Generally speaking, when it comes to investment portfolios, the 3 key questions are:

*How much does it make?

*How much does it normally fluctuate along the way?

*How bad does it get hit when things go wrong?

The first question is important because of the obvious fact that people want to make money.  The other two matter a lot because different people have different levels of risk tolerance.  If an individual invests in a manner that is “too volatile” for their own risk tolerance there is a danger that they won’t “stick to the plan” when things get rough.

In any event, the real point for the purposes of this piece is that for the last 5 to 10 years the only question that most people focused on was “how much does it make?”  Because there really wasn’t a whole lot of volatility – particularly downside volatility to deal with.  Sure, there were downdrafts (2012, 2015, 2018), but for the most part they were very short-lived.  So, by the time an investor realized that maybe they should be worried, the market had already turned back to the upside.

Ah, for the “good old days”.

In 2020 investors were abruptly reminded that – uh, paraphrasing here – “stuff happens”, and that being prepared to deal with downside volatility is still very much a part of the equation.  So, this piece will look at one “portfolio approach”, and then attempt to “dial it up” just a bit.

The “Permanent Portfolio”

The impetus for this piece comes from this article on www.SeekingAlpha.com from an author who goes by “Greybeard Retirement.”  His piece grew from work originally done by Harry Browne in the 1980’s.  The portfolio consists of:

*25% stocks

*25% long-term U.S. bonds

*25% money market

*25% gold

The only change that I will make to this lineup is to replace money-markets with 1-3 year treasuries.

Data Used

In order to generate the longest test possible, I am using index monthly total return data rather than actual mutual fund data, as follows starting in January 1976:

Stocks: S&P 500 Index

Long-term treasuries: Bloomberg Barclays Long Treasury Index

Short-term treasuries: Bloomberg Barclays 1-3 Year Treasury Index

Gold: S&P Gold Spot Price Index

The Method

I rebalance the portfolio on January 1 each year so that each of the 4 categories starts the year as 25% of the portfolio.

Then we just hold the portfolio for the rest of the year.

The Results

Figure 1 displays the equity curve and Figure 2 the summary results.

Figure 1 – Growth of $1,000 for Permanent Portfolio (1976-2020)

Figure 2 – Permanent Portfolio Results (1976-2020)

If you are looking for “steady growth” the results look pretty appealing.  At least until you consider an alternative such as the one that gain great popularity in the last 5 years – just buying and holding an S&P 500 Index fund.

Figures 3 and 4 compare the Permanent Portfolio to buying and holding the S&P 500 Index.

Figure 3 – Growth of $1,000 for Permanent Portfolio versus S&P 500 Buy/Hold (1976-2020)

Figure 4 – Permanent Portfolio Results versus S&P 500 Buy/Hold (1976-2020)

Beauty is in the eye of the beholder, so I am not going to try to tell you what you are supposed to take away from this. I will simply point out the tradeoff:

*Buying and holding the S&P 500 Index will generally be expected to generate for gross return over time, with:

-a much higher degree of downside volatility

-a higher instance of extended periods of sideways activity (ex., 2000 to 2012 no net gain)

So is there a way to:

*Use the Permanent Portfolio

*Generate comparable gains to buying-and-holding the S&P 500 Index

*Still generate consistent, low volatility returns?

Would I as the question if the answer was “No?”

The Slightly More Aggressive Permanent Portfolio (Permanent Portfolio+)

We will refer to this approach as Permanent Portfolio+. For this test we will use the exact same data with one exception:

*For the S&P 500 Index portion of the portfolio we will use leverage of 2-to-1 (in real-world investing this would be accomplished by holding a 2x mutual fund or ETF)

Does this make a difference?  You be the judge.  Figures and 5 and 6 display the results for the Permanent Portfolio+ versus buying and holding the S&P 500 Index.

Figure 5 – Growth of $1,000 for Permanent Portfolio+ versus S&P 500 Buy/Hold (1976-2020)

Figure 6 – Permanent Portfolio+ Results versus S&P 500 Buy/Hold (1976-2020)

The two key things to note regarding the Permanent Portfolio+ are:

*It gained 40% more than S&P Buy/Hold

*Had a standard deviation of 11.2% versus 16.2% versus S&P Buy/Hold

*Had a Worst 12 months of -16.5% versus -43.3% versus S&P Buy/Hold

*Had a Maximum Drawdown of -17.8% versus -50.9% versus S&P Buy/Hold

*Had a Worst 5-years of +16.7% versus -29.1% versus S&P Buy/Hold

Summary

So, in the Permanent Portfolio+ the “be all, end all” of investing.  Probably not.  For the record, it lags buying-and-holding the S&P 500 much of the time and mostly outperforms by holding up well during bear markets.

Of course, that’s kind of the point, isn’t it?

In any event, as always I am not “recommending” that anyone adopt this as their approach to investing. But it is food for thought. As a potentially lower volatility alternative to just buying and holding the stock market, the Permanent Portfolio and the Permanent Portfolio+ seems to show some promise.

Jay Kaeppel

Disclaimer: The information, opinions and ideas expressed herein are for informational and educational purposes only and are based on research conducted and presented solely by the author.  The information presented does not represent the views of the author only and does not constitute a complete description of any investment service.  In addition, nothing presented herein should be construed as investment advice, as an advertisement or offering of investment advisory services, or as an offer to sell or a solicitation to buy any security.  The data presented herein were obtained from various third-party sources.  While the data is believed to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets.  Past performance is no guarantee of future results.  There is risk of loss in all trading.  Back tested performance does not represent actual performance and should not be interpreted as an indication of such performance.  Also, back tested performance results have certain inherent limitations and differs from actual performance because it is achieved with the benefit of hindsight.

In this article I wrote about an example intended to highlight a speculative trade designed to play the bullish side of the market for ticker AMD.  The position involved simply buying a 2-lot of an out-of-the-money July call option.

Well, lo and behold AMD has jumped from $48.38 to $54.66 and the trade now looks like what you see in Figures 1 and 2.

Figure 1 – Original AMD trade (Courtesy www.OptionsAnalysis.com)

Figure 2 – Current risk curves for original AMD trade (Courtesy www.OptionsAnalysis.com)

Now here is where things can get interesting for an alert options trader.  Recall form the original article that the tentative price target (generated by the Elliott Wave count using ProfitSource by HUBB) was $64 a share.  So, there is a ways left to go before that happens. 

However, an option trader does NOT necessarily have to “sit around and wait.”  Rather than going into a long discussion of “could do this” or “might do that”, let’s look at one simple adjustment and see how the adjusted trade compares to the original position.

The Adjustment

To adjust this trade, we will simply sell 2 July 60 calls @ $3.60 apiece.  For the record, this may be premature – ideally, we would want to sell them for $3.75, which is what we paid for the call options we bought.  Selling the 60 calls at $3.75 or higher (maybe via a limit order?) would completely eliminate the risk of loss.  But for the sake of completing the example, let’s continue.

New adjusted trade would look like what appears in Figures 3 and 4.

Figure 3 – Adjusted AMD position (Courtesy www.OptionsAnalysis.com)

Figure 4 – Risk curves for adjusted AMD position (Courtesy www.OptionsAnalysis.com)

The tradeoffs in making this adjustment are:

*The reduction of risk (the original trade can still lose -$750, the adjusted trade -$30 at most)

*You retain most of the upside potential up to AMD at $64 (at expiration, if AMD is at $64 a share the original trade shows a profit of roughly +$1,550, the adjusted trade would show a profit of $1,470)

If you DO make the adjustment:

*You retain much of the upside potential while eliminating most of the downside risk. 

On the other hand:

*If AMD really does take off and soar the original position enjoys unlimited profit potential, while the adjusted trade has a maximum profit of +$1,470.

One other possibility:

*A little patience might allow AMD to rise even more, which could allow us to sell the July 60 call at a price higher than $3.75, which would completely eliminate the risk of loss.

Decisions, decisions….

Jay Kaeppel

Disclaimer: The information, opinions and ideas expressed herein are for informational and educational purposes only and are based on research conducted and presented solely by the author.  The information presented does not represent the views of the author only and does not constitute a complete description of any investment service.  In addition, nothing presented herein should be construed as investment advice, as an advertisement or offering of investment advisory services, or as an offer to sell or a solicitation to buy any security.  The data presented herein were obtained from various third-party sources.  While the data is believed to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets.  Past performance is no guarantee of future results.  There is risk of loss in all trading.  Back tested performance does not represent actual performance and should not be interpreted as an indication of such performance.  Also, back tested performance results have certain inherent limitations and differs from actual performance because it is achieved with the benefit of hindsight.

Before proceeding, lets quickly review the title of this piece and its implications.  First off, please note that it is NOT titled “A Solid Long-Term Low Risk-Investing Plan for Semis”.  Which is good, because there really isn’t any of that in what follows.  What in fact follows is a discussion of an extremely speculative approach to trading.

Are we clear?  Great, let’s proceed.

The Keys to Successful Speculation

The first key to successful speculation is money management.  In as few words as possible the phrase to remember is “bet small.’ 

Too often an individual gets bit by the “I want to make a lot of money, so I guess I’ll risk a lot of money in order to make a lot of money” bug.  And that is the downfall.  So remember, bet small.  Risking a little to make a lot is better than risking a lot to make a lot.

The next two things are:

*Spotting opportunity

*Finding a trade to take advantage of the opportunity

Spotting opportunity can come from anywhere, but generally speaking you want the odds to be in your favor as much as possible.

Finding a trade – for most traders – involves buying shares of a stock or ETF.  In this article we will use options as an alternative.

Ticker AMD

For this piece we will focus on ticker AMD.  As always, the example trades highlighted on JOTM are just that, examples.  I am not making any “predictions” nor “recommendations”.  In fact, AMD is a tad “overbought” (if one looks at the 3-day RSI for AMD), so in a perfect world I might even consider waiting for at least a slight pullback before acting on the example idea below.  But I am getting ahead of myself.

For the record, I am not a huge Elliott Wave guy, however, I do pay attention on those occasions when the daily AND weekly wave counts align to either the bullish or bearish side.

For Elliott Wave counts I rely on ProfitSource by HUBB.  The reality is that it is hard to get two “Elliott Heads” to agree on the correct current wave count for much of anything, and I personally have no ability whatsoever to “count waves” in any objective or useful manner.  Which is why I like the fact that ProfitSource – for better or worst – has an objective built in algorithm for doing so.

Figure 1 displays the daily Elliott Wave count for ticker AMD, which is projecting a Wave 5 advance to the $64-$71 a share range sometime between late April and late May.  Sounds optimistic to me, but there you have it. 

Figure 1 – AMD daily with Bullish Wave 4 buy (Courtesy ProfitSource by HUBB)

Figure 2 displays the weekly Elliott Wave count for ticker AMD, which is projecting a Wave 5 advance to the $66-$78 a share range sometime between mid-October and July 2021.

Figure 2 – AMD weekly with Bullish Wave 4 buy (Courtesy ProfitSource by HUBB)

Will either of these counts prove prescient?  It beats me.  What does get my attention is that both the daily and weekly are projecting Wave 5 advances at the same time.

As I mentioned earlier, one of the keys is putting the odds on your side.  So, let’s look at a few more potential “pieces of the puzzle.”

Figure 3 displays the annual seasonal trend for ticker SMH – which is an ETF that tracks the semiconductor industry.  Note that we are now past the typical period of weakness and that the seasonal trend going forward is positive.  At the very least, we are not sailing into any seasonal headwinds.

Figure 3 – Semiconductor seasonality (Courtesy Sentimentrader.com)

Figure 4 displays trader sentiment towards the semiconductor industry.  Note that this is generally a contrary indicator – i.e., low readings suggest bearish sentiment is overdone and high readings suggest bullish sentiment is overdone.  Note that sentiment WAS overly bullish buy is now neutral.  While this is not necessarily a positive, the point is that at the moment it is NOT a negative working against semiconductor stocks.

Figure 4 – SMH sentiment (Courtesy Sentimentrader.com)

Figure 5 displays the price chart for AMD with the 90-day option implied volatility (black line).  Note that after the big “spike”, IV has now declined back down to the normal range.  In other words, while AMD options may not necessarily be “cheap”, they also are NOT “expensive.”

Figure 5 – AMD option implied volatility (Courtesy www.OptionsAnalysis.com)

One Way to Play

If one is bullish on AMD the most straightforward play is simply to buy shares of AMD.  For sake of example, we will make the following assumptions:

*The daily wave count will prove accurate and AMD will rally towards 64 sometime in the next several months (this is NOT a prediction I am making, just an example assumption that a trader must either make – or not make, when deciding, a) whether or not to trade in the first place, and if so, b) which trade to make

*We are willing to risk a maximum of 3% of our capital.  For sake of example we will assume of $25K trading account, so 25K x 3% = $750 maximum risk we will take

Given all of the this a trader might consider buying 2 July2020 52.5 AMD calls at $3.75 as shown in Figures 6 and 7

Figure 6 – AMD July 52.5 calls (Courtesy www.OptionsAnalysis.com)

Figure 7 – AMD calls risk curves (Courtesy www.OptionsAnalysis.com)

Things to Note:

*Maximum risk if held until expiration is $750

*Breakeven price is $56.25

The good news is that this trade gives us unlimited upside potential for a cost of $750 for a 2-lot.  The bad news is that with the stock presently trading at $48.38, the stock MUST advance 16% in price between now and mid-July in order to even breakeven.

Hence the use of the word “speculation.”  In other words, AMD MUST rally sharply in the next 3+ months or this trade will lose money.

Remember though that the catalyst for the trade is the belief that the Elliott Wave count will prove accurate and that AMD will in fact rally strongly.  If you don’t believe that then there is no reason to make this trade in the first place.

A Closer Look

*The daily EW count suggested that AMD would reach $64.05. 

*We also know that the recent low is AMD was $36.75. 

*So, let’s zoom in and take a closer look at “where this trade lives” – which is between $36.75 and $64.05 between now and 6/22 (which is 25 days prior to option expiration – most time decay would occur between that day and July expiration).

*Figure 8 displays the risk curves for this trade as of 6/22, which is 25 days prior to option expiration (and before most of the time decay will occur as the option gets closer to expiration).

Figure 8 – AMD call risk curves as of 25 prior to option expiration (Courtesy www.OptionsAnalysis.com)

*If AMD DOES reach $64.05 a share this trade will show an open profit of roughly $1600 to $1950, depending on whether that price level is reach later or sooner.

*If AMD is below $54.32 on June 22^nd chances are this trade will be showing a loss

*If AMD sinks in price, this trade will absolutely, positively lose most of its value.

The bottom line: If you are not willing to bet on a sharp advance in AMD shares in the next several months, and/or if you are unwilling or unable to risk $750, then this trade is to be avoided.

Summary

Is making a bullish bet on AMD a good idea?  I am not saying that it is or is not.  Please remember, this is NOT a “recommendation.”  I am merely highlighting several factors that a trader “might” consider to be favorable signs (bullish daily and weekly EW counts, positive seasonality, no negative sentiment headwind, option volatility back in a normal range (i.e., option premiums are not “expensive”, etc.).

Does any of this mean that the example trade will end up profitable?  Not at all.  Hence the reason:

a) only 3% of total capital is committed to the trade, and

b) it is clearly labeled as “speculation.”

One last note: A trader might also consider buying a longer-term option to give AMD more time to “move.”  The upside is that you may have more time for AMD to stage an advance.  The potential negatives are:

a) longer-term options are more expensive that shorter-term options,

b) bid/ask spreads tend to be wider,

c) longer-term options are affected more by changes in implied volatility (if AMD does rally, chances are IV will decline more, thus a longer-term option may lose more time premium due solely to a change in IV than a shorter-term option)

A lot to chew on for a silly little speculative trade, no?  But remember, if you want to succeed in speculating in the long run, remember these words:

“Nothing worth doing is ever easy”

(Sorry, but I don’t make the rules…)

Jay Kaeppel

Disclaimer: The information, opinions and ideas expressed herein are for informational and educational purposes only and are based on research conducted and presented solely by the author.  The information presented does not represent the views of the author only and does not constitute a complete description of any investment service.  In addition, nothing presented herein should be construed as investment advice, as an advertisement or offering of investment advisory services, or as an offer to sell or a solicitation to buy any security.  The data presented herein were obtained from various third-party sources.  While the data is believed to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets.  Past performance is no guarantee of future results.  There is risk of loss in all trading.  Back tested performance does not represent actual performance and should not be interpreted as an indication of such performance.  Also, back tested performance results have certain inherent limitations and differs from actual performance because it is achieved with the benefit of hindsight.

Leveraged funds hold a certain allure to traders and investors.  “Gee, if I can make 10% with a standard fund or ETF, I can make 20% – or even 30% – with a 2x or 3x leveraged fund.”  Uh, yeah, about that….

First off most leveraged funds reset on a daily basis, which – without going into the full explanation – means that if you hold a 2x fund for 3 months and the underlying index goes up 20% it does NOT necessarily mean that you are going to make 40% (sorry, I don’t make the rules, nor did I invent math).

In addition, when things go wrong with a leveraged fund, they often go really wrong!  See this article about an entire slew of leveraged ETFs that in some circles garnered a fair amount of interest – right up until March 2020 when they ceased to exist!

I actually have a few more caveats, but they are more directly related to the “strategy” that I am about to show you, so I will get to those a little later.

How To Use Leveraged Funds

In a word, the answer is “conservatively.”  “But wait, I am using a leveraged fund because I want to be aggressive.”  You are, just by using a leveraged fund.  The problem is simple:

“If you focus too much on the reward side of the equation you ignore the risk side of the equation”

And ignoring the risk side of the equation is what gets you killed.  So let’s consider an alternative.

A “Diversified Leveraged Strategy”

As always, I am NOT “recommending” that anyone rush out and adopt the strategy that follows.  It is presented as “food for thought” and to highlight the gist of (at least in my market-addled mind) the proper mindset to have when using leveraged funds.

This strategy splits capital between 3 securities:

*The S&P 500 Index

*Long-term treasury bonds

*Intermediate-term treasury bonds

But it’s a little more involved than that.  Specifically:

*25% in a 3x leveraged S&P 500 Index ETF

*25% in a 3x leveraged long-term treasury ETF

*50% in a non-leveraged intermediate-term treasury ETF

The Data Used

We will use ticker UPRO to trade the S&P 500 Index, ticker TMF to trade long-term treasuries and ticker IEI to trade intermediate-term treasuries.  Both UPRO and TMF are triple-leveraged ETFs.

NOTE: All 3 of these funds existed by July 2009, so we will start using actual monthly total return for those ETFs then.  However, in order to generate a longer test we will use index data starting in January 1973.  So, the actual data used is as follows:

Figure 1 – Data Used

Portfolio Construction

On January 1^st every year we will rebalance the portfolio to hold:

S&P 500 Index (x3): 25%

Long-Treasuries (x3): 25%

Intermediate Treasuries (x1): 50%

For comparison’s sake we will compare the performance to that of a fully non-leveraged portfolio (using index data only)

The Results

Figure 2 displays the growth of $1 using both a leveraged approach and a non-leveraged approach. 

Figure 2 – Growth of $1 Leveraged approach versus non-leveraged approach (Logarithmic scale)

Figure 3 displays the comparative numbers

Figure 3 – Comparative Facts and Figures (Jan1973-Mar2020)

The bottom line, if you want low risk and low volatility, the non-leveraged approach generated an 8.7% average annual return with a maximum drawdown of -9.4%.  $1,000 grew to $44,167 over roughly 47+ years.

Willing to “roll the dice” (and able to stomach much bigger swings in equity)?  The leveraged approach generated a 20.5%% average annual return with a maximum drawdown of -33.8%.  $1,000 grew to over $3 million dollars over roughly 47+ years.

Looking for something in between?  A 10% leveraged SPX, 15% leveraged long treasury and 75% non-leveraged intermediate-term treasury approach (NOT SHOWN) generated a 13.4%% average annual return with a maximum drawdown of -14.7%.  $1,000 grew to over $288,000 over roughly 47+ years.

Discussion of Results

Figure 4 displays the hypothetical annual results for both the leveraged and non-leveraged versions.

Figure 4 – Year-by-Year Hypothetical Results

In theory, and investor using the originally leveraged strategy detailed above would have accumulated a great deal of wealth over the past 47 years.  This is an illustration of the potential usefulness of leverage – AS LONG AS the leverage is “managed” (i.e., in this case, we had a large allocation to low volatility intermediate-term treasuries).

Now for some caveats for anyone thinking “hmm, maybe I should do this.” 

*The last 47 years have been most extraordinarily bullish for both stocks and bonds, particularly long-term bonds, as interest rates have gone from 15%+ to less than 1% since the early 1980’s. 

*There is no guarantee that the stock market will perform anywhere near as well in the years ahead as it did since 1973. 

*And we can be certain that bond performance will look different in the future as there is only so much further that interest rates can fall.

*Of particular note is that both the leveraged and non-leveraged versions show a GAIN through the first three months of 2020.  The leveraged version showed a drawdown of just -3.8% in March.

Summary

The real lesson is this: Leveraged funds used aggressively will more than likely end in disaster.  So don’t do that.

Jay Kaeppel

Disclaimer: The information, opinions and ideas expressed herein are for informational and educational purposes only and are based on research conducted and presented solely by the author.  The information presented does not represent the views of the author only and does not constitute a complete description of any investment service.  In addition, nothing presented herein should be construed as investment advice, as an advertisement or offering of investment advisory services, or as an offer to sell or a solicitation to buy any security.  The data presented herein were obtained from various third-party sources.  While the data is believed to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets.  Past performance is no guarantee of future results.  There is risk of loss in all trading.  Back tested performance does not represent actual performance and should not be interpreted as an indication of such performance.  Also, back tested performance results have certain inherent limitations and differs from actual performance because it is achieved with the benefit of hindsight.

In this article I highlighted the fact that a big number of new highs OR new lows can be bullish for the stock market.  As it turns out, a big price movement – either up or down – can also have the same effect. 

The kernel of knowledge for today comes from the work of Wayne Whaley, who last I knew worked at Witter & Lester.  The truth is I kind of lost touch with Wayne in recent years, but the relevant fact is that he does a lot of very unique market analysis.  Like this for instance:

*A = 5 day % change in price for the S&P 500 Index

*If A is >= +10.00% OR A is <= -13.85% it appears to be bullish for the stock market

To quantify a little bit let’s add the following rules:

*If A is >= +10.00% OR A is <= -13.85% then hold the S&P 500 Index for 252 trading days (ostensibly 1-year)

*If a buy signal is already in force and another signal occurs then extend the holding period for another 252 trading days

For lack of a better name we will refer to this “indicator” as WW (in Wayne’s honor).  Figure 1 displays the 5-day% change in price for the S&P 500 Index starting in 1970.

Figure 1 – S&P 500 Index 5-day % price rate-of-change (1970-2020)

Figure 2 displays the Buy and Sell dates using the rules above.

Figure 2 – Buy and Sell Dates for WW; 1970-2020

A few things to note:

*The median gain 12-months later was +26.0%

*The median maximum drawdown from the entry date was -7.7%

*There aren’t many occurrences so it is more of an anecdotal piece of information than the crux of a system or strategy

*However, what is interesting to note is that signals tend to occur at very significant points in time for the market:

-The end of the 1970 bear market

-The end of the 1974 bear market

-The early stage of the 1982 bull market

-The day of the 1987 Crash

-The late stages of the 2000-2002 bear market

-During the 2008 bear market (this signal was a bit early as the market declined another -32% before bottoming)

-During the late stages of the March 2020 panic

Overall, these marked some of the most important buying opportunities in the last 50 years.

Figure 3 displays the cumulative % growth for the S&P 500 Index if bought and held ONLY during the dates displayed in Figure 2.

Figure 3 – Cumulative price change for S&P 500 Index during bullish periods as signaled by WW (1970-2020)

Figures 4 through 10 display the periods shown in Figure 2

Figure 4 – 1970 Signal (Courtesy AIQ TradingExpert)

Figure 5 – 1974 Signal (Courtesy AIQ TradingExpert)

Figure 6 – 1982 Signal (Courtesy AIQ TradingExpert)

Figure 7 – 1987 Signal (Courtesy AIQ TradingExpert)

Figure 8 – 2002 Signal (Courtesy AIQ TradingExpert)

Figure 9 – 2008 Signal (Courtesy AIQ TradingExpert)

Figure 10 – 2020 Signal (Courtesy AIQ TradingExpert)

Summary

One cannot discount the potential for more downside in the market.  Remember that following the October 2008 WW signal the market worked its way 32% lower over the next 4.5 months. 

Still, if history is an accurate guide, we may look back on March 2020 as an opportunity on a par with 1970, 1974, 1982, 1987, 2002 and 2008.

Here’s hoping.

Jay Kaeppel

Disclaimer: The information, opinions and ideas expressed herein are for informational and educational purposes only and are based on research conducted and presented solely by the author.  The information presented does not represent the views of the author only and does not constitute a complete description of any investment service.  In addition, nothing presented herein should be construed as investment advice, as an advertisement or offering of investment advisory services, or as an offer to sell or a solicitation to buy any security.  The data presented herein were obtained from various third-party sources.  While the data is believed to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets.  Past performance is no guarantee of future results.  There is risk of loss in all trading.  Back tested performance does not represent actual performance and should not be interpreted as an indication of such performance.  Also, back tested performance results have certain inherent limitations and differs from actual performance because it is achieved with the benefit of hindsight.

History suggests (see data below) that now is the time to be looking to increase exposure in the mid-cap space. Ironically, now is the time when investors are most likely to look away. Same as it ever was when it comes to investor psychology.

In the 1^st quarter of 2020, the S&P 400 Midcap Index suffered its worst quarterly loss since it was first created in 1981.  While this was a painful gut punch and may naturally cause reactive investors to turn away from mid-caps, if history is a guide mid-caps may be setting up to perform exceptionally well on a relative and absolute basis in the short-term as well as over the next 5 years.

Chances are good we will look back at the current period as a good time to increase exposure to the Mid-cap sector.   Consider the following…

The Historical Record

The S&P 400 Midcap Index has been a stellar performer over time, handily outpacing large-cap and small-cap stocks.  Figure 1 displays a logarithmic chart displaying the growth of $1 invested since January 1981 on a buy-and-hold basis for:

*Mid-Caps – S&P 400 Index (blue): +9,246%

*Large-Caps – S&P 400 Index (orange): +5,171%

*Small-Caps: Russell 2000 (grey): +2,853%

Figure 1 – Mid-cap, Large-cap and Small-cap; Growth of $1, 1981-2020

As you can see, since the S&P 400 Midcap Index was created in 1981, mid-caps have outperformed large-caps by a factor of 1.79-to-1 and small-caps by a factor of 3.24-to-1. 

Surprisingly, very few investors are aware of this.

Most investors tend to be lured to the “growth potential” of small-caps and/or the “steady nature” of “established” large-caps (i.e., this is often code for “companies whose name I recognize”).  But the long-term record clearly points to the fact that the mid-cap space is “where the growth is.” 

The simplest explanation backing this theory states that “mid-caps are former small cap on their way to becoming large caps”, i.e., it’s where the growth is.

What the Historical Record Says About Potential Future Performance

While the performance of mid-caps has been abysmal in early 2020, history suggests that this dismal performance may be setting the stage for a significant bounce back.  To wit:

Figure 2 displays S&P 400 performance 1 to 5 years after the worst quarterly performances for the index since it was first calculated in 1981.

Figure 2 – Worst Quarters for S&P 400 MidCap Index and subsequent forward performance

Note that the average 1, 2, 3, 4 and 5 year forward performance handily outperformed the average performance for ALL 1, 2, 3, 4- and 5-year periods.

Regarding the next 12 months, Figure 3 displays the cumulative growth for the S&P 400 Index during the 12 months following each of the dates listed in Figure 2.

Figure 3 – Cumulative performance Mid-caps held ONLY during the 12-months following each of the worst quarters for S&P 400 Index listed in Figure 2

Mid-Caps vs. Large-Caps after Mid-Caps experience exceptionally bad quarter

The tables below display the returns for mid-caps AND large-caps over 1 to 5-year periods directly AFTER Mid-Caps experience a quarterly decline of -11% or more, and the difference in performance between the two.

NOTE: Except for the 1-year performance after the Dec-2018 signal, Mid-Caps have outperformed Large-Caps over every time frame with rare exceptions.

Figure 4 – Mid-Caps invariably outperform S&P 500 after experiencing a large quarterly loss

Summary

Emotion has a strong impact on investors.  When a security suffers a large loss, human nature tends to make investors believe that that security should be avoided. But quite often this is exactly the time that investors should be flocking to a given security as the back-and-forth nature of markets sets the stage for a strong rebound.

Large-cap stocks have been the “go to” segment during much of the recent bull market and in the early stages of the current decline.  History strongly suggests that this trend will not last forever, and that a powerful reversion to the mean will soon favor the mid-cap space once again. 

Well I’ve been meaning to make a video, so since I am trapped here at home I figured “why not now?”  Please click the link below to see my video discussing all kinds of things related to the big picture, long-term outlook as well as the current trend, and prospects for the market for the next 12 months.

Jay’s Research Video

You can make it Full Screen by clicking the two opposing arrows near the lower right.

For the record, I flubbed the opening not once, but twice and have no way to edit them out. So your choices are:

a) Click ahead to about the 1-minute mark

b) Watch the first minute to observe the “How Not To” lesson

Topics include:

*Where we stand now in relation to market history

*The Decennial Pattern

*The first 2.5 years of this decade

*The current trend for the market and how to use my market bellwethers

*Two very positive developments for the next 12-months

*The most consistent market trend

*3 trend reversals to watch for

Enjoy! (endure? Whatever!)

Jay’s Research Video

Jay Kaeppel

Disclaimer: The information, opinions and ideas expressed herein are for informational and educational purposes only and are based on research conducted and presented solely by the author.  The information presented does not represent the views of the author only and does not constitute a complete description of any investment service.  In addition, nothing presented herein should be construed as investment advice, as an advertisement or offering of investment advisory services, or as an offer to sell or a solicitation to buy any security.  The data presented herein were obtained from various third-party sources.  While the data is believed to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets.  Past performance is no guarantee of future results.  There is risk of loss in all trading.  Back tested performance does not represent actual performance and should not be interpreted as an indication of such performance.  Also, back tested performance results have certain inherent limitations and differs from actual performance because it is achieved with the benefit of hindsight.

They always say you should buy when there is “blood in the street.”  They also say, “buy them when nobody wants them.”  So, let’s consider today what could be the most unloved, bombed out, everybody hates it “thing” in the world – coal.

Ugh, just the mention of the word coal elicits a recoiling response.  “Dirty energy!”  “Climate change inducing filth!” “Ban coal!”.  And so and so forth.  And maybe they have a point.  But “they” also say “facts are stubborn things” (OK, for the record, I think it’s a different “they” who says that but never mind about that right now).

So here is a stubborn fact: coal supplies about a quarter of the world’s primary energy and two-fifths of its electricity.  As I write, two of the fastest growing economies (at least they were as of a few months ago) – China and India – are not only heavily reliant upon coal for energy, but are still building more and more coal-fired plants.  Now I am making no comment on whether this is a good thing or a bad thing but the point is, it most definitely is a “thing.”

So however one feels about coal, the reality is that it is not going to go away anytime soon.  Does this mean it will “soar in value” anytime soon – or even ever for that matter?  Not necessarily.  But as an unloved commodity it’s sure is hard to beat coal.  And as “they” (they sure are a bunch of know it all’s they?) say, “opportunity is where you find it.” 

Ticker KOL is an ETF that invests in coal industry related companies.  And what a dog it has been.  Figure 1 displays a monthly chart of price action.  Since peaking in June 2008 at $60.80 a share, it now stands at a measly $6.29 a share, a cool -89.6% below its peak.  And like a lot of things it has been in a freefall of late.

Figure 1 – Ticker KOL Monthly chart (Courtesy AIQ TradingExpert)

So, is this a great time to buy KOL?  That’s not for me to say.  But for argument’s sake, Figure 2 displays a weekly chart of KOL with an indicator I call Vixfixaverageave (I know, I know), which is a version of an indicator developed a number of years ago by Larry Williams (Indicator code is at the end of the article).

Figure 2 – KOL weekly chart with Vixfixaverageave indicator (Courtesy AIQ TradingExpert)

Note that Vixfixaverageave is presently above 90 on the weekly chart.  This level has been reached twice before – once in 2008 and once in 2016.  Following these two previous instances, once the indicator actually peaked and ticked lower for one week, KOL enjoyed some pretty spectacular moves. 

To wit:

*Following the 12/19/08 Vixfixaverageave peak and reversal KOL advanced +252% over the next 27.5 months

*Following the 2/19/16 Vixfixaverageave peak and reversal KOL advanced +182% over the next 23.5 months

When will Vixfixaverageave peak and reverse on the weekly KOL chart?  There is no way to know.  One must just wait for it to happen.  And will it be time to buy KOL when this happens?  Again, that is not for me to say.  None of this is meant to imply that the bottom for KOL is an hand nor that a massive rally is imminent.

Still, if there is anything at all to contrarian investing, its hard to envision anything more contrarian that KOL.

Vixfixaverageave Calculations

hivalclose is hival([close],22).  <<<<<The high closing price in that last 22 periods

vixfix is (((hivalclose-[low])/hivalclose)*100)+50. <<<(highest closing price in last 22 periods minus current period low) divided by highest closing price in last 22 periods (then multiplied by 100 and 50 added to arrive at vixfix value)

vixfixaverage is Expavg(vixfix,3). <<< 3-period exponential average of vixfix

vixfixaverageave is Expavg(vixfixaverage,7). <<<7-period exponential average of vixfixaverage

Jay Kaeppel

Disclaimer: The information, opinions and ideas expressed herein are for informational and educational purposes only and are based on research conducted and presented solely by the author.  The information presented does not represent the views of the author only and does not constitute a complete description of any investment service.  In addition, nothing presented herein should be construed as investment advice, as an advertisement or offering of investment advisory services, or as an offer to sell or a solicitation to buy any security.  The data presented herein were obtained from various third-party sources.  While the data is believed to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets.  Past performance is no guarantee of future results.  There is risk of loss in all trading.  Back tested performance does not represent actual performance and should not be interpreted as an indication of such performance.  Also, back tested performance results have certain inherent limitations and differs from actual performance because it is achieved with the benefit of hindsight.

In this article I detailed an example of a bear call spread using options on GLD.  And while I got a little long-winded in detailing all of the considerations involved in selecting and entering this type of trade, for the sake of brevity the one thing I did not discuss was when to take a profit.  Two important points on this:

*You absolutely, positively should have a profit-taking plan in place at the time you enter the trade. 

*When trading options there are a variety of choices when it comes to taking profits.

When you get a profit on an option position you have several choices, including:

*Do nothing – i.e., let it ride

*Close the entire position – i.e., take your profit and move on

*Close part of the position and let the rest ride – i.e., take some money/risk off the table and still have the potential for further gains

*Adjust the existing position into another position – this is a more advanced topic, but is one of the great advantages available to option traders

Our GLD Bear Call Spread

In our example GLD trade we:

Sold 4 May2020 180 calls @ $2.60

Bought 4 May2020 185 calls @ $2.10

*Maximum profit potential is $200

*Maximum risk is -$1,800

Where Things Stand

Since the example trade was entered on 3/24, GLD has fallen from $153.40 a share to $148.05 as you can see in Figure 1.

Figure 1 – GLD falls (Courtesy ProfitSource by HUBB)

The out-of-the-money calls in our trade have both declined in value, and as of the close on 3/31 the trade had an open profit of $148.  See Figures 2 and 3.

Figure 2 – GLD bear call spread (Courtesy ProfitSource by HUBB)

Figure 3 – GLD bear call spread risk curves (Courtesy ProfitSource by HUBB)

Any of the 4 choices listed above are fair game, i.e., we can:

*Hold on and hope GLD continues to hold below $180 a share for the next 45 days

*Close the position and take our profit and not concern ourselves anymore that GLD might rally

*Close half the position and hold the rest

*Do something creative – for example we could sell a bull put spread and create a condor spread (but I am not going to go into all of that right now)

The good news with options is that we have a lot of choices.  The bad news is that there are no “correct” answers, which is why having a profit taking plan in place at the time of trade entry is important.  Since I did not cover that in the original article, let’s assume we did not make a profit-taking plan (needless to say, it wouldn’t be the first time a trader failed to do so) and now have to decide.

While any of the choices above is valid, my “gut instinct” says to close the position, take the profit and move on.  Here is my rationale (and “Yes”, you are absolutely allowed to disagree):

*GLD did exactly what we hoped it would do (i.e., decline fairly sharply in price) in just 5 trading days

*We have the opportunity to capture roughly 75% of our maximum profit potential in just one week and to completely eliminate risk

*The reward-to-risk picture has gone from potential $200 profit versus -$1,800 in risk, to an additional profit potential of $52 versus -$1,948 in risk (in other words, if we hold on until mid-May our maximum profit potential from this point is $52.  On the other hand, if GLD DOES rally we could give back our $148 gain AND lose and additional $1,800)

For the record, one can strongly make the “just hold on” argument given that GLD is quite far from our breakeven point of $180.50 and the odds strongly favor the options expiring worthless.  And in “normal times” exhibiting patience is often exactly the correct course of action.  My somewhat subjective argument in this situation is that given:

*The extremely volatile nature of the financial markets at this point in time

*The fact that the Market Gods bequeathed us a quick profit of 75% of our maximum profit potential, I am OK with “ringing the cash register” and taking a profit and exiting the full position.

Going Forward

Closing the trade does NOT mean that we have to forget all about GLD.  Remember, there is still significant resistance at $159.37.  If GLD rallies again and fails to break out above that level, we may be able to enter a new position and try it all over again.

Jay Kaeppel

Disclaimer: The information, opinions and ideas expressed herein are for informational and educational purposes only and are based on research conducted and presented solely by the author.  The information presented does not represent the views of the author only and does not constitute a complete description of any investment service.  In addition, nothing presented herein should be construed as investment advice, as an advertisement or offering of investment advisory services, or as an offer to sell or a solicitation to buy any security.  The data presented herein were obtained from various third-party sources.  While the data is believed to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets.  Past performance is no guarantee of future results.  There is risk of loss in all trading.  Back tested performance does not represent actual performance and should not be interpreted as an indication of such performance.  Also, back tested performance results have certain inherent limitations and differs from actual performance because it is achieved with the benefit of hindsight.

The recent panic in the financial markets witnessed a very unusual – though not unprecedented – phenomenon.  U.S. treasury securities performed well while virtually all other forms of debt – municipal, corporate, mortgage-back, leveraged loan, etc. – got clobbered.  This spasm reminds us that for all things there is a season.

One Approach to Risk-On/Risk-Off in Bonds

I detail several other caveats below but a couple things to mention at the outset.  First off, I do not actively use the model I am about to present.  Likewise, I am not telling you that you should use it.  It is presented here as “food for thought”, based on the fact that using the strategy presented (hypothetically) has vastly outperformed buying and holding the securities involved.  The securities used in the test are:

Long-Term U.S. Treasuries:

For indicator calculations we use monthly total return data for the Bloomberg Barclay’s Treasury Long Index.  For trading result purposes, we use the Bloomberg Barclay’s Treasury Long Index from July 1980 through May 1986, then we use monthly total return data for ticker VUSTX (Vanguard Long-Term Treasury).

High Yield Corporate:

For indicator calculations we use monthly total return data for ticker VWEHX (Vanguard High-Yield Corporate Fund) starting in July 1980.

IMPORTANT: For actual real-world trading purposes these funds may not be viable choices as Vanguard imposes certain switching restrictions.  An ETF-based alternative would be to use tickers TLT for treasuries and ticker HYG for high yield corporates.

The Calculations/Rules

A = 50-month cumulative % return for Bloomberg Barclays Treasury Long Index

B = 50-month cumulative % return for VWEHX

IF:

A < B then hold VUSTX for the next 7 months

A > B for 7 consecutive months then hold VWEHX

In actual English:

*If long-term treasuries have underperformed high-yield corporates over the previous 50-months, buy and hold long-term treasuries until they outperform high-yield corporate for 7 consecutive months – then sell long-term treasuries and buy high-yield corporates.

Figure 1 displays the 50-month cumulative % return for both long-term treasuries (blue line) and high-yield corporates (orange line).  As you can see it goes back and forth.

Figure 1 – 50-month cumulative % total return for Long-Term treasuries (blue) and High-Yield corporate (orange)

Figure 2 subtracts the orange line from Figure 1 from the blue line in Figure 1.  When the result is positive it means long-term treasuries have outperformed and when it is negative it means high-yield corporates have outperformed.

Figure 2 – Long-term treasury 50-month cumulative % return minus High-yield corporate 50-month cumulative % return

So, when the value in Figure 2 is negative it means we will hold long-term treasuries for at least the next 7 months.  And when the value in Figure 2 turns positive for 7 consecutive months it means we will sell long-term treasuries and hold high-yield corporates until the value in Figure 2 falls to negative once again.

IMPORTANT NOTE:  The total return data source that I use reports results for the prior month early in the next month.  In other words, I can’t make a calculation using January total return data on January 31^st because January total return data does not get updated until early February.  As a result, I follow this with a 1-month lag. 

To spell it out: A trading decision at the end of February is based on data from the end of January.  In other words, when the total return data for say January is updated in early February, we can do the “end of January” calculations and determine if a trade is to be made.  If so, that trade gets made on the last trading day of February.

Results

Figure 3 displays the growth of $1,000 invested using the Strategy versus buying-and-holding VUSTX and VWEHX, with an annual 50/50 rebalance at the end of December.

Figure 3 – Growth of $1,000 using Risk-On/Risk-Off Strategy (blue) versus Buy/Hold/Rebalance (orange); 1984-2020

Figure 4 displays some relevant comparative performance data. 

Figure 4 – Comparative Results

On the negative side, the Strategy does have a significantly higher standard deviation, a slightly higher maximum drawdown and a lower risk-adjusted return (Average 12mo. % divided by standard deviation). 

On the plus side, the Strategy achieved a cumulative gain of +4,406% versus +1,809% for the buy/hold/rebalance approach (NOTE: March 2020 data is through 3/30 using price performance ONLY).

The Latest

The Strategy has been in long-term treasuries since the end of August 2018 and will continue to hold them through at least the end of August 2020. Since the end of August 2018 through 3/30/20 long-term treasuries have gained roughly +38% while high-yield corporates have lost about -4%.

Summary

So, is this the be all, end all of bond investing?  Not likely.  Given that interest rates have been in a downtrend since about 1981, it is fair to assume that at some point this trend will reverse.  And when it does, it is more than fair to wonder how well long-term treasuries will perform. 

But for now – and repeating – this Strategy is presented as food for thought and for further analysis by those so inclined, not as something that anyone should rush out and employ without some additional thought.

Disclaimer: The information, opinions and ideas expressed herein are for informational and educational purposes only and are based on research conducted and presented solely by the author.  The information presented does not represent the views of the author only and does not constitute a complete description of any investment service.  In addition, nothing presented herein should be construed as investment advice, as an advertisement or offering of investment advisory services, or as an offer to sell or a solicitation to buy any security.  The data presented herein were obtained from various third-party sources.  While the data is believed to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets.  Past performance is no guarantee of future results.  There is risk of loss in all trading.  Back tested performance does not represent actual performance and should not be interpreted as an indication of such performance.  Also, back tested performance results have certain inherent limitations and differs from actual performance because it is achieved with the benefit of hindsight.