The Van Tharp Institute

August 10, 2005 — Issue #232

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In this Issue:

Feature Article

The Psychology of Your Fund Manager, By Van K. Tharp

Coming Workshops Five Premium Workshops for Traders and Investors. Sign up early and save.
Trading Tip

Two Smart Guys; Two Prudent Actions, By D.R. Barton, Jr.

Listening In Mechanical Trading System? 
Special Report Eight Page Report by Van Tharp, Does Your System Still Work in Changing Markets? 

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Feature

The Psychology of Your Fund Manager

By

Van K. Tharp, Ph.D.

"Okay, Van, the stock market was up again, despite the fact that the Fed has raised short term interest rates on ten straight  times .  If this is a bear market, why isn’t the market going down?"

I often hear this question.

First, it’s a sideways market.  This is the eighth month of the year and two out of the three major averages are still lower than they were at the end of last year – although they are all very close.  Perhaps this might continue for several years but I doubt it.

My friend Steve Sjuggerud recently sent out an amazing email newsletter (www.investmentU.com, letter #458) pointing out a contrary indicator that strongly suggests that a major downturn could be right on top of us.  It has to do with the attitude of major fund managers.  Generally, they don’t have a clue where the market is headed because two thirds of them always fail to beat their benchmark indices.

Furthermore, it’s uncanny how poor they are at timing the market.  And how can you measure what they are thinking?  That’s easy, just look at how fully invested they are.  At the top of market, fund managers are usually fully invested.   And, of course, market tops are usually followed by declines.  And when fund managers have lots of cash, then the market usually does very well  and goes up .

Steve looked at fund manager data going back to 1970.  When fund managers had more than 9.5% cash in their fund, which occurred about 20% of the time, then the stock market was up about 18% a year later.  

  • At the bottom of the 1974 crash, just before a huge upturn, fund managers held about 12% cash.
  • Throughout most of the early bull market from 1982 through 1991, fund managers typically held over 10% cash.
  • During the 1990-1991 recession, fund mangers had 12.9% of the funds in cash, while the stock market took off.

 And, since 1970, the opposite has also been true.  When fund managers have very little cash, say 6% or less,  then stocks do very poorly.  According to Steve, fund managers had 6% cash or less about 27% of the time.  And when this happened, stocks rose about 1.2% of the time over the next twelve months  -- which is rather dismal performance. 

  • Just before the 1974 crash, fund managers had about 4% cash as the Dow Jones Industrials dropped about 50%.
  • There was a more moderate crash around 1977 and fund managers held about 4.5% cash going into that.  
  • As the great bull market accelerated, fund mangers typically held less and less cash (i.e., they  got it right for a while).
  • When the cyclical market changed to a primary bear market in 2000, fund mangers again held less than 5% cash.  And though out most of this bear market, mutual fund cash has only peaked above 6% in 2001 – which is when the major averages like the S&P 500 joined the NASDAQ in the crash.

And what’s the situation now?   Since the primary bear market started w e’ve had three down years in the stock market, one up year and two flat years.  And what do fund mangers think now?  In June of 2005, they had just 4% of their funds in cash.   In fact,  we could hit a new record for fund manger optimism when the July readings came out.

However, this is only part of the story.  Steve also points to an excellent analysis by Jason Goepfert (www.sentimentrader.com).  Jason decided that interest rates should play a part in this as well.  For example, when short term interest rates are 15%, it make sense to be in cash because markets seldom go up as much as 15% per year.  But when short term rates are very low (i.e., prior to all the rate changes they were as low as 1%), then one should be in stocks because of the lack of return.

According to Steve, Jason wrote a paper  ( awarded a prize by the MTA )  in which he showed that about 55% of the cash level of mutual fund managers could be explained by the current interest rate.  For example, they were about 10% cash in 1980 when interest rates were very high and they had very little cash when interest rates hit 1%.  As a result, Goepfert came up with a formula to determine how much cash a fund should have.

And right now, according to Goepfert, mutual fund managers are hold about 2% less cash than they should have based upon interest rates.  This is a very low level and it typically suggests ominous results in the stock market.

Is this a prediction?

Can we say for sure that the market is going down soon?  No, we cannot.  It could go up for six months and make a new high at the end of the year.  Cash rates first went below 6% in 1997 and the bull market still had three years left to run.  It could go sideways for another couple of years.  And it could crash soon as short-term interest rates start to get very close to long-term interest rates.

However,  let's  look at the big picture.  We see evidence for a clear primary bear market, in which we can probably expect a big loss or at least a flat market for the next 10 years or more.

Oil, which affects most aspects of economic activity, is now above $60 per barrel. 

The market has been going up for the last six weeks and is beginning to approach new highs for the year.  However, my point is that you need to be very careful at this stage.  The big fund managers are bullish and that’s usually not a good sign.  And what about any funds you might be in?  Is your fund manager super bullish and holding very little cash.  And if that’s the case, are you prepared to get out quickly should the market turn?  These are just a few of the things you should think about.

There are better trends out there than we are seeing in the stock market.  Look at the futures market, the currency markets, and the real estate market.  While many are predicting a bubble in real estate in highly speculative parts of the country, you are probably pretty safe in futures and currencies – at least if you have enough capital and practice risk control through stops and use proper position sizing to meet your objectives.  But that’s another story.

More "About Dr. Van Tharp"

 

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Trading Tip: 

Trading Tip

 

Two Smart Guys; Two Prudent Actions

by  D. R. Barton, Jr.

Some analysts just get it right more often than not.  This week, I’d look to look at two of them (plus one extra, for a bonus), what they’re saying and what traders and investors might want to do about it.

Smart Guy #1: Martin Barnes.  Our first smart guy has a few neat distinctions.  He’s an economist that I really respect (no small feat).  Steve Sjuggerud is a big fan of his (he turned me on to his stuff in the first place).  And Barnes will actually tell you if he doesn’t know something or hasn’t been very good at forecasting in a particular area.  He’s the Economist of BCA Research in Montreal and was featured in Baron’s a couple of weekends ago.

Barnes anticipates low inflation, and low returns in the stock market.  He makes a compelling case for an economy with many speed bumps (my word, not his) that will keep a damper on stock returns in general (including that nasty phrase “housing bubble” – more on that with our next Smart Guy). 

For the general investor, I think this has significant ramifications.  Broad based index fund investing will yield fairly low returns, under Barnes’ scenario.  And given the risk levels inherent in long-term buy and hold investing in index funds, Barnes makes me very reluctant to recommend the old “buy a good index-based mutual fund and hold it through the economic cycles” mantra of Wall Street (which is especially popular among the mutual funds).  The only reasonable alternative for minimally involved investors is to take a look at sector investing where one can ride a long term trend (say in energy, health care, etc.).

Smart Guy #2: Stephen Roach.  Also from Barron’s, last week’s Alan Abelson article sites my favorite “big firm” economist, Stephen Roach from Morgan Stanley.  Roach is almost a household name – a rock star among economists, and for good reason.  He brings more bad news to those who are hoping the “housing bubble” is just a myth.  One of the arguments used by the housing bulls is that the U.K. and Australia have seen corrections in their housing market and moved along just fine.  Roach puts a finer point on the comparison between the U.S. housing market and the Aussie / U.K. markets.  He concludes that the housing market action among our English-speaking counter-parts “tell us little about what could happen here.” 

I’m in the “housing bubble” camp (meaning that I believe there is one), but I’m just smart enough to know that I have no idea when we could see a downturn (or worse) in real estate.  As I’ve mentioned before in this piece of cyberspace, continuing strong demand can sustain bubbles for longer than any of us suspect.  I don’t think we’re in “buyer beware” mode yet, but we’re certainly in the “buyer take extra care” zone of the housing cycle.

Also, “Smart Guy #1a”, Bill Gross from Pimco Funds, is worth a read this month, as always.  While waxing rhapsodic about stamp collecting, Gross uses a different method to come to Martin Barnes’ same conclusions about returns that can be expected over the next decade or so.  His article can be found at www.pimco.com .

 

D. R. Barton, Jr. will be teaching the upcoming Proven Tactics of Swing Trading Course. 

He is the Chief Operating Officer and Risk Manager for the Directional Research and Trading hedge fund group. D. R. has been actively involved in trading, researching and teaching in the markets since 1986.  D. R. has taught extensively in many investment areas including intra-day trading, swing trading, and cutting edge risk management techniques. 

His writing credits include co-authoring Safe Strategies for Fin-ancial Fre-edom and co-creator and contributing author on Fin-ancial Fre-edom Through  Electronic Day Trading

 

Listening In... 


Mechanical Trading System? 
Author: trader 
Date: 08-04-05 05:11

Is it possible to build a mechanical trading system that makes money?! 

Many top traders say it's impossible but many successful hedge funds use trading systems. Which one is easiest to developed: trend following, counter trend or trading range -system? 

I have just started to backtesting some of my own ideas (thanks to CBOT webseminar about quants, it was excellent) but they don't seem to work 
I have not done any optimizing, just made some rules and tested them. Should I optimize?

Any good books, message boards (other than this) about this subject?


Reply To This Message 


Re: mechanical trading system? 
Author: PMK 
Date: 08-04-05 08:20

Trader,

Yes it is possible to create a mechanical trading system that makes money, although one can significantly increase the return of a purely mechanical system by adding a relatively small amount of discretion based on experience.

In terms of which is easier to develop, in my opinion they are all equally hard/easy. Which one is easiest to accurately implement and stick to is based on your personality, and this is the key question you need to find an answer to.

Optimization should be used very sparingly so you do not just get a system that works perfectly on historical data (but not on future data). The more 'sound' an idea is, the less it needs testing, and the less optimization it should need to make money.

The Turtle Trader forum is specifically oriented around mechanical trading and has lots of good information at www.turtletradingsoftware.com/forum

As for other books/material. Van's 'Develop a Winning Trading System That Fits You' is very worthwhile and you could take a look at my site pmkingtrading.com as well :-).

Hope this helps

Paul

Participate on Van's Trading Forum. A place for traders and investors to share ideas and learn from each other

 

Special Report

"Does Your System Still Work In Changing Markets." 
By Van Tharp  

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Quote of the Week

"That you may retain your self-respect, it is better to displease the people by doing what you know is right, than to temporarily please them by doing what you know is wrong." ~William J.H. Boetcker

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Van Tharp's Market Update for Period Ending July 29, 2005

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