Lessons From A Trading Great: Ed Thorp

Ed Thorp, the father of quant investing, might be the most impressive market wizard. He turned seemingly random processes into predictable events, transforming the art of speculation into a science decades before Wall Street’s quants became mainstream.

His domination in the financial world began in the casino. Thorp figured out how to beat the most “unbeatable” games. In roulette, he created a wearable computer that gave him a 44% edge. And in blackjack, he developed the very first card counting system that’s still widely used today.

These gambling skills transferred perfectly to markets. Thorp’s first hedge fund, Princeton Newport Partners, never had a down year. It compounded money at 19.1% for almost 20 years — destroying the S&P 500.

His second fund, which he ran from August 1992 to September 2002, performed just as well with an annualized return of 18.2%.

Thorp’s list of discoveries, inventions, and people he’s influenced and invested in is comically long:

  • He discovered an options pricing formula before the Black-Scholes model became public.
  • He started the first ever quant hedge fund.
  • He was the first to use convertible and statistical arbitrage.
  • He was the first limited partner in Ken Griffin’s Citadel — one of the most successful hedge funds ever.
  • His books on blackjack and trading heavily influenced “bond king” Bill Gross.
  • He discovered that Bernie Madoff was a fraud many years before it became public.

And the list goes on…

Thorp’s advice on approaching games of incomplete information is methodical and scientific, making it very useful to incorporate into your own trading process. The following is his most valuable wisdom with our commentary attached:

Rare Events (Fat Pitches)

Fat pitches — the types of trades Buffett, Druck, and Soros salivate over— happen seldomly. And that makes sense because is takes extraordinary circumstances to push markets far enough from equilibrium to create these opportunities.

When these dislocations occur, it pays to go on high alert. It’s possible to make your year or even your career in a few days by hitting these fat pitches on the nose.

Here are a few of Thorp’s best plays:

1987 Crash

Black Monday was a traumatizing experience for most traders… but not for Thorp. When the crash started to accelerate Thorp was having his daily lunch date with his wife Vivian. The office called to report the news and Thorp didn’t even flinch. He had already accounted for all possible market scenarios, including this one, and didn’t have any reason to panic. He calmly finished his lunch and then went home to think about how to exploit the situation. This is what he came up with:

After thinking hard about it overnight I concluded that massive feedback selling by the portfolio insurers was the likely cause of Monday’s price collapse. The next morning S&P futures were trading at 185 to 190 and the corresponding price to buy the S&P itself was 220. This price difference of 30 to 35 was previously unheard of, since arbitrageurs like us generally kept the two prices within a point or two of each other. But the institutions had sold massive amounts of futures, and the index itself didn’t fall nearly as far because the terrified arbitrageurs wouldn’t exploit the spread. Normally when futures were trading far enough below the index itself, the arbitrageurs sold short a basket of stocks that closely tracked the index and bought an offsetting position in the cheaper index futures. When the price of the futures and that of the basket of underlying stocks converged, as they do later when the futures contracts settle, the arbitrageur closes out the hedge and captures the original spread as a profit. But on Tuesday, October 20, 1987, many stocks were difficult or impossible to sell short. That was because of the uptick rule.

It specified that, with certain exceptions, short-sale transactions are allowed only at a price higher than the last previous different price (an “uptick”). This rule was supposed to prevent short sellers from deliberately driving down the price of a stock. Seeing an enormous profit potential from capturing the unprecedented spread between the futures and the index, I wanted to sell stocks short and buy index futures to capture the excess spread. The index was selling at 15 percent, or 30 points, over the futures. The potential profit in an arbitrage was 15 percent in a few days. But with prices collapsing, upticks were scarce. What to do?

I figured out a solution. I called our head trader, who as a minor general partner was highly compensated from his share of our fees, and gave him this order: Buy $ 5 million worth of index futures at whatever the current market price happened to be (about 190), and place orders to sell short at the market, with the index then trading at about 220, not $ 5 million worth of assorted stocks—which was the optimal amount to best hedge the futures—but $ 10 million. I chose twice as much stock as I wanted, guessing only about half would actually be shorted because of the scarcity of the required upticks, thus giving me the proper hedge. If substantially more or less stock was sold short, the hedge would not be as good but the 15 percent profit cushion gave us a wide band of protection against loss.

In the end we did get roughly half our shorts off for a near-optimal hedge. We had about $ 9 million worth of futures long and $ 10 million worth of stock short, locking in $ 1 million profit. If my trader hadn’t wasted so much of the market day refusing to act, we could have done several more rounds and reaped additional millions.

Kovner Oil Tanker

In the 1980s, Bruce Kovner discovered a trading opportunity in buying oil tankers for scrap value. Thorp instantly recognized the fat pitch and invested.

Along with Jerry Baesel, the finance professor from UCI who joined me at PNP, I spent an afternoon with Bruce in the 1980s in his Manhattan apartment discussing how he thought and how he got his edge in the markets. Kovner was and is a generalist, who sees connections before others do.

About this time he realized large oil tankers were in such oversupply that the older ones were selling for little more than scrap value. Kovner formed a partnership to buy one. I was one of the limited partners. Here was an interesting option. We were largely protected against loss because we could always sell the tanker for scrap, recovering most of our investment; but we had a substantial upside: Historically, the demand for tankers had fluctuated widely and so had their price. Within a few years, our refurbished 475,000-ton monster, the Empress Des Mers, was profitably plying the world’s sea-lanes stuffed with oil. I liked to think of my part ownership as a twenty-foot section just forward of the bridge. Later the partnership negotiated to purchase what was then the largest ship ever built, the 650,000-ton Seawise Giant. Unfortunately for the sellers, while we were in escrow their ship unwisely ventured near Kharg Island in the Persian Gulf, where it was bombed by Iraqi aircraft, caught fire, and sank. The Empress Des Mers operated profitably into the twenty-first century, when the saga finally ended. Having generated a return on investment of 30 percent annualized, she was sold for scrap in 2004, fetching almost $ 23 million, far more than her purchase price of $ 6 million.

Sometimes the best trades aren’t on public exchanges. Looking outside traditional trading vehicles can reveal huge opportunities other traders pass up.

SPACs

An unusual opportunity to buy assets at a discount arose during the financial crash of 2008–09, in the form of certain closed-end funds called SPACs. These “special purpose acquisition corporations” were marketed during the preceding boom in private equity investing. Escrowing the proceeds from the initial public offering (IPO) of the SPAC, the managers promised to invest in a specified type of start-up company. SPACs had a dismal record by the time of the crash, their investments in actual companies losing, on average, 78 percent. When formed, a typical SPAC agreed to invest the money within two years, with investors having the choice—prior to the SPAC buying into companies—of getting back their money plus interest instead of participating.

By December 2008, panic had driven even those SPACs that still owned only US Treasuries to a discount to NAV. These SPACs had from two years to just a few remaining months either to invest or to liquidate and, before investing, offer investors a chance to cash out at NAV. In some cases we could even buy SPACs holding US Treasuries at annualized rates of return to us of 10 to 12 percent, cashing out in a few months. This was at a time when short-term rates on US Treasuries had fallen to approximately zero!

Runaway Inflation

Short-term US Treasury bill returns went into double-digit territory, yielding almost 15 percent in 1981. The interest on fixed-rate home mortgages peaked at more than 18 percent per year. Inflation was not far behind. These unprecedented price moves gave us new ways to profit. One of these was in the gold futures markets.

At one point, gold, for delivery two months in the future, was trading at $ 400 an ounce and gold futures fourteen months out were trading for $ 500 an ounce. Our trade was to buy the gold at $ 400 and sell it at $ 500. If, in two months, the gold we paid $ 400 for was delivered to us, we could store it for a nominal cost for a year, then deliver it for $ 500, gaining 25 percent in twelve months.

Notice the commonalities between Thorp’s fat pitches:

  • They’re rare and typically occur during crises. Crises create large dislocations that cause investors to act irrationally, creating huge opportunities.
  • They all have asymmetric risk/reward ratios.
  • Fast action was needed to capture each of them. Fat pitches don’t last long. Other traders will eventually find them and pounce.
  • They’re all “one of a kind” opportunities. The exact scenario had never happened before and creative thinking was needed to capitalize. Although history rhymes, it does not repeat. The next fat pitch won’t be exactly like the last one.  

Gambling As Training

Understanding gambling games like blackjack and some of the others is one of the best possible training grounds for getting into the investment world. You learn how to manage money, you learn how to compute odds, you learn how to reason what to do when you have an advantage.

Gambling is investing simplified. Both can be analyzed using mathematics, statistics, and computers. Each requires money management, choosing the proper balance between risk and return. Betting too much, even though each individual bet is in your favor, can be ruinous.

Notice how Thorp didn’t say anything about MBAs, economic degrees, or finance classes. Those don’t prepare you for the core challenges you’ll face as a trader like position sizing and risk management.

Our favorite cross-training exercise at Macro Ops is poker. Poker forces you to think in terms of probabilistic outcomes while managing your risk and establishing an edge.

Edge

You can’t succeed in trading without an edge. And a good way to find that edge is by asking yourself how the market is inefficient and how you can exploit it.

In A Man For All Markets Thorp details sources of inefficiency:

In our odyssey through the real world of investing, we have seen an inefficient market that some of us can beat where:

  1. Some information is instantly available to the minority that happen to be listening at the right time and place. Much information starts out known only to a limited number of people, then spreads to a wider group in stages. This spreading could take from minutes to months, depending on the situation. The first people to act on the information capture the gains. The others get nothing or lose. (Note: The use of early information by insiders can be either legal or illegal, depending on the type of information, how it is obtained, and how it’s used.)
  2. Each of us is financially rational only in a limited way. We vary from those who are almost totally irrational to some who strive to be financially rational in nearly all their actions. In real markets the rationality of the participants is limited.
  3. Participants typically have only some of the relevant information for determining the fair price of a security. For each situation, both the time to process the information and the ability to analyze it generally vary widely.
  4. The buy and sell orders that come in response to an item of information sometimes arrive in a flood within a few seconds, causing the price to gap or nearly gap to a new level. More often, however, the reaction to news is spread out over minutes, hours, days, or months, as the academic literature documents.

He then explains how to exploit these inefficiencies (emphasis mine):

  1. Get good information early. How do you know if your information is good enough or early enough? If you are not sure, then it probably isn’t.
  2. Be a disciplined rational investor. Follow logic and analysis rather than sales pitches, whims, or emotion. Assume you may have an edge only when you can make a rational affirmative case that withstands your attempts to tear it down. Don’t gamble unless you are highly confident you have the edge. As Buffett says, “Only swing at the fat pitches.”
  3. Find a superior method of analysis. Ones that you have seen pay off for me include statistical arbitrage, convertible hedging, the Black-Scholes formula, and card counting at blackjack. Other winning strategies include superior security analysis by the gifted few and the methods of the better hedge funds.
  4. When securities are known to be mispriced and people take advantage of this, their trading tends to eliminate the mispricing. This means the earliest traders gain the most and their continued trading tends to reduce or eliminate the mispricing. When you have identified an opportunity, invest ahead of the crowd.

Pay special attention to his second point: Don’t trade unless you’re sure you have an edge that’ll create better than random outcomes.

An easy way to do this is by backtesting or paper trading your strategy before investing in it.

It’s also a good idea to try finding a solid trading edge in markets you love. As Thorp explains:  

To beat the market, focus on investments well within your knowledge and ability to evaluate, your “circle of competence.”

If you love following small companies then just trade those. If you come from an energy background then focus on crude oil and natural gas. And if you like math and volatility, options are a good place to start. Only venture into a new market after spending a significant amount of time studying it!

Efficient Markets

Anyone who’s actually traded knows the Efficient Market Hypothesis is bogus. It’s a poor mental model used by lazy academics. Thorp has a much better take:

When people talk about efficient markets they think it’s a property of the market. But I think that’s not the way to look at it. The market is a process that goes on. And we have, depending on who we are, different degrees of knowledge about different parts of that process.

. . . market inefficiency depends on the observer’s knowledge. Most market participants have no demonstrable advantage. For them, just as the cards in blackjack or the numbers at roulette seem to appear at random, the market appears to be completely efficient.

Markets aren’t actually random. They only appear random to those without expertise. The right knowledge transforms the market from a sequence of random numbers into a predictable process.

Combining Technicals With Fundamentals

In the mid 2000s Thorp developed a trend following futures strategy. During the process he discovered that combining fundamental information with technical signals was superior to just technicals alone.

Here he is in Hedge Fund Market Wizards:  

The fundamental factors we took into account varied with the market sector. In metal and agricultural markets, the spread structure—whether a market is in backwardation or contango—can be important, as can the amount in storage relative to storage capacity. In markets like currencies, however, those types of factors are irrelevant.

Combining technicals with fundamentals can boost your win rate. Find the key fundamental drivers in your market and add them into your process.

Anchoring

In A Man For All Markets Thorp describes his first ever trade buying a company called Electric Autolite. In the subsequent two years the stock declined 50%. He decided to hold out, hoping it would return to his entry point so he could break even. The stock eventually did rebound and Thorp got out for a scratch, but he later realized how stupid that was. Here’s Thorp reflecting on it:

What I had done was focus on a price that was of unique historical significance to me, only me, namely, my purchase price.

Thorp’s early mistake is called anchoring. Humans tend to place special significance on price levels they originally entered at. But in reality, these prices have little significance. Don’t ever emotionally attach yourself to any price.

Interpreting Financial Headlines

It’s important to take news headlines with a grain of salt. Journalists build narratives behind every market move because it’s their job. Thorp warns about getting caught up in the noise:

Routine financial reporting also fools investors. “Stocks Slump on Earnings Concern” cried a New York Times Business Day headline. The article continued, “Stock prices fell as investors continued to be concerned about third-quarter results.” A slump? Let’s see. “The Dow Jones Industrial Average (DJIA) declined 2.96 points, to 10,628.36.” That’s 0.03 percent, compared with a typical daily change of about 1 percent. Based on the historical behavior of changes in the DJIA, a percentage change greater than this happens more than 97 percent of the time. The Dow is likely to be this close to even on fewer than eight days a year, hardly evidence of investor concern.

One way to separate signal from noise is to track the market’s expected move for the day. To calculate the expected percentage move of the S&P 500, take the VIX and divide it by the the square root of 252. If price stays within that band, any “news” for the day is likely not worth paying attention to.

Correlation

All the trading greats stress the importance of correlation. A low correlation among positions diversifies the portfolio and creates a much better risk/reward profile.

Here’s Thorp from HFMW:

We tracked a correlation matrix that was used to reduce exposures in correlated markets. If two markets were highly correlated, and the technical system went long one and short the other, that was great. But if it wanted to go long both or short both, we would take a smaller position in each.

A common problem traders face when monitoring correlation is the lookback period. Thorp found that 60 days was best. A shorter window is too noisy and a longer one will produce correlations that aren’t relevant anymore.

The Moore Research Center has a free to use correlation matrix for all major macro markets. Check it here.

Leverage

Use leverage incorrectly and you’ll blow up. But properly harness it and you can engineer a risk to reward ratio that perfectly suits you.

Heres Thorp:

The lesson of leverage is this: Assume that the worst imaginable outcome will occur and ask whether you can tolerate it. If the answer is no, then reduce your borrowing.

Don’t rely on a risk control model that uses probability to estimate your max loss. Always assume the absolute worst case and manage from there.

Position Sizing

Thorp popularized the position sizing formula called the Kelly Criterion. Here he is from Hedge Fund Market Wizards:

The Kelly criterion is the bet size that will produce the greatest expected growth rate in the long term. If you can calculate the probability of winning on each bet or trade and the ratio of the average win to average loss, then the Kelly criterion will give you the optimal fraction to bet so that your long-term growth rate is maximized.

Here’s the version of the formula that works best for trading:

So for example, if a trade has a 1:1 reward to risk ratio, with a 60% chance of winning, you would bet:

((1)(.6)-(.4))/1 = .2 or 20% of your account

The one issue with Kelly sizing is that we’ll never know our true win rate or reward to risk ratio in markets. The best we can do is estimate.

Also, the effectiveness of a trading edge changes over time. Because markets evolve, the same edge won’t work forever.

This is why Thorp only uses the Kelly number as a reference. In practice it’s better to bet around half-Kelly because you get about three-quarters of the return with half the volatility.

If you’re less certain of your edge, you should bet an even smaller amount. When Thorp was working on his trend following model in the mid 2000s, he was simulating 1/10 of the Kelly number.

Thorp also has advice on drawdowns. He suggests lowering your position size during rough patches and then ramping up again as you come out of them.

If we lost 5 percent, we would shrink our positions. If we lost another few percent, we would shrink our positions more. The program would therefore gradually shut itself down, as we got deeper in the hole, and then it had to earn its way out. We would wait for a threshold point between a 5 percent and 10 percent drawdown before beginning to reduce our positions, and then we would incrementally reduce our position with each additional 1 percent drawdown.

This is an extremely robust risk management technique used by almost all the trading greats. To read more about them, download our special report by clicking here.

 

 

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Macro Ops




Hedge Fund Manager Mark Sellers On Becoming A Great Investor

This is a killer talk I came across from Hedge Fund manager Mark Sellers, speaking to some Harvard MBA kids on what it takes to make it in markets. Regardless of whether you consider yourself a trader or investor, Mark’s “seven traits” apply.

Enjoy…

First of all, I want to thank Daniel Goldberg for asking me to be here today and all of you for actually showing up. I haven’t been to Boston in a while but I did live here for a short time in 1991 & 1992 when I attended Berklee School of Music.

I was studying to be a jazz piano player but dropped out after a couple semesters to move to Los Angeles and join a band. I was so broke when I lived here that I didn’t take advantage of all the things there are to do in Boston, and I didn’t have a car to explore New England. I mostly spent 10-12 hours a day holed up in a practice room playing the piano. So whenever I come back to visit Boston, it’s like a new city to me.

One thing I will tell you right off the bat: I’m not here to teach you how to be a great investor. On the contrary, I’m here to tell you why very few of you can ever hope to achieve this status.

If you spend enough time studying investors like Charlie Munger, Warren Buffett, Bruce Berkowitz, Bill Miller, Eddie Lampert, Bill Ackman, and people who have been similarly successful in the investment world, you will understand what I mean.

I know that everyone in this room is exceedingly intelligent and you’ve all worked hard to get where you are. You are the brightest of the bright. And yet, there’s one thing you should remember if you remember nothing else from my talk: You have almost no chance of being a great investor.

You have a really, really low probability, like 2% or less. And I’m adjusting for the fact that you all have high IQs and are hard workers and will have an MBA from one of the top business schools in the country soon. If this audience was just a random sample of the population at large, the likelihood of anyone here becoming a great investor later on would be even less, like 1/50th of 1% or something.

You all have a lot of advantages over Joe Investor, and yet you have almost no chance of standing out from the crowd over a long period of time.

And the reason is that it doesn’t much matter what your IQ is, or how many books or magazines or newspapers you have read, or how much experience you have, or will have later in your career. These are things that many people have and yet almost none of them end up compounding at 20% or 25% over their careers.

I know this is a controversial thing to say and I don’t want to offend anyone in the audience. I’m not pointing out anyone specifically and saying that you have almost no chance to be great. There are probably one or two people in this room who will end up compounding money at 20% for their career, but it’s hard to tell in advance who those will be without knowing each of you personally.

On the bright side, although most of you will not be able to compound money at 20% for your entire career, a lot of you will turn out to be good, above average investors because you are a skewed sample, the Harvard MBAs. A person can learn to be an above-average investor. You can learn to do well enough, if you’re smart and hardworking and educated, to keep a good, high-paying job in the investment business for your entire career.

You can make millions without being a great investor. You can learn to outperform the averages by a couple points a year through hard work and an above average IQ and a lot of study. So there is no reason to be discouraged by what I’m saying today. You can have a really successful, lucrative career even if you’re not the next Warren Buffett.

But you can’t compound money at 20% forever unless you have that hard-wired into your brain from the age of 10 or 11 or 12.

I’m not sure if it’s nature or nurture, but by the time you’re a teenager, if you don’t already have it, you can’t get it. By the time your brain is developed, you either have the ability to run circles around other investors or you don’t.

Going to Harvard won’t change that and reading every book ever written on investing won’t either. Neither will years of experience. All of these things are necessary if you want to become a great investor, but in and of themselves aren’t enough because all of them can be duplicated by competitors.

As an analogy, think about competitive strategy in the corporate world. I’m sure all of you have had, or will have, a strategy course while you’re here. Maybe you’ll study Michael Porter’s research and his books, which is what I did on my own before I entered business school. I learned a lot from reading his books and still use it all the time when analyzing companies.

Now, as a CEO of a company, what are the types of advantages that help protect you from the competition?

How do you get to the point where you have a wide economic moat, as Buffett calls it?

Well one thing that isn’t a source of a moat is technology because that can be duplicated and always will be, eventually, if that’s the only advantage you have. Your best hope in a situation like this is to be acquired or go public and sell all your shares before investors realize you donít have a sustainable advantage.

Technology is one type of advantage that’s short-lived. There are others, such as a good management team or a catchy advertising campaign or a hot fashion trend. These things produce temporary advantages but they change over time, or can be duplicated by competitors.

An economic moat is a structural thing. It’s like Southwest Airlines in the 1990s, it was so deeply ingrained in the company culture, in every employee, that no one could copy it, even though everyone kind of knew how Southwest was doing it.

If your competitors know your secret and yet still can’t copy it, that’s a structural advantage. That’s a moat.

The way I see it, there are really only four sources of economic moats that are hard to duplicate, and thus, long-lasting. One source would be economies of scale and scope. Wal-Mart is an example of this, as is Cintas in the uniform rental business or Procter & Gamble or Home Depot and Lowe’s.

Another source is the network affect, ala eBay or Mastercard or Visa or American Express.

A third would be intellectual property rights, such as patents, trademarks, regulatory approvals, or customer goodwill. Disney, Nike, or Genentech would be good examples here. A fourth and final type of moat would be high customer switching costs. Paychex and Microsoft are great examples of companies that benefit from high customer switching costs.

These are the only four types of competitive advantages that are durable, because they are very difficult for competitors to duplicate. And just like a company needs to develop a moat or suffer from mediocrity, an investor needs some sort of edge over the competition or he’ll suffer from mediocrity.

There are 8,000 hedge funds and 10,000 mutual funds and millions of individuals trying to play the stock market every day. How can you get an advantage over all these people? What are the sources of the moat?

Well, one thing that is not a source is reading a lot of books and magazines and newspapers. Anyone can read a book.

Reading is incredibly important, but it won’t give you a big advantage over others. It will just allow you to keep up. Everyone reads a lot in this business. Some read more than others, but I don’t necessarily think there’s a correlation between investment performance and number of books read.

Once you reach a certain point in your knowledge base, there are diminishing returns to reading more. And in fact, reading too much news can actually be detrimental to performance because you start to believe all the crap the journalists pump out to sell more papers.

Another thing that won’t make you a great investor is an MBA from a top school or a CFA or PhD or CPA or MS or any of the other dozens of possible degrees and designations you can obtain.

Harvard can’t teach you to be a great investor. Neither can my alma mater, Northwestern University, or Chicago, or Wharton, or Stanford. I like to say that an MBA is the best way to learn how to exactly, precisely, equal the market return. You can reduce your tracking error dramatically by getting an MBA.

This often results in a big paycheck even though it’s the antithesis of what a great investor does. You can’t buy or study your way to being a great investor. These things won’t give you a moat. They are simply things that make it easier to get invited into the poker game.

Experience is another over-rated thing.

I mean, it’s incredibly important, but it’s not a source of competitive advantage. It’s another thing that is just required for admission. At some point the value of experience reaches the point of diminishing returns. If that wasn’t true, all the great money managers would have their best years in their 60s and 70s and 80s, and we know that’s not true. So some level of experience is necessary to play the game, but at some point, it doesn’t help any more and in any event, itís not a source of an economic moat for an investor.

Charlie Munger talks about this when he says you can recognize when someone gets it right away, and sometimes it’s someone who has almost no investing experience.

So what are the sources of competitive advantage for an investor?

Just as with a company or an industry, the moats for investors are structural. They have to do with psychology, and psychology is hard wired into your brain. It’s a part of you. You can’t do much to change it even if you read a lot of books on the subject.

The way I see it, there are at least seven traits great investors share that are true sources of advantage because they canít be learned once a person reaches adulthood. In fact, some of them can’t be learned at all; you’re either born with them or you aren’t.

Trait #1

Is the ability to buy stocks while others are panicking and sell stocks while others are euphoric.

Everyone thinks they can do this, but then when October 19, 1987 comes around and the market is crashing all around you, almost no one has the stomach to buy. When the year 1999 comes around and the market is going up almost every day, you can’t bring yourself to sell because if you do, you may fall behind your peers.

The vast majority of the people who manage money have MBAs and high IQs and have read a lot of books. By late 1999, all these people knew with great certainty that stocks were overvalued, and yet they couldn’t bring themselves to take money off the table because of the ìinstitutional imperative, as Buffett calls it.

Trait #2

The second character trait of a great investor is that he is obsessive about playing the game and wanting to win.

These people don’t just enjoy investing; they live it. They wake up in the morning and the first thing they think about, while they’re still half asleep, is a stock they have been researching, or one of the stocks they are thinking about selling, or what the greatest risk to their portfolio is and how they’re going to neutralize that risk.

They often have a hard time with personal relationships because, though they may truly enjoy other people, they don’t always give them much time. Their head is always in the clouds, dreaming about stocks.

Unfortunately, you can’t learn to be obsessive about something. You either are, or you aren’t. And if you aren’t, you can’t be the next Bruce Berkowitz.

Trait #3

A third trait is the willingness to learn from past mistakes. The thing that is so hard for people and what sets some investors apart is an intense desire to learn from their own mistakes so they can avoid repeating them.

Most people would much rather just move on and ignore the dumb things they’ve done in the past. I believe the term for this is repression.

But if you ignore mistakes without fully analyzing them, you will undoubtedly make a similar mistake later in your career. And in fact, even if you do analyze them it ís tough to avoid repeating the same mistakes.

Trait #4

A fourth trait is an inherent sense of risk based on common sense.

Most people know the story of Long Term Capital Management, where a team of 60 or 70 PhDs with sophisticated risk models failed to realize what, in retrospect, seemed obvious: they were dramatically over leveraged. They never stepped back and said to themselves, “Hey, even though the computer says this is ok, does it really make sense in real life?”

The ability to do this is not as prevalent among human beings as you might think. I believe the greatest risk control is common sense, but people fall into the habit of sleeping well at night because the computer says they should. They ignore common sense, a mistake I see repeated over and over in the investment world.

Trait #5

Great investors have confidence in their own convictions and stick with them, even when facing criticism. Buffett never get into the dot-com mania though he was being criticized publicly for ignoring technology stocks.

He stuck to his guns when everyone else was abandoning the value investing ship and Barron’s was publishing a picture of him on the cover with the headline “What’s Wrong, Warren?”

Of course, it worked out brilliantly for him and made Barron’s look like a perfect contrary indicator.

Personally, I’m amazed at how little conviction most investors have in the stocks they buy. Instead of putting 20% of their portfolio into a stock, as the Kelly Formula might say to do, they’ll put 2% into it.

Mathematically, using the Kelly Formula, it can be shown that a 2% position is the equivalent of betting on a stock has only a 51% chance of going up, and a 49% chance of going down. Why would you waste your time even making that bet? These guys are getting paid $ 1 million a year to identify stocks with a 51% chance of going up? It’s insane.

Trait #6

Sixth, it’s important to have both sides of your brain working, not just the left side (the side that’s good at math and organization.)

In business school, I met a lot of people who were incredibly smart. But those who were majoring in finance couldn’t write worth a damn and had a hard time coming up with inventive ways to look at a problem. I was a little shocked at this.

I later learned that some really smart people have only one side of their brains working, and that is enough to do very well in the world but not enough to be an entrepreneurial investor who thinks differently from the masses.

On the other hand, if the right side of your brain is dominant, you probably loathe math and therefore you don’t often find these people in the world of finance to begin with. So finance people tend to be very left-brain oriented and I think that’s a problem. I believe a great investor needs to have both sides turned on.

As an investor, you need to perform calculations and have a logical investment thesis. This is your left brain working.

But you also need to be able to do things such as judging a management team from subtle cues they give off. You need to be able to step back and take a big picture view of certain situations rather than analyzing them to death. You need to have a sense of humor and humility and common sense. And most important, I believe you need to be a good writer.

Look at Buffett; he’s one of the best writers ever in the business world. It’s not a coincidence that he’s also one of the best investors of all time. If you can’t write clearly, it is my opinion that you don’t think very clearly. And if you don’t think clearly, you’re in trouble. There are a lot of people who have genius IQs who can’t think clearly, though they can figure out bond or option pricing in their heads.

Trait #7

And finally the most important, and rarest, trait of all: The ability to live through volatility without changing your investment thought process.

This is almost impossible for most people to do; when the chips are down they have a terrible time not selling their stocks at a loss. They have a really hard time getting themselves to average down or to put any money into stocks at all when the market is going down.

People don’t like short term pain even if it would result in better long-term results. Very few investors can handle the volatility required for high portfolio returns.

They equate short-term volatility with risk. This is irrational; risk means that if you are wrong about a bet you make, you lose money. A swing up or down over a relatively short time period is not a loss and therefore not risk, unless you are prone to panicking at the bottom and locking in the loss.

But most people just can’t see it that way; their brains won’t let them. Their panic instinct steps in and shuts down the normal brain function.

I would argue that none of these traits can be learned once a person reaches adulthood. By that time, your potential to be an outstanding investor later in life has already been determined.

It can be honed, but not developed from scratch because it mostly has to do with the way your brain is wired and experiences you have as a child. That doesn’t mean financial education and reading and investing experience aren’t important.

Those are critical just to get into the game and keep playing. But those things can be copied by anyone.

The seven traits above can’t be.

~~~~~~~~~~~~~~~~~~~~~~~~~~~~

Do you possess these 7 traits?

 

 

The post Hedge Fund Manager Mark Sellers On Becoming A Great Investor appeared first on Macro Ops.

Macro Ops




Republicans Craft the Next Great Healthcare Failure

Those who claim that the Senate Republican proposal to replace Obamacare will kick millions of people out from health insurance coverage are dead wrong. Yes, it will cause the number of insured people to decline, but that will happen because millions of healthy individuals will be incentivized to voluntarily opt-out of traditional health insurance. For those people, the law will make traditional insurance a sucker bet. Instead of buying comprehensive health insurance policies, as they are currently known, they will either go without insurance for as long as possible or purchase a new type of low-cost insurance that the new proposals will likely create if they become law.

Let’s be clear. No one really wants to buy health insurance. When you do, you are effectively making a bet with your insurance company that you will get sick while they are betting you don’t. If you do get sick, you get a potential payoff. If you don’t, the insurance company keeps your premium. The same is true with all insurance. No one wants to buy auto or fire insurance, but we do in case we get into a car accident or our house burns down. But if the laws were changed so that fire insurance claims could be made after the fact, then consumer behavior would change significantly. People would simply opt-out, and then put in claims when and if they have a fire. But the only reason insurance companies can afford to rebuild houses is because so many of their customers pay premiums but never file claims. So if fire insurance companies could not discriminate against people with pre-existing fire conditions, they would cease to exist as businesses.

The architects of Obamacare saw this problem in advance and attempted to solve it by imposing financial penalties on those who made the rational decision not to buy. The Law’s fatal flaw was that the penalties were not stiff enough to stop people from opting-out. (If they were that high the law would have likely been declared unconstitutional). When the healthy individuals left the system, many insurance companies experienced huge losses, forcing them to either exit markets completely or to raise premiums steeply on those who remained.

Amazingly, despite the many clear warning signs that too many people were dropping out, the original version of the Senate bill did even less than Obamacare to encourage healthy people to stay. That version allowed such individuals to forgo insurance when they didn’t need it, but guaranteed that they could buy, without penalty, when they did. This would have exacerbated the huge losses that insurance companies are already seeing under Obamacare and would have forced the government to step in and transfer those losses to taxpayers. But, on Monday, the Senate belatedly recognized what they should have realized from the start, and came up with what purports to be a solution to prevent people from gaming the system. But like the veiled attempt made by the House, the Senate version falls well short of the mark.

The House attempts to keep healthy people in the system by imposing a 30% surcharge on insurance for one year after a person with lapsed coverage (of 63 days or more) came back into the system. In fact, it was this provision that prompted Present Trump to call the plan “mean.”  But the 30% one year bump is a small price to pay for those who may go years, or even decades, paying nothing at all.

Once the Senate realized that they needed some kind of penalty, they devised something that is even “meaner” by Trump’s standards. They now propose a 6-month waiting period on people with a 63 day lapse in coverage. This means those hoping to get a free ride will risk exposing themselves to six months of bills if they get injured or sick. On paper at least, that could be a steep incentive to keep coverage current. But, already, Democrats have jumped on the proposal as unfair.

But like every far-reaching regulatory proposal, this plan does not anticipate the changes in the market that it may itself create. It is likely that insurance companies will respond to this provision by offering “waiting period insurance” that will pay medical bills only between the time a real health insurance policy is purchased and the waiting period for that policy ends.  To submit a claim under such a policy, the insured would only need to provide proof that he had already purchased an actual health insurance policy. Only then would the “waiting period policy” actually kick in to pay claims during the interim.

Since these waiting period policies would only provide coverage for a short time period, the risk to insurance companies would be relatively low. That means that the costs to consumers would be considerably lower than long-term plans. Some consumers could maintain such policies for years, and save lots of money in the process. To further reduce costs, buyers could opt for waiting period policies with higher deductibles, or that exclude coverage for things like pregnancy.  The Senate bill makes the cost even lower by providing that premiums on traditional policies do not kick in until the waiting period ends, meaning consumers will never be on the hook for paying both waiting period and longer term health insurance premiums at the same time. To guard against people waiting until they are sick to buy waiting period policies, those selling those policies can also impose a 6-month waiting period of their own on people with pre-existing conditions. This will ensure that only healthy people buy these policies, keeping premiums as low as possible for buyers, while maintaining profitability for sellers.

People would not opt to buy real health insurance policies until after they were sick enough to need one. But such policies would no longer constitute insurance at all in the traditional sense, as buyers would know the outcome in advance of placing their bets. Since they would only place winning bets, the insurance companies would be guaranteed to lose money on every policy sold. This will create a vicious cycle of rising premiums, more dropouts, and ever-greater government bailouts until taxpayers were responsible for everything.

While many Republicans originally and correctly opposed Obamacare, their concerns seem to have evaporated in the face of political gamesmanship. In order to achieve some kind of victory they are now promising the impossible. Trump is the leading figure on this bandwagon. He doesn’t seem to care in the slightest what is actually in the law or what it will do to health care. He just wants something to pass so that he can take credit for the victory. But another layer of regulation surely won’t help.

Over the past half-century, U.S. health care costs have risen sharply because of a raft of government policies and tax incentives that have shifted routine health care payments from individuals to insurance companies. Believe it or not, before the 1960s  a very large percentage of Americans paid for medical care out of pocket, according to a 1963 study by the Social Security Administration called Survey of the Aged. At that point, health care as a percentage of Gross Domestic Product hovered around five per cent.(1) Today that figure is more than three times that at around seventeen per cent.(1) Despite the huge increase in costs, health outcomes are not radically different from what you would have expected in light of the medical breakthroughs, technological improvements and the decline of smoking.

As it turns out, insurance is a very inefficient way to pay for many of the health care services we use, the vast majority of which are actually highly predictable.  Our current insurance system incentivizes consumers to over utilize health care without any regard for its cost and removes any market based restraints on prices charged by hospitals, doctors, and pharmaceutical companies. As a result, health care costs have risen considerably faster than the rate of inflation.

The advocates of greater government involvement have always said that health care is too important to be left to the free markets. But you could make the same claims about food, clothing and shelter as well. The free market is perfectly capable of delivering those necessities at costs that fit all budgets. In fact, the relative costs of all three of those things have stayed the same, or come down, over the years. But health care, distorted by regulations, subsidies and tax incentives, has seen costs spiral out of control.

Republicans are now presented with a rare opportunity to make the radical departure that they promised when they did not control the White House. The best approach would be to seek to eliminate the entire insurance apparatus, reduce regulation, increase free market choice, legalize interstate and international competition, and clamp down on malpractice lawsuits. The money currently being over spent on health and malpractice insurance, excess paperwork and unnecessary defensive medicine, could then be used to fund the kind of charity hospitals that once served as the backbone of our health care system.

But since Republicans do not have the guts to stand up for the free market principles they pretend to stand for, they should not make the fatal political mistake of affixing their brand to a sinking ship. Better to let the S.S. Obamacare sink, and then come up with a free market system that will actually float.

1. SOURCE:  Centers for Medicare & Medicaid Services, Office of the Actuary, National Health Statistics Group;  U.S. Department of Commerce, Bureau of Economic Analysis; and U.S. Bureau of the Census.

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Commentaries By Peter Schiff




The Great Gold Supply Disconnect

The market has no clue that it has severely undervalued the price of gold. While Central bank intervention has worked hard at capping the gold price, the “Great Gold Supply Disconnect” will most certainly remedy that situation. This gold supply disconnect took place after the gold price peaked in 2011.

That being said, the world is speeding recklessly towards an epic market catastrophe. No, this isn’t hype… I wish it was. But, unfortunately, the poor folks who continue to believe their STOCK, BOND & REAL ESTATE portfolios will provide them with a healthy retirement in the future, have no idea that their true values evaporated many years ago. However, the market just hasn’t BAKED THEM INTO THE CAKE YET… LOL.

Before we get to the Gold Supply Disconnect, let’s look at this wonderful chart that shows the carnage taking place in the commodity market. This is “Commodity Index” divided by the S&P 500 Index:

GSCI/S&P500 ratio: equities expensive, commodities cheap?

This chart shows that the commodity index is at the lowest ratio to the S&P 500 since 1971. Thus, the commodity prices have reached a 50 year low versus the S&P 500. Moreover, the commodity index is lowest ratio (below 1.0) when we compare it to the average median which is 4.1, shown as the red dotted line on the chart. Now, either commodity prices are too low, or the S&P 500 and its illegitimate older brother, the Dow Jones Index are severely over-inflated.

I would like to remind investors, without a properly functioning commodity supply market, companies wouldn’t be able to produce and manufacture their products. Which means, energy and commodities are the foundation of our markets.

Of course, if an individual still had a semi-functioning brain-stem and wasn’t one of the millions of Americans now suffering from serious BRAIN DAMAGE, they would realize that the stock markets are in record bubble territory.

Now, another thing that it totally overlooked by most Americans and the Mainstream analyst community is how the falling oil price is gutting the U.S. and global oil industry. Today, we received news of one of the largest U.S. gasoline and distillate inventory builds in the past five months. However, if we look at the total U.S. Oil/Product SPR inventory, it rose the most since August 2015.

This had a wonderful impact on the price of U.S. crude oil…… which is now down $ 2.15 to $ 46.05 a barrel. This low oil price continues to gut the U.S. oil industry even though the media suggests that the Shale Oil Industry is now profitable at $ 20-$ 40 a barrel. I will be publishing an article shortly on the Permian Basin in Texas, which is now the Darling of Wall Street and the U.S. shale oil Industry. Everyone is jumping into the Permian to make that big money… or so they believe.

Regardless… collapse is on its way because the very energy we use to run everything is rapidly disintegrating. And without energy, the global gold supply would most certainly evaporate into thin air.

THE GREAT GOLD DISCONNECT: How The Market Has Severely Undervalued The Gold Price

The Fed and Central bank magicians have fooled the audience with a clever slight of hand that a newly printed $ 100 bill, which costs 13 cents each to produce, is worth $ 100 in gold, it isn’t. However, the skyrocketing gold price hasn’t been BAKED INTO THE CAKE YET, but it will.

Before I show you the Gold Supply Disconnect, let’s look at this interesting chart which show the falling ore grades of five different gold producing countries:

Ore grades of gold mines, 1830-2010

At one time (1900), the average gold ore grade in the world was over 20 grams per ton… 32 grams equals one troy ounce. Today, the top gold miners are struggling to produce gold at a little more than 1.2 grams per ton. Back when Nixon dropped the U.S. Dollar-Gold peg in 1971, the average gold ore grade from these five countries was approximately 8-10 grams per ton… nearly EIGHT TIMES higher than today.

When means, the gold mining industry is now producing the most expensive gold dust in history…. and doing so for mere peanuts.

Furthermore, we also have the falling EROI – Energy Returned On Investment of oil that is used to extract and produce gold:

Dimishing Oil Energy ROI

Thus, falling global gold ore grades and the declining EROI of oil means it costs a great deal more to produce gold today than it did in the 1900’s and especially in the past 15 years. However, the profitability and the share prices of the top five gold miners have suffered greatly since the gold price peaked in 2011.

If we take a look at the next five charts, we can see that the gold miners share prices have under-performed the gold price since the beginning of 2012:

BARRICK GOLD

Barrick Gold Corp.

NEWMONT

Newmont Mining Corp.

ANGLO-GOLD

Anglogold Ashanti Ltd.

GOLDCORP

Goldcorp Inc.

KINROSS GOLD

Kinross Gold Corp.

You will notice in all five charts, the price of gold (Gold color) was underneath all the gold mining companies stock price trend up until 2011. Then after 2012, the Great Gold Disconnect took place as the gold price is now higher than these companies share prices. Some of these gold miners share prices are much lower than the gold price trend, such as Kinross Gold, AngloGold and Barrick.

What is quite amazing is that Kinross (ranked 5th largest gold miner) produced 2.7 million oz of gold in 2016, and its share price is currently trading at less than $ 5. Think about that. Kinross produced $ 3.8 billion worth of gold in 2016, and its share price is trading at less than $ 5 a share. Now, compare that to the first chart in article (above) which shows the commodity index trading at a 50 year low versus the S&P 500 Index.

What we have today is a totally insane and hyper-inflated STOCK, BOND and REAL ESTATE market, and a severely under-valued gold market price and gold mining shares.

The investors of the world believe the hyper-inflated values of STOCK, BONDS and REAL ESTATE will continue indefinitely. Unfortunately, the gold supply disconnect that took place in 2011 is a big RED WARNING LIGHT that the something is seriously wrong.

When the broader stock, bond and real estate markets start to crack and drop like a rock, watch for the gold price and the mining shares to head in the opposite direction.

Precious Metals News & Analysis – Gold News, Silver News




The Great Deflation, Gold, and the Dollar

The coming GREAT DEFLATION will impact the value of Gold and the Dollar much differently than what most analysts are forecasting. Unfortunately, most analysts do not understand the true underlying value of gold or the U.S. Dollar, because they base their forecasts on information that is inaccurate, flawed or imprecise.

This is due to two faulty theories:

  1. monetary science
  2. supply-demand market forces

While some aspects of monetary science and supply and demand forces do impact the prices of goods and services (on a short-term basis), the most important factor, ENERGY, is totally overlooked. You will never hear Peter Schiff include energy when he talks about the Federal Reserve, Commercial Banks, money printing or debt. Schiff, like most analysts, is stuck on studying superficial monetary data that does not get to the ROOT OF THE PROBLEM.

Furthermore, the majority of folks who believe in the Austrian School of economics, also fail to incorporate ENERGY into their analysis. For some strange reason, most analysts believe the world is run by the ENERGY TOOTH FAIRY (term by Louis Arnoux). Without cheap and abundant energy, monetary science and supply-demand forces are worthless.

That being said, as the debate on whether the world will experience, inflation, hyperinflation or deflation will continue to go on and on, I guarantee we are going to experience the MOTHER of all DEFLATIONS. Again, this will be due to the disintegrating energy sector and its inability to provide sufficent profitable net energy to the market.

The falling net energy and declining EROI – Energy Returned On Investment, are totally gutting the entire market. This can be seen quite clearly as the U.S. added $ 4 of debt for each $ 1 of GDP growth in 2016. According to the Zerohedge article, It Took $ 4 In New Debt To Create $ 1 In GDP:

As a reminder, according to the latest BEA revision, nominal 2016 GDP was $ 18.86 trillion, an increase of $ 632 billion from 2015; the question is how much credit had to be created to generate this growth. Well, according to the Z.1, total credit rose to a new record high $ 66.1 trillion. This was an increase of $ 2.511 trillion in the past year. It means that in 2016, it “cost” $ 4 in new debt to generate just $ 1 in new economic growth!

2016 Change in Credit vs Change in GDP

As we can see, adding $ 4 of debt to create $ 1 of artificially inflated GDP is not a long-term sustainable business model. I get a laugh hearing “Conspiracy Theorists” explain how the ELITE have been planning this take-over all along and have the markets totally under control. While conspiracies do indeed take place, the ELITE have been SHOOTING FROM THE HIP and WINGING IT just to keep the entire market from imploding.

For those who believe that the elite want to crush the market to buy assets for pennies on the Dollar, I am here to tell you… it CHAIN’T gonna happen. When the Ancient Roman Metropolis collapsed from a population of one million people down to 12,000, I can assure you, the majority of the ELITE were wiped out… KAPUT.

Real Estate values and revenue streams in Ancient Rome evaporated into thin air. There was no “RECOVERY” or “PLAN B.” Death had come to the once great Roman Empire… for good.

Regardless, the coming GREAT DEFLATION will destroy the value of most assets shown in the chart below:

Global Mainstream Asset Universe 2015

Of the $ 369 trillion in global asset values (2015), gold and silver accounted for $ 3.1 trillion or 0.8%. That’s correct, not even 1% of total global assets. Savills Research, who put together the data shown in the chart above, recently published figures on Global Real Estate Investment:

Global investment by region (less China land deals)

Now, this chart does not represent total Real Estate values, but rather shows how much money is being invested in the Global Real Estate Market (minus China). Interestingly, global real estate investment has never regained its previous peak set back in 2008. Furthermore, the data shows that global real estate investment has rolled over and declined since the first quarter of 2016. This is not a good sign.

This means, deflationary forces may already be taking place in the global real estate market.

How The ‘GREAT DEFLATION’ Will Impact Gold & The Dollar

To understand how the coming GREAT DEFLATION will impact gold and the U.S. Dollar, we must throw out the window all preconceived notions about economics and money. Any individual who continues to believe in the standard orthodox economic theory, you might as well also accept that the EARTH IS FLAT and GROWTH on a finite planet is possible.

Unfortunately, the U.S. educational system and alternative media continue to misinform the public about the role of MONEY. So, the blind continue to lead the blind as Rome burns… so to speak.

The GREAT DEFLATION is coming due to the disintegration of the U.S. and global oil industry. As I mentioned in a precious article, the top three U.S. oil companies slashed their Q1 2017 capital expenditures (CAPEX) by 40%, versus the same period last year. Furthermore, the world only found 2.4 billion barrels of new oil in 2016 while it consumed 25 billion barrels:

Global Oil Consumption 2016 versus Discoveries

I hate to be a broken record, but precious metals investors better WAKE UP. How many new barrels of oil do you think the global oil industry will find in 2017 as they continue to slash their CAPEX spending even greater than last year??

Regardless, the Fed and Central Banks are propping up the market with more money printing and asset purchases than ever. This will not solve our financial and economic problems, however it is a last ditch effort to postpone the inevitable.

To truly understand what will happen with the value of Gold and the U.S. Dollar, we have to grasp the data shown in the chart below:

Gold Cost vs Price & $ 100 Bill Cost vs Face Value

To produce an ounce of gold in 2016 (top two gold miners – Barrick & Newmont), it took $ 1,113. Thus, the top two gold miner’s total production cost was 89% of the gold market price ($ 1,251). This is why gold stores wealth. Stored wealth has always been “STORED ECONOMIC ENERGY.” Gold has been the King Monetary Metal because of its rarity in the earth’s crust and its ability not to corrode or tarnish like many other metals.

On the other hand, the U.S. Treasury Department of Engraving and Printing produced a new $ 100 bill for a mere 13.4 cents. Thus, the U.S. Treasury’s $ 100 bill cost of production was 0.13% of its face value, versus 89% for an ounce of gold.

The production cost figures for the U.S. Federal Reserve Notes came from the U.S. Treasury Department of Engraving and Printing, shown in the table below:

BEP Printing Costs

It cost the U.S. Treasury $ 134.14 per thousand of $ 100 bill’s printed. While the U.S. Treasury spent more money to produce the lower denomination bills versus their total face value, 71% of the $ 213 billion of Federal Reserves Notes printed in 2016 were $ 100 bills.

If we are able to understand the information presented above and are able to do some “CRITICAL THINKING”, then it is easy to understand that the U.S. Dollar will suffer signficantlyu during the GREAT DEFLATION….. not gold.

We also must remember, a “NOTE”, as in the “Federal Reserve Note”, means an “OBLIGATION” or “DEBT.” Money is not supposed to be an obligation or debt. Money is supposed to be a store of value and medium of exchange.

Thus, when the GREAT DEFLATION arrives, the value of the U.S. Dollar has a much farther way to fall versus gold. Why? Because the value of most things, always reverts back to their COST OF PRODUCTION. The innate value of a $ 100 bill is a mere 13.4 cents…. so, its value still has room to fall 99%+.

Again… the innate value of most things are based upon their cost of production, not supply and demand. What’s the use of being in the business of producing goods at a loss????

Here is one last example. In 2016, total global gold mine supply was worth $ 103.6 billion. This figure was based on the of 3,222 metric tons of gold mine supply (GFMS 2017 World Gold Survey), multiplied by the average spot price of $ 1,251. The estimated cost to produce this gold was $ 92.2 billion:

Total Gold-Cost-Value vs $ 100 Bill Cost-Face Value

Here we can see that the gold market price, was based on its cost of production. On the other hand, the U.S. Treasury was able to print $ 151.7 billion in $ 100 bills for the total cost of $ 235 million ($ 0.235 billion). Which means, the U.S. Treasury’s production cost was only 0.13% for the $ 151.7 billion of new currency (fake money) it issued last year.

People need to realize the U.S. Dollar’s value is backed by U.S. debt, which is being propped up by burning energy. Thus, ENERGY = MONEY. The huge increase in U.S. and Global Debt means the quality of energy that runs everything is rapidly declining. Which means, the more debt that is added, the lower interest rates have to go. It is a one way street.

Analysts who think interest rates need to normalize to a much higher level, have no idea about ENERGY…. ZIP, NADDA, ZILCH. They look at the markets as if the ENERGY TOOTH FAIRIES run everything. There are only a small handful of analysts who understand the energy dynamics. The rest are the blind leading the blind.

The coming GREAT DEFLATION will destroy the value of most STOCKS, BONDS, REAL ESTATE and PAPER CURRENCIES. The reason Real Estate prices will plummet below their cost of production is due to their 20-30 year financing and their inability to function during the disintegrating energy environment. The same will be for automobiles and many other assets and items.

Investors need to understand how ENERGY and the FALLING EROI- Energy Returned On Investment, will impact the value of most assets going forward. Most assets will collapse in value, while a few will hold or gain in value. Gold and silver will be two of the few that will hold or gain in value during the GREAT DEFLATION.

Precious Metals News & Analysis – Gold News, Silver News




Lessons From A Trading Great: Amos Hostetter

Amos Hostetter cofounded Commodities Corporation (otherwise known as CC) along with Helmut Weymar back in 1969. CC is the trading shop that produced more legendary trading talent than the Yankees have All-Stars. Alumni include: Bruce Kovner, Michael Marcus, Paul Tudor Jones, Ed Seykota and more…

Hostetter was considered the wise sage and mentor of the group. He’s credited with imbuing many of these trading greats with the wisdom and knowledge they used to achieve their grand heights.

Upon his untimely death in a car accident in 1977, the directors of CC commissioned one of their traders, Morris Markovitz, to gather and record Hostetter’s timeless philosophy on markets and trading. The goal was to ensure future CC traders could benefit from his invaluable teachings. The resulting work was an internal booklet titled Amos Hostetter; A Successful Speculator’s Approach to Commodities Trading.

Hostetter’s trading philosophy could be boiled down to the following (in Hostetter’s own words):

  1. Try to acquire every bit of fundamental information available. Read extensively.
  2. Simultaneously, post daily charts on commodities and develop a feel for trends.
  3. Follow the fundamentals in your trading but only if and as long as the charts do not cast a negative vote.

He regarded money management as the first priority for any serious market speculator. From Markovitz (emphasis mine):

Sound money management is crucial to successful trading. The best market analysis won’t get a trader to the bottom line — consistent profits — unless he has a sound money-management policy. This is an area where Mr. Hostetter excelled.

Sometimes it is hard to draw a sharp line between trading principles and money-management principles. If I were to paraphrase a famous saying, I think it would provide an accurate summary of one of Mr. Hostetter’s most important trading and money-management principles: the market, to be commanded, must be obeyed. As a trader, Mr. Hostetter was aware of his own fallibility. He tried to protect himself from errors by the trading rules he used and by trying to anticipate areas of potential surprise. This alone, however, was not enough. If the market moved against him for a reason he did not understand, he would often exit without waiting for a trading rule to take him out: as a money manager, he knew he could not afford the luxury of a prolonged argument with the market.

Perhaps his most important money-management principles was “Take care of your losses and the profits will take care of themselves.” This means that a trader should place strong emphasis on keeping his losses small, because two or three large losses in succession would be a crippling blow.

His risk management principle of “taking care of your losses” is similar to Howard Marks of Oaktree Capital: “if we avoid the losers, the winners will take care of themselves.” This truth is the single most important law of speculation. It sounds glib, but cutting your losses and letting your winners run is the most common thread amongst all great traders. If I could travel back in time 15 years, I’d go back and beat this fact into my thick skull… and I’d be much richer today for it.

Hostetter used a multi-pronged approach to assessing markets and potential trades. It’s from him that Michael Marcus likely developed the “Marcus-Trifecta” to gauge markets — looking at “technicals, fundamentals, and market tone”. Here’s an overview of his approach to fundamentals:

Mr. Hostetter’s fundamental approach was, to use his own phrase, “broad brush.” This means that he would look at the overall balance sheet and the statistics that applied to the commodity in which a trade was contemplated. Then, certain basic questions would be asked:

— Will production exceed consumption this season (a stocks build-up)? If so, then the initial premise would be bearish.

— Will consumption exceed production (a stocks draw-down)? If so, then the initial premise would be bullish.

The initial premise would then be refined by other considerations. For example: weather could destroy the current production estimate for an agricultural commodity; a change in general economic conditions could destroy the demand or consumption estimate; the high price of meat could increase demand for potatoes.; the low price of corn could increase demand for soybean meal; and so forth. The last two items are intended to illustrate the flexibility, or creativity, of Mr. Hostetter’s thinking, and represent the personal style he brought to commodity analysis. He held facts in the highest regard, yet he remained constantly alert to the principle that the facts can and do change.

The key phrase is flexibility of thinking, which is the opposite of stubbornness. Mr. Hostetter knew that, whatever his fundamental analysis might show today, there was a good chance it would show something different by the time the last day of the season had arrived… In brief, Mr. Hostetter would never wed himself to a precise position on the outlook for the future; he had often enough experienced the phenomenon of a significant price change before the reasons behind it became general knowledge. He kept himself prepared for surprises, in both directions, in advance. If one does a little “dreaming” about the possibilities on both sides, then he is in possession of possible explanations for surprises, and will be less hesitant to act if and when they come.

Maintaining an open-mind and staying aware of your biases is critical. Markets serve ample helpings of humble pie to those who arrogantly wed themselves to a “market prediction”.

Hostetter took a nuanced approach to using technicals, similar to how we utilize price action in our trade analysis at Macro Ops. Markovitz writes:

Mr. Hostetter definitely did not accept the clear-cut dichotomy between fundamental and technical trading. Both methods can be used successfully, but he blended the two. It is my impression that Mr. Hostetter would have agreed with the following statement:

The pure fundamentalist concerns himself with production, consumption, stocks, and other basic economic data, viewing these as the causes and price as the effect, while the pure technician regards price as its own cause. In fact, to draw a sharp line of choice between these two approaches is not the best policy. Price itself should also be regarded as a fundamental. It can play the role of cause or effect or both under different circumstances.

The market’s own behavior can, in a real sense, be classified as a fundamental variable. The method of analysis, however, is completely different. The technical aspect of Mr. Hostetter’s trading consists primarily of:

1. Trend following
2. Support and resistance areas
3. Pattern recognition

These are listed in order of their importance, although any one of them may be the dominant influence at a  given time.

Within this technical framework Hostetter employed a number of useful heuristics to help him read the tape:

Many of the techniques Mr. Hostetter used depended on a time factor. In general, as with congestion areas, most patterns accrue more significance if they take more time to form, and a trader should be aware of time as well as price when considering any technical pattern. For example, a bear market that has persisted for a year is unlikely to form its bottom in a week, nor is a two-month bull market likely to take a year to form a top. A trader should keep in mind the duration of recent major moves and expect commensurate time periods for the formation of the current pattern. (Patience is an important virtue — hastiness rarely pays).

I find Hostetter’s thoughts on the “time factor” useful in analyzing where price may be headed. Markets tend to follow a certain symmetry over long periods of time. Some technical heuristics Hostetter used are:

  • He would become seriously concerned if a bull market was unable to make a new high for thirty days (the same is true for a bear market that hadn’t made new lows for thirty days).
  • A poor price response to bullish news is itself an ill omen for long positions, especially if other cautionary signs are present (e.g., the bull market is old, the vigor has shown some signs of waning, prices are near a fundamental objective, etc.)
  • The most important timing issue is patience. One should wait for his opportunity, wait until everything lines up according to his expectations. It is far better to miss an opportunity here or there than to jump in too early without a clear plan. Too much patience is rarely the problem for any trader.
  • A trader should do his fundamental homework, keep his eye on the charts, and patiently observe. Once he is able to form a definite fundamental opinion, he should wait for confirming market action before proceeding.

Practicing the necessary patience to win is one of the hardest aspects of speculation. Fear is man’s strongest emotion and is behind one of a trader’s most common foibles — the fear of missing out (FOMO). Success comes to those who realize that Pareto’s Law dominates the distribution of returns. Only a handful of trades a year will account for the majority of profits. It pays to sit and wait patiently for those fat pitches to come along.

Lastly, here’s a list of maxims and trading do’s and don’ts as recorded by Hostetter in his own words.

GENERAL PRINCIPLES AND MARKET MAXIMS

  • A very general and important rule is: take care of your losses and your profits will take care of themselves. This is both a trading maxim and a money-management tool. A trader needs big winners to pay for his losses and he won’t capture these big wins unless he stays with the trend all the way.
  • There is never any objection to taking a loss. There must always be a good reason before you can permit yourself to close out a profit.
  • When in doubt, get out. Don’t gamble. Be sure, however, that your doubt is based on something real (fundamentals, market action, etc.), and not simply on your own nervousness about the price level. If it is only the price level that is making you nervous, then either stick with the winner or at worst use a more sensitive stop-loss point. Give the major trend all the chance you can to increase your profits.
  • All major trends take a long time to work themselves out. There are times when the best approach is just to sit and do nothing, letting the power of the underlying trend work for you while others argue about the day-to-day news. Be patient.
  • Surprising price response to news is one of the most reliable price forecasters. Bullish response to bear news, or vice-versa, means that the price had already discounted the news and the next move will probably go the other way. Actually, this is only one example of a wider principle: When a market doesn’t do what it “should”, then it will probably do what it “shouldn’t”, and fairly soon. (Note that false breakouts, up or down, are also subsumed under this more general principle. When new lows are achieved in a long-term bear market, for example, the market ‘ ‘should” follow through with weakness—after all, it is a bear market. If, instead, it rallies quickly, this provides some evidence against the bear market premise).

THE DANGERS IN TRADING CAUSED BY HUMAN NATURE

  1. Fear — fearful of profit and one acts too soon.
  2. Hope — hope for a change [in the] forces against one.
  3. Lack of confidence in one’s own judgment.
  4. Never cease to do your own thinking.
  5. A man must not swear eternal allegiance to either the bear or bull side. His concern lies in being right.
  6. Laziness prevents a trader from keeping posted to the minute.
  7. The individual fails to stick to facts.
  8. People believe what it pleases them to believe.

DON’TS

  1. Don’t sacrifice your position for fluctuations.
  2. Don’t expect the market to end in a blaze of glory. Look out for warnings.
  3. Don’t expect the tape to be a lecturer. It’s enough to see that something is wrong.
  4. Never try to sell at the top. It isn’t wise. Sell after a reaction if there is no rally.
  5. Don’t imagine that a [market] that has once sold at 150 must be cheap at 130.
  6. Don’t buck the market trend.
  7. Don’t look for breaks. Look out for warnings.
  8. Don’t try to make an average from a losing game.
  9. Never keep goods that show a loss and sell those that show a profit. Get out with the least loss and sit tight for greater profits.

SUGGESTIONS

  1. Experience must teach. Follow it invariably.
  2. Observation gives the best tips of all. Observe [market] behavior and experience shows how to profit.
  3. Buying on a rising market is the comfortable way. The point is not so much to buy as cheap as possible or go short at top prices, but to buy and sell at the right time.
  4. Remember [a market is] never too high for you to begin buying or too low to begin selling. Let your tape reading show you when to begin. After the initial transaction don’t make a second unless the first shows a profit.
  5. There is a great deal in starting right in every enterprise.
  6. When something happens on which you did not count when your plans were made, it behooves you to utilize the opportunity.
  7. In a bear market it is always wise to cover if complete demoralization develops suddenly.
  8. Stick to facts only and govern your actions accordingly.
  9. What is abnormal is seldom a desirable factor in a trader’s calculations. If a [market] doesn’t act right, don’t touch it.

To get more wisdom from trading greats like Hostetter, click here.

 

 

Macro Ops




Credit Card Nation: Why The Facebook Killer And The U.S. Congress Have A Great Deal In Common

Most Americans have seemingly convinced themselves that as a society we will never pay a great price for going into so much debt and that we will never pay a great price for the horrendous crimes against humanity that we are committing on a daily basis.  If you don’t understand what I am talking about, just keep reading the rest of this article.  Just as there are consequences for our actions individually, so there are also consequences for our actions as a society.  And although our national day of reckoning has been put off for quite some time, when it does finally arrive the pain is going to be absolutely unimaginable.

Just recently, I was astounded to learn that the total amount of credit card debt in the United States has crossed the trillion dollar mark.  It boggles my mind that so many Americans could be so foolish, because credit card debt is one of the worst forms of debt in existence, and financial experts all over the country have spent an extraordinary amount of time and energy trying to get this message across to people.

But even though people know that going into credit card debt is bad, they just keep on doing it anyway.  We have become a “buy now, pay later” society that gives very little consideration to long-term consequences.

On a national level, we are now nearly 20 trillion dollars in debt, and a historic showdown over government spending and debt threatens to absolutely paralyze the federal government at the end of this month.  At this point many believe that it will be virtually impossible for Congress to avoid a government shutdown on April 29th, and once it begins Donald Trump’s entire agenda will come to a complete and total crashing halt until the crisis is resolved.  The following comes from David Stockman

In the meanwhile, everything else — health care reform, tax cuts, infrastructure — will become backed-up in an endless queue of legislative impossibilities. Accordingly, there will be no big tax cut in 2017 or even next year. For all practical purposes Uncle Sam is broke and his elected managers are paralyzed.

The Treasury will be out of cash and up against a hard stop debt limit of $ 19.8 trillion in a matter of months. But long before that there will be a taste of the Shutdown Syndrome on April 28 owing to the accumulating number of “poison pill” “riders” to the CR.

These include the virtual certainty of riders to the House bill to “defund” Planned Parenthood and sanctuary cities. Other extraneous amendments will also possibly include funds demanded by the White House to start the Mexican Wall, enhance deportations and fund some of Trump’s $ 54 billion defense increase.

I am so glad that Stockman mentioned Planned Parenthood, because the decision whether or not to continue funding Planned Parenthood is going to be one of the central issues of this upcoming crisis.

Currently, the U.S. government gives Planned Parenthood roughly $ 500,000,000 a year.  By law, none of that money is supposed to be used to provide abortions, but everyone knows what the real deal is.

Some Planned Parenthood clinics do provide other services, but at the end of the day Planned Parenthood’s core business is abortion.  In fact, since Roe v. Wade was decided in 1973 they have killed far more babies than anyone else in the United States by a very wide margin.

And for decades, the U.S. government has been the number one source of funding for Planned Parenthood.  In fact, there are questions as to whether or not Planned Parenthood would be able to continue as a viable business without money from the federal government.

Over the years, when members of Congress have voted to shower Planned Parenthood with hundreds of millions of dollars a year, they have not done it in the heat of the moment.  Rather, their votes have been the result of cold, calculated decision-making processes.

In other words, the members of Congress that have been voting to keep funding Planned Parenthood year after year have the blood of millions of dead children on their hands, and there is very little difference between them and Facebook killer Steve Stephens.

When Stephens broadcast the cold-hearted murder of a 74-year-old man on Facebook on Sunday, he instantly became a worldwide celebrity.  And even though most people in the country have now seen his face, he continues to somehow elude authorities.

What Stephens has done is absolutely horrific, and when he is finally caught he will pay greatly for his crimes.

Just like Stephens, America is on the run today.  We keep thinking that we will never have to pay a price for the tens of millions of children that we have killed, and our government continues to fund the slaughtering of the innocents that goes on every single day in this nation.

But now Congress is going to be given one more chance to make the right decision.

The Republicans have control of the White House, the Senate and the House of Representatives.  They have the power to defund Planned Parenthood, but it is going to take a tremendous amount of resolve.

That is because under the current rules it is going to take 60 votes to get a spending agreement through the Senate, and so the Republicans will need at least 8 Democratic votes to get any bill to Trump’s desk.

Sadly, the Democrats are pledging to stretch out a government shutdown indefinitely if Republicans try to defund Planned Parenthood.

So what will the Republicans do?  Well, they could change the rules in the Senate to require only a simple majority vote on spending bills, and that would essentially be the “thermonuclear option”.

Or they could give in, but if they do that it would likely mean that Planned Parenthood will never be defunded, because the Republicans will never have a better opportunity than they do right now.

And I have a feeling that is what is going to happen.  I have a feeling that the Republicans are going to give in at some point and agree to keep giving Planned Parenthood half a billion dollars a year.

If that is indeed what happens, both the Democrats and the Republicans that help pass such a bill will be cold-blooded killers just like Facebook killer Steve Stephens, only those Democrats and those Republicans will have far more blood on their hands than Stephens does.

Most people do not realize this, but without a doubt this is one of the most critical moments in modern American history.  And if the funding of Planned Parenthood continues, I have a feeling that is going to mean that our national day of reckoning is much closer than most people would dare to imagine.

If we do not stop what we are doing, someday our crimes will catch up to us, and the debt that we will owe at that point will be far beyond what we can bear to pay.

The Economic Collapse




Lessons From A Trading Great: Jim Leitner

Jim Leitner is the greatest macro trader you’ve never heard of. He was once a currency expert on Wall Street, pulling billions from the markets, but now he plays the game through his own family office.

Leitner understands the Macro Ops “go anywhere” mentality better than any other trader:

Global macro is the willingness to opportunistically look at every idea that comes along, from micro situations to country-specific situations, across every asset category and every country in the world. It’s the combination of a broad top-down country analysis with a bottom-up micro analysis of companies. In many cases, after we make our country decisions, we then drill down and analyze the companies in the sectors that should do well in light of our macro view.

I never lock myself down to investing in one style or in one country because the greatest trade in the world could be happening somewhere else. My advice is to make sure that you do not become too much of an expert in one area. Even if you see an area that is inefficient today, it’s likely that it won’t be inefficient tomorrow. Expertise is overrated.

He’ll jump into any asset or market, no matter how esoteric. Some of his craziest investments include inflation-linked housing bonds in Iceland and a primary equity partnership in a Ghanaian brewer. He even had the balls to jump into Turkish equities and currency forwards with 100% interest rates and 60% inflation during the late 90’s… the man is a macro beast.

FX Trading

Leitner was one of the first traders to understand and implement FX carry trades. A carry trade involves borrowing a lower interest rate currency to buy a higher interest rate currency. The trader earns the spread between the two rates. Here’s his own words from Drobny’s Inside The House Of Money:

The most profitable trade wasn’t a trade but an approach to markets and a realization that, over time, positive carry works. Applying this concept to higher yielding currencies versus lower yielding currencies was my most profitable trade ever. I got to the point in this trade where I was running portfolios of about $ 6 billion and I remember central banks being shocked at the size of currency positions I was willing to buy and hold over the course of years.

FX carry trades can be extremely lucrative. But if you get caught holding a currency during a surprise devaluation, it can instantly erase all your profits and them some. Leitner was able to protect himself by keeping a close eye on central bank action:

I was always able to sidestep currency devaluations because there were always clear signals by central banks that they were pending and then I just didn’t get involved. Devaluations are such a digital process that it doesn’t make sense to stand in front of the truck and try to pick up that last nickel before getting run down.You might as well wait, let the truck go by, then get back on the street and continue picking up nickels.

Leitner understands that currencies mean revert in the short-term and trend in the long-term. He’s explored the use of both daily and weekly mean reversion strategies:

The other thing that is pretty obvious in foreign exchange is that daily volatilities are much higher than the information received. Think of it like this:

The euro bottomed out in July 2001 at around 0.83 to the dollar and by January 2004 it was trading at 1.28. That’s a 45 big figure move divided by 900 days, giving an average daily move of 5 pips, assuming straight line depreciation. Say one month option volatility averaged around 10 percent over that period, implying a daily expected range of 75 pips.That’s a signal-to-noise ratio of 1 to 15. In other words, there was 15 times as much noise as there was information in prices!

Noise is just noise, and it’s clearly mean reverting. Knowing that, we should be trading mean reverting strategies. In the short term, it’s a no brainer to be running daily and weekly mean reverting strategies. When things move up by whatever definition you use, you should sell and when they move back down, you should buy. On average, over time you’re going to make money or earn risk premia.

Options

No one has mastered global macro options better than Leitner. He knows when they’re overpriced and when they make a great bet:

Short-dated volatility is too high because of an insurance premium component in short-dated options. People buy short-dated options because they hope that there’s going to be a big move and they’ll make a lot of money. They spend a little bit to make a lot and, on average, it’s been a little bit too much. When they do make money they make a lot of money, but if they do it consistently they lose money. Meanwhile, someone who consistently sells short-dated volatility, on average, would make a little bit of money. It’s a good business to be in and not too dissimilar to running a casino. So there is a risk premia there that can be extracted. (Side note: this is the risk premia we harvest in Vol Ops, one of our portfolios in the Macro Ops Hub).

Longer-dated options are priced expensively versus future daily volatility, but cheaply versus the drift in the future spot price. We need to make a distinction between volatility and the future drift of the currency. Since the option’s seller (the investment bank) hedges its position daily, it makes money selling options. Since some buyers do not delta hedge but instead allow the spot to drift away from the strike, they make money on the underlying trend move in the currency. So both the seller of the option and the buyer make money. The profit for the seller comes from extracting the risk premia in the daily volatility, and for the buyer it comes from the fact that currency markets tend to exhibit trending behavior.

We had a study done on the foreign exchange options market going back to 1992, where one-year straddle options were bought every day across a wide variety of currency pairs.We found that even though implied volatility was always higher than realized volatility over annual periods, buying the straddles made money. It’s possible because the buyer of the one-year straddles is not delta hedging but betting on trend to take the price far enough away from the strike that it will cover the premium for the call and the put. Over time, there’s been enough trend in the market to carry price far enough away from the strike of the one-year outright straddle to more than cover the premium paid.

If the option maturity is long enough, trend can take us far enough away from the strike that it’s okay to overpay.

This is a key concept that very few option traders understand. High vol doesn’t mean huge trends. And low vol doesn’t mean no trends. It’s possible to have low vol trends and high vol ranges.

Leitner exploits this kink in option theory by “overpaying” for optionality from a volatility perspective, but still winning from trending markets.

These overpriced long-dated options become essential in choppy markets. They allow you to “outsource” risk management. You can play for a long-term trend without the risk of getting stopped out by a head fake:

Options take away that whole aspect of having to worry about precise risk management. It’s like paying for someone else to be your risk manager. Meanwhile, I know I am long XYZ for the next six months. Even if the option goes down a lot in the beginning to the point that the option is worth nothing, I will still own it and you never know what can happen.

Psychology, Emotions, And Fallibility

Like every other star trader, Leitner has strong emotional control. He views all trades within a probabilistic framework and fully accepts his losses:

At Bankers, I came to realize that I was absolutely unemotional about numbers. Losses did not have an effect on me because I viewed them as purely probability-driven, which meant sometimes you came up with a loss. Bad days, bad weeks, bad months never impacted the way I approached markets the next day.To this day, my wife never knows if I’ve had a bad day or a good day in the markets.

Along with reigning in his emotions, he also acknowledges his own fallibility:

Another thing that I realize about myself that I don’t see in other traders is that I’m really humble about my ignorance. I truly feel that I’m ignorant despite having made enormous amounts of money.

Many traders I’ve met over the years approach the market as if they’re smarter than other people until somebody or something proves them wrong. I have found this approach eventually leads to disaster when the market proves them wrong.

It’s not possible to “crack” the market. You’re guaranteed to eventually be proven wrong no matter how smart you are. And when that time comes, you have to stop the bleeding before death occurs. The trading graveyard is littered with “smart guys” who thought they solved the market puzzle… don’t be one of them.

Investment Narratives

A compelling narrative is both a blessing and a curse.

On the one hand, understanding the dominant market narrative will keep you on the right side of a powerful trend. But it can also lure you into some dumb trades. Not all narratives are rooted in fundamental reality. Oftentimes a false trend will form and lead to a boom/bust process. Here’s Leitner’s take:

We need to quantify things and understand why things are cheap or expensive by using some hard measure of what cheap or expensive means. Then there has to be a combination of story and value. A story is still required because a story will appeal to other people and appeal is what drives markets. If there’s no story and something’s cheap, it might just stay cheap forever. But if there’s a story involved, make sure that you first look at the numbers before you get involved to be sure there is some quantitative backing to the idea.

Leitner’s team always starts with quantitative scans when hunting for equities. If the quant data doesn’t check out, there’s a higher risk of falling prey to an overhyped narrative.

In equities, we start by looking at various valuation measurements like price to book, price to earnings, and price to cash flow. It’s very important to not be too story-driven. A way to avoid that is by using quantitative screens to determine what is cheap. Once you find things that are cheap, then look for stories that argue why it shouldn’t be cheap. Maybe a stock is cheap but it’ll stay cheap forever because there’s no good story attached to the cheapness.

Longs Vs Shorts

It’s no surprise that being long financial assets has a positive expected value over time. Stocks and bonds pay a premium to incentivize investors to move out of cash and take risk.

This is why you need twice your normal conviction to go short. The system is designed to move higher over time, so you better have a damn good reason to fight that drift.

Owning assets, or being long, is easier and also more correct in the long term in that you get paid a premium for taking risk.You should only give your money to somebody if you expect to get more back. Net/net it is easier to go long because over portfolios and long periods of time, you’re assured of getting more money back. Owning risk premia pays you a return if you wait long enough, so it’s a lot easier to be right when you’re going with the flow, which means being long. To fight risk premia, you have to be doubly right.

Leverage

Mention the word “leverage” around rookie traders and they’ll run for the hills. Most think it’s a quick way to blow up a trading account. But the pros view leverage as a tool that can completely transform and enhance risk-adjusted returns. Ray Dalio is traditionally the one credited with using this concept to make billions.

Let’s say you have a 30-yr bond that returns 6% a year above the cash rate. It has a max drawdown of 20%.

You then compare it to a stock index that returns 9% a year above the cash rate. It has a max drawdown of 50%.

By applying leverage, you can transform the bond into the higher performing asset. Using 2x leverage on the long bond will give you 12% returns with 40% drawdowns. This is a much better deal than the stock index on a risk-adjusted basis. This technique is known as “risk parity.”

Leitner applies it to his fixed income investments:

When using leverage, you want the highest Sharpe ratio because you’re borrowing money against your investment, and the best Sharpe ratios are found in the two years and under the sector of fixed income. On an absolute return basis, two years and under bonds are not going to pay as much as a 10-year bond because the yields are usually lower. But the risk-to-return ratio is also very different.You could be five times levered in the two-year and get a higher payout with the same risk as a 10-year bond because of duration.

Going levered long 2-year notes is a better risk-adjusted trade than going long a 10-year note. You get the same return in the levered 2-year, but with less volatility.

Most investors can’t exploit this because they can’t use leverage. But a macro trader using futures can perform all sorts of financial wizardry and vastly outperform a typical cash-only fund.

Portfolio Construction

Over time Leitner has adapted his strategy away from traditional global macro. Instead of using market timing, trend following, and gut feel — the pillars of old school macro — he’s shifted to a multi-strategy approach.

He combines various system-based strategies across five main asset classes: Equities, Fixed Income, Currencies, Commodities, and Real Estate. His goal is to earn the risk premia present in each category. He then reserves a certain amount of his cash for special situation big bets that only come around a few times a year.

We start off by acknowledging that we are ignorant, so we need to be systematic, clip some coupons, and earn some risk premia. It doesn’t matter if it is in currencies, bonds, commodities, real estate, or equities. Of course we have to be smart about it by reading a lot, talking to smart people, and being on top of it all, while acknowledging that we’re not that much smarter than the rest of the world.Then, every once in awhile, we’re going to stumble upon an exciting idea that’s going to give us some extra alpha and the ability to outperform.

After these five main asset categories, we have a last category which we call absolute return.This is where we stick those great, out-of-the-box ideas we come across about twice a year. Sometimes we’re lucky and find major mispricings once or twice a year, and sometimes we’re unlucky and it takes 18 months before the next one comes along. When we find these fantastic ideas, we’re willing to bet up to 10 percent of our fund on one idea. One that we think will double or triple, earning an extra 10 or 20 percent return for the entire portfolio.

The absolute return category is there in order to leave us open to making unsystematic money.

The multi-strat approach is the most robust way to allocate capital. Most of the macro legends of the 70s, 80s, and 90s have moved to a family office format and implemented something similar to what Leitner describes. At Macro Ops we too use a combination of discretionary and systematic strategies to make sure the cash register keeps ringing year after year.

For more details on how Jim Leitner analyzes, sizes, and manages his trades, check out our Ops Notes by entering your email below:

 

 

Macro Ops




Virtually Everyone Agrees That Current Stock Market Valuations Are Not Sustainable And That A Great Crash Is Coming

Stock Market Collapse Toilet Paper - Public DomainCurrent stock market valuations are not sustainable.  If there is one thing that I want you to remember from this article, it is that cold, hard fact.  In 1929, 2000 and 2008, stock prices soared to absolutely absurd levels just before horrible stock market crashes.  What goes up must eventually come down, and the stock market bubble of today will be no exception.  In fact, virtually everyone in the financial community acknowledges that stock prices are irrationally high right now.  Some are suggesting that there is still time to jump in and make money before the crash comes, while others are recommending a much more cautious approach.  But what almost everyone agrees on is the fact that stocks cannot go up like this forever.

On Tuesday, the Dow, the S&P 500 and the Nasdaq all set brand new record highs once again.  Overall, U.S. stocks are now up more than 10 percent since the election, and this is probably the greatest post-election stock market rally in our entire history.

But stocks were already tremendously overvalued before the election, and at this point stock prices have reached a level of ridiculousness only matched a couple of times before in the past 100 years.

Only the most extreme optimists will try to tell you that stock prices can stay this disconnected from economic reality indefinitely.  We are in the midst of one of the most outrageous stock market bubbles of all time, and as MarketWatch has noted, all stock market bubbles eventually burst…

The U.S. stock market at this level reflects a combination of great demand, great complacency, and great greed. Stocks are clearly in a bubble, and like all bubbles, this one is about to burst.

If corporations were making tremendous amounts of money, rapidly rising stock prices would make logical sense.

But that is not the case at all.  Corporate earnings for the fourth quarter of 2016 were actually quite dismal, and this disconnect between Wall Street and economic reality is starting to really bug financial analysts such as Brian Sozzi

The S&P 500 has gone 89 straight sessions without a 1% decline. Considering that Corporate America didn’t exactly light up on the top and bottom lines during the fourth quarter, such a streak is rather troublesome. Granted, the stock market is a forward-looking mechanism that appears to be trading on hopes that Trump’s unannounced stimulus and tax plans will be lifting economic growth in 2018. Even so, the inability of investors to at least acknowledge persistent struggles among companies and ongoing chaos in Washington is starting to become disturbing.

It is a basic fact of economics that stock prices should accurately reflect current and future earnings.

So if corporate earnings are at the same level they were at in 2011, why has the S&P 500 risen by 87 percent since then?  The following comes from Wolf Richter

The S&P 500 stock index edged up to an all-time high of 2,351 on Friday. Total market capitalization of the companies in the index exceeds $ 20 trillion. That’s 106% of US GDP, for just 500 companies! At the end of 2011, the S&P 500 index was at 1,257. Over the five-plus years since then, it has ballooned by 87%!

These are superlative numbers, and you’d expect superlative earnings performance from these companies. Turns out, reality is not that cooperative. Instead, net income of the S&P 500 companies is now back where it first had been at the end of 2011.

The cyclically adjusted price-to-earnings ratio was originally created by author Robert Shiller, and it is widely regarded as one of the best measures of the true value of stocks in existence.  According to the Guardian, there have only been two times in our entire history when this ratio has been higher.  One was just before the stock market crash of 1929, and the other was just before the bursting of the dotcom bubble…

Traditionally, one of the best yardsticks for whether shares are over-valued or under-valued has been the cyclically adjusted price earnings ratio constructed by the economist Robert Shiller. This ratio is currently at about 29 and has only twice been higher: in 1929 ahead of the Wall Street Crash, and in the last frantic months of the dotcom bubble of the late 1990s.

We can definitely wish for the current euphoria on Wall Street to last for as long as possible, but let there be absolutely no doubt that it is going to end at some point.

It would take a market decline of 40 or 50 percent to get the cyclically adjusted price-to-earnings ratio back to a level that makes economic sense.  Let us hope that the market does not make such a violent move very rapidly, because that would likely be absolutely crippling for our financial system.

Markets tend to go down a lot faster than they go up, and every other major stock market bubble in U.S. history has ended very badly.

And this bubble is definitely overdue to burst.  The bull market that led up to the great crash of 1929 lasted for 2002 days, and this week the current bull market will finally exceed that record.

Trying to pick a specific date for a market crash is typically a fruitless exercise, but market watchers are becoming very concerned about some of the signs that we are now seeing.  For example, the “CCT indicator” is currently showing “the lowest bullish energy ever”

The first factor is the CCT indicator. This indicator is a proprietary internal measurement of the general volume of the New York Stock Exchange. The measurements take into account the institutional participation as a ratio of the overall volume. Also measured is the duration of heavy block buying in rallies.

The sum total of all the measurements now shows the lowest bullish energy ever — even lower than in 2008, just before the market crash.

In other words, this current bull market appears to be completely and utterly exhausted.

The laws of economics cannot be defied forever.  Traditionally, commodity prices and stock prices have tended to move in unison.  And this makes perfect sense, because commodity prices tend to rise when economic conditions are good, and in such an environment stock prices are typically going to move up.

But now we are in a time when commodity prices and stock prices have become completely disconnected.  In order to bring this ratio back into line, the S&P 500 would need to fall by about 1000 points, and such a decline would cause a level of financial chaos that would be absolutely unprecedented.

This current stock market bubble has lasted much longer than many of the experts originally anticipated, but that just means that the eventual crash will likely be that much more devastating.

In the end, you don’t need to know all of the technical details in this article.

But what you do need to know is that current stock market valuations are not sustainable and that a great crash is coming.

It may not happen next week or next month, but it is going to happen.  And when it does happen, it is likely to make what happened in 2008 look like a Sunday picnic.

The Economic Collapse




Lessons From a Trading Great: Ray Dalio

Ray Dalio is the founder of Bridgewater. Two years ago, Bridgewater surpassed Soros’ Quantum fund for the title of most profitable hedge fund of all time; returning over $ 46 billion since inception.

In your author’s humble opinion, Ray Dalio is one of the more original thinkers alive today. In the investing world he stands alone in his depth of understanding of how the “economic machine” works. His “principles” for life and management are like beautiful computer code designed to produce desired outcomes while stripping away the non-essential. The man is a philosophizing engineer taking apart and designing machines for all aspects of life. Dalio has devoted himself to pursuing truth at all costs (I know, it sounds like I’m fawning, but I admire the guy’s thinking. He’s also one of my three favorite traders next to Livermore and Soros.

It’s this radical devotion to “finding out what is true and what isn’t” that unnerves many and makes Dalio and Bridgewater easy targets for ridicule. The two have been frequent subjects of poor journalism. Recently, a few hack reporters have tried painting Bridgewater as cultish and its founder as an egomaniacal Jonestown leader.

Nothing could be further from the truth. I’ve been lucky enough to spend some time at their headquarters in Connecticut and my opinion is that Dalio and company simply practice what they preach, which is “radical transparency”. Yes, the culture is, well, radically different than anything you’ll find elsewhere and definitely not for everyone. But it’s also completely, perfectly, logical. He refers to the company as an “intellectual Navy Seals”, which I think is a fair analogy.  

Dalio has built a machine to produce a desired outcome. That outcome is excellent long-term risk-adjusted returns. There’s no doubting he’s been successful at it… or actually, THE MOST successfully at it. Though different, or rather because of this difference, Bridgewater’s unparalleled success is worthy of examination.

With that let’s explore and dissect the thinking and practices of the man who’s built the world’s best money making machine.  

On Philosophy and How to Build the Machine to Get What You Want

The framework for Dalio’s philosophy and the way in which he views/evaluates the world is summed up in the following chart (via Principles).

That schematic is meant to convey that your goals will determine the “machine” that you create to achieve them; that machine will produce outcomes that you should compare with your goals to judge how your machine is working. Your “machine” will consist of the design and people you choose to achieve the goals. For example, if you want to take a hill from an enemy you will need to figure out how to do that—e.g., your design might need two scouts, two snipers, four infantrymen, one person to deliver the food, etc. While having the right design is essential, it is only half the battle. It is equally important to put the right people in each of these positions. They need different qualities to play their positions well—e.g., the scouts must be fast runners, the snipers must be precise shots, etc. If your outcomes are inconsistent with your goals (e.g., if you are having problems), you need to modify your “machine,” which means that you either have to modify your design/culture or modify your people.

Do this often and well and your improvement process will look like the one on the left and do it poorly and it will look like the one on the right, or worse:

I call it “higher level thinking” because your perspective is that of one who is looking down on your machine and yourself objectively, using the feedback loop as I previously described. In other words, your most important role is to step back and design, operate and improve your “machine” to get what you want.

This is a powerful model. It forces you to be objective in assessing the quality of your beliefs and habits, thus leading to improving outcomes through the feedback loop of continuous iteration.

Now compare this to how most people go after their goals. The average person’s machine is akin to throwing spaghetti at the wall to see what sticks. Most people are reactive to life; never objectively assessing the quality of their beliefs or habits. This is why they never attain their desired outcomes.

The first step in effectively working towards your goals is to clarify what they are and why you really want them. From there you work backwards.

Without clarity of purpose and planning out the “how”, you’re doomed to walk circles. Stoic philosopher Seneca the Younger mentioned this in his writings Tranquility of Mind, “Let all your efforts be directed to something, let it keep that end in view. It’s not activity that disturbs people, but false conceptions of things that drive them mad.”  

Law 29 of The 48 Laws of Power is: Plan All The Way To The End. Author Robert Greene writes, “By Planning to the end you will not be overwhelmed by circumstances and you will know when to stop. Gently guide fortune and help determine the future by thinking far ahead.” The second habit in The 7 Habits of Highly Effective People is to “begin with the end in mind.”

The end is always your starting point. Here’s Dalio further spelling out the process for creating optimal outcomes.

My 5-Step Process to Getting What You Want Out of Life

There are five things that you have to do to get what you want out of life. First, you have to choose your goals , which will determine your direction. Then you have to design a plan to achieve your goals. On the way to your goals, you will encounter problems . As I mentioned, these problems typically cause pain. The most common source of pain is in exploring your mistakes and weaknesses. You will either react badly to the pain or react like a master problem solver. That is your choice. To figure out how to get around these problems you must be calm and analytical to accurately diagnose your problems. Only after you have an accurate diagnosis of them can you design a plan that will get you around your problems. Then you have to do the tasks specified in the plan. Through this process of encountering problems and figuring out how to get around them, you will become progressively more capable and achieve your goals more easily. Then you will set bigger, more challenging goals, in the same way that someone who works with weights naturally increases the poundage. This is the process of personal evolution, which I call my 5-Step Process.

In other words, “The Process” consists of five distinct steps:

Have clear goals.

Identify and don’t tolerate the problems that stand in the way of achieving your goals.

Accurately diagnose these problems.

Design plans that explicitly lay out tasks that will get you around your problems and on to your goals.

Implement these plans—i.e., do these tasks.

By and large, life will give you what you deserve and it doesn’t give a damn what you “like.” So it is up to you to take full responsibility to connect what you want with what you need to do to get it, and then to do those things—which often are difficult but produce good results—so that you’ll then deserve to get what you want.

This mental model can — and should —  be applied to every endeavor, especially trading and investing.

But objectively assessing the quality of our beliefs and habits is a lot easier said than done. It’s the main reason why the majority of people keep spinning their wheels.

To be truly objective requires us to acknowledge frequent mistakes and wrong beliefs — both of which everybody is guilty of. I can assure you that you hold a number of completely false beliefs and have numerous poor habits. I know I do. And dealing with these are initially painful. That initial pain stems from the human ego.

Here’s Dalio on the many harmful 1st and 2nd order effects of being ruled by ego and how to work to tame that ego.

Watch out for people who think it’s embarrassing not to know.

Be wary of the arrogant intellectual who comments from the stands without having played on the field.

Don’t worry about looking good – worry about achieving your goals.

I believe that one of the best ways of getting at truth is reflecting with others who have opposing views and who share your interest in finding the truth rather than being proven right.

There is giant untapped potential in disagreement, especially if the disagreement is between two or more thoughtful people.

The pain of problems is a call to find solutions rather than a reason for unhappiness and inaction, so it’s silly, pointless, and harmful to be upset at the problems and choices that come at you.

The best advice I can give you is to ask yourself what do you want, then ask ‘what is true’ — and then ask yourself ‘what should be done about it.’ I believe that if you do this you will move much faster towards what you want to get out of life than if you don’t!

More than anything else, what differentiates people who live up to their potential from those who don’t is a willingness to look at themselves and others objectively.

Life is like a game where you seek to overcome the obstacles that stand in the way of achieving your goals. You get better at this game through practice. The game consists of a series of choices that have consequences. You can’t stop the problems and choices from coming at you, so it’s better to learn how to deal with them.

If you can stare hard at your problems, they almost always shrink or disappear, because you almost always find a better way of dealing with them than if you don’t face them head on. The more difficult the problem, the more important it is that you stare at it and deal with it.

Unlike in school, in life you don’t have to come up with all the right answers. You can ask the people around you for help — or even ask them to do the things you don’t do well. In other words, there is almost no reason not to succeed if you take the attitude of One: total flexibility — good answers can come from anyone or anywhere. Two: Total accountability. Regardless of where the good answers come from, it’s your job to find them.

You’ll see that excuses like “That’s not easy” are of no value and that it pays to “push through it” at a pace you can handle. Like getting physically fit, the most important thing is that you keep moving forward at whatever pace you choose, recognizing the consequences of your actions.

Life is like a giant smorgasbord of more delicious alternatives than you can ever hope to taste. So you have to reject having some things you want in order to get other things you want more.

People who worry about looking good typically hide what they don’t know and hide their weaknesses, so they never learn how to properly deal with them and these weaknesses remain impediments in the future.

People who confuse what they wish were true with what is really true create distorted pictures of reality that make it impossible for them to make the best choices.

People who acquire things beyond their usefulness not only will derive little or no marginal gains from these acquisitions, but they also will experience negative consequences, as with any form of gluttony.

Since the only way you are going to find solutions to painful problems is by thinking deeply about them — i.e., reflecting — if you can develop a knee-jerk reaction to pain that is to reflect rather than to fight or flee, it will lead to your rapid learning/evolving.

I believe that we all get rewarded and punished according to whether we operate in harmony or in conflict with nature’s laws, and that all societies will succeed or fail in the degrees that they operate consistently with these laws.

Though how nature works is way beyond man’s ability to comprehend, I have found that observing how nature works offers innumerable lessons that can help us understand the realities that affect us.

Success is achieved by people who deeply understand reality and know how to use it to get what they want. The converse is also true: idealists who are not well-grounded in reality create problems, not progress.

I believe there are an infinite number of laws of the universe and that all progress or dreams achieved come from operating in a way that’s consistent with them. These laws and the principles of how to operate in harmony with them have always existed. We were given these laws by nature. Man didn’t and can’t make them up. He can only hope to understand them and use them to get what he wants.

I believe that our society’s “mistake-phobia” is crippling, a problem that begins in most elementary schools, where we learn to learn what we are taught rather than to form our own goals and to figure out how to achieve them. We are fed with facts and tested and those who make the fewest mistakes are considered to be the smart ones, so we learn that it is embarrassing to not know and to make mistakes. Our education system spends virtually no time on how to learn from mistakes, yet this is critical to real learning.

I learned that everyone makes mistakes and has weaknesses and that one of the most important things that differentiates people is their approach to handling them. I learned that there is an incredible beauty to mistakes, because embedded in each mistake is a puzzle, and a gem that I could get if I solved it, i.e. a principle that I could use to reduce my mistakes in the future.

Sometimes we forge our own principles and sometimes we accept others’ principles, or holistic packages of principles, such as religion and legal systems. While it isn’t necessarily a bad thing to use others’ principles — it’s difficult to come up with your own, and often much wisdom has gone into those already created — adopting pre-packaged principles without much thought exposes you to the risk of inconsistency with your true values.

Don’t be a perfectionist, because perfectionists often spend too much time on little differences at the margins at the expense of other big, important things. Be an effective imperfectionist. Solutions that broadly work well (e.g., how people should contact each other in the event of crises) are generally better than highly specialized solutions (e.g., how each person should contact each other in the event of every conceivable crisis).

Experience creates internalization. A huge difference exists between memory-based “book” learning and hands-on, internalized learning. A medical student who has “learned” to perform an operation in his medical school class has not learned it in the same way as a doctor who has already conducted several operations. In the first case, the learning is stored in the conscious mind, and the medical student draws on his memory bank to remember what he has learned. In the second case, what the doctor has learned through hands-on experience is stored in the subconscious mind and pops up without his consciously recalling it from the memory bank.

It is a law of nature that you must do difficult things to gain strength and power. As with working out, after a while you make the connection between doing difficult things and the benefits you get from doing them, and you come to look forward to doing these difficult things.

Ask yourself whether you have earned the right to have an opinion. Opinions are easy to produce, so bad ones abound. Knowing that you don’t know something is nearly as valuable as knowing it. The worst situation is thinking you know something when you don’t.

There are far more good answers “out there” than there are in you.

When you think that it’s too hard, remember that in the long run, doing the things that will make you successful is a lot easier than being unsuccessful.

Remember that experience creates internalization. Doing things repeatedly leads to internalization, which produces a quality of understanding that is generally vastly superior to intellectualized learning.

At Bridgewater people have to value getting at truth so badly that they are willing to humiliate themselves to get it.

For those of you who have studied the literature on performance psychology, you’ll recognize a large number of influences in Dalio’s work. Everything from the teachings of Buddhism to est to Tony Robbins and many others are woven into Dalio’s framework for success. In my opinion, his Principles are the most comprehensive and effective framework for getting what you want that I’ve read… and I’ve read a lot on this topic.

Dalio has taken this framework and has ruthlessly applied it to markets as well.

On the Nature of Trading

Alpha is zero sum. In order to earn more than the market return, you have to take money from somebody else.

If you’re going to come to the poker table, you’re going to have to beat me. … We have 1500 people who work at Bridgewater. We spend hundreds of millions of dollars on research and so on, we’ve been doing this for 37 years.

The nature of investing is that a very small percentage of the people take money, essentially, in that poker game, away from other people who don’t know when prices go up whether that means it’s a good investment or if it’s a more expensive investment.  Too many investors are reactive decision-makers. If something has gone up, they say, ‘Ah, that’s a good investment.’ They don’t say, ‘That’s more expensive.

This is something many traders forget but it’s a very important truth to keep front of mind. There’s always another person on the other side of your trade. If you’re buying, someone is selling to you. If you’re selling, someone is buying from you. And everybody has the same goal: To Make Money! But the buyer and seller can’t both be right. Obviously one party always has to be wrong. Couple that with the fact that some of the smartest people in the world are working with enormous amounts of money and incredibly advanced tools (like Bridgewater) to extract profits from the markets and trading doesn’t seem so easy, does it?

Not to discourage you, that’s just the reality of it. Consistently beating the market is as difficult as becoming an olympic athlete… or probably even more so.

But it’s not impossible either…

It all comes down to interest rates. As an investor, all you’re doing is putting up a lump-sum payment for a future cash flow…. The big question is:  When will the term structure of interest rates change? That’s the question to be worried about. .. He who lives by the crystal ball [in trying to forecast interest rates] will eat shattered glass.

Risky things are not in themselves risky if you understand them and control them. If you do it randomly and you are sloppy about it, it can be very risky.

We think of commodities from a few different perspectives: as an alternative currency and store hold of wealth, as a growth-sensitive asset class, and as an asset with specific supply and demand considerations.

The biggest mistake investors make is to believe that what happened in the recent past is likely to persist. They assume that something that was a good investment in the recent past is still a good investment. Typically, high past returns simply imply that an asset has become more expensive and is a poorer, not better, investment.

People tend to think that my success, or whatever you want to call it, has been because I’m a really good decision-maker. I think it is actually because I’m less confident in making decisions. So in other words, I never know anything really. Everything is a probability.

You can’t make money agreeing with the consensus view, which is already embedded in the price. Yet whenever you’re betting against the consensus, there’s a significant probability you’re going to be wrong, so you have to be humble.

On What Moves Markets and How to Profit From Them

If you’re interested in macro — if you’re a trader or investor, you should be — then it behooves you to take some time and read through Bridgewater’s paper titled “How the Economic Machine Works”. It’s the best framework on how to view and understand markets and economies.

At the foundation of this framework is the Transactions Approach; which is a different way of looking at transactions and price discovery compared to classic economic supply and demand models.

Every time you buy something, you create a transaction and transactions are the building blocks of the economic machine. Understanding transactions is the key to understanding the whole economy. An economy consists of all of the transactions and all of its markets. Adding up the total quantity of transactions in all markets gives you everything you need to know to understand the economy. The biggest buyer and seller is the government, which a) through a central bank controls the credit in the economy and b) collects taxes and spends money.

These transactions form markets and markets form economies. One of the keys to successful trading and investing is to understand who the buyers are, what their motivation is, and what the credit/liquidity picture looks like.

Following the transaction model we get to debt cycles (which you can read more about here). Here is the basic premise below (via Economic Principles).

As shown below in chart 1, real per capita GDP has increased at an average rate of a shade less than 2% over the last 100 years and didn’t vary a lot from that. This is because, over time, knowledge increases, which in turn raises productivity and living standards. As shown in this chart, over the very long run, there is relatively little variation from the trend line. Even the Great Depression in the 1930s looks rather small. As a result, we can be relatively confident that, with time, the economy will get back on track. However, up close, these variations from trend can be enormous. For example, typically in depressions the peak-to-trough declines in real economic activity are around 20%, the destruction of financial wealth is typically more than 50% and equity prices typically decline by around 80%. The losses in financial wealth for those who have it at the beginning of depressions are typically greater than these numbers suggest because there is also a tremendous shifting of who has wealth.

Swings around this trend are not primarily due to expansions and contractions in knowledge. For example, the Great Depression didn’t occur because people forgot how to efficiently produce, and it wasn’t set off by war or drought. All the elements that make the economy buzz were there, yet it stagnated. So why didn’t the idle factories simply hire the unemployed to utilize the abundant resources in order to produce prosperity? These cycles are not due to events beyond our control, e.g., natural disasters. They are due to human nature and the way the credit system works. Most importantly, major swings around the trend are due to expansions and contractions in credit – i.e., credit cycles, most importantly 1) a long-term (typically 50 to 75 years) debt cycle and 2) a shorter-term (typically 5 to 8 years) debt cycle (i.e., the “business/market cycle”).

I find that whenever I start talking about cycles, particularly the long-term variety, I raise eyebrows and elicit reactions similar to those I’d expect if I were talking about astrology. For this reason, before I begin explaining these two debt cycles I’d like to say a few things about cycles in general.

A cycle is nothing more than a logical sequence of events leading to a repetitious pattern. In a market-based economy, cycles of expansions in credit and contractions in credit drive economic cycles and they occur for perfectly logical reasons. Each sequence is not pre-destined to repeat in exactly the same way nor to take exactly the same amount of time, though the patterns are similar, for logical reasons. For example, if you understand the game of Monopoly®, you can pretty well understand credit and economic cycles. Early in the game of Monopoly®, people have a lot of cash and few hotels, and it pays to convert cash into hotels. Those who have more hotels make more money. Seeing this, people tend to convert as much cash as possible into property in order to profit from making other players give them cash. So as the game progresses, more hotels are acquired, which creates more need for cash (to pay the bills of landing on someone else’s property with lots of hotels on it) at the same time as many folks have run down their cash to buy hotels. When they are caught needing cash, they are forced to sell their hotels at discounted prices. So early in the game, “property is king” and later in the game, “cash is king.” Those who are best at playing the game understand how to hold the right mix of property and cash, as this right mix changes.

If you can grasp this and understand the role of credit in driving demand and both the short-term debt cycle (aka business cycle) and longer-term debt-cycle, then you are already leaps and bounds ahead of any economist with a PhD attached to their name.

Dalio is great at breaking things down to their essentials or first principles. An example of this is how he looks at the drivers of various asset classes. This is called the quadrant approach, which he uses as a basis for his All-Weather fund.

The idea is that every asset class performs a certain way depending on the economic environment. There are two primary forces that comprise an economic environment. These are: inflation and growth. You combine these and you get four states: decreasing inflation, decreasing growth; decreasing inflation, increasing growth; increasing inflation, decreasing growth; increasing inflation, increasing growth.

In our view, there are many markets but just a few primary market forces, and these forces influence all of them. A market price is the discounted present value of future cash flows. Economic growth and inflation are the two most significant drivers of those cash flows, and discount rates and risk premiums determine how these cash flows are reflected in current prices. Given this, prices largely reflect discounted future economic scenarios, which are a combination of discounted growth, discounted inflation, risk premiums and discount rates. The magnitudes of price changes reflect shifts in these four forces.

Bonds will perform best during times of disinflationary recession, stocks will perform best during periods of growth, and cash will be the most attractive when money is tight. Translation: All asset classes have environmental biases. They do well in certain environments and poorly in others.

When I say uncorrelated asset classes, what I’m really doing is not using the classic measure of correlation, like stocks and bonds are 40% correlated. What I am instead really referring to us, do you know how they behave, and is it intrinsically going to behave alike or differently?

The only way to achieve reliable diversification is to balance a portfolio based on the relationships of assets to their environmental drivers, rather than based on correlation assumptions, which are just fleeting byproducts of these relationships. To do this, we recognize that while asset classes offer a risk premium that is by and large the same once adjusting for risk, their inherent sensitivities to shifts in the economic environment are not the same. Therefore you can structure a portfolio of risk-adjusted asset classes so that their environmental sensitivities reliably offset one another, leaving the risk premium as the dominant driver of returns.

Underperformance of a given asset class relative to its risk premium in a particular environment (e.g., nominal bonds in higher than expected inflation) will automatically be offset by the outperformance of another asset class with an opposing sensitivity to that environment (e.g., commodities), leaving the risk premium as the dominant source of returns, and producing a more stable overall portfolio return.

The only free lunch in investing is diversification. But what is true diversification?

Many investors thought they were diversified in 2008 but quickly found out that was wrong when their asset correlations all went to one.

Recent beta and short-term backward looking correlations are a poor indicator of future correlations and risk. To truly diversify, you need to understand the principle drivers (inflation, growth) of the broader asset classes you hold and deduce the correlations (risk) from there.

As soon as you understand that, you can then apply what Dalio calls, “The Holy Grail of investing” (first paragraph via Market Wizards).

[Dalio walks over to the board and draws a diagram where the horizontal axis represents the number of investments and the vertical axis the standard deviation.] This is a chart that I teach people in the firm, which I call the Holy Grail of investing. [He then draws a curve that slopes down from left to right—that is, the greater the number of assets, the lower the standard deviation.] This chart shows how the volatility of the portfolio changes as you add assets. If you add assets that have a 0.60 correlation to the other assets, the risk will go down by about 15 percent as you add more assets, but that’s about it, even if you add a thousand assets. If you run a long-only equity portfolio, you can diversify to a thousand stocks and it will only reduce the risk by about 15 percent, since the average stock has about a 0.60 correlation to another stock. If, however, you’re combining assets that have an average of zero correlation, then by the time you diversify to only 15 assets, you can cut the volatility by 80 percent. Therefore, by holding uncorrelated assets, I can improve my return/risk ratio by a factor of five through diversification….I strive for approximately 100 different return streams that are roughly uncorrelated to each other. There are cross-correlations that enter into it, so the number works out to be less than 100, but it is well over 15. ~

So for example, if I had return streams that were 60% correlated, and I had a thousand of them, I would only reduce the risk by about 15%. And after 5 or 6, it’s limited. SO there’s a certain notion when approaching investing. What do I want? I need to have a certain structure. That can come in the form of alphas and betas. What is my risk neutral position?  I’ll say everybody in the room, they say what should I invest in? They don’t start off, I think, with what is a neutral position. What represents a good neutral position, balance? For example, does gold represent a part of my portfolio? What should, if I had no view, what should the concentration in dollars be? What is a structural beta portfolio? And then how do I take a deviation from that beta portfolio? And how do I do that in an uncorrelated way, so that I can then maximize my return to risk? So in that first principle, what I’m saying is that if you follow that first principle and you get 15 good — don’t have to be great — uncorrelated return streams, you’ll improve your return to your risk by a factor of 5. That means 5 times the return for the same amount of risk. That’s just a principle; that’s a reality.

So that’s the framework, the Machine, for not only how to view markets and economies but for how to attain everything you want in life, all via Ray Dalio.

His thinking has had a profound impact on my own, as I hope it does with your thinking as well.

 

 

Macro Ops