Saturday, December 5, 2015

High Valuations and Low Yields

This is how your average buy-and-hold investor probably feels right now if they are looking to deploy new capital for the long run.

Today, bond yields are puny while stock valuations are rich. In fact, we currently have one of the worst yield and value combinations in history as seen in the charts below dating back to 1880:


Notice on these charts the years 1921 and 1982, when valuations were very low and yields were high. This launched the two largest bull markets in stocks ever, with the S&P 500 gaining over 4-fold in the Roaring Twenties and 15-fold from 1982-2000. And that's not even including dividends.

Now look at the years 1902, 1929, 1965 and 2000 when we had the opposite: high valuations and relatively low-to-medium yields. This led to all four secular bear markets in the past century, with each one lasting over a decade.

We can visualize this better by creating a scatter plot of the above data. We plot stock valuations (S&P 500 Shiller P/E Ratio) on the vertical axis and 10-year Bond Rates on the horizontal axis. The color of the dots will be used to indicate the future 10-year nominal, annualized, total return of a 60/40 portfolio containing the S&P 500 and 10-year treasury bond fund. This plot is shown below: 

Data for this plot from:

The dark red dots indicate the weakest future 10-year returns while the dark green dots indicate the strongest 10-year future returns. Black diamonds are for years after 2006 which we don’t have future 10-year returns for yet. One thing immediately jumps out: Dots in upper left hand of graph correspond to very weak future returns while dots in lower right correspond to strong returns. Everything else is a mix.

Currently, we are sitting in an area that would suggest a high likelihood that stocks will be weak (annual returns under 6%) for the next 10-years. Although admittedly, my chart only gives a very rough idea of future returns, a model with better predictive power has been produced by market analyst John Hussman. According to his chart below, we see that future 10-year returns on the S&P are likely to be near 0%.

Source: Hussman Funds

You might be saying “This is not fair. We just recently came out of a weak decade!”

Unfortunately, it’s what the data tells us. While the 2000’s were difficult, the current decade has been very good to us so far. It would be very healthy for the market to churn sideways, digest gains of recent years and set itself up for a great bull market further down the road.  

That doesn’t make me feel any better!” you might say. OK, I do have some good news for you.

The scatter plot above only gives a rough forecast for average annual 10-year returns. It doesn’t tell us a thing about the path that those returns will take. 

While in the long-run (5-10 years) markets are tied to valuation and mean-revert, they are dictated by momentum in the short-term (6-12 months). This is why valuation is not a good timing tool - it does not tell us when to enter and exit markets the way momentum does. These two points are really the key differences between value and momentum to understand. Please also refer to our post: The Philosophy of Momentum that tries to explain how momentum works in the market.  

So just because we are likely to face a challenging market environment doesn’t mean we can’t profit. If we look back to 2000, we also had high valuations and low yields. What happened next? Essentially, the stock market went nowhere over the next 12 years (as the valuation model correctly predicted), but in the process there were two times when stocks halved and two times when stocks doubled. In this highly choppy environment, the Global Equities Momentum (GEM) model continued churning out nice positive returns. 

The graph below shows how GEM performed against stocks and bonds in the first decade of this millennium. 

Over this decade, GEM gave a total annualized nominal return of 11.4% while a 60/40 portfolio returned just 2.8%. Furthermore, GEM only had one negative year during this whole period, and even that was a mere -7%. Now that is alpha! In terms of our scatter plot, GEM just turned a dark red dot into a nice green dot.

Side note: While GEM produced admirable returns during the 2000’s, they were quite a bit less than its past 40-year average return of 17.8%. This is not surprising given the challenging market environment.

In summary, today’s high stock valuations and low bond yields will likely mean a fixed 60/40 portfolio will not make much money over the next 10 years. However, the ups and downs during this period are likely to allow tactical GEM investors to achieve better risk-adjusted returns.

This is the real beauty of GEM. We don’t need to worry about valuations, yields, or whether the economy will accelerate or slow down. We don’t need to worry about lost decades. We are in a system that will dynamically change depending on the environment. It’s the buy-and-hold crowd that needs to be worried, arguably now as much as 15 years ago.

Happy holidays and see you in the new year!

Results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Additional information regarding the construction of these results is available upon request. Past performance is no assurance of future success. Please see our disclaimer page for more information.

Sunday, November 8, 2015

Slow and Steady


Why is it that every time you hear your average investor talk about markets, it’s usually about the latest high flying glamour stock? It’s because our lizard brains get lured by the thrill of fast gains and bragging rights.  

Let’s look at Apple for a moment. Apple is now the largest company in the world by market cap. It has more cash than the GDP of New Zealand or combined GDPs of Vietnam, Morocco and Ecuador. If Apple were a country, it'd be the 55th richest country in the world.  There is no doubt this company can be considered one of the greatest tech success stories in history.

If someone were lucky enough to put money into Apple when it IPO’ed back in late 1980, they would have enjoyed an almost 300-fold gain on their investment. In comparison, had that same investor put their money in the S&P 500, it would have gained 15-fold – which is puny in comparison.

This leads your average retail investor to ditch investing in broad market ETFs and chase the next Apple. But these “investors” don’t realize how extremely difficult it is to correctly predict which micro/small cap stock will become the next giant success story. Nor do they seem to realize how much risk they are taking on by holding concentrated positions in volatile growth stocks.

I remember from 2012-2013 how much hype there was around the company 3D Systems Corp (DDD). Watercooler chatter, CNBC pundits and Twitter – everywhere you looked there was feverish excitement over DDD. The stock gained over 10-fold in those two years. Where is it today? Back to square one. 

Likely even fewer people realize there are ways to invest systematically in large & diversified market indices that can outperform even Apple! Global Equities Momentum (GEM) is one such strategy, which I argue is the best (very simple, robust and stable while having low portfolio turnover, maintenance and costs).

The chart below shows what I mean.

Update (Nov 27, 15): I realized the S&P 500 data in this graph does not include dividends. With dividends, the S&P 500 would have grown 3,900% from 1981-2014.

Since Apple’s IPO, GEM has outperformed Apple in terms of total return. Not only that, but it did it with much less volatility. The tables below show the drawdowns for both Apple and GEM:

We see that Apple investors would have had their faith severely tested numerous times. There were four torturous periods where investors would have lost between half to more than three quarters of their portfolio. In comparison, GEM had fewer and much less severe drawdowns - all of which were under 20%.  

Isn’t this neat? It shows that systematically trading broad indices is more important than finding and holding a basket of home-run stocks. Yet most of Wall Street and most retail investors are blindly doing the latter.

By investing systematically in broad markets, you not only achieve better risk-adjusted returns but also save yourself a lot of time and stress. No more spending countless time pouring through company financials, listening to CNBC or forecasting market trends in search of the next great stock. No more holding concentrated positions in volatile stocks and having night terrors about company-specific risk.

You just can’t put a dollar value on stress reduction. Welcome to the wonderful world of systematic index investing. 

Results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Additional information regarding the construction of these results is available upon request. Past performance is no assurance of future success. Please see our disclaimer page for more information.

Saturday, October 3, 2015

Should we consider Gold?

I read a post on Mebane Faber’s blog a few months back about something he calls the “Three-Way Model.” It’s a simple trend following model that uses 3 ETFs: Stocks, Bonds and Gold. The rule is simply: Invest equally in whatever is going "up" (ie. 3 month moving average > 10 month moving average). The results over the past 40 years have given a 12% annualized return (see below).

This is not nearly as good as GEM’s 18% compounded annual return over the same 40+ year back-test period. Nevertheless, this got me wondering: What would happen if we added gold to GEM’s relative momentum engine?

In a previous post, Markets are Interconnected, we saw that GEM already indirectly profits from US Dollar and commodity cycles when it switches back and forth between US and non-US stocks. But curiosity struck me and so I took a look at adding gold to the model. The below chart shows this modified model (in blue) compared against the original GEM (in red):

By adding gold to the model we get a compounded annual return of 21%, up from the original model's 18%. Over the past 43 years, the modified model would have taken a mere $100 and turned it into a staggering $400,000!

Now before we go running out on the streets of Syracuse naked shouting “Eureka!” let’s take a closer look. 

First, the modified model's higher returns came at the cost of higher volatility. The standard deviation of the modified model shot up to 18%, which is up from 13%. So the Sharpe Ratio didn't improve that much at all. Second, the modified model made 40% more trades over the 43-year backtest period.

Third, and most important, is that all of the modified model's higher returns were concentrated in the '70s. In 1971, President Nixon took the United States off the gold standard. This decoupling from the US dollar led gold to quickly rise to a level determined by the market, instead of being artificially suppressed.

Take a look at the chart below. It shows the modified model (blue) and gold (purple). From 1971-1980, gold increased almost 18-fold! If we remove this period from our backtest, we actually see that the modified model produces lower returns yet has higher volatility than the original GEM. 

Finally, below is a distribution of monthly returns for both the original and modified model as well as the S&P 500.

We can see that the original model (red curve) produces its mean return with greater consistency than both the modified model and the S&P 500. Furthermore, the original model doesn't rely on just a few strong outlier months like the modified model.

Hence, we can conclude that the original GEM is the best. Without the one-time boost that gold received in the '70s, the original GEM offers higher returns with lower risk. Furthermore, the original GEM already profits indirectly from cycles in the US dollar (and hence commodities like gold) due to its switching between US and non-US stocks. 
I think this post is a great example of why you should not blindly strive to optimize backtest results. You want a model that will do well even in the absence of special one-time boosts.  

Results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Additional information regarding the construction of these results is available upon request. Past performance is no assurance of future success. Please see our disclaimer page for more information.

Saturday, September 5, 2015

Power of Compound Interest

If you care to learn only one thing about investing, it should be the concept of compound interest. This is a core topic everyone should know about and is truly what got me excited about investing. I first learned about compounding when I read The Wealthy Barber at age 17 and it remains one of my top 3 most important investing concepts today. 

Compound interest is simply interest on top of interest. Let’s say you are earning a 5% return each year and started with $100. At the end of year 1, you would have $105. But at the end of year 2, you would have $110.25 – an extra quarter.  “A measly quarter!” you say? I know this might sound minuscule and boring but the effect of compounding builds exponentially over time to an enormous amount. 

Very few people I know understand just how powerful this effect really is. Someone who hasn’t been introduced to compounding may think that a 20% annual return will grow your portfolio about twice as much as a 10% return. This is completely wrong. Let’s take a look at what happens when $10,000 invested today grows at various return rates of 5%, 10%, 15% and 20%. 

At the end of 30 years, the portfolios growing at 5%, 10%, 15% and 20% were worth $43K, $174K, $662K and $2,378K, respectively. After 30 years, the 20% portfolio was 14 times larger than the 10% portfolio and after 40 years, it was 33 times larger.

Notice how just three things influence the portfolio value:
  1. Time horizon
  2. Rate of return
  3. Invested capital

As investors, we can become wealthy if we maximize our investment time horizon, rate of return and invested capital. It is easiest to do the first one – just start investing as early as possible. The effect of compounding isn’t really seen in the first 10 or even 20 years but after that – it builds rapidly. You may have heard that phrase “The best time to start investing was in your 20s. The second best time to start is today.” I couldn’t agree more.

The second factor – rate of return - requires significantly more work to maximize. It took me a lot of time and research to find a strategy that has the potential of generating double digit returns while managing risk (please refer to my performance page for more info). Lucky for you, this blog and the book Dual Momentum Investing should be able to accelerate the time needed for you to implement a sound & robust strategy. Keep in mind that a strategy isn't the only thing you need to ensure a high rate of return. You will need unwavering, ironclad discipline to stick to your strategy through thick and thin.

Invested capital is the third factor. 10 years ago I graduated from university with not a penny in my bank account, although thankfully I had no debt. Each year since then, I have been good at saving over 30% of my after-tax income and putting it into my investment strategy. It is highly important you put aside at least 10% of your monthly income for investing. A good way to implement this is by setting up a Pre-Authorized Chequing (PAC) plan that automatically funds your investments each month before you have a chance to spend that money. Forced savings can work wonders. 

In the chart above, the 20% return portfolio dwarfs all other portfolios. When plotting something growing exponentially over a long time frame, it helps to use a log scale on the vertical axis. In a log scale, each level on the scale is 10-times greater than the previous level. Below is the result. 

Now we can better see what’s happening in each portfolio. Look at the 15% portfolio - isn’t it amazing how a mere $10,000 can be turned into almost a million in 30 years?

Here’s a neat little rule when trying to think about compound interest in your head: The number of years it takes for your investment to double is roughly equal to 72 divided by your rate of return. So if you earn 20% per year, it takes only about 4 years for your money to double but if you earn just 5% per year, it will take about 14 years.

Since it's back to school week, I want to leave you with some homework: 

Download a financial calculator app on your phone. Type a few scenarios that meet your own personal criteria (initial investment amount, time frame, rate of return) and see what you can grow your portfolio to. Show this fun little experiment to your family & friends. Everyone I’ve ever shown this to immediately gets excited about investing. 

The app I like to use on my Android phone is called “Financial Calculators.” You can find it here. Below is a screenshot of the “TVM” (Time Value of Money) calculator included in this app. Enjoy

Saturday, August 8, 2015

Enjoy Summer


I'll be taking a break from blogging for the rest of the summer. Get your friends and go for a bike ride, lay on the beach, visit a farmer's market, attend a concert, do a road trip or have patio drinks. Health and relationships are what really matter - everything else is just meant to support these.

See you in mid-Sept

Thursday, July 30, 2015

Markets are Interconnected

There are four major markets or asset classes: Stocks, Bonds, Commodities and Currencies.

When it comes to stocks, the US is the largest and most liquid stock market in the world. In the bonds arena, US Treasury Bonds are very important. In commodities, gold, oil and copper are key products. And in the currency space, the US Dollar Index and Euro are kings. I will be doing a series of posts later discussing each asset class in detail.

I feel it’s highly important for investors to understand how these asset classes are one big interconnected web. It is really satisfyingly elegant. As we take a look at the major relationships, there may be a few that will surprise you.

1. Inverse relationship between Bonds and Yields

This is the strongest relationship there is. When a bond matures, you get paid a fixed amount. So the cheaper the bond is to purchase, the more yield you will get. Hence the relationship.

By the way, you can think of the term “yield” as meaning “interest rate.”

2. Inverse relationship between US Dollar Index and Euro

This is the second strongest relationship there is. The US Dollar Index ("USD") is referenced against a weighted sum of foreign currencies. The Euro represents the largest weight at almost 60%.

Note: The US Dollar is also inversely correlated with the Yen, British Pound and Canadian Dollar, but not nearly as tightly as with the Euro. 

3. Inverse relationship between USD and Commodities

Since commodities are priced in USD, it makes sense that these two would have an inverse correlation. 

I have plotted below USD with Gold. A similar relationship exists between USD and oil & copper. This isn’t the tightest correlation, but nonetheless there is one.

4. Direct relationship between US to non-US stocks ratio and USD

This relationship basically says that the relative performance of US stocks to non-US stocks is mainly driven by changes in USD. This makes sense, since when US stocks are doing better than the rest of the world, foreign investors want to invest in the US. This drives up demand for USD.

5. Direct relationship between Real Bonds and Gold

This one might seem very abstract at first, but let’s think about it. First, a couple concepts to review: 
  • The term “real” just means “adjusted for inflation.” If we subtract inflation from an interest rate, we get the real interest rate.
  • Hard assets such as gold and real estate have been shown to keep up with inflation. However, gold doesn't pay any income so its main purpose is simply a store of wealth.

Let's suppose real interest rates are positive. This means interest rates are higher than inflation and we would rather invest our money in bonds than gold. Now suppose real interest rates are negative. This means inflation is higher than interest rates and we would rather invest in gold than in bonds. A drop in real interest rates causes increased demand for gold (and vice versa).

Thus, gold is inversely related to real interest rates. But interest rates are inversely related to bond prices. That means gold is directly related to real bond prices.

6. Direct relationship between Foreign-to-US-stocks Ratio and Mining Stocks

This one may surprise you. But the biggest reason this relationship holds is that compared to the US, foreign markets have a much larger percentage of their GDP coming from the resource sector. The chart below shows how the performance of emerging markets relative to US markets is heavily tied to the gold miners index:

Similarly, the Canadian stock market is heavily commodities-based (40% of the Canada’s TSX Index is based in the resource sector compared to only 20% for the S&P 500). As one would expect, the Canada-to-US-stocks Ratio is also highly correlated with the gold miner's index. 

NOTE: I picked gold miners to compare against here. But I could have used Steel producers or Coal miners as well, as the following chart shows:

7. Direct relationship between Currencies of Resource-Based Countries and Commodities

Similar to relationship #6, the currencies of resource-based countries are highly correlated with commodities such as oil and copper. This makes sense, since when commodities are booming, the GDP of resource-based countries is strong and so foreign investors want to invest in those countries. This increases demand for those countries’ currencies. 

8. Direct relationship between Relative Interest Rates and Currency Exchange Rate

When the interest rates for a country rise, it attracts foreign investors. This causes an increase in demand for that country's currency, which then appreciates in value. The chart below shows the the 2-year Relative Yield (Germany minus US) and how it tracks the Euro.

Source: Jeroen Blokland, Bloomberg

9. Varying relationship between Stocks and Bonds

There is a popular misconception out there that US stocks have a direct relationship with US Treasury yields (and so inverse relationship with bonds). I myself was guilty of believing this for a long time during my market education.

The chart below is from Pimco and shows the annual correlation between US stocks and 10-year Treasury Bonds. From 1927-2012, the correlation between stocks and bonds has ranged from -93% to 86%, changing sign 29 times! It's safe to say there's no reliable relationship here.

 Source: Pimco

Now, that doesn't mean there's no link between stocks and bonds. The Pimco article I linked explains that there are four economic variables that affect the stock-bond relationship: policy rate*, inflation, unemployment and growth. Policy rate refers to monetary policy - when the Central Bank buys/sells bonds to change interest rates (raise rates when economy is strong to curb inflation; lower rates when economy is weak to stimulate it).

Stocks and bonds react in the same direction to policy rate and inflation (eg. if policy rate is dropped, both stocks and bonds go up). But they react in opposite directions to unemployment and growth (eg. when growth is slowing and unemployment is rising, stocks weaken and money flows into bonds as a "flight to safety"). This tug of war between the first two economic variables and second two is why the stock-bond relationship has varied so much.

10. Matrix summary

Here is a handy little matrix I put together to summarize everything I've written about above. Hopefully this shows what I meant about markets being interconnected and elegant.

All the correlations that I've shown so far are true correlations. This means that they can be backed with logical explanations, hold across different periods in time and can be expected to continue holding into the future.

You can use the above matrix to derive new relationships but they won't be as pure. For example: The Yen is inversely related to USD, which is inversely related to gold. That means the Yen is directly related to gold. But we know that gold is also directly related to bonds. Therefore the Yen is directly related to bonds. Now, because we did a lot of conversions, the resulting correlation won’t be very strong as the chart below shows. Furthermore, I cannot give a logical explanation for this one. 

11. How is any of this relevant to Dual Momentum?

This post really dove into the deep end and may leave you scratching your head wondering what any of this has to do with the dual momentum strategy. There are several ways the charts above help Global Equities Momentum (GEM):

  • GEM uses relative momentum to switch between US and non-US stocks. According to relationship #4, we see that GEM therefore protects against, and profits from, fluctuations in the US Dollar. More on this in a future post.
  • If GEM is benefiting from trends in the US dollar, this in turn means GEM exploits commodity cycles to some degree due to relationship #3. For example: from late 2003 to early 2008, GEM was in foreign stocks (during the commodity boom). Then from 2010 to now, it's been in US stocks (during the commodity bust). This concept is further reinforced by relationship #6, which also shows how the performance of foreign stocks relative to US stocks is tied to commodities. 
  • This helps answer the question in my previous blog post: "Should the split of GEM be between developed vs. emerging markets instead of the current US vs. non-US stocks?" The current split means GEM exploits US dollar and commodity cycles. If we changed the split to being developed vs. emerging, then we wouldn't be benefiting as much.
  • GEM uses absolute momentum to switch to bonds when stocks are weak. While stocks and bonds don't have a strong static correlation, we do know that during recessions, stocks often suffer from large drawdowns and there is a flight to bonds during that period (see notes in relationship #9). This is how GEM limits downside risk.

The information in this post is meant to just be another wrench in our toolbox. I also wanted you to get a sense of appreciation for how asset classes are linked together in one way or another. On the surface, markets can seem very noisy and chaotic but the more you study them, the more order you observe.

Sunday, July 19, 2015

What If Emerging Markets Eat Our Lunch?

Source: Stocks for the Long Run by Jeremy Siegel (5th Edition), Page 65

If you are unfamiliar with the term “GEM” please refer to the performance tab of this website for more information.

I was reading Jeremy Siegel's classic book Stocks for the Long Run in greater detail today. In it, there's a chart for projected share of world GDP by country (above) that has me thinking. This chart suggests that emerging markets may produce a larger % of world GDP: from 45% currently, to possibly 70% in under 3 decades.

I have no doubt stocks should be the core of GEM (I'll explain this in a separate post), but the question is whether US vs. non-US stocks is the right split for GEM. Based on the chart above, wouldn't it be better if GEM’s split is developed vs. emerging market stocks?

First, GEM’s creator Gary Antonacci points out the problems with emerging markets as a core holding:
  1. Very high and unusual volatility
  2. Low liquidity/high transaction costs
  3. Accounting unreliability
  4. High fund expense ratios
  5. Limited market history

Second, I want to show how the current GEM setup (which uses a US vs. non-US stocks split) would be able to take care of the economic scenario shown in the above chart. Here’s three reasons how:

  • If emerging markets grow faster than developed countries, then the country holdings of ACWX (the ETF representing non-US stocks in GEM) would shift accordingly. This is the beauty of the GEM strategy as momentum is even working on the ETF level: Strong countries gain a larger share of ACWX while allocation to weak countries shrinks.
  • Developed countries are increasingly generating revenues from emerging markets, so this helps partially offset risk of growth slowing in the developed world. 
  • Siegel points out that as an increasing number of people in developed countries retire, their assets would be bought by increasingly wealthier investors in emerging markets. Yes, I know, this is a shocking realization. But it would keep the assets of developed markets in demand over the long-term.

To summarize, it would be wrong to replace ACWX with EEM (the ETF for Emerging Markets) today in anticipation that China and India may dominate world GDP in the future.  You should never fine-tune your strategy based on one specific economic scenario. Instead, you should ensure that your strategy is robust enough to handle a wide range of scenarios, one of which is the one shown in the above chart.

In a future post, I will show how GEM is robust in different currency environments as well. More to come, stay tuned!

Sunday, July 5, 2015

Never Override Your System

In the previous post, I gave an analogy showing that investors shouldn’t follow a passive (buy-and-hold) strategy. That instead, they should have an active strategy that changes their portfolio to prevent severe bear market drawdowns. This strategy must be systematic, simple and thoroughly researched. In this post, I want to give another analogy to show the importance of not trying to outsmart your system.

Let’s begin.

This weekend, I went to Manning Provincial Park in BC. This is about a 2.5 hour drive from Vancouver and travels mostly along our Trans-Canada Highway #1. As we were driving back home, we were hit by a big traffic jam.

We had three options:
  1. Stay on Highway #1 no matter what because it’s the highway 
  2. Use Google Maps to try and bypass the traffic
  3. Use our own intuition to try and bypass the traffic

Option 1 is analogous to a passive (buy-and-hold) investment strategy. Options 2 and 3 are analogous to active strategies, with 2 being systematic and 3 being discretionary. Just like Google Maps successfully uses traffic data from local drivers to help you dodge traffic jams, a proven systematic investment strategy can help you dodge bear markets.

Immediately, I pulled out my phone and checked Maps for the best way to bypass the traffic. However, the route that Maps was displaying looked strange to me so I used my gut feel to override it. I told my friend who was driving to exit off the highway and get onto this small road that traveled in parallel with the highway.

Initially, we were thrilled to be zipping past all the highway cars. But it wasn’t long before our road ended at a canal. After wasting time searching for a way to get back on the highway, we were significantly behind both method 1 (staying on the highway) and 2 (Google Maps).

From my investing experience, I can tell you that when I first started using a systematic approach, my lizard brain often got in the way and tempted me to override my system. I thought that somehow, my intuition was much more intelligent than an unconscious mechanical model. Whether it was a new fancy indicator that I found or a news headline screaming financial crises after just a small pullback, I would be tempted to go against my plan.

And sure enough, anytime I bypassed my system it was often followed by disastrous results. Just like when I bypassed Google Maps this weekend. There is simply no place in investing for intuition, gut feel and predictions. You must be an unwavering slave to your system.

Thursday, June 25, 2015

Cycling vs. Investing

You might be thinking what these two things can possibly have in common. Let me explain.

Here in Vancouver, we're becoming obsessed with biking. There are over 400 kilometers of bike lanes in the area and half of all trips now consist of walking, biking, or transit.

I got sucked into this culture. It's been about three months that I've been proudly biking to work every day. However, I’m very ashamed to admit that for the first little while, I kept my bike fixed in high gear.

This city has a lot of hills. I loved the high gear as I went downhill or on a flat road. But going up-hill in this gear was painful. I used to always pedal standing up and was completely out of breath by the time I reached the top. Everyone else seemed to be riding the same hill seated with ease and so I wondered why I could be having such trouble.

After some research, I found the answer. Whenever I was going downhill or on flat road, I kept in my regular high gear. But when I was going uphill, I downshifted to a low gear. Magic. What a painless ride.

The same concept applies to investing. You can’t be holding the same fixed portfolio allocation in both boom times and in recessions. You need to occasionally shift gears between stocks and bonds depending on the prevailing environment. And just like with cycling, the method to switch gears should be very simple and systematic.

However, the common mantra in the financial industry is that you must hold a fixed allocation to stocks and bonds regardless of the market environment. Most advisers and fund managers love to hug the benchmark indices. Finance textbooks told them that the market is efficient and they should not try to beat it. In addition, they want to minimize their “career risk.” This is the risk of their customers abandoning them if the fund has a period of under-performing the benchmark.

Then every so often, a recession hits and these "experts" and their unaware clients get tortured through it. Just like I suffered biking uphill in fixed gear, but worse. Thankfully, it doesn't have to be this way.

Sunday, June 21, 2015


Hello and welcome to my blog.

I thought I'd write this post to introduce myself and outline what this new website will be about.

Who am I?

Contrary to what my friends tell me, I am not a robot that is becoming self-aware. My name is Gogi Grewal and I'm from Vancouver, BC. I wrote a brief bio about myself and my personal investment journey. Please be sure to read that in the About page.

What is this blog about?

Investing. I know this topic is highly broad and often intimidating, confusing and downright boring. But my goal is to simplify it by discussing only relevant areas in plain English. There will be the odd post that will be heavy with numbers, put I promise to keep that to a minimum.

Here's a brief outline that I have in mind for this blog:

  • Basics - Any discussion on investing needs to start with a solid foundation. I will discuss the power of compound interest and why you need to start investing immediately, the concept of risk, the 5 major asset classes, and the myriad of investment products available today.

  • Human behavior - This is a very important area of discussion. When it comes to investing, our lizard brains really are our own worst enemy. How often do our emotions cause us to buy and sell at exactly the wrong times? What is happening in our brains when we gain and lose money? Behavioral biases such as anchoring, herding, and the disposition effect contribute to the markets being less than efficient. We will show this with examples from history.

  • Strategy - If markets are not efficient, what is the best way to actively invest? While my focus will be on momentum investing, I will describe other types of active strategies (eg. value, macroeconomic, charting, etc) to show why momentum stands out from the pack. I will also discuss back-testing basics and the importance of simplicity and diversification in investing. 

  • Execution - This is everything that comes after developing a sound investment strategy. It includes: the importance of self-discipline & patience (arguably the hardest part about investing), tuning out the news, minimizing costs, selecting an online broker, tax tips, and useful software & websites. 

You can also get a sense for what this blog will be like by looking at my bookshelf page.

Is that a typo in my blog name?

The word "Sharpe" comes from the term "Sharpe Ratio." This is simply a measure of an investment's risk-adjusted return and has become a standard measure in the financial industry. So our name Sharpe Returns is just some clever word play :)

Finally, why did I start this this blog?

This is a place to organize my thoughts, keep a diary of my continuing investment journey, record any good articles and books I find, and hopefully provide value to my readers along the way. As this is a brand new blog, I welcome any feedback on ways to improve it.

Thanks for visiting this site and hope you enjoy it.


Friday, June 19, 2015

The Philosophy of Momentum

What is momentum and why is it so pervasive? This is something I think about a lot.

Momentum in Everyday Life

First off, momentum is the tendency for something to continue in the short-term doing what it’s been doing. It’s Isaac Newton’s first law, which applies to all physical objects having a mass and velocity.

When we are driving a car on a flat road and take our foot off the gas pedal, the car continues to move forward for a certain period of time. When a train is approaching a station, the operator needs to apply the brakes well in advance since the train wants to keep pushing forward. When the captain of a cruise ship sees the ship is heading in the wrong direction, it takes a while to change course. These are simple examples of momentum as applied to physics.

Momentum not only applies to physics and financial markets, but life in general. Dorsey Wright pointed out:

"Momentum is pervasive, both in the financial markets and in life in general. Andre Agassi found that past decisions created a momentum-effect in his life that made it very difficult for him to change course."

Think about your career for example. You spend a lot of time going to school and then gaining experience. Once you get good at a job, you have momentum. Trying to make any career path change at that point is slow since it often takes a lot of time and effort to get good at something else.

I recently started going to a local cooking workshop that is held in my area once a month. The organizer was telling us how it took a lot of effort initially to find a venue with a kitchen, volunteers, come up with workshop ideas and then build up a sizable attendance. "But now that we've been doing this for two years, it has gained momentum. People just show up without us having to do any advertising."

Another example is with car traffic. Suppose you are driving on a highway with two lanes going each way and you need to reach your destination efficiently. You observe for a while that cars are travelling faster in one lane. Without thinking twice, you switch into that lane because it has relative momentum. 

Momentum Investing

Let’s shift our focus to momentum investing. We have seen momentum backtest results going back over 200 years showing its strong persistence. But we need to discuss why this anomaly exists in financial markets and why we expect it will continue.

Blogger Miles Dividend recently wrote a nice blog post looking at this very topic. He says that from an individual investor’s point of view…

"…momentum is simply human beings’ inexorable tendency to chase performance. Think about the first time you had to make an investment decision. What did you look at first? I’m guessing that one of the first things that you were drawn to, like a moth to flame, was the past performance for the various funds listed. I know that was the case for me."

In Dual Momentum Investing, Gary Antonacci of Optimal Momentum has a whole chapter dedicated to human behaviour. Gary shows that behavioral biases (such as anchoring, herding, and the disposition effect) can cause stocks to underreact on a short-term basis and overreact longer term. It takes time for investors to realize what’s going on, seeing their friends & neighbours getting rich, before they feel compelled to jump in too. The market builds momentum, as price gains beget even more price gains. Even Isaac Newton, the father of momentum, was sucked into the power of emotional biases during the South Sea bubble:

Source: Jeremy Grantham, GMO, “On the importance of asset class bubbles,” Jan 2011

Momentum investing works not only due to our individual behavioral biases, but also because of the way large fund managers, businesses and economies operate.

Miles discusses fund managers by saying:

"...on an institutional level transactions occur much slower as funds move away from losing funds and towards winners. This latency is caused by the inherent cost of moving large sums of money, and the constraints on moving large amounts in and out of funds."

I can elaborate on this by saying that it takes time for economic data to be generated and for fund managers to react to that data. On top of that, fund managers need to slowly build or liquidate positions so as not to affect price and hence get the best trade execution. When large positions are being built, this causes a basing/accumulation phase. When large positions are being liquidated, this causes a topping/distribution phase. The chart below depicts this and is the main concept behind what is known as the “Wyckoff Method.

The exact same reasoning can be used to describe momentum seen in large economies. Miles writes:

"When an economy begins shrinking, it takes time to for those in power to recognize that it is in fact shrinking. And when second order actions occur, and interest rates are dropped by central banks, and stimulus bills are passed by governments, it takes time for the pain to work its way through the system, and for the corrective actions to have any effect at all."

I can give a further example of how momentum applies to the way a large company operates. It takes some time for a company’s management to discover any failing business units, take cost cutting measures, improve those units and/or diversify into new ones, and then finally see the benefits of their efforts. Hence, weak companies continue to stay weak in the short-term, and vice versa for strong companies.

Jim Collins, author of "Good to Great" explains the role that momentum plays in getting a company to become successful:

"Picture a huge, heavy flywheel. It’s a massive, metal disk mounted horizontally on an axle. It's about 100 feet in diameter, 10 feet thick, and it weighs about 25 tons. That flywheel is your company. Your job is to get that flywheel to move as fast as possible, because momentum—mass times velocity—is what will generate superior economic results over time. 
Right now, the flywheel is at a standstill. To get it moving, you make a tremendous effort. You push with all your might, and finally you get the flywheel to inch forward. After two or three days of sustained effort, you get the flywheel to complete one entire turn. You keep pushing, and the flywheel begins to move a bit faster. It takes a lot of work, but at last the flywheel makes a second rotation. You keep pushing steadily. It makes three turns, four turns, five, six. With each turn, it moves faster, and then—at some point, you can’'t say exactly when—you break through. The momentum of the heavy wheel kicks in your favor. It spins faster and faster, with its own weight propelling it. You aren't pushing any harder, but the flywheel is accelerating, its momentum building, its speed increasing. This is the Flywheel Effect"

Thus, we see that there are very deep-seated mechanics that have made momentum investing so successful in past centuries and why it should continue being successful. It simply takes time for markets to build a new uptrend and time for it to change that trend. Hence, in the short-term markets continue trending in the same direction. This is largely because of behavioral biases and the natural lags between when large fund managers, businesses and economies discover a change is needed and when the effects of that change become visible.

History has shown that changing the direction of a giant ship like the S&P 500 took a while. From 1982-2000, 2003-2007 and 2009-Present, US stocks went in one direction: Up. Before the 2000-2003 and 2008-2009 bear markets, it took over a year-long topping formation before the market changed course. It’s for this reason that momentum investing and trend following in general works.