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The VIX : Coming to the Right Conclusion the Wrong Way

5/27/2014

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by Joshua Enomoto

With the S&P 500 closing a hair under 1,912 points and setting a blistering record (at least on paper), is it now time to stop the worrying and enjoy what has been a disconcerting but nonetheless stable ride? After all, experts have reiterated that the markets are flooded with cheap liquidity (thank you, Mr. Bernanke...) and that the core financial institutions are more cash-rich than they were just prior to the 2008 collapse.

Unlike previous moments when equities hovered around peak thresholds, there is still a respectable number of bearish prognosticators producing all manners of arguments as to why the current situation in the markets is unsustainable. The most recent offering is speculation towards a volatility reversal, or a switch in sentiment for the CBOE S&P 500 Volatility Index, best known as the "VIX."

This volatility indicator is often cited by mainstream analysts and financial journalists who truth be told, probably have little understanding of the math that indirectly results in simplified summaries that are too general for scientific research but fits perfectly within media soundbytes and the "corporatocracy" that sponsors the networks.

Right now, the VIX is trading under 10, a "low" number that suggests market participants are complacent and that valuations may be reaching a top. On the other hand, a "high" number such as 25, a target "achieved" in May of 2012, suggests extreme fear. Contrarians use this indicator to perform the opposite action that is undertaken by the masses (oh, those foolish masses!)...because you know...you're supposed to be greedy when others are fearful and be fearful when others are blah, blah, blah...

Taken literally, the VIX is telling you to sell : just like in retail psychology, it doesn't make sense to buy items at inflated prices. While the stock market is obviously different from a retail market in the sense that yes, sometimes the items on Wall Street can reach higher plateaus, seemingly never to come back down again, nothing takes a straight turn up indefinitely. Even the best names need a break from rampant speculation. And thus, as a contrarian, this is a perfect opportunity to take profits from the table.

I agree with the ultimate conclusion that the risk assessment does not favor doubling down on new positions at this immediate juncture but don't let my alignment with an opinionated result confuse how I got to this point.

I could care less what the VIX says : at the root, it is another tracking mechanism of an index's price history that is used to predict future volatility of the stock market. To me, it sounds like a fancier version of the simple moving average, the holy grail of some technical analysts but at the end of the day, it's just an average. It's not that mathematical models don't have their place in finance : they clearly do and I champion their usage!

But this comes with an important caveat : the methodology has to be appropriate for the madness. I wouldn't take a straight edge to measure the surface area of an inflated balloon but for reasons yet unknown, many financial analysts continue to employ pseudo-science as their definitive measure for determining risk and reward.

Does that sound crazy? I hope so...because that's what a sole reliance on the VIX (or any other indicator) amounts to.

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Off to the races?

5/21/2014

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by Joshua Enomoto

The markets are off today with flying colors, a somewhat expected result from a bounce-back from Tuesday's sudden decline. As I write this, the Dow Jones Industrial Average is up 140 points, which if the markets were to close right now, this would result in a mid-week performance that has ended at parity with Monday's opener. In other words, after 3 days of back-and-forth trading, the major indices have netted exactly 0%.

Unlike other financial analysts, I don't see stalemate as a unique category. In the markets, if you are not moving, you are dying. The one truism that applies to both bulls and bears is that movement is necessary for their survival : nothing meets universal contempt than a sideways trending market.

Of course, it is better (as a long-term bull) to be stuck in consolidation rather than to witness a sizable drop in valuation, but consider this : in a massively traded equity market like that of the U.S., stativity is not an indefinite circumstance. Either people will see value (either present-value or perceived future-value) or they will not. The latter decision will almost surely result in a substantial correction.

But is there a case for the former argument? Can a reasonable assumption be made that people see value in the domestic equities sector? I find that though the present value of the overall markets are not over-priced based on a traditional methodology such as the P/E ratio, the ability to wage competitive battle for our leading companies have waned.

A recent solution for the economic recession brought forth by Dr. Amir Sufi, a professor of finance at the University of Chicago Booth School of Business, is perhaps most telling. Dr. Sufi's research finds that in times of great economic turmoil, societies have adopted a form of "debt forgiveness" for its populace that were forced under by circumstances outside of their control. Implicit in his argument is that the U.S. government failed to provide such protection for its constituents, but instead, awarded it to the banking and financial conglomerates most responsible for our present crisis in the form of bail-outs. Dr. Sufi goes on to state further that by saving large institutions and not the middle-class worker, consumption as an aggregate total has deteriorated.

What is apparent in the stock market today is that the large-cap companies are doing just fine, thank you very much! However, the base upon which these companies sell their wares to have practically declined, though not in number. This creates a watered-down effect where foot-traffic and revenue may go up, but profitability may go down. But according to historical data, revenue is going down while earnings (net income) are beating expectations.

How is this possible? Before a company reports net income, they must filter through several layers of revenue streams, costs, and expenditures. Amongst the favorite of large companies is cost-reduction, ie. layoffs, ie. store closures, ie. "bottom-line thinking." This reduces costs and top-line sales but it increases profitability (when done correctly).

While Wall Street encourages the practice, companies that engage in such low-level strategies are acquiescing to defeat by permanently curtailing its forward-basis potential. In human terms, it's a losers mentality and when you have a losers mentality, you typically lose.

This mentality is celebrated on one side of the books (the investment community) and that is why the practice continues. If we live in a disposable society, how much more so is the stock market? But eventually, the situation cannot indefinitely perpetuate itself. At some point, you're making money or you're not.

The domestic markets may be reaching that point. I could be wrong but the warnings are readily apparent. And I'm just not ready to take that risk...

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Is it still contrarian to be a contrarian? 

5/19/2014

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by Joshua Enomoto

With the S&P 500 making little head-way since hitting 1,900 points last week (an all-time intra-day record), many mainstream financial analysts are beginning to take on a bearish outlook for the domestic stock market, at least in the near term. Does this mean that the contrarian play is now over for those holding a short position as a hedge against downside volatility or should they keep the "faith" and commit to the possibility of inverse gains?

Before directly answering this question, we must first acknowledge that the markets are not run on contrarianism nor any other psychological methodology. Merely taking the opposite side of what everybody else is doing is not guaranteed to net profitable results. Often times, there's a very good reason why the masses are investing in a particular manner and going against the trend in such cases is an exercise in painful futility.

Also, it is very difficult to quantify what the variability in market sentiment truly is in order to apply contrarian strategies effectively. To what degree are market participants leveraged towards one direction or another? Is the contrarian strategy to be applied only in options trading using a put-call ratio? What determines whether this ratio is over-levered or not? How do we apply contrarianism towards stocks or funds that have no derivatives market?

But let's get back to the issue at hand : are the bears justified in maintaining their "short sidedness?" The fundamental arguments still hold in their favor, namely, the economic underpinnings not supportive of excessive premiums in equity ownership. The reason why this argument hasn't resonated deeply until recently is that market valuation, or price, is a product of speculation. There is no hard and fast rule as to what fair market value really is. Ultimately, the price of an asset comes down to a negotiation between buyer and seller and if someone is willing to buy stocks at a particular rate no matter how ridiculous it may seem to select individuals, the market will move according to the terms of the negotiation.

However, astute investors can still make a calculated bet to put the odds in their favor. Obviously, there are a number of analytical approaches to the markets that people can employ. My personal favorite is the statistical approach, using science-based models to better predict the nuances and tendencies of specific stocks and funds.

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But the whammy for large-cap equities is the divergence between the S&P 500 index's growth rate versus the revenue growth rate of the companies that comprise said index. As has been noted by several mainstream commentators, the market has risen dramatically, especially so in 2013. Unfortunately, the actual sales performance of the collective whole has not caught on with investor enthusiasm.

That's not to say that sales haven't been improving : they have, just not at the rate of the stock market. History shows that revenue growth rate has been on the decline and that eventually, discrepancies between market valuation and sales performance are consolidated in a mathematical journey called the regression of the mean. The key question is, will revenue regress up?

We have our doubts...

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for the one-hundredth time...

5/15/2014

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by Joshua Enomoto

Sun Tzu once said that when "armies engage in actual fighting, if victory is long in coming, the men's weapons will become dull and their enthusiasm will wane." While originally intended for a literal interpretation, the military general's sage words would come to describe the state of the Dow Jones Industrial Average thousands of years later and in a land quite foreign to his own.

Let's skip the existential meanderings and get straight to the point : year-to-date, the Dow is up a little over three one-hundredths of a percent.

As in +0.03%.

Of course, the mainstream media will opine that the underpinnings of the economy are trending up, that jobless claims are down, and the American consumer is getting back on the saddle. Never mind the fact that in this day and age of legally fabricated accounting "adjustments" that government reports often contradict each other, the more crucial element is time. After five months, the (arguably) most popular equity index in the world managed to gain only 0.03%.

If the economy was really doing so great, how come the big money are not putting up the capital to fund it? I don't buy into this crap that the markets need to absorb the "realities" of the economy before we see that magic secular bull explode into the stratosphere. The financial markets have always been a leader in speculation : they don't absorb the news in so much as they slit its throat and hang it out to dry. "Waiting for news" is what the common plebian is known to do because that's the only thing they can do, so careful are they with what precious funds they have available.

The big money is not like that. They could care less if they lose millions because they have millions pouring in from all manners of passive revenue streams. So if the elitists who are so carefree with their money don't want to participate in this contrived of bull markets, why should anyone else?

It's a good question and until I hear a good answer, my choice has already been made quite some time ago. With a YTD performance of 0.03%, this implies an annualized return of only 0.079%, a pathetic yield that would find a more appropriate home in a boring savings account at your local credit union!

Seriously, when will people understand at that implied rate, your money is literally better served sitting in a bank vault than it is being managed by a pre-pubescent fund manager who thinks he's a hot shot because he watched a few YouTube videos and can do an impersonation of Gordon Gekko?

But don't take my word for it. Look at the chart of the Dow. Witness for yourself the tiredness inherent in the consecutive failures of the hopelessly optimistic to breach and secure new highs.

Then ask yourself which side of the trade you'd prefer to be on...


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gold manipulation and the meritocracy of technical analysis

5/13/2014

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by Joshua Enomoto

Noted precious metals investment expert Michael Maloney is no stranger to bold statements and even bolder predictions. Those familiar with Maloney's work will undoubtedly recall his multiple arguments about a deflationary crash in the Dow Jones and an inflationary explosion in the price of bullion. While the case for $10,000 gold and beyond will ultimately be decided by its culmination, or lack thereof, there is another point Maloney made that deserves special consideration.

Back in 2010, Mr. Maloney was invited to speak at the 8th International Banking Forum in Sochi, Russia. There, he gave his usual expose of rampant monetary expansionism by global central banks and an impending sovereign debt and currency crisis. In order to prove some of his heavy accusations, he cited the discipline of technical analysis, specifically mentioning the occurrence of "head-and-shoulders" patterns (part of a sub-sector of technical analysis called Elliot Wave Theory) as a harbinger of bearish events in global equity markets.

Citing technical analysis is nothing new but assigning a nominal probability range for its accuracy is. Technical analysis has always suffered from a "meritocracy" problem by which its calculated implications can only be asserted on a subjective basis. That is, the discipline's usefulness is palpable but sadly unquantifiable. This prevents the technical approach from achieving scientific credibility and will likely never attain such a status.

So it was a bit of a surprise when Maloney in his speech blurted out that technical analysis has a success rate of 55- to 60- percent! There is no doubt that he pulled this number out of his ass (or that he cited someone who pulled this number out of his ass). No entity to my knowledge has ever performed an empirical study on the merits of technical analysis. Further, such a study is made impossible since there is no concrete consensus on what exactly constitutes technical analysis.

However, Maloney should not be blamed for announcing this assertion. While the technical approach lacks scientific standing, that by itself is not reason to dismiss it. Even the widely accepted discipline of accounting lacks such status, and is thus considered an "art." Also, that technical analysis "works" is starting to gain more mainstream acceptance. Media outlets such as CNBC regularly examine select stocks from a fundamental and technical perspective.

But no one has bothered to empirically check the discipline's validity...until now!

Writing a simple program, I calculated the nominal parameters of what constitutes a head-and-shoulders pattern, the key subject of Maloney's discussion on technical analysis. A big part of the reason why no one else had undertaken the task of empirically testing the technical approach is the logistics of the project : no one is going to manually rifle through pages and pages of price charts looking for specific patterns and formations. For such an undertaking, an algorithm is necessary.

Upon completion of my program, I ran it through the entire history of the S&P 500 index, noting when a head-and-shoulders pattern occurred and the percentage by which such a pattern led to a decline in market value. I also ran the exact same experiment for an "inverse" head-and-shoulders pattern, its twin model that implies a bullish future for market valuation.

To my surprise, the head-and-shoulders pattern was remarkably accurate, producing a bearish outcome 67.82% of the time. The inverse variety was even more accurate, producing a bullish probability of 81.3%. This confirmed to me that the U.S. equities market has an upward bias ; indeed, a separate study that I conducted shows that on any given day, the market will produce a positive result more than 52% of the time.

Since we are on the topic of Michael Maloney, I decided to conduct the same experiment with the popular GLD, an exchange-traded fund that tracks the gold market. Here, the head-and-shoulders pattern produced a bearish result 66.82% of the time, a minute 1.49% variance against the S&P 500. But a substantial difference occurred when comparing the inverse pattern, with the GLD only achieved a bullish probability of 79.17%. While this may seem small, the variance of the inverse pattern in the GLD is almost twice that of its equivalent in the S&P index.

On surface level, this tells us that an inverse head-and-shoulders pattern is slightly more likely to "fail" than an equivalent pattern appearing in the equities market. Such an observation may embolden the gold and silver bugs who adamantly claim that the bullion market is rigged. From a non-partial perspective, it is interesting and worthy of further research. The variance between the inverse results of the two markets is in my opinion statistically significant ; however, on a pure nominal basis, it will be difficult to condemn an entire market as being manipulated because of a 2% discrepancy in a discipline that can often produce more questions than answers.

Even my own analysis is subject to criticism. Even though the methodologies that I have applied were consistent throughout the analysis, some of the "hits" that my algorithm found would not be considered a true head-and-shoulders pattern. This meets an input dilemma (as the programmer, I had to define to the computer what a head-and-shoulders pattern is) and an empirical dilemma (nobody knows what a head-and-shoulders pattern really is). Using statistical language, my degree of error is unknown. Ironically, an attempt to quantify the degree of error will lead to an existential discussion and an inordinate amount of academic bickering, a journey that I just plainly refuse to undertake.    

Still, the consistency of methodology over several years of data does confirm semi-empirically what technicians have always believed : technical analysis is accurate. And when performed by the right people, it may be more accurate than you may be giving it credit for! 


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What just happened?

5/8/2014

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by Joshua Enomoto

Watching the complete market action from the opening drive to the closing bell is a unique experience that while "personified" accurately using Japanese candlesticks (a specific type of price chart favored by technical analysts), leaves out much of the raw emotions inherent in the investment business. This is particularly so during times of market volatility, where one hour can vary dramatically from the next.

For instance, what the hell just happened today? From the onset, the markets hit a slightly dissonant tone, off a few basis points from the prior close. By mid-day, all three major indices (S&P 500, Dow Jones, NASDAQ) were in the green, with the Dow challenging its all-time closing record while the NASDAQ was the clear intra-day leader, up over 1% against the prior. I assumed that the markets would hold on to a majority of these gains : after all, geopolitical tensions faded into the background as much of the mainstream focus was on a generally positive earnings season, with nearly 64% of reporting S&P 500 companies posting better than expected results.

How surprised I was to look up at the ticker tape and discover that only one of the three indices managed to post a gain, with the Dow adding on 32 pretentious points. That really is not the type of progress you would expect from investor sentiment when the underlying fundamentals of the flagship equity market in the S&P 500 have come strongly ahead of expectations.

Perhaps it's a reflection of people not appreciating how undervalued the fundamentals are against the technicals. It was Warren Buffet who advised us little folks to buy when others are fearful ; well, they sure look fearful today!

Then again, it could be that the smart money has left the stadium and are now waiting for the markets to determine the next move. These are the people that have access to the best information and rely on a systematic combination of qualitative and quantitative factors to help guide their decision-making process : if they are leaving (which they are), what does that say about the retail investor who is often the last person to know anything and is keeping his investment precariously exposed to the markets because his or her fund manager told them a wonderful story of a magical wizard called compounding interest and historical trends?

Once the smelly stuff hits the fan, it's often too late to do anything about it : the crowds have already gotten out at the best price possible and at that point, you would potentially be forced to sell at fire-sale prices. Either that or hold onto that day when you would be able to break even or sell at a profit.

Since I'm not quite sure when that day will occur, I'll take my chances with my flight to safety.

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the seduction of the fat tail

5/5/2014

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Every year, investors of a particular stock, commodity or sector fall prey to the "fat tail" conundrum, a statistical anomaly that distorts the greater context of historical price dynamics. Unlike a black swan event, which I personally view as a sudden loss of valuation for an already held asset, the fat tail conundrum is a dramatically positive event that entices investors to buy into what essentially is the latest flavor of the week. Fat tails are dangerous because of the silent manner in which they appear to change the probabilities of a market.

My favorite example is J.C. Penney. Yes, I have picked on this company several times in the past, but it arguably poses one of the greatest fat tail conundrum risks in recent memory. Management has been battling bankruptcy concerns for several years but eventually staved it off with a complete restructuring plan and a huge influx of capital represented by an intra-day jump of more than 25%. Based on this one giant up-day alone, JCP managed to eek out a +2.54% valuation advantage despite an implied probability disadvantage  of -2.44% for calendar year 2014.  

How did the valuation potential go positive when the probability of the market went negative? It's all thanks to the fat tail! Removing this obscene outlier nets a valuation disadvantage of -13.3%, which matches the downbeat sentiment evident in the market's probability. Outside of this one-off event, the implied regression for JCP's stock price is $5.18 at the end of 2014. Including the fat tail, implied regression skyrockets to $9.43.

Of course, regression is a target based on probabilities ; there's no guarantee that JCP's stock will hit a number within the previously discussed range, or even anywhere close to it. But the longer an asset is held, the more likely the asset will regress to established baseline probabilities ; since JCP has a historical baseline that is not "buyer favorable," or less than 50/50 odds, the chance that new buyers will lose faith is relatively high. This then poses a risk to the fundamental turnaround story, which in and of itself has very substantial headwind.

The moral of the story? Don't bite on the fat tail...it just might bite you back at a very inopportune moment.

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the federal minimum wage 

5/1/2014

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