none if it is going to matter in the long-run. If you’re wondering what to do in the face of these headlines my advice is to ignore the noise and focus on implementing a strategy that is robust, stupidly simple, and dirt cheap. One of the easiest way to accomplish this goal is to go back to the ol’ standby of momentum trading to put new money to work.

Momentum Trading Asset Selection

The first step in implementing Momentum for Dummies is to select commission-free ETFs (we’re using ones from Fidelity) to mimic as many as the asset classes as possible:

  • SHY: T-Bills
  • IVV: US Large Cap
  • IJR: US Small Cap
  • IEFA: EFA
  • IEMG: EEM
  • IEF: US 10-year
  • LQD: US Corporate Debt
  • FREL: REITs
  • FMAT: Commodities/Gold

There isn’t a good commission-free option for commodities or gold so I’m substituting FMAT, which is Fidelity’s Materials Sector ETF.

Bridesmaid Momentum

The crux of the Momentum for Dummies strategy is to take a look at the past twelve months performance and buy the second-best performing asset. That asset is then held for 12 months and the process is repeated.

Where’s the Exit?

I typically preach that a trader needs to have a well-defined risk management strategy that takes into account the macro environment and some sort of stop loss. The Bridesmaid momentum strategy doesn’t use one; however, you can always add a long-term moving average as a stop loss or diversify the number of ETFs you’re holding at any given time (e.g., hold the top 3 or 4 ETFs instead of the second-best performing ETF) to diversify asset-class risk.

What’s your benchmark?

Trend Trading vs Buy & Hold

An interesting argument was recently raised where it was posited that a trend trading strategy should be the default benchmark instead of a buy and hold strategy. If this benchmark was adopted it would represent a fairly large shift in thinking in the financial advisory and asset management industry.

The buy and hold benchmark that has been almost universally adopted in the current asset management industry suffers from hindsight bias and cherry picking the data. It’s even worse when the benchmark is set to the S&P 500. As an industry we have collectively decided to pick one of the best performing assets of the past century and say that this is the benchmark to beat. There’s a significant amount of appeal to using it: the S&P 500 was easily investable by institutions and later retail investors. There were no decisions or trading that had to be done as the rules-based market cap index methodology made all the changes for you.

But America, and the S&P 500, is truly exceptional. The question is whether it will continue to be exceptional. It’s possibly unpatriotic to ask this question or build a portfolio that doubts that bedrock principle, but managing true risk, which is the permanent loss of capital, is the only way to stay in this game for the long run.

Global Real Returns

The US is an outlier – out of all the investable markets it had the best real return at 4.3 percent. If you look at the chart below from “Everyone is Wrong on the Internet, stock market returns edition” published by the Financial Times, it shows that 21 markets had positive annualized real returns while 17 had negative annualized real returns.

Global Returns

Now, it’s pretty obvious that you could improve your odds by avoiding the countries where the rule of law is fairly absent and corruption abounds, but there are five developed country markets on the chart that not a lot of investors would have avoided.

Just think if you were a Greek, Argentinian, or Peruvian and had all your money in your home country. You’d be broke. Investing in a global portfolio and avoiding home country bias is one way to avoid negative real returns. Diversifying into other types of assets is another.

An Alternative to Buy & Hold

Trend trading can avoid the giant drawdowns. In a trendless market where swing trading does well a trend trader will get chopped up, but it does a decent job of wealth preservation. Since wealth preservation is towards the top of the list of important things an investor should focus on, it makes more sense to set trend trading as the default benchmark than looking at something like the S&P 500’s performance over a most extraordinary century.

How to Fail as a Trader

The two biggest causes of failure among new traders are bad trading systems and unfettered emotions.

Bad Trading Systems

Trading is a game of probabilities and sequence of returns. Systems run the gamut from trend following and breakout systems on one end that have low win rates but (hopefully!) big winners to short-term mean reversion systems that have lots of small wins with losses that aren’t too large. Stanley Druckenmiller said he only targets trades that will return 5x his money so he only has to be right slightly more than 20 percent of the time to make money. But the only way a system like this works is if he has a bunch of small trades going at the same time so he doesn’t get wiped out with losses while waiting for that 5x trade to happen. Too many traders accept small wins and big losses. They trade positions that can permanently go to zero and they compound the issue by using stop losses purely based on price. Even if 90 percent of your trades are profitable, the remaining 10 percent of trades that are losses can more than wipe out your gains.

Emotions

The second most common cause of failure for new traders is decisions made because of panic or euphoria. If a trader’s position goes against him, oftentimes a new trader will sell out at a loss just to see the trade bounce back. To be a successful, a trader has to have a plan to manage the position no matter if it goes up or down, and be able to stick with the plan no matter what.

Euphoria is just as bad as panic. Occasionally a trader will find himself in a situation where seemingly everything he touches turns to gold. Profits are easy and account balances grow. Instead of taking the good fortune in stride, knowing that the hot hand will eventually end, he increases his position sizes, uses leverage, or goes outside his area of expertise. The end result is easily anticipated as the new trader circles back to panic.

Emotions can be tamed in two ways:

  • Trade small until you can handle the losses that will inevitably happen on any single trade. Slowly increase the size of the trade and the size of the losses that you incur. If you panic sell, lose sleep, or want to check prices every 30 minutes then your position size is too big.
  • Instead of trying to come up with your own system or edge when you’re first starting out use the free core position trading system from Signalee. It’s a mechanical system with well-defined purchases and exits and is easily scaleable.

Position Trading

There are a million ways to make money in the stock market and a million more ways to lose it all. Signalee uses position trading to grind out profits over the long-term. We just stick to the boring basics: buying low, selling high, repeating ad nauseum.

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.

Appearances vs Reality

Or why position trading works.

I recently had a conversation with my wife about what options exist to solve the mass shooting crisis in America. She’s come a long way from being 100 percent anti-guns when we met to meeting me halfway in the middle. We’ve both learned from each other – I grew up in the country where hunting and shooting sports were common and she did not.

What I never understood about anti-gunners was their fear. For me and my friends, gun safety and gun handling were drilled into us at a young age. I assumed that everyone had gun safety drilled into them. My wife assumed that no one did. I started turning her around on guns when she agreed to go to a shooting range with me and I spent the 30 minute car ride explaining gun safety, gun handling, and range etiquette to her. And then spent another 15 minutes at the range repeating it.

But even with her becoming more comfortable with guns she said she was still in favor of an outright ban on AR15s. She was in favor because they look scary.

My response to her was that you needed to ban capabilities and not appearances as a Ruger Ranch rifle shot the same bullet, had the same magazine capacity, a similar size and weight, and was just as lethal.

And just in case any firearm aficionados or armchair commandos happen to stumble upon this by accident: please save me the hassle of filling up my inbox saying an AR15 is superior to a Ruger Ranch rifle. That isn’t the point.

Banning an AR15 but not a Ruger Ranch rifle makes no sense. Same thing for any of the other common military rifles that are easily obtainable like the AK47, SKS, SCAR, IWI Tavor, Steyr Aug, or PS90. These rifles obviously fit in the same category but there hasn’t been a single mention in the news about adding them to a ban.

Position Trading: Appearance vs Reality

This conversation got me thinking about how to explain why position trading works. The public has been brainwashed to believe that volatility is bad and mark-to-market losses are even worse. Hedge fund managers live and die by promising investors smooth returns. It’s the appearance of the investments they hold that drive behavior, not the reality of the value of the investments.

What’s really going on?

My best guess is that investors look at the account value and make plans for its uses. When they see the account balance go down they imagine all the uses quickly slipping out of reach. As a result, they liquidate holdings to try to stem the bleeding. This creates a virtuous cycle that forces prices lower and lower as more and more people sell more and more to avoid the nominal loss in their account.

The reality is that the underlying fundamentals of an investment haven’t changed nearly as much as the price volatility makes it seem. Assuming an investor isn’t chasing a bubble, and has realistic expectations of cyclical industries, the fundamental value of the holding is much less volatile than the price would indicate. Eventually enough investors figure this out and pile back in and bid up the now undervalued asset. This causes prices to climb back up and the whole process eventually repeats itself.

This is where someone who ignores price volatility can repeatedly make money using position trading. Position trading relies on reality instead of appearances to consistently grind out profits in volatile markets.

Savings vs Returns vs Trades

Signalee is ostensibly about position trading. But there’s a second point that is important to make for anyone trying to a large trading account: adding a relatively small amount of money on a periodic basis to your account initially “compounds” the value of your account faster than the position trading strategy we use.

Using simple math, if a trader starts with $1,000 and compounds the account by 5 percent per trade, then after 142 trades she’ll have $1 million. However, if the trader deposits $100 every two weeks into the account from a paycheck then that deposit is just as good as a successful trade.

The first $100 deposit will knock out 2 of the 142 trades needed to get to $1 million. Now, the number of trades that can be knocked out with a $100 deposit will get smaller and smaller as time passes and the account grows, because, you know, math. But at the end of the first year of a trader’s road to $1 million, even if she doesn’t make a dime from trading, she’ll have knocked out 26 of the 142 trades. By the end of Year 2 she’ll have knocked out another 11 trades and have 105 trades remaining with an account value of $6,200. Still a long ways to go until $1 million, but in 2 years she has reduced the number of trades needed to get to her goal by 26 percent. She’ll be a quarter of the way there.

Savings vs Returns vs Time

Building a large account balance is a function of savings, returns, and time. Increasing the amount of any of them has a fairly drastic impact on the final balance with a long enough time horizon. Consider the following scenarios:

Scenario #1:

  • $10,000 starting balance
  • $1,000 added annually
  • 6 percent return
  • $71,064 ending balance after 20 years

Scenario #2:

  • $10,000 starting balance
  • $1,000 added annually
  • 10 percent return
  • $130,278 ending balance after 20 years

Scenario #3:

  • $10,000 starting balance
  • $5,000 added annually
  • 4 percent return
  • $176,757 ending balance after 20 years

You’ll notice that Scenario #3 has the highest ending balance after 20 years even though it has the lowest annual return. It’s not until you get past 20 years that the 10 percent annual returns in Scenario #2 start to overcome the higher savings rate of Scenario #3.

What’s the point?

Of the three variables tweaked above, savings rate, returns, and time, which do you have the most control over?

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.

Screenshot 2018-02-20 at 4.26.46 PM

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.

Screenshot 2018-02-20 at 4.31.06 PM.png

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.