About Predictions and Markets

Two things happen when enough people react to a prediction:

1) the prediction comes true faster than it otherwise would under normal circumstances.

2) the prediction doesn’t happen at all.

Let’s take a look at two cases that cover each of the aforementioned scenarios:

Scenario 1: If enough people believe in the bright future of a company, they start bidding up its share price even if it is still losing money every quarter. The higher stock price will allow that company to hire the brightest employees and management; to buy promising smaller competitors, which will lead to a better market position. The overall improvement in profitability will be accepted as a positive feedback by the market and even more people will buy this company shares. Everything will happen a lot faster than it otherwise would. In this case, the initial expectations of a brighter future could turn into a self-fulfilling prophecy. When good market faith meets smart management, a story stock could appreciate very quickly.

Scenario 2: If enough market participants believe that there’s a major correction coming around the corner, many would simply buy put options to protect long-term positions and ride out the storm with a minimum drawdown. One could argue that if enough people believe there’s a deep correction coming, everyone will sell and actually cause this correction to happen faster and be even bigger. The truth is that funds that actually move markets don’t go to 100% cash. They just reallocate capital between less liquid, but more lucrative asset classes and hedge. Since everyone will start buying protection, volatility will spike. Equity prices might not drop more than a few percent because most funds would be already protected and they won’t sell their positions. Put options will expire worthless. Correction predictors will be made fun of. Everything will go back to normal. By definition, deep market correction always comes by surprise for most. If enough people expect a correction and act on their perceptions, it will either not happen at all or it will be much shallower than most expect. I’d be a lot more concerned when the market is down 5% and everyone is blindly buying the dip than when the market is down 5% and implied volatility is through the roof because everyone is afraid and buying protection.

About Over-trading and Under-trading

When volatility picks up, we should become less active and move slower. Hedge fund manager Frank Teixeira has good anecdote on the subject (ht midnight trader)

Most people think that Titanic sank because it hit an iceberg, when the real reason was because it was traveling too fast. The Titanic was traveling at a high rate of speed when it crashed into that iceberg. The ship was plotting a course through freezing waters. It was dark. Yet it didn’t alter its speed. Not exactly a great strategy– and certainly not smart risk management…

Many trading issues come for two reasons – over-trading and under-trading. Over-trading comes when we chase sloppy setups in unfavorable market environment. Since losses are more frequent and winners are smaller, it is easy to justify that trading more and bigger should compensate. The end result is usually a big drawdown. And what happens after a big drawdown? People are so scared to trade that they miss perfectly great trading opportunities when they start to arise. Equity selection, pattern recognition and risk management are essential stepping stones of consistently profitable trading, but they are not enough. Knowing when to be super aggressive and when to stay down is half the battle.

How Private Markets Are Impacting Public Markets

I believe that active management has a place in everyone’s portfolio. With that said many people might do reasonably well over time if each month they simply dollar cost average in a simple portfolio that consist of an U.S. equity index like the S & P 500, a few international  ETFs that cover both developed and emerging markets and some muni bonds. This approach has helped consistent savers to average about 6-7% per year over the past 30-40 years.  Can we expect this approach to continue to work in the future? No one could know for sure. Past data is all we have. Any speculation about the future is just that – speculation.

There is a good reason to opine that the 6-7% average annual return that a diversified portfolio has returned over the past will significantly diminish in the future. The cause – private markets have changed substantially. In “The Next Apple”, we wrote that investors need to adjust their expectations about new IPOs:

Nike, Microsoft Amazon and similar companies went public relatively early in their growth cycles. As a result, public investors had the opportunity to participate in 95 to 99% of their overall price appreciation. Founders, early employees and VCs took all the risk. Most of the reward was left for grabbing – anyone could’ve bought those stocks on the secondary markets.

As the Federal Reserve prints more money and interest rates remain low, an increasing percentage of capital is flowing into risky asset classes like venture capital and “angel investing.” This capital has chased up valuations in the pipeline preceding IPOs, making the IPOs feel more like the end of the journey, not the beginning. Thus, investors must adjust their expectations and understand the new metrics in the context of the speed at which companies are being created, growing staff and revenue, and expanding globally.

It has become harder to get small companies to market. The venture capital industry is playing the role that the public market used to play for micro-cap IPOs. As a result, nearly all of the market value of public technology companies is accruing while they are still private.

The IPO market has changed tremendously over the past few decades. It used to be that companies went public because they needed cash to expand. In 2015, high-growth companies can raise all the money they need in private markets.

Look at the data below, and tell me if you notice a trend: Total VC money ever raised by select companies:

Microsoft: 1MM

Apple: 3.6MM

Intel: 2.5MM

Cisco Systems: 2.5MM

Google: 25MM

Webvan: 441MM

Facebook: 2,426MM

Uber: 4,000MM

The growth that is supposed to come from young public companies isn’t likely to come. Nowadays, many of the companies with a great growth story are staying private longer and going public as much more mature companies. As a result they leave a lot less meat on the bone for public investors. This trend is likely to accelerate.

Yes, recent IPOs continue to be amazing short-term trading vehicles. Due to their small float and supply/demand imbalances in the first 6-12 months after they go public, many new issues could appreciate substantially. By the time they are fit to join any of the major indexes, many of them are likely to have bloated valuations and slowing growth numbers.

This means that simply buy and hold an index isn’t likely to work as well as in the past. The only way to have a shot at achieving good returns in public markets today and in the future is active management, which includes timing market exposure, swing trading, position trading, trend following, proper risk management.

Just my biased opinion.

Using Overbought Signals

Many traders use RSI to measure overbought and oversold conditions. The textbook says that a reading above 70 is typically considered overbought, a reading below 30 is considered oversold. Different traders use RSI in a different manner.  Some sell a long position that has been in a long-term downtrend when it becomes overbought on shorter time frame. Some buy stocks in a long-term uptrend when they become oversold on a shorter time frame. Some only buy when a stock suddenly becomes overbought – usually after a high-volume gap, and then sell when it stops being overbought.

Here’s Greg Harmon’s take on the subject:

Perhaps there is a better way to understand and interpret the overbought condition. It may be easier if you let go of the label all together, since it is randomly selected anyway. What if instead you looked at just two things to determine if a stock is for you or not. First, is the RSI rising, falling or flat. If it is rising or flat then the momentum is increasing or holding by definition. This is not a time to avoid a stock.

Second, is the price confirming or diverging with what you see in the RSI? Price and its direction is always more important that any indicator. That is because price is all that matters to your transaction when you buy or sell. I do not like to buy stocks when they are falling. That is my rule and it is not for everyone, nor the only way to make money.

In “The Next Apple”,  I wrote about using weekly RSI above 80 as a means for partial profit taking:

The technical term “overbought” basically means acceleration in buying to levels that might not be sustainable for too long. What could possibly be wrong about an overwhelming number of buyers? It might be an indication that there is no one left to buy. Some institutions need the liquidity that new highs provide in order to exit a big position.

Using a weekly RSI above 80 is a good rule of thumb, but it is not perfect. There are stocks that remain overbought for a very long time and go up 100% – 200% after hitting that level. It is rare, but it happens. In 2013, Tesla Motors went from $ 55 to $ 200 while its weekly RSI stayed above 80. The hottest stocks of each year often don’t care about overbought conditions.

Under overbought conditions, you need to look at everything in context. Those conditions could resolve through time consolidation or through a price pullback:

– Is it a fresh breakout from a humongous base? Have earnings just accelerated? In this case, an overbought condition is likely to be the beginning of a powerful new trend, not the end.

–  Is the stock already up more than 800% in the past three years? Do most analysts have a buy rating on the stock? Is the institutional ownership above 90%? Are the CEO and the company featured on the first page of magazines, newspapers, websites? In this case, a severely overbought condition is a good reason for partial profit-taking.

About Booms, Bubbles and Busts

Noah Smith has an interesting piece on bubbles and busts:

For the past half-century, the academic macro story has gone something like this: There is a general trend of rising growth and prosperity in the U.S. economy, caused by steady improvements in technology. But this steady course is disturbed by unpredictable events — “shocks” — that temporarily slow growth or speed it up. The shocks might last for a while, but a positive shock today doesn’t mean a negative shock tomorrow. Recessions and booms are like rainy days and sunny days — when you look back on them, it looks like they alternate, but really they’re just random.  

Yes, the economy is cyclical and the duration of the cycles might vary every time. The more relevant questions to ask are do all booms result into bubbles, do all bubbles result into busts, do all busts lay the foundations for new booms, and most importantly how could one benefit from this seemingly perpetual cycle?

Here’s what I wrote about bubbles and busts on this blog a couple years ago:

There are a thousand definitions for a bubble. Some say it is a huge trend you have not participated in. Others stick to a more conventional description – unsustainable valuation.

One of the purposes of free markets is to correct excesses. If you believe that something is a bubble, devise a plan to profit from it. Don’t just stay on the sidelines. There are several ways to participate:

1) You could become part of the momentum and help early short sellers to part with their money. George Soros loves bubbles: “When I see a bubble, I buy that bubble, because that’s how I make money”.

2) If momentum is not your forte, then short it and see where it gets you. Just because something seems overly expensive, it does not mean that it won’t become more expensive. Hundreds of money managers thought that the housing market in the U.S. was in a bubble in 2004. They ended up being right, but between 2004 and 2006, many homebuilders stocks quadrupled in value. You cannot afford to lose 300% of your clients money. Most will take it back, when you down 30%, so even if you end up being right, you might not even be able to benefit from it. Timing is of crucial importance when you bet against a bubble, because “the market could remain irrational longer than you could remain solvent” – as Keynes pointed out. You could wait for a technical breakdown and short the crap out of the bubble – some say that catching trend reversal are the most favorable risk/reward trades/investments. Keep in mind that the higher the potential reward for each unit of risk you take, the lower the probability that it will actually work. This is how financial markets work. If you could make 10 times your money in a deal, the odds are high that this deal might end up wiping our your entire investment.

3) Wait for the bubble to busts and then pick up the pieces at extremely low prices and sell them during the next bubble. Here’s the thing. You need leverage to create bubble. Financial leverage. Leverage is the main reason why when a bubble bursts, the market over-shoots to the downside and send asset prices to extremely low and some would call them “favorable” prices. Without a big bubble, you cannot have a big bust. And without a big bust, you cannot pick up assets at extremely attractive valuations. So stop complaining. As Peter Lynch likes to say: “ I don’t know what exactly causes big market corrections, but I know that the track record of most successful long-term investors would be impossible without them ”. To benefit from a bust, you need to have an ample supply of cash, because credit markets are often “closed” when prices are at their lowest and perception of risk is elevated. People think in terms of capital preservation, not in terms of making more money.

Most people take the passive approach of side-lined viewers. Everyone has an opinion, but very few have an idea how to turn that opinion into an actionable plan. It is the trading and investing ideas that matter.

If you believe that something is a bubble, you could actually profit from it. Usually, people who point fingers and call something a bubble, do it for one main reason – to declare to the world that they will never put their money there and other people should do the same, because “it will end badly”.  And you know what? Maybe it will. The financial history is full of booms and busts and actually both precipitate each other. Learn to live with it. Bubbles are not going anywhere. Neither are busts. But you could make a big difference in your life if you learn how to participate in them.

The end of one boom is usually the beginning of another. Capital just rotates. As we wrote in The Next Apple:

Every crisis brings an opportunity. Every bust in one area of financial markets puts the foundations for a boom in another area. Money never sleeps. It constantly goes somewhere – sometimes, because of rational reasons, but other times, because of sheer speculation. Nevertheless, as long as humans are involved in financial markets, there will be booms and busts, crises and recoveries.

America went into recession in the early 2000s, and Americans went to school to gain another diploma. As a result, education stocks rallied to the sky. Between 2000 and 2004, shares of Apollo Education went from $ 10 to $ 100.

Terrorists hit the Twin Towers in 2001, and America went to war. As a result, defense stocks appreciated substantially. Between 2002 and 2005, shares of Kevlar  makers Ceradyne went up 1800%.

The bust in tech stocks in the early 2000s alienated regular Americans from stocks, and they decided to put their money into houses. Homebuilders’ stocks went up five times and more in a fairly short period of time, before they went bust. Between 2001 and 2005, shares of Beazer Homes went from $ 40 to $ 370, Toll Brothers went from $ 7 to $ 50, Ryland Group went from $ 7 to $ 80, etc.

The Fed’s aggressive monetary easing coupled with emerging markets’ hunger for basic materials caused a massive spike in demand and inflation. As a result, commodities went through the roof. While market averages deteriorated in the first half of 2008, many basic material stocks quadrupled. Yes, in the second half of 2008, they gave up most of their profits and then some more, but they created incredible opportunities for people who were simply following price trends and had an exit strategy. Between 2007 and mid-2008, shares of potash maker Mosaic went from $ 15 to $ 150.

The financial crisis of 2008 – 2009 brought all stocks down on their knees. Many small caps were priced for bankruptcy. Most of them survived and went up more than 1000% in the ensuing four to five years. Mattress maker Select Comfort was trading near 25 cents per share in early 2009. In early 2015, it is trading near $35.

Big corrections create the opportunity for big recoveries. The European sovereign bond crisis of 2011 and the overall slow employment recovery in the United States encouraged the Federal Reserve to launch a series of unprecedented monetary policy injections with the code name “Quantitative Easing.” Waves of capital flooded public and private markets and caused material appreciation in most financial assets.