This Will Make You Feel Good About Our Indicators
Today an article appeared on Bloomberg headlined “Robot Takeover Postponed as Quant Funds Flattened in Equities.” It makes the point that the much-ballyhooed switch from human-managed macro and bottoms-up hedge funds to so-called quant funds has failed badly in 2017. And it failed badly even though most hedge funds themselves are lagging the S&P 500. For the record, quant hedge funds have managed a less than 2 percent gain compared to a nearly 10 percent gain for the S&P 500.
I mention this in the context of today’s closeout of our SPDR S&P 500 ETF (NYSE: SPY) January 19, 2018 $250 call option trade for a loss of less than 10 percent. If you were to compound or in any way calculate our performance so far this year – whether on the basis of our option results or by imputing the changes in the ETFs to trading futures, assuming leverage of 4 to 1 or 5 to 1 (less leveraged than the typical quant fund) – I think it would be evident we’ve dramatically outperformed the market.
Today’s loss is based on indicators that, as we discussed previously, we recently refined to where we think they’re improved over the ones that have proven so successful. Why then such a rocky start? Two factors account for it. First, I was anxious, and perhaps over-anxious, to get a trade under my belt with the revised indicators, and I used a cut-off that was slightly lower than what I had determined was optimal (i.e., was just a touch less bullish than I’d ideally prefer). But since the new indicators now incorporate weekly as well as daily values, I expected to get a clear buy signal by the end of this week. This expectation was upended by the dramatic ratcheting up of the Korean crisis, and I admit to being blindsided by the market’s reaction. But I still expect, though obviously can’t promise, that we will have a clearer buy signal by next week.
If the indicator had been more firmly positive, I would have recommended an option with a shorter time frame and probably more out of the money, i.e., one that was more leveraged. A big reason for trying to improve my indicators, as I’ve previously noted, was to have a better methodology for knowing when to take more aggressive positions with the potential for much bigger gains. That remains the goal, and nothing that has occurred has changed my expectation that we’ll achieve it very soon.
The advantage of weekly numbers is that they tend to be less volatile than daily ones. Even more important, they make it possible to include variables that make an appearance only once a week, such as oil demand and unemployment insurance claims. Moreover, employing some straightforward numerical operations, almost all the information from the daily indicators can be transformed into a weekly number.
Validation of the indicators is based on four-week forward performance. They aren’t designed to be day-to-day indicators. But occasionally we’re faced with an out-of-the-blue occurrence that can’t be readily quantified and that requires a judgment call. This doesn’t mean the indicators are badly designed. In the present case, it doesn’t even mean that the recent positive (if slightly below what we’d like to see) signal was wrong.
In other words, the betting is still on a market that will be higher four weeks from where it was this past Monday. Korea threw it off course, as will happen at times, but barring some drastic worsening of that crisis, or some other unexpected crisis, or a dramatic change in the direction of any of the variables that make up our indicators, we expect to re-initiate the trade.
You might ask, if our indicators are designed to be right four weeks forward, and then the next indicator point is in the opposite direction, is that a contradiction? No.
To understand why it’s not, imagine you’re betting on a Super Bowl game a month before it’s played. You analyze the players, the match-ups, etc., and end up betting that New England (aren’t they always there) should win the game by at least seven points. But then two days later you observe that Tom Brady at practice is wearing a knee brace and seems to be moving less well than usual. That might change the number of points you think they’d win by. And if you then learned he was seriously injured, the odds might even turn against New England winning at all.
In other words, changes in underlying variables can affect the probabilities of performance four weeks ahead. That’s one reason we use cut-offs that are higher than zero.
In ending, we note that we’d still label our market indicator as bullish. The only indicator that we’d give a bearish rating to is the one for oil stocks; while improving, it’s still negative. The indicator for oil itself is neutral.