Wednesday is the Critical Day for the Stockmarket

On Tuesday the S&P 500 made a strong advance and went beyond the upper trend line of a bearish wedge that bears have been following and hoping for since mid-July. This move is still legitimate in Elliott Wave Theory and is called a throwover. Any further rise though would call the pattern into question or negate it entirely.

As usual recently I have been rather confused about market direction as the NDX has chopped up and down in recent days. My models though also put Wednesday as a critical day - either up or down from here.

Here is a very interesting discussion of whether we have already seen the lows for the four year cycle.

Second Thoughts on Retirement Accounts?

As I begin to realize that maybe I can realize my dream of financial independence much faster than I ever thought possible, I am beginning to rethink the role of retirement accounts in my financial plans. Up till recently I have always contributed the minimum to retirement plans with my employers. The other side of the coin is that my main employers have had extreme levels of retirement contributions. In my first academic job in the UK contributing to the retirement plan was voluntary. It was defined benefit and I was only planning on staying a year or two. I thought reducing my debt was more important. The cost-benefit analysis I did at the time showed that the right choice was to opt out. In my next job (in the US) I didn't stay long enough to become eligible for the retirement plan. Then when I moved to Australia, participation was mandatory. Between employer and compulsory employee contributions, 24% of my nominal salary was going into my retirement account. I thought this was enough especially as it is almost impossible to get the money out in the Australian system before age 60. Then after a gap where I claimed to be "self-employed" :) I was back in the US and here we have to contribute a minimum of 1% and the employer 8%. My goal was to rebuild my savings from the 2002 drawdown and then head for the goal of financial independence. Then this year I opened a Roth IRA account when I learned that you can always withdraw the contributions without penalty and use up to $10,000 in earnings towards the first time purchase of a house. My plan was to save towards a potential downpayment using a Roth IRA. This summer, as I began to understand the tremendous profit potential of my trading model I began to rethink my Roth plan. I think I will hardly miss the $4000 annual contributions and the earnings on them. Therefore, I now plan to continue contributing as long as I can and not withdraw my contributions as soon as I hit $10,000 in profit (I am halfway there at the moment).

Now a new idea has struck me. If I maximized my 403(b) contributions to the $15,000 annual limit I could rollover my account into my Roth when I eventually leave my current employer (subject to paying the appropriate taxes). This would be a way of getting much more money into the tax-free Roth environment. I think I may do this as soon as my trading program has reached its full size and if I continue to be profitable money will then be flowing out of the trading program into long term investments (in order to minimize the potential of a catastrophic loss there is a maximum sensible leverage that should be used in a trading program relative to total net worth - in the long term probably 70% of net worth will be directed to long-term investment and 30% to margin for trading). At that stage I will no longer need my salary to expand the size of the trading program and can direct it to a more tax advantaged environment.

The bottom line is that if you are following a Kiyosakian path at first you want to maximize the assets you have to achieve immediate financial independence. But once that goal is achieved, it makes sense to take full advantage of tax sheltered retirement accounts.

Mayne Pharma to be Acquired

Mayne Pharma is to be acquired by Hospira. It has been in a trading halt for a couple of days pending a transaction. Yesterday most commentators were still thinking that Mayne would announce an acquisition. But in the last day all the speculation has been about a takeover of Mayne. The takeover price is $A4.10 which results in a $A1972 capital gain for me from a roughly breakeven position at the time of the trading halt. I am still carrying a loss of $A1055 on Symbion the other half of the Mayne Nickless company that demerged last year. It's been a long story since I first invested in Mayne Nickless :) The only question now is whether I should sell or hang on for a possibly higher price. I tend to get impatient during these merger arbitrage situations. This is nice news as the news on the U.S. trading front was not good today for me. The model is still however short but the picture is now a bit unclear.

PS 9:19pm After reading all the info about the proposed takeover I decided that a higher bid was unlikely. The stock opened an hour late at $4.21. I sold at $4.25.

Update from Croesus Administrators

Croesus Mining's administrators have provided an update on the state of negotiations to either sell Croesus' assets or recapitalize the company. In the latter case, the suspension of trading in Croesus' shares may be lifted. I guess that there is a 50/50 chance that my shares could be worth say 2 Aussie cents each (vs. 27.5 when the trading halt was called) or zero if the assets are sold. The latter would probably mean that there was only sufficient capital to partly pay the creditors (Mitsui Bank and Macquarie Bank are the main ones). Macquarie Bank has been really great through this whole process. Mitsui are the villains. I couldn't link the announcement but it gives a schedule for their meetings with interested parties and for due diligence to be carried out.

PS: 22 September - received a letter today from a fellow shareholder and her lawyers... the lawsuits over the Croesus debacle are beginning to fly. They want $A550 to represent each shareholder without even explaining what their strategy is apart from stating that we should have the same rights as creditors.

Trading Record for the Year So Far

It ain't pretty:

The chart shows the running total of profits from short term trades so far this year. As you can see I got a nice profit early in the year and then blew it all up. Particularly on 29 June. Then I started trading with "the model". I have slightly exceeded the previous maximum level of profits but went through two periods of bad and confused trading against the model. All of this is documented in this blog as it happened. I will need to see a decisive break to a new highwater mark for the year before I will really get convinced that trading this model is practically profitable in the real world. Both pre- and post-model there are some long streaks of mostly winning trades. These tend to engender overconfidence and consequent blowups. Psychology is the hardest part of trading for me.

This might look like irresponsible and reckless risktaking. But losing $4000 in a period of bad trading is a loss of only 1.25% of net worth. This is nothing compared to the reckless risktaking at Amaranth Advisors :). More on Amaranth Advisors.

What's Next for the Market?

This scenario has now played out. The model is switching to short at the close today. The S&P 500 index has now had 3 weeks of sell signals on my old model. Now maybe it is finally time for this much delayed longer term scenario to play out. Near today's highs I bought 20 put contracts in my Roth IRA account. So now I am effectively short 5000 QQQQ shares worth just over $200k. The short-term trend is going to be down from here. The stochastic will have to fall tomorrow unless there is a significant rise in prices. The McClellan Oscillator looks set up for a fall too. This isn't all the evidence to show that the "stars are aligned". So maybe now I will be surprised? :)

Business and Tax Planning

I am reading the two books on taxes for traders that I ordered. Green's book is not as well written, but his strategies are simpler and less aggressive. Tesser takes things to the next level. There may be some contradictions between their advice but I have only read part of each book so far. I am learning a lot. I am understanding more about what Kiyosaki was hinting about regarding business tax deductions. Deductions taken on a Schedule C for example have no effect on triggering the AMT. Traders have many special tax advantages. So if you think you could qualify as being in the business of trading rather than investing it is well worth reading these books. You don't have to set up a company to get business deductions but it allows you to take some other deductions - particularly deducting health insurance from income and making contributions to retirement plans (and social security). If you have another job or your partner has a job with health insurance this will be less important for traders and investors.

Tesser discusses a program I had never heard of: VEBA - a voluntary employee benefit association. Tesser claims that this program can be used as a retirement program. All the information I can find online though says that it is only for medical expenditures. I think his advice is relying on shutting down the program at some point and distributing the proceeds to the employees. The money in the program is tax deductible and tax deferred. The advantage is that none of the limitations that apply to regular retirement programs regarding contribution limits and age restrictions apply to VEBA. Seems that this is a rather aggressive strategy though he claims that none of the strategies in the book get anywhere near the legal limits.

The IRS has never stated what exactly allows one to qualify as a trader rather than investor but instead lays out some vague criteria in Publication 550. If trading isn't your major income source it seems unlikely you will qualify and instead you will trigger an IRS audit. Trading futures seems to make it easier to claim trader status than trading stocks as futures are prima facie trading instruments. Otherwise you will need to show that you do extensive, frequent, and continuous trading. That can be hard to prove if you have a full time job.

The good news is that I can take things step by step:

1. Planning stage - current: proving profitability of trading strategy - learning about tax law etc.
2. Switching to trading futures - which are taxed at lower rates than stocks.
3. Claiming trader tax status - only possible when income is sufficiently high or I quit my current job.
4. Setting up a management company
5. More advanced strategies for estate planning etc - Tesser recommends partnerships.

That Was a Bad Call

Why do I keep trying to trade against the model? It doesn't make sense. I don't understand why I am doing it. But for some reason it is very hard to stick with what the model says to do. Currently, it is long through Monday's close at least.

Back to the Short Side

Yup. The model is still long but probably Friday will turn out to be the last day of the uptrend in the stochastic. The stochastic can still rise as long as the index remains above 1582 (assuming a high higher than Thursday's 1629 or a low below 1558 do not occur). Friday is also options expiration day. After a strong rally one might expect a sell off on options expiration day as the "max-pain effect" comes into play. Many buyers of call options will have in the money positions. If they sell them to take the profits rather than exercising them the option sellers will then sell the stock they used to hedge their short options positions (delta hedging). This puts a downward pressure on stock prices. Well, just a theory. Futures also expire this time so a lot of stuff is happening - what is called a "quadruple witching". The Elliott Wave formation that began at Monday's low looks complete too. Also my weekly model's forecast for next week would make more sense if prices back off a bit on Friday. So that's my reasoning.

Can an Economist be a Trader?

Fin_Indie asked for me discuss how I reconcile being an economics professor and an active trader. I assume he is thinking about the efficient markets hypothesis (EMH) that states that all known information is incorporated in stock prices and prices only move when new information is revealed. This is also often taken to imply that stock prices move according to a pure random walk and changes in prices are unpredictable. Some take this idea further arguing that investors should simply invest in a diversified buy and hold portfolio as there is no way to profit from trading or even deviating from a market weighting of securities.

There are two parts to my response. One is to explain what I think EMH really implies and second to question whether the strong version of EMH holds. As a good economist I don't believe in too many free lunches. Financial markets are highly competitive markets and there should not be easy ways to make above average risk-adjusted returns (taking on more risk is a simple way to get above average returns). Otherwise, participants should simply get a standard return for their provision of investment capital to the market. That is, if that is all they provide. I argue that other inputs provided by investors should also receive returns in this market. These include returns on skill, returns on effort (time spent investing), and returns on special information. Of course if you don't have any of these then don't try to beat the market... It defies imagination that say Warren Buffett's track record is the result of pure chance. Rather, his excess returns reflect returns to these additional inputs. If you think you have these additional inputs you might have an edge, which you can test statistically and then it will allow you to beat the market.

Of course it helps that I am not a professor in the field of finance. I don't even have a PhD in economics (but another field instead). I do have a BA in economics (and the other field) and some graduate classes. I have been published in economics journals, I am a professor in an economics department, and I obviously teach economics. But my background is interdisciplinary and I think makes me much more open to alternative ideas than I might be if I had been indoctrinated in mainstream finance theory in grad school. Most of my research has been empirical and uses time series analysis.

The second part is to argue that while EMH is a good benchmark the strong form of the hypothesis does not hold. Countless anomalies have been documented. The most obvious is that stock prices fluctuate far more than do earnings or interest rates, which are their supposed determinants. A major issue that prevents the market from being perfectly competitive is as I have blogged before most participants in the market do not short-sell and many have mandates to remain fully invested in equities whatever happens. Active traders and hedge funds remain a minority of the participants, despite being very active. Even in among the active traders few are directional traders. Most are arbitrageurs, market-makers etc. Therefore, some forms of technical analysis do work. This is not a "belief" of mine but something I have now tested in the statistically validated trading model I am using. A lot of technical analysis out there makes no sense and a lot of the publicly available TA won't produce excess returns. This is not surprising. But a little digging will produce some useful approaches. Still, most participants have been persuaded that TA is nonsense. That is their problem not mine.

Fin_Indie also asked about my philosophy and inspiration. My basic approach is to trade my account like a global macro hedge fund, with a fairly conservative approach to adjusting the market exposure of my investment portfolio and an aggressive TA approach to trading the trading account. My biggest inspiration on how to trade and invest has been George Soros. But I have drawn elements of what I now do from all over and testing what works and what doesn't. Robert Kiyosaki's books were a big inspiration too.

Aligned with the Trend

The model has now been long for a day and I am again aligned with the model and up on the month a little. This feels better. The uptrend should run through Friday or Monday based on the current forecast. Spent the weekend in Vermont. Sunday went apple picking and other activities. Beautiful weather. Very relaxing.

Planning

A beautiful day here today - trying to appreciate it a little in between the things I have to do. The market has been making me nervous too as I've been confused lately about its direction. It's looking better this afternoon and I don't think I have to bail out (I'm long, though the model is short - go figure). So I can relax a little. The beginning of the Fall Semester is when we start planning for the Spring Semester. I requested to teach classes in the middle of the day most days of the week so I'm free from teaching at market closes and opens. As you can see I am getting addicted to trading :) Most profs try to concentrate all their classes into two days a week. But I have found that pretty tiring. Teaching is like acting or performing in some way. This way I spread my various activities across the week rather than concentrated. Not sure whether I've blogged about my longer term career plans? The downside of academia is immobility and I want to get out of that trap. I also am much less interested in the research part of the job than I was. In fact I enjoy more the management/adminstration aspects now! As long as something useful is getting done by doing them. I am trying to develop trading as a mobile do anywhere source of income that will give me much more flexibility. It won't neccessarily be my main activity. But I would be free to go where I like and do what I want. I am not planning on working in one job or career until I am 65 and then retiring. Why do the same thing your entire life? You only get one life to try out different things. But if I want to stay in the US I first need to get my green card and I am waiting and still waiting. The main driver is on the personal side. My girlfriend is also a potential immigrant and will be limited to visa-compatible jobs employment-wise. Total lottery where those potential jobs may be. The probability that they are close to where my current job is is infinitesimally small. Actually she was just talking about jobs in Sweden again... I won't rule it out, though am not really looking forward to another international move. Probably anyway it would be a 1-2 year position. OTOH I can travel to and live in Sweden with no problems as I have European citizenship.

On another planning front we are finally moving my mother's account from Citibank to two other financial management firms. I had high hopes from Citibank when we opened the account 4 years back and initially we got a decent guy assigned as our "relationship manager". But since then service has gone downhill. Don't think that if you have $1-2 million you will get any better service than a small investor. Many discount brokerage firms would put Citibank to shame. I was reading recently about why wealthy clients dumped managers. The number one reason was poor customer service, not poor investment performance. We just wanted no-hassle peace of mind and as long as we are making a little money we aren't concerned neccessarily about pursuing the highest returns. The last thing I wanted is for my mother to worry about what was happening with her money. One of the new providers is UBS. We will see if they live up to their image of better customer service. The other is a small local firm where she lives. Over time, we will probably place more money with the smaller firm if they are nice to us :) But we can't transfer some of our funds to their custody and don't want to sell them and therefore also need the big bank.

Confused

Yes, I am feeling very confused by the market today, even though so far I guess it is playing out the chart I posted in my last post. Just it went up one more day and then went down and so I ended up losing... Longer term NDX still looks like it is going up, though I still have that sell signal on the weekly SPX I posted about. Probably I should have just gotten out of the market if I was unclear about what was going to happen. Still learning!

New Weekly Model Says: "Get Long"

For the first time today I estimated a model with weekly data. Again, I was stunned by the results - the high correlation between the forecasts and the actual change in the stochastic oscillator in the following week. The R-Squared (a measure of the goodness of fit of the model) between the one step ahead forecasts and the actual data is above 0.9 (very high). This is the sort of number that got my girlfriend to say "whoa!" when I told her about it :) Anyway, to cut to the chase the model predicts the stochastic will increase next week. Therefore, one should be long. I intend to use this model when the daily model is ambiguous as seemed to be at the moment. Well actually my model has clearly been long the last two days but I was stubborn and thinking that the potential turning point on Tuesday after Labor Day would actually lead to a turn to the downside. A day or two down is possible before the market continues to the upside.

Of course all this goes against the fundamentals as I see them. But so be it. The bond market is forecasting recession, but the stockmarket is beginning to change its mind.

Here is a chart that points out the analogous point last November and a guess of the likely price action going forward:

Books on Tax for Traders

Just ordered a couple of books about tax for traders. The Tax Guide for Traders by Robert Green and The New Traders Tax Solution by Ted Tesser. This is definitely a topic I need to understand much better before taking my trading business to the next level. I know about several of the issues but am unclear how the following interact: 60/40 treatment of futures, mark-to-market accounting, trader tax status, self-employment tax. Well I know that mark-to-market accounting results in you not being allowed to use 60/40 treatment of futures. But I was reading that you still can claim trader tax status, and somewhere I read you can still avoid the self-employment tax. Need to get this all straight and also understand whether I should set up a business entity such as an LLC or S-Corporation.

August Report

August was another good month. Net worth increased by $14,000 to $330k, investment return was 3.61%, and total investment income $11380. Expenditure was $2062. I have now increased net worth by $60k year to date. So there is still $40k to go or $10000 per month to reach my goal of increasing net worth by $100k for the year. If I keep up the pace of the last two months I will be able to achieve it. The best investment performers in terms of dollars earned were: QQQQ $4712, Colonial First State Conservative Fund $A2731, and Challenger Infrastructure Fund $A1587. As something like one third of my net worth is in the QQQQ position and more than half in the CFS Conservative Fund those rankings aren't too surprising :).

My return on equity on my trading account was a little more than 15% - slightly more than in July. The goal is therefore to earn trading income of $5400 in September (15% more). My eventual goal is to earn at least as much from trading as from my salary ($6250 per month). So I am not too far from that as things are going now.

Trading Model Performance for August

Another month has gone by trading "the model". I have further improved my trading rules and produced a decent performance for both the model and my account in August. The results in percent terms look like this:

NASDAQ 100 Index: 4.66%
Model(Improved Version): 8.36%
Trading Account: 15.26%

This means I captured 182% of the model's performance using about 3 times leverage. Before the improvements were added the model would have only been up about 5% and my performance captured 300% of that lower rate of return. As a result I earned $4700 for the month from trading vs. $3900 in July when the account gained 14.57% on the back of a model performance of 9.57% and a decline in NDX of 4.80%. This chart compares the model performance and the market action to date:



Clearly if you were short in early July and long in mid-August you would capture most of the model's gains.

It is going to take about 3 months from now, therefore, to achieve my goal of regaining all past trading losses on this account. In the meantime I am also saving up cash in my HSBC Online Savings account to open a futures trading account which will be the next adventure. But first I want to prove I consistently trade QQQQ profitably using the model over several months.

At Midday the Rally is Looking Dead

This rally is looking pretty dead here.

Based on the prices earlier this morning my model would have switched to long, and I got close to pulling the plug/switch or whatever metaphor, but now in fact the spike up has extended the recent range and makes the model more likely to remain short at today's close.

Also I mentioned that my indicators were very similar to last November. Another difference is back then the full(5,5,3) stoch went above 80 on a 20 point up day. And the follow through day was another 20 points up and a runaway rally ensued. Here the breakthrough was a 3 point day and the follow through day was something like 9 points.

Of course things might look entirely different by 4pm. Tomorrow morning there is a bunch of very important economic news. This morning's economic news pretty much met expectations and so hasn't moved the market much either way.

Market Teetering Between a Crash and a Rally

My indicators derived from the stochastic were in exactly the same pattern as they are now twice in 2005. Once in mid to late February and once in early November.

In the first case there was an upturn in the stochs from a high level and a small spike in the stochastics and a small but essentially failed rally. That is what I am betting on here. But in early November the upturn turned into a massive overbought rally.

So distinguishing between the two situations is of utmost importance :)

I'm still short but the market has been rising. In reaction I have dug up a tool I developed to help forecast the most bullish of my indicators. I had been skeptical that this tool was useful. But maybe it is useful in just such a situation. It says to be long at the moment. An alternative is if, for example, your standard position is 3000 shares, to allocate 1000 shares to each of the three indicators. So on a day like today where two indicators are short and one is long you would be theoretically short 2000 shares and long 1000 shares and, therefore, in practice short 1000 shares. I have read people discussing allocating their trading capital across multiple models and indicators. It could make sense. It is an agnostic approach to market direction.

I also found a distinction between February and November 2005. In November the fast %K stochastic was very strong - over 90 on the day that is the best analog for today. In February it was declining and around 80. If today ends up not too much it is going to look more like February and the case for the failed rally hypothesis will be strengthened.

Confusing Market Action

Bulls and bears both seem confused at this point. One bear calls for a week of sideways action. This morning the Federal Reserve did a massive permanent open market operation - i.e. buying bonds and putting new money into the money supply. Someone on Silicon Investor who follows the Fed closely said it was the biggest he's seen. Changes in money supply in both Japan and the US often have a strong relation with stock market action. So in retrospect it wasn't surprising then that the market went up. I'm still puzzled about what is the causal driver in these money supply changes - is it market players or the monetary authority? Most commentators seem to assume that it is the Central Bank that drive these actions. However, standard macro theory says it would be investors and traders driving the Central Bank to respond.

In other news my "other model" - what I call the "autoregressive model" (as opposed to the "stochastic model" - both nicely obscure names :)) - the best I had before the latest one - has given a sell signal on the S&P 500 on the weekly chart. The previous signal was a buy for the week of 19 June. Previous to that was a sell in the week of 1 May. So the model is behaving pretty nicely in recent months and I wouldn't ignore it. Previous to that there was a sell for the week of 20 March... but before that a buy for three weeks in April 2005. On the other hand one of the indicators from the "stochastic model" is indicating a buy, but others aren't. So maybe we do just keep going sideways all week.

Bursting Real Estate Bubble and Coming Recession

Seems this weekend there is stuff everywhere on the bursting housing bubble. Too much to post! One of the best is this powerpoint slide show from the National Association of Realtors chief economist. They are still trying to put a bullish spin on things of course. But it is hard to do that anymore. Also more evidence of coming recession. This week the yield curve inverted more. And apart from the state of the housing market there is evidence such as this chart of retail employment.

Adjusting Investments

It might seem like all I've been doing lately is trading. But I also have been adjusting my long-term investment positions. I am cutting back on a couple and increasing some others in an attempt to make the sizes of the different positions more consistent with the goal of having about 1.5% of net worth in each individual stock, not counting closed end funds which have shown their ability to withstand market corrections. I sold entirely out of IYS. This was originally a "corporate event arbitrage" trade -the fund was going to be wound up and was trading much below the final payout level. But recently we got a letter from Deutsche Bank saying that in order for the bank to pay us we had to agree to a settlement with the Australian Taxation Office. This introduced a risk of complications for foreign investors like me - I am an Australian Citizen but I am resident in the US. So I decided to get out now with a decent profit. I am planning in the coming week to reduce my positions in Telecom NZ and Challenger Infrastructure Fund. I've been waiting for Telecom's dividend book closing which happened on Friday. I just have too much of that stock. The latter looks like it is performing well but reading the annual report, there is a lot I don't understand about its accounting. So following Warren Buffett's maxim I am reducing my position. I have also put a bid in to buy more of Everest Capital after the destapling of this hedge fund management firm from its fund of funds which I am also invested in. Oh, and I also reduced my position in Ansell. There is probably something else I have left out. So actually I have been pretty busy.

PS: Wikipedia has a nice graphic of real UK house prices. The growth rate over the period is 2.4%. I suspect that rate will be lower when a few more years of data accumulate. And leverage doesn't make this look much better if you are paying 1-2% real interest on your loan.

Model Update - Progress Towards Goals

At this point it is looking like there will be a buy to cover signal generated at next Tuesday's close. This is about as accurate as weather forecasting so as that date approaches the forecast might be brought forward or pushed out further in time. I continue to be shocked and stunned by the performance of the model and the ease of trading with it. I am getting used to trading the model. In July I got about 1.5 times the model return on my main trading account using roughly 3 times leverage. So far this month I am getting more than 3 times the model return. And, therefore, that performance goal has been realized. The model is on track to match last month's results. It is now up about 18% since 29 June. My taxable trading account is up 40%... The Roth IRA account is up 70% since I opened it earlier this year. I am now more than half way towards my initial goal of making $10,000 in profits in the Roth IRA. I thought that goal might take a few years to achieve. At this rate it could be achieved by the end of this year. I am pretty much also back on track towards this year's goal of increasing total net worth by $100,000. I think multiple near term goals are good - performance targets, profit targets, net worth targets etc. You can always be approaching some goal. Better than a single goal of some huge number you have to reach by "retirement".

P.S. Maybe I should just have bought real estate instead as common wisdom suggests :P The data in the article suggest that the real rate of capital gain on the typical house is 1% per annum. This article assumes 2% and still thinks housing is an inferior investment strategy.

Traits that Lead to Success

How many of these traits and habits do you have? I think I have several, though I'm not a very good networker. That's my weakest point.

DIY Recession Probability Calculator

Cool tool for estimating the probability of a recession. The tool is based on an academic paper by a Federal Reserve economist.

Expert Systems vs. Expert Opinion

John Mauldin's latest mid-week newsletter is an interesting exploration of the performance of formal quantitative systems that systematize expert knowledge vs. informal expert judgement. Generally, the formal systems perform better. People also tend to be overconfident of their abilities to make better decisions than the formal systems do. Of course this will depend on how good the quantitative model is. Anyone can make a bad model.

Freestyle Management and Black Box Trading

There are actively managed mutual funds and then there are "freestyle managers". A subclass of hedge funds use systematic trading of futures with decisions being generated by "black box systems". One of the biggest is Man Financial. I have been interested in the past in investing with them, but either I didn't have the minimum amount at the time or more recently couldn't apply to their Australian offering as I am not resident in Australia and the US sales representive never responded to my contact... My investment strategy is now a combination of a black box trading system for short-term trades and very freestyle management of longer term investments largely "outsourced" to other investment managers.

Sell Signal

I got another short term sell signal at the close today. It is possible that this is the beginning of the big decline into Fall that I have labeled C. This rally increased the NDX more than 5%.

At the end of the rally I am at a new maximum level of short-term capital gains for the year. The Roth IRA account has made almost $5000 in profits so far since I opened it in February. My general US trading account still has an all time deficit of around $11000 since I started trading in 1998. But now there is only $6000 to go to achieve my first short term goal of breakeven on my two Ameritrade accounts. The next goal is break even on the taxable account. After that I will look at gradually building up trading with the model to the full scale and opening an account to let me trade futures. The latter are more tax effective than short-term stock trading.

Are We Still in the 2000- Bear Market?

I just came across Ian Gordon's website, which has some interesting charts of the Kondratief cycle. He plots the actual stock index (rather than growth rates) alongside the Kondratief cycle and other variables such as interest rates. From looking at his charts it seems to me that there could be two types of "secular bear markets". One is short and sharp like 1929-1932. The other is sideways and protracted like the late 1960s and 1970s etc. The short bears happen at the beginning of the Kondratief Winter - the final stage in the descending wave of the Kondratief cycle. 2000-2002 would then be another of these short bears. People looking for future stockmarket lows below those of 2002 and a protracted sideways bear market would be wrong if this conjecture is correct. Instead a bull market with corrections would be underway for the next 15 years or so. Of course there only appears to be a bear market still underway that started in 2000 if you look at large cap US stock indices and some European indices. Look at small cap US indices or Australian stocks for example and we appear to be in a bull market.

One More Rally?

I am looking for a rally starting either intraday or at the close on Monday on US and most world stock indices. The rally should last a bit longer than a week. I speculate that this will be the final rally before a renewed decline into the Autumn. This is the simplest and most likely scenario for the S&P500:



The levels of these moves are very imprecise - I think the upcoming rally should exceed the recent high at 1293. How far it will go beyond that though is guesswork. Volkmar Hable's latest newsletter concurs with this scenario more or less. He is more vague about what might happen.

PS 4:33pm 14 August

It seems now that the rally got started late on Friday just about where I closed my short position. I went long late this afternoon using call options (September $34) in both my Ameritrade accounts. Kind of dispiriting to see oneself immediately down $400 due to the option spread. Maybe not such a great idea. I did an intraday short trade using 3800 shares at the end but only made $50. That was probably my biggest single financial transaction to date. You can buy a decent house in my town for the value of the closing buy to cover trade, executed at the click of a mouse.

The Paradox of Indexed Investing

Recently I have been reading a lot on the theory of trading and hedge funds and musing about what trends in investment strategies mean for the future of returns on different forms of investment and trading. The following thoughts are hypotheses rather than any worked out kind of theory.

In a world where everyone is an active investor (and investing on the long side only) trying to exploit valuation anomalies perhaps the market index reflects the average of their returns. Therefore, if you hire a manager, the average manager will return to you less than the index return once you pay their fees. The best managers will also migrate to the hedge fund world where they can charge larger fees leaving the average mutual fund manager making less than the index even before fees.

Hedge fund managers can also exploit opportunities on the short side and therefore even after their fees do better than long-only mutual fund managers - at least the better hedge fund managers do.

In comes passive indexed investment. What is the point of paying for an active manager if they earn less than the index say investors? So they put their money in index funds, ETFs, futures etc.

That is about where the investing world was at a few years ago.

The potential paradox is this - all the investors who are putting their money into indexed products are no longer pursuing valuation anomalies except to the extent to which they do this is when losing stocks are dropped from the index and winning stocks added. These market participants are no longer contributing to making the market efficient. This means that the remaining active investors have more opportunities to exploit as some of their competition is removed! The bigger indexing gets the more it will again underperform active management.

In recent years actively managed funds have outperformed the index in the US markets. I blogged before that this was likely because we were no longer in the strongly trending markets of the 1980s and 1990s. This is probably true but could indexation also be a factor?

We could even envisage long term cycles of active and passive management being more and less popular. Any thoughts?

It's Nice When Losers Become Winners

Today's star is Challenger Infrastructure Fund. I bought into this fund which invests in infrastructure primarily in Britain soon after the IPO. One thing I liked about it was that the Challenger Investment Group and managers had put their own money into the fund. But it didn't do well and at one point I was down $A2000. Maybe it was because of the complicated structure that involved two payments for the shares - one at the IPO and one a year later. But today my investment finally came back into the black. The price is still below the IPO price but I bought more shares at a lower price. Funny thing is that the shares just started trading at a price that reflects the second payment and up it goes...

Trading with Stops

This morning's rally hit my model's stop loss which is set 1.25% from the previous close. I ignored it, which turned out to not be a good move. Most writers on trading state that risk control including use of stops is more important to trading success than finding good trades. For example, notorious hedge fund LTCM had no problem finding good trades, but their risk control was way out. Same with Victor Niederhoffer's fund that blew up a little before then. Less spectacularly you can make profits and then give them away again. Which is what I was doing till recently.

But setting stops is very tricky. If they are too close to the current price they will get hit all the time unnecessarily. Too far away and you lose too much money before the stop is triggered. For the moment I am sticking with 1.25% but adding two rules:

1. If the price comes back to the stop I should re-enter the trade. The 1.25% stop means that only powerful moves will trigger the stop. If those reverse sufficiently to return to the stop then the reversal is probably serious. This rule would have added a little less than 4% to returns in 2003 the one year I have tested fully.

2. If the next day's forecast suggests a trade in the opposite direction to the current trade then you should reverse to the opposite position at the stop. This adds more than 30% of compounded returns in 2003. I know it is hard to believe that - but it is true - it lets you get in on the beginnings of powerful new moves.

This chart shows the model's performance to date relative to the NASDAQ 100 index, assuming $1000 was invested in both at the close of trade on 29 June, and assuming no commissions, no spreads, and no leverage. Given the high rate of return a little leverage could offset the trading costs anyway:

Another Fed Day...

This one a lot better than the last for me.... The day after the last one is when I started running "the model". I am currently short and added a little bit to the short after the direction of the market got clearer after the FOMC announcement. It was pretty much exactly as expected. The probability of a rate hike was less than 20% and we had one Fed member dissenting and voting for a hike. The others voted to keep rates on hold. And the statement says that future rate hikes will be data driven. Goldman Sachs had been looking for a rise in rates. Given I was short I wasn't worried about that.... So why is the market down - well the technicals are pointing down, which is why I am short. The only other thing might be that dissenting voice. It is hard to think major market participants would be naive enough to think the Fed would confirm that that was the last rate hike.

I am still short and currently expect to be so at least through Friday unless the stochastic goes below 20 in which case the short would continue into next week. Cisco announces after the close today. It is a major NDX stock so could have some effect on the NDX going forward from here.

Secret to Planning a Successful "Retirement"

Well I don't believe in retirement as usually construed, but thought this was a good article as he seems to be saying the same thing. Of course there isn't a point in pursuing something as a career that you like but you aren't really talented at. That better stay as a hobby or sideline. And maybe you need to do some job to make money while you develop your alternative career. But the ideal is to do what you like and are good at and look for ways to make money from it.

This has been my path up till now and will continue to be so. Successful academics get into it either because they love teaching or research (latter in my case), or both. The path to a tenured professorship in today's world is one of high risk and uncertainty particularly in the United States and particularly on the research track (and the latter particularly in fields that don't have high research funding). Getting to be a tenured professor shouldn't stop one from switching career and doing something else if one wants to and has the opportunity. Quite a lot of academics in fields that are more prone to application find money making ideas which they then develop in a second career. In economics for example there are also opportunities to move into government etc. Often I read about successful figures in various fields that they started their career getting a PhD or being a professor. But a lot of my fellow academics seem to lose their appetite for risk and in fact become very risk averse (a lot I think are actually risk averse and are traumatised by the path needed to get to tenure). But if you are not going to be a world class star in your field and have a good idea of something else to do, why not do it?

This is the "industry" I am in but similar things will apply in other professions too.

End of Week Report

Today the market rallied initially on an unemployment report and then ended the day lower. The model got stopped out because the NDX rose more than 1.25% intraday. However, I ignored the model as other indicators suggested that was the right course. So far this month my account is up 1.13% though the model is down 1.54% and the market down 0.37%.

Though everyone thinks the Fed will not raise interest rates on Tuesday, I have a suspicion that this time there could just maybe be a surprise (PS: According to Barron's published on Saturday Goldman Sachs have the same suspicion). The Fed almost always raises interest rates too much and induces a recession. Long-bond yields fell today. I have been reading Brian Berry's book on long-wave cycles. The first thing I have read on this that actually makes sense - actually it was Michael Alexander's columns that got me interested. I think we are still essentially in a declining interest rate cycle that started in 1981. After the next recession interest rates will start rising for real along with inflation according to the Kondratieff Cycle Theory. One thing that could help the next cycle be more inflationary is if the Fed triggers a deep recession here and future Fed chairmen dare not be so aggressive. This is just a wild speculation of course. With big bets on bonds, I of course want to see interest rates fall (which pushes up the value of bonds).

At the moment I am still in the real time testing phase of the model. I am only using about a third of the capital that I think would make sense to allocate to the model trading eventually. The eventual plan, if things check out consistently, would be to put about half of my non-retirement capital into it and trade that with about 3 times leverage. The rest of my non-retirement capital would be in unleveraged long-term investments so that the overall leverage is only 2 times, which I believe is a safe level. That is a limiting level. If I felt scared to trade that much I would trade a lesser amount. The ratio of trading to investment capital will also differ in bull and bear markets. The model performs best in bear markets. In bull markets good quality stocks could match it. Problem is finding those stocks!

Amusing Article about a Hedge Fund Conference

An amusing article about a hedge fund conference. One guy wants to start a hedge fund and has never traded anything! Even if my trading model works out really well, I wouldn't want to start a hedge fund. Not anytime soon anyway.

July Report

Net worth increased by $13059 to $316,244. This is still about two thousand below the May high but a nice recovery. My retirement accounts hit a new high. The portfolio rate of return was 3.41% vs. the 0.71% gain for the MSCI. The biggest positive contributers were the rise in the Australian Dollar of about 2 US cents over the month and $4350 in profits from trading QQQQ. The most important negative "contributers" were Ansell and my Australian mutual funds. This month is a good example of my hedging strategy working with gains from currency and trading offsetting investment declines. Performance would be much worse if I wrote off Croesus this month. I plan to adjust the past figures when Croesus is finally presumably delisted assuming its value fell smoothly from the time of the initial trading halt to delisting. On the spending and saving side, my spending seems to be about $1700, which implies around $2700 in saving from salary and retirement contributions. I am surprised spending was so low actually. Maybe I amde a calculation mistake.

Further Downside Risk?

The stock futures are off this morning and in recent days the Bank of Japan continues to try to reduce its money supply - a move that has preceded market slumps in recent months. A news releases on personal consumption spending is due at 8:30 EST which should give the market some further information on economic growth and inflation. If the downtrend is confirmed I will likely buy more put options in my Roth IRA account that is currently 90% in a money market account.

Update: 4:58pm

I added 5 QQQQ $39 August Put contracts... I reached a milestone today. Finally, my QQQQ trading over the last several years became profitable. As Investment of course it was lousy. But It helped teach me to trade. Next goal is to regain all trading losses on my US trading account. That's going to probably take a few more months of successful trading to achieve. Currently the model is predicting that the trend will reverse to an uptrend the day after the FOMC announcement next week.

Upside Risk Reduced

Today the market fell a little, but pretty much went sideways all day. The pop up in the NASDAQ 100 index in the morning extended its trading range and meant that though the stochastic oscillator increased, it didn't increase by much. The risk that the oscillator and the market will actually go up in the near-term is much reduced. Yes, that is the risk that it will rise. If you are short the market like me, you want the market to go down... I get more and more annoyed by the bullish bias in the media that talks about good days when the market goes up and bad ones when it goes down. I think it is discrimination against bears :)

What Type of Trader are You?

Everyone trades to some degree, even when they buy or sell a passively indexed investment. Some traders lose from trading and some gain. Find out which sort of trader you are.

Going Short

The model is saying to be short on Monday. I have shorted QQQQ before the end of the day ($37.01). Could be early (the price already went to $37.10 and then fell back again), but eventually will be right I think. Based on the chart, this upcoming downmove could be signficant. The model though gives no information on future levels of the index, just the direction.

4:05pm Update:

I was a bit early going short but still up substantially for the day. Updated performance stats since 6/29/06:

Market Gain: -4.75%
Model Gain: 8.80%
Excess Return over Market: 14.22%

Account Gain: 14.90% (about $4000 on this account - not keeping track of gains in the Roth account but it is now up almost 40% on the contribution made earlier this year).
Excess Return over Market: 20.63%

Which is 145% of the model's gain. Using leverage and some intraday trades should result in a gain greater than the model and we are now seeing that. This kind of trading gain for a month is not unusual. What is hard is to not give the money back again. That is the next challenge.

If the index continues to rise on Monday and the full(5,5,3) stochastic goes over 80 (it is now at 75) I will close the short and go long as we will have entered the persistent overbought state. There is a risk of this based on my most forward looking indicator. I am short 2500 QQQQ shares in the trading account and long 5 $39 August puts in the Roth account. A one cent change in QQQQ therefore has a $30 impact on my net worth...

Bill Gross' Latest Commentary

More evidence that in Gross' opinion the recent bear market in bonds is over.

Limited Transactions on Online Savings Accounts

One downside of these high interest online savings accounts that I didn't know about till today. Received a letter from HSBC telling me that I had been doing too many transactions on my account and was violating Federal regulations. If you do this for three consecutive months they will close your account or change it to another account type. The limit is six transactions per month including transfers to your own accounts online. I had been trying to do as many transactions as possible using my savings account in order to maximize my interest income. I would move most of my pay into the account each time I received a pay check. So from now on I will only move money there that I think is really going into savings but I am not yet ready for whatever reason to move to its final "home".

Bernanke Financial Disclosure

Like PF blogs financial disclosures by public officials are always fascinating.

Balance Transfer

Just completed a balance transfer, paying off about $8500 on my Amazon credit card using a balance transfer from my HSBC credit card. The balance on the HSBC card is now $7000. My total credit card credit line is $19500. I like to keep plenty of the credit line free for emergency spending, even though from what I understand it doesn't have a long-term impact on your credit score. The new HSBC loan is at 2.99% and the old Amazon one was at 0%. I get lots of zero percent offers in the mail almost every day. I am not taking them since I learned that these do have a long term impact on your credit score. Why carry any balance? The loan helps fund my trading account. If the balance is below $25000 you can't make day trades and this money is free or very cheap. Hopefully, if and when I finally grow my trading account more I will probably pay off the credit card loan just because it is a hassle to think about and only amounts to about 2% of net worth at the moment and I like to keep life simple.

Elite Trader

I have been a member of Silicon Investor for 8 years but only just discovered a site called Elite Trader today. Read an interesting discussion of Jim Simons' hedge fund. Don't know how useful it is in general but thought I'd just pass it along for those interested in learning more about trading.

Today, finally things seem to be going to plan trading wise. Much more relaxing. At this point it is looking like the rally continues all week long though there could be a significant correction in it around Wednesday.

4pm update - since 30 June:

Model: +6.8%
NDX: -6.5%
Excess Return: 14.2%

Trading Account: +2.9%
Excess Return: 10.0%
Capture of Model Performance: 70%

Am happy to be back on the positive side :) This is the revised version of the model. My account perfomance is as it happened. Excess return measures the difference between an account invested in NDX and an account invested in the model from inception. Excess return increases only when the model is correctly short.

Heads and Shoulders

No not a special deal on shampoo :) Everywhere you look across the stockmarkets there are head and shoulders formations or closely related chart patterns. One of the most prominent is on the Dow. The implication is a fall to around the low of August 2004. In Elliott Wave terms the move down from the top is an ABC (or WXY) pattern with the wave C ( or Y) down just getting started. I and Volkmar Hable both think there will, however, be a rally in the coming week, which on the NASDAQ and SPX indices will complete wave 2 of this C wave, an upmove which started some time on Tuesday.

Will the head and shoulders correction be the end of this current short-term bear market? It is impossible to say but I think there is a strong probability that it will be. Most bears are looking for a low in October or even 2007. What most people are looking for often doesn't happen. I'm now thinking that this year will turn out to be more like the mid-cycle slow downs in 1985 and 1995 rather than a full blown recession and the market might act more like 1987 (but without the dramatic crash) or 1998 - i.e. a short, sharp correction over a few months. This is partly based on trying to fit Elliott Wave patterns to various foreign stock indices. It's hard to believe that their rallies since 2002-3 are corrective in nature rather than bull market impulse waves. If the latter is true then the current correction is just wave 4 of an ongoing bull-market and the market should not go below the 2004 (e.g. FTSE, DAX) or 2005 (in Australia) highs in these indices.

Learning from your mistakes is one of the most important habits of successful investors. So I have been busy analysing where I sent wrong in the last few days. I've come up with at least one or two useful additional trading rules. Also it is clear that some times my technical analysis tools and model give trades with higher probabilities than others and the size of the trading position needs to be modified accordingly.

Losing Streak

The model has now lost money for 5 days in a row :( This is the longest losing streak so far in the simulation I did for this year. On average the model only loses money for 5 or more days in a row one time each year. The longest losing streak in the last 10 years is 6 days.

Trading Performance Update

Since I have been using the model the NASDAQ 100 Index is down 7%, the model is up 3%, and my account is at... zero. Actually, this is not so bad - I beat the market by 7% and captured 70% of the model's excess return over the market. Over time, I hope my trades will capture more of the model's returns as I get used to using it. Of course, if you were in cash you also would make close to zero percent over this period. But if the market had instead gone up you wouldn't have beaten the market. Today the market corrected much of the recent rally. I am predicting a 4 day rally through Wednesday which might take the QQQQ's to $37.50 (optimistically). This evening the market is reacting well to the Microsoft earnings report and negatively to Google who beat their numbers but.... There were wild fluctuations in GOOG following the announcement. I think this is because Google has such a lot of numbers computed in non-GAAP ways as well as according to GAAP in its earnings report and traders get very confused.

Croesus Again

A glimmer of hope of getting something back from the Croesus debacle. Trading was rough today as I was still short when the market rose in response to Bernanke's comments. The model now switches to a long recommendation as the stochastic rose above 20. In yesterday's post I labeled the beginning of this upward correction in the market wave iv. That will have to be relabeled wave 2. Wave 1 down is therefore complete. The outlook for the next month or so is still bearish, however.

Bearish Outlook

I went long and lost money and then went short and lost money... Of course if I followed my model and rules precisely I would have stayed short and ended up a little down on the day but not as bad as I was. I kept the short position.

Here is my latest Elliott Wave interpretation of what is happening:



The chart implies that there will be another day or two before a modest upward correction. There will be two more stochastic cycles before we hit bottom though as there should be five waves in total in a wave C which we are now in. So this is very bearish. Will that be the end of the bear market? I don't know. Will update you when I have a more solid idea.

Yahoo reported this evening and its stock is getting totally trashed. This supports my interpretation and forecast.

All Bets Off

On Tuesday, Japan reversed the change in money supply to reduce money supply relative to last Thursday and plans a further reduction on Wednesday. Market isn't responding much to this morning's PPI figure. The CPI will be announced tomorrow. Lots of corporate earnings reports this week too. The stochastic oscillator is still below 20 - it increased a little yesterday - at this level the presumption is to still be short. But yesterday the oscillator increased a little and to remain constant today prices pretty much need to rise.... movement of the oscillator tends to be pretty smooth and so this suggest higher prices today. A very big rally is needed to get above 20 still - about 3.5%. So I am again going tentatively long this morning but not holding overnight positions until the trend is clear.

Bank of Japan Massively Increases Money Supply

The financial mass media does not discuss this major driver of the stock market very much if at all. More specialized sources are only recently beginning to understand the importance of changes in Japanese Money Supply on global asset prices. Fluctuations in the Japanese monetary base dwarf those in the money supply of any other country including the United States. It seems that Japanese monetary policy is far more important than the actions of the U.S. Federal Reserve. Before and during the May decline in global financial markets the Bank of Japan sharply reduced the money supply. Only when they began to increase it again did the collapse in the markets mitigate. Then starting on July 4th the BoJ again withdrew liquidity. On July 14 they increased the current account balance by an unprecedented 40% in one day! If history is a precedent this should trigger a strong rally in the market in coming weeks. The BoJ does, however, plan to reduce the increase, which was unplanned. How do you accidentally create $40billion in high powered money?

This morning the US Dollar is up strongly - this might indicate dollars being bought with those Yen? The Japanese market was closed Monday for a national holiday. I went long QQQQ at 35.88 around 8:15am this morning.

A More Positive Post!

At mid-month things are looking a lot better than at the end of last month. Since the disastrous 29 June FOMC Day I have recouped my trading losses of that day and more by trading QQQQ. The market has fallen 8%, my model has added 5%, but my trading account has added 18%. This is due to trading on margin and buying and selling intraday - the model is based on closing (day-end) prices only. Don't believe the real estate gurus who tell you that only real estate allows leverage. Using leverage in the stock market is no more dangerous than in the real estate market if you know what you are doing... And if you don't know what you are doing it is just as dangerous in both (though I know how I could lose all your money for you in a day in the stock market, which isn't possible in the real estate market - it takes longer to lose all your money there - put all your money in an out of the money option the day before option expiry if you really want to lose it :)).

My Roth IRA account has reached a new high $10,860 from a total investment of $8000 a few months ago. So I am 28% of the way to the goal of making $10,000 in profits on my Roth IRA. Net worth is now only $3000 from my highest month-ending figure (though I reached maybe $328,000 at one point intra-month). I am $55,000 from reaching my end of year goal and so am behind where I should be at this point - $324,000. I am fairly confident now of achieving the goal though.

Recently my blog has discussed trading moves more and more and I hope that isn't too boring for those of you not interested in trading. By the way, it is dangerous to follow my moves blindly as maybe I won't have time to post when I change direction. Please just use these posts as additional opinions about market conditions. It is dangerous to try to follow anyone else's trading moves blindly!

Finally, nice to see a positive article about one of my more disappointing investments: Challenger Infrastructure Fund.

Ameritrade Sucks But I Love the Streamer

Today I placed an order to cover my QQQQ short at $35.80. This was 1 cent above the low price of the day. Just as I did so, Ameritrade's servers crashed - the order was not accepted and when I tried to log-in again, I couldn't even get the login page. From reports on the Yahoo website, all of Ameritrade's customers were affected. Eventually I did cover - I missed a couple of good opportunities after I got back on and finally closed out at $35.95. The difference is $375. I have seriously considered moving my account to Interactive Brokers in the past. But I really liked the Ameritrade interface and so decided not to. Also for orders of more than 1000 shares Ameritrade is cheaper. The big advantage of IB is that you can trade futures as well. I think I may now make the move and keep the Ameritrade account for the sake of the charts as well as keeping the Roth IRA there. I haven't gone long yet, but based on the model will likely do so on Monday.

Change of Plan

Went long at the open at 36.61 on the QQQQ. Stopped out at 36.45. Went to a long meeting (PhD dissertation defence - environmental research in China was the topic) and then came back and went short again at 36.71 with 3000 shares this time instead of the 2000 + 3 option contracts in the Roth the first time. The stochastic is below 20 which is the persistent oversold state and though other diagnostics from the model didn't suggest that we were persistently oversold, and looking at the S&P 500 index would hardly make you think so... I should probably have just stayed short. Anyway, I am up for the day at this point and that is what matters I guess. The market looks like going lower than today's low so far. The whole correction from 3 July looks now like a double zigzag in E-Wave terminology. This morning was the end of wave A of the second zigzag and now we are in the wave C of the second zigzag.

Cover Shorts and Go Long

The model says to be long from tomorrow. So I sold my QQQQ put options and bought back the QQQQ stock I had sold short. The underlying QQQQ position was a bit more than 50% of my net worth. Today's gain alone was $2700. I plan to establish long positions in the morning. The market closed very close to its lows and the stochastic is in the persistently oversold range. So best to still be cautious about going long. I didn't have time to buy options in my Roth account either before the close. Intraday the price action played out in almost perfect Elliott Wave Theory fashion. SPX/SPY has a clear 9 waves down - an extended impulse. In the QQQQ/NDX that itself is the 5th wave from the July 3rd high.

Over the last month or so I have developed my new approach to trading through a couple of different versions. Trading using my new systematic model based approach is so different to using traditional "analog" approaches. I am fairly confident that I have discovered something very significant. Am trying "not to count my chickens before they hatch" but it is hard not to speculate about the future. I don't feel at all euphoric. That is probably a good thing.

Mutual Funds Improve

Interesting article about improving performance of mutual funds. I've posted a couple of times about how actively managed funds seem to do better than passively managed funds in weaker stock market conditions and vice versa. Last night I was checking out the performance of TIAA-CREF's variable annuities (these are basically mutual funds - not the standard variable annuities). Over a 10 year horizon their indexed stock fund has essentially performed the same as their actively managed Stock Fund. But in the last year the actively managed fund has strongly outperformed the indexed fund. Their Growth Fund however has totally underperformed over every time horizon. But interestingly their best fund of all is the TIAA Real Estate Fund which invests directly in real estate. It has outperformed the equity funds on every time horizon. Currently my TIAA-CREF account is invested in the Real Estate Fund and the Bond Fund.

Forecast Update

Currently my model is projecting Thursday as the turn around day in the market when a new uptrend will start. Of course this can change as we approach that date and new info updates the model. Am visiting in Burlington, Vermont for the last few days. beautiful weather. Went hiking to the top of the highest mountain in Vermont. We cheated and got a cable car to the top of the ski slopes. Then we hiked to the summit from there. After that though we hiked all the way back down to the valley bottom. Still sore :( Very steep and rocky descent involving lots of jumping down rocks and just the continual shock of taking my weight onto my legs in the descent. The ascent route involved a little rock climbing, some people were giving up and turning back but once you figured the route it wasn't too hard. It was rated DDD for very difficult on the map they gave out and there were lots of warning signs at the beginning of the trail to only try it if you were well prepared (we had no special gear was just wearing sneakers). From the top we could see right across the state from the Adirondacks in NY , Lake Champlain, and up and down the green mountains. May post pictures some time when we have them available.

Trading Update

My trading model automatically stopped me out this morning when QQQQ reached 1.25% down. It then fell further and I went long for a daytrade. But I expect to go short before the close. The model is a bit ambiguous today on the forecast for tomorrow, but looking at a bunch of other stuff I have to side with the more negative view. Today's downmove was ostensibly started by the North Korean missile launch putting pressure on the Japanese market. Then some strong economic reports came out this morning in the US, raising interest rate fears again. The model didn't fail today despite prices falling - we can't predict prices and don't try to. The stochastic oscillator I am forecasting will end the day up, validating the forecast. The stop loss helped boost my returns above those of the market. Perhaps I should have reversed to short when the stop was hit. But you can't win them all.

June Report

June 30 is the end of the financial year in Australia and is when mutual funds make distributions including tax credits. Therefore, this month's figures may still need to be adjusted when all the information is in.* Net worth fell $15233 to $303249. Investment return was -4.61% for the month. The MSCI index was flat. Spending came in at $1949:



Non-investment income is low this month because of the strange schedule we get paid on. We receive June's pay at the end of May. The other income for June is some money from a research grant I got last year and wasn't paid this bit till this year and retirement contributions related to it and the combined May and June pay.

I report my numbers a bit differently to most other PF bloggers. Most people seem to list things according to accounts and note the change in the accounts each month. I think of investments as individual assets rather than accounts and I think of income in terms of whether I have direct access to that income - i.e. current income - or whether it is in a retirement account - retirement income. I am most concerned with raising my current assets and income rather than retirement income and assets. Mostly it is locked up till age 60. Though, as I've discussed in previous blogs, it is true that the US 403(b) portion (about $30k) can be withdrawn at marginal tax rates and penalties or perhaps without penalty as a 72t. The Roth contributions ($8k) can be withdrawn any time without tax or penalty, so perhaps I should list them as current assets. Roth profits can be withdrawn tax free for a first time home purchase... But the Australian superannuation account is the bulk of my retirement assets and is very hard to access before age 60. My goal is to reach a level where I can live off investments and trading way before that age. So essentially the money is useless to me.

Unlike most PF bloggers, I am not only concerned with the change in net worth but also in the rate of return on investment. Is net worth changing due to spending/saving behavior or due to investment gains or losses?

I also split out the effects due to changes in exchange rates on the current assets. A loss in terms of USD means there was some gain in terms of AUD. Therefore, this loss is not as critical as a loss in the actual base value of assets which I call core investment income.

*P.S. 13 July - adding in tax credits on mutual fund distributions in Australia the return for this month improved to -4.54%...

Buffett and Gates

EI just posted my take on Buffett's donation in response to a poster on the Silicon Investor website:

"Why are you so suspicious? Gates got to be the richest person on Earth. So once you've done that what's the point in accumulating more billions (by selling MSFT stock and investing in other stuff). So you move on to plan two: Create the world's largest charitable foundation. Yes you do get a massive tax deduction so you never pay tax on your income for the rest of your life. Best of both worlds!

Buffett is more interesting. He stopped short of overtaking Gates - he realizes though that in dollar numbers he will never reach in his lifetime the level that Gates reached when MSFT stock was at its peak. The next move is more interesting - he has exchanged the option of making the Buffett Foundation bigger than the Gates one for outsourcing the job and not having to run a foundation - just sit on the board - so he can keep doing what he wants which is running Berkshire.

There is no point I think in giving billions (rather than millions) to your children unless you want them to retain control of your firm. In Gates case he was a minority shareholder anyway - though the biggest. So this wasn't going to be an option. In Buffett's case this ain't going to happen. His three children dropped out of college and aren't interested. They will now have plenty of charity to manage.

OTOH in Australia where there are no inheritance taxes you don't see this happening. Recently the wealthiest Australian resident, Kerry Packer, died. His son was already an executive in the family and public firms. He is now CEO and the shares primarily passed to him, so he is now the wealthiest Australian. Murdoch seems to have struggled with this. Though he is a US citizen now and even transferred the News Corp listing to NY. Will be interesting to see what the eventual outcome is there. Currently the inheritance will be divided among his various children. The News share structure is complex like Berkshires with voting and non-voting shares."

Learning to Trade

Picking stocks isn't easy and neither is learning to trade. This is why most people are better off buying ETFs or mutual funds, dollar cost averaging and some of the other strategies I have suggested.

When I first started trading I tended to lose money. I would make money for a while and then lose more than I had made. This stage was the "tuition stage". This term is often used by traders.

Recently I have only lost as much as I have made. We could call this the "internship stage" :) Working for free.

Hopefully the next stage when I am trading according to the model will finally be the regular job stage. At least a side job at first.

Why bother? I have learnt a lot through this process. I think there is a high probability that I now start to make serious money from it. Unless my model breaks down and stops working that is. That's what happened to the guys at LTCM. The key to survival is to never take the kind of risks that they did in terms of leverage.

Will report detailed financial results for June soon. What I can say now is: I stayed above $300k in net worth. I lost around 4-5%. The MSCI index was flat for the month. Last month I was up when the MSCI was down. As a result I have about matched the index over these two months. In Australian Dollar terms the loss is about 1% less than in US Dollar terms.

End of June, Finally :)

A calm day after yesterday. Glad this month is over. I lost money but think I have developed a tool that will make me a lot of money in future. So actually, maybe, it was a good month.

These are the average monthly returns of the MSCI All Country World Gross Equity Index over the last ten years:

January 0.20%
February 0.04%
March 1.02%
April 1.60%
May 0.17%
June 0.94%
July -0.66%
August -2.06%
Septembe-1.51%
October 2.20%
November 3.22%
December 2.34%

And here are mine:

January 1.13%
February-1.48%
March 0.97%
April 0.11%
May -0.42%
June 0.55%
July -0.11%
August 0.41%
Septembe-2.31%
October 3.95%
November 2.85%
December 1.65%

I don't tend to do well in summer but do beat the market in July and August. I do very well in October too. At this point July is looking likely to be negative if I end up writing off Croesus Mining (around 2.5% of net worth). Will be nice to end up with a positive investment return.

FOMC Day

Apparently the markets think the Fed's statement is bullish. I was short and suffered a big loss. Mainly due to being short individual stocks. If I had traded strictly according to the model I would have lost only about 25% of what I did. If you reversed to long when the stop was hit you would be flat for the day. The stop is at a 1.25% loss and the market rose another 1.25% after that. It makes sense I think to reverse at the stop when the next day's forecast is for a change of trend.

I closed all positions and went long... too late in the day though. The model is now forecasting up (like that's hard to do LOL).

From now on I am trading only QQQQ in position trades and now and then in day trades to improve my position. I may also do trades in individual stocks if there is a good reason to do so. But I won't use them to capture the market direction. I may use other ETFs like HHH too. Of course I also invest but I follow strict risk control there too in terms of position sizes.

Let's see if this improves my net worth. This month will be very bad. If I am lucky I will stay just over the $300k mark.

The Market Went up Today... Better News from Australia

The market went up today, but my model is still on short heading into the FOMC announcement tomorrow. We are getting close to a turning point in the market though. Better financial news out of Australia for me today. There was an update about a very complicated real estate security (IYS) I invested in which is going to be wound up and the capital distributed. The final distribution will be 21 Australian cents a share more than previously offered ($A1.91 vs $A1.70). Should wind up in September. I am tempted to buy more but the risk control side of me says: "who knows what might happen?". The spread is enormous. The bid is $A1.24 and the offer $A1.72. It almost never trades. Maybe put in a bid at $A1.25 and see what happens? I can't see why anyone would sell at that price though. But why sell at the offer price either?

Croesus Mining Declares Bankruptcy

I wrote in an earlier post about the trading halt in the shares of Australian gold miner Croesus Mining. In the last couple of days the firm went into "administration" the Australian equivalent of Chapter 11 after the Japanese Mitsui Bank refused to reschedule the gold hedging contracts between it and Croesus. Macquarie Bank in Australia had agreed to reschedule the hedging commitments. This means the value of the shares is likely totally wiped out. I won't write down the loss to my net worth (about 2.5%) until this is finally confirmed. At least some of it can be used as a short-term capital loss reducing the hit somewhat. The basic problem was that Croesus was not producing enough gold to meet its commitments to sell gold to the banks at the prices of the hedging contracts. Therefore, they would be forced to buy gold on the open market at a much higher price fill the contract. Macquarie was happy to reduce the monthly commitment. I suppose they thought that the price of gold will continue to rise so it doesn't matter if they have to wait a while for their cheap gold. And, additionally, they let a borrowing client survive to borrow another day.

Kiyosaki Wrong on Mutual Funds

I like a lot of what Robert Kiyosaki says usually and there are serious problems with a lot of mutual funds, but the basic point in his column on Yahoo's website is plain wrong. He says that if a mutual fund earned 8% a year and charged 2.5% in fees (the first number is plausible as an after inflation return on a long stock mutual fund, the second number is high but not totally implausible) then your after fees return is 5.5% which means that over a 65 year period $1000 would grow to $140,000 if there were no fees but only $30,000 after fees. So far so good. But then he says that this implies that the fund manager makes 80% of the return and you only make 20%. Not true. You make 21% of the potential before fees return but the fund company only makes 10% of the potential return ((2.5*30,000/5.5)/140,000). 69% of the potential return just disappears. So it is just as bad as he said but the mutual fund company isn't benefiting from this. The idea that if you lose someone else must be gaining is a common myth among investors - many people think that if the stock market goes down and investors who own stocks lose someone must have gained. Not true - a few short-sellers do gain, but most of the value just evaporates.

The truth about mutual funds is that actually fees don't matter. Fund companies like Vanguard who have low fees would like you to think this. All that matters is your net return after fees. If the return after fees is better than you can do on your own after taking into account the value of your time you would rather spend on something else then the mutual fund is worth buying and otherwise not. You could just buy an ETF invested in a stock index. If an actively managed mutual or hedge fund returns after fees more than this investment then it is worth buying. I find that in very strong trending markets, passive investing beats active investing. In weaker markets active investment seems to win out even after fees. Last year in the US active funds beat passive funds. But in Australia the opposite was true. In the 1990s, active investing won in Australia and passive investing in the US.

Market Forecast

Despite the market being up today all my newly developed indicators are pointing the same way - down. Some other indicators and the chart pattern too are ambiguous. The NDX (NASDAQ 100 index) would need to rise around 14 points I think to reverse this. Something unexpected can always happen. I'm thinking now when I do reverse position I will set up main position using stock after all. This is so I can do an after hours trade if neccessary - you can't trade options outside regular market hours. But the position in my Roth IRA will remain in options. Will be interesting to see how the two approaches work out.

Technical Analysis Modeling

Been spending a lot of time recently on developing new technical analysis methods (commonly known also as "charting" - but the stuff I am developing barely involves a chart). In my academic career most of my research has involved applying time series models (statistical modeling methods related to regression analysis applied to data that is available as observations over time like historical temperatures, GDP, stock prices, population etc.). I have also done some work to apply these methods in the stock market.

I have found that, not surprisingly, it is pretty much impossible to forecast daily changes in stock prices using any standard time series model. This is why academic economists who work in finance say that technical analysis is rubbish and can't work. It is also why technical analysts use indicators which rather than forecasting changes in stock prices try generally to pick out turning points in the trend. I have created one indicator myself that is fairly useful by using an unusual combination of time series methods. My new approach is to try to forecast an indicator.

Recently, I have found that if you could predict the direction of the %K(5,5) full stochastic oscillator correctly (see this chart) you would beat the market by maybe 100% in bull market years and by hundreds of percent in bear market years. So being able to predict it is definitely a worthwhile thing. And it is far more predictable than stock prices themselves. Of course, no forecast can be 100% accurate and so these kinds of returns are not possible.

The time series model I have developed so far (in the last couple of days) can predict it well enough to increase the value of the account in bear markets. But in bull markets, following it blindly could lose money big time. Interestingly, we are now in a bear market by that definition. I tested each year from 1997-2006 and see how the model does over each year separately. This is called backtesting and is standard in developing technical analysis methods.

So I think my focus should be on improving those forecasts. Next step is to try some things that aren't in the time series textbook.

Anyway at the moment we have a very high probability forecast that the oscillator will be lower on Monday - i.e. stay short. This is backed up by the McClellan Oscillator and my E-Wave discussed in previous posts.

Plutonomy

Plutonomy is a term invented by some analysts at Citigroup. Download their articles here. The central thesis goes against everything you probably thought about people's saving behavior and what is taught in macroeconomics and development economics. They provide evidence that today in the more unequal developed economies - the plutonomies - the rich save less than the poor or the middle class. In order to understand this idea you need to remember that in the national accounts capital gains are not included as part of personal income. Most capital gains go to the highest income and wealthiest segment of a society. If you are a CEO with big options grants it is easy to spend your salary and save the profits from your option exercises and have a zero savings rate. This turns the popular notion that the decline in the US personal savings rate is due to poor and middle income consumers spending beyond their means (by cashing out housing equity in the middle class or running up credit card and other consumer debt in the working class) on its head. Another thing they don't mention is that people who save successfully for retirement are going to end up in the wealthier segment of society and they are dissaving. This phenomenon does not apply to developing economies apparently even though many are far more unequal than the United States. It is certainly an intriguing idea and the evidence looks strong but something is still nagging in my mind that makes it hard to 100% believe in it.

The Correction Continues - Technical Analysis

We are still in what I believe is a correction of the 14 June rally in US stock markets. Even though yesterday's rally exceeded the previous highs it took place on weak volume. Volume only really picked up when the selling off started. Today was mostly down and then sideways. This type of correction is called a "flat" in the terminology of Elliott Wave Theory.

Check out this chart of the NASDAQ 100 index. The stochastic oscillator maps out the waves pretty clearly. And the last wave of the oscillator is clearly pointing down and has some ways to go before it bottoms out. So market timing doesn't work and technical analysis is rubbish? It is still hard to determine a turning point as it happens. Once the move is underway though the momentum is pretty clear. But a rally like yesterday's is just noise as far as the oscillator on a daily chart is concerned. You need to go down to the hourly chart to detect it... and then keep the daily one in mind too. And this is part of the reason why I am thinking of using multiple trades simultaneously some longer term (based on the daily chart) and some shorter term (based on intraday charts). My mutual fund investments would be traded on the basis of a montly chart perhaps.

Trading Diary Part II

9:33am

I won't post hour by hour detail today. Have a big meeting from 12-2 anyway. Market is showing early strength. For the moment I will hold my positions until I am clear a bottom has been reached and then reverse course to the long side. Will report positions at the end of the day. Right now I am short 50 GOOG, 500 QQQQ, and 100 AAPL as at the close yesterday.

4:03pm

A mixed day - not much to report - ended down $50 overall in my Ameritrade accounts and with more short positions than I started. So the new plan still isn't implemented but my trading positions are not bigger than my risk management allows: 1000 QQQQ, 50 GOOG, 100 HANS, 100 AAPL all short (and 4 QQQQ puts and 150 GLD long in my Roth account). The GOOG and HANS positions are in the 5-6% of net worth range. QQQQ positions can be much bigger as this is a market index. My current position is conservative.

Trading Diary

Today I am trying to exit from my previous strategy and initiate the new one.

9:54am

I went into today short 100 GOOG and 500 QQQQ in my trading account (I also have 1 BRKB in this account. I added 500 QQQQ and 100 HANS to the short position in pre-market or the first few minutes of trade. Let's see how it goes. Barrons had a negative article on GOOG (as did the Economist) over the weekend. In Friday trading GOOG's share price got pinned down to the $390 strike at the option expiration. Maybe it can fall a little now that the options expiry is over. I see the market as a whole as needing to consolidate a little after last week's rally. HANS is very volatile and so sometimes is good for daytrading though often spreads are big and often it can't be shorted and because of the relatively low liquidity spikes in either direction can easily appear from nowhere. So not the ideal daytrading stock. But I don't have any other real ideas.

I have the market running on my laptop while working on other stuff on my desktop. Using the F9 key on my Mac I can get all the windows to be visible nicely spreadout across the screen and monitor various stocks for anything unusual out of the corner of my eye....

10:10am

Perfect reason not to trade individual stocks in large amounts - $5 spike up in GOOG came out of nowhere in 5 minutes. $2 of the spike happened in 1 minute. As I write the stock is falling back. No news out, nothing. I don't need this kind of stress. If I had half the number of shares I wouldn't worry.

10:23am

GOOG's back in the red for the day LOL

12:53pm

I am tracking the SP500 index. Tech stocks are showing relative strength today and it is hard to tell which way the market will go by just looking at the NASDAQ indices alone. The SP500 index though is much easier to read and if it goes down it is hardly likely the NASDAQ will go up. Looking at correlations across multiple indices and securities is one of the ways I try to work out what will happen next. Most individual traders and market commentators seem only able to focus on one thing in isolation.

1:40pm

With AAPL showing relative strength today and everything else near or at session lows. I add 100 AAPL to the bundle of shorts. Maybe this is getting too clever for my own good. But I figure the downside can't be too bad. Now I am using my full daytrade buying power.

2:47pm

With indices at session lows I bought to cover half my QQQQ and GOOG positions. The remaining positions are around 6% of net worth each and so much closer to my comfort zone. I am also well within the overnight margin requirements. So from now on if the market goes down more good, if it goes up a bit no big deal.

3:31pm

I covered the HANS position for about $500 profit. Actually I accidentally pressed the button :) I had the order set up and was looking for the price to fall back a bit and then accidentally leant on my laptop.... anyway the probability of more gain is too low now to make reshorting it worthwhile.

7:24pm

Well it was a good trading day, but we will need to wait till tomorrow to complete the transition plan. But at least I no longer have an outsized position in an individual stock.