The quarter went in like a lion and out like a lamb. A quick look back at Q1 market action and a deeper look at momentum divergences and how they can help your investing can be viewed in my latest video at the link below
Surviving the Continuous Chain of Disappointments
I thought I would repost an article written last week by Morgan Housel talking about one of the greatest investors, Ed Thorp. For those of you who may not have heard about him, Ed Thorp was the first person to systematically beat casinos at blackjack. He made piles of money, and wrote a book laying out a formula showing how you could do it too.
But not many people did.
Card counting is simple on paper and maddeningly hard in practice. That’s partly because casinos are good at catching card counters. But it’s mostly because even successful card-counting means long, tiring stretches of losing money, which most people can’t stomach.
The casino usually has a 0.5% edge over blackjack players. Thorp’s system titled the stakes, giving players about a 2% edge over the house.
A 2% edge is enough to secure a fortune in the long run. But it also promises hell in the short run, since Thorp was still likely to lose about half his hands. His road to success was paved with agony, as he writes:
I lost steadily, and after four hours I was behind $1,700 and discouraged. Of course, I knew that just as the house can lose in the short run even though it has the advantage in a game, so a card counter can fall behind and this can last for hours or, sometimes, even days. Persisting, I waited for the deck to become favorable just one more time.
The key to Thorp’s system was the ability to survive losing long enough for the 2% edge to materialize. It meant constantly absorbing manageable damage. Many people can’t, or refuse to, do that. Thorp once enlisted a partner, Manny, who was fascinated by the counting system but couldn’t stand the long bouts of losing. “Manny became in turns frantic, disgusted, excited, and finally close to giving up on me as his secret weapon.” As did most who attempted Thorp’s system.
It’s ironic that the secret to winning was learning how to put up with losing, but there it was. “Having an edge and surviving are two different things,” Nassim Taleb once wrote.
This is a great analogy for most business and investing endeavors.
Capitalism doesn’t like edges. It unleashes competition to bang them back toward zero. When edges do arise they’re usually small. A system that gives you a 55%, or 65% chance of success is phenomenal, but it still means you’ll spend close to half your life getting beat up. Since 100% odds of success are either not lucrative, illegal, or ephemeral, the ability to survive losing is a prerequisite to any shot at eventually winning. The business world is a continuous chain of disappointments – recessions, bear markets, brutal competition, employees quitting, supply chain breakdowns, whatever – so every chance at success has to be framed as a net reward down the road amid a constant state of battle and hassle. Thorp understood this. Most of his disciples did not. Most people don’t in general.
Two things come from viewing success as the ability to absorb loss:
It’s easier to be an optimist. Optimism is usually defined as a belief that things will go well. But it’s not. It’s a belief that the odds are in your favor, and over time things will balance out to a favorable outcome even if what happens in between is filled with misery. I’m optimistic about the economy because the odds of success are in its favor. But I still expect a chain of recessions, panics, pullbacks and upheavals. Same for businesses. There are companies whose future I am extremely optimistic about but whose quarterly investor updates I expect to be peppered with setbacks. The two are not mutually exclusive.
You value the margin of safety. Many bets fail not because they were wrong, but because they were mostly right in a situation that required things to be exactly right. Room for error – often called margin of safety – is one of the most underappreciated forces in business. It comes in many forms: A frugal budget, flexible thinking, and a loose timeline – anything that lets you live happily with a range of outcomes. It’s different from being conservative. Conservative is avoiding a certain level of risk. Margin of safety is raising the odds of success at a given level of risk by increasing your chances of survival. Its magic is that the higher your margin of safety, the smaller your edge needs to be to have a favorable outcome. And small edges are where big payoffs tend to live, since most people don’t have the patience to wait around for them.
The point is that short-term loss is usually the cost of admission of long-term gain. It’s a price worth paying, but takes time for the product to be delivered.
Some may be wondering how this all relates to my investing blog. Besides his casino beating system, his Princeton Newport Partners fund, which was set up in 1969, is recognized as the first quant hedge fund (one that uses algorithms). Over 18 years it turned $1.4m into $273m, compounding at more than double the rate of the S&P 500 without suffering so much as one quarter with a loss. Thorp’s then revolutionary use of mathematics, options-pricing and computers gave him a huge advantage. Ed’s moneymaking abilities have made him the “godfather” of many of today’s greatest investors. The takeaway here is that to be successful at Investing, gambling or any endeavor that puts capital to work in an attempt to profit requires both patience and also an “edge”.
It’s Whats for Dinner
Back at the end of April in 2015 I wrote about the potential topping pattern developing in the price of beef. At the time, the futures Live Cattle Subindex was ~$80 and looked very vulnerable to lower prices. I wrote that if the head and shoulders pattern played out it projected a target price of $63, which would be a healthy 21% drop. As you can see in the chart below, price not only hit the $63 initial target but continued lower down to $54 before it eventually bottomed in Sept of last year while forming positive RSI momentum divergence.
Since that time, price has moved higher and has now formed the exact same reversal (but inverse) pattern that developed at the top. In addition, the 200 day moving average is flattening and given additional time and a continuing uptrend, will curl northward. Interestingly, a break and hold above the (blue horizontal) neckline will be technical confirmation the pattern is in play and the upside target is right back where it was at my original post in 2015, $80.
If the charts are correct you should expect this summer’s BBQs to cost a bit more than last year.
Texas Tea
With the stock market stretched and in need of a pullback, I thought it a good time to look back at what oil is doing since it’s been almost 4 months since we last checked in. As I wrote last October, I expected oil to break higher out of the $50 consolidation range which had developed after forming the double divergent low bottom. It took almost 8 weeks, but it finally broke out to the upside at the end of November (and was confirmed with big volume), peaked its head just above $55 in January and then immediately stalled out. It looks like my $77 dollar upside target will have to wait.
Consolidations that occur immediately after breaking out of a consolidation are nothing out of the ordinary. It is a reflection of a market very much in equilibrium. What makes this most recent consolidation of interest is its tight range ($52-$55) and the fact it has lasted 10 weeks. The greater the time period, combined with the small range, pinches the Bollinger bands and warns that whenever it does breakout it will likely be very a powerful move. Unfortunately, it doesn’t tell us which direction it will go or when. I still give the benefit of the doubt the next move will be higher since that is the direction of the trend prior to consolidation.
Digging a little deeper for some additional ammo to confirm the expectation for oil higher oil prices, we see in the seasonality chart below the fact we are just coming into a time which is normally very bullish for oil. Over the past 30 years the period from March through October has seen oil’s price rise an average 15%.
But what about that nagging fundamental data that shows the world is awash in oil and inventories continue to climb? What about the laws of supply and demand that we learned in econ 101?
As written in the Financial Times …
“A mystery is confounding the US oil market: when inventories rise, prices rise, too. That is not the way it is supposed to work. At 518.1m barrels, stocks of crude sitting in commercial tanks are the highest in records dating to the early 1980s. Fundamentals tell us that excess supply should weigh on markets and drive prices lower. But this year a loose pattern has emerged after the US government releases weekly oil data: surprisingly large increases in crude stocks have prompted spurts of buying.”
Are we living in the Matrix?
What’s an investor to do? First and foremost, recognize that price is all that matters and there are always times when fundamentals, logic and common sense don’t matter. As such Its prudent to use them with caution. Times like this typically occur during fundamental shifts or when irrational exuberance has taken control. The risk averse approach is to sit on the sidelines and watch. The bolder and riskier style is to recognize that uncertainty can offer a chance to pile up big profits and consider throwing caution to the wind and jump in. If the second option is your style, whatever you do insure you have an exit strategy determined before entering and follow it to a tee. Because when it ends, and it will eventually, it usually leads to an equally nasty move in the other direction.
Listen to Dr. Copper
Scanning as many charts as I do, quite frequently there are “themes” that arise. One that continues to present itself since the Trump win is that of inflation. Interest rates have risen as are commodity prices and their related stocks. When you speak of inflation its always prudent to check in with Dr. Copper. Why? Because it is reputed to have a Ph.D. in economics because of its ability to predict turning points in the global economy. Because of copper's widespread applications in most sectors of the economy - from homes and factories, to electronics and power generation and transmission - demand for copper is often viewed as a reliable leading indicator of economic health. This demand is reflected in the market price of copper. Generally, rising copper prices suggest strong copper demand and hence a growing global economy,
As you can see in the 5-year chart of the price of copper below, price bottomed at the beginning of 2015 and formed a divergent momentum low which warned the extensive multi-year downtrend may be coming to an end. As typically occurs after a bottom, price chopped around for more than a year, trading within a tight 35 cent range and formed a symmetrical triangle. The week before the election it broke out to the upside on slightly higher than average volume. With triangles you always have to be concerned whether the breakout will turn out to be a fake out since they are so unreliable. The answer to that question came the following week (and Trump was elected) as it had its greatest weekly rise over the past 5 years on enormous volume.
Since that breakout and while the bulls caught their breath, price consolidated, successfully back-tested its (red) support/resistance line and appears to have broken out last week.
The chart is staying the short to intermediate term copper prices are likely higher and has the room to move potentially significantly higher if the trend continues. Those not having futures accounts have limited investments to capitalize on this potential move. There is one ETN (JJC) that attempts to mirror its price but it is fairly illiquid and as with all ETNs has inherent contango issues. A better bet would be to look at the copper miners/producers as they typically do as well as, if not better than, the ETN in tracking its price. Keep in mind though, while prices do move in directional lockstep, they are a leveraged play and move significantly greater (both up and down) on a percentage basis than the base metals price.