Top Macro Manager Talks Through Set-Ups, Triggers and Sizing Positions

This week I heard a presentation by a senior trader at one of the large global macro hedge funds which has been in business for nearly 20 years. He put across several insights into the way of working of those who engage in the strategy. The particular trades under discussion were in foreign exchange, in the Euro/U.S. Dollar, during last year.



Fundamental Set-Up

In FX there are three elements to the fundamentals that should be aligned for putting on a position, according to the trader. The first is valuation. In FX there are several valuation models which are commonly used though each has limitations. Purchasing power parity (PPP) for a currency pair is a value which is unobservable in markets, and is a conceptual level that actual FX rates pass through without pausing. Extreme deviation from PPP is taken as an under or over-valuation. The Economist uses the price of the ubiquitous McDonald's meal to calculate the "Big Mac Index", a guide showing how far from fair value different world currencies are. The Big Mac theory, which is based on an observable purchasing-power parity, says that exchange rates should even out the prices of Big Macs sold across the world.

The second element of the fundamentals to consider is the interest rate differential between the two countries on each side of the currency pair. This is not a static element, as the FX markets (spot rate) move with forward forward rates. So expectations of future interest rate differentials are what count. The relative growth outlooks of the two economies is what the senior trader emphasised in getting a handle on interest rate differentials. For my part I would say that the perceived prospects for medium term inflation are now taking a much bigger role in the mind of the market than hithertofor in looking at interest rate differentials.

The third fundamental element to a good FX set up for a macro trader is the policy environment. Last year presented a classic opportunity (in looking at Euro related trades) in that European politicians/central bankers commented on levels and movements in traded rates (CDSs as well as bond auctions and FX parities). Some of the great macro trades have been set up by governments attempting to talk down markets when their policy objectives clash with what the markets discount as sustainable. So last year was a classic of its type in this regard, though interest rate policy specifically was a stale issue according to the bulge-bracket macro trader. That is, changes to interest rate policy were not expected to be a driver of the market condition for the trade under consideration in the time-frame envisaged. For trades at the market level like those illustrated here, and particularly in FX it is very important to understand the market drivers at the time. The graphic below indicates what the macro trader stated were the major drivers for the €/$ level last year through the different phases.

Technical Set-Up

The technical set up for a macro trade can be about flows and positioning by the various categories of market participants (say hedgers, speculators and governments). For example, the Commitments of Traders report for listed US futures showed there were very high levels of Dollar bear positions just before the monthly employment report for July 2010 released on the 6^th August last year. So the positioning in the market shifted the odds of the labour market data being bad enough to move the Euro up further versus the Dollar. That date marked an interim top for the Euro versus the Dollar.

The other form of commonly used technical set up is pattern recognition, which in its crudest form is chartism. Along with the rest of the market, the senior trader from the well-known global macro firm was onto the break in the multi-quarter uptrend for the Euro (versus the Dollar) that occurred in December 2009. The Greek debt crisis powered the multi-month fall in the Euro which lasted into the middle of 2010. The break in trend of itself is often a good entry point for a trade, but as FX markets have lots of minor reversals against the major trend traders have to have tools to identify the second and third high quality entry points as the new major trend unfolds. In the middle of January 2010 there was a good secondary entry point on such a short term reversal – as is typical the secondary entry point corresponds to a support/reversal level on the previous major trend – in this case around 1.45 on the €/$ in the period 13-15^th January.

This secondary, high-quality entry point can be illustrated in another trade mentioned on this website – in Gilt futures (see here and here).

Technical Set Up for Trade in Gilt Futures Showing High-Quality Entry Point

The significance from a money management perspective is that the second entry point - as the security price accelerates away from a key support or resistance level - can be a higher conviction entry point than the first. This is because the investment hypothesis ("the market is going to go down", say) has been tested by market action and passed the test. So depending on style, the macro trader can trade in several risk units at the second entry point. In no way is the second entry point a secondary entry point!

The global macro trader also disclosed the use of a particular tool to assess sentiment – the world wide web. The fund monitored the occurrence of the phrase "quantitative easing" on the web in August, September and October to ascertain the degree of dominance in the minds of investors.


Trigger

Global macro trading is often about assessing the persistence of action by the various actors in the market drama. It was interesting that the senior macro trader said that the trigger for putting on the position was often the behaviour of the markets themselves. Note that the crucial observations are across markets, not necessarily from market action within the market under consideration. So for the €/$ last year the maturity of the Euro rally that began in June was under consideration in August by the trader because the co-movements of the S&P500 (as a proxy for global equities) and the fx rate diverged. The €/$ and the SPX had synchronised price changes for a period of some months, but over the first few trading days of August days the S&P was flat whilst the € was still appreciating against the $. For the macro trader this signalled a change of behaviour was imminent for the Euro/Dollar relationship because the S&P action signalled at least a pause in the driver for the FX rate (the slowing US economy). To quote the trader directly, "divergences between markets are the best clue for market behaviour. A correlation break that lasts for one-to-two days and can indicate a movement to follow that lasts for 2-3 months." He also stated that more than 50% of a macro trader's insight comes from understanding the message of the markets, that is the behavioural inference is key. Like many traders, including those with a macro framework, the presenting macro trader only puts capital to work if the market has already started to move in the direction he wants to play.


Sizing

Sizing of positions in macro is usually a function of risk/reward and correlation. The senior trader didn't mention correlation himself in this regard, so we'll concentrate on the potential profit and loss as the key input to position sizing. The target price and stop loss levels for positions in markets are typically placed at or near significant support and resistance levels – the difference between current price levels and these two levels gives the upside/downside ratio for the potential trade. The potential loss between current levels and the stop is used to scale the maximum position size. A loss of say 5% on a position that is 20% of the gross equity of the fund would give a portfolio level loss of 1%. If two percent loss at the fund level for a single position is the outer bound then a 3% loss to the stop would equate to a 24% of equity maximum position size. The principle is determine how much you are prepared to lose – "anything else is bad discipline, or has ego in it," admonishes the trader.

This particular macro fund also uses drawdown from peak as an additional risk limiter at the level of the individual trader. So the risk capital of the trader will be reduced if his P&L is down 5% from his own peak, and he will be out of the market for a period if he loses 10% from his peak P&L, even if he is still positive on the year.


Closing the Position

The macro trader acknowledged his belief in the concept of reflexivity – Soros' concept that positive price changes themselves impact how positively investors think about the market – such that prices can waterfall down or continue upwards way beyond most expectations. Conceptualising potential price changes and unusual market impacts helps macro traders mentally prepare for a range of market outcomes. But still an all, positions have to be closed even after exceptional profits – so what feeds into the decision making at the closing of a trade? "A position should be reviewed when a price target is hit, and should be closed for sure when a lot of the market has joined you in that position."

How do you make money in macro trading? – "You need to take risk aggressively to make money, but you need to take it well." 



One of the reasons I posted this article is that the trader uses several methods I use in my own style of investing. If you run a hedge fund and would welcome input on your processes (investment, research and risk management) from my consultancy or want to persuade me to share my expertise full-time contact me on s-kerr@tiscali.co.uk 

The January Effect v QE v Market Internals

December US equity markets have been typical in the shrinking of traded volume which makers them prone to being squeezed. At this point I hesitate calling it squeezing (hurting the shorts by mark-ups which forces closures (buying) of positions) as there have been 18 up-days out of 20 trading days in the MTD. Short squeezes are short-term phenomena. Although December began with a powerful rally, there has been anaemic follow-through as we near the end of 2010. As is common with the Christmas period, trade has been light, and price action muted. Based on market internals, institutional involvement has been clearly absent from the market over the past two weeks. In the last week or two of trading the broad market has exhibited indecision, and market internals (advancing volume to declining volume, for example) have differed between exchanges and indices. In addition there has been a noticeable flow of money into sectors that have significantly lagged the market over the past year (oil-related, homebuilders, banking, pharmaceuticals, and real estate). This is often a leading indicator that a rally may be nearing exhaustion. It is too early to definitively suggest that the market is about to change trend, but when laggards become leaders, caution is warranted.

There will likely be institutional buying early in the New Year as the whole staff comes back to work and markets are still hitting minor new highs. But will this persist? At this point the influence of QE on markets should be more important than calendar effects, but is the impact waning? Evidence from the bond markets suggests it may be.

As for the calendar effects I have reproduced below a long term study on the January effect. It comes from www.cxoadvisory.com/calendar-effects/



Does long term data support belief in exceptionally strong performance by the U.S. stock market during the month of January? Could this conventional wisdom be an artifact of data snooping or a victim of market adaptation? Robert Shiller's long run sample, which calculates monthly levels of the S&P Composite Stock Index since 1871 as average daily closes during calendar months, offers data for testing. Using monthly levels of the S&P Composite Stock Index for January 1871 through November 2010 (nearly 140 years) and monthly closes of the S&P 500 Index for January 1950 through November 2010 (nearly 61 years), we find that:

The following chart shows the average return by calendar month for the S&P Composite Stock Index over the entire sample period, with one standard deviation variability ranges. The average return for all 1,678 months in the sample is 0.42%. At 1.51%, January has the highest average return of all months. January has the lowest standard deviation of returns (2.86%), so this high return is not compensation for high variability.

October is the only month with a negative average return (-0.39%).

Is this apparent January effect consistent across subsamples?

The next chart compares the average return by calendar month for the S&P Composite Stock Index over the entire sample period and three approximately equal subperiods (46-47 years each). The performance of the stock market is consistently strong on average during January, and January is the best month for two of three subperiods. However, there is generally substantial variation in average returns by calendar month over the three subperiods.

For greater granularity and trend analysis, we examine relative performance during January by decade.

The next chart shows the outperformance of the average return for January relative to the average monthly return by decade over the entire sample period, along with a best-fit linear trend line. The trend line indicates that the magnitude of any January effect is declining, but the sample size in terms of number of decades (14) is small.

For even greater granularity, we examine the effect by year.

The next chart shows the outperformance of the return for January relative to the average monthly return by year over the entire sample period, along with a best-fit linear trend line. The trend line again indicates that the magnitude of any January effect is declining. Outperformance appears to disappear, or even reverse, during the past two decades.

A plausible interpretation of the above results is that there used to be a somewhat reliable January effect, but the market has adapted to extinguish it.

Since the Shiller data calculates monthly index levels as average daily closes during months (perhaps representing typical investor experience) rather than monthly closes, we compare the above results to those for monthly closes of the S&P 500 Index.

The next chart shows the average return by calendar month for the S&P 500 Index during 1950-2010, with one standard deviation variability ranges. For this calculation, we approximate the January 1950 return using the opening level for that month (since the December 1949 close is not available). The average return for all 731 months in the sample is 0.69%. At 1.10%, January has the fifth highest average return of all months, behind December, November, April and March. January has the second highest standard deviation of returns (4.84%), trailing only October.

Is performance during January consistent across sub-samples?

The next chart compares the average return by calendar month for the S&P 500 Index during 1950-2010 and two approximately equal subperiods (30-31 years each). During the first (second) subperiod, the performance during January is tied for third (seventh) place among the 12 calendar months.

For greater granularity and trend analysis, we examine relative performance during January by year.

The final chart shows the outperformance of the return for January relative to the average monthly return by year during 1950-2010, along with a best-fit linear trend line. The trend line indicates that any outperformance during January disappears or reverses during the past two decades.

In summary, evidence from long run data suggests that the conventional wisdom regarding outperformance of the U.S. stock market during the month of January derives either from snooping of an insufficient sample of older data or a real effect that the market has recognized and extinguished. Recent January returns are relatively weak.

Long Gilt Future Confirms Downside Break - Increasing Position Conviction

A week ago I suggested that Gilts had broken down at the long end. The successful test of the resistance at 120 (overhead supply) increases confidence in the short position. The standard trader response is to increase the position size, as the hypothesis of a breakdown has been confirmed.

Today there is also cross-asset confirmation - Sterling has depreciation against the Euro and $ in a break of previous action. That Sterling is doing this independently of other currencies is significant. 

source:Bloomberg LLP

PODCAST FOUR – CTA Beach Horizon

A Discussion with Head of Research of Beach Horizon, Dr. Paul Netherwood.
Dr. Netherwood spent four years in the Nineties in trading systems research and development at AHL (Adams, Harding and Lueck, now part of Man Group), and for the last 9 years he has been at Beach Capital Management and Beach Horizon LLP, a systematic fund management partnership. Beach Horizon is based in the City of London.

 
Clicking on the link will open a page containing the sound file - download or play in your browser



Part One (Link Here) (15 minutes)


 0.00 Introduction to Beach Horizon and sytematic CTAs
 5.50 Portfolio construction and diversification including milk and pork bellies
 9.20 Targets for outputs return and volatility
 10.50 Upside volatility
 11.55 Margin-to-equity as a proxy for risk

Part Two (Link Here) (13 minutes)

 0.00 The team - an advantage in being able to tap into a trader with a discretionary background for idea creation  and assessing research ideas.
 4.45 An FX research project
 6.20 Prioritising research, co-opting the sciences
7.35 Research productivity
10.00 People power - intellect is not scalable
12.05 Beyond trend-following - different frequencies

Part Three (Link Here) (8 minutes) 

0.00  Different time horizons of investors - a dominant frequency
1:06 Performance of CTAs in 2008
3.40 Performance in 2009
5.06 Current Drawdown - when will we see outperformance of CTAs? Influence of QE?
 

 
Drawdown Analysis for Beach Horizon May 2005 to December 2009

   

Source: Beach Horizon Database

 

My thanks go to Dr. Paul Netherwood for his contribution to this podcast.

Chart of the Week – Bond Mutual Fund Flows

I often write about the US stock market for a number of reasons. I have been a professional investor investing in that market. The US market is the largest and most developed in the world. The US stock market usually sets the tone and the pace for other markets – correlations are very high between other equity markets and the US equity market. The expression "if New York sneezes London catches a cold" is a truism that could be applied to most markets. Since the globalisation of US portfolio flows first by Capital International and Fidelity and then by US hedge funds the sectoral out and under -performance within stock markets have become global phenomena. Plus the ready availability of data and a long history of data collection and analysis allow investors to use tools based on American market phenomena that should work elsewhere, but if not the market-level call will still prevail. So looking at and analysing the American stockmarket is looking at the world of equities on a week-to-week or month-to-month basis.

I often have a "fact of the week" and "chart of the week". This week's chart is below and comes courtesy of Citigroup's research. It shows US mutual fund flows over the last five years.

This year the stock market has been about bear psychology in the first quarter, and since then about liquidity. I believe in Marshallian K, so to me the rally was mostly explicable by the enormous money creation and liquidity creation we saw in the last 18 months being channelled into financial assets because the real economy could only use it up with a lag. The US economy has started to grow, so towards the end of the year the rate of gain in stocks tailed off, as the real economy started to use the money that was created a year ago.

So having a rally in 2009 was not a surprise. The scale of the rally did surprise me but should not have done – the historical precedent of the Great Crash had an analogous rally – also a 50% retracement, and up around 50% from the low. One of the reasons that I thought that the rally might be significantly smaller was the psychology of investors. The Coppock indicator is based on recovery from trauma. In my mind the Coppock indicator is of limited use. Indeed it is only useful for non-professional investors – it is lagging and confirms only buy signals, but does tell long-term investors that a market is safe. The Coppock indicator is based on 11 and 14 month moving averages. I has assumed that we would have a limited recovery because it just takes longer than a few months to get over the trauma of what happened in the 2H of 2008. It turned out that the balancing item of liquidity provision was so huge that it overwhelmed the psychological imperative in 2009.

I think the chart of US mutual fund flows from the Investment Company Institute tells us a lot about the state of psychology of the US individual investor, and to some extent about the psychology of all investors in equities. We are still very much in the mode of "it is the return of my money that is important rather than the return on my money". I first heard the expression that "cash was trash" in the early '90s. At that point a bull market was still in gear, the bail-out of S&L s had taken place and returns on cash were derisory by the standard of recent decades. There was a compulsion to put money into stocks and other financial assets because there was nowhere else to go. The events of 2008, and the money market fund scandals, and the level of trust in banks all reinforce staying out of money market funds and other cash proxies to a degree. Sales of domestic equity mutual funds have been minimal this year. The positive flows to equities such as they were went into overseas equity mutual funds, as if Main Street didn't want to give its money to Wall Street. Almost by default US mutual fund investors have moved out on the steep yield curve and bought bond funds. Over the last 18 months more money has been put into bond funds than was taken out of US equity mutual funds.

So the current state of psychology of US investors is keep me out of Wall Street, I want the return of my cash, and I can only trust Uncle Sam with my money at the moment, thank you.

The equity market low was mid-March 2009. Eleven months on from there is February 2010. If the trauma of the Credit Crunch of 2008 is mitigated in the period around March-to-May 2010, where will US and other investors put their capital then? Cash will still be trash: even if the Fed raise rates it won't be by much. So a big question for next year, maybe even THE big question for next year is whither inflation, government borrowings and bond yields?


POSTSCRIPT
Two prominent hedge fund managers are making big bets on U.S. Treasury yields.

John Paulson’s Paulson & Co. has begun shorting U.S. government bonds, believing that inflation will lead to higher yields, which will drive down the price of the securities, the Financial Times reports. “It will be difficult for the government to withdraw the economic stimulus,” Paulson said in a recent speech. “An increase in the monetary base leads to an increase in the money supply, which leads to inflation.” According to the FT, another major hedge fund, TPG-Axon Capital Management, is also betting on rising yields.

Non-Confirmations Multiply according to Prechter

Although I am not an Elliott Wave technician, they do have market influence. Hence awareness of leading practitioners is a useful background input. Robert Prechter is such a practictioner. Bob Prechter's "Elliott Wave Theorist" newsletter published the 23rd November notes that the DJIA has achieved a 50% retracement of the fall from the 2007 high to the 2009 low, and has done so in 50% of the time it took to fall.

The following is taken from the same publication:

"Non-confirmations continue to multiply, as no other significant market index – among the S&P, NASDAQ, Transports, Utilities and the broader Value Line indices – joined the Dow in making a new intraday high today.

This morning's high occurred 39 minutes into the session, immediately after an upside gap in the DJIA during the session (his italics), an extremely rare event…I am betting that it was an exhaustion gap, not a continuation (wave 3 of 3) gap.

After 8 months of rally and a 52% retracement, I believe I have seen enough to recommend that traders move to 200% short. Those who were "maximum leveraged" for the 2007-2009 decline and reinstated half their positions on the recommendation in the August 5^th issue may return to their full former holdings now."

Prechter's services can be found at http://www.elliottwave.com/

The NYSE cumulative advance/decline indicator is a measure of market breadth. It is giving a non-confirmation at the moment - the NYSE Composite hit a minor new high a week ago, but the advance/decline did not then or since. Non-confirmations are useful to give confidence for high conviction calls on the market. The evidence is building for a high confidence bear entry point.

Interim Top on S&P Signalled on Close on Wednesday

On Wednesday there was a new high followed by a close at the low of the day on the S&P. This is a sign of an interim top. Sometimes there can be a weak minor new high after, but over the course of weeks we are going down on the basis of this one signal. Other signals are already in place on momentum, and valuation has been in a warning zone for a while (high but can go higher).

Yesterday's market action of up 1% net on the day, finishing just under the high of the day, did not negate the call of an interim top. Yesterday also had a lower opening than the previous day's close and the close (and intraday high) were some way below the previous day's high of the day.