As 2015 draws to a close, this would be a good time to review how I did during the year. As regular readers know, I have two personas, my inner investor and my inner trader. My inner investor had a decent year, while my inner trader had a year that he would rather forget.
What went right
First the good news, I was mostly correct in calling both the top and the bottom in 2015. I was cautious in the spring. My bearishness was contrarian enough that I got a ton of hate mail. In response, I wrote a post entitled Why I am bearish (and what would change my mind) in May 2015 (red arrow below).
As the stock market weakened in August, my fundamental models identified the episode as a correction and not the start of a bear market, which was contrary to the atmosphere of panic at the time. See Relax, have a glass of wine (blue arrow below) and Why this is not the start of a bear market (purple arrow below). All turned out to be prescient calls.
What went wrong
By contrast, 2015 was a difficult year for my inner trader, who used the trading model of my Trend Model. To explain, the Trend Model applies trend following principles to global equity and commodity prices to arrive at a risk-on (buy) or risk-off (sell) signal on US equities. Further, I found that changes in Trend Model readings, e.g. a “buy” signal getting less strong or a “sell” signal getting less weak, can identify short-term market turning points – and that formed the main basis for the trading model. In addition, I supplement trading model signals with overbought-oversold and sentiment indicators to spot market extremes.
The chart below of past trading model signals shows the limitations of this approach. When the market is trending, the trading model had superb results. In a sideways choppy market, trend following models get whipsawed, as it did during the summer of 2015. Worse was the behavior of the trading model during the August sell-off. Despite my general bearishness throughout the summer, sentiment models moved to a crowded short reading in the initial phase of the decline. As a consequence, my inner trader was “long and wrong” during this period.
To be sure, my inner trader did spot the Zweig Breadth Thrust and correctly bought into the subsequent rally (see Bingo! We have a buy signal!). However, those gains weren’t enough to offset the damage caused by the combination of the summer market whipsaws and being “long and wrong” during the August sell-off.
As a result, both my inner investor and inner trader learned some valuable lessons in 2015.
My inner investor learned that once you have constructed a well thought out macro case for taking a position, the amount of pushback and hate mail can be a positive contrarian sign that you are likely correct, though early in your analysis.
My inner trader learned that not all models work all the time. He learned that all models have limitations. Trend following models are known to perform poorly during sideways markets like the summer of 2015. Moreover, overbought-oversold models identify market extremes, but overbought markets can get more overbought and oversold markets can get even more oversold. My inner trader learned both those lessons in 2015.
Both learned the valuable lesson of model diversification in portfolio construction.