The Price of Caution

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Is it possible to be too cautious? I think I am learning the hard way this year that being too cautious is very possible and can be expensive. I have had a really tough year with Returns (or rather, lack of) and although a big chunk of this has been down to a sucession of Profit Warnings from big Positions, another aspect has been down to me taking a very cautious stance this year. It has hurt in 2 ways - the most obvious is the drag I have suffered from large Short Positions and the other impact comes from me failing to “Buy the Dips” when Markets were low (although at the Brexit Vote Lows back in June I did close half my Shorts which was in effect the same as Buying the Market in a big way).

This is a bit of a cathartic blog for me, cleansing the WheelieSoul (no, not the WheelieAr**hole, that’s a different part of the WheelieAnatomy and best avoided…..)

Why have I been so cautious?
At the end of each year, I start to think about the year ahead and how I should approach it and I amend my ‘Rules / Trading Parameters‘ accordingly. The following 5 Possible Outcomes for my Portfolio each year very much colour my thinking:

• Big Loss
• Small Loss
• Breakeven
• Small Gain
• Big Gain.

Of these Possible Outcomes, there is only 1 that really fills me with terror - the first one, A Big Loss (by the way, this is a structure of thinking that Ken Fisher espouses in his ‘The Only 3 Questions that Count’ book).

Most years I start off expecting one of the ‘middle’ Outcomes - i.e., Small Loss, Breakeven, or Small Gain and this essentially means that I can start off with near 100% Long Exposure and be reasonably aggressive with Buying Stocks and adding to Positions where appropriate. However, this year I was very much thinking there was a large likelihood of my Portfolio making a Big Loss over the year - and obviously it was very much in my mind that I needed to avoid this entirely undesirable Outcome.

The reason for me expecting the ‘Big Loss’ Outcome was obvious - the Brexit Vote was due in June and it was most likely that this would cause some falls in the Markets (I hate the use of the word ‘Volatility’ by the Financial Media - whenever Markets are in trouble they call it ‘Volatility’ when what they really means is “Markets are dropping like a brick”). In addition to this upcoming Vote, Markets had already come off their Highs in April/May 2015 and we certainly seemed to be heading for a Bear Market with Indexes falling out of their 5 Year Uptrends in many cases and Moving Averages looking pretty rough.

I got caught out very early in 2016 - we had a big collapse in February and I got suckered into placing Protective Shorts on the FTSE100 as Low as 5800 - needless to say this was just before it bounced big time. A possible error I made here was not using a Stoploss - ths is something I have been thinking about a lot this year and I have yet to decide how to do this when placing Hedges but it might have helped me a lot. 

As we had the Brexit Vote coming up, I was not too concerned about letting the Short Hedges run - it was pretty obvious they would be needed at some time and as it happens I was spot on. The Markets rallied before the Vote and I managed to place more Shorts higher up and when the Markets tanked just after the Vote, I managed to close half of them for a very small Loss but I made an error perhaps in keeping the other half open. If I had closed those Shorts I would have crystallised a Loss of probably about 3% of my Portfolio value - that is a lot but in reality I would probably have been better off if I had done that (and it would have avoided a lot of angst and soul-searching). Unfortunately, this is Outcome Bias - otherwise known as Hindsight…….and entirely unhelpful.

This has left me in the situation where I am sitting on a chunky Paper Loss on a FTSE100 Short Position and I am eager for a Drop in the Markets to enable me to ‘escape’ in as cheap a fashion as I can. To help with this task, I have just in the last week added to my Shorts so in effect I am ‘Averaging Up’ (the Opposite of Averaging Down when you are Long on a Position). We are now coming into the historically worst period for the Year after a strong rebound from the Brexit Lows - it strikes me that the Upside here is now pretty small for various reasons but the Downside is disproportionately large.

Why did I get caught out in February?
I was doing the washing up this afternoon and somehow my mind drifted to thinking about what I was going to write in this blog to finish it off and I thought it would be useful to investigate what went wrong (if it did) earlier in the Year when I shorted after the markets had already tanked a lot (which with the wonderful advantages of Hindsight now looks like an unbelievably dopey thing to have done).

Regular Readers will no doubt have heard me reciting ad infinitum about how I try to make Buying and Selling Decisions ‘Out of Hours’ and not while the Markets are in full swing during the day which can impact my emotions. Building on this, I rarely make snap-judgements and quite often I am thinking about buying or selling a particular Stock for as long as several weeks before I actually make the Decision to act. Bearing these concepts in mind, I don’t think I can be accused of making an Emotional Decision - I certainly considered it a lot and probably discussed with a few mates as well. Rather than using my ‘Fast Thinking’ Brain and making an emotion charged knee-jerk Decision, I guess it is possible that I did think very rationally and carefully but still came up with the ‘Wrong’ answer !! 

Since reading Daniel Kahneman’s utterly brilliant ‘Thinking, Fast and Slow’, I am very conscious of the ‘System 1’ kind of instant, emotional, thinking and try to avoid this as much as I can (in reality you can probably never over-ride all the System 1 emotions and biases). If you are fascinated by the Psychology of Investing and Trading like myself, then pop over to Wheelie’s Bookshop and there is a half decent summary of the Book I scribbled a while back.

One of the big difficulties of doing this kind of ‘after the fact’ analysis is that it has copious amounts of Hindsight and Outcome bias - and of course I cannot really replicate the Emotions I would have been feeling at the time. One of the big factors around this fall in February was that no one could really sensibly explain why it was happening and it caught everyone off guard. This is most unusual, normally the Media has a very clear narrative on why the Markets are tanking (even if it is daft or overdone or whatever) but this time it was rather Woolley. Market ‘Experts’ seem to be saying now that it was caused by fears over China growth but I’m not sure that really was the consensus at the time - much of it seemed to be related to the plunging Oil Price and the impact this could have on Banks that had lent to the US Fracking Industry - there was a lot of fear around a possible repeat of the 2008 Banking Crisis.

My thinking at the time I believe was that I was very concerned that Markets were in serious trouble and my placing of the Shorts was to act as Insurance to protect my Long Portfolio of Stocks. It was a Preventative measure and I still think that was a reasonable Decision.

However I think about this, the reality is that maybe I made the ‘correct’ Decision based on the information available at the time - but as I hinted earlier, maybe my real error is to have not used a Stoploss. Had the Stoploss been triggered, then that would have been the Cost (the Premium) for the Insurance.

What was the Alternative to Caution this year?
As it turns out (keep ‘Hindsight’ in mind whilst reading this) being very much ‘Risk on’ and buying the Dips has really paid handsomely this year and I am obviously very envious of the superb Returns many Investors and Traders have made so far this year. This gives me terrible FOMO (Fear of Missing Out) but that is a subject for another day……

How much of this is Skill and Analytical Ability and how much is really down to Luck? I suspect this might be simplifying things as I will explalin in a bit, but to a large extent I think many Investors (not Traders, I will come on to that in a mo) have a Default Position of “I just stay 100% Invested” and I see comments to back this up along the lines of “I don’t know what the Markets will do so I don’t take any Risk in trying to Time the Markets” - my issue with this statement is that by being 100% Invested in the Markets such Investors are in reality taking Enormous Risk - so far in 2016 this stance has paid off big time but what happens when we do get the next serious collapse in the Markets? Would this “Stay 100% Invested” stance have paid off in 2008? (the answer is no obviously).

At some point, ‘Buy the Dips‘, will no longer work…….

Traders do not run these kind of Risks - by being In and Out of Positions over short periods of time, they can be Out of the Markets when things are bad (or go for tactical Shorts) and they can be In the Markets when things are good on the Long Side - but this takes Special Skills, Screen Watching, Focussed Time and the inclination to do this kind of thing. It is not for me and I can’t imagine anything more miserable to be frank.

I guess the Approach to the Markets for each year depends to an extent on your Financial circumstances and other ‘Assets’. I guess for many People they actually have a decently paid Full Time Job and this means that if they screw up on the Stock Portfolio, then they can always earn a living from the Job and this is a sort of Safety Net - it is using their ‘Human Capital’. This in a way may apply to many Full Time Investors as well - they either have huge piles of Capital or perhaps a Spouse that Works or maybe they are in a position where if the worst comes to the worst, then they can go back and earn good money doing a real Job.

Sadly this ‘Get a Job’ option is not available to me. Firstly, I cannot imagine anything less appealing after 7 years of Retirement and secondly my Health just won’t allow it. Therefore, whenever I foresee a difficult year ahead where a ‘Big Loss’ is a very real possibility, I have to take appropriate actions to lower my Risk and play things in a cautious manner.

On the flipside of this, when I think Markets look very favourable, I really do take an aggressive stance and try to maximise my Gains - this was certainly the case in 2015 and regular Readers will be able to see how I added to Positions in Winners and did little in terms of Hedging.

Complacency is off the Scale
The crux is that Risk taking has hugely paid off this year but it is just as possible that things could have turned out very badly - in fact, I suspect even many of the Risk takers are surprised by just how strongly the Market has rallied - I saw very few (if any) People on Twitter saying that they expected Markets to rally hard after the Brexit Vote result.

I am seeing many comments along the lines of “didn’t we do well buying the Dips and staying invested” etc. - but I suspect there is a huge amount of Outcome Bias here - what would people be saying if the FTSE100 was now at 5500?

Obviously I am Jealous, Bitter and extremely Twisted……..

Many comments on Twitter strike me as utterly complacent - there seems to be a belief that Markets will keep rallying forever and this is based on nothing apart from the momentum effect of the rebound so far and the low Pound Sterling. In order to appreciate this complacency, you only need to look at the VIX Volatility Index (the ’Fear Gauge’ - this is based on US Options Contracts or something and moves Inverse to the US Indexes), which is at multi-year Lows and the sad truth is that a Low VIX is a predictor of a High VIX - and the latter means trouble.

In fact, the VIX is now at pretty much its lowest point since 2007 and just before the Credit Crunch - that seems rather ominous to me……

Where are we now?
Something people with decent Gains this year might want to think about is how to protect those Gains to make sure they come out of 2016 with a commensurate Result - it is no good being up hugely on Paper now if you then go and lose it all during an Autumn Sell-off. Of course there are no guarantees that Markets will struggle in the Autumn but the history is totally against the Bulls here. For me the likelihood is for falls in the Fall and the Risk of further Gains is very small. However, the end of the Year with the November and December months is nearly always a very strong Period and I intend to be very much ‘Long and Strong’ for those final Months of 2016 and I might even do some Tactical Longs on the Indexes.

I recently added to my FTSE100 and Nasdaq100 Shorts to try to Hedge my Long Portfolio as we come into this difficult period (see my ‘Trades‘ page for full details). In addition, the Possible Downside Catalysts are mounting up as follows:

• Valuations are stretched everywhere - I see loads of Stocks on P/E Ratios in the Mid 20s or higher and although this lacks any science, I sense that these are the highest I have ever seen since the Dotcom Boom in 1999/2000. In addition (ok, I accept it’s rather simplistic and crude) if you look at Historic P/Es for all the Major Global Indexes, very few, if any, look decent Value.
• A good guide for me personally is that when I look through the ‘Company Results’ section at the back of Investors Chronicle every week, I am finding less and less Stocks that appear worth buying - that is a very noticeable development in recent months.
• Oil seems to have got itself into a Downtrend again - from what I can tell there is a huge Glut of the stuff and it will take a long time to work this excess inventory off - with Oil low, the FTSE100 may struggle.
• Central Bank Policy has lost the plot - Negative Interest Rate Policies (NIRP) are everywhere and Bond Yields have fallen across all time periods and Risk Ratings - I struggle to see how this can end well.
• I am totally of the belief now that Gold is back in a full on Major Bull Market - the implication of this is that if Gold starts to really rise up then Higher Risk Assets like Stocks, Asset Backed Securities, weird ‘Alternative Investments’ like Classic Cars and Low Rated Corporate Bonds etc. may start to sell off.
• Western Economies are turning Japanese - I still see talk about Inflation but I have a suspicion that Inflation is rarer than a live Dodo - the reality is Deflation and it is chronic. Economies are stagnating and have only been fuelled by high levels of Immigration and Central Bank Magic Money - this is not sustainable and the cracks in Social Cohesion (in terms of Racism and Terrorism) are starting to show and wealth Inequality is resulting in the rise of Extreme Political Parties on the Left and Right. Ageing Populations and over regulated Economies are combining with advances in Information Technology and Robotics to drive down Wages and hollow out Jobs. If you want to see where Western Economies are going then look at the state of Japan after 20 years or Recession.
• The US has a real possibility of electing an utterly useless President - either the continuation of failed Foreign Policy and entrenchment of Wall Street and Washington Elites under another Clinton or the unpredictable knee-jerk policies of Trumpy (daft haircuts will be compulsory).
• High Risk of Bank Sector collapse in Europe and the rising problems of Terrorism which in many Countries is staring to take on the flavour of a Civil War. Chronic underemployment of the Young in the Southern States - a timebomb waiting to blow I suspect.
• UK facing an Economic Slowdown despite the best efforts of the Bank of England to pump in Monetary Stimulus and the likelihood of a splashing of Cash by the new Chancellor in the Autumn Statement. The obvious culprit is Big Business delaying Investment Decisions until clarity of the relationship with the EU is determined (this will take years) but it also appears that the UK Economy was already struggling prior to the Vote. No one should be surprised, we all know that the UK Economy has been overly reliant on the Housing Sector and Consumer Consumption for many, many years.
• Apart from the US which has a Presidential Problem, other Economies around the World are a mess. China is clearly not in good health. Japan is an utter Basketcase and the Poster-Child for how Western Economies will turn out in coming years. Brazil is nuts (took me ages to think of that one !!). Much of Latin America is worse than Brazil. Australia is struggling as it was too reliant on Mining. Africa is Africa. Middle East is a War Zone. France is screwed. Spain is barely recovering but has an inability to form a Government. Greece is very sad. Ireland is apparently booming but it is very small in the big scheme of things. Italy is facing a Banking Collapse. Germany is ok but clearly Brexit puts them under immense pressure and the Immigration and Terrorism issues could easily see Merkel out of office. I could go on……..
• The simple fact is that the recent Rally in Stocks has no justification in terms of Fundamentals - it has all been fuelled by an expansion in Valuations as ‘Investors’ (and Traders) have been taking on more and more Risk. I even saw some Commentator or other saying something like “this time it’s different, Valuations on Stocks can go much higher because of Low Rates” - to be frank that is utter boll*x and whenever someone says “this time it’s different” it’s well worth remembering that with the Stockmarket it never is. Valuations matter.

For completeness, there are some reasons for more Upside:

• Markets have strong Momentum (The Big Mo) especially in the US where pretty much all of them have broken out to New All Time Highs - which is usually a Bullish development.
• The preponderance of copious dollops of QE (Quantitative Easing - Money Printing) - the theory is that QE drives Stock Prices up but in reality this link is unproven and the link could be coincidental rather than causal. In addition, it is very possible that at some point the negative side-effects of QE could cause Markets to fall - this might already be happening in Japan where ever increasing Stimulus Measures seem to have little effect now.
• Pockets of Stocks are cheap - for example in the UK I think Housebuilders are still good value. This might not mean that Indexes keep rising though, it might be that there is a rotation out of the more expensive Sectors and into the cheaper Sectors. This rotation could also happen if Markets were to fall.
• This is not a reason for more rises in the Markets per se, but some support could come from decent Dividend Yields on many Stocks - the ‘Hunt for Yield’ has got even more powerful with Rates so low now.

Conclusion
I am pretty pleased that I have scribbled this blog - it has certainly forced me to face up to a major screw up that I made earlier in the year with regard to placing Shorts when the Market was far too low - the error was clearly around not using a Stoploss. I must learn this lesson.

I have paid the Price this year for being very cautious (although that was a reasonable stance prior to the Brexit Vote) - if I am fortunate, I will be able to close my Short Positions over the next couple of Months and I can be a bit more aggressive going into November and December. As a result of the strong rebound in the Markets in recent Weeks, I have a lot more confidence that we will not be seeing a major collapse in the Markets this year and I am already planning my Strategy to heavily increase my Exposure if we get a decent Autumn Sell-off - if I can pull this off, I might be able to save what has been a very difficult year for me so far.

Something that has helped the Psychology of lagging badly in terms of Results is that the problem is really confined to my Spreadbetting Account which is suffering from the impact of the Shorts. I can draw strength and fortitude from knowing that my Trading ISA is now up a bit on the year and my Income Portfolio is up around 12% - so I must be doing something a bit right !!

I guess these things are all sent to try us……..

Cheers, WD

Related Blog you might want to partake of:

My Parameters/Rules Template (I amend each year):

http://wheeliedealer.weebly.com/blog/yearly-trading-rules-parameters-template