Big Boy Pants

Accountability and transparency are words that get tossed around a lot in the financial world. However, I have found that they rarely are seen in action. 

Let’s be honest, it’s tough to be accountable, especially when you’ve made a mistake. Accountability and transparency are easy when you’re right. And in financial markets, that being “in the right” means you made money. It’s easy to be accountable and transparent when you get to take a victory lap saying “I called that!” Well, today, it’s time for me to put on my big boy pants and be accountable and transparent for my decision to carry a SHORT bias on the SPY since early January. 

Most people assume that if you lose money on a given trade that you were “wrong” or made a “mistake.” Both of these labels imply that there is a flaw in your decision making process. Frankly, the outcome of one trade, profitable or not, says very little about the robustness of your investing process. You can use a dynamo momentum indicator, combined with a crossover of a TRIX oscillator and a downside Tasuki Gap price pattern to buy a stock that goes up 3% but does that mean your decision making process is sound?

I can promise you that using a process without an edge, like the one I just described, will ensure that you’ll be eating cat food in retirement. 

Likewise, you can use a sound, time-tested process and have losing trades. Losing trades are part of the game. The key is to consistently evaluate each decision in your process to ensure its viability. This process is ongoing, never complete and should be occurring whether you’re clocking winners or losers.

Financial markets are nothing more than a range of probable outcomes. The key is to develop a process that, more times than not, puts you on the right side of the major themes driving asset prices. If you can do that, then over time, your profitability will take care of itself.

While I make nuanced changes to my process as needed, the core of my process never changes. For simplicity, I call it my 3G process, which focuses on understanding the 3 primary forces, or gravities, that impact markets: fundamental, quantitative and behavioral. 

The fundamental gravity for a market is primarily driven by the trajectory of economic data and central bank policy. 

I’ve spoken ad-nauseam about the Fed’s current policy stance, so I won’t rehash my views here. But the executive summary is that the Fed won’t hike rates this year and starting early in 2017 they will actually reverse course and begin easing again. If they force a rate hike into this slowing US economy, then they will cause a recession. And that's a scenario there's no point in exploring until we're headed in that direction.

As for the current economic environment, I can summarize it best this way. There are 20 critical economic indicators here in the US that help me gauge growth across the entire economy. These indicators include everything from housing sales, to personal consumption data to labor reports and factory orders. As of June 3, 15 of the 20 economic indicators I monitor are worse than they were in January. When faced with this deluge of deteriorating data, all of the pro-Fed, pro-rate hike pundits point to the labor market as the beacon of hope.

Unfortunately for them, the labor market hasn’t looked healthy in months and is only getting worse. Last week we received the latest update to the Fed’s Labor Market Condition index, which is a 19-factor labor market conditions index developed by Janet Yellen herself. This index is much more robust than a single ADP or non-farm payroll number and gives us a much better picture of what’s occurring at all levels of the labor market. The latest LMCI reading shows the 5th monthly contraction in a row and more importantly, that labor market conditions are deteriorating at their fastest pace since the Financial Crisis.

The Fed is in a box and it would be nuts for them to raise rates given that 75% of the critical economic activity in this country is worse than it was 6 months ago and the labor market is deteriorating at the quickest pace since the Financial Crisis. Poor economic data and a wishy-washy Fed mean that the fundamental gravity is decidedly bearish.

Quantitatively, there are two primary catalysts I’m monitoring. First, the S&P has attempted to get above 2100 on 30 different trading days in the last 18 months. Now, maybe this is the precursor to a breakout that leads to an extended rally. Or maybe there is a reason that the S&P hits a wall of selling every time it gets around 2100.

Second, I’m watching the divergence between US equities and emerging market equities. As I mentioned several weeks ago, 3 times in the last year, US equities have rallied higher while emerging market equities have rolled over. Each of the previous 2 times, the S&P declined 11%. Both of these scenarios are downside catalysts, not upside.

Behaviorally, the conditions are ripe for a decline. No matter what measure of investor complacency you evaluate, no one thinks there is any risk in the market right now. The VIX, for example, is trading at 2016 lows and is closing in on decade lows. When everyone believes there is no risk is the exact time that there is the most risk, when it’s not recognized and not being priced in.

In addition, there are a couple of investor sentiment measures that are measuring levels of bullishness not seen in 2 years. Yet, despite the complacency and the bullishness, we are seeing investors selling massive amounts of US equity holdings. In fact, there have been net outflows in 10 of the last 12 weeks, with another $2.6B leaving equities just last week alone.

The trifecta of complacency, uber-bullish attitude and investors using any and all rallies to lighten up their equity exposure, is the hallmark of a correction. This is the kind of backdrop that lends itself to US investors waking up one random day to a sea of red and being reminded that US stocks can, in fact, go down. 

All 3 gravities in the 3G process are tilting bearish. We have deteriorating economic and labor conditions, we have an equity market bumping up against all-time highs while other equity markets are rolling over and investors are complacently selling into this most recent rally, not buying more of it. Oh, and a central bank that flip flops from slightly dovish to slightly hawkish depending on how long they had to stand in line at Starbucks this morning. 

This is why I remain SHORT SPY.

For the record, I’m not one of these guys that goes around calling for the end of the world. You know the gloom and doom types, they’ve been calling for a market crash for the last 7 years and at some point the market will correct and they’ll take a victory lap saying they knew it all along.

Making a market call and putting on trades are 2 completely different things.

I’m a risk manager first and a profiteer second. I trade a market based on what the 3 gravities are telling me is the most likely intermediate term direction for that market. LONG or SHORT doesn’t matter to me.

And I don’t get wed to a bias either. I’m not perma-bullish or perma-bearish - I’m agnostic. I change bias as soon as my process says that a bias change is warranted.

Since the inception of TWR, I’ve carried a SHORT bias on SPY only 20% of the time, which means I’ve been LONG or NEUTRAL the other 80%. The process dictates how I trade markets, not my feelings, not Wall Street forecasts and not gloom and doom gurus who are right once every 10 years. 

The beauty of the way I trade is that I make on average about $3 for every winner and each loser costs me $1. By having articulated risk prices and keeping losses manageable means I can afford to be wrong multiple times before I nail a winning trade and still come out profitable at the end.

I’m 0 for 3 in 2016 when it comes to trading the SPY SHORT and I’m accountable for my track record. I’m also accountable for my process. My big boy pants are on and my process is telling me to continue to trade US equities from the SHORT side.