In investing you want to seek individual investments that are the outliers, that represent low risk, and high return. Additionally you may consider betting against those that represent high risk, low return for investors. In any case, you want to seek out the “outliers” of the following chart.
Although everyone wants a higher return, it must not come at the expense of risk. You can always leverage a low risk, medium return to make it a medium risk, high return if you must although generally it’s better to use both using the low risk to provide stability to your portfolio, particularly if both of the results aren’t highly correlated with the direction of the market. If you want an overall portfolio that is higher risk and has higher returns, simply concentrate a bit more an opportunities that are outliers in the higher risk area, but still have some in the lower risk area to keep you grounded, particularly if you use leverage. It also means recognizing where each given market condition for each particular area is likely to be so you can reduce position when the risk is higher and return is lower (below the “line”) and so you can add and increase position in areas where the return is high and risk is lower (above the “line”).
Looking at individual names in isolation by using that chart neglects the larger picture of your overall portfolio and risk management. The subtle difference is in how “independent” your investments are from each other or “non-correlated” they are. So while identifying these outliers is important, you also want to come up with a portfolio that is relatively independent. Multiple independent bets at a smaller position size are superior to one single bet at the maximum. 1/2 the optimal amounts on two separate bets results in half the volatility (risk) but 3/4ths the return. This means you are moving further out towards the outliers of low risk, high return by having more bets with smaller position sizes. You can, if you must, apply leverage to move roughly parallel to the risk reward line.
The more you can reduce your position size and add as many profitable trades at “low correlation” (ideally 0) to each other, the better.
People say “buy low, sell high”, but many people during a bull market, buy low, and then sell, only to find stocks much higher which they then buy, missing out on the gain. The balance of your portfolio should shift to increase positions low, and decrease higher, so you are not forced to go back in higher and miss out. What constitutes as low and high depends on oversold conditions, and what time frame. You must keep things in a longer term perspective as well. Strictly based on price, this is what it would look like, although in reality it is never this simple, and you will use a combination of indicators to determine what low and high is.
It’s difficult to buy such dips with precision, so it isn’t necessarily as cut and dry as the lines show, however the green lines are buying opportunities and the red lines are selling opportunities. It perhaps would be more appropriate to look at a slow stochastic or RSI indicator. When a threshold is crossed, you begin adding to maintain a certain percentage allocation and perhaps even change the allocation slightly to buy more lower, and sell more higher. Theoretically you never should be fully invested, or completely sell out of a stock or asset area entirely, respecting that it could always go lower or higher. However in reality there is a limit to the share price, and due to transaction costs at times it isn’t practical to hold a small amount of shares, and makes it more difficult to manage anyways.so you can’t reduce the shares indefinitely.
The balance must shift from risk on and risk off trades as the market moves like this. Although finding as many 0 correlation stocks to the market as you can and leveraging them each might provide the ideal return, it isn’t realistic to have zero correlation and to be able to find an unlimited supply of independent returning assets. Everything has some degree of connection, so the best thing you can do is to SHIFT your overall correlation to be gradually more positive on the extreme lows and more negative (or at least closer to zero) on the extreme highs. The range of what constitutes extremes and what your allocation is should depend on how well you can time it. . If you are extremely good at timing a move on a daily close, you might only rebalance potentially 3 times where you increase position each time it goes to more extremes. If you are not so good, you might attempt to position more gradually.
Looking at the chart above, lets say this measures weekly extremes and monthly extremes with the longest representing a yearly extreme or contrarian indicator at extremes.
At the monthly extreme high, you might be 30% “risk on” and 70% “risk off”. At the weekly extremes you might add or subtract 10%. So you could be as low as 20% “risk on” (80% risk off), or as much as 40% risk on (60% risk off) depending on the weekly extreme. Given the yearly overbought signal, yearly might be less accurate perhaps, so you might only change 5%. If the oversold is more accurate than overbought, you may have rules that add an unequal amount when oversold to more aggressively get long. This above diagram is more an example of what to do at extreme readings that indicate overbought or oversold as buying those exact dips and selling the peaks is not so easy nor will the market look anything like a perfect sine wave on any timeframe.
Another important thing is identifying trends early and using those situations to get more aggressive in playing the trend, and less aggressive in buying the dip. Depending upon the accuracy of the signals again, you can use trend following to identify the “sweet spot” of a particular move.
This will give you 8 different situations now if you only look at monthly and weekly:
Uptrend
monthly overbougt
weekly overbought
both monthly and weekly overbought
no extremes
Downtrend
monthly oversold
weekly oversold
both monthly and weekly oversold
no extremes
How aggressively you change your allocation depends on a multitude of things, as well as how active you wish to be, and how aggressive you are willing to be, and how much cash you have (Those with very little should trade less to reduce fees and make more extreme adjustments. Those with a lot have more cash to manage and should make smaller, more frequent adjustments.)
An example might be as follows:
Monthly trend up signal=add 50% to stocks, risk on, or neutral trades
monthly oversold extreme=add 55% to stocks, risk on, or neutral trades
weekly trend up signal=add 20% to stocks, risk on, or neutral trades
weekly oversold extreme= add 25% to stocks, risk on, or neutral trades
daily oversold signal= add 5% to stocks
For the opposite trend or overbought conditions, simply reverse it by adding 55% to “risk off” *cash,bonds,etc* or neutral trades at monthly overbought extreme. You may wish to be a little more or little less aggressive at a given extreme, if you believe the signals are more accurate, but you want to decide well in advance so you don’t succumb to your emotional fear and exuberance.
In order to keep this about the concepts, I will try to keep this post as simple as possible… Thus, I will not go into details about what indicators to use and how heavily to weight each one and where to use such indicators or any additional details on this subject.
The concepts of contrarianism and value are important so you don’t add to an oversold market that may appear significantly more oversold in the future, or an overbought market that may become drastically more overbought.
You should have fairly specific allocations for all of these, with maybe a given range of flexibility (such as 5 or 10%) with the ability to continue to gradually and slightly increase or decrease position size depending upon how oversold or overbought you are. If you have reliable daily extremes, you might add a few percentage points as well, but only if the transaction fees are low enough relative to the upside you gain from such small adjustments, and you can consider the same for intraday moves if you must.
You will at times need to weight the portfolio based on putting the best opportunities weighted the most. If you have many non-correlated assets that you consider “risk on” (but not much) you can be a bit more aggressive at all times, so perhaps even when you are bearish you still have as much as 50% “risk on”. If you plan on “shorting” or betting against stocks (via puts), This is in it’s own category, and you have more flexibility and a wider range to move from with “negative risk” as it’s own category, or else you will just have “risk on” have the possibility of turning negative if the conditions re bearish enough.
Because you have multiple assets that will have lower correlations with the market, the exact allocations are perhaps not that easy as “risk on” and “risk off”. You instead might want to calculate your overall correlation by weighting individual position’s correlation (and weighting by position size) to the SPY which is an index fund of the S&P. You can find correlation calculators all over the place, I will talk about using them and where to find them in another post sometime.
Among the category of “risk on” you may have to shift your assets between say commodities and stocks, or anything of this nature. Aside from trying to achieve the balances set by the conditions of the market, you should use the same principals of using the signals of oversold, overbought, etc… but instead you are comparing how bullish one is in relation to the other, or in some rare cases “the least bearish” in that particular area. If you do not just hold an etf such as the SPY itself, then among stocks, you want to use principals of price based upon value. You want to spread your stocks over multiple sectors, and put a larger percentage into the stocks you expect a higher return. You may use monthly or weekly changes to change the allocation. Going into details about “expectations of return over risk” and considering the risks as well is a difficult thing to do briefly. There are multiple of ways to value a stock.
The most difficult thing for me to illustrate, is the actual assessment of value within individual names as well as the assessment of growth. I just can’t find a real good way of simplifying this by using a picture, other than one saying given a certain set of fundamentals and expectations, return goes up as price goes down It is based upon numbers. Rather than going into deep detail I will briefly summarize a number of ways at which you can determine a stocks “value”. All anticipated/expected returns should be annualized where possible.
1)Yearly earnings per share times the historic multiple of an area, or better yet what you think the multiple will be in 10 years.
2)Add 10 years of earnings per share to the books and consider the book value. Compare to a book value of 1, the book value of the market, and historical averages.
3)Look at what a companies earnings will be in 10 years, factoring in expected growth, along with an eventual slowing down or contracting of earnings. From that point, you can either add the earnings accumulated over those 10 years, or look at what the expectations might be at that point.
4)Price to Enterprise value, price to book, price to earnings and so on in comparative terms
5)Book value per share plus accumulative earnings per share over time such as a 10 year period
6)Liquidation value, Buyout value,etc
7)Some assets return based upon yield over time discounted for taxes the company must pay as a result of that yield, provided they have more cash coming in than going out and continue to have the finances to pay such a yield. companies that convert to MLPs that don’t have to pay taxes on dividend payouts thus will increase in price to match a risk free interest rate yield such as a 10 year treasury yield. There are a number of different ways to come up with the estimate this way.
Some returns can be a probability game. This occurs for FDA approval, and pre earnings among other things. There could be a 50% chance that something goes through, that doubles the value of a company and a 50% chance the value cuts in half. Take $100 and double it. Multiply it by the percentage or .5 Repeat with $100 and the deal not going through (cutting it in half). Add these numbers up(125). If they are more than the $100 it started with, your expected value is positive. I prefer to use a kelly criterion calculator as it relates my return to my risk. I then have the factor of time to work with to annualized my long term return. The probability game is largely a guessing game because it is difficult to know how likely a particular deal is to go through.
9)Averaging all of the above that are relevant. This means adding the calculated return from 1 through 8, and dividing by 8.
10)Weighting all of the above by relevance and calculating a weighted average expected return. This is better because you can determine the importance of each valuation. One particular valuation may not apply as well, so you may weight that by multiplying a fraction less than 1 over the number of ways you valuate stocks, if you use all 8 then 1/8 or multiplying the results by 0.125 means the valuation is of average importance. Make sure the sum of all of the weightings adds up to 1 and then add all the results after multiplying up to give you your valuation.
There are many more ways to look at value. Oldschoolvalue has a good blog explaining a lot of different ways to come up with valuation metrics. You may use assistance from a site like wikiwealth or gurufocus to save time at the expense of lack of involvement and ability to make adjustments yourself depending upon conditions.
Now aside from weighting on value, you also will want to keep track of what percentage of growth stocks vs value stocks you have. Growth stocks do the best when money is flowing into the market, and liquidity is high, and this occurs in the middle to later half of the business cycle. Value stocks fall the least during bear markets, and are usually best to own near bottoms after corrections. In hindsight, the end of 2008 and 2009 would be best to accumulate value stocks, and after the recovery is fully underway in 2009 and 2010 and even parts of 2011 growth would become key. Unfortunately, Growth stocks are more susceptible to large declines if the expectations of growth change since they are priced based on high expectation of future earnings, if there are upward revisions they tend to do well as expectations of growth increase. You can either use method #9 and simply change the weightings towards value or growth depending upon what stage of the 7-11 year business cycle we are at, or you can manually adjust your weightings by being aware of the value stock names and the growth stock names. I believe we are in an atypical business cycle, that will engage in a period of contraction this year due to global concerns, but those concerns globally will mostly be gone, and the cycle will still finish according to the same general time-frame after the problems are behind us.
Another thing to understand are principals of contrarianism as well as the system. At any given time the amount of money is fixed, the changes over time may reflect stocks going higher as more debt is added to take place of the old debt that is coming due. There certainly will be periods of deflation when the amount of new debt and capital added cannot make up for the amount due, but the excesses went beyond what was sustainable, and the amount of capital you have over time tends to still rise. Contrarianism is about understanding both the liquidity cycle of individual areas which is somewhat similar to the overall liquidity cycle, as well as understanding the mechanics of the market place.
At any given time the market is fixed and capital generally reflects sentiment. The market price is a reflection of the most recent transaction. Any transaction can only take place when both the demands of the buyers and sellers meet. Seller at a given point in time may say “I will sell for $8 or higher” and buyers may say “I will buy for $12 or less”. In this case, conditions are ideal for many transactions. Now within this range comes a particular offer as people use past history of the most recent transaction as a guide. This is where you have extreme conditions of price at $8 and $12, provided not much change. Over time as access to capital increases, more people are willing to pay more, because they can. If the confidence and expectations of growth go up, more people sell at higher prices. However, when a particular area erupts in a bubble, the buyers are willing to suddenly pay higher. Their expectations of growth rise, and they see the price going up believing it will continue to do so. They pay more and more for it. Wishing they had bought more lower, they buy more now. Those who still wish to buy at $12 suddenly will have to either do without a purchase, or pay more. There are only so many people willing to sell and unless the prices go higher, they won’t be able to attract enough sellers to meet the demand. Eventually the buyers push up prices to absorb the remaining supply, but at this point, buyers can run out of capital to fuel the high prices. The price has to drop to where there is overlap. So the sellers may still be willing to sell at $8 to and up and the buyers may be able to only pay $10 so it drops. But as the price drops, people’s expectations and confidence may drop as well, so suddenly buyers don’t want to buy, and sellers are more willing to sell at lower prices. Those who say “I will only sell at $10 or higher” and see prices lower feel they are delusional to think they can get their price, and suddenly they need to lower their expectations, or increase their expectations at how long they need to wait until they can sell. As such they look at their return over time and it seems diminished. Additionally when the company is short of capital, it tends to have trouble earning money. When it gets more money it can use it to grow, and pull in more money to grow more. However too much money and it has trouble growing at high rates indefinitely. Prices based upon expectation of these levels of growth are over confident, and so when the money comes out, the company may continue to do poorly causing money to continue to flea. So there is an inflection point in which “too much growth” becomes a problem, believe it or not. The levels of growth are unsustainable, and pricing stocks based upon these rosy expectations becomes a bad thing to do. Contrarianism means recognizing those extremes. When buyers cannot continue to buy at prices that continue to go out of their reach and when everyone (or at least the majority) who is going to buy has done so. But also, when sellers have already sold and those remaining that hold the stock are not going to sell and are too stubborn to sell into the hype of doomsday. At low enough prices, capital will shift from other areas, nd at high enough prices, capital will eventually shift back towards other growth opportunities. Contrarianism is identifying the areas that have been neglected or that have been oversold. It is the understanding of extreme value. A contrarian must be extremely patient. There is room for a degree of contrarianism within a portfolio in any particular area, however an entire strategy based on contrarianism would most likely be uninvested for too large of a period of time, or not really a true contrarian at all times. The closest model I have during the time between contrarianism is still the same that I have mentioned above, of shifting in and out of “risk off” and “risk on”. The difference is, a contrarian would be closer to 50% “risk on” and 50% “risk off” and only change slightly based upon weekly and monthly extremes, unless very long term extremes are made.
Contrarianism requires you to expect growth that isn’t there yet and isn’t fully anticipated, or to bet against growth that is that you bet won’t be there forever. Valuation metrics still should generally apply, but the key is, having a reason why you think the value is drastically different than what the market thinks.Why should the P/E be higher? Why should earnings come in better than expected? If you are bullish on an area where supply is abundant and demand is low, why should the demand increase in the future? Perhaps capital will come in because of the cheap prices, and perhaps the high prices of other similar commodities will force society to look for alternatives. Perhaps low natural gas prices are justified based upon the very large amount of supply and new discoveries, or perhaps they aren’t because laws will be passed to use it instead of oil where possible, consumption will eventually rise, the supply will eventually over enough time will be worked off and prices can go up. Sometimes even looking at value isn’t enough because the supply and demand may shift. When capital flows into an area, production is done. When things are very bad, other companies go bankrupt, then there is less competition, and the area can gain higher margins and do well. There are various factors involved, but contrarianism is about anticipating changes and recognizing that so much capital has already flowed away from an area, that it isn’t likely for risk to be high. AlIt is about buying when all the people that are going to sell at this point are not likely to do so. The risk is reduced, even if the upside may take some time, you are likely buying an “outlier” as shown in the graph at the top of the page, even if the reward is less, the risk is less at this point too. The growth name eventually becomes a value name.
Any asset that has fallen 50 to 90% from it’s highs is worth considering, or an asset that has been ignored and neglected for a number of years is fair game. The growth may be out of the picture at this point, but it is here when the expectations of future growth have already been reduced and it doesn’t have a lot of downside left. How many people are going to sell a stock or asset that has declined by 90% over 3 years if they didn’t when it was at an 80% loss? Short sellers may sell it, but they will probably have to cover. A 50% reduction in price can be simple deleveraging and margin calls, followed by a slwew of trend followers and short sellers. It is an extreme move Typically not much has changed but expectations, which provides for the outliers. However, stocks that have declined 50% certainly can decline ta full 90% and in individual assets perhaps more.. If a stock goes from $100 to $10, the decline from 50% ($50) is still not a remaining 40%, but a full 75%. So it’s important to keep several things in mind.
1) There is a drastic difference between a 50% decline and a 90% decline from a peak
2a)If the peak wasn’t rational, measuring decline from the irrational peak may not be a rational measurement as a way to determine when the prices are rational…. thus
2b)Another rule of thumb other than a 50% to 90% decline is to wait for a decline that at least returns to or near the previous (rational) trend.
2c)Another rule of thumb, is to consider waiting for the price to return at or below the previous low that was made prior to the most recent run up (which lead to irrational expectations and thus price levels.)
3)A purchase of an asset can turn much worse before it gets better and as such…
4)smaller amounts should be purchased in contrarian names than other names, but since prices may decline further you should…
5)Take advantage of lower prices by increasing the amount of shares to maintain and even gradually increase your allocation percentage as the stock goes lower and do this…
6)Over a much longer period of time than usual, and thus…
7)Be very patient before you make an addition in your allocation percentage or even to rebalance, and be very careful to only do so gradually (increase position size by small amounts as well)
Principals of value (earnings, future earnings, price, etc) are still important and valid, so make sure valuation metrics and fundamentals are still at least decent.
That concludes the contrarian concept.
Overall, your portfolio should be made up of assets that do well in good times, bad times, and those with a high independent of how the market is doing. You should seek to add on lower, and decrease higher, and seek to reduce correlation, with a positive correlation when markets are oversold and/or the trend is up, and low, or even negative correlation when the market is overbought or a trend down has been signaled. Your assets should be those that represent principals of value and growth with a balance between value and growth depending upon how far in the business cycle you are, and the principals of contrarianism may apply at extremes.
With all of these concepts in mind, you likely will be able to come up with a spectacular portfolio and make good money from it.
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