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Now is the time to diversify, not after stocks crash again
October 19, 2009
It is not often in life that people get a second chance, and even rarer to be able to correct a wrong or get a ‘do over’ in the investing world.
As US stock markets closed today at 12 month highs, with the Dow closing over 10,000; we’re faced once again with the question of where do stocks go from here. Is the crisis over and stocks are set for another mega rally up to new all time highs? Is it safe to get back in the market? Is this just an impressive bear market rally the likes of which Japan has seen during its 20 year down market?
The bulls have a great case, with US stocks up +62% since the March 9th lows (based on the S&P 500, source: Bloomberg). Wow! That sure does seem a bit more robust than a simple bear market rally and more the start of something very real. There’s also the ability of companies to beat lowered expectations, very cheap money, and no inflationary pressures thanks to lack of pricing power. It can be argued the US Fed saved the world and has us in a nice little sweet spot here where corporate profits can grow. Whether such an environment is sustainable over the long term doesn’t seem to worry many, as they are merely pricing in where they think corporate profits will be in 6 months time.
In the end, it is hard to argue with the impressive 6 consecutive winning months off the March lows. I would like to know who was actually buying at those lows. I’m sure there were a few lucky soles, but most of us were huddled in our bunkers hoping the world wasn’t going to end. But even if you only look at the more realistic stock market gains since the beginning of the year, up 21% in the S&P 500, that is worth noting.
The bears are saying we have come too far too fast, especially with all of the problems still hanging over the global banking system and economy. There remains the little problem about $3 Trillion or so of bad debt on banks books, yet their only having raised $500 Billion or so of capital to cover those losses. There remains the little problem of a ballooning deficit in the US. And oh yeah – the tough to hide problem of 10% of the largest economy in the world without wage paying jobs (which one would think would be needed to purchase goods and services).
Stocks have admittedly trounced managed futures so far this year, and especially since that low point in early March. But a good 7 month run does not tell the whole story. The graph below shows that stock have a long way to go to overtake managed futures as the better performer over the past 12, 24, & 36 month, and 5 and 10 year periods. [Past performance is not necessarily indicative of future results. Stocks = S&P 500, managed futures = Credit Suisse/Tremont Managed Futures Index. The Credit Suisse/Tremont index only includes those CTAs meeting the index inclusion criteria who submit to their database, and does not represent the entire universe of manged futures programs.]
Despite managed futures much stronger long term performance over the past 10 years, money continues to flow into stocks as the rally extends its gains and keeps clawing back 2008 losses. It is an interesting paradox in investing that the more something goes up in the short term, the more people invest in it – but at the same time – the more something goes up in the short term, the more likely it is to fall.
Consider the example of everyone’s favorite Thanksgiving bird - the turkey in Nassim Taleb’s fabulous book: The Black Swan. Mr Taleb tells us how the turkey gains confidence every day that he goes out in his pen to be fed. Mr Turkey gains confidence that every day he gets fed makes it more likely that he will be fed again tomorrow. I believe the psychologists call it a positive feedback loop. Problem is… every day he gets fed moves him one day closer to the day he gets gutted in preparation for the Thanksgiving meal.
This is a silly way of looking at something quite profound and misunderstood by the grand majority of investors. Most investors chase returns. They saw managed futures up big last year while stocks were down and poured into managed futures. They see stocks up 62% since March and now pour into stocks. The case of the turkey highlights that this chasing of returns is the exact opposite way to approach the markets. Consider that our friend the turkey actually gets closer to death with each positive result, and then reassess the logic of momentum investors who often increase their bets with each positive result. Could it be that those piling into stocks at these lofty levels are primed to be gutted soon?
Who is right? That’s the big question, to be sure; but we’re here to ask whether it really matters who is right. We can all probably agree that stocks can’t keep up this breakneck pace, and I’m sure nobody would object to the notion that there is a greater than zero possibility of a big correction (a sell off of about -40% will return us to the March lows). So whether the Bulls are right and we keep going up, or the Bears win the day and we start to head lower – we should all be able to agree that there is at least a chance of the markets seeing another big sell off over the next 5+ years.
Here’s your 2nd Chance
If you berated yourself for most of last year for NOT diversifying your stock market holdings, here’s your second chance. What was a disaster in early March is now much, much better – meaning you can reallocate some assets out of stocks into other asset classes at prices roughly 2/3 better.
Don’t be the normal “lemming-like” investor, who looks into diversifying his/her stock holdings AFTER a big sell off. Diversification works much better BEFORE you need it. Imagine going to purchase insurance for your home AFTER it floods – that won’t do much to help the damage done. Or, an example more telling to the current environment – imagine not having insurance and your house floods, destroying nearly everything. Then, miraculously – there is a warm, windy day which fixes roughly 62% of the damage. Would you take the second chance and insure the house at that point, in case the home floods again? I sure would.
In our experience, successful investors look to diversify before there is even a hint of a problem. They even look to diversify when their main holding are making new highs. The other 95% of the investing public tends to chase returns and run away from losses, creating a death spiral of sorts where they are constantly getting in at the highs and out at the lows. Wouldn’t it be nice to break that cycle? To actually get out (of a portion) at the highs, and get in at the lows.
[past performance is not necessarily indicative of future results; source = Attain data]
But you may ask what if we keep going up in stocks? Won’t I be worse off for diversifying a portion of my portfolio? Possibly? Stocks could outperform managed futures over the next 2,5, and 10 year periods, making a portfolio with stocks alone better than one including stocks and managed futures. But remember two things here.
One, we’re talking about diversifying a PORTION of your traditional stock & bond portfolio, not the entire thing. We recommend anywhere from 5% to 40% of your overall assets invested in managed futures (the efficient frontier for many asset classes moved significantly last year – view it here) And a study by the CME, see it here, calculated 20% of assets as the ideal level of managed futures exposure.
Secondly, a managed futures investment will not necessarily lose money if stocks continue higher. This isn’t insurance like you buy for your house, and it isn’t even like insurance you may buy for your portfolio via purchasing puts. Both of those are wasting assets. That is, they have a consistent cost which you pay, in exchange for a certain payout when and if something happens. If nothing happens, you lose the money you paid for your insurance.
Insurance via alternative investments does not have to be a wasting asset. It can actually make money even if nothing happens. That is, your insurance against portfolio losses won’t necessarily cost you money, and may even make money (it may even outperform) when and if there isn’t a crisis. That’s the beauty of managed futures….they aren’t like dedicated short funds which will, by definition, struggle when the market goes up. Futures investing carries the risk of substantial losses, meaning they of course can lose money when the market goes up, as they have done so far this year, but that hasn’t always been the scenario in the past. In fact, managed futures tend to hold their own in boom times for stocks. See some stats in one of our past newsletters here.
How does this work? It works because managed futures are NON correlated with stocks and bonds. Since 1994, the S&P 500 and CSFB/Tremont’s managed futures index have a correlation of -0.15. As a refresher, correlation is a statistical figure with values which range between -1.00 and +1.00, meant to show how inter-related two sets of data (in this case monthly % returns) are. If they have a correlation of 1.00, they are perfectly correlated, meaning when one market rises 1%, the other will do the exact same, and when one loses -1%, so will the other. If they are at -1.00, they are exactly opposite; with one making the exact opposite amount the other loses each day, and vice versa. The ideal situation is to have the correlation be 0.00, which tells us they act independently of one another. In practice, values from -0.35 to +0.35 represent non-correlated data, while values above +0.50/below -0.50 represent positively/negatively correlated data.
So, managed futures have proven to be non correlated in the past, versus negatively correlated, meaning they move independently of the stock and bond markets. This means a strong stock market isn’t necessarily a bad thing for managed futures. It also means a big sell off in stocks won’t necessarily result in big returns for managed futures, but the past history has shown managed futures to outperform during times of market stress.
How can I diversify:
We have touched on this in a past newsletter, and it bears repeating here. When looking for the stress period performance of managed futures – it doesn’t do to diversify into just any managed futures program. You want a managed futures program which tracks the managed futures index as closely as possible, and not one which may actually end up increasing your stock index exposure. View the old newsletter here.
So, the first step is finding a program you are comfortable will be diversifying you away from stock market exposure, not adding to it. The next is figuring out how much, and when – to allocate to managed futures. The how much can be trickier than it looks. Say you have $1 Million in assets and are looking to diversify 20% into managed futures. That $200K could be invested by only putting $50K into an account and having the manager(s) trade it as $200K, thereby leaving you with $150K in cash at your bank, still in stocks, etc. Or, you could put your $200K into a managed futures account and have it traded as $500K or so, thereby leveraging up your managed futures exposure on a nominal basis, while remaining at your target level on a cash basis.
We touched on the when a little earlier in this piece, and in my opinion the when is BEFORE you see trouble on the horizon. Ideally, the when would be right before stocks have one of their classic sell offs – where you could deftly lower your stock exposure at their highs and increase your managed futures exposure to protect against a big sell off.
If anything, start scaling out a bit of stocks….perhaps ratcheting down your allocation by 2% -5% each month until reaching the 40% level, during which time you can increase your managed futures allocation. The goal of course is to be prepared for times of market stress. No one knows for sure when those periods will be, so the wise course of action is to always be prepared by having some exposure to managed futures.
History shows us that managed futures is the place to be during bear markets and crises situations. Futures based investments are often viewed as a way to generate oversized returns due to the leverage built into futures contracts [the use of increased leverage can substantially increase the risk of loss] and potential for large moves, but it is their low correlation with traditional markets which causes managed futures investments to be volatility reducers and portfolio diversifies during the bad times.
IMPORTANT RISK DISCLOSURE
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A firm tone was experienced by most sectors of commodity and index futures as another round of supportive economic signs and stronger than expected earnings continued to lead more risk capital into derivative investments. The overall growth tone around the world has sparked ideas that demand will again spark price rationing which has been the catalyst of the rally in most sectors of commodities. Early earnings continued to be a supporting factor as some companies again showed better than expected results leading to the rally in the index futures sector. Last week’s comments from Fed Chairman Bernanke that banking conditions were on the improve enough to consider winding down recent stimulus measures were emulated by his European counterpart. Asian headlines continued as a market supporting factor with news of a Chinese land IPO jumping more than 20% in 1 day sparking ideas of stronger than expected investment demand. The lineup of economic reports this week is fairly light with the headliners being the release of the PPI and Beige Book with a few housing numbers mixed in. Energy futures were the most active sector during the past week posting new highs for 2009 in some products as a better than expected weekly stocks led the rally higher. RBOB Gasoline +11.95% led the way followed by Heating Oil +9.55%, Crude Oil +9.42% and Natural Gas +0.23%
Commodity and Food products again posted strong rallies in most sectors as ideas of stronger growth and weather issues continued to spark investor interest. Weather concerns again led to higher prices in the grains with dryer foreign wheat regions and frost concerns in the U.S. sparking support. Wheat +6.54% led the way followed by Corn +2.71% and Soybeans +1.39%. The livestock arena posted advances on another round of higher cash and product prices with Lean hogs +2.52% and Live Cattle +1.00%. The Soft arena was also firm with support stemming from stronger worldwide growth and supply rationing ideas. Sugar +12.57% led the way followed by Cotton +8.24%, OJ +6.26%, Coffee +5.31% and Cocoa +0.93%.
Stock Index futures garnered a second consecutive week of higher price activity as stronger than expected earnings early in the week and firm industrial data helped ignite the rally. Late week earnings misses by GE and Bank of America took some of the starch out of the rally on economic recovery worries. For the week S&P 500 futures +1.30% led the rally followed by Dow futures +1.19%, Mid-Cap 400 futures +0.67%, NASDAQ futures +0.35% and Russell 2000 futures +0.34%.
The metals complex ended the week mostly higher, but price performance was fairly lax as profit taking seemed to stifle the rally after Gold hit a new all-time high. Investors remain fixated on the precious metals as an inflation hedge especially with world growth seen better than earlier anticipated. For the week Palladium +2.16% led the way followed by Platinum +0.68%, Gold +0.28%, and Copper +0.26%. Silver -1.53% found profit taking pressure.
Currency activity during the past week was again mixed, although traders favored the British Pound +3.25% on ideas that the Bank of England will cease their asset purchase program due to improving economic conditions. This action helped support the Swiss Franc +1.30% and Euro +1.23% on ideas improvement will be seen throughout Europe. The U.S. Dollar Index -1.11% and Japanese Yen -1.20% were under pressure from the news as well as the lingering effects from the recent interest rate increase in Australia. The rate sector was again under pressure from poor auction results with 30-year Bond futures ending -0.11% followed by 10-year Note futures -0.04%.
Multi Market managers have had a fairly decent month in October with stocks and commodities drifting slightly higher. The weak US Dollar has played a role as both asset classes to when the dollar moves lower. The Futures Truth SAM 101 program +4.83% est. remains the top performer for the second week in a row. SAM 101 is a shorter term multi market program and has taken advantage of improved trading conditions in October. Futures Truth MS4 has also done well so far in October at +1.72% est.
Other top performing multi market managers include Quantum Leap Capital Management +2.63% est. , Dominion Capital Management Sapphire +1.99% est., Robinson –Langley Capital Management +1.86% est., Attain Portfolio Advisors Modified Program +1.04% est., GT Capital CTA Dynamic Trading +0.73% est., Sequential Capital Management +0.36% est., and APA Strategic Diversification +0.10% est.
There are some multi market managers that have had a slower start to October and those with long treasury futures positions seem to have been suffering the worst. Managers in the red include Lone Wolf Diversified -0.13% est., Integrated Managed Futures Global Concentrated -0.41% est., Dighton Capital USA Aggressive Futures -1.58% est., Hoffman Asset Management -2.83% est., Clarke Capital Global Magnum -11.75% est., and Clarke Capital Global Basic -18.14% est.
Option Trading, once again, has started out October slightly ahead. For index trading managers like Ace, Cervino, and Raithel Investments the continued run up in the equity market has presented an opportunity to collect premium by selling puts below the market while commodity option traders have benefited from the stalled gold rally and oscillating currency prices. Current month estimates are as follows: ACE +1.98%, Cervino Diversified +0.15%, Cervino 2x is break even, Crescent Bay PSI +0.84%, Crescent Bay BVP -2.31%, FCI OSS +2.34%, FCI CPP -2.69%, HB Capital +0.47%, and Raithel Investments +1.05%.
Specialty managers have had difficulty compensating for the plunging US Dollar as it has led to short term / rapid rises in agriculture and energy markets traded by both the agriculture and spread managers. Current Agriculture manager October estimates are as follows: NDX Abednego -0.23%, NDX Shadrach -2.38%. Spread trading manager Emil Van Essen is down -0.44%.
Elsewhere short term index trader Paskewitz Asset Management Contrarian 3X Stock Index +0.90% est. has had a good start to the month, while yield curve trader Typhon Capital Management Drakon Yield curve is at -0.16% est.
US Stock Indexes extended the global rally last week, hitting one-year highs. Unfortunately, similar to previous week, a lot of this movement was observed on overnight sessions, leaving the day session choppy and not ideal for systems.
Beginning with the swing trading systems, Bam ES traded had a small positive trade of $645 for the week, followed by Ultra mini ES also traded once made +$507.5. On the losing side, Polaris ES end up losing -$10 for the week, followed by Jaws Daily losing -$217.5 and AG Mechwarrior lost -$1302.5, Strategic SP dropped -$5500 after some nice trades the previous week. Along those lines, Strategic ES followed with -$1122.5.
In Day trading, Spanish systems ATB Trendy Balance v2 DAX finished the week making $715, BetaCon ESX end up losing -$380 and Rayo plus DAX lost -$1865 on four trades. On local systems, Clipper ERL made $320 on two trades, cobraII ERL end up with a break even trade of+$1.83 for the week. Coming to our S&P systems Compass hit the lower edge for the week; compass S&P made +$379.725, on the other hand Compass ES bagged +$52.5. Finally, Jaws breakout lost -$1350 on big S&P.
IMPORTANT RISK DISCLOSURE
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.
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.