Specialize on regimes!

Wait to hit! OTHERWISE PROTECT!

Specialize on regimes!

As posted, you can expect the following base regimes with the following distribution:

·        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)

www.42Macro.com for example defines both inflation and deflation as risk off regimes and I agree 100%.

So now the big question: Can you make money in all 4 regimes?

Yes possible, but the variance of your returns is totally different. For me and my guess is for almost all traders it’s much easier to make money in goldilocks and especially in reflation.

My take: You can be happy if you keep your money in inflation or deflation and do not suffer from big DDs. Do not expect a +50% year in a deflation or inflation environment.

Yes, you can make a ton of money in let’s say deep inflation regime that goes for 3-4 Quarters (like in the 70s!), in such a blazing inflation regime you buy gold and small cap gold miners or bitcoin, and you make a ton of money. If that comes, be ready, but do not expect every inflation regime to give you such a chance.

And yes, you can make money in a deep deflation regime, but most likely that will not go on for more then 1-2 quarters, because policy (Fed, Government) will try to get out of it as fast as possible.

And in a super deep deflation regime liquidity crisis arise and all correlations can go to 1. You might be right 100% on a trade but counterparty risks bankrupts you. Let’s say you are long $VXX in such a regime and they (your counterparty) stops trading it or they go out of business. Unlikely yes, but possible in when correlations go to 1. Why take that risk? Do you go sailing in a hurricane?

Just have a look at the behavior of long duration treasury bonds in March 2020, they should have gone up but at one point the market was so illiquid that they went down with the market (and the FED had to step in to save the bond market). For me the only alternative in such regime is the dollar and the dollar will not make you 100% in 3 Months.

And let’s face it, turbulent markets like in Feb 2020 or in 2008 are simply very hard to trade. These markets are much faster than smooth goldilocks or reflation regimes. They are faster and also, we (usually) have not much experience trading it. Yes, there are traders who get famous (“The Big Short”) in such environments but watch the film on see that the BIG SHORT almost did not work out and a ton of people where short and still lost everything (being short BBB rated Asset Backed Securities and long AAA, both went to (almost 0) since correlation went to 1 and counterparty risk kicked in).

If you are not the best of the best, my take is you need to specialize on regimes

“Bulls make money, Bears make money, but pigs do not” is an old saying on wall street. And the way institutions (FED, Government) behave I doubt that in general even the best short traders (specialized on inflation and deflation regimes) had a good time since 2008.

Furthermore, shallow regimes behave totally different then deep regimes. That is a huge trap. Right now, a ton of people are long gold expecting a ton of outperformance in a shallow inflation regime (following one service that has that regime called).

I lightened up (unfortunately cash instead of $TLT) since March 2021 much too early because I did not understand that a shallow deflation regime was in the outlook and that this one is a whole other story then a deep regime.

Shallow means, the market does not know and so we do not know. Shallow means that one relatively small external factor (FED, another virus, a war, whatever) can move the regime to another or make it deep fast.

Basically, that happened in the first quarter 2020. A shallow deflation regime was expected and then Covid made it deep very fast. Everyone wanted to ride it through, positioning got extremely crowded (that and Covid was the tell, see @Crowded_Mkt_Rpt) and then boom.

Portfolio Construction

Portfolio construction is the hardest part of everything in trading. You can be right on the regime and still mess it up within the portfolio construction phase. I am an expert on this mistake ;-).

So, what means that to your portfolio construction?

I try to keep it simple: Specialize! Make a ton of money in goldilocks and reflation and protect money in deep inflation and deflation and protect money in all shallow regimes.

And yes, try to make a bit of money in all shallow 4 regimes but be protected and prepared for a fast regime change or a deepening one.

Let’s begin with a deep goldilocks regime

Easy for me because my strengths are in quality small caps (ranked by momentum, industry momentum, value, growth, growth estimates going up recently, quality).

I go long 100% long those stocks following my systems specifically designed for this regime.

I do not meddle around with risk ranges; I simply stay long and ride the relatively small drawdowns out.

Now let’s go to a deep reflation regime

Since we just had it from November to let’s say February and my memory is still fresh let me define it.

First of all, economic data needs to confirm it. Secondly price behavior needs to confirm it too. If it’s then global including China, you have the mother of all bull markets. Everything (besides long duration bonds, gold and defensive industries) goes up like hell. Valuations do not matter, quality does not matter, meme stocks occur.

I know I need to be better at that blazing reflation regime because I played it much too conservative.
I was up 53% from November 2020 – Feb 2021 and I tell you the market gave room for much more performance!

If you have a small account (sub 1 Million) and it goes on for 1-2 quarters, you can make money for the next 5 Years. I am talking 100% and much more in a very short time frame.

That is the regime to get aggressive! If you have good stock picking strengths just do not play ETFs in such a regime, because under the hood of the market there are stocks that go up 10-Fold and more!
CANSLIM Trader like @markminervini make their money with 5-7 Stocks and 50% - 100% margin (pretty scary but get yourself into the offensive zone in such a regime) Microcap runner Trader (trading obscure China-plays) make 100-1000% in one trade.

I think its going to be a long stretch until such a regime comes back.

But that is how I try to trade it:

I would trade it with 5-10 small caps out of a system that is specifically designed for that regime (EPS estimates up is heavily weighted!), and I will go up to 50% leverage. Obviously, no hedges via $TLT, because it’s looser during a blazing reflation tape.

I do also not meddle around with risk ranges; I simply stay long and ride the relatively small drawdowns out and let my system churn the portfolio.

Inflation

50% $TLT, the rest in high quality small caps. If the regime takes long enough the industry momentum ranking factor starts to pick small cap (gold) miners and stocks that do well while inflation kicks in.

Why $TLT: it’s a hedge that does not cost you much or even profits in that regime!

Deflation

At least 50% TLT, 50% Big cap growth compounders are a good selection. As soon as volatility is trending: Cash!

Why $TLT: it’s a hedge that does not cost you much or even profits in that regime too!

Why not TLT if volatility is trending? Because a deep deflation can produce correlations go to 1 and then everything has counterparty risk!

Now let’s get to a shallow regime. All 4 shallow regimes!

As I laid out, a shallow regime means that it can be pushed to a deeper or to another shallow regime quite easily by whatever event. Sentiment, positioning and policy get more important.

So, it’s time to be careful and to lighten up your expectations!

Shallow means, nobody knows anything because it can change very fast. A train going 30 km/h can be stopped (or reversed) faster than a train with 200 km/h.

I stay in TLT with 40-50% of my port and the rest are high quality small caps with great EPS up revisions. The only thing I have to time then is the reflation regime, since long duration bonds do o.k. in goldilocks and good in inflation and deflation.

Closing thoughts

Obviously, I am still learning that stuff and being in the heat of fire is something else then writing about it.

Since institutions like the FED and the Government want a goldilocks regime or a reflation regime why should I specialize on inflation or deflation? In deep deflation counterparty risk kicks in. Additionally, for me and I think for the most traders reflation and goldilocks are easier to trade.

My main point is: Specialize on regimes. Make your money in goldilocks and reflation and try to protect it at all costs in all shallow regimes and in a deep deflation or inflation. Just do not expect that a shallow regime or a deep deflation or inflation regime will produce extraordinary results. Patience is key.

Wait to hit! OTHERWISE PROTECT!