Thursday, December 26, 2013

Industry Risk Cycle

The rotation of stocks within an industry is as follows as taught by "option addict" found at ibankcoin and trading addicts.
My view is only a little bit different, but it is more complex and thus this method above is probably more practical. The most simple explanation is that sentiment moves from an extreme low to an extreme high and back and it manifest itself in various layers, but the layers get complicated due to different goals and size of capital needed to be moved. Rather than get into the complications right now I better explain this cycle first.
When you expect a rotation into an industry, you should understand there is a bit of an order that TENDS to occur as a result of the perception of risk and other factors. By knowing this tendency you can use it to anticipate movement and provide a bit more focus into a particular name and boost your results.

The market will usually be driven by a leader outperforming and then the trending momentum names will continue their charge strong. The rotation into momentum has a lot to do with liquidity and the largest players providing the positive equity and signalling a more long term sustainable rotation into the industry. This way the smart money can get ahead of the rotation that will take these mega institutions a lot longer to accumulate. The laggards are again an instance of the recognition that the industry will continue its rotation, and that those that lagged the move are relatively undervalued compared to how they were relatively valued before the rotation began. Also, there is a perception that laggards are riskier as those who buy it are more than likely going to have to wait on a loss before the return goes positive. Finally once you have the liquid laggards there is nothing left that hasn't really moved besides the companies that are perceived to be the kind you don't touch with a ten foot pole. Rather than chase these, the peddle goes to the floor as the buyers simply target the high short interest stocks. These are companies that people have been betting against but now as the tide has turned, the shorts will eventually have to cover in and if they get enough capital in there and trigger a short squeeze, they can simply CREATE liquidity through the short sellers margin calls and go for the big short squeezes. Finally, once everyone is starting to become convinced of the move, the short sellers will cover the names they have a profit in that they intended on shorting to zero (as a result of the margin call?) creating the bottom of the lowest quality names and also there will be some liquidity from the retail investor always predictably showing up late to the party chasing performance.

You'll notice that "liquidity" is a common theme I mentioned above. That is because my knowledge of WHY this occurs has a lot to do with my understanding of other principals that I use to infer an entirely new way to look at the cycle as a "liquidity cycle" within an industry and ultimately a more complicated look at the risk cycle. I will save this for another time.

Tuesday, December 24, 2013

The Anatomy of a Short Squeeze

In the stock market a short squeeze is a fantastic way to make wealth. SHORT squeezes are a situation where a large number of shares get caught short during a price move higher. As a result, many will potentially be forced into a margin call which means they have no choice but to either cover, send money, or raise funds elsewhere. This usually results in forced buying which can result in even higher prices and force even more short sellers to cover.

When it comes to a playing for a short squeeze there are two things you need to know:
1)The short squeeze potential of a stock (i.e. which stocks are most vulnerable to a short squeeze).
2)When a short squeeze is likely to occur in those stocks. (i.e what things can you look for to actually make a purchase in anticipation of a short squeeze).

Understanding the anatomy of the short squeeze is important, for it happens to some stocks more than the others and the underlying fundamentals don't really matter at this point. This article will discuss where it will occur and which stocks are most vulnerable to a short squeeze.

A stock that has zero short positions on cannot see a short squeeze. Stocks with a small number of shares cannot see much of one. So, you should be looking for a HIGH market cap of shares short as a percentage of market cap. You can actually estimate this reasonably accurately.
1)Go to finviz screener and make sure you have Market Cap, Short Float %, Shares Float % and filter it so you don't include any ETFs.
2)Click the "export" button and download the .csv or excel file.
3)Set up formulas.
Step 3 I must explain.

We need to calculate Market cap SHORT as a % of market cap. Float * % of float short * Price= MARKET CAP SHORT. Market cap short/ market cap= market cap short %.

The higher the number the more difficult it will be for all of them to simultaneously cover at current prices. For example, a market cap short % of 50% indicate that IF all those short had to cover at current prices, they would basically need HALF of all owners of the stock to sell to them. That is substantial because it is very unlikely half of the shares can be sold to them at current price. IF those holding refuse to sell, those short must offer a higher price until they can sell.

This gives huge potential power for a short squeeze the higher this number is.

Next we want to look at % of market cap that FLOATS= (Float * Price) / market cap.


The "FLOAT" represents the available shares that are actively traded as opposed to those held by insiders and institutions that HOLD. The fewer that FLOAT, the harder it is to accumulate shares and the more likely a buyer will have to pay a higher price if he wants in since the rest of the owners are likely to either hold or in some cases are FORCED to announce their sale well in advance. So not only if scarcity of shares FLOAT good, but if a large percentage of the float is short, that also signals that of the shares traded, a high percentage of them are short and thus will have difficulty covering.
So we want:
1)Market cap short % to be high
2)Short as a % of float high
3)Float as a % of market cap low

We can do a simple formula.
We want the numbers where HIGH is better in the numerator, and the small to be in the denominator. For those that skipped high school math that means we want market cap short % and short as a % of float divided by float as a % of market cap.
So
((Market cap short %+Short as a % of float)*.5)/Float as a % of market cap.
The higher the number the better.

Now I want to fix up this list and that means I have no patience for erroneous numbers. I will use the sort function in excel and eliminate these.
Things like market cap short over 100%, short as a % of float over 100% and float as a % of market cap over 100% or error messages for dividing by zero I delete. I also want to delete individual categories near the worst of that stat. For example the market cap short % I want to be around 5% or higher. The short as a % of float I want to be maybe 5-10% or higher. The float % as a market cap I want to be less than 90% (that represents at least 10% held between insiders, major owners and institutional holders). Then the final metric I will use as the determiner how to rank stock's short squeeze potential from there and get rid of the worst and focus on the start of that list.

This only tells you that ONCE a stock starts being bought aggressively AND the shorts start to cover that the potential for a short squeeze exists and is large. It does not give you any clue as to IF/WHEN this short squeeze will occur which is why it is also important to recognize and adjust.

With that being said here is a list of all those remaining with a formula that says they have a ratio equal to at least .15 or more.

ATLC
SCLN
SNTA
FMD
BTH
VRA
SWFT
SPWR
NQ
JAKK
JASO
CSUN
XONE
TTS
CALL
GTXI
SODA
AFSI
CAS
PHMD
EBIX
USNA
ANGI
TITN
RES
VHC
LQDT
NGVC
UNIS
ALJ
BRLI
WNR
TSLA
GMCR
MILL
SCTY
LF
WRLD
BONT
BBRY
CLNE
CLNT
PAMT
NEON
BKS
RATE
SPPI
IPGP
TEAR
PACW
IMAX
GNK
TPH
END
KIOR
KWK
VRNG
CONN
KBH
RVLT
MFRM
IOC
YGE
NLNK
Z
BKE
MITK
HOV
MELI
IRWD
TRIP
MOH
IPI
OPK
HLF
AFOP
MNKD
APP
ROIAK
CNS
MNI
GPRE
RBA
HXM
FRO
WPRT
DANG
CBZ
CHCI
ECHO
SA
IRDM
ETM
HGG
CAB
SUSS
WTI
VPRT
OLED
GOL
VCLK
SHLD
DLB
CCXI
AMRN
KNDI
MR
LULU
STSI
HK
CRR
JBLU
KEYW
EAC
MUX
PSUN
CVC
GTI
SZYM
QDEL
WBMD
ZUMZ
AXDX
ENPH
DGIT
MLNX
AMKR
TFM
RAX
USG
AXL
SVU
CNQR
ELLI
DHI
OSIR
ATRS
CWTR
DWA
MBLX
SIGA
AH
ARCO
MANT
BPZ
SOL
FWM
SD
HNSN
FSLR
GRMN
SAM
BYD
MACK
PRLB
MEET
YELP
FRP
CCBG
MTZ
AKRX
PATH
IMH
GLNG
AMRI

Wednesday, December 18, 2013

Individual Stock Selection Trend Trades and Investments

For trend trades and indivudal investments I want a sector theme that makes sense with my understanding of risk and an industry that makes sense as well. So I will look through the sector "basic materials" and look for industries within it that have done well. These are likely the "leading industries" as we are anticipating a rotation. However, it is important to understand that often times those that peaked first and have performed the worst will eventually lead and often times really early in the rotation.

In this case, "chemicals" are vaguely in the materials sector and have performed the best.
http://finviz.com/screener.ashx?v=111&f=ind_specialtychemicals
http://www.barchart.com/stocks/sectors/-CHES?f=ind
And I look on a weekly chart this time
http://finviz.com/screener.ashx?v=211&f=ind_specialtychemicals&ta=0&p=w&o=-marketcap

I see an established trend by many names. I believe a lot of the momentum names have had their runs as well. But If I am right about the rotation into the space, I want laggards on a weekly basis. These are ones that should be near support and more of a sideways trend than vertical. I also want medium risk names so not the lowest beta and highest market cap. This isn't an exact science here and involves more of an "art" in assessing risk tolerance of the masses, so I may also be interested in looking at more severe laggards (those in more of a downtrend to sideways trend) and "potential short squeezes" . Technical analysis still matters but it's much different when you are anticipatory and trying to pick a bottom. If you pick a bottom you are looking for a consolidation and accepting of price. The only "severe laggard" I really like is HWKN. There are plenty of other what I would consider "laggards" because they are near a trendline and showing a temporary pause in an uptrend and near support. But I would lean towards the earlier stages of the rotation as a sector, even if specialty chemicals are really more likely to be among the early stages of the rotation and thus that particular industry may be in it's mid stages.

SHW,SXT,KRO,HWKN. If I choose one of those names I may keep an eye on some of the higher risk short squeezes and high risk small and micro cap stocks.

I will also glance at the monthly chart. If I am willing to do some more due diligence into the fundamentals of the company, I really love the looks of HWKN and KRO on the monthly chart. I would really have to determine whether or not I think Specialty chemicals as an industry could be likely to pan out for a significant length of time as well.

Also keep in mind that this type of analysis applies to all different ways to slice up a market. For example, you might identify that Technology is ready, specifically search engines are ready for some quality and momentum names while simultaneously China is looking like it is receiving a rotation of capital and ready to rotate into quality and momentum. BIDU at that point may be the best of all worlds and could possibly receive multiple inflows of capital. Your odds go way up that Bidu will be the recipiant of one of those flows of capital and if it is all it could skyrocket quickly.

So, now you know a methodology towards selecting individual stocks while being mindful of the big picture, the next step is knowing how to properly manage a trade and analyze risks/rewards.

Individual Stock Selection - Swing Trades

There are many layers that go into individual stock selection.
I like to be in the right sector, and from there identify some of the best industries and from there, identify the right stocks within the industry. I like to be anticipatory rather than a trend follower, but at the same time, I still need to see the initiative strength out of a sector/industry.

The sector analysis is about recognizing the sector rotation that goes on long term and really trying to identify where we are in the cycle, and what's next. I believe we have seen industrials rise and thus should see some material related as the next to move followed by energy.

I also believe at looking which individual industries are hot as information that can be useful on it's own, but can also confirm a sector rotational theme.
http://www.barchart.com/stocks/sectors/industry.php

This cycle is all about a rotation in sentiment of "risk" and actually goes through somewhat of a predictable cycle that is "fractal" and overlaps on many time frames. For example within one large wave there are a few sub-waves which have their own set of sub-waves.
The engine of the economy is the banks that lend, that allow transportation companies to transport the needed raw commodities, that allow companies to run that get the industrials going that allow energy and raw material businesses to work off their excess inventories and start growing and producing profit, and the profit of those businesses first fuel a boom in demand for raw commodities as maximum business activity takes place creating an over saturation in business, an eventual oversaturation in energy prices (which lag the rest of the economy) and then capital rotates into defensive names that isn't as correlated with the economy and that can produce when the economy is bad. So you have staples, drugs, and utilities and finally the financials lead again.
This cycle makes no sense until you understand the WHY it occurs and it occurs because of how the economy functions and how capital moves according to their tolerance for risk and outlook for the economy.

The same rotation of risk happens within individual industries although since there are hundreds of industries it is difficult in really developing an understanding of the rotation. I can tell you though that many industries will lead well ahead of the broad sector rotation either because of their ability to grow quickly as a small industry, or as a real leader and more stable idea in the field. Within the industries you also have a rotation among individual stocks according to the same concept of outlook and risk.

The cool thing is, that you can select names as a trend trader looking at a weekly chart to trade the trend at support and get the full scope of the rotation of large institutional funds (or monthly and get the rotation of the pension funds, sovereign wealth funds and largest mutual funds). But you can also look at the daily chart and recognize the wave like nature as these same institutions look to accumulate a position in a particular orderly fashion that while ultimately could take weeks, could have predictable 3-5 day swings upwards, followed by a pause for a couple weeks.

The thing to really understand is that which particular stocks the mutual funds and all others will get a position in also depends upon their appetite for risk. They will NOT start buying the first stock in an industry they see, but instead are not going to immediately start buying the stocks that are declining because they don't want to sit through declining accounts while they wait for it to catch on. Instead they will pick the stuff that is liquid. If their thesis and rotation into the industry, sector, or stock is wrong, they want something they can get out of. If they are going to wait on it they probably will want a dividend yield, and they want a stock that has some relative strength.

The primary line of thinking when you first rotate into the sector/industry or the market is first just shorts that cover and decide to take profits and look elsewhere, along with contrarians and deep value investors that represent the minority. This will set up conditions where some of the higher quality companies typically will begin to form it's first bottom and a higher low in which NOW the major mutual funds and such can actually begin to consider a rotation into quality first. But they are thinking about preservation of capital and it is really not their primary investing thesis right away. So they are not at all aggressive. They want strong fundamentals and technicals in high market cap companies with a dividend yield. IF some of those stocks start doing well, THEN they might look for some of the higher risk momentum names that can trend for weeks and that may be a bit over extended and may be considered more vulnerable. It is now when the "chase" mentality in the industry kicks in IF the thesis works. If everyone else begins to follow through and position into the sector, their will suddenly be an appetite for risk in the industry and this causes some stocks to take off that are capable of producing more substantial returns.  Ahead of this, the SMART money decides to look for the bargains. This is followed by the rest of the money managers wanting to get in the industry but not dumb enough to chase. As a result they begin to find anything that isn't moving yet that has lagged. The buying frenzy really begins to kick off in the industry and the thesis is more widely recognized. At this point the shorts get nervous and the aggressive investors and traders smell blood. They go after the stocks that have large short positions,thin float, and large short as a percentage of the overall float as they recognize it is only a matter of time before some of the shorts will have to cover. When they do, they will be forced in many cases to buy at the market and push prices much higher. The short squeeze is capable of even more dramatic returns, and the appetite for risk represennts the market going into even that which some "smart money" is actually or has been bearish on. This starts to become slightly "irrational" at this point, but is not without it's reasons.

Finally, the riskiest stocks start taking off. The bankrupt, penny stocks. Desperate buying and short covering takes place and the speculation of buyouts. When the buyouts on a large scale start occuring and the penny stocks start rocketing higher, be ready for a correction on whatever time frame you are observing this cycle. Get into the defensive names in the sector, if any at all. Many mutual funds want to be diversified and thus want to remain in the sector but will reduce their size and rotate into real defensive names. Then if the industry is to get going again, it will start with the quality and start over. If not, it could enter an industry/sector bear market.

The other col thing is that you can look at this sector and apply it to an individual industry, or you can look at the market as a whole as going through this process if you want a wider view and to look for "short squeezes".

Also, there is a more simple rotation into and out of risk that can often be measured at looking at the relative daily and multiday performance between the dow/S&P (quality, lower risk) vs the nasdaq and russel (growth, higher risk), and look for divergences. This gives you a clue as to where the rotation will take place, into risk and stocks, or not.
----------------------------------------------------------

So the hottest industry right now according to barchart is solar which does correspond somewhat well to the eventual sector rotation into energy as it is alternative energy and is more about the industry being small and having long term potential to become a more dominant player in the sector than it is about large and liquid. As a result, I may be less likely to use this as a reason to rotate into the sector, and more willing to look at it as taking a swing at a hot industry with potential and large moves being made, by identifying select individual stocks according to the cycle..
So we can look at this particular industry more in depth.
I like reinforcement by another site, so I will take this list from barchart:
http://www.barchart.com/stocks/sectors/-SOLA?f=ind

and plug it into finviz
http://finviz.com/screener.ashx?v=111&t=CSIQ,JKS,CSUN,SCTY,SPWR,TSL,SOL,YGE,FSLR,JASO,ENPH,FNRG,LDK,RSOL,STRI
I can see that many of these have different industries listed, but most are in the "specialized semiconductor space".
I will set those that are not aside and take a look at the industry.
http://finviz.com/screener.ashx?v=111&f=ind_semiconductorspecialized
So if I want to be thorough, I can compile a list of these and combine it with the others above and get a list which I like to sort by market cap to help identify where in the risk cycle we are.
http://finviz.com/screener.ashx?v=151&t=ACTS,ALTR,AOSL,ARMH,ASTI,CEVA,CRUS,CSIQ,CSUN,DSTI,ENPH,FNRG,FSLR,GTAT,HIMX,HSOL,IXYS,JASO,JKS,LDK,LLTC,LSCC,LSI,MCHP,MPWR,MX,NVDA,NVEC,RSOL,SCTY,SIGM,SLAB,SOL,SPWR,STRI,TSL,UCTT,VIMC,YGE&o=-marketcap

From here, I manually scan the charts.
In this case, I can also look at the solar ETFs for a broad look at the industry. Recently, there has been a pullback in the sector on a swing trading basis. There are plenty of individual "quality" names that are strong, and a few that have yet to move. I put my focus on that. I look for quality technical setups as well, and I also am willing to consider momentum names while also paying attention to laggards and short interest in the back of my mind for the next potential play afterwards.
So FSLR,SCTY are good plays YGE was a couple days ago but has started to move since then. CSIQ is not bad but has already moved quite a bit longer term and I think there are better setups for now, yet if it works sideways a bit longer could work.  After that I might be ready to try to pick a bottom in some of the laggards which will likely have better setups by then.

So Now I add FSLR and SCTY to my list and then move onto the next sector. Once I have a large list I may decide to filter it down a bit.

If I was looking at solars for a longer term play to get ahead of a sector rotation? Well, we will cover that later.



Thursday, October 24, 2013

Optomizing A Rebalance Strategy Using Seasonals and Rebalancing period

In a hypothetical market Claude Shannon once proved that by rebalancing at an "equilibrium" of 50% cash, 50% stocks, you could profit because of volatility even in a random market.
Yet realistically we can improve upon this model by looking at the long term upward drift expectations and rebalancing period. In real life fees may become an issue, but only if volatility is not great enough. Depending upon account size and size of fees, you may want to occasionally not rebalance unless the move is great enough, and you may also want to adjust the rebalancing period.

For example, on a typical day the market on average goes up about 52% of the time after adjusting it so all up days are equal to down days. In other words, your adjusted "edge" during "average" conditions historically has been 52% and as a result, you can position such that you have 52% in stock, and 48% in cash and rebalance daily. However, if your "rebalancing period" was more frequent, you should position much closer to 50%, and if it was less frequent, you should rebalance more often. But how much exactly?

Typical market

Rebalance
Daily 52%
Weekly 54%
Monthly 56%
Quarterly 58%
Yearly 62%
3years 68%
5years 72%

November1st - April30th period
Daily 54%
Weekly 57%
Monthly 61%
Quarterly 66%
--------
Since the period lasts 6 months there is no "yearly" re-balancing period. Yet, for comparison purposes only I ran the calculations anyways.
Yearly 74%
3years 83%
5years 88%

The May1-Oct31 period is close enough to a 50% proposition that I didn't bother calculating it.

Please note, I assumed a 5 day trading week and a 4 week trading month when making calculations and rounded to nearest percent. I also believe there was an improper calculation when using a 4 day period since I took all events that were up PLUS only HALF that were "flat" as I wasn't sure how to calculate this. Also, these number potentially are slightly generous due to every 1% loss requiring 1.01% gain to get back to even over a long period of time that may matter, however I was conservative in estimating 4 week trading month rather than 4.28.


A table if you prefer your data in this manner:


Table daily weekly monthly quarterly yearly 3yr 5yr
November1-April30 50% 50% 50% 50% 50% 50% 50%
typical market 52% 54% 56% 58% 62% 68% 72%
May1-October31 54% 57% 61% 66% 74% 83% 88%
Strong Market 56% 61% 66% 74% 83% 92% 96%
Very Strong Market 58% 65% 71% 80% 90% 97% 99%
Super Strong Market 60% 68% 76% 86% 94% 99% 100%

I draw the line at 50% because the ideal way to play less than 50% probability of an upward move is either all cash, or even short plus cash which is much more complicated due to margin costs, and risks of ruin.


Commodities:
The probability of commodities outperforming stocks changes seasonally as well, but I don't have data available for far enough back to determine this easily. The data I found only goes back to 1992 and 11 data points per month, or even broken up into a 6 month period providing 66 data points is not all that statistically significant. Even if it were, there is a vast difference in correlation between base metals, rare earth and precious metals, agriculture, and energy commodities where in stocks the correlation between broad sectors is actually still very high. As such, the primary role of commodities for now is just providing reduced correlation to the portfolio, and individual commodities should be assessed according to expectations based upon success rate of indicators in specific conditions.

Really that's how all things should be evaluated and weighted according to confidence with excess income and cash for rebalancing, opportunity costs, stability and reduced volatility.... However the above table helps put a number on it and illustrates the importance of knowing your re-balancing period.

Wednesday, October 23, 2013

Adaptive Elastic Portfolio Management

Have too much risk in any one area and you are vulnerable to more substantial decline because you are vulnerable to a large potential draw down. Below is the loss and corresponding gain required to get back to even.
 
loss required gain to break even
1.0% 1.01%
2.0% 2.04%
3.0% 3.09%
5.0% 5.26%
10.0% 11.11%
15.0% 17.65%
20.0% 25.00%
30.0% 42.86%
40.0% 66.67%
50.0% 100.00%
60.0% 150.00%
70.0% 233.33%
80.0% 400.00%
90.0% 900.00%
95.0% 1900.00%
97.0% 3233.33%
99.0% 9900.00%
99.9% 99900.00%

The more concentrated the portfolio, the greater the risks of consequences of an individual stock decline. But selling short of the target or reducing is not a goos strategy either as it can turn a winning strategy into a losing one as you fail to give your winners room to run. A strategy that is continuously adjusted to maintain the optimal allocation is best.

If we never made adjustments to the dollar amount in our portfolio and just let the long term position grow, then the long term trades would grow and then either finally reach a sell signal, or you would be forced to rebalance, OR they would continue the growth until they eventually composed the entire portfolio.


The amount of risk would increase beyond intended amounts as the positions grew, OR the alternative of selling positions before their targets compromises your otherwise profitable, low volatility strategy, strategy making it very dangerous to have this strategy.


Short term positions suffer the same risks of substantial draw downs of your portfolio, not because size eventually gets too large, but instead because the risk/reward ratios of investments and longer term trades are usually much better (at expense to compounded return and available liquidity to adjust.) The ideal adjustments are to maintain the overall level of "risk" without selling anything "early", and only using the allocation towards stocks as the adjustment.

Short term trading provides thinner profit margins, but more volume. in other words, less per trade, and more risk that small mistakes each trade can make a strategy unprofitable but potentially much more per year. Long term trades have a higher reward to risk but take longer, tie up more capital in a position with lower annually compounded results, and provide less liquidity for making adjustments.

BUT... the combination of short term trades and allocation model in addition to cash, income and potential hedges COMBINED with your long term positions you will produce much more frequent cash inflows from quick trades, and that will allow itself to be distributed among all assets making rebalancing more efficient, more frequent, and your portfolio to only make minor changes. That would cause the rest of your portfolio to grow so that the long term never gets to be too large and the desired balance can be maintained. The positions of each portion complement the other parts of the portfolio.


The result is a reduced need to adjust your portfolio allocation and reduce it to maintain balance of risk, increased overall balance, and better, more stable results.


The allocation to stocks can adapt and adjust to displace the overall amount of risk towards stocks. Short term trades don't last enough to offset the balance, but if you are concerned you may take on short term hedges. For this model we will ignore short term hedging and only focus on a portion of cash on the side either being active as a intermediate term hedge or not.


As long term position grows
http://cdn.makeagif.com/media/10-23-2013/GCLaKV.gif
As long term positions contracts
As you can see, such a strategy keeps the other positions stable and overall keeps the strategy at the optimal risk according to your goals at all times. Over many trades, there will be many minor and major adjustments that develop as portfolio changes, but this strategy is elastic enough to adapt to various conditions and maintain the desired composition without selling early.

Tuesday, October 15, 2013

Acheiving a goal at Minimum Risk

A given strategy has an entire set of expectations and probabilities of those specific expectations. This along with how much you risk per trade, and the average time per trade (how many trades per year) will determine whether or not you reach your goal, and with how much volatility and risk. Over the short run, luck can certainly play a role which is why you might look for a 10 year goal based upon 10 years worth of compounding at your expected return.

Your goal should aim a little bit higher since these are only "expectations", and then aim at reducing the risk to get to that goal. There are limits to any strategy so your goal has to be something that is mathematically reasonable based upon a long enough sample size of your past history with this model. Any "backtesting" method may show you great returns, but until you also take what worked in the past and see if it continues to work as effectively as it did when you backtested it you simply don't know, and even then it may not work as good in the future and is not without potentially substantial "unknown" (black swan) risks such as a 1987 event. Some common sense and respecting that the possibility for an even greater decline than the 1987 crash in a very short period of time exist, however rare.

If your goal is realistic the next step is minimizing the risk. The best way to do this is determine at what point can you reduce the amount risked and still achieve the goal?

You do this with multiple bets at a low correlation until the point where adding any more bets or reducing the bet size becomes harmful to your return due to the fees making a greater percentage of the trade. Also, each trade should have a slightly lower expectation than the best available trade even though due to uncertainty the first few trades there may not be much difference..

With everyone's bankroll they will have to adjust. You can review your 10 year strategy every year and make adjustments, but by looking 10 years into the future, you seek to minimize your risk and work on a goal that works without being unrealistic and also while understanding that each year at a time you may be on or off track.

This sounds all nice in theory but the actual calculation involving both fees, probabilities, percentage ROI given those probabilities, bankroll size, variability of bankroll over time, changing dynamics of the non-linear system known as the stock market (which may effect your expectations) and money management strategies over time appear to be a nightmare of a calculation.

Fortunately taking things one step at a time and adjusting the spreadsheet over time I believe I will accomplish the construction of this tool. I am very excited to see how it integrates a large bet size meaning a small fee, and more bets at a lower correlation adding to the effectiveness of the trade at various bankroll sizes.

At what point can one no longer "diversify" without reduced long term growth than if they concentrated their portfolio into one bet with the rest in cash? Or perhaps 2 or 3 or 4? This will be real fun to work with because I can come up with some very interesting conclusions about just how much one needs to get started.

Of course, not everyone will be experienced to have the kind of edges I am tinkering with, or the ability to leverage via options or the mental and emotional composure to handle the swings or monitor multiple trades. And reality just doesn't always work out as well as theory. If people just ran with the system completely and totally and managed their money properly every single time they might be able to achieve those kind of results but it simply isn't reality. Everyone wants to bet more after they've won 3 or 4 or 5 in a row.There are psychological reasons people make mistakes and eliminating all of those is a series of several long posts just to scratch the surface and requires the development of discipline on your own.

Most everyone is afraid to risk as much after 4 or 5 losses in a row while some people even risk more than they should after a few losses. Everyone comes across something that convinces them to do something else than their strategy. There may be a few exceptions to some of these statements and perhaps there even are some traders where none of this applies, but it is extremely rare if it exists and most of the people who believe "they're different" are exactly the ones to be humbled by the market the hardest.

But I believe I can take what I know with regards to the spreadsheet and my trading and apply it. And If I can do it, certainly that gives hope to those just starting who are using excuses such as "I don't have enough money" to get started. Certainly the spreadsheet and knowledge that it works in simulation even after some hardships can be helpful.

Also, I must mention that I am not the only one who has proven being low funded isn't something that will prevent you from success entirely. Dan Shy aka Airelon over at investorandtrader.blogspot and nononsensetrading.com has achieved a few "challenges" such as starting with a very small account and adding very minimal capital and achieved success growing account.

Once I complete my spreadsheet, I will be aiming for the moon in returns with a very small account, with minimal volatility to aim for that goal to show not only is starting small possible, but the "big returns" that are reserved for the elite traders are still possible.

I may be overreaching my own abilities and experience here, but I will construct a challenge intended on stretching me and getting me to really focus down on what I can do.

Just an idea what I think I may aim for is a 20% return with $1000 without violating kelly criterion strategy based upon expectations that are at least somewhat realistic. I plan on turning a lot of heads. Maybe I will aim for larger with more capital at risk, I don't know yet.

The big problem is the difference between that strategy having that kind of success and failing miserably is really a fine line. if you have $7 per trade it's $14 to both buy and sell and thus with bet size of say $400 thats 3.50%. That just isn't going to fly because you have winners and losers and it hurts you on both. Averaging 3.5% per trade just doesn't work. So for starters I need $5 commission or less. (possible). Then $10/$400 is only 2.5% and that I can deal with. But if I run a strategy where I gain around 3.% average per trade that turns out to be 1% But I could only afford to do 2 trades at once which would probably be too much anyways. With 1% per trade the volatility makes it worse and the fact I will be using 40% of my portfolio means it will even be less. maybe .2% per trade with a trade a week will be 10.5%. To generate the other 10% I really will have to work some magic. Part of the process will be improved if I get some gains because the fees will be less (but it can go the other way and get to the point of not even being worth the bet).

I may be better off using options, but if I am spending $5 per option contract of say $.50 that's $50 per option contract plus $10 fee or it requires 20% gain per trade. Well if I use 2 contracts I get that down to 10%. With leverage, is it even possible with a small amount to make up the fees at a smaller cost? It may be. I really have to crunch the numbers. The numbers are going to give me the revelations that I need to determine the exact challenge once I am ready with all the spreadsheets I want to have. This will determine the strategy and allow me to maximize it. I can run expectation on trade one and continue on trade two, but keep in mind every individual trade could go one of two ways leading to possibilities that the fees really hinder me if I get a few losses. Especialy if I am trading short term rather than looking for some bigger gains. I am not quite sure what the ideal play is to grow my account but I will figure it out at some point.

Ultimately once you determine the "goal" your idea should be to maximize your chances and minimize your risks while still doing the minimum to obtain that goal. You may fall short, but it's much better than doing too much and potentially falling way short or even losing as a result of being overly aggressive.

A Sneak Peak Into My Money Management Spreadsheet

This is my spreadsheet set to help manage your money and correlation and to adjust for fees given a specific strategy with certain expectations.
My spreadsheet going forward will focus on that.


The data is based upon a leveraged trade with lots of time value following the best trader I know. I have a LOT of work before the spreadsheet is ready to simulate a sequence of all possible outcomes and determine the probability of achieving a certain result after "X" number of trades. For now it just gives you "expected return" but if it says a return of 100% after 50 trades, it could easily be a somewhat small to moderate chance of being up dramatically such as 1000% and a very strong chance of being down slightly. If you plan on preparing for retirement in 5 years, you would want to maximize the chance you can achieve a certain result in those 5 years... Or perhaps reduce chance of falling under a certain amount if you are close to, or in retirement, as opposed to maximizing your return. Not even someone in their 20s is likely to live forever and they will have a time when they plan to retire. The maximization of return is thus not as valuable as maximizing the probability of achieving a certain threshold by retirement date.

For now the spreadsheet is exciting because it can still draw powerful conclusions based upon data, particularly for someone with a lot of time. For those that understand the nature of the kelly criterion, they can still seek a very powerful advantage by using it to achieve their objectives of lower risk and more bets, provided the return is still acceptable after accounting for fees. Some early conclusions? If you are doing a "stock trade" with a $5000 account, you probably want only 2-3 trades at once with about 40-60% of capital on the side in cash. This is a very aggressive strategy, but fees are very detrimental.  Doing only 1 trade at a time risking maybe 30-35% of your bankroll is probably a bit safer since less capital is at risk, but not by much since you are so leveraged to that one trade's outcome. Even if you have $50,000 in a stock portfolio the above shows you still shouldn't really have more than 5 names. This was the shocking information that really made me rethink everything.

However, further analysis also shows that risking significantly less capital is better than risking slightly more than suggested Until I come up with a way to simulate a ton of trades in a short period of time and draw conclusions quickly about position sizing and probability of certain results I won't be able to verify any of this though.

Gold Bulls Are Misguided, Gold Bears are Getting Crazy

The bearish calls for gold and silver are getting more and more ridiculous the more it falls, while the past ones are validated... Well if gold $1400 was right then $1200 must be. Well if $1200 is here, then it will first go to $1000 then $800 then $600. And "Can't wait until silver is $5". On the other hand, the fact is, we still have not had the type of sentiment you would expect at a bottom either.

This type of ridiculous bearishness coupled with the bulls not figuring out yet either means we probably will stay quite range bound at some point for a significant period of time. I do have a feeling we will find the "low" of the range. The gold bulls have it all wrong on the REASON to own gold as money was FIAT since the 70s, the dollar declined 50% from 1987-1985 and the money supply tripled from 1980-2000 yet from then gold went into a major bear market Their wild stories scare the regular non paranoid person who does his research and sees the type of insanity in the market and calls for hyperinflation and just factually inaccurate statements. They end up preaching to the choir repeating their "facts" over and over again even as interest rates rise and gold falls.

I think the advantages of owning gold are more about correlation and a hedge against events that cause global political uncertainty. The gold-tlt-spy-cash portfolio has been proven to work with low volatility and higher returns in the past. You can substitute oil, or silver for gld and EEM for SPY and UUP for TLT or whatever and still see great results over time. This has been discussed and will continue to be mentioned for advantages of repetition. It's the low correlation that means one asset or the other is going to offer either a great buying or selling opportunity. Even if you can't learn to recognize them, merely by rebalancing high and/or low and selling and reducing the overall dollar amount of the shares that are high and increasing those that are low to maintain the same percentage holdings will work to benefit from all markets over time. Although such a strategy calls for "equal weighting" I would be more likely to call for weighting that adjusts according to outlook. This way you aren't "timing" the market, but are increasing position to accord with your outlook. I would have minimum limit of 10% in a portfolio of 4 and maximum of 40% with few (if any) exceptions. This way you have the wiggle room. Typically you should adjust according to performance relative to history. You can measure all the bull runs of the past and see where the average trough to peak run was. The "average" represents 25% invested the low represents 40% invested and a record high run-up represents 10% invested. This is just another of many ways to buy low and sell high. It is much better than completely liquidating (unless you are trading with tighter stops which should be separate from your investing account. As you learn to market time, you can shift your allocations slightly, while still protecting you against the possibility of being wrong.

Thursday, October 10, 2013

Capital Rotation


When I discussed how Capital Rotates, I merely wanted to illustrate conceptually how it worked but I am still not at the point where I can easily explain how to implement it. Ultimately coming up with my strategy has taken years and years of experience, and it is only what I found works for me. However, it is based upon sound mathematics, statistics, game theory and understanding of perception.


But in terms of understanding the capital flows I want to illustrate this as simply as possible, so I will use a few images rather than thousands of words.

Capital must flow because there is debt which must be paid back, plus interest. To keep economy going new debt must replace old as new loans provide capital in excess of the principal plus interests. That capital will move around to try to generate a return.


As capital rotates, it may at any given time concentrate too heavily into one area. If you compare 2 assets you can see at various points in history relative extremes are reached. Although in the intermediate run this can be entirely rational because of expectations of growth, the credit cycle dictates that at some point all debt has to be paid back and cannot sustain an increasing velocity forever without a pause. As such, there are relative extremes.

It is not just bonds and stocks that capital rotate between, you can see that relative extremes in valuation between stocks and their earnings and housing and their yield that also create extreme that provides opportunity and thus creates a "cycle" or "wave".

Because of capital rotation, there is a cycle of individual companies and industries or even sectors. Startups usually will start negative earnings and then start to improve. Expectation often drives price so changes in earnings and surprises can create a cycle. As companies continue to beat the expectation is that they will beat until eventually they miss and cannot push growth any more.

 The nature of fund managers is such that they will have to try to beat a bench mark to keep their job, and as a result ultimately will have to take more risks.


 You can outperform by identifying the "outliers" and acting accordingly.
 An Understanding of "equilibrium" and game theory can help.
 An understanding of "exploitative strategy" rather than equilibrium can help find the proper "value weighting" to increase returns at less risk. In effect, greater position sizes to the greatest outliers.


The sectors rotate and various companies do better or worse depending upon interest rates and the international interest (strength in dollar). This creates a rotation among sectors and sometimes industires.




The risk cycle can help you to position accordingly and help to identify the part of a swing low or high cycle in the market as a whole and/or the particular sector or industry.

The cycles are usually "P Waves" as there isn't necessarily a specific consistent timing element to them, however they still follow an orderly process, reach extremes and continue. In other words, you can "game" the cycle if you know what happened last and you can predict what should happen next, even if the timing won't always be an exact fixed number of days until the next part of the cycle.




The strategy should be to try to get ahead of the rotation and as a particular part of the cycle is starting to come from "in phase" to "out of phase", you then take that particular area off. As it rotates, you anticipate the next phase and continue this throughout the cycle.

Since there are so many different types of cycle happening it can seem a bit complex but the concept is the same. Focus on a particular sector a bit more often and with a bit larger allocation on your trades. Or pick long term investments that are held over a longer cycle, as you trade over the shorter swing cycle. The allocation towards stocks and risk also will come into and out of phase and you must be able to have strategies that can have more aggressive allocation in time periods such as 1990s-2000. Then as you approach 2000 you begin to lower your allocation, increase your hedges, increase your allocation to gold. As the market declines into 2002 and 2003 then you increase your allocation and then decrease it into 2006 and 2007 and begin to hedge and rotate/increase allocation to energy and then as energy starts to go, you take that off, and start to bet against it as a hedge, close your hedges in the S&P and begin to look at getting long the financials specifically.

Of course, you aren't going to get it right that easily when you are in the middle of it, many of that can only be entirely clear in hindsight, but you can at least understand the cycles and recognize what is going on on various timeframes.

Since anticipating these moves will at times be costly particularly buying the banks in late 2008 before the market actually bottomed, you should be diversified among multiple asset classes, understand position sizing concepts, and most importantly SURVIVE long enough to stay in the assets before and after they go up and get out before they go down. This way, bonds and cash and the dollar increase in value during the worst parts of 2008 which can help insulate you a bit from losses and provide opportunities.

My strategy is to understand asset allocation and game theory and use it appropriately either with "equilibrium" or a balanced "exploitative" strategy



And also have strategies where individual long positions are expected to gain even in down markets, and individual short positions that are expected to gain even in up markets. These won't be very profitable or easy to find, but the basic strategy is to primarily be long in an up market with bearish bets on specific stocks only as a hedge to protect you while providing potential to gain and stability of your account.

Overall the strategy every where from:
1)Grabbing individual short term positions
2)Grabbing individual long term positions
3)Selecting individual hedges
4)Selecting individual asset allocation ETF plays
5)Selecting time and strike price and buy points
6)Knowing how much to allocate to the "baseline strategy"
7)Knowing when to deviate from "baseline strategy"
8)Knowing How much to deviate from "baseline"
9)Knowing how large of position on each individual position to apply
10)Knowing when and how much to adjust those position sizes.
11)Knowing WHEN you deviate, what else to change in order to achieve a safe and profitable balance overall

Must be understood and implemented. The actual "specifics" must also be determined and used to generate a maximally profitable return on your risk, of which, the risk/position size/allocations should be adjusted to help you achieve your goals the meet the returns you want at a volatility you are comfortable with.

That's all I have to say for now.

Wednesday, October 9, 2013

Understanding How Capital Rotates

This shall be one of the greatest posts and most important posts that I have made on this blog so pay attention. It will be a guideline for how you can anticipate and get in front of major market moves and produce significant gains.

Capital Rotates according to sentiment and risk. The market basically is a set of financial decisions in the long run driven in the short run by emotions and the long run by certain wants and needs.

Emotion can bee seen by investors, trend traders, swing traders, or even day traders if you learn to "see the code".

From Justin Mamis "Nature of Risk"

This is the cycle that markets go through. What cannot be seen is how this manifests in the particular sector selection, industry selection, or individual stock selection... but I assure you, it's there.
So it looks a little like this:
I would add in "reduce or take hedges off" somewhere in the range after defensive to just after quality. Then I would add in "put on hedges" somewhere in the range of just before "floaters" to just after "defensive".

The thing I noticed is near the oil peak where oil hit 140 a barrel, that all these no name trashy stocks came out of nowhere to produce multiple hundreds of percentage points of gain. That along with the teachings of many, particularly the "option addict" helped me to realize this was actually quite normal and is about the risk appetite the market takes which occurs in a predictable cycle. To vaguely paraphrase Niccolò Machiavelli, history repeats because the passions of man go through the same cycles of emotion.

I learned to go beyond and "see" that not only did individually assets go through this type of phase where the worst of the stocks performed the best near the end, but that it had an entire cycle that was predictable and "fractal".  Even in larger cycles a similar concept occurs and you can equate what's happening to "emotion". Fundamentals also change so the perception of "what is quality" may change as well but this process of shifting up the "risk" ladder can be phrased in a number of ways.

See, the experienced traders recognize that they personally as well as many others have a certain tolerance for sitting in names that aren't moving and so what they will do and what institutions will do is when the market is beaten down and they want to try to pick a bottom, they will only go with the names where "quality" has started to form. That means low beta, lots of support, strong fundamentals, strong trend, strong dividend, mega market cap and so on. IF the market sticks and the stock sticks and a higher low is made (in the discouragement phase), then they might go after the high growth and momentum stocks that can really run for weeks. Then if they suspect "aversion" they will want to be in the stocks that can take a hit or already have. That means those that are already at great valuations, but have been neglected. Once those start to take off and market is in a full confirmed uptrend they have confidence and the bears are weak. So they are going to attack the high short interest plays to try to squeeze the shorts out and force them to buy back their shares to "cover" which will send stocks even higher. Now when the short squeezes have taken off, that puts you in "returning confidence" and  even euphoria. That is when I would start to add in "hedge" into the equation.

At that point, there is no other place to attack except for the very small market cap delisted stocks or those on the path to being delisted that have basically the worst relative strength but maybe have consolidated near their lows. They might be the over the counter penny stocks and stocks under $10, but they also might just be a stock like JCP or some of the gold miners under $10 which have chronically underperformed for years. Much different then the laggard which has yet to go, but on a long term basis still hasn't been in constant decline. These stocks are more illiquid, but with the major upswing EVERYONE wants in on the rotation of capital and the next phase is to sell to the average joe on the sideline who gets caught on the mania and will buy any "hot stock tip" of a very bad investment. So they buy up all they can of anything and everything, and with a market cap that small it doesn't take much to cause it to double in price.

Once the "turd" stocks start hitting new 52 week highs and really taking off and moving 15% or more in a day, that is when you have to be careful, because everyone who wants to buy finally buys even at ridiculous prices and that is when you get the "rug pull" so switching to "defensive" names that you can sit in for years such as coca-cola and wall-mart and other dow stocks start to be a place you may want to consider, if not cash and bonds.

For the most part institutions drive capital flows among sectors and industries, if they are not blind sided by an even larger international mega institution that take an entire ASSET class rotation approach (think global governments, sovereign wealth funds central banks and perhaps even the primary dealers). The institutions are required to beat benchmarks to keep their job and will have to go with what's working. They do not have time to stick with the undervalued laggards that has not began an uptrend unless market is taking off. They won't stand in the way of heavily shorted names unless the market is really breaking out and they know the shorts are as good as dead and will soon be forced out if the rally continues. And they certainly won't go for bankrupt names unless they have no other choice and all the other assets have reached a "saturation point" in which they can no longer provide average gains on average risk.

But I have come to learn how to "go beyond" this understanding. You see I start to get a "feel" for what the market is looking for. In other words, lets take a situation where market is declining. You want to look for positive signs such as the russel and nasdaq getting hit a lot harder than the dow and S&P first, followed by an oversold signal and a McCllelan reading approaching oversold. Then maybe even a dow and S&P up with russel or nasdaq down. This is when the quality starts to lead. Individual stock picks are mostly out at this point, HOWEVER, the "feel" the market has is going to be to go into "quality", I KNOW specifically what stocks will probably do well, not just what type.

You gain an even greater advantage by knowing what the quality names are and where the greatest focus will be.

That also involves KNOWING how the sector rotation is basically a sentiment or risk cycle for INVESTORS through the credit cycles as Financials get hit the hardest and offer the greatest value, then as economy gets moving and trade starts to occur, the transports will pick up. Then economy will start to improve and the latest technological breakthrough that can transform some of the old ways of doing things will start to lead. Then Capital Goods and industrials and consumer services will all go closely together as economy is rebuilt, housing and infrustructure is rebuilt, and consumers start spending. As the economy starts to overheat the materials become scarce and there is a huge demand for miners and the like, and ENERGY output starts to hit cycle highs as the cost of energy and need for it starts to pick up and scarcity of oil occurs. Then the stocks reach their saturation point and raw commodities such as gold as well as defensive stocks like consumer staples and drugs and utilities start to become the only area to rotate into, as market declines the rotation OUT of stocks as an asset class and into bonds, and even eventually just CASH or even foreign currency may take place.

See investor cycle charts below:






You can identify quality by passing a visual test. The visual test is identifying stocks that LOOK like the market, particularly the DOW on a longer term basis, but START to act differently on a short term basis (such as making higher highs and/or higher lows on a intraday chart while market makes lower lows and/or lower highs). This is a "divergence" that is bullish and means that particular individual stock is starting to act higher quality than the market and will likely lead it higher. That is basically the "confirmation" If you know what asset specific stock is likely to lead by knowing which sectors are strong and which specific stock is in favor, THAT will be the confirmation that it is starting to be TIME for a move.  "QUALITY" means the stocks have established a solid trend which means they have been in favor for awhile and means the relative highs and lows are typically higher than the previous ones. The sector rotation may require you to go back a couple cycles when identifying quality. For example, recently we have been seeing industrials outperform a bit, yet financials... particularly goldman sachs (GS) has been the "quality" play to buy when you are trying to grab a stock in a rough market that has been declining over most of the past several days, but you think is nearing a bottom (swing trader's low within an uptrend). I suspect that using the cyclical investing chart that AUTOS will likely be next as a name like WMT is more "defensive" and may lead even before a name like GS or GM will, but won't make much of a move in either direction. Housing is not currently a bad bet, but the long term chart shows no signs of market correlation, which makes it more of a laggard.

You can identify sectors or industries as a whole in terms of how the perform, but also what sector they are in, and where you are in the cyclical/sector rotation. Momentum is basically the equivalent of the sector or industry that is currently outperforming and the "laggard" should be the focus on what was supposed to have gone but hasn't, or what is next on the plate. "short squeeze" is the sector that everyone has been underweight that is breaking out and basically the "returning confidence" phase. The "floaters" is basically the "desperation play" when people HAVE to buy whatever they can, but will focus on whatever is left that hasn't been bought yet. In the terms of a credit cycle that may be real estate and leveraged buyouts going nuts but also will be the  energy, materials, and raw commodities. These are basically derivatives OF the economy as the "floaters" are derivatives of the stock industry groups, or sectors. That means they are those that are somewhat independent from, but still derive from that sector. In other words, gas is derived from oil, and the rally in "floaters" is derived from the capital rotation into the sector. Similarly, energy derives it's boom as a result OF the economy booming, rather than focusing on what is being produces as a result OF the economy, you are at this point focusing on one of the things that it uses (as an expense) in order to produce). The reason this works is the BOOM brings all sorts of new economic activity and eventually drives up oil demand to it's peak and starts producing explosive earnings. Finally, you have the derivative of the derivative... which is an entirely new asset class in commodities. The energy producers and material producers and miners all eventually compete when their sector booms until it gets crowded and the competition eats into their margins, particularly as the rest of the economy is oversaturated and will have no place but to decline as their earnings go negative even as they continue to try to produce profits and burn up resources in the process. At this point, even the energy companies get oversaturated and the only thing that can go up is the raw commodities until the negative earnings starts to drive people out of business and the success stories turn into horror stories that start to drive everyone away. At that point, people go to cash and bonds and you see a rotation into defensive stocks such as healthcare+biotech (more independent and non correlated from other stocks), consumer staples and utilities.

But as I said before, the major institutions are still victims to the capital rotation of the MEGA players (global governments, sovereign wealth funds, central banks, pension funds, primary dealers).
The motivations they have and what they are capable of doing is entirely different. See, those with trillions of dollars of value to protect can't just go out and buy an individual 100M market cap stock. They have too much money to move. They have to go with ENTIRE asset classes. They have to focus on the MOST liquid until it becomes over saturated, or until fundamentals of the particular debt market changes.

Right now, the US debt market is the largest at over $17T in debt. It also is the world reserve standard and made to expand in order to accommodate demand. If there is a need for liquidity that is where central banks must park their capital. Due to decisions made by Washington and the US central bank (federal reserve), this could change. In that case, initially there would likely be a shift from a longer dated maturity on the bond (such as 30 years) to intermediate and eventually shorter term. They then might rotate globally according to
1)Liquidity (the larger the market the better)
2)Safety and Stability (the more capable a nation is of paying it's bills and honoring the debt the better)
3)Interest rates (the higher the better)
A market such as the YEN or the YUAN or the EURO could eventually come into play, but ultimately the default source of liquidity is still the dollar because it is more fundamentally structred strongly and since it is the global reserve currency the primary dealers and other central banks will gladly accept it.

As mega wealth makes decisions to shorten maturity eventually they can only shorten it to zero (cash), and in the meantime they will be rotating into perhaps the corporate bond markets. Corporate bond markets have a risk cycle of their own. If both those markets are out, they could consider rotating some of it into the stock market. Because of the size, the sovereign wealth funds basically must be diversified as some markets are too large to sell completely. A a result they typically want INCOME from their investments since they don't want to deal with the hassle of selling and finding a buyer (which since their size, that will cause markets to move down as they try to get rid of their shares) So in stocks, if they rotate there at all, (mostly just the primary dealers who broker the debt but can use depositor money and leverage as investment banks to buy a very large amount of stocks) they will only look for the highest quality, largest market cap, or just S&P futures.They may also consider commodities as an asset class or investing in banks debt backed by real estate in order to get some real estate exposure in a more safe and stable manner.

What they do has consequences. If they rotate into mega cap stocks the price will go up. As this happens institutions will likely sell and rotate into medium or small cap stocks and individual investors as well. This creates an entire risk ladder where everything is compared on a relative basis to everything else.

The largest institutions are looking to add value due to stability and liquidity (average return with less risk), while those with the luxury to move capital around more freely are looking to add value with larger gains (above average return at the same risk).



Everything can be adjusted and priced on a relative basis as interest rates change, and it will have consequences. With interest rates near zero, dividends must be driven down by driving up the price to obtain an equivilent risk/reward. In other words, since stocks present more risk, they should have more reward, but the nature will not get too carried away as if it ever offered too much reward, people would buy it until it's the same. If people bought it up too much, it would be more vulnerable to a decline as capital seeks "equilibrium" ( a fancy term for "balance). Low interest rates will eventually force people out of money markets as pensions will start to go bankrupt unless they seek higher yields. So the federal reserve can lower interest rate as a tool to boost returns in the long run at the expense of savers. However, there is a serious lag and other factors that determine what is "fair". Each asset class has it's own set of risks that will change as the way the countries change. Pensions will likely kick off a rotation of capital into corporate bonds or longer dated treasury, but given the political environment and risks, they may actually determine that the interest rates for a 5 yr or 30 yr or any government debt is too risky. At some point it will also seek higher return and move out of treasuries and into corporate bonds and even high quality high yielding stocks. At any given time, an asset class could be ignored offering superior return at reduced risk in relationship and when that happens eventually capital will be repelled from other places.

But asset classes acts a lot like gravity in that it obtains more momentum and attracts more capital the more mass (capital) it accumulates. However, eventually it reaches a "saturation point" where the momentum cannot continue as other assets will be ignored for too long. It basically is similar to how water reaches a boiling point as temperature is increased. First little movement in the water, then a bit, and then it explodes into bubbles and gasses into the air. It is at this point that a company that has parked a ton of money can now SELL without dropping the stock. You see those with tons of capital cannot sell because there aren't enough buyers at the price. They would have to drop the stock tons of points before they could get out so it's unreasonable for them to do anything but collect dividend. But in  a parabolic run up top, those that PARK their money HAVE to sell, and in doing so they will choose to rotate, and dictate a trend of capital elsewhere, while the masses exploding into a buying frenzy will have run out of new buyers interested in paying that price. At this poit nearly EVERYONE in the stock all ends up under water and the least amount of selling pressure will cause the stock to collapse as there simply is the least amount of buyers left. Now is when you can see the parabolic top manifest in a collapse as all those underwater now have felt pain and want to exit. This is like a spring. The capital reached the point where it had completely coiled the spring and now the slightest bit of those exiting or unable to continue to put any more pressure on the spring now causes it to uncoil rapidly and now rather than ATTRACTING more capital it REPELS it.

Since the long term investor has so much more time that they will have to sit in an asset, they are only looking at the very long term nature of things, and this provides a much longer and slower rotation that may last decades for a full cycle. If the long term mega wealthy institutions have been sitting in an asset collecting a dividend and watching it eventually go exploding higher, they HAVE to get out then or they will never get out until the next cycle. In other words, the liquidity is where they need it to be, the dividend has been pushed way down as a result of the increasing demand, the valuation has no longer become attractive and there is nothing else for them to do but sell.

So now you should be able to understand the two natures and drivers of market action, the institutions and the soverign wealth and mega institutions, and of course emotion, and the cycle it goes through. Actually, I will speak briefly of a cycle that lasts for multiple lifetimes. Entire nations will also drive the fundamentals by the current government type and global setiment for a particular government type and the result it has on the public treasury or debt markets. That cycle exists as well as described by Alexander Tytler (1747-1813):

"A democracy will continue to exist up until the time voters discover they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy, which is always followed by dictatorship.
  • From bondage to spiritual faith;
  • From spiritual faith to great courage;
  • From courage to liberty;
  • From liberty to abundance;
  • From abundance to complacency;
  • From complacency to apathy;
  • From apathy to dependence;
  • From dependence back to bondage. "
That drives the government type until the people become dependent upon government. We actually have a constitutional republic, however the self interests and corruption drove out that government type eventually to collapse in ancient ROME as the people rejected the "Roman gods" and discovered christianity (which Rome also tried to maintain power by reforming), and eventually the people turned on them as a result of economic hardships. They no longer could pay the soldiers their pension promises and they had no one to defend them after expanding their empire too far and not having enough soldiers to defend them from barbarians. The wealth was buried into the ground to protect themselves from tax collectors, which is why there are still today so many roman coins available, and the faith in the productive capacity of Rome declined as counterfeit coins were used and found in places around the continent and even in parts of Asia and surrounding continents.

A more direct democracy ultimately reached it's end in ancient Greece, and Marxism and the rotation to communism eventually results in financial catastrophe as capital rotates towards the free nations and away from those who will take away the incentive to produce and attempt to flatline the business cycle. Then you have your dictators and despots take over and rule by war, but eventually historically you run out of the ability to produce weapons or eventually the war is ended one way or another and economically the nations one way or another will have to reform. There are many other causes, but the cycle is probably too long term to really verify that it exists, although I will say the nature of spending and creating dependency seems consistent with the nature of mankind and thus I believe it exists even though if there is really nothing to do to capitalize off of it, I find it interesting.

If you take the time to connect the pieces and pay attention, you should be able to see WHAT particular asset class, what particular sector, and what particular stock is on deck and next to move. You can also look at what HAD moved recently to see what is likely next. This is a tremendous advantage, and when you combine it with an incredible knowledge or skill set on technical analysis and/or fundamental analysis and learn how to manage your own psychology, this is a tremendous advantage.

I will cover more on this later.

update: Speaking of psychology, check out this post titled, Wired to Lose: The Psychology of Trading