How much business risk is hiding in your portfolio?

This is the second in an occasional series of posts on how to build a robust investment process. Part 1 was addressed to the individual investor and trader (see The ways your trading system could lead you astray). This posts explores the issues that face the professional and institutional investor.

I had illustrated in the past why managers closet index. That`s because even a single misstep in an individual position could sink portfolio performance (see How Valeant revealed the dirty little secret of fund management). In this post, I would like to focus on how style and factor exposures affect business risk.

I recently came upon a study by Research Associates, which showed the tradeoffs between investment returns and business risk. The authors modeled a series of hypothetical portfolios with different styles, namely value, growth, momentum, quality, and random selection, which they called the "4 Orlandos", for the period 1967-2016. As it turns out, the styles that showed the best performance also had the highest chance of getting a manager fired.

The termination criteria for a manager (which they called an "agent") is detailed below and roughly reflects the patience level of institutional sponsors:

We select two highly stylized rules for a hypothetical investment board to use in evaluating the agent’s performance: 

1) Fire the agent if more than 50% of funds selected by the agent underperform the benchmark in a given period.
2) Fire the agent if the equally weighted portfolio aggregated from the selected funds underperforms the benchmark by more than 1%.

In the light of these results, the big question for institutional investors is, "We all want good performance, but how far do you want to stick your neck out?"

The full post can be found at our new site here.

FOMC preview: Hints of a dovish tilt?

I had been meaning to write about a preview of the upcoming FOMC meeting. Here are the elements of the Yellen Labor Market Dashboard, courtesy of Bloomberg.

As you can see, many of the components have either fully or nearly recovered from the depths of the GFC, with the glaring exception of a subpar labor force participation rate. These factors put pressure on the Fed to start normalizing rates.

However, there is one important exception that may cause the Fed to have a slightly more dovish tilt than the market expects.

The full post can be found at our new site here.

Forget politics! Here are the 5 key macro indicators of Trump's political fortunes

Wow, Trump's political honeymoon didn't last very long! In the past few days, there have been numerous objections of Trump's Executive Orders. I'll spare you the details of the protests and demonstrations, particularly from the Left. What stood out were the objections from the Right and within the GOP. As an example, Eliot Cohen, who served under Condeleeza Rice, fretted about the threats that Trump posed to the American Republic:

I am not surprised by President Donald Trump’s antics this week. Not by the big splashy pronouncements such as announcing a wall that he would force Mexico to pay for, even as the Mexican foreign minister held talks with American officials in Washington. Not by the quiet, but no less dangerous bureaucratic orders, such as kicking the chairman of the Joint Chiefs of Staff out of meetings of the Principals’ Committee, the senior foreign-policy decision-making group below the president, while inserting his chief ideologist, Steve Bannon, into them. Many conservative foreign-policy and national-security experts saw the dangers last spring and summer, which is why we signed letters denouncing not Trump’s policies but his temperament; not his program but his character.

Precisely because the problem is one of temperament and character, it will not get better. It will get worse, as power intoxicates Trump and those around him. It will probably end in calamity—substantial domestic protest and violence, a breakdown of international economic relationships, the collapse of major alliances, or perhaps one or more new wars (even with China) on top of the ones we already have. It will not be surprising in the slightest if his term ends not in four or in eight years, but sooner, with impeachment or removal under the 25th Amendment. The sooner Americans get used to these likelihoods, the better.

Cass Sunstein objected to Trump's economic approach by invoking Fredrich Hayek:

If American conservatives have an intellectual hero, it might well be Friedrich Hayek -- and rightly so. More clearly than anyone else, Hayek elaborated the case against government planning and collectivism, and mounted a vigorous argument for free markets. As it turns out, Hayek simultaneously identified a serious problem with the political creed of President-elect Donald Trump.

Sunstein worried aloud about Trump's conservative credentials and autocratic tendencies:

In "The Road to Serfdom" and (at greater length) in "The Constitution of Liberty," Hayek distinguished between formal rules, which are indispensable, and mere “commands,” which create a world of trouble, because they are a recipe for arbitrariness. When formal rules are in place, “the coercive power of the state can be used only for cases defined in advance by law and in such a way that it can be foreseen how it will be used.”

Like the rules of the road, formal rules do not name names. They are useful to people who are not and cannot be known by the rule-makers -- and they apply in situations that public officials cannot foresee.

Commands are altogether different. They target particular people and tell them what to do. (Think Hitler’s Germany, Stalin’s Soviet Union, Mao’s China, Castro’s Cuba.) They require the exercise of discretion on the spot. As examples, Hayek pointed to official decisions about “how many buses are to be run, which coal mines are to operate, or at what prices shoes are to be sold.”

Forgive me for being cynical, but blah blah blah...None of this matters very much.

The main objective of these pages is to make money for my readers. I try very hard to divorce my investment views from my political views. As the chart below shows, the stock market can prosper under both Democratic and Republican presidents.

With that preface in mind, here are some key metrics to watch that Donald Trump needs to achieve in order to politically prosper in his first term.

The full post can be found at our new site here.

A focus on growth

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"

My inner trader uses the trading component of the Trend Model to look for changes in direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.

The latest signals of each model are as follows:

• Ultimate market timing model: Buy equities*
• Trend Model signal: Risk-on*
• Trading model: Bearish*

* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.


It's not all about Trump
In the past few weeks, market analysis in these pages have been all Trump, all the time. As America`s 45th president assumed his first full week in office, his administration made a number of rookie mistakes that gave the impression of a government in disarray.

Politico reported that many of presidential executive orders were drafted by Trump aides Stephen Miller and Steve Bannon without consultation with the relevant departments or Congress. These actions made the implementation of some aspects of the executive orders difficult, impractical, or possibly illegal. CNBC reported that the Trump aides were leaking stories as a sign of infighting between different factions. Not only that, the Washington Post reported that most of the senior bureaucrats at the State Department, most of whom had served both Democrat and Republican administrations, had resigned en masse, which deprived the department of years of experience in the nuts-and-bolts of foreign policy.

So how did the stock market react to these events? The Dow proceeded to rally above 20,000 to make an all-time high, as did the SPX. This kind of market reaction in the face of negative political news is bullish. Moreover, it showed that investors and traders had turned their focus to the most important metric of equity performance, namely the growth outlook.

Indeed, analysis from Deutsche Bank showed that macro growth surprises have been the biggest driver of equity prices for the last 15 months (via Bloomberg).

The full post can be found at our new site here.

The ways your trading model could leading you astray

I have had a number of discussions with subscribers asking for more "how to" posts (see Teaching my readers how to fish). This will be one of a series of occasional posts on how to build a robust investment process.

For traders and investors, one of the challenges is how to build a robust discipline that works well through different market regimes. As a case study, consider this study from Simple Stock Model that generates signals based on the cash flows in and out of the SPY ETF as a sentiment signal. The trading rule is: "If the 4-week average of the 3-month change in SPY's percentage of shares outstanding is greater than +5%, be out of the market."

The chart below shows the equity curve from this trading system (white line = buy and hold, blue line = trading system). The results look pretty good, especially for a relatively low turnover model. (Incidentally, it's on a sell signal right now).

SPY shares outstanding trading system

Not so fast! Don't jump to conclusions before digging into the data and reading the fine print.

The full post can be found at our new site here.

Global market rally = Dow 20K

Mid-week market update: Since the time I issued a correction warning in late December (see A correction on the horizon?), the US equity market has traded sideways in a narrow range. Moreover, the SPX has alternated between a seesaw up-and-down pattern since early January - until today.

As the SPX breaks upwards to a new all-time high, and the DJIA breaches the psychologically important 20,000 mark, it's hard to argue with price and momentum.

Overbought and vulnerable markets can correct in two ways. It can correct through price, with lower prices, or through time, with a sideways consolidation. The latter scenario is often accompanied by an internal rolling correction characterized by weakness in market leaders and nascent strength from laggards, which seems to be what has happened (see The contrarian message from rotation analysis).

The full post can be found at our new site here.

The battle for the hearts and minds of the Fed

Now that the Trump team has moved into the West Wing of the White House, investors still one big Trump policy question mark that overhang the market. Who will Trump appoint to the two vacant governor seats at the Federal Reserve?

CNBC reported that David Nason is a leading contender for a board seat, but he is rumored to be considered for a regulatory role. Such an appointment gives us no hints about the likely future direction of monetary policy and who might replace Janet Yellen, should Trump choose not to re-appoint her as Fed chair in 2018.

Bloomberg reported that the latest rumor mill has the leading candidates for Fed chair, namely Glenn Hubbard, John Taylor, and Kevin Warsh, advocating a tighter monetary policy than the current Fed:

Potential candidates to head the Federal Reserve in 2018 suggested that monetary policy would be tighter if they were in charge.

Speaking at the annual American Economic Association meeting that ended Sunday, Glenn Hubbard of Columbia University, along with Stanford University’s John Taylor and Kevin Warsh, criticized the central bank for trying to do too much to help an economy struggling with problems that monetary policy can’t solve.

“The Federal Reserve is a little behind the curve” in raising interest rates, Taylor, a Treasury undersecretary for international affairs under the last Republican president, said Saturday during a panel discussion in Chicago.

Hubbard, who headed the Council of Economic Advisers under Bush, said he agreed with what he perceives as Trump’s stance that the U.S. has depended too much on the Fed to support the economy in recent years.

Is that what Trump really wants? There is a battle going on for the hearts and minds of the Federal Reserve. The outcome will have profound implications for the direction of monetary policy, the likely trajectory of economic growth for President Trump's next four years, and the stock market.

The full post can be found at our new site here.

Could "animal spirits" spark a market blow-off?

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"

My inner trader uses the trading component of the Trend Model to look for changes in direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.

The latest signals of each model are as follows:

• Ultimate market timing model: Buy equities*
• Trend Model signal: Risk-on*
• Trading model: Bearish*

* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.


Trump's challenge
Now that Donald Trump is the President of the United States, the real work of his administration begins. In inauguration speech, he invoked the spirit of Horatio Alger as a way to take America to new heights:

Finally, we must think big and dream even bigger. In America, we understand that a nation is only living as long as it is striving...

Do not allow anyone to tell you that it cannot be done. No challenge can match the heart and fight and spirit of America. We will not fail. Our country will thrive and prosper again.

Ray Dalio of Bridgewater Associates was optimistic about this "can-do" attitude of Americans:

This new administration hates weak, unproductive, socialist people and policies, and it admires strong, can-do, profit makers. It wants to, and probably will, shift the environment from one that makes profit makers villains with limited power to one that makes them heroes with significant power.

Despite inheriting an economy that is in the late stages of an expansion, Dalio believes that the incoming president can spark a second wind of growth by reviving the economy's "animal spirits":

This particular shift by the Trump administration could have a much bigger impact on the US economy than one would calculate on the basis of changes in tax and spending policies alone because it could ignite animal spirits and attract productive capital. Regarding igniting animal spirits, if this administration can spark a virtuous cycle in which people can make money, the move out of cash (that pays them virtually nothing) to risk-on investments could be huge.

Bob Shiller went further and postulated a speculative stock market blow-off, followed by a crash (via The Telegraph):

America should brace for a final blow-off surge in stock markets akin to the last phase of the dotcom boom or the “Gatsby” years of the Roaring Twenties, followed by a cathartic crash and day of moral judgment, according to a Nobel prize-winning economist.

Prof Robert Shiller said the psychological “narrative” behind Donald Trump is powerful and likely to carry Wall Street to giddy heights before the aging business cycle finally rolls over.

“I think there will be a Trump boom for a while. Stocks look high, but they are not yet super-high. In 2000 the (Cape Shiller) price-earnings ratio was over 45 and we may see a repeat of that,” he told The Daily Telegraph.

For investors, the stakes are high. Under this scenario, a Trump inspired "animal spirits" revival could spur the SPX to its point and figure target of 2523 or more.

The question is, can Trump spark the "animal spirits" to Make America Great Again?

The full post can be found at our new site here.

Weaken the USD to Make America Great Again

About a month ago (see The bear case: How Trumponomics keeps me awake at night), I highlighted a Bloomberg interview with BAML currency strategist David Woo. Woo pointed that there is an inherent contradiction in a couple of Trump's policies. His fiscal policy of tax cuts is pro-growth and therefore USD bullish, but his "America first" trade policy needs a weaker dollar. So what does he really want, a strong dollar, or a weak dollar?

We may have an answer. In a recent WSJ interview, Trump said that the dollar is “too strong”, especially considering the China’s yuan is “dropping like a rock.” While those remarks were made in the context of Sino-American trade relations, Trump signaled that, if he had to choose, he would prioritize a weaker currency over fiscal stimulus.

Trump`s priorities of trade policy over fiscal policy is consistent with his criticism of the House Republican border tax adjustment plan as “too complicated“ (via WSJ). Already, the spectacle of passing a fiscal budget, even with Republican control of the White House, the Senate, and the House, is turning into a public “sausage making“ exercise.

A strategy of USD weakness makes more sense for Trump if he wants to achieve his trade policy objectives. As Larry Summers pointed out, Trump's populist message of attacking trading partners like Mexico has the unintended effect of depressing the Mexican Peso. A lower MXNUSD exchange rate paradoxically incentivizes companies to move production south of the Rio Grande (via AP and Business Insider):

Summers told a panel at the World Economic Forum on Wednesday that the president-elect's "rhetoric and announced policies" over Mexico have led to a big fall in the value of the Mexican peso against the dollar.

That, he said, is a "dagger at Ohio," as it will make it even more attractive for firms to move to Mexico.

The full post can be found at our new site here.

The contrarian message from rotation analysis

Mid-week market update: Occasionally, it is useful to step back and view the market through a different prism. I was reviewing the RRG charts of sector, region, and factor, and I found that they are all telling a similar story.

First, let's start with a primer. Relative Rotation Graphs, or RRG charts, are a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which changes to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.

The latest sector rotation chart shows that financial stocks and cyclical stocks (energy, industrials, materials) are the leading groups, but they are weakening. By contrast, defensive sectors are starting to improve from the lagging quadrant to improving. In particular, the upgrade of interest sensitive utilities from lagging to improving quadrant is consistent with the nascent counter-trend rally seen in the bond market.

The full post can be found at our new site here.

Main Street bulls vs. Washington bears

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"

My inner trader uses the trading component of the Trend Model to look for changes in direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.

The latest signals of each model are as follows:

• Ultimate market timing model: Buy equities*
• Trend Model signal: Risk-on*
• Trading model: Bearish*

* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.


Bifurcated opinions
Opinions are starting to split badly on the market and the economy. Main Street has become more upbeat on the economic outlook. The NFIB small business survey showed that optimism surged in December, though Renaissance Macro pointed out that optimism has not translated yet into a significant upswing in sales growth.

The preliminary January report of UMich consumer confidence shows that it is elevated, though opinions are reportedly split along political lines:

The post-election surge in optimism was accompanied by an unprecedented degree of both positive and negative concerns about the incoming administration spontaneously mentioned when asked about economic news. The importance of government policies and partisanship has sharply risen over the past half century. From 1960 to 2000, the combined average of positive and negative references to government policies was just 6%; during the past six years, this proportion averaged 20%, and rose to new peaks in early January, with positive and negative references totaling 44%.

Chart via Calculated Risk:

By contrast, I am seeing signs of doubt from political circles that Trump will be successful with his pro-growth agenda, even among Republicans. Traditional approaches to sentiment analysis states that the public tends to be slow. When the public finally latches onto an economic theme, it is indicative of a contrarian top (or bottom). On the other hand, the improvement in business and consumer confidence can be signals of broad based economic strength.

So who is right? Main Street, or Washington?


The stakes are high
Here is what's at stake for equity investors. As we enter earnings season, Factset shows that forward EPS continues to rise, which is indicative of Street expectations of broad based cyclical strength.

However, broad based cyclical upturn can only get you so far. This Factset chart also shows that forward P/E ratio is elevated and expensive compared to its own history. Current forward P/E is based on bottom-up derived earnings based only analyst expectations of economic conditions without the Trump fiscal plan. That's because you can't make estimates when you don't have the details of the proposals. A top-down analysis suggests that the Trump tax cuts could add roughly 10% to forward earnings, which would bring down the forward P/E ratio to more reasonable levels (annotations are mine).

To rephrase my previous question: Who is right about the expectations for the Trump tax cuts? Main Street or Washington?

The full post can be found at our new site here.

A test for the markets

Mid-week market comment: Arthur Hill at stockcharts recently observed that the Russell 2000 was in a tight consolidation range, which is characterized by a narrowing Bollinger Band. Such conditions tend to resolve themselves with volatility expansions which represent breakouts from the trading range.

His remarks about the Russell 2000 could also be applicable to the current conditions of the SPX as well. The key question is which direction will the breakout occur?

The full post can be found at our new site here.

Good news, bad news from December Jobs Report

I had been meaning to write about the December Jobs Report, which was released last Friday, but I hadn't gotten around to it. The report had elements of both good news and bad news.

The good news is the December report showed a solid market. True, the headline Non-Farm Payroll figure missed market expectations, but November was revised upwards, and the positive revision in November was bigger than the December miss.

In conjunction with the December Jobs Report, the Council of Economic Advisers released a report indicating that the American economy had added more jobs than other advanced economies in the last eight years (via Business Insider).

Notwithstanding the political victory lap nature of the CEA`s report, the December Jobs Report should keep the Fed on track with its expectations of three rate hikes in 2017.

Here is the bad news. There are worrisome signs that the economy is starting to overheat. The combination of Fed actions on interest rates and wage pressures on operating margins are likely to be unfriendly to the stock market. Unless the Trump administration comes through on their promised tax cuts in the near future, upside for equity prices will be limited in 2017.

The full post can be found at our new site here.

How Trump/Navarro could spark a market crash

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"

My inner trader uses the trading component of the Trend Model to look for changes in direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.

The latest signals of each model are as follows:

• Ultimate market timing model: Buy equities*
• Trend Model signal: Risk-on*
• Trading model: Bearish (downgrade)*

* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.


How the market could crash
At the end of 2016, WSJ reporter Greg Zuckerman made a tweet with ominous implications. Hmm...what happened in 1929?

Here is how a market crash can happen. Donald Trump's appointment of Peter Navarro, the author of Death by China, represents the biggest source of policy tail-risk for the capital markets. Bashing China may be satisfying for Trump supporters, but the Chinese economy is increasingly fragile (see How much 'runway' does China have left?). Impose tariffs on Chinese goods, and you risk a Chinese economic slowdown that drags the world into a synchronized global recession.

While a crash is most definitely not my base case, the scenario of collapsing trade flows from a Chinese hard landing would first tank the Asian economies, followed by Europe, whose banking system are still over-levered and have not fully recovered from the Great Financial Crisis. Under such circumstances, an equity bear market would be a 100% certainty, and a market crash would be within the realm of possibility.

It's hard to estimate the actual probability of a US induced China hard landing scenario. However, we should get better clarity as the Trump team moves into the West Wing of the White House in the coming weeks. In addition, President-Elect Trump may give us some clues on trade when he holds his press conference on Wednesday.

The full post can be found at our new site here.

Top-down meets bottom-up: How expensive are stocks?

Recently, I have seen several variations of market analysis concluding that stocks are expensive based on forward P/E ratios. Here is a tweet from Jeroen Blokland. David Rosenberg characterized the current equity environment as picking up pennies in front of a steamroller.

Blokland followed up the above tweet with an additional comment indicating that earnings growth is badly needed.

Does this mean it's time to get cautious and sell your all stocks? Not so fast! A case can be made that the analysis of the forward P/E chart is based on a misread of how forward EPS expectations are formed. On an adjusted basis, stocks do not appear to be expensive at all.

The full post can be found at our new site here.

A 2016 report card

As 2016 has drawn to a close, it's time to review the report card from my 2016 calls. My inner investor performed very well, though my inner trader suffered a number of hiccups. Overall, I had a solid year in 2016.


My inner investor: Steadfastly bullish
The chart below depicts the key highlights of my investment calls, which are based on a 6-24 month time horizon. I remained steadfastly bullish for most of 2016 even as others panicked. The jury is still out on my latest call for a correction in early 2017 (see A correction on the horizon?). My analysis has turned out to be largely correct.

Buy! Blood is in the streets! (January 2016)
Super Tuesday Special: How President Trump could spark a market blow-off (March 2016)
How the SPX could get to 2200 and beyond (June 2016)
A correction on the horizon? (December 2016, the jury is still out on that call)



My inner trader: The devil is in the details
The chart below depicts the calls of my trading model. While they appeared to be very good at first glance, I discovered a couple of problems in implementing the trades.

First, the model was a little slow and did not react to the slow deterioration in the market during the late summer. Even as the model remained long, the slow drip-drip-drip downtrend in prices (marked by the white arrow in the chart) was a little disconcerting. As the trading model is based on sensing changes in price trends, the lack of trade signals highlights a problem when the market moves sideways.

On the other hand, another problem arose when the model became overly sensitized to changes in prices. The trading model experienced whipsawing signals in the aftermath of the Brexit election (buy to sell to buy within a few days) and the US election (buy to sell to buy in the overnight futures market). These two issue highlight the need for further research in the future.

These problems highlight the problem with short-term trading and trading models. The chart above is a weekly chart and therefore does not show the actual price volatility experienced by traders.

Sometimes trading is like that. You think you have the perfect setup, followed by the perfect signal, then you miss on your execution, which results in an unfortunate outcome (click this link if the video is not visible).

I have no idea of what 2017 will bring, though I outlined my market views in my last post (see The cloudy side of Trump). In all likelihood, the incoming Trump administration will create a high degree of uncertainty and market volatility.

I hope that I can help you navigate it in the year to come.

The cloudy side of Trump

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"

My inner trader uses the trading component of the Trend Model to look for changes in direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.

The latest signals of each model are as follows:

• Ultimate market timing model: Buy equities*
• Trend Model signal: Risk-on*
• Trading model: Bearish (downgrade)*

* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.


Is the Trump honeymoon over?
Bloomberg had a marvelous article that captures the market's mood right now. It is entitled "The sunny side of Trump:There’s reason for short-term optimism. Then he has to deal with his policy contradictions".

How long will this honeymoon last? For American business, the positive scenario is that Trump appoints sensible people, matures in office, and puts most of his considerable energy into the pro-growth parts of his agenda. The negative scenario is that he goes back to being the inciter who flew off the Twitter handle so much during the campaign that his people temporarily seized control of his account.

The bull case, which I laid out two weeks ago (see How Trumponomics can push the SP 500 to 2500+), is well known. Since the election, the stock market has embraced the prospect of a global cyclical upturn, anticipated fiscal stimulus, and buyback gains from a tax holiday fueled repatriation of offshore corporate cash. I went on to outline the bear case as the second part of my series the following week (see The bear case: How Trumponomics keeps me awake at night).

As Inauguration Day approaches, acts such as the appointment of Peter "Death by China" Navarro as trade czar has begun to unnerve the bulls. Market psychology is starting to turn from greed to fear. Concerns are rising that new Trump edicts may see parallels to this scene from Woody Allen`s 1971 comedy, Bananas (click this link if the video is not visible).

To be sure, bullish sentiment has surged in the short-term. Stock prices may have run ahead of themselves and a corrective period is likely. The bigger question is how will the bull and bear case resolve themselves in the longer term? I address that question this week with a scenario analysis that has some surprising results.

The full post can be found at our new site here.