Receding Tides

As the Federal Reserve announced the end of QE or at least a pause in their asset purchasing plans after six years, the market experienced true volatility for the first time in ages. Indeed, all of the major US Stock Indices ventured near or into correction territory at a frenetic pace. Meanwhile, several commodity trends that had been intact for months with nary a bounce also began to exhibit more typical, two-sided behavior.
It’s volatile times such as these when it becomes apparent who has sound investment theses and who is really just following the herd. For those who have been generating outsized returns through excessive leverage, it must have been difficult to ride the 10% plus equity corrections without a little panic. The same goes for those riding the absurdly overcrowded agricultural trends as well. I imagine the funds who were excessively short Corn during the nearly 20% bounce in recent weeks can relate to this statement. (We just so happened to have quietly been building a contrarian long-position in Corn for the past two months, while hedging our downside risk, more on this a little later).
Unfortunately, albeit typical, all of the volatility occurred when excitement in the Managed Futures space over recent returns was beginning to spike. It will be interesting to see how October 2014 industry results look with a somewhat receding tide.
For DCM, October proved to be kind as we were soundly positioned throughout most of our portfolio. With that said, what exactly makes for a sound investment thesis anyways? At DCM we’d argue that there are two key components to a sound plan that when used in unison can yield solid long-term results. The first is generating a directional bias. Of course there’s any number of ways to do this, from top-down and bottom up fundamental analysis, data-mining, to technical analysis and so on. Regardless of which method or methods used, the important thing is to be right at least occasionally and have conviction in your analysis.
As a multi-strategy firm we use all of the methods above to generate our biases. Typically we give our top-down analyses in our quarterly commentaries. Referring to last quarter’s commentary we laid out our thesis that interest rates would remain persistently low for quite some time. As a result, we continued to believe the markets would have an upward bias. We presented this however, with the caveat that one should be nimble and protect their equity index positions. Protection was suggested by either downsizing, or hedging with options, particularly on any new market highs. Size and options however, apply more to our second key investment component, which we will discuss shortly.
Using the S&P 500 may be a bad example, as it is quite easy for one to argue that we are simply following the rest of the lemmings. Thus, let’s take a look at our argument for being long corn recently despite the largest crop in US history.
From a top down perspective, the increasing percentage of middle class making up the world population, has steadily increased demand for meat in diets. That combined with the fact that the production of livestock requires substantially more grain than for human consumption there is substantially more demand for corn.
From a seasonal perspective, the Corn market has made its annual low in the months of September or October nearly 50% of the time. Such a rate is 3-fold greater than would be statistically expected.
Additionally, using data mining combined with mean reversion analysis of the last 20 years, we found that on every occasion Corn was priced above three dollars and made a move of 35% or more in any direction, a correction of least a 10 percent occurred within 6 month’s time. Typically, the correction was substantially larger.
Finally, from a technical perspective Corn had recently surpassed its monthly 161.8% Fibonacci extension and was testing the robust $3 price support level. Over the past 8 years, the $3 level has been so reliable that the cash market has not had a monthly close below $3.20. As one can see, there were several reasons to construct a long argument in Corn, much as in the S&P 500.
However, all of the arguments in the world won’t matter in the long run if you don’t utilize our second component effectively; Money Management. At DCM when we refer to Money Management, we mean how you manage the risk and reward components of each trade or investment you make. Like forming a bias, there are many ways to manage risk/reward components of a trade. We prefer to focus on the risk aspect of our trades and we do this in more ways than can be described in one short commentary. So we will focus on the aforementioned Corn trade and the DCM method of Cost-Averaging.
Cost-averaging is a method of trading where you increase exposure as a trade works against you. The thought process behind the method is that if you thought an asset was undervalued at a higher price, you should like it even more at a lower price. It’s a method widely looked down upon in the investment world and for good reason too.
The London Whale trade and just about every other headline rogue trading event over the past 20 years has in some way been the result of cost-averaging losers. With the Whale, the trader himself in fact wanted to cut his losses at 200 million and his superiors instructed him not to take losses. The total loss wound up being in excess of 6 billion. Paul Tudor Jones is famous for saying, loser’s average losers.
We agree, which is why we don’t average losers. At first this might seem like a confusing statement, but it’s accurate. If we are in fact Cost-Averaging a trade that has worked against us, it’s extremely likely that we have some sort of hedge against the position. We believe having an effective hedge is an absolute necessity to Cost-Average trading. Our hedging method with Corn focused on a variety of option strategies, that for proprietary reasons we won’t delve too deeply into. Suffice it to say that when Corn was trading at its lowest, our option hedges were quite profitable and thus sufficiently protecting our downside risk. Such protection allowed us to add exposure to our futures contracts without fear of a run-away market.
Again, this certainly isn’t the only way to manage risk, but it works for us. In fact, similar methods have allowed us to produce our best winning bets of the year fighting some of the strongest trends of the year. The method has not only allowed us to trade counter-trend, but it has allowed us to follow and improve with trend performance, as we have in the Equity Indices all year. We believe the method became most valuable to us this month when many of the broader averages broke their 200 day Moving Averages, an area where a great many technicians place their stops.
Fortunately, with most of the Averages at all-time highs, we were not one of those technicians. With that said, where do we go from here? From a long-term rate outlook, very little has changed for us. We still believe for the time being that markets will bear low rate levels for an extended period of time. Perhaps well into the next decade. International Central Bank policies continue to reinforce this belief as the world seems hell-bent on preventing deflation. As such, global interest rates remain under pressure with no end in sight. We continue to monitor foreign 10-year bonds as a gauge for US rate ceilings, which currently seem to be near their upper limits.
The most aggressive of the World’s Central Banks is without a doubt the Bank of Japan. Earlier today they announced their plans for what has been dubbed “QE 9,” which includes direct purchasing of Japanese ETF’s at a rate of 3x of their previous stimulus package. Talk about giving new meaning to “plunge protection team.” Not only that, but their total stimulus has rung in at 60% of their GDP compared to just 20% for the US QE packages.
I’d have to be a fool to put forth some sort of short-term bearish argument against the Japanese package. As could be expected the world stock averages all shot up markedly on the news, while the Yen lost in excess of two percent against the dollar. Although I can’t give a bearish argument in the short-term, a moral hazard argument is pretty easy to formulate.
I can however, formulate a long-term bearish argument. Initially, it seems hard to believe that other competing Asian economies, namely China and S. Korea will standby idly while their competitive advantages are slashed into by devaluation of the Yen. This poses at least some threat to stability of one of the World’s largest trading regions.
Even if stability isn’t threatened, with the whole world ramping up their printing presses, I wonder how long deflation remains the issue? Low rates are one thing, massive asset and stock purchasing is another altogether. I fear that perhaps inflation is going to behave in a Wiley Coyote fashion. Meaning, by the time the world recognizes they have gone far enough with the stimulus we are already over the inflationary bubble’s edge. Regardless of whether the Coyote scenario plays out, we are all likely to witness the greatest history lesson in modern finance. In the coming years we will know whether or not the reduction of stimulus in the 1930’s was the real mistake made by Central Banks, an argument set forth by so many Keynesian economists. Make no mistake; this time around there will be no shortage of stimulus.
In regards to the US Stock Market, our tone has changed quite markedly. Although we rode through the last down-turn and in fact added exposure at much lower prices, we think it would be a grave mistake to ignore the damage that was done to the Markets over the past 30 days. Indeed the end may be near. In fact, for the first time we have begun building a short position (option hedged of course) against the Russell ETF in our equity portfolio. Going forward we suggest the following:
• Reduce Equity exposure especially on overbought conditions or have down-side hedges, including outright short positions as hedges.
• Maintain fixed income exposure of 3-5 years.
• Maintain exposure to income producing commodities & assets that provide inflation hedges.

Although the end may be near for the current equity rally, we are not in the business of making wild predictions. We will leave that for the talking heads. We believe that focusing solely on market direction is analogous to a poker player predicting the flop before it’s dealt. Sure it might help set their frame of mind, but it’s what they do after that really counts. That’s why at DCM, our focus is on preparing to manage the next move. Whether up, down or sideways we believe we’ll be ready when the tide recedes.

Best Regards,

Duane Cronin