Ideas About Investing & the Markets – #1

Last week, a really close friend of mine and I sat down for a cup of coffee (none for me though, as I love the smell of coffee but don’t like to drink it) at a Starbucks on Bloor Street (the financial district in Toronto) to discuss and share our trading strategies. You wouldn’t believe this, but he’s making 80%+ returns trading currencies! And he’s only leveraged 5 -1 (for those who aren’t familiar with currencies, 5-1 is a really small number). His numbers totally blew me away, and of course, I peppered him with a ton of questions.

After talking to him, I decided to publish some of the things he mentioned. So without further ado:

Watch the Small Cap

Superior to other market participants, speculators love to trade small cap stocks because they’re small and easy to manipulate. Hence, they’ll advance the furthest and fastest in a bull market and sink the fastest in a bear market because big price movements are always created by speculators.

At the end of a bull market, small cap stocks usually don’t move because speculators will usually foresee the storm clouds and be the first to get out. When this happens, you’ll notice that large indexes such as the Dow or S&P 500 are making all-time highs while small cap indexes like the Russell 2000 have plateaued or drifted downwards. This happens because the institutional funds, who always buy at the peak, only understand and invest in institutional stocks. Remember the Nifty Fifty?

Another lesson can be taken away from this insight. When the large cap indexes keep moving upwards but the small cap stalls, you know that speculators, the smart traders, believe that the market has peaked.  And vice versa.

Characteristics of a Bull Market’s Beginning.

Because all market stages have their own unique characteristics, the beginning of a bull market isn’t extremely difficult to spot. When a bull market starts, there will be heavy buying (the result of investors who predict the new bull market), but also heavy selling (the result of investors who want to hit the price down). However, the supports are very strong, so although there will be many sharp downwards corrections, the market will never break the support line. Instead, the support line will continuously inch upwards, making each support higher than the previous support.

When Corporate insiders don’t lie….

Corporate insiders, who want to doll out good news and attract investors, might be lying if say “things are great” during a bull market. BUT, that doesn’t mean they always lie.

When a corporate insider says something that’s against the prevalent opinion at the time, he’s probably not fibbing. For example, the common view in January 2009 was that the financial system was going to end, stocks would all go bankrupt, and the modern economic system as we knew it was over. However, a few corporate managers dared to say that things weren’t actually that bad. Going against the prevalent bearishness at the time, these executives turned out to be right because a string of positive earnings report supported the market at its low in March 2009.

As you can imagine, I took away quite a bit from this conversation, and because it was so useful, I rushed home to incorporate some of these thoughts into my investment model. Because it was the Canada Day long weekend, there were cops everywhere (to catch speedy tourists), and I almost got a ticket (oops, shouldn’t have said that)! 

After incorporating his beliefs into my investment model, I finally understood the answer to a problem that has nagged me for a long time. For some reason, the ETFs that I had invested in didn’t match the underlying asset very well. Here’s why:

ETFs Aren’t Meant for Long Term Investing

One of my favourite financial products, ETFs allow investors to hold a wide index of assets. For example, I can invest in the entire S&P 500 outright by buying the individual stocks according to their weight to the overall index, but that would be time consuming and difficult. ETFs simplify this problem by doing the stock-matching themselves, so I can easily have a single index. In addition, ETFs also allow you to leverage up. The nice thing about this is is that a leveraged ETF can never fall to zero, whereas a 25% decline will wipe out a standard 3-1 leveraged portfolio. But, there are inherent problems when investing in leveraged ETFs. Over long periods of time, an ETF’s value will erode, especially if the asset behind it experiences massive volatility.

Here’s how an ETF’s value is calculated (based on above chart).

E.g. C3 = (B3/B2-1)*C2+C2

E.g. D3 = (-B3/B2+1)*D2+D2

E.g. E3 = (B3/B2-1)*2*E2+E2

E.g. F3 = (-B3/B2+1)*2*F2+F2

But as you can see in the graph below, an ETF’s value will respectively match its asset IF market volatility is low (usually occurs in the middle of a bull market where price action is steady).

This means that over time, a leveraged ETF’s value will significantly erode because it’s not possible for the price action to be steady all the time. As a result, the conclusion can be made that leveraged ETFs are meant to be traded, not invested.