How to build a professional investment portfolio

In this article you will get a beginner’s guide to building your own investment portfolio (4 different methods). In the next article you’ll see how you’re screwed anyway. But first this:

Burying the grand piano

Pianos were all the rage in the early 1900’s. The iconic Steinway & Sons thrived together with hundreds of other piano companies.

You would almost be forgiven for investing your pension in Steinway as part of your BAH, Trend, Quattro or BLSH portfolio strategy (more about these four classes of investment methods last in this article).

Then, quite suddenly actually, recorded music stole their march, and the dying piano company had to use its aging wood inventory for building coffins (!) for war casualties.

Peak piano was reached quickly and early.

Since then the recorded music industry of course has expanded rapidly, and employs many more than ever worked in piano related jobs*. It’s only fitting that the futurologist Ray Kurzweil was responsible for the final nail in the coffin by inventing the piano synthesizer.

(*it’s not every day I use the word “piano related jobs” in a sentence, but when I do it’s glorious)

Peak everything

Malthusians have throughout history predicted peak food, peak wood, peak oil, peak energy, peak jobs and other catastrophic developments associated with the growing global infestation called humanity.

Right now, it’s automation that piques the doomsayers’ interest.

Is it different this time? It might be. Will unemployment rise uncontrollably, or will the advent of increasingly competent machines (as always before) just result in relieving humans of boring, heavy and dangerous work, rather than create an irreversible increase in unemployment?

Could the accelerating speed with which new inventions are made make a difference vs. history? Companies like Amazon and Google, e.g., have replaced labor intensive industries with machines and machine intelligence. Where are those laid off supposed to go? Unless they acquire new sets of skills, probably straight into long term unemployment. It really could be different this time with technology causing massive unemployment (not necessarily a negative development though).

A recent Freakonomics podcast episode elaborated on the death of the middle class, where clerical and blue collar employees in repetitive jobs risk being replaced by robots and AIs. Only work requiring a responsive and adaptive human touch, both in the low end (massage therapists, dog walkers) and high end (business managers, creative artists, psychologists, physicians, marketing) are safe (for now). The process of automation is speeding up and machines are increasingly crowding out humans from the middle and out.

Note: whatever career path you choose, make sure it’s creative and change resistant, preferably something where you utilize the rapidly evolving technological tools to ride upon into the future, rather than being replaced by them.

How is it different this time?

This article is neither about the death of jobs, nor about the future of technology. It’s not even about the new version (with a disturbing duplo picture of me) of my book The Retarded Hedge Fund Manager (free for newsletter subscribers).

It’s not about asking if various aspects of today are different from similar historic episodes. It’s about asking in which way it is different this time. Not least regarding the economy, money, wealth and in particular the financial markets.

The stock market is different this time

Okay, read-bait, I admit. But still, the market is different, everything is different. The question is only how. More about that later (my next article which I will publish shortly). Here is what is not different: investing.

The principles of investing remain the same as always, i.e. postpone consumption for productive endeavors, as opposed to gambling and speculation (buying things at any price, hoping for luck or a bigger fool). Investment is about value, true intrinsic value that is likely to be realized and compensate for the risk involved. You should approach investments in the stock market and investments in your own business in the same manner.

Four classes of investment methods

These are four of the most common investment methods:

Buy And Hold
- Main local index
- Global
- Selective
Trend Following
- Long only
- Long and Short
Quattro Stagione (recommended)
- Static
- Adaptive
Buy Low Sell High
- Long only
- Long and Short

Let’s go through the models in more detail below.

Buy And Hold

It couldn’t be more easy: Buy stocks any time and every time. Hold on to the stocks forever. Live off of the dividends and reinvest what you don’t need right now.

Over time (100 years, and most 25 year intervals) BAH has produced real returns of around 6 per cent per year. But remember that even the fantastic cycles of 1994-2003 and 1995-2015 only returned 7% per year (including dividends and adjusted for inflation)

The best things with BAH are:

It’s super easy, no maintenance at all
The returns are decent, as long as you don’t start investing too late in life and happen to get in near a peak
You’ll ride every bubble all the way to the peak, periodically making you feel like a genius

The main drawbacks are:

Sometimes the return is negative over 10-20 years
You have to stay calm when your portfolio halves in value every now and then, since you’ll ride every crash all the way to the bottom, making you feel exactly like the schmuck you probably are :)
- (e.g., 2001-2002 and 2007-2009. In addition, before that, a BAH investor had to live through the downturn of 1998, the 1987 overnight crash, not to mention the crashes of the 1970s, which was an era eerily reminiscent of the current period since the year 2000)
The last 20 years leading up to your death can be hard to manage – the method has no guidance as to how or when to sell

If you want to try to improve on the model, you could be selective in which stocks to buy and hold, e.g.:

You could choose last year’s worst performing stocks and hope they rebound. This is most famously known as Dogs of the Dow, but it can really be the “dogs” of anything.
You could choose high growth stocks, e.g. stocks with the highest historical or projected growth rates or measured any other way you like.
You could choose particular industries, such as high tech only, media only or pharmaceuticals only or any combination that suits your preferences
You could choose your main national index – or some other country, or diversify globally.
You could churn your portfolio annually and replace your most expensive stocks with the cheapest stocks, or cheapest markets based on any valuation method or methods you fancy: P/S, EV/EBIT, market cap/GDP, various forms of P/E

In short, with BAH you’ll get low single digit returns over time (typically 2-6% real return per year depending on when you buy and how long you stay invested), while experiencing dizzying doublings, triplings as well as gut wrenching halvings. If you are lucky enough to buy near a trough and eventually sell at a peak, your average returns will of course be much higher.

The coming years any BAH investor should expect the S&P 500 index to dip below the peak level of year 2000, thus producing negative returns over 16-18 years, depending on when the downturn and subsequent recovery occur.

S&P 500 index 1994-2015

Green line: 600 day moving average

Trend Following

Device a trend identifying model (e.g., based on a moving average), calibrate and back test. Consider fees, trading too often on false signals and missing turning points by a mile. Then set your alarms and start trading.

Trend Following takes more work than BAH, at least initially, and it can be stressful when the model doesn’t deliver. In return, a well calibrated model can deliver (much) better than BAH. The hedge fund Lynx within the Brummer group (the same group as my fund Futuris), e.g., has delivered spectacularly well with its trend following models in all conceivable asset classes (stocks, bonds, currencies etc) over the last 15 years.

Look at the chart above and imagine you base your trend discovery and trading on the 600 day moving average for the S&P 500 index. Let’s say you decide to buy when the index breaks through the moving average from below and not just sell but go short when it breaks through from above. After one signal you have to wait one year (1 yr filter to avoid false signals) before trading again and then you buy or sell (or stay put) depending on which side of the MAV the index is by then.

With that extremely simple and non-optimized model you would achieve the same return over 1995-2015 as a buy and hold strategy. However, you would only experience one episode of -32% return, instead of two -50% crashes. With my settings above you unfortunately wouldn’t have caught the current rally until 1400-1450 and if a downturn starts soon you wouldn’t sell higher than around 1750, thus only bagging some 20%-points of the recent 200% rally. On the other hand, if the rally continues you would stay invested.

The best with Trend Following models is that they can produce higher returns with less downside risk than a BAH strategy.

The worst is that it can be difficult to trust one’s models fully. Back testing is not the same as future testing.

Quattro Stagioni

The four seasons model of portfolio building is a simple diversification model. Invest one quarter of your assets in, e.g., respectively stocks, treasuries, corporate bonds and gold. The asset classes can be complemented with real estate, soft commodities or longer shorter maturities for government bonds. Other adaptions include the same as for BAH (local, global, selective industries, laggards [aka dogs], cheap, growth etc.)

Reset the asset weights to 25% once a year or semi annually on fixed dates. Usually 2-3 of the asset classes will perform decently every year and make up for the one(s) lagging.

A more adaptive model, that I strongly advocate, increases the stock weights by 15%-points for every consecutive negative year on the stock market: 25%, 40%, 55% etc all the way up to 100% after five consecutive negative years (at which point you would have zero weight for the other three asset classes). Halve the stock weight after the first up-year but with a floor at 25%.

Another (daring) amendment could be reducing the stock weight by 6% points for every consecutive up-year that returns above 25%. After five such years you would be 5% net short in stocks. Or, set a floor at 0%, prohibiting yourself from going short.

The Quattro model takes a fair bit of work, in particular if you want to control the type of stocks and corp bonds in the portfolio rather than just pick the main index constituents. Perhaps you should avoid too much detailed work that eats into your quality time and might produce negative returns unless you know exactly what you’re doing.

The diversification reduces volatility. Adaptive weights both improves performance and reduces volatility. The Quattro model thus is better than both the BAH and Trend models, in particular on a risk adjusted basis (which also means you could try leveraging up, i.e. using borrowed money to invest more than your actual net worth).

In summary, the Quattro takes some work (as much as you like really), but it’s still simple enough for most. The draw downs are small (no crashes), the stress much less than for trend followers that doubt their own models, and the average return is at least as good as for BAH. This is the model most amateurs should adhere to.

Buy Low Sell High, a.k.a. the bullshit (BLSH) model

It really should be called Buy Cheaply and Sell Expensively, but old habits die hard.

Sounds good? Too good? Anybody calling “bullshit” on buying low and selling high? How do you do it?

Choose an objective valuation parameter (or combine several) for the stock exchange. Consider e.g. Price/Sales, CAPE (cyclically adjusted Price/Earnings ratio) and Market cap/GDP.

Over a century of market data, BLSH has performed consistently and remarkably well, for investments with a full business cycle’s (7-10 years) investment horizon. The returns have been at least as good as for the other three strategies and with much lower volatility and draw downs, thus opening up for using leverage (borrowing to increase the return).

Just make sure you do some serious back testing to identify appropriate trading levels. Decide whether to allow for going net short or not. Set alarms and start trading.

You probably should combine the pure fundamental valuation signals with trend measures (e.g., uniformity among industries) and other technicals (such as junk bond yields) that could help signal peaks and troughs when valuation already is extreme. Just look at John Hussman’s trouble in the current cycle, where ridiculously high valuations have gone stratospheric, leaving him stranded with a fully hedged portfolio (and me fully short!).

BLSH takes a great deal of work. It’s difficult to set fixed levels for trading signals. It’s difficult to once and for all pin down what is expensive and what is cheap. In addition, extreme valuations can be sustained for years depending on the level of investors’ risk tolerance/aversion. The model performs nominally in line with the other models, but (potentially much) better on a risk adjusted-basis.

The best thing with the model is that it intuitively feels right, and like true investing, to buy things that are priced below their intrinsic value and that thus can be bought and hold indefinitely for a good return. And then sell (even go short) at levels where investor euphoria has driven prices above any reasonable measure of true value.

The next best thing is that the returns will be less volatile than BAH and thus allow for leverage (or simply sleeping tight)

The worst thing is that it requires real work (as all real investing does). Buying low and selling high can be made just as complicated as you like.

In addition you will miss riding bubbles to their peaks, thus making you look stupid in the final years of every mania.

The last 20 years of bubble blowing, and in particular the last 6 years, have given the BLSH a bad rep, whereas BAH has gotten the upper hand. Since I think both models will continue to hold up over time, it’s time for the tables to turn now, and let BLSH catch up to BAH the coming decade or so.

I personally prefer to use the BLSH model as a guidance for entire stock markets (right now it’s screaming SELL for the S&P 500) and short or stay neutral the market in the down phase.

Once markets are reasonably valued or getting cheap, I’ll start accumulating individual stocks, that I like and know particularly well, and stick to them until my market model signals SELL again (mainly based on big picture variables such as market wide P/S, complemented with risk aversion signals in the bond market and narrowing advance/decline ratios in the stock market).

In addition, I complement my stock portfolio in a Quattro Stagion-like fashion with gold and commodities, fixed income (lending to individuals and companies, buying convertibles etc.) as well as counting my living quarters as a real estate investment.

When to choose which model

If you are lazy but calm and composed, go for Buy and Hold.
If you are a little more easily stressed, and willing to do a minimum of work, go for the Quattro Stagione.
If you are somewhat more industrious, first check if the market is extremely expensive. Wait if that’s the case. Once it’s less extreme, start buying and holding. If you’re a Quattro guy, just adjust the stock weight appropriately – perhaps to 13-19% currently instead of 25%.
The next level, no matter if you started out with BAH or Quattro, is to keep a lookout for when the market is becoming extremely highly valued (like now). Then sell your holdings and wait for more reasonable times. That, however, takes constant surveillance – at least annual check points.
If you like to gamble and think you might be able to improve on billions of dollars’ worth of trend research, try your own trend following models. It’ll probably work like a charm for a while. And then you’ll go broke. Good luck.
If you’re really into investing and not easily stressed go for BLSH; stocks only.

I‘m somewhere between the Quattro and the BLSH type of investor.

A note on switching models:

If you have two models, like BAH (Buy and Hold) and BLSH that have both performed more or less equally well over a hundred years of investing, then you should switch from the one that has outperformed in the most recent 5-10 year period to the one that has underperformed. Well, unless you think the table really has turned and that it is fully different this time and going forward.

The last 2-3 years, BLSH has performed poorly, while BAH has been a spectacular success. Some might get an urge to switch from the lagging BLSH to the better performing BAH. That would, however, probably end in tears, as the BLSH is bound to catch up with BAH over the coming years, unless a hundred years of investing information suddenly has become worthless.

State of play – summary

I would advice against trying trend following. You’re up against mighty opponents and it has nothing to do with actual investing. It’s pure speculation.

Do go for buy and hold, but be prepared for 10 years of no or negative returns first (with a couple of halvings in between), before you start getting any rewards for your risk.

The market is currently more expensive than it has ever been (on some important measures for the median stock – more about that in my next article). That is not a good time to start investing in stocks.

I would thus recommend building a Quattro Stagione inspired portfolio of gold and safe corporate bonds and keep money in the bank, money market or short term treasuries. Given 6-7 years of consecutive bull years, I would keep the stock component to a minimum (rather than the standard 25% weight) until we see a significant correction (at least -25% from the peak). Personally I’m short the stock market now, but that’s not for everyone.

When the stock market is more reasonably valued on a P/S or market cap/GDP basis, and some market technicals turn more positive (dispersion, advance/decline, junk bonds), I would increase the stock weight to 25% (normal Quattro).

Since I am a stock guy at heart, if stocks fall deeply for 2-3 years, similarly to the troughs of 2003 and 2009, I’ll go 100% long in stocks only, going full retard BLSH until markets look expensive again, where I’ll switch to a Quattro strategy.

What do you do now?

There it is, four (three) time tested investment models, but really all boiling down to the Quattro Stagione – perhaps complemented with the Rothschild advice of buying (more) when there’s blood in the streets. See any revolutions on the horizon?

And right now? Buy gold, keep cash, perhaps try buying some oil (I don’t have any right now, March 15, 2015), but stay away from U.S. stocks in general (unless you have some special, unloved, single stocks the market has forgotten about).

Wait. Study. Pounce (next year perhaps – stay tuned by subscribing to my newsletter if you want to make sure to get a note when I start buying stocks again). Continue reading the next post to see how things are different, and what it means for your potential investment returns.

Disclaimer: Nothing above constitutes any kind of recommendation to buy or sell financial instruments or engage in any kind of investing behavior

February 12, 2015February 17, 2015

Negative interest rates – what does it mean and what must you do?

Negative Interest Rates Everywhere

Negative interest rates are all the rage among central bankers these days. Today even the usually so moderate swedes lowered the policy rate to a negative -0.1 per cent.

What should you do about it? What does it mean for your job security, stock portfolio, pension etc.? Read on…

(or skip to the very end for a few quick points on education, mortgage and stock market strategies in a NIRP world; Negative Interest Rate Policy).

Earlier this year, the Danish central bank did the same (several times, actually, over the course of a few weeks; going deeper and deeper into negative territory).

The European central bank, ECB, had since long cast off its previously conservative German heritage and gone negative. The same goes for the Swiss National Bank.

Not even the U.S. or Japan have gone negative (yet)

Amazingly, neither Japan or the U.S. have tried negative rates – otherwise strong advocates of monetary experimentation.

They prefer the more “moderate” stratagem of printing trillions of new dollars to purchase newly minted treasuries and bonds from their friends at the big banks instead. (The Treasury issues bonds that the banks buy. Moments later, the latter turn around and sell the bonds to the central bank at a slightly higher price, pocketing the difference. It’s a nifty way to enrich banks while simultaneously circumvent the rules against central banks buying bonds directly from the Treasury).

What Draghi (ECB) & Ingves (Sweden) et al. are trying to do vs. what actually happens

In theory lower interest rates, including negative ones, are supposed to:

lower borrowing costs for companies (Lower borrowing costs mean more investments will be profitable and thus companies borrow more, invest and hire more people. Higher employment means more consumption and even more hiring in a virtuous cycle)

make banks safer (increased profits and strengthened balance sheets, thanks to lower funding costs due to, e.g., lower deposit rates paid to clients and lower coupons, or yields, on issued bonds)

lower the costs for households (lower interest rates on loans both directly and indirectly, as real estate and other companies get lower interest costs)

lower the borrowing costs for the government (reducing the burdens of a welfare state, enabling more transfers and subsidies)

stimulate more risk-taking (moving savers from zero-interest investments, like accounts and bonds, to equity and start-ups, thus promoting growth)

Increase inflation (higher prices and stable tax rates mean higher tax income for the state, thus making more room for welfare transfers. Higher prices on everything also means that loans [that are nominal] will fall as a proportion to income and asset prices. The latter is good for everybody with loans, but bad for everybody with savings)

**What’s so special about negative rates?**

Nothing really. What matters is the difference between nominal rates and inflation, adjusted for risk.

However, psychologically, nobody wants to pay money for the “privilege” of owning a bond or keeping money at the bank. Hence, people and decision makers feel forced to do just about anything with their cash, except keeping it idle at the bank.

In theory, when rates go negative, people spend their cash on more shopping and shares on the stock market.

Quantitative Easing (bond buying for newly printed money) aims to boost the effects of low rates

The Swedish central bank (SCB) today decided to accompany the negative policy rate with some bond buying. Most central banks do that nowadays. The Bank of Japan, of course, has done it for several decades (all but proving it doesn’t do any good).

The SCB started carefully with 10bn SEK (1.2bn USD), which would be equivalent to approximately 40-50bn USD in the US. The Fed typically buys in the trillions (1 Tn/year) so don’t worry; the Swedes still honor their heritage of moderation.

A 500% interest rate was the best they could do

A historical note: 23 years ago, when I was still at business school, the SCB raised its policy rate to 500%, manifesting beyond all doubt that it had no clue at all to what it was doing. Now the SCB is trying negative rates instead. I dare predict future economists won’t look back with admiration to today’s experiment either.

QE is thought to relieve weak hands of their bonds and put cash in their hands.

That cash then needs to be reinvested (and hardly in anything paying negative interest). The cash thus moves up the risk ladder into, e.g., longer term bonds, large corporate bonds, or even stocks with historically stable dividends. Gradually, investors at all levels are pushed further up the ladder and some money ends up at the very top; in new investments and start-ups, which should promote economic growth.

**So, why ever have have positive or high, instead of negative interest rates? (or, what really happens is this)**

If you buy into the Keynesian world view, where it’s a good thing to have politicians manipulate the economic cycle by varying interest rates and budget deficits, why not go “all in” and set negative rates once and for all?

Why not have ever falling rates, plunging deeper and deeper into the negative every year? Why have taxes at all, why not just issue debt to cover all welfare costs and let the central bank buy it all?

The intuitive answer is easy: It’s impossible, you can’t print wealth.

Money isn’t worth anything if you can’t get anything for it. Somebody has to work and produce. Somebody has to postpone consumption (a.k.a. “save”) for there to be anything to invest, for there to be anything produced. With negative rates there will be very little saving going on, but a lot of speculation and consumption instead.

Everybody knows you never go full retard in monetary policy.

The lessons from Zimbabwe, Venezuela and not least Germany (1923), are still fresh and raw in the memory of most economists. The death of money or hyperinflation is the most devastating economic phenomenon there is. Production ceases completely and an ever increasing bulk of money chases after an ever diminishing pool of assets and goods, fueling wild speculation and zero long-term investment.

Apart from doomsday scenarios, this is what negative rates means for you

In short, it actually means a doomsday scenario, just very slowly. The lo-down:

You’ll earn less interest on your bank account. Since most people don’t have any cash this is probably not a problem for you. If you have retired and live off a state pension, cash savings or bond coupons – tough luck!

Your variable interest housing loan becomes cheaper. Good for you, more money over for other things. Get out there and splurge!

Share prices, house prices and other asset prices rise for a number of reasons (most of them temporary and psychological). Good for you if you have all the assets you want. Bad if you were planning to buy more.

Companies start investing in anything they can find that might produce more return than the cost of borrowing. This means a lot of investments with lower return than usual get done. These lower quality projects fail more often. In addition, if interest rates rise, investors lose money even if the projects deliver as promised.

Short-term, the economy gets a boost, unemployment falls etc, as it did in 1996-2000 and 2003-2007, but when the low quality projects mature or interest rates rise, the true costs of low quality investing (malinvestment) become obvious. Remember that central banks lowered interest rates, to no avail, all the way down in the 2001-2002 and 2008 stock market crashes.

Longer-term, jobs disappear, banks fail.

The economy’s resilience and growth potential has been hollowed out by low quality investments. The easy job gains in real-estate, financial markets, service industries and consumption during the NIRP* induced boom are soon lost again. The loans for second houses, stocks, third cars, watches and other consumption go bad, consumption fall, and banks fail (subsequently rescued with tax money – congratulations all tax payers, they’re doing it again. But, no worries, the bankers will get to keep their bonuses from the boom).

*NIRP=Negative Interest Rate Policy

Inflation takes hold. Sooner or later inflation takes hold, due to more money and less goods. Then interests rise and many holders of variable rate mortgages will be toast. There actually already is rampant inflation – it’s just that it’s in assets, instead of goods. Whatever inflation there is in goods, the authorities choose not to include in the calculations, but there is a limit to how much they can hide.

Banks take more risk (and sooner or later go bankrupt) since they know the state and central bank will save the bank with tax payers’ money when needed. Up until the bankruptcy/state rescue bankers can pocket their bonuses and get to keep the money after the inevitable collapse.

Financial markets fall (they always do, sooner or later – and have already halved twice in less than 10 years; 2001-2002 and 2008-2009). Whatever artificial appreciation of stock prices accomplished today will be gone tomorrow. Bank failures in the wake of higher interest rates, malinvestments and bad loans is often a reliable way to start a market crash.

The value of a stock today is the discounted sum of about 25-50 future years of cash earnings after tax. Those earnings are being eroded, due to easy money, by current malinvestment and speculation, instead of sound long term investments in production. A mania in the wake of negative interest rates actually reduces the value of stocks, leading to lower lows in the downturn than what otherwise had been the case. Thanks Draghi! Thanks Ingves!

Enough with the economics and Fimbulvetr stories. What should you do now?

Should you fix your mortgage rate, borrow more, buy stocks, study, WHAT?

To start with, -0.1% isn’t that different from 0% or +0.25%, so you really could ignore the whole circus. As you were. In theory though… (and ceteris paribus):

In the short term things will look better. More employment, higher stock prices, higher house prices. In the long term things will still turn ugly.

This is how I would prepare:

Make yourself change resistant; don’t take your job for granted. Acquire more skills, make yourself indispensable, look for future-proof work places. Many will relax in the easy times of negative rates, but you should work harder than ever to secure your place in the job-less future to come.

Amortize your loans, or fix the rate for 7-10 years. Interest rates have never been as low as they are today. Don’t just do as all the other lemmings and go deeper into debt with variable interest rate – be contrarian and either reduce your debt (you can afford to amortize now that your monthly interest cost is so low) or fix the rate for a long time, in case inflation eventually ramps.

The family of two medical doctors I lived with when I studied finance asked me in 1990-92 whether I thought they should change their mortgage to variable interest (10-12% or so) or continue with 5-10 year fixed rates at around 12-15%. I repeated what I had learned in school (“you have always gained from variable rates”, except the very recent period). I hope they listened, because they were quite worried that rates might rise again, from 12%!

The coming decade, 2015-25, we are due such an exception again, where fixed rates are better than variable. Do you dare to time your fixing? Early 2015, late 2015? 2016? 2017?

I wouldn’t buy stocks or more living space. A very short summary of the entire article and the consequences of ultra-low rates would be “This already happened“. As I said, the small increment lower doesn’t change anything much. Stocks (everywhere) and house prices (Sweden; they never fell in Sweden during the financial crisis) have already skyrocketed due to ultra-easy money.

Stocks: Guess what will happen when rates rise, when profits fall, when speculation loses its luster, when growth expectations crumble… Do you think stocks will rise or fall then? Once again, remember that stocks crashed more than -50%, twice, while the Fed kept lowering its policy rate.

Once speculation fades and stocks are seen as risky (potentially negative returns to the tune of -10-60%), then zero or even negative rates in risk-free instruments will be seen as superior investment alternatives. As John Hussman keeps telling his readers, the writing is already on the wall in that respect, as gauged by increased dispersion of market internals (yield spreads, stock sectors etc).

In other words, investors are becoming more and more anxious and any little thing can topple that first crucial domino that fells the rest.

Stocks overshoot, and stocks undershoot. Respect that cycle and use it to your advantage rather than the other way around.

Did you like the article, even find it useful? Share it with a friend and hit subscribe for future and off-site content (such as my oh-so-almost-ready-just-polishing-and-trimming-e-book about my 15 years at Futuris, the European Hedge Fund Of The Decade)

January 13, 2015February 17, 2015

Are you too ‘smart’ to short the market? Then do this

Unlike most smart investors, financial pundits, TV commentators…

…and not least my eloquent friends at Wall Street Playboys,…

I do time the stock market, and I don’t shy away from making my recommendations or investments public.

Right now every fiber in my body screams to short the stock market:

Risk aversion is on the rise (seen in general market dispersion, chaotic and nervous intraday patterns, loss of trend uniformity, increasing High Yield spreads) and any little event could topple that first crucial domino that sets off the rest. The whole market is nothing but an unstable pile of fingers of instability.
The rally is extremely long in the tooth and some robot traders could just as well take that as a cue to try the downside (NB: 80% of the trading is automated robot trading)
Oh, did I mention the US stock market is the most expensive it has ever been (on some measures, and just 10-20% below the epic peak of year 2000 on others)? Swedes hoping for a safe haven in dear old Stockholm should note that the OMX index usually mirrors the US indices perfectly in downturns, no matter if OMX lagged a little before.

The stock market in a nutshell (pic from Hussman)

Directly from Hussman, just as the picture above: The yellow shaded areas show points where credit spreads might be defined as “rising.” For simplicity, I’ve shaded all points where credit spreads had advanced 90 basis points from their 6-month low, and were greater than their 150-day moving average. Observe that the steepest losses we’ve observed in the S&P 500 in recent decades have been concentrated during those periods of objectively widening credit spreads. I’ll say this again: low and expanding risk premiums are the root of abrupt market losses.

The purple shading identifies only a subset of those points that also match the market return/risk profile that we currently observe (basically identifying recently overvalued, overbought, overbullish conditions that were then joined by deteriorating market internals or widening credit spreads).

But, I get it, you just don’t want to short the market. It seems immoral, dangerous, unnatural… You’d rather just wait for a good buying opportunity – and you don’t want your money to sit idly on a zero per cent bank account meanwhile.

You could copy my strategy, which is to slowly accumulate investments that have already become somewhat cheap (but, as always, risk becoming cheaper, much cheaper, further ahead) and trade others opportunistically (I like gold and currencies, since they don’t really have ‘intrinsic values’ like stocks. That makes it easier to disregard the dangers of picking unknown pennies in front of an unknown bulldozer)

So, what am I doing exactly? I mean, I have retired, I am officially a retarded hedge fund manager. I could live splendidly off of my capital for the rest of my life. However, as the retard I am, I want to prove that I am right. Just saying I said so afterward simply isn’t enough. I want to make some money too.

Except for my big short (which is waaaaay under water) on the Swedish stock market, this is what’s currently in my direct financial portfolio (except apartment, pension funds, private companies like the publishing company and the floating sauna company, russian art etc.)

Software as a service: A convertible loan and a sell option in a Human Resources software company – if things look okay, I’ll convert to shares and later use the sell option, if they look really good, I’ll convert and keep the shares for a while. If things turn really ugly, I’ll end up with a large mansion in the countryside
Cash at the bank (dry powder)
Loans to friends (not that dry gun powder, but perhaps I’ll get to call on these when the time comes – at least they stick to regular amortization schedules)
Gold (albeit “paper gold”) SPDR Gold shares ETF – gives me some USD exposure as well as some insurance against Yellen’s next move (+21% so far on this trade)
Gold mines (senior = actually producing gold) Market Vectors Gold Miners ETF – like above but with more juice (+24% on this trade so far)
USD 3x leverage – I halved my position in the USD yesterday (75% profit in a year) but still have a fair amount left. The Swedish Krona, SEK, usually falls in times of trouble. If China falters probably doubly so due to Sweden’s export dependency to Asia. The USD on the contrary, despite all its shortcomings, is the safe haven of first choice for most investors (incl. americans themselves selling foreign assets). The Fed might even consider raising rates this year which I can’t see any other central bank doing.

Smaller investments and speculative short-time bets (oil):

Creditsafe – small unlisted credit service company, provides credit quality information on companies and private individuals
Oil (Brent) 5x Leverage (entered today )
Peptonic medical – oxytocin pioneers (very small investment)
Opus – small investment (testing services and testing equipment mainly for the auto industry – hopefully a secular growth story, the share price has recently halved and that’s why I stepped in. However, the shares will likely fall a lot more before this is over)

My suggestion to you (except shorting stocks) is:

Invest in a business (your business perhaps?) or learning a skill
Keep cash ready for opportunistic buying in the case of a (flash) crash
Think outside your geographic region (stocks, currencies)
Slowly, slowly accumulate stocks that really excite you and have become forgotten by other investors that chase a shrinking pool of rising large caps
Consider buying things like gold or oil, but do your homework first, don’t just follow my lead