Navigating Asset Bubbles for Profits

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:

  1. Heavy retail investor involvement
  2. New-era thinking
  3. Irrational valuations
  4. Five or more years of swiftly rising prices
  5. Parabolic rise in price
  6. Shorting is unattractive or impossible
  7. Social mania
  8. Product providers exploit excessive demand
  9. Leverage fuels more buying
  10. 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…)

Seasonality

iStock_000085081023_SmallIn 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…)