Tread Lightly!

I generally leave it up to my partner Tim to ascertain overall market direction, but I'm going to "Break Bad" and infringe on his space to make a strategic observation about the market as a whole. Tim usually makes shorter term observations, but this is a longer term one. I'll sum up the thesis with perhaps the most memorable line from the hit series "Breaking Bad", and say what Walter White said best "Tread Lightly". That is how I feel about the market. By now, most readers in the investor-oriented blog space have seen all the "lines" : bloggers whose drawings show the overall lack of breadth in the market, the disparity among market sectors, the decline in the number of new 52 week highs despite the market itself making new highs, a six year bull market historically being "long in the tooth", the relative performance of "Safe" vs. "Risky" markets, the surge in the dollar... and in treasuries ... and the collapse in commodity prices. Certainly, all of that is concerning. My attempt here is to do a little more "digging" and add yet another data point supporting the conclusion that everyone (silently or boastfully) believes, that is... all is not well with Mr. Market.

Here, an observation is made with respect to both fundamentals and market psychology simultaneously. It is, in a nutshell, the market's "voice". Consider the following thought experiment. If one were to become more and more concerned with holding stocks but were, nevertheless, forced to hold them (i.e. all of your long-only mutual fund managers), what would one do? One would play defense, of course. One would seek only the highest quality investments: those with reliable cash flow, dividend growth, low volatility, low leverage, and conservative accounting practices. Right? So what happens to the opposite investments, say, the unreliable cash flow and dividend growth, high volatility, high leverage, and aggressive accounting companies in this environment? They begin to lag.

What we show below is the compounded growth of two markets: The blue line is the market itself, as defined by the Russell 3000, the green line shows the performance of those companies in the bottom quartile based on their quality of earnings. We define a company's lack of earnings quality as one that has higher working capital accruals scaled by its average total assets over the last year, relative to its industry. So we have, in fact, captured a fundamental data point (earnings quality), and related it to a psychological data point (the actual buying and selling of high or low quality shares). What we see below is concerning. The market continues to make new highs, while low quality companies fail to keep up. They are failing to keep up at an accelerating rate. The last two times we saw this was between January and March of '00, and August and October of '07, the last two major market tops. Only now, this phenomenon has been occurring for a longer period of time. That might be a reason to become even more worried.

Russell 3000 (Blue Line) Vs. Low Earnings Quality Companies (Green Line)

Pill Bottles and Oil Barrels: A Perversion of Mean Reversion and Excursion Part II

We're following up from the last post to give you some actionable ideas on both sides.

In terms of individual names, the following setups look interesting to us based on classic “Edwards and Magee”-style pattern interpretation (the charts use weekly data):

For those betting on an acceleration in the relative performance of Biotechs versus Oil Services companies (Excursion):

Interesting Biotechs on the long-side:

PBYI – A classic break of trend to the upside after a period of consolidation following a heavy volume up-thrust:

NWBO – A classic long-term “basing” pattern, with a failed short candle last week:

Interesting Energy Services Names on the Short Side:

NR – A classic topping pattern. Merely revisiting the point of breakdown where “pissed-off longs” generally want their money back. Be patient here and wait for a close below this week’s candle:

OGE – Ditto, but wait for a close below this week’s candle.

Now the flipside. For investors patient enough to wait for the mean reversion (possibly already in progress), here are some long Energy Services and short Biotech ideas.

Interesting Energy Services Longs:

GTLS – A classic break of trend with a new swing high. Stop out if trade quickly reverts below $40.

MTRX – A classic break of trend near long-term support levels:

HP - A classic break of trend with a new swing high. Stop out if trade quickly reverts below $70:

FI – A classic break of trend:

Interesting Biotech Shorts:

CELG – A classic break of trend to the downside:

AGIO – A classic break of support around $100. Disclosure: Author is Short AGIO in his personal account:

What this means for the market as a whole you might wonder?

Notice that the last two times we reached this extreme we were either near a trough (’09) or near a peak in the market (’00). So there is precedent that we are near an important inflection point for the market as a whole. Given that we have been going up-Up-Up for over six years, one might guess that the next major move is down. Classical market wisdom posits that when there is great “disagreement” between important industries (re: Biotechs and Oil Services), this is “unhealthy” for the market as a whole. Think back to Energy and Materials versus Financials in ’07-08. Think back to Technology versus Consumer Staples in ’99-’00.

For the Theorists …

An area of future work might include examining all sector-sector combinations for max excursion to see if there is anything more specific that we can conclude about 1. how long such phenomena last, and 2. what implications, if any, such extremes have for the market as a whole. Keep in mind that, of late, Biotechs have had lower betas than Oil Services companies. If we were to mean-revert, that would mean low-beta biotechs declining and high-beta Oil Services companies rising. Since beta is a measure of correlated market volatility, the mean reversion scenario might argue for more market strength. Continued excursion might argue for an imminent crash. What I find interesting is that the performance differential between Biotechs and Oil Services accelerated after the U.S. Fed ended its Quantitative Easing Program. And… as I write this, we are about two months from a “jawboned” interest rate hike in June. But the market will likely make its move in advance of the June Fed meeting. Whether the Fed actually raises rates in June probably matters less in terms of subsequent market action than what happens leading up to the meeting.  This is why we study price action. Much to the chagrin of our newspapers, financial statements, periodicals, and journals, we use those to kindle fires.

Bryan

Pill Bottles and Oil Barrels: A Perversion of Mean Reversion and Excursion Part I

I never thought my inaugural piece in BlogoLand would be without a conclusion. Nevertheless, there IS a trade here, so my only attempt would be to find actionable ideas given that one of two possible situations must unfold.

1) Biotechs continue to massively outperform Oil Services companies (Excursion)  OR

2) We’ve reached (or are soon to reach) an extreme, and it all comes crashing-in (Reversion).

Here is a chart of the Amex Biotechnology Index (BTK Index) from Inception:

And here is a chart of the S&P 500 Oil Equipment and Services Index (S5OILE) from Inception:

Here is a chart of the ratio of first chart divided by the second chart, a measure of the relative performance of the two industries:

Clearly we are at or near an extreme. For aggressive investors, there is precedent for such extremes to become even more extreme. For patient investors, there is just as much precedent that we are near the point where it all comes crashing in.

Here are the facts:

• The BTK has outperformed S5OILE by more than 100% for five weeks in a row (currently 104%).

• This has only happened four other times since the inception of the S5OILE index in 1989.

• It happened between 12/5/08 and 2/20/09 and lasted 11 weeks for a max excursion of 161%.

• It happened between 12/31/99 and 2/25/2000 and lasted 8 weeks for a max excursion of 245%.

• It happened between 12/6/91 and 1/10/92 and lasted exactly five weeks for a max excursion of 144%.

• It happened between 9/13/91 and 9/20/91 and lasted, well… 1 week, for a max excursion of 142%.

• Max excursion is defined to be the peak relative outperformance of BTK vs. S5OILE.

• The time that this excursion “lasted” (mentioned above) refers to the instance when this outperformance first breached 100% until it reached its highest peak. Thus, we are looking at just the extreme part of this outperformance. 

So… if you are highly tactical and aggressive and think there is another 50-100% of Biotech outperformance (entirely reasonable based on the facts), then you go long Biotechs and short Oil Services for the next several weeks.

From the above we see that, in terms of time, we are right around the middle of this pathetically small sample (5 weeks). From a price perspective, we are nowhere near the extreme which has averaged 173%. The biggest caveat here is that it is possible we have already reached our extreme this time around in early March - at 124%. Thus, there has been some reversion already. We don’t know if this is “IT”, as there is also precedent for the reversion to exceed 20%, only to go back into excursion mode and reach a “higher high”. We define a reversion as having officially “crashed in”, when it exceeds 40%, as it has every time, after every peak.

Bryan Franco

Introducing Mr. Bryan Franco: A "Real-World" Quant

After a lot of emails requesting that I start the blog back up with regular postings of ideas and market analysis, I have decided to dedicate the time and effort to continue providing content that previous visitors said they enjoyed and appreciated. Even better news, I'm very happy, proud, and excited to announce that Bryan Franco has partnered up with me in accomplishing this task and sharing his knowledge, experience, and expertise! So, introducing.. Mr. Franco:

Here is the part where I say I, I, me, me…

Hi, my name is Bryan Franco, I am Tim’s blog partner. I have worked as a fundamental analyst, a “Quant” portfolio manager, and as a trader/pm for a hedge fund. Currently, I am a portfolio manager at Flexible Plan Investments, a RIA in Bloomfield Hills, Michigan. Previously, I co-managed a hedge fund at Oppenheimer in New York. Before that, I managed a small quantitatively-oriented long-only fund at Northpointe Capital in Troy, Michigan. My first job was covering Real Estate Investment Trusts for Dividend Capital in Denver. I received the right to use the CFA Charterholder designation in 2008. I received a Bachelors and Masters Degree in Industrial Engineering from the University of Michigan in ’03, and ’05, respectively.

Ok, enough of the mundane…

Over my career I've found myself increasingly underwhelmed by work that is either overly scientific or overly artistic. Much more inspiring to me is to be able to combine the two professions. My only interest in this pursuit is in making money. As a result, you won’t get much theory from me. What you will get are actionable investment ideas that come from taking a balanced and humble view of the markets.

Tim and I are much more interested in studying price action. Much to the chagrin of our newspapers, financial statements, periodicals, and journals, we use those to kindle fires.

Bryan Franco