Newsletter of Danny Merkel - Issue #120
Market Review:
Hello, and thank you for your patience while I took some time off. Since my last publication there have been some bullish developments.
The most bullish view of the market can be seen through the lens of QQQ. The long-term trend has turned up (white arrow) and the bulls have been printing higher highs:
Even though using just a 100 & 150 day moving average to define the trend may seem ridiculously simple, the fact remains that it does a good job of keeping me out of trouble. Countless traders went broke last year fighting these moving averages.
Anyway, the last hurdle QQQ has to face at this stage is to clear its all-time-high. Put another way, 100% of the advance has simply been recuperating losses from last year. What if you had a system in place that prevented big drawdowns in the first place?
Furthermore, I don’t consider the QQQ to be a valid index from a risk management point of view. It’s far too concentrated in a small number of stocks which themselves are all highly correlated to one another.
This top-heavy over concentration can lead to powerful rallies in good times, but also to unacceptably painful drawdowns during bad times. QQQ has experienced a maximum drawdown of 82% in its past and also multiple 50% drawdowns as well.
If you look at a broad-based index, such as all stocks in America that aren’t part of the S&P 500, the bull market simply ceases to exist.
The ETF above contains 3,666 stocks - everything except the S&P 500 - and over the past 18 months, these collectively are down an average of 25%.
In other words, outside the hype of a handful of stocks such as NVDA, MSFT and AAPL, the average stock in America is struggling massively.
Put/Call Ratio:
I don’t trade directly off the put/call ratio, but I do find it interesting and, with hindsight, perhaps I should have used it.
When investors become nervous, they will tend to purchase a lot of puts for hedging or to bet on a falling market. The idea is that when there is an overabundance of fear, that can lead to a contrarian signal.
The problem with the put/call ratio is that there’s a lot of noise day to day and so I smoothed it out by taking a 100 day moving average, colouring it as purple in the chart below:
As you can see, there was a tremendous accumulation of put options that built up at the start of 2023.
With so many people on the bearish bandwagon, myself included, the market refused to drop and there has been a painful unwinding of these vast bearish bets.
The unwinding of these bearish bets, in turn, has produced a deluge of short squeezes in individual stocks as rising prices force short-sellers to cover, which causes prices to rise further, which causes more shorts to cover.
Because it’s been the most beaten down stocks that have experienced the greatest short-squeezes, last year’s losers are tending to be this year’s big winners.
The reverse is also true - stocks that did well last year are struggling this year. This means that momentum based trading, which overweights past strong performance, is struggling.
The Momentum Factor ETF (MTUM) hasn’t been able to gain even a single percent point at any stage this year and is consistently underperforming SPY:
In conclusion, the name of the game this year has been to buy the weakest stocks and sell the strongest. In the long run, this is a strategy that leads to ruin and explains why countless traders got crushed in 2022, but it is working in 2023 at least for now.
Gold:
Trend Following trading is not buying a bunch of growth stocks and praying the market goes up for you. It’s about participating in a wide variety of different asset classes both long and short.
Completely uncorrelated to growth stocks, Gold managed to print a new 52-week-high recently, so naturally GLD has been on my radar screen.
Now had you bought those new highs, you would have experienced a breakout to nowhere as price just chopped sideways for months.
However, by strategically writing a put option at gap-support levels, as explained in previous issues, you could have allowed this sideways grind to work for you through time-decay:
The problem I had with Gold and the reason I didn’t outright buy it is simply that there wasn’t an all-time-high.
Bigger picture, GLD is still struggling with its 2011 top, never decisively clearing this hurdle:
Although writing put options isn’t exactly Trend Following, it appears to be the only option available at this moment that is working.
Interesting ETFs:
Given that the breakout in Gold failed and also a lack of trends in oil and bonds, it’s no surprise that classical Trend Following firms are hurting this year.
For example, Bill Dunn’s flagship fund is flat YTD:
Also, I previously mentioned a Trend Following strategy that is wrapped up in a convenient to trade ETF.
Trading under the symbol DBMF, the strategy does a lot of things right: it follows trends, it cuts losses, it goes both long & short, and it trades a wide variety of markets.
The only trouble is that doing all these great things isn’t working this year.
DBMF originally got smoked by gap down in November of last year and hasn’t been able to regain its footing ever since:
I still believe that Trend Following works, but there will always be losing years. Losing years are necessary otherwise, if it always worked, it would become too popular and stop working.
Trend Following Discussion:
Great traders have losing years. For instance, here is a track record of one of the world’s best traders that you likely have never heard of named Paul Mulvaney:
While growth stock gurus and Bitcoin pumpers got all the media attention, Mulvaney was working away anonymously and silently, generating almost a 90% gain last year.
No tweets, no CNBC interviews, just pure performance.
Although this guy is extremely reclusive and avoids attention, he finally appeared in a podcast interview for the first time in his life.
He sounds like an absolutely hardcore, stone-cold trading robot. I highly recommend listening to the podcast.