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How to Improve Stock Market Backtesting

In this video, I’ll show you one way to improve your stock market backtesting results.

This method is the one used by my research partner Roger Crandell and me when refining The 9% Signal.

One common problem with backtesting is curve fitting, which is finding a system in retrospect that would have maximized returns in the past market. For example, getting the most out of this two-year TQQQ chart:

[Chart shown in the video, at 1:09.]

The problem is that how the market moved in any period of the past is not guaranteed to repeat. What worked then, probably won’t work now.

We can extract elements from past price behavior, however, to construct a market characteristic.

For instance, this a seven-year scatter plot of TQQQ’s daily percentage price changes:

[Scatter plot shown in the video, at 3:20.]

We can defining this price behavior profile.

Then put it into a restricted randomizer that generates daily changes within this profile to simulate many markets.

This is key: Why is the real market of the past any more valid than a simulated one of the same profile?

We believe it’s not, and put the 9Sig plan through a rigorous test bed of not just a lengthy real-life backtest of 30 years, but 100 simulated 30-year markets.

Listen to this pull quote from this year’s Note 1 from The Kelly Letter:

[Quote shown in the video, at 5:42.]

From this, we zeroed in on the parameters that delivered the best results most of the time.

Could still be wrong, but offers better odds than just the one test bed of actual historical market data.


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How to Handle Rising Interest Rates

In this video, I’ll consider whether you need to take any steps to prepare for higher interest rates.

The Federal Reserve has signaled its desire to raise interest rates. From The Telegraph:

[Story shown in the video, at 0:24.]

There are three primary areas of your financial life to review in preparation for higher rates on the way: stocks, bonds, and debt. Let’s look at each.

Stocks
The one thing to certainly NOT do in the stock market is sell everything because you were told to “never fight the Fed” because higher rates are bad for stocks.

[Story shown in the video, at 1:41.]

In the three months after John Hussman’s stock-market warning shown in the video, the S&P 500 gained 6%, a very strong showing, and…

Now pundits are saying that the Fed’s desire to raise rates is a vote of confidence in the economy, and therefore good for stocks.

As usual, nobody has a clue in this department.

If you actively manage your stock portfolio, sector allocation can make sense to move your money where rising rates should help.

Financials do well when rates rise because their profits go up. Just look at the Financial Select Sector SPDR (XLF) over the past few months:

[Chart shown in the video, at 3:45.]

Finance is not alone. The classic five defensive sectors were covered by the Financial Times a year ago, and they still apply:

[Story shown in the video, at 5:19.]

In you’re running my Signal system, and you should be, then you need not worry about any of this. Keep running the system because whatever volatility unfolds will boost the system’s profits.

We thrive on changing prices, not constant up or down.

Bonds
If you actively manage a bond portfolio, consider laddering. What’s a bond ladder?

Here to answer that is Neighborly, the municipal bond broker. From Neighborly.com:

[Story and image shown in the video, at 6:33.]

If you use a general bond fund in conjunction with a stock fund, the way my Signal system does, then just stay put.

As rates rise, bond prices drop. But most of a bond fund’s profit is from payouts, not price change, so eventually the higher rates offset the price drop.

Plus, my system moves money back and forth between the stock and bond funds, enabling benefit from moving prices on both sides of the equation.

Debt
Personal finance reminder: The only good debt is the type used to buy an appreciating asset that will be worth more than the cost of the debt, i.e. a house.

Consumer debt, car loans, all of that borrowed money for depreciating assets should always be zero. If it’s not zero for you, now is a good time to pay it off.

For your home, is now a good time to refinance?

This is tricky to answer. To see why, look at this chart of 30-year rates from the St. Louis Fed:

[Chart shown in the video, at 10:02.]

Key points:

1. Bottomed below 3.5% end of 2012
2. Spiked in 2013 on taper tantrum fears, not increase
3. Jumped only a little when rate rose 25 bp Dec 2015
4. Rose a lot after rate rose 25 bp Dec 2016

Tough call, but I would say there’s no rush.

The Mortgage Bankers Association is predicting a 30-yr rate of 4.7% in Q4

The National Association of Realtors is predicting a 30-year rate of 4.6% in Q4

The current rate is slightly above the midpoint between the recent low and the predicted year-end rate. The easy low rates are gone and there’s no reason to expect a quick jump, so sitting tight hoping to grab 4% later this year is probably as good a plan as any.

Conclusion
To recap: If you’re running my Signal system, keep running it as usual because it’s already built to take advantage of price fluctuations for any reason.

If you’re actively managing your stock and bond funds, consider buying defensive sector stocks and funds, and creating a laddered bond portfolio.

For your mortgage, sit tight and see if you can snag 4% sometime this year, about the middle of the recent range.

Surprisingly, not a lot to do!


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Stock Market Analysts Are Useless

In this video, I’ll provide more evidence that stock market analysts are useless, with help from Sarah Gordon at the Financial Times, who recently summarized today’s installments.

I call analysts “z-vals” for their 50% mistake rate. It’s a shorthand of the term “zero-validity environment” used by Daniel Kahneman in his book Thinking, Fast and Slow when discussing stock pickers and political scientists whose “failures reflect the basic unpredictability of the events that they try to forecast.”

A 2002 academic paper found that analysts merely follow glamour stocks.

[Paper abstract shown in the video, at 1:20.]

They’re just stock cheerleaders, with far more buy recommendations than sell. A waste of time.

In April 2013, the personal finance website Nerdwallet reported that 49% of analysts’ ratings on the 30 components of the Dow in 2012 were wrong. Have a look:

[Key findings shown in the video, at 2:39.]

Of course they’re better at identifying winners — the stock market rises twice as often as it falls!

If you have to guess, guess that a stock will rise because up is where the market usually goes.

A stock market analyst guessing a stock will rise and then bragging when it does is about as sophisticated as somebody guessing that the sun will rise and then jumping for joy when it does.

Useless!

The strong odds of the market rising is why almost no analyst ratings are “sell.” In February 2015, Bespoke Investment Group put a finer point on it, as reported by CNBC. Take a look:

[Article excerpt shown in the video, at 4:45.]

In this round-up of evidence, we see analysts chasing the same glamour stocks everybody sees in the news, and almost never advising to sell.

This is completely unnecessary to you because you can already accomplish the results of this advice by just owning index funds, which go up with the market two thirds of the time.

Stick with a system of rational price reaction, the way I do. Analyst ratings are useless.


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Do Investors Need News?

In this video, I’ll consider whether investors should see any difference between fake news and useless news.

Since Donald Trump was elected, there’s been an obsession with fake news. This story from Politico shows Facebook in the fray:

[Story shown in the video, at 0:25.]

Factually incorrect news is obviously useless, but what about factually correct and still useless news? For investors, this type has been damaging for longer and remains so.

A pundit’s honestly held belief about the future of markets is not fake, but it is useless because it’s unreliable. Ditto information about, say, interest rates or the price of oil or another war.

These are unhelpful for purposes of portfolio management because you don’t know the impact of the news, if any.

Consider this May 19, 2016 installment from The Economist’s Free Exchange blog:

[Story shown in the video, at 2:06.]

What shall we do? Sell stocks to avoid higher rates? It doesn’t seem good, what with the “ruins summer” quip.

Yet, here’s the Huffington Post on June 15, 2016, just one month later:

[Story shown in the video, at 3:40.]

There was nothing fake about reporting of the Federal Reserve’s key interest rate last May and June, but it was useless to investors.

You should not be guessing how to respond to news. You should run a proven portfolio system of price reaction only, like mine.

For rational investors, all news is pointless. We could say, “Don’t sweat the useless news, and it’s all useless!”


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How to Use Leveraged ETFs

In this video, I’ll show you the right way to use leveraged ETFs.

Their high volatility requires a set of defined reactions.

Leveraged funds were first offered to investors in the early 1990s. The first leveraged ETFs appeared in 2006.

The idea behind leveraged funds is to increase an investor’s performance by magnifying the movement of an index.

For example, the SSO ETF seeks to provide twice the daily movement of the S&P 500. If the S&P 500 rises 1% on Tuesday, SSO should rise 2% on Tuesday. If the S&P 500 falls 2% on Friday, SSO should fall 4% on Friday.

Other ETFs provide 3x leverage. There’s also inverse 2x and 3x leverage, where the ETFs move twice and three times farther than the index in the opposite direction, thus rising when it falls and falling when it rises.

In all cases, the leverage is applied daily.

Eager investors drew the hasty conclusion that this doubling and tripling of performance could be applied to longer time periods. “If the market rises 10% this year, I could make 20% by just owning a 2x ETF,” they thought.

But it’s not that simple.

Because the daily performances of the index are magnified, the difference in the leveraged ETF’s performance over time will not be exactly 2x or 3x the index’s.

It’s easy to demonstrate why.

If an index starts at 100, and drops by 20% one day and 20% the next day, it’s down to 64. Would rising 20% each of the next two days take it back to 100?

No. It would take it back to just 92. Why? Because 20% of 64 is not as much as 20% of the initial 100.

Starting from the smaller place it ended up after falling, the index needs a greater percentage gain than the decline that preceded it, in order to return to its pre-decline value.

In total, the index needs to rise 56% from 64 in order to regain 100.

If this is the case, wouldn’t leverage magnify the problem? Sure it would, because all numbers are magnified, specifically by 2x and 3x on a daily basis.

Instead of falling 20% one day and 20% the next, a 2x leveraged ETF of this index would fall 40% one day and 40% the next. From a starting level at 100, this would take it down to 36.

To recover from 36 back to 100 would require a 178% gain, more than twice the 56% needed by the index.

Seeing this situation, the financial media made a different hasty conclusion about leveraged ETFs. They boldly declared that “Leveraged ETFs decay over time. They are not suitable for buy-and-hold investors.”

For example, look at this story in the Wall Street Journal on May 11, 2012: “Beware ‘Leveraged’ ETFs.”

[Story screen capture in the video, at 3:40.]

Here’s another, this one from Business Insider on September 21, 2016 titled: “Buyers Should Beware of This $3 Trillion Market.”

[Story screen capture in the video, at 4:05.]

These articles and many others like them warn that due to the daily tracking issue I just explained, investors should avoid leveraged ETFs.

While it’s true that leveraged ETFs are not for everybody and must be managed with care, the daily tracking issue is not a flaw that makes them unusable. There are two reasons why.

First, even though buying and holding leveraged ETFs is not the preferred way to use them, it actually does work out in most long-term time frames.

The market rises more often than it falls, and big crashes are rare, so while it’s possible to find time frames where the leveraged ETFs trailed their indexes, they usually come out ahead.

For proof, look at this shot from my website’s Strategies page, at jasonkelly.com/resources/strategies:

[Performance table in the video, at 5:05.]

The table shows the growth of $10,000 without dividends, just price change, from the end of 2002. This screen capture picks up at the end of 2004.

The first column shows the $10K’s growth in the plain Dow without leverage.

The third, titled “Double The Dow,” shows it in a Dow 2x fund. The fourth, “Maximum Midcap,” shows it in a Midcap 2x fund.

All of these are just buy-and-hold.

Were the Dow 2x and Midcap 2x funds a disaster, something to beware of? Not at all. After they were crushed along with everything else in the subprime mortgage crash of 2008, they roared back.

By the end of 2016, look how much farther ahead they were than the Dow:

[Performance table top row in the video, at 5:56.]

The Dow ended 2016 having grown $10,000 to just $23,472. Double the Dow, or Dow 2x, grew it to $39,394. Maximum Midcap, or Midcap 2x, grew it to $60,984.

Dow 2x didn’t perfectly double the Dow’s balance, but it delivered a much bigger performance than the Dow’s and that’s good enough, certainly within the spirit of what the leverage is supposed to do.

So, while it’s a fact that setbacks become magnified in the leveraged funds, it is not true that they are certified disasters over time periods longer than a day.

The second reason why media warnings against leveraged ETFs need to be understood in context, is this: If the ETFs are used the right way, the daily tracking issue becomes a strength, not a weakness.

Leveraged funds are simply more volatile than non-leveraged. They follow the index’s same directional moves, but rise more and fall more.

That’s all. If you react appropriately to these rises and falls, then they work for you, not against.

I use a 2x and a 3x ETF in The Kelly Letter within a predefined framework of reaction to their magnified moves.

On a quarterly basis, so just four times per year, I look at their prices in relation to a growth target line.

If they’ve delivered surplus profits above the target, I sell the excess and put it in a safe bond fund. If they’ve fallen short of the target, I buy the shortfall with money from the bond fund.

This process works with both leveraged and non-leveraged funds, but the higher highs and lower lows of leveraged ETFs can make it work better. The reason is straightforward: they present bigger profits and bigger bargains due to their wider zones of fluctuation.

This is the right way to use leveraged ETFs.

To sum up, while the media are right to warn investors about the dangers of higher volatility in leveraged ETFs, they are wrong to state that the ETFs cannot work over the long term due to “performance decay.”

In fact, they can work even in a buy-and-hold approach spanning years.

But a much better way to use them is with an automated system of extracting excess profits and buying excess bargains, both of which are delivered by leverage.

I hope you found this to be helpful. If you did, please like and subscribe.

You can learn more about the way I use leveraged ETFs in The Kelly Letter at jasonkelly.com.


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