What every investor wants.

What every investor wants.

I was recently asked to speak at a conference hosted by one of the largest financial publishers in the industry.  There were no restraints placed on me….I could talk about anything within my area of expertise.

I mulled multiple possibilities.  Since I didn’t know beforehand the level of audience sophistication, I knew I should try to keep the presentation fairly basic.

The challenge then became, how in twenty-five minutes can I share everything an investor needs to know about rules-based investing?

And more importantly, why should they care?  And why should you care?

As I was preparing my notes and outline, one benefit seemed to stand out more than others.


It was the single word on my second slide.

For me at least, one reason we use models is that it creates a certain degree of predictability. (I will discuss mathematical expectancy in greater detail in a future post)

I think that one reason that people don’t invest who should, is because of the uncertainty that often surrounds investing and the emotional angst caused by the uncertainty.

There are two types of data.  That which is known, i.e. the past; and that which is unknown, i.e. the future.  Everything else is just noise.

None of us are diviners of the future.  Thus all future market data is unknown.  (Which is why “forecasts” are worthless despite investor fascination and interest in them)

Traditional investing advice such an indexing and buy and hope have you accepting the market’s future returns regardless of the outcome.

It’s random.

And it is highly unpredictable.

And psychologically, deep down, there is something unsettling about this.


What if, we placed our focus on strategy.  On process.   After all, that is the only thing we can control.

What if our process managed our major concerns? Meaning…it had the ability to always adapt to the best opportunities at any given time.    And if the “best opportunity” at the time was to be defensively positioned on bonds or cash, so be it.

In essence, we manage the unpredictable stream of future market data with a clearly defined, tested, researched, and predictable process.

How many investors have watched this market from the sidelines waiting for a pullback for better entry?   Thinking all along that “it was too high”.

If however, investors knew that it did not matter…that the investment strategy would protect them should the need arise…then investors could and should invest anytime capital is available.

Unfortunately, many investors approach investing as an all or nothing proposition that is rigid.  And this is where the internal psychological battle begins.   Questions like” what if I’m wrong” or “what if the market declines” and “what if this is a mistake?” take command.  And the result is often paralysis that results in inaction.

Markets adapt and change.  Why shouldn’t your portfolio be allowed to do the same?

Strategic allocation approaches, indexing, and buy and hope do not adequately address the element of predictability.  Consider the following table of historical returns for the market.  Notice that even in 20 year periods of time that the range of returns is from 1.9% to17.9% for the S&P 500.

Does that seem predictable?

And it’s worse the shorter your time frame.

The financial industry is always quick to say that every 20 year period in the market has been positive.  True.  But what it doesn’t mention is the possibility that half of the returns will be below the 20-year average return of 10.1%

If you were estimating on achieving an “average return” to reach your financial goals, there is a 50% chance you will fail.  That after all is the simple mathematics of an “average”.

I ask again if any of this makes investing seem predictable?

What if your timing is unlucky and you earn well below the average?   Success becomes based upon luck and hope that the return sequence delivers what is required.

So we come back to focus on process.  To make sure that our portfolio is allowed to breathe.  To make sure that our portfolio can adapt to new market regimes.

This is why I am so passionate about rules-based investing.  It allows us to program in the ability for our portfolio to maximize profits when times are good and protect our capital when markets start to head south.  Simple mathematical formulas can replace our emotional involvement and provide a predictable process to manage the market, no matter what it throws at us.

In my next post, I will discuss how some of the tools we use can help create an element of predictability.

Tim’s Technical Take – Breathe

Tim’s Technical Take – Breathe

With war rhetoric taking center stage this past week, the geopolitical risk for investors certainly increased.  At times like these, it’s very easy to let your emotions take over your investment plan.

Which is why I love adaptive, rules-based investing.  We can leave out emotions at the door knowing good and well that our portfolio will get adjusted…IF IT NEEDS TO BE.

With that said, I still do like to keep an eye on the markets.  After all, our models must operate within the market environment we find ourselves in, so any insight to market activity, in my opinion, helps provide understanding to model adjustments.  Further, and as I will explain, our attention to the market can help us make portfolio “tilts” which are smaller adjustments within our portfolio.

Clearly, it was not a good week for stock market investors.   The S&P 500 lost 1.4% and the MSCI All World Index lost 1.5%

The beneficiaries of all of this were gold (GLD), up 2.34% for the week, and US Treasuries (TLT), which gained 1.09%.

With that as our background, here are a few charts of interest.

Some of my favorite kinds of charts are that which depicts what is going on beneath the surface of price action alone.  Trends are less likely to be sustained unless the market as a whole is in synch.  And when evidence suggests otherwise, its good for investors to be at least cautious.

On Wednesday of this week, I posted the following chart to my Twitter account.  It is the Bullish Percent Indicator the S&P 500.  What is shows is that the Bullish Percent has been weakening as the market was rising, meaning fewer and fewer stocks have been participating as the market was making new highs.  This generally, is never healthy.

Another way of looking at this in a similar fashion is to measure the number of stocks trading above their 200-day moving average.  If this number is rising, stocks are in demand and generally, prices should be rising.  Conversely, if this number is falling, it tells us that more stocks are succumbing to selling pressure.

What we look for are divergences and recently the market has been rising but the indicator has been falling.

So based upon these market breadth indicators, I believe that investors have reason to be cautious.  By and large, it has been the mega cap and high-quality stocks pushing the popular averages higher.  (And incidentally, exactly how Portfolio Cafe models have been positioned for members)

Price action confirms this view, at least for the near term.

Price action for the S&P 500 SPDR ETF shows prices below the 21-period moving average and also the 8-period moving average has crossed below the 21-period.  According to successful trader John Carter, this set of conditions shifts the short-term trend from up to down, however at this time, price still remains above the long-term moving average.

Where the real damage is being done is in the Small Caps.  Here both the short-term and the long-term trend have turned negative. Small caps have been dramatically underperforming for all of 2017 and there is nothing to suggest this is about to change anytime soon.

This is where, as I said at the beginning of this post, that this information can be useful to make small adjustments to your portfolio.  Personally, when I see what I see happening to the Russell 2000, I would be minimizing my exposure to Small Caps.   This even means I would be minimizing exposure to Portfolio Cafe models that emphasize Small Caps because, in this environment, you are fighting a headwind to do otherwise.

To step back and take a look at the long-term trend, a very simple but effective chart that I like to look at is the Vanguard Total Market Index on a weekly time frame with a 13 and 34 period moving average.   When these cross investors need to pay attention. In 2008, this simple indicator would have gotten you out of the market in plenty of time to avoid the losses that were to come.

The present situation shows we are nowhere close to seeing this pair crossing.

So at the moment, this looks like a short-term correction within a long-term uptrend.  But don’t let that fool you.  That could still mean a 5-10% correction as I see it.

The best-performing markets YTD have been the international markets, so let’s see how they now look.

The MSCI EAFE index shows price action below the 21-period moving average and the 8/21 very close to crossing.  Short-term this is a caution.

The picture is the same for the MSCI Emerging Market Index.

So yes, I anticipate that the correction has further to go.  The market is now in a seasonal period when weakness often occurs – which often shows up when complacency is high, markets are overbought and sentiment is very bullish.  These conditions all existed at the start of last week.

Over 18 months have now passed since a meaningful pullback.

That is the longest period during this bull market.

Looking back over the last 60 years, that is also one of the longest periods without even a 5% correction.

Complacency reigns in the credit market too.  Currently, Euro Junk debt is yielding the same as 10-Year U.S. Treasuries.  This is insane.  Risky assets are being priced beyond perfection.

But please remember.  While technical analysis can provide a view into the market, and warning signs do exist, they aren’t perfect predictors and the future is unknown.  We can only approach the “unpredictable future” with our “predictable process” that never varies.

That is the power of rules-based systematic investing and adaptive allocation.  And it leaves time for us to breathe.

The “First Pancake” Rule of Investing

The “First Pancake” Rule of Investing

If you have ever made pancakes you know this to be true.  The first pancake usually goes to the bin.  Or a super hungry kid.  Or a dog 🙂

I am not sure why this but it seems to be a law of nature that the first pancake will either be not done enough or too done.  

What’s really interesting is how we react to this.  

Everyone just seems to accept the fact that to get a stack of perfect pancakes, you need to screw the first one up 🙁

With pancakes, we accept failure as the first ingredient to success.   

BUT when it comes to investing…WE react completely differently.   

Heaven forbid that we have a stock in our portfolio that shows a loss!   

Investors will focus obsessively on one investment that is losing money even if the rest of the portfolio is in the black.  

This behavior is called loss aversion.   

Investors have been shown to be more likely to sell winning stocks in an effort to “take some profits,” while at the same time not wanting to accept defeat in the case of the losers. Philip Fisher wrote in his excellent book Common Stocks and Uncommon Profits that, “More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason.”

It also doesn’t help too that we tend to feel the pain of a loss more strongly than we do the pleasure of a gain. It’s this unwillingness to accept the pain early that might cause us to “ride losers too long” in the vain hope that they’ll turn around and won’t make us face the consequences of our decisions.

We refuse to eat burnt pancakes and make no hesitation to throw them out and so too we should refuse to hold a losing stock position.  

And if you think that hiring a professional money manager saves you from such mistakes, I have bad news for you.  A couple of white papers by Barberis and Thaler (2003) and Shefrin (2000) find that professional money managers are far from immune to these biases. They are human after all.

And this leads us to the big reason that we use a systematic, rules-based process for our investing.

Rules based investing helps eliminate human emotion and the negative impacts of human behavior.  

By consistently applying the same rules over and over, we can quantify our probability of expected outcome.   

We know that there will be some “burnt pancakes” along the way.  But we also know that the quicker we are to get rid of them the sooner our plate is stacked with “perfect pancakes”.  

So the next time you are staring at your portfolio, remember the “first pancake rule”.  

Hedging Tail Risk within an Adaptive Asset Allocation Framework

Hedging Tail Risk within an Adaptive Asset Allocation Framework

Systematic models offer investor many benefits that can include the automatic and dynamic process of defensively adjusting a portfolio during periods of market duress.  


When using cross-sectional or time-series momentum to rank and allocate a universe of ETFs the common rebalancing period is monthly.  I have tested longer and shorter rebalancing periods and the returns degrade significantly. 


One of the more common questions I receive is “what happens if there is a significant market event between monthly signals?”.   If there is an Achilles heel to monthly rebalancing, this is it.


Nassim Taleb made popular in his book, “The Black Swan”, the idea that important events are both rare and unpredictable.  It is the nature of this unpredictability that causes angst for investors.  


One approach to managing this risk, and as practiced by Universa Investments L.P, the firm to which Nassim is an advisor to, is to engage in tail risk (portfolio insurance) through specialized option trading.  (Incidentally, in a recent interview, Taleb sees worse tail risks than in 2007.)


Such an approach is more practical to an institution that can afford to engage in such a strategy and who makes the decision to allocate a portion of their portfolio to portfolio insurance. Overall the strategy provides asymmetric, positively-skewed payoffs exposed to small losses when refuted and very large gains when not.


For a smaller investor, attempting to construct an option strategy could be both time consuming and costly and assumes one has the expertise to do this on their own.


Inverse funds are not a solution either when considered as a permanent allocation given the mathematics of the daily rebalancing.  Inverse funds can and do work to provide a source of positive returns during market declines but should not be used as a permanent allocation as a way to hedge unpredictable market declines.  I have found a way to successfully utilize them into our rules-based strategies but their use is for limited periods of time only.   


This begs the question as to what an individual investor can do.


Fortunately, a new ETF from Cambria (Meb Faber’s company) may provide a solution for investors who want to make a more permanent allocation in an attempt to mitigate tail risk.  


The Cambria Tail Risk ETF (TAIL) invests in a laddered portfolio of “out-of-the-money” put options with a portion of the fund’s assets while the majority of the assets being held in intermediate treasuries.   


What I like about this strategy is that the income from the treasuries can help offset some of the costs associated with the put options.   The other potential advantage is that the fund will buy more options when volatility is low and  fewer puts when volatility is high.    


What could go wrong?  Since the greatest percentage of assets are held in 10 year U.S. Treasuries, any losses in the credit markets could negatively impact the price of the fund in addition to the expected losses that will occur during rising stock prices and periods of low volatility.


Historically, the 30-day correlation between 7-10 year U.S. Treasuries and the S&P 500 has ranged between .58 to -.89 with most of the observations since the beginning of 2001 being negative.   This would imply that the USTs are in themselves a non-correlated return stream. And of course, a basket of market puts will also be negatively correlated to a U.S. stocks suggesting that TAIL should provide true diversification for investors looking to add a non-correlated strategy to a long-biased portfolio.


Within the framework of a systematic rules-based approach such as used within Portfolio Cafe models, I see TAIL as a potential tool to help mitigate unpredictable market events that can be easily implemented with minimal costs.