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Name Your Psychoses (The Ballad of Howie and Weezy)

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Allow me, first, to offer a belated, celebratory acknowledgement of the 80th anniversary of Jim Morrison’s birth, which occurred this past Friday. Jim was born precisely 37 years before that cockroach did Lennon (and FWIW, four solar circular circumnavigations to the day before Greg Allman came down the shoot). He died exactly two years after they found Brian Jones floating face down in his own swimming pool.

It was my mother’s 36th birthday.

Such are the circumlocutions of our existence, but it’s time to move on to the theme of this here note, which centers around the ill-fated love story of Howie and Weezy.

Probably you don’t know either of them. Howie’s been my friend for about forty years, and it is through him I met Weezy. NGL — I was pretty impressed with Howie’s romantic exploit. Weezy is attractive, articulate and pleasant to be around. Howie is a bit of a Renaissance Man (among his acting credits is his legendary Reparatory Theater portrayal of Puck in Midsummer Night’s Dream), but, while I won’t say that he is entirely bereft of redeeming features, and embarrassment of such riches he has not.

As can perhaps be expected, they had a quirky kind of love. Weezy, for instance, would go batshit if not able to consume her daily breakfast grapefruit, and would often, if denied, and no matter the true cause, take it out on Howie. Of Howie’s, er, idiosyncrasies, there is not adequate space to enumerate; suffice to say they are both acute and manifold.

So, they would routinely fight like cats and dogs, often while in the company of friends such as me. One time, having invited them for the weekend to my house in Eastern Long Island, and having picked them up upon their disembark from a public conveyance, I was greeted not with a “hello old chap” or any of that sort of thing, but rather with the following statement:

“We’ve figured it out. One of us has ADHD. The other is OCD.

“We’re just not sure which is which”.

Attention Deficit Hyperactivity Disorder (ADHD) and Obsessive/Compulsive Disorder (OCD). Are they mutually exclusive? I rather think not, and it is thus probable, maybe even likely, that both Howie and Weezy suffer from each malady.

As do many of us — including, it must be feared, those in the investment community.

With an approximate baker’s dozen of trading sessions left to this year, investors have been trained on asset purchases like Weezy trolling the Sunday morning fruit bins of lower Manhattan bodegas. The long forsaken Japanese Yen is now also the object of a relentless bid. Capital pools are tapping the Fed’s repo facilities at levels last seen during the ’20 lockdowns.

No love for the Energy Complex, though. WTI broke into a 6 handle last Thursday, before staging an ADHD rally to close out the week, nominally due a strong jobs report which runs in analytical conflict with a socialized belief that the Inflation beast is, if not dead, then, at minimum, in the Critical Care Unit.

But the happy gas emanating from Inflationary Expectations measures, has, if anything, accelerated in OCD-like fashion, as evidenced by the massive divergence between the University of Michigan (professional home/alma mater to the ADHD/OCD-addled Jim Harbaugh) survey expectations (4.3%) and published result (3.1%):

And now, somehow, some way, we’re one month from the start of the Presidential Primary season. It seems like only yesterday we were counting votes stored in shady storage boxes, trucks, and meat lockers — producing, in result, the sponsors’ hoped for outcome. This time ‘round, it appears almost certain that the combatants on the top card will be the two guys that the country least wants.

It’s been a tough quarter at 1600 Penn (to say nothing of the hardships at UPenn). The Big Guy seems to have alienated nearly all the flimsy, sketchy coalition that fixed his election. He receives low marks in particular for his performance on the economy, and here, in fairness, I must say I don’t get it.

To wit, let’s wind back the clock to January 2021, and project forward. Three years ago, what would have been y’all’s mood if you knew, heading into ’24, you’d be experiencing an economy that had cut inflation by more than 2/3rds, with no accompanying recession, with Crude Oil prices 25% below their post-Russian Invasion highs and Nat Gas prices at sub-lockdown levels, the raging of jets and the raining of missiles in two key oil-producing regions notwithstanding? With the labor market not only achieving but sustaining full employment?

My guess is that you’d happily have locked that in. As would have I.

Now, trust me here, as I believe that: 1) the remarkable resiliency of the domestic economy may be owing to any number of factors, but the effective stewardship of same by Biden is not among them; and 2) as has been beaten to death in the economic press, it no doubt feels worse out there than the published metrics would suggest. But objectively, the economy has held up pretty well under Shady 46.

*******

But now, as is consistent with my legendary ADHD, I must inform you that I am pretty much done with ’23, and ready, to turn my attention to MMXXIV.

It promises to be a wandering journey, worthy of the most nomadic expression of Howie’s wits, and featuring a wide range of plausible potential outcomes. I have only one firmly established hunch here: that the first material move is a big fade.

If, for instance, we commence affairs with a material selloff, then it will be, I believe, simply a matter of time and valuation until investors, flush as they remain with government supplied liquidity, determine that the time has come to do some shopping. And my guess is that when they do, the spree will extend itself for a spell.

But I’l  feel particularly strongly about prevalence of “the fade” construct if the market comes out hot, as it will, I believe, set up a classic, oft-repeated paradigm of a raging early-in-the-year rally encountering a brick wall just at the time when All God’s Children are fully invested.

The most prominent recent episode of the latter transpired at the start of 2018:

I post the accompanying Vixen VIX chart because as it became immediately apparent, the selloff was triggered by the unwind of a series of wonky VIX derivatives. It was a total fiasco, but I won’t say more.

The flipside emerged the following year, triggered by some pre-Christmas hawkish smack talk by Chair Pow, which absolutely crushed ’18 returns. Then, in January, to most everyone’s surprise, Pow wowed ‘em with a hard 180. On 12/19/18, having already indecorously raised rates twice, he promised more of the same. Not two weeks later, he walked it all back “more rate hikes?” he says “who ever suggested that? I thought we were all friends”.

It set off a whale of a rally – one that lasted until those mutating viral cells worked their way across the Pacific Ocean, and, for a brief time at any rate, killed everyone’s investment buzz.

However, while those pesky covid buggers caused all kind of mischief, they could not quell the market bulls for very long, as their impacts were counteracted (and then some) by a gargantuan Fed money printing/fiscal giveaway cycle:

21/22/23 broke the mold, with a strong/sucky/strong sequence, but I believe The Big Fade will reemerge in ’24. It may be caused by something obtuse and technical, or by a more substantial turn of affairs, but either way, I’m kinda figuring that early ’24 may feature this type of particle collider action, and I urge reactive caution in the early innings of the contest.

Because that’s the best way to play ‘em in an ADHD/OCD world – one which featured cruel endings for both John Lennon and Jim Morrison.

And as for Howie and Weezy, they’re still around but not together. As part of their separation, they agreed to an equitable split of their accumulated psychoses.

As I retain mine. Taking care to pick up a few new ones as time passes. I am not always able to be selective in these acquisitions, but, in this ADHD/OCD heavy world, it behooves me to take what I can get.

TIMSHEL

Coronavirus Risk Management Note

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I am taking this opportunity to share whatever insights I have gleaned thus far from the spread of the Coronavirus and its attendant impacts upon market risk.

I must begin by disclaiming any specific knowledge of either the trajectory of infectious diseases in general or of the ultimate outcomes of this particular outbreak.

Moreover, and at the risk of stating the obvious, market impacts are unknowable absent an understanding of how this episode plays out.

Published reports suggest an extraordinary range of potential outcomes, and it would be wise to discount the extreme ones at both ends of the spectrum.

Market Synopsis:

What we do know, from a market perspective, is that events to date have catalyzed:

  • A high-single-digit or greater drawdown in equity indices.
  • A massive risk reallocation – primarily into global Treasuries but also into other “defensive” risk factors such as Gold.
  • A huge spike in volatility measures, with benchmarks such as the VIX doubling within a handful of sessions.

There’s absolutely more to the story, but these are the key elements on which I am focusing.

Economic Implications:

Not much visibility here, but there’s a near certainty that even what has transpired thus far will have taken a significant bite out of 2020 Global GDP, and that the more the virus spreads, the bigger the reduction will be.

It is also a hard to dispute the reality that governments and central banks in major jurisdictions will counter the financial/economic carnage with massive monetary and fiscal stimulus.

Risk Management Implications:

Generally speaking, NO ONE has an edge here – of any kind.  Perhaps there are a few unicorns out there who have some degree of certainty that the virus will either run its course or evolve into a pandemic.  These individuals and entities are on their own, and neither need nor want any help from me.

For the rest of us, it is wise, I believe, to be reactive – carefully parse the information overflow, and make judgements based upon the most informed assessments you can muster. And only effect portfolio adjustments based upon a totality of factors that extend beyond Corona.  Information, of widely divergent degrees of accuracy, is flooding in in contemporaneous time.  It’s best, I think, to ignore the most overwrought of these reports as noise.

My best advice is to stay the portfolio course, while shading to the defensive.  Just as the timing is sub-optimal to load the risk boat, it is equally dubious to undertake a wholesale reduction of portfolio risk.  Neither approach presents risk/reward tradeoffs that are particularly favorable.

Instead, I’d play it a little on the tight side here, while protecting core positions.

A few other risk management notes:

  • At this moment, the markets are rallying back.  Historically, this is a sign that the risk premium rise has yet to run its course.
  • On a related note, high-volatility corrections do not historically end until the volatility dissipates.
  • My assumption is that the episode will run its course, and that current conditions represent a buying opportunity.  If so, it will be better to buy on the way up; not on the way down.
  • If, on the other hand, you see bargains too compelling to resist, then understand you should anticipate enduring uncomfortable volatility on your path towards monetization.
  • I would protect your core positions as a top priority.  This being stated, and with respect to other risk reduction options, my thoughts are as follows:
    • Long Treasury positions remain the ideal offset to equity exposures, record low yields notwithstanding.  If the virus spreads to our shores in critical mass, long-term US rates will go negative.
    • By contrast, it is absolutely the wrong time to buy index options and other long volatility products.  They are overpriced here, and the fact that the sell-side is in full-on pitch of these instruments at the moment, you should avoid them.
    • If you MUST own vol here, please consider doing so in spread (e.g. collar, straddle, strangle) configuration.
    • I’d go so far as to suggest that short vol positions – particularly writing covered calls, is a much more effective strategy.
    • In terms of direct portfolio risk reduction (always my preferred method), I’d begin by cutting non-core positions, and then, as necessary, trimming key holdings.

Overall, unless Corona kills us all, my sense is that this will pass, and the markets will resume their upward trajectory.  There is still a shortage of investible securities out there, and it’s growing.  The custodians of big capital pools know this, and my guess is that they are making plans to increase their holdings share – as enabled by what are certain to be even lower borrowing costs than the prevailing microscopic levels.

But us mere mortals must be more careful.  Manage this day by day.  Minute by minute.

Good News Week

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It’s good news week

Lots of blood in Asia now

They’ve massacred the sacred cow

They’ve got a lot to eat

— Hedgehoppers Anonymous

Brothers and sisters: would it kill us to offer up (as Oddball asked of Moriarty in Kelly’s Heroes) something righteous, something hopeful, instead of all of these negative waves? At any rate we can try. After all, this past week marked the 49th Anniversary of the Woodstock Music and Arts Festival, held on Max Yasgur’s farm, in Bethel, NY. And what an event that was!

So, attempting to pay it forward with a Woodstock Vibe, I offer up my salute to those one-hit Australian wonders: the aptly (for our purposes) named Hedgehoppers Anonymous. I hope you dig.

More importantly, I am happy to report a couple of small steps towards the narrowing of the chasm that separates right from left in this increasingly divided nation; one which if taken to extremes, threatens to destroy what has been one hell of a ride since the Civil War (or WWII at any rate).

First, it would appear that contrary to widely, er, socialized perception, Senator Elizabeth Warren (D-MA) doesnot wish to destroy capitalism as we find it. In fact, she wants to help, and, seeing as how she’s a Senator and all, she has actually introduced a bill to strengthen its foundation. Specifically, the bloodchillingly named Accountable Capitalism Act would require domestic companies with $1B or more in revenues to apply for a national charter, under which approval (and continued operation) would rest upon their perceived ability to maximize benefits to ALL stakeholders – including (one can assume) employees, regulators, customers, community, creditors, and maybe even competitors (I mean, after all, don’t your competitors have a significant stake in your fortunes?). Presumably, shareholders are not to be excluded from this warm embrace (because don’t shareholders need love like everybody else?), but not under the prevailing terms of monogamy. In fact, if I properly understand the provisions of The Act, being overly attentive to the actual owners of your enterprise can land you in hot water with Sen. Liz: a place where (trust me) you do not want to be. The bill also proscribes that at least 40% of Board Seats of chartered companies must be assigned to employees, and prohibits top executives from selling shares —whether purchased on the open market or acquired as part of a compensation package — until, well, until forever.

What, in heavens name, could possibly go wrong?

Well, for one thing, investors in enterprises that must, as a price of doing business, de-emphasize shareholder interests might not be willing to pay as much for the privilege of ownership – particularly when one considers that there’s a whole wide world – full of companies that are willing to place their objectives at the highest level of the priority chain. In addition, Corporate Research and Development efforts that might’ve otherwise driven whole new innovation/monetization cycles might not do enough for employees or the community to meet the newly-engineered, federally-mandated underwriting standards. Management teams, confused and disincentivized by the Act, might make suboptimal decisions.

Yup, on the whole, I’m forced to conclude that the passage of The Act would be a market short. Securities of every stripe would probably decline in value,and face a twisted path to valuation recapture. My guess is that there would also be fewer Googles, Ubers, Sovaldis, etc. emerging, because the potential financial returns associated with devoting a life to One Big Idea would have taken a severe downward turn. As such, the pace of development of such life-enhancing tools as those that allow for the immediate access to all information in the world, the booking of a ride that materializes immediately with a few screen clicks, and the creation of bona fide cures for chronic diseases such as Hepatitis C would slow dramatically.

So there’d be a lot of buzzkill for investors. However, before you plunge into a cycle of despondency, please consider my other piece of glad tidings. In a rare show of cross-party back watching, President Donald J. Trump came to Senator Liz’s rescue, by floating the notion of reducing the frequency of earnings reporting from quarterly to semi-annually.

Thus, under the proposed bi-partisan paradigm, while the stocks you own are likely to decline in value, at least you won’t have to hear about it as often.

And one last happy thought before moving on: these initiatives, ladies and gentlemen are the flower of your tax dollars at work.

However, I strongly suspect that the markets wouldn’t cotton to even the Trumpster’s portion of this elegant solution. Being creatures of obsessive habit, I’m guessing that investors would be frustrated if their sequences of noodling over every line item on an income statement, dissecting every word and even the body language of Corporate Chieftains, were to be cut in half. The markets would be rendered riskier; more prone to discrete price jumps in both directions, and as such, less likely to be embraced by institutions and individuals alike.

But in the final bit of positive waves I am able to share on this mid-August day, the markets appear to have ignored both initiatives. All of our indices rallied, and the Gallant 500 now rests a skinny 80 basis points below its January all-time highs (remember those)? That little beyotch of a VIX got beaten back to a 12 handle. And even the perpetually beleaguered Bloomberg Commodity Index was able to register a pulse this past week:

Extrapolating from the market economics playbook, this positive reversal of fortune may have been catalyzed by published reports of progress in trade negotiations with both Mexico and China. But outside of Commodities, nobody seemed to have much noticed these developments either. I feel, however, that if they are signs of legitimate progress, they’re significant indeed. I’ve been in the habit lately of benchmarking geopolitical exposure by asking myself where, in the absence of looming trade wars, the SPX would be trading, and my guess is at least10% higher.

But I don’t blame the equity crowd for discounting these reports in their valuation calculus. From what I’m told, we’re pretty close on terms with the Mexicans, which would certainly be a step in the right direction. The Chinese, however, are another kettle of fish. I suppose it’s encouraging that our trade reps will soon be sitting down at the table with theirs, but it will probably take more than polite discussions to bridge the gap between the two bull goose economies in the world.

Market participants were, on the other hand, justifiably giddy at the results presented by the late reportingWalmart Corporation. And it was indeed a thing of beauty. Particularly encouraging were the positive trends in both Grocery and On-Line sales: elements of their vast enterprise where the Arkansas Colossus faces direct, arguably dire threats from the Kings of the Columbia Gorge: Amazon.com.

But on the whole, I feel that the next migration in security valuations will be driven by and large by developments in the dodgy world of international trade. As I’ve suggested before, there’s more riding on this than whether Premier Xi buys his Soy Beans from Butler County (IA) or Brasilia. For one thing, I believe that the ebbs and flows of these discussions will impact the outcome of midterms, now a mere 9 ½ weeks away. If we make progress (which can only happen if 45 is able to spin it with trademark bluster), the markets will rally, the economy will surge, and I suspect as a result the President and his minions will experience much better outcomes in November. Conversely, if talks break down (as they well might), it will continue to drive up the risk premium – both in the markets and in the actual economy. Everyone will be nervous/agitated, and I feel that these vibes will manifest in the post midterm electoral map.

Even that wouldn’t be so bad for us market types if the party currently on the outside looking in wasn’t, by all accounts, out for blood. There are a lot of grey areas here, and if the result is some sort of Congressional balance in both chambers, I reckon we’ll survive. However, if the Dems run the table, I fear that they will use their newfound powers in ways that (let’s just say) won’t be overly accretive to the fortunes of wide ranges of risk capital allocators. Imagine, if you will, a market that falls under the iron auspices of Liz’s Accountable Capitalism Act, but without the relief of Don’s reporting cycle relaxation. Great Caesar’s Ghost! I don’t even want to think about it.

Importantly, I don’t believe the markets will wait to know the actual outcomes of our great, bi-annual exercise in democracy to adjust risk appetite and investment configuration. More likely, the rising and falling political fortunes of each side will have a material impact upon valuation trends – as soon as Labor Day if not before.

All of which sets us up for a rather overwrought last trimester of 2018. But hey, let’s not get ahead of ourselves, shall we?

After all, it’s good news week. And, if worse comes to worst with respect to the foregoing, we can perhaps take comfort in the prospect of those world-class market economists: Donald J. Trump and Elizabeth Warren, working together to fix a market structure that has done so little to enrich the lives of so few, for so short a time.

TIMSHEL

The Ten Commandments of Risk Management, Updated Edition

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During the heady days of 2013, I published a piece called the Ten Commandments of Risk Management.  As always, it was meant to entertain along with enlighten.  Now, five years later, I am putting the piece out in slightly modified and enhanced form.  I hope you don’t think this makes me a bad person.  If I remember correctly, after all, Moses himself received the tablets from God – not once but twice, so perhaps my readers will grant me a similar mulligan.

Much has changed since the original publication of this document, but more remains the same.  Most of The Commandments, are in fact, timeless.  But context, always context, changes with the very cells in our bodies.  So I think it’s time to take another look.

The Ten Commandments of Risk Management

The subject of risk management, while increasingly topical in the modern financial universe, is often abused through over-analysis, over-complication and hubris among purported experts.  As a longtime risk manager, I think the Number One goal of risk management as a professional discipline, is to take complex, content-rich concepts such as transactions and portfolios, and simplify them down – for the purpose of making clear-headed decisions.  Do I want to do this trade or not? Am I comfortable with the amount of money I could lose in my current portfolio, based upon available information? What changes can I make if I’m not comfortable?

These are the questions that “true” risk management seeks to answer, but too often, these simple objectives are obscured by the very human tendency to meet challenges with complexity versus simplicity, derive nuanced solutions, and, when this works, to pat our own backs in wonderment at the clever people we are.

Do you want to be the smartest guy in the room or the richest?  Most would choose the second option, and, while risk management can be of enormous assistance in achieving this objective, it is only one tool in the trading/portfolio management arsenal, and the simpler it is to use the better.

Trends towards simplification of objectives and ease of interpretation are beginning to work their way into the murky field of risk management, and the purpose of this piece is to provide you with some basic guidelines in a familiar form – The 10 Commandments – which, if you follow them, will give you a sustained edge over many market participants who routinely violate them.

It may or may not surprise you to learn that my 10 commandments, like the ones that came down from the biblical Mount Sinai, read as mostly blindingly simple rules of common sense.  Yet even the most sophisticated portfolio managers routinely abuse them.  However, this is also true of Moses’ tablets, as, even the most righteous among us will occasionally lie, covet our neighbor’s wife, or fail to honor our fathers and mothers.

So I offer the following set of simple rules, with the forewarning that, like biblical teachings, the enumerating of them is a much easier task than that of living by them.

Commandment I:  Establish/Understand Market Participation Objectives

In terms of sound risk management, forming a clear understanding of the forces driving your market participation is as good a place as any to start.  After all, if you don’t know why you’re trading or investing, you are placing extra burdens on yourself in terms of the already-difficult-enough-as-it-is challenge of actually making money in the markets.  Some of you are professional investors; other participants are in this game for more personal reasons.

Let’s start with this latter, more diverse group.  If you’re not paid professionally for your toil and sweat with research reports, lazy, know-nothing brokers and flashing screens, you should take a moment to determine what you’re hoping to accomplish by being in the markets at all.  Here, the answers might run the gamut – from very active market participants who actually trade their own capital for perpetual income generation, to those who dabble occasionally and hope for the best, to those who own stocks, bonds and commodities simply because they believe they are critical tools for wealth preservation and enhancement.

It’s best then to determine exactly what drives your own market participation, and setting objectives accordingly.  If trading is more than an avocation, and occupies significant portions of your time, then managing how you use this time is a tool to address one of the most binding constraints to performance success.  Alternatively, if you are a routine, occasional dabbler, then the constraints shift: from time, to market information and access to resources, and it behooves you to make sure these are best in class.  Finally, if you’re simply a passive investor, then your success is largely a function, at least on a relative basis, of the quality of your advisors.  Whichever category you call home, it is certainly in your interest to have identified it, as this will drive many actions and choices set forth in the remaining 9 commandments.

If you are a professional investor, a similar, but far from identical, exercise is in order.  Presumably, you’re working for some institution, and, while you can clearly identify a personal goal of making the highest return possible in the shortest period of time, and getting paid as much as possible, these objectives may not align with precision to those of the organization for which you work.

So it is absolutely in your interest to understand the investment mission of your employer.  But go deeper than that.  Understand how it gets paid, how it achieves growth and enterprise value, and this, in turn, may require a look-through to the types of clients that fund your institution, and an associated understanding of their investment goals and objectives.

You’d think these things are obvious, but in my experience, many market participants, both professional and amateur, fail to undertake this simple exercise, and, without doing so, almost certainly set themselves up for failure, or, at minimum, sub-optimal success.

As a last point regarding this new-age self-analysis, for both professional and personal investors, the objectives of the investment process may change over time, so my further advice is to go through this exercise, at minimum, once every couple of years.

Commandment II:  Establish an Investment Approach that is Consistent with Commandment I Outcomes

Once you’ve determined where you fit into the market mosaic, you can and should make a detailed study of the various roadmaps to success.  For full-time traders (professional or personal) this involves determining what markets in which you wish to participate, and what resources you need at hand to be at your best while navigating these markets.  Even for less active investors, a similar path is recommended.  You should, for your own benefit, determine what markets you will focus on – based upon what advice and information – and how much personal attention is required.

Virtually all investors should establish look-back methodologies for measuring their relative success, on a routine, periodic basis, with an eye towards understanding clearly what they did well, where they under-performed, and what steps they can take to learn from past experience, and achieve improvement in future cycles.

I’d like nothing better than to discuss this with you privately (it is, after all, a highly personal matter), so if the spirit moves, shout me a holler.

Commandment III:  Establish Financial Objectives and Constraints

No matter what your market orientation, you are likely constrained, in gravity-like fashion, by one unshakeable reality: there is a finite amount of money that you are able to lose and still remain in the game.  This will vary by the type of market participant you are or wish to be (in adherence with Commandment I), but even within any given participant class, it will shift and evolve along with market conditions, performance, the sources of your funding and other factors.

So it behooves every market participant to determine, periodically, how much money they can comfortably lose, and in order to do so rationally, this impels them to set return targets as well.  Except under very narrow circumstances, no clear-thinking market participant would set a maximum loss level, at, say, 25% if his or her target return was in the low single digits.  So, entering every period (and for many, most importantly at the beginning of each year), effective portfolio management implies a comprehensive analysis of the range of likely outcomes, which yields the simple, declarative outcome of identifying with clarity the variables in the following statement: “My objective is to generate a return of X, and am willing to lose up to Y to achieve this goal.”

The most visible objectives of this exercise are to create focused parameters for success and failure, but there are indirect benefits to be gained as well.  In my experience, it is impossible to derive an honestly formed estimate for X and/or Y without undertaking an analysis of general concepts such as market conditions and resources at your disposal, down to more granular details of what instruments you intend to trade/invest in, and why.  Trust me: you only stand to benefit from routinely performing this exercise, and, at various points, looking in the rearview mirror to see what went right, what went wrong, and why this was the case.

For professional investors, these “mission critical” parameters may be set by your capital providers and not by you personally, but sorry, Mr. Wall Street, this doesn’t let you off the hook; if anything, it places extra burdens on you with respect to Commandment III.  In a highly constructive work environment, you will have a say in these matters, and even if your return budget and loss limit is set at levels with which you fail to agree, you’ll be doing yourself a world of good by making your arguments on an informed basis.

Perhaps, if proven right with enough consistency, your bosses may eventually start listening to you, or you will find a professional home wise enough to take your input into their decision-making process.

Commandment IV:  Stick to Your Methodology

These commandments, at least the ones set forth thus far, are sequential and path-dependent in nature, and if you follow the course, by now you’ve figured out why you’re in the markets, developed a methodology consistent with this first commandment, and have parameterized your return objectives and maximum loss thresholds.

It’s now time to go get them out there, and it will serve you in good stead to operate by the precepts of Commandment II.  You may be a superstar at your investment approach, or you may simply be a legend in your own mind.  But one thing I’ve learned from experience is as follows: if you deviate substantially from your methodological disciplines, you stand almost no chance of succeeding in the markets.  Heck, it’s hard enough to succeed even when you are rigidly sticking to your approach.

This means keeping to a list of tradeable instruments with which you are comfortable, knowing the ranges of your investment sizes and holding periods, and, ideally, both having tools and self-awareness to know when you’ve gotten it wrong, as well as the discipline to act upon mistake identification – ideally by wiping the slate clean and starting over again.

If this happens, and you find yourself compelled to retrench, I implore, nay command you to stick to your knitting.  For the personal investors among you this means resisting the temptation to rush into some hot stock tip you heard about at the country club bar, or a complex structure that your broker/advisor is very keen to stick in your portfolio.  These transactions are indeed money-makers, but for others (e.g. your broker/advisor); not you.

The same dynamic applies to you fabulous pros.  Sell-side folks of every stripe will try to sell you on clever angles that seldom, in my experience, provide benefit to those to whom they are pitched.  So if you crawl down the rabbit hole, start climbing, and use the path of your descent, as it is the clearest way back towards high ground.

Commandment V:  Understand the Profitability Dynamics of Your Portfolio

The sum total of your trading and investing activities create something we risk geniuses refer to as a portfolio.  It contains, in most cases, a mix of financial instruments, and, in some instances, may include short bets and derivatives.

It is worth your while to understand what drives this aggregation of your market activity: what conditions will cause it to make money and what dynamics will be either dilutive to returns, or generate outright losses.  For both pros and amateurs, it behooves you to review these hypotheses with routine frequency.

A word, here, to most of the personal investors and a few of the professional ones as well: many of you have multiple accounts, often held at different financial institutions.  But your financial fortunes are tied to what happens to the totality of your holdings, so, in order to adhere to the 5th Commandment, it may be necessary to find a way to aggregate your holdings across investment accounts, possibly held at multiple financial institutions.

We are now half-way through the entire exercise, and can move from the left tablet to the right one.  Nothing too painful has happened to us yet, right? But fair warning, we’re about to enter the murkier ground where risk analytics cannot be entirely avoided.  I am confident, though, that you can handle this.

Commandment VI:  Understand the Volatility Dynamics of Your Portfolio

Each individual financial instrument that you own has its own unique volatility characteristics, which, to further cloud matters, will change over time and market conditions.  Your favorite Canadian Oil Exploration company or Bio-Tech concern is more volatile, and therefore, all things being equal, riskier, than, say, your money market holdings or your dividend yielding stakes in, say, Consolidated Edison.  You should understand these dynamics, using such tools as Beta and volatility (the standard deviation of returns).

Of course, the volatility of your portfolio will not be equal to the sum of its individual risks, but here I have good news: the portfolio as a whole will almost certainly be less risky than the sum of its parts – due to the impacts of diversification.  Individual instruments will not likely move in lock step with one another for extended periods, and this means that under most circumstances, when you are taking noticeable pain on individual positions, others will provide some relative comfort, and even more so if you add hedges or long/short balance to the mix.

In any event, there are tools available that enable all of you to measure the volatility of their portfolios as though they were single, individual instruments.  These are extremely useful – particularly in today’s environment, under which external events can change volatility profiles dramatically, and without notice.  To provide one recent example, after a positively sail on the somnolent, forgiving market seas of 2017, in February of ’18, the becalmed waters began to churn angrily.

If you held a static portfolio and didn’t do a single trade since the vol picked up, then it is likely that your volatility doubled, tripled or more — relative again to ’17.

These trends of instability of risk across market cycles are likely to continue well into the future, so, in order to manage in a clinical manner, the risks you are assuming, it is necessary to understand over dynamic investment cycles, the overall market risk profile, and its incremental impacts on your portfolio.

Commandment VII:  You Are Able to Risk More When You’re Up than When You’re Down

Though buried in the middle of the second tablet, Commandment VII is as important a rule as exists of the ten.  If you’re p/l is positive and rising, you are essentially playing with “house money,” and can take risks that are not wise to assume when the opposite condition exists.  However, I hasten to add that these concepts are asymmetric in nature.  Just because you happen to be making money doesn’t mean you should increase your risk-taking; being up is thus a necessary but not sufficient condition for opening up the throttle.  The other prerequisite is that you like the forward-looking opportunities you see on the horizon.  If you don’t, then either stand pat or take chips off the table, as no rational risk-taker should increase his or her bets if they don’t like the forward-looking feel of the markets.

Conversely, if you’re losing money, your viewpoints on the market become largely irrelevant to us risk managers, and we will encourage you to remove risks from your portfolio no matter how much money this may cost you in terms of future returns.  Here, we revert back to the third Commandment: the one where I have instructed you to set a maximum aggregate loss for your trading and investment.  The closer you get to this stop-out level, the less firepower you have, and, if you want to stay in the game, it really doesn’t matter how much you like the markets.  After a bad spell, you should reduce risk.  If you’re proactive about this, you can still nail your best ideas – albeit in smaller sizes.  But if you do the opposite – double down, and subsequently happen to be wrong, I suspect we won’t have much to talk about in the future.  The professionals among you may be looking for new lines of work, while personal investors might be too occupied with mundane matters such as how to pay the mortgage to devote much time to the markets.

I have some simple formulas we can share with you that will provide you with an adherence roadmap for Commandment VII.  In the meantime, I will conclude thoughts on the seventh with the following truism: the risk more when you’re up/less when you’re down thing works in all endeavors of chance.  It’ll perform just as well in Las Vegas as it does on Wall Street.  Trust me on this one.

Commandment VIII:  Set Targets for All Individual Positions/Themes and Stick to Them

Before buying or selling short a stock, bond or option, you should determine the price which you seek to achieve, the one on the negative side that will cause you to admit the folly of your ways and exit the position, and some idea of the timeframe over which you intend to hold these positions.  Keep a spreadsheet of these Objectives, Stops and Dates and update them frequently.  It will also do you a world of good to keep a close eye on positions that have reached or exceeded your positive and negative targets.  Here, you have two choices: either change your target, or exit the position.  There’s simply no reason to hang around in themes that have already played out, positively or negatively, according to your expectations.

Adhering to Commandment Eight may cause you, fair warning, to deviate from the long-standing, but in my view fallacious risk management platitude that you should sell your losers and let your winners ride.  Call it blasphemy if you will; I call it common sense.  More often than not, and particularly if you truly have an “edge” in your area of market focus, your risk-reducing activities should more productively be shaded towards getting out of positions that have already done their work for you, while holding on to losers that, if you’re right, will pay off in spades.

The best means of achieving risk reduction on a name-by-name basis, in my view, is to go through what I call the “Vince Lombardi/Gentlemen, this is a football” exercise.  Review each individual position, and forget whether they’ve made or lost you money in recent innings.  Pick the positions that you believe offer the best value at current prices, and discard the rest.

Empirically speaking, I promise you that this process will lead you to shed more of your winners than your losers.

Commandment IX:  Fear Not Options, Including Their Short Sale

Without getting into great detail, changing market conditions wreak havoc on options pricing, and these markets often give away some of the best opportunities you’re ever likely to see.  Moreover, if you buy into this, combined options positions, including bull spreads, bear spreads, straddles, strangles and butterflies, can, if properly timed, be had for a song.  I also believe strongly, particularly in high-volatility markets, in using covered write strategies, as a means of reducing exposure to individual names, and for yield enhancement purposes.

To further express risk management sacrilege in this otherwise holy document, I believe that those who believe that selling options is riskier than buying them are deeply misinformed.  Empirical evidence suggests that well over 90% of options expire worthless, so who’s making money/taking more risk: the buyers or the sellers? This is not to say that I countenance the unconstrained selling of premium; quite to the contrary.  My main philosophy with options is to seek to apply the basic strategy of buy low/sell high to this instrument class.  If options are cheap, buy them.  If they are expensive, sell them.  Quite often, you can find both conditions within the framework of an individual underlier, and, if you do, you can benefit from arbitrage opportunities that much of the market seems to routinely ignore.

Commandment X:  Obey the 10 Commandments 

I feel compelled to inform you that in the revised set of tablets, I was sorely tempted to move Number 10 up to Number 1.  One way or another, I think that adherence to the actual laws handed down from on high, are for our unilateral benefit. They represent the core precepts of righteous human behavior, and in the 3,500 years since their original, well, publication, no one, to the best of my knowledge, has ever even legitimately questioned them.  While observing to them with perfection is perhaps beyond the abilities of individual members of the human race, attempting to do so will do you a world of good, including in terms of portfolio returns.  Remember: our universe was created by the Lord, while markets are entirely the creation of Man.  When we seemingly needed it the most, He gave us the Law, as embodied in the Commandments.  Following them just might give you, divinely speaking, a little extra edge.

Similarly, following the Golden Rule will also do neither you, nor your portfolio, any harm.

In these troubled times, I can’t emphasize how strongly I feel about #10.  So stop lying, stealing, committing adultery, coveting your neighbor’s wife and taking the Lord’s Name in vain.  Some good will come of this, I promise you.

There’s a lot more to be said about all of the above, but we can only do so much with the written word, right?  If the spirit moves, contact me and we’ll talk.

Trust me my brothers and sisters, it’ll do you no harm.

TIMSHEL