Thursday, April 16, 2015

2015 earnings headwinds in 3 charts

Further to my recent post on how USD strength was retarding EPS growth (see Earnings Season: It's all about the USD!), Ed Yardeni wrote a timely piece on how forward net profit margins appeared to be declining. As the chart shows, net margins appear to be peaking for large caps (blue line) and they seem to be definitely rolling over in mid and small cap stocks.

Yardeni went on to say that if margins are peaking, then the heavy lifting in profit growth will have to come from sales growth:
[P]rofit margins may be peaking across the board, though they aren’t likely to tumble until the next recession. If they have peaked, then profits growth will be determined mostly by revenues growth, which is likely to be below 5% this year and next year.
At this point, I got worried. As I pointed out in my previous post, the USD strength seems to be having a negative effect on report sales when compared to expectations. As USD strength continues, how will expectations be for revenue and EPS evolve over the year?

Here is the key question: Supposing that margins are flat to down for 2015 (as per Yardeni) and therefore earnings growth will depend increasingly on sales growth (Yardeni), but the relentless strength of the USD is proving to a headwind for sales growth, unless the American consumer steps up and spends wildly (which hasn't happened so far), what will drive earnings growth in 2015?

As Earnings Season progresses, here is what I will be watching:
  1. The body language of management when discussing currency effects on sales and earnings
  2. The trajectory of the USD

Appendix: Geek note on Yardeni vs. Butters
Eagle eyed readers will also note that apparently contradictory analysis from John Butters of Factset shows that net margins are expected to increase, compared to Yardeni`s analysis that they appear to be peaking. Here is Butters:
Higher Margins Projected for Remainder of 2015
Analysts are also expecting profit margins to continue to expand in 2015. Using the bottom-up sales-per share (SPS) and earnings-per-share (EPS) estimates for the S+P 500 as proxies for expected sales and earnings for the index over the next few quarters, profit margin estimates can be calculated by dividing the expected EPS by the expected SPS for each quarter. Using this methodology, the estimated net profit margins for Q1 2015 through Q4 2015 are 9.8%, 10.4%, 10.7%, and 10.7%. These numbers (starting in Q2 2015) are above the net profit margin for Q4 2014 (10.1%), and are also well above the average net profit margin of 9.4% recorded over the past five years.
Both Yardeni and Butters are correct, the difference can be explained by a difference in calculation (and interpretation). John Butters takes a snapshot of current EPS and sales projections and divide earnings by sales to arrive at quarterly margin projections by quarter. He finds that net margins are expected to rise on a quarterly basis.

Ed Yardeni calculates the evolution of the forward net margin. For each data point, he divides the forward estimate earnings by forward estimated sales to arrive at a forward net margin for each point in time. This technique is stylistically similar to how John Butters comes up with his forward EPS line (shown in blue) in the chart below.

For the purposes of analyzing the expected change in net margins and how they are likely to affect EPS expectations, I believe that Ed Yardeni has the better approach.

Wednesday, April 15, 2015

How to make your first loss your best loss

I have always found that the time when I have learned the most about an investment process is when it does not perform well. After all, it is during periods of drawdown that the blemishes that appear in a model and no amount of backtesting will warn you of those shortcomings. If you are willing to learn from periods of underperformance, you can, in effect, make your first loss be your best loss. This is a case study of how I learned to diagnose a model`s shortcomings and learn from that experience.

Trend Model underperforming
My Trend Model has seen some stellar returns for the past 18 months (last report card here), but had experienced some spotty performance in the past few months. While the returns were not disastrous, they were not up to the levels seen in earlier periods. A look at buy and sell signals in 2015 show a pattern of market choppiness and signal whipsaw:

In a way, that`s not a surprise. Regular readers will know that the Trend Model is based on the application of trend following techniques to global stock and commodity prices. The price volatility experienced for most of 2015 has led to an environment that is unfriendly to trend following models.

Is this just a "feature" of these kinds of models that has to be endured?

A long and short term regime change
Maybe not. In a recent post (see 3 secrets from the Book of (Trend Following) Revelations), I highlighted a study by James Paulsen of Wells Capital Management showing that the long-term trend in equity prices were getting overdone. Paulsen found that stock prices had more or less gone up in a straight line in the last few years and with only minor corrections.

He went on to calculate the rolling three-year R-squared of stock prices and found that they follow cycles of high and low levels of price trends. We just happen to be at the top end of a trending period, which is likely to end soon. When it ends, it will signal an intermediate term top for the US stock market.

In a more recent post (see Calling an audible (for more choppy markets)), I reproduced the Paulsen study and further extended some of the conclusions of that research.

Instead of just looking at the R-squared of 36-month rolling regression, I also examined the R-squared of a 6-month rolling regression as a measure of the short-term trend, largely because my Trend Model uses a much shorter lookback period and it is therefore more correlated with short-term trends than long-term trends. In my last post, I reported that I found that we are in the period where the long term trend is strong (top panel), but the short-term trend is weak (bottom panel).

I further showed that stock prices are likely to roll over in the next few months, given how extended the long-term trend is. In addition, the rollover of the short-term trend is likely a leading indicator of the long trend.

Going back to 1900
I am grateful for all the comments, feedback and suggestions that I have received since I started writing on this topic. One of the comments that I received is that the sample size of this study is absurdly low. I could extend the lookback period of the study using data for the Dow, which goes back to 1900, instead of the SP 500, which only goes back to 1950.

With that suggestion in mind, I reproduced the study using DJIA going back to 1900. Here is the R-squared chart. While the readings are slightly different from the SP 500 study, the longer time horizon revealed some interesting insights. First, the incidence of high 36-month R-squared readings was higher in the pre-1950 period. Nevertheless, the current reading of 0.957 is comparable to the reading of 0.930 in pre-Crash 1987 and 0.911 in pre-Crash 1929. Similarly, the spread between the 36-month and 6-month R-squared readings (bottom panel) is also at a similar order of magnitude when compared to 1987 and 1929.

There is an important caveat to remember! This model measures the direction of the move and not the magnitude. Just because the trend is so extended today doesn't mean that a market crash is around the corner. Other episodes have resoled themselves in 10-15% corrections.

Nevertheless, based on the current 36-month to 6-month R-squared spread of 0.844, I looked at what the return pattern of the DJIA was during past episodes with similar characteristics. The sample size was a more reasonable 16, compared to the minuscule N=4 in the SP 500 study that went back to 1950. The market outperformed initially, but rolled over at between 3-6 months after the first time the spread went above 0.8 (which was March 2015).

And if the trend got even more extended and the 36 to 6 month spread went to 0.9? The results were more dramatic, as the market declined almost immediately.

Historical analysis from Dana Lyons found a number of narrowly range-bound markets that appeared to coincide with tops in 36-month R-squared readings, though the samples did not totally overlap. Lyons had some good news and bad news for stock investors:
First, the good news. All 9 of the prior ranges saw the SP 500 eventually go on to make new highs, though some initially broke the range to the downside first. 2 months later, 8 of the 9 instances saw the SP 500 not only higher but at a new 52-week high. Only the 2007 instance saw the index lower 2 months later, although it was at a new high 3 months afterward (and it had made a new high immediately following the range break).

Now the not-so-good news. On 5 of the 9 occasions, the new highs were very small and very short-lived. Following occurrences in 1965, 1976, 1983, December 1993 and 2007, the market’s upside “breakout” resulted in tops shortly afterward that would predominantly hold for the following year. Only the occurrences in 1951, 1964 and 1995 saw the market persist at new highs for an extended period of time. Furthermore, only 1995 saw the SP 500 continue on to double digit returns over the following year.
In other words, the market did perform well initially, just as my analysis shows, but they more often than not marked a significant intermediate term top.

Weakening long-term trend, choppy short-term trend
My research results using DJIA data going back to 1900 confirm the conclusions of past studies. We are in an environment where the long-term trend is strong but starting to weaken. The weakness is evidenced by a faltering and choppy short-term trend, or price momentum.

For someone using a trend following techniques with lookback periods similar to the shorter 6-month trend, this suggests that the current unfriendly period for this kind of trend following model is temporary. Under these circumstances, I can choose from four options going forward:
  1. Status quo: Continue to run the Trend Model as is and accept the drawdowns as a "feature" of the model.
  2. Wait for a friendly environment: Go to cash and wait for signs that the trending environment has re-established itself.
  3. Focus on the long-term trend and ignore the short-term trend: Most trend following models use a long term moving average to define the trend, e.g. 200 days, and a short-term moving average for risk control, e.g. 50 days. This approach would throw away the shorter (50 dma) and focus on the longer (200 dma) for trading signals.
  4. Focus more on counter-trend models. Examples would be contrarian sentiment models looking for crowded longs and shorts, as well as overbought-oversold trading models.
I rejected options 1 and 2 out of hand. Following the status quo is an example of not learning about the investment process and not allowing your first loss to teach you a lesson. Going to cash is a cop-out and detracts from learning. I did consider option 3 seriously, but rejected it as it would result in excessive return volatility because of it strips away the risk control element out of the investment process.

I wound up adopting a version of option 4. I would focus on one side of the counter-trend models by fading strength (but not buying weakness). As my analysis indicates that the long term trend is turning and the decline from an intermediate term top could only be weeks away, buying weakness is the equivalent of picking up pennies in front of a steamroller. Selling strength when the market is overbought, on the other hand, is likely to be a higher percentage play.

The acid test of learning
In conclusion, this is a case study of how I learned about a model from drawdowns. When I interviewed investment managers in the past, I have always asked the acid test question about how they have learned, "Under what circumstances would your investment approach fail?"

If the manager has thought sufficiently about his strategy and he has learned from past mistakes, he will give an intelligent answer. It also shows that he sufficiently understands the kinds of bets that he is making, why it works and when it might fail.

That`s how you learn to make your first loss your best loss.

Monday, April 13, 2015

Earnings Season: It's all about the USD!

As the latest Earnings Season kicks off, investors need to recognize that EPS estimates have been falling dramatically in the last few weeks - so much to the extent that a view is developing that expectations have been lowered so far that they are relatively easy to beat. The latest update from John Butters of Factset shows that forward 12-month EPS have fallen, but they have started to tick in in the last 2-3 weeks.

How low is the bar?
With 1Q growth faltering, the key question for US equity investors is whether the expectations have been racheted down sufficiently that they are easy to beat. For some context, Factset compiled the issues raised by companies in their earnings calls and pointed out that 70% of the negative factors cited so far have been currency related.

Analysis from Goldman Sachs (via Nick) shows the impact of the USD on sales beats:

Further analysis shows the effect of foreign sales compared to estimate revisions (the red line is my best guess at a regression slope):

In other words, this Earnings Seasons all about the US Dollar!

Strong USD effects may not be over
To put the USD effect into context, the chart below compares the US Dollar Index (top panel) with the price of oil (bottom panel). First of all, just look at the magnitude of those moves! Now look at the developing divergence. Even as the price of oil appears to be stabilizaing and carving out a bottom, the USD Index continues to rise. So while the negative effects of lower oil prices are mostly reflected in energy stocks, the strong USD effect on the rest of the market may not be over.

It is still very early into Earnings Season and I have no idea whether the bar has been lowered sufficiently that companies can beat Street estimates. However, we should never forget that the market is forward looking. Should the USD continue to rally, the chorus of company currency "excuses" might be enough to spook the markets into a sell-off on the basis that 2Q earnings will be weak because of further negative FX effects..

Sunday, April 12, 2015

Calling an audible (for more choppy markets)

Trend Model signal summary
Trend Model signal: Neutral
Trading model: Bearish

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"

My inner trader uses the trading model component of the Trend Model seeks to answer the question, "Is the trend getting better (bullish) or worse (bearish)?" The history of actual (not backtested) signals of the trading model are shown by the arrows in the chart below. In addition, I have a trading account which uses the signals of the Trend Model. The last report card of that account can be found here.

Update schedule: I generally update Trend Model readings on my blog on weekends and tweet any changes during the week at @humblestudent.

Market rally, or more chop ahead?
I suppose that with the rally in risky assets, the trading model should get upgraded to bullish from bearish. In the US, the SPX has recovered and exceeded its 50 day moving average (dma). European bourses have strengthened and Asian markets, led by Shanghai and Hong Kong, have been on fire. These are the classic signs of a global bull trend.

I remain skeptical. Recent experience has shown that US equity prices has shown the tendency to reverse itself. As the chart below shows, the market has done the stutter-step and crossed the 50 dma, which is a reasonable proxy for a medium term trend, a total of 13 times in 2015, compared to only four times in the same period in 2014. By last Friday, the market was either overbought or mildly overbought on the 5 and 14 day RSI (top two panels) and at levels where rallies have petered out. At the same time, the VIX Index, which tends to be inversely correlated to the market, is now testing a key support level where it has stopped declining in the past.

Will the bulls be successful in pushing price up to test the old highs, or will the market roll over as it has done for most of this year? Despite the bullish technical and fundamentals underpinning this latest move, I am leaning towards the latter scenario, where the market falls to the bottom of the trading range.

Possible regime change = Intermediate term top
Let me explain why. I wrote about a possible change in the technical market regime in my last post (see 3 secrets from the Book of (Trend Following) Revelations). I referenced a study by James Paulsen of Wells Capital Management, where he showed that the long-term trend was getting a little too good and therefore investors were getting a little too complacent. To recap, the Paulsen study showed that US stocks have been going up more or less in a straight line since 2012, with few drawdowns. By contrast, 2011 saw a reversal of the upward price trend from the 2009 bottom as it grappled with both an impasse in Washington and a eurozone crisis.

Paulsen went on to calculate the rolling 3-year R-squared, which measures the fit of a trend-line, of the market and showed how it had up and down cycles. When the fit is too good, it can breed investor complacency and the stock prices ultimately reverse themselves. In other words, we may be on the verge of an intermediate term top.

I was sufficiently intrigued by the Paulsen study that I downloaded month-end SPX prices going back to 1950 from Yahoo Finance to reproduced the results and add some of my own insights. As the top panel of the chart below shows, the rolling 36-month R-squared reached an astounding 0.976 at the end of March 2015. This was the second highest reading in its history, only to be exceeded by an episode in July 1956 with a 0.977 reading.

The bottom panel of the chart shows the difference between the rolling 36-month R-Squared and the rolling 6-month R-squared. When the readings are high, it indicates that the long-term trend is much stronger than the short-term trend and when the reading is low, the short-term trend is much stronger than the long-term trend. We have an instance where the long-term trend is strong, but the short-term trend is weak, which can be seen by the choppy up-and-down markets this year.

I have marked with vertical red lines to show how circumstances today are very similar to the instance in July 1956, when the market was trending strongly long-term but choppy short-term. Then, stock prices soon turned down, but the correction was relatively mild as the decline was only about 10%.

Current conditions are setting up the same way. I took a look at what happens to stock prices when the 36-month R-Squared first exceed 0.95, which occurred last year in June 2014. While the sample size is small, it does give us a rough roadmap as to what happens next. Stock prices continued to rise initially because of the powerful momentum underlying the long-term trend. They then peak out at between 6-12 months, and the decline bottoms out at around 18 months afterwards. We are now 9 months into this period.

While the number of data points in this study is very small and therefore confidence is low, let me try to torture the data a little further so that it talks. As the 36-month R-squared is 0.976, or the second highest level in its history, I looked at what happened when R-squared was above 0.97. The data points only fell by one (N=3) and the results are instructive. The market decline started almost right away, followed by a rally and a fall into the ultimate low in 18 months.

Watch your time horizon
There is a couple of important caveats to this analysis. I would urge investor not to panic, as this approach seems to be good at forecasting direction, but not necessarily the magnitude of the market move. As there is no fundamental trigger for an all-out bear market in the form of a recession on the horizon, my base case scenario calls for a correction, much like the episode seen in 1956.

As well, traders need to keep in mind that the time horizon for this analysis is in months, while the time horizon for many traders is in days or even minutes. While stock prices are likely on the verge an intermediate term top, that doesn't necessarily mean that the market goes down right away. Bret Steenbarger wrote a series of excellent posts where he observed the conditions of strong long-term trend, but weak short-term momentum. Here is one example:
The recent rise in realized volatility and vol of vol helps to explain why short-term traders have had difficulty trading U.S. stocks: We've had movement, but not trend. It's been a choppy, volatile range trade. Buying strength or selling weakness--trading with a fear of missing out--has been a consistent way to lose money. Viewed on a longer time scale, however, this market appears to be one of narrowing breadth--even among those smaller cap sectors that have been strongest. That keeps me cautious
In subsequent posts, he adopted the trader's perspective to say that current breadth readings does not support an imminent bear attack. One example here:
As a whole, the signals are showing reduced breadth of market strength, but not net weakness--consistent with the waning breadth readings noted in yesterday's post.
And here:
While a market without weakness might appear "overbought", in fact it is healthy in the short run. In order for the broad stock market to roll over, we have to see some leading stocks and sectors display weakness. At the moment, we are indeed "overbought", but not weak.
In other words, be cautious, but don`t get too bearish.

A test next week for bulls and bears
If I am correct in my analysis, we are in for more choppy markets. The week ahead will be a key test for my thesis. On one hand, overseas markets have rallied, which is bullish from an inter-market analysis viewpoint. As well, the upcoming week is option expiry week, which has historically had a bullish bias. This study from Quantifiable Edge shows that April OpEx has been one of the most positive weeks in the year:

Earnings Seasons starts in earnest next week. The latest update from John Butters of Factset shows that Street forward 12 month EPS estimates are edging up again, which is a positive sign for equities:

On the other hand, the market is short-term overbought and it has paused at these kinds of levels in 2015. In addition, past analysis from Ryan Detrick showed that the reaction to Alcoa earnings can be an early portend of stock market action. (Recall that Alcoa beat expectations on EPS, but missed on revenue estimates and the stock tanked as a result).

No doubt there will be lots of headline driven volatility in the days ahead. But if stock prices can't manage to stage a meaningful advance next week in light of the bullish tailwinds, it will be a validation of my choppy market and intermediate term top thesis.

My inner investor is cautious, but he is setting his stock-bond mix at policy weights. My inner trader is cautiously short the market with tight stops in order to to scalp a possible move to the bottom of the recent trading band.

Disclosure: Long SPXU, SQQQ

Tuesday, April 7, 2015

3 secrets from the Book of (Trend Following) Revelations

Good investors know about the adage that diversification is the only free lunch in investing. But diversification can mean more than just asset class diversification or the number of stocks in a portfolio, it can also refer to model diversification, where you combine models with uncorrelated return streams.

Regular readers will also know about the investment results of my Trend Model (last report card here). The Trend Model is based on the signals of a trend following model as applied to global stock and commodity prices. One of most naturally diversifying class of models to trend following are counter-trend strategies, such as overbought-oversold models or contrarian sentiment models. In the course of studying the dynamics of trend following models and counter-trend strategies, I came to three important observations:
  1. Bull and bear markets behave differently and therefore they should be traded differently. Bull markets tend to get overbought a lot more easily than bear markets get oversold, which is another way of saying that bear markets are far more emotional than bull markets.
  2. We may be on the verge of an intermediate term top in US equities. Just as markets become "overbought" and "oversold", so can models. Trend following strategies, when applied to US equities, are becoming "overbought". Momentum is starting to fade and we may be seeing a top building in the US stock market. That process has led to a choppier market, which has created difficulty with trend following returns, but...
  3. Trend following strategy returns are subject to overbought and oversold conditions too. As the market tops and rolls over, trend following returns will disappoint because of the whipsaws as price momentum flags. However, as the market transforms from a bull to a bear market, that`s when long-only investors need trend following the most as these strategies will go short and profit from falling prices - which is precisely when the diversifying effects of this class of strategy is most valuable. Hence, a good time to commit new funds to a trend following program is when it is suffering from a period of poor returns.
Let me explain.

Has it been too good for trend following?
The chart below shows the SPX for the last two years. I have imposed a standard 50 and 200 day moving average (dma) as a proof of concept of a trend following system. Supposing that we were to use a simple trading rule of:

  • Buy: When the price is above the 50 and 200 dma
  • Short: When the price is below the 50 and 200 dma
  • Hold cash: All other times
You would have done very well during this period. As the stock market has more or less gone up in a straight line, you would have participated in the rallies while limiting downside drawdown risk during the past two years.

In the bottom two panels, I showed the Percent Price Oscillator (PPO), which measures how far the price of SPX is away from the 50 and 200 exponential moving average (ema) is in percentage terms. The 50 day PPO has varied between +5% and -5% during this period and the 200 day ema has been mostly positive during this time (largely because of the steady market uptrend), but has topped out at around 10%.

Based on these observations, the time to be hypersensitive to counter-trend strategies is when the PPO is "overbought" or "oversold", defined as +/- 5% on the 50 day PPO and +/- 10% on the 200 day PPO. There was one occasion during the last two years - and that was marked by the dotted vertical line on the chart.

Interesting research observation? Not so fast!

How bulls and bears are different
When I stretched my research window out from two to 15 years, the conclusions changed. The chart below shows the same analysis for 15 years. I have also added the 50-200 PPO in the top panel, which measures how far away the 50 ema and 200 ema are away from each other in percentage terms.

When I examine the PPOs, I noticed that the overbought and oversold levels are very different for bull and bear markets. Bull markets tend to get overbought much more quickly, while bear markets can decline a lot further before the price starts to revert. A more realistic overbought level for the 50 day PPO is 5%, compared to -10% for an oversold reading. Similarly, the threshold for the 200 day PPO is 10% and -20%. We can also observe the same effect in the 50/200 day PPO in the top panel - bull markets get overbought more easily than bear markets get oversold.

My first conclusion: The overbought and oversold thresholds should be asymmetric for bull and bear markets. Apply counter-trend strategies differently, depending on whether you're in a bull or bear phase.

Flagging momentum = Intermediate term top?
Another important observation from the chart above is that we are seeing the PPO starting to fade at a both 50 and 200 day level (marked by the arrows on the chart). Fading PPO means that short term price momentum is flagging. Even though the trend is positive, buying short-term momentum yields lower returns as the strength of momentum surges seem to fade with every rally episode. These conditions are consistent with a recent comment in a post by Brett Steenbarger:
Overall, chasing new highs and stopping out of long positions on expansions of new lows has brought subnormal returns. We have had a trending environment since 2012, but not a momentum environment. Understanding that distinction has been crucial to stock market returns.
In the past, such episodes have see either full-blown bear markets (2000-03, 2007-09) or corrections (2004, 2011), which are marked on the chart.

Research from James Paulsen of Wells Capital Management seem to support that conclusion that we may be on the verge of a market top. Paulsen observed that stock prices have more or less gone up in a straight line. The chart below fitted a trend line to stock prices for the past three years and found that the R-squired came to 97%. In other words, we could be setting up for a Minsky Moment for US stocks (my words, not his).

Given that kind of fit, is it any wonder that trend following models have performed so well! Paulsen showed that stock prices haven`t always moved in a straight line as it has recently. Here is the R-squired of rolling fitted trend lines for stock prices since 1900. Note how R-squared has oscillated between 0 and 1 in the last 115 years.

This is starting to look an overbought-oversold model! In that case, could trend following model returns be getting "overbought"? Maybe. Paulsen went on to show the returns and batting averages of returns by R-squared deciles (recall that the latest R-squared is 97%, or leftmost decile).

Based on Paulsen`s research and the observation that short-term price momentum is rolling over, we could be seeing early warning signs of an intermediate stock market top. However, I am not panicking just yet. The market tops in 2000 and 2007 were marked by well-defined fundamental bearish drivers, but I am not seeing similar bearish signs from the macro data. If the stock market were to see an intermediate term top, then the most likely outcome is a corrective episode like we saw in 2004 or 2011.

Bear phases are profitable for trend followers
Further research into the characteristics of trend following models led to a more subtle observation. Trend following models are excellent diversifying strategies during bear phases because these kinds of strategies offset long-only portfolio losses because they can and will short the market during bear phases.

Research from AQR Capital Management on what they call "momentum", which are really trend following strategies illustrate my point. The x-axis is the return of the SPX, while the y-axis represents an indicative return of a "price momentum" strategy. As the chart shows, as stock prices go negative, momentum relative returns rise to compensate to cushion the effects of the market decline.

Here is another way of thinking about current market conditions. This is an idealized scenario, but bear with me on this. Stock prices have more or less been going up in a straight line for the last few years (trending), but short-term price momentum is fading and price trends are getting choppy. As a result, trend following returns start to disappoint. If the intermediate term top scenario unfolds as predicted, then stock prices will start to fall. Trend following will see positive returns once more as the model shorts the market.

Such a scenario is consistent with past research which indicates that drawdown periods are excellent opportunities to increase allocation to trend following strategies. As an example, Attain Capital did a study of trend following programs and allocated capital according to the following three sets of rules:
We first tested the ‘normal’ performance, compounding each manager’s returns individually, and then summing the performance of each (you can’t sum the returns and compound the total, as each manager is only trading the portion of the total allocated to them, and isn’t increasing or decreasing positions based on the movements of the overall portfolio). This is the hold tight, or ‘call’ method, where you rely on the portfolio as a whole to protect you against drawdowns in individual managers.

We then tested the ‘fold’ method, whereby you set a line in the sand at 1.5 times max drawdown, exit the program if that level is hit, and then replace it with the program showing the highest past 12 month Sharpe ratio that is not already traded or has been traded. This method resulted in 7 different programs coming into the portfolio over the 8 year period, as three of the original programs hit their lines in the sand; and four of the replacement programs hit their stop points. We started this portfolio with even weightings for each manager, and then used that same initial weighting for a replacement program if it was replacing a program which had lost money; and used the current allocation of the program being replaced if it had made money since inception.

Finally, we tested the ‘raise’ method, where you don’t just sit tight and you don’t head for the exits; you actually stare down the drawdown and increase your allocation. For this method, we tested using 50% of the past historical drawdown and 100% of the past historical drawdown as trigger points for doubling the allocation to whichever manager hit those drawdown levels. We also assumed this double allocation was only done until the program returned to equity highs, and that it was done with no extra capital - only with an increase in the nominal trading amount.
As it turned out, the "raise" method, which doubles down on losing trend following programs, had the best returns. It beat the buy-and-hold benchmark, which outperformed the "fold" method, which panicked out of programs that saw excessive drawdowns.

Conceptually, these results are consistent with the idea that trend following strategies can have overbought and oversold conditions. The research from Wells Capital Management, which showed that 3-year R-squared can oscillate between very low (high drawdown) levels to very high (high returns) is another way of thinking about this issue.

Don't panic!
One last word.

Despite my conclusions about a possible top, I would reiterate my observation that investors shouldn't panic over the prospect of a possible intermediate term top in US stocks. The fundamental drivers of a major bear market are absent and if the market should top out, it will most likely be a correction.

It would be entirely appropriate for James Paulsen should have the last word on this matter:
Our advice is to stay overweighted equities but to diversify away from the U.S. toward offshore stock markets. Most international markets have underperformed U.S. stocks in the last few years and currently offer more attractive relative valuations. Moreover, investors can diversify away from increasingly hostile U.S. policy officials toward hospitable policies for the foreseeable future in both the eurozone and in Japan.
Don't panic, diversify - it's the only free lunch in investing.

Sunday, April 5, 2015

Growth scare = Tactical sell signal

Trend Model signal summary
Trend Model signal: Neutral (downgrade)
Trading model: Bearish (downgrade)

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"

My inner trader uses the trading model component of the Trend Model seeks to answer the question, "Is the trend getting better (bullish) or worse (bearish)?" The history of actual (not backtested) signals of the trading model are shown by the arrows in the chart below. In addition, I have a trading account which uses the signals of the Trend Model. The last report card of that account can be found here.

Update schedule: I generally update Trend Model readings on my blog on weekends and tweet any changes during the week at @humblestudent.

A possible growth scare on the horizon
The Trend Model threw in the towel on the bullish call last week as readings deteriorated sufficiently to move the gauge to "neutral" for my inner investor, which translated into a trading "sell" signal for my inner trader. In case you missed it, I tweeted the following on Wednesday, April 1:

At the heart of the downgrade is a growth scare that is starting to grip the markets. The Atlanta Fed's GDPNow nowcast of 1Q GDP growth has tanked from 2% in February to 0.1% today - and that is starting to cause concerns.

Doug Short`s Big 4 Recession Indicators have turned negative.

Before we all panic about a coming recession, I would point out that the deterioration is attributable to the softness in real sales, while the other three components of the index remain positive.

Forecasters like Ed Yardeni, who has had a bullish tilt, is now sounding a bit uncertain:
On March 18, I observed that spring is coming. Just as I predicted, it started two days later on March 20. On the other hand, the latest batch of economic indicators for March suggests that I may have been too optimistic when I wrote: “I agree with Chauncey Gardiner’s prediction: ‘In the spring, there will be growth.'”

I argued that the economy’s weakness during the first two months of the year reflected an ice patch rather than a soft patch. There are still grounds for optimism as the ground thaws. However, the latest data suggest that it could be a cold spring:
Yardeni went on to cite business surveys, specifically the soft ISM report, and employment (and this was before the big NFP miss Friday) as his reasons for cautiousness. Scott Grannis also had good summary of the growth concerns facing the market here.

Earnings estimates are also looking a little wobbly. The latest update from John Butters of Factset shows that forward EPS estimates are starting to flatten out after recovering from the double whammy of falling oil prices (which affect Energy and Materials) and rising USD strength (annotations are mine):

The huge NFP miss on Friday did not help matters. The 126K print (vs. 245K expected) was a shocker, but I pointed out that the Fed was mainly watching for inflationary pressures (see Why you should discount the headline NFP number).

We now have the worst of both worlds. There are signs of weakening employment growth, which the Fed discounts as being transitory but the market interprets as faltering growth. We also have signs of rising inflationary pressures. as Average Hourly Earnings ticked up, which will not change the Fed`s likely path of interest rate normalization. As things stand now, the Fed may be tightening just as economic growth stalls.

Indeed, the slowdown story has gone mainstream. Just look at the weekend headline on Marketwatch:

These are all indications of an impending soft patch in stock prices.

Mr. Market gets nervous
The stock markets have responded accordingly. I mentioned last week the lack of confirmation of the trend break in the SPX, along with uptrends in a number of other measures, as reasons for my bullishness (see Risk-reward skewed to the upside). The picture is a bit more uncertain today. As the chart below shows, the technical uptrend has been violated in the SPX and NASDAQ. In addition, the Dow is looking very iffy, especially in light of the big downdraft in futures in the wake of the big NFP miss on Friday. Only the small cap Russell 2000 remains in an uptrend.

Using the 50 day moving average as a metric, the intermediate term trend is starting to falter on a global basis. Both the SPX and FTSE 100 have violated their 50 dma (and the DJ Global Index is current testing that level). These conditions indicate a loss of momentum in other parts of the world.

Just as worrying is the poor relative performance of cyclically sensitive industrial sectors of the stock market. The top panel of the chart below shows that the relative market performance of Industrial stocks (XLI) compared to the market has violated a relative support level and is in a downtrend. Because XLI is heavily weighted with GE, the second panel shows the equal weighted Industrial stocks against an equal weighted SPX - and that chart looks even worse. The third panel shows the relative performance of the cyclically sensitive semiconductors, which has violated a relative uptrend and showing signs of rolling over.

The bottom three panels are reminders of the non-confirmation of the Dow Theory buy signal, as the Dow Jones Transportation Average is far weaker than the Dow Jones Industrials Average and the DJTA is now testing a key support level - which could easily be breached on Monday should the weakness in the future market continue.

Commodities and commodity related indicators are also starting to act up. The failure of commodities to sustain a rally, especially the all-important cyclically sensitive industrial metals, and the weakness in the AUDCAD exchange rate (which is an indirect measure of Chinese demand as Australia is more China sensitive but Canada is more US sensitive) are worrying. These may be early signs of faltering global demand.

Sentiment models suggest more weakness
In addition, sentiment models are tilting bearishly. I prefer to watch sentiment readings that indicate what people are actually doing with their money than opinion surveys, which can be volatile and fickle. As an example, the latest Rydex fund flows suggest that Rydex investors are tilted bullishly, though they are pulling back. At the very least, this group has a lot further room to panic should stock prices hit an air pocket.

By contrast, the latest data from Barron's show that insiders, who are regarded as the "smart money", are selling a lot more stocks than they are buying.

Risk appetite still healthy
To be sure, the technical picture isn't all gloomy. My measures of risk appetite remain healthy. This chart of the relative performance of the high-beta and glamour groups of the stock market all appear to be constructive.

In addition, there are also no signs of panic from the HY market as yield spreads have narrowed.

I am also encouraged by the constructive performance of Greater China stock markets, which all remain in uptrends, as defined by their 50 dma:

The technical condition of the Greater China stock markets stand in direct contradiction to the cautious signals of the commodity markets.

Temporary market weakness ahead
When I put it all together, the relatively sudden onset of growth nervousness is pointing to a minor hiccup in stock prices, which will likely amount to no more than 5% or so. The technical picture is indicative of more near term downside. ES futures have dropped about 1% in the wake of the Friday Employment Report:

A 1% drop would put the SPX just above the first support level of about 2040 (dotted blue line) shown in the chart below. However, the decline may not stop there. Both the 5-day RSI and 14-day RSI (top two panels) are not oversold, which is suggestive that more downside is possible. Should the first support level of \2040 gets violated, the next logical support level is the support zone at about 1980-1990 (shown in grey).

I wrote last week that one of my concerns was that the market wasn't sufficiently oversold (see Risk-reward skewed to the upside). In light of current technical conditions, it appears that we may need to seen an oversold reading and investor capitulation before a durable bottom can be seen. Numerous measures from illustrate the point that the market isn't oversold enough. Here is the chart of net 20 day highs and lows, whose reading is neutral:

Here is the chart of the average 14-day RSI in the SPX. The picture is the same:

I could go on, but you get the idea.

An air pocket first, then recovery
My base case scenario calls for some market weakness for the next 1-2 weeks, followed by a V-shaped bottom and recovery.

The bear case can be summed up simply. Growth expectations are getting revised downwards. In addition, the Fed views 1Q GDP weakness as weather-related and transitory. The FOMC remains on track for a first rate in the June to September time frame.

On the other hand, the US economic recovery remains on course. Globally, we are likely to see more stimulative measures out of China and the positive effects of ECB QE as time progresses. As support for the medium term bull case, I would make the following bullish points:
  • New Deal democrat, who does an excellent job of monitoring real-time economic releases, described the current conditions as "poor coincident indicators with positive long and short leading indicators", which indicate that the current soft patch is temporary. However, he still "anticipate[s] a poor March industrial production number, and a poor Q1 GDP", which has the potential to spook the markets in the short run.
  • Sam Eisenstadt remains bullish: A recent Mark Hulbert column on former Value Line research director Sam Eisenstadt, who is forecasting a September SPX level of 2310.
My inner investor has pared back some of his equity positions to the policy weight of stocks and bonds. My inner trader flipped from long to short last week in anticipation of lower stock prices next week. Should the market decline, he will be watching for oversold readings and signs of capitulation to reduce or cover his shorts.

Disclosure: Long SQQQ