Last Call

The markets always provide an education. The month of October has been a challenging one personally speaking. We went in with a long bias but gave up those early gains as we started to fade the rally and are now tilted towards a short bias as the market goes higher. We are sticking with our position until further data confirms that we are on the wrong side of the trade.

It appears that the market hasn’t fully weaned off the elixir of the past several years that is Fed driven. The Fed has in essence held off on raising interest rates fully admitting that the U.S. economy isn’t strong enough to withstand a twenty five basis point increase off of zero interest rate policy conditions.  To have the market rally off of such news is indeed curious market action.

A recent article by Jon Hilsenrath of the Wall Street Journal (via Business Insider) indicates that chances of Fed action this year are quickly deteriorating. “Hilsenrath says after jobs, consumer spending and inflation data this month, the chances of a rate hike this month have been “virtually eliminated”. That accords with market price approximating around a 5% chance of a hike.

As a consequence, the focus has turned to the final FOMC meeting of the year with market pricing around a 30% chance of a rate hike. But Hilsenrath suggests even that might be too much, given that vice-chair Stanley Fischer’s much-heralded recovery in growth after the first quarter’s weakness does not appear to be materialising.

“Fed officials have given up on expectations that growth would accelerate in 2015, as they hoped would happen at the beginning of the year,” Hilsenrath wrote. “Their hope now is that a healthy domestic economy can withstand slowing overseas economies and turbulent financial markets and keep growing at a fast enough pace to modestly reduce unemployment further.””

Then we had Federal Reserve Governor Lael Brainard come out specifically questioning Fed policy and future inflation expectations. To have a Fed Governor come out in this way is unique. In her policy speech to the National Association of Business Economists she openly questioned the merits of the Fed’s inflation expectations and its assumptions on the labor recovery. She also questioned the ability for the Fed to react too quickly to stem off inflationary pressures. On his blog Tim Duy's Fed Watch, he wrote an excellent piece comparing the views of Yellen v. Brainard.

And just a day later Fed Governor Daniel Tarullo told CNBC that it wouldn’t be appropriate for the Fed to raise rates this year. This past week saw several market experts come out and reveal their insight on the Treasury market. Gary Shilling warned that he believed 30 year Treasury bonds would fall to 2%.  Komal Sri-Kumar has called for the 10 year yield to drop to 1.5%.

The stock market continued its ascent throughout the week of Fed-speak but I for one am questioning the logic of the rise. With the Fed basically admitting the global – U.S. economic picture is softening confirmed by meek employment, soft wage growth and disappointing retail sales data one would think the market would interpret this as bad news. Certainly other areas of the capital markets are providing warnings, just not stocks.

Warnings

The U.S. Treasury market is increasingly telling us that risk appetite appears lacking. The 10-year treasury yield briefly dipped below 2% in October but more shocking was the sale of three month Treasuries with a zero yield. From Business Insider, “The US Treasury was able to sell $21 billion of six-month bills at a minuscule yield of 0.065%.

It also auctioned off $21 billion in three-month bills. Each dollar of the bills offered got chased by $4.14 in bids – the highest bid-to-cover ratio since June 22 when China was in full-crash mode. With buyers jostling for position to grab whatever they could, these bills sold at a yield of zero for the first time in history.

Even more liquid one-month bills have sold at zero yield in five of the six most recent auctions. And in the secondary market, some bills have traded at slightly negative yields for a while; investors who hold these bills to maturity end up with a guaranteed loss, the price they’re willing to pay to keep their money save and liquid.

But this was the first time for the Treasury to sell three-month bills at zero yield.”  

Not exactly a high sign of economic confidence. High yield spreads are also concerning.

Business Insider, “Surging borrowing costs for companies with speculative-grade credit ratings have some market watchers warning that the US economy is heading into a recession.

The debt issued by these companies — also know [sic] as high-yield bonds or junk bonds — have experienced a surge in spreads. In other words, the interest rates these companies are paying to finance their operations are spiking, making it more challenging to refinance while pushing more companies toward default.

While much of the pain is occurring in the high-yield energy bond market, it nevertheless signals tighter financial conditions are coming.

"This is not just an energy story, but a broader conversation about the credit cycle and our place in it," UBS's Steven Caprio said.

Caprio thinks the US economy is heading for a period of tighter, more expensive money. He observed that what happens in nonbank lending markets, like the bond markets, leads what happens in bank lending.

He homed in on a segment of the junk-bond market.

"Our analysis suggests it is actually the lowest of low quality issuers (B-rated and below) that provides the first leading signal that credit stress may lie ahead, as Figure 3 illustrates," Caprio wrote. "Worryingly, this chart is flashing red. While BB net issuance has held in quite well, B-rated and lower net issuance has plunged in a replay of late 2007, as investors cut back in the face of growing default risk and rising illiquidity."”

“"In sum, we believe that non-bank lending standards illustrate an overall tightness in US financial conditions that signal a downside growth risk to the US economy," Caprio said. "While bank lending standards are healthy, we ultimately believe this misdiagnoses the pulse of the corporate credit cycle. Nearly all of the additional financing provided to nonfinancial corporates has come from non-bank sources, post-crisis. And expecting the banking system to meaningfully pick up the baton from a non- bank slowdown is unrealistic in today's highly regulated environment. In short, non-bank liquidity has been the main driver of the corporate credit cycle post-crisis, and there are now early signs that it is evaporating."”

Low Quality Rally

I was watching CNBC one morning and a guest made a point that the worst performing stocks of the past year were leading the October rally. Indeed Materials, Energy and Industrials – the market laggards of months past had led the surge higher in October.

From MarketWatch, “The recent bounce back in the S&P 500’s weakest sectors is looking like a “bear trap,” according to James Paulsen, chief investment strategist and economist at Wells Fargo Capital Management, in a recent interview.

“Think about how the bull rally was led by growth in health care, tech and consumer discretionary,” Paulsen said. “Now piece by piece it is all been peeled away. It looks more like a bear rally, led by the weakest sectors.””

Manufacturing is a Mess

Data from Business Insider conclude, “On Thursday, regional manufacturing reports for October showed very slight improvement but made clear that the sector is in contraction. In September, all seven regional manufacturing purchasing manager's indexes fell into contractionary territory.

 

The Empire State manufacturing index from the New York Federal Reserve for October was -11.36, improved from -14.67 in September, but still indicating contraction in the New York region. The Philly Fed's index came in at -4.5 for the month, also an improvement from September's reading but still pointing to a deceleration in manufacturing activity.

And the details of the latest regional indexes paint an even bleaker picture than the headlines, according to Pantheon Macroeconomics' Ian Shepherdson.

For instance, new orders in the Philly Fed's index fell to -10.6 from +9.4, the lowest since June 2012. Employment plunged to -1.7 from 10.2. And, shipments tumbled to -6.1 from 14.8.

Shepherdson wrote, "In short, a grim [Philly Fed] report, but it can be argued that the weakness in the sub-indexes represents something of a catch-up after overshooting relative to national ISM manufacturing index."”

“In a note to clients last week, Renaissance Macro's Neil Dutta highlighted that in recent months, manufacturing inventories have run ahead of sales. And in the most recent national manufacturing PMI report, the share of survey respondents who said inventories were "too high" exceeded those who said they were "too low."”

While the manufacturing sector of the economy is smaller relative to consumer spending, it does carry heavy implications for the stock market. As Seeking Alpha points out, “As you can see in the chart[s below], a meltdown of this size or greater in manufacturing has led both a recession in the economy and a decline in the S&P 500 by 30-50% over the next two years. In other words, we need to be very cautious in the coming months. If manufacturing is able to stage a recovery, then I believe that we will be "out of the woods". However, as the economy continues to slow, we need to be vigilant to ensure that we are either out of the market, hedged, or outright short to profit from the slowdown.”

 

 

Oddities

There are a few other tidbits of information that I stumbled upon during my weekly readings. These are items that I don’t typically track but I thought they were interesting enough to mention.

Black swan risk rises to highest level ever – CNBC: “Investors fear a "black swan" catastrophic event in the financial markets right now more than ever before. At least according to the CBOE Skew Index, which measures the prices of far out-of-the-money options on the S&P 500. Its goal is to determine the benchmark's tail risk or the "risk of outlier returns two or more standard deviations below the mean," according to the CBOE website. Put simply, traders are buying options that pay off only if the stock market drops a whole lot.”

 

Dividends: U.S. Economy Back in Contraction in September 2015 – Political Calculations

U.S. Consumer Driven Growth

While it is way too early to start drawing solid conclusions from 3Q15 earnings season I would like to point out one early trend that I will be watching as the quarter progresses – Consumer Discretionary earnings results. According to research at Factset 9 out of 10 earnings pre-announcements – that is guidance on coming quarters has been negative. That appears to be running higher than normal but what strikes me are the early negative preannouncements in the Consumer Discretionary sector. Given that our economy seems to be resting on the strength of the consumer these early signs are not good. Four of the nine negative preannouncements were from that sector.

I probably wouldn’t have even noticed it if not for the complete earnings debacle that Walmart announced last week. The bomb from Walmart (via Business Insider), “Walmart shares had their biggest intra-day drop since 1988, falling by as much as 10%, after the company cut its forecast for profits over the next two years. As it held its investor day, the world's largest retailer forecast an earnings decline of 6% to 12% in 2017. The reason? Higher wages. "Operating income is expected to be impacted by approximately $1.5 billion from the second phase of our previously announced investments in wages and training as well as our commitment to further developing a seamless customer experience," CFO Charles Holley said in a statement. And Walmart CEO Doug McMillon gave some color on the economy, in a CNBC interview. He shrugged when asked how the US economy was doing. "It's steady. It's OK," he said. He added, however, that back-to-school sales were "pretty good". On why consumers aren't splurging savings from lower gas prices, he said they had debt and other issues to deal with.” 

Technically Challenged

The S&P 500 appears to be short term over-bought and is nearing a key resistance level. We will be continuing to sell into the rally unless proven otherwise from the market data we collect.

Bottom Line:

The Global economy is in deceleration – negative.

The U.S. economy is slowing – negative.

Both of the above points have been confirmed by the Fed – negative.

Treasury yields point to risk aversion – negative.

The latest stock market rally is led by the weakest of sectors – negative.

U.S. manufacturing has entered a recession – negative.

Corporate earnings and revenues are contracting – negative.

Consumer Discretionary sector earnings appears to be slowing – negative.

The stock market is still technically challenged – negative.

Given these assumptions we find it hard to get excited about the latest stock market rally. We will continue to assume a downward bias until the data dictates a change in our investment thesis. This rally reminds me of the last call at a cocktail party and the few remaining guests are ordering one last round before its time to leave.

 

 

 

Joseph S. Kalinowski, CFA

 

No part of this report may be reproduced in any manner without the expressed written permission of Squared Concept Partners, LLC.  Any information presented in this report is for informational purposes only.  All opinions expressed in this report are subject to change without notice.  Squared Concept Partners, LLC is an independent asset management and consulting company. These entities may have had in the past or may have in the present or future long or short positions, or own options on the companies discussed.  In some cases, these positions may have been established prior to the writing of the particular report.   

The above information should not be construed as a solicitation to buy or sell the securities discussed herein.  The publisher of this report cannot verify the accuracy of this information.  The owners of Squared Concept Partners, LLC and its affiliated companies may also be conducting trades based on the firm’s research ideas.  They also may hold positions contrary to the ideas presented in the research as market conditions may warrant. 

This analysis should not be considered investment advice and may not be suitable for the readers’ portfolio. This analysis has been written without consideration to the readers’ risk and return profile nor has the readers’ liquidity needs, time horizon, tax circumstances or unique preferences been taken into account. Any purchase or sale activity in any securities or other instrument should be based upon the readers’ own analysis and conclusions. Past performance is not indicative of future results.

What Is The Fishbone Investment Model?

One recurring theme in our investment methodology is that stock prices are a reflection of fundamental intrinsic value and perceived investor emotion / sentiment towards the stock market. This puts an important weighting on behavioral market variables and in our opinion negates the concept of the Efficient Market Hypothesis (EMH).

My background as a Chartered Financial Analyst has focused almost exclusively on the fundamental drivers of a company and its stock price. The basis of almost all of our investment ideas are rooted in the analysis of corporate financials and company variables first and then expecting the stock to trade based on the underlying corporation. Fundamental analysis is sound and proven and is a staple in our investment decision making process. This type pf analysis helps us establish which investments may be a great fundamental endeavor but tells us very little about the near-term movement of the actual stock itself.

Early on in my career I had been thwarted at times when a seemingly fundamentally sound company didn’t have its stock cooperate in my investment thesis. As my studies in behavioral finance expanded I started to realize that fundamental analysis has its uses in pinpointing an appropriate investment but did little to indicate the appropriate entry point to start purchasing the stock. In short, fundamental analysis assisted in establishing which investments to make but did little to provide insight on when to make the investment. 

As my education and research expanded into the field of behavioral finance, it was only then did I realize the importance of investor emotion and sentiment in the investment decision making process. It seemed to contradict many years of teachings that surrounded the EMH but the more I learned about the phycology of investing, the more enlightened I became. It allowed me the opportunity to self-reflect on the shortcomings of focusing exclusively on one field of investment theory. Understand that the use of fundamental analysis still carries a strong influence on the decision making process, but through the works of people like Amos Tversky and Daniel Kahneman it allowed me to grasp a more rounded and holistic approach to portfolio management.

What is Fishbone?

The fishbone model was designed to assist in adding a timing mechanism to the portfolio. The portfolio itself has core holdings that have been introduced based on the fundamental merits of that particular underlying investment vehicle. The Fishbone program allows us to “trade around” our core position to insert portfolio protection when the market trends are unfavorable to the portfolio. It attempts to capture the investor emotion / sentiment part of the equation that if left unchecked can damage even the highest quality fundamentally derived portfolio. The name Fishbone may appear odd but it was given its name by the way it functioned.

While conceptualizing and back-testing the theory, it initially started on a large white board and was a series of “if-then” functions. If the first variable was met, then the model would progress in a straight line to the next variable. If it failed the first variable it would splinter off into a non-investment criteria.

 

 

 

 

 

We completed a twenty year back-test and found that using the Fishbone model indeed offered statistically significant results that indeed enhanced the return of our core fundamentally driven portfolios.

Fishbone Assumptions

Like many other of our quantitative investment theories this one comes with a set of assumptions that we need to believe hold true in the capital markets today.

Assumption #1 – Mean Reversion: What is irrational will soon become rational. Bubbles do exists. There will be times when an investment is profoundly over or under valued based on fundamental analysis. This can create outlier opportunities. The concept of mean reversion is of the utmost importance in our investment methodology. The entire market is a mean-reverting mechanism and finding those outlier opportunities offers the greatest potential for capital appreciation in our view.

Assumption #2 - Overconfidence: We as investors will never be smarter than the whole of the market. That is a key element to understand and respect. Thus the second assumption is that investors are over-confident in their investment abilities. This is a straight forward assumption but very difficult to quantify in practice. Knowing that investor overconfidence (also framed as investor under-reaction) can take stocks and markets to new highs well after the fundamental picture has deteriorated to the point of leaving even the most sophisticated fundamental analyst scratching their head. I attempt to overcome this behavioral shortfall by keeping a healthy respect for the information that the market provides and if a trade or investment isn’t working as anticipated, I don’t wait around for the market to prove me right. In aggregate the Fishbone directional trading probability is right almost 62% of the time. That means it is wrong 38% of the time. Quickly surveying the investment landscape and realizing when one of those 38 percenters have been introduced to the portfolio and eliminating the threat quickly is paramount to portfolio performance. I’d rather take several smaller losses and admit a miscalculation than have a few holdings deteriorate the gains in the portfolio as I stubbornly wait for the market to wise-up to my way of thinking. That doesn’t usually end well.

Assumption #3 – Overreaction: As a result of assumption #2, when it finally comes to light that investors had been wrong in their highly confident investment projections and the market moves against them, there are at times an over-reaction to the new market dynamics. Highly volatile and large price swings can be a result of this phenomenon. This is a condition that I think I struggle with the most. Having the courage and discipline to remain in control and adhere to a contingency plan in the face of extreme market turmoil is difficult. As an investor, I set out to battle through emotional shortcomings when the market dynamics become excessively turbulent. I haven’t always succeeded in the task but the lesson hasn’t been lost and through self-reflection I hope to better control this aspect of portfolio management.

Assumption #4 – Herd Mentality: Market participants will formulate patterns and procedures that become a self-fulfilling prophecy. This herd-like behavior from market participants is what allows technical analysis to flourish in my opinion. Why is it that certain patterns and trends tend to hold so often? The greater a specific pattern or trend is recognized by a group of investors the more relevant it becomes. Trend analysis is a dominant trait in the Fishbone model.

Fishbone Model   

The Fishbone model attempts to recognize oversold opportunities (negative sentiment) in an up-trending market (positive momentum). It also attempts to find overbought opportunities (positive sentiment) in a down-trending market (negative momentum).

To track momentum we incorporate the distance between the 20 and 50 day moving average (DMA) and the 50 and 200 DMA. We also incorporate the moving average convergence divergence (MACD) histogram using the MACD daily variables 60, 130, 45. When aggregated together it produces a bar chart that seeks a mean reverting zero balance. The outer bounds are infinite so the further out the indicator ventures from zero (+/-) the greater the momentum reading. An increasing figure represents positive momentum and a declining figure represents negative momentum. The figures below represent the Fishbone momentum reading back to the year 2007.



 

 

 

 

 

 

 

 

 

 

To track the shorter-term sentiment within the longer-term momentum profile we use a combination of two oscillators. The relative strength indicator RSI (5) and fast stochastics %K (14). This is an oscillator with the outer bounds of 0 to 10. Those investments that exhibit a reading of 8 or better are considered overbought and those investments with a reading of 2 or less are considered to be oversold. The following graphic shows the Fishbone oscillator going back to the year 2007.

 

 

 

 

 

 

While the Fishbone model was designed and tested for use in an established portfolio for the purposes of portfolio protection or enhancement, we launched the model as a standalone investment vehicle and have funded it for the purposes of tracking and monitoring its success or failures. We will be releasing the quarterly results of the model as we progress. While back-testing is important for establishing conceptual integrity, only through actual investments and the building of a track record will the execution of the model be proven. In the model we trade stocks, ETF’s and options on stocks and ETF’s. We do not allocate more than 5% of the total portfolio to any one single idea and are sector agnostic in our equity selection. We do not venture outside companies that reside in the S&P 500. We use a systematic and objective approach to selecting which securities will go in the portfolio but keep a subjective eye towards miscalculation and a low tolerance for positions that are quickly proven to be a net negative to the portfolio (tight stops).

Bottom Line: The Fishbone model was created to focus on the investor phycology part of the investment decision-making process. It combines several behavioral rules and establishes short and long term parameters to find investment opportunities with the highest likelihood of success. We strive to buy securities with positive long-term momentum but negative short-term sentiment. We will short securities with negative long-term momentum but positive short-term sentiment.

Joseph S. Kalinowski, CFA

Additional Reading

3Q15 Fishbone Results

 

No part of this report may be reproduced in any manner without the expressed written permission of Squared Concept Partners, LLC.  Any information presented in this report is for informational purposes only.  All opinions expressed in this report are subject to change without notice.  Squared Concept Partners, LLC is an independent asset management and consulting company. These entities may have had in the past or may have in the present or future long or short positions, or own options on the companies discussed.  In some cases, these positions may have been established prior to the writing of the particular report.   

The above information should not be construed as a solicitation to buy or sell the securities discussed herein.  The publisher of this report cannot verify the accuracy of this information.  The owners of Squared Concept Partners, LLC and its affiliated companies may also be conducting trades based on the firm’s research ideas.  They also may hold positions contrary to the ideas presented in the research as market conditions may warrant. 

This analysis should not be considered investment advice and may not be suitable for the readers’ portfolio. This analysis has been written without consideration to the readers’ risk and return profile nor has the readers’ liquidity needs, time horizon, tax circumstances or unique preferences been taken into account. Any purchase or sale activity in any securities or other instrument should be based upon the readers’ own analysis and conclusions. Past performance is not indicative of future results.

 

 

 

Third Quarter 2015 - Fishbone Model Results

The launch of the Fishbone investment strategy has been a successful one. For the third quarter of 2015 the model returned 15.5% versus a loss of 9.4% for the S&P 500. For the month July we held a slightly bullish bias as the market trended. In August we decided to increase portfolio protection as written in the blog on August 9: Time to Consider Portfolio Protection.

The momentum figures were deteriorating but the shorter-term sentiment indicators were not reflecting this weakness. This divergence raised red flags for us and was the impetuous for our taking a bearish stance. The fact that the market sold off aggressively two weeks later is a function of strategic planning but luck is a wonderful thing. We don’t expect the timing of this model to be the norm. It assists us in planning for potential outcomes and investing accordingly.

As the selloff accelerated we formulated a strategy to attempt to profit from what we envisioned as an oversold condition. We positioned ourselves based on our modeling and made a significant portion of our gains at the height of the August volatility. Our strategies were outlined in How We Position Ourselves From Here and We Expect Additional Market Weakness Going Forward.

We participated in the market rally off its August lows and held until our range of levels provided were reached. It just so happened to coincide with the Fed interest rate decision and we closed our long positions and decided to take a bearish bias into the end of the quarter.

The chart below outlines the Fishbone model performance against the benchmarks assigned to it through our trading account held at Interactive Brokers. It compares our returns to that of the S&P 500 (SPX), the Vanguard Total World Index (VT) and iShares MSCI EAFE Index (EFA). For the quarter the Fishbone model averaged 4.8% return per month versus -3.2% for the S&P 500.

The chart below represents the cumulative return of the Fishbone model versus the selected benchmarks. The cumulative return for the Fishbone model was 15.1% versus -9.4% for the S&P 500.

The chart below shows the Value Added Monthly Index (VAMI) for the Fishbone model versus its benchmarks. Interactive Brokers defines the VAMI as, “A statistical figure that tracks the daily/monthly/quarterly performance of a hypothetical $1000 investment.” The VAMI for the Fishbone model is a superior 1151.32 compared to 906.29 for the S&P 500. The standard deviation for the Fishbone model was 2.66% for the quarter which is largely in-line with the comparable benchmarks. Superior risk-adjusted returns result in a Sharpe Ratio of 6.3 for the Fishbone model. For the three months that it has been actively launched it has not had a negative month so we cannot calculate the maximum drawdown figures or the Sortino and Calmar Ratios.  

The following graphic also shows our monthly distribution of returns.

The chart below shows the Fishbone model action indicator for the S&P 500 for 2015. This model can be applied to many other stocks and ETF’s. We usually target only those companies that reside in the S&P 500. For additional information on how the Fishbone model works please click here.

Joseph S. Kalinowski, CFA

Additional Reading

What is the Fishbone Investment Model?

 

No part of this report may be reproduced in any manner without the expressed written permission of Squared Concept Partners, LLC.  Any information presented in this report is for informational purposes only.  All opinions expressed in this report are subject to change without notice.  Squared Concept Partners, LLC is an independent asset management and consulting company. These entities may have had in the past or may have in the present or future long or short positions, or own options on the companies discussed.  In some cases, these positions may have been established prior to the writing of the particular report.   

The above information should not be construed as a solicitation to buy or sell the securities discussed herein.  The publisher of this report cannot verify the accuracy of this information.  The owners of Squared Concept Partners, LLC and its affiliated companies may also be conducting trades based on the firm’s research ideas.  They also may hold positions contrary to the ideas presented in the research as market conditions may warrant. 

This analysis should not be considered investment advice and may not be suitable for the readers’ portfolio. This analysis has been written without consideration to the readers’ risk and return profile nor has the readers’ liquidity needs, time horizon, tax circumstances or unique preferences been taken into account. Any purchase or sale activity in any securities or other instrument should be based upon the readers’ own analysis and conclusions. Past performance is not indicative of future results.