(Part 5 of ten-part series on Financial Truths)

Section 1: The Efficient Market Hypothesis

Section 2: Who Is Your Competition?

Section 3: What Is Your Edge?

Section 4: The Wrong Ways to Use Technical Analysis

Section 5: Certainty vs. Probability

Section 6: The Winning Way = Big-Picture View + Timing Tools

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Section 1: The Efficient Market Hypothesis

  • Definition and forms: Weak-form, Semistrong-form, Strong-form
  • Why the efficient market hypothesis does NOT hold in the real world

Section 2: Who Is Your Competition?

  • The vast majority of shares are held by institutions or individuals who cannot or do not transact frequently
  • Paper by Edward Wolff of NYU – chart on top of page 15
  • Active vs Passive: Approx. 2/3 of US equity fund assets are classified as “actively managed”, 1/3 passive – statistic from Bloomberg article – but are they really “active?”
  • Who’s actually trading, reacting to new information that should affect prices?

Section 3: What Is Your Edge?

Section 4: The Wrong Ways to Use Technical Analysis

  • Ignoring one or more of the dimensions: Price, Pattern, Momentum, and Time (credit to Robert Miner – I recommend his book)
  • Magic indicators
    • Overbought and oversold indicators ARE NOT trading signals
    • Trading on momentum signals (e.g. Stochastic or MACD crossovers) by themselves will generate losses
    • “Bearish crossovers” marked by red lines would have produced large losses and significant trading costs, if used as signals to go short.

  • Trend-following: generates huge losses at major highs and lows, and repeated small losses in choppy markets
    • A simple method of trading moving average crossovers (20-day over 50-day) produced 6 wins, 11 losses, and lots of trading costs. Awful!

  • Failing to make a trading plan
  • Failing to make a risk management plan or to adhere to your plan
  • Ignoring trading costs and the cost of leverage

Section 5: Certainty Vs. Probability

  • You can never know for certain what the market will do
  • Technical analysis, when used correctly, identifies high-probability zones

Section 6: The Winning Way = Big-Picture View + Timing Tools

 

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(Part 4 of ten-part series on Financial Truths)

Section 1: What Is Diversification, and How Do You Measure It?

Section 2: Determine Your Personal Risk Tolerance

Section 3: Set a Baseline Asset Allocation

Section 4: Define Ranges (Min/Max) Around Your Baseline Asset Allocation

Section 5: Trade and Invest, Staying Within the Ranges

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Section 1: What Is Diversification, and How Do You Measure It?

  • Diversification = Owning a variety of assets that are less than 100% correlated with one another
    • Every pair of assets has a correlation coefficient, a statistic (between -1 and +1) that measures how likely they are to move in the same direction over a given period of time
    • Example: A portion of the correlation matrix I use, calculated from historical data:
  • If the standard deviation (volatility) of your overall portfolio is significantly lower than the standard deviations of most of the individual assets inside it, you are well-diversified
  • Owning a few stocks in the same sector, or the S&P 500, isn’t enough diversification
  • For options (puts and calls), calculate the true underlying exposure (number of contracts * underlying share price * delta)

 

Section 2: Determine Your Personal Risk Tolerance

 

Section 3: Set a Baseline Asset Allocation

  • Map your investment universe
    • Long-term investors: use the short list of six major asset classes
    • Traders & active investors: use the longer list of asset subclasses, which includes the ten stock sectors
  • Start with your personal balance sheet (introduced in Episode 3); set Cash % = Cash Requirement / Total Assets
  • Divvy up the rest between stocks and bonds according to your age
  • Carve out a little for precious metals and commodities
  • Adjust up or down for long-term market conditions (prospective 6-14 years).  Learn how to make long-term forecasts here.
    • Traders & active investors: steer your stock allocation towards the sectors with the highest forecasted returns
    • Can use individual stocks, just make sure to account for the higher volatility

 

Section 4: Define Ranges (Min/Max) Around Your Baseline Asset Allocation

  • First, choose the following parameters:
    • Maximum permissible loss on a single position
    • Typical stop-loss
  • Calculate minimum and maximum in each asset class/subclass:
    • Max % = Max Permissible Loss Per Trading Position / (Asset SD * Stop-Loss Multiple)
    • Min % = (-1) * Max %, subject to any other restrictions on short positions
  • Make sure these allocations fit within your risk tolerance
    • Have us run your portfolio through our Trade Analytics Service – we do all these steps for you
    • If you want to do the math yourself: Estimate the expected return and standard deviation of returns, under different scenarios
    • Model with a lognormal probability distribution, and/or run a simulation
    • Sample:
    • Calculate the 1/N percentile of the loss distribution (the loss that occurs 1 in N years)
    • If greater than X, go back and change your baseline asset allocations until they fit within the risk tolerance you defined
  • Check out episode 10 for sample asset allocation ranges.  You’ll find a free, downloadable spreadsheet there.

 

Section 5: Trade and Invest, Staying Within the Ranges

 

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(Part 3 of ten-part series on Financial Truths)

 

Section 1: Why You Must Not Trade Until You Can Set Aside $15,000

Section 2: Constructing a Personal Balance Sheet

Section 3: Figuring Out How Much You Can Afford to Risk

Section 4: Your Road to $15K

Section 5: How to Develop Your Trading Skills While on the Road to $15K

 

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Section 1: Why You Must Not Trade Until You Can Set Aside $15,000

  • It’s way too tempting to use leverage
    • Many exchanges require as little as $2,000 to set up a new margin account.
    • Margin debt carries an interest rate almost as high as credit card debt.  E-Trade: 9.25% on balances below $10,000
    • Buying options?  This is another form of leverage, and often even more expensive than margin.  With more capital, you can sell options instead.
    • Futures have MASSIVE leverage: e.g. 18-to-1 for crude oil on the CME – you’ll blow up your account unless you’ve got a long track record of successful trading, either in a real money or paper account
  • Commissions and fees will eat you alive

 

Section 2: Constructing a Personal Balance Sheet

  • Assets
    • Bank accounts, investments, retirement accounts, businesses, home equity, vehicles, other property, etc.
    • Contra-Assets (reduction to assets): Example – taxes on tax-deferred retirement accounts, like 401(k) and IRA accounts.  Could be as much as 30% or more depending on tax rates when you retire
  • Liabilities
    • Home mortgage, auto loans, student loans, credit card debt, business debt, medical debt, personal loans, etc.
  • Net Worth = Assets – Liabilities

 

Section 3: Figuring Out How Much You Can Afford to Risk

  • Establish an emergency fund
    • Think of a scenario that would be devastating for you financially (but nothing far-fetched/crazy like the end of the world!).  For example, being out of work for 6 months and your family facing $3,000 of extra medical bills during the same time period
    • Account for ALL costs you’d face, including staying current on debt
  • Don’t plan to rely on outside sources of funding like credit cards, cash advances, personal loans, etc.
  • Consider going further – perhaps a 12-month emergency fund, or keeping a year’s worth of mortgage payments or rent set aside on top of a 6-month emergency fund
  • Keep all emergency funds safely invested in cash-equivalents
  • If you’ve got $15K left over to deposit, then go forward.  But be sure to establish a risk management plan and limits in advance.  I introduced this topic in Episode 2.
    • What is a “significant loss” to you?  10%?  20%?  Don’t mind if you lose it all?
    • Over what timeframe?
    • How often can you accept this loss?  1 in 10, 20, 30 years?  Or more often?  To determine this, imagine that loss occurred just now.  Think about what you would do.  A big reaction, like selling lots of assets or closing an account – or small reaction, just watch things a little more closely?

 

Section 4: Your Road to $15K

 

Section 5: How to Develop Your Trading Skills While on the Road to $15K

  • Absorb knowledge
  • Follow the financial news for 15 minutes a day: Start with Reuters
  • “Paper trade”, but pretend the numbers are real – celebrate wins, feel the pain of losses

 

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(CC image by Chase Lindberg on Flickr)

 

“Intermediate-term” market cycles – which I define as 6 to 14 months in length in most cases, with an average of 10 months – are the “sweet spot” of trading.  I make the most money trading these cycles, and you can too.

Shorter-term trends and cycles are more prone to unpredictable random noise.  Longer-term ones can be accurately forecasted, but because long-term cycles average around 8 years in length, it takes a long time to extract profits from them.  Good for a long-term investor, but not enough if you are serious about trading and you want to make a living from it or generate enough trading profits to meaningfully supplement your annual income.  Active traders must be aware of the long-term trends but will place trades according to the intermediate-term trends instead, even when those intermediate-term trends oppose a slower-moving long-term trend, because active traders have a shorter time horizon for holding positions.

 

Don’t Trade Without an Intermediate-Term Forecast

In my earliest foundational post, I introduced a framework for building wealth entitled “The Five Components of Successful Investing”.

The five components are the blue boxes in this flowchart, taken from that post (with the blue circle added to mark today’s focus):

In the earlier post, I briefly touched on how I make my intermediate-term forecasts.  Again, when I refer to the “intermediate-term”, I mean cycles that generally last between 6 and 14 months, with an average of 10 months.  In another post, entitled “Want to Conquer the Investment Universe? First, Make a Map!”, I listed the asset classes and subclasses I forecast.  They include: the US dollar, major commodities, bonds, and each of the ten stock sectors.  Now, I’ll explain my forecasting methodology in more detail.

 

Start with Your Long-Term Forecast

Always consult a long-term chart (30+ years of data, if possible) before placing an intermediate-term trade.  In my post titled “Fearless Forecasting for Long-Term Investors”, I introduced my methodology for making long-term forecasts.  Here’s a high-level summary:

  1. Begin with a baseline trend, which you expect to observe over several long-term cycles.
  2. Establish a range around the baseline trend, based on the depth and length of prior long-term cycles.
  3. Determine the current long-term trend direction by looking for a series of higher lows (an uptrend) or a series of lower highs (a downtrend).  Also, determine whether this trend is strong or weak.  If there isn’t any clearly discernable trend, look at the prior trend direction.  Most likely, what is occurring is a flat correction and we would expect the prior trend to resume once the correction is over.
  4. Forecast the long-term trend direction and strength based on: The current long-term trend direction and strength, momentum, intermarket analysis, and fundamental factors.  Look for more details on this in future posts, podcasts, and videos.
  5. Take the actual and forecasted long-term trends from steps 3 and 4 and translate them into a single percentage between -100% and +100%.  This percentage determines where your long-term forecast will fall within the range of possible forecasts we defined in step 2.

Let’s use the technology sector as our example for this post.  My long-term forecast for tech stocks is +1.4%.  Here’s how I got there:

The range of possible long-term forecasts is -15.3% to +18.0% with a baseline of +7.0%.  Technical note: The positive skew exists so we have symmetry across up and down cycles.  (1+.180) * (1-.153) = 1.000.  The percentage I apply to this range is -25%, which reflects that the current long-term trend is “Up” and the forecasted downtrend is “Down (?)”.  In other words, there is a strong uptrend now, but I expect a weak downtrend to emerge so I select a long-term forecast that is below the midpoint of my forecast range by 25%.  Calculation: 1.4% = 7.0% + (-25%) * (7.0% – (-15.3%)).

 

Study Prior Intermediate-Term Cycles

Using a daily or weekly chart with at least 10 years of history, identify past uptrends and downtrends.  Let the price be your guide – don’t assume that every single cycle will follow the same length of time.  It rarely works out that way.  But, although the duration of any two cycles may vary, their average duration is usually stable over time.  The half-cycles will average approximately 10.5 months from low-to-high or high-to-low.  Thus, the full cycles will average approximately 21 months (10.5 * 2) from low-to-low or high-t0-high.

Here’s how it shakes out for the tech sector (as tracked by the XLK exchange-traded fund):

Lots of variation in cycle length, indeed – but averaging 23 months apiece when examining the last 10 years of history.  Pretty close to our 21-month expectation.  It’s very helpful to know that the cycle lengths tend to revert to a mean over the long-term.  This knowledge helped us anticipate a couple quick turns in late 2015 and early 2016 following the extremely long uptrend that ran from August 2011 to July 2015.

The fourth column in the chart above shows the lag between the tech sector and the S&P 500.  This is part of the intermarket analysis framework I’ll mention later in the post.

Identifying the past trends is pretty simple and is done in just the same way as the long-term trends.  Look for a series of higher lows (an uptrend) or a series of lower highs (a downtrend), in alternating fashion.  If the price action looks choppy or flat, look at the prior trend direction.  Most likely, what is occurring is a flat correction and we would expect the prior trend to resume once the correction is over.

There are other nuances that make this both an art and a science.  Sometimes I select a cycle low or high that is not the precise low or high that was reached.  For example, the XLK hit 11.44 on 11/20/08, which is below the low of 11.53 I marked on 3/9/09.  But, I chose 3/9/09 instead because it coincided with the overall low in the S&P 500 and because the points immediately before and after the 3/9/09 extreme were lower, indicating the 11/20/08 low may have been a fluke.

A note on trading being both an art and a science: I’m always skeptical of trading schemes that claim to be purely quantitative, or algorithm-based.  There is simply no way to get around the fact that anytime you develop a trading system, whether it explicitly allows for the use of educated judgment or not, you ARE using judgment.  All mathematical models rely upon some sort of assumptions, such as: market returns following a given distribution, a random process being stationary, or the model having an error structure that follows a normal probability distribution with a mean of zero.  By using a mathematical model to make trading decisions, you’re making the judgment that those assumptions are valid.

Why do we record and study the prior cycle highs and lows?  Because, we need the following info for our forecast:

  • The depth of a typical low-to-high or high-to-low cycle: the percentage gain or loss that usually occurs.  This is one piece of evidence we use to determine whether the current trend is nearly exhausted or has more room to run.  First, select a depth of a low-to-high cycle, expressed as an annual return.  For the tech sector, I chose +40.0% as the annual return during an upward cycle after examining the data.  This seems like a very high return, but remember that it’s the return from the exact day of a cycle low to the exact day of a cycle high, with hindsight.  It’s not meant to be a real-life return.  For a downward cycle, I solved for -26.5% because this is the annual return that produces an annual return of +1.4% across an upward cycle and a downward cycle.  Recall that +1.4% is our long-term forecast for tech stocks from the section above.
  • How long the typical cycles are: do they average close to 21 months between highs and between lows?  Have recent cycles slowed, suggesting the current and next cycles will accelerate?  Or vice versa?
  • Is there another sector, market, or asset class that typically lags or leads this one?  In our example, the tech sector usually turns within a month or less of the S&P 500, so we’d look at any divergence between the two with great skepticism.  This is intermarket analysis – drawing connections between different sectors, markets, or asset classes.  The S&P 500 highs and lows should themselves be determined by considering highs and lows in bonds, for example.  Most traders fail to consider this big-picture view, focusing on narrow indicators or chart patterns instead.  Many of the best opportunities to rake in serious profits are found in scenarios where the asset you’re trading is out-of-line with similar stocks, sectors, or asset classes.  If you learn to spot these situations, you’ll start to capture those profits and avoid traps.

We will choose an actual trend (direction and strength) and a forecasted trend (direction and strength) for the intermediate-term, as we did for the long-term.  We’ll choose from one of the five options below:

  • “Up” – representing a clear upward trend
  • “Up (?)” – representing a weak upward trend
  • “Down” – representing a clear downward trend
  • “Down (?)” – representing a weak downward trend
  • “??” – representing a situation where the trend cannot be determined

Now that we’ve recorded and studied past cycles, the actual trend for tech falls right out of that analysis.  The last low was 2/11/16, so an uptrend is in place and it’s a clear one, as the below chart shows.  So we pick “Up” as the actual trend.

As far as the forecasted trend goes, we’ve already gathered some info that will help us make a prediction.  Yet there’s more we can and must consider.

 

Forecast the Intermediate-Term Trend

So far we’ve looked at the depth and the duration of the current cycle and we’ve seen how it compares with past cycles.  We’ve also brought in intermarket analysis as part of this process.

Next, let’s join this insight with some more technical analysis to select a trend forecast and to pinpoint entry and exit points for a potential short-term trading position.

I’ve organized this into categories of: Pattern, Price, Momentum, and Time in homage to Robert Miner’s outstanding book High Probability Trading Strategies: Entry to Exit Tactics for the Forex, Futures, and Stock Markets, which I selected as one of my ten most essential books for traders and investors.  Each of these categories deserves its own follow-up posts, so stay tuned for those.  I’ll simply introduce each for now.

Pattern

In general, a “trend” usually consists of five distinct sections or “waves”.  During a trend, as “trend” is defined here, the market is reaching successively higher or lower extremes.  A “correction”, during which the price moves in the opposite direction from the trend, usually consists of three distinct sections or “waves”.  The corrective waves will also usually be shorter in time than the trend waves.  These principles come from Elliott Wave theory.  Many well-known traders have integrated these principles into successful trading strategies.

How does this fit in with the framework we’ve defined?  I’ve called every cycle a “trend”, and haven’t used the term “correction.”  It’s simple!  Since we’re talking about the intermediate-term timeframe here, the trend (5-wave) direction is the direction of the long-term trend.  The corrective (3-wave) direction is the opposite of the long-term trend.

For the tech sector, the actual trend we’ve chosen is “Up” in both timeframes.  Therefore, we expect upward intermediate-term cycles like the one we’re currently in to have 5 waves.  We expect downward intermediate-term cycles to have only 3 waves, and to be shorter in time than the upward cycles.  This will hold until the long-term trend changes direction.

In the tech uptrend that began 2/11/16, there is a 5-wave pattern:

 

Consider also checking for other, more complex patterns.  I recently began incorporating harmonic patterns, as found in Scott Carney’s book Harmonic Trading, Volume One: Profiting from the Natural Order of the Financial Markets, into my technical analysis framework.  Simpler patterns like a head-and-shoulders top, double bottom, or wedge/triangle formations are also useful.

Price

The introduction of a wave structure also allows for the projection of price target points using Fibonacci principles.  This is a deep subject that I’ll tackle in a later series of posts.  Here, the most likely endpoints of Wave 5 are between 51.72 and 52.51, so we should expect a little further rally before this upward cycle ends.

Momentum

Many traders use momentum oscillators like the MACD, Stochastics, or RSI to measure how rapidly price is changing.  This is what momentum oscillators do well, but most new traders go too far with them.  They trade using very simple rules like MACD crossovers, and they aren’t successful.  Never, ever, trade based on one indicator or one simple rule in isolation!  A crossover, in which a more responsive momentum indicator crosses over a smoothed momentum indicator, may indeed signal an important reversal in momentum and may be a sign of an important trend change.  But, you need to look at all the other market conditions first before executing a trade based on this single factor.

I recommend looking at momentum across multiple time frames, as Miner teaches in his book.  As a general rule, you want to trade in the direction of the longer-timeframe momentum and execute your trades when the shorter-timeframe momentum reverses in the direction of the longer-timeframe momentum.  For instance, when momentum on a weekly chart is rising but not yet in the overbought area, you would want to look for an entry point to buy when the momentum on a daily chart makes a bullish crossover.  Again, don’t execute the trade unless you’ve first studied the overall market conditions.

In our tech example, the momentum on a monthly chart is positive but very overbought and starting to decline.  This reinforces my view that the high between 51.72 and 52.51 will represent a long-term high in tech stocks.  The momentum on a daily chart, shown in the screen capture above below the price chart, has risen into the overbought zone but has not yet reversed.  This reinforces the view that there is just a little more room to run in this intermediate-term cycle.

Volume (the number of shares traded) can also be a useful indicator of momentum, but has become far less reliable than it was in the past because many trades take place off the major market exchanges so they are not part of volume statistics.  Many of these are large block trades between institutions.

Time

The only thing I’ll add on time, besides what I already mentioned in the context of intermediate-term cycles, is that you can layer time projections onto a 3-wave or 5-wave price structure to identify dates where a wave is more likely to end.  Like Fibonacci price projections, it’s a deep topic that I’ll save for future posts.

Fundamentals

I added fundamental analysis as another crucial element to consider, although some traders will consider it anathema.  Fundamental analysis is a broad term for factors that aren’t viewable on a price chart.  It includes: political trends, demographics, social patterns, economic indices, and other factors that may impact a single sector or all financial markets over a very long period of time.

Many technical analysts believe all information is reflected in the market price, so they’d say it’s merely a distraction to look at fundamentals.  I agree that much of the “market news and commentary” out there is distraction, but I strongly disagree that you can ignore the fundamentals.  They can provide clues that you’ll never find on a price chart.

I believe fundamental analysis is most valuable for spotting major extremes in price or bubbles.  In 2000, 19 online startups bought very expensive Super Bowl advertisements.  Certainly, this would add some evidence in favor of the dot-com bubble being about to burst, which it did shortly after.

The Verdict

Considering all the above info, I’ve chosen an intermediate-term trend of “Up (?)”, signifying that the uptrend is still in place but has weakened and is almost done.

 

Translate the Trend Into A Fearless Forecast

Like we did with the long-term trend, next we take the actual and forecasted long-term trends (“Up” and “Up (?)”, respectively) and translate them into a single percentage between -100% and +100%.  I have a grid I use to define the percentage for every possible combination of actual and forecasted trend (5 x 5 = 25 combinations in total).  Here, the percentage is +20%.  This indicates that although we still want to hold tech stocks (the percentage is positive), we are only slightly positive on the sector and we certainly don’t want to buy more of it.

When the XLK gets above $52, or breaks down from its current levels, I’ll mark the forecasted trend “Down”, the percentage will go negative to -50%, and I’ll be going short the tech sector.

We want to go long the sectors, markets, and asset classes that have the highest percentages (closest to 100%) and go short the ones that have the lowest percentages (closest to -100%).

If you have a baseline asset allocation, you’ll want to adjust it up or down based on the percentages in each asset class, but staying within a minimum and maximum for each asset class.  This is what I do to ensure that while I act on opportunities, I don’t get too carried away with a single asset class.  More on this in future posts.

Also, look forward to many more examples of this framework in action throughout future live streams, videos, and of course our free trading podcast.

I know this approach takes more time than the easy single-indicator “strategies” (advertised as such, but really a total fraud!).  But it works.  This is a winning approach for managing a large portfolio of assets or for swing trading a smaller account.  It is a comprehensive, time-tested, and successful strategic framework when it is used in conjunction with good risk management and a sound mental approach to trading.

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(Part 2 of ten-part series on Financial Truths)

 

Section 1: What is Volatility?

Section 2: What is Risk?

Section 3: How to Profit from Volatility and Risk

 

 

Section 1: What is Volatility?

  • Volatility: the variation in asset prices or other financial indices over a given time horizon.
    • Changes in stock prices
    • Movements in interest rates, currency exchange rates
  • Some of this volatility is random and unpredictable, but some can be anticipated by savvy investors who are skilled in technical and/or fundamental analysis
    • I believe that as you expand the timeframe, from minute-by-minute to hourly, daily, weekly, and monthly charts, you get less random noise and more predictable trends and patterns
    • Others believe the shortest timeframes are the most predictable
    • Both perspectives are OK!
  • Actual volatility: can be calculated from historical prices
  • Implied volatility: is the volatility for a future period of time, as estimated by market participants
    • As implied volatility increases, the prices of options (calls and puts) increase along with it
    • The Volatility Index (VIX), calculated by the Chicago Board of Exchange, measures the market’s expectation of the 30-day volatility of S&P 500 Index options.  The VIX is commonly quoted in the media
    • Exchange-traded funds that track the VIX, for short-term speculative trades: VXX, XIV

 

Section 2: What is Risk?

  • Risk is a specific type of volatility: the probability of suffering a loss of a certain size
  • Rooted in probability and statistical concepts
    • A wide range of outcomes can happen over a given time period, from large losses to huge profits
    • The simplest illustration is a bell curve: height represents probability, width represents range of possible outcomes (left=bad, right=good).  Two sample curves below:
    • The market doesn’t follow a bell curve in reality, but it’s a simple illustration
  • Risk is defined differently for every investor and trader
    • 1- You choose the amount that represents a significant loss to you (percentage?  dollar amount?)
    • 2- You choose the timeframe over which to measure profit/loss
    • 3- You choose how often you can accept this amount of loss (there is NO WAY to trade with zero chance of a significant loss)
    • What will you do if/when the loss occurs?  This determines how often you can accept that significant loss (1 in 5 years?  1 in 30 years?)
  • Most trading books recommend limiting the risk of each trading position one-by-one.  Simple, but misleading
    • Common rule: set a stop-loss at 1%, 5%, or 10% of your trading capital
    • Far better to understand the risk level of the entire portfolio of investments and trading positions together.  It’s more complex, but our Trade Analytics and Coaching services will assist you
    • Calibrate the risk level of your portfolio so it matches up with your definition of risk, determined by the 3 components of the prior step.  (1-Amount, 2-timeframe, 3-how often)
  • Your personal risk tolerance determines how aggressively you can invest in the markets, and what kinds of financial instruments you can trade.

 

Section 3: How to Profit from Volatility and Risk

  • Most important: Stay within your own risk management plan
    • Keep enough cash reserves OUT of the markets for things like: job loss, adversity, major purchases or down payments
    • Define a maximum loss over a certain time horizon, and know what you’ll do if it’s reached
  • When implied volatility is too high, sell options (calls and/or puts) to put those fat option premiums in your pocket
  • Keep extra dry powder for crises, panics, downturns, buying “fallen angel” stocks & bonds
    • When the market is stricken by fear, but better times are around the corner, you’ll be able to load up on bargains and wait for normal conditions to return
    • Many institutions aren’t allowed to invest in stocks and bonds below a certain size or credit rating, so they’ll be forced to sell
    • As long as you’re within your overall risk management plan, buy from them at “fire sale” prices
    • Example: VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL) vs. oil ETF

 

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(Part 1 of ten-part series on Financial Truths)

 

Section 1: The old model of: go to school, get a stable job, get pension / save in your retirement accounts, buy-and-hold for the long run, retire with lots of money set aside – it’s dead, over, gone, buried in history.

Section 2: You can easily become over-concentrated in a few highly correlated asset classes; correlations rise in a crisis

Section 3: “Leaving it to the experts” is leaving money on the table

 

 

Section 1: The old model of: go to school, get a stable job, get pension / save in your retirement accounts, buy-and-hold for the long run, retire with lots of money set aside – it’s dead, over, gone, buried in history.

  • Employment/population ratio (data.bls.gov) – peaked at 65% around 2000, down to 60% now and will keep dropping
  • Shift towards part-time jobs, freelancing: A survey by Upwork and the National Freelancers Union suggests that 55 million people, or 35% of the US workforce, made money by freelancing in 2016 – up by 2 million in the last 2 years. The largest growth rate has been in “diversified workers” who combine different part-time and freelance gigs into a full-time income. http://www.citylab.com/work/2016/10/the-two-sides-of-the-freelance-workforce/502955/
  • Today, 27% of private sector workers have access to defined benefit plans, and 58% to defined contribution (Bureau of Labor Statistics) https://www.bls.gov/ncs/ebs/retirement_data.htm
  • IRAs only became popular starting in 1981; Roth IRA began in 1997, 401(k) in 1980; there isn’t a long track record of them working for people from start to finish
  • Need a diverse skill set and good financial literacy to be successful today – take charge of your life
  • Fortune: nearly two-thirds of Americans can’t pass a basic test of financial literacy, 5 point drop since 2009 (http://fortune.com/2016/07/12/financial-literacy/ ).  Example – calculating interest on a loan.
  • Dave Ramsey: “Growth stock mutual funds make 12%/year”; Suze Orman says to dollar-cost average, it’s nonsense. Past performance does not indicate future results.

 

Section 2: You can easily become over-concentrated in a few highly correlated asset classes; correlations rise in a crisis

  • What does diversification really mean?
  • Examples of alternative assets that offer real diversification
  • Diversification is NOT: (but these are a start)
    • Having more than one brokerage account or retirement account
    • Different stocks, like in an ETF, mutual fund, tracking a market or index
    • A bunch of ETFs or mutual funds, tracking different markets or indices; all paper assets
    • Having money denominated in various currencies
    • Different paper assets like bonds (beyond a certain point)

 

Section 3: “Leaving it to the experts” is leaving money on the table

  • If you need your savings to be there for you when you retire, you need to know what you’re invested in, and why
  • Very few of the real experts are managing public money
  • They cost too much, extract lots of fees out of you
  • Some are compensated based on revenue they bring to the firm
  • Narrow-minded thinking, limited skill/knowledge of these experts, not looking at big picture
    • Thomas Picketty on demographics: In Capital in the Twenty-First Century (2013/2014), he states that global output grew at an average annual rate of 1.6% from 1700 to 2012, 0.8% of which reflects population growth and 0.8% of which came from growth in output per person.  Growth averaged 3.0% from 1913 to 2012, but this was largely due to population growth and is not sustainable.
  • Robo-advisors are selling a lie
    • Same type of garbage mathematical models that were used to justify mortgage-backed securities before the 2008-2009 financial crisis
    • Short time horizon, static models, not accounting for enough inputs or qualitative factors
    • Might seem cheap but what are you getting?  They don’t offer anything other than a very short list of ETFs, like a 401(k) – no PMs, no digital currencies, no country- or region-specific ETFs, no way to use options to manage portfolio risk.
    • Wash sales – not integrated with other holdings outside of that robo-advisor – false sense of security.
  • More sophisticated strategies achieve better results
    • Hedge funds (before they grew too large) – http://www.businessinsider.com/hedge-funds-and-sp-500-nearly-identical-2013-8 Hedge funds outperformed the S&P 500 only slightly from 1993-2006, but with much less volatility and far smaller drawdowns.  Risk management matters.
    • Private equity – https://www.bloomberg.com/gadfly/articles/2016-05-11/private-equity-has-diminishing-returns – The Cambridge Associates US Private Equity Index returned 13.4% annually net of fees from 4/1986 to 12/2015, with a standard deviation of only 9.4% (vs. Russell 2000 at 9.9% return, 16.7% standard deviation)
    • Picketty research (Capital in the Twenty-First Century) – the largest university endowments consistently outperform the smaller ones.  These have the funds needed to employ sophisticated advisors and invest in alternative assets that improve portfolio returns and reduce volatility
    • You can learn and apply many of the same strategies these sophisticated investors use to manage multi-billion-dollar portfolios.  In fact, you have an advantage they don’t.

 

Intro music by audionautix.com

Find more episodes of the Torpedo Trading Podcast at this link

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(CC image by Jullen Belli on Flickr)

 

Some say that long-term trends in the financial markets are impossible to predict.  Not so!  Markets follow cycles that, while not precisely predictable to the exact date, time, or price point, can be reasonably well-anticipated in advance.

If you’re a day-trader with a time horizon of minutes or hours, long-term trends won’t have any impact on your results at all.  But if your investing time horizon is multiple days, weeks or months as we recommend, then a good understanding of the long-term trend will enhance profits and reduce drawdowns.

If you have a long-term time horizon and you don’t like to make trades more than a few times a year, these long-term trends will be the single most crucial factor in deciding where to invest your money.

 

Don’t Invest Without a Long-Term Forecast

In my earliest foundational post, I introduced a framework for building wealth entitled “The Five Components of Successful Investing”.

The five components are the blue boxes in this flowchart, taken from that post (with the blue circle added to mark today’s focus):

 

For a longer-term investor, someone who can’t or does not want to make trades every week or every month, this simpler framework applies:

In the earlier post, I touched on how I make my long-term forecasts.  When I refer to the “long-term”, I mean cycles that generally last between 4 and 12 years, with an average of 8 years.  In another post, entitled “Want to Conquer the Investment Universe? First, Make a Map!”, I listed the asset classes and subclasses I forecast.  Now, I’ll explain my forecasting methodology in more detail.

 

Begin with a Baseline Trend (The “Very Long-Term”)

First, I make an assumption for what the trend will be across the next few long-term cycles.  This is the baseline trend that would best fit the long-term cycles, if we could knew them in advance.  To develop the baseline trends, I consider several factors:

  • Historical returns, in the form of risk premiums over the risk-free rate (the difference between the annual return and the risk-free interest rate).  This paper, by Aswath Damodaran of the Stern School of Business, explains the concept of equity risk premium in detail.  The author estimates the average annual risk premium for stocks as having been 4.10% (using geometric averages and the long-term risk-free rate) over the period from 1928 to 2010, albeit with a declining trend across that time period.  This means it is ok to make a choice that is slightly different than the longest average, because the risk premium may vary over the course of decades or a century.  Assuming that today’s 10-year US Treasury rate of 2.58% will be representative of the next few decades, the long-term baseline return for US stocks I’d derive from this approach would be 2.58% + 4.10% = 6.68%.
  • Inflation expectations.  In my post titled Inflation, Deflation, and Your Portfolio, I explain what inflation really means, as well as how essential it is to have a good forecast of inflation before making any long-term forecasts.  I expect deflationary pressures to continue to rule the day, up until the point where the massive amounts of unrepayable worldwide debt are either defaulted upon or renegotiated, as explained in my inflation forecast for 2016 and beyond.  Deflation depresses returns across all asset classes, but inflation tends to increase returns as long as there are not sudden shocks.  Because I expect deflation followed by an inflationary shock, it is hard to estimate what the overall impact of the two together will be, but it has to be considered.
  • Fundamental analysis, including political trends, demographics, social patterns, economic indices, and other factors that may impact a single sector or all financial markets over a very long period of time.

Here are the baseline long-term trends I am using as of today:

I also establish a range around each baseline trend value.  I do this by defining and measuring the depth of previous long-term cycles that have occurred in each asset subclass.  For example, the range of possible long-term annual returns I’ve established for gold mining stocks (“PM Stocks”) is -25.9% to +35.0%, but for consumer staples stocks it is only -11.1% to +12.5%.  [Technical note: The positive skew exists so we have symmetry across up and down cycles.  (1+.125) * (1-.111) = 1.000].  I use these ranges later in the process.

 

Determine Trend, Using a Long-Term Chart

Next, I look at a weekly or monthly chart to determine the direction and strength of the current long-term trend.  You can see countless examples of how I gauge trend direction and strength on my YouTube channel.  Recall that the definition of an uptrend is a series of higher lows, and the definition of a downtrend is a series of lower highs.  If there is not a clearly discernable trend, look at the prior trend direction.  Most likely, what is occurring is a flat correction and we would expect the prior trend to resume once the correction is complete.  For example, in the chart below, I have marked the rising yield cycle from 2003 to 2006 which appears as a flat correction when looking at the 30-year yield.

Long-term chart of US Treasury Bond yields, with long-term cycles marked by the blue lines.

 

This example also illustrates how price outweighs time when evaluating long-term cycles.  Often, cycles don’t follow regular lengths, so it is very dangerous to assume that major highs or lows will occur X months from now merely because that happened the last couple times around.  I’ll go more in-depth on this subject in later posts on intermediate-term cycles, another component of my framework for successful investing.

Besides examining the price action in a long-term chart, I also consider the following factors when forecasting the future trend direction:

  • Momentum: The rate at which prices are increasing or decreasing.  Technical indicators that measure momentum include the Stochastic Oscillator, RSI, % rate of change, and deviation from a long-term average.  If prices make a new long-term low or high, but momentum is weaker than another low or high that recently occurred, the odds favor a change in the long-term trend direction.
  • Intermarket analysis: The performance of other asset classes that tend to move in the same direction as, or opposite direction from, the asset class we’re examining.  For instance, the US dollar index and the price of gold (in dollars) tend to move in opposite directions.  When the typical relationship doesn’t hold, it is a warning sign that the trend may be changing.  John Murphy has written several excellent books on the subject, one of which is on my list of essential books for trading and investing.
  • Fundamental factors: shifts in political trends, demographics, social patterns, economic indices, or other factors that may impact a single sector or all financial markets.

Based on the long-term chart, I select an “Actual Long-Term Trend” and a “Forecasted Long-Term Trend” from one of the five choices below:

  • “Up” – representing a clear upward trend
  • “Up (?)” – representing a weak upward trend
  • “Down” – representing a clear downward trend
  • “Down (?)” – representing a weak downward trend
  • “??” – representing a situation where the trend cannot be determined

 

Translate the Trend into a Fearless Forecast

So far, we’ve selected a baseline long-term trend, defined a range within which the long-term forecast can fall, and assessed the current long-term market situation.  Now that we have assembled all the info we need, we can proceed to make our long-term forecasts.

I take the actual and forecasted long-term trends from the prior step and translate them into a percentage between -100% and +100%.  This percentage determines how much my long-term forecast will vary from the baseline trend.  A percentage of -100% represents the most bearish, or negative, stance on from a long-term standpoint, and would produce a long-term forecast at the absolute bottom of the range.  Conversely, a percentage of +100% represents the most bullish, or positive, stance on from a long-term standpoint, and would produce a long-term forecast at the absolute top of the range.  Anything in between will fall within the range, with higher percentages giving higher forecasts and lower ones giving lower forecasts.  A percentage of 0% puts us right in the center of the range.

I have a grid I use to define the percentage for every possible combination of actual and forecasted trend (5 x 5 = 25 combinations in total).  The grid is the same for all asset classes.  The forecasted trend carries much more weight than the actual trend, because the future trend will determine our profit or loss, not the past trend.  As legendary hockey player Wayne Gretzky famously said, “skate to where the puck is going, not to where it has been.”

When I am confident in the forecasted trend, and differs from the actual trend (e.g. actual trend is Down, forecasted trend is Up), the percentage will be positive but not too strongly positive.  We want to start getting on-board the new trend, but not too heavily in case the current trend extends longer.  As the new trend begins to emerge, we become more confident in the forecasted trend so the percentage goes up.  At an actual trend of “Up (?)” and a forecasted trend of “Up”, I am at a percentage of +100% which means I am as bullish on that asset class as I can be, and I’m putting a higher percentage of my assets into it.  In this case, I see the actual trend beginning to turn up, in line with my forecast, so I have more confidence that my forecast is indeed correct.

As another example, let’s continue the earlier case of gold mining stocks.  As of today, my assessment of the actual long-term trend is “Down (?)” and I have chosen “Down (?)” for the forecasted long-term trend.  This is a weak situation, and negative for the gold miners.  However, because both forecasts have low confidence, the percentage is -40% and not any lower.  Applying this percentage to the range we established, -25.9% to +35.0%, and the baseline trend of +6.5%, we get a long-term forecast of -6.5%.  Calculation: -6.5% = 6.5% + (-40%) * (6.5% – (-25.9%)).

This forecast applies to the stage of the long-term cycle that we are in.  For example, if a few months from now the downtrend seems to be exhausting, causing us to change our forecasted trend to “Up (?)”, the percentage would go to +35% (as defined for that combination of actual trend “Down (?)” and forecasted trend “Up (?)”) and the long-term forecast would increase to +16.5%.  This is a big move, but I don’t change my long-term forecasts very often, only when conditions warrant.

To see this in action, including loads of real-life examples, check out our live stream, YouTube channel, and free trading podcast.

Armed with a fearless long-term forecast, we can now take action.

 

Turn Forecasts into Profit

With forecasts on all areas of our investment universe, we are ready to face the market.

Long-term investors can stop here, allocating their wealth to the asset subclasses with the highest projected forecasts.  It’s still important to monitor the risk level of the portfolio to avoid overconcentration.  More about risk levels in Episode 2 and Episode 10 of my investing podcast.

Intermediate-term traders, or swing traders, will want to layer intermediate-term forecasts onto the long-term ones.  Here’s a link to another post with more details, as I continue my series on the Five Components of Successful Investing.

So get started today on your fearless forecasts, and be prepared for the volatile times that lie ahead for financial markets.

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(CC Image by Samantha Marx on Flickr)

(CC Image by Samantha Marx on Flickr)

 

In today’s world, opening up a book may seem like an old-fashioned way to learn.  However, despite the popularity of virtual webinars and other online learning tools (like our free trading podcast, live stream, and YouTube channel), books remain a critical resource for professional traders and investors.  You’d be hard-pressed to find one pro that couldn’t name at least a couple books they read that taught him or her fundamental skills or inspired a new strategy.

For me, books were the first place I turned when I started my investing journey over a decade ago.  Over the years, my collection has expanded through regular purchases as well as inheriting a collection of classic trading books from my uncle.

In the spirit of the holiday shopping season, I’d like to share my list of the ten most essential books for anyone who wants to become a better trader or investor.  Every book on this list is one I personally endorse because it influenced my growth and development as a trader.

These are foundational books that will give you a strong base of knowledge that you’ll be able to apply right away, without overwhelming you with technical mumbo-jumbo.  Many of these books have a practical focus with plenty of examples to illustrate the concepts shown.  That said, I couldn’t resist including one textbook (Derivatives Markets) on the list so those who are mathematically inclined like myself will have something to sink their teeth into.

Without further ado…

Technical Analysis Explained, Fifth Edition: The Successful Investor’s Guide to Spotting Investment Trends and Turning Points, by Martin J. Pring

Pring introduces all the commonly-used technical analysis concepts and indicators in this book.  It’s a great reference book to have on hand and a solid introduction to technical analysis.

The Layman’s Guide to Trading Stocks, by Dave Landry

This accessible and slightly irreverent book is a fun place to start for the beginning trader.  Landry covers several basic yet fundamentally important trading strategies here, along with good coverage of the mental aspects of trading.

Intermarket Analysis: Profiting from Global Market Relationships, by John J. Murphy

John Murphy has written several books on intermarket analysis, all of which are classics that continue to stand the test of time.  Murphy’s excellent analysis of the connections between global stock, bond, currency, and commodity markets had a tremendous influence on the technical strategies I’ve developed.

Tragedy & Hope, by Carroll Quigley

What, a history book?  Yes – a 1300+ page history book, no less.  And I honestly believe it may the most valuable book on this list for investors.  Quigley’s magnum opus, first published in 1966, is an unparalleled study of 20th century history.  Social and political trends have been a major influence on the financial markets since markets were invented, and they always will be.  Reading this book will help you ensure your investments are aligned with these trends.  The book is freely available in PDF form here, although you’ll be missing out on the pride you’d have if this beast was on your bookshelf for all to admire.

Derivatives Markets, by Robert L. McDonald

This comprehensive textbook teaches important theoretical concepts related to the pricing of futures, forwards, swaps, and options.  This textbook is part of the syllabus for the Society of Actuaries’ MFE Exam.  When I took the actuarial exams I learned from a similar book, Financial Economics by Harry H. Panjer.  The Panjer text, published in 1998, is out of print but used copies are still available.

The Volatility Edge in Options Trading: New Technical Strategies for Investing in Unstable Markets, by Jeff Augen

Every trader must understand the concept of volatility, because trading is all about managing risk.  Augen does a great job of explaining volatility in this book in a way that is understandable for newer investors.  He also introduces strategies to take advantage of mean reversion and other concepts related to volatility.

Harmonic Trading, Volume One: Profiting from the Natural Order of the Financial Markets, by Scott M. Carney

Carney introduces several harmonic patterns which are composed of four price waves each, with all the waves related to each other by Fibonacci ratios.  These patterns don’t appear tremendously often, but they are reliable when they occur.  You’ll want to have harmonic pattern analysis as part of your technical toolbox.

High Probability Trading Strategies: Entry to Exit Tactics for the Forex, Futures, and Stock Markets, by Robert Miner

Miner provides a thorough yet accessible framework for successfully trading all markets and all timeframes.  One of the biggest mistakes I see traders making is having too narrow of a focus.  Miner covers all the bases with his four-part framework consisting of price, pattern, momentum and time.  His writing style can be a little abrasive at times, but it’s clear he knows what he is talking about.

Forecasting Financial Markets: Technical Analysis and the Dynamics of Price, by Tony Plummer

This little-known gem is now out of print, but used copies can still be found.  Plummer’s writing style can be hard to decipher, hence the mixed reviews, but patience is rewarded here.  I have read it several times and unlocked new secrets each time through.  Fibonacci ratios are at the core of Plummer’s ideas.  The 2010 book, linked above, shares the emphasis on theory over practice.   It’s not the place to start for a new trader, but it contains quality insights I’ve yet to find anywhere else.

The Education of a Speculator, by Vic Niederhoffer

This is the most enjoyable book I’ve read about trading, hands-down.  Vic experienced more than his share of ups and downs in the markets, and his writing provides a lot of insight into how he managed through those experiences.  You won’t get charts or trading strategies in this one, just an entertaining glimpse into how the trader’s mind works.

 

I’ve tried to include a mix of easy and challenging books here, with a variety of subject matter, so traders of all experience levels will find something to enjoy.  Now get started!

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(CC image by Hubble ESA on Flickr)

 

Think back to your most successful trades – the ones that made you jump out of your chair and run around the room, high-five your friend, enjoy a celebratory drink, or all of the above.  As traders, we all want more of this kind of trade.  In these moments, we feel like masters of the investment universe!

It takes lots of dedication and practice to achieve mastery, but it is not difficult to get started on the path towards success.  One of the critical first steps is defining what your investment universe will be.  After all, we can’t master something unless we first know what it is we want to master!

I call this mapping your investment universe.  It’s the process of deciding which markets you will follow and analyze, along with making a list of the securities you will trade.

 

Every Winning Plan Includes a Map of the Universe

In my earliest foundational post, I introduced a framework for building wealth entitled “The Five Components of Successful Investing”.

The five components are the blue boxes in this flowchart, taken from that post (with the blue circle added to mark today’s focus):

activemgtplan-univ

While the Universe of Securities box sits to the right of the other blue boxes, because it doesn’t need to be updated as often as the other components of successful investing, all the others depend on it.  We can’t make forecasts unless we have first chosen what types of investments (e.g. stocks, commodities, bonds) we want to forecast!  Also, most of us will use technical analysis of chart patterns to inform our trading decisions, which first requires us to select which charts we want to look at.

So, what should your investment universe be?  The answer is: it depends!  It depends on what YOU like to learn about, follow, and trade.  Some traders prefer to follow one industry, such as tech stocks or retailers, and get to know it in great depth.  These type of traders might define their universe as all the stocks in that sector, including small-cap stocks that they feel comfortable trading given their specialized knowledge.  Their universe might also include options or warrants on these stocks, depending on risk tolerance and other factors.

My approach to trading and investing is more broad than this.  It can be best categorized as “macro investing”.  Macro investing is all about trading a wide variety of assets and investment vehicles with the goal of capitalizing on large-scale trends and cycles.  I might buy a small-cap security if I think there is an opportunity there which aligns with a larger trend, but generally I am trading larger ETFs (exchange-traded funds) that hold a basket of securities in any given area.

I believe that macro investing is the optimal approach for most investors.  Here is why:

  • If your universe includes ALL the major asset classes, you’ll be able to take advantage of the best opportunities to bet alongside or against every area when it is becoming underpriced or overpriced, respectively.
  • Having a larger universe requires you to stay current on all the important trends, which makes you a better-informed trader.
  • Using ETFs as your primary investment vehicle, as opposed to individual stocks, provides better diversification within an asset class.

The exception to this would be if you have the time and desire to do lots of research on individual stocks, above and beyond the larger market trends.  In that case, you’d want to select stocks yourself for better returns and lower risk.  The vast majority of traders simply don’t have the kind of time needed in order to select stocks across many different sectors.

In the remainder of this post, I’ll explain how I map out my universe of securities.  This will serve as an example that you can adapt for your own situation.

 

Select Asset Classes

As I mentioned above, I try to include all categories of tradable assets in my investment universe.

First, I group them into major asset classes:

  • Currencies;
  • Precious Metals;
  • Commodities;
  • Bonds;
  • Equities (Stocks); and
  • Pure Derivatives.

Next, I further define “subclasses” within many of the asset classes.  For example, beneath Equities (Stocks) I have the ten market sectors (e.g. energy, utilities, financial services) along with mining stocks.  Beneath Commodities, I have: Soft Commodities, Base Metals, Oil, and Natural Gas.

Now that I’ve defined the scope of my universe, I can choose which securities I’ll trade.

 

Select Securities

To keep it simple, I choose only one preferred investment vehicle within each subclass.  Typically, this will be an ETF that tracks all major components of that subclass.  In some cases, there will be multiple “go-to” choices, as in the Currency Derivatives category where we can use UUP to trade the U.S. dollar, FXE to trade the euro, or FXY to trade the Japanese yen.

My list changes periodically as funds change and new choices become available.  Here is the list as of today:

asset-classes-w-tickers

My investment universe

These are the criteria I use to form the list, in order from highest to lowest priority:

  • Coverage (i.e. low tracking error);
  • High trading volume (i.e. low bid/ask spreads);
  • Low expense ratio;
  • Availability of options;
  • Trading volume in options.

I recommend you use some combination of the above criteria to form your own list, since your priorities might differ from mine.  For example, if you are a very frequent trader of options, the amount of trading volume in options could be your top priority.  In that event, you’d want to entirely remove the ETFs that don’t have high trading volume in options (e.g. DBA, DBB).

 

Follow Your Map, Unless You Are Absolutely Sure Where You’re Going!

Over 75% of my trading activity is in the ticker symbols found in my list.  I only deviate from the list when at least one of the following conditions hold:

  • I am trying to get more exposure outside the United States markets (e.g. I’m bearish on the dollar or U.S. markets have become overbought).  In this case, I’ll choose a fund with more foreign-listed stocks (like RWX instead of VNQ).  I keep a list of favorites.
  • Or, I’m trading a niche that is only a small piece of a subclass.  For instance, while uranium stocks are part of the energy sector they trade quite differently from the rest of the sector, which is dominated by oil and gas companies.
  • Or, I’ve thoroughly researched a company and am confident enough in my view of that firm that I’m willing to take on company-specific risk by trading it.

In the past, when I’ve strayed from my list by trading in different securities without one of these valid reasons, my results have been mediocre to poor.

I learned this lesson in the FactorShares 2x Gold Bull S&P 500 Bear ETF (FSG), an ETF that, mercifully, no longer exists.  From mid-2011 to mid-2012, this fund extracted over $9k from my account before the pain stopped.  I’d been buying it on the thesis that the ratio of the S&P 500 to gold would decrease.  As we see below ….

fsg_2011

… it was a faceplant.  Ouch.  But although the ratio rose instead of falling as I’d expected, I suffered a bigger loss than necessary.  FSG wasn’t in my universe of securities, and I didn’t trade it for any of the three reasons listed above.  I used it because it looked on the surface like it tracked the ratio I wanted to trade.  I’d have been better off creating a synthetic long-short position with GLD and SPY instead of using this ill-contrived fund.

What I discovered later was that FSG was managed terribly.  Factor Capital Management, the managing owner of FSG and 4 similar ETFs, shut down its operations in 2013 and liquidated its funds, but not before:

  • Charging excess expenses above its stated 0.75% fee (already too high) which weren’t clearly disclosed in the fund’s prospectus;
  • Failing to provide required tax forms to investors before March 15 as required by law (I had to amend my taxes in 2012 because of them – what a pain!);
  • Failing to adequately promote its funds, which kept volume low and hurt the fund’s liquidity.

I shared this example because I don’t want to see you fall into the same trap.  Stick to your list of preferred funds only, and don’t deviate unless one of the three conditions in my list is true.

Macro investing can seem like too much to handle.  It can look like the universe is far too vast to navigate.  But make a map, stick to it, and you won’t get lost!  You’ll be ready to pounce on opportunities anywhere they appear, and you’ll be on the path towards mastering your investment universe.

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(CC image by Mario Donati on Flickr)

(CC image by Mario Donati on Flickr)

 

We’ve seen relatively low and stable inflation levels for the last 30 years, so it’s easy to forget that it hasn’t always been this way.  What will the next 30 years bring?  More of the same, a return to the high inflation of the 1970s and early 1980s, or deflation as in the Great Recession of 2009-2010?  Or, could we experience all of the above?  Is your portfolio ready?

My prior post explains the real meaning of the terms “inflation” and “deflation” with several examples.  It also guides you towards making better forecasts of inflation, based on its three main drivers.

When the inflation rate shifts suddenly, it causes major damage to investors who haven’t prepared for these episodes.  Often, it’s the investors with the most conservative approach that are left worst-off once the dust settles.

If my forecast comes to pass, few investors will be spared from the damage.  That’s because the conditions today are ripe for BOTH deflation AND inflation, one after the other.  Only by taking specific steps now, and remaining alert as events unfold, will you emerge with your portfolio intact.

 

Historical Perspective

Prior to 1971, when the United States fully broke all ties between the dollar and gold, consumer prices in the United States underwent phases of high inflation and deflation.  However, when averaging across these cycles, prices maintained stability over the long run.   This happened because the dollar was backed by gold and the supply of gold grew only as quickly as it could be mined and processed.  Overall price levels stayed roughly the same from generation to generation, rather than increasing over time like everyone accepts as normal today.  (Look at how much prices have gone up from 1975 to 2015 – imagine if college was still that cheap today!)

Since 1971, the inflation rate has been less volatile, as the U.S. Federal Reserve has closely managed monetary policy in the United States.  The Fed’s objectives, as defined by the Federal Reserve Act, are to maximize employment, maintain stable prices, and moderate long-term interest rates.  These objectives existed long before 1971, but in the eyes of the Fed’s Board of Governors and the Federal Open Market Committee (FOMC) who are charged with carrying out these goals, “stable prices” now means something very different than it used to.  Today, they say that “stable prices” does not mean actually mean “stable prices” over the long run, but gradually rising prices!  If they really cared about stable prices, you’d still be able to buy a postage stamp for 13 cents or a car for $3,800, as in 1975.

The Fed has managed to keep prices rising gently for most of the last 45 years because it has responded swiftly and dramatically to any threat of falling prices in the economy, whether real or perceived.  By contrast, they react slowly when the economy is booming because they do not want to be blamed for the damage that would occur if they suddenly withdrew stimulus from the economy.  This behavior creates a strong bias towards rising prices rather than stable or falling prices, as we see below.

cpi_graph_70yr

The Fed’s focus has been on using monetary policy to smoothing out the boom-bust cycles that naturally occur in a free market economy.  When the economy starts to contract, the Fed expands the money supply through actions like buying US Treasury bonds (indirectly, because doing so directly would be illegal!), cuts key interest rates, or takes other actions to try to juice up the economy.

On the surface, this seems like a great thing for everyone.  Who cares if prices go up over time, as long as it’s gradual and predictable and there are no major shocks to the system?  If they’ve kept inflation tightly controlled for decades, certainly they can continue to do so?

Not so fast.  This “over-management” of the economy harms us all, especially savers and investors.  It allows bubbles to grow bigger and bigger over a longer period of time, rather than deflating on their own.  We saw massive bubbles burst in currencies (1997), real estate (2008), stocks (1987, 2000, 2008), banks (1980s S&L crisis), junk bonds (1989), and commodities (2008, 2014-15) to name just a few.  These bubbles would likely have still happened without misguided policy from the Fed and the U.S. government, they would just have been smaller and easier to recover from.

In summary, the Fed has kept the inflation rate moderate and positive for decades, but at the cost of pushing more volatility into asset markets.  This is wonderful news for alert traders and active investors, but bad news for savers and passive investors.

 

Current Conditions

Under a “lower-for-longer” interest-rate policy like we observe today, businesses respond by expanding debt, refinancing old debt that they’ll still never be able to pay back, and other financial engineering like massive stock buybacks, all of which are value-destroying in the long run.  They don’t deploy as much capital into real investment that would produce long-run growth and more jobs.  Furthermore, retirees, and savers have to set aside more money when interest rates are low, otherwise they won’t have enough interest and dividends to live on.  Pension funds and insurance companies must set aside more money to meet future obligations.  What does this all mean?  Money sits idle or chases bad investments instead of being invested into job creation, good technologies, or production plants.

We see this most clearly in the velocity of money: the rate at which money, credit, and liquid assets circulate in the economy.  Lower velocity means more money sitting idle instead of being used to purchase goods and services.

A similarly steep drop in velocity happened right before the Great Depression.

A similarly steep drop in velocity happened right before the Great Depression.

 

At the same time, the money supply is rapidly expanding:

m2-60yr

Most measures of credit I monitor are growing too.  Corporate debt, student loans, and auto loans are breaking records month after month.

Yet despite all this credit creation, and consumer prices that are nominally rising, I see deflationary pressures far outweighing any inflationary ones.  Neither government nor the Fed can stop it using their existing tools.

Commodity prices continue to trend downward:

These are two commonly-cited indexes of commodity prices I track. The Dow Jones-UBS index (purple line), has more weight in energy than the CCI (red line).

These are two commonly-cited indexes of commodity prices I track. The Dow Jones-UBS index (purple line), has more weight in energy than the CCI (red line).

 

Gold and gold stocks remain below their 2011 highs:

gold_2006

 

Investors’ inflation expectations keep falling:

infl_exp_5yr_2006

 

Lastly, actual realized inflation continues to fall short of investor expectations:

infl_dev_1_5_2009

 

These charts don’t look anything like what we’d expect to see if inflation were right around the corner.  This is deflation all the way.

 

What’s Next?

When debt builds up in the economy, all is well-and-good until enough borrowers become unable to service their debts.  Debt levels across households, corporations, and governments continue to grow far faster than incomes.  This is unsustainable.  Default rates will reach crisis levels in one area first – state and local governments are a likely starting point, but I cannot be certain which area will tip off the crisis.  It could even be a geopolitical crisis, natural disaster, or any number of events that could set the process in motion.  Timing is even more difficult to predict, but it’s hard to imagine we can go another 3-5 years on the path we’re on.

As default rates rise, the crisis will spread to other sectors of the economy with a speed and severity that will exceed politicians’ and the Fed’s abilities to respond.  Therefore, expect a sudden decrease in virtually all asset prices, with few places to hide.  Gold, income-producing real assets like land and some real estate, will be best protected.  This will be the deflationary phase of the crisis.  (I’d argue the deflationary pressures we see today are a sign that the crisis period has already started!).

But I don’t expect politicians or central bankers to accept this reality for long.  There will be too much pressure on them to act, and to act in ways we have not seen before.

As an example, I believe we are likely to see a large-scale debt forgiveness program for households accompanied by a revaluation of the U.S. dollar at a lower level.  I also think we’ll see a global renegotiation of debts, since a great deal of debt is owed to other governments.   U.S. President-Elect Trump, whether you like him or not, certainly is a man who understands how to renegotiate debt and emerge from bankruptcies.  To make these measures more effective, I also expect governments will initiate capital controls, restricting the movement of money across borders.  We may also see an attempt to introduce regional currencies or a global currency at this time.  These actions will represent the inflationary phase of the crisis.

The length of time we remain in the deflationary and inflationary phases will depend on how effective global policymakers are at achieving consensus during the crisis.  The more rapidly they are able to successfully “reset” the global economy, the faster we’ll move from deflation to inflation and then return to some semblance of normalcy.

 

How To Stay Safe, Or Even Profit, From These Events

If there is one thing all good traders love, it is volatility.  Even in times of crisis, markets remain open (with limited exceptions).  Many of the skills I teach will help you preserve your capital and even make money during both phases of the crisis.  For instance, shorting stocks, buying put options, and trading the VIX in a crisis environment can be immensely profitable!  Keep in mind that these strategies do carry risk, and should be used carefully as your own financial situation permits.

You should also consider owning some hard assets like gold, silver, and income-producing real estate if you are able.  Minimizing your own personal debt will benefit you in a crisis period as well.  Stay tuned for more on all these topics.

Above all else, it goes without saying that you’ll want to take steps to ensure your personal safety, diversify your skillsets, and overall become more self-sufficient.  I highly recommend Jack Spirko’s podcast, The Survival Podcast, for a rational and thoughtful discussion of preparedness topics.  I’ve been a listener and subscriber for many years.

Deflation and inflation don’t have to catch you off-guard.  By sharpening your trading skills, you can use volatility to your advantage.

 

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