A Frustrated David Einhorn Asks "Will The Market Cycle Never Turn?"

Just days after Third Point"s Dan Loeb took a victory lap in his latest letter to investors, boasting a 14.5% YTD performance, outperforming the S&P and virtually all of his peers, a decidedly more downcast letter was released today by Greenlight"s David Einhorn, who also had a good quarter, generating 6.2% in Q3, which brought his YTD return to 3.3% after a subpar first half. Yet despite the solid Q3 performance, Einhorn admits that "the market remains very challenging for value investing strategies, as growth stocks have continued to outperform value stocks. The persistence of this dynamic leads to questions regarding whether value investing is a viable strategy. The knee-jerk instinct is to respond that when a proven strategy is so exceedingly out of favor that its viability is questioned, the cycle must be about to turn around. Unfortunately, we lack such clarity. After years of running into the wind, we are left with no sense stronger than, “it will turn when it turns.”

Such an open-ended answer, however, is a problem for a fund which famously opened a basket of "internet shorts" several years prior, and which have continued to rip ever higher, detracting from Greenlight"s overall performance.

This, in turn, has prompted Einhorn to consider the unthinkable alternative: "Might the cycle never turn?" In other words, is the market now permanently broken.

Einhorn goes on to explain that his strategy "relies on the assumption that the equity value of a company equals the market’s best assessment of the current and future profits discounted at the company’s cost of capital. Our ability to outperform often comes from our skill in finding opportunities where the market has misestimated current or future profitability or miscalculated the cost of capital by over- or underestimating the risks."

It is here than an unexpectedly exasperated Einhorn emerges:

Given the performance of certain stocks, we wonder if the market has adopted an alternative paradigm for calculating equity value. What if equity value has nothing to do with current or future profits and instead is derived from a company’s ability to be disruptive, to provide social change, or to advance new beneficial technologies, even when doing so results in current and future economic loss? It’s clear that a number of companies provide products and services to customers that come with a subsidy from equity holders. And yet, on a mark-to-market basis, the equity holders are doing just fine.

Ah yes, the Fed-funded "deflation trade" which lowers prices for goods and services courtesy of ravenous investors who will throw money at any "growth" idea, without considerations for return or profit, because - well - more such investors will emerge tomorrow.  After all, in this day and age of ZIRP, what else will they do with their money.

Here Einhorn took aim at his favorite "bubble" shorts: Amazon, Tesla and Netflix. This is what he said:

When we consider the business performance of our three most well-known “bubble” shorts, we wonder if this alternative paradigm is in play. Last quarter, we noted Amazon.com’s (AMZN) earnings estimates had fallen over the prior few quarters. This quarter, AMZN revealed a much lower level of long-term structural profitability, causing consensus estimates for the next five years to drop by 40%, 22%, 18%, 14% and 8%, respectively. Ordinarily, stocks trading at nosebleed multiples fall sharply when such a dramatic reassessment happens. Instead, AMZN fell less than 1% during the quarter. Our view is that just because AMZN can disrupt somebody else’s profit stream, it doesn’t mean that AMZN earns that profit stream. For the moment, the market doesn’t agree. Perhaps, simply being disruptive is enough.

 

Tesla (TSLA) had an awful quarter both in its current results and future prospects. In response, its shares fell almost 6%. We believe it deserved much worse. So much went wrong for TSLA in the quarter that it is hard to only provide a brief summary. The main near-term problems are poor demand for its legacy vehicles and manufacturing challenges for the new Model 3. Notably, TSLA dramatically reduced its gross margin assumption for the September quarter and publicly blamed ramp-up costs for the new Model 3 sedan. More quietly, the company used the lower gross margin hurdle to offer incentives and to lower the cost of options on the Model S and Model X vehicles, and even offered significant markdowns on showroom models. Given the depth of the price cuts, we were surprised that demand for the Model S and Model X only improved modestly.

 

Meanwhile, it is becoming clear that scale manufacturing is actually a skill. While the CEO makes bold claims about TSLA’s superior prowess, continued production shortfalls, defects and product recalls disprove him. TSLA faces competition from established OEMs that have decades of scale manufacturing experience. Some of TSLA’s presumed market lead in areas like autonomous driving may more likely reflect TSLA’s willingness to put inadequately  tested and dangerous products on the road rather than a true technological advantage.

 

Finally, there is Netflix (NFLX), where the quarterly results beat expectations and the shares advanced 21%. Competition is heating up and media companies such as Disney will be removing their content from NFLX to compete directly (bulls used to believe that Disney would pull a Time Warner/AOL and pay-up for the highly promoted but profitless business). NFLX continues to accelerate its cash burn as it desperately tries to compensate for its inability to rely longer-term on licensed content. On the second quarter conference call, the CEO stated, “In some senses the negative free cash flow will be an indicator of enormous success.” To us, all it indicates is that NFLX is capable of dramatically changing the economics of stand-up comedy in favor of the comedians. Perhaps, there really is a new paradigm for valuing equities and the joke is on us. Time will tell.

Einhorn also highlights the biggest winners and losers in the quarter including CONSOL Energy (CNX), General Motors (GM) and Uniper (Germany: UN01) which were the largest contributors, while Caterpillar (CAT) short and Mylan (MYL) were detractors.

Some more details: Greenlight added long positions in Hewlett Packard Enterprise, Micron and Tempur Sealy; exited a short position on Best Buy and a long position on PVH. The fund"s largest disclosed long positions at quarter end were unchanged from the end of 2Q: AerCap, Bayer, Consol Energy, General Motors and gold. The parternships had an average exposure of 118% long and 73% short.

The full letter is below:

Jack Bogle Warns Of Market "Chaos, Catastrophe" If Passive Investing Wins

In 2016 investors poured $480 billion into passive funds, a mix of mutual funds and exchange-traded funds, while pulling more than $380 billion from active mutual funds, according to data compiled by Bloomberg. Passive equity investments may become as much as 45 percent of the mutual fund industry within five years as investors move to low-cost funds, Bogle said in an interview on Bloomberg Radio in March. But just how much can the market take?

"If everybody indexed, the only word you could use is chaos, catastrophe," warned Jack Bogle, 88-year-old founder of Vanguard, at the Berkshire Hathaway annual meeting on Saturday.

“There would be no trading,” Bogle told Yahoo Finance editor-in-chief Andy Serwer. “There would be no way to turn a stream of income into a pile of capital or a pile of capital into a stream of income... the markets would fail."

“We have too much trading in the market,” Bogle said. “The index really just neutralizes x-percent of the market… And it just, those stocks don’t get traded. So the other stocks would get traded, the market would go on as ever."

“So [the market] gets a little less efficient, but if it gets less efficient some managers can win by more. And some managers will lose by more. This is the equation. So, I’m not concerned about it. It’s going to take a long, long time [for indexing to get] anywhere near 50% [of the market], and things will change a lot in other ways by then."

“Markets are going to be efficient as long as there are managers, or investors, trying to find little holes in the system... price discovery, as they call it,” Bogle said.

Yahoo"s Myles Udland reports that currently, Bogle notes, about one-quarter of the U.S. stock market is currently indexed. In his view, indexing could account for 50% of the market “easily.” Asked by Serwer what level of indexing would concern him, Bogle said he expects indexing could exceed 75% of the market and not have it become dangerous.

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.