Sunday, February 14, 2016

Profit by thinking like Big Money

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 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 seeks to answer the question, "Is the trend getting better (bullish) or worse (bearish)?" 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 this model has shown turnover rates of about 200% per month.

The signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Risk-off*
  • 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 any changes during the week at @humblestudent.

The value of an investment process
In the past few weeks, I have heard from many worried investors and traders as stock prices fell. These difficult period illustrate the need for an investment process. In bull phases, no one needs a process because the market is rising, When the market declines, however, investors and traders need to have laid out a decision process that details an analytical framework of what to do ahead of time. Otherwise, they wind up panicking because they either under or over-react to the bear story du jour.

In the current case, the bear story du jour description is apt because there is no clear fundamental reason why the stock prices are falling (see the different explanations advanced in this Reuters story, What`s behind the global stock market selloff?). This decline began over concerns about falling oil prices and their possible effects on junk bonds, then it was China, then the excuse of the day became worries about European banks...and so on.

Don`t get me wrong. There are some very valid reasons to de-risk a portfolio, but unless you have laid out the proper analytical framework ahead of time, you can easily get lost.

Think like an institutional investor
A sustainable bear market needs valid fundamental and macro reasons for equity prices to retreat. That`s because, after the fast money hedge funds and nimble traders sell, the slow institutional behemoths still have to evaluate the situation and act.  Institutional funds represent the Big Money. While they may not make investment shifts very often, when they do move, the fund flows are enormous, unrelenting and glacial.

As an exercise, imagine being an analyst at an institution manager with $10 billion in US equity assets. Our analyst is part of the Strategy and Asset Allocation group. The Investment Committee is meeting next week to consider what to do in light of the current market turmoil. Our analyst has been asked to prepare a report and make recommendations.

The full post is at our new site here.

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1 comment:

John Brady said...

I just would like to say. you post on humble student of the markets is timely. In fact with North Korea's latest missile test, China will more than likely see additional pain from it capital markets as Beijing tries to pump up North Korea's poor financial situation. This was a great article.