Trading Systems: What to do when Surprised
Sometimes the investor or trader — who must have a disciplined method — may be surprised by the results of that system. What is the appropriate reaction?
In developing methods with our systems guru, Vince Castelli, we came up with a useful analogy. In the movie, The Right Stuff, the NASA scientists and engineers are competing to put man in space faster than the Soviet competition. They come up with a pilot module with no window. From the engineering perspective, this made sense. They had developed a capsule ridden by a monkey; putting a man in the capsule was symbolic, not essential.
The early astronauts, all high-profile test pilots, had a different view. The window was necessary so that the pilot could control the craft!
In our methods we agreed to have such a window, allowing the human managers to override model trades when circumstances dictated. Given this discretion, how should it be used?
We knew from experience that many traders used model results as suggestions. They made the trade when they agreed, sold quickly on any pop, and bailed rapidly if it did not seem to be working. We documented the results of this approach and discovered that it under performed simple adherence to the model — by a wide margin.
So why have a "window"? The only valid reason is if there is some surprise event that is not captured by regular market data. This means that the trader must understand the model, knowing when something has happened that is really unusual. It is not enough to have a different opinion. The trader who uses his own opinion is acting just like everyone else, not following the method.
Adhering to method when sentiment suggests otherwise is the definition of discipline.
Recession Obsession. CNBC asks everyone about a recession. Most of the non-economists express the greatest worry. Meanwhile, the actual economic indicators show the slow growth to be expected in attempting to achieve a "soft landing." Economists see 4th quarter growth in the 1 – 2% range. The data we follow — employment numbers, jobless claims, consumer sentiment, and the ISM confirm this reading. The ECRI, the best at recession forecasting while avoiding false positives, sees the same thing.
Fed Failure? Traders hate the Fed. Our survey of the blogosphere shows a tremendous divergence between traders and economists. The former group wants more rate cuts. Economists are much more nuanced in their interpretation. They have actually analyzed the TAF plan, and the need to direct liquidity where it is needed.
Valuation. Meanwhile, stocks have already priced in the recession. When this will change is anyone’s guess, but the continuing skepticism about financial companies weighs on the market. Lehman beat (lowered) earnings estimates, but the stock traded lower. My astute colleague, Brian Gilmartin, at TheStreet.com’s RealMoney site (subscription required) noted that if Lehman missed, everyone would say "I told you so." If they beat, people would not believe it. We add that this is in spite of the FAS 157 requirements, intended to force key disclosures. There is an almost daily rumor about Goldman Sachs, despite their repeated denials of write downs, and their announced employee bonuses of $16.5 billion.
As Morningstar suggests, it is time to buy.
All of this left us somewhat surprised that the TCA-ETF model has moved to a fully-invested position. As we have reported, the sector ratings partly reflect trends, so there is an element of momentum. The model also captures a cyclical component in sector moves and incorporates an element of anticipation: Trend, Cycle, Anticipation.
As part of our continuing effort to demonstrate the importance of system and discipline, we continue to show the weekly updates. While the last cycle was excellent, this one is off to a slower start. Looking at a cycle or two is no substitute for complete testing, so results are not intended to be indicative of future performance.
The model once again emphasizes foreign holdings and energy.
(We have no position in LEH. We are long GS.)