How We've Managed to Come Unscathed in Recent Tumultuous Weeks

11/16/2018 3:12 pm EST

Focus: MARKETS

Landon Whaley

Editor, Gravitational Edge

If you’ve ever been deep sea scuba diving, you know that once you breach 75 feet, it’s easy to get disoriented and confused about which direction is up. The solution is to watch the direction of the bubbles. They always rise toward the surface, writes Landon Whaley.

In a similar way, we know it’s easy to get disoriented and confused in our 24/7/365 news and social media cycle world with stock market tipsters at every cocktail party.

We liken our research to the “bubbles” telling you which way is up and safely guiding you back to the surface. Each week in Gravitational Edge, we distill the most critical economic and financial market developments and then provide you with clearly articulated game plan for the week ahead, we call this section “The Playbook.”

Today I’m going to review how we’ve so far managed to come unscathed through the recent tumultuous weeks. It will act as a case study of how we successfully risk manage our model portfolio to minimize drawdowns and maximize opportunities. We’ll then look to the future and answer a question that keeps coming our way: is the FG4 environment already priced in to markets?

September Night

When September began, both our portfolios were damn near fully loaded. We held eight positions in the Asset Allocation Model (four long and four short) and 11 (of a possible 15) positions in the G15.

But as we crept closer to Q4 2018 we realized we were entering an “FG4 in Q4” environment, and we made that call publicly on September 24. We began closing positions in both portfolios, reducing our long and short exposure. What we couldn’t know for sure was exactly when markets would wake up to this new Fundamental Gravity reality. To minimize risk, we took the following approaches:

1. Reduced our overall exposure, and
2. Made sure we weren’t leaning too far in one direction, long or short.
These approaches left the Asset Allocation model with just four positions (two long and two short) and the G15 holding stocks in just eight companies as we turned the calendar to October.

October Road

During the carnage that ensued in October we eeked out a small +57 basis point gain in the AA Model and lost just -66 basis points in the long-only G15 portfolio. These results show the success of our risk management practices. So how did we weather the storm so successfully?

First, we didn’t chase markets lower and short them while they were in free fall, because that’s the quickest way to get your face ripped off. Countertrend rallies in bear markets occur quickly and without warning, and they can be quite violent. Instead of chasing markets lower, you channel your inner Axel Rose and show a little patience, selling the rips when you get them.

Secondly, we didn’t liquidate our longs on the way down, either. We were patient and used those same quick and violent countertrend bounces to profitably reduce our long exposure in both portfolios.

The net result of our risk management over those two months was that we closed 12 trades in the Asset Allocation Model, nine of them for gains, and closed 12 trades in the G15 stock portfolio, 10 of which were winners.

November Rain

Entering November, we were left with just a single short position in the Asset Allocation Model and a single utility company in the G15. This was a risk-conscious decision to be as small as possible so that we could assess the dynamically shifting probabilities in markets before we put more capital at risk.

Over the last two weeks, we’ve patiently taken what the market has given us and built positions on both sides of the newly minted Gravitational 15 global macro portfolio. We used pullbacks in the U.S. dollar (USD), Treasuries and our Shift Work sectors to initiate new longs. On the flipside, we used the eight-day dead cat bounce from October’s wreckage to short our favorite U.S. sectors based on our active macro themes: Reflation’s Rollover, The Other Korea and U.S. Shift Work.

We are currently positioned for an FG4 environment and will continue to add positions on both sides of the portfolio as the opportunity arises across our active macro themes.

Don’t buy the dips, sell the rips!

One of the questions we’ve received repeatedly over the last two weeks is whether the FG4 environment is already priced in. And the answer is a resounding “No!”
A quick glance across futures positioning and options markets tells me that investors have already forgotten October. They are back to acting like S&P 500-trained Pavlov’s dogs, once again buying the dip.

The latest futures positioning data shows that investors added another 26K contracts to their long S&P (SPX) positions, bringing the total number of long contracts to 248,269. Folks, the largest long positioning over the last three years was 249,638 contracts, which means investors are within 1000 contracts of being as long as they’ve been in the last 36 months. WTFudge?!

Options market data is telling us the same dip-buying story because the growthy U.S. sectors are once again trading with an implied volatility discount to realized volatility. Investors are loading up on the stuff that worked for 27 months. The problem for these guys is that it ain’t 2016, 2017 or even Q1 2018. It’s Q4 2018, and the S&P has a bearish Quantitative Gravity (with the VIX flashing a bullish QG) for the first time in forever. What these guys think are dips are actually drawdowns, and they’re buying them.

My framework and my process are telling me to continue pressing the U.S. Shift Work sectors on the long side (along with the greenback and Treasuries) and continue selling the rips across semiconductors, financials, industrials and crude-oil-related equities.

The Bottom Line

Could I be wrong, or early? Could we get a “Santa Claus” rally that sends our longs down and our shorts up? Of course. But as I highlighted in The Weekender’s “Coddiwomple,” both U.S. markets and economic data are confirming an FG4 environment, and it’s clear based on the Behavioral Gravity across most U.S. asset classes that investors are clueless to this. Remember, the best opportunities for us arise when there is a divergence between the Fundamental Gravity for an economy and the investor perception of the asset classes that trade in that economy.

That divergence is occurring big time here in the U.S. and we are positioned to take advantage of it.

Please click here and sign up if you’d like to receive the latest edition our research reports as well as to participate in a four-week free trial of our research offering, which consists of two weekly reports: Gravitational Edge and The Weekender.

Watch Landon Whaley’s 3 Ideas for Investing and the meaning of coddiwomple in a short video here.
Recorded: MoneyShow Dallas Oct. 5, 2018.
Duration: 6:42.

Watch Landon Whaley discuss When Markets Cycle  in a short video here.
Landon Whaley: We have a generation of investors and asset managers who know only one market. The reality is markets and economies cycle and catch people off guard.
Recorded: MoneyShow Dallas Oct. 5, 2018.
Duration: 5:51.

Landon Whaley interviews Adrian Manz: How I approach stocks here.
Recorded: MoneyShow Dallas Oct. 5, 2018.
Duration: 7:48.

Landon Whaley interviews trader Jackie Ann Patterson: How I got started trading and how I approach it with my Truth about ETF Rotation here.
Recorded: MoneyShow Dallas Oct. 5, 2018.
Duration: 6:14.

Landon Whaley interviews John Carter: How I started trading here.
Recorded: MoneyShow Dallas Oct. 5, 2018.
Duration: 5:37.

Related Articles on MARKETS

Keyword Image
Get Long Taiwan
04/23/2019 1:18 pm EST

Emerging markets appear to be on the cusp of a recovery, but for now stick with investments in Taiwa...