Monthly Archives: October 2017

Leverage, Weekly Wrap 10/22-28/2017

Macro and Markets

The last weekly wrap featured a flag breakout pattern in the Russell which fell back into the consolidation channel earlier in the week. My own portfolio is highly leveraged to the NDX so I went into Thursday with plenty of angst. Fortunately they didn’t disappoint. The Christmas rally is now in “full on” mode. Naturally big tech earnings will be fingered as the proximate cause but I believe money coming out of the bond market will provide the more sustained fuel. The last time I showed the 10 year yield ($TNX/10) it was sitting at the recent low of 2.03%. It has since shot up to 2.43%, a huge move. I expect it to reach 2.8% in the first half of next year and eventually over 3% to force investors who have been piling into bond funds to switch into stocks, setting the stage for the final bubble mania.

Below is the ratio of the Energy ETF ($XLE) to the price of Wester Texas Intermediate. The ratio has dropped below support as energy stocks stagnated while crude price advanced on supply cuts. $XLE just tested its 200 DMA and has the potential to get back to $73-75. I continue to monitor this space for an opportune time to unload my Exxon and Chevron.

There were a number of important geopolitical events this week. Abe won convincingly again which means BOJ will maintain its loose monetary policy (~$50bn per month?). Draghi announced a “dovish taper” of €30 bn per month to at least Sep’18 (note combined they are greater than the projected $50 bn Fed balance sheet reduction, before anything from the PBoC). Xi JingPing consolidated his power — I’ve never worried about the Chinese debt, much less so after this expected development. The final solution for any debt problem is some kind of equity/debt swap which only a country like China can successfully pull off. Congress is likely to expand CFIUS review (source). As far as seed-stage tech investing is concerned I can see how this can backfire. Chinese VCs will simply ask early-stage start-ups to move to China — in ZhongGuanCun, they work harder and for less. The market and users are there, so why not?

Gold

Gold price movement is unfolding as laid out last week. Next significant bounce may occur at the 200 DMA ($1260) around the next FOMC meeting (Oct 30 – Nov 1). The bounce will likely fail.

Portfolio

Despite the movement in rates noted above, many Pimco multi-strategy CEFs gained in NAV, i.e. they have negative effective duration. I added to PCI. Muni CEFs are under pressure but I believe their distributions are safe and will continue to hold/add. I added to Tencent ($TCEHY) to bring its weight in-line with other tech stocks.

A portfolio allocation breakdown can be found in the annual review in July. There has been some changes since then: PMs have dropped to 10%, equities increased to 58%, fixed income slightly lower at 23%, and the “Other” category more than doubled to almost 5%. The “Other” category has three components: cryptocurrencies (2.5%), 3x leveraged ETFs (1.1%), and options (0.9%). The market value of the options is quite deceiving. As of Friday, the total delta times the underlying equals about 55% of the total portfolio. In other words, there is a leverage ratio of 55-60X on the current market value. I expect the delta to increase due to positive gamma; as I move up the strike of the puts I use some of the gains to buy more calls. This level of leverage is possible with futures. However I like the liquidity of QQQ options vs. NQ, I also plan to get long term capital gain rates instead of the 60/40 split of section 1256 contracts.

I have debated whether to reveal the exact option trades but have decided not to, at least at this time. The basic mechanics have already been discussed in this blog. Basically, naked puts were sold to finance calls, and a million variations on that theme. All transactions were for credit, i.e. there was no cash outlay to build up these positions. There is margin impact for selling naked puts for sure. At IB where I have portfolio margin, it’s 10% of the max loss or assuming the underlying drops to zero. On that basis, the leverage ratio is about 13X. Note margin impact is not the same as margin balance. I don’t buy on margin or pay any margin interests.

The main reason for not revealing my exact option trades is that they’re of little use to the readers. First, I don’t expect many to have the level of trading authorization to sell naked puts. Second, the right time to put on those exact positions was before the market took off. I started at the of June. Last but not least, it takes a tremendous amount of conviction to with them. Following someone else blindly into a trade is just about the worst thing one can do.

Good Reads

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

Fear and Loathing, Weekly Wrap 10/15-21/2017

Macro and Markets

S&P made new highs everyday of this week, something of a record. RSNBS. This is precisely the kind of behavior required to reach my end-of-year target of 2700 and beyond. There are multiple flag breakout patterns like the one in Russell that portend higher prices to come. This bull market will continue until every bear is decimated and every market-topping sign they point to stretches beyond imagination. The analogy “1998” was made with both the timing and magnitude of the dot com bubble in mind.

With apologies to Johnny Depp, Benicio del Toro, and two of my favorite bloggers, the title of this post was borrowed from the 1998 black comedy of alcohol and psychedelic excess. In particular fear and loathing refer to Josh Brown’s poignant “Just own the damn robots”, and Kevin Muir’s spirited reply “The Winners of the New World Redux”.

Josh Brown’s post, as well as its similarly themed predecessor “Tech Stocks as Career Obsolescence Insurance”, makes the point that the AI/ML/robotics stocks are being bought as insurance against a future where only “engineers and managers” are gainfully employed — “in this context, the FANG stocks are not a gimmick or a fad, they’re a f***ing life raft”. I find there to be more than a grain, more like a boulder, of truth in that. This is from somebody who recently made a career pivot to work on products that have a intersects both IoT and machine learning, and one who is relatively level-headed about both the promise and limitations of these technologies. While not concerned with my own career, I have more than a little angst when I ponder the future of my daughters who are not as math/science inclined as I was at their age. I cannot fault them for being who they are but I’ll be remiss not to worry about their places in a society where every decent paying job requires coding experience.

It took Kevin Muire’s post to pull me back from the brink of loading up on $ROBO. He quotes a Jim Cramer speech from 2000 “The Winners of the New World” where he touted “724 Solutions (SVNX), Ariba (ARBA), Digital Island (ISLD), Exodus (EXDS), InfoSpace.com (INSP), Inktomi (INKT), Mercury Interactive (MERQ), Sonera (SNRA), VeriSign (VRSN) and Veritas Software (VRTS)”. For sure it was a cautionary tale. There is a right price for every stock no matter how strong the fundamentals. Nothing is a buy at any price.

For now at least, my heart or rather my fear falls on the side of Josh Brown. It’s why I took on additional risk when in theory I can coast for a decade and into retirement. To me the current market is the last chance to establish a lasting foundation for my family. The danger, of course, is to overstay the welcome, so Kevin’s words should always be at the back of my mind.

Cryptocurrencies

Bitcoin broke $6000 on Friday. I hadn’t been expecting that until the end of the year. The other cryptos continue to lag as pointed out last week. I have a few crypto-related links below but will not continue this section in the future as my focus will be elsewhere. The plan is still to sell down to 75% of the peak coin holding across the board in December/January, at which point I will have withdrawn more than the initial deposit made in March. I’ll then sell 2.5-5% at regular intervals once public participation starts.

Gold

Last week I wrote “$1307 and $1320 are likely upside targets for the current move”. Spot gold topped out at $1306 on Monday and likely started C of an ABC decline. There are two likely scenarios: A) continue moving down below the July low of $1204 around the December FOMC meeting on 12-13th; this intermediate low thus becoming the yearly low coinciding with a short 63-week/13.5-month cycle; B) the current leg finding a bottom around $1208; one more low in January for the normal 63-week/13.5-month cycle. They are drawn as the solid and dashed lines in the chart below. Of the two, scenario B is harder on trader’s psyche thus more likely in my mind. COT data should provide us a confirmation. The easy money continues to be in stocks.

Portfolio

The week finished strong and the Activision Blizzard ($ATVI) I picked up last week came above water. The 65 strike puts were rolled forward 1 week and down to $63.5. Consumer staples Philip Morris ($PM) and Kimberly Clark ($KMB) missed earnings and were duly punished. Biotech ETF ($XBI) was another blight in an otherwise strong portfolio. Month-to-date the individual stocks gained 3.61% vs. 2.34% for the SPY. I like to focus on the losers, sometimes even force myself to take losses when my own hubris becomes unbearable. That point may be reached soon.

Pimco multi-strategy CEFs were under pressure after a hit piece on $PCI appeared on SeekingAlpha. The author didn’t seem to know anything about interest rate swaps. I can’t say I understand them either but at least I know what they are which is more than the author can say. The issue of under-earning the distribution was flagged here a month ago and was extensively discussed on the MorningStar CEF forum, my go-to source for CEF information and knowledge. The NAVs of these funds remain strong and I’m satisfied with that. Friday’s data indicates Pimco is doing a terrific job navigating the current rate environment. These are managers who can easily command 2-and-20 and I feel lucky to only have to pay a 2% management fee. I took the de minimus cash left in my solo 401K and added $PCI. I wish I had space for more.

Good Reads, Crypto Edition

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

Some of You Will Sell or the Achilles Heel of the Arithmetic of Active Management

I’ve made no secret of my fascination with the active/passive debate. I don’t have a dog in this fight: my perspective is that of an active individual DIY investor. There is strategy diversification in my own portfolio: 40% of my total portfolio is in what I call a “passive strategy” where the equity allocation consists entirely of low-cost index funds; nearly all of the rest is in an “active strategy” where the equity allocation consists of individual stocks. However, since this secular change from active to passive has the potential to affect security pricing and the persistence of trends everyone should care deeply. Last time, we took a look at possible float manipulation, today the attention is on the corner stone of the argument for passive indexing. I don’t think I came close to disproving it, only weakened it by considering real people who make suboptimal decisions. That seemed appropriate in a year when the father of behavioral economics won the Nobel memorial prize.

Risk Tolerance or Why People Sell at Bottoms

A typical questionnaire for an investor’s risk tolerance includes questions such as: “If the stock market drops 30%, will you A) Sell everything, B) Sell half, C) Do nothing, D) Buy more stocks”. In my opinion, these questions are worth less than the paper they’re printed on. People don’t sell because the market has dropped 30%; they sell because after the 30% drop the market looks to be dropping another 30% ‐ a virtual certainty according to the perma-bears whose advice they wish they had heeded. In addition, serious market declines often don’t not appear out of thin air, rather they tend to be accompanied by real economic malaise: in 2000-2002 it’s the mal-investments of the dot com era and closure of countless “new economy companies” and those that service them; in 2008-2009 it was the collapse of the housing bubble and the veritable brink-of-collapse of the global financial system. Imagine the following scenarios and ask how many would sell:

  • A nuclear attack on US soil.
  • US losing its superpower status which has underwritten its prosperity since WWII.
  • Total collapse in Japan/EU. Sovereign debt crisis. US 10Y treasure yields above 5%.
  • Banking crisis, bank bail-in
  • Wide spread job loss including one’s own

This is not at all a prediction that any of the above may actually happen, but rather that a questionnaire or even thoughtful introspection during times of peace and prosperity can never capture the emotional and psychological stress investors will be under in a real economic crisis. Time and again, many who know they should, and think they can hold through a bear market ended up selling at the worst time. In fact wide-spread capitulation is a prerequisite for bear-market bottoms. Nobody sells? Fine, the bear market continues until a lot of people do — this is the way it works.

Time Horizon for Most Investors is Shorter Than Expected

The long term stock market average is often plotted as an uninterrupted bottom-left to upper-right squiggle. “In the long run, stocks always go up.” is the prevailing mantra. The rub is the definition of the “long run”. As I discussed in The Arithmetic of Prudence, for a typical worker saving for retirement, what really matters is the the return during two decades — one on each side of the retirement date. During the accumulation phase, the money weighted return necessarily depends more on when the portfolio value is greatest, i.e. near retirement. The closer the investor is to the distribution phase the less he can rely on the “long run”, the less he can afford to suffer through a severe draw down. Success of the withdrawal phase largely depends on the period immediately after retirement, i.e. the dreaded sequence of return problem. No matter how one slices it, two decades is not long term given the natural gyrations of the stock market. The standard recommendation of “invest for the long run” should be understood as an expediency — most people are even more terrible at being a short term trader — than a truth.

Note that on average there is 1 bear market per decade (source).

The Arithmetic of Active Management and Its Achilles Heel

Nobel laureate William Sharpe made the observation that in the aggregate active investors and passive indexers must both own the market portfolio, hence the passive indexer must outperform, in the aggregate, due to lower fees. That is the gist of the arithmetic of active management. It’s tautologically true and has proven to be the bane of active fund managers everywhere. I have only seen this argument applied to stocks and that’s where our discussion will remain.

Index funds are a great invention and Jack Bogle deserves all the accolades going his way. I’m all for the little guy getting the most he can and sticking it to the banksters in the process. It can only be a good thing if LBYM, invest early and often, passive indexing become part of the ethos &mdas; Americans consume too much and save too little IMO. However, thinking individuals must also realize there is no such thing as an unmitigated good: by-passing financial advisors and active management also removes gate keepers and return dispersion during bear markets. The issue with the popularity of index funds is the synchronicity of selling and the echo of negative emotions during market duress. Even die-hard Bogleheads readily admit it is not easy to hold through a bear market (thread 1, thread 2). As the democratization of investing via passive indexing gathers more adherents we can expect a fair number to lack the fortitude to hold through a down turn. Such is the Achilles heel of the arithmetic of active management if there ever is one: the passive indexer must hold the market portfolio to earn the market returns; if he sells, all bets are off.

Let me recast this argument which I’ll call the Corollary of the Venditor (Latin: seller).

  • In general and among the passive indexers there are two types: type A who holds through market ups and downs; and type B who makes poor timing decisions: hesitates to buy when the market is trending up, and/or sells at market bottoms.
  • Type A indexers receive market returns; type B indexers must receive below-market returns on account of their poor timing.
  • Therefore, passive indexers as a whole receives below-market returns.
  • Active investors who make up the rest of the market, must receive above-market returns equal to that surrendered by the type B indexers.

It’s not necessary to estimate the proportion of type A and B indexers, only that B is non-zero. There are type B active investors as well, but their losses accrue to other active investors not type A indexers. Nothing above dictates how the return among active investors is distributed. This is not a defense of actively managed funds with high fees that eat into investor returns. The obvious recommendation for passive indexers is not to be distracted by emotions but that’s like saying everybody should eat healthy and exercise. Lastly, the net alpha of active investors comes from poor timing decisions of some passive investors, in other words timing counter to type B investors is a path to above-market returns. This counter move can be achieved by allocation adjustment during bull/bear markets, market timing in the traditional sense with active managed funds, or even market timing with index funds (I know you were wondering where these guys are).

In summary, I believe the Corollary of the Venditor points to an a priori opportunity for the aggregate active investors to achieve above-market returns. The advantage is probably not large enough to overcome the fees of active fund managers per SPIVA records but the active individual investor can claim his due by: cost-reduction (fees, trading and taxes), differentiated positioning (concentration, factor tilts, active share), and above all adaptation to macro cycles that occur on the order of years or a decade. These are precisely the things I practice and write about in this blog.

This post is not meant to be a detraction of passive indexing which is still the best recommendation for most people. Type B investors exist irrespective of the investment vehicle so they may as well pay less fees while invested. Studies have shown small out-performance by active mutual funds before-fees and now we have an explanation for it being a systemic effect. With that we can reject the more fundamentalist passive indexers who claim there is only one way to invest, who also tend to be over-allocated to equities. Though I remain grateful — a fair number of them and their converts will end up being type B investors without whom people like me will have diminished hope of out-performance.

References

  1. Sharpe, W. “The Arithmetic of Active Management.” Financial Analysts’ Journal, Vol. 47, No. 1 (1991), pp. 7-9. Link
  2. Pedersen, L., “Sharpening the Arithmetic of Active Management” (2016, SSRN 2849071) Link Talks about the effect of trading.
  3. Vertes, D., “Active vs. Passive Investing and the ‘Suckers at the Poker Table’ Fallacy” Link I believe is saying the same thing, but boy is it a long read.

Opium for the Mind, Weekly Wrap, 10/8-14/2017

Macro and Markets

Another week, another set of all time highs. Readers of this blog should not be surprised — I’m going to use this acronym RSNBS from now on to save me some typing. The leading stocks, Apple, Alphabet, Amazon, and FaceBook are all pointing up so the rally has every reason to continue. In March, I wrote that I expected “the S&P to end the year with a 27 handle”. The expectation stands and now looks to have a very good chance of coming true. FWIW, my model does not forecast a pause until well into 2018.

My modus operandi is in direct violation of the cardinal rule of making predictions: price or time but never both. Naturally only a no-name blogger with nothing to lose can afford to do so. More to the point, the predictions are not made to gain a reputation, but rather to make money which is only possible by being right, early, and backed up with capital. This week was a continuation and confirmation of the trend, where the CNN Money Fear and Greed index retreated form 95 to 73 without any discernible mark on the indexes. On investing forums there are people left and right talking about going to cash or bonds or even shorting. Then there are articles and commentators like this on Zerohedge. Once again I had to remind myself that famous saying from Jesse Livermore, “It was never my thinking that made the big money for me, it always was sitting.”

Switching topic, above is the long term price chart of West Texas Intermediate ($WTIC). The range between $40-60 goes back to 2015. Shale should continue to cap the upside in short to medium term and longer term auto electrification is definitely a headwind. I’m not in the camp of $5 oil nor do I believe the long term effects have been priced in. I would suggest a re-reading of Morgan Housel if you believe prices reflect all available information. Investor with different time horizons can value the same asset differently. Since the asset can have only one price at any given time, it will be above some investor’s fair price and blow some other’s. QED.

Anyway, $55 or even $60 look achievable looks achievable in the current cycle at which point I’ll exit my Exxon ($XOM) and Chevron ($CVX) positions.

Cryptocurrencies

Bitcoin broke to new highs with volume this week. RSNBS. Initially other cryptos were sold but they eventually followed suit. BTC dominance is back above 50% again and there is less correlation between cryptos. All these point to a different trading regime which is in agreement with my theory that there is a new set of buyers to start a whole new bubble.

Gold

Gold had a strong bounce this week although I maintain we’re still in an intermediate cycle down. $1307 and $1320 are likely upside targets for the current move. In the last weekly wrap I brought up the the 63-week or 13.5-month cycle. A full length cycle will put the bottom in Jan’18 but it can run a little short and the current intermediate cycle can extend to coincide in December, making a year-end low third time in a row. The year cycle low, whether in December of January, could break the July low of $1204. Likewise, COT is saying we’re not ready to head back up yet. For now the easy money is definitely in the stock market.

Portfolio

$PCQ continues to trade at a premium of around 22%. I ended up buying the Nuveen CA muni fund $NAC. It has a lower yield (5%), but a 5% discount and better liquidity. The dividend has already been cut twice since July so I hope it’s safe for now. With CA muni in demand there just aren’t many attractive CEF options. Elsewhere I continue to manage the short put leg of synthetic type positions, this time taking advantage of the rally in Alphabet ($GOOGL). I also added a synthetic long in the Biotech ETF ($XBI).

Activision Blizzard ($ATVI) took a beating this week ostensibly due to a negative report from Canaccord that had a pretty speculative reasoning: its Overwatch eSports league not meeting expectations. I bought the stock as it touched the lower Bollinger band. Previously I sold 65-strike puts expiring next week and will probably roll them out. My interest here is for fundamental reasons — video games are the opium for the mind. Easy-money fueled asset bubbles are giving young people everywhere a raw deal. The plight of young man in our society is well known, the latest report links low marriage rate to their not making enough money. Others have reported they play video games rather than getting a job or a girlfriend. Back in my college days I had a phase with Doom that thankfully ended. Quality of games today is vastly superior. Their hold is likely to continue, even if, or especially when, Universal Basic Income becomes a reality.

You may accuse me of being callous, trying to profit from a pre-Matrix dystopia. The fact is I cannot and will not invest for a world I want to live in vs. a world that I do live in. An ESG investor I am not. I’m more like a fish in the ocean having to go with the current. The best this fish can hope for is to jump out of the water once in a while, and in that fleeting seconds before falling back see a little further ahead.

Good Reads

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

Fed Chair, Crypto Script, Gold Cycles, Weekly Wrap, 10/1-7/2017

Macro and Markets

The next Fed Chair was the speculation of the week — more precisely it reached a fevered pitch after brewing for months. Jeff “I’ll make 400% on my S&P puts” Gundlach predicted Neel Kashkari would be the choice, causing his odds to soar in the prediction market. Kashkari is another giant squiddy who ran TARP back in the day. He also ran for the CA governorship in 2014 before becoming the President of the MN Fed in 2016 where he has taken on a very dovish policy slant. I can definitely see Gundlach’s point. The MarcoTourist, Kevin Muir, had something to say about the leading contender Kevin Warsh, in There are no atheists in foxholes that’s well worth a read. The choice of the Fed Chair will impact monetary policy but probably only in the long term. In the short to medium term the path for Fed balance sheet reduction has already been set and global money supply is more in the hands of foreign central banks who are still engaging in QE.

The NDX finally broke through 6000 to new highs following most other indices. Those who have been following my weekly wrap shouldn’t be surprised in the least. Rotating sector leadership is a classic pattern in bull markets and this one just got started. The CNN money Fear and Greed index reached as high as 95 this week, there may be a short-term pull back but any dip will likely be shallow and brief.

The Script for Cryptocurrencies

Cryptos have been quiet all week with lower than usual trading volumes. LTC daily volume has been under $100MM when it was routinely several hundred million or over a billion not too long ago (Coinmarketcap data). I’ll reiterate my take on this space. It was a bubble and it popped in September just like the previous five or six crypto bubbles. However; a bitcoin month is equivalent to a stock market year so the next bubble will be here sooner than most think. The miners have invested enormous capital into their mining equipment that they can’t let go to waste so they’re propping up prices (lest the whole idea go cold) along with hedge funds who are accumulating in anticipation of a public trading vehicle. Meanwhile, there are plenty of public who wants to get in but can’t or don’t know how. Once the public vehicle becomes available it’s lambs to the slaughter time. Hedge funds will dump their coins on the public and the slow-moving institutions and miners will sell forward years of supply. It will end like every other bubble, when it finally runs out of buyers. Then out of the ashes of this burnt that the future winners will emerge, many years after the end of this next bubble.

The last time bitcoin prices started ramping up two weeks before the Aug 1st hard fork. So let’s see if organic buying interest materialize in the next week or so. As for me personally, there is no change to my managed withdrawal plan. YMMV.

Gold Cycles

Gold remained weak last week. The reversal on Friday may have finally kicked it into a bounce; nonetheless, the intermediate trend is still down and I stand by my view that it will test $1240-50. Seeing how much time it has taken the bounce to arrive, that low may have to be pushed into November. In the COT, Commercial net short positions have seen a fourth week of decline but still at elevated levels which is conducive to further downside.

On the fundamental front, China will soon launch a crude oil futures contract priced in yuan and convertible into gold. I suppose a lot of yuan will be kept to facilitate trade with China but some amount will be off-taken as gold from London. Those who think it’s a needlessly roundabout way to get paid in gold or US$ need to think from the POV of a country that may be subject to US sanctions. At the root of it all is the shale revolution that has turned US into a significant oil exporter (though still a net importer, see EIA data). That’s the lens with which we need to view the warming between Saudi and Russia, and the coming IPO of Aramco, etc. There should be plenty of takers for this oil-for-yuan-for-gold scheme. It remains to be seen how well that launch of this futures product line up with the January bottom mentioned above.

Portfolio

The figure is the return of my main taxable account vs. SPX/EFA/VT for the last 30 days. Due to leverage my return was more volatile and started pulling ahead of the benchmarks now that NDX had broken out. This was the week that I dropped all pretense to contain capital gains. There was a flurry of activity in the options department. I took losses in Disney ($DIS), but most trades were to roll-up the short put legs of synthetic equity type of positions — to move the strike price from below the underlying to above since gamma peaks there. I did this for Gilead ($GILD), Alphabet ($GOOGL) and the Q’s and got about 48 delta all told.

Afterwards I increased my tax withholding which got me thinking. If SALT were to be eliminated next year, and it’s a big IF, I would expect state tax refund not count toward federal taxable income, in which case overpaying my CA taxes this year is not so bad. — I must emphatically point out that I’m not a tax professional and you should consult your tax adviser about this!

Good Reads

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