have to test back further than 1980, but it is a start. The overall point,it seems, is that relative difference is of more interest than static differencebetween the yields, contrary to what the Fed Model suggests. (See Table 9.1and Table 9.2.)TABLE 9.1
Trades Executed (based on extreme shifts in Fed Model)
Entry Date
Price
Exit Date
Exit Price
% Change
2/1/19847/2/19843/3/19868/1/198612/1/19877/3/198910/1/1990
163.41153.16226.92236.12230.32317.98306.1
6/1/19843/1/19856/2/198610/1/19863/1/19899/1/19893/1/1991
150.55181.18246.04231.32288.86351.45367.07
–7.8718.298.43–2.0325.4210.5319.92
TABLE 9.2
Trades Executed (based on extreme shifts in Fed Model)
Entry Date
Price
Exit Date
Exit Price
% Change
9/1/199212/1/199411/1/19969/1/19983/1/20008/1/20008/1/2002
414.03453.55705.27957.281,366.421,430.83911.62
3/1/19942/1/19961/2/19971/4/19995/1/20006/1/2001Open
467.19636.02740.741,229.231,452.431,255.82Open
12.8440.235.0328.416.29–12.23–2.1
4199_P-09.qxd
12/30/03
3:21 PM
Page 113
The Relative Fed Model (and Other Fun Things You Can Do with Yields)
113
THE BOND ALLOCATION TRADEWhen people are in a panic about the state of the world and the economy,it is often the case that both bond yields and stocks fall. Stocks drop for theobvious reasons: If the economy falters, earnings will falter and stocks willunderperform. Bonds drop for two reasons: (1) People assume that theFederal Reserve will cut rates in order to juice the economy a bit and (2)funds are fleeing stocks and going into safer bonds.This panic is a situation that cannot last, however, for two reasons (atleast):1. As yields drop, the discounted back cash flows of corporate America
get less discounted, that is, the intrinsic values of companies go up,making them more compatible to the tastes of fundamentally mindedinvestors.2. As stocks go up and bonds go down (because yields are going up), theallocations in multibillion-dollar pension funds get away from the allocation ranges these funds have set for themselves. In other words, itwill suddenly be the case that pension funds find themselves with toolarge an allocation of bonds and not enough stocks. They have alreadydetermined the level of risk and exposure they are willing to take ineach category and if that level is exceeded they need to reallocate.Hence, money flows out of bonds and into stocks.
Bond Allocation System• Buy when the 10-year yield is 25 basis points lower than it was onemonth prior and when the Dow is down 2 percent in the past week.• Sell one month later.See the results in Table 9.3. As shown, there is 75 percent success with3 percent average return per trade, which compares favorably with an average monthly return of about 0.7 percent on the Dow since 1990.To up the odds a little bit you can wait for those occasions where yieldsare down 50 basis points over a one-month period. Then the results are 11out of 11 successful trades with an average return of 7.12 percent per trade.The trades that resulted from that variation of the system are shown inTable 9.4.Bond allocation does occur at extremes in both stock market fear andbond market fear. Front running those allocations can be achieved by paying attention to the changes in both markets.
4199_P-09.qxd
12/30/03
3:21 PM
Page 114
114
TRADE LIKE A HEDGE FUND
TABLE 9.3
Bond Allocation System (Dow, 1990–2002)All Trades
All TradesAverage Profit/Loss %Average Bars Held
953.09%20
Winning TradesAverage Profit %Average Bars HeldMaximum Consecutive Winning Trades
71 (74.74%)6.28%2027
Losing TradesAverage Loss %Average Bars HeldMaximum Consecutive Losing Trades
24 (25.26%)–6.36%207
TABLE 9.4
Results
Position
Symbol
Entry Date
EntryPrice
Exit Date
Exit Price
%Change
LongLongLongLongLongLongLongLongLongLongLong
^DJI^DJI^DJI^DJI^DJI^DJI^DJI^DJI^DJI^DJI^DJI
8/20/19919/22/199810/1/199810/2/199810/5/199812/20/20008/2/20028/5/20029/20/20029/23/20029/24/2002
2,913.707,897.207,632.507,784.707,726.2010,318.908,313.108,043.607,986.027,872.157,683.13
9/18/199110/20/199810/29/199810/30/199811/2/19981/22/20018/30/20029/3/200210/18/200210/21/200210/22/2002
3,017.908,505.908,495.008,592.108,706.2010,578.208,663.508,308.058,322.408,538.248,450.16
3.587.7111.310.3712.682.514.223.294.218.469.98
4199_P-09.qxd
12/30/03
3:21 PM
Page 115
The Relative Fed Model (and Other Fun Things You Can Do with Yields)
115
DON’T THROW OUT THE JUNKPerhaps more predictive than looking at 10-year yields is looking at thejunk bond market. When banks and funds are eager to lend money to companies rated as junk, then that activity is potentially a sign that corporateAmerica is doing well. Junk investors spend more time looking over thebusinesses they lend to—their balance sheets, their quarterly filings, and soforth—than the typical day trader or even mutual fund manager spends onthe companies they buy.When banks are eager to lend, the yields go down and the junk bondsgo up. The question is: What happens if junk bonds are going up and thestock market is going down? Is there a potential trade (albeit longer time)that might result?
The Junk System• Buy the market at the end of a month where the S&P has underperformed the Merrill Lynch High Yield Index by 5 percentage points overthe prior three months.• Sell one month later.As shown in Table 9.5 an average return of 2.03 percent for a monthlytrade compares favorably with the average monthly return of 0.68 percenton the S&P 500 since 1990. Now see Table 9.6 for the trades.
TABLE 9.5
Results, S&P 500 since January 1, 1990All Trades
All TradesAverage Profit/Loss %Average Bars Held
282.03%1
Winning TradesAverage Profit %Average Bars HeldMaximum Consecutive Winning Trades
21 (75.00%)4.21%16
Losing TradesAverage Loss %Average Bars HeldMaximum Consecutive Losing Trades
7 (25.00%)–4.50%12
^SPX^SPX^SPX^SPX^SPX^SPX^SPX
^SPX^SPX^SPX^SPX^SPX^SPX^SPX
^SPX^SPX^SPX^SPX^SPX^SPX^SPX
^SPX^SPX^SPX^SPX^SPX^SPX^SPX
LongLongLongLongLongLongLong
LongLongLongLongLongLongLong
LongLongLongLongLongLongLong
Symbol
7/1/20028/1/200210/1/200211/1/20023/3/20034/1/20035/1/2003
989.82911.62815.28885.76841.15848.18916.92
1,160.331,249.461,255.821,040.941,059.781,139.451,067.148/1/20029/1/200211/1/200212/1/20024/1/20035/1/20036/1/2003
5/2/20016/1/20017/1/200111/1/200112/1/20011/3/20027/1/2002
911.62916.07885.76936.31848.18916.92963.59
1,249.461,255.821,224.381,059.781,139.451,148.08989.82
415.35970.431,098.671,163.631,388.911,366.011,160.33
304322.22371.16395.43392.45417.09408.78
ExitPrice
–7.90.498.645.710.848.15.09
7.680.51–2.51.817.520.76–7.25
0.11.578.035.911.913.46–6.42
–0.696–4.781.961.1811.19–1.98
%Change
–21.63–8.58–5.72–1.55–6.21–0.04–1.54
–5.89–1.4–4.2–1.36–0.52–2.19–10.7
–1.23–3.19–9.210–1.21–3.46–12.8
–3.79–0.78–5.6–3.54–3.03–1–2.01
MAE%
0.475.8611.36.336.518.975.29
9.395.322.456.699.7830.34
0.923.238.538.584.584.782.22
4.446.2602.321.5311.521
MFE%
116
4/2/20015/1/20016/1/200110/1/200111/1/200112/3/20016/3/2002
6/1/19921/1/199811/1/199812/2/199812/1/19992/2/20014/1/2001
11/1/199012/1/19907/1/19919/1/199111/1/19911/2/19922/1/1992
Exit Date
3:21 PM
414.95955.41,017.011,098.671,362.931,320.281,239.94
306.1303.99389.81387.81387.86375.11417.03
EntryPrice
12/30/03
5/1/199212/1/199710/1/199811/2/199811/1/19991/2/20013/1/2001
10/1/199011/1/19906/3/19918/1/199110/1/199112/2/19911/2/1992
Entry Date
Trades on S&P 500 Using the Junk System
LongLongLongLongLongLongLong
Position
TABLE 9.6
4199_P-09.qxdPage 116
TRADE LIKE A HEDGE FUND
4199_P-09.qxd
12/30/03
3:21 PM
Page 117
The Relative Fed Model (and Other Fun Things You Can Do with Yields)
117
CONCLUSIONMost stock investors do not look at bonds at all and I think this is a mistake.For one thing, bonds are actually a pretty good trading vehicle if you do notmind the leverage. For another, bonds are the primary alternative to largeasset allocaters such as state pension funds. If bonds are making a huge runin either direction, it could be that an asset allocation trade is about to takeplace and you should be aware. Finally, bond investors are, on the whole,usually somewhat more aware of company issues, economic issues, andglobal macro issues than the average investor. Following their lead is oftena profitable way to make money for us folks who often find ourselvescounted with the dumb money.
4199_P-09.qxd
12/30/03
3:21 PM
Page 118
4199_P-10.qxd
12/30/03
3:22 PM
Page 119
TECHNIQUE 10
Deletions fromthe Indexes
he market is fairly efficient and absorbs new information quickly.When a company announces bad earnings, the stock usually falls fast,too fast to take advantage of the new information by shorting. When acompany announces it is going to be bought, arbitrage funds instantly startbuying up the shares, propelling it to the merger price sometimes withinseconds. One case where the market retains a pocket of inefficiency iswhen it comes to the addition and deletion of stocks into the various indexes that track the broader market.Index funds have become increasingly popular ever since 1976 whenJohn Bogle proposed to the Vanguard Group that it create the first indexfund to track the S&P 500. His goals seemed unambitious at the time—allhe wanted to do was to perform as well as the S&P 500. Not pick stocks thatwould outperform, not try any fancy growth or value strategies. Just simplykeep pace with the index. Since then index funds that track all of the relevant S&P indexes, Russell indexes, Nasdaq 100, Wilshire 5000, and so onhave sprung up, and these funds have outperformed approximately 80 percent of the actively managed mutual funds out there. The largest period ofgrowth occurred in the 1990s when the S&P 500 increased at an annual rateof 17.4 percent. In the 1990s we also saw the advent of the ETFs, such asSPY and QQQ, that allow investors to invest in (and, of course, day trade)funds that track the S&P 500 and Nasdaq 100, respectively. The amount ofmoney in index funds is in the hundreds of billions of dollars, and any smallchange in the indexes effects the flow of that money.A common strategy that many people play is to buy a stock after theS&P announces that it is going to be added to one of its indexes. Index
T
119
4199_P-10.qxd
12/30/03
120
3:22 PM
Page 120
TRADE LIKE A HEDGE FUND
funds are typically not buying on the announcement (since it is not in theindex until the “effective date,” which could be several weeks later). It is aguarantee that they will be buying the stock, so individual investors and actively managed funds can begin buying ahead of the announcement. In thepaper “Investor Awareness and Market Segmentation: Evidence from S&P500 Changes,” the authors, Honghui Chen of the University of Baltimore,Gregory Noronha of Arizona State University West, and Vijay Singal of Virginia Tech, analyze the effect of index changes prior to the effective date.They conclude that, on average, between the announcement date and theeffective date, a stock tends to rise about 5 percent. Deleted stocks, theysay, do not fall as much, the reason being that part of the new buyers ofadded stocks are investors who have become newly aware of the stock because of the addition. Investors do not suddenly become aware of thedeleted stocks, so the effect is less pronounced going into the effectivedate although they do note that there is some selloff.My favorite example of a stock running up into the addition date wasJDSU, which was added to the S&P 500 on July 26, 2000. Many people considered JDSU to potentially be the next MSFT, a stock with almost infinitepromise and growth potential. Telecom was booming and everyone assumed that the telecom companies would have to buy enough fiber andcomponents to put fiber directly going into your home. The demand wasthought to be extreme and would last for years. In the months prior to theaddition, posts on the Yahoo! message board for JDSU like the followingwere quite common:What I do to make money is buy and hold QCOM and JDSU (andothers) . . . when they pull back I play options. When JDSU pulledback from 273 to 210 a few weeks ago, I bought a ton of MAR250and MAR280 calls . . . I sold some of these the other day for a +250%profit and bought more JDSU shares for long term with the profits . . .and today I bought more. Like I said before, I don’t care if JDSU follows the entire market down, over the long term it will far outperformthe overall market. By the split in March, I guarantee we’ll be wellover 200. This is how to make money.Figure 10.1 shows JDSU for the months of July and August, 2000. Thisis a classic example of a stock that ran up, in this case more than 40 percenton high volume as speculators and index funds started buying up theshares, in the three weeks before addition, culminating in the stock hittingan all-time high of 140.50 on the effective date of the addition. Buyers ofS&P 500 funds never had it so good again as JDSU began a nonstop fall atthat very point, never hitting 140 again. Within one year, the stock was insingle digits and at the time of this writing, JDSU is at 3.58.
4199_P-10.qxd
12/30/03
3:22 PM
Page 121
Deletions from the Indexes
121
140.00138.00136.00134.00132.00130.00128.00126.00124.00122.00120.00119.87118.00116.00114.00112.00110.00108.00106.00104.00102.00100.0098.0096.00
Volume
80.00M60.00M40.00M20.00M
FIGURE 10.1
JDSU for July–August 2000.
4199_P-10.qxd
12/30/03
3:22 PM
Page 122
122
TRADE LIKE A HEDGE FUND
Is this a strategy that is still playable? To be honest, I don’t know. I havenot studied or even considered studying it. Too many people are lookinginto this idea, so even if this strategy works now, it will not work in the future. Web sites and services have sprung up to predict the most likely to beadded to an index so people can start buying even before the announcement date. Also, index funds have been improving their strategies for buying up shares, further nullifying the effect. It is not an interesting strategyto me.However, the subject of deletions and what happens to them is an interesting and, I think, playable strategy. A stock is deleted from an index formany reasons: the price has gotten too low, earnings have gone down, liquidity has dried up, the company went bankrupt or was merged, or the stockmight have been promoted to another index (e.g., from small cap to midcap). Going into the effective date, again, many people are playing the strategy of shorting the stock until the effective date. Also, in addition to indexfunds selling the stock, many actively managed funds might also be sellingthe stock. Despite being actively managed, they might be required by charter to only invest in stocks that are members of a select group of indexes.In other words, there is a heavy amount of irrational selling that is taking place having nothing to do with the basic information flows about thecompany. Opportunity must be lurking somewhere when this happens!
EXAMPLESORB, October–November 2001Figure 10.2 shows the chart for Orbital Sciences, ORB, for October and November 2001. On November 2, 2001, the stock was scheduled to be deletedfrom the S&P 600. Through the month of October, the stock was sliding,touching a low of almost 20 percent lower from the beginning of the monthto mid-October. On November 2, it was deleted and then began an incredible rise from 2.1 to 3.21, 13 days later—a gain of greater than 50 percent. Noserious news about the company was coming out. On the Yahoo! messageboards investors were completely perplexed. Nobody had any idea whatwould make the stock go up 50 percent. Sixty trading days after the effective date of the deletion from the index, the stock was at 5.40.
4199_P-10.qxd
12/30/03
3:22 PM
Page 123
Deletions from the Indexes
123
4.604.604.504.404.304.204.104.003.903.803.703.603.503.403.303.203.103.002.902.802.702.60
Volume1,000K800K600K400K200K
FIGURE 10.2
ORB for October–November 2001.
4199_P-10.qxd
12/30/03
3:22 PM
Page 124
124
TRADE LIKE A HEDGE FUND
FTUS, Mid-September to Mid-November 2002Figure 10.3 (see page 125) shows the chart for FTUS from mid-September,2002, to mid-November, 2002. The stock was deleted from the S&P 600 indexon October 11, 2002. In the month leading up to the deletion date, the stockwas down almost every single day, going from a high of 2.80 to 1.26 the day itwas deleted from the index. Thirteen trading days later the stock was at 1.55,a gain of over 20 percent. Then, on November 8, a random buy recommendation on an obscure Web site sent the stock into a short squeeze frenzy. Itopened that day at 2.40 and closed at 4.45. Again, no news. Just pent-up selling into the index deletion that created a short squeeze condition.
WHX, September 15 to November 21, 2000Figure 10.4 (see page 126) goes from September 15, 2000, to November 21,2000. WHX was deleted from the S&P 600 index on the 26th of September.The selling and volume increase drastically right before the deletion date.On the 25th, the day before the deletion date, the stock opened at 7.50 andthen promptly hit a 52-week low at 3.38 before closing at 4.12. It took 5 daysafter the deletion date for the stock to make its way back to 7.50. Twentydays after deletion the stock was at 6.00. Currently, 3 years after the deletion from the index, the stock is sitting in the 2s.
A STUDY OF THE DATACharles Kornblith, an undergraduate student at Wharton University, hasdone an excellent study on the effects of deletions on the S&P 600 index,the results of which are presented here with his permission. Why the S&P600 index? There can be no more beaten down, humiliated stock than thedregs that are kicked out of the S&P 600 Small Cap index. These stocks areusually being kicked out with no other home to go to, and, in many cases,are on their way to the over-the-counter (OTC) boards or worse. Nevertheless, the snapback after a deletion in these stocks is often extraordinary.As one can see from Table 10.1 through Table 10.8 (see pages 127–132),the average return from 1997 to 2002 per stock deleted from the S&P 600was 7.94 percent the day after deletion and 15.84 percent within 10 daysafter deletion. Is this a playable strategy? It might be. While the price performance has been very good for these stocks the problem is, as Kornblithmentioned to me in his e-mail documenting the study, the illiquidity of someof these stocks plus the low prices could cause much slippage and commissions pain.
4199_P-10.qxd
12/30/03
3:22 PM
Page 125
Deletions from the Indexes
125
4.404.204.003.803.60
3.503.403.203.002.802.602.402.202.001.801.601.401.20
Volume
3.00M2.50M2.00M1.50M1,000K500K
FIGURE 10.3
FTUS from mid-September to mid-November 2002.
4199_P-10.qxd
12/30/03
126
3:22 PM
Page 126
TRADE LIKE A HEDGE FUND
12.0011.5011.0010.5010.009.509.008.508.007.507.006.506.00
5.625.505.004.504.003.50
Volume
800K600K400K200K
FIGURE 10.4
WHX from September 15 to November 21, 2000.
4199_P-10.qxd
12/30/03
3:22 PM
Page 127
127
Deletions from the Indexes
TABLE 10.1
Stocks Deleted from the S&P 600 from 1997–2002, with Returnsthe Day of the Deletion (T), 10 Days After, and 20 Days After
Titan InternationalTrenwick GroupAspen TechnologyFactory 2-U StoresAXT Inc.Electroglas, Inc.Franklin CoveyEPresence Inc.Stratex Networks Inc.Therma-Wave Inc.Cygnus Inc.Aspect CommunicationsInterVoicePenton Media PublishingRead-Rite Corp.Seitel, Inc.Valence TechnologyAdvanced Tissue SciencesStratos Lightwave, Inc.Mississippi ChemicalVisual NetworksSLI Inc.BMC IndustriesOrganogenesis, Inc.Mutual Risk ManagementBrightpoint Inc.Foster Wheeler Ltd.APW Ltd.Amcast IndustrialAuspex SystemsTenneco AutomotiveOrbital Sciences Corp.Mayor’s Jewelers Inc.SpeedFam-IPEC Inc.Int’l. FiberCom, Inc.SONICblue Inc.Innovex, Inc.Hartmarx Corp.Polaroid Corp.Alliance Pharmaceutica
Ticker
DateEffective
TWITWKAZPNFTUSAXTIEGLSFCEPRESTXNTWAVCYGNASPTINTVPMERDRTSE