Thursday, December 18, 2014

Dear Santa, may I have new highs for Christmas?

I have been calling for an oversold rally to start in the past week. Even though my calls were early, it seems that a V-shaped bottom and meltup is in process. In my last weekend post (see 2015: Bullish skies with scattered periods of volatility), I pointed to the combination of VIX term structure inversion and TRIN over 2 as a virtually certain bottom calling indicator.

The chart below shows the past instances, marked by vertical lines, when this indicator has generated buy signals. The blue lines indicate past episodes when it successfully marked a short-term bottom in the last four years and the red line shows the one time when it failed.

In addition, I have been watching the levels of NYSE new 52-week highs (green) and 52-week lows (red). Most recently, the new low count has spiked to extraordinarily high levels and then retreated. I have marked with vertical lines the past occurrences of this condition in the last four years. Each of those episodes were associated with V-shaped bottoms and subsequent rallies to new highs in the SPX.

If history is any guide, we should see Santa Claus bring investors new highs in the major US equity averages, either before year-end or shortly into 2015. As the stock market has been on a tear in the past two days, it would not surprising to see it pause Friday and possibly stage a minor pullback. Should that happen, it would provide a good entry point for traders who missed have missed this powerful rally to get long.

Disclosure: Long SPXL, TNA

Monday, December 15, 2014

No guarantees, but...

I have been writing Humble Student of the Markets for a little over seven years. I have used this blog to voice my own thoughts and I have asked nothing in return from my readers, except for their comments. There is, however, one way that you can show your appreciation for my writing.

During this holiday season, I would like to launch my personal appeal for support of the Vancouver Youth Symphony Orchestra, to which I am a volunteer board member. I have kept my writing free since I started this blog. If you have found my work to be valuable, please show your appreciation by donating to this worthy cause by clicking here.

I have long believed that one of the ways to nurture youth is to give them a focus in their lives, whether it be music, sports or other pursuits. This is especially critical during their adolescent years as they start to form their own identities. It's one of the key reasons why I became involved with the Vancouver Youth Symphony Orchestra Society. Participation in a VYSO orchestra teaches young musicians to focus on both their individual musical and orchestral skills. The latter is particularly important as many people can learn to play music, but a different skill is required when the conductor points to a section and have them all play the same sound at the same time. It's much like the difference between learning to walk and learning to march in formation.

The Vancouver Youth Symphony Orchestra Society is a registered charity and tax receipts are available to contributors who are Canadian residents.

They say that there are no guarantees in life or investing, but there is one guarantee that if you participate in this offer, you'll feel better about yourself.

Thank you for your support and my best wishes for everyone for this festive season.

Sunday, December 14, 2014

2015: Bullish skies with scattered periods of volatility

Trend Model signal summary
Trend Model signal: Risk-on
Trading model: Bullish

The Trend Model is an asset allocation model used by my inner investor. The trading component of the Trend Model keys on changes in direction in the Trend Model - and it is used by my inner trader. The actual historical (not back-tested) buy and sell signals of the trading component of the Trend Model are shown in the chart below:

Update schedule: I generally update Trend Model readings on my blog on weekends and tweet any changes during the week at @humblestudent. In addition, I have been trading an account based on the signals of the Trend Model. The last report card of that account can be found here.

The equity market analytical framework
Last week I allowed my inner trader to take the stage (see My trading plan for December) and this week my inner investor will take to the podium. However, I will have a brief trading comment in light of the stock market downdraft seen in the last week.

My inner investor's main analytical framework for US equities is:
  1. How are forward earnings evolving?
  2. What is the outlook for the US economy? What are the chances of a recession, which would induce an equity bear market?
  3. What are the risks? 
My main conclusion is that investors were spoiled in 2014 as stock prices went up more or less in a straight line, but the 2015 stock market, though appearing bullish, will see bouts of gut wrenching volatility.

How quant models respond to shocks
John Butters at Factset has neatly illustrated the importance of forward EPS to stock prices with this chart (annotations in red are mine). Forward EPS has tracked stock prices closely in the last 10 years and there is no reason to believe that they won't continue to do so. 

Past episodes of market weakness has been associated with stalling forward EPS growth, which is what we are seeing now. However, the downdraft is going to be temporary for a couple of reasons. First of all, we are seeing most of the negative effects of falling oil prices first. Much of the downward revisions have been attributed to falling Energy sector estimates, which has tracked the price of oil (via Factset):

On the other hand, the positive effects of falling oil prices have not been quantified by the Street yet. During the Asian Crisis, I can recall sitting in a meeting to assess its effects in light of what we were seeing in our quant models. One of our EM portfolio managers said that estimate revisions were not moving yet because analysts know that earnings are bad, they just have no idea how bad so they are not revising them yet. In the current instance where oil prices have cratered, the Street knows that the effects are good because of lower input prices and higher consumer spending, they just have no idea how good yet. As a consequence, EPS estimates are not rising.

The chart below from Factset (red annotations are mine) show that we are mainly seeing only the negative effects of the oil price drop, as SP 500 EPS estimates have been dragged down mainly by resource sectors (and Telecom, which has a tiny index weight), while EPS estimates for the other sectors are flat to slightly up. Expect the positive effects to start filtering through in the weeks ahead.

The economy is not the stock market, but...
The second question in my analytical framework is to gauge the health of the American economy. While economic growth does not correlate well with the stock prices, it does bear a major influence on the corporate earnings and revenue outlook. This chart shows how closely tied the employment picture, as measured by initial claims (inverted), to the SPX.

The US economic picture is one of steady improvement, which can be summarized by the comment from Bespoke about the Q3 GDP report, which showed positive internals:
Looking at the internals of the report, there were broad upward revisions to key areas that were slightly weak last quarter, including consumption, fixed investment, and inventories. We previously said that inventories were due for an upward revision after a very weak initial reading, while we expected net trade - especially imports - to be revised upwards, negatively impacting total growth. The rest of the revisions, which we did not expect, were positive: higher consumption and higher investment. As a consequence, domestic final private demand, which strips out trade, government, and inventory changes, jumped half a percent, coming in at a healthy 2.48%, while final demand registered a 4.02% increase.
While Q3 GDP was unusually high and Q4 will likely see a negative snapback, the general outlook remains positive. Indeed, we saw a clue of the positive effects of falling fuel prices when retail sales and consumer sentiment surprised to the upside last week. Indeed, the Citigroup US Economic Surprise Index is ticking up.

The combination of a steadily growing economy with falling energy prices should result in rising EPS estimates in the very near future. I therefore look for stock prices to continue their climb into 2015.

Lower oil price boosts growth
Falling oil prices should also be a net positive for global growth. Business Insider recently highlighted the UBS estimates of the effect on GDP growth.

If we were to focus on the US, UBS estimates that a $10 decline would boost US GDP growth by 0.1%. Assuming that oil prices stabilize at $70-80, the current fall from about $105 would translate into incremental GDP growth of 0.3% for the American economy.

Historically, an oil price drop caused by oversupply has generally been bullish for equities (via Ambrose Evans-Pritchard):
Tumbling oil prices are a bonanza for global stock markets, provided the chief cause is a surge in crude supply rather than a collapse in economic demand.

HSBC says the index of world equities rose 25pc on average over the twelve months following a 30pc drop in oil prices, comparable to the latest slide. Equities rose 19pc in real terms.

Key risks
Despite the bullish outlook for stock prices, no review is complete without some assessment of the risks. In 2015, there will be plenty of risks that will likely induce much higher volatility in asset prices. Here is what I am watching, in order of likelihood:
  1. What happens to interest rates?
  2. The ups and downs of European theatre
  3. The specter of British political instability
  4. Geopolitical instability in oil producing countries.

The Fed expects higher volatility
2015 will be the year when the Fed starts to normalize interest rates and move off ZIRP. In a must-read speech, New York Fed President William Dudley stated that not only is a mid-2015 rate liftoff more or less baked-in, the Fed will be watching if the markets freak out when short rates rise:
When lift-off occurs, the pace of monetary policy normalization will depend, in part, on how financial market conditions react to the initial and subsequent tightening moves. If the reaction is relatively large—think of the response of financial market conditions during the so-called “taper tantrum” during the spring and summer of 2013—then this would likely prompt a slower and more cautious approach. In contrast, if the reaction were relatively small or even in the wrong direction, with financial market conditions easing—think of the response of long-term bond yields and the equity market as the asset purchase program was gradually phased out over the past year—then this would imply a more aggressive approach. The key point is this: We will pursue the monetary policy stance that best generates the set of financial market conditions most consistent with achievement of the FOMC’s dual mandate objectives. This depends both on how financial market conditions respond to the Fed’s policy actions and on how the real economy responds to the changes in financial conditions.
If the reaction is relatively gradual, then the Fed will continue its normalization policy. On the other hand, it may moderate its interest rate trajectory if volatility is too high (note he said nothing about their reversal). Keep in mind that the volatility pain threshold for the Fed is probably higher than the pain threshold of a lot of traders (emphasis added):
Because financial market conditions affect economic activity only slowly over time, this suggests that we should look through short-term volatility and movements in financial markets. We should not respond until we become convinced that the movements will likely, without action on our part, prove sufficiently persistent to conflict with achievement of our objectives. Often, financial markets can be quite volatile and move a lot without disturbing underlying economic performance.
The Fed expects higher volatility in 2015. So should investors.

More European theatre
In addition to likely Fed induced volatility, investors should expect volatility from the eurozone in 2015. In the near-term, we have the uncertainty introduced by the Greek Presidential election. If the current head of the government, Antonio Samaras, can't muster enough votes for his candidate, it will mean early parliamentary elections and the current polls show the leftist Syriza party in the lead. This is what happened when the Syriza leader Alexis Tsiprias roadshowed party policies.  (via FT Alphaville):

Ever present is the ECB will-they-or-won't-they QE guessing game as the tensions between Draghi and the Bundesbank linger. I believe that the more serious problem in Europe is the lack of action by member states on reform (via the FT Brussels Blog):
The dance had become so routine that we at the Brussels Blog were thinking of giving it a name, the Eurozone Two-Step.

Ever since the eurozone crisis first rocked international markets nearly five years ago, European Central Bank chiefs – first Jean-Claude Trichet, then Mario Draghi – sent a very clear message to the currency union’s political leaders: we can only act if you act first.

The deal was never explicit, but both sides knew what was required. The ECB’s first sovereign bond purchase programme in May 2010 came only after eurozone leaders created a new €440bn bailout fund; its €1tn in cheap loans to eurozone banks in early 2012 only came after political leaders agreed to a new “fiscal compact” of tough budget rules.
Now one partner of the eurozone two-step, the eurozone governments, are stalling reform initiatives:
Back in October at a eurozone summit, Draghi was able to get a little-noticed statement out of the assembled leaders committing them to another “Four Presidents Report”, a reference to the blueprint delivered in 2012 that set a path towards further centralisation of eurozone economic policy. The report helped kick-start the EU’s just-completed “banking union.”

Progress on that 2012 blueprint has since stalled, however, and at his last summit press conference, then-European Council president Herman Van Rompuy said the new “Four Presidents Report” would be delivered at the December EU summit, which starts next Thursday. Many in Brussels saw this as the quid for Draghi’s quo – once the leaders agreed to another blueprint for eurozone integration, Draghi would have a free hand to launch QE.

But according to a leaked draft of the communiqué for next week’s summit, Draghi may have to deliver his quo without a eurozone quid. The text (which we’ve posted here) makes clear that leaders have no intention of delivering a new blueprint any time soon.
Bottom llne:
This means Draghi won’t have the normal political cover he needs to make a bold decision early next year – a problem only compounded by the European Commission’s decision last month to put off the day of reckoning for France and Italy over whether they will face sanctions for failing to live up to the EU’s crisis-era budget rules.
This kind of uncertainty will undoubtedly spook markets. But make no mistake, regardless of what the Greeks, Draghi, Weidmann, Merkel et al say, the major players are all wedded to the idea of a united Europe (see A history lesson, why Europe should try to be more Canadian and Lest we forget, or why you don't understand Europe). Even the leftist Syriza party in Greece has stated that they would like to remain in the euro.

Just remember this. Mom and Dad fight and the kids hear everything, but the parents remain committed to each other and they will find a way past the crisis. In the short-term, however, the combination of sputtering European growth, uncertainty over ECB policy and political turmoil in Greece will likely spark more market volatility in 2015.

British political instability
While most Europeans on the Continent are committed to a united Europe, the British do not have the belief system and the greatest political threat to the EU originates from the other side of the English Channel. One of the tail-risks that I have not seen on the market radar screen is the threat political instability in Britain. Jeremy Warner of The Telegraph warned about this risk in light of the election to be held on May 7, 2015:
Yet perhaps the biggest cloud on the immediate horizon is the one implied by Mr Cameron’s warning – that of political instability. Nowhere is this more apparent than in Britain itself. Whatever your views on Britain’s Coalition government, it has, against most predictions, proved a remarkably stable political construct, which – given manifest challenges – has also achieved a commendable degree of economic stability.

This is unlikely to be the case after the general election on May 7. Political leaders in the UK do occasionally manage to shift the dial in the last few months of campaigning, John Major in 1992 being the most recent example.

But it’s a rarity, and in any case, the old bi-polar rules of politics no longer apply. Unless something dramatic happens to change things, we can be pretty sure that the polls as they stand are roughly where they will finish.

This would give rise to two possible governments, neither of which would be at all appetising or would last for very long – a Conservative-led minority government with support from Ukip and Irish Unionists, or some kind of cobbled-together Left-wing coalition of Labour, SNP, Lib Dem and Greens.
Anatole Kaletsky sounded a similar warning about fringe parties dominating UK politics in the post-electoral landscape. The choices for Britain would be unpalatable and the markets would not like that outcome at all (emphasis added):
Britain could become literally ungovernable after the election, with no single party or coalition of parties able to form a majority government. Current public opinion polls predict that neither the Conservatives nor the Labour Party will win enough seats to form a majority government — even in a coalition with Liberal Democrats.

Conservative-Liberal and Labour-Liberal majorities may both prove arithmetically impossible because of the rise of previously insignificant fringe parties. The Scottish Nationalists look able to boost their six seats in Parliament to anything between 20 and 50, largely at Labour’s expense. The United Kingdom Independence Party is threatening dozens of Conservative incumbents. Meanwhile, the Liberals are almost certain to lose about half their 56-seat representation. As a result, a ruling coalition may have to include not just two parties but three or four, including fringe nationalist groups.

The Scottish National Party is sure to demand another Scottish independence referendum as its price for supporting a coalition, while the UK Independent Party will likely insist on Britain’s withdrawal from the European Union. It is hard to imagine either Labour or Conservatives agreeing to such terms.

This means that a government may have to be formed without a majority in Parliament. While minority governments are quite common in continental Europe, the British Parliament has only once failed to produce a government majority — during a brief interlude in 1974 under Harold Wilson. It created seismic upheavals in Britain’s adversarial politics.
Political chaos would ensue:
A multiparty coalition or minority government, even if it can be patched together in post-election haggling, will probably collapse within a year or two. Whether the next prime minister turns out to be Cameron or Labour’s Ed Miliband, he will be seen as a short-term caretaker, passing only non-controversial measures.

At some point in 2016 or 2017 at the latest, the opposition parties are almost certain to unite in a vote of no confidence on some major issue — bringing down the government. This would force a new election in spite of the theoretical requirement that Parliament should serve a fixed five-year term.

The near-certainty that whatever government emerges in May will fall within a year or so, raises the third and most troubling business issue. A snap election in 2016 or 2017 is most likely to produce an overtly euro-sceptic government, committed to taking Britain out of the European Union.
At worst, the specter of a Brexit vote would loom over Europe. At best, Westminster politics would become Italian. The markets wouldn`t like that kind of political roller-coaster ride at all.

Geopolitical instability from low oil prices
While the first three risks that I outlined are relatively high probability events whose outcomes are uncertain, there is one major geopolitical macro tail-risk that I am watching carefully. The intent of the Saudi decision to maintain production is said to try and squeeze relatively high-cost US tight oil and gas production, but it may have the unintended consequence of missing its target and destabilizing OPEC and other EM governments, according to Ambrose Evans-Pritchard:
In the meantime, oil below $70 is already playing havoc with budgets across the global petro-nexus. The fiscal break-even cost is $161 for Venezuela, $160 for Yemen, $132 for Algeria, $131 for Iran, $126 for Nigeria, and $125 for Bahrain, $111 for Iraq, and $105 for Russia, and even $98 for Saudi Arabia itself, according to Citigroup.
What happens if the regime change occurs and the west has to put boots on the ground in Nigeria, Libya or Algeria? Are those kinds of scenarios in the market?
Opec may not be worried about countries such as Nigeria, but even there a full-blown economic and political crisis could turn the north into a Jihadi stronghold under Boko Haram.

The growing Jihadi movements in the Maghreb – combining with events in Syria and Iraq – clearly pose a first-order security threat to the Saudi regime itself.

The Libyan city of Derna is already in the hands of the Salafist group Ansar al-Shariah and has pledged allegiance to Islamic State. Terrorist movements in the Egyptian Sinai have also rallied to the black and white flag of IS, prompting Egypt’s leader Abdel al-Sisi to call last week for a “general mobilisation” of all leading Arab and Western powers to defeat the spreading movement.

The new worry is Algeria as the Bouteflika regime goes into its final agonies. “They have an entrenched terrorist problem as we saw in the seizure of the Amenas gas refinery last year. These people are aligning themselves with Islamic State as part of the franchise,” said Mr Newton.

Algeria exports 1.5m bpd of petroleum products. Its gas exports matter more but the price of liquefied natural gas shipped to Europe is indirectly linked to oil over time.
The one key tail-risk that I have not heard discussed is Mexico, which shares a border with the United States? Already, the Mexican Peso has plunged to levels that challenge Lehman Crisis lows:

Notwithstanding what has happened in the energy market, political instability is rising in Mexico with protests that some analysts have compared to an Arab Spring (via Business Insider):
Mexico's biggest protests in years began two months ago in response to the Sept. 26 attack on students by corrupt police and drug cartel gunmen. Demands have widened to include the resignation of President Enrique Peña Nieto. Protesters also rage against pervasive corruption, violence and disappearances suffered during years of narco bloodshed. The movement has even led to solidarity rallies in the US.

Political analysts are trying to figure out what the movement represents and where it could lead.

Some are comparing it with “Occupy” in the US and the “Indignados” (the outraged) in Spain: Fed-up Mexicans are spreading their messages using social media and have few visible leaders.
John Ackerman of the Institute for Legal Research of the National Autonomous University of Mexico warned:
If the situation continues along the present course, Mexico may soon follow the path of Peru during the auto-coup of Alberto Fujimori in 1992 — all while the Obama administration looks on. Unless the citizens of the United States rise up in support for and solidarity with their Mexican neighbors, the country could fall prey to a new U.S.-backed dirty war against students and activists similar to the repression during the 1970s and 1980s, which took hundreds of thousands of lives in Guatemala, El Salvador, Nicaragua and Honduras. There is still time to act before North America today becomes a copy of Central America 30 to 40 years ago.

Choppiness, but no bear market
I don't want to be a doomster or fear-monger. While I have laid out a number of dire scenarios, you should not necessarily interpret them as bull market killers. The US economy remains in the mid-cycle phase of an expansion and such a scenario should be equity positive. The key question to ask of any risk is, ”How will this event affect the outlook for earnings, interest rates or global financial system stability?” If the answer is, ”Not very much”, then the likely outcome is some sort of corrective action in a stock market bull trend.

Even if the Fed were to miscalculate and raise interest rates either prematurely or too quickly, history tells us that the initial stock market reaction has been relatively positive (via A wealth of common sense):

In short, my inner investor remains cautiously bullish on equities for 2015, though with higher levels of volatility. Choppiness and gut-wrenching corrections, yes, but don't expect a bear market to start.

Inner trader: Too late to sell
Finally, I have a brief trading comment. My inner trader was caught off-guard by the swiftness of the the sell-off. The Trend Model had flashed an unconfirmed trading sell signal on Tuesday and I usually wait a couple of days before acting on trend following signals as they have a habit of reversing themselves. But the short-term trading model was signaling oversold conditions consistent with a market bottom at the close Tuesday (see Why today (Dec 9) was like the October bottom) and Thursday (see Here for a good time, not a long time).

As the closing bell rang on Friday, my most consistent bottom-calling models were flashing buy signals. As seen in the chart below, the combination of an inversion of the VIX term structure and TRIN greater than 2 forms a powerful buy signal that was 100% in the last two years. In addition, the VIX Index had closed above 20, which is a level that is consistent with trading bottoms.

In retrospect, my inner trader wished that he could have caught the downdraft, but by the time he received confirmation of the downtrend, it was too late to sell and it was time to buy. Nevertheless, there remains a high level of event risk next week, with the FOMC meeting and Greek election on Wednesday (see the discussion at Here for a good time, not a long time).

My inner trader therefore remains modestly long equities at this point and nervously hoping for a rally in the early part of the week.

Disclosure: Long SPXL

Thursday, December 11, 2014

Here for a good time, but not a long time...

OK, I was a day early in my bottom call (see Why today (Dec 9) was like the October bottom), but my short-term trading models continue to indicate that we are seeing a short-term bottom in the SPX.

Option market flashes buy signals
First, option traders are getting frightened, which is contrarian bullish. The ISEE equity-only call-put ratio were very low all day, on Thursday December 11. Readings under 100% often indicate a crowded short.

As well, Bill Luby, who blogs at VIX and More, observed in a tweet that the VIX term structure had briefly inverted just before the market close. VIX term structure inversion is an indication of extreme fear in the market.

Inside Day reversal signal
From a technical standpoint, the SPX chart below also flashed a couple of tactically bullish signals. First, the 5-day RSI, which is useful for swing trading short-term moves, moved off an oversold level of below 30. Such events are often signal upside for the index.

In addition, the SPX also experienced an "inside day" today (Thursday, December 11, 2014) after hitting the lower Bollinger Band yesterday. An "inside day" occurs as when the daily range of a stock or index is inside the previous day's daily high-low range. According to Jamie Saettele at Investopedia, the appearance of an inside day while the price touches either the upper or lower Bollinger Band can be an indication of reversal. The Bollinger Band defines the overbought or oversold reading, while the inside day signals indecision or trend exhaustion (emphasis added):
Prices at the upper Bollinger Band® are considered high and prices at the lower Bollinger Band® are considered low. However, just because prices have hit the upper Bollinger does not necessarily mean that it is a good time to sell. Strong trends will 'ride' these bands and wipe out any trader attempting to buy the 'low' prices in a downtrend or sell the 'high' prices in an uptrend. Therefore, just buying at the lower band and selling at the upper band is out of the question. By definition, price makes new highs in an uptrend and new lows in a downtrend, which means that they will naturally be hitting the bands. With this information in mind, our filter will require that buy signals occur only if the candle following the one that hits the Bollinger Band® does not make a new high or low. This type of candle is commonly known as an inside day. The best time frames to look for the inside days are daily charts, but this strategy can also be used on hourly, weekly and monthly charts. Combining inside days with Bollinger Bands® increases the likelihood that we are only picking a top or bottom after prices have hit extreme levels. As a rule of thumb, the longer the time frame, the rarer the trade will be, but the signal will also be more significant. (For more insight, see Using Bollinger Band® "Bands" to Gauge Trends and Capture Profits With Bands And Channels.)

Candlesticks and their respective patterns illustrate the psychology of the market at a particular point in time. Specifically, the inside candle represents a period of contracted volatility. If, in an uptrend, volatility begins to slow and the market fails to make a new high (as illustrated by the inside candle), then we can deduce that strength is waning and that the chance for a reversal exists. When combined with a Bollinger Band®, we ensure that we are trading a reversal only by either selling high prices (higher Bollinger Band®) or buying low prices (lower Bollinger Band®). In this way, we trade for the big move; not necessarily selling the low tick or buying the bottom tick but definitely buying near the relative bottom and selling near the relative top. The key is confirmation.

Event risk next week
Should the stock market rally as I expect, I would nevertheless be wary of volatility stemming from major event risk next week. First, there is the Greek presidential election on December 17. Already, Greek bond yields and stock market are plunging over the political uncertainty.

As well, the FOMC is meeting December 16-17. There is a strong possibility that we may not only see the removal of the "considerable time" language from the statement. Not only that, we may see a far more hawkish tone from the Fed as the most recent speech from NY Fed Governor and Yellen circle insider William Dudley stated that a mid-2015 liftoff in interest rates is more or less baked-in:
Market expectations that lift-off will occur around mid-2015 seem reasonable to me. Although that could change depending on how the economy evolves, my views on “when” do not differ appreciably from the most recent primary dealer and buy-side surveys undertaken by the New York Fed prior to the October FOMC meeting.
Not only that, he warned the market against the expectation of a Yellen Put:
Let me be clear, there is no Fed equity market put. To put it another way, we do not care about the level of equity prices, or bond yields or credit spreads per se. Instead, we focus on how financial market conditions influence the transmission of monetary policy to the real economy. At times, a large decline in equity prices will not be problematic for achieving our goals. For example, economic conditions may warrant a tightening of financial market conditions. If this happens mainly via the channel of equity price weakness—that is not a problem, as it does not conflict with our objectives. In contrast, when we want financial market conditions to be extremely accommodative—as has been the case in recent years when we have been far away from our employment and inflation objectives—then we will take into consideration a broad set of developments with respect to interest rates, the stock market and other measures of financial conditions in choosing the appropriate stance for monetary policy.
Just be warned that traders who go long here should be here for a good time, but not a long time. On December 17, all bets are off.

Tuesday, December 9, 2014

Why today (Dec 9) was like the October bottom

When I woke up this morning, I saw that stock index futures were deeply in the red. The headline explanation was the Chinese authorities had taken steps to cool off stock market speculation. Later, I saw that there were jitters over a the unexpected Greek Presidential election call.

Whatever the cause for the weakness, US stock indices gapped down at the open, but started to recover at around noon after the European close. By the end of the day, the SPX managed to recover all of its losses and close the day flat and the NASDAQ Composite and the small cap Russell 2000 were actually positive on the day.

As the chart below of the SPX shows, the market displayed a classic pattern of a reversal bottom. There were also a number of quirky signs that today marked a bottom of any temporary stock market weakness. First and foremost, the 5-day RSI (top panel) moved from an overbought reading of over 70 on November 28 to under 30 on an intra-day basis, which indicates an oversold reading. Such conditions are often indicative of either short-term bottoms or minimal market downside.

The Josh Brown "Santa Claus" indicator
I have also noticed that Josh Brown has a habit of making irreverent remarks at market extremes. He tweeted a flippant comment about a Santa Claus rally on October 15, 2014, the day of the October bottom and market reversal. Today, he tweeted a similar remark:

The Marketwatch "Mark Cook" indicator
Coincidentally, Marketwatch featured a column by Mark Cook warning about a 10% correction today:
The key short-term stock market indicator that I have used for many years is exceptionally rare, but once triggered is deadly for the bulls. The last time it triggered, the S&P 500 SPX, -0.02% shed 180 points — and the configuration now is almost identical to then.

Accordingly, I expect a 10% decline in the S+P 500 before Jan 30 if the S&P 500 dips below 2049 this week.
On Sunday, August 3, 2014, Marketwatch also had an article about Mark Cook warning about a 20% decline in stock prices. Cook based his conclusion based on his proprietary Tick indicator:
“The Tick readings I am seeing (-1100 and -1200) is like an accelerator on the floor that is pressed for an indefinite amount of time,” Cook says. “Eventually the motor will run out of gas. Now, anything that comes out of left field will create a strain on the market.” Since the CCT is a leading indicator, prices have to catch up with the negative Tick readings.

“Think of a dam that has small cracks that are imperceptible to the eye,” he says. “Finally, the dam gives way. Eventually, prices will go south, and the Tick numbers will be horrific.”
To be fair to Cook, he did warn that the market may not go down right away and there could be significant lags from this signal:
Unfortunately, Cook can’t say when this vulnerable market will crack. “The CCT is similar to the new-high, new-low indicator,” he explains. “As the market goes higher, fewer stocks make new highs. Some people might say it’s ‘different this time,’ but it’s never is. Could the market go higher? Yes, it could, but the extension of time will create an even greater divergence that has to be snapped back together.”

How did the 20% decline forecast work out? The stock market fell slightly after the publication of that warning in August but bottomed out that week (see SPX chart above). 

While this is not meant to be an indictment of Mark Cook and his technical analysis abilities, it is more of an indictment of Marketwatch editors, who chose to feature bearish headlines just as the selling frenzy hit its peak. 

Sometimes it can be rewarding to monitor these quirky market indicators as measures of sentiment. Based on my assessment of the market technicals today, I would venture a guess that the near-term downside for stock prices is limited.

Monday, December 8, 2014

Cautious retail investors = More room to rally

There have been a number of cautionary signs from sentiment models lately. On the weekend, Barron's featured an interview with Neil Leeson of Ned Davis Research:
Leeson on Friday pointed to his firm’s crowd sentiment poll, which recently clocked in at “extremely optimistic” levels. Chart watchers often consider sentiment to function as a contrary indicator, one that can presage overly enthusiastic markets that are ripe to turn lower.

“This typically is not a great sign for the market going forward, at least in the near term,” Leeson said...

More specifically, Leeson singles out massive money flows into large-cap stock ETFs like the SPDR S+P 500 ETF (SPY) and the SPDR Dow Jones Industrial Average ETF (DIA) as a red flag. In November, all large-cap stock ETFs took in $25 billion, the most ever.
Yesterday, I also highlighted a possible crowded long position from Rydex sentiment data (see My trading plan for December):

On the other hand, the latest release of the TD-Ameritrade Investor Movement Index (IMX), which tracks the equity commitment of TD-Ameritrade accounts, showed that retail investors retreated from their bullishness:

I differentiate the contradictory readings this way, on the basis of different investor constituents and time horizons:

  • Fast HF money: Money flows into ETFs like SPY and DIA reflect the commitment of hedge fund fast-money first and retail funds flow second;
  • Fast retail money: Rydex sentiment measures how the individual swing trading community is behaving; and
  • Patient retail money: TD Ameritrade IMX is more reflective of the behavior of the slower, patient individual investor.
I interpret these readings as the stock market looking a bit overbought in the short-term and may be in need of a pause, but, as the mom-and-pop retail investor isn`t all-in yet, stock prices have more room to rally on an intermediate term basis.

Sunday, December 7, 2014

My trading plan for December

Trend Model signal summary
Trend Model signal: Risk-on
Trading model: Bullish

The Trend Model is an asset allocation model used by my inner investor. The trading component of the Trend Model keys on changes in direction in the Trend Model - and it is used by my inner trader. The actual historical (not back-tested) buy and sell signals of the trading component of the Trend Model are shown in the chart below:

Update schedule: I generally update Trend Model readings on my blog on weekends and tweet any changes during the week at @humblestudent. In addition, I have been trading an account based on the signals of the Trend Model. The last report card of that account can be found here.

My inner trader takes the stage
As the year draws to a close, I thought that I would do something a little different and allow my inner trader to outline his trading plan for December. Next week, my inner investor will have his chance to address his views for 2015.

You may recall that last week (see Trust (the bull), but verify (the trend)), even though the trend remained bullish, I had "called an audible" and gone to cash because I was unsure of the market reaction to the drop in oil prices. The OPEC decision had occurred over the US Thanksgiving and, while the US markets were open Friday, many major market participants had gone away and volume was light. By Wednesday, I was sure enough about the trend that I dipped my toe back on the long side:

As my inner trader surveys the landscape, he continues to see a global uptrend in equities. The Chinese stock market has gone parabolic.

Even though that kind of advance is unlikely to be sustainable at the current pace (see tweet below from Tom Orlik), the other Greater China markets, namely Hong Kong, South Korea and Taiwan, are also in solid uptrends.

The picture also looks bullish in Europe. Despite Mario Draghi's heming and hawing last week about whether the ECB is ready to proceed with QE, European markets have been rising and the STOXX 600 is now testing an important resistance level. The advance is supported by confirmation from the 14-day RSI. The German DAX (not shown) staged an upside breakout from resistance last week, which is another positive sign for European stocks.

In the US, the SPX tested an intra-day all-time-high on Friday and pulled back from resistance. Unlike the STOXX 600, this index is seeing a negative divergence from RSI-14. Longer term, however, the advance appears to be healthy in the context of a continued uptrend and a recovery from a V-shaped bottom.

Despite the negative divergence seen in the SPX, I would not be too quick to get overly bearish. The Dow broke out to an all-time-high on Friday with confirmation from its RSI-14.

Reasons to be cautious
On a more cautionary note, the chart below shows the Rydex Bear-Bull asset ratio (middle panel), as well as the Bear-Bull flow ratio (bottom panel). Both ratios are important indicators of investor sentiment. The asset ratio is a barometer of how much bullish and bearish investors have committed to their directional bets, but it could be misleading if viewed in isolation. Imagine that investors committed $X to the bull side and $Y to the bear side; there were no cash flows and the stock market went up by 10% during this period. The bear-bull asset ratio would fall to reflect the increase in stock prices but an observer might see misinterpret this as contrarian bearish because it had fallen 20% (+10% for bulls and -10% for bears). That`s why it`s important to view this in the context of the bear-bull cash flow ratio as well.

In the chart, I marked with vertical lines instances the dual conditions where 1) the asset ratio has reached a new low and 2) the flow ratio has also reached a low, indicating possible excessive bullish sentiment among Rydex investors. I further color coded the lines where the blue lines indicate that the stock market continued to advance and the red lines indicated future declines.

As the chart shows, we got a signal recently where both the asset and flow ratio reached a crowded long extreme. However, the track record of this indicator shows that it is not perfect and it can have relatively long lags before a decline can begin - this seems to be a characteristic of many sentiment indicators.

A hawkish Fed?
Another reason for caution is the possibility of some market turbulence ahead from the FOMC meeting due on December 17. Notwithstanding the blowout surprise from the November Jobs Report, that report made the trend very clear - the economy continues to recover in a manner consistent with Fed expectations.

Unless we see significant signs of economic weakness in the months to come, the Fed should start to raise rates in June. In a recent speech, New York Fed Governor William Dudley confirmed that timing:
Market expectations that lift-off will occur around mid-2015 seem reasonable to me. Although that could change depending on how the economy evolves, my views on “when” do not differ appreciably from the most recent primary dealer and buy-side surveys undertaken by the New York Fed prior to the October FOMC meeting.
As to what happens next, Dudley had an answer to that (emphasis added):
With respect to “how fast” the normalization process will proceed, that depends on two factors—how the economy evolves, and how financial market conditions respond to movements in the federal funds rate target. Financial market conditions mainly include, but are not necessarily limited to, the level of short- and long-term interest rates, credit spreads and availability, equity prices and the foreign exchange value of the dollar. When the FOMC adjusts its short-term federal funds rate target, this does not directly influence the economy since little economic activity is linked to the federal funds rate. Instead, monetary policy affects the economy as the current change in short-term interest rates and expectations about future monetary policy changes influence financial market conditions more broadly.
In other words, they want to watch how stock and bond markets react:
First, when lift-off occurs, the pace of monetary policy normalization will depend, in part, on how financial market conditions react to the initial and subsequent tightening moves. If the reaction is relatively large—think of the response of financial market conditions during the so-called “taper tantrum” during the spring and summer of 2013—then this would likely prompt a slower and more cautious approach. In contrast, if the reaction were relatively small or even in the wrong direction, with financial market conditions easing—think of the response of long-term bond yields and the equity market as the asset purchase program was gradually phased out over the past year—then this would imply a more aggressive approach. The key point is this: We will pursue the monetary policy stance that best generates the set of financial market conditions most consistent with achievement of the FOMC’s dual mandate objectives. This depends both on how financial market conditions respond to the Fed’s policy actions and on how the real economy responds to the changes in financial conditions.
In my opinion, the Fed would not be fazed by the market reaction to November Jobs Report. Bond yields rose in anticipation of Fed tightness, while stock prices were up modestly in response to better growth outlook. In addition, Dudley warned that the markets should not expect a stock market put from the Fed:
Let me be clear, there is no Fed equity market put. To put it another way, we do not care about the level of equity prices, or bond yields or credit spreads per se. Instead, we focus on how financial market conditions influence the transmission of monetary policy to the real economy. At times, a large decline in equity prices will not be problematic for achieving our goals. For example, economic conditions may warrant a tightening of financial market conditions. If this happens mainly via the channel of equity price weakness—that is not a problem, as it does not conflict with our objectives. In contrast, when we want financial market conditions to be extremely accommodative—as has been the case in recent years when we have been far away from our employment and inflation objectives—then we will take into consideration a broad set of developments with respect to interest rates, the stock market and other measures of financial conditions in choosing the appropriate stance for monetary policy.
Dudley, along with vice-chair Stanley Fischer and chair Janet Yellen, represent the inner circle of Federal Reserve decision making. This was an extraordinarily hawkish speech by a member of that group. At the very least, expect the "considerable time" phrase to be replaced by a statement that the market consider to be hawkish in tone and therefore stock market bearish. I would expect that stock market bulls may not find the December FOMC statement too friendly.

Weakish early December, strong late 
My inner trader interprets current market conditions as a possible pause in a market uptrend. The global uptrend in equities cannot be ignored and he is giving the bull case the benefit of the doubt. On the other hand, the combination of negative divergences and sentiment models do indicate that caution may be warranted. As well, traders should also remember that investors often engage in tax loss selling this time of year.

My base case scenario therefore calls for either a slow grind up in stock prices or a sideways consolidation for the first half of December, with a seasonal rally to begin in the latter half of the month. Charlie Bilello at Pension Partners created a chart that described this pattern well and it seems to be a reasonable roadmap to use.

Tactically, current conditions suggest approaching the market as a market of stocks, rather than a monolithic stock market. It suggests either remaining modestly long, or using a long-short strategy of emphasizing market leaders, which reflect the optimism of a growing economy, on the long side while either avoiding or shorting laggards, which could be vulnerable to tax-loss selling.

The chart below shows the relative performance of a number of market leaders relative to the SPX. The top panel shows the Healthcare sector and its component industries, which have all outperformed the market for much of the year, and the semiconductor stocks on the bottom panel.

Speaking of semiconductors, I would also like to mention the post from Andrew Thrasher who believes that semiconductors has replaced Dr. Copper as a leading barometer of the global economy. In that context, the emergence of semiconductor stocks as a leadership group should be regarded as intermediate term bullish.

As for the laggards, small cap stocks have been roughly flat for the entire year and underperformed the SPX more or less all year. This pattern is suggestive of continued small cap underperformance for the next couple of weeks, followed by a typical seasonal small stock rally into January.

Resource stocks are also the most likely candidates for tax-loss selling in December. The top panel of the chart below shows the absolute performance of the Energy sector as well as the Metals and Mining stocks. The bottom panel shows the relative performance of the oil service and exploration and production groups relative to the already disappointing Energy sector. The Energy sector averages are dominated by the integrated oils like ExxonMobil and Chevron, whose profitability are cushioned by their downstream refining and marketing operations. The oil service and exploration and production companies have no such protection. They are more vulnerable to oil price weakness and therefore further weakness from tax loss selling.

As the year draws to an end, I would expect that these weak sectors and groups, such as small caps, energy and mining stocks, to weaken and then stage a snapback rally in the last week of the year. My inner trader is watching market conditions and preparing for such a possibility. In the meantime, he is nervously long with relatively tight stops.

Next week, I will discuss how my inner investor views the challenges and opportunities for equities in 2015.

Disclosure: Long SPXL, BIB

Friday, December 5, 2014

Is the put/call ratio be a contrarian indicator?

In these pages, I have analyzed both quantitative and technical analysis models in the past. The most recent was an analysis of the Hindenburg Omen (see The hidden message of the Hindenburg Omen). I have also said that I demand two things from a model, or indicator (see Why I am not (just) a technician):
There are two things that a model should do, at a minimum. First, it must have sound theory behind it (book smart). Second, it has to make money (street smart).
It is with those two basic requirements in mind that I turn my sights to the put/call ratio.

A contrarian indicator?
On Friday, the CBOE equity-only put/call ratio closed at a recent low. Consider the following chart of that ratio. Would you interpret the low reading as bullish or bearish?

Viewed in isolation, most technical analysts tend to view the Friday reading bearishly. Casey Murphy at Investopedia writes:
The put-call ratio is primarily used by traders as a contrarian indicator when the values reach relatively extreme levels. This means that many traders will consider a large ratio a sign of a buying opportunity because they believe that the market holds an unjustly bearish outlook and that it will soon adjust, when those with short positions start looking for places to cover. There is no magic number that indicates that the market has created a bottom or a top, but generally traders will anticipate this by looking for spikes in the ratio or for when the ratio reaches levels that are outside of the normal trading range.

Sell signal from the 21 dma
At the same time, I have been seeing comments like this all week. The 21 day moving average of the equity-only put/call ratio has been reached a low and starting to rise - it`s a sell signal, (I am not singling out Mr. Prybal, but his commentary is one example out of several that I`ve encountered.)

So let me get this straight. When the put/call ratio is low, it indicates excessive bullishness and is therefore contrarian bearish. When the 21 dma of the same ratio is low and starting to rise, which indicates receding levels of trader bullishness, the condition is also bearish.


Did the 21 dma signal work?
On that basis, this use of the put/call ratio does not pass the first test of my criteria. It does not have a sound theory behind it. As well, the 21 dma equity-only put/call ratio has shown limited value as a timing signal. Consider this chart of the ratio with the SPX for the last three years.

I have defined the "sell signals" as occasions when the ratio has fallen to a local low and started to rise again. Each signal is marked with a vertical line. I have further color coded the lines, where green=the market continued to rise, red=market fell and black=market was flat. A glance at the chart shows slightly more red lines than green lines, but barely. Even if we were to regard this ratio as a black-box indicator, without regard to understanding the theory behind how the signal was generated, its record can only be described as weak.

Last week, the equity-only put/call ratio has reached a low and began to rise again. How should the latest signal be interpreted? How much trust should you put in an indicator that has little theoretical backing and has shown a spotty track record?

A put/call cycle?
From a technical viewpoint, the ebb and flow of the put/call ratio might better be described using cycle analysis. The chart below shows some quick and dirty cycle analysis by overlaying a 61-day cycle on the put/call ratio. The blue vertical lines correspond to highs in the ratio while the red vertical lines correspond to the lows of the ratio. An examination of the chart shows that if we were to regard the blue lines as buy signals and the red lines as sell signals, the record looks reasonable. On the other hand, using the red line as a short signal and the blue line as a cover signal seems to be effective.

In conclusion, I would not suggest using the 21 dma of the equity-only put/call ratio as a timing tool, largely because it runs counter to the contarian underpinnings of the use of put/call ratio. However, technical analysts may use this exercise to conduct further research in whether the rise and fall of the 21 dma of this ratio is subject to a cycle that might prove to be profitable.

Thursday, December 4, 2014

The hidden message of the Hindenburg Omen

There it is again. The "dreaded" Hindenburg Omen reared its "ugly" head again (chart via Tomi Kilgore at Marketwatch):

The Hindenburg Omen has cried wolf so many times that it has become a subject of derision. The best reaction that I have seen so far comes from Urban Carmel:

Does this latest occurrence of the Omen indicate the ending of the story where that the wolf is comes, while the villagers stay home? To answer that question, let's examine the elements of the Hindenburg Omen (via Wikipedia):
These criteria are calculated daily using Wall Street Journal figures from the New York Stock Exchange for consistency. (Other news sources and exchanges may be used as well.) Some have been recalibrated by Jim Miekka to reduce statistical noise and make the indicator a more reliable predictor of a future decline.
  1. The daily number of NYSE new 52 week highs and the daily number of new 52 week lows are both greater than or equal to 2.8 percent (this is typically about 84 stocks) of the sum of NYSE issues that advance or decline that day (typically, around 3000). An older version of the indicator used a threshold of 2.5 percent of total issues traded (approximately 80 of 3200 in today's market).
  2. The NYSE index is greater in value than it was 50 trading days ago. Originally, this was expressed as a rising 10 week moving average, but the new rule is more relevant to the daily data used to look at new highs and lows.
  3. The McClellan Oscillator is negative on the same day.
  4. The number of New 52 week highs cannot be more than twice the number of new 52 week lows (though new 52 week lows may be more than double new highs).
The traditional definition requires each condition to occur on the same day. Once the signal has occurred, it is valid for 30 days, and any additional signals given during the 30-day period should be ignored, or one signal does not mean very much, but more than one is a confirmed signal, or five or six are even more important. During the 30 days, the signal is activated whenever the McClellan Oscillator is negative, but deactivated whenever it is positive.

The hidden message of the Omen
The Hindenburg Omen indicator has a lot of moving parts and it is therefore confusing. I believe that the most important message in the Hindenburg Omen is the expansion of both new highs and low, indicating divergence among stocks and points to market indecision.

A recent post by Brett Steenbarger puts the new high and low expansion in a slightly different context (my interpretation, not his) in a way that did not refer to the Omen (emphasis added):
Truly outstanding has been the plunge in my measure of correlation among stocks, which looks across both capitalization levels and sectors. Indeed, this is the lowest correlation level I have seen since tracking the measure since 2004. Correlation tends to rise during market declines and then remains relatively high during bounces from market lows. As cycles crest, we see weak sectors peel off while stronger ones continue to fresh highs. As those divergences evolve, correlations dip. Right now we're seeing massive divergences, thanks to relative weakness among raw materials shares (XLB), energy stocks (XLE), regional banks (KRE), and small (IJR) and midcap (MDY) stocks. Why is this important? Going back to 2004, a simple median split of 20-day correlations finds that, after low correlation periods, the average next 20-day change in SPX has been -.33%. After high correlation periods, the average next 20-day change in SPX has been +1.43%.
Does this mean that the stock market is going to crash?

No. First and foremost, I would point out that the first appearance of the Omen is only a warning. It needs to be confirmed by a second appearance within 30 days to be a valid bearish signal. That hasn`t happened yet.

However, Steenbarger's analysis does show that this latest episode should be regarded as a potentially bearish market factor to keep an eye on. The divergence between the major averages and the resource sector can largely be explained away by the precipitous fall in oil prices. Whether you believe that is an exception to the correlation divergence bear case is up to you.

Tuesday, December 2, 2014

Trend Model report card: +3.0% (Nov), +38.1% (1 year)

This is the latest performance update on my long-short account based on my Trend Model signals (see An intriguing Trend Model interim report card). The Trend Model account had another solid month as it returned 3.0% for November; the one-year return was 38.1%; and the return from inception of September 30, 2013 was 38.5%.

I reiterate my disclaimer that I have nothing to sell anyone right now. I am not currently in a position to manage anyone`s money based on the investment strategy that I am describing.

Trend Model description
For readers who are unfamiliar with my Trend Model, it is a market timing, or asset allocation, model which uses trend following techniques as applied to commodity and global stock market prices to generates a composite Risk-On/Risk-Off signal (risk-on, risk-off or neutral). I have begun updating readers on the Trend Model signals on a weekly basis (for the last weekly comment, see Trust (the bull), but verify (the trend)) and via Twitter (@humblestudent) as new developments occur.

The chart below shows the actual (not back-tested) changes in the direction of the signal, which are indicated by the arrows, overlaid on top of a chart of the SP 500. You can think of the blue up arrows, which occurred when the trend signal changed from negative to positive, as buy signals and the red down arrows, which occurred when the trend signal changed from positive to negative, as sell signals.

Trend Model Signal History

A proof of concept
While the results from the above chart representing paper trading is always interesting, there is no substitute for actual performance. As a proof of concept, I started to manage a small account that traded long, inverse and leveraged ETFs on the major US market averages and, on occasion, sector and industry ETFs. Trading decisions were based on Trend Model signals combined with some short-term sentiment indicators. The inception date of the account was September 30, 2013 and the chart below represents an interim report card of that account.

When evaluating the performance of this trading account, keep in mind that this is intended to be an absolute return vehicle. While I do show the SPY total return, which includes re-invested dividends, for illustrative purposes, the SP 500 is not an appropriate benchmark for measuring the performance of this modeling technique.

A solid November
The account was up 3.0% in November, 30.7% YTD. 38.1% for one year and 38.5% from inception (September 2013). However, I would also like to point out that turnover averaged about 200% per month, so this strategy is not for everyone.

In line with the results for the second half of 2014, this strategy continue to be promising:
  • Returns are strong and the Trend Model is performing better than expected.
  • Returns are highly diversifying compared to major asset classes. They are uncorrelated with equities (correlation of -0.20 with SPY) and bonds (-0.29 with AGG).
I reiterate my points from last month's report card, when I wrote that this account and strategy has benefited from an extraordinarily friendly environment for trend-following models:
To be sure, the Trend Model has benefited from an extremely favorable environment as the stock market has more or less risen in a straight line with very few hiccups. Under more normal market conditions, where the market can be expected to regularly correct 10% or more and move in a more choppy manner, this strategy is unlikely to perform as well in sideways and volatile environments. That`s why I had hoped to see greater market volatility in order to stress test this model.
I am also sticking to my estimate of a sustainable return of 15-25% for this strategy, which is substantially lower than the 35-40% range observed recently:
Given the return pattern of the Trend Model trading account observed in the past 13 month of its young life, my best wild-eyed guess of a more reasonable long-term USD return expectation of this strategy might be in the 15-25% per year, instead of the astounding 35-40% experienced so far.
Results continue to be promising for this model. Readers who want to monitor the signals of the Trend Model to subscribe to my blog posts here, which include Trend Model updates, or follow me via Twitter @humblestudent.

Monday, December 1, 2014

Portrait of the advisor as a businessperson

Sometimes it's interesting to see the unexpected paths that blog posts take me. A recent post sparked some feedback and intelligent discussions with a number of investment professionals (see How to rebalance your portfolio (NAAIM maniac edition)). In that post, I referenced the chart below of the history of NAAIM (National Association of Active Investment Managers) equity exposure index and wondered out loud why investment professionals and fiduciaries could move their equity exposure around so wildly.

The answers turned out to be revealing. First, the NAAIM survey sample is relatively small. In addition, the NAAIM website states that there is only a limited number of responses to the survey, which creates data problems:
  1. 200% Leveraged Short
  2. 100% Fully Short
  3. 0% (100% Cash or Hedged to Market Neutral)
  4. 100% Fully Invested
  5. 200% Leveraged Long
They qualified their survey results with the following disclaimers:
Use of a single, composite number for each adviser may not accurately represent the market view of a manager who has short term and long term strategies that are providing conflicting signals or a manager who uses both contra-trend and trend following strategies for different portfolios.

Investment Styles very widely among managers participating in this survey. They may include managers that trade very frequently and can switch long and short positions daily. Other managers stay fully invested at all times and only change allocations among market segments or sectors. Still others trade around core positions and only a portion of their portfolios change, but that portion could potentially go from long to short very quickly.
Notwithstanding the data issues surrounding the survey, one key point that came up several times in my discussions was that investment advisors are struggling with redefining their business models. To put in more simply, investment advisors are struggling to formulate a new business model and present a better value proposition for their practices. The wild swings in the NAAIM survey is explained by 1) survey data methodological problems and 2) advisors trying to add value in a differentiated fashion.

The advisor as small businessperson
When I started in the business in the 1980`s, one advisor explained his practice to me this way, "I don`t work for XYZ, XYZ works for me." What he meant by that statement was that he uses his firm`s infrastructure to run his own small business, much like a franchisee at a restaurant chain.

Back in those days, it was much easier to get started as an advisor. Brokerage firms hired young graduates out of university, gave them a desk and the phone book and told them, "Go find some clients."

That business model worked reasonably well for a number of reasons. There were a fair number of potential clients as not everyone was in the market. Advisors could spend the time to build up books of business and make a reasonable living at their practice. Their pay depended on "the grid", which is a compensation system designed by the firm to encourage certain kinds of behavior and discourage others. For example, if a client paid $100 in trading commission, the advisor will likely get paid less than if he steered the client into a certain type of mutual fund that paid recurring fees, especially now that most firms are encouraging their sales force to move from a stock trading business model to an asset gathering AUM model where the fees are recurring. Advisor compensation for fixed income products, like tend be relatively lower. Often, the compensation for a GIC, regardless of size, will be a fixed dollar amount rather than one based on a percentage invested.

Fast forward 30 years and the landscape has changed completely. Today, the full-service advisor business model is threatened by discount brokers, which was virtually unheard of 30-40 years ago, online trading with all the tools that encourage DIY investors, the advent of low-cost ETFs, robo-advisors who threaten the advice business and so on. What's more, the market is now saturated. The twentysomething young advisor who comes out of school rarely succeeds in building a book in the same way his counterpart did 30+ years ago, largely because virtually everyone either has an advisor or is using one of the aforementioned solutions.

In speaking with professionals in the business, the most successful new advisors have been people starting their second careers and they can leverage their past contacts, e.g. as an accountant, into their new role as an investment advisor. Many have found success by focusing on the relationship development by offering a full financial advisory business. They are no longer just investment professionals, but offer tax advice, insurance services and so on.

Looking for the new business model
Today, the individual advisor is struggling with re-defining their business model. The transition to an AUM and fee-based model is a start, but it`s not a complete solution. To explain, advisors used to be mainly stock brokers who pushed individual stock ideas to their clients. That approach suffered from recurring bouts of feast-and-famine cyclicality during bull and bear markets. In bull markets, clients traded a lot and volumes were high, but volumes shrank in bear markets and therefore broker compensation fell precipitously as a result. The transition to an AUM fee-based model has moderated some of that cyclicality, but doesn`t entirely solve the problem.

It seems that a lot of advisors are, simply put, poor business managers. ThinkAdvisor pointed to a study showing how advisors spent little time managing their own practices:
A new study by the Financial Planning Association Research and Practice Institute found that business growth is a major challenge in today’s financial advisory businesses, with only 25% of advisors reporting that they exceeded their business growth goals in the past year.

During a visit to ThinkAdvisor’s office on Tuesday, Janet A. Stanzak, FPA president and soon-to-be chairwoman, called these study results “so ironic.”

“We are a profession of financial planners, and yet what our studies are revealing? This one says financial planners are not doing business plans and marketing plans well,” she said. “… It’s ironic as heck that here we are group of planners and where we in our own businesses fall down is in some of the planning aspects of what we do.”
They had no idea of how to grow their own businesses:
While the study found that “most advisors are struggling to grow their businesses in a way that is directly impacting their bottom line,” as Lauren Schadle, FPA executive director and CEO, said in a statement, it also found two overarching solutions that could help the advisors that are struggling.
Many lacked marketing plans business plans and clearly defined marketing tactics:
The study found that successful firms had a defined value proposition. Of those who exceeded their goals, 79% had a defined value proposition, compared with 57% of those who fell short of their goals.

A formal, written business plan also proved to be important to those who exceeded their goals and those that experienced high growth (those who grew 20% or more). According to the study, high-growth advisors were considerably more likely to have a formal, written business plan (38%) compared with low-growth advisers (21%) and even more so among those who exceeded their goals (48%) versus those who fell short of their goals (18%).

The “right marketing tactics” that the study focused on were center of influence referrals, client events and thought leadership, which the study defines as building a personal brand or platform using thought leadership and social media.

While a relatively low percentage of respondents are using thought leadership as a tactic, the study found that the larger and growing businesses were more likely to be using this strategy.

What happens in the next bear market?
Even the right marketing tactics may not be enough. I know that the regulatory authorities crack down on investment professionals who give guarantees, but here is some guarantees that I can give:
  • Some time in the next 5-10 years, the stock market will suffer a setback of at least 20%
  • Some time in the next 30 years, the stock market will crumble by 30-50%
Those are the kinds of risks that all investors assume when they commit funds to equities. All investment professionals know that. The key question is, “Are their own business prepared for the next bear markets?“

Michael Kitces, writing in Nerd’s Eye View, believes that they aren’t:
While early adopters of the assets-under-management (AUM) model got started in the late 1980s or early 1990s, the model only really began to become widely adopted in the early 2000s. Yet as the AUM model has become increasingly popular, and firms have had time to build, the “typical” advisory firm has grown significantly, from an average of only $25M of AUM in 2002 to more than $200M of AUM in 2013. And with an average profit margin of about 22%, the typical advisory firm owner with an AUM practice is enjoying record take-home pay.
Think about it this way. If an advisor is working for a large firm, he gets paid based on his production on “the grid“, which maxes out at about 50% and goes down depending on the source of revenue, or financial product sold, and the total size of production and AUM. The dirty little secret of the financial advisory business is that exotic investments, derivatives and equity based products pay more while fixed income products pay less. Such a compensation scheme puts the practice at risk during the next equity bear market.

In addition, there are limits to the AUM fee-based model because it becomes that much more harder to grow assets on a percentage basis once the AUM gets to a certain size:
Yet the caveat is that as advisory firms on the AUM model have grown, their growth rates seem to be slowing, a combination of both the ongoing crisis of differentiation for advisory firms, and the simple fact that as the firm gets bigger the denominator of the growth rate fraction is difficult to overcome; after all, adding “just” $4M of new assets a decade ago would have been double-digit organic growth, yet the same new asset flows yielded barely a 4% growth rate for a typical firm in 2009 and would be less than a 2% growth rate for the average firm today!
Kitces observed that the 2008-2009 bear market created significant challenges:
The end result in the 2008 bear market: many advisory firms saw, for the first time, a decline in annual revenue in 2009 (after a tepid year in 2008), and what amounted to a significant step back in annualized revenue projections from the prior peak in the 3rd quarter of 2007. Between declining assets from market returns, possible client attrition, pressure on fees, and the fact that there were more retired clients taking withdrawals (rather than accumulators who would keep saving into accounts), it just wasn’t feasible for most advisory firms to grow through the bear market. In other words, growth alone was no longer a sufficient defense to market volatility for the advisory firm owner; profit margins had to play a role, too.

True, the markets have recovered so have AUM, but the organic growth picture is not exactly stellar:
As the chart reveals, once market returns are backed out, growth of advisory firms has been far more erratic than the steady AUM growth charts of the industry studies implied. 2009 was a virtually flat year, as clients remained locked in place (shell-shocked after the market crash?); it was only in 2010 that clients began to really move and change (to) advisors. In 2011 and 2012 the growth rates continued, but at a greatly diminished rate relative to 2010.

What happens in the next bear market?
Kitces asked if advisory firms are prepared for the next bear market (emphasis added):
The reason all this matters is that in today’s environment, advisory firms are now so large that not only is organic growth not realistically capable of sustaining the firm through a bear market (as the growth that produced double-digit growth rates a decade ago can’t even produce a 2% growth rate today), but profit margins aren’t necessarily wide enough to sustain the impact for many advisory firms, either.

Across the entire industry, the latest Investment News study found that the average operating income of an advisory firm was 24%, which – even at a 0% organic growth rate – would be barely sufficient to handle a 25% decline in AUM due to a bear market. However, within advisory firms, the Investment News study found significant variability; while top performing (top 25%) solo firms had profit margins of 42.8%, the rest (the other 75%) were only 20.6%; amongst ensemble firms, the top had 44.5% profit margins, but the rest averaged only 16.5%.
He concluded (emphasis added):
The bottom line, though, is simply this: while many have criticized the profit margins of advisory firms as being unjustly rich and generous, and therefore prone to disruption (e.g., from robo-advisors), the reality is that for a large number of advisory firms the profit margins actually may not be large enough to withstand the next bear market, especially given that firms have become so large that they can no longer just grow their way through with new clients as they have in the past. At best, most firms will likely find the next bear market to be the most traumatic ever as a firm owner, simply given the sheer operational leverage of today’s typical advisory firm… and for those who don’t have the profit margins nor the growth potential, many advisory firms may not even survive. Is your firm well positioned at its current size to withstand the next market downturn when it comes?
Here in Vancouver, home of the old "Vancouver Stock Exchange" where penny stocks were once bought and sold, there are still firms whose specialty is selling shares of junior companies and have not really migrated to the AUM fee-based model. For those firms, the bear market has been here with a vengeance for quite some time and we are seeing their effects in spades.

What's the answer? I have no idea. There are many avenues but no single one stands out (not everyone can be Divesh Makan).

The next major bear market is likely to be highly disruptive to the financial advisory industry. That's why many advisors are trying different things and struggling to find the next business model. It also partially explains the volatility of the NAAIM survey results - advisors are trying to find a new value proposition in order to better serve their clients and build a sustainable business for themselves.