05/05/2012 How the Mousetrap is Different

Condition	Bear Market	Rally
S&P Target	1250
Small Portfolio	IAU & XLF	12.20%
Hedge	XLU	-3.57%
Position	Date	Return	Days	Call
GCI	7/14/2011	1.14%	296	Hold
CSGS	10/3/2011	26.98%	215	Hold
NLY	10/25/2011	6.72%	193	Hold
DD	10/27/2011	16.65%	191	Hold
KBR	10/27/2011	4.10%	191	Hold
VG	10/27/2011	-43.77%	191	Buy
TTM	11/30/2011	66.83%	157	Hold
BT	1/4/2012	11.86%	122	Hold
PDLI	3/7/2012	3.78%	59	Hold
CLF	3/19/2012	-18.33%	47	Hold
S&P	Annualized	1.91%
Small Portfolio	Annualized	13.11%
Mousetrap	Annualized	14.34%
Hedged	Annualized	10.50%

In my “Time Frames” post I mentioned that there are only two things that make a stock go up: money from investors into the stock (technical), or money from customers into the business (fundamental).

That’s it.  After all the smoke clears there’s nothing else.

And there are only two kinds of reasons people will buy a stock: they think it will stop going down (mean reversion) or they think it will keep going up (momentum).

Again, that’s it.

1)      Technical and fundamental analysis.

2)      Momentum and mean reversion traders.

Like everyone else, the so-called “dumb money” investors go for either mean reversion or momentum, but they don’t use any kind of systematic analysis.  They are just following their gut, the news, or some “hot tip” scam they get in email.

But we’ll ignore “dumb money” for now and draw a matrix to find out what kind of traders we want to be:

	Mean Reversion	Momentum
Fundamental	1-2 years	2-4 quarters
Technical	1-2 quarters	1-3 months

The time frames in this matrix do not overlap: and that’s the problem most of us encounter.

There’s also another problem that is becoming increasingly dangerous by the day: high frequency trading algorithms.  These are high speed automatic trading robots with self-adapting heuristics to manipulate quirks in human behavior.

Added to that are the news headlines.  After a down day they will be filled with well thought out and researched articles that have taken weeks to research and make their point that the sky is falling.  After an up day the exact opposite will happen, and all of the well thought out articles will be showing that the sky is the limit.

Just for fun go to www.realclearmarkets.com one day and count the bullish and bearish headlines.  If there are more bulls, chances are the previous day was a good one, or we had a good gap up in the morning.  If there are more bears, the previous day was likely a bad one.  They didn't write these articles over night.  Writers DO sleep at night.  The editors get both bullish and bearish articles and just publish the ones each morning that match the current price move.  They aren't trying to make you more money as investors.  They are trying to get THEMSELVES more business by getting you to read their "timely" articles.

And the high frequency trading robots are programmed to scan those articles for certain key words so they can make a quick buck off of the readers who will buy or sell based on the news.

We’re in the matrix fighting robots!

Remember all those stock market billionaires?  They got rich off of your money, and now they have robots making sure you never get your money back.

So we have a choice: we can fight robots and help the Warren Buffetts Goldman Sachs of the world stay rich, or we can take an entirely different approach.

Human instinct is to work harder, trade faster, build our own robots.

Human instinct is to put the gas pedal to the floor of our VW MicroBus and try to outrun the terminator robot in the Lamborghini.

The Mousetrap doesn’t hit the gas.

It hits the brakes.

It you want to change lanes, don’t get in front of the Lamborghini.  Let it pass and then drive in whatever lane you want.

They aren’t building slower robots.  They are building faster ones.  Human instinct isn’t to slow down; it’s to speed up (and run right into their lair).  The only way to escape the robots is to slow down so much that the robots can't see you.

The slowest approach is a fundamental mean reversion strategy.  The more chaos the robots create, the better fundamental bargains they’ll leave in their wake.  The Mousetrap then selects stocks that are a fundamental bargain within industries that are a technical bargain.  In other words, the Mousetrap picks up the debris left behind by the high frequency robots, rather than fighting them directly. 

This is very similar to using something like a “Value Investor” portfolio from www.validea.com and buying stocks within sectors that have a low bullish percent index on a site like www.dorseywright.com. The only difference is that I’m using my own bullish percent valuation as a ratio of price to volume-breadth.  In simplest terms, I’m looking for a stock with a low P/E (price to earnings) in an industry with a low P/V (price to volume-breadth).

While that’s not the entirety of my valuation method, that’s a good piece of it.

The final element I’m measuring is time.  How long does it take for a selected stock to reach its maximum return rate?  The technical aspect of my model loses steam after 3 months, and the model gets its second wind after about 4.5 months.

I was initially rotating stocks after a quarter.  Now I am holding them until they hit an average maximum return rate (I’m including trading costs and tax rates as part of the return rate calculation).

I have not yet reached that maximum point.

It therefore appears that the technical part of the model gives the fundamental selections enough liftoff for a skittish human like me to hold them until they fully mature.

And that’s a good thing, because the purpose of my “robot” isn’t to capitalize on the human nature of other people, but to protect me from my own human nature. Fundamental investing isn’t complicated from a logical perspective; but it’s almost impossible from an emotional one.

In the simplest terms, then, we are twice victims of our own short sightedness.  First, by making bad decisions, and second by robots that live in our bad decision time zone (the short term).  The Mousetrap is just my way of staying focused on the long view, getting away from the noise of news, robots, and my own irrationalities.  The Mousetrap won't always be right.  But that's not its goal.  It's goal is to be less wrong than my own instincts... with the added benefit that I can sleep at night and forget about these investments for a while.

Tim

PS: I hear the sky is falling in France...

Explanation and Disclaimer: http://market-mousetrap.blogspot.com/2012/04/explanation-and-disclaimer.html

Time Frames: http://market-mousetrap.blogspot.com/2012/05/time-frames.html