A Hard Look At Risk

Mechanical systems trader Larry Hite has a great quote in Market Wizards: “Risk is a no-fooling around game; it does not allow for mistakes. If you do not manage the risk, eventually they will carry you out.”

In one of the greatest rock and roll songs of all time, Led Zeppelin puts it another way: “When the levee breaks, momma you got to move.”

Why bring this up? Because, as you may have noticed, risk is back on the table in a very big way this week…

In a recent Barrons interview, the new “King of Bonds” Jeff Gundlach predicted the S&P is going to 500. Quite a contrast with Laszlo Birinyi’s call for S&P 2,800 by 2013.

Which one is right? If you’re a trader, it really shouldn’t matter. Seriously.

As the old saying goes, bad traders don’t actually make profits. They just take out short-term loans from the market. If you let your capital ride on a big gaudy market call without managing the risk, then it doesn’t matter your orientation — bull or bear — because sooner or later the market will clean you out. (Or bleed you out, one of the two.)

A fluid and flexible trader, meanwhile, can adjust their main hypothesis — or even temporarily discard it if need be — in order to flow with prevailing trends. There is no excuse for a bearish trader to lose huge chunks of capital in a bull market, or vice versa for a bullish trader in a bear market. As a worst case scenario, your risk management protocols should keep your drawdowns under control and the vast majority of your capital intact — even when your deepest convictions are wrong!

Cannon Fodder

Just as summer begets fall begets winter, periods of low volatility eventually beget periods of high volatility. All too many investors are happy to forget this basic truth. And thus a lot of happy-go-lucky “buy the dip” LOLOs — our acronym for leveraged outright long only investors — are at risk of being slaughtered in the coming months.

Like this guy, as cited by Brett Arends in the WSJ:

How crazy have people become? Last week a portfolio manager I know told me about a conversation he’d just had with one of his clients. This manager runs a conservative practice. His clients are solid, sensible types—some old money, and some new money that thinks a bit like old money. One of his clients, a partner in a small private firm, had called him up and said, casually, that he and his partners were discussing this year’s bonus pool. “We’re thinking about putting it all in Apple stock for the year. What do you think?” he asked.

The portfolio manager thought the guy was kidding. “No, we’re serious,” the client replied.


“Why not?” he went on. “I mean, it’s not like Apple’s going to go down. It’s a sure thing.”

Talk about cannon fodder. Maybe that guy will be OK — but if he and all his partners get completely blown out, puking up their positions at the bottom of some surprise horrific decline, they will 100% deserve it.

Speaking of risk and “sure things”… a lot of investors become convinced over time that their favourite investment has become a sure thing — that such and such a stock can never go down because the business is so bulletproof, the franchise is so great.

But this belief falls somewhere between daydreaming and idiocy because, in a true free market, “sure thing” business models do not exist. There is a little something called “competition” that comes along and eats away profit margins.

As with Amazon and Netflix for example. From the WSJ:

Amazon.com Inc. thrust itself further into the online-video business Tuesday by offering key customers movies and TV shows for instant viewing over the Web, heightening its competition with Netflix Inc.

The Internet-retailing giant said the service will be a perk for U.S. members of its Amazon Prime package-shipping program. Those members will be able to watch more than 5,000 movies and TV shows online. Amazon Prime customers pay $79 a year to get special shipping rates on purchases at Amazon’s website.

Amazon said it hopes the new service will bolster both its digital business and retail business. The streaming-video offering could lead customers to buy or rent the 90,000 movies and shows that Amazon already offers on an a la carte basis.

Gee, think that’s bad news for a stock (NFLX) trading at 71 times trailing 12 month earnings? This is how free markets are supposed to work: Fat profit margins tend to attract hungry competition, which in turn grinds those profit margins away — great for consumers, but not so great for starry-eyed investors who extrapolate unreasonable returns out to infinity. The rosier the scenario, the greater the risk.

Stubborn bears are guilty of ignoring risk too. Earlier this month, value investor Whitney Tilson and his firm, T2 Partners, were forced to publicly cover their Netflix short. They took a bath on it.

In contrast, we Mercenaries have taken a couple shots at NFLX over the past few months, but never really lost money on the trades — either breaking even or only losing a minuscule amount on each attempt. That’s because we always adhere to five key principles:

  • Practicing aggressive risk management
  • Waiting for attractive entry points
  • Quickly moving stops to break even
  • “Earning the right to swing” before going big
  • “Never using valuation to time a market”

And those simple principles highlight much of the difference between traders who understand and manage risk, versus supposedly more conservative investors who don’t.

If you manage the risk, you can keep your initial exploratory forays small and controlled, which in turn gives you the staying power and mental fortitude to truly go big when the real move develops.

In otherwords, if NFLX breaks wide open and has a screaming-mimi downside move with ample pyramid opportunities along the way, will we be in on it? Most likely. We are again short NFLX as of this writing. As is our custom, we accept the risk of losing a little for a shot at making a whole lot.

Meanwhile, will the guys who got in too early and failed to manage their risk be in place for the big drop? Doubtful. They’ll be sidelined by fear and nursing their wounds.

That’s why the practice of rigorous risk management is more than just preachy self-discipline or boring bean counter talk. Managing risk is a key source of trading longevity, a means of positioning for future profits, and a hallmark of competitive excellence. Smart risk management not only helps preserve capital, it puts money in your pocket by ensuring you have the mental and financial capacity to swing with conviction when the time is right.

Canary in the Great Compression Coal Mine

For a business model that isn’t broken but is nonetheless struggling, look to retail giant Wal-Mart. Again via the WSJ:

Shares in the world’s largest retailer fell Tuesday after it reported a seventh straight quarterly decline in comparable-store sales at its key U.S. locations. The good news: Business is much healthier at its international stores, which posted a 12% sales increase last fiscal year. Unfortunately, 73% of total segment operating profit still comes from U.S. Wal-Mart stores, making a domestic turnaround critical.

…Wal-Mart still looks like a value trap. First, its core customers have less income than the average shopper at rival Target and probably have benefited less from the economic recovery. Government transfers, such as food stamps, already are at historically high levels, and there is no clear sign the government is ready to ramp them up further. That leaves Wal-Mart highly dependent on job creation before its cash-strapped shoppers spend more freely.

In the meantime, loose monetary policy likely has helped spark inflation in categories like food and oil, squeezing household budgets further. Expensive gasoline also could deter customers from driving to the nearest Wal-Mart and instead opt for neighbourhood shopping centres.

Wal-Mart’s woes bolster our Great Compression thesis as laid out last week. The type of shoppers who drive Wal-Mart’s U.S. domestic sales also fit the profile of the “left behinds”… those struggling with reduced or lost wages, sharply curtailed discretionary income, and poor employment prospects moving forward.

We would argue the Wal-Mart constituency is an invisible majority, and that the Federal Reserve is myopic and possibly criminally negligent in ignoring the impact of its policies on such a group. Given developments like the following, though, one wonders if the Fed — and the markets — can do their ignoring much longer:

  • Home prices plummet in most big cities (YahooFin)
  • Highest gas prices in Feb since 1990 (ABC News)
  • Regional contagion “Nowhere Near Over” (TBP)
  • Nervous China puts security apparatus into overdrive (FinTimes)

Blame Libya?

If faith in the “Bernanke put” all comes to naught — a combination of geopolitical turmoil and Fed-induced inflation pressures sending stocks into a tailspin or worse — the irony is that caught-out bulls will have a ready made excuse.

They will blame Libya.

You can see it now, via the classic mutual fund manager on CNBC, explaining why his portfolio swung from plus 15% to down 40% (and why he is still holding on):

“You can’t predict events like Libya. Exogenous shocks are just part and parcel of participating in markets. Besides, we are patient long-term investors and all of our holdings are extremely sound, blah, blah, blah…”

Except this argument will be bogus, just as all “unprecedented situation” arguments are bogus in the absence of a solid risk management program.

As traders and investors we may not know what will happen, but so what: You don’t need a crystal ball to manage risk. There is a duty and an obligation to “expect the unexpected,” and to safeguard accordingly.

And how unexpected were these Middle East developments in the first place?

We laid out the odds for major danger scenarios, including the geopolitical element, in “Twelve Major Risks for 2011.” We then later expanded our thoughts — well prior to Libya’s eruption — via Deeper Implications of Middle East Turmoil. The warning signs were there, for those who chose to heed them.

In sum, a blind-sided investor may claim no one could have “predicted” the make and model of the Mack Truck that hit him. But if he was out playing freeze tag on the highway, that’s no excuse.

Leaning into the Hiking Cycle

Our trading book has shifted from significantly net long to aggressively net short over the last few sessions. Current shorts run the gamut from select financials to emerging market plays to casinos (with a few meteoric high flyers mixed in such as NFLX). We have cashed for partial profits in some of these areas and are actively building exposure in others.

In recent weeks our highest conviction theme has been the “E.M. hiking cycle,” as various emerging markets, dangerously exposed to rising food and energy prices, are forced to raise interest rates and tighten monetary policy in aggressive efforts to keep inflation under control. This is bad news for E.M. equities in the context of a “risk-off” environment.

The underlying drivers of the E.M. hiking cycle, and the potential ramifications of a China hard landing and property bubble burst, were already strong before Libya erupted. Those drivers will only be stronger now.

At the same time, the widely acknowledged U.S. economic recovery is anything but bulletproof. Case-Shiller economist Robert Shiller has given a “substantial” weighting to the possibility of home prices falling another 25 per cent. Couple that with Nomura’s prediction that Brent crude oil prices could double, with attendant affects on already high fuel prices, and you’ve got real trouble brewing.

Given the above backdrop, it is not at all inconceivable that overbullish sentiment, taken to complacency extremes by tepid economic improvements and blind faith in the Federal Reserve, could be dashed to pieces (along with corporate profit margins) on the rocks of a new oil shock — or simply the growing threat of one.

Now, in other words, is a better a time than ever to take a hard look at risk. Traders should embrace the opportunity not only to sidestep large losses through risk management controls, but to rack up powerful and substantial gains in the event of a major downside move.



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