Saturday, March 7, 2009


Version 1: CFA

After learning portfolio diversification and efficient market theory in CFA for years, I have tried to use all CFA ideas to experiment in the market. I have spent long time to figure out 5 sectors in Toronto market: real estate, financial, energy, gold and information technology, as these 5 sectors have the minimal correlations. Having used dynamic rebalance, I tried to beat the market. The result was pretty much in line with market performance. If you really try to think about such an idea, there is no way that you can beat the market very much, maybe a little bit. The whole idea of CFA is to pretty much use long-term market performance as the reference.
You can hugely improve your model, and still no grantee that you can give a little bit better than the market. Furthermore, if there is bear market, you will definitely lose money, and even you can beat market for example, when market loses is –20%, your loss is –15%.

These two problems cause me to challenge myself whether all these ideas are not right. Bear in mind that many ideas are the main foundations of all investment in the public, many of which were awarded by noble Prize. Current public investment idea is good for public to get market performance without loss big percentage of money, it is the good idea for investment company as well because they charges commission fee. However, such a idea has no way to beat the market and no way to avoid loss when there is bear market. To realize that CFA doesn’t work is a very important breakthrough for me to look into new investment idea.

After checking many books outside CFA, I find that there are many other investment ideas that are not well documented in our learning process, which do present some opinions to challenge the CFA idea. Today, I can frankly tell you that CFA theory doesn't work for you if you want to beat market. If you try to tell people in the professional world that you don’t believe diversification, you may be considered as a crazy person.

Version 2: Correction

Having said that I don’t believe in CFA, I still apply one basic concept from CFA not to invest heavily individual company, as individual company can have very big operation risk that market, or a sector. After reviewing many short term market fluctuations, I find sometimes market crashes so quickly, down a few percent for a few days, then bounce back very quickly as well. Why don’t I capture these sell offs. To maximize advantage of such an idea, you need to have leverage; therefore I have applied option strategy. Usually, most of people use options very aggressive, they buy short term, out of mosey options. They made either very big money, or lose everything. What I have applied is to buy long term, deep in the money strategy, with three times leverage. The main reason to use this strategy is to avoid a downside risk. This strategy gives you time to change your idea, and has minimize the time value. From the beginning of time, I don’t believe in daily trading strategy, I find there is no way for to capture market daily movement. This strategy did yield me some very good return.

There are a few problems with this solution:
How do you know it is correction? Market could continue down and down, such as the NASQ in 2000, real estate in 2006, credit crunch in 2007.
Assume that it is indeed a correction; the question is how can you capture the bottom?

I have formulize some rules there, such as not the first day, not the second day in deep correction, you can start to buy option only from the third day, in addition, the market as whole sector must at least down more than 10%. No matter what you do, you still have a big question in case when it is in deed NOT a correction, you could loss a huge percentage of your money. This problem can destroy your performance by selling option much quicker as you are worry about market could change it quickly. It becomes very challenging.

Version 3: LSC

How to you it is correction, not a market trap? After reviewing many books from money master, I find Jesse Livermore idea shed a light for me. Based on his book, you can realize that he believe in general market, not in individual stock, focus on primary trend, not a daily fluctuation. The whole philosophy is so called “be right and sit tight”. Believe or not, my thought is pretty much in line with him, as I like to trade in general market, not in individual stock, and I like to call doing nothing, or only act when there is real correction. However, what does mean “primary trend”? It has to be relative long-term market outlook. To judge whether market is correction or not is based on long term market outlook. Based on this new think, I find the following idea as LSC approach, or long-term bullish, short term bearish and with an enough consolidation period.
V31. Long term bullish:
Please look at the follows S&P 500 historical data:
. 2000-2004: bearish cycle, -5.0% (as of March 2004)
· 1983-1999: bullish cycle. 12.1%
. 1967-1982: bearish cycle, -3.8%
· 1950-1966: bullish cycle, 9.3%
. 1930-1949: bearish cycle, -1.8%
· 1922-1929: bullish cycle, 19.3%
. 1903-1921: bearish cycle, -4.4%
· 1898-1902: bullish cycle, 11.8%
. 1882-1897: Weak cycle, -1.2%
You may be wondering what to do during bearish stock market; The good news is that commodity is always bullish during stock bearish market. We must be very happy, as there is always bull market at any time. In other word, we can always find the long-term bull market, either stock market or commodity market.
We can simply invest in this identified long-term bullish market.
V32. Short term bearish:
However, it may be not the best solution, as market can’t keep move higher without any setback during this long-term bullish market. For example, Gold bull market start from 2001,
The HUI has achieved about 1000% Rate of return. However, there have been three times up market, and three time down market. Each time market has been corrected three times with the return of -30%. We can find the similar patent in the technology cycle as well.
V33. With a consolidation period
Therefore, the better solution is to enter the market during the setback in the long-term bullish market.
The question is when to enter the market. Different market have different pattern, for example, energy market have relative clear seasonality, and it has always a rally during the wintertime. We need to have enough patience to allow market to have an enough consolidation period.
So the best solution is to enter the market during the setback in the long-term bullish market after an enough consolation period, it has always a rally during the wintertime. We need to have enough patience to allow market to have an enough consolidation period.This idea answers the correction question in some degree. Meanwhile, in order to make sure that we can capture the bottom, I have developed a so called “Fish Net” idea, meaning that setup orders within multiple baskets to be triggered when market is down. However, as you see here, we’re talking about long term is about 17 years, short term about more than one year. In addition you may notice that market sell off happens much quicker than market build up. Why don’t you take advantages of market sell off?

There are still two questions for this solution:
Do we wait for correction when market dramatically shoots up? Such as oil market in summer 2008
Should we touch bear market at all, when market is identified as bear market

Based on the LSC concept, we can only long the market, which is very bad when there is chance to short market, especially when bubble bursts, such as 200 NSDQ, 2005 real estate, 2007 credit crunch. Now it comes idea H4E – Hunting for Extreme

Version 4: H4E - Hunting for Extreme

V41: What is extreme
Market extreme is a period of time when market price is much higher or much lower than market itself, including market bubble and market sells off. A few samples are listed below:
1. Oil price from 50 at the beginning of 2007 to 147 in summer 2008,
2. Credit crunch 2008
3. Real estate bubble 2007
4. NSDQ 2001
5. Chinese market shanghi index from 2000 to 6000 within one year
6. 1997 financial crisis
7. 1987 market crashed in October

V42: Four kinds of extreme
Based on long term and short term framework, there are 4 cases:
1. Long term bullish, short term bearish There is always correction in the bullish market, remember that no matter how bullish the market is, there is always correction, please check the last section for reference.
2. Long term bullish, short term too bullish If you agree with the case 1, then you have to agree with case 2, as the case 1 and case 2 coexist. Actually, market gets much ahead itself.
3. Long term bearish, short term bullish Even it is the bearish market, market sell off can be over done. Market needs to rebalance the sentiment.
4. Long term bearish, short term too bearish

V43: Why extreme happens
Reviewing financial history, you probably wondering why bubble never stops to occur. Bubble is one kind of extreme, you can’t avoid it. The reason is very simple, because we’re human with emotion. What is the market, it is the balance between supply and demand, and the balance between buy and sale. Who decide to buy and sell is people, ourselves with emotion. The whole function is that when market is bullish, it will be pushed much higher than it is supposed to be. When market is bearish, then market will be pushed much lower than it is supposed to be. This is how the market works, not based on efficient market theory. Since people drive the market, extreme has happened and will happen forever because of human nature. The more profit you get, the more opportunistic you are, the more aggressive you will be, The more loss you have, the more pessimistic you are, the less aggressive you will be.

V45: How to identify extreme
This is the main topic to be figured out. One of idea I have is to you don’t need to be smart to spot the extreme. Why? Because everybody talk about the extreme. You can see such news on the first page of main newspaper; you can see it on TV and radio. When market is the stage of bullish extreme, you can see many people get rich so easily. When the market is the stage of bullish extreme, many main companies bankrupt. The next very important topic is to get a set of clear criteria, such as volatility index to quantify it.

V46: How to capture extreme
We should change our attitude to the market to against crowed, once we have identified extreme. First of all, never afraid of working against public opinion. The more profit you get, the more careful you should be. The more loss you get, the more aggressive you should be. 1. BUY: Long term bullish, short term bearish 2. SELL: Long term bullish, short term too bullish 3. SELL: Long term bearish, short term bullish 4. BUY: Long term bearish, short term too bearish

V47:Your weapons
As you see, this investment idea is very difficult to perform, as it requests you to do against the crowd. It is very unaffordable to act the opposite. However, whether comfortable or not is dependable on you. How to make yourself comfortable depends on how good of your understanding and knowledge of following weapons:
1. Financial history: It is the best defense weapon. The more stories you know, the more comfortable you’ll be. I always use Japan stock as sample. Japan index topix from 40000 in 1990 to current 12000 (2008). There is cycle everywhere, not only the market, but also for human life span.
2. Psychology of money master: All successfully money master have very strong mind. Image how difficult for you not to invest in IT in 2000 as warren buffet.

V48: Open questions
How do you really know it is indeed market extreme? 100% is too extreme? Or 200% is extreme? There is no way that you can have an absolute number to decide. For example, DOW, S&P and TSX are down about 25% right now (at the beginning of October 2008), are they in the extreme situation? Whether the answer is yes or no is based on something, for sure 25% is definitely a number, however, this number is not enough to decide. To make the extreme term better defined, we need to add a “relative” to define extreme, or simply called relative extreme.

V49: Relative extreme
Relative extreme is to put the current investment situation on the historical background, or compare the current situation with historical situation. For example, if the current situation is bear market, then we should compare it with 1929 depression, 1970s stagflation, 1987 Long term investment crash, 1997 Asia financial crisis, 1990 Japanese market crashes. If we think market is very bullish, then we should compare 1920s market boom, 1982-2000 market boom, especially NASQ climax. Once we have a clear understanding of where we are now in a middle and long term, which can be considered as market primary trend, then we can figure out whether there is extreme or not. The key is to have one, or many historical cases to compare with current situation.

V410: next?
This concept has a few issues to be resolved:1. What to do if there is no extreme. The good system must be capable of making money in different situations. The extreme is one situation. We need to extend system to go beyond extremes, as most of time when market goes sideways.2. Even in the extreme situation, market won’t go one way for a long period of time. Market is always with big fluctuations during any primary trend, whether it is bull or bear market. It could be very big emotional challenge when you see your profit lost again and again.To resolve these two issues, a new concept call adaptive investing has been formulized.
adaptive investing ...