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Performance on the Market Emotions Cycle

July 12, 2010


We have talked in this space before about trying to escape the vicious negative feedback loop most investors are stuck in through enacting the discipline to stick with an investment until it crosses a predetermined line in the sand, and through having the patience to wait for a better spot to enter into new programs (while in DD).

And it appears we’re not alone in this belief that the grand majority of investors are stuck in some sort of cycle in which they usually invest at the point where it is most risky to do so, and get out of their investments at the point where the most future opportunity exists.  We came across the following graphic on Barry Ritholtz’s Big Picture blog a while back which does a great job of displaying what we call the negative feedback loop, and what they call the ‘market emotions cycle’.



While the faces are a little hokey, and we don’t think the dotted line is meant to portray an equity curve; we thought the labeling of the ‘Point of Maximum Financial Risk’ and the ‘Point of Maximum Financial Opportunity’ at the points corresponding with the high and low of the “chart” perfectly show what we mean by not getting out at the lows or in at the highs. If we changed the title to investor emotions at various points on a trading system or managed futures equity curve – then the points of maximum risk and opportunity would line up perfectly with the equity highs and max DD of this fictitious program.

Unfortunately, the bulk of investors get into not just managed futures, but all investments, somewhere between the optimism and euphoria stages on the ‘market emotions cycle’ – which we have long told anyone who would listen is likely at the point of maximum risk. And hardly anyone gets into investments in the desperation, capitulation, or despondency stages – which we have again told anyone who will listen is likely the point of maximum financial opportunity.

You don’t have to look far for proof that the euphoria and despondency stages are indeed the points of maximum risk and opportunity as the graphic instructs.

Consider the peak of the internet bubble in 2000, where there was such euphoria that the percentage of American households owning stocks was at one of its highest ever levels. Likewise, at the peak of the real estate bubble in 2007; the percentage of Americans “owning” a home was at its highest level ever.  Even institutional investors fall victim to this - as they were racing each other to put as much mortgage backed securities as they could afford (and then well beyond that) onto their books.

In managed futures, one only need look at option selling managers at the end of 2006, when three years of low volatility had created optimism, excitement, and euphoria for those investments – just as they were at the point of maximum risk (they went on to see losing years in 2007 and 2008). Or conversely, at option selling managed futures programs at the end of 2008, when the credit crisis had wiped many out and put those left at new max drawdowns. Talk about despondency,  I would wager good money that there wasn’t a single option selling account opened between October 2008 and March 2009 (they have since been the best performing managed futures sector since then)[past performance is not necessarily indicative of future results].

Now, there is one important difference between the investor emotional cycle in traditional investments like stock, bonds and real estate and the negative feedback loop in alternative investments in hedge funds and managed futures. The traditional investments are more closely tied to the emotional cycle, because market prices of stocks, bonds, and real estate are based in part on demand for the investment.  Just consider looking to buy a house which has 10 other offers on it – you would have to increase your offer above the rest to insure the purchase, which would drive up the price.  Traditional investments will go up and down based on investor sentiment - when many investors want to own stocks, stocks go up; when everyone wants out, stocks go down.

Conversely, investments in alternative investments such as managed futures are independent of the investor interest in the specific program or asset class as a whole.  If 10 people want to get into a managed futures program, that does not drive up the ‘price’ (performance) of the program.  In alternatives - the more people who want to invest - the more money managers have to place trades both long and short in the futures markets. It is the success of those long and short trades which affect the performance of managed futures as a whole – not the fact that more trades are being put on.

But even though investor sentiment is independent of performance in managed futures - there is still a high correlation between how investors view a particular program or sector of programs and that programs performance over the next 12 months. While it is hardly scientific – we can usually tell right when a program is due for a pullback based on investor interest. The more calls and new accounts flowing into a program, the more likely it seems that program will see below average performance over the short term.

Whether it is Murphy’s Law, the old axiom that the market will do that which causes the most people pain, or just the simple fact that all investments tend to cycle between good and bad performance – managed futures investors tend to mirror their traditional investor counterparts by entering into investments in the optimism to euphoria stages, and unfortunately see some losses in the short term to usher in the anxiety through despondency stages.


Putting the emotional cycle to the test:

We’re urging you to not invest at the top of the emotional cycle, and instead wait until the bottom of the emotional cycle or as it is turning back up (and also to not get out at the bottom of the emotional cycle if you are already in).  But how has such a tactic performed?

For the optimists out there, it is hard to accept that it would be more beneficial to wait to invest in a program with a nice upwardly sloping equity curve which clearly shows that would not have been the best tactic in the past.  

This got us to thinking – what if we test the performance of some programs at different points along the ‘investor emotional cycle’ to see whether the euphoria stage really is the point of maximum risk and despondency stage the point of maximum opportunity. But how do you go about testing an emotional cycle?  Managers are not polling their clients and reporting their emotional state along with the returns of their program each month, unfortunately.

So we stepped back and asked - when do we see clients at each of the stages outlined in the emotional cycle? After theorizing over several methods which considered the distance from equity highs, from the max DD, average DD, and more – we finally came up with a simplistic way to map the emotional cycle to actual data by assigning a high or low milestone (such as a new 12 month high) to each of the emotional categories.

There are two sides to drawdowns, with investors feeling both the magnitude and the duration; and for that reason we considered whether a program was at a high or low point (magnitude) on a monthly basis, and how many months (duration) that high or low point eclipsed.


emotion cycle time frames.gif


Starting with the extremes, Euphoria and Despondency, we theorized that clients are usually in those mental states when their investment is at fresh two year highs (euphoria) or lows (despondency), and then rounded that to 21 months. From there, we figured the difference between each mental state to be 3 months worth of performance. The table above shows the duration and high/low level we assigned to each of the emotional states in the market emotional cycle.

Using these proxies for the emotional states, we then plotted which high/low period a program was at to see if the investment tended to cycle as we would expect from the original emotional cycle graph. The chart below shows the popular Compass trading system as plotted using the high/low proxies for the emotional states.

The image is quite telling, with a definite cycling between the top emotional stages and the ones at the bottom. One surprising feature (although to be somewhat expected with a trading system, which is more volatile than a managed futures program) was the volatility of the cycles – with the cycles shooting right up to the 21 month highs, not climbing slowly to the top through the different stages as we would expect from the original graph.


compass hl emotion cycle.gif


Once we were comfortable with our mapping of the emotional stages to measurable statistics on a program’s track record, it was time to test the performance at each emotional level. To do this, we looked at the 12 month return for the 12 months following the programs piercing of the high/low level assigned to each emotional stage.  

For example, in the graph above – the Compass system hit a 21 month high in November 2001.  We then analyzed the 12 months performance from Dec. 2001 through Dec 2002 and assigned that performance to the 21 month/ Euphoria “bucket”. We then averaged the performance for all 12 month periods following 21 month high/Euphoria points – to arrive at the average 12 month performance following the Euphoria stage; and then repeated that for each of the emotional cycle stages at each of the high and low points (3,6,9, month highs…. and so on, then 3,6,9, month lows…. and so on).  To normalize the numbers between programs with different volatilities, we then divided that performance by the average rolling 12 month performance to come up with a number which would show us whether the performance following each period in the emotional cycle was better or worse than average.

We tested across 12 different managed futures programs spanning the various trading strategy types (options, trend following, short term, discretionary, etc) plus the Compass system mentioned above, and included 3 programs from our CTA graveyard database which are no longer offered to protect against a survivorship bias.  

You can see the results in the graph below, with the amount that the average 12 month performance following each stage was above or below the overall rolling 12 month moving average listed besides each emotional stage.

emotional perf above_below.gif


While the middle of the cycle sees some noise, the top and bottom of the emotional cycle show performance right in line with what we would expect. Following the Euphoria stage (investment at a 21 month high), the following 12 month performance was just 0.70 times what it normally is, while the 12 months following the Despondency stage (21 month lows) are 2 times better than normal, on average.

While we would prefer a larger sample size for this analysis, the cross section of programs we selected still do show that the emotional cycle graph’s labeling of the Euphoria point as the point of highest risk, and the despondency point as the point with the greatest opportunity is more than just a ‘feeling’, and is in fact backed up by the statistics.

In closing, check where you are on the emotional cycle scale next time you are looking at starting an investment. If you are along the top end, our experience and the data from this test tell us that you will likely see performance below what you are expecting over the next 12 months. And likewise, make sure to take a long look in the mirror next time you are considering quitting a program, as you could very well be at one of the points along the bottom – where the following 12 months just could be up to 2 times the average.

Jeff Malec


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Feature | Week In Review: Stocks recover, bringing energies and metals along for the ride

The best performing week in a year for stock index futures filtered into most commodity sectors as well last week as anticipation for a strong second quarter earnings season drew in money on the long side. The earnings expectations were backstopped by news out of China indicating the Chinese government would remain fixed in normal investment operations which put to rest fears that they were in the mode of dumping U.S. Treasuries. The report also stated that the Chinese were interested in the U.S. Government keeping a responsible attitude toward managing the U.S. Dollar price direction along with indication that Gold purchases might slow in the near future. The IMF upgraded their global economic forecast for 2010 pointing to robust Asian expansion and strong demand from private sources in the U.S. The only caveat the IMF seemed to be worried about was the European debt crisis, but indicated that member Euro countries were taking extreme measures to alleviate the pressures.  The final pieces to the constructive week for most U.S. markets were indications from retailers that June sales were very solid and the weekly jobless claims report falling to levels not seen since early May. The rally in the stock index sector was led by S&P500 futures +5.74% followed by Dow futures +5.59%, Mid-Cap 400 futures +5.27%, NASDAQ futures +5.24% and   Russell 2000 futures +5.16%.

Price activity in most energy futures participated in the hubbub for the potential demand growth along with indications refiners were in the middle of ramping up operations to meet peak summer demand.  Heating Oil futures +5.48% led the surge followed by Crude Oil futures +5.48% and RBOB Gasoline futures +4.67%. Natural Gas futures -6.08% fell to its lowest level in five weeks victimized by heavier supply indications and a calmer tropical weather situation. 

Industrial metals experienced a surge in price participation as ideas built that global economic strength would spark more building demand, especially from Asian concerns. The activity was backed by expanding jobs reports from Australia and Canada which are directly affected by industrial mining. Palladium +7.04% led the renaissance followed by Copper +4.49%, Platinum +1.97%, Silver +1.54% and Gold +0.39%.       

Weather was the main market mover for most commodity and food products as drought or dry situations are beginning to intensify in Russia, Europe and China. Extremely wet conditions in Canada also have the attention of the marketplace, especially Wheat futures +7.07% which is a main crop for all countries involved. Soybeans +5.26% and Corn +2.81% benefitted from the extreme conditions. The Soft complex had the reverse price activity from the weather as calm tropically weather hampered price activity in OJ -8.07%, Sugar -0.54% and Coffee -0.27%. The livestock sector was mixed as favorable foreign demand aided a rally in Live Cattle +0.82, but Lean Hogs -0.04% felt pressure from expanding supplies.       

Currencies futures were fixed in a low volume holiday type trade, despite indications for better times ahead as far as world economic activity was concerned. The complex also seemed reluctant to tip its mitt as participants try to figure out China’s policy change of managing the Yuan. For the week Swiss Franc +0.72% and Euro +0.67% posted modest rallies. Japanese Yen -0.91, British Pound -0.84% and U.S. Dollar Index -0.61% ended with weak tones.        

Managed Futures

The beginning of July has not been kind to most multi-market CTAs who have struggled to perform due to choppy market conditions.  One multi-market manager who continues to perform well is Applied Capital Systems at +1.16% for the month. Applied Capital Systems is an emerging CTA at Attain and has done well despite very tough market conditions over the past few months.  This systematic manager has had recent success trading metals, foreign currencies, and fixed income markets.  

Another program that has done well of late is Dighton Capital USA Aggressive Futures Trading.  As you can tell from the program’s name, the Dighton program is an aggressive discretionary program that primarily looks to buy value in markets traded on the NYBOT including Sugar, Coffee, and Dollar Index.  Thus far in July this program is up +1.60%.

Other managers that are in the black or breakeven in July include Dominion Capital Management Sapphire +0.15%, while Auctos Global Diversified, DMH, GT Capital, Hoffman Asset, Futures Truth SAM 101 are all near break even.

Unfortunately, there are quite a few multi-market managers in the red to start the month including Futures Truth MS4 -0.33%, Mesirow Low Volatility -0.34%, APA Strategic Diversification -0.56%, Mesirow Absolute Return -1.21%, 2100 Xenon Managed Futures 2X -1.40%, Quantum Leap Capital -1.44%, Clarke Global Magnum -1.61%, APA Modified -2.40%, Clarke Worldwide -2.52%,  Sequential Capital Management -2.63%, Integrated Managed Futures Global Concentrated -2.96%, Accela Capital Management Global Diversified -2.58%, Robinson-Langley Capital -5.78%, Covenant Capital Aggressive -5.79%,  and Clarke Global basic -8.97%.

Short term index traders have not fared much better in July with Roe Capital Management Jefferson -1.73%, Roe Capital Monticello Spread -2.01%, and Paskewitz Asset Management Contrarian 3X Stock Index -2.54% all down for the month.

One category that has continued to perform well week in and week out has been the Option Trading managers (all but one manager we track is positive so far in July).  So far in July Crescent Bay BVP is leading the way with an estimated return of +4.98%.  Crescent Bay is now ahead close to 24% for the YTD. The manager trades exclusively in the S&P 500 futures and options.  Other eestimates for July to date are as follows: ACE SIPC +1.68%, ACE DCP +0.01%, Cervino Diversified Options +0.76%, Cervino Diversified 2x +1.64%, Clarity Capital +3.74%, Crescent Bay PSI +1.05%, FCI OSS +1.35%, FCI CPP +1.68%, HB Capital +1.56%, and Kingsview Management +0.49%.  Liberty Funds Group is the lone negative strategy thus far with a loss of -3.77%.

Specialty market managers focusing on the grain markets exclusivly have been mixed while spread trader Emil Van Essen is slightly in the black with an estimated gain of +0.04%.  Agriculture trading is currently being led by Oak Investment Group who is ahead an estimated +1.30%.  Elsewhere, NDX Abednego, NDX Shadrach, and Rosetta Capital are all down -0.53%, -1.19%, and -1.38% respectively.

Trading Systems

Last week was a pretty solid week for swing and day trading systems, with most systems going long before the big rally in the equity markets to produce some nice profits.

Leading the way for swing systems was Strategic SP. Strategic SP actually started off the week on a bit of a rough patch, going long on Tuesday only to reverse its position and go short later on in the day. But then on Wednesday, Strategic SP reversed once again and got long before the big push up in the equity markets, riding the 3.3% move in the S&P market for a profit of $2,650.00. MoneyBeans S, which trades the soybeans contract, started off the week by getting short on Tuesday, but then MoneyBeans reversed early on Wednesday and benefited from a 47 cent price jump that took place during the week. MoneyBeans S earned a profit of $1,478.39 for the week. Other swing trading results were Bounce eRL at $60.00, Strategic US at $63.75, Bounce Filter ERL at $70.00, AG Mechwarrior ES at $270.00, Strategic ES at $360.00, Bounce EMD at $760.00, Strategic ERL at $1,085.84, Strategic EMD at $1,204.18, TurningPoint X2 ES at $1,402.50, TurningPoint ES at $1,470.00, Waugh CTO ERL at $1,790.00, and Bam 90 ES at $2,065.00. 

On the downside for the week was Strategic NQ, it was short on Tuesday and unfortunately remained short throughout the whole rally on Wednesday before finally exiting its position Thursday morning. Strategic NQ lost -$1,270.00 for the week. Other systems caught wrong footed last week were MoneyMaker ES at -$167.50, Jaws US 60 at -$530.00, Waugh Swing ES at -$655.00, and Polaris ES at -$785.00.

Although some of the day trading didn’t do as well as their swing system counterparts they still produced some nice results. Leading the way was UpperHand ES. Upperhand ES got long at 1030.75 on Wednesday and rode the 29 point increase in the S&P market on Wednesday for a profit of $1,245.00. Other day trading results were BounceMOC EMD at $10, Balance Point ES at $227.50, PSI! ERL at $310.00, Clipper ERL at $610.00, ViperA EMD at $839.66, EVP 1 US at $860.29, Waugh ERL at $870, and Beta_DT ERL at $1,056.10.

Unfortunately, some of the day trading systems were caught wrong footed last week. Barely missing out on a positive profit was NPI Traders GC at -$33.33. Other results included BounceMOC ERL at -$170.00, NPI traders US at -$341.25, Compass ES at -$372.50, NPI Traders CL at -$853.33, and Compass SP at -$1768.53.

Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.

Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.

Please read carefully the CFTC required disclaimer regarding hypothetical results below.