The players all showed up and the game was never played

The players all showed up and the game was never played.  Markets ignored most of the potential stimuli yesterday to do… well not much at all.  Yesterday’s session began with a Retail Sales number, which was quite possibly the only major economic number of the week, coming in right around expectations and it was unable to get rise out of the market.  Bank of America announced earnings in yesterday’s pre-market and handily beat estimates helping to get a rise out of its shares but it too was unable to affect the broader markets.  That left crude oil, which continued its recent rout holding the markets back for most of the session (see chart 11).  After trading through its Fibonacci support, crude settled into a comfort zone created back late April and will most likely test its $66 support. Finally,  the long awaited summit between Trump and Putin was a dud… for the markets anyway.  Besides crude, the most notable move came from the small cap Russell 2000 index which saw continued selling yesterday closing down -0.5% (see chart 7).  The Russell has little in the way of support until 1643, but it should be noted that this is typical behavior of the index, which is the one with the most volatility and subsequent upside opportunity. Remember risk – reward?

Let’s talk about risk – reward shall we?  Lots of us learned the maxim early on in our careers if not our lives and it refers to the risk reward curve which is used by economists, professional and armchair, to show the relationship between risk and potential returns.  The greater the risk, the greater the potential return.  “Potential” being the word most often omitted.  Modern portfolio theory uses the relationship of risk and reward as the basis for its mean variance optimization equation in which it maximizes expected returns while minimizing risk.  A form of this is used by most portfolio managers, including myself, to build portfolios of different assets while controlling overall risk.  To graphically illustrate this, I have attached a risk – return scatter plot taken directly out of my algorithms (see attached png, trust me its worth it).  On it the Y (vertical) axis is the historical annualized return of different asset classes and the X axis (horizontal) is the historic annualized risk (which can be expressed in volatility such as variance or standard deviation of returns).  So as you go up, you get more return and as you go right, you take more risk.  This is how the relationship works: more risk, more return and um… vice versa.  So, for example on the chart you will note short term municipal bonds on the bottom left (orange) making it the least risky of all the asset classes.  It has the least historic and expected future return and is not very volatile, as we know in practice.  If you set your gaze on the upper right, you will find small cap value stocks (light blue), which offer the highest expected return of all assets being assessed.  What is interesting is that it doesn’t posses the highest risk.  That distinction goes to REITS (brown), which has a higher risk but lower expected return.  Hmm… are we on to something?  How about emerging market equities (neon green) down below.  Investing in those alone, one would expect a very low return with a risk even greater than small cap value stocks.  Wow, we are on to something.  So if we want great returns, we must take risk, but with that potential we can also experience greater losses.  We use these risk-return relationships to construct diversified portfolios of varying risk by blending the various asset classes in order to tailor investments to match different requirements.

OK, so that’s the nerd divergence of the day.  Assets, which include indices, stocks, bonds, commodities, or whatever that have greater potential returns are most risky or… volatile.  That is why we see the indices with high potential such as the small cap Russell 2000 and the larger cap NASDAQ 100 make new highs one day and ditch diggers the next.  Speaking of digging ditches, the NASDAQ, which flirted again with its all time high yesterday has been a market leader over the past several sessions (as one might expect based on the aforementioned lecture).  Now for the risk: last night Netflix, of “N”-in-FANG fame, announced earnings after the close yesterday and traders were unimpressed with subscriber growth causing a strong selloff in the aftermarket.  Expect the FANGS to be volatile today as they earn their ability to produce high returns.  All of this leaves Fed Chair Jerome Powell’s testimony on capital hill today as fuel for the markets.  We can’t expect much in the way of the testimony but Fed watchers (AKA bond traders) will be watching carefully for hints about that elusive 4th hike in December that continues to be debated.  A rate hike in December has just above even odds with a 59% chance of occurring.  So we suit for another game today and seek some rewards knowing that someday soon we will have to pay the risk fiddler.  Please call me if you have any questions.

risk reward plot

daily chartbook 2018-07-17

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