Know the tape of the market!

And if you trade and do not know the regime its gambling.

O.k. let us dive into it.

Without knowing in which regime (the “tape”), the market is in and putting money at risk is not trading. Its investing.

Yes, you can invest. If you are young and cost average as much as you can into the SPY for the next 25 years, I think it’s a great way to build a small fortune, also because the SP500 index itself is an o.k. kind of big trend following system that rebalances yearly. And you use the cost average effect. Further, I am a huge fan of investing in the USA (#secularbullmarketUSA), but this is another post.

And if you trade and do not know the regime its gambling.

But if you are a trader, you read the “tape” in order to know in which regime the market is.

I know dozens of traders - including me :-) - who made a fortune from 1996-2000 just to lose everything or almost everything from 2000-2003.

We usually had a (high beta) momentum strategy that made a killing between 1996 and 2000 and it worked beautifully. But a (high beta) momentum strategy works only in some of the market regimes and get destroyed in others.

So that is my main first point. No standalone stock trading strategy works well in all market regimes.

Therefore:

1.      Stock Strategy Portfolio

2.      Market Regime —> Picks stock strategies out of the strategy portfolio —> capital allocation to the selected strategies.

Well, you can also run a book of strategies that combined bring a good performance. But the holy grail of trading is to pick the right strategies for the right regime.

So how to know the market regime?

1.      A real good way to start is the following letter:

Read it from top to bottom.

If you got this consider 42Macro.com and sub to the daily and weekly product (most important is the weekly product). Yes, its 100$ a month (combined for both weekly and daily service) but in my view it’s the best service out there for picking up the market regime. It will be a steep learning curve but put in the work! Darius is running 42Macro, I am not affiliated with him, but he is a good friend of mine even I never met him personally (besides E-Mail and Skype Contact).

Furthermore, a good source is https://www.businesscycle.com/. Unfortunately, they are not open to retail investors, but they give a way a ton for free.

Look, my strengths are not in macro. I do not want to be disrespectful, but I simply have that part outsourced to 42Macro (and some other services).

2.      You have to think in rate of change terms and the second derivative (or the slope) of the rate of change

O.k. that’s hard to understand first, it took me decades. But this is how markets work. Nothing is absolute in markets. Absolute numbers mean almost nothing.

You might for example wonder why a stock gets beaten down on a great quarterly report, which might have a 50% earnings per share growth and a 30% sales growth number sticked to it. But then the company releases guidance that the next quarters they will only grow with 43%. Mostly (depending on the market regime) such a stock gets beaten down hard. Why, because the second derivative of its growth outlook (let’s say the acceleration of the acceleration) turns negative. So, it’s still fast growing, but it grows less fast.

The same thing happens right now on a macro level. GDP and Inflation were going up from approximately November 2020 – April 2021. Now we are slowing (a bit) on both and that is enough to change the behavior of markets completely.

3.      Most important Rate of Change Factors

Macro:

·        GDP: is the rate of change positive or negative?

·        Inflation: is the rate of change positive or negative?

·        Fed Policy: is the rate of change positive or negative?

·        Government Policy: is the rate of change positive or negative?

·        External Shock: like 2008 or 2020. You can see that there is an external shock if volatility is trending. Just pull up a chart of $VXX and see if it makes higher highs.

If you take GDP and Inflation, you get a grid. 2 times 2 = 4 Market Regimes.

Goldilocks (Regime 1): GDP up, Inflation down (around 26% of the time)

Reflation: GDP up, Inflation up (around 15% of the time)

Inflation: GDP down, Inflation up (around 37% of the time)

Deflation: GDP Down, Inflation down (around 22% of the time)

(I got the % behind the Regime from

)

And it is a bit more complicated than this. There are more then 4 regimes.
It depends on how deep the regimes are in their space. Is GDP and Inflation tanking fast at the same time? That would be a deep deflation regime. Now, if they are not tanking and only slowly decelerating from a high absolute number and at the same time the Fed is still pumping money into the system certain parts of the market can do actually still pretty well.

Also, there is an economical tape and a price, volume, volatility tape (so how the market is behaving right now: what has relative strength? Growth versus value etc.).

When both align you have a strong signal. I will go deeper in that nuance at a later post.

Back to my points:

Now if you can nearcast the above macro factors for example via Prometheus Research or 42Macro.com you have a great start.

You can trade for example futures or ETFs based on the market regime!

Which is fine, if you simply do not have the time to invest or want to start here. If you master that step, you are better then let’s say 95% of the pack. Even (the biggest) institutions cannot trade those regimes in an agile way, because the portfolios of Blackrock can not put on their trades fast enough (not enough liquidity!) to fit the market regime (so they go 60% Stocks /40% Bonds and stuff like that).

But this is not what this letter is about. I want to go one step further!

Stock Factors (know CANSLIM, then you will find some stuff here!)

·        Earnings and even better Earnings estimates: Rate of change positive and if yes, does the acceleration even accelerate more?

·        Value (yes, on small caps still important but only if you combine it with other factors)

·        Momentum

·        Industry Momentum (by the way this will very often, but critically not always pick the right stocks fitting the market regime, but there are 10% of the case exceptions and then you lose your shirt!)

·        Quality

·        Institutional Ownership

If you know me, you know I am a big fan of www.Portfolio123.com and I created over 250 (mostly capacity constrained) Strategies the last 11 Years on their platform and I am actively using about 10 now.

So here is my strength, I am good at the stock level. But I am not so good at the macro level, so I simply outsource it, learn and try to improve my tape reading skills at the same time.

4.      Use your strength!

My main point here is: Usually the strength is in one of the above camps: macro or stock picking level. Some of the best traders read the tape observing their stocks and the sentiment of the market. They go both strengths, but my assumption is this combination is rare.

If you have a great stock picking strength:

Use it. But know when to press (progressive exposure) and know when to lighten up, to hedge with long duration bonds or be in 100% Cash (or long the dollar).

Therefore:

Know the tape!