Many investors use options strategies while other investors avoid options because they believe options carry high risks. The truth is that all investments carry risk whether the investor is buying stocks, bonds, real estate, options or other assets.

But, there are some differences in the level of risk for each asset. For options, the risk can be managed in ways that are unique.

Managing Risk

Many investors are familiar with risk management in the stock market. Some may buy a stock and immediately place a stop loss order to manage the risk of the position. But, the stop loss order will not limit risk precisely. The chart of Twitter (NYSE: TWTR) provides an example.

In July, the stock traded in a narrow range as traders waited for the next earnings report. Much of the price action was between $42 and $46 a share. Consider an investor who bought the stock at $44. They may have decided to risk 10% and set a stop loss at $40.

When earnings were announced, the stock opened at $37.25. That would have triggered the stop loss and the order would have been executed shortly after that. The trade might have been executed at $37, a loss of about 16% which is more than intended. In dollar terms, the loss was $6.75 instead of $4 per share.

Instead of a simple stop loss order, the trader could have added a limit price to the order. Perhaps the order would have been a limit of $40 which means the sell has to be executed at $40 or higher. That order would not have triggered and the trader would now be holding the stock at about $30, a loss of about 32%, or $14 per share.

This example illustrates that when there is a gap down, the limit order will not allow for precise risk management. A gap occurs when prices open below the previous day’s low and are fairly common although gaps as big as the one seen in TWTR are less common.

Using Options to Manage Risk

Now, instead of buying the stock, the trader could have used a simple options strategy. In this case, the trader could buy a call option. Before turning to the specifics, we will look at exactly what a call option is.

A call option gives the buyer the right to buy 100 shares of a stock at a predetermined price at any time before a predetermined date. The price and date are determined before the trade is opened so that options buyers know exactly what they are buying.

Note that the call buyer has the right to buy the stock. They do not have an obligation to buy. That means that there is a limited amount of risk in the trade. If the price does not behave as expected, the option’s value will drop to zero. In that case, the trader would lose what they paid for the call.

Options generally trade at low prices. In the middle of July, for example, the TWTR August 17 $44 call was trading at about $3.35.

This call gave the buyer the right to buy 100 shares at $44 until August 17 and costs $335, or 100 times the quoted price of $3.35.

Now, assume TWTR moved higher after the earning report. If the stock jumped to $48, the option would be worth at least $4. This is because the trader could exercise the option, buying 100 shares of TWTR at $44, and immediately sell them at $48, realizing a gain of $4 per share.

This would be a gain of $0.65 or 19.4%, much more than the 9% gain in the stock price.

But, we know that TWTR didn’t rise. The price fell. This meant the option became worthless. That’s because the trader could still exercise the option at $44 but would be selling at $37 or less. In this case, exercising the option would result in a loss rather than a gain.

Since that would be irrational and no trader would exercise an option at a loss, the option has zero value. That means the maximum loss on the trade is $3.35 in this example. Note that this is less than the value at risk with the 10% stop loss order in the example of buying the stock shown above.

Unlimited Rewards and Limited Risk

In this case, and in many others, the call option provided better risk management tools than owning the stock. This does not mean that buying calls is always the best choice. Remember that a call option has an expiration date and provides exposure to the stock for only a limited time.

However, before the call expires, the rewards mirror those of owning a stock and carries limited risk. This is illustrated in the diagram below.

Source: Options Industry Council

In this article, we have focused on just one option strategy, buying a call. There are other strategies, including buying a put option. Puts give the buyer the right to sell 100 shares of stock at a predetermined price for a predetermined amount of time. A put increases in value as the price of the underlying stock does.

Traders can also sell options but selling an option does carry more risk than buying an option. The risk and rewards of selling a put option are shown in the next figure.

Source: Options Industry Council

Notice that when selling a call, the rewards are capped and the risks are now, in theory unlimited. Other strategies can be used to limit the risks when selling a call option while still enjoying some of the benefits of selling the option.

These are the simplest options strategies and there are more complex strategies. However, the complexity varies and few, if any, of the strategies will be beyond the ability of the typical individual investor.

We will be detailing other strategies in additional articles, highlighting the potential benefits of options to manage risk and to pursue returns. Because options have an expiration date, many strategies are suitable for short term trading and could be beneficial to small traders looking for income.

 

 

 

 

Value investors often look at earnings. Stocks with low price to earnings (P/E) ratios can be favorites of value investors. Other metrics including the price to sales (P/S) ratio, the price to book (P/B) ratio and dividend yields, each focus on an important aspect of value.

Finding Value in Financial Statements

The P/E ratio identifies companies that have reported earnings, an indicator of profitability. The P/S ratio focuses in the top line of the income statement. Some investors believe sales are more stable than earnings and provide a better indicator of value.

Book value is also generally considered to be a more stable metric than earnings. In addition to being slow changing, the book value provides a measure of how much investors could expect to receive in a worst case scenario if the company enters bankruptcy.

Dividend yields offer investors return on their investment. Rather than having to wait for capital gains, the investor receives dividends which can provide steady income as long as they are maintained.

While each of these metrics measures something different, none of them will work under all market circumstances. That’s why some investors combine multiple indicators.

Cash as a Value Indicator

Cash might be among the most important indicators of value. A firm with cash is capable of meeting its operating expenses and paying required interest on loan obligations. Cash also allows a firm to invest in its future by funding research and development, acquisition of other companies or expansion in addition to maintaining current operations.

When a company has more cash than it needs, management can decide to reward investors with dividends or with share buy backs. By buying its own shares, the company can increase its own stock price in the short run by creating demand for the shares.  

Buy backs can also increase the value of the stock in the long run by decreasing the number of outstanding shares which can increase the reported earnings per share in the future.

Because of its importance to operations and value creation, cash can be an important factor in finding value.

A Screen For Cash Rich Firms

Specifically, we looked for companies with lower than average price to cash (P/C) ratios. But, for added safety, we also required companies to have debt levels that were lower than its peers and we also required the company to have reported earnings in the past year.

Finally, we restricted our list of potential buys to low priced stocks. One study looked at how low priced, or cheap, stocks performed relative to more expensive stocks. The study found that cheap stocks delivered more than six times the average return of the more expensive stocks in a typical quarter.

Just five low priced stocks passed our screen.

Global Cord Blood Corporation (NYSE: CO)

Global Cord Blood Corporation, together with its subsidiaries, provides umbilical cord blood storage and ancillary services in the People’s Republic of China.

The company offers cord blood testing, processing, and storage services under the direction of subscribers; and tests, processes, and stores donated cord blood, as well as provides matching services. It does this through three operating cord blood banks in the Beijing municipality, the Guangdong province, and the Zhejiang province.

The stock appears to be forming a base after an extended decline.

Willi-Food International Ltd. (Nasdaq: WILC)

Willi-Food International Ltd. develops, imports, exports, markets, and distributes various food products worldwide.

It offers canned vegetables and pickles, an assortment of olives, garlic, roasted eggplant, and sun and dried tomatoes; and canned fish comprising tuna, sardines, anchovies, smoked and pressed cod liver, herring, fish paste, and salmon.

The company also provides canned fruits that include pineapple, peaches and fruit cocktail; edible oils comprising olive, sunflower, soybean, corn, and rapeseed oil; dairy and dairy substitutes consisting of cheese, feta, Bulgarian cubes, goat cheese, butter spreads and other products; and dried fruits, nuts, and beans, such as figs, apricots and organic apricots, organic chestnuts, sunflower and sesame seeds, walnuts, pine nuts, cashews, banana chips, pistachios, and peanuts.

In addition, it offers instant noodle soups, frozen edamame soybeans, freeze dried instant coffee, bagels, breadstick, other food and light and alcoholic beverages under the Willi-Food, Donna Rozza, Manchow, Gold Frost, Tifeeret, Say cheese, and Emma brand names.

The stock is relatively illiquid and limit orders should be considered to enter and exit positions in WILC.

BBX Capital Corporation (NYSE: BBX)

BBX Capital Corporation is a private equity and venture capital firm specializing in investments and acquisitions of middle market companies.

The firm also invests in mergers and acquisition, add-on acquisitions, divestiture, taking public companies private and private companies public, leveraged buyout, partnership, recapitalization, and restructuring. It typically does not invest in industries or companies whose ultimate returns are event driven.

The firm seeks to invest across a broad range of industries ranging from service to manufacturing businesses. The firm prefers to acquire controlling interests in its portfolio companies and can also consider minority investments.

This stock also appears to be forming a base after an extended decline.

Richardson Electronics, Ltd. (Nasdaq: RELL)

Richardson Electronics, Ltd. engages in power and microwave technologies, customized display solutions, and healthcare equipment businesses in North America, the Asia Pacific, Europe, and Latin America.

The company’s Power and Microwave Technologies Group segment provides engineered solutions, power grid and microwave tubes, and related consumables; high value flat panel detector solutions, replacement parts, tubes and service training for diagnostic imaging equipment; and customized display solutions, as well as power conversion and RF and microwave components for broadcast transmission, CO2 laser cutting, diagnostic imaging, dielectric and induction heating, high energy transfer, high voltage switching, plasma, power conversion, radar, and radiation oncology applications.

Its products are used to control, switch, or amplify electrical power signals, as well as are used as display devices in alternative energy, healthcare, aviation, broadcast, communications, industrial, marine, medical, military, scientific, and semiconductor markets.

The company’s Canvys segment provides custom display solutions, such as touch screens, protective panels, custom enclosures, specialized cabinet finishes, application specific software packages, and certification services to corporate enterprise, financial, healthcare, industrial, and medical original equipment manufacturer markets.

Its Healthcare segment manufactures, refurbishes, and distributes diagnostic imaging replacement parts, including CT and MRI systems and tubes, hydrogen thyratrons, klystrons, and magnetrons; flat panel detector upgrades; and additional replacement solutions. This segment serves hospitals, medical centers, asset management companies, independent service organizations, and multi-vendor service providers.

This stock appears to be either forming a base or a rounding top and traders should consider risk management strategies including stop loss orders if they trade this stock.

Photronics, Inc. (Nasdaq: PLAB)

Photronics, Inc. manufactures and sells photomasks in Taiwan, Korea, the United States, Europe, and internationally.

It sells its products to semiconductor or FPD designers, manufacturers, and foundries, as well as to other high-performance electronics manufacturers through its sales personnel and customer service representatives. 

PLAB appears to be pulling back within an up trend.

Remember, there is no guarantee any stock will increase in value. Also, it is important to remember when we search for stocks using quantitative measures, our goal is to identify stocks that meet those criteria.

 

Traders are often forced to deal with conflicting information. They may look at different indicators, for example, and some of the indicators will be bullish while others might be bearish. For some, this leads to confusion or inaction as they wait for clear agreement from the different indicators.

This condition can be present for years with some indicators like the price to earnings (P/E) ratio and price. Even variations of the P/E ratio like the cyclically adjusted P/E ratio or CAPE can suffer from this problem despite being designed to avoid this problem.

The problem is that the indicator will say the stock market is overvalued while the price action pushes prices up and the indicator becomes even more overvalued. CAPE has been in overvalued territory almost continuously since 1998.

For this reason, indicators are a warning device rather than a standalone trading strategy. While valuation is an indicator in an almost continuous state of warning, other indicators signal far less often.

Breadth Indicators Can Offer Early Warnings of Trend Changes

Market breadth indicators can be among the most important early warning systems. Breadth indicators are different than price indicators and are defined at StockCharts.com.

“Like a technical indicator, a market indicator is a series of data points derived from a formula. In this case, however, the formula for market indicators is applied to the price data for multiple securities within the market, instead of just one security.

Price data can come from open, high, low or close points for the securities, their volume, or both. This data is entered into the indicator formula and the data point is produced.”

Breadth indicators measure the number or percentage of stocks in the group that are participating in a trend. Market breadth indicators are typically based on the price data of the stocks in the group.

For example, the Advance-Decline (A/D) Line is calculated using the number of stocks in the group that increased in price (“advancers”) vs. the number that decreased in price (“decliners”). The Net New 52-Week Highs indicator measures the difference between the percentage of stocks making new 52-week highs and those making new 52-week lows.

Popular market breadth indicators include the Advance-Decline Line, McClellan Oscillator, and Net New 52-Week Highs.

A popular way to consider breadth is in military terms. Traders think of stock market leaders as the generals in an army. Breadth measures how many troops are marching behind the generals. If the troops are not backing the generals, the battle is lost.

In a similar way, if breadth is weak while the market indexes are moving up, the troops are not participating in the advance, the index is likely to pull back.

The A/D Line Now, and In 1999

The A/D Line might be the most popular breadth indicator and one reason for that is because the indicator has been useful over the years. There are multiple ways of interpreting the A/D Line. Among the simplest way is to watch for the development of divergences.

A divergence occurs when the trend in the indicator differs from the trend in the price action. For example, a bearish divergence occurs when the indicator declines while the price index is advancing. This is considered bearish because the indicator is assumed to lead the price action so prices are expected to reverse to follow the indicator.

In the chart below, the A/D Line is showing a bearish divergence from the S&P 500 Index.

This is a bearish divergence because the price index is reaching new highs while the breadth indicator is not. This tells analysts that many stocks are not participating in the up trend. That is a potential warning that the price trend is likely to reverse.

History tells us that the reversal in the price trend could take time to develop. The next chart shows the A/D Line and the S&P 500 in 1999, the time period leading to the 2000 top.

As the price index reached new highs, the A/D Line was failing to reach new highs. This demonstrated that the market indexes were being driven by fewer and fewer stocks. At that time, it was internet stocks that drove the indexes.

Now, there are concerns that the majority of the price gains in the indexes are being driven by just a few stocks. Those stocks are the FAANG group, Facebook, Amazon, Apple, Netflix and Alphabet, the parent company of Google.

Monitoring the Market Breadth

As concerns of the influence of the FAANG stocks grow, it could be important for investors to monitor market breadth. One simple way to do this is with the A/D Line. However, that could require monitoring the trend and could be subjective.

An objective breadth is the percentage of stocks in the S&P 500 index that are above their 200 day moving average (MA). The 200 day MA is used to determine the long term trend. When prices are above that MA, they are in an up trend.

The indicator, which uses the symbol $SPXA200R at StockCharts.com, is considered to be bullish when it is above 50% and bearish below that level. The chart of that indicator is below.

Source: Stockcharts.com

The chart above shows that there has been a deterioration of this indicator even as prices of the major indexes are reaching new all time highs. This is just a warning and the warning can be in place for an extended period of time before the indexes follow the trend.

However, the warning is important to consider. Prices of major market indexes can not continue moving up without most stocks following the trend up. History has shown that is almost always the path of the market action.

Breadth indicates that investors should be concerned. This concern can be put into action by reducing exposure to stocks or by adding put options to the portfolio. Puts increase in value when prices fall and breadth indicates that now could be an ideal time to add put options to potentially benefit from market weakness.

 

Investors are often told that risk and reward are inseparable, and it is impossible to have one without the other. Higher potential rewards carry higher than average risks and lower risks require investors to accept lower than average returns.

Recent research shows that this may not be true. In other words, it might be possible to beat the market while lowering downside risks. The strategy for this approach to investing is contained in a paper called “The Conservative Formula: Quantitative Investing Made Easy.”

The paper was written by Pim van Vliet and David Blitz, both of whom work with Robeco Asset Management.

Before digging into the paper, which can be found for free at SSRN.com, we will jump to the bottom line. The conservative formula delivered an average annual return of 15.1% per year since 1929.

Source: The Conservative Formula

Details of the Formula

The researchers set out to find stocks that met several important criteria:

• Low return volatility.
• High net payout yield.
• Strong price momentum.

Low return volatility is associated with low risk. High net payout yield is a value metric and is designed to find value stocks, Strong price momentum is a factor designed to ensure the stock is going up so that value traps can be avoided.

In short, the formula is identifying low risk value stocks that are in up trends. The abstract explains,

“We propose a conservative investment formula which selects 100 stocks based on three criteria: low return volatility, high net payout yield, and strong price momentum.

We show that this simple formula gives investors full and efficient exposure to the most important factor premiums, and thus effectively summarizes half a century of empirical asset pricing research into one easy to implement investment strategy.

With a compounded annual return of 15.1 percent since 1929, the conservative formula outperforms the market by a wide margin. It reduces downside risk and shows a positive return over every decade.

The formula is also strong in European, Japanese and Emerging stock markets, and beats a wide range of other strategies based on size, value, quality, and momentum combinations.

The formula is designed to be a practically useful tool for a broad range of investors and addresses academic concerns about ‘p-hacking’ by using three simple criteria, which do not even require accounting data.”

That last point indicates the authors tested for statistical robustness to avoid developing a strategy that is optimized on past data and unlikely to hold up in the future. The fact that the strategy worked in the U. S., Europe and Japan also shows its robust nature.

The Process for Implementing the Conservative Formula

The authors focus on large cap stocks in an effort to enhance safety. Larger companies are generally considered safer than small companies because the risks of bankruptcy are lower in large companies with a proven track record of sales over time.

They limit their selection process to the largest 1,000 stocks, sorted by market cap. They then use this list as the starting point for finding potential buys.

The process to find buys followed several steps:

1. The list of 1,000 stocks is sorted by volatility over the past 36 months. The highest volatility stocks are ignored and the 500 with the lowest volatility move to the next step.
2. Each stock in the low volatility group is ranked on its price momentum. The authors used a momentum measure defined as “12-1 month price momentum” which is commonly used in the academic community. It involves calculating the stock’s performance over the past twelve months with the most recent month’s performance ignored. So, only eleven months of the past twelve month’s data are used (in effect) and the most recent month is excluded.
3. Each stock on the lower half of volatility is also sorted by total net payout yield which considers the stock’s dividend yield and any buybacks the company has completed over the past twelve months. Specifically, “this shareholder yield consists of dividend yield and the net change in shares outstanding (calculated as the latest level divided by the 24-month average)”.
4. A momentum and net payout rank is assigned to each stock, with 1 being the best value and 500 the lowest.
5. The two scores for each stock averaged and the 100 best stocks in the final portfolio are equally weighted.

This process is completed once a year and the portfolio rebalanced at that time. To create a benchmark for comparison, a speculative portfolio is also formed using the same process to select the 100 worst ranked stocks form the 500 high volatility stocks.

Consistent Returns

Given the extended test period, it is possible to see how the strategy performed over different time frames. The chart below shows the results by decade and the authors note that “there is never a lost decade” with negative returns.

Source: The Conservative Formula

As the chart shows, the conservative formula beat the market in each decade except the 1990s. That is consistent and heartening performance. It is also important to note that the conservative formula performed well in the 2000s when the market lost money.

Now, the question is how could this strategy be implemented by individual investors. The answer lies in finding stocks that meet the criteria even though it won’t be possible to precisely duplicate a strategy that requires owning 100 individual stocks which is beyond the means of many individual investors.

First, the conservative formula focuses on large caps. This is relatively simple for an individual to consider.

Second, the formula focuses on low volatility. Beta or other volatility metrics could be used. Momentum is also relatively easy to measure even if the precise formula is not. And, shareholder yield should be used instead of dividend yield.

Using these criteria, an individual may be able to obtain consistent, and low risk, results. That is worth considering since the market wisdom generally holds these two factors are incompatible. That may be the greatest value of this paper which shows low risk and high returns are possible.

 

Wall Street is a unique place. It is an actual place where many people work in the financial sector. It is also a description of a theoretical place since many jobs connected to finance are not physically located in New York.

But, the idea of Wall Street is a powerful one and demonstrates the importance of ideas to the finance industry. After all, there is a degree of marketing associated with the industry and the marketing can, at times, be found in names of indicators.

Among the indicators that appears to be named to capture headlines is the Hindenburg Omen. This indicator is triggered when five different conditions are met including that “the daily number of NYSE new 52-week highs and the daily number of new 52-week lows must both be greater than 2.2% of total NYSE issues traded that day.”

The indicator appears to have been developed to fit the unique circumstances of the 1987 crash.

Since then, the indicator has had a less than stellar track record. To help improve the performance of signals, many analysts now look for a cluster of signals which means that a number of omens appear within a short period of time. That approach is now signaling a sell.

A Cluster of Omens Appears

Bloomberg reported that “Sundial Capital Research Inc., points to a (controversial) group of potentially bearish technical signals known as the Hindenburg Omen.

Deteriorating breadth in share gains and a jump in the number of individual stocks falling to 52-week lows has triggered a warning flag every day for over a week,” Jason Goepfert, the firm’s president, told clients.

On both the New York Stock Exchange and the Nasdaq there have been eight of these technical patterns over the past six sessions, he said, the biggest cluster since 2014 and the third-longest stretch in 50 years.

Source: Bloomberg

The indicator, named after the German zeppelin that caught fire and crashed more than eight decades ago, gauges indecision in the market and is designed to predict a decline within 40 days.

While it has a mixed track record and has been derided in some corners of Wall Street, references to the Hindenburg Omen in investment-bank research still trigger discussion.

Goepfert says it’s rare to see this number of clusters so close together on both exchanges and, in the past, they preceded declines. The median two-month decline after similar clusters was 2.2 percent, he calculated.

As for specific trading advice, “Consumer staples and health-care stocks performed best, with technology shares lagging behind, he said.”

But, the chart above shows that just two of the four highlighted signals led to significant market declines. Investors would have missed significant gains by following all the signals. That means if this signal is followed, the investor should define what would cause them to buy back into the market.

That could be the most important part of any defensive action an investor takes. Knowing when they will invest again could avoid problems with holding cash for too long.

Concerns With the Hindenburg Omen

There are reasons to be wary of the signals generated by this indicator. One is that the calculation appears to be curve fit.

Curve fitting is the process of constructing a curve, or mathematical function, that has the best fit to a series of data points. The problem with curve fitting is that the indicator will be designed to work perfectly in the past, but the future is unlikely to be the same as the past.

One sign that the indicator could be curve fit is the use of so many criteria. Generally, an indicator with more than 3 criteria should be followed with caution. Each additional criterion decreases the likelihood of future success in some way.

Another indication of curve fitting is the use of precise but seemingly variable variables. For example, in the Hindenburg Omen, one of the criteria is that the daily number of NYSE new 52 Week Highs and the daily number of new 52 Week Lows are both greater than 2.2%.

That is a precise value but one might wonder where it came from. Testing shows that if 2% is substituted, the Omens are frequent and not useful. The same with 2.3% and other values that are close to 2.2%. It appears that this variable was selected because it worked for the 1987 crash.

The chart below shows the history of signals before the current bull market began. Notice they do not occur close to all important market tops.

That is a problem. Missing out on gains that occur near the end of a bull market can be a costly mistake. This is the time when prices tend to move sharply higher and gains can be quick. Missing these gains can have a large and adverse impact on accumulating wealth.

Ignore Omens or Sell?

This leads to the important question of whether or not the signals should be ignored or acted upon. There is no easy answer to this question.

An important consideration is that if the stock market does sell off in the next few weeks, some traders may regret ignoring the signal if they do not act on it. This could lead to problems in the future if it affects their confidence to make buy and sell decisions.

That problem must be considered, but it should not be the determining factor. If an investor decides to act on the Hindenburg Omen or on any signal that is derived from the price action, they should consider committing to act on all of the indicator’s signals in the future.

No signal will ever be accurate 100% of the time. That means picking and choosing which signals to take and which to ignore increases the possibility of making an unprofitable decision. This behavior could also lead to regrets and regrets could lead to inaction in the future.

It could be best to focus on several indicators. The Hindenburg Omen could be one but trying to time market turning points can be difficult, if not impossible to do on a consistent basis. Many successful investors adopt trend following strategies to avoid this problem.

From a trend perspective, investors should be holding onto stocks since prices are rising.

 

 

 

 

Gold is an investment in the eyes of some investors. It is a hedge against catastrophe in the eyes of other investors. For others, gold is simply a trade which means it is something to be bought when it is going up and sold when it is declining.

No single view is correct because each investor has a different perspective. But, any view is likely to be considered correct at least some of the time. The chart below shows recent returns in the price of gold over different time frames.

Source: Kitco.com

The chart shows that an investor’s returns depend on when they bought. The long term gains justify the outlook of the bulls, but the shorter term returns could leave investors frustrated.

Overall, that table confirms that gold could be useful for traders to consider. Trading can be done in any time frame. This could mean a trade could last for days, weeks or months. Some trade without an objective of how long a position will be held.

Many traders allow the market action to dictate their trading decisions. They buy when the price trend is up and sell when the price turns down. Among the traders that do this are groups known as commercials and large speculators.

Data Shows Gold Could Rally

Information on which groups are buying and selling in futures markets is available from the Commodity Futures Trading Commission’s Commitments of Traders (COT) report.

That report details the positions of large speculators, which include hedge funds. It also provides data on individual investors and traders known as commercials which include the largest investment banks. In the gold market, commercials include the miners who produce gold and large users of the metal.

Weekly updates to the data show changes in the positions of each group. Tracking the changes can be profitable for traders. As a group, large investors tend to outperform small investors. But, large speculators tend to be trend followers. Commercials tend to be value investors.

The chart below shows the COT report for gold futures. The raw data is in the center of the chart and an index of that data is at the bottom. The green lines are the commercials. Large speculators are the black line and small speculators are the red line.

The index shows how the current week’s data ranks relative to COT reports over the past six months. Right now, the commercials are extremely bullish, the speculators (both large and small) are at their most bearish.

Raw data in the center of the chart shows an unusual pattern. Commercials are long, meaning they hold more gold than typical. This is the first time we have seen this setup since late 2015.

In 2015, the long position of the commercials was an unusually profitable trading opportunity. The price of gold increased about 25% over the next six months. That was an excellent trading opportunity and in part, the gains are driven by the large speculators.

Large speculators include the hedge funds and commodity trading advisers. As a group, they control billions of dollars. And, many of them use a trend following approach. That means they will be wrong at important turning points but will have buying power to fuel trends as they develop.

One Analyst’s View on GLD

MarketWatch.com recently highlighted a bullish outlook for the gold market.

“Investors do not seem prepared for anything but a continuation of the current upward trend, something that is hard to fathom if U.S. tariffs on $200 billion in Chinese goods go into effect,” wrote Lisa Shalett, head of investment and portfolio strategies at Morgan Stanley Wealth Management.

In such an environment, Shalett suggested that gold could have an important — if minor — place in one’s portfolio. She doesn’t see it as a long-term holding, she wrote in a recent report, but “we believe it can be used tactically as a potential hedge for a stock market correction and/or a reversal in the dollar and real interest rates.”

She’s recommending investors take profits on their U.S. equities exposure, while “tactically deploying” 3% to 5% of the portfolio to gold.

“We make this recommendation with all the usual caveats,” Shalett wrote, describing her relatively bullish call on gold as “rare” and adding that her firm’s global investment committee “no longer views gold as a strategic asset class, as it provides no interest or yield — and in the case of physical gold, there is a cost to store it.”

She added, “From an asset allocation perspective, gold’s correlations with stocks and bonds are unstable and it is subject to large sentiment swings around periods of crisis and fear. What’s more, gold has not proven to be a good inflation hedge as it has generated little long-term wealth net of inflation.”

Nevertheless, “in the current environment, we see gold as oversold and the likely beneficiary if recession fears rise and real rates begin to fall, if the U.S. dollar weakens, if market volatility picks up, if there is broadening contagion in emerging markets or if there is an inflation shock.”

This view could be appealing to traders. Stock prices have delivered significant gains and gold has languished for some time. That means it could be time for a rotation from stocks to gold.

One way to obtain exposure to gold is through the SPDR Gold Shares (NYSE: GLD).

It is important to understand that GLD is treated as a trust for tax purposes and, as the fund sponsor explains, “Trust’s income and expenses “flow through” to the Shareholders, and the Trustee will report the Trust’s income, gains, losses and deductions to the Internal Revenue Service on that basis.

Investors should consult their own tax professionals to determine the tax consequences of their investment in the Trust.”

When GLD is sold, “under current law, gains recognized by individuals from the sale of “collectible,” including gold bullion, held for more than one year are taxed at a maximum rate of 28%, rather than the 20% rate applicable to most other long-term capital gains.”

Again, investors should consult their own tax professionals to determine the tax consequences of their investment in GLD.

An alternative to GLD is to invest in mining stocks which are treated as standard investments for taxes.

 

Emerging markets, as a group, are now more than 20% below their recent peak. A decline of 20% is the commonly accepted definition of a bear market. And, now, by that measure emerging markets are in bear market mode.

To measure emerging markets as a group, traders can turn to the iShares MSCI Emerging Markets ETF (NYSE: EEM). The chart of EEM is shown below.

Before digging into what the drop means, it could be helpful to define the terms. An emerging market is a country that has some characteristics of a developed market but does not satisfy standards to be termed a developed market.

This includes countries that may become developed markets in the future or were in the past. The economies of China and India are considered to be the largest emerging markets.

Emerging markets fit between developed markets and “frontier markets,” a term used to describe developing countries with slower economies than those that are considered to be emerging. This can all be confusing, so economists have tried to refine the definition.

Some definitions require an emerging economy to display the following characteristics:

• Intermediate income: its PPP per capita income is comprised between 10% and 75% of the average EU per capita income.
• Catching-up growth: during at least the last decade, it has experienced a brisk economic growth that has narrowed the income gap with advanced economies.
• Institutional transformations and economic opening: during the same period, it has undertaken profound institutional transformations which contributed to integrate it more deeply into the world economy. Hence, emerging economies appears to be a by-product of the current globalization.

But that definition, more than 50 countries, representing 60% of the world’s population and 45% of its GDP, are emerging. The ten largest Ems are, in alphabetical order, Argentina, Brazil, China, India, Indonesia, Mexico, Poland, South Africa, South Korea and Turkey.

Turmoil Is Spread Around the World

Often when emerging markets make a large price move, there is one region that stands out. That’s not the case right now. Problems in Turkey, Argentina and South Africa are ongoing and potentially serious.

iShares MSCI Turkey ETF (NYSE: TUR) is down almost 60% since the beginning of the year.

Related to Turkey, there is a diplomatic dispute over the release of evangelical pastor Andrew Brunson that sparked President Donald Trump to authorize the doubling of metals tariffs against Turkey. There are also economic concerns.

“It is about credit, since Turkey has been a huge borrower in global capital markets over the past number of years when the world’s central banks were encouraging investors to stretch for yield,” David Rosenberg, chief economist and strategist at Gluskin Sheff, said in one of his daily market notes.

“Over half of the borrowing is denominated in foreign currencies, so when the lira sinks, debt-servicing costs and default risks rise inexorably.”

Because the crisis involves private rather than public debt, the IMF could find it harder to justify a bailout. The moral hazard of using IMF funds for corporate debt issues would be substantial.

There is a more traditional crisis in Argentina. Global X FTSE Argentina 20 ETF (NYSE: ARGT) is almost 40% below its lows.

Here, the IMF is trying to bail out the country and interest rates have soared to as much as 60% on short term loans. This is a move that economists frequently apply to stop the flow of capital out of a country. It is too early to tell if the high rates will stem the crisis.

iShares MSCI South Africa Index ETF (NYSE: EZA) is also more than 30% as populist policies in that country threaten economic growth.

These three countries show that this crisis is different than other crises in the past. For example, in 2008, there was a common problem in emerging markets and developed economies as a credit crisis threatened the financial system.

That’s not the case this time and that indicates there could be different factors to consider when trading.

Safety Could Become Important

Traders are generally thinking about the possible returns on their capital. In other words, they are seeking opportunities to earn rewards of perhaps 10% a year on their investment accounts. In times of crisis, they often start to consider the importance of return of their capital.

When crises and bear markets hit, traders become increasingly concerned about losses of capital. They can react by putting their capital into investment opportunities that appear to be the safest. This explains why Treasury securities often rise in price when the stock market crashes.

In the current market environment, the crises are geographically diversified. Few stock markets around the world are in decisive bull markets with major stock market indexes at or near new all time highs. One market trading near new highs is the US stock market.

That means the US could offer safety to traders and markets in the country could benefit from a flight to safety trade. This could benefit large cap US stocks, the ones included in the S&P 500 index, for example, and US Treasury securities.

Treasuries could be beneficiaries of increased cash flow since they offer safety and the Federal Reserve is one of the few central banks in the world raising rates. That could make the market attractive to overseas investors.

In fact that is what happened in the previous two emerging market bears. This is the third time EEM has fallen by at least 20% in the past ten years. Neither of the previous bears resulted in a bear market for US stocks.

In 2011, the S&P 500 Index fell 17.8% during the emerging market bear market. In hindsight, that was a buying opportunity for US investors.

The next emerging market bear developed in 2014. That time, the S&P 500 fell less than 7%. US stocks then rallied 12% before selling off by 12% as the emerging market continued for 16 months.

This time is probably the same as the other two times. US stocks could pull back but a bear market in the US won’t start until the US economy contracts. For now, there’s no sign of that.

 

 

Traders know that stocks move up and down. The same is true for the market in general and for sectors and industries. In general, sectors are broad groups and industries are more specific collections of companies.

As an example, Walmart is in the food and staples industry and in the hypermarkets and super center industry according to some classifications. Other classifications are possible, depending on the data provider.

That fact highlights an important point. When building a sector strategy, it is not necessary to focus on precise definitions. It is important to find a data source and to use that data source consistently and with discipline.

Defining Sector Rotation Strategies

Sector rotation strategies are based on the idea that traders rotate from one group. Some theories contend this is a natural part of the business cycle and the sector with the strongest performance is tied to where the economy is in the business cycle.

The business cycle is the expansion and contraction of the economy. It is measured with data like the GDP report and the employment report and other economic data series offer insights into where we are in the cycle.

But, the economic cycle is impossible to measure in real time. GDP data, for example, is released once a quarter and is frequently revised. In fact, economists expect the data to be revised.

The economic cycle is also an imprecise construct. In math or in physics, a cycle is strictly defined by time and once the down trend of the cycle begins, that trend continues until its scheduled conclusion. In the economic cycle, there is no definite time between tops and bottoms.

There is also no defined magnitude of the size of peaks and troughs. And, it is not predetermined. The cycle can start and stop and behave in unexpected and unpredictable ways.

Despite its approximate nature, the business cycle is still useful for traders. The fact is that some sectors or industries do better at different times. And, the leadership in the market varies from sector to sector. This gives rise to the sector rotation strategy.

The chart below is typical of the ones used to define the strategy. It shows a business cycle and imposes an expected pattern of which sectors will do best in each part of the cycle.

Source: StockCharts.com

The next chart presents the same type of information in a different and perhaps more understandable style.

Source: StockCharts.com

What’s important is the idea that different sectors lead at different times and traders could potentially benefit from that.

Dynamic Markets Require a Dynamic Strategy

The charts above give the impression that there will be a time when traders should sell health care, for example, and but consumer staples. When consumer staples are sold, the investor would rotate into utilities.

This is, of course, a theory. In practice, the market does not behave so predictably. That means many traders have developed dynamic strategies to decide when to rotate between sectors. We will build out a simple example of a strategy.

While there are a number if data sources that a trader could use, we will look to FinViz.com, a free site that has a screening tool that could be used to trade this strategy. The rules for the strategy are shown in the next chart and we will explain the concepts in the next section.

Source: FinViz.com

Specific Strategy Rules

We have elected to consider only exchange traded funds (ETFs). An ETF holds dozens or hundreds of individual stocks. That reduces the volatility of the holdings. A trader could also use individual stocks instead but that would lead to higher expected volatility.

Volatility in general terms is the size of the expected price swings. Higher volatility could mean larger potential rewards and higher potential risks. Each trader should consider their risk tolerance in deciding exactly how much volatility they are willing to accept.

Next, we required minimum trading volume of 1 million shares. That is a liquidity filter to make it easy to trade. By requiring a relatively large amount of volume, we are doing all we can ensure that we can trade at a reasonable cost under any market conditions.

We then get to the heart of the rules. We require the ETFs to be up in the last six months and we require the closing price to be above the 200 day moving average. This is our complete set of rules that will determine which ETFs to trade.

Recently 44 ETFs passed this screen. That is too many to trade for many individuals. So, we next selected just the top five. Their ticker symbols are shown in the next figure.

Source: FinViz.com

These ETFs could be bought. Remember, this is just one approach and we are searching for the best performers. You could tailor this to your risk preference.

Now, the decision on when to sell must be considered. One approach is simply to run this screen once a month. If an ETF is no longer among the top five, it could be sold and replaced with the top performing ETFs that are not currently in the portfolio.

There is no reason that one month holding periods need to be used. Research completed in the academic community has shown that this approach could be successful with any time period from about one month to one year. Rerunning the screen every three months is an approach that could be considered.

This is a relatively simple sector rotation strategy and there are a number of ways that it could be refined. However, all will have risks since the top performing ETFs in a bull market can, and often do, reverse sharply. This means volatility will still be high, even with ETFs.

However, in the long run, strategies like this one that are based on momentum have been shown to beat the market. That means this could be a useful strategy in a retirement account which has a long term outlook. Sector rotation could be a valuable addition to long term, and even short term traders.

 

 

 

 

Economists often say “There ain’t no such thing as a free lunch” although sometimes they will use better grammar and say, “There is no such thing as a free lunch.”

Historians note “the phrase was in use by the 1930’s, but its first appearance is unknown. The “free lunch” in the saying refers to the nineteenth-century practice in American bars of offering a “free lunch” in order to entice drinking customers.”

The free-market economist Milton Friedman also popularized the phrase by using it as the title of a 1975 book, and it is now widely used in economics literature to describe opportunity cost. One economist, Campbell McConnell, even wrote that the idea is “at the core of economics.”

But, Fidelity Offers Free Funds

There probably isn’t anything in the world of finance that is truly free but there are some free funds available to investors.

RIABiz.com recently noted that Fidelity CEO Abby Johnson “launched Fidelity Zero Total Market Index Fund and Fidelity Zero International Index Fund and now it can boast $1 billion in new assets in one month. 

Dan Sondhelm, principal of Sondhelm Partners, a financial services consultancy in Alexandria, Va., praised her gambit.

“Fidelity’s move is a smart one. They’re subsidizing a small number of basis points in exchange to gain market share with potentially new investors. They’re betting they will recapture profits by selling these clients additional services over the long term,” he says.

Millennials are a key market for Fidelity because — like all legacy firms — its asset base, largely from boomers and older, gets a bigger withdrawal hit each year.

The Fidelity Zero Total Market Index Fund collected $753 million and the Fidelity Zero International Index Fund attracted $234. million as of Aug. 31, according to the company website.”

Barron’s also reported on the news, “The $1 billion in the two mutual funds is a success,” Todd Rosenbluth, director of ETF & mutual fund research at CFRA, tells CNBC. The in-flow levels make sense, he notes, given Fidelity’s girth and marketing strength.

Given Fidelity’s prowess and the crowd mentality of many investors, more clients may be asking their advisors in the coming months about these products, so it pays to be prepared.

MarketWatch columnist Mark Hulbert notes that advisors can “perform a real public service” by teaching clients to look beyond cost alone. The differences between Fidelity’s expense ratios and other low-cost offerings can be “dwarfed by other considerations,” he writes.

Investors also have to take into account an index’s benchmark, tracking error and tax efficiency, for example.

“We can all celebrate the competition between index providers that has brought expenses as low as they now are. But one consequence of these low ratios is that they no longer are near the top of the list of factors we should take into account when choosing an index fund.”

Free Boosts Returns

Ignoring for a moment the question of whether or not the funds are truly free, there is no doubt that low fees can help an investor increase their wealth over time.

Source: My Money Blog

In the chart above, the investor with no costs earned more than 30% more than the investor with the highest fees. That is the reason many investors focus on fees and look for the lowest fee funds. Assuming equal performance, the lowest fees will be best choice.

Of course, there is no way to ensure equal performance in advance. And, as a new fund, there is no way to measure the actual performance of the Fidelity Zero Total Market Index Fund which trades with the symbol FZROX.

However, Fidelity does offer a similar fund, the Fidelity Total Market Index Investor, which trades under the symbol FSTMX. The long term performance of that fund is available and is shown below.

Source: Yahoo Finance

There are some differences between the two funds and this should serve only as an approximate comparison. There is no guarantee that the new fund will have any similarity to the older fund.

But, the chart above does show that the older fund has done a fair job of approximating its category average.

Is Free the Right Answer?

Given the funds zero fees, investors may wonder if this is the right investment for them. There are important factors to consider in making that decision.

First, the investor should ask if Fidelity is the right broker for them. For active traders, there could be other discount brokers that offer lower commissions and the lower commissions could be more valuable to active investors in at least some cases.

Then, there is the question of whether or not a mutual fund is the best investment choice for an investor. They certainly may be and mutual funds have served as the cornerstone of many individual investors’ portfolios for many years.

But, some investors may prefer the instant liquidity of exchange traded funds (ETFs) which are available at low costs. Some brokers even allow investors to buy and sell some ETFs for free.

There are other factors such as whether or not the investor typically uses margin, either for trading or as a cash management strategy. If they do, there could be brokers offering lower margin interest rates than Fidelity that could be a better choice for some investors.

However, if this mutual fund is right for you, the fact that it is a no fee fund could make it a better choice than other funds and it could make Fidelity the best choice for a brokerage account.

The fund could be right for investors with a focus on the long term, such as younger investors who don’t have access to a retirement plan at work and are opening a self directed IRA or for young investors supplementing their retirement accounts.

Of course that is not the only group of investors this fund could benefit. It could also be the first of many no fee funds as other firms may seek to compete with Fidelity. That could lead to lower fees in other funds and benefits to many investors.