by Dennis Tilley | Jul 8, 2019 | Intermediate-Term Edge, Investing, Long-Term Edge, Trading Edges
In the last of our asset-class valuation series, I discuss costly value traps that can derail even the best-reasoned asset-class value themes. A lot can go wrong when you bet on value. In particular, an asset class that appears to be an excellent value can stay that way for years.
All investors face this problem and most professional investors who manage billions of dollars have only one option, which is to leg into these investments over time. Asset class traders have the benefit of being small enough to wait for a catalyst before trading a compelling value opportunity. In this blog post, I review various catalysts I use to get the timing right and avoid the value traps.
Most traders and investors know to be aware of value traps when investing in cheap assets. Value investors comment that risk of permanent loss is the true risk associated with investing, and a worst-case scenario is losing 100% of capital. Although asset classes rarely lose 100% of their value, value traps in the asset class arena are not much different.
My main concern when using the “compelling valuation” trading edge to overweight an asset class is that it underperforms an equity benchmark. In other words, if I own Korean stocks because I feel they’re irrationally cheap, and they underperform my benchmark during the hold period, then the trade didn’t work. Either I didn’t assess the situation correctly, or the timing wasn’t right, or perhaps fundamentals changed the assessment over time. The opportunity cost associated with this mistake is what hurts the most.
by Dennis Tilley | Apr 27, 2018 | Intermediate-Term Edge, Investing, Long-Term Edge, Market Timing, Trading Edges, Trend Following
Large price runups, such as a gain of 100% over two years, are rare.1 In a previous blog post, I presented 10 attributes to distinguish asset class bubbles from large price runups that are justified by improving fundamentals. Those bubble attributes are:
- Heavy retail investor involvement
- New-era thinking
- Irrational valuations
- Five or more years of swiftly rising prices
- Parabolic rise in price
- Shorting is unattractive or impossible
- Social mania
- Product providers exploit excessive demand
- Leverage fuels more buying
- Bubbles are late-cycle phenomena
As asset class traders, we are especially interested in bubbles as a potential huge source of alpha when they collapse. As it turns out, bubbles are a lot tougher to exploit than it might seem. In this blog post, we’ll delve into bubble characteristics in more detail, and then investigate the best ways to trade asset classes that are experiencing a bubble.
We’ll examine bubble characteristics over the short term (plus and minus three years around the peak) and then longer term (a decade or more). When doing this sort of analysis, we need to at least acknowledge that various forms of hindsight bias can creep into such work since we are examining known price runups that ultimately crashed spectacularly.
It’s possible that we should include a few historical parabolic runups that did not ultimately pop.1 I’m hopeful that the lack of bubble attributes associated with these moves provides the justification for eliminating these from consideration, but I’m not completely sure. I may have also declared a few large up and down moves as bubbles (for instance, Chinese equities in 2007), when perhaps this price move had no more bubble attributes than a big move that ultimately didn’t end in a long period of underperformance (for example, the 1987 crash). (more…)
by Dennis Tilley | Jun 6, 2017 | Intermediate-Term Edge, Short-Term Edge, Trading Edges
In the Market Tells – Part 1 blog, I introduced the concept of market tells as an enduring trading edge that can be used to enhance returns over the long term. Developing the ability to identify market tells and act on these signals takes practice. It’s important to keep track of trading results to get better and gain confidence to jump on these opportunities in size when they occur.
In this blog, I first clarify thoughts on a few instances when the market tell guidelines are not met. The most important guideline for identifying a market tell is the 80% rule, which states that to consider market action as unusual (and thus providing a market tell), the usual behavior must occur at least 80% of the time. Otherwise, it’s just too difficult to associate the unusual behavior with a market tell rather than normal market gyrations. Next, I’ll review three more market tell techniques that can be used to trade asset classes. I’ll close with some thoughts on crowded trades and implementation hints.
On some days, one sector may be up while the rest of the market is down. If the behavior is explained by news, then this price action is totally normal. Even without news, this sort of divergence occurs often enough to consider it normal activity. If a security is illiquid, such as a closed-end fund, then this action might be correcting a stale price from the previous day, which is not unusual at all.
To contrast, if all risky assets are aggressively moving higher (such as when the S&P 500 is up 2%+ for the day), and one sector is flat, then this behavior is much more unusual and may be the basis of a market tell, especially if no news explains the behavior. However, we need to remember that the time scale of this edge is on the order of a day or two.
Watching how a stock or asset class reacts to news associated with a known announcement date (such as an earnings call or a central bank news release) is very difficult to use as a market tell. There is usually an enormous amount of trader attention to these known release dates, which probably means there’s no trading edge. Much of the news and all the probabilistic outcomes have been priced in before the announcement, which is another way of saying the pre-announcement price is set such that there is no edge in buying or shorting the security ahead of the announcement, or in fading or chasing the post-news reaction.
Finally, watch out for interpreting short-term market action when there’s a lot of unwinding of positions. For instance, at the first of the year, it’s best to wait a week before interpreting market action as hedge funds unwind their end-of-year trades. This sort of behavior can occur during bear markets also. This is a very chaotic time when a lot of unwinding is occurring – it’s a very difficult time to interpret market action versus any sort of playbook. Wait until the dust settles and stocks start moving in unison before interpreting market action.
Divergences and Market Tells
In discussing market tells, I’ve used the term “divergence” to describe local price action where an asset class’s price or relative strength line is diverging from normal expectations. Searching for divergences is a staple of technical analysis.1,2 In the past I have falsely interpreted a divergence as a market tell. These misinterpretations generally occurred during relatively quiet times in the market, usually during bull markets, when the 80% rule did not apply.
Ask a market strategist about divergences, and the first thing that comes to their mind is the case where the stock market is making new highs while some other risky asset class is moving lower. For instance, from mid-2014 to mid-2015, the S&P 500 was moving higher, while junk bond markets where moving lower. This isn’t supposed to happen, and such a divergence is often interpreted as a warning of future weakness in the S&P 500, leading to a convergence of the two markets. (more…)
by Dennis Tilley | Apr 21, 2017 | Intermediate-Term Edge, Short-Term Edge, Trading Edges
In any competitive field, the awareness of tells can provide a significant and enduring edge. Most people think of poker when they hear about tells.1 Is a player acting strong to encourage other players to fold? Does a player seem nervous when they throw their chips in the pot? Can any useful information about an opponent’s poker hand be gleaned from these actions?
Tells occur in many aspects of life and competition. For most sporting events, searching for tendencies in an opponent’s play is an integral part of game preparation. In the home arena, parents look for facial clues when interrogating a fidgety teenager as the youngster explains what she’s doing on a Saturday night.
Tells are an important source of feedback when trading the financial markets. I call these “market tells” to distinguish between the variety of tells that occur in other forms of competitive environments (more on this distinction later). A market tell is a powerful approach to sensing moments in time when market participants are not positioned correctly.
A simple example of a market tell is a stock that’s acting strong when it should be weak. Perhaps the stock is in an uptrend when extremely bearish news is released about the prospects of the company (such as a product recall). Unexpectedly, after a momentary dip on the news, the stock price continues to go higher. That’s a positive tell for future outperformance.
Properly identified, tells can get you out of a trade much sooner than waiting for a technical trend-following sell signal. Tells can help you identify future outperforming asset classes. They can provide positive feedback that a current trade is working. No matter what your trading discipline or time scale, searching for market tells is a great trading edge.
The more you clarify and develop your thoughts around market tells, the more confidence you’ll have to quickly jump on trades and to trade with high conviction and size. I began noticing market tells soon after I started trading in the late 1990s. In 2005, I decided to be more disciplined about it by keeping track of results. When I observed a tell, I printed out a chart and documented what I expected to happen, and then slipped the paper into my “market tells” folder. I also traded on this information, and over the next four years, avoided looking at the results.
In mid-2009, I checked to see how these predictions worked. The success rates for these trades at both the short and intermediate time scales were excellent. These results piqued my interest to further investigate and refine the use of market tells in my trading. In 2014, I performed yet another trade analysis, and in 2017, I find myself slightly reshaping my views while writing this blog.
Classification of Tells
To provide a framework for thinking about market tells, I’ll review various forms of tells. (more…)
by Dennis Tilley | May 10, 2016 | Intermediate-Term Edge, Market Timing, Trading Edges, Trend Following
In this blog I’ll examine the old “sell in May and go away” seasonal pattern associated with risky assets. It’s timely to consider this pattern since the markets are now entering the seasonally weak period. Furthermore, stock market performance has been relatively weak in a number of recent “strong periods,” such as in January 2016, November 2015 through January 2016, and November 2015 through April 2016, which often provides a foreboding tell of additional weakness during the traditional seasonal weak period of May through October.
Seasonality as a trading edge is also worth considering because trend following has become very trendy these days, with billions of dollars flowing into this discipline every year via managed futures funds. The problem with these flows is that the effectiveness of trend following diminishes as more assets are devoted to the discipline, since trend following is naturally capacity constrained due to high turnover (>200%) and the liquid demanding nature of trading. It seems that trend following is crowded.
At this point in time, it may be interesting to examine other market timing signals as an alternative way to add and reduce risk exposure. One such approach is seasonality, which is probably underutilized by the asset class trading community and thus might be more effective than trend following over the near term.
The seasonal pattern has been well known for decades – the stock market’s best period is from November through April, and its poor-performing period is from May to October. This is not the case every year, but on average this seasonal pattern has held up really well with stock markets around the world for decades.
Academics call this pattern the Halloween effect since the buy signal is generated by buying at the close on October 31 every year and the sell signal is on every April 30. What’s amazing is that seasonality has not been arbitraged away, even though the cost of implementing a seasonal trading system has been low since the 1980s. The old adage of “sell in May and go away” still works! (more…)
by Dennis Tilley | Feb 26, 2016 | Asset Classes, Intermediate-Term Edge, Investing, Trading Edges
The beginning of the year marks the time when chief investment officers, market strategists and other chief prognosticators publish their top investment themes. Barron’s also publishes their much anticipated “round table” issues in mid to late January, which pull together top investors to discuss the state of the markets and where they see investment opportunities.
There are hundreds of firms producing research all the time, most of it free. The big Wall Street firms produce enormous amounts of content, but so do practically all buy-side investment management firms these days. If you’re not careful, combing through research reports for trading and investment ideas can absorb all of the day. There are also the independent firms such as Ned Davis Research, BCA Research and the Leuthold Group, which are very expensive, but provide lots of interesting and useful information for asset class traders.
Common sense suggests that you can’t just read the research, implement the trades suggested and expect to outperform the market. That would be too easy. This is the case even for costly research from the independents, because after all, tens of thousands of professional portfolio managers can afford these services.
For an asset class trader, reading research and market commentary is important, primarily so you understand what everyone else is thinking, become aware of crowded trades and estimate what information is already priced into the markets. Every once in a while, a new piece of information is gleaned or a new way of thinking about an asset class is found. If discovered ahead of most other market participants, this information can be the seed of a new trade.
At any point in time, there are industry thought leaders who seem to have a special knack for investing and trading the markets. When they speak, I pay careful attention because the probability of discovering a new trade idea from them is much higher than reading the everyday, run-of-the-mill content.
Generally, these thought leaders are very experienced, talented and rich. They’re not inhibited by career risk. Their motivations are aligned with us, because being right about an investment theme is the most important goal associated with speaking publically since the prediction is on the record. Contrast this motivation with that of research content providers and newsletter writers, where maximizing readership is the primary goal. (more…)