Mean Reversion vs. Momentum Strategies

This is an interesting interview. About half way through he makes a deep point that if you use an oscillator type indicator and sell it when it is overbought and buy when it is oversold that is a mean reversion strategy. If you do the opposite - buying when overbought and selling when oversold then it is a momentum strategy. And those are really the only two options for directional trading using such indicators. Well, he also says that 95% of assets follow a random walk and can't be predicted. My system basically tells me when to switch between momentum and mean reversion. For me there isn't really something that is not predictable though when volatility is low predictability goes down.

How Many Households in Australia are Rich?

Every couple of years the Australian Bureau of Statistics surveys the distribution of household wealth in Australia. The most recent data is from the 2015-16 survey. It doesn't provide a lot of detail though. The downloadable data provides the averages for quintiles and the level at the top of each decile. They report that net worth at the 90th percentile is $1.979 million.

We can get more information by using the reported mean and the Gini coefficients and assuming that the data follow a log-normal distribution. You can get details of the necessary calculation here - use Wolfram Alpha to get the inverse of the erf function.

The distribution fits well for the 30th (ABS: $232k, lognormal: $240k) to 90th percentiles (ABS: $1.979 mil, lognormal: $2.1 mil). Below the 30th percentile the lognormal predicts too much wealth, while right at the top it would predict at most one billionaire in Australia. But I think we could use it up to the 99th percentile without too much error. The top 5% starts at $3.26 million, 4% at $3.7 mil, 3% at $4.3 mil, 2% at $5.3 mil, and 1% at $7.4 mil. All these numbers will be a bit higher now, of course. The most recent figure for mean household net worth is over $1 million rather than $929k here.

The ATO regards anyone controlling more than $5 million as wealthy, so that is the top 2 to 2.5% (with current mean net worth). To be a wholesale investor you need individually $2.5 million of net assets. So assuming a couple have $5 million, that also is the top 2.5%. So, the top 2.5% in Australia are considered "rich". That is roughly 250,000 households.

P.S.
In 2015-16 we were at the 16th percentile.

If You Follow This Advice You Won't Be Able to Buy a House

If you follow this advice from Ramit Sethi, you won't have any money to buy a house or start a business, unless you have a lot left over after doing all these things. The image that accompanies the article is very apt:

If you follow this advice you will be locking all your time away in the piggy bank until you are 59 1/2 (or 60 in Australia). I think I should start writing my own financial advice:

The first step is the same - if your employer requires you to match to their retirement contributions in order to receive it, do it. In Australia that isn't normal, but in some jobs in the public sector there can be additional tax advantaged employee contributions on top of the employer contributions. I would suggest skipping those until you do my step two unless it really reduces the retirement benefits you will get.

Step two is also paying down debt, but only on high interest loans like credit cards. If you have debt where the after tax interest rate is lower than the after tax expected return on investment, pay those off as slowly as you can. So yes, get rid of credit card debt ASAP, but student loans and home mortgages are usually debt you don't want to get rid of in a hurry. Taking on a moderate about of extra debt if the rate is good (as in leveraged managed funds or even margin loans) can be good, but don't overdo it.

Step three is the "emergency fund" or equivalent. Get some cash together to cover emergencies and opportunities. Having the ability to borrow more is good too of course, but don't just rely on that. I had about $20k in cash before I started to invest. As that is 20 years ago, you probably should double that number now.

Step four is probably investing outside of retirement accounts. This means your money isn't locked up till you retire. The supposedly lower tax of retirement accounts comes at a heavy price. With low long-term capital gains tax and reduced rates on dividends (especially in Australia) the tax on non-retirement accounts may be not much higher than on retirement accounts in Aus (and you can make bigger contributions later in Aus as I am now contemplating when you have plenty of money). US 401ks are taxed heavily on withdrawal in retirement though they have no tax during accumulation. The US Roth IRA though is an attractive investment as it leaves options more open.

Step five - if house prices are reasonable relative to rents in your area and you aren't planning on moving a lot, once you have more than enough for a downpayment, buying a house is probably a good move. But do a proper cost benefit analysis of this.

Step six - once you have done these and if you aren't thinking of getting into business, now you can look at maxing out retirement accounts.

I didn't mention trading - unless you have a proven model and want to pursue this as a real business you can do this as a hobby alongside Step 6. Most traders lose money though, so it is definitely an expensive hobby for them.

Mercantile's Bidder Statement Provides No Rationale for 9 Cent Offer Price

Mercantile (MVT.AX) released a bidder statement for Yellow Brick Road (YBR.AX) which provides no justification whatsoever for the 9 cent per share offer price. I think that is quite remarkable. Normally, such statements provide a detailed justification from "independent experts" for the price. Mercantile's bidder's statement for IPE did. YBR shares are currently trading at 10.5 to 11 cents.

August 2018 Report

The Australian Dollar fell from USD 0.7432 to USD 0.7201. The MSCI World Index rose 0.83% and the S&P 500 rose 3.26%. The ASX 200 rose 1.76%. All these are total returns including dividends. We gained 2.04% in Australian Dollar terms and -1.13% in US Dollar terms. So, we  outperformed the Australian market and underperformed international markets.

The best performing investment in dollar terms was CFS Geared Share Fund gaining AUD 9.2k  followed by Unisuper (CDM.AX) gaining AUD 6.9k and Bluesky Alternatives (BAF.AX), gaining AUD 4.5k. The best performing asset class was "real estate", gaining 2.45% followed by US stocks, gaining 2.28%. The worst performing asset class was hedge funds, gaining 0.26%.

The following is table of investment performance statistics computed over the last 60 months (extended from 36 months previously) of data:

The first two rows gives the annual rate of return and Sharpe ratio for our investment performance in US dollars and Australian dollars. The other statistics are in comparison to the two indices. Based on beta, compared to the MSCI World Index we seem to be slightly geared, while compared to the Australian index we are less sensitive to market movements. We have a slightly positive alpha compared to the Australian and a negative beta compared to world markets. Finally, we now capture more of the up movements and less of the down movements in the Australian market and the reverse in the international markets. The fall in the Australian Dollar over this period explains the poor performance compared to international benchmarks.

This month I only made a relatively small amount of money trading futures – USD 1.8k – though this is the second best performance so far in dollar terms. The table * compares my performance to the market and the model:

This month was the fifth month of the futures trading experiment. The first month was the model development phase, and since then I have been trying to get disciplined at trading and further incrementally improve the model. August was rather erratic. At one point I was up AUD 11k over the amount originally put into this trading account and then blew almost all of it in a mixture of bad model trades and bad trading in and out of positions. One of the bad model trades would now not happen, due to improvement of the model, so I have learned something from this experience. In the early part of the month I was trading two NQ contracts. After the bad trading I cut it back down to one contract again. So we are back in Stage 2 of the trading experiment, which is learning to consistently trade one contract. I am only doing long trades for the moment, due to the reduced volatility at the moment. Still, I unnecessarily sacrificed about USD 1,500 by closing a long position early. The model slightly underperformed the market this month. The same thing happened in May when the market had a very strong result. The model is bearish and under-performs when the market is strong and outperforms when the market is weak.

We reversed progress towards the new long-run asset allocation:

Total leverage includes borrowing inside leveraged (geared) mutual (managed) funds. The allocation is according to total assets including the true exposure in leveraged funds.

The deterioration in allocation, came mostly due to investment activity. We invest AUD 2k monthly in a set of managed funds, and there are also retirement contributions. Then there are distributions from funds and dividends. During the month, I also:

• I added another AUD 10k to the Winton Global Alpha fund, but withdrew AUD 50k from the trading account, for a net reduction in the allocation to commodities.
• I received the payment for the takeover of IPE but bought some more shares in OCP.AX, overall reducing the allocation to private equity.
• Added to positions in PMC.AX and CDM.AX, increasing the allocation to hedge funds. 
• I added a small position in Yellow Brick Road (YBR.AX), increasing the allocation to Australian small cap stocks.

* The statistics at the bottom of the table are based on only 5 months of data and so are not at all reliable yet.

Yellowbrickroad and Tribeca Natural Resources

Yellow Brick Road (YBR.AX) is an Australian mortgage broker and financial planning company. Mercantile Investment Company (MVT.AX), who took over IPE has made an offer to take over the company at 9 cents per share. However, the company has rejected the offer and the market is trading higher than 9 cents under the assumption that Mercantile will have to increase the offer. The company has net tangible assets of 13.4 cents per share, though much of that is future expected trail commissions. Regulators are clamping down on trail commissions and these might go away in the future, but I doubt that existing deals would be cancelled. The company just announced it made a small loss this year after a small profit last year. So, net tangible assets would seem to be the minimum reasonable price for the business.

I have started to make a small investment in the company. As it is risky to buy above the announced takeover price, this won't be a big position. The CEO and his brother own 19% of the company as does Nine Network. So, these big shareholders would have to get a price they are willing to accept for the takeover to actually proceed. MVT owns about 20% too, so smaller shareholders have 40% of the company.

Commsec announced the IPO of a listed investment company (closed end fund) managed by Tribeca. This will be a listed hedge fund. The managers have an extremely strong track record, though returns have fallen from the very high returns they made in 2015. I suspect that as money under management increased, returns fell. Still, they show the potential to perform very well going forward and I think this LIC should trade above net asset value. So, I plan to participate in the IPO. I also plan to redeem my units in the Colonial First State Janus Henderson Global Resources Fund, which has not performed that well in recent years.

Just Follow the Model

Yesterday, based on looking at the candlestick patterns and Oscar Carboni's caution about a possible "holiday reversal", I decided to close my long position. I missed a big rally today as a result. At least I didn't lose money. But I shouldn't doubt the model. Now the model is signalling short. However, due to low volatility, I won't take this short signal. There was a similar signal on 9 January that made small gains for a couple of days and then lost big. Another similar signal on 11 May also lost money. So, seems a good point now to just step out of the way, especially as on Tuesday I am traveling to Europe.

The model gained 3.19% on this long trade.

That Worked Pretty Well

The model passed the test. We are now back to a positive return from trading for the month.

Started Trading Again on the Long Side

Following up on this post, I took the next long signal from the model, which was yesterday. I got in at NQ=7418.75, which was almost the low for the day. The market ran up sharply at the beginning of the cash session and then corrected sharply, ending down, but still above my entry point. Today's forecast is long again using the latest version of the model, which smooths one of the signals but using the old version with an unsmoothed signal, it might be short, or maybe I'd invoke the "close to zero rule", which said to ignore a change in direction of the indicator if the indicator was close to zero. Now, we have a clear objective rule. Let's see what happens.

But until volatility shows some sign of increasing, I won't take the next short signal.

NetWorthShare

NetWorthIQ seems to have died. So, following up on EnoughWealth's blogpost, I have opened an account with NetWorthShare. It's surprising that NetWorthIQ didn't make more of their website. I would have thought they could have got a lot of advertising from the financial industry.

Does it Ever Pay to Go Short?

I did some tinkering with the model to avoid the kind of false buy signal that resulted in the stop out last week. I applied Hodrick-Prescott filtering to one of my indicators. This eliminates these kind of false turning points but also eliminates a fairly subjective rule in my decision tree. So, overall that improves the model. This is one step further to a fully objective system that can be automated.

You need to be careful with HP filtering as it uses all the data in computing the smoothed estimate. So in back testing you have to run the filter repeatedly using just the data that was known up to that point.

The model is currently short. But I don't have a trade on. I am thinking to put a trade on when it switches back to long.

In a recent post, I showed that a hedged portfolio levered 1.5 times would track the market when the market does well and track the model when the model does well. Instead of thinking of this as trading plus investment we can examine it as a pure trading strategy. That suggests that it doesn't pay to go short. Just stay out of the market when the model is short and only take the long trades and lever up the returns. In 2018 so far, going short would add to returns though. But in 2017 going short detracted from returns. The model only won 45% of trades in 2017. The average win (1.57%) was almost double the average loss (-0.9%) though so, the expected value of a trade was still 0.2%. When we split trades into long (22) and short trades (24) instead the average long trade made 0.83% and the average short trade lost 0.39%. So, avoiding short trades would have doubled returns, returning 20% instead of 10% for the year. Of course, just going long for the whole year would have returned 32%. But we don't know that will happen ex ante. Levering the 19% by 1.5 times or so reproduces the long-only result.

The question now is whether you can win by going long only in a year like 2008. My intuition is that trading would result in a positive return for the year but that this would be insufficient to hedge the losses in an investment portfolio. It would moderate the downside though.

Testing that hypothesis will have to wait a little while.

But for the moment, volatility is low and so going long only might pay off.