03/10/2013 Nothing -- Yet

Sector Model	XLI	1.90%
Large Portfolio	Date	Return	Days
BBRY	7/16/2012	80.14%	237
SEAC	9/25/2012	36.96%	166
CAJ	9/25/2012	3.87%	166
CFI	10/31/2012	51.39%	130
RE	11/26/2012	22.71%	104
BOKF	2/4/2013	7.81%	34
SWM	2/12/2013	4.95%	26
GMCR	2/19/2013	19.10%	19
OKE	2/25/2013	-4.58%	13
TTM	3/4/2013	5.80%	6
S&P	Annualized	8.35%
Sector Model	Annualized	26.59%
Large Portfolio	Annualized	32.82%

 

Full stop – no rotation for Monday.

As I noted on Friday’s post, the sector model has been in transition this week, and ended with a position in XLI.

Thanks to a request from one of the readers, I’ve changed the reporting on the sector model to only include the profits in the latest call, which is 1.9%.

There are some other changes that aren’t visible yet, but soon will be:

I’ve personally transitioned to a hedged version of the model.  Although I won’t be reporting the hedged trades, there WILL be occasions that the “cash account” version of the model on the blog will be affected.  When the hedged version of the model reflects a bearish bias in the market, some (or possibly all) of the blog trades could end up in cash.

That actually should increase the performance of the model, by avoiding some of the more negative events of the market.  While no one can perfectly time the market, there are times when it is prudent to raise some cash.

Under the hood, then, this week has seen the hedged model move from a net 100% long bias, to a net 60% long bias.  That’s still bullish, but not quite as bullish as it was just a week ago.  The positive thrusts of the market lately are not being supported by breadth and money-flow.  It’s like a moving car when you lift up on the accelerator.  You still have forward momentum, but the car itself will eventually decelerate.

No changes are visible on the blog… YET.  But caution is warranted.  If you’re someone who uses margin, you may want to review your trades and make sure you’re comfortable with a market that may find itself slowing during the next few months.

In particular, retail and recreation stocks are most likely to slow first, which indicates a hit on parts of the economy that people “want” instead of what they “need.”

Tim

 

03/08/2013 Sector Change

The sector model has gone through a lot of whipsaws this week.  It is no longer long XLU (utilities), but is now long XLI (industrials).

Although technically a "bullish" sector, XLI is also historically associated with a correction.  The average annualized return rate for the S&P during an XLI selection is -11.18%.

Could be different this time, but a bit of caution is prudent.

Incidentally, I do check the sector model each week before the close on Friday, and will post any changes here in real time.

03/07/2013 The Marshmallow Style of Investing

How much money do you want to make?

Do you need 6% returns compounded for life?  Heck, hold an ETF like SPY, IWM, or RSP and call it a day.  It will fluctuate from year to year, but if your time frame is in decades and you aren’t greedy, that’s your ticket.

How about 15%?

Well… is that before or after taxes?

Let’s put this in perspective, using some ETFs as surrogates:

	Base Return	Decay Rate	Short Tax	Long Tax
SPY	8.43%	N/A	4.74%	6.42%
SPY*2	16.86%	N/A	9.47%	12.85%
SSO	8.74%	8.11%	4.91%	6.66%
SPY*3	25.29%	N/A	14.21%	19.27%
SPXL	1.41%	23.88%	0.79%	1.07%

 

This is a weird table, but bear with me.

SPY is an ETF that tracks the S&P 500 index.  The 8.43% annual returns are what it averages since it began in the 1990s.  SPY*2 and SPY*3 are simply 2 and 3 times the return rate of SPY.  The ONLY WAY to get 15% or better returns, after taxes, is to TRIPLE the return rate of the S&P500 index – year after year after year.

SSO is an ETF that tries to double the returns of SPY.  SPXL tries to triple the returns of SPY.  If you only hold it during the day, it works okay.  If you hold it overnight you get the leveraged decay effect.  (I got the decay rates by measuring the difference between actual SSO and SPXL returns against SPY*2 and SPY*3).

There are a number of reasons for that decay rate, such as leverage costs embedded into the ETF.  But the biggest reason is simple math.  If you have 1000 dollars and lose 10% you have 900.  If you gain 10% you have 990.  If you TRIPLE those moves, you have 1000 to 700 on the first move, but only 910 in the end.

The difference between 990 and 910 is a result of leverage decay.

So, SSO, which is supposed to double SPY, instead runs about dead even (with twice the risk).  SPXL, which is supposed to triple SPY, gets left in the dust with 1.41% annual returns.  If you pay short term capital gains taxes you end up with 0.79% for your troubles.

So much for leverage.

What about market timing?

Best overview of the subject is a book called Technical Analysis.

Thick book.  Great read.  Disappointing revelation: pretty much all the ways to time the market stopped working about ten years ago when all of these methods were fed into high frequency trading algorithms that are now self-adapting (i.e. evolving) faster than human nature can keep up.

It CAN be done, but it’s EXTREMELY difficult and requires a high degree of sophistication.

But don’t some people get rich in the market?

Yes they do.  But here’s another disturbing thing: some of it is luck.  The concentration of wealth follows a power law.

A simpler example is to picture “trades” like the flip of a coin.  Heads I win and tails I lose – but I win FROM YOU or lose TO YOU.  Take a thousand people and pair them off.  After one flip you have 500 winners.  Two flips you have 250.  Another flip 125.

Keep flipping a few more times and only a handful have all the money.

Now, most of us don’t lose ALL our money on a single trade, but we do a LOT of trades and it accumulates fast.

Although the losers aren’t entirely out of the game, they can only stake what they have left from the loss.  Enough losses and they will never make it to the wealthy group, no matter how many times they win afterward.

So, you STILL want to beat the market?  You CAN do it, but the VAST MAJORITY of our coin flippers have nothing left and only a few are wealthy.

How about cheating?  Will that help?  Get a good inside stock tip and you’re set, right?  First, you have the problem of getting arrested for cheating.  But what’s even worse is that many of these cheaters get convicted EVEN THOUGH THEY LOST MONEY cheating!

(remember him?)

Ever get a stock tip email?  Gosh I love those…

Basically those stock tips are from people who own a stock with such small liquidity that a little buzz will give them enough room to pop out with a profit, while you’re stuck with a stock that you cannot sell to anyone at any price, and so you sit on it till doomsday – which eventually comes while you watch a train wreck play out over a couple of years.

You’ll see the stock pop up 100% and then… fall 100%.

What about trading the news?

Too late.  There’s a robot that does it faster than you:

 

As I said in the previous post – the ones who win the game are the ones who aren’t playing.  Investing in BUSINESSES is a BUSINESS venture.  If you try to gamble you’ll get wiped out by the power law.  If you try to cheat you’ll get wiped out by the legal law.  And if you try to leverage you’ll get wiped out by your in-laws.

Relax – you can beat the market, but only if you don’t play the MARKET.  There are thousands of stocks out there.  Each one is its own market.

Let’s compare two stocks:

AAPL (Apple Computer) and BRCD (Brocade Communications).

Although BRCD doesn’t have the greatest chart in the world, it’s been beating the pants off of AAPL since June of 2012.

Going on price alone, a person invested in BRCD would be a lot happier than his neighbor who’s grumbling about AAPL.

Not only that, but earnings per share has been growing since last quarter in BRCD (20), but falling in AAPL (-0.41). 

The daily and weekly moneyflow have been crushing AAPL, and kind to BRCD.

Looking at just price, moneyflow, and earnings growth, BRCD should be the one to ride.

But we aren’t looking to RIDE a stock.  We are looking to INVEST in a company.

Let’s examine those earnings.  3 quarters ago AAPL was at 12.3 and BRCD at 0.06.  That’s a HUGE difference.  No wonder BRCD’s earnings have been “growing”.  They’ve been growing from dirt.  For the past 10 years AAPL’s earnings have grown (58.5) while BRCD’s have fallen (-0.5).

Sure the next quarter’s earnings growth “forecast” is negative for AAPL (-8.51) and positive for BRCD (33.33), but forecasts are just people extrapolating the present into the future – and humans are notoriously bad at doing that.  In fact, we’re SO bad at it that I actually TARGET stocks with negative forecasts.

For the past 5 years, Book Value has grown better in AAPL (47.5) than in BRCD (13.5).  5 year Cash Flow has favored AAPL as well: 61 to 11. 5 year sales growth has favored AAPL: 39.5 to 12.

AAPL has a better operating margin: 35.5 to 21.2.

AAPL pays a dividend (10.6) and BRCD doesn’t (0).  If you consider that dividends are taxed at LONG TERM capital gains, we want to invest in as many dividend stocks as possible.

Now – I picked those two since I’m not planning to be long OR short either one in the near future.  This is a completely disinterested view of AAPL against another stock.  And if these were the ONLY two stocks in the universe I’d go to AAPL and not BRCD.

Heck, if I were to get a job in either one, I’d feel more secure in AAPL than BRCD.  Wouldn’t you?

So, AAPL is “out of favor” right now.  Heck, the stock price could drop like a rock.  Even the fundamentals could turn ugly.

But the ODDS are more in favor of AAPL than BRCD.  If you were to invest in ten companies like AAPL or ten like BRCD, you’d more than likely be better off with the AAPL type fundamentals than the BRCD type technical traits and forecasts.

The reason is actually rather mundane.  People think short term and give recent information more value than long term information.  And the odds are that BRCD will continue to do better than AAPL in the SHORT TERM.  1 to 5 weeks, BRCD will probably win.  1 to 5 months BRCD will possibly win.  1 to 5 years, AAPL will much more likely win.

People are generally right about good and bad news – but they are horrid at QUANTIFYING it.  They almost always overshoot. And that’s what we should look for.

Find something that looks better long term than short term, and you’ll find value.

Find something that looks better short term than long term, and you won’t.

This is the “marshmallow” style of investing; eat one now or get two later:

 

Tim

03/02/2013 Playing Games

Sector Model	XLU	40.16%
Large Portfolio	Date	Return	Days
BBRY	7/16/2012	84.28%	229
SEAC	9/25/2012	41.00%	158
CAJ	9/25/2012	5.73%	158
CFI	10/31/2012	32.80%	122
RE	11/26/2012	19.10%	96
NSC	1/28/2013	5.56%	33
BOKF	2/4/2013	6.01%	26
SWM	2/12/2013	2.47%	18
GMCR	2/19/2013	7.57%	11
OKE	2/25/2013	-5.10%	5
S&P	Annualized	6.89%
Sector Model	Annualized	21.21%
Large Portfolio	Annualized	30.67%

 

Rotation: selling NSC; buying TTM (Tata Motors)

Basically we’re moving from a railroad to a car company.

Cars are a consumer cyclical industry, more indicative of a market bottom than of a market top.  My full industry model is NET 100% bullish.

And yet… the sequestration apocalypse happened on Friday.

In light of the stand-off between the two political parties, a few words on game theory:

 

Game Theory.  We see it in movies and TV shows every time two characters pull guns on each other and don’t fire.  If you put the gun down, the other guy will pull the trigger.  If you pull the trigger, the other guy will have just enough time to pull his trigger.  If the other guy pulls his trigger, you’ll have just enough time to pull your trigger.

So no one puts the gun down, and no one pulls the trigger.

Stalemate.

But you only see it on screen.

I used to be a firearms instructor in law enforcement.  You never see these standoffs in real life.   In real life, you pull out a gun in order to pull the trigger as fast and as accurately as you can, hoping to do so before the other guy.  If you see the gun pointed at you, you’ll fire faster.

Game theory, for all its beauty and elegance, doesn’t work in real life, because real life has real people in it.  Most of the books on game theory point out how people do NOT operate in a mathematically optimal way.

When it comes to stocks, here are just SOME of the variables in the game:

Known fundamentals that are correct.

Known fundamentals that are incorrect (and there are plenty).

Technical momentum.

Technical mean reversion.

Right – each set cancels itself out.

Plus, here are just SOME of the players in the game:

Insiders who are operating on unknown information that is correct.

Insiders who are operating on unknown information that is incorrect (a lot of insider traders who have been convicted, were convicted over illegal trades in which they still lost money…).

Fundamental mean reversion players (Warren Buffett).

Fundamental momentum players (David Lynch).

Technical mean reversion players (Tom Dorsey).

Technical momentum players (Sam Weinstein).

And, to make matters worse, two ways to play a stock: up & down.

So, a stock is plummeting and Weinstein is shorting it for all it’s worth.  As it starts getting too cheap Dorsey will look at a bullish percent index under 10 and get the heck out of the short.  He sells to Buffett, who just buys more as it gets cheaper.

The stock starts to turn.  The bullish percent index trips above thirty and Dorsey is now long with Buffett.  The volume picks up and the stock trips above its long term moving average and Weinstein covers his short.  An earnings report shows that earnings are growing faster than price, so Lynch goes long.

Once everyone is in, the last of the Buffett style traders sell to the last of the Weinstein and Lynch traders and the Dorsey traders hang on until the bullish percent index tops 70 and then falls back below it – then the whole thing cycles, over, and over, and over again.

Add in the seasonal traders and you have yet a fifth kind of player.

Add in the inter-market analysis traders – (John Murphy and Sam Stovall), and they’ll be playing wild cards like “Financials are doing great, so let’s pile into Consumer Cyclicals.”

And these are just the strategic traders.

There’s also the full business cycle to consider, the Federal yield ratio, quantitative easing, the exchange rate effect, commodity inflation, etc.

And there are the trading robots stalking prey, piling in more and more variables in an effort to manipulate what is known about technical and behavioral factors.

And there are demographics – young people flooding the marketplace for work in the 1970s created both inflation and unemployment, while the retirement of those same people in the 2010s is creating both deflation and suppressing the unemployment numbers.

Do you REALLY want to trade stocks based on what you THINK they might be worth to someone ELSE?

That’s not investing; that’s speculating.  And there are too many KNOWN variables to even hope to play it correctly.

You’ll never be smart enough, informed enough, sane enough, prescient enough, or fast enough to beat the high frequency trading algorithms out there.

So, there are four choices.  Play your gut and lose money, buy and hold the index, stay out of the market, or…. OR… ask something not covered in game theory.

Instead of asking what the stock might be worth to SOMEONE else, ask instead what the stock is worth to YOU.

No, really.  That’s why you buy a house isn’t it?  Granted, the previous decade was full of people trying to flip houses, but the traditional reason to buy a house is to have a place to sleep at night.

You buy a house to LIVE IN IT.

If real estate gets cheaper you don’t despair; you take advantage of the cheap building prices and add a room.

If the price of a stock is going down, do you cut it for a small loss or buy more of it?  Weinstein will pile on short while Buffett will be snatching it up long.

Here’s the key – you aren’t buying a piece of paper for what it’s worth to someone else; you are buying a company for what it’s worth to you.

Isn’t that was a stock is, after all?  It’s not a blip on a screen or a piece of paper.  It’s a piece of a company, with managers, employees, inventory, brand name, cash flow, debt, and profit.

Would you own the company?

Would you own the product?

Is it at a good price?

Friday morning I texted on a blackberry while I was getting a document from a canon printer.

I even had some coffee.

And I don’t just own those companies – I’m also a client (yes, I stole that from the hair commercial).

What does game theory have to do with all that?

Why, nothing at all.

The people who win the game are not the ones who are playing around, but the ones who mean business.

Do you REALLY want to spend your time trying to second guess how other people second guess your second guesses?  Or would you rather learn a bit about business risk and profits?

I thought so.

Next up – I’ll devote some blog posts to what’s really good in those fundamental details and why value investing is the way to find some sanity in the midst of news driven chaos.

Tim

 

 

 

03/01/2013 timing note

Unbelievably (to me), the industries are even more bullish than yesterday.

For a holding period of three months, the model would be 75% long and 25% short.