Dan Russo on Mastering Systematic Investment Strategies and the Art of Risk Management

Embark on a journey to the heart of systematic investment strategies with Dan Russo, Portfolio Manager at Potomac Fund Management. This episode promises to elevate your understanding of professional money management, as Dan recounts his evolution from the dynamic NYSE floor to masterfully employing technical analysis and a disciplined, rules-based investment approach. Our conversation cuts through the noise of financial folklore, showcasing how to test and quantify the predictive power of market indicators using innovative tools, and peeling back the layers of history to uncover what truly moves the market needle.

We zero in on the pivotal practice of risk management, where Dan and I dissect Potomac's composite model approach to investment decisions, explaining its influential role in navigating market participation. The delicate dance of understanding when to harness the potential of different funds and mandates is unraveled, as we emphasize the significance of tail risk indicators like the VIX. We also unravel the self-adjusting nature of asset correlation and market cycles, presenting an eye-opening glimpse into a strategy that sidesteps the need for individual stops, instead favoring a dynamic rotation that responds to market ebb and flow.

Finally, we wade into the bond market's murky waters, exploring the shifting relationship between treasuries, credit spreads, and stock market volatility. As we analyze the transformation from an inverse to a positive correlation between stocks and bonds, our conversation offers valuable insights into portfolio implications amidst the current inflationary backdrop. Listen closely as Dan imparts wisdom on the precursors of market turmoil and underscores the art of loss mitigation—a cornerstone of enduring investment triumph. This episode is an essential guide through the ever-evolving investment landscape, assuring listeners a richer understanding and a sharper toolkit for financial decision-making.

Nothing on this channel should be considered as personalized financial advice or a solicitation to buy or sell any securities. 

The content in this program is for informational purposes only. You should not construe any information or other material as investment, financial, tax, or other advice. The views expressed by the participants are solely their own. A participant may have taken or recommended any investment position discussed, but may close such position or alter its recommendation at any time without notice. Nothing contained in this program constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments in any jurisdiction. Please consult your own investment or financial advisor for advice related to all investment decisions.

 Sign up to The Lead-Lag Report on Substack and get 30% off the annual subscription today by visiting http://theleadlag.report/leadlaglive.

Foodies unite…with HowUdish!

It’s social media with a secret sauce: FOOD! The world’s first network for food enthusiasts. HowUdish connects foodies across the world!

Share kitchen tips and recipe hacks. Discover hidden gem food joints and street food. Find foodies like you, connect, chat and organize meet-ups!

HowUdish makes it simple to connect through food anywhere in the world.

So, how do YOU dish? Download HowUdish on the Apple App Store today: Support the Show.

Transcript

Speaker 1: 0:08

My name is Michael Guy at, publisher of the Lead Lag Report, showing me the hour at Dan Russo. Dan, been a minute. I know you, but introduced up to the audience. Who are you? What's your background? Have you done throughout your career? What are you doing currently?

Speaker 2: 0:17

Hey, Michael, Good to see you. Thanks for having me on. Hopefully everyone can hear me, okay. Yeah, so I'm Dan Russo, Portfolio Manager at Potomac Fund Management, where I've been for coming up on three years now. We are a tactical manager using technical analysis systematically, meaning we don't do anything without testing it to manage four funds.

Speaker 2: 0:37

Now, just a quick compliance out of the way. I cannot talk about the funds, I will not talk about our funds and I will not talk about anything that we currently hold inside of our funds, so let's just get that out of the way. Quickly Started my career on the floor of the New York Stock Exchange right at the top of the dot-com bubble, had a front row seat for the bursting of that, the collapse of Enron and all the things that kind of happened in the 2000 to 2003 timeframe, Before moving to a sales and trading desk where I covered meaning they were my clients some of the largest hedge fund managers in the world. If I said their names you would know them. Before landing in this seat here. I always wanted to be in a money management role and this is where I sit now for the past three years.

Speaker 1: 1:16

Okay, so on this point, I'm glad you mentioned you started off saying systematically investing and testing things. I often critique what I call the squiggle boys right through the people that reference technical patterns without having any clue of whether or not it has predictive power. I was looking at your timeline and seeing that you have a similar sort of disdain for that. Let's talk about the importance of testing a strategy, testing a rules-based, systematic approach, and why do you think it's so hard for people to want to actually get proof about what they're saying if there's any real power to?

Speaker 2: 1:48

it, because I think the majority of the time they'll find out what they're saying is there's nothing to it, right? It's a lot of folklore passed down over the years, things that might have made sense at a time when you couldn't readily test what was being told to you, and I'll admit that early in my career I was that way right. The New York Stock Exchange is full of a lot of old folklore and rules of thumb passed down from trader to trader over decades, and it wasn't until I was deeper into my career that I started to think about things more systematically and testing them, and I think it's just really. It's kind of like the way we think about it is money ball rate for the markets. It's about probabilities, not prediction.

Speaker 2: 2:33

Invariably, when somebody understands or learns that you're involved in the market, they ask you what do you think the market's going to do? And my sock answer to that is I have no idea. But here's what my models are saying and what that means over time. I just think it's a good way to get a baseline for the investment decisions that you're making and a good way to build a repeatable process, which I think if you are going to be a professional money manager and I will separate out the term investor. When I say investor, I mean professional money manager. In the context. I don't mean money manager as in trading your own account, where you're probably not going to fire yourself right. I'm talking about investors who have to manage to a prospectus, manage to a mandate, answer to clients other than themselves and whenever you're in that situation, having a repeatable process that you can point to is a good way to determine whether what you're doing makes sense or whether your results are maybe not repeatable and largely due to luck.

Speaker 1: 3:40

And a lot of that also has to do with a recognition around what cycles a process does better or worse, in which we'll touch on. But on the testing and models, let's talk about some of the tools that you use. When I first started doing back testing in 0708, I was all over trade station easy language. I was downloading white papers on SSRN, back testing, all kinds of factors and I found a lot of stuff really had no predictive power back then, just running all kinds of iterations on things. But there's things like trade station, there's Excel, there's R. What are some of the things that you look to validate a systematic approach?

Speaker 2: 4:15

So we do everything inside of a software called Amy Broker, which has its own coding language. Tyler Lovegood, who I see is on this call, came to us recently as a research associate, largely because he also used Amy Broker. It's not something that's widely used. We mostly use data from Norgate and FastTrack. So anything kind of that we want to test, we can write code for, test it over specific look back periods and see if there's any predictive power to it. We don't do anything without doing that first.

Speaker 2: 4:52

And what's kind of interesting about how we look at the world is, whenever we say systematic, I think the first thing that people think of is black box, quantitative, and that's not what we are at all. A lot of the indicators that we use can be traced back to books like Edwards and McGee and Fossback's book like stock market logic, et cetera. It's just the implementation and combination of indicators that we use that adds value. We use a version, not the exact version, but we use our take on Douth here. This is something that's over 100 years old. We have a take on Marty's Wags Bond model again something that's decades old. So nothing black box about what we're doing. It's the thoughtful combination of indicators and the software that we use is really what allows us to do that testing. It's pretty powerful.

Speaker 1: 5:46

If you were to guess what percentage of available indicators have legitimate predictive power? Is it 15%, 10%, less than 1%? What's your sense of that?

Speaker 2: 5:59

I think you have to separate out indicators and combinations of indicators.

Speaker 2: 6:02

I think most indicators on their own are pretty terrible for the most part, at least in their stock form that we all first learn about them. A great example of this is the RSI indicator. We all know what the RSI indicator is. It's an oscillator. The default settings are 14 days, oversold at 30, over bought at 70. Well, I would be willing to bet that if you test this and you bought some product every time it became oversold I eat cross below 30 and sold it every time it came over bought I eat close but 70 you would have a really short career as an investment manager. If that's all you use, what percentage? I would say probably I'm. Maybe 20% have predictive value on their own.

Speaker 2: 6:44

However, the I hate to use the word art, but it is kind of the most apropos term the art is the combination of indicators, right, and I think that gets back to setting an environment. You know, do you want to buy oversold blindly? Probably not. But if you have some way of defining the environment I, you weren't a strong uptrend and then you want to buy Oversold within the context of that uptrend, you're probably going to get different results. So individual indicators I mean when you're doing research, it's never about one data point. It's always going to be about building this mosaic and a weight of the evidence approach. Fundamental analysts do it in their own way, right. They start by usually reading up on a company, building out their financial statements, and then start connecting the dots to a research perspective. It's no different for technical analysis. It's this combination of data points or indicators is what adds value.

Speaker 1: 7:40

Any one indicator on its own it's probably pretty useless you use the exact word that was coming to mind when you were speaking mosaic. I was literally about to interject and say that word. I think that is the right way to frame it. Now, just because you test and approach, just because you back test, it doesn't mean that it's going to work in all environments.

Speaker 1: 7:58

And I think this is where there's a lot of confusion and, from my perspective somebody like you's in business Frustration, because everything has cycles, including factors, everything is cycles, including indicators. There are times when particular indicators or combination of indicators are just firing all cylinders. There are times when it's not how much of a repeatable alpha generating process is Because of the that process, those indicators, or because you happen to be executing that process in the right environment for what you're trying to take advantage of. Because I think this is where it gets into a bigger discussion on active versus passive, the last decade of large cap, us only dominance, and it goes really into the name of the space, which is how do you beat the market?

Speaker 2: 8:43

right. So I think that's a good point. I think that anytime anyone Says that they had something that works a hundred percent of the time, you should run fast and run far in the other direction. Right there they're about to pick your pocket, they're going to scam you in some way, shape or form, and nothing works a hundred percent of the time. I mean listen, derek trend followers Hardcore, like what I said old-school, cta type trend followers when some of those investors are happy to have a 40 to 45 percent hit rate.

Speaker 2: 9:11

I think environment is important, but I think risk management in all environments is the key to long-term success as An investment manager. Right, because you can have a lower hit rate as, but if you're making substantially more on the trades where you're Right, then you're losing on the trades when you're wrong. You can have a long career as a professional money manager, but I do think environment is important. Look, I'm a momentum person and you know all my life, all my career, all I want to do is get to the money management side. All I want to do is manage money. I get to the money management side three years ago and Momentum kind of you. Just look at an ETF like MTUM, go up until this year goes into a two and a half year, right? Does that mean momentum works? Doesn't work. Rather, I'm not willing to say that. Things come and go, which is why I think risk management it is the most important factor that will allow you to do well through a lot of cycles and have that longevity. The key is to stick around.

Speaker 1: 10:08

Yeah, meb favor of Cambridge has got a number of funds. It's his line is. You know, survival is the key, right?

Speaker 2: 10:15

Yeah, I ran into a med by the conference a few weeks ago out in Park City, Utah, and we were chatting and you know mebs work has been a huge influence on how I view markets. I actually I teach a the technical analysis class at Baruch College in New York City and I assigned probably two or three of mebs papers as a sign reading for the class and you know a lot of his work has influenced my views on the world. So I tend to agree with most of what mebs says okay, so I think I'm pulling.

Speaker 1: 10:42

I pulled up the MTUM and yeah, I mean it looked like small cap sideways for a whole bunch of last year and then obviously that you know enormous runoff, the November level, but yeah these things factors come and go, to your point, investment styles come and go, which is why you know a discipline risk management Process is important.

Speaker 2: 10:59

You know, and this is where this is where there's a huge difference between Managing money for yourself, right, who you're probably, like I said, not going to fire. I mean, if you fire yourself, I guess you are really honest with yourself and you're saying, hey, I'm not good at this, let me hire somebody else or, as opposed to managing money for other people, right, because Investors are impatient and we all know that investors tend to chase performance. So, you know, if you're running too long with a style that that goes out of favor, great, there's career risk to that, which is why risk management again, I will always come back to risk management because that what that's what gets you to Mebs theory of you know, just survive longevity.

Speaker 1: 11:40

Let's explore that risk management, because a lot of people use that term, risk management. But you know, let's talk about in execution. Now I am be personally separate from my own strategies which, as you know, a run-to-perspectives right I've. Your risk management in terms of conditions and probability is not in terms of stop losses. I know a lot of technicians like to use stop losses. I need to find risk management on a position basis, but then really on a total portfolio basis, because I think if you're gonna do it on the total portfolio, it does kind of go back to what's the cycle you're in that favors, yeah, the approach agreed.

Speaker 2: 12:10

So for risk management, again, we have composite models that we use here at Potomac, and those composite models drive the decision-making process right. Obviously there are inputs from myself now, tyler, who's on board, and our CIO and CEO, menish Kata, but once the model is in place, that drives the decisions right. So the step one for us is the model. What's the model saying? Basically, the model answers the question do you want to be invested? And then, if the answer to that question is yes, you want to be invested, then we have four separate funds that each have their own mandate, right? So risk management starts at the model level, right? If, do you want to be invested or do you not want to be invested? Now the model itself crunches data every day. We run it every day and it answers that question do you want to be in the market or do you not want to be in the market?

Speaker 2: 13:04

Some individual indicators within the model do have a stop, largely because we understand that tails are fat ready. Great example of that is it. We have An indicator that references the vix, and we all know that a lot of the time, the vix tends to be mean reverting. However, that handful of times when the vix is not mean reverting Meaning, when the vix kind of get the bugs 30 and then just keep going right and all of a sudden you wake up one day in the vix was at 30 and now it's at 80 and you have this massive gap risk in the market, right.

Speaker 2: 13:41

So we try to understand each of the individual indicators that makes up the models, right? So something that you like is the vix probably has a stop on not probably it does have a stop on it, but the model itself, the composite model itself, does not have stops. We don't have stops on individual positions. Now to the strategies that we run a rotation strategies. So the risk management there kind of take care, takes care of itself. If something is strong enough relative to the rest of the Investment universe, it gets into the portfolio. If it doesn't maintain its place at the top of the list, it rotates out of the portfolio. So we do not have individual stops and positions. A few of our indicators have stops, but generally speaking, risk management is driven by the model itself.

Speaker 1: 14:23

Now, you said you know, use the term the market a few times there, right, and obviously most people when you say the market, their mind goes to the S&P 500, even as that as well. But the market is really a question of sort of what your opportunity set right that you are playing with right. If you're Going to play the market in terms of small caps and use a set of signals, you're likely in the last year to have been whipsaw to death right with a whole bunch of sideways, at least in the Rosalto K. If you did that on a merge market for the last decade plus, yeah, volatile cash, yeah, you're not really going anywhere. And I reference that because I think there's a.

Speaker 1: 14:59

There's always this question of sort of does the opportunity set how you're defining the market to have a broader tailwind to reduce whipsaw right? The last decade or so has been great for momentum. If you're doing momentum in large gap US, not so much for a lot of other parts of the marketplace. So I think through from model perspective, what are the options to play with? Right? Because again, you need to have that tailwind, otherwise from an active perspective, you can get a lot of these type two errors.

Speaker 2: 15:26

Yeah, I think that's a good question. So, generally speaking, we are using the data that we're using. We use a lot of NYSE data, right. So so, broader than, say, just the S&P 500. Our biggest fund, however, invests in the S&P 500, predominantly concentrated positions in the S&P 500. The other funds that kind of have a broader investment universe or opportunity set, to use your term. That's again where some of the arc comes in, right, what goes into that basket?

Speaker 2: 15:56

Now, momentum kind of handles that for you to some degree once you've established the basket right. So if you're going to run a model that is going to fire, buy and sell signals on the S&P 500. Then the first step would be your basket of investment opportunities should probably be pretty highly correlated to the S&P 500 right on an individual basis. Right, because if the S&P 500 is the quote unquote market and we're saying, ok, we want to be in the market and then determining where we want to be, if we're deciding to be in the market because we think the market is going to be bullish, the S&P 500 is going to be bullish, you probably don't want to buy something that's inversely correlated to the S&P 500 in your basket. So you want to probably find build a basket that has funds or stocks or whatever you're looking at. That's highly correlated to what your kind of trigger system is and then from there, momentum kind of takes care of it, right?

Speaker 2: 16:51

I would argue that small caps are positively correlated to the S&P 500. However, since they have not had momentum, they're never strong enough relative to their peers to get into the portfolio, in which case you're constantly just rotating into the investment opportunities that are number one correlated to the broader market in this case the S&P 500 and that are performing best. So momentum does take care of that for you and not you don't have to make a quality. I think this is a cycle for small caps, right? If it's a cycle for small caps, then small caps will bubble up to the top rate of the investment universe and then the momentum strategy will buy them.

Speaker 1: 17:29

But that's going to also be a fun time. To look back period right, meaning you have a longer look back period, then you need more evidence of that relative strength picking up to be sustainable, whereas if you're short of look back period, you're. There's more whiff, tall risk, which means of course you got you know ground to death or you might get a just in time for the compounding. So I think there's a little bit of a nuance also just in terms of your time frame, even when thinking those terms.

Speaker 2: 17:51

There definitely is, but there's, there always is. I think that comes down to you know how are you as an investor if you're doing this individually? Do you want to be a short term trader? Right, I teach the class, like I said. You know there's their college seniors and some of them want to be short term day trader type people. So I tell them, like look, ok, you should probably be looking at five minute charts, one day charts. Others don't really care, they just want to have a have an idea of how the market works, because they're going to graduate at the end of the semester and they know they're going to be putting money in their 401k. Ok, cool, you look at weekly and monthly chart.

Speaker 2: 18:21

Time frame is always personal for individual investors. As a professional money manager, your time frame kind of comes down to your mandate. But I think, yes, your point is 100% correct. You have to take time frame into consideration or like anything else, just like we were discussing earlier with the indicators. There's no rule out there that says you have to use just one time frame. You can blend time frames, which is what we do to get a blended momentum score to kind of incorporate some of the shorter term momentum that creeps into the market, while still kind of honoring the bigger picture longer term trends that are out there.

Speaker 1: 19:28

So I'm going to ask a question which which I think is important, but I'm sure some people not in the industry might have in the back of their minds which is the that word mandate? Why even have a mandate meaning? Why not just be, go anywhere, invest any which way you know, from a discretion perspective?

Speaker 2: 19:45

I mean you can do that right. I mean, I guess it's a function of the funds that you launch and the type of investor that you choose to be. As a professional, you know, but most people gravitate towards a certain investment style, whether through training or experiences throughout their career. Right, some people gravitate towards Be, you know, growth investors and you know people like Ron Baron of Baron funds here in New York City, or you know the growth teams that alliance Bernstein Are their heroes and they want to own growth stocks and move with the market and then there are some people who, you know, our disciples of Warren Buffett and gravitate towards being value managers.

Speaker 2: 20:31

But the funds themselves? You know there are products that is better, you know, being sold to investors and those products have a mandate. Great for us. We are tactical managers. I think you and I are probably in the same morning start bucket, if I'm not mistaken, as tackle managers. Now, why does that make sense to me? Because I believe in tactical management. I believe Bad timing, the market went, done properly, ads, value largely by side, stepping drawdowns, right. So why have a mandate? Listen, I think, would it be great to be able to go anywhere, do anything? Sure, you know that's just not how I choose to invest and it's not even you know I shouldn't say that's not how I choose to invest. I mean, the funds were in place here when I joined. So we're tactical managers largely as a result of our systematic strategy and the beliefs of the folks who run the firm it doesn't be necessarily staying on and compete on.

Speaker 1: 21:28

From an industry perspective it is. I think it's hard for a lot of people that are not in the industry to understand if you're going to try to raise ads, as you have to create a strategy which is also different. Right, yeah?

Speaker 2: 21:37

so that's always. That's interesting too. And it's a double. I think be different is a double X sort, because everybody says they want something that's different until they get a different result right, right, right, you're right yeah.

Speaker 2: 21:50

More likely to be seen in a market a runaway bull market where the technical strategy might lag because it chooses to look different. Right, I always say that choosing to look different is opening yourself up to questions. It's also opening yourself up to career risk, which is fine. But to your point, what we try to do as much as possible is not put ourselves in a situation where we get the risk off signal right and still lose money. So we can and will go to cash within our portfolios across the board, we can go 100% to cash and ride out risk off situations as we define them by our composite model. One of the first projects that I worked on when I arrived here three years ago was seeing if there was a way to improve upon that, ie when our model fires risk off or their positions that we could take. That would still add value.

Speaker 2: 22:56

And what's interesting is we agree with a lot of your work that historically, treasuries as a risk off asset can add value. Digging deeper into them, there was some well, we found, with some nuance into that. Largely speaking, it became a function of trend, so rotating into treasuries as a risk off asset as long as the trend was up. Broadly speaking, it was more nuanced than that, but it tends to be good, but if the trend is down, they tend not to help you. I think 2022 ended up being a great example of that. So we kind of just came to the conclusion that we want to minimize these situations where we get the risk off, call right and still lose money.

Speaker 1: 23:36

Which is worth.

Speaker 2: 23:36

Yeah, you and I both know it's easier said than done, and as much as you said than done, because you're probably you're not always going to time it completely Right and we're not trying to. I think one of the other things that we run across is people who have a technical angle to the market or people who are systematic Is everyone wants to know where's the top, where's the bottom? And for the most part, we are not trend following in the CTA sense of trend following, but trend following is a large component of what we do. So the majority of the time, we are probably we probably didn't miss the turns, quite honestly, and that's okay. We're okay with that because the way we structure the portfolios allows us to either catch up or, hopefully, or sidestep a large part of a drawdown if it does turn into something bigger. So we're not trying we're not consciously trying to sell the top and buy the bottom.

Speaker 1: 24:30

Yeah, and there's also this added new watch which is just yeah, at least in the world that I live in from the mutual fund ETF side. You know there's so many ETFs, so many mutual funds out there. That point about differentiating yourself, yeah, it's like how is kind of fun to compete against Vanguard. Again, I go back to have to do something different, which, to your point, then brings up questions when you have these times when you're really dislocated relative to the cycle and the process you have. But you know there are elements to the industry which are myth by those that don't understand how somebody could be in quotes, a professional money manager, but not be participating, because participation alone doesn't get you assets Diverging. When things are going to hell, you know which is the real risk off is what gets you assets Right. That's the sort of more industry mindset.

Speaker 2: 25:14

Well, we have. I mean, our one liner to that is if you want the S&P, just buy the S&P. Right, you could buy the S&P 500 for three basis points, right, and you know there are. I mean, everybody thinks of the S&P 500 ETF as spy, but you know there are actually two ETFs out there that are cheaper than spy from an expense standpoint. So you know, if you want the S&P, buy the S&P, and if you want something different, make sure you really understand what different is and understand if that's what you really want in your portfolio.

Speaker 2: 25:45

And we do a good job, in my opinion, of educating our client base. Now, our client base is predominantly financial advisors who tap our strategies through various platforms, and we do what I think is a really good job of educating them about what we do, how we do it, why we do it. So the folks that invest with us generally have a pretty good understanding of what that ride could be like. And I think that's important as a money manager is to really kind of level, set expectations, because see it right. But until you actually live the life cycle of that fund and understand what the ride is like, you're not really going to have a full understanding. So I think it's important, as money managers as well, to do a good job of educating your clients about what you do and why you do it.

Speaker 1: 26:36

Just to reach out the roof of me 20, 25 minutes every. Please make sure you follow Dan Russo here on X. If any of you want to come up and ask questions, click that bottom left micro request button and, as always, this will be in podcast under lead lag, live on all your favorite platforms. Okay, you mentioned some of the nuances on treasuries as the risk off play. The nuance I keep going back to from my own research is that treasuries are not a hedge to the stock market. Treasuries are a hedge to credit spreads, which means they're a hedge to ball spiking VIX spiking because there's a direct link between the VIX and credit spreads and that's what makes it look like a hedge to stocks. You need to have the spread widening to full trust to spark the flight to safety.

Speaker 1: 27:12

What I put on X is the Phoenix. You know, giffy, which I keep being wrong on timing, which I hope I'm gonna be right on at some point. But let's bring the discussion to where we are now in terms of the market environment I keep going back to. I find it incredible how many divergences I myself am seeing. Now, maybe it's looking at faces in the cloud, but the bond market seems to not be worried about credit with credit spreads where they are. Meanwhile default bankers sees a rising, suggesting that the default premium, or this guy rather, is underappreciated. It should be higher. And I see things that say that small cap are worried about credit risk because there's no other explanation for why the rest of the 2000s has gone largely sideways, while cash flow small cap companies are doing quite well. How do you think about the bond market here, the duration side and the credit side, because I think people are confusing the two.

Speaker 2: 28:03

People generally confuse the two. The bond market is kind of a big behemoth that's not super easy to understand and I think there were a lot of people out there who probably do a better job than I do of breaking it down. So I'm just kind of coming at it from the perspective of how I view the world, which is from a trend and momentum perspective, and I think you're right. The bond market at this point doesn't seem to be sniffing out anything major. Whether you're looking at high yield OAS spreads, whether you're looking at triple C OAS spreads or just looking at junk bonds in general. Right, I mean, you have an environment where funds like JNK and HYG are holding up well, while investment-grade credit via a fund like LQD has started to roll over and treasuries have been heading lower throughout most of the year. So I think that the message of the bond market is very kind of muddied and convoluted at this point, which again kind of gets to the point of you can't just have one data point and one way of looking at the world. It has to be. It has to be that mosaic. But for the most part, what we're seeing is treasury yields are drifting higher while junk holds up. So I mean, if you believe the bond market is smart money, the smart money is kind of telling you that there's nothing to worry about. Now that doesn't mean a situation can't crop up pretty quickly. What I've noticed about spreads is that the OAS spreads do a slightly better job than the VIX of getting in front of potential volatility situations. I mean, like the VIX tends to be really coincident, whereas high yield OAS spreads tend to give you a little bit of a heads up, and that's not the case right now. So high yield OAS spreads are still heading lower. The VIX, as we know, has just kind of been grinding out in the middle low teens.

Speaker 2: 29:49

I think what you said about treasuries being a hedge not a hedge so much against equities but a hedge against credit risk is interesting and I think we're going to get a chance to see that thesis play out or not play out potentially, because one of the big themes that we've been talking about for I guess, coming up on two years now is the correlation between stocks and bonds, and the correlation between stocks and bonds has turned positive over both the one year and five year. Look back, periods notwithstanding the first quarter of this year where treasuries have drifted lower and stocks have drifted higher, and I think that's interesting because the major you and I are about the same age probably started our careers about the same time. For the entirety of our careers up until 2022, stocks and bonds were mostly inversely correlated, right, and that created an environment where a 60, 40, 70, 30 portfolio does really well for the average investor. But what's interesting is that is not the norm, right. What played out for I call it 24 years. I marked long-term capital as the start of the change in correlations and we can just mark 2022 as the end for now.

Speaker 2: 31:05

So for 24 years, the inverse correlation between stocks and bonds is not the norm and, generally speaking, stocks and bonds tend to move together and the driver of that is inflation, and we were predominantly in a disinflationary environment again 1998, collapsed the long-term capital and kind of the start of the bailout era, if you will, is where I market and where you had these disinflationary events.

Speaker 2: 31:33

Right, we all know what happened in inflation. We all know what happened interest rates, and now we've shifted to a more inflationary type environment. And I'm not saying inflationary means CPI has to be running 9%, but simple fact of the matter is, for the past 15 years CPI has been running between zero and 2% and now, even if you settle out in the three to four range, I would argue that's an inflationary type environment which ships the correlation between stops and bonds. So you could be in a situation where, under normal circumstances, as stock strif lowers, so do bonds, and then they don't really provide the protection that you're looking for until you have some sort of event, which is your view, which I think gets confused by a lot of people.

Speaker 1: 32:12

Yes, that is exactly what. Yeah, because I keep going back and credit events are just another way of saying a VIX bike. I mean, it's the same dynamic and you're right, Credit press tend to move slightly ahead of the VIX not by huge bound as a lead.

Speaker 2: 32:25

No, you're not going to get a six month lead Right exactly.

Speaker 2: 32:28

You do get more of a lead, at least from what I've seen, relative to the VIX, which is really coincident. If the VIX is spiking, the market's already heading, whereas if you look at something like the high yield OAS, that started to drift up ahead of, say, 2020. And it certainly started to drift up ahead of I think, you. 2018 was kind of the start, in my opinion, was the start of a bear market. If you looked at anything other than the S&P and the Nasdaq 100, 2018 to 2020, it was a bear market and high yield spreads started drifting up ahead of that.

Speaker 1: 33:03

I had a question from the audience saying what if risk off provides a full signal and the market runs away? Do you move from 100% cash to positions immediately or, on average, what's the churn in the last several years? Now I think this is actually a good question. It's also why I'm very much against shorting, because it's in the full signal where you lose money with shorting. But at least if you're long what I call imperfect hedges, like gold, the dollar utilities treasuries you can be wrong, the market can run away, but you can sell the chance at compounding because it's not a pure directional bet on equities. But in terms of what you guys do, when it seems increasingly clear you're in a false signal, what?

Speaker 2: 34:07

do you do? We wait for the model. And the key to the model is there's not just one input. Again, it's the thoughtful combination of indicators. So, again, we're confident that if it is a confirmed uptrend and the market is going to continue to drift higher, we are confident that the way we structure our portfolios will help us catch up over time. Does that mean we're immediately going to get caught up to the market? Absolutely not. There could be a period of time where we'd lag, but if we think about things over the course of a cycle, we're confident that the way we position the portfolios is what's going to help us catch up.

Speaker 2: 34:42

Just why, again, we're not trying to catch the bottom. We're not trying to catch October, we're trying to see a confirmed uptrend. Get that confirmation from our indicators. Our indicators, broadly speaking, are trying to identify what is the trend? The market going up or down, or sideways? How healthy is the trend? We do that through various breath indicators. If the market's going up and it's strong, you'd expect to see strong breath, more stops going up and going down, more volume in the stocks that are going up and going down. And then we use intermarket analysis, which I know, you know well, I have read your father's book and we incorporate intermarket themes into our work. So that level of confirmation, but it's really Over time.

Speaker 2: 35:26

My view, the way to outperform over time is not even so much being right on the upside, it's being less wrong on the downside. Right, because it's just simple math. Right, if the S&P 500 or your benchmark or your account, whatever it is, gets cut in half, you need 100% to get back to even. Right. If you, instead of getting cut in half, only lose 25%, well then you only need 33% to get back to. Even If only 33 sounds ridiculous. It's still a big number, but it's not 100%. So long-term outperformance of strategies, in my opinion, doesn't so much come from catching up on the way up. Well, that is important. It's not being down as much in the catastrophic drawdowns, not wearing the entirety of catastrophic drawdowns, is, in my opinion, the key to long-term success in the market.

Speaker 1: 36:18

And it's also just outright fact.

Speaker 2: 36:20

You can't dispute it Right.

Speaker 1: 36:22

So you do comparative analysis of any strategy. You look at up capture versus down capture metrics. How much do you capture against the S&P, let's say, as your benchmark, versus the down capture percentage? It's okay if your up capture is not 100%. Let's say, your up capture you're only getting 90% of the upside, 80% of the upside. Well, that's fine, because you're capturing only 60%, 50% of the downside. You're generating meaningful alpha right and you are outperforming because of the down capture being less than the up capture.

Speaker 1: 36:49

Your up capture is going to be less than 100% because of false signals. Your down capture will be less than the up capture because at some point you get the true signal and the magnitude of the decline and hopefully the mitigation of it is what causes you to really do well. But then even goes back to a discussion around cycles. Because if we agree, that's the fact that you generate outperformance from the downside and not the upside, and that's why it's so hard for most people to beat the market in quotes unless they take leverage or excess risk, well then you still need to be in a cycle where there's downside to capture. You still need to be in an environment where you're going to get those occasional drawdowns and equities to show the value of avoiding them. And that can still take a while, right as we've seen in the last two years.

Speaker 2: 37:30

Yeah, which again get back to your point of why shorting the quote unquote market is so hard. Systemat. Listen, I spend a percentage of my time trying to look for ways to systematically short the market and add value. It's extremely difficult to find a strategy where you can systematically short the market and actually make money, because why the market drifts up over time right To actually be a perma bear is to argue with probability, because over a rolling 12-months periods the market's up 70%, 75% of the time.

Speaker 2: 38:08

You have to be nuts to be permanently bearish.

Speaker 2: 38:11

That being said, my default setting is actually bearish.

Speaker 2: 38:14

I turn bearish in a heartbeat if you ask me my views, which is why I have to be a systematic investor, which is why I cannot view the market any other way, because on any given day, if you ask me my view of the market after I say I don't know, I'm probably going to try to pitch you the bear case. That's just how I'm wired. I think it's a function of when I started at the top of the dot-com bubble and kind of having a front row seat for some major disasters in the financial markets over time. But being systematic is important because I would literally be one of those people just catching the mattress and getting crushed by inflation, if I wasn't a systematic investor. That being said, systematically shorting the market is ridiculously hard to do right. The people who do well on the short side tend to be stock specific. They tend to be catalyst-driven, ie they have a call on an event and they get that event right to the downside. It is very difficult to do well and very difficult to do systematically.

Speaker 1: 39:11

That should gear a little bit to where there's some resurgence of momentum, maybe even the start of a resumption of an uptrend you mentioned. You want to touch on commodities actually have been writing about it a little bit more recently. It is interesting. It's not just oil. A lot of commodities are showing some renewed size of strength. Maybe it's noise, maybe it's signal. Copper had a pretty sizable week last week, from what I saw. But what's your take on commodities here? I'm going to assume it all consisted with this second wave of inflation narrative that's starting to get out there.

Speaker 2: 39:45

I think that, if you're trying, I think the narrative that inflation has been beat can probably put through some questioning based on what we're seeing in the market. So I write a weekly note for our clients, people who are invested in our funds. I wrote today about things like gold breaking out and heading higher, coin breaking out and heading higher. If you just look at a ratio of tips to aggregate bonds, you can do this pretty easily. Tips relative to AGG, you'll see a nice steady uptrend that pulled back to a key moving average and is now moving higher. So I think, while we are not in the narrative business, I think that if you are in the narrative business and you are being pitched we've whipped inflation you probably need to question that narrative, because the market is questioning that narrative, whether it's through a drift higher in interest rates, whether it's through an uptick in some of the key commodities. You mentioned copper, you're seeing gold oil has started to turn higher off of the low and again, I always just get a kick out of people who not gold and they say well, gold went nowhere for the past two years while inflation spiked to 9%. Yeah, but what did gold do for the year and a half leading off to that. It rallied hard. So did Bitcoin, right. If you believe that markets are discounting mechanisms, then you have to believe that things like gold and things like Bitcoin are going to rally ahead of an uptick in the CPI, which is what you saw, right. Bitcoin bottomed in I believe it was March or April of 2020, and then started to rip higher ahead of the turn higher in CPI. Gold bottomed, I believe it was somewhere in 2019, and then started to turn higher ahead of the CPI. So you're seeing, I guess, what would be considered leading indicators of inflation starting to move higher once again. Right, bitcoin recently took out its prior high. Gold just broke out, took out its prior high.

Speaker 2: 41:46

Some of the other industrial type commodities are heading higher. And then just look from a sector standpoint, right, you don't even have to look, you don't even have to be super deep in the weeds the way we are on markets. Just take the 11 S&P 500 sectors and look at who's leading and who's lagging. To plug your note, over different look back periods and over the past 12 months, it's what you'd expect. It's tech, it's discretionary, it's calm services. However, over the past month, what is it? Energy, materials, utilities and staples. That's interesting, right, but telling you that, well, I guess energy and materials are that inflationary impulse, and utilities and staples might be saying a little bit of defensiveness. And those were the top groups last week as well, or at least two of them were. So that's kind of interesting to me, yeah and it could be ominous.

Speaker 1: 42:43

I mean both the. That could be a full signal.

Speaker 2: 42:45

It could be it could be a full signal. Those could be false signals as well, but I mean, again, you're starting to see it. So I think that, at the very least, if you want to be intellectually honest and you're being pitched a narrative that we've beaten inflation and inflation is going to go right back down to 2%, I think that if you're paying attention to the market, you should at least question that and ask yourself is this true? Does the market agree with this? Because right now, it seems to me that the market is not.

Speaker 1: 43:13

Dan, for those who want to track market thoughts more your work, or might be able to learn about some of the strategies you guys run where to point them to?

Speaker 2: 43:20

You can check out our website, atomicfuncom. I'm on Twitter at DanRusso, underscore CMT. We're actually pretty active on LinkedIn as well, under our own names. We're easy to find. We're not hiding anywhere. We're not trying to be a black box. If you're interested in more information about what we do, I would start with our website, and that will take you through it.

Speaker 1: 43:44

All right, please make sure you give Dan a follow. Great conversation. I hope this is a podcast in a couple of days here and hopefully I'll see you all tomorrow on another space. Thank you, dan. I appreciate you man. Thanks everyone. I appreciate it. God bless–.