Addressing the Billions Underserved

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Trading the World’s Biggest Trend

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Over the past several months it has become increasingly clear that the US dollar has been the best house in an otherwise bad neighborhood. At Phoenix Capital we have been both a vocal proponent and a benefactor of this notion. There are several factors that support our stance on USD.

First, is the status of the US dollar as the world’s reserve currency. This has held true through the best of times, and the worst of times. Looking back at the 2008 recession, not only did the US dollar remain strong, it reached record highs through the tough times. Fast-forward to 2014 and the dollar rose significantly against all major currencies including the Euro, the British pound, and the Yen. In 2014 the dollar even surpassed levels we saw in 2008 and has remained strong early in 2015. While all of this has been happening, Phoenix Capital has been holding USD as a significant portion of our hedge fund portfolio.

There has been a distinct timeline of events that reinforced our initial justification for the position and allowed us to even amplify it. We began buying PowerShares DB US Dollar Index Bullish (UUP) towards the end of August 2014. Not long after that, the Euro began a decline coupled with rising U.S. bond yields. We continued to buy aggressively through September, and low and behold, the dollar continued to strengthen against other global currencies.

By November, US QE began to wind down and crude oil was well into a slump that it remains in today. All the while, the dollar increased in value, soaring to new peaks as crude oil and industrial metals both plummeted. Our last purchase of UUP was in December, and from there we have sat back and enjoyed the ride.

Our trading decisions in the case of UUP were not solely motivated by macro factors but were also based on support from some key historical data and statistics. At Phoenix Capital, we use a statistical methodology laid out in “The Big Trade: Simple Strategies for Maximum Market Returns” to support our market timing hypothesis. This strategy dictates that after choosing a fundamentally sound security or ETF, we use its past movement in different time frames to enter the market with confidence supported by clearly defined probabilities.

Our first purchase of UUP was made on Aug 28th, 2014. Based on weekly statistics with observations of high price, low price, opening price and closing price, we were able to craft some useful statistics. We noticed the price of UUP had been oscillating around 21.70 for the two weeks prior to entry, but this was followed by a distinct change when the week of the 18th closed at $21.94, indicating an upward trend.

One upward bar is not enough, however, and we needed more confirmation of a sustainable upward trend. The following Monday, August 25th closed at $22.00, thus exceeding the previous week’s high. From our historical data of a 476-day period for UUP, Mondays very often set a low for the week. Based probabilities derived from this data we could positively conclude that this week as a whole would likely mark a second-consecutive week of upward movement for UUP.

Upon choosing the week of the 25th as an opportune time to enter the market, we then moved forward with the next steps in “The Big Trade” methodology. The 25th opened at $22.00 and we waited for an incremental move to define the entry, but $22.00 remained the price at close. In cases where Monday is the week’s low, we have found a high probability that the week’s high will then fall on either Thursday or Friday. Based on this, we entered at the average price of $21.985 on Wednesday of that week. At this time, we were prepared to take a 10% stop-loss if the trend were to reverse. However, from the initial entry the stock has continued increasing and we have continued to build up our position to where it currently sits.

Moving forward, we anticipate this position to remain strong in the near future. The Federal Reserve recently announced their intentions to refrain from raising interest rates until “further improvement” is seen in the US economy. Many are interpreting this as saying we will have several more months of low rates.

But just how much longer can we expect the USD bull market to continue? There are certainly signs indicating that the bull run is nearing its tail end. First, the current USD rally has well exceeded its historical averages. Dating back to the 1970’s, USD rallies average 20% and last under one year. The current bull run has seen the USD rise 25% since June 2014. If we consider the low in April 2011 as the starting point this rise becomes roughly 40%.

In addition, one could argue that the dramatic downtrends we have seen recently in EUR and JPY as a result of aggressive QE policies are coming to an end. Historically, the anticipation period leading up to QE implementation, and the period when that QE is initially implemented are the times marked by the most significant downtrends. A period in which the currencies level out typically then follows these downtrends. If the EUR and JPY do level out, this will mean less significant gains for UUP, especially considering the significant weight carried by JPY and EUR within UUP.

Despite all of this, it is our conclusion that the USD will remain strong at least in the short term. With that said, there is plenty of evidence to indicate that the party is nearly over. It is not too late to get in on the trend with a purchase of UUP, however one must monitor the situation closely in the coming months, and by as early as the beginning of 2016 we could all be singing a different tune.

The American Bull Market

 

U.S. stocks have been going up for six years now. That’s a lot longer than the typical bull market cycle, which usually lasts about 3.5 to 4 years. So how much longer can this upswing last?
There are plenty of reasons for investors to be nervous right now: the Federal Reserve is likely to hike interest rates soon and the strong U.S. dollar is hurting some companies that do a lot of business overseas, among other factors.
But here’s why I’m still bullish on America:
The Fed rate hike: Yes, the Fed is likely to raise interest rates in the coming months, but that isn’t necessarily a negative for stocks. In the last 20-plus years, the Fed has only had three major cycles of rising interest rates, beginning in 1994, 1999, and 2004 respectively. In each case, the stock market went up in the months before the interest-rate hike, had a short-term correction of roughly 7%, and then started going up again — with a significant rally after the correction.

A good example to consider is the bursting of the dot-com bubble in 2000. The Federal Reserve began raising interest rates in 1999 leading up to the impending recession.

What is interesting is that at that time, U.S. Treasury Bonds were facing an inverted yield curve, where the yield on short-term bonds was higher than the yield on long-term bonds. The previous nine recessions in the US were all preceded by yield curve inversion, with an average lead time of 14 months.

There are currently no signs of an inverted yield curve in US Treasury Bond yield, meaning that a relatively small, incremental rate hike by the Fed would do little to push towards an inverted yield curve. The Fed will almost definitely increase rates in small increments.

Fed rate hikes, if done incrementally, will not have an immediate negative impact on US equities in the current environment.

Consider tech stocks: Another factor to consider is stock market valuations.

On March 2, the Nasdaq hit the 5,000 mark for the first time since its all-time high in the year 2000. As we all know, this was quickly followed by a sharp decline and talk of a bubble. But the Nasdaq is still up over 3.5% for the year, and there are some important factors that differentiate this time from 15 years ago.

First, back in 2000, the Nasdaq was in the midst of the dot-com bubble, and companies trading on the index were clearly overvalued. In comparing the Nasdaq in 2000 to now, we can see that the 12-month trailing P/E ratio for the Nasdaq composite index was around 190 in 2000, while today it sits around 30. This same trend can be seen among some of the largest companies on the Nasdaq, including Microsoft (MSFT, Tech30), Apple (AAPL, Tech30), and Google (GOOG), all of whom have more grounded P/E ratios today than they did in 2000.

Apple in particular, which alone makes up just over 8% of the Nasdaq’s market value, appears to be of tremendous value, trading at a forward-looking P/E ratio of around 13. Similarly, Google and Microsoft, who each represent about 4% of the Nasdaq’s market value, are trading at forward-looking P/E ratios of 16 and 14, respectively. Together, these three companies account for over 16% of the index.

Low interest rates also allow companies to borrow cheap and create shareholder value via shareholder buybacks that might be more difficult in a high interest rate environment. In 2015 we have already seen share buyback announcements from several big players on the Nasdaq includingQualcomm (QCOM, Tech30), Gilead Sciences (GILD), and Comcast (CCV), to name a few. These three companies combine to account for nearly 5% of the Nasdaq. I don’t see this letting up.

Improving global economy: Looking internationally also gives more reasons for investors to remain bullish on U.S. equities. An aggressive quantitative easing (“QE”) policy is being implemented in Europe, which has resulted in a dramatic rise in equities. For example, the German DAX-30 indexcrossed the 12,000 threshold Monday after crossing the 11,000 level in January.

Similarly, Japan has stated its intentions to continue an aggressive QE policy in 2015, aiming to inject ¥6.65-trillion a month. With European and Japanese companies doing well, we can expect to see that money trickle into US equities as foreign sovereign funds begin investing into US equities.

In the long term, however, it would be wise to be wary of the DAX and European equities, as equity markets are a poor reflection of economic health, and some leading indicators are showing German exports on the decline.

Strong dollar: Even the surging U.S. dollar probably isn’t as bad as some claim. In the days of globalization and the ease of outsourcing and cost cutting, there are countless ways for multinational corporates to cut costs and maximize profits. The concern of a strong U.S. dollar impacting multinational performance is surely overblown, and can easily be addressed by management rather than being cited as an excuse in quarterly reports and conference calls.

Investors should look to maximize current market trends with the dollar and U.S. equities. An effective strategy to do so might be to buy an S&P 500 ETF like SPY and to hold U.S. dollars.

http://money.cnn.com/2015/03/17/investing/stocks-market-2015-federal-reserve/

Order and Chaos: The Past Present and Future of Markets

In 1948 Claude E. Shannon published a landmark paper entitled “A Mathematical Theory of Communication”, detailing what we now know as information theory. Information theory aims broadly to quantify information in a way that allows us to understand the limits of compressing and storing data.

Central to Shannon’s theory is the idea of information entropy. Information entropy in Shannon’s theory refers to the level of uncertainty contained within a particular message. A message containing more information will have higher entropy and thus creates higher levels of uncertainty. In other words, entropy is maximum when all outcomes are equally likely. Any move away from equally likely, or random, outcomes through the introduction of predictability lowers information entropy. Simply put – entropy is chaos, and the only way to combat chaos is through the introduction of probability.

The universe is made up of information. The manifestation and interpretation of that information is accompanied by a certain degree of entropy. That is to say, the universe consists of events and outcomes. Some of these events are purely random, while some can be predicted with relative ease. We are constantly trying to construct models to predict the world around us and create order. Whether it is something as simple as gambling on a sporting event, or something slightly more complicated like constructing a financial model for a new business. We are always looking to compress information, and thus reduce uncertainty in the decisions we make. It is how we try to understand the world around us.

 

So how can all of this be applied to capital markets? To the untrained eye, the stock market might look like a world of uncertainty. In fact, one could argue that trends of increasing volatility and increasing trading volume have rendered markets more uncertain, or chaotic than ever before. Traders today often operate based on a host of patterns or models in an attempt to compress massive amounts of information. Unfortunately, more often than not such models are inherently entropic, and thus generate uncertain, or high entropy outcomes, in turn contributing to market chaos.

A key theme within the various models used in the realm of financial markets is their lack of basis within the scientific method. This means that many models used to predict financial markets do not hold up under repeated trials, and cannot produce consistent results with any degree of certainty over periods of time. Technical analysis in particular comes to mind due to its reliance on subjective patterns. The issue with using subjectivity in an attempt to create order is that instead of bringing order to the system as a whole, it creates a ripple effect generated by the initial subjective, irrational decision, making the greater system more difficult to predict.

A successful model will compress information in a way that creates orderly, probabilistic results. An interesting example to consider is the use of DCF analysis in constructing a valuation. The DCF approach compresses elements of past, present, and future performance effectively in generating a valuation based at least somewhat on probabilities. Where this falls short is the subjectivity of the variables input across different individuals constructing the valuation.

 

 

So, how can one reduce information entropy and make high probability trades? Through the use of models grounded within the scientific method that eliminate the randomness of subjectivity and operate based on probabilities. At Phoenix Capital we employ a high probability approach to trading. We monitor price moves for statistical significance, and use this information in buy or sell decisions. This strategy has yielded tremendous results, particularly in our positions in UUP and SPY. From August 2014 to February 2015, a span of 184 days, this strategy has yielded us a 12% return on investment.

For more information, please contact Phoenix Capital at info@phx-cap.com.

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Peter Pham is an author, international fund manager, and a registered financial director by the Cayman Monetary Authority (CIMA). In 2013 he published his first book entitled, The Big Trade: Simple Strategies for Maximum Market Returns. He currently manages the portfolio of a global hedge fund and runs an asset management company, Phoenix Capital.  (read more)

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