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Managing the Tail Risks

(May 31, 2009)

Dear Subscribers and Readers,

Let us begin our commentary by reviewing our 8 most recent signals in our DJIA Timing System:

1st signal entered: 50% short position on October 4, 2007 at 13,956;

2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

3rd signal entered: 50% long position on January 9, 2008 at 12,630;

4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

6th signal entered: 50% long position on June 12, 2008 at 12,172, giving us a loss of 3,671.67 points as of Friday at the close.

7th signal entered: Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 3,362.67 points as of Friday at the close.

8th signal entered: Additional 25% long position on February 24, 2009 at 7,250, giving us a gain of 1,250.33 points as of Friday at the close.

We first articulated our own concept and perceptions of risk in the financial markets in our October 30, 2005 commentary (“The Concept of Risk”).  Specifically, we argued that quantifying risk – especially in light of today's information age – is next to impossible (as many “quants” have found out to their dismay in the last two years).  What is needed is the ability to simplify each potential investment and filter out all the unimportant information – as well as minimize the number of real-world variables that we need to guard against.  From a practical standpoint – before one makes an investment or speculates – one should also do as much research as possible, and try to figure out whether one has an “edge” or information advantage over other investors (this typically is not the case when investing in US large cap equities).  Time is also a factor.  The longer term the investment horizon, the riskier the investment.  That is why having an exit strategy is as important (if not more important) than having a good entry strategy.  For those not familiar with our work, please read our October 30, 2005 commentary in full.  The steps we illustrated in that commentary have worked throughout financial history – from the period of the Medici family to today's modern portfolio theory and government intervention.  And they will continue to work even as the financial world continues to evolve in the 21st century.

I realize I had promised to pen a follow-on commentary outlining what we believe are some of the most important (both investment and social) trends over the next five to ten years.  In order to do so, however, I first need to put my way of thinking into context – specifically how I go about managing my risks (including life as well as investment risks) and exposure to certain trends and phenomena.  Only then could you, dear readers, understand why I focus on certain trends, while leaving out others.

While our concept of financial risk was clearly articulated in our October 30, 2005 commentary, it is not a sufficient framework – especially given today's globalized world full of capitalistic societies.  This has the fortunate (or unfortunate) result of exposing most of the world's citizens to “fat tail risks” – both on the downside, and happily, on the upside.

The concept of “fat tail risks” within many socioeconomic phenomena, such as wealth and income distribution, securities' returns, and crime statistics are clear.  These phenomena can typically be modeled by a “fat tail” distribution such as the Pareto distribution.  Our original concept and methodology of managing risks – including doing as much exhaustive research as feasible, and minimizing the number of risk variables within an investment or endeavor – is clearly not enough.  In order to have a complete framework of managing risk, we need to better understand the potential magnitude of each of our risk variables, and most importantly, the implications should any one of our “fat-tailed events” occur.

This is far from a trivial matter.  As a matter of fact, not only are seemingly “random events” occur more often than we believe they could, they also have a disproportionally big impact on our lives (such as an unexpected layoff, a tragic accident, or losing one's savings).  Thankfully, there are certain decisions one could make (aside from being one of the lucky few in the gene pool) in order to minimize exposure to the downside “fat tails” and maximize exposure to the upside.  Some of the obvious decisions include:

· Obtaining as much formal education as your ability (and psychological makeup) allows.  Not only does the amount of formal schooling have a high correlation to higher lifetime earnings, it also exposes one to a network that could be immensely helpful in one's future career.  In addition, there is a wide variety of high-paying professions that are simply not available to those without the necessary formal education – not even to those with a bachelor's degree.  Sure, some do succeed famously – including college dropouts (such as Bill Gates or Larry Ellison) – but those are the rare exceptions.  Conversely, having a minimal amount of formal education not only results in a lower average lifetime earnings, but would also expose one to other downside risks, including having to work in hazardous professions or having to work in hazardous areas.

· Marrying an understanding spouse, or foregoing marriage altogether for those who simply cannot make the commitment.

· Living in an area or working in organizations where one could find great mentors or others who could help one achieve his/her lifelong goals.  This should start as early as junior high school (7th grade or Form 1 for those not familiar with the US educational system) – although at this point, mentoring is more about helping instill leadership skills than in finding one's true calling in life.

I am of the belief that “the harder you work, the luckier you get.”  Be prepared to tackle what is needed to achieve your life-long goals, and one day, the opportunity will come.  In order to maximize the probability of achieving my long-term career goals (and our goals for MarketThoughts), I try to learn as much as possible about what's relevant for the financial industry (hint: nearly everything except for the gossip pages – well maybe except for Michael Jackson), and almost as important, network and as much as possible.  Conversely, I also try to minimize my exposure to downside “tail risk” with seemingly trivial decisions, such as never driving through the “bad parts” (i.e. areas with high crime) of Los Angeles, never getting drunk, and never burning bridges.  Remember, every life-changing “accident” originates with a seemingly trivial decision at first – and while these events could be classified as “random,” they don't appear to be so random after all if one made a rational decision early on to minimize the probability of that occurring.  A specific discussion of such events could be controversial, so I will stop here.

As most of you know, I started my MBA program at UCLA Anderson School of Management on a full-time basis last September.  Extending on the theme of maximizing my exposure to upside “tail risk,” not only will my MBA schooling allow me to tackle future business problems (if I never got my MBA degree, I would not even know where to start), it has also provided a forum for me to network with others in the financial industry as well as many UCLA Anderson alums.  As some of you know, I am also interning at a $1 billion fund of private equity funds this summer here in Los Angeles.  The combination of my MBA degree, the network, and my summer experience will propel me to a higher level of knowledge achievement and allow me to solve economic/business problems and better communicate my market views to you that none of my prior knowledge could provide.

Unfortunately, possessing an MBA degree – especially as the private and the public sectors continue to converge – is no longer sufficient.  Taking a step back, it is glaringly obvious that many money managers were “sideswiped” by the events over the last two years simply because they did not possess a broader background – a background that includes a sense of history and knowledge of how public policy is formed and implemented.  In light of what I believe will be a structural increase in government intervention and spending over the next five to ten years, I have decided to also obtain (and have been accepted) the MPP (Master of Public Policy) degree at the UCLA School of Public Affairs, with the following two concentrations: US social policy and international policy.  Among my many goals, I intend to develop a better understanding of US healthcare policy and financing, US poverty and education, and international political economy.  During the summer of 2010, my goal is to obtain an investment internship serving for a large public pension plan (or university endowment) such as CalPERS, CalSTRS, LACERA, etc.  CalPERS, in particular, has played a significant role in shaping investment and social trends, and I am looking forward to gaining significant experience and a group of future friends both this summer and next summer.  Extending my schooling for one year (the joint MBA/MPP degree takes a total of three years) would also allow me to network more and to make more friends – which would further increase my “optionality” to the upside.  Next week, I will go into more detail regarding other important trends that subscribers will need to focus on – within a personal context and from a standpoint of managing risks by minimizing exposure to downside tail risks and maximizing exposure to upside tail risks.

Let us now discuss the most recent action in the U.S. stock market via the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from July 2006 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 2006 to May 29, 2009) - For the week ending May 29th, the Dow Industrials rose 223.01 points, while the Dow Transports rose 196.66 points. From the March 9th bottom till now, the Dow Industrials and Dow Transports have risen 30% and 49%, respectively. Their most recent highs, however,occurred on May 8th, when they peaked at 8,574.65 and 3,351.17, respectively. While the short-term outlook for the market remains tited towards the down side, the strength of the rally since the early March lows has been strong - suggesting that this rally has further to go. Should the fallout from the GM bankruptcy be minimal, I expect the the May 8th highs to be broken in a matter of days. The intermediate term uptrend remains intact. For now, we will maintain our 125% long position in our DJIA Timing System.

For the week ending May 29, 2009, the Dow Industrials rose 223.01 points while the Dow Transports rose 196.66 points.  With the two Dow indices having risen by 30% and 49%, respectively, from their March 8th lows, there is no doubt that the market is still overbought in the short run.  That said, the Dow indices have encouragingly held up well.  While the market is still biased towards the downside in the short-term, the strength of the rally since the early March lows has been strong.  Combined with improving liquidity (especially given the successful recapitalization of the US banking sector and the more dovish stance of the European Central Bank), probability suggests that the rally has further to go over the next several months.  Furthermore, recent evidence suggests that the “tail risk” of an Eastern European financial collapse is off the table, for now.  Because of this, we will maintain our 125% long position in our DJIA Timing System.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The latest four-week moving average of these sentiment indicators increased from a reading of -2.9% to –1.3% for the week ending May 29, 2009.   Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending May 29, 2009, the four-week MA of the combined Bulls-Bears% Differential ratios increased from a reading of -2.9% to -1.3%. There is no doubt that this reading has reversed from a historically oversold reading in Marchand is now on a sustained uptrend. Moreover, this reading remains oversold on a historical basis. Subscribers should note that any reversal (and continuation) from historically oversold readings is usually accompanied by a significant rally. We will remain 125% long in our DJIA Timing System, and are now looking for a continuation of the rally over the next several months.

With the four-week MA still on an oversold condition (from a historical standpoint), probability suggests that both the rally and bullish sentiment has further to run, especially given the recent uptrend.  Again – combined with the recent recapitalization of the US financial system, the elimination of the Eastern European “tail risk,” the more dovish stance of the European Central Bank, and the dark clouds over the GM bankruptcy clearing – probability suggests the rally should continue over the next several months.  For now, we will remain 125% long in our DJIA Timing System, and do not anticipate shifting back to a 100% long position until this sentiment indicator rises into overbought territory.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator for the stock market.  Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present) - From its most recent peak on March 24th to just a few days ago, the 20 DMA has been consolidating in the 127- to 137 range - indicating that this sentiment indicator has been working off its short-term overbought conditions. As of last Friday, not only has the 50 DMA has caught up to the 20 DMA (suggesting that this sentiment indicator has now worked off its ST overbought conditions), the 20 DMA has also broke above it 127 to137 range. This suggests that we should see a continuation of the rally over the next several months.

From its most recent peak on March 24th to just a few trading days ago, the 20 DMA has been consolidating in the 127 to 137 range.  This consolidation phase has allowed this indicator to work off its short-term overbought conditions.  More importantly, as of last Friday, the 20 DMA has finally “broken out” to the upside of its recent range, rising to close at 140.01.  With this indicator still far from historically overbought levels, the ISE Sentiment reading suggests that the stock market should continue its rally over the next several months.

Conclusion: With the world's financial markets and economies still in the midst of evolving – and with many sectors set to undergo a fundamental “reboot” (including not just US financials, but also the US retail, restaurant, and media industries, among others) in the next five to ten years – it has become increasingly important to manage one's “fat tail” risks – not just on the downside but on the upside as well.  In next week's commentary, I will attempt to outline more of these risks and provide a framework to remedy some of these risks. 

As has been the trend since the March 8th lows, I continue to expect levered beta strategies to outperform for the rest of this year as global policy makers remain committed to halting the deleveraging in the financial markets.  With a recapitalization of General Motors, I expect more the bearish sentiment surrounding the stock and fixed income markets to lift over the next several weeks.  Consequently, I expect financial stocks, high yield bonds, and distressed debt to outperform all other asset classes on a risk-adjusted basis in 2009.  Starting in 2010, however, this trend should shift, as consumers and corporations around the world start to rebuild their balance sheets.  On a country-specific basis, I expect Taiwan to outperform as the Greater China region continue to liberalize and encourage cross-border fund flows and as the market has turned very favorable for semiconductor and technology stocks.    Whatever future growth we achieve will need to come mostly from Schumpeterian growth (I expect a new bull market in technology stocks), while true alpha would mostly be extracted from “exotic beta” strategies such as microcap stocks, foreign small cap stocks, private equity, and private real estate strategies.  With the darkest sentiment in decades and the sheer amount of capital on the sidelines, we have decided to “break with tradition” and go to a 125% long position in our DJIA Timing System on February 24th.  We will sell this additional 25% long position once the market rally starts to lose steam.  For those with a long-term timeframe, the stock market is still a good buy.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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