Monday, November 9, 2015

Who's the Current Sucker?

POST 6 - Who's the Current Sucker?

Garrison Keillor, the NPR host and comedian has a tagline about a town where "all the children are above average." It's somewhat funny (at least it was the first time), and highlights what this post is about. The fact is that generating positive alpha is a zero sum game. For every supergenius hedge fund manager who outperforms, there is a corresponding schlub who loses. So one way of analyzing the markets is figuring out who the suckers are and how much money they have to lose.

In the past there was a steady and reliable supply of suckers. In the equity markets they were retail investors and actively managed mutual funds. There have been numerous studies, both from academics and industry, that show these two groups underperform. So there was a lot of alpha on the table to harvest. The rise of index funds and ETFs have sharply reduced this. Note that hedge funds have underperformed a balanced portfolio for about fifteen years.

In the commodity space, the situation is a little more complicated. Sure, the retail commission house customer is a reliable loser. But another loser is the passively managed funds. Why? Because these index funds regularly come to the market to roll very large positions. The short term traders see them coming (I was going to say "the floor", but that dates me.) and front run their rolls. Over time this adds up to a lot of money.

Another important set of losers, more important to my style of trading,  are the financial investors. These are long-only portfolio investors who buy the commodity asset class as part of their portfolio. Now we can argue whether commodities ex gold are in theory a reasonable part of of a balanced portfolio. But what happens in practice is that these buyers come in when commodities go up, and they leave when commodities go down. In other words they are late stage trend followers.

I started my trading career in the 70s, during the big commodities run up. I remember the financial investors (We called them crossovers.) coming in in the late 70s and early 80s. I remember the analyses they wrote about the portfolio diversification commodities would give. I am ashamed to admit that I even wrote one for a commodities hedge fund. Well, what happened? Volcker tightened, and the bubble burst. Commodities went down in real terms for twenty years (see Post 1). The crossovers crossed back again, back into stocks and bonds and out of commodities. In net they lost a lot. It gave that generation of investors a bad taste about commodities.

It took another generation to repeat the mistake, but repeat they did. In the 70s, the mantras were non correlation and inflation. In the 00s, the mantra was BRIC. Same result. We are now in the stage of their exiting commodities. I believe we still have a ways to go on this. The point is that once they leave, they won't be back soon. So a large pool of commodity suckers has left the table.

What does this mean for trading? It means that we should be looking for singles and doubles, not home runs. It also means we should favor mean reverting trades rather than momentum. The late stage momentum guys will not be there to bail you out.

P.S. I realize the last few posts have been pretty general and not about tradable ideas. I'll get to that in then next post.

Next Post - Milk and Eggs for Breakfast

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