Absolute Alpha

Absolute Alpha

What better day to launch a new investment strategy than D-Day? 78 years ago today, America launched the largest offensive the world has ever seen to help defeat Nazi Germany and the Axis powers. Men dropped from the sky, motored on boats, and stormed the beachheads of Normandy. By sunset, blood-red tides lapped the sands...but we were victorious.

D-Day marked the beginning of the end of World War II. Nearly every freedom we enjoy today was defended and secured that day through enormous sacrifice. Much of this "paid-up capital" came at the cost of lives unlived. Thousands that day, and millions of progeny this day are not with us because of past battles. And almost every meaningful battle in history had at its core the fight for truth: What is right? What is wrong? What is the truth?

What better way to pay this sacrifice forward than a search for the truth? One of the greatest challenges investors face is trust. Indeed, a hallmark of our era is the collapse in public trust in both government and various "experts" of all types. Who do you believe? What are their qualifications? What is their track record? These questions beget another: Why should we care?

Traditionally, stock return estimates are predicated upon using macroeconomic variables, financial ratios, and to a large extent, data provided by corporations themselves. The summation of these forces has formed the bedrock of the financial industry throughout the world. CNBC, Bloomberg, Wall Street Journal, etc., etc. 

The list of established mediums of "trust" is long. Absolute Alpha strives to relieve investors of dependence on traditional stock market "trust" such as financial commentary, corporate messaging, or even Government reassurances. These data may or may not be accurate. Absolute Alpha is interested in sustained market movements, regardless of direction. Commentary, forecasting, and assurances be damned, Absolute Alpha seeks the truth!

The Absolute Alpha trading goal is simple: Seek a positive yearly return (absolute alpha), regardless of market conditions. Consider the chart below showing the performance of the S&P 500 from Jan '22 until May '22:

From a pure date-to-date perspective the S&P 500 was down 13.85%. Yet look closer and you will see something else entirely. Buried in this chart is an abundance of "truth." Rather than struggling with emotional turmoil experienced on a regular basis worried about whether XYZ will beat earnings, or how many units were sold, or if FDA approval was granted, investors can potentially benefit from a broad market approach focused solely on momentum vectors.

As previously discussed, Absolute Alpha's goal is to consistently produce alpha, regardless of market conditions. But how? By being on the right side of longer-term momentum vectors. In the chart above there are MULTIPLE (most likely infinite) vectors during this 5-month snapshot. The trick is capturing as many sustained momentum vectors as possible, while limiting downside losses by being late to a trade.

If we were to "cut" this chart into various date ranges there would be both negative and positive momentum vectors whose cumulative absolute total would far exceed the negative 13.85% value if timed correctly. Why not capture alpha on BOTH the upside and downside? Simply put, when the wind changes, a sailboat tacks. Investors need to do the same. Therein lies the truth.

 

Market Timing

 Market Timing

Conventional wisdom suggests that market timing is impossible, because a high or low is only made in retrospect...ie timing is only in the realm of Monday morning quarterbacks. "Impossible" may be too harsh a word though as market timing, like rocket science, might just be really, really challenging.

Literally billions of dollars, yen, euros, and every other currency is spent each year trying to forecast economic outcomes before they happen; ie how much will the Fed raise rates? What will consumer sentiment come in at? What's the unemployment number? etc., etc. And each of these metrics can have serious impacts on the global markets.

To accurately predict a market outcome one would need almost God-like knowledge of both the dataset and corresponding behavioral reaction. And that assumes the behavior reaction is rational. Often it isn't. And that's what makes successful market timing the Holy Grail of investing. 

Imagine be long (owning) stocks when the market is on an uptrend, and then quick as a cat being short (betting against) stocks when the market is on a down treat. It is financial nirvana for an investor capable of precisely timing the market. Consider the title chart above.

This example chart illustrates the hypothetical possibility of precisely timing the market from Apr 2007 through Mar 2012. The investor who perfectly timed the market would have pocketed a 120% return while the poor Buy-and Holder would have suffered a 10% loss.*

*There are a couple caveats to keep in mind dear readers before selling the farm and pawning the family heirlooms to become signal traders. First, you need perfect (or extremely accurate signals.) Signal source is paramount to success. Junk data will produce...well...the part of the farm that stinks. There's no way around it; junk in, junk out.

Second, there are signifiant tax implications to taking down short-term trades. So although the data may be good, and you may act on it, that hypothetical 120% return might be reduced by some 40% (or more!) Third, the "Wash Sale Rule" is always looking to put the hurt on you. Familiarized yourself with it immediately.

With that said, signal trading might be a compelling strategy for a disciplined trader(s) willing to address the above concerns.

 

Non-Linear

 Non-Linear

A 40-year chart of the DJIA obscures an almost infinite number of non-linear events. Judged over time by the eye, stock market volatility looks benign and performance linear. It looks resoundingly positive, and it is, but zooming in on almost any short period reveals intense periods of volatility. How can this be?

Statistically speaking, the long-term stock market performance may be the finest example of linear regression next to species genetics. In many ways there are similar. Multiple non-linear events occurring simultaneously over longer periods of time result in many economic failures, and also several sustaining successes. Consider the private equity world.

In the private equity world (PE for the pros) for every Apple, Facebook, Google, Uber, Amazon, success story there are probably 1,000,000X or perhaps even 1,000,000,000X failures to reach fruition. Put another way, investing works best when you own the survivors. A great example is the S&P 500 Index. 

The companies in an S&P 500 Index are not static; ie losers drop out and off the face of the Earth, while winners survive and populate the index. By default, investors are buying a basket of winners. To be a member of the S&P 500 Index, at this very snapshot moment, you must be a non-linear survivor. The failures by default are members of the S&P 1T failure index...that has a value of zero.

The Navy Seals have many excellent quips, one of my favorites is "It pays to be a winner." You got that right! The all-weather mentality of being in the stock market through thick and thin is a tough one to adhere to when volatility spikes and misery ensues. But being a winner means surviving and thriving, just like a member of the S&P 500.  

By default the longer an investor is in the stock market the greater her fortune should be (as evidenced by the 40-year chart above.)  The danger then becomes one of timing...more to come on that next post. 

 

Nibble, Don't Bite

My advice for beginning investors and those that come into random fortunes is the same; nibble, don't bite. For those individuals who ultimately wish to Invest Like A Farmer, it is prudent to deploy capital strategically, thoughtfully, and over time. Dollar cost averaging works, especially if you are entering the market for the first time or putting a significant sum of capital to work and plan, in both cases, to be in the market for some time.

It is nearly impossible to perfectly time the market; there are obviously better times to buy than others (nearly every correction or depression has proven to be an excellent time to buy for long-term holders), while some peaks has been good, and some not so good. (Imagine "selling on the high" in January 1982, 1983, etc. The bull market ran almost unabashedly higher for nearly 20 years!)

Nibbling offers superior advantages, in my view, to going "all-in" or "all-out" on any particular day, trade, or philosophy. It allows investors to test the water, build positions over time, and gradually construct a meaningful portfolio while still having plenty of seed capital in reserve.