This Is The "Dilemma From Hell Dacing CBs"

We present some somber reading on this holiday Sunday from Macquarie Capital’s Viktor Shvets, who in this exclusive to ZH readers excerpt from his year-ahead preview, explains why central banks can no longer exit the “doomsday highway” as a result of a “dilemma from hell” which no longer has a practical, real-world resolution, entirely as a result of previous actions by the same central bankers who are now left with no way out from a trap they themselves have created.

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"It has been said that something as small as the flutter of a butterfly’s wing can ultimately cause a typhoon halfway around the world" – Chaos Theory.

There is a good chance that 2018 might fully deserve shrill voices and predictions of dislocations that have filled almost every annual preview since the GFC.

Whether it was fears of a deflationary bust, expectation of an inflationary break-outs, disinflationary waves, central bank policy errors, US$ surges or liquidity crunches, we pretty much had it all. However, for most investors, the last decade actually turned out to be one of the most profitable and the most placid on record. Why then have most investors underperformed and why are passive investment styles now at least one-third (or more likely closer to two-third) of the market and why have value investors been consistently crushed while traditional sector and style rotations failed to work? Our answer remains unchanged. There was nothing conventional or normal over the last decade, and we believe that neither would there be anything conventional over the next decade. We do not view current synchronized global recovery as indicative of a return to traditional business and capital market cycles that investors can ‘read’ and hence make rational judgements on asset allocations and sector rotations, based on conventional mean reversion strategies. It remains an article of faith for us that neither reintroduction of price discovery nor asset price volatilities is any longer possible or even desirable.

However, would 2018, provide a break with the last decade? The answer to this question depends on one key variable. Are we witnessing a broad-based private sector recovery, with productivity and animal spirits coming back after a decade of hibernation, or is the latest reflationary wave due to similar reasons as in other recent episodes, namely (a) excess liquidity pumped by central banks (CBs); (b) improved co-ordination of global monetary policies, aimed at containing exchange rate volatilities; and (c) China’s stimulus that reflated commodity complex and trade?

The answer to this question would determine how 2018 and 2019 are likely to play out. If the current reflation has strong private sector underpinnings, then not only would it be appropriate for CBs to withdraw liquidity and raise cost of capital, but indeed these would bolster confidence, and erode

pricing anomalies without jeopardizing growth or causing excessive asset price displacements. Essentially, the strength of private sector would determine the extent to which incremental financialization and public sector supports would be required. If on the other hand, one were to conclude that most of the improvement has thus far been driven by CBs nailing cost of capital at zero (or below), liquidity injections and China’s debt-fuelled growth, then any meaningful withdrawal of liquidity and attempts to raise cost of capital would be met by potentially violent dislocations of asset prices and rising volatility, in turn, causing contraction of aggregate demand and resurfacing of disinflationary pressures. We remain very much in the latter camp. As the discussion below illustrates, we do not see evidence to support private sector-led recovery concept. Rather, we see support for excess liquidity, distorted rates and China spending driving most of the improvement.

We have in the past extensively written on the core drivers of current anomalies. In a ‘nutshell’, we maintain that over the last three decades, investors have gradually moved from a world of scarcity and scale limitations, to a world of relative abundance and an almost unlimited scalability. The revolution started in early 1970s, but accelerated since mid-1990s. If history is any guide, the crescendo would occur over the next decade. In the meantime, returns on conventional human inputs and conventional capital will continue eroding while return on social and digital capital will continue rising. This promises to further increase disinflationary pressures (as marginal cost of almost everything declines to zero), while keeping productivity rates constrained, and further raising inequalities.

The new world is one of disintegrating pricing signals and where economists would struggle even more than usual, in defining economic rules. As Paul Romer argued in his recent shot at his own profession. a significant chunk of macro-economic theories that were developed since 1930s need to be discarded. Included are concepts such as ‘macro economy as a system in equilibrium’, ‘efficient market hypothesis’, ‘great moderation’ ‘irrelevance of monetary policies’, ‘there are no secular or structural factors, it is all about aggregate demand’, ‘home ownership is good for the economy’, ‘individuals are profit-maximizing rational economic agents’, ‘compensation determines how hard people work’, ‘there are stable preferences for consumption vs saving’ etc. Indeed, the list of challenges is growing ever longer, as technology and Information Age alters importance of relative inputs, and includes questions how to measure ‘commons’ and proliferating non-monetary and non-pricing spheres, such as ‘gig or sharing’ economies and whether the Philips curve has not just flattened by disappeared completely. The same implies to several exogenous concepts beloved by economists (such as demographics).

The above deep secular drivers that were developing for more than three decades, but which have become pronounced in the last 10-15 years, are made worse by the activism of the public sector. It is ironic that CBs are working hard to erode the real value of global and national debt mountains by encouraging higher inflation, when it was the public sector and CBs themselves which since 1980s encouraged accelerated financialization. As we asked in our recent review, how can CBs exit this ‘doomsday highway’?

Investors and CBs are facing a convergence of two hurricane systems (technology and over-financialization), that are largely unstoppable. Unless there is a miracle of robust private sector productivity recovery or unless public sector policies were to undergo a drastic change (such as merger and fiscal and monetary arms, introduction of minimum income guarantees, massive Marshall Plan-style investments in the least developed regions etc), we can’t see how liquidity can be withdrawn; nor can we

see how cost of capital can ever increase. This means that CBs remain slaves of the system that they have built (though it must be emphasized on our behalf and for our benefit).

If the above is the right answer, then investors and CBs have to be incredibly careful as we enter 2018. There is no doubt that having rescued the world from a potentially devastating deflationary bust, CBs would love to return to some form of normality, build up ammunition for next dislocations and play a far less visible role in the local and global economies. Although there are now a number of dissenting voices (such as Larry Summers or Adair Turner) who are questioning the need for CB independence, it remains an article of faith for an overwhelming majority of economists. However, the longer CBs stay in the game, the less likely it is that the independence would survive. Indeed, it would become far more likely that the world gravitates towards China and Japan, where CB independence is largely notional.

Hence, the dilemma from hell facing CBs: If they pull away and remove liquidity and try to raise cost of capital, neither demand for nor supply of capital would be able to endure lower liquidity and flattening yield curves. On the other hand, the longer CBs persist with current policies, the more disinflationary pressures are likely to strengthen and the less likely is private sector to regain its primacy.

We maintain that there are only two ‘tickets’ out of this jail. First (and the best) is a sudden and sustainable surge in private sector productivity and second, a significant shift in public sector policies. Given that neither answer is likely (at least not for a while), a co-ordinated more hawkish CB stance is akin to mixing highly volatile and combustible chemicals, with unpredictable outcomes.

Most economists do not pay much attention to liquidity or cost of capital, focusing almost entirely on aggregate demand and inflation. Hence, the conventional arguments that the overall stock of accommodation is more important than the flow, and thus so long as CBs are very careful in managing liquidity withdrawals and cost of capital raised very slowly, then CBs could achieve the desired objective of reducing more extreme asset anomalies, while buying insurance against future dislocation and getting ahead of the curve. In our view, this is where chaos theory comes in. Given that the global economy is leveraged at least three times GDP and value of financial instruments equals 4x-5x GDP (and potentially as much as ten times), even the smallest withdrawal of liquidity or misalignment of monetary policies could become an equivalent of flapping butterfly wings. Indeed, in our view, this is what flattening of the yield curves tells us; investors correctly interpret any contraction of liquidity or rise in rates, as raising a possibility of more disinflationary outcomes further down the road.

Hence, we maintain that the key risks that investors are currently running are ones to do with policy errors. Given that we believe that recent reflation was mostly caused by central bank liquidity, compressed interest rates and China stimulus, clearly any policy errors by central banks and China could easily cause a similar dislocation to what occurred in 2013 or late 2015/early 2016. When investors argue that both CBs and public authorities have become far more experienced in managing liquidity and markets, and hence, chances of policy errors have declined, we believe that it is the most dangerous form of hubris. One could ask, what prompted China to attempt a proper de-leveraging from late 2014 to early 2016, which was the key contributor to both collapse of commodity prices and global volatility? Similarly, one could ask what prompted the Fed to tighten into China’s deleveraging drive in Dec ’15. There is a serious question over China’s priorities, following completion of the 19th Congress, and whether China fully understands how much of the global reflation was due to its policy reversal to end deleveraging.

What does it mean for investors? We believe that it implies a higher than average risk, as some of the key underpinnings of the investment landscape could shift significantly, and even if macroeconomic outcomes were to be less stressful than feared, it could cause significant relative and absolute price re-adjustments. As highlighted in discussion below, financial markets are completely unprepared for higher volatility. For example, value has for a number of years systematically underperformed both quality and growth. If indeed, CBs managed to withdraw liquidity without dislocating economies and potentially strengthening perception of growth momentum, investors might witness a very strong rotation into value. Although we do not believe that it would be sustainable, expectations could run ahead of themselves. Similarly, any spike in inflation gauges could lift the entire curve up, with massive losses for bondholders, and flowing into some of the more expensive and marginal growth stories.

While it is hard to predict some of these shorter-term moves, if volatilities jump, CBs would need to reset the ‘background picture’. The challenge is that even with the best of intentions, the process is far from automatic, and hence there could be months of extended volatility (a la Dec’15-Feb’16). If one ignores shorter-term aberrations, we maintain that there is no alternative to policies that have been pursued since 1980s of deliberately suppressing and managing business and capital market cycles. As discussed in our recent note, this implies that a relatively pleasant ‘Kondratieff autumn’ (characterized by inability to raise cost of capital against a background of constrained but positive growth and inflation rates) is likely to endure. Indeed, two generations of investors grew up knowing nothing else. They have never experienced either scorching summers or freezing winters, as public sector refused to allow debt repudiation, deleveraging or clearance of excesses. Although this cannot last forever, there is no reason to believe that the end of the road would necessarily occur in 2018 or 2019. It is true that policy risks are more heightened but so is policy recognition of dangers.

We therefore remain constructive on financial assets (as we have been for quite some time), not because we believe in a sustainable and private sector-led recovery but rather because we do not believe in one, and thus we do not see any viable alternatives to an ongoing financialization, which needs to be facilitated through excess liquidity, and avoiding proper price and risk discovery, and thus avoiding asset price volatilities.

Is Financial Argmageddon Bullish For Stocks? One Bank"s Surprising Answer

Everyone knows that after nearly a decade of capital markets central planning by the world"s central banks, "good news is bad news." But did you also know that financial armageddon has become the most bullish catalyst to buy stocks? That"s the understated take-home message from the year ahead preview by Macquarie"s Viktor Shvets published last week. It is also the conclusion that One River Asset Management"s Eric Peters reached in his latest weekend notes.

While we will have much more to comment on Macquarie"s rather macabre 2018 preview, which is arguably one of the most honest, comprehensive, and objective predictions of what to expected from the "central bank/market confidence boosting nexus", we will highlight the one argument that has served to promote countless BTFD algo-driven stock rips, summarized in the following blurb, which is a sublime explanation by Viktor Shvets the worst things are, the more you should buy:

If volatilities jump, CBs would need to reset the ‘background picture’. The challenge is that even with the best of intentions, the process is far from automatic, and hence there could be months of extended volatility (a la Dec’15-Feb’16). If one ignores shorter-term aberrations, we maintain that there is no alternative to policies that have been pursued since 1980s of deliberately suppressing and managing business and capital market cycles. [T]his implies that a relatively pleasant ‘Kondratieff autumn’ (characterized by inability to raise cost of capital against a background of constrained but positive growth and inflation rates) is likely to endure. Indeed, two generations of investors grew up knowing nothing else. They have never experienced either scorching summers or freezing winters, as public sector refused to allow debt repudiation, deleveraging or clearance of excesses. Although this cannot last forever, there is no reason to believe that the end of the road would necessarily occur in 2018 or 2019. It is true that policy risks are more heightened but so is policy recognition of dangers.

 

We therefore remain constructive on financial assets (as we have been for quite some time), not because we believe in a sustainable and private sector-led recovery but rather because we do not believe in one, and thus we do not see any viable alternatives to an ongoing financialization, which needs to be facilitated through excess liquidity, and avoiding proper price and risk discovery, and thus avoiding asset price volatilities.

Translation: central banks remain trapped by the mountain-sized bubble they have blown with years of QE and ZIRP/NIRP, and once volatility returns, and risk assets plunge, CBs will have no choice but to scramble right back and prevent the pyramid from keeling over and undoing a decade of fake "wealth creation" which was pulled from the future to the tune of $15 trillion in central bank asset purchases, which while still rising is about to go into reverse in just over a year"s time.

 

If that"s not enough, here is One River"s Eric Peters, with the exact same conclusion:

Anecdote

 

“The market has an accident, the Fed returns to QE, slashes interest rates, bonds surge, stocks recover,” said the CIO, high atop his prodigious pile, alone. Staring into the distance. Squinting, straining.

 

“The correlation between bonds and equities remains negative, the risk parity equity/bond portfolios are dented but not destroyed. And we descend to the next lower level in real interest rates. US bond yields turn negative. In essence, we prolong the paradigm that has driven markets for a few decades.”

 

Far below, economies hummed in harmony, capitalists collecting their expanding share. “A continuation of this paradigm is what everyone believes. And I just doubt that outcome so sincerely.” Hidden within the distant economic whir, labor strived, struggled. Their wage growth anemic, their children indebted, career prospects uncertain.

 

“It has taken time, but the political context for a regime shift is now established; populism is evident in recent elections. And the academic context for a seismic economic policy shift is in place too.”

 

The extraordinary response to the global financial crisis prevented depression. But the price of salvation is proving to be as profound as it is impossible to precisely measure -- unexpected election outcomes, political paralysis, an isolationist America, de-globalization, fake news, opioid epidemics.

 

And connecting it all, a corrosive, woven thread; injustice, unfairness, inequality, hypocrisy, distrust, endemic, growing. “We are on the cusp of great change, the old paradigm is set to shift,” he said, at altitude, the air crisp, clear.

 

“The market has an accident, monetary policy is seen to be bust, the models have been wrong, we have to change what we do, we can’t go down the same route, we need to move to a different policy mix. Fiscal expansion, infrastructure, labor over capital. We’re moving to something that may be great for the economy, but no good for asset markets. New Regime -- end of story.”

Dow 500,000?

Authored by Lance Roberts via RealInvestmentAdvice.com,

I genuinely admire Morgan Housel. I think he is a brilliant and talented writer. However, he sent out a tweet on Friday that really struck a chord with me.

If you"re less than 50 years old and the market returns at least 5% a year on average the Dow will hit 100,000 in most of your lifetimes. Less than age 30, it"ll hit 500,000 for most of you. Enjoy the weekend.

— Morgan Housel (@morganhousel) October 20, 2017

It’s an innocuous tweet, meant with the best of intentions to leave you with a sense of optimism as you headed into your weekend.

I get it. Really.

As Bob Farrell once quipped:

“Bull markets are more fun than bear markets.” 

Bull markets also “sell” financial products, services, and offerings. Wall Street makes money selling products and services to “Main Street” who makes money with higher prices. Financial media makes money as advertisers market their “wares.” Being bullish also gets views, likes, comments, and shares. Bull markets thrive when “greed” erases the memories of previous “bear market” losses.

As Gordon Gecko said:

“Greed is good.” 

The problem with being “bullish all the time” is that it is also very dangerous.

This is particularly the case in late-stage “bull markets,” where poor investment decisions, and excessive portfolio “risk,” are masked by seemingly ever-rising prices. Previously bad investment ideas, products, and strategies tend to resurface in a different form or package. Investment strategies like “buy and hold” and “dollar cost averaging” become popular even though they are absolutely guaranteed to leave you well short of your financial objectives in the future.

So, what does this have to do with Morgan’s tweet?

It has everything to do with one of my “pet peeves,” and the biggest fallacy pushed by Wall Street today – “compound returns.”

Markets Don’t Compound

Morgan states that in 30-years, if the Dow grows at just 5% annually, it will hit 500,000. However, if the Dow actually compounded returns at 5%, in the future, as Morgan suggests, it would have done so in the past and would ALREADY be at 500,000. 

But it’s not. We are just stuck here at a crappy ole’ 23,000.

There is a huge difference between compound returns and average returns. The historical return of the markets since 1900, including dividends, has averaged a much higher rate of return than just 5% annually. Therefore, the Dow should actually be much closer to 1,000,000 than just 500,000.

But it’s not.

Nope…we are just hanging out way down here at 23,000.

Why? Because crashes matter. This is particularly the case when it comes to your financial goals and investing time horizons.

Think about it this way.

If “buy and hold” investing worked the way that it is preached, then why are the financial statistics of 80% of Americans so poor?

The three biggest factors are: 

1. Destruction of capital;


2. Lack of savings, and;


3. Time.

While lost capital gain be regained, the time lost “getting back to even,” cannot be. Unfortunately, we don’t live forever, and time is our ultimate enemy. This is also, after two major bear markets, the majority of “boomers” are simply unprepared financially for retirement. 

It is also the reason why we are facing a massive “pension crisis” in the not so distant future as capital destruction, low contribution rates, and over-estimation of returns has led to massive shortfalls to meet required distributions in the future.

Who wouldn’t love a world where everyone just invests some money, the markets rise 6% annually and everyone one’s a winner. 

Unfortunately, there is a vast difference between an “index” which benefits from share buybacks, substitutions, and market capitalization weighting versus a portfolio invested in actual dollars. The chart below shows the S&P 500 index (nominal since that is the way it is primarily discussed) versus the actual, inflation-adjusted value, of a $100,000 investment and compared to the 6% annual return rate promised by Wall Street.

See the problem? People 30-years ago who were hoping to retire, simply can’t. It will likely be the case for individuals today looking to retire 30-years from now.

With markets now back to the second highest level of valuations on record, forward returns over the next 10-years are going to be substantially lower than they have been over the past 10-years.

That isn’t being bearish. That is just math.

Dr. John Hussman previously wrote the most salient point on this topic.

“Put simply, most apparent ‘opportunities’ to obtain investment returns above zero in conventional assets over the coming decade are based on a misunderstanding of valuations, total returns, and historical yield relationships. At current valuations, virtually everything is priced for a decade of zero.” 

Throughout history, bull market cycles are only one-half of the “full market” cycle. This is because during every “bull market” cycle the markets, and economy, build up excesses which are “reverted” during the following “bear market.”

As Sir Issac Newton once stated:

“What goes up, must come down.” 

Looking beyond the very short-term overly optimistic view of “this time is different,” the coming unwinding of current speculative extremes will occur with the completion of the current market cycle. As I noted in this past weekend’s missive:

“Also, when we look at 20-year trailing returns, there is sufficient historical evidence to suggest total, real returns, will decline towards zero over the next 3-years from 7% annualized currently. 

(These are trailing 20-year total real returns, not forward)”

“Re-read that last sentence again and look closely at the chart above. From current valuation levels, the annualized return on stocks by the end of the current 20-year cycle will be close to 0%. A decline in the next 3-years of only 30%, the average drawdown during a recession, will achieve that goal.”

The second-half of this current cycle will begin likely sooner, rather than later. As stated, it is a function of time (length of market cycles), math (valuations) and physics (price deviations for long-term means.)

I am not bullish or bearish.

My job as a portfolio manager is simple; invest money in a manner that creates returns on a short-term basis while reducing the possibility of catastrophic losses over the long-term.

While “bulls have more fun” while markets are rising, both “bulls” and “bears” are owned by the “broken clock” syndrome during the completion of the full-market cycle.

The biggest secret in achieving long-term investment success is not necessarily being “right” during the first half of the cycle, but by not being “wrong” during the second half.

It’s okay to be “always be bullish” with your attitude, just not with your money.

This Chart Signals China's Housing Bubble May Burst Soon

Via MauldinEconomics.com,

The probability that a real estate bubble may burst in China is rising. The financial sector heavily depends on real estate, which in turn exposes the entire Chinese economy to systemic risk.

This link means that a downturn in real estate could soon spread to other areas of the Chinese economy if banks face liquidity shortfalls.

Also, falling housing prices could result in more non-performing loans (NPLs). While NPLs officially account for only 1.75 percent of all Chinese loans, the government is likely understating the figure. BMI Research, a financial consulting firm, estimated in a 2016 report that NPLs could be close to 20 percent of loans.

As banks gave more credit to real estate developers and buyers, their profitability stalled. In theory, China’s economy is not based on capitalism and thus doesn’t revolve around profitability; but in practice, money needs to come from somewhere. A company that doesn’t make a profit can’t survive in the long run. The Chinese government can’t afford to let banks fail since it would threaten both the financial system’s health and the key lifeline to state-owned enterprises that provide jobs.

This surge in China’s real estate prices, fueled by ongoing credit expansion, are forcing the government to choose between deflating the housing market and slowing growth.

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BNP Risk Indicator Flashes "Love" Warning Signal For US Stocks

While the market itself has exhibited the exuberance we have all seen before (and never seem capable of learning from), BNP has quantified this love-panic relationship (and the news is not great for the bulls). When in "love" mode, the average drop in stocks has been 12% in the next six months. The biggest drivers of this "love" have been investor confidence, CoT positioning, short-interest, relative trading volumes, and sectoral outperformance with fund-flows shifting away from "love" suggesting the short-term top is in. The index itself peaked last week at the highest level of "love" in two years...

h/t @Not_Jim_Cramer

BNP explains their framework:

In our Love Panic model, we try to identify distress and euphoria in an attempt to predict forward market returns. In order to successfully predict the market we have chosen parameters with good predictive capabilities during different market cycles but also those that make qualitative sense. Investment should be dispassionate but not automatic. Some investors solve this problem by hiring a mechanic (or quant) to build a machine to invest on their behalf. This indicator is not for them. Instead, this indicator highlights when market sentiment is either overly depressed or excessively optimistic. This helps one at least adjust for ones mood. So we suggest that when the market has reached a level of distress, it’s a good time to buy. Meanwhile, when investors are euphoric,we advocate a sell. As a result we have developed a contrarian indicator model. When our signal is in panic (negative), it indicates a buy. While when the signal reads positive it’s a sell signal. In our Love Panic model, we try to identify distress and euphoria in an attempt to predict forward market returns. In order to successfully predict the market we have chosen parameters with good predictive capabilities during different market cycles but also those that make qualitative sense.

And the market has not done well once investors fall in "love"...

Trump's Right - NATO Is Obsolete For The US

Submitted by George Friedman via MauldinEconomics.com,

Donald Trump deeply upset the Europeans when he raised the possibility that NATO is obsolete and that the European Union is failing.

But this isn’t the first time these issues have been discussed. I wrote about it last year, and the conversation has only continued.

What Trump has done is simply bring into the open the question of Europe’s relationship with the US.

The missions and motives of NATO and the EU

NATO was an alliance with a single purpose: to protect Western Europe from a Soviet invasion.

The basic structure of NATO didn’t change when the Soviet Union collapsed in 1991. It simply grew to include the former Soviet satellite states and the Baltic states.

The motive behind the expansion was to bring these countries into the framework of the Western defense system in order to give them confidence in their independence. And help support the development of democracies.

The motivation was roughly the same for expanding the EU. The bloc was primarily an economic union. Simply being an EU member was believed to enhance prosperity, so that even the economically weakest country would become strong after attaining membership.

The real goal was to expand the EU as far as possible. As with NATO, EU expansion had less to do with the EU’s primary mission than with political and ideological factors.

NATO is obsolete if it can’t support the US’ interests

The EU question is ultimately a European problem.

But NATO is an alliance. The US has important and legitimate interests. But there are questions.

First, with the Soviet Union gone, what is NATO’s purpose?

Second, how does NATO serve the American national interest?

Third, given that the EU has almost as large a GDP and almost 200 million more people than the US, why isn’t its collective contribution to NATO’s military larger than the US?

The automatic answer to the first question is fairly basic: NATO’s purpose is to guarantee its members’ security.

On the second question, it cannot be argued that NATO has served American interests since 1991.

It is true that NATO’s area of responsibility is focused on Europe. The US’ current wars are outside of this area. But from the American point of view, having an alliance with a region where large-scale warfare is unlikely makes little sense.

NATO must evolve with the needs of its members. If it can’t, it can be seen (as Trump put it) as obsolete.

This brings us to the third question, the size of the European force. A military alliance needs a military.

Many European countries, in times of wealth as well as constraint, have chosen not to create a force large enough to support American interests.

Even when NATO commits to fighting alongside the Americans, European capabilities limit their contribution. There is no automatic support from NATO. The countries that want to participate, fight with as much or as little as they choose to send.

This is their right as sovereign states. But this radically changes their relationships with the US. They would participate in a US-led war if it was in their self-interests.

Nations have the right and obligation to carry out their foreign and military policies as they wish. But an alliance holds nations to behave in a certain way given certain events.

Europeans must face two facts

First, the wars that matter to the US are being fought in the Islamic world. Second, Europe is not struggling to recover from World War II. Its military capabilities should be equal to those of the US.

NATO is obsolete if it defines its responsibility mainly to repel a Russian invasion. Especially since it refused to create a military force capable of doing that. It is obsolete in that it regards the US as the guarantor of Europe’s security when Europe is quite capable of incurring the cost of self-defense.

If European nations are free to follow their own interests, then so is the United States.

When we step back, we see a broader truth. First, the European Union is breaking. Europe is in no position to do unanimously supported NATO operations. For the Europeans, NATO is important because it means that, in the rare chance of a European war, the US must be there.

The United States wants to stop Russian hegemony over the European Peninsula. But the US can deal with that by placing limited forces in the Baltics, Poland, and Romania. The Europeans have devolved NATO into bilateral relations between the US and each NATO member. So, the United States can do the same. Also, the US can accept the status quo in Ukraine, written or unwritten. The US is not going to war in Ukraine. Russia is not going to war there either.

Trump’s approach to NATO has been forced on the US by the Europeans. NATO doesn’t work as an alliance. It is a group of sovereign nations that will respond to American requests as they see fit. The US knows this and at some point, someone was going to point out that NATO is obsolete.

The matter can be summed up the following way. What is the commitment of European countries to the United States? And what is the US commitment to Europe?

It is not clear that there is a geopolitical basis for this commitment any more. Interests have diverged. NATO is not suited to the realities of today.

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The 5-Step “Evolution” Of A Family Office

By Chris at www.CapitalistExploits.at

Warning: This story is entirely fictional except for all the parts which are not. It is the story of a 5-step process of the "evolution" of a family office.

I felt compelled to pen this missive since it’s representative of so many family offices out there and maybe in doing so one or two save themselves some potentially painful headaches.

Step 1: The Patriarch Builds His Wealth

This is the story of Hans Krapenschitter and his progeny. It was in the late 80’s that Hans, then in his 30"s, made his fortune. Germany was gripped by recession, factories had closed, people had lost their jobs, real estate prices had plummeted, and so too had hemlines. Horrid stuff.

Gurus emerged, telling everyone that the world would never again see greed, avarice, easy credit, or mini skirts.

 

Instead, the future lay in gathering kale and cabbages from local community gardens, and being subjected to films where “maidens" in long flowing dresses and bonnets roamed meadows, gathering daisies, while falling in love with schoolteachers. There"d be no films where people got punched and shot and even at the raunchiest of clubs, girls skirts would be well below the knee-line.

To Hans, this all sounded like a worst nightmare come true, and knowing a little bit about human nature Hans saw his opportunity. Bucking the trend, he started a company producing T-shirts with skulls on and slogans such as “Ich werde deinen Arsch treten” (I’ll kick your ass).

In addition, he began making the most outrageous revealing woman clothing he could think of. If the world was to devolve into a global version of the Sound of Music, it wasn"t going to do so without a fight from Hans.

Fortunately for Hans the recession ended and greed, avarice, and easy credit return with a vengeance. The easy credit helped fuel Hans" business growth, and he captured the vast market share for a new zeitgeist, as footballers" wives became celebrities and women clothing prices became inversely correlated with the amount of material used. The good times were back. 

Ummmm, ok.

Step 2: The Bankers Take Notice

After depositing some sizeable checks with his local bank Hans receives a letter from the bank.

"Dear Mr Krapenschitter,

Let me introduce myself. My name is Mr. Frederick Arsenlichker, and I am delighted to have been appointed as your private banker. We at Ditschke Bank pride ourselves in providing outstanding personal service to our most valuable clients, and I will be at your service to provide you with our most exclusive range of services which are now available to you.

Please let me know a suitable time for us to meet in person to discuss your business and needs.

Sincerely,

Frederick Arsenlichker (Private Wealth Management, Ditschke Bank)"

Hans is flattered. He feels valued, not really understanding what just happened (what it really means is that he’s now in line to get spammed all the products the bank has on offer - whether he wants them or not and whether they"re any good or not).

Now to Frederick...

To understand Frederick, he’s a guy who spends over an hour in the bathroom every morning, double checks his fringe when passing anything with a reflective surface, and now in his mid-30"s has learned all the ins and outs of sales. To be sure, he’s great fun to have a drink with and knows enough about his products to sound awfully smart to the layman. He"s damn good at selling the bank"s products, but he"s never had to manage risk - and this is where the real problems surface (as you’ll see).

This isn"t his fault. He’s spent his life on the sell side. Fortunately Frederick is smart and he knows what he doesn’t know. Many like him are like 10-year olds after watching Rockie and, despite not having the muscles and never having learnt how to fight, think they’ve got what it takes to take down 10 men. Just because they’ve watched buy side guys, they think they know what it takes. Most don’t.

Step 3: Hans Needs Help

Hans" business spreads like an Australian bushfire as he breaks into the UK market where "lad culture" is pioneering an entirely new obnoxious breed of buyers, and where there are no ladies, only girls. His clothing brand is THE brand. After securing a distribution agreement with the country"s second largest retailer his wealth accelerates.

Aside from the ridiculous house his wife encouraged him to buy on the French Riviera, he now has more and more money which he realises he should probably do something with.

He"s made a few investments based on "suggestions" made to him by multiple private bankers.

You see, Frederick isn"t the only contact Hans has in banking. Due to his business needs Hans has opened no less than 8 banking relationships and they"ve all taken notice, appointing private bankers to "assist" Hans.

These private bankers regularly invite Hans to private gatherings and to his delight he"s found that tickets to the Grand Prix in Monaco, the finals of the European football championships, and the like are easy to come by. Not that he couldn"t pay for them if he wanted to, but it"s nice to get free stuff. The problem is that Hans is feeling a little overwhelmed. All this wealth comes with the responsibility to manage it.

He’s known Frederick for several years now and likes him. Many of these other private bankers are a bit too aggressive. There was that one Spanish banker, Eduardo, who tried to get him a prostitute the last time they were at a special cocktail function put on by the bank. He didn"t think his wife would appreciate that.

Frederick, on the other hand, has about 100 clients like Hans who he “manages”. He’s getting sick of a base salary with commissions bonus, having to clock in and out of his cubicle like a well trained gopher, and the intellectually vaporise environment of a big bank is suffocating.

On the sly, he’s been looking to leverage his network of investors and putting out feelers.

Step 4: Hans Hires Help

Hans: "Frederick, I"m swamped here. I"ve known you for a long time now and I trust you. Do you by any chance know of someone in your field who you"d recommend to help manage my money full time?"

Frederick: "Funny you ask. I"ve been thinking of doing just that myself for a number of clients and would be very interested in doing this for you."

Over some schnapps and sausages, Frederick becomes CIO of the Krapenschitter Family Office, and at long last he can take off the bloody suit and tie and dress in jeans and T-shirts because Hans, after all, has made a living out of clothing that bankers would never wear.

Step 5: The Muddle

And now Frederick must learn really quickly the difference between selling product and investing in product. He quickly reaches out to all his private banker buddies and sources a number of products which Hans can allocate capital into. Since the banks are large fee generating businesses they have two mandates:

1. Generate as much fees as possible and


2. Try keep your clients

Managing the two is tricky business. It requires gently raping the client, but not too roughly that they feel the pain.

One lesson that Frederick has learnt from his years at the bank is that clients hate losing money. As such, fixed income is an easy sell. The fees are still pretty reasonable, and importantly you typically get to keep your customers as you can"t lose money on fixed income, right? Ah well, sort of.

What the Sales Guys Don"t Fully Understand

Frederick"s buddies are all selling either fixed income products or the latest best thing: Low volatility funds. It"s the place to be.

You see, they"ve done nothing but go up for their entire careers (which is to say a decade, two at most). Experience has taught them that this is what works. Their only sense of history is that the iPhone never used to take pictures, like waaay back, and how mad was that?

Frederick"s buddies know only that the firms they work for are pushing them to sell these products.

What they don"t know is that the low volatility funds they"re selling are being repackaged into synthetic bond like products and sold to institutional dumb money.

The way it works is that the proprietary desks write options against these funds and thereby deliver a steady stream of income. This gets packaged and sold as "yield bearing" instruments to pension funds and other dumb money. "They"re very low risk," the salesmen say because these are solid equities with extremely low volatility. They"re almost like bonds. No, really.

Some of the proprietary traders (the older ones) know the risks and many don"t really get it. But so long as Frederick and the long list of clients in the banks" affiliate network keep buying the products, these babies are guaranteed cash cows.

Frederick, after having been in the business for enough years, realises that equities should make up a decent portion of Hans" assets. Because he doesn"t follow the markets (I mean, he watches Bloomberg and CNBC but couldn"t tell you what drives liquidity, cross border capital flows, money velocity, or why anyone should track the gold price) he"s got no sense of market cycles, and simply becomes an asset allocator reliant on his buddies (who are all sell side, remember?) for advice.

And so Hans" portfolio, on paper, looks pretty reasonable, while sporting the kind of risk that Evel Knievel would have shied away from.

Hans is presented with some investment opportunities and, knowing nothing about them, passes them to Frederick to review. Frederick takes a look.

A gold fund? Why on earth would anyone invest in a gold fund, he asks himself?

He googles the gold price and finds that it"s been in a bear market for 20 years. What lunatic would invest in this? Crazy!

He emails his buddies asking them if they"ve got a gold fund in their product lineup and what they think of it. One had a gold fund but it was closed down after lack of performance and lack of interest. Clearly this is a waste of time.

And so Hans, the family patriarch and generator of immense wealth, who never understood the difference between sell side and buy side hired Frederick the now CIO of the Krapenschitter Family Office, in charge of over $450 million.

Unwittingly - and neither realise - it both are drawn into a long daisy chain beginning with product sales which nobody in charge of managing the money actually understands. A chain designed to allow the major banks to make money on both the product fees as well as quietly trading proprietary positions against the products sold which generate amazing returns.

Frederick, for his part, wants to ensure he keeps his job and so he essentially benchmarks and follows his sell side buddies, who, in turn, push products the banks need sold.

While all this is taking place, the market builds the momentum for the inevitable – because every market has a cycle and this one is about to turn.

But Hans is on the Riviera enjoying the sunshine and Frederick is looking forward to a holiday with his new girlfriend. He’s going to take her to Ibiza wearing some of Hans latest product line. It’s truly ridiculous and he can’t wait.

- Chris

"A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain." — Mark Twain

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Trading For A Living

Submitted by Erico Matias Tavares via Sinclair & Co.,

Adam Grimes has two decades of experience in the industry as a trader, analyst and system developer. His trading experience covers all major asset classes–futures, currencies, stocks, options, and other derivatives, and the full range of timeframes from very short term scalping to constructing portfolios for multi-year holding periods. Adam is currently Chief Investment Officer of Waverly Advisors, LLC, a research and advisory firm for which he writes daily market commentary and trade notes. He is also a contributing author for several publications on quantitative finance and related topics, and is much in demand as a speaker and lecturer on the topics of technical trading, risk management, and system development. When not doing finance stuff, Adam is also an accomplished musician and a classically-trained French chef.

E. Tavares: Adam, you have dedicated most of your professional life to trading, as a private trader and later also including research publisher and coach. You have traded for a living since the 1990s and at this point have looked at all kinds of systems and approaches out there. This is actually a very valuable perspective today. In addition to a tough jobs market central banks have condemned savers – especially retirees – with zero interest rate policies, and so trading might be an alternative to generate income. Have you seen an increasing number of people trying to trade for a living in recent years?

A. Grimes: I think it comes and goes with market cycles. When markets get difficult the number of people interested in doing this drop off because as we know trading profitably is a very hard skill to develop. I may have missed it but I have not really seen people driven by the low interest rates moving into active trading. However, there is a perennial ongoing interest from people trying to figure out the markets.

ET: Your background is quite unique in that regard. You went from a trained musician to a full time trader. What prompted you to do that? Are there similarities between the two professions?

AG: I honestly don’t know if there was any rationale for that. Trading caught my interest. I had some negative early experiences but then I was fortunate to figure some things out—I think the negative experiences were good learning experiences, and probably part of why I eventually did figure it out. It was more of a hobby which eventually grew into something significant.

People talk a lot about the parallels between the two professions and maybe make too much of that. A lot of the skills and a lot of the intelligence we develop are very domain specific, meaning if you study chess it will make you a better chess player. I don’t know if studying chess makes you better or more intelligent at other tasks.

Maybe the things that I carried from being a musician centered around focus. It was very natural for me to work six to eight hours a day, day after day, for months at a time in a project. That’s not a normal skill for people to have; and also the emphasis on basics, on the importance of really understanding the basic building blocks and how if you have a strong foundation you can build an impressive structure.

It seems that many people just want to get to the cool stuff and they ignore the basics. They don’t understand that the soul of any discipline truly is the basics.

ET: Indeed. Trading is very difficult, extremely difficult in fact, as it requires a range of skills and a level of performance that most people are not even aware of when they begin that journey. Today we would like to briefly explore three core trading fundamentals, or basics as you call them: technicals, risk management and psychology.

Let’s start with technicals, meaning having the right tools. One concept that is enormously helpful particularly for new traders is a proper understanding of the expectancy formula, roughly speaking the number of times you win times the gain per trade less the number of times you lose times the loss per trade over time. Can you talk about this and the importance of developing a system that has a trading “edge”, meaning a sustainable positive expectancy (expected gains greater than expected losses)?

AG: The key is that we have a positive expectancy and we hope that it is enduring. All of our system work, if done correctly, should point us towards having something that is robust, meaning that if it works today it should still continue to work tomorrow. Of course, depending on the system the edge may be more or less stable and may require some work here and there. There are plenty of quantitative systems that require a good deal of refitting and rework on a semi-regular basis and that’s fine, it’s part of the game.

It’s very easy when you start trading to look at patterns, to start thinking about all the money you are going to make and to forget – coming back to those basic concepts – that if you don’t have an edge, a positive expectancy, then nothing else matters.

One of the reasons why traders struggle is because they are using systems that don’t work and they cannot work because those systems just don’t have an edge. It is essential that you have an edge.

ET: Yes, in fact there are thousands of trading systems out there being advertised to retail investors using every financial instrument possible, from buying stocks to highly sophisticated option strategies. Some promise very high win rates, meaning the chances of having a loss are small, which intuitively is appealing because nobody likes to lose money. But that is not the whole story, not if you want to make it in this business. How can you use that expectancy formula to evaluate the system you are looking at?

AG: Well, for one there is a difference in quality in what I consider to be three types of data or system stats.

First, doing some type of backtest, meaning going back in time and testing different parameters in search of that positive expectancy. You should never trust a backtests done by others, certainly from anyone wanting to sell you things. Even if they are not dishonest people make all kinds of mistakes, not to mention things like aggressive marketing and the like. You want to do your own backtest but even that I would not really trust because there are so many ways it can be wrong. In general, any backtest is highly suspect!

The next piece is some type of forward test. Perhaps do some paper trading where you can execute the system without real money. Basically what you are looking for here is if the paper trading resembles the results of the backtest. In both of these cases we are looking for that positive expectancy.

And then the third piece is trading with real money where what we are looking to do is see if each of these kind of link together. We are talking statistical measures with a good deal of variation, it is not always easy to say yes, they do look the same, but we want to have some consistency between all of these different expressions.

You talk about the high win ration and this to me is pure marketing. There are a lot of people who have made a lot of money winning just 25% of the time. I can tell you from my own experience that you can win 90% of the time and not make money. What matters is that you have a positive expectancy.

ET: Let’s focus on that trading edge now. Your research indicates that securities behave differently, something that perhaps is not widely understood: stocks trade differently from commodities and foreign exchange, for instance. As such, in order to find that edge your system either needs to be adapted to the asset class you are trading or be so robust that it can be applied across the board. How do you go about doing that?

AG: You are correct. One of the great lies of technical analysis that is perpetuated in so many places today is that you can apply any tool to any market in any timeframe and you can make money. Somebody doing statistical tests with no more powerful tools than Microsoft Excel and freely available data can show you that there are basic differences between asset classes, for instance in the way they mean revert, and it’s illogical to think that you can apply tools the same way if markets behave differently.

ET: If you do a backtest when stocks are at all-time highs this means by definition that you could have bought at any time in the past in any imaginable way and you would be in the money. So you can come up with any number of parameters and you will always end up with a system that has a positive expectancy, provided that you stay in the market. Can this stock market condition make people develop systems which are not as reliable going forward? Actually, this may be more relevant at this juncture into a seven year bull market in stocks. Investors seem to forget that in nature – as in markets – trees don’t grow to the sky…

AG: If we take stocks that are at all-time highs and then look at statistical edges going forward that is different. Otherwise you are correct. If you take stocks now and look at how they have performed over the past you would have made money – in theory.

There are things that we can do to have more robust results. One of the huge problems we need to account for is survivorship bias. In other words you want to make sure that in your backtesting you are somehow incorporating delisted stocks and stocks that are undergoing some type of market action.

But in general you need to be very aware of how you are constructing your test and being aware of any leakage from the future, meaning that you have to make sure that your system does not in any way know about what will happen after.

However, I consider that the stock market has a fundamental element in that stocks over any appreciable period of time always seem to go up. It is quite difficult to imagine anything happening that would move us out of that environment. So I would not have a problem dealing with stocks in the conditions you described. But you can develop systems and edges that are not conditional on this fundamental upward shift in stocks.

ET: A quick note on market indicators, which seem to fill trading screens these days. Some are very sophisticated and based on exotic proprietary formulas. In your opinion are they worth the complexity and often the cost?

AG: It’s definitely hard to make a hard generalization. But the efficiency of simple tools for instance ultimately depends on how they are applied. You can have a tool that works very well but if you don’t apply it properly you will not get good results. Complexity is not a bad thing but may not be necessary.

ET: Can you comment on using purely mechanical systems, where the parameters are predefined (largely as a result of the backtesting we just discussed) and you just follow that plan day in day out, versus more discretionary systems, where you can add your own input to the final decision, some of it more subjective like economic conditions, supply and demand and so forth? It seems you use both in your work, do you favor one in particular?

AG: There are certainly people who do both effectively, others who are more effective in just one. But particularly for developing traders, if you are going to be a discretionary trader you need to make sure that you are aligned with the market. You can’t just trade any old idea and hope that it works. So there needs to be some type of education there. Other than that I don’t have a particular bias towards any approach.

ET: Is it fair to say that the quicker you turn over your positions (day trading being the most extreme for retail investors) the more technical systems you should use, and the longer your timeframe the more you should consider factors like longer term trendlines, fundamentals and economic conditions? Is it also fair to say that in trading the real money is made in the bigger moves, meaning trading less and being positioned for the bigger swings over time? The short term, especially day trading, appears to be very noisy, perhaps too noisy to consistently make money.

AG: You certainly can make money day trading. More people talk about it than doing it effectively but it is possible. Most developing traders will probably find better success in longer time frames. I don’t think that a generalization is possible, other than using fundamental data for short-term systems makes less sense to me.

ET: That gets us to risk management, another fundamental of trading, which in very simplified terms deals with how much you should invest in each trade. This is another area where that expectancy formula can be very helpful. If a trader is seeking to change her approach to limit her loss per trade she will very likely find that her win ratio will drop as a result, so that the expected result may not change that much. In other words, in efficient markets there are no free lunches; any improvement comes at the expense of something else. So can risk management really help you?

AG: What you just outlined is a very good expression of the edge, the expectancy. Yes, you can change your win ratio and the relationship between average win and average loss but at the end of the day the other side will compensate such that your expectancy will be more or less the same within some limits.

To me risk management is a bigger topic than just position sizing. How much you risk on each trade is certainly a part of that, but the idea is to maximize your equity curve while reducing the chance of something very bad happening. Basically position sizing lets you stay in the game, make the most money you can with the minimal chance of going broke.

ET: Actually, we often hear that “you will not go broke by taking a profit”. That’s actually not quite true. If your system needs to have profits per trade 5x larger than your losses just to breakeven this means that if you always sell as soon as you reach 2x or even 4x you will eventually go broke. Your thoughts?

AG: Yes, that saying is one of the great lies told to traders. That is absolutely untrue. In fact one of the biggest psychological barriers of developing traders is managing winning trades. I hear this over and over from people: “it’s very easy for me to get out of my losers but I can’t hold on to winners, I always take profits too early”. This is something that people don’t think about often enough but it is a serious problem.

ET: That’s a great point. In fact, while it is hard to consistently make money over time there are things that will definitely put you on the losing side over time. Can you briefly talk about those?

AG: The biggest, I think, is simply doing something that doesn’t work, having some trading system that you don’t understand because you got it off some chat room or bought it from someone else. Even if the system has an edge it’s not your system so you can’t execute it appropriately.

And then there are things like sabotaging yourself, meaning taking the wrong size in trades, the behavioral issue of ignoring stops, getting lazy and not doing the necessary work, skipping trades, not managing your positions and so forth. There are many things you can do wrong that will effectively sabotage you.

ET: How would you rate the importance of finding a trading edge versus risk management? You closely liken the two but some traders suggest that the latter is the absolute key and even propose different optimization formulas.

AG: Yes, they’re equally important but the idea that you could go into a market and make money provided you have good risk management is incorrect. There’s this famous trading book where only one random test in a group of commodity markets is presented confirming this idea, but it was a bad test—the standard obviously should be the baseline drift, not that the tests made money, and it was just one result. Though this test is famous, it was poorly constructed as a statistical argument.

 Risk management is not enough. You can’t make money if you don’t have an edge and risk management does not solve that problem.  

ET: So let’s look at psychology, the third fundamental which ties together all that we just discussed. Its importance is of course beyond dispute. If you have a winning system but the inevitable losses put you off trading then you can never be a trader. Full stop.

It can also be more subtle than that, as each trader needs to find and adapt a trading system that truly suits his or her personality. In other words, to be a profitable trader there are no shortcuts, it requires a lot of introspection, research, hard work and confidence. Like every other challenging undertaking in life actually. Your thoughts here?

AG: Again, trading psychology is not an edge by itself, but you can certainly have an edge and sabotage it with the wrong psychology. It is vital in many level and stages. You have traders who may do well for a while but then they struggle with some aspect and everything comes crashing down. You can also have inherent conflicts with money, the wrong reasons for trading or you are not a coherent human being, all of these can come out and affect your trading over the long run.

All of this is important but it is critical to understand that you need these three pieces: the edge, the risk management to apply the edge and the psychology to make sure you do what you are actually supposed to do.

ET: Should trading be boring or exciting, especially if you want to do it for a living? What should motivate you each day as a trader?

AG: When I talk to a trader who wants to work with me as a coach or mentor, I get very concerned when somebody tells me that they are looking for excitement in trading. If that is your motivation you can have that; simply put on some positions that are too large or ignore your stops and all of the sudden your trading will be very exciting.

To be a profitable trader this means that you find something that is robust and repeatable and sadly this means it’s boring. Effective professional trading is really doing the same thing over and over. One of my closest mentors said that the best definition of good trading is like being a stonemason or bricklayer. You put a brick down, then put the mortar, smooth it, then put another brick down, then the mortar, smooth it and so on. If you continue doing the same thing over and over at some point you will build a big wall. But the actual act of doing is the same boring, tedious routine. It is almost an insignificant thing.

And by the way this parallel goes a bit further because most people can’t build a brick wall. It’s not as easy as it looks and they don’t have the skills to do it. Even though the basic elements seem to be simple, it takes real work to develop the skills—the same as in trading.

Your motivation for trading cannot be excitement. An important stumbling block is once you become a successful trader it can get pretty boring. All of the sudden you realize you lack excitement, that you will not solve any of the world’s problems trading. You’re just doing the same thing over and over, it’s a reality shock that many people having difficulties coping with.

ET: You have written extensively over the years on all these topics in your blog and even produced a video trading course, all which are available for free. We can’t recommend those enough to anyone wanting to think through and improve their trading skills. Why did you go through all that effort and then charge nothing for it? These are excellent resources that can be further explored in your book, The Art and Science of Technical Trading, which was very well received, and even help to better understand the thinking behind your excellent research product at Waverly Advisors, but aren’t you concerned about giving away your “secret ingredients”?

AG: First of all thank you for your kind words on my work. Everything I do I try to put out information that I wish I had had when I started trading. I have certainly been immensely touched by the feedback that I have received and I think I’ve shortened the learning curve for some people.

Regarding the trading course I wanted to put out a product that was equal to or better than courses that cost $10,000+, and I did that. This course has been very well received and has put me in touch with a lot of smart people, but it really did have an altruistic beginning.

It’s been a great way to get in touch with a lot of intelligent people. It is free, there is no upsell, no hidden fees and it will always remain free. I very much believe that anyone starting from scratch will learn enough to build a profitable trading system, and that’s based on actual feedback.

ET: That’s excellent. Final question. In light of everything we just discussed, can retail investors prevail in the markets and find consistent ways to supplement their income, if not outright trade for a living, or does it all boil down to a coin flip?

AG: The answer is yes you can do this, but the way I would think about it is that you have a choice to make.

If you treat trading as a hobby then you can certainly do that and there’s room in the market for that. But realize that this is entertainment and you probably will not make much money doing that. Your primary motivation is an interest in the financial markets, you want to solve the puzzle but let’s be honest: hobbies cost money.

If you want to make money in the market then I think you need to make the commitment to trade with a professional mindset. This does not mean that it is your full time job necessarily, that you should take your focus away from your family and anything else that you are doing but it does mean that you approach the market with a full professional mindset, understanding that you operating within the bounds of probability and that you’re looking to apply the same simple system over and over.

I don’t know how else to put it. You have to make the commitment to become a professional trader because I don’t think the hobbiest has much of a chance to make money. Having said that, virtually anyone in the world with that desire could commit to becoming a professional trader. If you want to do this, you can do it.

ET: Adam, thank you very much for sharing your thoughts.

AG: My pleasure, thank you.

Is A Short Squeeze Coming From This?

By Chris at www.CapitalistExploits.at

Market dislocations occur when financial markets, operating under stressful conditions, experience large widespread asset mispricing.

Welcome to this week"s edition of “World Out Of Whack” where every Wednesday we take time out of our day to laugh, poke fun at and present to you absurdity in global financial markets in all it"s glorious insanity.

While we enjoy a good laugh, the truth is that the first step to protecting ourselves from losses is to protect ourselves from ignorance. Think of the "World Out Of Whack" as your double thick armour plated side impact protection system in a financial world littered with drunk drivers.

Selfishly we also know that the biggest (and often the fastest) returns come from asymmetric market moves. But, in order to identify these moves we must first identify where they live.

Occasionally we find opportunities where we can buy (or sell) assets for mere cents on the dollar - because, after all, we are capitalists.

In this week"s edition of the WOW we"re covering volatility ETPs (Exchange Traded Products)

Before we get into what exactly is Out Of Whack with volatility linked ETPs let"s cover what the heck a volatility ETP actually is.

What are Volatility ETPs?

Since it"s probably the most commonly known animal in the zoo we"ll turn to the iPath S&P 500 VIX Short-Term Futures ETN (VXX) for an explanation:

The iPath® S&P 500 VIX Short-Term Futures™ ETN is designed to provide investors with exposure to the S&P 500 VIX Short-Term Futures™ Index Total Return. The S&P 500 VIX Short-Term Futures™ Index Total Return (the "Index") is designed to provide access to equity market volatility through CBOE Volatility Index® futures. The Index offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects the implied volatility of the S&P 500® at various points along the volatility forward curve.

In English now:

Any ETP including VXX is a derivative of some underlying asset so let"s take a look at the underlying "asset". In this case it"s the VIX futures. The VIX itself is actually a calculation based on the implied volatility of a basket of options on the S&P 500. Included in the calculations are options which are about to expire and those with 30 days to expiry. The net result is what amounts to a best guess as to what the market believes is in store for the next 30 days trading.

Attentive readers will realise that the VIX is therefore not the actual volatility of the S&P 500, but rather a forward looking best guess of what it is. For example it"s possible for actual volatility of the S&P to be low while traders are freaking out about something they see in a months time which would send VIX higher.

You can buy futures contracts on the price of VIX and they"re actively traded but like any futures contract you"re betting on a where a price lands on a future date, in this case 30 days out.

Volatility ETFs are particularly strange animals since you"re buying a derivative (ETF) on a derivative (the futures contract) which itself is based on a derivative (the implied volatility of options) and those options themselves of course are derivatives which themselves are based on the S&P 500.

So what"s going on with Volatility ETPs?

Volatility ETPs can provide investors the ability to be bullish or bearish. In other words those expecting low volatility can buy something like the ProShares S&P 500 Low Volatility Portfolio (SPLV) and those expecting high volatility can buy something like the VXX mentioned above.

It"s one thing that investors are expecting continued complacency and thus buying the low volatility ETPs but there is a perverse craziness that makes it all the more dangerous (more on that in a moment).

To explain why there has been such a rise in the popularity of low volatility ETPs just imagine driving the Eyre highway which takes you across the Nullarbor plain in Australia. For those unfamiliar with what this is, it"s a 1,675km stretch of road that is pretty much dead straight and has nothing to see - nada. It is I assure you, more boring than watching grass grow and takes 2 days at high speed.

The thing is you land up clocking speeds that would get you arrested anyplace else, in large part because it doesn"t feel like you"re going that fast and certainly doesn"t feel like you"re getting anywhere at all. It"s why when accidents happen on the Eyre highway they"re more often than not fatal.

Every 50km or so the road kinks a little and so one minute you"re hurtling along and the next thing you know, the roads not there anymore and you"ve got to control a ton of metal and rubber screaming through the outback at 180km/h. The rental car guy I spoke to told me that about 10% of all his cars are never resold, they"re rolled.

What does this have to do with volatility ETF"s?

Everything.

Long periods of complacency are often interspersed with brief but frightening jolts of "holy sh** where did that come from?"

Betting on increased volatility has been a losing bet. Below is the VXX in blue (long Volatility) vs SPLV in red (Short Volatility). 

VXX in Blue and SPLV in green/red

Now there are structural reasons why VXX is such a pig of a long term ETF to buy, and I"ll cover why that is in a future article but the point I want to make is that going short volatility has been a winning trade.

I"ve written about this so much that my fingers are going to bleed, more recently when discussing how bonds no longer trade based on yield but based on a future price but the hunt for yield has created some truly amazing set of circumstances and this brings us squarely to low volatility ETF"s.

Enter the beast - When the Cure Becomes the Poison

As reported recently by Market Watch:

"More than $50 billion has poured into low-volatility indexed exchange-traded funds over the past five years or so, in the wake of the 2008-09 market meltdown. There are now 14 “lo-vol” ETFs with assets exceeding $100 million each, and many more with less. Whenever the market hits a pothole, these ETFs enjoy a bump-up in assets."

Now this is where the perverse part comes in. Bear with me on this - it"s important.

Every time you sell volatility you get paid by the counter-party who is typically hedging the volatility (going long) of a particular position and paying you for the privilege. This is not unlike paying a home insurance premium where the insurer takes the ultimate risk of your house burning down and you pay them for the privelage. The difference however between selling volatility in order to protect against an underlying position and selling volatility in order to receive the yield created is enormous. And yet this is the game being played.

The central banks have managed to create a sense of calm in the markets exhibited by record lows in volatility and for their part Joe Sixpack investor has used linear thinking extrapolated well into the future assuming ever greater risk ignoring market cycles and extremes at their peril.

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Two things are happening here:

1. When the proverbial house burns down the insurance company (ETF) can"t cover. It"s all in and was never designed to protect holders for the inevitable reversal.


2. Investors have been selling volatility in order to achieve yield and thus treating these structured products like bonds, when they are in fact similar to bonds in the same way that the iPhone is similar to a water buffalo.

Traders are aggressively hunting for yield and finding it in selling volatility. This works wonderfully... until it doesn"t.

Remember equities are something like 7x more volatile than bonds (depending on what you"re looking at) and these ETPs are inherently more volatile than the underlying equities upon which they"re ultimately priced. Treating them like bonds and buying them for yield is quite simply INSANE.

What"s interesting is that the VIX is trading near all time lows at the same time that short interest on low volatility ETFs is at record highs.

While I"m not predicting it though we are due a recession purely based on the business cycle, a market crash would almost certainly wipe out the entire low volatility ETP complex, and a market correction (overdue) will see a scramble amongst those who"ve been treating an ETP as a bond. It could be more entertaining to watch than the current clown show US presidential race.

The question is:

Cast your vote here and also see what others think

Know anyone that might enjoy this? Please share this with them.

Investing and protecting our capital in a world which is enjoying the most severe distortions of any period in mans recorded history means that a different approach is required. And traditional portfolio management fails miserably to accomplish this.

And so our goal here is simple: protecting the majority of our wealth from the inevitable consequences of absurdity, while finding the most asymmetric investment opportunities for our capital. Ironically, such opportunities are a result of the actions which have landed the world in such trouble to begin with.

- Chris

"To buy when others are despondently selling and sell when others are greedily buying requires the greatest fortitude and pays the greatest reward." — Sir John Templeton

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