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Liquidity, The NFCI, And Leverage
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Liquidity, The NFCI, And Leverage

If you want to trade macro, you need to understand liquidity.

PTJ, Druck, Soros, Dalio — all these legends have expressed this fact multiple times.

Liquidity is what moves markets.

This is even more true now than in the macro heydays of the 70s and 80s.

With the rise of “blind investing” in the form of passively buying and holding ETFs, the majority of investors don’t care about valuation or merit. They just auto-shuttle their excess funds to the nearest robo advisor without a second thought.

This amount of “excess funds” is largely dependent on liquidity conditions.

When liquidity is loose, it’s cheap to get levered. People have extra cash and plow it into risk assets. Prices rise.

When liquidity is tight, people have less cash to spend. They may even sell stuff to service their existing debt. Prices fall.

There are a myriad of ways to measure and monitor liquidity conditions. No single method is best, but one of our favorites is using the Chicago Fed’s National Financial Conditions Index (NFCI).

This index combines over 105 different indicators of financial activity to form one easy-to-read liquidity measurement. Money markets, debt markets, equity markets, traditional banking systems, “shadow” banking systems — they’re all included.

The zero line represents average liquidity conditions. Positive values indicate tighter-than-average conditions and negative values indicate looser-than-average conditions.

The Chicago Fed also publishes the Adjusted National Financial Conditions Index (ANFCI).

Since financial liquidity conditions are highly correlated to economic conditions, this index isolates the uncorrelated component. It tells us what liquidity conditions are like relative to economic conditions.

Positive values indicate liquidity conditions are tighter than would be suggested by current economic conditions, while negative values indicate the opposite.

You can see the difference between the standard and adjusted index in the graph below.

We prefer the ANFCI because it isolates liquidity conditions better than the NFCI.

The NFCI doesn’t always tell you when liquidity is deteriorating. In the late 90’s and 2014/2015, liquidity conditions were worsening but the strong stock market and strong economy kept the NFCI below 0, signaling liquidity was loose.

In contrast, the ANFCI was above 0 during the same period, signaling conditions were actually tightening.

The ANFCI is a little noisy to look at, but if you smooth the data with a 12-month MA, you get a nice picture of liquidity conditions in the U.S.

The cyclical nature of our economy becomes clear and it’s easy to see how liquidity predicts business cycles. You can use this tool to help you trade on the right side of the market.

When liquidity is tightening, take bearish trades. When liquidity is loosening, take bullish trades.

This index is also broken down further into 3 sub indices — risk, credit, and leverage.

Risk is a coincident indicator, credit is a lagging indicator, and leverage is a leading indicator of financial stress.

For trading purposes, the leverage part of the equation matters the most to see where the stock market is headed.

Above average leverage sows the seeds for a recession and a falling stock market. Below average leverage precedes economic booms and stock market rallies.

Ray Dalio discovered this logic long before the Chicago Fed and has made billions trading off it.

The leverage index can be broken down yet again to only include nonfinancial leverage.

Nonfinancial leverage is one of the most powerful leading indicators of stock market performance.

Liquidity, The NFCI, And Leverage

This graph might look familiar to you because it’s basically the short-term debt cycle, which can help you time markets.

For example, debt was at obscene levels before 2008 and signaled a shorting opportunity. And by 2010 debt was back below average and signaled a buying opportunity.

People are always the most levered at a market top and the least levered at a bottom.

A skilled macro trader wants to do the opposite. Paying attention to nonfinancial leverage will help you do that.  

Lever up when others are unlevered and delever when others are highly levered.

Despite all the financial doom and gloom we’re drowned with nowadays, nonfinancial leverage readings tell a different story.

Current levels are only average.

Before making your next trade, take a look at these indicators.

How’s liquidity? Where are we at in the debt cycle?

Knowing these answers will make you a lot more confident in your trading. It’s hard to get blind sided by a big crash or miss out on a huge rally when you have a handle on liquidity.

To learn more about how we measure liquidity at Macro Ops, check our our Trading Handbook here.

Summary

  • Liquidity is a key variable in determining the macro landscape
  • We can monitor liquidity using the ANFCI
    • If the ANFCI is trending higher, liquidity is tightening and we want to lean bearish
    • If the ANFCI is trending lower, liquidity is loosening and we want to lean bullish
  • The nonfinancial leverage component of the NFCI tells us where we are in the debt cycle
  • We want to buy risk assets at the bottom of the debt cycle (below average leverage) and sell risk assets at the top of the debt cycle (above average leverage)

 

Exploit Errors To Find Your Edge
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Exploit Errors To Find Your Edge

Market speculation is a zero-sum game. In order for someone to win, someone else needs to lose.

You can think of the market as a collection of players… some weak, some average, and some strong. Your goal is to take action against the weak players and relentlessly separate them from their money.

To do this you’ll need an edge.

Now the word edge is thrown around a lot in finance, but what it really means is the ability to exploit the errors of your opponents.

If you can’t find these errors, or if your opponents just aren’t making them, you can’t win.

Why?

Because to make a bet with positive expectation, someone else needs to make a bet with negative expectation.

A bet with positive expected value or “positive EV” means that placing it repeatedly will result in net profits. The outcome of any single instance may be negative due to variance or luck, but over the long-run the bet’s edge will express itself and profit.

The opposite is true for a “negative EV” bet. A negative EV bet may win in the short-term due to variance or luck, but over the long-term it’ll produce net losses.

To thrive in this zero-sum environment you need a relentless focus on other players’ errors. You need to find and exploit them.

How To Find Errors

Finding errors begins with asking the right questions:

  • Which market players make the most errors?
  • Why do they make them?
  • What market situations trigger these errors?

In answering these questions, we can break market errors into two types — unintentional and intentional.

Unintentional Errors

Unintentional errors are made by players who try to win, but then fail because of flaws in their process and implementation. Taking advantage of these errors can be very lucrative.

Here’s a list of the most common reasons weak players make bad bets:

  • Ego
  • Fear
  • Myopia
  • Labeling

Ego

Many players are only in the market to stroke their own ego. True or not, they want the world to know they have the “biggest dick” in the room.

In the poker world we call these guys “ballers”. They aren’t at the casino to win, but are instead trying to bully the table in order to come off as rich and aggressive. They could care less about making positive EV bets. These guys are there to show off.

You can easily spot ego-driven market players on Finance Twitter. These are the ones who hold onto particular narratives with a vice grip until the bitter end, win or lose. In the process they make tons of negative EV bets which are perfect for the astute Operator to exploit.  

Look no further than the gold bugs to see ego in action.

Gold bugs will never stop buying gold. It doesn’t matter where the price is going. They have a certain set of beliefs about inflation and central bank policy that need to be proven right. The system has to fall apart, vindicating the gold bugs who can finally yell “told ya so!” Nothing else matters.

Their desire to be right about gold is purely to satisfy their own ego.

Making a trading decision based on ego instead of positive expectation is a huge error that can easily provide you with profit. A gold bug will always be there to buy the gold you’re trying to short in a downward trend. And as you know, it’s pretty easy for a bear to crush a bug…

Fear

Fear is a key evolutionary emotion that helped keep us alive over millions of years. But in the game of speculation, it only kills us.

Succumbing to fear creates large unintentional trading errors. A great example is the investing public that consistently sells at market lows. Fear overwhelms their trading decisions and leads to them sell at the bottom when they should be buying.

It takes a considerable amount of time, effort, and mental rewiring for an investor to overcome the fear of losses. But doing so gives you an edge over those who haven’t.

Take hedge fund titan David Tepper for example. In 2009 he loaded up on shares and debt of various banks when everyone thought they were headed for bankruptcy. By the end of the year he pocketed himself a cool $2.5 billion…  

Watch for trades made out of fear. You can take the opposite side for huge gains.

Myopia

It’s tough for investors to picture a future drastically different than their immediate past. Weak players lack the imagination and foresight to do so. This can be exploited.

Many short sellers, for example, constantly step in front of innovation trains and get mowed down in the process. The unimaginative bears in Tesla have been getting flattened for years…

Tesla Revolutionize Auto and Energy Industries

Their first mistake is not accepting that Tesla could indeed revolutionize both the auto and energy industries. Their second mistake is discounting the power of other investors’ belief in that same possibility. Herding and reflexivity can push prices much higher than what “conventional” valuation methods infer.

Watch for these trigger happy short sellers fighting large upside momentum. Most of them can’t take the pain and puke out. The resultant buying pressure they create from covering their shorts will send the market screaming higher once again. It’s easy to benefit if you’re on the right side.

Labeling

In professional fund management there exists a game within a game. You have the trading game and then you have the asset gathering game. Managers have to balance both. This means that sometimes a manager may have to take a negative EV action in trading because it’s a positive EV action in asset management.

I call this “labeling”.  

Since a manager may be known as the “oil bull”, “equity bear”, or “value guy”, he’s forced to tilt his bets towards his brand. That way he can maximize the business side of his fund (sales and marketing).

The charming and brash founder of Eclectica, Hugh Hendry, paid greatly for his industry label. Hugh defined his brand by betting on a market collapse in 2008. He knocked it out of the park and his assets under management swelled.

But from then on he was forced to stick to his permabear view. That’s what his new investors hired him to do. They didn’t want him to own beta. They wanted protection if the global economy went double dipped.

Unfortunately for Hugh that meant fighting the central banks and putting up multiple years of poor performance.

Eventually this label drove him mad. In late 2013 he finally decided to flip the cards and go full bull.

I was actually on the investment call the moment he announced his decision to bet on higher prices. The fund of funds at my prior employer had money with him.

His reasons for turning bullish were sound. The central banks had too much control over the current macro narrative and it was a fool’s errand to fight them. But his investor base didn’t listen. Everyone began pulling out like crazy, including my employer.

And guess what? Hugh ended up being right!

Despite the fact that he took a positive EV bet in the trading game, Hugh took a massive negative EV bet in the asset gathering game. His fund management business suffered greatly for it. Hugh’s assets under management are now a fraction of what they were even though he’s trading better.

Errors stemming from the reality of professional fund management make fertile hunting grounds for traders on the outside. Track the “big brands” and fade their trades when the data clearly supports the opposite of their brand biases.

Intentional Errors

Capitalizing on unintentional errors is definitely lucrative, but it takes significant time and energy. Players making these errors still want to win the game. They’ll put up a fight and force you to wrestle their money away. Sometimes they’ll even beat you if you aren’t on your A-game.

On the other hand, players committing intentional errors are literally giving you their money. These guys are much easier targets.  

Intentional errors come from players who don’t care if their trade has positive expected value. They’re willing to lose on trades because their goal isn’t long-term profitability.

Now that may sound a little crazy… who in their right mind is willing to consistently lose on every trade?

Answer: Central banks and hedgers.

Central Banks

CB’s are the ultimate source of intentional errors. They’re like the guys at the casino willing to donk off millions of dollars with no regard for risk control. In poker we call these players Whales. Nothing is more profitable than exploiting a Whale. Nothing.

CB’s don’t care if their trades have positive expected value. Their goal, no matter the cost, is market stability (whatever that means). Post-2008 CB’s made their intentions very clear when injecting record stimulus into the system. They said they’d buy bonds no matter the price. You can make a TON of money exploiting scenarios like this.

Ray Dalio has been taking advantage of CB’s for decades. He modeled their behavior into his macro machine and has been benefiting ever since.  

George Soros plays the CB’s like a fiddle as well. Back in 92’ he broke the Bank of England by taking the other side of their negative EV trade defending the European Exchange Rate Mechanism. Then in late 2012, when Japan began their unprecedented QE program, Soros shorted the yen and massively increased his Scrooge McDuck sized chip stack.

These guys know how to exploit a whale — a must-have skill for any serious speculator.

Hedgers

Central banks may be the most lucrative whale in the game, but they’re not the only profit gusher. Hedgers make plenty of intentional errors you can take advantage of too.

Trader’s have been extracting profits from commodity hedgers since the beginning of the futures markets.

When a farmer shorts grain futures, he’s doing so to avoid unexpected shocks to his income come harvest time. The farmer isn’t worried about his hedges’ expected value. He’s only focused on his crop and its profits.

A large portion of the CTA industry lives off this fact. They consistently make money by taking the other side of farmers’ hedging.  

The same goes for FX markets as well. Multinationals hedge foreign currency exposure to keep their core operations running smoothly. And once again, they’re not focused on making positive EV bets on the trading side.

In equity markets, large institutions like pension and insurance funds hedge their accounts to meet short-term cash flow obligations during volatility events. They purchase protection at a premium and are willing to consistently lose money to avoid liquidity crunches.

These negative EV hedging trades create extraordinary opportunity for the nimble speculator who can take the other side when conditions align.

Attack The Whales First

Whales making intentional errors don’t care that they’re losing. They’re willing to pay you for decades without batting an eye. You can systematically extract profits without them noticing.

Compare that to a weak speculator. They need to win or at least break even to stay active. If they’re consistently losing it won’t be long until they go broke or evolve to stop the bleeding. Once they leave the game, there’s nothing left for you to harvest.

Ask yourself, “How long can I expect this player to continue making errors?” The best edges come from those who are willing to make mistakes repeatedly without changing their strategy.

Use this concept as a starting point for your search.

It’s All One Giant Competition

Speculation means fighting for a living. Instead of delivering value in exchange for dollars, you need to find weak players and take their dollars. This means constantly searching for poorly performing players and the errors they make. If you’re not thinking in this fashion… then you’re probably the one getting exploited.

I’ll let Buffett close this one out.

“If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”

If you’d like to learn more about exploiting errors, then check out our Trading Handbook here.

 

 

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Managing Your Losing Trades

Amateurs focus on finding trades.

Operators focus on managing trades.

Inexperienced traders spend far too much time on trade identification. Their misguided goal is to find the perfect trade with the perfect entry.

The truth is… perfect doesn’t exist. You’re not gonna find some magical combination with a 98% win rate.

Identifying a trade is really only 10% of the process. The other 90% is managing the trade.

Take it from Peter L. Brandt, a legend who’s averaged over 40% compounded returns throughout his 40 year trading career(!!):

Consistently profitable commodity trading is not about discovering some magic way to find profitable trades. [T]rade identification is the least important of all. In my opinion, learning the importance of managing losing trades is the single most important trading component. Consistently successful trading is founded on solid risk management.

Consider an average year for PLB. Only 30% of his trades become winners. The rest either break even or lose. Yet he’s still extremely profitable.

How is that possible?

It’s because he keeps his losses extremely small. PLB’s major edge is in risk management. Limiting his losses ensures his winners more than make up for the losers. He consistently avoids the big mistake that would knock him out of the game. That’s how he achieves long-term success.

Recently our team dug into a stock called Neonode (NEON).

The fundamental thesis was solid.  

We had a left-for-dead company on the brink of a massive turnaround. NEON previously suffered from “too early” syndrome with its product fit, but now its market was finally catching up.

The play was contrarian to say the least. The stock had already fallen over 80% from its recent highs. Investors hated it. But these same investors were also blind to the drivers behind its soon-to-be revival…

We entered our position.

A few weeks later, quarterly earnings were released. And sure enough the stock plummeted over 20%.

Ouch.

You’d think a loss like that would put a dent in our portfolio…

But it didn’t.

And that’s because we managed our risk.

We deployed a three-pronged defense for this trade.

First, we entered on a breakout from a long-term descending triangle pattern. This technical setup gave us an intelligent price level to determine where we’d be wrong. If our risk point was hit, we’d exit our position.  

Second, we put an automatic stop at our risk point. That way if price overshot that level (as it did on earnings day) we’d automatically be out.

Third, we sized our position small. As we said, this was a contrarian play. And while these plays can be extremely lucrative, they’re also very hard to time. We weren’t surprised to get knocked out on our first attempt. That’s why we entered small with the goal of building size over time.

Had we entered NEON heavy, with no technical breakout, and no stop, we’d be in a tough situation right now.

But because of our risk management, we’re just fine. Our portfolio is intact and we plan on establishing another position when a new technical setup forms.

Our original fundamental thesis hasn’t changed. If anything, this price drop makes it an even sweeter deal. But it may take some time before the market comes around to this stock’s value. We’re willing to wait.

That’s the benefit of trade management. It allows you to play another day. Our first entry wasn’t the end all be all. We have an opportunity to try again.

PLB is no stranger to quickly getting knocked out of a position either. He gives himself three tries to hit a trend. We take multiple attempts as well.  

It’s hard being a contrarian. But the reason we not only survive, but thrive, is because of our risk management.

If you’d like to learn more about how we manage risk at Macro Ops, click here to get our Trading Handbook.

 

 

Expected Value (EV) & Bayesian Analysis In Trading
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Expected Value (EV) & Bayesian Analysis In Trading

An alternative title for a trader is “professional uncertainty manager.”

Trading is a business of possibilities, not certainties. Despite our best efforts to predict financial markets, we’ll inevitably be wrong time and time again. Many of our bets will lose purely due to bad luck or unforeseen circumstances. It doesn’t matter if they were objectively good bets. Read more

Guerilla Speculation
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Guerilla Speculation

The following is an excerpt from our weekly Market Brief. If you’re interested in learning more about Market Briefs and the Macro Ops Hub, click here.

 

“If you wait by the river long enough, the bodies of your enemies will float by.”

“He will win who knows when to fight and when not to fight.”

“If a battle cannot be won do not fight it.” ~ Sun Tzu

The Art of War by Sun Tzu dates from 6th century B.C and is the oldest known manual on military strategy.

I first read it in my early teens and was captivated by the weight of the wisdom packed into such a short book. It’s not just a treatise on war but a deeper philosophical look at the underpinnings of how nature works, and more importantly, how we should operate within it.

It’s one of the few books that I revisit every few years and still manage to come away with new insights each time.

Sun Tzu birthed the concept of guerilla warfare. Guerilla warfare enables a small force to defeat a significantly larger and more well equipped one. It accomplishes this through extreme patience, knowledge of thyself and thy enemy, and a superior strategy that shapes the rules of the game to one’s advantage. Read more

Plan Your Trades And Trade Your Plan
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Plan Your Trades And Trade Your Plan

The following is part 3 of our 3-part psychology series. You can read part 1 here and part 2 here.

Clearly our biology and the biases that come with it are hazardous to our financial health.

But how exactly do we solve this problem?

The trick is to plan your trades and trade your plan.

The first step to successful trading is creating a solid strategy that accounts for every possible market scenario. High volatility, low volatility, black swans, it doesn’t matter. Everything should be planned for. Nothing should be a surprise. Read more

Understanding The Difference Between Alpha, Beta, & Cash Returns
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Understanding The Difference Between Alpha, Beta, & Cash Returns

At their highest level, investment returns can be subdivided into three components: the cash rate, beta, and alpha.

return = cash + beta + alpha

The cash rate is the base interest rate controlled by central banks. Every other asset is priced off this rate, including stocks and bonds.

A majority of the time stocks and bonds return more than the cash rate to incentivize investors to take risk. This makes intuitive sense. Why would someone buy risky assets if they could earn the same return in their checking account? Read more

The Fallacy of Market Prediction
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The Fallacy of Market Prediction

Spoon boy: Do not try and bend the spoon. That’s impossible. Instead… only try to realize the truth.

Neo: What truth?

Spoon boy: There is no spoon.

Neo: There is no spoon?

Spoon boy: Then you’ll see, that it is not the spoon that bends, it is only yourself.

~ The Matrix Read more

Intuition In Trading And Investing
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Intuition In Trading And Investing: Can You Trust It?

Do you ever get that feeling that a certain trade will be huge? That you should size up on it and go for the jugular? You can’t exactly describe why this trade is the “one”, but you can definitely feel it.

This feeling is what we call intuition. Read more

How To Find And Execute Global Macro Trades Or Investments
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How To Find And Execute Global Macro Trades And Investments

The following is an excerpt from an email sent to one of our Macro Ops Hub members. It’s a cursory look at how we apply the Macro Ops’ Trade Identification Formula (MOTIF) to markets. The MOTIF series was originally introduced to our Operators through the Vault — a section of the Hub that contains a growing number of educational PDF’s to help advance our member’s trading knowledge and skill set. If you’re interested in learning more about the Hub and everything it offers, including the Vault and MOTIF series, just click here. Enjoy the MOTIF example below!

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The MOTIF structure simply serves as a starting framework to build other mental models and practices off of. It helps ensure that you’re trading with the larger trends and macro forces currently at work. This is extremely important. As traders, we want as many tailwinds behind our trades as possible. Read more