I believe what investors have experienced in the last decade is unprecedented. There was the dot-com bubble of the 1990′s where we saw companies without a real product or any earnings rise and fall at the speed of light. The bubble in the real estate market created by changes in the Community Reinvestment Act, which allowed individuals without proper qualifications to get financing and become a home owner, resulting in higher demand than usual for homes and the inevitable housing market decline. The pinch we all felt every time we pulled in to the station to pump gas as oil prices rocketed to $147 per barrel, and finally experiencing one of the biggest financial meltdowns in the history of our markets, where we witnessed some of the biggest and most successful institutions go bust.
Although our markets have somewhat stabilized since the turmoil we faced just a few years ago and our major indices are trading way off their lows of 2009, I am sure you have noticed that not much has changed as we face what now seems to be financial difficulties in Europe. It is amazing to see how our domestic markets make moves of such magnitude in a matter of a few minutes simply based on what people say. This is just to name a few of the many we have encountered in the last decade, so What’s Next?
I think at the very least the last 10 years should have proven that it is far too difficult for the average investor to analyze the financials of publicly traded companies. I am sure you have noticed even those who possess extensive knowledge and experience have found it difficult evaluating the financials of these companies to estimate their future growth. It amazes me how some stocks with significant drops from their all-time highs were rated and reiterated as strong buys by analysts covering them all the way down.
Although the numbers that are being examined by these analysts have been audited by some of the largest and well known accounting firms out there, we can never be sure of their accuracy. Enron, World Com and Tyco are just a few examples. Therefore, as an average investor, we face way too many unknowns; this is the basis for why I believe so strongly in automated trading strategies where we simply put our opinions to the side and follow in the steps of those that have more of an influence on our markets.
In an ongoing effort to provide transparency and clarity into how our Quant Trend Portfolio’s are managed, and to further educate our clients, I’ve decided to take the company that has dominated our financial media in recent few weeks MF Global, as an example to show how the strategy would have signaled the changes in its direction.
When you are using automated trading strategies, the computer doesn’t know anything about General Electric (GE), General Motors (GM), Bank of America (BAC) or MF Global (MF). The computer doesn’t know what the company does, who runs the company, how long it has been around, or that the company was at one point one of the darlings in many investors’ portfolios.
If you think about it, there are only two known things to the computer, Price and Volume. Prices are nothing but a set of numbers, placed one after another, and the order or the sequence in which they are placed is dictated by Supply and Demand. Understand that for every buyer there is a seller, and for every seller there is a buyer; There will always be two sides to every transaction. But if there is a greater number of buyers (Demand), these numbers will begin to rise. Likewise, if there is greater number of sellers (Supply), these numbers will begin to fall. And if one exceeds the other by a wide margin, they will begin to rise or fall at a faster speed. Volume shows the degree of supply and demand.
Therefore, to the computer the only thing separating Apple (AAPL) from Yahoo (YHOO), Gold (GLD-ETF) from Google (GOOG), or Silver (SLV-ETF) from the Euro (FXE-ETF) is just the order or the sequence of their prices being placed next to each other. When the sequence of the numbers representing AAPL rise faster than those representing GOOG, it simply means that there is a greater demand for the shares of AAPL than GOOG; or vice versa, if the sequence of the numbers that represent AAPL is falling faster than those representing GOOG, it means that there is a greater number of sellers for the shares of AAPL than GOOG. Quant Trend Portfolio’s screening process first starts by searching for the stocks where their prices are rising faster than 80% of all other stocks in our data-base.
To clarify this, let’s take a look at the chart of MF Global going back to its 2007 peak around $32 per share. As I am sure you know by now, once one of the largest broker dealers in the commodities and futures markets has filed for bankruptcy protection. At this point it’s not important what the company did or how smart the management was for the shareholders of MF Global. What’s significant for MF Global’s shareholders is that their investment has become almost worthless.
In the bottom pane of the chart on the following page, I have included our proprietary Relative Performance indicator. The indicator is plotted on a scale with minimum/maximum values set to 0 and 100. This is an indicator that measures the performance of one stock relative to the performance of all other stocks in our data-base. In simple terms, the indicator is measuring and ranking the Relative Speed of the order or the sequence of numbers that represent one stock, which in this case is MF Global to all other stocks in our data-base. A value of 0 means that the stock is falling faster than all other stocks, while 100 means that the stock is rising faster than all other stocks; a value of 50 means that the stock is just average suggesting that there are plenty of other stocks that have been outperforming this one.
The theory behind our proprietary Relative Performance indicator during a market uptrend rests in the belief that the stocks rising the fastest are experiencing the most amount of accumulation by the institutions, while those that are rising slower are experiencing the least amount of accumulation. When the market is in a downtrend, those stocks that are declining the fastest are experiencing the most amount of distribution, while those that are falling slower are experiencing the least amount of distribution.
Now that you have a basic understanding into how the computer looks at these stocks and the ranking process, let’s look at MF Global’s history. As you can see, MF Global’s rank fell below 20 in October 2007 and stayed below 20 for the better part of the next 14 months as the stock dropped from $32 to almost $1.50 per share by November 2008, this indicates that the price of the stock was falling faster than 80% of all other stocks. As the market bottomed in early 2009, we can see how MF Global’s rank rose from under 20 to over 80, suggesting the stock was beginning to move higher faster than 80% of all other stocks in our data-base. MF Global’s rank remained above 80 for most of the next year as it traded as high as $7.50 per share by November 2009. On November 27, 2009 MF Global’s rank fell below 70 which is an automatic sell signal in the Quant Trend Portfolio. This was an indication that other stocks are staring to outperform MF Global which means there are better investment opportunities.
As you can see over the course of the next few months we see a sudden drop in its rank. By January 2010, its Rank once again fell and remained below 20 for the better part of the next twenty months before the fallout and the sovereign debt stake that led to its bankruptcy filing.
I would also like to point your attention to the chart from January 2010 to July 2011, when the stock just traded sideways for almost a year and a half while its rank remained below 20. This was indicating that, while MF Global was trading sideways, there were plenty of other stocks that were rising and performing better than MF Global stock. Therefore, the indicator warned of its lack of performance relative to all other stocks, which was due to a lack of institutional accumulation way before its bankruptcy filing.
Below I have attached charts of Bank of America (BAC) and American International Group (AIG) as two other examples of companies that either flirted with bankruptcy or lost a significant amount of shareholder value in the last few years. Just like the MF Global chart, their charts are being painted green, yellow or red based on the sequence of their prices placed next to each other and nothing else.
We can clearly see how during the financial meltdown of 2008 their charts were painted red, which indicates that they were also falling faster than 80% of all other stocks in our data-base. Soon after our markets bottomed in early 2009, they both started to rise at a rapid rate which was indicated by their ranks moving higher than 80. But that strength did not last for a long time. Bank of America’s (BAC) rank fell below70 in March of 2010 while American International Group’s (AIG) rank fell below 70 in January of 2011 which was the initial indication in lack of performance and an automatic sell signal within the Quant Trend Portfolio. As we can see their ranks fell below 20 soon after and has stayed below 20 ever since to indicate their underperformance relative to all other stocks.
I understand it is underlying factors such as earnings, sales and their business models that drive the institutions to take action, but it is the actions of the institutions that influence their stock prices, which should be the most important factor to the shareholder.
The Relative Performance indicator has the ability to reveal the true strength of the stock’s price relative to all others, thus having the ability to avoid investments in companies for which their prices are falling at a rapid speed, in such cases as Bear Stearns, Lehman Brothers, MF Global and others.
The Relative Performance indicator is not a perfect indicator. Every indicator has its own strengths and weaknesses, therefore there is no such perfect indicator. Quantitative models are based on the law of probabilities, and the Relative Performance indicator is just one indicator that we believe increases those probabilities by allowing us to navigate institutional action. This is the reason why the Quant Trend Strategy uses multiple indicators, including fundamental ratings to generate their buy or sell signals.
In summary, it is our belief that the actions of institutions have a significant influence on the behavior of our markets. What we think about a company, its product line or the management team could be insignificant because, quite frankly, it is truly about what the institutions do that matters the most. In our opinion it’s best to put our emotions and opinions to the side and simply walk in their footsteps. So if the next decade is anything like the last one where we face bubbles in industries in which their companies trade at valuations never seen before, such as the dot-com, or we have industries that surge due to government corruption and a lack of proper supervision, like what led to the bubble in the real estate market and the financial meltdown of 2008, it won’t be our emotions or our opinions that will dictate what we do and when we do it, but the actions of large institutions that have a major impact on our markets.
As always if there is anything that you don’t understand or if you need further assistance please don’t hesitate to contact us.
You can either use the comment section on the bottom of this page or email Rabin at email@example.com.