An article on Keith McCullough’s bearish market call set off a furious debate in the comments.
First, Adam Grimes from Waverly Advisors gave a lengthy retort to McCullough. Then an anonymous commentor jumped in, attacked Grimes’ argument and Waverly’s market performance.
Grimes defended himself once more in newsletter this morning (below).
Swing Trader has his response to the newsletter here.
From Waverly Advisors:
I want to take a minute this morning to address some issues regarding losses and risk management. This discussion is motivated, in part, by some great feedback that we received to my post on a popular trading and markets website earlier this week.
First of all, losses are a part of this business. Learning to recognise when we are wrong, managing risk, and then taking losses quickly and unemotionally is a key to success in this business. There are, broadly speaking, two ways to make money in the market. Either you can be right more often than you’re wrong, or you can be wrong more often that you’re right but make a lot more when you’re right than you lose when you’re wrong. Either approach is valid and robust. Newsletter writers and pundits have many tricks to build a track record that looks “incredible”, but an undue focus on win rate can be detrimental to your financial health. Currently we do not present a track record for The Macro Report because we believe any theoretical mock portfolio returns are, frankly, worthless. In fact, the point of the Macro Report in the first place is to serve as a companion to the fund that we are in the process of launching, so when our registration is complete we will be publishing actual return data (we we assure you will not be as remarkable as the returns that can be produced in hypothetical “paper” portfolios—real money has a habit of producing less compelling results than fantasy). When we close out our “beta” mode this month and transition into our new site, this will all be much more clear.
When initiating a position, there are two key numbers to consider. The first is the expected stop on the position, which would be the total amount lost if the trade is wrong. The second is the percentage of your trading capital you are willing to risk on this idea, which will vary depending on your risk tolerance and investment goals. (Since we enter positions in three tiers, the risk on any tier must be 1/3 of the total capital at risk for the idea.) The idea is that losses are kept to a consistent percentage of capital, so the relevant number becomes what you made or lost as a multiple of your initial risk. For instance, on the recent Copper trade, we lost 0.93 times our initial risk on the entire series of trades, which frankly is pretty good considering we successfully navigated an earthquake in a major copper producing region. On our recent FXI short, we lost less than a third of our initial risk on a single tier—this is a loss of less than 10% of capital at risk on that idea and is completely appropriate for what we considered to be a low probability early entry in this market.
This morning we also want to address some of the poster’s direct questions to us on the website. Please ignore the seemingly hostile tone of the writer’s questions (in italics), the author is actually an old friend of ours who was having a bit of fun at our expense (and pointing out quite rightly that we should focus on our own work rather than commenting on that of others—valuable advice indeed).
If my maths is correct, the copper trade has gone against you by more than 25%? What sort of normal distribution do you use to generate stop losses? Or do you use more than one factor on that front. [sic]… am I correct in assuming that I had I followed you and Mr. Barber’s recommendations this year, I would have lost a good deal of money? …. Is this accurate sir?
No, sir, your maths is not correct, nor is it especially relevant. For the Copper trade we calculate an average entry price (accounting for the roll of one tier from March to May) of 3.1997 and an average exit price of 3.4357. Assuming equal tier sizes, this would have been a price change of 7.4% against the trade (certainly not 25%), but the actual loss should be reckoned as a factor of the initial stop loss, or the initial expected risk on the trade. In this case, the relevant losses on each tier were -1.5, -1.0 and -0.2, for a total loss of the trade of -0.9. By way of example, an investor risking 2% of total trading capital on this idea would have experienced a portfolio loss of 1.8%, which is completely acceptable and appropriate.
As for setting stop losses, we do not use any distributions, but rather focus on market structure, volatility, and previous swing points. Risk management is job number one.
The following questions relate specifically to my swing analysis in yesterday’s morning note:
Why are you using an analysis of the Dow Jones to refute a statement about the SP500?
The question of which market proxy to use is always complicated. In this case, I opted for the Dow Jones Industrial Average simply because of the longer data history available. The DJIA was first published in 1896. There are extrapolations of the S&P going back to that same timeframe, but the actual history starts in 1960. At any rate, big picture structural issues should not be much affected by choice of index. For instance, we calculated the average swings in the Dow for the last 10 years at 6.6% with an average length of 15 days. For the S&P, that number is 6.7% with an average length of… 15 days. I was not refuting a statement about the S&P500, but rather a statement about the US Stock Market as a whole. In this case, using more data to check for structural consistency was the right choice.
Do you use only a single factor model and normal distribution to make your trading calls? That seems oddly simplistic. If you haven’t read it yet, I would suggest a book called The Black Swan, which discusses the gross potential shortcomings of such simplistic analysis.
We have already dealt with issues of assuming normality in detail. In our 3/4/10 morning note I wrote: “Just that any mathematical model that depends on the assumption of normal, bell-curve shaped asset price distributions is profoundly flawed and risk management models that depend on this maths (VaR for instance) are actually dangerous because of the false sense of security they create.” We also have laid out our tactical / technical process in considerable detail in these morning notes. We do not rely on single factor (or multi-factor) models for anything. We use models and research to understand tendencies and typical behaviours in markets, and then we use that information to find good risk/reward opportunities that are in alignment with our strategic convictions.The question of which market proxy to use is always complicated. In this case, I opted for the Dow Jones Industrial Average simply because of the longer data history available. The DJIA was first published in 1896. There are extrapolations of the S&P going back to that same timeframe, but the actual history starts in 1960. At any rate, big picture structural issues should not be much affected by choice of index. For instance, we calculated the average swings in the Dow for the last 10 years at 6.6% with an average length of 15 days. For theto find good risk/reward opportunities that are in alignment with our strategic convictions.
As an aside, if you can track it down we recommend you read the discussion of risk between my colleague Andrew Barber and Mr. Taleb that was published in Trader Monthly some years back, the print version was truncated but there was a full version that was available online that may still be out there somewhere, despite that publication now being defunct. In that article Mr. Taleb made some great comments regarding VaR and other risk management models employed by large banks—all of this years before the collapse of Lehman and Bear Stearns.
Wasn’t [he] actually correct in his statement that the market was overbought? I am just a simple personal trader, but what I have learned is that the conclusions are what matter in this business. That is, being right.
What I was responding to was the writer’s thinly veiled sensationalism: “I’m not calling for a 2008 style crash, yet.” Newsletter writers can get away with this, in fact that is part of their job, to entertain, but traders and asset managers do not have this luxury. You can make a thousand vague insinuations like this, get lucky on one, and then say you called the crash! As for the market being “overbought”, my experience is that that is a very dangerous term without any real meaning. Is Natural Gas oversold now? Two months ago? Was Oil overbought at $95? Certainly Bear Stearns was oversold at $60, $50, and even more oversold at $30, right? You get the point. As a point of fact the author whose post we were commenting on is both exceedingly talented AND exceedingly entertaining, we are big fans of his work. The tone of our comments seems to have been misinterpreted—they were intended as a good natured discussion point, and not an attack on the process of someone who we deeply respect.
As for the poster’s claim that what really matters is being right, he is half right. What really matters in this business is knowing what to do on the next swing in your timeframe, which can be minutes to weeks to years. When the market turns down, do you press your shorts, get flat, or buy to position yourself for the next upswing? How far might we expect the correction to carry? These are the important questions and the writer’s claim that the marketis hugely overextended and possibly due for a crash is, according to the historical record, simply wrong.
We don’t like to trumpet our successes in The Macro Report, but already in the short history of our report do we have a pretty strong record. In our first note on the morning of 1/20/10 we said the US Stock Market was “at a critical decision point” and listed several technical factors that tilted “the near term picture decidedly in favour of the downside.” The previous day’s close was, of course, the exact high in January. The morning of 3/26/10 I wrote, “our short-term bias has shifted to bullish.” The SPY then proceeded to have the longest series of uninterrupted up days in its entire history as it staged a rally that carried to new highs for the year. As for the poster’s call that the market is overdue for a correction, yeah, we told you about that too. From our 3/22 morning note: “This is exactly what we expected as this short-term uptrend seems to have reached its temporary high water mark and we roll over into consolidation. Even though we expect the market to be soft for between 3-10 trading days (and possibly longer), we will maintain our short term bullish bias, highlighting the fact that we believe this pullback is a buying opportunity.”
…….of course all that sounds bit like a newsletter writer polishing his supposed credentials now doesn’t it? We are a small, start-up asset management firm that publishes our thoughts on the markets every day and shares them with people who are interested. We really do appreciate the feedback we have received and thank you so much for reading our work as we continue to build our business.
As always, feel free to contact us with questions at [email protected]
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