"Water shapes its course according to the nature of the ground over which it flows; the soldier works out his victory in relation to the foe whom he is facing. Therefore, just as water retains no constant shape, so in warfare there are no constant conditions."
Sun Tzu

Tuesday, July 31, 2012

What is a Good Covestor Model?

Even though I'm a Covestor Model Manager, let me take a different position and assume I'm looking for a Model to invest in. How would I decide which model to choose? Obviously, I'm a little bit biased here, but let me try to be neutral.

I think there are basically two approaches: one is to look at "fundamental" factors: does the model invest in bonds, commodities, macro events? Another is to approach from a quantitative standpoint and look at certain metrics.

A little bit of research is needed to compare various models, but the numbers are all there, at least for the short-term.

A first step could be to look for performance: which model performed will over the last 365 days? It is easy to sort all models by this criterion. Here is a chart of the returns of the 10 best performing models, which replicated relatively well (Timothy Sykes' model doesn't replicate well, so I didn't use it in the following charts):

As you can see, the Top 10 models outperformed the S&P 500 over the last year. (For the record: yellow color is the S&P 500, green are the top 3 performance models, red is my model). 

Performance is one story, risk is another: did the models outperform because managers were taking on too much risk? Covestor offers various risks metrics. One of them is the Value at Risk (VaR, 95%, 1 week), which basically quantifies the amount of money you can expect to lose in 5% of the weeks. Or in other words: within half a year, there will probably be one week, where you lose this amount. The following chart plots model performance over VaR for the models of the first chart:

Now things start to look a little bit different. It becomes clear that some models, especially the ones with the best performance, were more risky than investing in the S&P 500. Is that good or bad? Depends. It can be ok if one is willing to take on this risk and if returns are proportional. Roughly half of the models, though, offered better returns with less risk.

Another factor can be correlation: it is positive when someone is able to generate positive risk-adjusted returns independent from market returns, or in other words, with beta close to zero. The following chart shows the Sortino Ratio with portfolio Beta. The Sortino Ratio is a measure for risk-adjusted returns and has some advantages over the popular Sharpe Ratio:

So what is the best model? As can be seen, the answer is not that easy and depends on factors that only the individual investor can answer. Also keep in mind that 365 days is not a long period. If the same models show would show up in these charts over a 3 years history, the question of performance persistence could be answered on the base of a better data set.

Monday, July 30, 2012

AAPL: Earnings Gap Play

The Earnings Gap Play is my favorite trade during Earnings season. Check out my previous post on this topic here. AAPL has been setting up on Friday and it might be not too late to benefit from the pattern. Since price tends to overshoot with this setup ("from failed moves come large moves"), I could see Apple reaching $615 during the next weeks:

I'm not long yet, but intend to take this trade later today.

Friday, July 27, 2012

Morning Thoughts Jul 27

It was just a question of time when the markets would start speculating that the EZB will pull out the Bazooka. I don't know what all this Draghi talk is worth, but it is enough to push an oversold market up north. 
Fortunately, I scaled out of my short positions in the last days, so my only remaining short is Deutsche Bank, which I will probably close today.

I added a couple of longs yesterday. Gold (GLD) is one of them. Not my typical trade, but metal prices might experience a "volatility breakout" to the upside, which could push Gold to the $1,700 level in a short period of time. BTW, I closed my Silver short with a small loss on Wednesday. 

Overall, I'm almost 100% long, but keep in mind this is a short-term trading portfolio: the average holding time of my winners is 11 days, so things can change fast.

Wednesday, July 25, 2012

The Recent Intraday Price Action of Silver

Let's talk Silver this morning. As you know, I'm short but my edge has been fading every day, which is why I have to close this trade very soon. My initial premise was that high Dollar - Silver correlation would push the metal below important support at $26. As can be seen from the following chart, the Dollar has been rising (plotting the inverse ETF UDN here for visualization reasons) but the developments did not manage to move Silver prices to critical levels. In fact, buyers showed up each time Silver was trading below $26.80:

The following chart shows more intraday details. It is interesting that prices traded below $26.80 only for a very short period of time. It is almost like a piece of software code kicking in: IF price (SILVER) < 26.8 THEN BUY ALL. The opposite however could be true for prices above 27.10.

At this point, it is a better proposition to wait at the sidelines for a final range breakout. The problem, though, is that prices will move fast and I'm afraid it will be difficult to catch that trade.

Tuesday, July 24, 2012

Morning Thoughts Jul 24

It is amazing to see how equity markets have decoupled: while European stocks were a mess yesterday, US managed to rebound quite significantly.

I took some profits on the short side and reduced my position in DB. What's left are the Spain (EWP) and Silver (SLV) shorts, besides various long positions. Most of them are US housing (LEN, SPG, WFC) or consumer related (AEO, DIS, DFS, GPS). The trade here is straight forward: long US, short Europe.

The Silver position gives me a little bit of a headache: for weeks we have been seeing buyers stepping up below $26.80. The metal has been testing this support more frequently in recent days, so with continued pressure from the Euro it is just a question of time when this level will fail.

Spanish yields are again moving to record highs this morning and I'm surprised this is seen as an isolated problem for Spanish and Italian stocks only. Maybe investors are betting that central banks would pump liquidity into the markets should one or more of the countries blow up. Here is actually my long term bullish argument: the EZB hasn't even started yet with any QE-type stuff. If the going gets tough, they will IMO.

Friday, July 20, 2012

Why You Should Trade

Ray Dalio, head of the world largest hedge fund Bridgewater is must-read for investors. His basic investing thesis is that the world is undergoing a long-term deleveraging process, which can last decades.

The chart below shows what that means: Japan has been in deleveraging mode for over 20 years and still isn't done. The US started that process only 3 years ago and if Dalio is right, the DOW will move either down or at least sideways for at least another generation. 

In my opinion, this would be catastrophe especially for the US, since the whole retirement and academic funding system is built on the premise of positive stock market returns. If stocks don't rise in the next ten years, an entire generation of retirees will have essentially no money to spend, which will put additional breaks on the economy. 

Conclusion: the only *theoretical* way to gain decent returns will be to trade. I would consider buy-and-hold even more risky than trading in the current framework.

Thursday, July 19, 2012

AEO: Lesson on Buy the Rumor, Sell the Fact

On Tuesday I added another long - American Eagle Outfitters, AEO. It’s my classical setup: stock outperforming for the last months, consolidated the last weeks and now accelerates again on good relative strength vs. the S&P 500.

It is very interesting to look at how the stock has been trading in 2012: on March 7, the company reported disappointing Q4 earnings and Q1 guidance. Still, the stock gapped up and rallied on
hope that the company would improve margins and manage inventory well going forward. In fact, AEO caught various upgrades in the following days. For example, Goldman upgraded to "conviction buy" on March 8.

Two months later, on May 2, AEO raised Q1 guidance after strong spring sales. Obviously good news, so the stock gained over 16% on that day! Subsequent price action gives a good lesson on how institutions are playing this game: buying this piece of good news would not have been a good strategy. AEO fell during the weeks following guidance update: institutions were obviously selling into the positive story and taking profits.

AEO is also a good example of the "buy the rumor, sell the fact" philosophy. At the beginning of March, investors were buying the outlook for better Q1 earnings. In May, they sold this news.

In addition, AEO is a turnaround play since the company is operating under new management. The stock is now rising on a mechanism which is similar to the March/April run-up: on hope that
Q2 will surprise to the upside, similar to Q1 earnings.

Wednesday, July 18, 2012

LULU: Sellers Running Out of Steam

LULU is one of my short positions, its stock shows signs that sellers are becoming exhausted: the swings to the downside are not only getting weaker and thus creating a bullish "declining wedge" formation; volume also suggests that institutions are done selling:

 The stock is highly shorted with 26% of float, so one has to be careful to not get caught in a short covering price squeeze. I already took some profits on the position, but plan to take the rest off the table in the next days.

Tuesday, July 17, 2012

Morning Thoughts Jul 17: a Little Brother

The recent S&P chart starts to look like the second half of 2011, although with less violent moves (aka lower ATR). Note how the index after the strong initial August decline built up that symmetrical triangle during the last quarter of the year. It's almost like a  little brother was created in June/July this year. I'm curious if today's Bernanke testimony will do the trick and let prices break out:

Overall, I'm pretty much leaning to the long side, most of my positions would benefit from a stronger market. Homebuilder Lennar is still my favorite long, which could have tremendous upside potential because it is a heavily shorted stock: over 20% of float is shorted, according to Finviz.com.

Yesterday, I closed one of my shorts with a small loss: CMG. The position reached my (mental) stop. I'm still short Silver and the position is testing my patience: the Euro seems to lose downside momentum, which should be bullish for the metal. We'll see...

Saturday, July 14, 2012

My Trading Tools

I'm not using many tools for trading. In general I'm a big fan of the "less is more" principle. my requirements are a little different since I need to be able to monitor developments when I'm traveling. Over the years, the following paid services have demonstrated good value for me and I currently use them in my process:

Interactive Brokers

I had my trading account on IB even before Covestor. Commission structure is almost unbeatable and they offer great access for someone who trades out of Europe. I usually find the stocks I want to short there, which I like.

Telechart (www.worden.com)

I tried it and loved it, especially the speed to flip through charts and customizing options. Their real time scanner is quite important for my work. TC recently came out with an iPad viewer, which is helpful when I'm traveling, although it still needs some improvements. I'm sure they will come out with an update.


I have been working with Stockcharts.com since the beginning and still use their services to journal my trades and some watchlist management. I could replace most of it by TC, but Stockcharts still has some advantages when I travel.


Another service I couldn't live without. It is important for me to quickly find out why a stock is moving and Briefing does a good job here. It is the low cost alternative to a Bloomberg if you will.

So that's it. Besides these paid services, I've subscribed to tons of free blogs to get a feel for which topics are trending every day. I'm still doing my journaling BTW with Google Docs, again because of regional flexibility. You could argue I'm a fully "cloud-enabled" trader. The world is flat and I love it.

Thursday, July 12, 2012

Morning Thoughts Jul 12

I will focus on three things today: the S&P 500, because it is about to break important support; Silver, since the metal's chart is very vulnerable at these levels and my wife & son since they return from a two week trip to visit US family.

Concerning the S&P: as can be seen from the chart below, Futures actually broke the important uptrend line this morning. I remember commentators talking about a "inverse head and shoulder" pattern in June. Well, if this pattern fails, I would call it a bull trap with negative short-term implications. Now is the time where bulls have to step up.Remember, though: from failed moves come strong moves.

Silver is trying hard to stay above the important $26 level, but it will be hard to resist pressure from the declining Euro, which is marching fast towards $1.20 or even lower. 

Overall, I'm positioned mainly on the short side, but have still some longs (LEN, WFC, STLD), which demonstrated good relative strength in recent weeks. So far, they have been acting well.

Wednesday, July 11, 2012

Consumer Discretionary: Still Leading

Consumer Discretionary stocks have been leading the markets higher since the end of the Financial Crisis. So far, this hasn’t changed: even in the light of recent market weakness these stocks did hold up quite well. The Consumer Discretionary ETF XLY was the best performing major offensive sector ETF yesterday, losing just 0.6 percent while for examples the Industrial XLI declined 1.6 percent. As long as relative strength stays strong, I wouldn’t write off US stocks yet.