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.