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Risk Management

Just Follow The System

It is paradoxical but investor anxiety rises near all-time highs. This may have to do with cognitive biases and specifically hyperbolic discounting, i.e., the tendency to want an immediate payoff. At the same time, when markets are rallying, there is scarcity of bearish signals. There is a solution out if this conundrum: follow the system and if you do not have one it’s time to get one.

All my technical indicators, classical and based on machine learning, are bullish. There is no technical sign of weakness in the stock market. This is probably good. I say “probably” because it can be interpreted both way, and it should, because for every transaction there are always two opposite forecasts of market direction. For some, extreme bullishness could be a sign of exhaustion and coming weakness.

One of my favorite indicators to watch is the Kelly leverage, as defined originally by Edward O. Thorp, although at times the numbers have no practical meaning. Below is a chart of S&P 500 with the rolling 252-day Kelly leverage plotted.

It may be seen that the downtrend in Kelly leverage that started in the third quarter of 2014 warned that price action conditions were deteriorating. This indicator bottomed along with prices in 2016 and since it has been on an uptrend with a spike in the first week of this year. This is an extremely bullish signal.

However, investors know that fundamentals can derail technicals and they are correct. Investors have seen their gains evaporating twice in the last 17 years and many also lost part of initial capital. It is reasonable that investors feel anxiety near all-time highs, there is where bear markets start anyway.

Looking at this or that indicator will not offer any help. Drawing lines in the sand will only point to the obvious but not to the actual future. This can turn into a real mess, the kind of mess one sees in social media with indicators posted every minute, some bullish and some bearish. At the end of the day, if you add all the signals the net result is noise, as expected. There is a way out of this conundrum: just follow the system.

The system may be as simple as a formula or a few heuristics, or even a complicate machine learning algo. But it is still a system. Those who do not have one should consider getting one. Traders should try to develop their own systems and investors should either do that or ask a competent financial adviser to do it for them. In the longer-term, the markets reward disciplined traders and investors at the expense of those who rely on noise. Following a system is not easy at all but any alternatives are limited.

If you have any questions or comments, happy to connect on Twitter: @mikeharrisNY

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Charting and backtesting program: Amibroker


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