Tharp's Thoughts Weekly Newsletter (View On-Line)
2010 Fall Workshop Schedule, Including Something New!
Restructuring the Real Estate Market: What It Means for You by D.R. Barton, Jr.
Trading Tip Is Mechanical Trading Right for You? by Ken Long
Two Announcements for Our Fall Workshop Lineup
With three Ken Long workshops back-to-back (including a brand new workshop), it's a great opportunity for you to learn everything you can from this trading master.
Restructuring the Real Estate Market: What It Means for You
“This is like déjà vu all over again.” —Yogi Bera
I have spoken to folks who have recently started to speculate in real estate again. Frankly, the current real estate marketplace is one of the toughest areas to comment on. What happens in real estate is very important to the equity markets, though, so I think we need to dig in a bit and see where the data and analysis trail leads us.
One factor that makes commenting on real estate difficult (as well as commenting on other areas of the economy, by the way) is the 800 pound gorilla in the room throwing around its weight—the US federal government. Trying to discern where market forces might take prices and trends in any given sector is a difficult enough task. When the government, however, makes broad regulatory changes, implicitly and explicitly guarantees debt, and throws out unprecedented amounts of cash, well, they make it nearly impossible.
So with the caveat that any of these government intervention forms could override any credible analysis, let’s take a look at a couple of compelling factors affecting the real estate world. We’ll wrap up with why equities traders and investors need to pay attention to real estate.
Some Useful Data
In March of 2009, I wrote about how both the real estate and equities markets were buoyed by the first economic report of a month-to-month increase in new home sales in over a year. I have included the following chart (current through Feb 2009) to show how small this move up was in the big picture.
(To clarify an acronym, SAAR stands for “seasonally adjusted annual rate,” which means that they take the monthly numbers and project them to an annual number with some allowances for seasonal tendencies.)
In that article almost a year and a half ago, I opined that this was not a reason to get overly excited about the real estate market, since this was just the first sign of the market halting a drastic skid.
And while the real estate sector and its component stocks have improved since then, the argument could be made that the improvement is just the rising tide of the broader equities market lifting all ships. New home sales since that first move up have supported this view.
As the chart shows, there has only been a minor move off of the lows and now we are almost back down to the level of the bottom in February 2009. More telling is that the number of new home starts remains at slightly more than 40% of the relatively static rate of the mid-1990s, and at one-quarter the monthly rate of the unsustainable highs seen in early 2006. The outlook for a big move up isn’t that compelling.
Demographics Are Useful, but Take Them with a Grain of Salt
The Barron’s cover story from a couple of weeks ago was entitled “Renter Nation”. The most interesting data from the article centered on demographics. It’s no surprise that the number of households owning their own homes has dropped by almost 4 million since the peak from a few years ago. The interesting part came from the data about the shifting age demographic in the U.S.
While current overall home ownership stands at 67.2%, the number for households headed by someone under 35 years of age is just 38.9%. This is easy to understand—more folks will own homes as their income increases. The aging trend in America for the next five to six years, however, is toward younger households, with American Demographics magazine forecasting substantial growth in households headed by those under 35 and a decline in households headed by those in the prime house buying age bracket of 35 to 49 year olds.
Quite simply, there will be fewer eligible home buyers in the relatively near term. Add to this the tightening mortgage requirements and the outlook for real estate becomes strained. In fact, 2009 was the first year since the early 1990s when less than 10% of mortgages required less than 10% down. The high for this number was just 2 years ago when 29% of all mortgages were written with less than a 10% down payment.
Real estate speculation is not dead and certainly some there’s some interesting activity in several regions of the country. But those jumping back into that endeavor should do so with eyes wide open. I’m afraid that the days of real estate prices only going up are long behind us. A more likely scenario is another down leg in real estate prices before they can find a bottom and generate the conditions for a more sustained multi-year bull market.
For equities traders and investors, it would be very prudent to keep your eyes on what’s happening in real estate, especially at the national level. It’s a huge part of the economy; it interacts closely with the finance sector and there are big changes afoot. Pay attention to what happens at the meetings currently underway to overhaul what has become a nationalized mortgage financing systems. More on the outcome of that meeting when it concludes. Until then…
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Is Mechanical Trading Right for You?
When considering any trading strategy, your main criterion should be bottom line performance, that is, your bottom line performance. The primary question to answer is, “Could I execute the trading strategy according to the rule sets as defined?”
In this sense, whether a system is purely mechanical or discretionary or some combination of both is irrelevant. The rule set either makes money according to the plan or it doesn’t. If it does, then you can either follow those rules or not and make money or not.
Before you commit a lot of time and money to developing or investing in a particular trading system, it would be nice to know if your personality type fits that trading system. A lot of people believe that while they are working on developing their own trading system that fits them really well, they can trade a mechanical system since they just have to follow its rules to make money. Then, they discover that the mechanical system needs some of tinkering: bending the rules or otherwise adding a dose of discretion. Tinkering means breaking the rules (which may not have fit them) and they find they don't make money, even though they know the mechanical system makes money. It comes down to following the system's rules.
Here’s an example from my own trading experience from which I have had to learn to leave a system alone and follow its rules—even though that’s hard.
I have a mechanical system that is in the market only 10 to 15% of the time in a given year. It waits for specific high probability conditions to arise in the market, then it takes a position that is clearly against the mass psychology. It aims to capitalize on the market’s tendency to revert to the mean after extreme moves. The rule set guarantees that you enter the market in a direction completely opposite of what your natural human psychological tendencies advise.
I have back-tested this system extensively in multiple market types over the past 15 years with great results. I have traded it profitably with real money for more than four years. I have abundant evidence to be rationally satisfied that this system has a high probability of success and reliable results. Every time it fires a signal, though, I am still uncomfortable entering the position because of my psychology. I have had to learn how to accept the uncomfortable feeling as a positive sign of a good trade. Now I manage my psychology so that I can enter the position at appropriate risk levels when the system generates the signals.
In a larger sense, I think the following elements are necessary for pure mechanical traders:
- They have confidence in their analytical judgments.
- They have confirmed the reliability of the system.
- They have identified the risk level that allows them to apply their trading system without the danger of blowing up.
- They are committed to their periodic performance review and can approach the entire situation with analytical mind and rigor.
These are rare qualities for most people but for someone who wants to develop and exploit a good mechanical system, they are ideal.
When Do I Discard a System?
Q: Trading is mostly an internal game—that's one of the ideas I picked up after reading your work.
Let's say that we have a couple of great systems (for several market types), we have done the necessary psychological work and we are trading well. Statistically every system/method can (and will) run into a losing streak, sometimes even into a very long one. This is where my question comes in.
When do we discard a system, never to use it again, because it's "broken"
(not making money anymore) and when is it just a (longer than usual) losing streak after which the system will kick back into gear?
My own underlying assumption is that every method/system will eventually break down.
A: The answer to your question is complex as it involves your beliefs on trading system performance, statistics, market types, and psychology. We covered this topic in one section last week at the Blueprint for Trading Success Workshop. Understanding when you will stop trading a system requires quite a bit of discussion and a lot of thinking on your part.
I can tell you that the decision process depends on you really understanding your own criteria for trading in general and not just for one trading system in particular. This is part of your internal game. The criteria that I use to trade or not trade a system would not work for you. You'll have to explore inside to understand (or learn) what works for you.
Everything that we do here at the Van Tharp Institute is focused around helping you improve as a trader and investor. Therefore, we love to get your feedback, both positive and negative!
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