Babak's Take on the Markets

Includes: DIA, QQQ, SPY
by: Daniel Eskin

In this latest edition of our Blogger Interview series, Y&I is very excited to bring you the insights of Babak, one of the brightest young financial bloggers online, and a highly followed blogger on Seeking Alpha, with more than 4,600 regular readers. He shares with us his opinions on some of the major issues confronting investors in this market.

Babak is also the founder of Trader’s Narrative blog – offering “Freshly squeezed market commentary & analysis.” Babak created Trader’s Narrative to collect his thoughts in an honest manner, become a disciplined learner and generously provide guidance to his followers.

1. Your website offers “freshly squeezed market commentary & analysis.” What’s your background and what are your aspirations with the blog?

The tagline is a bit tongue in cheek, but it also encapsulates my approach. I mean, who doesn’t love freshly squeezed orange juice in the morning? Especially compared to the stale frozen variety. Not only is it higher quality, there is a personal touch, a craft, if you will, to it. That’s how I approach market analysis. I have an infinite curiosity when it comes to finance and wanted to share that sense of wonderment with others. A long time ago I discovered that I learn best and benefit the most when I try to share something with others so what may look like an altruistic endeavour, is in reality a rather selfish pursuit.

2. What is the most important idea that you have been trying to communicate to your readers in the past 3-6 months?

The one idea that has the most repercussion on future prices of almost everything is the battle between the two opposing economic forces of deflation and inflation. The economic collapse unleashed deflation, of course. We had the price of almost everything fall: real estate, commodities, stocks, etc. Central banks responded en mass with the largest cooperative effort to stoke inflation in modern history. Which force will ultimately win? I don’t know but I have my own ideas. If you happen to be a time traveller from the future, please let me know – I promise to not tell anyone.

3. How do you generate ideas? More importantly, how do you spot and distinguish the important trends from the noise?

I usually get a torrent of ideas just by watching the market and monitoring not only major stock indexes but also commodities and econometric indicators. I try to stay on top of sentiment as well. Most days I have about a dozen things on my mind and the hardest thing is to filter it and figure out which I really want to write about. Readers are also a great source of ideas. I have wonderful readers who are constantly challenging me, asking questions, teaching me, etc.

Regarding managing the noise to signal ratio, it is easy to get swept away by an idea or concept, especially when everyone is suddenly talking about it. Usually blogs and the mainstream media bombard you with it and then "poof!" everyone forgets about it, only to jump onto the next thing. Rinse and repeat. That’s just the nature of the beast so you have to step back and get perspective.

If you are a mental midget like me, stand on the shoulders of giants; listen to what they are talking about, what has captured their expensive attention and try to absorb their wisdom. To mix metaphors, I call these mental giants the “greybeards”: Doug Kass, Warren Buffett, Jeremy Grantham, George Soros, David Rosenberg, Marc Faber, Paul Desmond, etc. They have not only been around for more than a few market cycles, they also bear the scars and loot to show for it. Experience is an expensive teacher – what it gives you in wisdom, it steals in its own currency, time. So learn as much as you can from the experience of others. But let me stress, this doesn’t mean you shouldn’t think for yourself!

4. Your analyses and book-recommendations indicate your passion for technical analysis. How effective has technical analysis been for traders in the last 6-12 months?

It depends on which framework they used and how competent they were in applying it. For example, Stan Weinstein has a simple and effective framework. So does Prechter with Elliott Wave. So do the Turtles. And so on.

The superciliousness is off the charts when traders get into dustups over which framework is better. It reminds me of the endless nerdy debates I used to have with my friends in elementary school. “Who would win in a fight between Batman and Superman? Or Wolverine and Spiderman?” The question itself is ridiculous, of course. What will ultimately decide your success as a trader is discipline and money management.

5. After the confusion of the last few years, what indicators do you NOW follow to give you an accurate picture of the market that you didn’t use before?

As luck would have it, I took a break which coincided with the top of the market in 2007. I will always wonder, had I been watching the market, would I have identified it? To be perfectly honest, probably not.

I’ll never know really but unlike economists, regulators and rating agencies who should be questioning the very foundation of their work (if not their very existence), nothing much changed for traders. The financial crisis didn’t destroy any important indicators that I watch or create new ones, sadly. I say sadly because getting to play with a new indicator is as fun as groggily opening Christmas presents at 5 am.

Toward the end of 2008 I grew cautiously optimistic and then eventually outright bullish. For example, in late November 2008 when the S&P 500 was trading around 850, I wrote: Why Long Term Investors Should Consider Buying. As you may recall, this was also the time when “greybeards” like Grantham started to slowly build long positions while the majority of the investing public was running around mending their garments and wailing. By the end of March 2009 I wrote: Another Reason We’ve Seen The Market Low. And then by May 2009 I was quoting the Simpons: “I, for one, welcome our new bull market overlords.” anticipating the all clear from the Coppock Guide. So that should give you a good overview of some important indicators that helped me to be on the right side of the intermediate trend.

Watching sentiment is also an important part of how I approach the markets. Most people concentrate on the news. That is, what is happening or where the collective attention is at the moment: the President’s state of the union speech, LEI numbers, unemployment data, monetary policy meetings, etc. But the truth is that news does not make price. Price makes news.

Put another way, what really matters is not what happens but how the market reacts to it. If you’ll allow a tangential thought, this is also the key to life. What happens to us is not really important. What is pivotal is how we give meaning to it. Two different people can have the same experience and come away with vastly different destinies based on how they choose to find meaning in that experience. For that nugget of wisdom, I’m indebted to my brother who is a brilliantly successful therapist.

Anyway, as I wrote more and more bullish comments, there was a surprising amount of pushback from people. I could understand that from the general public, since they had been wiped out from the real estate and stock market crash. But even your average trader hated hearing positive things being said about the market. Without fail, every single time I wrote something bullish, they criticised it, picked it apart, came up with excuses why it wouldn’t work, etc. This went on for month after month as the market clawed its way higher. So it was obvious that the majority where leaning against the rally in a very emotional way.

6. You wrote about treasuries recently, and it appears that you don’t think treasuries are in a bubble. Would you put money on that theory?

I was taking the other side of the argument that I had made earlier and presented the bullish side. Previously, I had written several times about the bubble in the bond market. But I try to be agnostic when it comes to the market. I’m not a perma-anything and am only seeking truth and profit. So if you present to me a persuasive argument, I’m more than happy to consider it.

Nothing turns me off faster than when someone is fastidiously wedded to a belief, either bearish or bullish, and does not change their views no matter what. It is really easy to pick a side and continuously hammer away at it from that perspective. Congratulations! You’ve chosen to see the world from your particularly colored lens and you’re losing out on all of that marvellous reality. The pom-pom waving guys over at CNBC are a great example. On the opposite side of the spectrum are guys like Howard Ruff who are forever preaching the imminent approach of an economic Apocalypse. By the way, as you’ll see from that previous link, CNBC had Howard Ruff as a guest exactly at the market bottom, at the time I called it “a contrarian signal from the trading gods.” Another example is Jim Rogers, who has been pounding the table for commodities for 18 years.

It is much more challenging (and rewarding) to be humble and jump on trends in either direction. In any case, getting back to your question on treasuries, with all due respect to David Rosenberg, I find Michael Belkin’s arguments more persuasive: fixed income is a bubble. Retail investors are notoriously clumsy and they jump on the bandwagon right when it is about to topple. Also based on historical precedents, buying bonds here is like stooping down to pick up pennies in front of an oncoming road-roller. You can read the details of these historical studies here: Why Today’s Bond Investors Will Be Disappointed. If you disagree, then basically what you’re saying are the most dangerous words in investing: “No, this time it is different.”

7. These days an important variable one day that leads the market could be completely forgotten the next day in the face of more news. Do you feel the market has hardly any memory going from one day to the next?

Yes, the market definitely has a memory. The media may not, but the market most definitely does. Technical analysis is based on the price memory of market participants with support and resistance levels set by the aggregate behavior of traders based on this same memory. So the key is to concentrate on price, not headlines. To be honest, I get apprehensive when my favourite indicators get a lot of attention. I’d much prefer they stay as esoteric as possible. When CNBC started talking about the Coppock Curve, I think I aged 5 years in the 5 minute time span of the segment. But then they quickly forgot about it.

8. One of your goals with setting up Trader’s Narrative was to continue to learn every day and help others find their path. How’s that going?

I’m indebted to my amazing readers who come and share their expertise with me and each other. I’m continuously astounded and humbled at the caliber of my readership. I’ve met so many traders over the years; hedge fund managers, institutional traders, prop traders, CTAs, etc. Recently I checked my traffic data and noticed bulge bracket Wall St. firms reading my blog. That is something that I never really thought about when I began to write.

9. Now, starting with 100% cash, how would you allocate it to various asset classes, with an investment horizon of 5 years?

Answering that is difficult. Not only because I would need more information (for example, what is the risk tolerance, sophistication and goals of the person for the portfolio) but also because I wouldn’t be comfortable with a “set it and forget it” portfolio since we are not enjoying a secular bull market. Also a 5-year time span makes it difficult to use technical analysis since most of my tools in that regard are more short term in nature.

But I’ll stop being difficult and do my best to answer your question. For an autopilot portfolio like the one you’re implying, during a secular bear market, the goal should be preservation of capital. I would suggest high quality equities, Canadian REITs and a smattering of timber. I would also add a little bit of leverage – nothing crazy, maybe 20-25% depending on the risk tolerance.

There are some calling the Canadian real estate echo-boom a bubble. But I think there is an opportunity within your time frame. Remember, a bull market is just a bubble that you are invested in while a bubble is a bull market that you’ve ignored. If we do get inflation, then REITs will do well as the economy will have recovered and they will be able to increase rents and therefore, distributions.

As well, the Canadian government has basically outlawed income trusts through a tax law change that will go into effect in 2011. There are billions right now invested in income trusts and at least some of that yield starved capital will find its way inevitably into REITs.

Finally, Canadian REITs have incredibly solid balance sheets and are now peering over the border at the wreckage left in the wake of the residential real estate bubble and the impending commercial one. In the next few years, you’ll find them swooping down to take advantage of the carnage. So I would accumulate these REITS on any weakness.

I’m trying to stay well away from specific recommendations but will say that right now it is very easy to find large common household name US and Canadian companies with solid balance sheets, single digit P/Es and yields around 4%. So if you’re bullish on inflation, then that means that eventually, some time in the future, who knows when exactly, these companies will gain price traction. When that happens I think you’ll see dividends keep pace with inflation or outpace it due to the economic recovery as well as healthy balance sheet positions.

Basically it boils down to avoiding the expensive and buying what is on sale. Know the difference between price, value and worth. Be nimble and opportunistic. And when you figure out how to do that consistently, please teach me.

10. Where do you hope to bring the Traders’ Narrative in the future?

I hope to continue to share ideas on the market and develop as a trader.

Babak, thank you for that incredibly insightful piece. We wish you all the best!