The Inevitable 10% Correction

[audreyh1]

I figured that's what you were saying.

If we start to think "200 day moving average" we should be aware of such a methodologies pitfalls i.e. lots of whiplashes depending on how you set the get out and get in points. Just wanted to make that distinction for those who are unaware of this.

Probably I'm trying to be a bit too precise for some (who have already rejected this technique out of hand). Perhaps it's my engineering background and please believe I'm not trying to be a know-it-all. I just need something to analyze once in awhile and stock movements are interesting.

You're just trying to warn anybody off that thinks of using the 200 day moving average to buy and sell. Yep, they'd have sold last week, and bought this week - definitely a whipsaw.

Audrey (also an engineer)

 

[audreyh1]

One lesson I learned as a result of this episode is that when I am having a great year it is time to harvest some profits or sell stinkers to have some cash to invest for when the market swings down.

You're assuming you can tell when the market will swing down. Better to just have some target you reach to rebalance.

 

[Hamlet]

My theory involves thousands of coin-flipping monkeys.

That said, I don't think this correction is actually done yet. I think we'll have a serious drop pretty soon. I have a feeling we'll see a down 1000+ day in the Dow before the end of the year.

Of course, I felt like that last year, and the year before.

Eventually I will be right and look like a genius.

I think that the successful traders have the ability to sense the sentiment of the crowd. They may use more than these mechanical methods, and also intangible indicators like the "Wheee", or the number of posts in the "FIRE Milestones" thread for example.

I guess it is not an analytic method, but requires some people skills to sense the investor psychology. They can translate headlines and predict the crowd's action, and front-run them.

Just a theory, because I do not know how they do it.

 

[redduck]

My theory involves thousands of coin-flipping monkeys.

That said, I don't think this correction is actually done yet. I think we'll have a serious drop pretty soon. I have a feeling we'll see a down 1000+ day in the Dow before the end of the year.

Of course, I felt like that last year, and the year before.

Eventually I will be right and look like a genius.

After 1156 posts, it's way too late for that.

 

[sengsational]

Eventually I will be right and look like a genius.

You might find someone who disagrees with you and get a wager up on longbets.org. But that bet might not be far enough in the future.

 

[NW-Bound]

My theory involves thousands of coin-flipping monkeys. ...

I do not think successful traders jump all in/all out like the simpleton monkeys often talked about among popular circles. Rather, they realize that the real world is not binary, and the decision to be made is not black and white but probabilistic.

See: Kelly criterion - Wikipedia, the free encyclopedia

 

[robnplunder]

Audreyh1, Fox Biz channel, Bloomberg, etc. should invite you as a market pundit. You sound so much better than some bozos they invite.

 

[Hamlet]

Sure, but there are a huge number of traders that think that they been successful but have actually just been lucky. It's actually pretty difficult to determine which is which.

Take poker. Playing in person (live) a marginal player can go on a winning streak that lasts for a year or more. They think that they're a brilliant player, and actually they've just gotten better cards than average that year. Playing live, a player may play about 30 hands an hour, which amounts to only 1200 hands a week, which is a neglible number of hands when talking about long-term probability. Online players talk about win rates over hundreds of thousands of hands. Likewise, it is not unusual for winning players to have losing stretches that are 10s of thousands of hands long.

Say you have 1000 traders that are actually completely breakeven over the long-term. If they all trade for a year, it is pretty likely that a 100 of them will be up a huge amount, 100 will be down a huge amount, and there will be a bell curve with breakeven in the middle.

Those 100 winners will think that they're great traders, but they've actually just gotten lucky. How long does it take to really reach the long-term in trading? I bet it is at least as long as in poker.

I suspect that while there are skillful, successful traders, they are outnumbered by the lucky (or self-deluding) ones by a factor of ten, just like in poker.

I do not think successful traders jump all in/all out like the simpleton monkeys often talked about among popular circles. Rather, they realize that the real world is not binary, and the decision to be made is not black and white but probabilistic.

See: Kelly criterion - Wikipedia, the free encyclopedia

 

[NW-Bound]

I am not a poker player, but understand that the game or some variations of it involves bluffing, reading the opponent's reaction, etc... So there's skill involved. Other card games may be just like slot machines, i.e., all pure chance.

Regarding investing, I should have been more specific and talk about "active investing" and not "trading", as the latter term implies quickly jumping in/out or day trading. The quicker you buy and sell, the more it looks like a pull of the lever of the slot machines.

Kelly criterion, if anyone cares to read the article, says that the optimal bet size varies with the probability of winning. You increase your bet when the chance is higher, and decrease it when it does not look as good. Applying it to investments, you would increase the bet when a particular asset is on sale, and decrease the bet when it has been on the run. You do not go 100% one way or another, because how can you be sure of anything?

Applying Kelly criterion requires you to increase stock AA when the market goes down, and lower stock AA when the market runs hot. This is hard to do when the average investor has enough trouble maintaining constant AA.

 

[NW-Bound]

By the way, I remember reading some articles saying that even Warren Buffett could be simply lucky, because his history of investing is not long enough to prove that it was due to skill.

But, but, how long is the history of the American stock market for us to be sure that it will always go up? Did the economy of the Roman, the British empire keep on going up?

 

[haha]

I am not a poker player, but understand that the game or some variations of it involves bluffing, reading the opponent's reaction, etc... So there's skill involved. Other card games may be just like slot machines, i.e., all pure chance.

Regarding investing, I should have been more specific and talk about "active investing" and not "trading", as the latter term implies quickly jumping in/out or day trading. The quicker you buy and sell, the more it looks like a pull of the lever of the slot machines.

Kelly criterion, if anyone cares to read the article, says that the optimal bet size varies with the probability of winning. You increase your bet when the chance is higher, and decrease it when it does not look as good. Applying it to investments, you would increase the bet when a particular asset is on sale, and decrease the bet when it has been on the run. You do not go 100% one way or another, because how can you be sure of anything?

Applying Kelly criterion requires you to increase stock AA when the market goes down, and lower stock AA when the market runs hot. This is hard to do when the average investor has enough trouble maintaining constant AA.

I will read this article. I used the Kelly Criterion extensively in the 70s, when I was a fairly active horseplayer. I think it might be harder to apply to investing, but it is definitely worth a look.

Ha

 

[haha]

I've got a nice spreadsheet to check out the 200 day moving average method. It stinks. Siegel did a good study of it in his book (don't know about his current edition). There are decades like the 1990's where it didn't beat buy-hold. Using this method you get lots of whipsaws. Most people wouldn't like this and you'd have to be very disciplined to use it. A better method is something like a monthly but still some whipsaws.

BTavlin posted this Forbes article in his thread "3 ways to avoid going over a buy and hold cliff". Since you tested and rejected MA approaches, could you please take some time to criticize this one? Are the results falsified by the author, or do you make the data mining or other objections?

I would appreciate your thoughts.

Ha

 

[Lsbcal]

BTavlin posted this Forbes article in his thread "3 ways to avoid going over a buy and hold cliff". Since you tested and rejected MA approaches, could you please take some time to criticize this one? Are the results falsified by the author, or do you make the data mining or other objections?

I am certainly not looking to give anyone a lot of mouth, I would appreciate your thoughts.

Ha

I did a quick search and was not able to find this Forbes article.

I do think that if your objective is to not go over the cliff, a daily moving average approach might do the job. It depends on one being very diligent (sometimes daily) and keeping the faith. Some stats from my 200 day moving average testing:

Set sell at price just hitting 200 SMA, buy back if above 200 SMA by 1%. Tested this for 1950 to present.

sell + buys per year = 3.3 average
total trades = 106
loss avoidance = 18 trades (largest was 36% for June 2009 re-entry)
whipsaws = 88 (worst was -5%)
time out of market = 33%

A decades summary of results:

Here is a better approach using a 10 month moving average and selling when price is -3% below 10 month moving average, buy back when 1% above moving average. While out of the market one is in 5 year Treasuries (for the numbers below). It is better because one uses only monthly data and trades on the 1st of the month. It did not get out in Oct 1987 like the 200 SMA did.

Some version of this seems to be advocated by Mebane Faber:

In the table, 1.161 means a CAGR = 16.1% (compound annual growth) so for example in 2001 through 2010 the SMA CAGR=9.9% but buy-hold was only CAGR=1.3% .

42 trades in this period (or 21 sell-buy pairs)
21% of time out of market
Worst whipsaw was -12.3% in August to Sept 1998. Yep, this would be tough to stomach.

I'm personally not advocating any of this. I've just done the analysis to understand the method. If one employed this it would probably be best in a tax free account.

 

[haha]

I did a quick search and was not able to find this Forbes article.

I do think that if your objective is to not go over the cliff, a daily moving average approach might do the job. It depends on one being very diligent (sometimes daily) and keeping the faith. Some stats from my 200 day moving average testing:

Set sell at price just hitting 200 SMA, buy back if above 200 SMA by 1%. Tested this for 1950 to present.

sell + buys per year = 3.3 average
total trades = 106
loss avoidance = 18 trades (largest was 36% for June 2009 re-entry)
whipsaws = 88 (worst was -5%)
time out of market = 33%

A decades summary of results:

Here is a better approach using a 10 month moving average and selling when price is -3% below 10 month moving average, buy back when 1% above moving average. While out of the market one is in 5 year Treasuries (for the numbers below). It is better because one uses only monthly data and trades on the 1st of the month. It did not get out in Oct 1987 like the 200 SMA did.

Some version of this seems to be advocated by Mebane Faber:

In the table, 1.161 means a CAGR = 16.1% (compound annual growth) so for example in 2001 through 2010 the SMA CAGR=9.9% but buy-hold was only CAGR=1.3% .

42 trades in this period (or 21 sell-buy pairs)
21% of time out of market
Worst whipsaw was -12.3% in August to Sept 1998. Yep, this would be tough to stomach.

I'm personally not advocating any of this. I've just done the analysis to understand the method. If one employed this it would probably be best in a tax free account.

Thanks for your comments.

I meant to cross-post the article:
3 Ways To Avoid Going Off A Stock Market Cliff With The Buy-And-Hold Herd - Forbes

Ha

 

[target2019]

I did a quick search and was not able to find this Forbes article.

I do think that if your objective is to not go over the cliff, a daily moving average approach might do the job. It depends on one being very diligent (sometimes daily) and keeping the faith. Some stats from my 200 day moving average testing:

Set sell at price just hitting 200 SMA, buy back if above 200 SMA by 1%. Tested this for 1950 to present.

sell + buys per year = 3.3 average
total trades = 106
loss avoidance = 18 trades (largest was 36% for June 2009 re-entry)
whipsaws = 88 (worst was -5%)
time out of market = 33%

A decades summary of results:

Here is a better approach using a 10 month moving average and selling when price is -3% below 10 month moving average, buy back when 1% above moving average. While out of the market one is in 5 year Treasuries (for the numbers below). It is better because one uses only monthly data and trades on the 1st of the month. It did not get out in Oct 1987 like the 200 SMA did.

Some version of this seems to be advocated by Mebane Faber:

In the table, 1.161 means a CAGR = 16.1% (compound annual growth) so for example in 2001 through 2010 the SMA CAGR=9.9% but buy-hold was only CAGR=1.3% .

42 trades in this period (or 21 sell-buy pairs)
21% of time out of market
Worst whipsaw was -12.3% in August to Sept 1998. Yep, this would be tough to stomach.

I'm personally not advocating any of this. I've just done the analysis to understand the method. If one employed this it would probably be best in a tax free account.

Some that use similar techniques set a wider band than 1%. You would want to see the NAV pierce the 200dma by 3% on the downside for instance. This reduces the number of false signals.

 

[RAE]

I don't think this correction is actually done yet.

I agree. I will be surprised if the S&P 500 ends up on the positive side for this year. A lot will depend on whether the Fed continues to manipulate the market with more QE stuff (round 4?), or not. It has to end at some point.

 

[eta2020]

But, but, how long is the history of the American stock market for us to be sure that it will always go up? Did the economy of the Roman, the British empire keep on going up?

Could it be that total global wealth in 1800 was larger then in 1900 which was larger then one in 2000?

We have many many more people who enjoy higher and higher standard of living each decade....

BTW in global economy even S&P 500 is not reflection of US GDP only.

 

[NW-Bound]

Definitely, the world wealth keeps on increasing. But while it blooms here, it wilts there.

Yes, globalization changes a lot of things. The issue is how we should react to these changes. Your last sentence suggests that we do not need to change much, and can stay US-centric in our investment choices. Perhaps you are right. Just recently, there was an article showing the correlation between international stocks and US stocks is getting stronger and stronger.

But the underlying problem remains: the world-wide economy and stock markets evolve, and even to say that as things change they are self-compensating requires some analysis, not just arm-waving and ignoring the question.

 

[Lsbcal]

I just let the market pricing decide. My international allocation switches between US and international and has been mostly in US over the last 4 years. Probably no coincidence that the dollar has been in an uptrend over the last 3+ years.

 

[eta2020]

Yes, globalization changes a lot of things. The issue is how we should react to these changes. Your last sentence suggests that we do not need to change much, and can stay US-centric in our investment choices. Perhaps you are right. Just recently, there was an article showing the correlation between international stocks and US stocks is getting stronger and stronger.

Equity only investor would do quite well with for example 50% VTI and 50% VXUS. That's it. As simple as that.

The rest is having plan, stick with it, discipline, LBYM, stay away from timing....and add and add and add as years go by.

Algorithm:
Each month:
If VTI is below 50% add to VTI else add to VXUS.

That would give you portfolio with about 2.5% yield so at 2 million you are looking at 50k annual "qualified" dividend TAX FREE from federal government.

 

[eta2020]

But the underlying problem remains: the world-wide economy and stock markets evolve, and even to say that as things change they are self-compensating requires some analysis, not just arm-waving and ignoring the question.

If I try to be smarter than 50% VTI/50% VXUS I risk that I will in fact be stupider and make bad decisions. And indeed this is what most people end up doing.

With simple strategy I take no risks and I know I will do quite well. But I need to resist temptations that I am smarter then that....

So i elect arm-waving and ignoring if AAPL will do great or Europe will have 2 terrible years.

 

[HFWR]

The Fed has been winding down QE for some time, and it's near the end, and it's not a secret. I think it's priced in...

 

[Hamlet]

The problem with using the Kelly criterion for investing is that you don't neccessarily know the probability of winning or whether an asset is "on sale".

If stocks go down because their earnings power is impaired, that is not a reason to increase your holdings. If they go down because of irrational fear, it is a reason to increase your holdings. In practice, it is very difficult to tell the difference.

My general point is that the number of trials to separate luck out from skill in poker or active investing is very large, and the game itself is changing in the meantime. In practice, I don't think most people will ever really know with any confidence which led to their outperformance (or underperformance).

It's somewhat easier in poker, because you can analyse individual hands after the fact and come up with your true chances for winning and losing a hand, and figure out if you played that same hand 1000 times what your expected win/loss rate would be.

With stocks, you can't really do that. When a company starts having troubles and the stock goes down, what are the odds of it turning things around? Those odds are unique for each company, and they aren't something that can really be calculated. Ultimately, you're just making educated guesses, and there is no way to know what the odds really were, regardless of how it actually turns out.

Buffett's margin of safety is an acknowledgement of how hard it is to be precise about investing. He tries to find situations that aren't even close, so that even if his judgement is quite a bit off the mark he still won't lose money. Those situations are pretty hard to find though, and come up infrequently enough that you end up wondering if it really was just luck.

I am not a poker player, but understand that the game or some variations of it involves bluffing, reading the opponent's reaction, etc... So there's skill involved. Other card games may be just like slot machines, i.e., all pure chance.

Regarding investing, I should have been more specific and talk about "active investing" and not "trading", as the latter term implies quickly jumping in/out or day trading. The quicker you buy and sell, the more it looks like a pull of the lever of the slot machines.

Kelly criterion, if anyone cares to read the article, says that the optimal bet size varies with the probability of winning. You increase your bet when the chance is higher, and decrease it when it does not look as good. Applying it to investments, you would increase the bet when a particular asset is on sale, and decrease the bet when it has been on the run. You do not go 100% one way or another, because how can you be sure of anything?

Applying Kelly criterion requires you to increase stock AA when the market goes down, and lower stock AA when the market runs hot. This is hard to do when the average investor has enough trouble maintaining constant AA.

 

[NW-Bound]

If I try to be smarter than 50% VTI/50% VXUS I risk that I will in fact be stupider and make bad decisions. And indeed this is what most people end up doing...

I stay fairly diversified too. Using the Kelly mathematical criterion, one only puts 100% on a bet when he is 100% certain that it will pay off. Too many random things happen in real life, and only fools can be 100% certain of anything (other than facts like the sun rising in the east or 2+2=4, of course). Actually, the average Joe intuitively knows not to "go for broke" or "going all in", and he never hears about Kelly criterion. It's common sense.

This talk of diversification brings us back to the question of outperforming the market. Any fool can beat the market for a day, a week, one year. There is enough randomness to guarantee that. And it is not possible for anyone to beat the market every single year. How can one beat the market during the bubble years? Going on margin in 1999 and early 2000? One can only outperform a crazy market by being crazier. So, the period of measurements has to be longer, like 5 or 10 years.

Many value MF managers in the past beat the market when measured over periods of one, two, or three decades, but the EMH proponents still say that is not enough. They usually point to the coin-tossing monkey argument, and say that there will always be a lucky monkey if we add more monkeys.

And the longer the period, the more monkeys they will bring in to the argument. By that definition, they will never be satisfied that anyone can beat the market, because they do not run out of monkeys, but an investor has a limited life.

In fact, some even say that there is not enough evidence to prove that Buffett is not a lucky guy. I am serious. This for a guy with an investing career of 60 years!

The problem with using the Kelly criterion for investing is that you don't neccessarily know the probability of winning or whether an asset is "on sale"...

True. The market is not a textbook game where one can determine the chances a priori. What one can do is to apply it heuristically: increase stock AA during a downturn, and decrease it after a good run. If the stock is truly a random walk, then the above would not work (in fact if the stock movement is a mathematical random-walk like a coin toss, one has to be a fool to play). The simple explanation is that after a crash, the market has a higher probability to go up than down. The converse is true after a good run. It is just a probability, never a certainty, hence you cannot go all in/all out.

But as I said, maintaining AA in a down turn is already plenty hard. Buying more stocks is beyond what most people have the stomach for, but afterwards we all say "woulda, shoulda".

 

[Hamlet]

And that is one of the hardest things about stuff like this. You can't really prove Buffett wasn't just lucky. He chose a very concentrated portfolio. Sure, he's invested for 60 years, but you can probably distill a large portion of his success to less than two dozen investments that turned out really well. Given the massive numbers of people investing, you would expect some pretty amazing outliers using that investment method just given chance alone.

Do I think it was just luck? Nope. I find his explanation of his investing choices over the years to be pretty compelling. However, I think luck was certainly involved. GEICO could have gone bankrupt. The Buffalo News could have been prevented from having a Sunday paper indefinately by the courts. People could have lost faith in American Express during the Salad Oil Scandal. Solomon Brothers could certainly have gone under if Buffett hadn't managed to get the Feds to allow them to continue. Etc, etc.

How much of his performance was luck and how much was skill? It's a question that can't be answered. I think both are non-zero, but I also think the luck factor is bigger than most people think.

Many value MF managers in the past beat the market when measured over periods of one, two, or three decades, but the EMH proponents still say that is not enough. They usually point to the coin-tossing monkey argument, and say that there will always be a lucky monkey if we add more monkeys.

And the longer the period, the more monkeys they will bring in to the argument. By that definition, they will never be satisfied that anyone can beat the market, because they do not run out of monkeys, but an investor has a limited life.

In fact, some even say that there is not enough evidence to prove that Buffett is not a lucky guy. I am serious. This for a guy with an investing career of 60 years!