Category: Commentary

Over the past several years the money that has gone into ETFs has significantly increased. As a result the correlation between stocks from one sector and between stocks in general has ticked up. We live in market environment, where the impact of beta grows stronger, especially during corrections.

We like to think that it is a market of stocks and not a stock market; that equity selection matters. It actually does, but mainly on the way up and when earnings growth is scarce. In the era of ETFs, baskets of stocks are getting bought and sold simultaneously and often the weak rise with the strong and the strong fall with the weak.

Yes, of course if matters if a company grows its earnings by 200% y/y and its sales by 60% y/y. Eventually rising expectations for higher earnings will result in buying and price appreciation. Keep in mind that when the stock market declines, emotions rule decision making and all rationality is thrown out of the window. If you are an investor and the reason you bought still exists, the day to day volatility is just noise that needs to be ignored and corrections should be even welcomed as opportunities to add to a position. The question is, are you an investor or are you a trader and what is your time frame of market engagement? If you consider yourself a trader, price action should be your leading indicator and loss minimizing stops  need to be diligently honored in order to survive and prosper. Remember, there is one basic rule in the capital market jungle – fight only battles that you can win.

Higher liquidity leads to a decline in transaction costs (bid/ask spread + commissions) and therefore: a decrease in risk premium. If you are able  to sell your assets quickly at the current market price, the perceived risk is lower – not only for you as an investor, but also for your creditors. Liquid secondary markets cause a decline in risk premium, which by definition leads to an  increase in the value of the traded financial assets.

The existence of liquid secondary markets is essential condition for developed IPO markets. Secondary markets are the main exit strategy for IPO investors, therefore the higher the liquidity the higher the interest in IPOs.

IPOs are an effective tool for venture capitalists and entrepreneurs to transfer part of the risk to the public; to get paid for their work or simply to raise more capital for further expansion. In the same time investors (the public) receive the opportunity to participate in the growth of a promising business. There is no doubt that without enough interest in IPOs (which is a derivative of secondary markets’ liquidity), venture capital and entrepreneurs will be robbed from one of their main exit strategies; therefore VC funds are likely to raise much less money and less projects will be funded. The end result is less start ups, less entrepreneurs, less jobs, slower technological progress and ultimatelly lower living standard for everyone.

Hopefully the Congress will not take short-sighted decisions that are going to worsen the liquidity of US secondary capital markets. Am I opposing new regulations? No – the systemic risk in the economy needs to be addressed and intelligent changes in regulation are needed. The simple, but optimal approach to decrease systemic risk is to limit the size of leverage and prevent “too big to fail” companies to participate directly or indirectly in OTC deals. If you are “too big to fail”, you need to be accountable and transparent. If you don’t like it, become too small to matter for the survivability of the financial system.

The most powerful forces against poverty are technological progress and entrepreneurship, which scope and success are directly dependent on the liquidity of secondary capital markets. Don’t kill the liquidity.

If you manage money, your own or other people, you need to have a well thought out market philosophy, strategy and tactics on which to base your actions. Without clear understanding of those concepts, you will be lost in a jungle of biased opinions and you will never be consistently profitable.

Market philosophy is an understanding of how the stock market works and what moves prices. It is who you are and how you see the financial world. It could be derived from a comprehensive academic research or based on experience. There are three major approaches to the stock market – value, growth and price momentum. Which one is yours and why? Further, what is your time horizon? Are you an investor, swing trader or a day trader. Define yourself. There is no such thing as right or wrong market philosophy. You need to find the right philosophy for your level of patience and risk comfort.

People trade their beliefs. For example, I believe that stock price appreciation is a function of rising expectations for future earnings. Expectations are often altered when new information appears – information that is not already discounted in price. Such new information could be a new contract, change in regulations, substantial earnings and sales surprise, higher EPS guidance – a catalyst that has the power to start a new trend; an event that changes expectations. When expectations change, perceived valuation is altered and the market moves to solve the disbalance.

Strategy is all about proper allocation of capital and time. It deals with the essential subject of position sizing, risk management and leverage. It involves clear understanding of how much you can afford to risk (lose) on every investment/trading idea and with what level of volatility you are comfortable with.

Tactics are all about conditional thinking and becoming a specialist in trading one or few distinctive setups. If events A, B and C happen simultaneously, you buy. If they don’t, you stay on the sidelines. When I mention a setup, I don’t refer to a chart pattern. A setup could consist of only fundamental or only technical factors or a combination of both. A good setup is a sum of conditions that need to align in time and space, before you initiate a position.

Let me give you an example of three distinctive setups used by three successful hedge fund managers:

Todd Sullivan is a value investor. He  would only consider a new position if it meets his clear rules: wide margin of safety that will offer plenty of room for mistake and an upcoming catalyst that will help the market to recognize the value. Todd subtracts all liabilities from all liquid assets and requires at least 30% margin of safety. No matter how much he likes the story behind a business, if the stock doesn’t meet all his criteria, he will not buy it.

Howard Lindzon is a momentum investor. He only considers stocks that are at their all time highs, assuming that if a stock is at such level, the underlying company must be doing something right – it is in the right business at the right time. His setup is derived from comprehensive quantitative research made by Black Star Funds, which proved that trend following could be exceptionally profitable when proper risk management is applied. Howard believes that it is safe to invest in the stock market only when there is broad price appreciation and hundreds of stocks are hitting all time highs. He likes to buy stocks that are just emerging to new highs from a long sideways consolidation and he is looking for the catalysts that will continue to push the price higher in the future. He invests in trends that he understands.

Doug Estadt specializes in investing in biotech stocks and Chinese ADRs. He considers a new biotech position only if it meets his clear rules that have proven to be successful in his experience. He is looking for late stage drugs, at least at phase 3; management team that he trusts and  has a history of successful FDA approvals and new drug launching; drugs that treat a condition that no one is currently treating or it is not being treated successfully. He acknowledges the downside risk that biotech stocks bring and considers his investment as a call option – if it doesn’t work, the downside risk is limited; if it works, there is an incredible upside potential. Doug does his due diligence and put his money where his mouth is. He has managed to build a solid track record of successful biotech investments.

What is the common denominator between those three so different setups? – Consistency. Evey day these people wake up and look for the same conditions to align before they consider to initiate a new position or to add to an existing one.

When you have the same daily routine for a prolonged period of time, you become a specialist in what you are doing. Specialist is someone who is more productive that the average person in performing certain task. When you look for the same setup every day, gradually you will learn how to recognize quickly the combination of market conditions that will increase the probability of success. You will refine your entry and exit points and become better at risk management.

Random following of biased opinions will not get you too far in the investing business. Opinions do not make money consistently, setups do.