Long short strategies at a time when we are at all time highs

Markets are at all time highs – this is not uncommon – markets (since they are supposed to go up) should be at, or near, all time highs much of the time. That doesn’t mean that investors cannot be nervous about this condition. A number of respected investors will encourage caution, citing “all-time highs” as a reason for caution. The worry, of course, is that the market will come crashing down.

spy

(SPY at all time highs right now!)

Long short strategies, which have both long, and short positions are a nice way to hedge against the potential of a large market downturn. When engaging in a long short strategy, the first decision to make is are you going to be completely hedged (that is, your long positions and short positions are roughly equal, in terms of market sensitivity), or are you going to have a long or short bias. This is ultimately a decision that resolves into the question, “can you time the market?” There are many perspectives on this, but my take is that this is hard to do and I am not going to focus on this.

Rather, I will focus on a question that arises once you have decided on a net exposure: what should you be long? and what should you be short? Some solutions include:

1. Going long and short completely separate strategies – for example, profitability for a long strategy and some short screen for a short. This has the advantage in that you are, at least in back tests, gaining on both ends. However, we know nothing about the correlations of the long and short legs and there may be situations in which we lose money on both ends if the long leg goes down and the short leg goes up!

2. Going long and short separate ends of a single spectrum. For example, if we are separating stocks in the universe based on the PE measures, perhaps we go long low PE stocks (value stocks) and short high PE stocks (growth stocks).

vg

 

 

(Value – top line, growth, bottom line – we would make the difference in a long short strategy)

This has some advantages over the first technique, in that the stocks are otherwise likely to be similar in long and short legs, and hence the correlations should be high – thus the hedge from the short leg should work better. Also, this is the standard way in which academics document characteristics of stocks that affect future returns –  so there is a lot of literature and data easily available under this framework.

3. Going long something that’s “good” and being short the market. This is the most common way industry practitioners seem to run long short portfolios. Their long legs are driven by their proprietary research and secret signals but on the short side, they simply use the market. The real advantage to this is that from a practitioners perspective, shorting the market is much, much easier than shorting a collection of stocks. There is infinite liquidity in market indices and you never have to be worried about getting a locate.

These are just three possible ways to implement a long short strategy. Each with its own advantages and disadvantages. They are definitely psychologically useful when investing in markets that are at “all time highs,” but there’s no reason to restrict their use to such situations – they can be used any time you want to a hedge against potential large downturns in the markets.

 

Change the rules

As in most endeavors in life, quantitative investing requires learning from mistakes. An example I recently encountered involved one of my fairly complex short screens. The idea behind the screen was similar discussed here…. Shorting …. and a Happy New Year, but the execution was infinitely more complicated.

Anyway, this screen was spitting out 5 or so stocks each month when I did my rebalance. Last month, it returned only 2 stocks … I was not too concerned: there’s always variation in the number of stocks returned month to month. However, I decided to increase the allocations to each of these names since there were only two names … and then, one of the names (KPTI)  had a +60% month. With an oversized allocation and the large positive return, it certain made its presence felt in my overall portfolio return. Sigh.

No worries – it was an up March 2016, and my longs rallied to yield an overall profit .. BUT …. I was somewhat shaken. I did a bit of analysis on the short screen I was using and found something interesting. like KPTI, a large chunk of stocks returned in my short screen were biotech stocks. This made sense since biotech stocks generally look terrible from an earnings standpoint. In fact, these stocks are designed to basically lose money, until they get far enough in a clinical trials to be acquired by a large pharma company.

Enough biotech companies fail that, even accounting for the few that are sold at a massive gain to big pharma, the backtest on my screen was looking great. However, I was taking large risks on individual bets. So …. I did what any human (seemingly rational) investor would do and just excluded biotech from my short screen.

I had to reduce the other restrictions to get back to a reasonable number of stocks in the portfolio at all times … and it definitely reduced the spikes and cliffs. So I implemented it for my April rebalance – 4 non biotech names.

Seems like a win all around, but somehow I doubt this will be my only post on changing the rules. I also somehow feel my next post on this practice of changing rules won’t be as positive about the practice as this one, but we’ll see.

 

 

 

Shorting …. and a Happy New Year

2016 has begun with a fizzle. Markets have plummeted over 5% in the first couple of weeks and sentiment is dim. The perfect time to discuss shorting strategies. Shorting is selling stocks you don’t own. It’s a way to bet on something going down. The exact mechanics of a short is as follows. If I want to short shares of Apple, I will first have to find someone willing to lend me those shares. After I borrow the shares, I’ll sell them. When I’m finished with my bet, I will buy those shares back and return them to the person who lent them to me. If the price has gone down, I’d pay less to buy the shares back than when I sold them, making money. This sounds complicated, but in most brokerage accounts (short-selling requires brokerage accounts to be margin enabled), the process is pretty seamless and short-selling is as easy as selling a stock you own. Instead of a positive share count you see for stocks you’ve bought, short positions will show up as a negative share count.

So how do you decide what to short? It’s pretty much exactly the same as deciding what to buy, except you want things that have historically gone down in value. Think of criteria that were associated with future out-performance (low P/E ratios, small cap stocks, winning stocks, etc.) and flip them. For example, high P/E ratio stocks, or even better, stocks which negative earnings (the companies lose money) will generally do badly going forward. Large cap stocks will do badly compared to other stocks. Stocks that went down the past year will continue going down next year.

Here’s a screen that does these 3 things …

Capture

A hundred dollars invested in this screen goes down to about a quarter in last decade, while the market is up 80%. In the first 16 days of 2016, this screen has decline 15% (vs. the market’s 6-ish% decline). That means if you had been short $100 worth of the stocks that passed this screen on Jan 1st (or Jan 4th, the first trading day) you’d be up $15!

Disclaimer: Short selling has significant risks. Unlike a long position, where the most you can lose is your original investment (if the stock you bought ends up worthless), in a short position, your potential loss is theoretically infinite as a stock price could keep increasing forever. People betting against Netflix over the last few years found this out the hard way … Short with caution.