Bonds in a Box

The market has already baked in an almost certainty for a quarter point rate hike as the outcome from tomorrow’s FED meeting. The 30 year bond yield has risen almost 50% from last July’s bottom and currently sits in its consolidation “penalty” box as is seen in the chart below. Additionally, yields remain are testing the highs last seen in October 2014.

The market has a tendency to do exactly opposite of what everyone expects. With the dumb money currently long yield and the smart money short, I find this setup up very fascinating and am interested to see how it all plays out. If the FED response is to push rates higher and the market follows, I would expect we see much higher yields (lower bond prices) in the future as the bull flag pattern that has developed points to a 30 year yield north of 4%. While that will be good for bank stocks, bond holders, especially those holding long-dated maturities and those buying or refinancing property will be likely be in for some pain.

Surviving the Continuous Chain of Disappointments

I thought I would repost an article written last week by Morgan Housel talking about one of the greatest investors, Ed Thorp. For those of you who may not have heard about him, Ed Thorp was the first person to systematically beat casinos at blackjack. He made piles of money, and wrote a book laying out a formula showing how you could do it too.

But not many people did.

Card counting is simple on paper and maddeningly hard in practice. That’s partly because casinos are good at catching card counters. But it’s mostly because even successful card-counting means long, tiring stretches of losing money, which most people can’t stomach.

The casino usually has a 0.5% edge over blackjack players. Thorp’s system titled the stakes, giving players about a 2% edge over the house.

A 2% edge is enough to secure a fortune in the long run. But it also promises hell in the short run, since Thorp was still likely to lose about half his hands. His road to success was paved with agony, as he writes:

I lost steadily, and after four hours I was behind $1,700 and discouraged. Of course, I knew that just as the house can lose in the short run even though it has the advantage in a game, so a card counter can fall behind and this can last for hours or, sometimes, even days. Persisting, I waited for the deck to become favorable just one more time.

The key to Thorp’s system was the ability to survive losing long enough for the 2% edge to materialize. It meant constantly absorbing manageable damage. Many people can’t, or refuse to, do that. Thorp once enlisted a partner, Manny, who was fascinated by the counting system but couldn’t stand the long bouts of losing. “Manny became in turns frantic, disgusted, excited, and finally close to giving up on me as his secret weapon.” As did most who attempted Thorp’s system.

It’s ironic that the secret to winning was learning how to put up with losing, but there it was. “Having an edge and surviving are two different things,” Nassim Taleb once wrote.

This is a great analogy for most business and investing endeavors.

Capitalism doesn’t like edges. It unleashes competition to bang them back toward zero. When edges do arise they’re usually small. A system that gives you a 55%, or 65% chance of success is phenomenal, but it still means you’ll spend close to half your life getting beat up. Since 100% odds of success are either not lucrative, illegal, or ephemeral, the ability to survive losing is a prerequisite to any shot at eventually winning. The business world is a continuous chain of disappointments – recessions, bear markets, brutal competition, employees quitting, supply chain breakdowns, whatever – so every chance at success has to be framed as a net reward down the road amid a constant state of battle and hassle. Thorp understood this. Most of his disciples did not. Most people don’t in general.

Two things come from viewing success as the ability to absorb loss:

It’s easier to be an optimist. Optimism is usually defined as a belief that things will go well. But it’s not. It’s a belief that the odds are in your favor, and over time things will balance out to a favorable outcome even if what happens in between is filled with misery. I’m optimistic about the economy because the odds of success are in its favor. But I still expect a chain of recessions, panics, pullbacks and upheavals. Same for businesses. There are companies whose future I am extremely optimistic about but whose quarterly investor updates I expect to be peppered with setbacks. The two are not mutually exclusive.

You value the margin of safety. Many bets fail not because they were wrong, but because they were mostly right in a situation that required things to be exactly right. Room for error – often called margin of safety – is one of the most underappreciated forces in business. It comes in many forms: A frugal budget, flexible thinking, and a loose timeline – anything that lets you live happily with a range of outcomes. It’s different from being conservative. Conservative is avoiding a certain level of risk. Margin of safety is raising the odds of success at a given level of risk by increasing your chances of survival. Its magic is that the higher your margin of safety, the smaller your edge needs to be to have a favorable outcome. And small edges are where big payoffs tend to live, since most people don’t have the patience to wait around for them.

The point is that short-term loss is usually the cost of admission of long-term gain. It’s a price worth paying, but takes time for the product to be delivered.

Some may be wondering how this all relates to my investing blog. Besides his casino beating system, his Princeton Newport Partners fund, which was set up in 1969, is recognized as the first quant hedge fund (one that uses algorithms). Over 18 years it turned $1.4m into $273m, compounding at more than double the rate of the S&P 500 without suffering so much as one quarter with a loss. Thorp’s then revolutionary use of mathematics, options-pricing and computers gave him a huge advantage. Ed’s moneymaking abilities have made him the “godfather” of many of today’s greatest investors.  The takeaway here is that to be successful at Investing, gambling or any endeavor that puts capital to work in an attempt to profit requires both patience and also an “edge”.

February 2016 Charts on the Move Video

A February follow through pushed stocks higher. Stocks are overbought and overstretched while sentiment is at an extreme. Add to that the potential (now sitting at 80% probability) the FED raises rates, stocks are facing some headwinds.  Sounds like a perfect recipe for a short to intermediate term pullback.

My latest market video can be viewed at the link below

https://www.youtube.com/watch?v=ZfT8VOGBYJ8

Another Punch to the Gut?

So much of the financial media’s recent attention has been focused on the impulsive rally in stocks. For those not aware, we have had an equally spontaneous rally in bond yields which means their bond holdings have declined. Since the election, the US Treasury 10-year note lost more than 5% while the 20 year has declined more than 8%.  Because we have been in a 35+ year falling rate environment this move has caught some investors off-guard as they have been conditioned to their bond positions only rising in value (falling yields)

Looking at the 5-year movement of the 10-year US Treasury yield we see some interesting developments. As you can see in the chart below, the election triggered a huge move, pushing yields higher out of the downward (blue) channel. After yield peaked just slightly above 2.6% it created an overbought condition and has since been consolidating sideways and digesting its gains. As we know consolidations either lead to 1) a reversal or 2) a continuation and this one, as of now, looks very much like a continuation as it has formed a bull flag suggesting we may only be halfway done.  

It’s too early to tell which way this consolidation will eventually take, patterns can morph, the FED can take action and of course, Trump can tweet so we have to be open to all options. But, as of now the charts are telling us market participants are expecting higher interest rates ahead. Unless investors have immunized the duration of their portfolios, they need to be open to the possibility of another punch to the gut in their bond holdings.

Dollar Retest

I haven’t spent much time talking about retests in the past but because the dollar is in the process of one, I thought this would be a good time to do some teachin’ to ya’all. Quite often, after a long consolidation and breakout, an investment will struggle after the breakout and then fall back to retest the original breakout level. The reasons for this are numerous and I will leave them to another post but for now the key is recognition and the understanding this is a normal occurrence and provides an objective entry for those not already invested.

Using the US Dollar chart below you can see the dollar consolidated between the lower and upper blue (support and resistance) lines for almost 2 years before it broke out higher and peaked the first week of this year. Since that time it has fallen back to the original upper blue line which has flipped from resistance to now becoming support.

If you are a new reader you may be wondering why I spend so much time on watching the dollar. As investors we are very interested in what the dollar does because it can have a dramatic effect on other assets including bonds, stocks, commodities, energy, etc. Most global commodities are priced in dollars. Because the dollar is now sitting on support combined with the fact it is still in a long term uptrend, we must give the benefit of doubt that this will resolve to the upside.  But we also know there are no guarantees so you need to have a plan in case this thesis is wrong. 

If the dollar were to break down below support and move substantially back into the prior consolidation area, I would view this as a very bearish signal and the potential signal the uptrend is over (and my prior blog post declaration of our next stop for the dollar of 108 being wrong).  There is a saying in TA that states “from false breaks come big moves” and means that when an investment breaks out of consolidation, does not hold and falls back, it usually leads to big moves in the other direction. While the odds are not in stacked in the favor of that happening, if it does, the ramification for investors could be huge.