Macro Tsimmis

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Archive for the ‘B. Speculative Tactics’ Category

Posts relevant in general to our Intelledgement Speculative Opportunity Portfolio (ISOP).

Performance and Volatility: an Inverse Relationship

Posted by intelledgement on Wed, 14 Oct 09

Volatility in the ebb and flow of the S&P 500’s valuations declined for the third straight quarter in 3Q09. The average daily change in the value of the S&P 500 index for 3Q09 was ±0.8%, down sequentially from ±1.3% in 2Q09, from ±2.0% in 1Q09, and a nightmarish ±3.3%—the highest level of volatility in a quarter since the inception of the S&P 500 index—in 4Q08 (as discussed in the previous articles, This Volatility is Off the Charts! in April 2009 and Not Your Father’s Market Volatility in July 2009).

For the entire year, 2009 at ±1.3% overall is still on track to be the second most volatile year on record—2008 set a new record at ±1.7%—but if the calming trend continues through 4Q09, we may drop below the pre-2008 record ±1.2% posted in 2002. Still, at this point we remain 118% more volatile than “normal” (namely, the all-time average daily change in the value of the S&P 500 index, which is ±0.6%).

Why do we care? Well, if you are a short-term trader, obviously more volatility is a good thing, because the opportunities for you to profit are larger and more frequent. But it turns out that if you are a long-term investor, volatility is bad news. In general, higher volatility is associated with a lower return-on-investment. Indeed, the big peaks in the above chart—when the S&P 500 experienced unprecedented volatility—were all negative ROI years: 1974 -30%, 2002 -23%, and 2008 -38%. In fact, not merely negative, but the worst three years in the history of the S&P 500 index.

But wait, there’s more! It isn’t just peak volatility that hurts. In general, the higher the volatility, the worse the ROI. Check out this chart measuring performance at various levels of volatility:


To build this chart, we calculated the ROI for the S&P 500 index for each year since 1950, and then sorted those years by the average daily change in the S&P 500 index—up or down. Clearly if you are a long-term investor seeking a 10%-or-better annual ROI, you want to root for average daily volatility around ±0.6% or less. In years when average daily volatility has exceeded ±0.8%, the S&P 500 has a negative ROI, including those three major meltdown years.

We also did a little vector analysis. Since 1950, there were 29 years in which volatility declined from the prior year and in 18 of those (62% of the time), performance improved compared to the prior year. There were 30 years in which volatility increased from the prior year, and in 24 of those (80% of the time) performance was worse than the prior year.

We are not saying that volatility causes market declines; in fact, it presumably works the other way round. But if you are a long term investor and detect a rise in volatility, be prepared for an increased probability of sub-par performance by the stock market.

Posted in A. Investment Strategy, B. Speculative Tactics, General | Tagged: , , , , , , , , | Leave a Comment »

Why you should sell short yourself

Posted by intelledgement on Sun, 23 Sep 07

We took our first short position in the Intelledgement Speculative Opportunity Portfolio (ISOP) this week, by selling 178 borrowed shares of Beazer Homes (BZH) for $11.18 a share.

The mechanics of this are simple:

  1. You place an order to sell shares of a stock you don’t own
  2. Your broker attempts to borrow the shares and, if successful, sells them for you, placing the proceeds (minus his commission) in your money market account
  3. So long as you maintain this position, the current value of the shares (number of shares multiplied by the price per share) shows up as a liability in your brokerage account
  4. To close your short position, your broker buys the same number of shares you sold, returns the newly purchased shares to where they were borrowed from, and decrements your money market fund to pay for the purchase (and for his commission)

The vast majority of individual investors never short a single stock in their entire lifetimes. There are a variety of reasons for this. One big reason is that shorting is inherently more risky than “going long” (buying a stock). Overall, the market tends to go up 10% per year so there are generally fewer stocks going down than up. Mathematically, therefore, it is more likely that any given stock—all other things being equal—will go up than down in an average year.

Also, your upside is limited. If you sell a stock short, the best you can do if the company goes out of business and the stock becomes worthless is keep 100% of the money you were paid when you sold it. If you buy the same stock and the company does really well, the stock could triple or quintuple or more…everyone knows the apocraphyl story of the couple who invested $10,000 in WMT when Wal-Mart went public in 1970 and now are sitting on $53,000,000.

Conversely, the worst-case scenario for shorting is…well…worse. If you buy a stock (go long), the worst thing that can happen is that the company goes bankrupt, the value of the stock plummets to zero dollars per share, and you lose 100% of your investment. But let’s say your research uncovers a consulting services company that the market is (over)valuing as if it were a software publisher (software publishers have much higher profit margins than services companies)—so you sell short 100 shares at, say $10/share expecting the price to fall to $5/share. Unfortunately for you, it is the middle of the dot com boom, the market is irrationally exuberant, and the share price runs to $60. You were paid $1,000 when you sold the shares short, but to buy them back now, you need to come up with $6,000…and you only have $3,000 in cash in your brokerage account…and now your broker calls and says you either have to deposit another $3,000 or else he will be forced by the margin requirement rules to sell off some of your other holdings to raise the money to close out your short position…which will saddle you with a $5,000 loss. Theoretically, the value of the stock could keep on rising and thus the limit on your loss for your short position is…well, theoretically, infinity.

Some folks also object to shorting a stock on philosophical grounds. It’s one thing to research a company, understand the vision of their management, learn their strengths and weaknesses, and conclude either that you both believe what they are doing is worthwhile and likely to be profitable—and put your money where you analysis is—or not. If decide to invest, then you can root for them, exult in their triumphs, possibly even advise them, and, if they start screwing up or having bad luck, cut your losses and move on. It’s quite another to find a company which you discern is badly run, or facing difficult strategic circumstances, or is just overvalued, and sell their stock short. In effect you are actively rooting for them to fail. If your analysis is right, then you will profit from the misfortunes of others, who may lose money or their jobs or—in extreme cases—face criminal charges.

And, of course, it’s an image thing. If you say “stock market,” virtually no one associates those words with selling short. It’s like marketing cars…the image that comes to mind is zooming down an open road on a sunny day…sometimes there is no road if the ad is for an off-road vehicle…sometimes it is a dark and stormy night if the ad is for a particularly safe vehicle…but you never see the cars going in reverse. Remember Vin Diesel’s great hard sell scene in Boiler Room? Those calls are never about selling short; they are always about buying something.

Our view is that while reverse gear may not be sexy and is rarely employed, it would be hard to drive a car effectively if you couldn’t go backwards in some situations. When we sell short, we are not necessarily rooting for the company to fail—although as badly as Beazer has behaved here in North Carolina, we won’t be shedding any tears for that management team if, as we expect, things continue to deteriorate for them—but rather we are doing our level best to help the market properly value that enterprise. It is not healthy for the economy for Yahoo! to be valued at $200/share because it distorts decisions and leads people to move in directions that are not optimally productive. Anybody wise and brave enough to short YHOO at $200 in 1999 deserves as much credit for helping make our markets efficient as anyone who plunked down $10,000 for WMT in 1970.

Our macro analysis tells us that the real estate bubble has a long way to contract before it’s done, and our review of Beazer tells us that they are in worse shape than most homebuilders. Having the option to stake out an appropriate position—in this case, a short position—is a no lose proposition: if we are right, we will profit and if we are wrong, that will call into question a lot of other expectations which may need to be adjusted…sort of a canary-in-the-coal-mine. In this case, the canary is expected to expire but if it keeps on singing, then we are dealing with an unanticipated supply of oxygen, which is the sort of thing it’s good to know about sooner rather than later. Oxygen and coal dust can be an explosive combination, and we sure don’t want our investments blowing up unexpectedly.

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Our tactics for the ISOP (speculative portfolio)

Posted by intelledgement on Sun, 31 Dec 06

The Intelledgement Speculative Opportunity Portfolio (ISOP) starts at $10,000, which is one-tenth the size of our investment model portfolio (Intelledgement Macro Strategy Invesment Portfolio or “IMSIP”). Although we are putting only one-tenth as much money into this one, we anticipate the components of the speculative portfolio will be significantly more risky and higher maintenance than those of the IMSIP; consequently, we anticipate a lot of turnover here.

Why do we plan to spend time on a portfolio only one-tenth the size of our main model portfolio…one we are warning folks not to invest any serious amount of money in? Two reasons: [a] it will be fun and [b] it will provide us with valuable intelligence.

The ISOP is not an investment portfolio; it is a speculative portfolio. What’s the difference? Essentially, the risk is greater, as are the potential rewards. Branch Rickey, the general manager of the Brooklyn Dodgers in their most successful years, famously stated that “Luck is the residue of design.” Clearly it is our intention in placing speculative bets here to position ourselves to benefit from—or take advantage of—good luck. With our investment portfolio, our intention is reduce risk and position ourselves to benefit from what the market is going to do anyway. In effect, with the investment portfolio we are emulating a conservative hitting approach in baseball, whereby the batter is just trying to “go with the pitch” and “put the bat on the ball,” content to settle for a sharply hit ball anywhere, which is likely to result in a single—modest success. With this portfolio, we are “swinging for the fences” and trying to hit a homerun. When we connect, at least one and maybe more runs will score for sure—dramatic success—but the odds of striking out—total failure—are much higher.

However, we believe that in order to make optimal investment (strategic) decisions, we need to be aware of what is happening on a tactical level in the trenches. What we learn while tracking some key speculative positions will increase the chances that our strategic decisions will be good ones. Even if we get badly burned on some of these speculative adventures, with the downside limited (because we are not investing much in any one idea), we expect the value of the information we learn will outweigh any loss.

And speaking of warning folks not to invest any serious amount of money here…it would not be prudent to invest any sum of money that you can’t afford to lose in any speculative portfolio component. Even the biggest and best run companies are vulnerable to Bhopal-scale disasters, automobile-scale technological advances that roil existing markets, and dollar-decline-scale macro trends. Most of our spec plays here are likely to be smaller companies who also have to worry about losing key personnel, Microsoft (or equivalent) entering their market, or two guys in a garage dreaming up a product that will knock them off…in addition to all the bigger-scale risks. This is why for investment—as opposed to speculation—we recommend ETFs, wherein diversification reduces risk.

And if, after all that, you do stubbornly pursue any of these ISOP recs, then you need to pay attention to what is going on there to optimize your ROI.

For our part, the same ROI accounting rules apply here as to the IMSIP: any transaction announced here when the market is open will be settled at the closing price. For announcements made when the market is closed, the next opening price will be used to settle the transaction. Exception: announcements made less than one hour prior to the close of the market are considered to have been made after the close. Initial positions will generally be limited to 10% of the ISOP and may include stocks, options, bonds, and other securities. We may also sell equities short if it seems like a good idea at the time.

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