Stock Exchange: Can We Trade Geopolitical Risk?

Summary

• The headlines are full of geopolitics - even more than usual.
• Many believe that these problems are important market risks.
• Is this true? Is there a way for traders to exploit the volatility?
• Our models have a few interesting choices.
• The best trading strategy is not obvious!

Our Stock Exchange is all about trading. Each week we do the following:

• Discuss an important issue for traders;
• highlight several technical trading methods - including current ideas;
• feature advice from top traders and writers; and
• provide a few (minority) reactions from fundamental analysts.

We also have some fun. We welcome comments, links, and ideas to help us improve this resource for traders.

Review

Our last Stock Exchange took up the trend toward evidence-based trading. If you missed it, check back to see what evidence you should be using and how to acquire it. Dr. Brett has added another post and a valuable link on this topic.

This Week - How Can We Trade the Known Geopolitical Risks?

This important topic is in the headlines. The G20 meetings, the Trump/Putin session, and North Korea’s missile tests are all front-page news. What does it mean for traders?

Trading Tips

• Dr. Brett Steenbarger is coming to Chicago for a trading workshop. If you have never seen him in person, this is a special opportunity. If you have seen him before, you already know you will enjoy a repeat. One of his topics will be personal awareness and states. This is the key to accessing your peak potential and avoiding your greatest weaknesses.
• Capital Market Laboratories suggests how to take advantage of volatility with options. One caveat: You need to have some idea of when the volatility is coming. In some stocks, the potential earnings moves are not fully reflected in option pricing. On geopolitical risks, finding a date certain might be a problem.
• Cornell University Professor Eswar Prasad, an economist with special credentials on trade policy, sees both protectionism and cyberattacks as underpriced risks. He cites next year as the time of peak concern. It is a good article to read, but finding specific trades will be a challenge. In itself, that is a message for normal trading time frames.
• Daily news reports of all stripes attribute market behavior to the headline risks - at least when selling occurs! Quiet markets or gains have the same international background, but without the commentary.
• Surprisingly, crises matter little to financial markets. Adam S. Posen of the Peterson Institute for International Economics has a great article on this topic. He describes the “natural experiment” of a series of past crises. Here is a hint at the conclusion:

It may not make much sense that geopolitical risk has little equity market impact, but it should not surprise us. Historically, even actual outbreaks of war or recurrent terrorism have caused little in the way of deviations of market outcomes from their usual patterns - and when they have had an impact, those impacts have tended to be transient. This is an empirical regularity of outcomes in the wealthy West, definitely since nuclear deterrence and avoidance of direct great power wars have come into play.

For those who want to go even deeper into history, you can learn about the 19^th century as well.

As always, I’ll share my own observations in the conclusion.

Expert Picks from the Models

This week’s choices include several market sectors.

Roadrunner: Align Technology (NASDAQ:ALGN) is my pick of the week. Regular readers may remember that I picked this one up a little over a month ago, near the end of May. I might as well take you through the whole thing; it’s a good explanation of how I work.

I choose stocks when the price is near the bottom of the trading channel. This was definitely the case when I staked out my initial position on 5/25. By 6/23, the stock had appreciated just over 8%, up to around $151 per share. Not only was this a sizeable gain, but also it put the price near the top of the channel. I sold my shares and moved on.

Then, on 6/30, I noticed another dip down to the $150 mark. As a result, that brought the channel down lower and made a re-entry look attractive. I’ll be holding this position for another four weeks at the very most.

J: As you can see from the F.A.S.T. Graphs chart below, this is a P/E ratio of 54.2. The earnings growth is uncertain and fluctuating through a significant range. Are you sure the coyote is not influencing you again?

RR: That is what you said the last time, but it was a profitable trade. My system does not require earnings.

J: At least there is some earnings foundation. I see risk to 55 or so.

RR: That is why you are the investor, and I am the trader. Beep, Beep!!

Holmes: This week I am highlighting Archer Daniels Midland Company (ADM), the American global food processing and commodities trading corporation. It is a company established way back in 1898 and is headquartered in Chicago. It is especially familiar to our team.

My focus as always is on the chart below. At first, what interested me was that the stock is trading much below its 50-day and 200-day moving averages. Surely, a sign that it has room for upside. Second, I saw the stock was at its lowest 52-week price level at the end of June. Delving into its historical price movements, last October-November, the stock saw a sudden spike in price which was followed by a huge fall. After its recovery with time, the stock dipped again in late-April to touch its lows. Since May, it has been seeing short ups and downs for another two months. So, I thought the end-of-June low was a very good entry, and it did give me the weekly gain. I expect to collect more gains in the next few weeks.

J: ADM seems to have little upside and very slow growth. With a reasonable dividend, it is a better candidate for our Enhanced Yield program than one of your trades.

H: It might work there as well. I see a chance for a nice, short-term bounce toward the former highs.

J: The plummeting price in May came because of terrible earnings, attributed to a "grain glut."

H: Temporary. There will be more hungry people.

Felix: I don’t have anything new this week, but don’t go thinking I’m off on another vacation! I just like to hold stocks a little longer than most of my friends here. Let’s do a blast from the past, instead. In early May I recommended Valeant Pharmaceuticals (VRX).

J: You are dating yourself with that language. Our young trader readership may not follow you. It reminds me of when I was going to use "Herbert Simon Jumps the Shark" as a post title. After some discussion, I found that a Venn diagram of those familiar with both the man and the term showed no intersection.

F: I know about Venn diagrams, of course, and I saw the famous Fonz episode, but who is Herbert Simon?

J: Exactly. So tell us about VRX, a very controversial company.

F: I bought on May 8, right during that sharp incline. Had I been taking a 2-4-week approach, this would not have been a good choice. But again, I take the long view. This worked out well, as you can see. My shares in VRX are up 42%, and I’m still looking to hold onto this one for another few months. Patience is a virtue.

J: This has been one of the most publicized stocks, engendering a major debate among hedge fund giants.

F: Is that bad?

J: Not necessarily, if you choose the right side!

F: I suppose that you will next show a chart from a fundamental analyst, like Chuck Carnevale.

J: Of course. His tools are the best! Anyone serious about buying a stock should begin with a look at Chuck’s analysis.

J: The price has gotten low enough that the reduced earnings are OK - if they do not decline further. Do you have a ratings update for us?

F: Indeed I do.

Oscar: This week I have no new choices.

J: You had another tough day today.

O: Yes, although my biotech holdings had an earlier rebound.

J: You also hold bonds. That is usually a good hedge in a dicey market.

O: Right now, at least, bonds and stocks were both selling off.

J: You sound like you are in a slump.

O: Just look at the Cubs. It even happens to champions. I’ll rebound soon.

J: I’m sure you will. Do you have a ratings update for us?

O: Yes. I respond to reader requests. The list reflects their current sector interests.

J: What about Athena?

O: She has been in her office, but did not have anything for this week. Like me, she needs some intermediate-term trends.

Conclusion

It is a mistake for traders to attempt, on the fly, to adjust their methods to fit the crisis du jour. A stronger approach includes the following:

• Stepping back. If the market climate does not fit your trading methods, it is better to wait than to reach for unsuitable trades. This is a lesson from great traders like Richard Dennis and the Turtles, and also from our models.
• If the unusual volatility creates an opportunity, be ready to hit it out of the park, since some believe that news events should drive markets, and they act on that belief. If enough do so, the trading algorithms will kick in.

Here is a summary of the cast of our characters. Find your own favorite!

Stock Exchange Character Guide

Character	Universe	Style	Average Holding Period	Exit Method	Risk Control
Felix	NewArc Stocks	Momentum	66 weeks	Price target	Macro and stops
Oscar	“Empirical” Sectors	Momentum	Six weeks	Rotation	Stops
Athena	NewArc Stocks	Momentum	One month	Price target	Stops
Holmes	NewArc Stocks	Dip-buying Mean reversion	Six weeks	Price target	Macro and stops
RoadRunner	NewArc Stocks	Stocks at bottom of rising range	Four weeks	Time	Time
Jeff	Everything	Value	Long term	Risk signals	Recession risk, financial stress, Macro

Click to enlarge

Background on the Stock Exchange

Each week, Felix and Oscar host a poker game for some of their friends. Since they are all traders, they love to discuss their best current ideas before the game starts. They like to call this their “Stock Exchange” (Check it out for more background). Their methods are excellent, as you know if you have been following the series. Since the time frames and risk profiles differ, so do the stock ideas. You get to be a fly on the wall from my report. I am usually the only human present, and the only one using any fundamental analysis.

The result? Several expert ideas each week from traders, and a brief comment on the fundamentals from the human investor. The models are named to make it easy to remember their trading personalities.

Getting Updates

We have a (free) service for subscribers of our Felix/Oscar update list. You can suggest three favorite stocks and sectors. Sign up with email to “etf at newarc dot com”. We keep a running list of all securities our readers recommend. The “favorite fifteen” are top ranking positions according to each respective model. Within that list, green is a “buy,” yellow a “hold,” and red a “sell.” Suggestions and comments are welcome. Please remember that these are responses to reader requests, not necessarily stocks and sectors that we own. Sign up now to vote your favorite stock or sector onto the list!

Analyst’s Disclosure: I am/we are long ADM, VRX, ALGN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.