Q&A – THE ANSWERS…

We got a ton of good questions on Friday so I am just taking a few and I’ll stockpile the rest for future weeks.   If you want to ask another question in the comments here then feel free to leave it and I’ll see if I can get around to it at some point during the day….Thanks for all the great questions.

From Student:  “I seem to get two contradictory ideas from pragcap. On the one hand, it is essential to understand the monetary system and the BSR in order to formulate a macro view. On the other hand, you yourself at times mention your algorithm (which you keep private) that you use for trading, which would suggest you yourself are buying into trading over “buy-and-hold,” thus in a way perpetuating financial engineering. How do you respond to this criticism and what do you truly think is the best way to make money and succeed in the financial markets – is buy and hold dead?”

CR:  I get this question a lot because I am somewhat vague about my approach and because I tend to cover a broad set of topics rather than keeping the focus on one sector or market.  You can see my top down macro multi-strategy approach in more detail here.   In essence, I view the world through a 30,000 foot lens.  Now, you have to understand the monetary system and how all these pieces come together first so if you don’t understand the monetary system there’s not point bothering with a top-down approach in the first place….So this approach is based on a progression of understanding.   You have to understand the overall system and how the pieces influence one another, then you have to understand the individual pieces and then you have to decide how the pieces will move markets in a particular way and how you can benefit…..It’s a lot to digest and I’ve spent thousands of hours refining the approach and I feel like I am still working at it every single day….

I like to pretend I am staring down at the ocean trying to gauge the storm clouds and how they’ll shift the waters below.  If you want to know where the boats are going you just need to navigate through the storms and following the winds/currents.  It’s all based on a risk management approach and the idea that if I can understand the risks and which way the water generally flows then I don’t need to be terribly precise about my micro approach.

Once I am comfortable with the macro I decide exactly how to implement the micro approach.  This all depends on the market environment to some degree.  I essentially use what is called a core and satellite approach.  I have core pieces that are not unlike a buy and hold approach.  And then the strategies I trade around this.  My algo that I mention on occasion is one of these.  The reason I trade multiple strategies is because nothing will always be working.  For instance, I use a specific event driven strategy that has been my best overall strategy, but it completely died in summer of 2008 and through much of 2009.  It became unusable because of the strange market environment.  That happens.  So it’s better to carry more than one weapon into battle because you never know when one will jam up on you.

Of course, finding the micro approaches are incredibly time consuming and intensive so it’s not for everyone.  In general, I am a big fan of lazy portfolios for the average investor because it’s too difficult to find good money managers (and the really good ones aren’t accessible) and trading your own portfolio is incredibly difficult and a full-time job….

Several readers:  “Is your algo still expecting a correction? This move feels like partying like it is 1999 or am I missing something? Is this a blow-off top or will the market move up for the rest of the year / next 2 years?”

CR:  Speaking of my algo….This is one of my multiple strategies and it’s generally a contrarian approach based on the idea of eliminating my emotions entirely from a component of my portfolio.  It’s based on many different market and economic indicators and is fully automated.  It works in different increments in a sort of dollar cost averaging trading approach and generally fires off what turns into one 8 week trade.  It’s not intended to pick tops and bottoms, but adds exposure when the environment becomes negative and reduces exposure when the environment becomes positive (ideally).  In other words, it’s meant to do exactly the opposite of what your instincts and herding behavior would have you normally do.  This is why it’s automated.  “Trade like a robot” is the approach.  Robots don’t have emotions and if you can take your emotions out of the game then you’re a step ahead of everyone else.

Currently, the algo is still firmly bearish and points to a “reduce exposure” environment for the tepid investor or an outright short for the more aggressive investor.  This strategy comprises one of the multiple strategies though so it is never representative of an “all in” or “all out” type trade.  I find shorting to be an outrageously difficult way to make money so short positions should never comprise the majority of one’s portfolio.

Several Readers: “If Mr. Beranke, and the Fed are wrong, and we have a sudden surge in inflation, what can they do to stop it in its tracks, or maybe back it off to reverse the damage? Or, would they just say “OOPS”.”

CR:  As I’ve been saying for several years now, a sudden surge in inflation will likely come from one of two places – an oil price shock which will likely drive us into recession and cause a bust with an ensuing price decline.  OR, we’ll get an economic boom and prices will rise because employment is surging, output is booming and the economy is generally well out of the doldrums.  I don’t think the Fed would say “oops” in this situation.  I think they’d say “see, we told you we had this under control!” and then everyone will start calling Ben Bernanke the New Maestro even though it was the fiscal stimulus that saved our skin in the balance sheet recession.   And if that really does happen they’ll go through the standard motions of raising rates and probably unwinding their portfolio with the belief that QE caused inflation, etc.   I see the likelihood of a 70’s stagflation as very unlikely unless we get an oil price shock like the 70’s (which can’t be entirely discounted, especially given the situation in the Middle East).

Several Readers:  “Furthermore, some perspective on the yen and the japanese…..are they now finally going down, now their current account disappears? They are the guys who everyone that I prime on MMT/MMR always point at, saying they will be the first falsification of the optimism that MMR may induce. They say japan is out of options.”

CR:  I talk to several traders in Japan fairly regularly who love to joke around about the BOJ sending bond traders to their deaths by suicide.  Japan is an autonomous issuer of the Yen.  So there’s no such thing as Japan “running out” of Yen.  It can’t happen.  They won’t default unless they essentially choose to (that would be a political decision and a very stupid one – kind of like US politicians choosing not to raise the debt ceiling).  Now, they could default in the form of hyperinflation, but this is the big problem in Japan.  They can’t get inflation up no matter what they do!  And they’ve tried.  There are lots of theories as to why this is, but it’s more important to understand that the theory around Japan defaulting because of their debt:GDP ratio or “unsustainable debts” is wrong.

Traders shorting JGB’s (Japanese Government Bonds) have been impaling themselves for 20 years now.  It’s not unlike the US Treasury market right now.  And why is this?  Well, it’s because the BOJ is the price setter in the Japanese bond market.  So when they want rates to remain low they declare it so.  Just like the Fed.  There are no bond vigilantes like in Greece and there’s no one to force Japan into default….If you’re confused on all of this I would recommend the section of the website on the monetary system and the video series as an introduction….

That’s enough for today.  I’ll get around to some of the others later in the week or for next week’s series….Hope this is somewhat helpful….

 

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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Comments

  1. Great answers to wonderful questions. Kids, the bottom line question is: Now that I understand this stuff a bit, how should I invest my money, e.g. the money that I want to save and have grow overtime? My 15% savings?

    My answer is “buy low” in companies that their employees and everyone loves, and that likely will have increasing market share over time. Buy “risk” equities when the market is near, at, or just past capitulation. Over the last 20 years this seem to occur most years during the period Oct-Nov plus or minus a couple of months.

    “But Dennis, during that time I have all my moola tied up in losers, where do I get the money to do this?” My answer is try to bail sometime in May. What I do is try to buy low during Oct-Nov +/- 2 months, then I do not look at the investment until a year is up so that I am dealing with long term gains during May. If I have picked up some downers — if it really looks like I chose a long term loser, I try to get rid of it in time to declare a taxable short term loss that year. Sell the losers just before Christmas. But that is also the time you need to buy those loved companies that are doing well vis-á-vis market share. May is the time you should raise some money for Oct-Nov.

    If you are the conservative type, you can buy retirement 2050 funds in Oct/Nov and swap these for retirement 2015 in May (the ones that are mostly bonds), and do that every year, it’s free.

    Also, don’t worry too much. The world’s economies are controlled by a bunch of crooks for the benefit of the top 1%, but most of all, themselves. They are not going to mess up if they can help it. So it’s best to be in the top 1 or 2%.

  2. Great comments on Japan, Cullen–it’s kind of ironic how the Japanese can’t seem to devalue their currency/generate inflation despite running enormous public sector deficits. IMHO, it’s because the BOJ, like Mr. Bernancke, doesn’t have a helicopter (all protestations to the contrary). The Japanese government, like the US government, doesn’t hand out money willy-nilly (except to the connected few); it doles it out a little at a time (Social Security, food stamps, defense contracts, etc.) and according to rules.

    They could get inflation up, but it won’t happen by running conventional deficits.

  3. FOR ME, it’s about relationships via the numbers. I have to have a minimum number of events to validate a concept and then I only expect to be within a percentage of those results in the application thereof. Having traded for over four decades, I’ve watched a lot of very smart guys come and go (broke), it’s a very interesting game and I truly love it. Unfortunately the game is becoming more and more fixed over the years and one must take that into consideration at all times. Which I believe is part of what Dennis referred to above.

  4. Great suggestions for keeping tethered to the ground while allowing yourself to float up above the clouds to see the broader trends – from around 30,000 feet or so. Thanks.

  5. Love the new Q&A format, Cullen. Very informative and a great way to see what’s on people’s minds. I know Q&A takes some time on your part — so thank you!

  6. Try as I might, I cannot understand why we can be so blase about Japanese debt. Yes, I understand that they issue their own currency, but insofar as I know, they are still going through the charade of selling bonds, which they are able to issue because the Japanese savers put their money into government bonds.
    Can Japan go on redeeming these bonds by borrowing more money?
    I’m enough of a historian to know that 20 years is a very short time, and many systems that looked strong and built to last collapsed in a very short time.
    I also suspect, but cannot articulate, that inflation is always and everywhere underreported these days, and probably is the same in Japan. The standard of living certainly has fallen.

  7. CR, you say something very interesting in your investing approach that Some people may not catch. So I will try to make it a bit more explicit and you can then finetune whatever I say.

    Typically, when people think about portfolio diversification, they think about diversifying among the well-known asset classes; stocks, bonds, commodities, gold, RE. But we all know what happens when hell breaks loose, correlations converge towards 1 and drawdowns of 40% or more, even for a well diversified portfolios are possible, e.g., 2008/2009.

    Another way of reducing volatility is diversifying by looking at different types of investing strategies. You mentioned some. One can, for example, use the typical buy and hold indexing diversification among traditional aset classes approach with periodic rebalancing (possibly the best strategy for most people) using low cost etfs/mutual funds at an appropriate level of risk for a suitable fraction of the portfolio (60-100%?) And for the active portion of the portfolio 0-40%?, use event driven active investment strategies such as deep value/small-micro-cap company, momentum based strategies based on moving averages, managed futures, shorting selective stocks with low short squeeze danger (I.e., do not short the ones everybody is shorting), long short options, covered call writing, etc. at a small amounts for each strategy e.g., not more than 2-5% for the riskier ones.

    This is not a trivial endeavor and possibly not recommended for most people as it requires LOTS OF TIME, even if you have the background to know (or believ you know) what you are doing. Remember we ALL BELIEVE WE ARE ABOVE AVERAGE DRIVERS, LOVERS, DRESSERS, INVESTORS, ETC. It is Possibly easier and safer not to fool ourselves and do what wise investors academics recommend.

  8. “Great comments on Japan, Cullen–it’s kind of ironic how the Japanese can’t seem to devalue their currency/generate inflation despite running enormous public sector deficits. IMHO, it’s because the BOJ, like Mr. Bernancke, doesn’t have a helicopter (all protestations to the contrary). The Japanese government, like the US government, doesn’t hand out money willy-nilly (except to the connected few); it doles it out a little at a time (Social Security, food stamps, defense contracts, etc.) and according to rules.”

    This is 100% right! This is why deficit spending/money printing in Argentina/Venezuea creates the highest inflation rates in the world. They give money freely – they do have the helicopters -, to the unproductive poor who then have money in hand to chase too few goods due to low productivity.

  9. Cullen, thank you very much for sharing this. I love this new Q & A format. Regarding the recent post you did on the Amazing year-to-date Stats for equity markets and risk assets, you did not state this, and I don’t want to put words in your mouth, but I strongly suspect that you are thinking that a risk-on rally this strong is probably unsustainable, and cannot last for much longer. Would you agree that mean reversion is one of the market’s more powerful forces? In that case, we could mean revert in two ways: either a long sideways move in equities to digest the sharp gains over time, or a substantial correction. Again, thanks for your detailed Q & A.

  10. Hi Larry. Yes, mean reversion is a component that I build into my algorithm specifically. It’s one of the few constants in markets and psychology. The problem is always the timing! :-)

  11. That’s essentially the strength in my approach. I am diversified across time frames AND strategies. So I have what some would call a buy and hold component (though it’s not just dumbed down value buy and hold), a medium term approach and then my trading approaches. So it’s really 5 strategies across different time frames and different classes. I sort of think of it like it’s super diversification.

  12. “try as I might”….. I think you need to start at square one… you said “Can Japan go on redeeming these bonds by borrowing more money?” which says to me you’re missing… well, everything.

    First, Gov debt EQUALS private sector savings. So if the Japanese Gov didn’t have any debt, their citizens wouldn’t have any savings. So when you say “how can they keep borrowing?” what you are also saying is “how can the people keep saving?”

    When people say the Gov has too much debt…. they are saying “the private sector has too much savings”. So, to fix the imaginary problem, the Gov must tax the private sector – stealing their savings.

    Also, “can Japan go on redeeming their own bonds by borrowing” needs to be re-written. “Can Japan go on printing bonds out of thin air, and offering them to the public to buy. And whatever the public doesn’t buy, can Japan go on printing Yen to sop of the bonds they printed?”

    There are many here far more knowledgeable about MMR than me, so if i’m mis-speaking I hope to be corrected. But to me it looks like this…. Bonds are the real “printing money”. Since they KNOW the bonds will be bought (EVERY SINGLE AUCTION IS OVER SUBSCRIBED) the bonds are GUARANTEED to become money. I hate to use this analogy, but it comes to mind – if life starts at conception, that is, a fertilized egg is a person – then bonds are money the moment they are issued, even before they are purchased. This idea that the “debt is monetized”, if I undertand it right, is just the “birth” or when the cash the Fed printed, and handed to the Primary Dealers, is used to buy up the bonds, turning them officially into money. But they were never not going to be money. So the Treasury is NOT borrowing – it is printing. And when the private sector buys that new money – they are swapping their cash, for a savings bond. I think I’m now confusing myself, but it seems to me this part does NOT actually create new money – isn’t this an asset sway (asking Cullen, et all)?

    I’m always trying to dumb this down for myself, so please help if you can correct or clarify my thinking?

  13. Good point–you might say that Venezuela/Argentina give money to people who aren’t going to hold onto it; in Japan, and increasingly in the US, they do. For Japan to have inflation, they need to convince their citizens that the money they (the people) are holding is not worth holding–problem is, it is worth holding since the population is aging and needs (or thinks it needs) savings to live on.

    The Japanese really put the fiat in fiat currency :>)

  14. Hi Cullen:
    Thanks for sharing your thoughts. It is always a great reading.
    But for trading strategy, I did not see you have a “cut loss” component. When market goes against you, do you just follow your algo or you always have a stop in mind in case your algo is wrong?

  15. I don’t see that government debt equals private savings. I can ‘save’ and put my money into my business; or I can buy stocks; or I can buy gold; or I can put it under my pillow.
    Yeah, yeah, I know that those dollar bills are created by the government and how that formula works. But practically, I think that if you are ‘saving’ by buying government debt, you are investing in foreign wars and Medicaid payments … not constructive things. Meanwhile, the cost of living decreases because we are substituting debt for production.
    And while, yes, I see that a sovereign can issue a debt and also find a market, even if it has to issue it to a bank as the Europeans do, I simply don’t believe that there won’t be consequences for that. Too clever people make me very nervous.