How I Measure Risk In Markets And Stocks

|
Includes: CRF, DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, LLSC, LLSP, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWL, RWM, RYARX, RYRSX, SBUS, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPSM, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, USSD, USWD, UWM, VFINX, VOO, VTWO, VV
by: Louis Navellier

Last week the S&P 500 rose 1.43%. I was on CNBC late last Friday talking about the "melt up" in stocks. I said the shorts are being squeezed and this remains a great buying opportunity. I also reiterated that I think June will be a great month. I'd say we look good through July; then it could get bumpy in August.

The U.S. GDP is rising, although slowly. On Friday, the Bureau of Economic Analysis revised its first-quarter GDP estimate up to a 1.2% annual pace, from 0.7% initially estimated. Meanwhile, second-quarter GDP estimates have been reduced from a robust 3.3% to a revised 3.0% due to a rising trade deficit in April. Put those two numbers together and first-half growth looks to be about +2.1%.

The economy is probably growing fast enough for the Fed to go ahead with their next interest rate increase scheduled for the next meeting of the Federal Open Market Committee in mid-June. The minutes of their last (May 2-3) meeting, released last Wednesday, confirmed that the Fed is leaning toward raising rates by 0.25% in June. However, the surprise in the FOMC minutes was that the Fed does not want to sell any assets from its $4.5 trillion balance sheet, preferring to let their balance sheet shrink from "attrition," by letting the securities mature. This "dovish" statement caused Treasury bond yields to remain near their 2017 lows, which is very bullish for future stock prices. Essentially, even if the Fed raises short-term rates, Wall Street does not seem to care, since long-term Treasury bond yields remain near 2017 lows.

The People's Bank of China has raised key interest rates twice since February in an attempt to discourage leveraged bets in its capital markets. Due to the recent gyrations associated with Chinese ADRs, I would like to explain how I calculate risk. Specifically, I define risk as "dispersion from the mean" (i.e., Standard Deviation). That means that we can think of "good" (up) volatility vs. "bad" (down) volatility," similar to how doctors measure cholesterol, where HDL is the "good" cholesterol and LDL is its evil cousin.

In addition, "Beta" is the risk level tied to the overall stock market. It is better known as "systematic risk." For a stock to score high in my quantitative rankings, it must typically have at least two the following three characteristics: (1) a low Standard Deviation, (2) a good up/down capture ratio, and/or (3) a low Beta.

My quantitative ranking is based on a ratio of Alpha to Standard Deviation, but is not as simple as that, since my management team calculates Beta against various stock market benchmarks, picking the benchmark with the highest reward/risk (R2) correlation. In other words, my management team calculates the better Alphas (unsystematic return uncorrelated to a market benchmark) and Beta (systematic return uncorrelated to a market benchmark). Alpha + Beta times the benchmark's return = a stock's total return.

Essentially, we identify low-correlating stocks that often "zig" when the stock market "zags." Essentially, my quantitative search for non-correlating stocks that exhibit relative strength on down days largely explains why my team is obsessed with finding fundamentally superior stocks as well as 'hot' ADR stocks.

We are obsessed with quarterly earnings announcements (which we call "judgment day" for our stocks). I also look at flow of funds and seasonal events like (1) the annual Russell index rebalancing in June, (2) 90-day smart Beta & equally-weighted ETF rebalancing, and (3) institutional quarter-ending window dressing. The primary reason why I expect the second half of June to be good is because I am expecting that our portfolios will benefit from persistent buying pressure from the annual Russell index rebalancing, 90-day smart Beta & equally-weighted ETF rebalancing, as well as the usual quarter-ending window dressing.

Good quantitative analysis is all about identifying quantitative and fundamental anomalies and then trading ahead of wave after wave of events that create persistent buying pressure. In light of my own techniques, I'd like to discuss The Wall Street Journal's article last week, entitled The Quants Run Wall Street Now.

Do "The Quants Run Wall Street Now"? - WSJ, May 22, 2017

On May 22, the Wall Street Journal revealed how the big hedge funds are controlled by quantitative engineers seeking and exploiting stock market anomalies via new adaptive algorithmic models.

I think what may be happening with the big hedge funds is that they are buying order flow intelligence from Wall Street firms to determine High Frequency Trading (HFT) order flows. They grade the HFT order flow and decide if they want to step in, by providing liquidity for selected stocks by surfing the HFT order flow until a stock gets volatile enough. Then, they decide when to reduce their position and/or exit the stock.

Essentially, when the NYSE switched to decimal pricing, it squeezed bid/ask spreads, replaced market makers and human specialists with computers, and started selling HFT order flow to the hedge funds. Selling order flow is now a big business.

Let me try to explain what is really going on. Essentially, when you surf the Internet through popular website portals, you are being tracked by an artificial intelligence algorithmic model that is being built from your personal searches and shopping patterns. That leads an Internet provider to make suggestions on items you search next. This is no different than your dog watching you and trying to figure out if you are headed to the refrigerator to eat - or going outside for a walk. So, just like your dog closely monitors your actions, the artificial intelligence algorithmic models are watching you closely for your preference signals.

To attract order flow, there is now a "commission war" on Wall Street. Some major brokerage firms have admitted on CNBC that their firms would still make money if they did not charge commissions at all! They make money by selling your order flow.

As I admitted above, I am also a quant, but I am not an "HFT quant." Instead, I am a fundamental quant striving to identify order flow and fundamental anomalies via my quantitative modeling in Dividend Grader, Portfolio Grader, and my management team's continuous back testing & modeling. I have to admit that I have become increasingly annoyed with restrictive trading platforms and pipes that force my firm's orders into models that encourage "fill at any cost" orders. Many firms are trying to force me into poor trading platforms and pipes, so my management company has been leaving what we decide are poor, uncompromising platforms and trading pipes. To be a successful quant, you have to be a sneaky trader, never revealing how many shares you want to buy and be ready to "back off" and "walk away" if your buy and sell orders cannot be filled in an orderly manner.

In summary, the good news is that the financial markets are liquid. The bad news is that the trading platforms, pipes, order management, and HFT systems may be selling our trades to the quants on Wall Street, who can take advantage of our order flow. In other words, when your dog watches you and predicts your behavior, is your dog a friend or a foe? Most of the time, your dog is your friend. Fortunately, most of the time the NYSE's HFT system adds liquidity, lowers trading costs, and has lately been helping many of our stocks "melt up." However, abuses and price anomalies can occur from time to time, especially in the ETF world, since they do not have to trade at NAV. The jury is still deliberating on whether the quants are good or bad cholesterol, but I want to reassure you that I will always try to outsmart the quants, while never paying too much for a trade.

Disclosure: *Navellier may hold securities in one or more investment strategies offered to its clients.

Disclaimer: Please click here for important disclosures located in the "About" section of the Navellier & Associates profile that accompany this article.

About this article:

Expand
Tagged: , , Market News Article
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here