Fundamental Trends for the New Year


Over the past few decades with the rise of a financial media that is always looking for something to say, the flow of information to the public has become more polluted. It has gotten to the point that investment news almost completely ignores politically non-biased economic thought or the fundamental analysis of companies. In the place of actual financial news, we have become subjected to the cult of personality that is flashy sexy entertainment first and information somewhere down the list. We can almost forget about getting unbiased information anymore and when we do it’s almost impossible to recognize being so hidden in the muck. 

The internet, while potentially a great source for information, has now become so overwhelmed with millions of websites and advertisements, that finding the information we need to make informed and rational decisions is difficult at best. Other advances in communications technology have also brought a dimension to the markets that is so confusing and illusive, that people have no idea how to deal with it.

Financial author Michael Lewis has discussed what is essentially a big skim in the financial markets, as machines and large brokerages conspire to shave money out of your retirement accounts each time a mutual fund company makes a trade. The result is that you get to work longer and they get rich. It is not unlike the movie plot in Office Space where technology nerds take a fraction of a cent of every transaction. In fact, that is almost exactly what is going on with high frequency trading.

In addition to the high frequency traders, we now have tens of thousands, if not hundreds of thousands, of algorithmic traders in the markets. Their goal generally is to follow trends and ride momentum. They pompously tell people their system is infallible because it is devoid of emotion – which is also to say that they don’t trust their human brains to analyze good from bad investments. What it really is though is a their attempt to create a better gambling system. We should all know that almost no gamblers have a winning system, and the ones that do, they don’t share it. 

The most dangerous trend followers are the small-time hedge fund manager wannabes who gather up money from naive investors who think that the algorithm they will be using will be able take part in the skim. While this is not ethical at either level, the hedge fund flunky’s or the investors, it occurs over and over. As results have proven out, most of those wishful thinking investors end up trailing the market averages net of their hedge fund manager’s large fees. 

Ultimately in today’s market, the machines can end up controlling up to 90% of trading on any given day. This drives volatility. While there is momentum to the upside and greater fools to sell to, the markets rise and volatility remains low. That is why we get to hear in the media all the time about “money on the sidelines.” The hope by the momentum followers and various hucksters is to draw that money into the markets near tops so that they – the momentum guys and hucksters – can sell to somebody after they have gotten their fill and the markets start to stall out.

2014-15

For the past three years, since the volatility of 2011, we have had an almost uninterrupted period of a rising stock market in America. This is in part because the United States does in fact have one of the strongest economies on earth. The problem with that idea is that on an absolute basis, it is not strong. The U.S. economy is just “less weak” than most of the others. Anybody walking around anywhere but a suburb can tell you that things aren’t as good as they were 15 years ago with regard to standard of living, which ultimately, is what economics tries to quantify.

The stock market has also risen because the Federal Reserve has been printing money via Quantitative Easing (QE) for most of the time since the Great Recession. The correlation between the markets and Fed easy money is undeniable. It is where the phrase “don’t fight the Fed” came from decades ago. In late 2014, the Fed closed its last QE program and is now talking about raising interest rates in 2015. That is a clear sign that the upward momentum in the markets will at least be challenged. 

Overall, there is an illusion that the world is overcoming the demographic and debt problems that caused the financial crisis. To the limited extent that a few years of time passing can help, that is somewhat true. The broader reality though is that there really isn’t much difference between global circumstances today than in 2007. This is a bad sign. Some would argue that regulations and cooperation among central banks will save us from another collapse. I don’t believe that. It really is just a matter of time before the chickens come home to kill the foxes guarding the hen houses. My hope is they don’t take the farmers too – you, me, our families.

Readers of this site might know Jesse Colombo. If not, I would encourage everybody to look at his writings. While I am not sure about his ability to forecast events, he is a savant at finding dangerous scenarios. 

Fundamental Trends

That brings us to what this site is for. While I am a good macro-forecaster and a good stock picker, I am also aware that nobody is perfect and there is no system for being perfectly precise for investing. So while my 2014 results were stunningly good to the point of a few clients being a little afraid of the returns compared to the markets, I know that the past is the past.

Back in 2007, I had started studying the trend traders. First the Turtles. I also became enamored with Paul Tudor Jones. I believed that somewhere in the math there was a hint, not an answer, but a good hint, at what was coming and about when it would come.

I was also a student of the real estate market, having held realtors license for a little while and liking the idea of hard assets. I knew the real estate market wasn’t right. I told members of the firm I was with at the time, that I believed a collapse was coming. I had said the same thing in 1999. In 2007 though, I was older and armed with some very good charts. The brokers – they call themselves advisers now – at my firm, told me the same thing they did in 1999 – only there were more of them in 2007 because the firm had grown during the financial bubble – they said I was wrong, stupid, crazy and generally devoid of any brainpower.

Today I believe the math is still a critical component to knowing when risk is rising and when opportunity is ripe. Unlike most people using quantitative analysis to make investments, I combine the mathematical trends with the fundamental economic and company analysis I do. This allows me to have two layers of safety.

Unlike those who refuse to use their brain to analyze risks and opportunities – because they are afraid of being emotional and therefore defer to “their system” – I simply try to remember a simple phrase I learned back in high school at Camp Enterprise which was run by the Rotarians, many of you will know it: 

“Direct your thoughts, control your emotions, ordain your destiny.”

After years of searching for somebody to help me with trend following, momentum and algorithms in particular, I have finally found somebody I consider to be among the best. His name is Rick Gobel.

I actually am a pretty good algorithm guy. However, I am better at analyzing companies and the broader economy. I am also better at assessing somebody else’s algorithms than building my own from scratch. Frankly, it drives me nuts to sit and program. Rick likes it and he’s very good at it. Our teamwork allows us to both do what we like and do best. If you know who Kathy Kolbe is, or have just had a good working relationship with somebody, you’ll understand what I am getting at. 

For this service, we have tweaked Rick’s day trading program so that what he does can be applied to what I do – which is pick out good companies and sectors of the economy to invest in. By combining fundamental analysis with algorithmic measures of risk, we can find good times and prices to invest in our favorite companies and avoid much of the systemic market risk. 

The easiest way to understand what we are doing is that I am trying my best to be Warren Buffett and Peter Lynch, and Rick is trying his best to be The Robot from Lost in Space yelling “danger” when appropriate. In essence we are getting closer to the ever elusive “buy low and sell high” we all wish we could do perfectly but know that we can’t. 

So, with that, here are some samples of what we will be doing. Next weekend, I will unveil my list of stocks and complete ETF list. Let’s start by looking at the major U.S. indexes:

U.S. Stock Indexes

The weekly and monthly algorithmic numbers, which I’ll refer to as algos from here out, will run from 0 to 100, with 0 and 100 virtually never occurring. The closer to 0 an algo is, the more oversold the asset, meaning, it has less and less risk the longer it is near that level. The closer to 100 an algo is, the more overbought an asset, meaning, the more and more risk it has being near that level. The basic scale is this: 

Algo risk/opportunity scaleBecause we are using weekly and monthly numbers, we are not looking to trade much. Day traders use daily and sometimes up to the minute numbers. That’s not what Fundamental Trends is. We are looking to find good longer-term opportunities and to use the warning signs to take profits and protect ourselves when necessary. 

I will be adding a more comprehensive guide soon, however, let’s use the indexes as examples.

We can see that the S&P 500 is the most overbought on the monthly time scale with a number of 88.16. It is approaching a longer-term overbought condition. That doesn’t mean it can’t continue to go up for an extended period of time, it just means that as it does, it becomes more dangerous. For the risk averse investor this is vital information. 

We also see that the Dow Jones has the lowest weekly algo at 76.22. If an investor were inclined to make a swing trade – generally weeks or months in duration, then the Dow, using an ETF presumably, would be the least risky of the major indexes in the short-term. 

What we are seeing across the markets is an above average, but not, extreme level of risk. Many individual companies are closer to the least risky edge of their range, for example, oil and gas companies with good balance sheets. Because those stocks have gotten beaten up so badly in the second half of 2014, we are getting closer to many good opportunities. We’ll examine some of those this weekend. 

Happy New Year

Kirk