Blue Belt Market Update: Investing in the Market Today

"warm gold"


In the last weekly I discussed my general approach to trading (EVT analysis) and some trading opportunities in the current market.  I define trading (speculation) as going long or short a security with the intention of exiting when the position shows a sufficient profit.  Investing, on the other hand, is buying a security that is undervalued with the intention of selling it when it becomes overvalued.1

I look at trading as a modern-day form of hunting – through living a disciplined life and sharpening certain analytical weapons, I aim to meet my basic needs for survival.  Just as we do not expect to amass wealth by playing the slot machines in Vegas, we should not seek to do so by trading.  I stress again – the odds are strongly against making money in the market over a short period of time.  Human emotions, transaction costs, and wielders of inside information make the expected payoff likely much worse than that of a slot machine.  With my personal trading account, I am merely experimenting with the idea that my several years of market study has provided me with some edge to make up for the inherent disadvantages we face as small traders.  In addition, I intend to take no more than I need from the market, keep position sizes small, and shun leverage.

Investing is the true vehicle for wealth accumulation in the market.  The dual effect of compounding and currency depreciation ensures that holding high quality assets for a long period of time will pay off.  So let’s get into more detail about how we find investment opportunities.

In keeping with the investing style that suits my personality (macro investor), I limit my attention to broad indices, bonds, and to a lesser extent, commodities and currencies.  Stocks and bonds are preferable for investment purposes because they provide regular cash flows with a calculable expected yield over a given time horizon.  Commodities and currencies tend to fluctuate more wildly and offer no calculable return on investment.  With that in mind, I look for assets within these broad categories that are rising over the very long term (years to decades).  Let’s look at some assets that satisfy these conditions:

S&P 500

10y UST yield

Sources: Yahoo Finance and Barchart Trader, respectively

Above we have the S&P 500, 10y bonds2, and gold.  Other examples include many other country equity markets (Germany, Canada, India, Mexico, etc.) and energy commodities.

So what creates value in these assets?  Bear markets.  Bear markets create value in assets and bull markets remove it.  To trade as a “smart money” investor, we should be accumulating assets when they are in the depths of bearish pessimism and liquidating them when they are in raging bull markets.  I define a major bear market (crudely) as when an asset’s price has fallen a significant amount, preferably over the course of greater than one year.  This is usually sufficient to reduce interest in the particular asset and cause holders of the asset to start selling out of fear.

Right now, at least two markets we follow satisfy attractive value investing conditions – US treasuries and gold.  Treasury yields have been rising for nearly two years and recently topped out at double the low yield of the previous bull market.  The current gold bear market is two and half years old, and prices recently touched close to 40% below the peak.  Neither market is experiencing the level of bearishness that US equities did in 2008-9, which is what creates truly exceptional investment opportunities, but we can begin accumulating positions and add more if such conditions develop.  Also note that gold is mostly currency and part commodity, so it is not ideal for providing an expected return.  We should still consider it for investment purposes given its long-term positive trend.  Options for investment in US fixed income include TLT, the long-term Treasury ETF, as well as more specialized funds such as Pimco’s total return fund (PTTAX mutual fund or BOND on Nasdaq) and the Doubleline Total Return Fund (DLTNX).  In gold, we can buy GLD, the gold ETF, or GDX, the gold miners ETF, which is even more depressed than the metal.

As for stocks, we own them reluctantly in the investment portfolio.  The raging bull market since the 2009 bottom has removed a great deal of value from equities.  Pimco3, John Hussman, and GMO agree that over a 5-10 year time horizon US stocks offer a paltry theoretical return.  But the holding horizon for our current investment is much longer (30 years+), and returns improve as we approach the duration of the S&P (currently 50 years).4

In order to keep me disciplined, as well as aid in my learning through reader feedback, I will expose my portfolio allocation in the trading and investment accounts for the world to see:

Investment allocation
40% cash
25% US fixed income
25% US equities
10% gold/related
5% other
YTD return: 3%

Trading allocation
95% cash
5% short GLD
YTD return: 0%

That’s it for this edition.  Good investing!

1 Selling a security that is overvalued with the intention of buying it back when it becomes undervalued again may qualify as investing.  The key difference is that the theoretical gains of buying a security are unlimited, while in selling short they are limited to the price of the security.

2 Note that this is a yields chart.  Bond prices move inversely to yields.

3 Note that the market has risen 30% since the publishing of this, putting 5-10 year returns now closer to 2-3% by the reported methodology.

4 The duration of a stock market is its price/dividend ratio.  See Wikipedia.