Lead-Lag Live
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Lead-Lag Live
Dan Russo on Volatility as a Trading Signal, Market Breadth Insights, and Systematic Investing Models
Ever wondered how to effectively use volatility as a trading signal while managing market risks? Join us as we unravel the complexities of tactical investing with Dan Russo from Potomac Fund Management and Chaykin Analytics. Discover Dan's unique insights into the VIX, market breadth, and the necessity of clear rules for risk management. Whether you're nearing retirement or just beginning your investment journey, Dan's philosophy on systematically managed tactical funds and understanding the investor's experience will provide you with invaluable strategies to navigate the market's ups and downs.
Monitoring market health is crucial, especially when it comes to managing downside risk. This episode sheds light on the importance of market breadth and sector performance in predicting deeper market declines. Learn how to balance potential gains with the need to avoid catastrophic losses through tactical management. Dan opens up about the behavioral aspects of investor reactions, emphasizing the role of quantifying divergences and intermarket themes to achieve long-term portfolio stability.
Finally, we delve into the enduring relevance of technical analysis and systematic investing. Hear Dan's thoughts on integrating different time frames and uncorrelated indicators, and gain insights into the construction of diversified and robust investment models. With a focus on data-driven approaches and ignoring market narratives, this episode is packed with practical advice and compelling stories from Dan's career journey. Tune in to enhance your investment approach and learn from one of the best in the field.
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.
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I think it's important to understand that anytime you're using volatility as a trading signal, you probably need specific rules to tell you that that trade is wrong. You don't ever want to be caught in a situation where you're using the VIX as a counter-trend indicator and the VIX goes from 40 to 80 in a day. That can happen it generally doesn't um. So there are opportunities to utilize the vix as a timing signal, with the caveat being that vol can expand further again.
Speaker 2:The tails are fat and you need to be mindful of that I always appreciate and enjoy talking to mr dan, who I've done a number of interviews with on Spaces, his audio podcast, before First time, he and I are actually doing this visually. This is, I think, the only second time I've actually seen Dan Russo and, of course, now that Gardner is coming in. So, with all that said, my name is Michael Guyatt, publisher of the Lead Lag Report, doing the Rough Hours with Mr Dan Russo. Atomic Fund Dan introduce. Publisher of the Lead Lag.
Speaker 1:Report doing the rough hours. Mr Dan Russo of Potomac Fund. Dan, introduce yourself to the audience. Who are you? What's your background? Have you done throughout your career? What are you doing currently? Yeah, so currently I sit as a portfolio manager at Potomac Fund Management. We are a tactical manager catering to the RIA community. We run for funds. Those funds get combined into different weights to create strategies that are available to financial advisors over different platforms.
Speaker 1:I've been in this seat for about three and a half years almost three and a half years now. Prior to that, I was the chief market strategist, working under Mark Chaykin at Chaykin Analytics. I did that for about three years and before that I was on the sell side, sitting on a sales and trading desk covering large institutional investors, hedge funds, mutual funds, pension funds predominantly New York, connecticut, with a scattering of a few funds in different parts of the country. I did start my career as a trading assistant and then a market maker on the floor of the New York Stock Exchange. The dubious distinction Starting my career for those of you who remember the week that AOL bought Time Warner and the whole.
Speaker 1:This time is different and everything that that signal right, new media buying old media couldn't have timed it worse. It was literally about two months before the top in the market, at least for the NASDAQ, and kind of have had a front row seat for a lot over the past 23 years, as a lot of us have. I'm noticing some changing dynamics in the market now which we can talk about. But that's high level where I've been and where I am.
Speaker 2:So you mentioned these four tactical funds. I'm curious how do they differ? Is it based on signals? Is it based on opportunities? What makes the tactical funds unique?
Speaker 1:So everything that we do is quantitative and systematic. What makes them unique is just the investment universe. Right, the funds are set up and I can't talk specifically about the funds, obviously, but at a tactical manager, we believe I mean the tagline for our firm is built to conquer risk. One of the key metrics that we look at over an investment timeframe is max drawdown, which you don't see a lot and that's kind of interesting to me. Max drawdown, for those who don't know, is simply what is the biggest loss, from kind of the highest level that the asset has achieved to its deepest loss, and that's interesting because that's the ride you take.
Speaker 1:We always laugh when we see market studies that talk about when X, y and Z happen, the market is higher a year later, and those are interesting and sometimes they're insightful. But generally speaking, the market is higher a year later, and saying the market is higher one year later is interesting. However, it doesn't tell you what the ride is like. So we focus on things like max drawdown and max adverse excursion within the work that we do, because that's what investors have to sit through. So we think that that's important context.
Speaker 2:So I used to say quite a bit on X to kill it in the stock market, you have to not get killed.
Speaker 1:Well, yeah, it's simple math, right? Because I mean just at a very, very, very high level and basic level, if you get cut in half, you need 100% to get back to even, and if you lose 25%, you only need and I say only kind of with quotes you only need about 33% to get back to even, and the 33%, all else being equal, should be an easier lift than the 100%. We are of the opinion that, yeah, you need to maintain upside with the market, but the key to long-term success is avoiding catastrophic drawdowns, right. Especially if you're at a point in your kind of investment career and I don't mean that, as in the investment industry, I mean point in your investment career, and I don't mean that, as in the investment industry, I mean in your investment career if you're getting close to retirement, a 30% to 50% drawdown could be, and likely will be, catastrophic. So, being a tactical manager, that becomes a key focal point for us.
Speaker 2:Is it really possible to avoid big drawdowns that still have the same upside as it quotes the market? I mean, I think this is what's missed by a lot of people yes, you need to manage risk, but you're going to get whipsawed managing that risk, which means you're probably going to be lagging in these unrelenting bull markets.
Speaker 1:Yeah, I think portfolio construction matters. There you can kind of mitigate your upside capture in terms of how much of it you miss relative to the broader market. But, all else being equal, our work has found that avoiding those catastrophic drawdowns is the key to long-term success. And I mean, if you just kind of think and I'm speaking generally here, I'm not speaking for anybody in particular I think that as humans and looking at the behavioral side of things, missing some of the upside is more tolerable than sitting through a 50% drawdown. And I know that we've kind of become spoiled here in the market, notwithstanding COVID.
Speaker 1:But as I said, I've had a front row seat for a lot of interesting events throughout my career and if you just kind of think about, I started in 2000,. Right, the beginning of 2000. In that timeframe I have seen the S&P 500 get cut in half twice. I've seen the NASDAQ down 80. We saw COVID with the S&P down 34. So these big quote unquote outlier slash every 100-year events happen more frequently than we think. Right, the tails are fat, human psychology being what it is, we know that most investors will likely make bad decisions at the worst time. So if we can kind of mitigate that downside. I'm not saying avoid it right, I'm saying mitigate that downside. We think that that's the key to long-term outperformance, and by long-term we mean over time, over cycles.
Speaker 2:Yeah, I think you and I both know that the definition of the long-term has gotten only shorter over time.
Speaker 1:No, it's true. I mean, I think investor time horizons, at least mentally, have definitely shortened. And listen, notwithstanding COVID, generally speaking, the majority of us within the past 10 or so years really haven't seen a massive sustained drawdown. Right, you know, 2022 was a big hit, especially to the growth stocks and kind of the large 2009. I mean, those were beat you down, kind of make you not even want to look at the market types of bear markets and I would argue that kind of. Since the global financial crisis, we really have not seen that. Stop at precursors to major drawdowns.
Speaker 2:There's always the whites of the eyes that show from an intermarket technical perspective. What are some of the eyes that show from an intermarket technical perspective? What are some of the things that you track that maybe give you a sense that the odds favor some kind of a deeper decline?
Speaker 1:So at a high level, the way we look at the market is purely technical, quantitative and systematic. And I'd say there's three legs to the stool. And first, as far as how we look at the market, what's the trend in the market right, up down or sideways? As how we look at the market, what's the trend in the market Up, down or sideways? You can look at the charts to see that and you can do it more quantitatively, obviously, with things like moving averages and bands around moving averages. From there we want to know how healthy is that trend? So that's market breadth for us predominantly In a strong bull market, we would expect to see a lot of stops going up, more stops going up than going down, more stops making new highs than making new lows, and we would expect to see more volume trading in the stops that are going up than in the stocks that are going down. So that's the how healthy is the market? And then from there we want to say is the trend confirmed by intermarket themes? And that, whether it's looking at something as old school as the transports, whether it's looking at what's happening in the bond market or what's happening in the commodity markets, those are the three legs of the school stool that we look at. What is the trend? How healthy is the trend as measured by breadth? And is the trend confirmed, based on intermarket themes?
Speaker 1:And I think that one of the biggest precursors to a large market drawdown is divergences in breadth, and people always kind of throw out the phrase divergence without really ever quantifying it. Obviously, as systematic and strategic investors, as tactical investors rather, we do quantify that, but generally speaking, you do tend to see a deterioration in breadth ahead of major market declines. You saw it leading up to the top in the dot-com bubble. You saw it leading into the global financial crisis. You even saw it.
Speaker 1:And I'm not saying that market breadth predicted COVID. But if you look at various breadth indicators, whether it was the advanced decline line, whether it was the percentage of stops above a certain long-term moving average, whether it was something like the McClellan oscillator, those all diverged negatively ahead of COVID and, if you recall, the market made a new all-time high. I believe it was February 19th, but breadth was already deteriorating, so even ahead of that, I'm not saying it predicted a pandemic. I'm saying it was a warning sign to the possibility of deteriorating market conditions and that is a key indicator that we focus on. Obviously, it speaks to the health of the trend If the S&P 500 is being dragged higher as it was in 2020,.
Speaker 1:2018 to 2020 was really your fan mag, the precursor to the mag seven. That was your fan mag market. If you looked at any other market aside from the S&P 500 and the NASDAQ 100, they all topped and went sideways, starting in 2018. Small caps commodities international was a disaster. Global breadth was deteriorating long before we got that top in the S&P 500 and the NASDAQ, prior to COVID.
Speaker 2:I've never actually looked at this, but I'm curious, if you have, how much of it is explained by breadth in terms of number of stocks versus sector leadership. So I'm going to make the assumption this is just my gut feeling that there's less stocks that are in the utility sector and the healthcare sector the consumer staple sector than cyclical stocks, right, just in terms of the universe of companies, and I think typically when you have poor breadth you tend to see the defensive sector is also leading and outperforming, like we're seeing utilities, especially this year. Is it more breadth or is it more just sort of defensive posturing and there have to be less companies that are defensive in nature.
Speaker 1:I think that people conflate those two and I think that they have to be separated right, largely because of the market cap weighting nature of indices like the S&P 500. When you talk about leadership, you're talking about performance. Right, what sector is doing better? What sector is doing worse? To me, that's not a breath argument. To me, it's more. I almost lumped that one more into the intermarket analysis portion of the stool that we look at.
Speaker 1:I think that that changes with the changing composition of the market.
Speaker 1:So, for instance, you could have a situation like 2022, where the market is under a lot of pressure and even though breadth didn't drastically deteriorate, the market was under pressure largely because your two kind of mainstay sectors, the largest one being tech and then another key one being calm services, with a lot of the big media companies in there leading the decline right.
Speaker 1:In an environment like that, it's just going to be hard for the market to go up, largely because the largest sectors are under pressure. It takes a lot more energy stops, utility stops, staple stops, material stocks to go up for every Apple or Nvidia that might be going down. Right, just the cap weighting nature of the market. So I think sector performance is important. Obviously it sends a message about what's going on in the marketplace, but I don't think sector performance should be lumped in with other breadth indicators and I think that in terms of breadth indicators the kind of way to look at it in my opinion is percentages right, like what percentage of stocks are making new highs, what percentage of stocks are trading at new 52-week lows, things like that can help kind of normalize some of that breadth work.
Speaker 2:If you see a disconnect between breadth and defensive sector performance meaning breadth is improving but sector defensive business is picking up do you tend to give more weight to one over the other, or is it just a conflicting message and it's hard to really tell them?
Speaker 1:No, I mean, I think that that part of it gets to more like portfolio construction, right? And I don't think you should ever focus on one indicator, right, I think? And the way we view the world is through a composite model, right? So a composite of indicators. For us, our composite model, answers the question do you want to be invested? And if the answer to that question is yes, then the next phase is all right.
Speaker 1:Let's drill down on specific sectors, industry groups or even asset classes and see which ones are outperforming, which ones are underperforming, and then, as you construct portfolios, if you subscribe to the momentum view, you should naturally gravitate towards the sectors of the market that are outperforming and away from the sectors of the market that are underperforming.
Speaker 1:So if you want to be invested step one then all right. Where do you want to be invested? If you subscribe to Momentum and Momentum tells you that staples and utilities and real estate are outperforming, well, then you can be invested in those sectors, and that would be following the process that you've laid out and hopefully articulated well to your clients. So it's not so much utilities are outperforming, so let's get out of the market, right? It's more. What is the composite model saying, okay, great, now where do we want to be? Or where do you want to be based on your investment process, and if you're choosing momentum, you should just gravitate towards the areas of the market that are doing better, so I didn't actually know that you do have a nickname in Doomsday, dan.
Speaker 2:I'm going to show a post here. This is going to end badly, bro, which I always like having the word bro, after a post. Vix is going to zero, bro, vix is not going to zero.
Speaker 1:Yeah, yeah, that was kind of a take on that. I think that this was a facetious headline and it was kind of to debunk a lot of what was being said at the time. I believe I wrote that in mid-July, when the market first started to roll over, and I just think that we are very anti-narrative, right, we are very much weight of the evidence. Look at the data. What does the data tell you? At the time the data wasn't pointing to this is going to end badly, bro, and the reason I kind of point that out and the reason that I can't invest any other way and why Potomac is a perfect place for me, because we are systematic, is because I think it's important for everybody to know this about themselves. And for those of you who don't take a step back and ask yourself how do you lean? My default is to be bearish, which is completely illogical, right. The market tends to drift up over time. Roughly 75% of all rolling 12-month periods the S&P 500 is higher. My default is to go bear fast. I can argue the bearish point pretty much at any time. I can find a bearish argument pretty much at any time. I can find a bearish argument pretty much at any time and I think that that's largely a function of when you start your career and the things you live through.
Speaker 1:So again, I started my career in 2000. Everything is rosy, new millennium. I go through four years of college where I was going to basically I wasn't even going to class. Some days I was just going to the library to day trade because we actually had to go to a computer to do that then and the market just went up. Just buy Microsoft, buy Cisco, buy all the tech stocks they're going to go up and you hit new millennium and all the happy feelings around that. And then the market crashes. And, mixed in with that, I'm working at the New York Stock Exchange, a few blocks from ground zero on 9-11. So live through that. And then things slowly start to get better. And then we live through the global financial crisis.
Speaker 1:So in the first 10 years of my career there were these two 100-year events where the S&P gets cut in half twice. So I'm like things can go bad quick and I think I was imprinted with that. So that has become my default. So it's a running joke around our firm and with some of our clients. But it's why systematic investing, in our opinion, is so important because I need to override, kind of my default wiring and the only way to do that is with objective data. So, regardless, I'm still known as Doomsday Dan, but for investment purposes, everything is systematic and data-driven right. It doesn't matter what Dan thinks from a narrative standpoint. It doesn't matter that Dan can argue the bear case. If our composite model tells us to be invested, we are invested.
Speaker 2:Yeah, I think it's also a misconception even around my way of approaching things, because here I think it's sort of the challenge. I always say path matters more than prediction, which is all that matters from a tax perspective.
Speaker 1:Which is another way, in my opinion, of focusing on things like max adverse excursion and MED.
Speaker 2:Right what you live through matters Right, as opposed to the end point, which is what all the macro guys, including me, tend to talk about. But the challenge is, as you know, from an asset gathering perspective, it's hard to communicate things just based on pure tactical quant signals. So you still need to let's call it from a story selling perspective, let's talk about from the business side of things be able to put some kind of a narrative, even though in reality it probably has very little to do with the way your signals are acting.
Speaker 1:For some people. Yeah, I mean not for us. I mean our narrative is essentially that we're anti-narrative, right that we don't get caught up in that. That we're not. You know our CEO and CIO, manish Khada. You know he and I aren't talking to each other on the day that you know Powell is speaking at Jackson Hole, or the day that there's a Fed presser and saying, well, he just said that, so let's buy or let's sell. It's none of that.
Speaker 1:Our view is that if it's important, it will show up in our models. If it matters to the market, it will show up in our models. We're of the opinion that our models are extremely comprehensive Again, not focused on one indicator, not focused on one timeframe, and we think that if it's important, it will show up in our models and if it shows up in our models, we act accordingly. But we're not sitting there saying push all in because that Jackson Hole, powell said the time is now. As it relates to monetary policy. That's just not how we look at the world, and we do convey that. We're very open. We do a lot of writing, we do a lot of videos geared towards our clients and we convey that. We tell them we focus on our models. We focus on what's important as it relates to the market and not so much as it relates to narratives.
Speaker 2:So let's talk about what the models are suggesting here, and I think it's always important to distinguish time frame right, because you could have a model that's short-term bearish, a long-term bullish or vice versa. They could all be aligned, they could all be wrong, they could all be right. So let's talk about what are some of the models that you are known for and that you track seeing by timeframe currently.
Speaker 1:So I mean we use, like as I said. So I mean we look at trends in key equity indices Predominantly from a trend perspective. Those tend to be more intermediate, term in nature. We will, however, look at short-term indicators based on the market environment. So the way that we kind of view things is we have what are known as base systems. Base systems kind of tell you what's the big picture bullish or bearish based on our models. And then, based on those base systems, we have what we call trigger systems that kind of get you to take action, right. So if our base systems are bullish, we're going to be looking for confirmation in the shorter term timeframes from things like breadth, things like intermarket confirmation, from you know and see, something like the transports, whereas if our base system is bearish, the indicators that we focus on will tend to be short term in nature and also counter trend in nature, right?
Speaker 1:It's kind of this idea that the market doesn't go down in a straight line. You can get too far, too fast to the downside and you want to look to take advantage of that. So we will look at some very short-term counter-trend indicators within the context of a longer-term downtrend to identify potential opportunities. But again, it's not. Dan looks at the chart and says, oh, we've gone too far, too fast, let's buy some stocks. That's not what we're doing. It's purely quantitative and we'll see a signal within one of those shorter-term countertrend indicators and take action as appropriately. And in a strong uptrend those indicators will never fire. We have indicators that are tied to the VIX. In a strong uptrend, you're usually not going to see those go.
Speaker 2:I'm glad you mentioned the VIX, because I think the VIX is interesting. I often don't see the VIX as being an indicator of anything except the extremes, because it's much more reactive. Some people use it as a signal of source, but I haven't found any backtests that prove that out. How do you think about volatility in terms of being tactical? Because I think one of the appealing aspects of being tactical is you're able to manage through volatility.
Speaker 1:Correct and I think that becomes regime specific and regime dependent. One of our indicators utilizes short-term Bollinger Bands right Predominantly for identifying oversold conditions in an uptrend. That's a situation where in an uptrend, presumably your volatility is going to compress and that is going to be a little bit more sensitive within an uptrend, whereas in a downtrend we will look at something like the VIX Largely as a counter trend indicator. Vix spikes tend to be short-lived, so within the context of a downtrend, the VIX could spike over a certain level and a few other criteria. That would be a signal to us that the market has gone down too far too fast and could be ripe for a short-term mean reversion type situation.
Speaker 1:I think it's important to understand that anytime you're using volatility as a trading signal, you probably need specific rules to tell you that that trade is wrong. You don't ever want to be caught in a situation where you're using the VIX as a counter-trend indicator and the VIX goes from 40 to 80 in a day. Right, like that can happen? It generally doesn't. So there are opportunities to utilize the VIX as a timing signal, with the caveat being that vol can expand further Again. The tails are fat and you need to be mindful of that.
Speaker 2:Let's talk about sectors versus individual stocks, I always go back to sector analysis as the equivalent of asset allocation driving a portfolio, but within an equity portion, anything interesting on the sector side that's getting some attention. I know a lot of people are still trying to play tech, but it seems to me at least that tech looks like in me, finally in the rollover process from a relative momentum perspective. But let's go through some sectors that your models are tracking here.
Speaker 1:Our models are generally keyed off of the broader market, as I said, and answer the question do you want to be invested? And from there it's our trend and momentum work that identifies sectors. So what is interesting to me and we do not trade individual stocks so as much as I came from a background of covering hedge funds and stock pickers and Dan personally still loves to follow stocks that's not what Dan, portfolio manager at Potomac, does on a day-to-day basis. So what is interesting to me now is kind of gets to the point that we were touching on a little bit earlier is you do have the S&P 500 fully rebounding that July, early August decline and on the verge of a new high. It's largely doing that without tech participating. So, to your point, maybe tech's rolled over, maybe it hasn't, but it certainly is not outperforming on this rebound that we've seen here throughout the vast majority of August and we're early days in September. I think that that speaks again. That does speak to some of what's happening within the breadth landscape, because you have the advanced decline line. So I'm not saying we don't trade stops, but obviously we pay attention to breadth, so we pay attention to what's happening with individual stops. You have the advanced decline line trading at all-time high. You have the advanced decline volume line trading at all-time high. You have about 70% of stops trading above their 50-day moving average. So you have this environment where the market is strong and breadth is strong, and it's doing it without tech. So I think that that's important because it shows that the rally is broader than just a mag seven theme that a lot of people like to talk about.
Speaker 1:From a sector standpoint, yes, there's no denying that, depending on the timeframe you use, defensive sectors of the market have been holding up better, and I run through my kind of just the 11 sectors of the S&P 500 across different timeframes. And you're seeing real estate towards the top of the list. You're seeing utilities and staples towards the top of the list. You're also seeing financials towards the top of the list, right. So I don't know where I'd classify financials in the risk on, risk off space. Maybe they're kind of neutral. But, yeah, there's no denying that momentum is favoring the defensive sectors of the market.
Speaker 1:But the market's kind of holding its own without tech and, more importantly, within tech, the market's holding its own without semis, and semis have kind of become the go-to industry group within the tech sector, everybody paying attention to NVIDIA. I mean, you can make of that what you want, but I do believe that semiconductors are a really important industry group for the economy. I've kind of tried to make the case that within the Dow theory, you should swap out transports for semis and the way we look at the world, that's not what we're doing, but I do think the semiconductors are vastly important to the global economy. There's really nothing that you touch in your life with the exception of probably your own skin that doesn't have a semiconductor in it. Sectors are definitely pointy defensive right If that's your message of the market but the market itself is holding up. So that's kind of interesting to me.
Speaker 2:So I'm sharing on the screen a look at a price ratio of the regional banks, just because I think it's interesting KRE, as a speculative part of financials, versus semis, smh, and the ratio does look like it bottomed in July, which is kind of funny to me that people are not really thinking about regionals as a way of outperforming semis, but maybe that's exactly what's about to happen. On your point about financials versus tech, I was just putting that in as well. That does indeed look like it's a base that's turning higher right. I mean, most people don't realize that when you look at the XLK ETF, relative to financials, it's pretty much had the same performance since like mid-April of 2020. Yeah, which is pretty remarkable given that the ratio is pretty much in the same spot, that is.
Speaker 1:I mean, listen, it is interesting. I think that we are in an environment now where a lot of people are going to be surprised by the way some of these relationships shake out, the way some of these relationships potentially change. Largely speaking, the majority of us myself, people like our vintage right, for the entirety of our lives we lived in a world where, for almost the entirety of our lives, we lived in a world where interest rates did nothing but go down and for most of our careers right, I pegged myself already starting in 2000. I pegged myself already starting in 2000. For most of our careers, inflation was benign and because of that this gets to intermarket analysis. Because of that there was an inverse relationship between stocks and bonds. Right, let's just kind of crack the John Murphy book and I know you know this from the work of your father on intermarket analysis In a disinflationary environment I'm not talking deflation, right, that's a disaster. In a disinflationary environment, stocks and bonds tend to move inversely to each other and therefore, within the equity market stock and bond proxies. In an inflationary environment, stock bond correlations turn positive. That started happening two years ago and none of us have ever seen it in our careers. The relationship between stocks and bonds turned negative right around 2000. I kind of mark it 1998, the collapse of long-term capital management, but for sake of a neat timeframe let's just call it 2000. And stock bond correlation went negative in that timeframe, meaning bonds and things like the 60-40 portfolio were provided great diversification.
Speaker 1:You had a declining rate environment which, all else being equal, tends to favor growth stops right. So now we have an environment where interest rates have moved higher. We have an environment where, despite coming in, the CPI still trades, doesn't trade, but the CPI is still higher than what it was coming out of the global financial crisis by a decent amount. So if you want to call that inflationary and it's the changes on the margin that matter If you want to call that inflationary you have a situation where a lot of these relationships that we've come to know and rely on could be changing. And if inflation is the cause of that, which I think it is, there are going to be interest rate implications. So there are going to be implications for relationships like the one you just showed of the relationship of financials to tech, and you're starting to see that play out.
Speaker 1:But these take time right. So, getting back to your point that it's kind of gone nowhere since 2020, because we have to kind of undo two decades worth of behavior. So I think that you could see these relationships take time to turn, but eventually they do. And again, for us, being quantitative, being systematic I'm not trying to make that call, I'm not trying to say, well, it looks like we're in an inflationary environment and rates are going to be higher, so buy financials, sell tax, right, that's not what we do. But if we get back to the momentum portion of it and financials are outperforming for the timeframe that we care, that's going to be important to us. If tech is also doing well relative to its group, that will be important to us too. And we're just not going to argue with the market as much as Doomsday Dan would like to the market as much as doomsday dan would like to.
Speaker 2:But, but I think there's an argument if you have some flexibility in your model in terms of figuring out what opportunities that you want to lean more towards, depending on the environment, right, so it's it. So I always go back to it's more than just signal. It's about the cycle favoring having a tailwind on the opportunity set. So if you're in this high inflationary environment and you have the which is a big part of this to change your opportunity set from, let's say, only using long duration treasuries intent versus using short duration treasuries intent, right, that's a very different. You'll have very different performance outcomes. So you can, I think, argue that it's still good to be aware of the macro, just from that tailwind perspective around what you're playing on, or off from the risk perspective it is.
Speaker 1:I think you could argue that. Or I think the other argument to be made is to kind of create your we call them baskets right. Create your investable universe or your basket such that you broaden that opportunity set right. So let's such that you broaden that opportunity set right. So let's, for example, let's say you have a composite model, as we do. That composite model is binary You're either in or you're out. If you're in, you're going to own the queues and if you're out, you're going to go to cash. Sounds great.
Speaker 1:If you ran that model in 2022, you got crushed right, because your only asset that you could buy was the Qs, so it didn't matter. Even if your model got it right from a timing perspective, you bought this underperforming asset that was in a downtrend. Now, if you took that same concept and broadened it out and kind of, if you kept it, even if you just kept it at the high level, industry index level, and you had the S&P and you had the Dow and you had the NAS and you throw some foreign in there, you probably fared better because your model would tell you to be invested and then you would skirt to the thing that was performing the best, as opposed to the one thin, only thing that you can buy, and you have a better chance in that environment of outperforming. So I would say that and this, in fairness, is where some of the nuance and the art comes from right, you can be 100% quantitative, but if you don't properly for lack of a better word, for lack of a better word build out your investable universe or, alternatively, vice for prospectus, you are confined to a specific investable universe then you're.
Speaker 1:You know that's where the art and the science kind of meet each other, right? You know, for instance, in 2022, if you were a large cap growth fund portfolio manager by prospectus you're running the XYZ large cap growth fund you were probably going to do poorly, no matter what. Right. Your investable universe in that fund is probably the stocks in the NASDAQ 100, right, maybe a few just outside of the NASDAQ 100. Those stocks got hit hard. You could have been the best stock picker on earth, but you were probably going to do poorly in that environment because you were confined to large cap growth. The Qs were down 40% or so in 2022 at one point. So it does prospectus matters, right. Your product matters, right what you've told your clients you're going to do matters. But I think, to the extent that you can, that you're not constrained, ie you're trading your own account or you're just an unconstrained fund manager. The art or the nuance is really constructing a broad enough investable universe so that you're not kind of hemmed into a corner.
Speaker 2:As we're streaming, somebody noted on X NVIDIA is down over 6% my favorite stock out there in the world and I've joked, not joke. I mean I've said this repeatedly and I've been maybe early in saying what I've said joke. I mean I've said this repeatedly and I've been maybe early in saying, but I've said, yeah, nvidia can take down the entire stock market, because I'd think you can make an argument that a lot of the momentum, especially in large caps, is narrative driven. It is AI, story driven and NVIDIA is obviously the poster child to that. From the intermarket perspective, what do you do when you're in a cycle where there's this overwhelming story that's out there, because I think it can throw some of the relationships off, at least for a moment in time, and make the divergences to your point about earlier maybe even more accentuated and longer lasting than you think it might be?
Speaker 1:Yeah, I think that it can. I think for us, the way that we think about that is we want to make sure that the models that we are running are robust across market cycles, across timeframes. Right, we don't want to get caught with recency bias. We're not in there changing the model. Right, we're not changing the models to account for the fact that NVIDIA has become a cult, if that's what you want to call it. What our job is, as systematic managers running composite models, is to make sure that those models are robust across environments and recognize that sometimes you're just not going to get it right. Anybody who comes to you and tells you they have this model or system or whatever stock picking service and they're right some ungodly amount of the time, right 80, 90, 100% of the time, I would say you should run, run fast and run far. The other way, if you think about, some of the best investors on earth openly tell you that they're right 50% to 60% of the time, that means you're going to be wrong 40% to 50% of the time and you kind of accept that and you understand that that's going to happen. So for us, in an environment where NVIDIA becomes a cult stock, we're not going to really do anything about that. Now, you would hope that semiconductors are part of one of our investable universes and that when our model tells us to be invested, and if semis are working, that we will gravitate to that right? If we're following our process, that's how that should play out, right? I don't have to tell you that bubbles are easy to identify but hard to call, right? I'm not going to sit there and say you know, nvidia seems ridiculous, so let's kick semis out of the basket to make sure we don't own them here. Not what we're going to do, right? Because we've tested our strategies with semiconductors in the basket and they seem to add value. So, and they add value over an extended period of time that robustness. So we're just going to continue to kind of look at our models and focus on our process.
Speaker 1:What we will do, however, is all of our indicators and composite models themselves have their individual stats that we look at and if an outlier event happens ie something kind of violates its historic max drawdown we will kind of take a look at it and see if things changed Other times. That we'll make changes is if market data changes. To give you an example, I used the VIX. Earlier we used to have an indicator that keyed off the vol of the S&P 100, right, so not the VIX as you know it, but the S&P 100. Well, the SIBO stopped reporting that data. Okay, now what do we do? Well, we have to go back and say, all right, well, let's look at the VIX data and see how that does you know what that does to our models and make the decision of whether or not we want to incorporate it at that point. But we're not making changes based on recency bias.
Speaker 2:Do you have a model for commodities? I mean, is it?
Speaker 1:primarily just equity focused. The model is primarily equity focused. We do have commodity inputs as part of the intermarket relationship. Commodities are kind of interesting because now for us the models are equity focused, right, and we're determining whether we are risk on, risk off, right. So if you are risk on, if our model is telling us that the environment is conducive to taking risks, we generally want this gets to the nuance of building your baskets. We generally want to have a basket of assets that are positively correlated to equities because the signal is based off of the equity markets, right? So if you're getting a bullish signal in the equity markets, you probably want to gravitate towards things that have a positive correlation to equities and that are outperforming, generally speaking, over time.
Speaker 1:There is little correlation between the equity markets and commodities. We all know correlations change but generally speaking, they are a low correlation asset. So why is that important For us? We don't want to own something that's going to go down when the market's telling us it's time to be bullish, right?
Speaker 1:However, for people who run strategic portfolios ie, they're not tactical the way we are getting in and out and kind of market timing For people that are building strategic portfolios with allocations to equities, bonds, commodities, etc. Having things that have little to no correlation. That is the true diversification Right, and we think personally that I think it was Cliff Asness who used this term that we agree with. There's been a bear. Things like the CTAs over time tend to have very low or even inverse correlation to the equity market, but for us, using equity signals to decide if we want to be invested, it wouldn't make sense to own things that are then uncorrelated For those that want to develop their own models, and when I say develop their own models, I'm not talking about going and checking out some random indicator like actually creating a robust investment approach.
Speaker 2:What resources would you point them to? I don't know if it's that easy for people to just wrap their head around constructing something that can tell them, from a portfolio perspective, what to do.
Speaker 1:What resources I mean? Obviously you need a good source of data for whatever indicator you're deciding to look at. I think the key to building robust and good models is to kind of have low correlation amongst your indicators. What does that mean? That means that I'm going to go into the CMT textbook. Now, if you're going to build a model and you say, okay, I'm going to use three indicators, I'm going to use the S&P 500 with its moving averages, call that one. I'm going to use the RSI, the MACD and stochastics. That's useless. Why? Because all of those indicators are derived from price and they're telling you the same thing. They're just telling it to you in different ways. So I would start by identifying the indicators that are not as correlated to the S&P 500 or to whatever market you're tracking. What's an uncorrelated indicator? I think volume is an uncorrelated indicator. Volume is not derived by the price, right? An RSI is just a mathematical formula applied to the price of something to get an indicator. Volume is not. I think intermarket analysis is a key component.
Speaker 1:I think the other thing I would focus on is just varying your timeframes and bringing them all together. You mentioned it earlier and I always run into this. I teach a college class, baruch in New York City, and one of the first things I tell my students is most disagreements amongst people in the market are a function of timeframe. I tell them listen, there can be three trends all playing out in the market at the same time right, there could be a short-term downtrend within an intermediate term consolidation within a long-term uptrend right, and if you're a day trader, you're bearish. And if you're kind of a swing trader, you're probably neutral. And if you're a long-term investor, you're bullish. And if the day trader and the long-term investor are having a conversation about the market, they're both going to look at each other, tell each the other one's stupid, that you don't get it. And it's really just a function of time frame and all three of those trends can be playing out at the same time and that's what people don't get. So the key and this kind of gets into cycle analysis the key is to identify the times when the key trends are lined up and that is an opportunity where probabilities probably favor being risk-off.
Speaker 1:Different time frames, uncorrelated indicators, intermarket analysis and I think that you don't have to reinvent the wheel. A lot of the old school, like the foundational technical analysis concepts. I think they still hold. We use transports as part of our intermarket analysis. For those of you who know, transports are a component of Dow Theory. Dow Theory is over 100 years old and I will tell you that within our model we did some testing. Because I like semiconductors and I do think they matter, we swapped out transports just as a test not in a live model, just as a test Because my thesis was the environment has changed, the world has changed. Semiconductors are more important than transports. That was my thesis. So we said okay, thankfully for us, we can test. That Swap out transports, swap in semis, degraded our model. So here you have this concept of Dow theory that's over 100 years old and still holds up for our work. So I don't think you need to invent the wheel.
Speaker 1:Now, what I'm not a fan of and I've really never been a fan of, but I'm not a fan of the subjective TA we're not going to take a position because there is a head and shoulders top or bottom. We are not going to take a position because there's a breakout from a bull flag right. We're not drawing lines on charts. But the concepts, the more mathematical and statistical concepts from classic technical analysis, still hold. So I'd start there.
Speaker 1:I'd start with books from people like John Murphy. I'd start your father's book. I'm just looking over now at some of the ones. I mean I still have the Edwards and McGee book, right, I have, you know. I think the Kaufman book on trading systems and methods is a key place to start if you want to come to the world from a more systematic and quantitative place. And concepts like dual momentum right, I'm just looking at my bookshelf. I mean I have them all right. I even have the books with the patterns and even in my class I do teach the patterns as part of kind of like the history of technical analysis.
Speaker 1:But I quickly tell my students, I tell all my students, that you should be thinking about how would I take this concept, code it and test it and prove myself right or wrong? So I know it's a long-winded answer because I don't think there's a very good answer to the question. You can go either way. I think you just kind of have to know yourself. If you're like me and you know that you tend to be bearish, I could find every reason to just stop gold bars. That's not going to help me over the long run. So I need a process that systematically tells me like hey, dummy, it's risk on. We know you hate the world, but you need to be invested.
Speaker 2:Your distaste for drawing lines on a chart is manifested whenever I say the squiggle boy is trading from their basement with their pet hamsters.
Speaker 1:Listen. I think that, listen, it's a starting point. It's you know, and if you it's a starting point no, no, I get it. I get it. It's not objective, right? And I say to myself I always, like I said, I tell my students and I think, could you test this right? If I gave you open, high, low, closed data, you could test a breakout. You could test a breakdown, you could construct a moving average of whatever timeframe makes sense to you and then test moves above and below the moving average. I don't know how you test the trend line right, especially because I can draw it differently than you. Are we talking about connecting the closes, the lows, et cetera? So it's just way too subjective for what we do.
Speaker 2:Dan, for those who want to track more of your thoughts, more of your words, point them to.
Speaker 1:I mean, social media is a good place. We do publish blog posts on our website, potomacfundcom, where you kind of get a high level view of our thoughts and our thoughts. Some of the more detailed analysis that we do is for our clients. Again, our clients are predominantly financial advisors who tap our strategies on various platforms, so we provide a lot of content for them. But potomacfundcom is a good place to start to get a high level of review of who we are and what we do everybody, please make sure you follow us today on Russo.
Speaker 2:Stay tuned for another episode of Lead Lag Live coming up literally in five minutes and appreciate those who watch this live stream. Thank you, dan. Always a pleasure. Thanks everyone, it was a pleasure, thank you for having me, michael.
Speaker 1:It was great. Cheers everybody. Thank you.
