Portfolio Yoga - Part 63

Trading vs Buy & Hold on Nifty

For a long time now, I have been advocating that any strategy that does not beat Buy & Hold returns is not worth following. The basic reasoning behind the said thought is the fact that Buy & Hold is the easiest way to earn money in markets and unless additional returns can be generated by trying to time the market, it makes very little sense to do anything at all and instead spend the time and effort in a venture of our choice.

But on the other had, the advantage of using a systematic strategy is that the probability of your draw-down being lower than the market is pretty high. While deep cuts do not happen at regular intervals, when they do such as in 2008, its always better to be out of the market (or better short the market) than twiddle the thumbs and hope that the markets start to react back to higher ranges.

Lets for sake of example, take a simple Moving Average Crossover – EMA of 3 crossing EMA of 5. The reason I have chosen this particular multiple is due to the huge amount of discussions that have happened previously as well as the fact that this is one of the best cross-overs among the many others than I have tested. But the fact does remain that this strategy (MA Cross is known for a very long time though much work in my circles has been done by Vish)

If I were to test the same with zero commissions and zero slippage (on Nifty Rolling Month futures from Start of Series in 2000 till date), we see that the strategy would have given us a profit of 7272 points in Nifty vs. a Buy and Hold (and ignoring for Dividends) which would have given us 6018 points in the same time span.

Since futures positions are generally created using leverage, this is not exactly a apples to apple comparison. But before we do that, lets include some transaction and slippage charges so as to make the results more realistic.

Those of whom have been trading for long would remember that its only in recent times that we have brokerage the kind Zerodha offers. I still remember paying 0.05% brokerage even in 2003 / 04. While brokerage has reduced, we now have STT to partially offset the gains from lower brokerages. Slippages too have reduced over time.

Since the back-test is being on a extremely long period of time, I would hence use a 3 times leverage with transaction charges kept at 0.03%. Now, lets look at the results once again.

The gains that we now have is close to 18750 points which comes to a bit higher than 3x of Buy & Hold. 3x of No Transaction charges would have given us 21816 points. The difference is what the cost of the transaction would equal to (on an approximate basis).

But this is not the end result either. You see, while a Buy & Hold investor has the advantage of not paying any tax on the gains (Long term gains being Zero), the same is not true for we, the short term derivative traders. The income so gained is seen as Business Income and charged under the slap which the investor comes into.

For sake of argument, lets assume that we fall under the highest slab and hence lets charge 33% of gains as tax payable. That would reduce our gains to 12562 points. Way less than what we initially started off with but still a little more than double what we could have made from a pure Buy & Hold strategy.

And what about the risk you may ask. Well, the risk (if you measure it through say Draw-down) is actually lower than Buy & Hold. While Buy & Hold would have seen you bear a max system draw-down of 60% (in Oct 2008), in the system you would have seen a max draw-down of just 18.5%, a number which is much more tolerable.

And best of all, I have not compounded my positions through the 14 year test. Even if one used a basic position sizing algorithm, I can assure you that the end result would be way higher than what has been showcased here.

Of course, what is life without some hitches along the way. While you have been a happy man in 2008 reaping your best profits even as the rest of the market was seeing blood on the streets, you would not be so happy as on date what with your strategy under-performing the markets since December of 2012 (current draw-down being 6.51% even as Nifty has moved by 1500 points in the interim).

The above trend following strategy is just a simple example to showcase how one can beat the markets even after accounting for all costs that are not accrued by a Buy & Hold investor. But that said, it also requires tremendous discipline since trend-following strategies generally tend to under-perform strong bull markets (this above strategy for example did not make a cent in the whole of 2007).

While Technical Analysis as seen on Television has been reduced to some sort of astrology, the fact remains that the true aim of technical analysis is to have the ability to reduce the risk. Once the risk of failure is controlled, its always easy to find a way to make more than what any other strategy can provide for.

Do note that I have not taken roll-over costs into account in the example above since I believe that the probability is high that over such a long period of time, roll-over costs shall cancel each other out (since we also take and rollover Short positions). But that maybe something to test some other time 🙂

A easy way to make money in markets

Is making money in markets easy? Well, its both Yes and No. Yes, if you are positioned rightly, making money is as easy as pie. And No, that does not mean that money can be made without a process driven approach and definitely not by trying the luck in markets when the whole herd of sheep is headed that way.

The simplest way to build wealth is by buying when cheap and selling when expensive. Fundamental Analysts go a long way to analyze what is cheap and what is expensive and while many do get it right, its not something that can be attempted by every other investor who may neither have the time nor the expertise in reading through and understanding balance sheets, cash flows, management guidance among others.

A easier way would be to buy the broader markets when markets as a whole are cheap and selling when they start turning expensive. I have in the past written about how one can use Index PE to determine where the markets are placed at the current juncture and use that info to decide what is the ideal strategy.

So, before we go any further, lets look at the monthly chart of Nifty trailing PE (Standalone)

As can be seen in the chart above, we are well below what can be said as over-valued though the caveat is that the price earnings is based on past earnings and if future earnings are bad, we may see the PE rise even without there being much movement in the Index.

On the other hand, we do have some cushion due to the fact that we use Standalone results to calculate the earnings instead of Standalone which is at a higher keel. But since the data we have is Standalone, we shall stick to that for the time being.

While its true that a picture can say a thousand words, I believe that its better to stick to numbers to be sure of what the chart conveys in reality.

While the above chart if of Nifty, I have used the Sensex PE to calculate returns based on where we entered. The reason for using Sensex data was that it provided me with a much larger sample size compared to Nifty.

What I have tried to do is calculate the Compounded Annual Growth Rates based on where the PE was present at that time. So, if the PE was at 20.5, its returns would be recorded in the 21 frequency (representing all data from 20 to 20.99)

As you can see , the best time to buy would be when the PE ratio is between 10 to 19 and the worst time would be when PE is above 24. Save for the two green picks at 26 PE for 7 years and 10 years, almost all of the rest is the worst returns for the period. Even the outlier is more due to happenstance than something which is worth pondering and investigating further (just for info, the sample size of PE between 25 and 26 is 2 – months of July and August 2000 being the data points). Even in that outlier, do notice that the 1 year return was a negative 33.5%, something that is not easily digestible even by die hard bulls, let alone normal investors.

As on date, Sensex PE is at 18.26 (Source: http://www.vectorgrader.com/indicators/india-sensex-price-earnings) or is at 19.2 (Source: http://www.equitymaster.com/india-markets/bse-replica.asp?order=eps%20desc) .Either way, we are at the top of the band and unless we see strong earnings growth in the coming quarter results, any strong gains from hereon will only push the PE of Sensex into area where the probability is high that returns will be below par.

While I still believe that the markets are a Buy on dips, I would wait for a larger correction to jump in (add to existing positions, that is) than jump in at the first sign of correction.

Is this a dip to buy

Nifty finally broke down today more than what we had seen in quite some time. The last time we had a 2% or more cut was way back on January 27th. While the damage seemed to be big in Indexes such as Small and Mid Cap, we need to understand that these indices are up quite strongly for the year even after accounting for today’s fall.

CNX Mid Cap is up 35.7% for the year while CNX Small Cap is up an astounding 53.6% for the year. It will take quite a few dips such as this to call it a buying opportunity.

While markets fell by 2.1% today, its interesting to note that markets have not seen a dip of 5% since 1248 trading days (last recorded dip being on 06-07-2009). What is interesting is that this is the current rally is 1248 days old – something that has not been seen since the beginning of the Indices themselves.

While passive index investing is not as famous as it has turned out to be in US, I do wonder what is the likely reason for such a large amount of time without a strong correction. In the 2003 – 2007 rally, we had 2 episodes of 5% fall, once when NDA fell and the second in 2006 (May).

To me, a better indicator of a Buy on dip would be when markets have declined by 3% in a single session. While that in itself does not mean that its the lowest point, historical evidence suggests that markets have indeed bottomed our round around those levels at least for the medium term.

This correction was very much overdue and unless the Finance Minister brings out something spectacular, markets seem more likely to be disappointed.

Thoughts on Media and Review of Clash of the Financial Pundits

A book review of a subject matter where I have my bias will not do justice without me putting out the story which led me to such a bias in the first place. So, before I review the book, here is some history

The influence of media in the development of trader / investors cannot be understated. When I entered the markets in 1996, we did not have CNBC but did have the pink papers that are available even now. My first dose of investing wisdom was through reading such columns and trying to execute on ideas presented.

My first major brush with losses was also due to the influence of one such paper which in its Monday Edition had come out with a article on how buying Dividend Yield stocks was the best way to bet in the markets and listed 10 stocks which had seemingly good fundamentals and were available at very good dividend yields (Yield being based on previous year’s dividend). Since I come with neither a MBA nor from a family who has experience in shares, I jumped headlong and bought every one of them. To make a long story short, that was the last time I saw my money and of course, many of those shares still lie in my drawer having been delisted years ago even before dematerialisation became compulsory.

My second brush and one that permanently led to me having a bias against reading pink sheets came in 2000 when a acquintance of mine who after accumulating a huge chunk of shares of a penny stock was able to post a article in a major newspaper on how the company was as good as gold with plans exceeding that of **** (name of the then favorite). Of course, once the article came out, the stock went up 20x before the crash of 2000 ensured that this along with other companies with dot come / Info sounding names bit the dust. Of course, well before this happened, the acquaintance of mine was able to bail out with a pretty hefty gains.

For some reason, I have never been a fan of Television (other than to watch Films 🙂 ) and in that aspect, CNBC was something that I have never become addicted to (other than watching it in the years before twitter for breaking news with respect to Dow / RBI decisions). A good friend of me once commented that he had on one fine day counted the number of stocks that are mentioned / discussed on a normal day in the channels and the count came to the high 90’s. With so many stocks being discussed, its just a matter of chance that some stocks that were discussed and many that have news flow along with it tend to do well in the immediate term giving rise to the thought of media being a good way to absorb information. Nothing can be further than the truth though.

Its with this bias that I set myself to read the latest book of Joshua Brown and Jeff Macke. What prompted me to write was the following quote by Joshua

Paying no attention to “the media” allows you the luxury of blissful ignorance, and if you plan to die young, we highly recommend it.

While I have no plans of dying young (or getting financially bankrupt), I have survived this jungle of a market for a pretty long time (as a full time trader / investor) without having to depend on the daily dose of media. In that sense, I believe that the statement over blows the importance of the Media as a medium of information for the retail investor.

Before the advent of social media, the small investor was at the mercy of the financial media for getting news on the companies / markets he had invested into. But today with information being the finger tip and crowd-sourcing of research becoming big, there is little excuse for anyone to depend on the media to get the information and analysis they are looking for. Of course, since both the authors are regulars on financial television, one could not have seem how the book could have come to a different conclusion.

Its in this context that I am reminded of this quote from the Oracle of Omaha in his recent Annual Report

“Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: “You don’t know how easy this game is until you get into that broadcasting booth.”)

To me, the greatest issue with television pundits is their uncanny ability to forecast the future. The more outrageous the forecast, the more the prime time they get to talk. Hence you have had Analysts commenting on how Nifty will go down to 4500 right when the markets were ready to take off higher or make a call to buy Infrastructure Funds / Stocks right at the time they peaked in 2007.

This is not limited to India only as the book provides ample evidence of how “Hedgehogs” tend to occupy the limelight as well as continue to attract followers and attention even after umpteen number of failures. The very fact that they are able to provide a convincing story as to why Dow may hit 4000 or that Gold shall touch 5000 a Ounce is enough to gather the TRP they clamour.

The book in itself can be divided into two parts. Half the chapters have been written by Joshua Brown who as draws upon history to tell stories of the past pundits and how they came unstuck. The other half of the chapters are of interviews by Jeff Macke who has interviewed a variety of persons connected with the financial media. In terms of pages though, Jeff Macke hogs more than 75% of it with the rest being occupied by Brown.

The biggest revelation of the interviews I gained was that even the biggest stars of TV actually watched very little TV themselves and in that sense, it just confirms my view that one need to not be hooked to television to get across to news and analysis. The interviews themselves are ok especially if you were to compare interviews Jack D. Schwager has had in his Market Profile series. There is just so little insight that can be gained here that its completely lost in the noise of the leading questions and answers that proliferate.

The best chapter I liked was the Chapter 15 aptly titled “All your investment rules contradict each other”. Other than that, this is a book that is once read and disposed off since there is not much to gain from a second or third reading.

I believe that most investors are better off sticking to index funds since evidence is plentiful about how very few investors actually are able to beat the Index in the long run. But then again, that is not a advise you shall hear on Television where the anchors want you to believe that you can be the next Warren Buffett or Rakesh Jhunjhunwala by buying the stocks that are recommended by their Star Analysts (and if you want more, you can always subscribe to the tips and newsletter they offer on their personal websites for a fee).

Watching television has made most of us experts in Cricket / Football (or any other sports you care to follow) and similar thought process gets developed by a investor who believes TV is the substitute for real analysis. Unfortunately the herd is seldom right and if your process of stock selection is dependent on the pontification of TV pundits, its just a matter of time before you shall see that while the analysts continue to be cheerful, your trading account is in tatters.

I think there’s…

I think there’s a desperate need for good financial advice for individuals. I think unfortunately the incentives on Wall Street and in the money management industry and in the media create an environment where there’s very little of that. For example, one of the things that became clear to me over two to three years of studying the best advice for individuals was that it is crazy for individuals to try to pick stocks and it is crazy for individuals to try to pick mutual fund managers or hedge fund managers who can beat the market.

For 99 percent of individuals, it’s just devastating to their financial performance. Really what they should be doing is keeping their money in low-cost index funds and only rebalancing once every couple of years, and that’s it.

And yet the problem is as a brokerage firm, as an advisor, as a media pundit, you can’t just go on and say everyone should just buy index funds. Stop trying to figure out what’s next for Yahoo or Google or Apple. Just buy index funds and forget it. Financial TV would just have to fold up the tent. The good news is there are lots of professional money managers out there and there are very dedicated individual traders out there who do, in fact, want to dissect stocks every day and try to figure out where the next trade is. That’s where the whole financial media industry is; they’re catering to those people

A quote by Henry Blodget – From the book

Clash of the Financial Pundits: How the Media Influences Your Investment Decisions for Better or Worse

In Defense of Technical Analysis

One of the ways to beat down a strategy is to apply it wrongly and claim since the results does not match expectations, the strategy has to be wrong. Technical Analysis has its faults and there is no denying that. But claiming that those who use technical analysis as the tool of choice tend to have their performances drag down is doing it a bit too far.

That thought is based on a survey which has been done by Arvid Hoffmann of Maastricht University and Hersh Shefrin of Santa Clara University (Link). The key reasons they come up for the under-performance are:

Investors using technical analysis are disproportionately prone to have speculation on short-term stock-market developments as their primary investment objective.

Investors tend to hold more concentrated portfolios which they turn over at a higher rate

Investors are less inclined to bet on reversals, choose risk exposures featuring a higher ratio of non-systematic risk to total risk

Investors engage in more options trading, and earn lower returns.

The biggest problem area for me in terms of Technical Analysis is the confusion whether it’s a science or an art. While it’s nice to say that it’s both a science and an art, it’s plainly illogical that something can be both. Think about Modern Art being said to be an Art (which is true) as also a Science. I am not sure if there is any other field where both Art and Science are seen to be acting in tango.

Now, let’s go back to the four points which the researchers say are the key reasons for the underperformance of investors who use Technical Analysis for their decision making.

The time frame of a trader / investor using technical analysis is way too short compared to an investor who uses fundamental analysis as his tool. While a fundamental investor gets 4 data points in any given year (4 Quarterly Results), guy who uses Technical analysis has a lot more data points based on what kind of time frame he operates in. A investors who looks at Daily chart would have around 240 data points to consider in any given year while a Investor who looks at a weekly chart will have 52 data points to consider in a year. No matter what time frame one chooses, the data points generally exceed the data points available to a fundamental investor

Having more data points is both a advantage and a disadvantage. Let’s take a example where more data points would have worked in the favour of the Technical Analyst – Satyam Computers. Long before the shit hit the fan, most guys using Technical Analysis as their tool would have seen that it made no sense to trade the stock with bullish bias. For a Value /Fundamental Investor on the other hand, Satyam was a strong case of a stock available for cheap.

It is interesting that the survey finds that Investors hold concentrated portfolio’s / bets compared to investors using other methods who may be holding diversified portfolios. A lot of water has flown down the bridge as to whether it’s better to hold concentrated bets or diversify as much as possible. Both have their advantages and disadvantages and I doubt that it can be proven that either concentrated or diversified portfolio is the best bet.

Personally I believe in concentrated bets since the more number of stocks one is exposed to, the closer we get to ordinary performance. The same was proved when I did the test of random portfolio strategy as well. But I strongly doubt that a concentrated portfolio is the key to under-performance since I know of many value / fundamental investors too who use the same approach and have been able to beat market averages by a mile.

This point interestingly goes against the point number 1. If investors using technical analysis as their trading tool are trading more, it goes on to prove that they are betting on reversal s to the existing trend at multiple points and in turn can miss the big rally when it comes.

Option trading as such has nothing to do with Technical Analysis but since Option traders are short term traders and are betting on charts to decide on what stock and what strike to buy, it’s easy to get clubbed with Technical Analysis even though one can search the entire technical analysis vocabulary and find not a single instance of a tool devoted to options.

In an earlier blog post, I had written about how people buying cheap options is not the path to riches and instead will result in ruin of capital in the long run. But then again, options are pretty enticing since unlike stocks, they can double / triple in no time at all.

But Technical Analysis as such has no role in how investors / traders risk their capital in the markets. Option trading is similar to buying lottery tickets (though the odds here are much better) and hence not something that is bound by any strategy other than human greed.

To me the biggest negative is the fact that Technical Analysis as a tool is far from refined and adapted to the world where it’s important that it’s scientifically proved beyond doubts. If I were to buy stocks based on PE, that would not make me a Value / Fundamental Investor but if I were to draw a line on a chart, I am seen as a Technical Analyst. End of the day, it’s the perceptions that seem to matter more than reality.

Over period of time, I myself have debunked multiple strategies that are associated with Technical Analysis and showed how they fail the traders / investors who use those tools. But to claim Technical Analysis as a whole is quack is akin to throwing the baby with the bathwater.

Test of Moving Average

A interesting use of Moving Averages is in Mean Reversion. While many trend followers swear by a Moving Average (or Moving Average Crossover), its interesting that the same can also be used for a Mean Reversion strategy (not that I would recommend doing that).

This pic from Wikipedia showcases the same

We can measure a trend in various ways. One way would be to see the number of times it retraces to its moving average before continuing with its previous trend. Based on that though, here are the charts on the number of times Nifty has come back to the moving average.

All data for 2014 is till date (30th May)

10 Day Moving Average

20 Day Moving Average

50 Day Moving Average

100 Day Moving Average

200 Day Moving Average

Based on just a overall view, the data above supports the fact that trend following has been pretty positive this year compared to say 2013. But shall it remain with low volatility and not too may dips remain to be seen

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