1998, Weekly wrap, 9/10-16/2017

Macro and Markets

What difference a week makes! The S&P finally made it over 2500 on Friday, brushing aside yet another NK missile test. While Amazon and Alphabet are still wallowing, the semiconductor index conclusively broke out of its triangle. Risk-off assets were sold: gold finally and bonds right after the yields were at resistance the previous week.

My first prediction for a final bubble phase of this market appeared in November 2016. In March 2017, I added that S&P will end the year with a “27 handle”. The words “post August moon-shot” appeared in the very first weekly wrap, where the target was set at “the S&P to 3300-3500 and the NDX to 10K in 12-18 months”, which, to be honest, were meant to be on the safe side. I didn’t really have to write all the preceding words to state my position since there is one number that that succinctly captures them all: 1998, as in the year 1998 in relation to the first tech bubble. E’nuf said.

Cryptocurrencies

Overnight BTC dipped below $3000, ETH to $200 and LTC was in the low $30’s. The sentiment was such that I’m willing to go out on a limb and call a bottom to this correction — or shall I say the conclusion to this particular bubble. I’m beginning to regard bitcoin as a series of bubbles each with a fresh group of hopefuls. Please note that I’m not a crypto trader and don’t take this as trading advice. Do check out the two bitcoin links below especially Charlie Bilello’s.

Portfolio

The Apple ($AAPL) puts were closed on Monday with a 50% gain. They would have expired today had I held but couldn’t take the chance over the iPhone X launch. I added to PM miner hedges on Monday such that I’m only 30% long. On Wednesday I sold puts on Activision Blizzard ($ATVI) as an attempt to acquire the stock cheaper. In addition, I swapped Qualcomm ($QCOM) for more Visa ($V) but regretted it almost instantly. I still have semi exposure elsewhere though.

Good Reads

None of the above is investment advice, the standard disclaimer applies.

Nagilum’s Market, 10 Year Yield, Weekly wrap, 9/3-9/2017

Nagilum is a powerful, immortal being from Star Trek: The Next Generation. Once it trapped the starship Enterprise and presented its crew with various apparitions to study their responses — all to satisfy its curiosity about the human race. I mentioned it because the stock market action of the past few weeks give the impression of traders “being played”, where listless see-sawing seemingly designed to frustrate and induce over-reactions. I won’t be surprised if it’s revealed at a later time that AI bots have taken over.

Below is a long term chart of the 10-year US treasury yield (X10) that got to as low as 2.03% this week. It’s pretty amazing to recall that early this year Bill Gross was drawing a line-in-sand at 2.6%, and Jeff Gundlach, making fun of “second-rate bond managers” had it a bit higher. Per my trend lines, we’re just above resistance (call it 2% flat, if broken 1.85% is the next stop); whether it holds will have major implications.

If you put aside the market timing element and just look at asset allocation and security selection, I expect (and have been getting) greater contribution from the fixed income side than the equity side compared with a 60/40 portfolio. In fact, with my individual stocks I’m happy to just match SPY. It is my fixed income allocation — currently at a 50/50 bar-bell of stable value funds and leveraged CEFs that’s been hitting it out-of-the-park, month after month. This is in stark contrast to most DIY investors who tend to have nearly all the portfolio risk exposure and return potential from equities. I’m aware of what William Bernstein said about where to take risks, I simply disagree. I want my fixed income space to deliver returns just like any other.

  • My baseline expectation is for rates to rise as indicated by the generally rising trend lines. I’m by no means married to my CEF positions. The critical timing decision is to catch the turning point in the credit cycle to swap CEFs with treasuries.
  • If rates continue to stay low, it might still be a good hedge to equities when the bubble pops. In fact, rates staying low will fuel the equity bubble even more.
  • The real concern is if both bonds and equities drop, or to be more precise a rout in bonds leading to a rout in equities. Sovereign default is a real possibility of course, but I expect it to start in Europe first. That said, there are scenarios in which US treasury is dumped (at which point a collapsing market may be only minor concern in the overall scheme of things). The question is whether there will be any safe-haven assets or whether the only right position is “short or fetal” to quote a Fast Money trader (I think it was Macke) during the GFC. This is a low probability event but must not be dismissed since the consequences are so dire.

These things will take a year or more to play out so there are no near-term implications on my portfolio. Though it’s good to be prepared.

The US dollar dropped further this week and gold went up some more. I have been expecting a short term turn since the end of last week. My PM miner positions have been slightly hedged to 60% net long while the bullion positions are long term holds. I would have liked to have better timing but I’m maintaining the small hedge since gold looks finally ready for a short term correction. $1300 will be the first target.

Cryptocurrencies

The correction that started at BTC/$5000 could have reached a bottom by now but the second announcement from China banning all exchanges may have changed the character of this correction. The furtherest I can see it running is into the potential November 1st bitcoin SegWit hard fork. Last time BCH rewarded all BTC holders with a free dividend and the bottom came two weeks before Aug 1st. These are not trading recommendations and there is no change to my “managed withdrawal”. FWIW, I’m planning to write a blog post to argue for continued bitcoin appreciation from a game theoretic perspective. Hopefully I can get it done this month.

Portfolio

Sold margin secured Apple ($AAPL) puts EOD Friday, meant to be a very short term trade.

Outlook

Frankly I’m not happy with the market action this week. I would have liked the June lows to be taken out, instead we stopped right at the intermediate trend line. We now have anemic action from that lack of catharsis. There are chatters about an October correction which even if true would likely be mild. Still I might tweak my stable of individual stocks that now number 31. I want to pare down the number but increase the dollar amount. In short each stock needs to be a high conviction idea. I have not avoided mentioning any individual names on this blog, but neither have I given a comprehensive list. I’ll consider publishing it once I’m done with adjustments.

Good Reads

  • Profit Margins, Bayes’ Theorem, and the Dangers of Overconfidence: anything by PhilosophicalEconomics gets an automatic mention but this is easily one of the top 5 posts there and that’s saying a lot. Excellent explanation of the Bayes’ theorem, the whole article is as close to a mathematical proof of “strong conviction, carried lightly” as they come.
  • Yet Again? Howard Marks memo covering all the topics near and dear to my heart: market and positioning (agree in principle but not timing), bitcoin, passive investing, and six ways to invest in a low return world (#6 here I come)

Edit 9/10/2017: added “10 year yield” to blog title

None of the above is investment advice, the standard disclaimer applies.

Passive Indexing and Float Manipulation

I have said multiple times in this blog that Bogleheads is one of my favorite investing forums — to read but never to post. There are many posters with deep understanding not jut in finance but also in many other areas of life willing to share their knowledge. But there is also a visible group with the “holier than thou” attitude for whom ignorance is displayed like a badge of honor. Not understanding something therefore choosing not to act is perfectly sane and prudent, and I’ll never hold anything against anyone for that. Not having the curiosity or the willingness to learn new things though is a fatal character flaw and a source of so much that is wrong in our society.

In this post I want to highlight two Bogleheads threads about whether passive indexing, as it becomes ever dominant, distorts markets and pricing, as well as if there are ways to take advantage of its dominance.

Our protagonist is user jbolden1517. I don’t know him (I assume it’s a he) personally but from his writings can surmise that he’s an investment professional and has been active since at least before the great financial crisis. I have an enormous amount of respect for him for no other reason than the amount of patience he displayed explaining things to a skeptical audience. jbolden1517 outlined a process of “float manipulation” where controlling shareholders can use index funds as a source of cheap financing:

User jbolden1517:

The real problem for indexers is float manipulation. If 70% of a stock’s float is going to be bought regardless of price it becomes incredibly profitable for a company to create float and sell shares to index funds (I’m including quasi-indexing and passive here) as a way to use index funds as a cheap source of financing. In a normal market, in CAPM’s theory investors are rationally pricing stocks based on their future discounted dividends using a discount rate that adjusts for risk. So under CAPM doubling the number of shares merely cuts the share price in half. Doubling the number of shares should have no impact on market cap. But of course index funds don’t rationally evaluate the future stream of dividends. Indexers hold a constant portion of any stock, buying or selling based on float not dividend prospects. So when the number of shares double they have to slowly raise they buy target till they get the shares back in balance. This is the same thing that happens to short investors in a short squeeze. They will end up paying far more than the company is worth.

User nedsaid finally getting the point:

So it is basically a game of now you see it, now you don’t. Those shares are technically float because B of A owns them, but not really. It sounds like what Company X does is over time release additional shares from its Treasury stock (stock it had previously purchased on the market reducing outstanding shares) to meet demand from the index funds. So Vanguard has to buy shares based on shares that are technically outstanding but not really because they are owned in synthetic fashion by B of A. What is being sold to the index funds is not B of A’s stock in Company X, but Treasury stock from Company X released incrementally to meet index fund demand.

The second thread contains discussions on inflows which is another way of looking at this crucial problem: what is the amount of trading due to passive index funds relative to those responsible for price discovery? Estimates today are that 35% of the total market capitalization is in index or closet index funds. Though this figure may not have any bearing on the composition of trade volume on any given day. According to this report from NYSC, for Q4 2016, U.S. ETF dollar volume represented approximately 29% of all consolidated tape issues in 2016. The vast majority of ETFs are cap-weighted indexers. We also need to keep in mind that there are also quant funds that “don’t read the earnings report” to use a phrase used by jbolden1517. He quoted a report from JPMorgan that 3/7th of the trading volume is from indexers, 3/7tg arbitrage and 1/7th fundamental. I have not been able to find a link to that report; however, the most recent memo from Howard Marks seems to confirm this:

Raj Mahajan of Goldman Sacks estimates that already a substantial majority of daily trading is originated by quantitative and systematic strategies including passive vehicles, quantitative/algorithmic funds and electronic market makers. In other words, just a fraction of trades have what Raj calls “originating decision makers” that are human beings making fundamental value judgments regarding companies and their stocks, and performing “price discovery” (that is, implementing their views of what something’s worth through discretionary purchases and sales).

Another piece of corroborating evidence can be found in the most recent Masters in Business podcast (Barry Ritholtz interviews Katie Stockton), there was a brief exchange starting around the 7:00 mark about the volume no longer being a good technical indicator which was attributed to index and quant funds.

My Own Thoughts

40% of my portfolio is passive, utilizing cap weighted index funds exclusively for the equity component. I see index funds as the most widely available, cost-efficient (in ER and time/energy) way of getting equity exposure. However, I also recognize their weaknesses which I discussed here. Lacking access to relevant data or studies, it was a purely mental exercise for me. So I was happy to have found a kindred spirit in jbolden1517‘s writing. In my own post, I was a little hazy on the “control share holder” aspect. An idea occurred to me after reading Eric Cinnamond’s The Passive Investor (PI) Ratio: a hedge/private equity fund could acquire a company with a high PI ratio and apply the float manipulation technique to use the index funds as its exit strategy.

In the spirit of intellectually honest exploration I want to present opposing views on the issue of trading volume attributable to fundamental discretionary traders. On one hand, there seems to be evidence to support the figure of 1/7th of trade volumes. It was probably 100% at one point in history, so 1/7th would be a big reduction. On the other hand, who is it to say it’s insufficient for price discovery? I don’t think anyone knows for sure. One other piece of data we may want to take into account is that the internal market correlation is a a low (source), although it could just be a sign of a top (source). In the end, I’m leaning towards there probably isn’t a big effect now but we’re probably closer to that point than most realize.

Defenders of passive indexing will rightly ask, what are the demonstrable ill effects of all these? The only possible answer is: very little to none, TODAY. It is no reason to be complacent, however. Imagine a real estate investor confronted with the malpractices in mortgage lending in 2005 and asking to see evidence of national housing price declines — there are real dangers in ignoring the warning signs.

I expect the migration to passive indexing to continue, consistent with my stock market projections. It’s a self-reinforcing cycle: more buy-at-any-price investors will prolong the bull market which tend to improve the relative performance of index funds over actively managed funds that limit their exposure, which leads to more passive indexers. While the trend is underway, it’s foolish to stand in front of it. At the same time, all the excesses and distortions will continue to build, providing opportunities when the trend finally turns. To me market timing in accordance with these trends is the most logical response.

Dollar Woes, Weekly wrap, 8/27-9/2/2017

Starting from this week I’m using a more descriptive title for the weekly wrap.

Macro and Markets

This week we had a preview of the “post August moon-shoot” that my model has been predicting. The Nasdaq established a new closing high. Gold was no slouch either with the spot reaching $1334.5 on Friday. Gold’s move mirrored the dollar’s fall through its 200 week moving average. Near term we’re likely to see a top in gold and rebound in the dollar but I’m leaning to the rebound being short-lived which is more consistent with my views on gold and equities.

If the dollar should fall definitively below its 200 week average, it will likely be the start of a multi-year decline and will have serious repercussions on the pricing of all financial assets.

Cryptocurrencies

The relentless upward thrust seemed to have been finally repelled by the psychologically significant barrier at BTC/$5000, LTC/$100 and prices might have started an intermediate decline. I have long given up making any short term predictions or at least trade with them. I sold some LTC this past week (well below the high). My LTC and ETH are at 75% of my peak holding, and plan to sell enough bitcoin to get to the same point by the end of this year. I have withdrawn 84% of my initial deposit and still hold coins with a market value 4.5 times that for an IRR of 3900%.

One thing obvious from looking at Coinmarketcap.com is that the premium at the Asian exchanges have all but vanished. It was only two month ago that prices in Korean Won routinely had a 20% premium. To me that’s the surest indication that the big-money arbitragers have arrived. There has been no shortage of reports of hedge funds getting into this space. This latest example happen to also contain useful data: I’ve surmised that bitcoin is not correlated to other assets by observing its price behavior, but it’s nice to see a piece of data.

So we’re knee-deep with institutions, but probably still a ways from massive public involvement, or the premium on $GBTC wouldn’t be nearly as high. There is renewed talk of a bitcoin ETF which could usher in the final mass speculation phase of this bubble and I would give it no more than a year after that to reach the final top. My current plan is to sell at least 5% every 6 months, but also to hold no more than 20% after the bubble pops.

Portfolio

I’m running out of options for tax-loss-harvesting this year. This week I harvested losses in Altria ($MO) due to an FDA announcement a while back. To maintain sector exposure my main options were Philip Morris ($PM) and British American Tobacco ($BTI). $PM had higher PE but a stronger balance sheet so it was a toss-up fundamentally. In the end I went with $PM due to its pure international exposure as opposed to $BTI with its Reynolds acquisition — the irony is that I used to own Reynolds before $MO. Just another example of the trajectory of USD making its way into all investment decisions.

Outlook

No change.

Good Reads

None of the above is investment advice, the standard disclaimer applies.

Performance Tracking August 2017

I made some changes to the reporting format. Monthly returns are still calculated with the simple Dietz method. Note half of the contribution is added to the denominator. I consolidated the DGI stocks and growth stocks into a single column with the heading “all actively picked stocks”. It makes more sense as dividend is no longer my focus although I still believe DGI incorporating other factors like quality and low volatility enhances total returns. I’m also starting to show annualized standard deviation, STDEV(monthly returns) X SQRT(12), and the Sharpe ratio, AVERAGE(monthly returns)/STDEV(monthly returns) X SQRT(12). For simplicity the risk free rate is taken to be zero.

SPY gained 0.29% for the month of August but the number doesn’t remotely do justice to the episodes of tension with North Korea. After shrugging off threats of a nuclear war is it any wonder that this market brushed aside Presidential antics and hurricane Harvey alike? Though bonds and gold disagree: AGG had one of its best months, up 0.94%; spot gold gained 4.1%. My portfolio delivered significant outperformance: the passive, active, and total portfolio returned 0.98%, 4.45% and 2.87% respectively, vs. 0.55% for the 60/40.

Generally speaking, there are two ways to outperform: 1) when the market is down, non-correlated assets like PM and crypto advancing; and 2) when the market is up, the leveraged option positions advancing even more. For most of August, the outperformance was of the first kind. The final week saw a preview of the “post August moon-shot” my model has been calling for and the outperformance was more of the second kind. YTD the total portfolio has now exceed SPY (13.88% vs. 11.75%) at a volatility comparable to the 60/40 even though it contains many highly volatile (albeit non-correlated) assets. The active accounts did even better (YTD 18.37%) but still with a volatility lower than SPY. I now expect to make back the ground lost in the fall of 2016 by the end of this year.

This month the return also benefited from market timing — in particular, adding to CEF and option positions on August 10-11. I had bids out in the third week of August that were never hit. Timing is an additional source of alpha and risk management that layers on top of all sources of return: equity, PM, credit, and crypto. Going forward I’ll cover trading and position adjustments in weekly updates instead of monthly.

Added Sept 4th: AllocateSmartly now tracks 39 different tactical asset allocation strategies. In August the highest monthly return was 2.63%, trounced by the 2.87% and 4.45% returns of my total and active portfolios. YTD the best return was 18.71% and the 2nd best 13.05% vs. 13.88% and 18.37% for mine. We shall see whether the market continues its upward trajectory as my model predicts.