Appetite For _ _ _ _ _ tion

If you’re looking at the blanks in the title…no, I’m not talking about the Guns ‘n Roses album. I would need two more letters for that, and there is no way that this report can do justice to the highest-selling debut album of all time. If you want to jam with me on some Marshall Silver Jubilees though, that is an entirely different topic for another time.

What I am referring to is the pricing of commodities, and the market’s general lack of appetite for them at moment. There are plenty of theories floating around the Internet for why commodities have underperformed, and any combination of them could be true, but as Refined Investors all we care about is price action. We do not buy assets that are in downtrends, and unless we are shorting them we will continue to keep a watchful eye on their wanderings. Here’s an updated chart on the $CRB and $SPX:

March 7th CRB SPX

Coming out of the 2009 lows, commodities and equities moved in lockstep, reflecting the growth that was happening in the real economy and the effects of QE1 and QE2. However, at the end of 2011 a large divergence began to form between the two (in the equal-weighted $CCI as well). As of today, the $SPX has continued to rise in its now extended 4-year cycle, while commodities look like they have succumbed to the reality of increased supply, decreased demand, and/or changing habits among consumers. The poster child of the 2000′s consumption economy, the Hummer, is no longer in production, and let’s face it – a Prius just doesn’t look the same with 24″ spinners.

But the bigger chess move was the change in policy approach from the Federal Reserve in September of 2011. “Operation Twist” represented a sterilized version of Quantitative Easing, and no longer was the Fed buying agency mortgage-backed securities and agency debt outright, but it was buying treasuries on the long end and selling them in equal amounts on the short end. This was not inflationary by itself, but it gave consumers the incentive to either invest in housing at all-time low rates or search for yield in dividend stocks and junk bonds. Just one look at the homebuilders chart below and we can immediately see the dramatic effect of the Fed’s policy:

March 7th XHB

It also represented a dramatic shift in investor preferences. Consumers living on fixed-income were, for lack of a better term, “smoked out” of the comfort of their bond portfolios in order to maintain their same standard of living and cash flows. Dividend stocks and junk bonds became the new treasuries because of their yield, and ironically, treasuries became the new growth stocks because the only reason to own them was to front-run the Federal Reserve’s purchases, regardless of their yield. The thirst for junk bonds benefits the corporations that traditionally would have difficulty selling debt, and as long as that feedback loop continues it will benefit the stock market. Commodities do not generate a yield and are volatile, and so far they haven’t been a beneficiary of this game of musical chairs. For all intents and purposes, what we have experienced is a true “twist” of the traditional roles of assets in the marketplace.

Nobody can predict the future, but at this point, we have come to an interesting dilemma with regards to equities. Markets eventually top on euphoria and a lack of buyers. This process does not happen overnight, but the longer it takes the more leveraged and complacent the market must become in order to generate the same gains as before at now higher valuations. Without real wealth creation in the underlying economy supporting the market at all-time highs, the only thing that the nominal numbers tell us is that the collective portfolios of investors have simply been redistributed from the larger bond market to the smaller stock market, with the Fed filling the gap left behind. The older generations are now sitting in investments that they typically have shunned as too risky, the Fed is buying the majority of treasuries, and volatility is at multiyear lows. That is the status quo, and right now there are very little catalysts or outlets for a makeover.

Referring back to our first chart, we now have to ask the question:

If investors have nowhere to go at this point, are we more likely to see bigger gains going forward in equities or in commodities?

To be honest, I don’t have the answer. To predict whether we are going to experience _ _ _ _ _ tion or _ _ _ _ _ tion over the short-term is a fool’s errand, and it definitely has humbled the commodities bulls for the last 15 months. Ultimately, at some point the true demand being generated from the underlying economy will make the decision for us. At that time we will either see commodities rise in response or equities fall in reaction and we will position ourselves accordingly to the changes in price across all markets. Until then, we must patiently temper our own personal outlooks and biases and maintain strict risk-management in all of our positions. It is admittedly a frustrating environment to invest in, and unless you receive fees for total assets under management, you probably don’t feel like sending the markets a fruit basket at the end of the year.

There were no large changes in the markets today as everyone awaits the employment report tomorrow. Expect to see significant volatility on the news as there are many narrow range candles and tight consolidations on the charts signifying coiled fractal energy. Honor the stops in our current positions and be ready to look for new ones when the dust settles. PALL made another nice move today and I will be looking for an entry if commodities gain some momentum.

Good trading all.

Steve Chapman, TRI

The Gold Bull – Something For Everyone

Ever since the top of the gold bull in September of 2011, gold bugs have been waiting (im)patiently for their yellow metal to continue its massive climb from the 1999/2001 lows. I don’t care if you think gold is a scam, a barbarous relic, an insurance policy, or a form of money, as Refined Investors all we care about is price, and price has been going up for over a decade now.

Gold brings out a lot of emotions in people, but it still obeys the basic rules of supply and demand. When something climbs very rapidly in price, it inevitably brings more supply onto the market. If somebody was willing to pay you $1,000,000 more for your house than you paid for it, you would probably sell it in an instant unless you had significant emotional ties to the property. When gold leaped above $1900/oz, there were a lot of people willing to part with grandma’s old necklace at the local “We Buy Gold” store. Rapid rises in price also bring a lot of weak hands into a trade, just ask any of the professional house flippers that came out of the woodwork in 2005 and 2006.

This oversupply brings a lot of slack into a market, and the only way to eventually get rid of it all is for genuine buyers to absorb it. This does not happen overnight, and it takes time for the supply to move from weak hands to strong hands. If you look at the chart below, you will notice that every time gold corrects from an intermediate peak it is taking longer and longer for the bears to take price back down to the low $1500′s where gold has found support (large file):

March 7th GLD Corrections

While the gold bugs will scream manipulation and the bears will growl that gold is about to plummet to $1200/oz, what I see is a market that is slowly and efficiently absorbing supply with every correction. The angle of each decline has been getting flatter and the time required to get to the bottom of each intermediate cycle is taking longer. That is the sign of a market that is strengthening and not weakening. While gold bugs would love for price to instantaneously skyrocket to $10,000/oz (or pick a number out of a hat), the markets are saying that it is going to take a little longer, but higher prices will eventually come.

If the next move continues the pattern of shallower correction angles, we are likely to see gold consolidate into the next intermediate low or possibly even begin a mild uptrend at some point. While this is not an exciting 2013 forecast for those looking for the bull market in gold to continue, students of fractals understand that after a large trending move a consolidation is required to build up enough energy for the next trend to resume. The longer that an asset consolidates, the larger the next trending move will eventually be when the fractal energy is finally unleashed.

If you want to see a great example of what higher prices do to a market, watch how a water ski jumper zooms out in front of his boat to create slack in his rope (representing higher prices). Eventually, the boat catches up (demand) and the ski jumper’s rope becomes taut, propelling him to the other side and launching him over the jump (resumption of the trend):

In conclusion: Gold Bugs – be patient. Traders – enjoy the trading range. Bears – you get your chance every four years and you’ve done well. Investors – you’re still up over 600% since 2001.

The gold bull, something for everyone.

Good trading all.

Steve Chapman, TRI


A Primer On Risk Management

Risk management is the single most important thing you do as an investor. While not a glamorous endeavor, it is the difference between making money and losing money over the long run.

In golf, you “Drive For Show and Putt For Dough”, and in the market the same method holds true. The little details that new investors often overlook are actually the most important. Investing is not about waiting for the perfect setup and then putting your entire portfolio fully-leveraged into one position. The longer you trade, the more you will realize that every trade has the potential to fail, and that often times your biggest gainers will be the ones you had the lowest expectations for. If you don’t have a disciplined exit point and position size before you place a trade, you will eventually lose money when you encounter a streak of losing trades.

Let’s look at a few scenarios to get an idea of how the math works. Using the classic coin flip example, let’s see what happens when we take different amounts of risk and have different lengths of losing streaks with a hypothetical $100,000 account:

Taking 1% Risk Per Trade (Account loses 1% Each Time) With The Following Consecutive Losses In A Row:

  • 1 Trade – $100,000 x .99 = $99,000
  • 2 Trades – $100,000 x .99 x .99 = $98,010
  • 3 Trades – $100,000 x .99 x .99 x .99 = $97,029
  • 4 Trades – $100,000 x .99 x .99 x .99 x .99 = $96,059
  • 5 Trades – $100,000 x .99 x .99 x .99 x .99 x .99 = $95,099
  • 6 Trades – $100,000 x .99 x .99 x .99 x .99 x .99 x .99 = $94,148
  • 7 Trades – $100,000 x .99 x .99 x .99 x .99 x .99 x .99 x .99 = $93,206
  • 8 Trades – $100,000 x .99 x .99 x .99 x .99 x .99 x .99 x .99 x .99 = $92,274
  • 9 Trades – $100,000 x .99 x .99 x .99 x .99 x .99 x .99 x .99 x .99 x .99 = $91,351
  • 10 Trades – $100,000 x .99 x .99 x .99 x .99 x .99 x .99 x .99 x .99 x .99 x .99 = $90,438

Taking 2% Risk Per Trade (Account loses 2% Each Time) With The Following Consecutive Losses In A Row:

  • 1 Trade – $100,000 x .98 = $98,000
  • 2 Trades – $100,000 x .98 x .98 = $96,040
  • 3 Trades – $100,000 x .98 x .98 x .98 = $94,119
  • 4 Trades – $100,000 x .98 x .98 x .98 x .98 = $92,236
  • 5 Trades – $100,000 x .98 x .98 x .98 x .98 x .98 = $90,392
  • 6 Trades – $100,000 x .98 x .98 x .98 x .98 x .98 x .98 = $88,584
  • 7 Trades – $100,000 x .98 x .98 x .98 x .98 x .98 x .98 x .98 = $86,812
  • 8 Trades – $100,000 x .98 x .98 x .98 x .98 x .98 x .98 x .98 x .98 = $85,076
  • 9 Trades – $100,000 x .98 x .98 x .98 x .98 x .98 x .98 x .98 x .98 x .98 = $83,374
  • 10 Trades – $100,000 x .98 x .98 x .98 x .98 x .98 x .98 x .98 x .98 x .98 x .98 = $81,707

Taking 3% Risk Per Trade (Account loses 3% Each Time) With The Following Consecutive Losses In A Row:

  • 1 Trade – $100,000 x .97 = $97,000
  • 2 Trades – $100,000 x .97 x .97 = $94,090
  • 3 Trades – $100,000 x .97 x .97 x .97 = $91,267
  • 4 Trades – $100,000 x .97 x .97 x .97 x .97 = $88,529
  • 5 Trades – $100,000 x .97 x .97 x .97 x .97 x .97 = $85,873
  • 6 Trades – $100,000 x .97 x .97 x .97 x .97 x .97 x .97 = $83,297
  • 7 Trades – $100,000 x .97 x .97 x .97 x .97 x .97 x .97 x .97 = $80,798
  • 8 Trades – $100,000 x .97 x .97 x .97 x .97 x .97 x .97 x .97 x .97 = $78,374
  • 9 Trades – $100,000 x .97 x .97 x .97 x .97 x .97 x .97 x .97 x .97 x .97 = $76,023
  • 10 Trades – $100,000 x .97 x .97 x .97 x .97 x .97 x .97 x .97 x .97 x .97 x .97 = $73,742

And for those of you that love to pull out the driver on the short Par 4′s with water surrounding the green, here are some more extreme examples.

Taking 5% Risk Per Trade (Account loses 5% Each Time) With The Following Consecutive Losses In A Row:

  • 1 Trade – $100,000 x .95 = $95,000
  • 2 Trades – $100,000 x .95 x .95 = $90,250
  • 3 Trades – $100,000 x .95 x .95 x .95 = $85,737
  • 4 Trades – $100,000 x .95 x .95 x .95 x .95 = $81,450
  • 5 Trades – $100,000 x .95 x .95 x .95 x .95 x .95 = $77,378
  • 6 Trades – $100,000 x .95 x .95 x .95 x .95 x .95 x .95 = $73,509
  • 7 Trades – $100,000 x .95 x .95 x .95 x .95 x .95 x .95 x .95 = $69,833
  • 8 Trades – $100,000 x .95 x .95 x .95 x .95 x .95 x .95 x .95 x .95 = $66,342
  • 9 Trades – $100,000 x .95 x .95 x .95 x .95 x .95 x .95 x .95 x .95 x .95 = $63,024
  • 10 Trades – $100,000 x .95 x .95 x .95 x .95 x .95 x .95 x .95 x .95 x .95 x .95 = $59,873

Taking 10% Risk Per Trade (Account loses 10% Each Time) With The Following Consecutive Losses In A Row:

  • 1 Trade – $100,000 x .90 = $90,000
  • 2 Trades – $100,000 x .90 x .90 = $81,000
  • 3 Trades – $100,000 x .90 x .90 x .90 = $72,900
  • 4 Trades – $100,000 x .90 x .90 x .90 x .90 = $65,610
  • 5 Trades – $100,000 x .90 x .90 x .90 x .90 x .90 = $59,049
  • 6 Trades – $100,000 x .90 x .90 x .90 x .90 x .90 x .90 = $53,144
  • 7 Trades – $100,000 x .90 x .90 x .90 x .90 x .90 x .90 x .90 = $47,829
  • 8 Trades – $100,000 x .90 x .90 x .90 x .90 x .90 x .90 x .90 x .90 = $43,046
  • 9 Trades – $100,000 x .90 x .90 x .90 x .90 x .90 x .90 x .90 x .90 x .90 = $38,742
  • 10 Trades – $100,000 x .90 x .90 x .90 x .90 x .90 x .90 x .90 x .90 x .90 x .90 = $34,867

As Refined Investors, I want to continually pound the table on this concept of risk management. It is inevitable that at some point in your investing career you will have a streak of losses. How badly you are damaged by those losses will greatly impact your final account balance when you eventually retire from the game. Just like in golf, where it is much easier to make a triple bogey on a hole (3 strokes over par) than it is to make a birdie (1 stroke under par), it is much easier to take a big loss on a trade than to make a big profit. Therefore, it is more important that you limit your losses and let your winners run, which is typically the opposite of how our brains think. We tend to hold onto our losses, hoping that they will turn back into profits, while we keep a short leash on winning trades because we don’t want to “give back” the gains.

Mathematically, it is also harder to earn back the money once you’ve lost it. The way that percentages work, here is how much money you will have to make just to get back to your original account balance after a string of just 5 consecutive losses, which almost all of us will experience in our careers:

  • 5 Losing Trades In A Row With 1% Risk = 5.15% to get back to even
  • 5 Losing Trades In A Row With 2% Risk = 10.63% to get back to even
  • 5 Losing Trades In A Row With 3% Risk = 16.45% to get back to even
  • 5 Losing Trades In A Row With 5% Risk = 29.24% to get back to even
  • 5 Losing Trades In A Row With 10% Risk = 69.35% to get back to even

So the next time that you want to buy a leveraged ETF, or take on a huge position size, acknowledge how much risk you are taking (I will cover this in a different post). Trying to find a great entry point with a definable level of risk should be your first priority in this game, not how much money you are going to make after you push the place order button. We spend a lot of time waiting for the right entries and using a multitude of different methods to do so, but there is no guarantee that any of them will be successful trades.

Percentages will compound in the positive direction as well, and that is why the rich get richer on the same percentage move as everyone else, because their starting balance is higher. It takes money to make money. Over time, you can actually take less risk and make the same amount of money, a beautiful thing.

As Refined Investors, we take the bogeys when they happen and move on…but by playing for par and avoiding the pitfalls that come from using our driver when we shouldn’t, we will all be surprised at the number of birdies on our scorecard at the end of the day. And that final number is the only thing that matters.

Good trading all.

Steve Chapman, TRI


Intraday Update – March 6th, 2013

For those that took a position in IBB, after being up 7 days in a row I think that we can be content with the move and step to the side. For those that didn’t take a position in GDX yesterday, it has formed a swing low this morning and it will be easier to manage risk if you are not forced to chase at this point. No move is guaranteed, but the further it goes from the low, the further your stop is away. Remember, we buy strength and sell weakness. Typically, this only happens when price jumps above the short-term MA’s, but we have an MA Envelopes trade in effect and so this is mean-reversion back to the 50 MA.

Don’t get greedy, and let the market work at this point. Miners have been going down for so long that it will be tempting to get out. Cut your losers off quickly and let your winners run, the opposite of what your mind tells you to do. If price doesn’t confirm, we wait for the next trade and do it all over again. Maintain the same expectations on every trade or you will get married to some of them.

Good trading all.

Steve Chapman, TRI