Macro Trading Experiment

So, let's do a little macro trading / money management experiment. None of this constitutes investment advice. But from my previous posts, you should be able to see that I think the US stock markets are headed higher this year. I had a feeling a few weeks ago, that those were the lows of the year for Nasdaq and Russell. The Russell is now re-testing that level, and the Nasdaq (NDX) is about 100 points higher. SPX likely had its lows in early February. There is always some volatility around a FOMC announcement, and the best case scenario is to get a move against your thesis, so that you can enter a trade at the best possible price. In general, trusting a feeling in any profession should be used cautiously, unless it has been kicked and slapped by feedback so many times that it has become a disciplined personal signal. Anyway, this is an experiment to give my analysis and feelings about the market some further discipline by putting them in a public space. I do manage some capital with a Chicago trading firm, so you can say that I have "skin in the game." In my mind, I've worked on this for so long that I have skin, bones, heart, and soul in the game. Paper trading with no risk at all is fairly useless, and more than likely an incentive to risk real money, which often results in losses. With some risk in reputation, I expect this will be a further benefit.

So suppose a hedge fund hired me to manage $10M. Here is what I'm going to do today. I'm going to commit to staying between a leverage ratio of 0 and 2. That's important to manage the drawdowns. Any major event that causes a market selloff could easily be 10%, or more, so what I'm saying is that if I can't anticipate it at all, then I'll have to live through a 20% or more drop in capital. I can live with that because I believe that I have a US macro model that predicts well at a 3-6 month timeframe. The out-of-sample Sharpe ratio for 2001-present historical testing is 2.7. And when I say drawdown, that could mean a market upswing, if the model is predicting lower market values. In that case I would hold a short position. I call my strategy a "Managed Macro Fund." Any portfolio drawdown is temporary on this 3-6 month timeframe, in my mind. Sometimes you have to just not watch the market in order to "sit on your hands," and avoid exiting a position out of fear. As Warren Buffett has said, "If you enjoy the weekends not watching the market, you should try it on weekdays." Admittedly, his timeframe is likely much longer than mine, but the message is still relevant. There are times you have to go do something else, because in this age of constant information flow, watching the markets can draw you in to make a poor decision. For this paper portfolio, I will use futures because they are the most cost effective tool to manage leverage. So I need to setup a portfolio based on my US macro model, with a notional value between 0 and $20M. I will use 3 index futures, ES and NQ traded on CME, and TF traded on ICE. My leverage is so low compared to margin requirements, that there should be no issue with the exchanges. The current range (as of 1:30pm on Wed Apr 30) of the futures in the order (ES, NQ, TF) is (1870-1875, 3560-3570, 1105-1115). The contract multiplier for (ES,NQ,TF) is (50,20,100). I will take the high of the price ranges, buying 32 ES contracts for $3M (32*50*1875), 84 NQ contracts for $6M (84*20*3570), 54 TF contracts for $6M (54*100*1115). The notional portfolio value is $15,018,600. Ignore transaction costs, but roughly they would be (depending on your membership at the exchanges) a few hundred dollars. Also ignore the possibility of holding T-bills as collateral in a futures account. My initial leverage ratio is just over 1.5. If the market sells off 10% from here, then the portfolio value will drop by 15%, and with only $10M in capital, that means the cash value of the account is $8.5M. I can live with that right now. If geopolitical risk picks up, or there is some unknown event that changes my views, I will make adjustments as best I can. If I can anticipate the fear, I will scale back a bit on the leverage. If things happen that I cannot anticipate, and my view is still bullish, I have some capacity to add when everyone else is selling. So to sum up, initial portfolio of (ES,NQ,TF) = (32,84,54) and initial account value = $10M.

Income Inequality and the Cooper Model

There is a lot of press lately about income inequality, economic growth, and how they are related. Some argue that we need more progressive taxation to get better growth. That may be true, I don't know enough about it. They point to a very long correlation between high marginal tax rates on the wealthy, and economic growth. Referring to this graph: Top Tax Bracket, the argument goes, the golden age of solid growth and a large middle class occurred in the years 1935-1980 or so. The years outside that range, with lower top tax rates, had larger income inequality, and presumably less stable economics. Notably, the 1929 market crash, as well as the 2000 tech bubble bursting and the 2008 financial crisis, all occurred when the top tax rate was below 45%.

I only have two thoughts about this. 1) Correlation is not causation, and 2) it may not be as big a problem now as it was in the past. The reason for point 2) is that, with each recession, or worse, even though the myriad of news sources will make it to look like the worst thing ever (after all, they are selling advertising, and competing for advertiser dollars, and hence readers or viewers), we have still had much technological progress in the intervening years. And people seem to like that. After all, they are buying cable TV broadcasts, smart phones, automobiles, refrigerators, washing machines, etc. As I've read somewhere, we are all living better than John D. Rockefeller ever did. So, at least as far as US culture (and of course Europeans like to say we have none), technology carries us along and apparently makes being in a low income level quite satisfactory. The only reason one might not be satisfied, is that we are constantly comparing ourselves to our peers or nearby social groups, and hence we are motivated to have a newer smart phone, a bigger or better car, more travel stories, etc., etc.

And that is the link to the Cooper Model (it's a lot easier to call it this, than the Darwinian competitive circulatory flow economic model). Any good economic model has to start with a competitive individual who has more than just a marginal utility function of financial gain. Quite probably, this basic competitive individual has a set of values, known or unknown, and is competing to achieve the highest rank in all categories. Sure, there might be some down time, taking a rest from all that, but even holidays and vacations are a point of competition among those who can afford to take them. (I expect several calls from friends about their great trips, just because I've written that;) It may be eventually shown, that we all have a multi-strategy game going on in our heads, and we continually assess potential behaviors in terms of how we can win that game (quite probably winning will involve a combination of serotonin and dopamine, and other feel-good brain activity).

All that micro-behavior adds up to a social / economic model as shown in Ch. 9 of Dr. Cooper's latest book. I think that picture should include lending / borrowing in addition to taxation as a way to keep the flow from the top to the bottom of the pyramid, but that is more about money flow than wealth flow. In any case, the analysis starting on p. 161 explains that part of the process very clearly. The recent press mentioned above is all about modifying taxation as a way to increase the circulatory flow of wealth in the economy. And that might work, it's true. I'm all for better circulation, no matter where in the pyramid I fall. Cooper's description of Quantitative Easing, as a way to increase the borrowing and lending portion of the flow, sounds accurate. QE probably is just short term help and a longer term hurt as far as economic growth. But I remember reading Paul Krugman's "Depression Economics", which I believe had the story of the Washington D.C. babysitting coop, where simply printing more coupons and distributing them to people who would use them, led to a re-start of the tiny model economy. So I cannot help but ask the question, why aren't we trying that? If the Fed is going to print money through QE, why give it to the banks to lend to people at low rates? Especially after the borrowers have all been hit with a "debt sucks" brick in the last 5 years.. Why not just print the money, and give it to those people directly, and let them spend it? I would call that QF, Quantitative Flowing. Let's see if it creates inflation; after all, it appears that we need some of that. It would almost certainly be a good test of the Cooper Model. Maybe it will be tried after the next banking crisis, which according to Hank Paulson's documentary on the last crisis, is certain to occur.

It's more than just bulls and bears out there..

Wayne Gretzky's Dad told him at a young age, "you can learn to anticipate. Go to where the puck will be." Good advice if you can do it. In terms of finance, and the larger stock market moves, that means you have to think about the question, who are the major competing groups with capital at risk? There are market participants at all different time frames, with fundamental, technical, quantitative, or other reasons for having their capital at risk. Many are very long term and passive, eg. mutual fund buy / hold participants. There are long term individual investors buying or selling their favorite stocks. There are hedge funds and traders of all sizes: macro, event-driven, long/short, intra-day, market neutral, dedicated shorts, emerging markets, the list goes on. There are new strategies entering the market, transitioning between asset classes or investor segments, funds closing down, and new funds opening up. It's obviously complex, but that doesn't mean a seemingly simple model cannot capture some of the behavior. The question is, are there times when most of these competitive participants are doing nothing, and one or two groups dominate. Geopolitical risk falls in that category. So the current question is, now that we've had one or two selloffs this year already, has the situation in Ukraine stabilized sufficiently such that event-driven hedge funds are not looking to put on massive short positions? No one knows the answer to that. I suppose at various times, you could get people leaking important information about the situation, and if there is the possibility that any event might scare some market participants, then you can bet that a large event-driven fund would look to put on a position in anticipation of that, and then exit once everyone knows about it, and the fear hits its peak. "Buy the rumor, sell the news" is the cliche there. But you really have to be on top of things, and have good informational connections to do that sort of thing. From an informational outsider's view, the market may push sideways for a week or two, while it becomes more clear what might happen in central europe. In recent past military scenarios, which were probably much more clear than this one (and everything is more clear looking backwards, of course), once the apprehension stopped, and the fighting started, the market generally rallied.

Apple Earnings Note

Apple earnings looks to have rallied the Nasdaq after hours, with NDX futures up over 1%. I can't say if it's the stock buyback, the positive iPhone sales, the dividend increase, or the 7:1 stock split announcement. It seems since AAPL has for a few years had a lower P/E ratio than one might expect, given its growth, that the stock split might be the big news there. Is it unexpected? I don't know what the rumor mills were saying, but my ex-post reaction is that it might have been anticipated by a close follower of the company and stock, if they had taken into account the idea that everyone is a competitive participant in the market, ie. George Cooper's economic model. After all, stocks used to split all the time, then google for a long time, chose not to, all the way to a stock price over 1000. Then google chooses to split. It's not too outrageous to suggest that that was the impetus for the apple split. Or at least a catalyst. Everyone competes: companies, CEOs, countries, governments, central banks, sports players, kids, adults, plants, animals, fish. Keeping in mind what the principal competition is doing can be quite useful in any type of market analysis.

Market Update

US stock markets making good rally off the lows of last week. Barring any unknown unknowns, the NDX should push up to 4000 by mid-summer, maybe by Memorial Day. SPX should get past 1940, that's only up 100 for the year, or about 5.4%. Small compared to last year's 30% climb. Even if the SPX were to get to 2140 this year, the percentage gain would be about half of last year's. The headwinds from last year were 1) June China credit selloff, which was hard to follow because, as far as I can tell, it was the first time it affected US markets. But tracking the SHIBOR (shibor.org) should give a good indication on that known unknown. The possibility that China growth will slow comes up from time to time, and could be a problem in the future. The next obstacle from last year was 2) the US budget / debt ceiling politics in October. As of right now, it appears that the Republicans have learned that it may be best to keep the government open for business, at least until the 2016 elections. Several FOMC presidents have noted that it's a bit silly to agree on a budget, and then require a separate agreement to raise the debt ceiling in order to pay for everything that was in the agreed upon budget. When the markets look good and calm and nothing seems like it could possibly go wrong, that is a good time to look for things that could rattle the calm. There are typically a few already-developed macro stories that could re-present themselves to the market short-term consciousness. The mini currency crisis we had in January comes to mind. More than likely that was a reaction to the continued tapering by the FOMC, and it could worry people again. The basic idea there is that having super low rates as well as QE1,2,3 allows financial institutions in emerging markets to borrow cheaply in US dollars, buy their own currency, and put the capital to productive uses in those countries. This brings in speculators who also just borrow the low rate currency, and buy the higher rate currency, which pushes the higher rate currency higher. Once it became clear that the FOMC was tapering, fear entered the market, and that trade began to unwind. If there is any institution that is excessively leveraged in that strategy, then it can push the markets the other way quickly, and in an extreme scenario, cause severe problems in global markets. That's what happened in 1997-98. Crisis was averted when Greenspan found a way to rescue LTCM. That very easily could have turned into a US recession, but did not. With Y2K bugs everywhere, there was lots of productive work to be done, and that helped us bounce quickly. As for unknown unknowns, well, those are by definition very difficult to predict. But it may pay off to put in more effort there. As far as types of crisis, there are emerging market currencies, european sovereign debt, russia vs ukraine, rating agency issues (are they still using a 5-yr lookback period in their models?), middle east stuff (iran, syria, israel, egypt), commodity-related moves, china banking / credit, china vs japan squabbles, earthquakes, tsunamis, hurricanes, tech bubbles, biotech bubbles, financial innovation / reaching for yield, income inequality, terrorist attacks, climate change, and that's about all I can think of. A good risk analyst will think of the worst all the time, and attach the right probabilities to each scenario.

Geopolitical Update

So the US, Russia, EU, and Ukraine all signed a document saying they are committed to de-escalation. This is standard negotiation technique, step 1. Get everyone to work on a common document, work towards a negotiated settlement. Then East Ukrainian separatist self-declared leader says, he didn't sign, it doesn't apply to him. So I guess they didn't include everyone in the negotiation. None of this seems too surprising. If you look at a map of recent Ukraine elections, the entire south and east supported the guy who was just removed, and the north and west supported the other side. Since there was a earlier "revolution" in 2004, and that side was not able to maintain power for more than one or two elections, it's not rocket science to say what probably needs to happen is for the south and east to have referendums to decide their own fate. It seems possible that if Putin had been a little more patient, and worked with everyone to create a referendum in Crimea with all 3 choices - 1) stay in Ukraine, 2) be independent, or 3) join Russia, then the process of the last month or so would have been smoother. But he chose the seemingly strong-handed approach, and only 2) and 3) were on the Crimean ballot. In my estimation, the Russian side seems to be about 60% unreasonable, and the Ukrainian / Kiev side seems to be about 55% unreasonable. This is all big picture, far from the details analysis, so take it for it is. If you choose to focus on some details of the conflict, and those details induce a lot of emotion in you, then the conclusions you reach will likely be dominated by excessive certainty, since feeling certain about something is addictive (try the book "On Being Certain" by Robert Burton), and an easy relief from the anxiety of complex conflict. Excessive certainty will lead to the overconfidence bias (try "Thinking Fast and Slow", by Daniel Kahneman), which leads to less than optimal decision making. At the end of the day, geopolitical events are hardly efficient, the road to resolution can be choppy, but often anticipated.

Scenarios 2014

How does the US stock market look today? Is this a brief rally before more volatility? No. It looks like we are coming out of the peak of the Ukraine fear. Sure, things could get worse, it's possible, but it doesn't seem likely. With both Ukraine and Russia asking the UN for help, this is more likely to be a very domesticated version of cold war politics. Little tit for tats, a jab here or a jab there, there is not going to be some massive central european war. Times have changed. Patterns remain, but times change. The SP500 hardly sold off this time (vs early Feb, does anyone even remember?), less than 5%. Nasdaq and biotech especially took the hit. Russell 2000 as well. Nasdaq and Russell were down 9-10%, biotech damage continues from the Gilead moment, when a letter was sent to US Congress concerning the extremely high price of a new drug. Look for Gilead eventually to defend themselves with the size of their research budget, and the probability that a single drug being successful is low. Going into a holiday weekend, markets closed on Friday, earnings mild, weather improving with the season. Pent up demand will come through in Q2. SP500 to reach toward 2050 sometime this year. German DAX likely to hit 10K, Nasdaq composite will drift up toward 4800, people will get nervous because they still remember March 2000. But this is not March 2000. At some point, that moment will arrive, the turning of the market from bull to bear, but not yet. If you have the time, read Minsky, read George Cooper (georgecooper.org), for the real deal on real markets.

First, the standard disclaimer: Past results are no guarantee of future success. The markets are always changing. There is risk, i.e. the "known unknowns," and there is uncertainty, "the unknown unknowns." Of course, that's what makes real markets interesting. If we knew what would happen with 100% certainty, then no one would pay attention. Yet like the movie "Zero Dark Thirty," if we know something with (near) certainty, but no one else does, then things get very, very interesting. Real Markets. Past results are no guarantee of future success. Nothing in this blog constitutes investment advice.