Directional Price Trends

Posted by Mike Shell on November 11, 2011

I think this is a good example that "a picture speaks a thousand words". While the human mind likes to hear the stories, which seem more exciting, we never really know if the story is accurate unless we have evidence afterwards. But if we define a upward trend in some simple way like higher highs and higher lows and a downtrend as lower highs and lower lows, then we can be pretty clear about defining the state of a thing. With that definition, I suppose you may be able to look at the chart below and determine a trend has been going on for some time. We don't need to have some theory why: It just is. In this case, it's the spread between diferent bonds rather than price, but it's still a trend.

click for PIIGS 10 year government bond spread .gif

 

Naturally, you may see this chart and what to know "why" the trends are what they are. Notice that I haven't told you what I believe the trends are- I believe we may all get the answer right if we've defined trend direction in a quantitative way. The creator of the chart, Chart of the Day, offers the following as an explanation of what may be causing the trend. They actually printed the explanation below first, then the chart showed the chart. I've presented it the opposite way to make my point. In fact, I haven't even read what's below because I don't feel I need to know the theory behind it all - I just know it is a trend and I prefer to be positioned in its direction and I wish to avoid being on the wrong side of it for too long. I can define all of those things quantitatively, so there is no need for qualitative subjective opinion about it that could be wrong. We can be pretty sure the chart above is objective and speaks for itself. 

All the European austerity and bailout plans have not managed to stem the European debt crisis. In fact, the severity of the crisis has only increased over time with Italy, the world's eighth largest and the euro zone's third largest economy, now becoming the latest European nation to likely require a bailout. Today's chart helps illustrate the risk of European debt by plotting out the 10-year government bond spread (versus the German Bund) for all the PIIGS (i.e. Portugal, Italy, Ireland, Greece, and Spain) from 2007 to the present. For example, the Greek 10-year government bond yield (light blue line) is currently a whopping 32.5 percentage points greater than that of the relatively stable German Bund. That is a far cry from where it was back in the summer of 2009. However, even more important is the status of Italy (dark blue line). Italy has €1.9 trillion ($2.6 trillion) of debt outstanding. This level of debt is greater than that of all the other PIIGS combined. Due to the severity of the situation, the European Central Bank may ultimately be forced to print a significant amount of euros – something they are very much ideologically opposed to doing.

Source: http://www.chartoftheday.com/20111111.htm?A

Bloomberg Businessweek Says: GRRRRR! with a Bear on the Cover

Posted by Mike Shell on June 15, 2010

On May 28th I posted the cover of The Economist magazine that pictured a shark swimming in the water with the headline "Fear Returns: How to avoid a double dip recession". I called that post Magazine Cover is a Bullish Signal for Crowd Sentiment suggesting the negatively toned magazine cover may be a positive. You see, by the time information hits the cover of the magazine and the public hears it, it isn't "new" anymore. Their sentiment is a countertrend indicator. We give a hat tip to Lee Edgcomb for pointing out another bearish magazine cover just released. Below we show the cover of Bloomberg Businessweek. Of course, for our purposes we are only making reference to the cover, not the content. The article was written by Jessica Silver-Greenberg and can be read in the link below the cover.

 

Bloomberg Business Week Bear Cover June 15 2010

Source: http://www.businessweek.com/magazine/content/10_25/b4183048417437.htm

I have empirical evidence that bearish magazine covers like these often mark the lows of a stock market correction and bullish covers are seen at peaks. I say this because I've witnessed it enough times in the past 15 years that it's become a contrary sentiment indicator for me. It's simply an indication of sentiment as the editors of these magazines are no more on the right side of the trend than the average person. We give another hat tip to Nicholas Manley, who is a student at the University of Richmond, who reminded me of a study completed by some professors at his school. Tom Arnold, CFA, John H. Earl, Jr., CFA, and David S. North found: “Statistical testing implied that positive stories generally indicate the end of superior performance and negative news generally indicates the end of poor performance.” To learn more about this study, read: Are Cover Stories Effective Contrarian Indicators?

 

As you will hear me say often: "If we are to have an advantage in the market, we necessarily need to do things others aren't. About 80% of the time, I'm going to do the complete opposite of the thing you think I should be doing". For me, that means I'll be going with the flow in the direction of the trend until its end when the sentiment gets to an extreme when I'll perk up in preparation for the trend to reverse. When it does, so do I...


Speaking of trend, I guess with the recent sentiment showing a lot of fear it is no surprise to see today's 2%+ rise in the popular stock indexes. You see, a reversal of the downtrend since April will occur once those who want to sell have sold and buying demand overcomes the selling pressure. It's a good time to offer an update from what I wrote on May 25th: A Follow Up on the Stock Market… and a Word on Loss Traps and Risk Management and Drawing the Line in the Sand for the Stock Market: A Look at the S&P 500 Index Trend (when you see the words are a different color, that means you can click on them to revisit the prior post).

You should probably revisit the prior comments to understand what the chart below says about "now". As you can see, today's action was a breakout to the upside, so we now at least have a higher high in the short run. It appears more likely this price may continue to advance for a while. The relatively high level of fear among investors recently seems to support that hypothesis. We'll see...

 

SPY 6-15-2010 4-14-11 PM

-9% Declines in the Russell 2000 Stock Index Over the Past Decade + Investment Objectives

Posted by Mike Shell on June 12, 2010

I recently had a conversation with an investor who explained his objectives. On the downside, he didn't want to see more than a -10% decline. On the upside, he wants to "outperform the market". He defined the market as the Russell 2000 Index; an index for U.S. listed small company stocks. There are issues with this objective. While I like the fact he was able to quantify his downside risk tolerance, we never like to hear someone anchor to an arbitrary index: it has nothing to do with his personal needs for capital growth or income. For example, over the past decade, from 6/12/2000 - 6/12/2010 this index has averaged only 2.43% and it has declined more than -50% during two bear markets along the way. I am unsure why anyone would tie their personal objectives to that.  But in this case, there is another issue. Below we show all of the declines of -9% or more over the past decade. We correctly use -9% declines since... beyond that point... the account would be at the loss tolerance.

-9% Declines in the Russell 2000 Index Over the Past Decade
9 percent Declines in the Russell 2000 Over the Past Decade
Source: Shell Capital Management, LLC / Ned Davis Research
 
As you can see, there were 29 declines of -9% beyond the risk tolerance. In fact, 7 of them occurred in the last year or so (since early 2009). He wants to miss them all, yet capture even more gains. See The Last 5 Years: a Visual of the Full Market Cycle for a chart of the Russell 2000 stock index over the past 5 years. In that chart, we see that the Russell 2000 declined over -56% from July 2007 to March 2009. So, a strategic allocator would only be able to allocate less than 20% of his capital to this index - the rest would need to be in cash. That is because of the maximum loss tolerance he has of only -10%. If this index declined -56% as it did then, and he had 20% of this capital in it, his drawdown (peak to trough loss) would be 20% x -56% = -11.2%, which is more than his acceptable level. Yet, he wants to achieve at least the indexes upside (or greater). Clearly, these objectives are far from the possibility of buying and holding the index.
 
But there is one more caveat to the objectives: he wants it to outperform the index over shorter term periods of time, too. For example, it didn't seem to matter if total return over a 4-5 year full market cycle was much greater than the index; he was also concerned about each arbitrary calendar year and the recent trailing 12 months. While our portfolio has achieved materially higher returns’ than this index over the last 5 years (as evidenced by our prior posts), I don't know of anyone who could miss all of those -9% declines and stay ahead of the index all the time.  If you do, please let me know!
 
So, I think we've learned two things here. First, our objectives and expectation for risk and reward must be within reason. After all, we believe the majority of financial planners believe a money manager like Shell Capital can't do what we do. They believe you must "be in, to win" and their results are created by asset allocation, so they are market-based, not skill-based. But as an active manager with an edge, even I must admit that a person’s objectives can stray so far from reason that we wouldn't attempt to try. You see, we aren't unwilling to take any loss. An investor must be willing to experience some drawdown (loss from a prior peak to a trough) in order to attempt a capital gain. It's when one starts trying to track an index, but only 100%+ of its upside while avoiding more than 80% of its downside that even I have to scratch my head. I say "even I" because to get where I am today, I've been willing and able to try almost anything. But this is one that I can already tell you: it's unlikely that we, or anyone we know, can do it. This is true for two primary reasons. As you've seen in prior posts, we've clearly trumped this Russell 2000 across the full market cycle of the past 5 years (though past performance is not a guarantee of the future). However, we do not track any index, nor do we have any intention to. That makes at least one part of the mandate impossible for us: we will not closely match any market index. Second, with a mandate of only a -10% drawdown but 100%+ of the upside of an index that's declined to the -10% point 7 times since early 2009 and 29 times in the last decade. Based on testing of tactical trading systems, empirical evidence, and our experience, its sounds like the risk tolerance threshold is too tight to be reasonable. 
 
More recently, at this point (June 12, 2010) this index is down -13.74% from its May 7th price peak...
 
Our Asymmetry Investment Program is designed toward objectives that have an asymmetric risk and reward distribution: more return over time, less risk. It's designed for investors who are willing to experience drawdown of account value in the  -10% to -15% range and with that amount of risk budget, we try to earn as much total return (capital gains, dividend, interest) as we can. We've achieved double digit average returns since inception during the second worst crash ever, so we like to think that when it comes to the upside return; the best is yet to come. We have an advantage as a money manager that we can manage our absolute risk - most investment managers can't say the same. But we cannot manage or control our profits - no one can...
 
We enjoy your comments and questions. To send a comment or question, registered subscribers can use the tab below.
 

The Last 5 Years: A Visual of the Full Market Cycle

Posted by Mike Shell on June 06, 2010

We consider a "full market cycle" to be a period that includes both an upward trending market and a downward trending market. The past five years have been an extraordinary example of a complete market cycle. Clearly, it has been a period that has separated the skilled investment managers from the unskilled and the skilled investment managers from the passive investors who claim no skill at all (those who passively buy and hold). 

After a recent discussion with someone about the past five years, we thought we would share some simple line charts so you can visually see how these markets have performed over a full market cycle. Below we show monthly charts of several market indexes over the past five years.

S&P 500 Stock Index: This index was around 1200 five years ago, on Friday it closed at 1064.This popular stock index is down approximately -13% in price since 5 years ago (1064 - 1200) / 1064)).

S&P 500 Index 5 Years 6-6-2010 7-53-03 PM

 source: eSignal

Russell 2000 Index: Below we show a monthly 5 year line chart of the Russell 2000 Small Company Stock Index. The Russell 2000 index represents the small company segment of the U.S. stock market. (Small company stocks are considered by many to be more risky than larger stocks). The price trend of this index is at around the same point it started 5 years ago.

Russell 2000 5 Years 6-6-2010 7-53-24 PM

source; eSignal

Since we are willing and able to trade and invest in various markets, we also include the S&P GSCI Commodity Index. The S&P GSCI® is designed to provide investors with a publicly available benchmark for investment performance in the commodity markets.The commodity index was very strong before its vast waterfall in 2008. But unlike the other markets, although its waterfall was even steeper than stocks since 2008, the commodity index has gained some ground over the past 5 years. Its price has increased from around 350 to 475 for a price appreciation of approximately 26%.

 GSCI Commodity Index 5 Years

 Source: eSignal

One "sign of the times" of the past 5 years is that the next index had a different name at the start of the period. What is now known as the Barclays U.S. Aggregate Bond Index was formerly known as the Lehman Brothers Aggregate Bond Index. Lehman Brothers, of course, didn't survive. So much for "too big to fail" (it was the largest bankruptcy in U.S. history). When Lehman failed, Barclays took over the bond index. Of course, the index was only maintained by Lehman, their failure didn't necessarily directly affect it. However, if you look closely at 2008, you'll see that this broad based bond index experienced a sharp price decline along with other markets. In fact, between 9/9/2008 and 10/10/2008 this bond index dropped -13.18%. The Barclays U.S. Aggregate Bond Index is intended to represent the United States investment grade bond market. This bond index price is slightly higher over the past 5 years.

Barclay Aggregate Bond Index 5 Years

Source; eSignal

 

And finally, we show the MSCI EAFE Index. It is an International stock index that is designed to represent the stock performance of 22 non- U.S. countries. As you can see, this index is down somewhat from its price point 5 years ago.

MSCI EAFE International Stock Index 5 years

source: eSignal

We hope that we have provided you with a interesting visual representation of a wide range of indexes covering stocks, bonds, commodities, and international stocks, by using some of the most popular indexes. As you can see, the past 5 years have been a fine example of a "full market cycle" made up of a rising trend, a falling trend, and then a new rising trend.

The Securities and Exchange Commission requires the following disclosure about indexes: Indices are unmanaged and cannot be invested in directly. Returns represent past performance and are not a guarantee of future performance.

Changing Trend in the Size of World Banks

Posted by Mike Shell on March 29, 2010

We mostly focus on directional price trends, but we sometimes we find other intriguing directional drifts, or changes in leadership.

Below is a interesting graph from Financial Times showing the rankings of how the top 20 financial institutions by market capitalization changed each year from 1999 to 2009. We can see that in 1999, Citigroup and Bank of America, both American banks, ranked the largest in the world. In fact, by 2001 5 out of the top 6 were U.S. banks.

 

 

On the Financial Times website, we can drag the slider at the bottom of the graph to see how the leadership has changed over time. U.S. banks like Citigroup and Bank of America were the consistent leaders until 2008. Since then, 3 China banks are at the top. Below we show the world financial institutions as of 2009. Now, we see the top 3 banks are Chinese banks. The largest U.S. bank, JP Morgan, is ranked 5th.

 

So, the trend here is that U.S. banks were larger most of the decade until the "banking crisis". Since that time, U.S. banks have gotten smaller while China financial institutions got larger. With the near failure of many of the banks on this list and outright collapse of Bear Sterns and Lehman Brothers and many other banks and brokerages, people shouldn't assume none are too big to fail.

You can access it and see for yourself here: Financial Times.

Market capitalization is the total dollar market value of all of a company's outstanding shares.  It's calculated by multiplying a companies shares ousstanding by the current market price of one share.