Current Framework!
What I have learned the last 2 Years as a full time trader...
O.k., this is going to be repetitive, but I need to clear my head and be very clear what my framework is.
1) Look at clean factor indexes (trading systems) with factors that trend well
Examples:
Above: See the weakness before the 2020 tank? Remember you are looking at the best of the best in small cap value momentum! And then the strength during the first pullback of the market after 2020 lows?
Above Buy Signal: Factor is strong (4 weeks - 3 Months) and does dip less when the market has a drawdown [DD]. See the logic: High Beta should tank with the market in a DD, but if it does not, it means something! Same with the sell signal, lower low on high beta + relative weakness to the market was a great warning (to be fair: after a 10-20% DD, but still!).
One other context. Have a look at $HUBS (above model is long that one!) —>
Do you see any deterioration of the fundamentals (besides it is and was expensive) early on?
No! Extremely important: if the factor turns sour, fundamentals do not matter anymore! It is much more important which factor you are long / short than the fundamentals of a single stock. If high beta is tanking, 90% (if not higher) of high beta stocks tank. It is great to look at fundamentals when the factor is doing well. If the factor is not doing well Fundamentals DO NOT MATTER!
Furthermore: By clean factor systems I mean that they have two or three factor combinations max. AND the factors you choose for the trading system should be known (by academic papers!) to trend well.
This is extremely important. Has the SPY a clean factor combination? Hell no! It has about every industry, it has value, it has growth, it has momentum, it has big caps and mid-caps. It has almost every factor out there (besides low size). It has high beta and low beta, etc., etc.
So, if you look at an index with a mixed factor combination you will get no idea what the actual factor momentum looks (what is weak, what is strong!) like, because it is all mixed into one bag.
My take: technical analysis on indexes with mixed factor exposures will cloud your vision and you will miss a ton of opportunities!
To be fair: I know a ton of very successful technical traders who heal this in the following way: they look at 1000+ Charts a week to get a feel which factor is doing great and / or they have good screens. I tried that and it’s not for me, because I cannot connect the dots on the fly. If you can do that, great approach!
Also, even if you look at ARKK (pretty clean high beta), but you will not look at the best EPS Growth and best momentum high beta stocks.
In order to understand which factor is doing what right now, you need the LEADING stocks of a factor, the best of the best of a factor. If the best of the best of a clean factor (or factor combination that is known to trend well) get into trouble (e.g., show relative weakness to the market) this is very significant.
Some papers:
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3116974
“Past industry returns predict future industry returns, and this predictability is at its strongest at the one-month horizon. We show that the cross section of factor returns shares this property and that industry momentum stems from factor momentum.”
Translation: 4 Week Industry / Factor Momentum is significant!
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3844484
“Therefore, we conclude that factor momentum may be specific to a certain set of factors but does not apply to all of them.”
Translation: not all factors trend well, some do better than others!
“We uncover why the betting against beta factor exhibits the strongest factor momentum.”
Translation and my grain of salt: Betting against high beta (factor ranked, e.g., the stocks with the highest beta get the highest weighting in the portfolio) is very profitable. Now my grain of salt: only if they are overcrowded and have established a downtrend + an inflation / deflation regime.
“Prior literature such as Rouwenhorst (1998), Hong et al. (2000), and Fama and French (2012) has documented that the stock returns of small firms yield stronger autocorrelations than those of large firms.”
Translation: THAT MEANS Small cap stocks trend well (up or down). + Factors work better on small caps!
Here are the factors in the order of their “performance power” (important: all those factors create alpha in a buy and hold port of this factor (over the long term!), so you got a lot of tailwinds to start with!).
In bold, factors I use (I know, I got some work to do!):
I do not want to overweight the findings of those academic papers.
I only believe what I can replicate with my trading systems!
BUT:
I found out that small caps trend very well with the following factors: low volume, stock price momentum, industry momentum, quality, EPS up revisions, quality, value. Kind of (not all, but mostly!) in line with the findings of above academics!
Residual Variance: I am not sure if I understood that factor. But I bloody need to because it trends perfectly (as you can see in the above table!). Still much work to do here!
From what I understood: those are high volatility stocks that is not explained by beta. Beta is (simply explained): Market goes up 1%, High beta stocks with a beta of 2 go up 2%.
Residual Variance is: Market goes up 1%. The stock does not move with the market. The market goes down 1%. The stock does not move with the market. Then the stock is up 20%, even the market is down on that day. Residual variance is volatility that cannot be explained by the market volatility. And tight price action follows monster spikes.
My best guess is that stuff is traded by Qullamaggie and co.
https://qullamaggie.com/my-3-timeless-setups-that-have-made-me-tens-of-millions/
I traded residual volatility on small cap runner stocks from Nov. 2020 - March 2021.
Stuff like that (got lucky on that one!):
I believe that this factor is captured by the breakout patterns of Qullamaggie. I watched his stream, and my take is that he implicitly gets a good feel when those setups are worth to be taken (based on the tape of the market!).
Once again, that factor trends like hell. No wonder Qullamaggie is monster successfull!
Also, my findings are that you not only can be short high beta, but there are also times when it is great to be long high beta (Trend follower I know are long and short extremely successfully depending on the trend!). In line on the short side, not in line on the long side with above academic papers.
To sum up the most important:
It is much better to look at indexes that have a clear and trending well factor combination instead of indexes which cloud your vision because they are a mixed bag of different factors! Industry indexes can help here too, Or go through a ton of charts to see strength and weakness (try to find a common theme / factor) below the surface.
Small caps trend well! Small caps with clean factor loadings trend even better! Same with high beta.
So, it is important (for me!) to create and look at systems (their capital curve!) that contain factors that trend well.
2) Pay attention at crowding
My best guess is, that crowding, and expensiveness of the factor is more important than the Rate of change of GDP and Inflation and ROC of policy.
At least that is what I saw the last 2 Years.
Why in hell was high beta trash (ARKK) not strong in 2021 even we had a blazing reflation / goldilocks market?
The factor was expensive historically to itself and it was extremely crowded (still is today: (https://www.msci.com/research-and-insights/insights-gallery/which-factors-may-be-crowded).
My assumption is: if a factor is overcrowded and is expensive to its historical basis and is weak, the big three in macro do not help anymore! If that is the case, even a blazing reflation regime does not help as we saw with the terrible performance of ARKK in 2021.
But also: The stronger (and higher cap) high beta stocks started to tank in the moment we went from a reflation regime to an inflation regime, so the strongest high beta (Bigger caps, good earnings) stock hold up (but stalled in Q2-Q3!) in a positive reflation / goldilocks regime and only started to tank when we went to an inflation regime mid-late November 2021.
3) The big three of Macro, Rate of Change in GDP, Inflation and Fed Policy (42Macro.com will help to find out where we are!).
GDP up, Inflation down: Goldilocks —> Small cap value momentum (stock momentum and industry momentum) is doing well! High Beta (small, mid and big cap) is doing well.
GDP up, Inflation up: Reflation —> Small cap value momentum is doing well. High Beta (especially mid cap) is doing well. Bonds are underperforming. Also, from the experience from November 2020 – March 2021: Residual Volatility is doing extremely well (small cap stocks with a runner pattern do great). Flat base over years, spike and then one tight flag after another, buy into the tight flag breakout. Also, if you have reflation in the USA, Germany and China at the same time you can make fortunes in a very short timeframe. Press hard on the long side and BTFD!
GDP down, Inflation up: Stagflation —> Small cap value momentum is doing well. High Beta is not doing well at all! Bonds are not doing well. Shorting High Beta in a downtrend with extreme high valuations is a good idea. Combine with longs on small cap value momentum and you are protected!
GDP down, Inflation down: Deflation —> Nothing is doing well, besides long bonds! Very big risk of a liquidity event! Shorting High Beta is a good idea.
Positive Storm for high beta:
Goldilocks or better Reflation —>
High Beta relative cheap to its history and not overcrowded.
High Beta Systems show relative strength, especially when the market has a drawdown.
Just look at the performance of high beta from April 2020 to November 2021.
High beta was relative cheap to its history up to around the beginning of 2021. 2021 the crowding started. BUT High beta no earnings trash (ARKK!) did not well the whole 2021 (crowding and very expensive!).
Negative Storm for high beta:
Inflation or Deflation —> Inflation is now the case
High Beta relative expensive to its history and overcrowded —> This is now the case
High Beta systems in a downtrend and relative weak to the market —> This is now the case.
Let us define a positive Storm for small cap value momentum:
Goldilocks or Reflation or Inflation (so, nice to see that small cap value momentum is doing well around 75% of the time!). —> We are in inflation!
Small caps relative cheap to its history (now the case) —> THIS IS THE CASE NOW!
Small cap not crowded —> This is the case now
Momentum not crowded —> This is the case now
Negative Storm:
Deflation —> we will get here in 2022, be carefull!
Small caps relative expensive to its history
Small caps overcrowded
Small caps getting more and more beta
Momentum crowded
External Risk event (War etc.)
What is important now?
Well, the question is how long the inflation regime will persist.
The moment inflation will tank with GDP (and this will be most likely the case in 2022!) my beloved small cap value momentum book will tank hard.
So now is not the time to be long only, because the risks are too high!
The short stays on and depending on what I see on SARK (a short ETF on ARKK), I will switch part of the IWM short to (be long) SARK.
Let’s see!
So here you have it, that is what I learned trading a sub 1 Million portfolio for the last two years. I hope I can transfer that knowledge into performance (which is the harder step!).