Opportunities coming back!

Dear L.,

This week I have been listening to the audio book “Trading in the Zone”, one of the classic books on trading psychology. At some point the narrator asked the following question: “If you had a wish and were to be given one trading ability, which would it be?”. At this point I was actually following the markets and therefore I did not really listen. Subconsciously my answer was: “Following my plans and taking action!”.

So, here we are again my best L. I have come back to reality. With hindsight and confirmation bias it all seemed so easy during the past three months when I was not able to actually trade myself. But now? Well, actually it still seems “easy” and “predictable” but pushing myself over the edge is a lot more difficult than I had expected.

But let me tell you this week´s story.

This week started like every other week in recent months with me going to work for Monday and Tuesday were the final days of my internship. Thus, once more I can only tell you with hindsight bias about the market action for these days.

But on Monday there were some very appealing bounce plays.

There was ALDX, bouncing from the $8.5s to $9.5 in a matter of four minutes. Pay attention to the daily chart here. It just looks perfect.

And there was KNDI, which went from the $4.70s to $5.4 in under 20 minutes too. You see – there were some nice opportunities.

After another day of work on Tuesday came, you may have already guessed it, Wednesday. The best trader in the world was back in front of his laptop (did I mention that I even have an additional screen now? – sweet huh?).

The first stock on our list was actually on my watchlist too. ITUS had gone totally nuts in the beginning of the week and went from $ 0.7 to almost $2 on news of an issued patent. You know that I like these high flyers later in their cycle. More specifically I think the risk reward is the best after some days of selling off. However, more recently I additionally became more fond of the setup of buying these stocks for a red to green move since they can squeeze shorts extremely easily. The problem with this setup compared to the bounce play setup is that in this case there is still much selling pressure left once people take profits.

Nevertheless, I was watching for a weak open and then a squeeze – the known old story. And what we got was actually exactly this move. ITUS sold off down to the mid 1.70s before finding support and grinding higher. Then, when it broke the opening level in the mid 1.80s, it quickly squeezed to $2.35. What was I doing? I was sitting at the sideline. Well, I guess that for this first trade I can use the excuse that this was just too fast for me after having been away for a few months…. Nah, this excuse does not sound not too convincing to me either.

Well, just for the sake of mentioning them, let us have a look at two more red to green movers which were not on my list. PULM squeezed nicely from around the mid 1.90s to the mid 2.30s. To be fair, even though it found support it did not put in higher lows and almost all of the squeeze happened in a single candle. Thus, playing this squeeze was very difficult indeed.

Additionally, SPI, which should have been on my list given the chart, went from just under 10 cents to just under 15 cents – not too bad!

On Thursday, there was not too much to complain about. One crazy move to mention was on the side of AKTX. Look at this crazy composium of shorts getting squeezed and longs chasing. From the low 6s to almost $12.

And then there was the newest pump PEKN, having its final crash and offering two very nice dip buying opportunities. Since I usually scan for OTC stocks with a price of under $3 this was not on my watchlist. I probably should adjust my criteria I guess.

So let us revisit the fateful day. There were a bunch of stocks on my watch list for Friday – so many nice setups.

First, we have HMNY. Based on the chart, this was not a real bounce play yet since it had sold off only marginally on Thursday. Nevertheless I thought that this may offer a nice red to green move. Pretty much right out of the gate HMNY started to spike. Thus, my favorite setup did not materialize and I was out. I´m ok with that. What happened later in the day however is impressive. HMNY broke out of its down trend at around 16:15, it subsequently spiked from around $5.8 to almost $8 before selling off again.

The next one on my list, and albeit one that makes me upset, is ITUS. This one had a very similar daily chart to the one of HMNY. But unlike HMNY, ITUS offered the red to green move – so I though. At the open ITUS sold off from $2.13 down to $2, which is a good range for the bounce in my opinion. At $2 it found support and put in higher lows. At this point I already missed some of my entries due to the fear of entering my position but finally I bought some shares at $2.07 which actually is a nice entry. Just after my purchase, ITUS started its squeeze – up to $2.18. At this point I thought about selling for a moment but decided that a squeeze should lead us much higher. However, ITUS failed to squeezed and sold off down to $2.06 again. I became a little nervous at this point. But why the ***? I had a stop at around $2 and was certain to be executed given the liquidity. There is no way of trading without having losses from time to time. So why be so nervous? Maybe I need more exposure again. Anyway, ITUS made another attack, crawling back to the crucial $2.13 mark. But once more, short sellers pushed ITUS right back and I threw in the towl at $2.12. ITUS went lower to $2.08 (a higher low), made a third attack and sold off to $2.1(yet another higher low), finally broke out and spiked to as high as $2.5.

So what is the lesson of this trade? First, my entry was nicely chosen. The fact that I was able to generate a small profit despite my unacceptable exit shows this. Second, once more I exited my position with a minuscule profit just avoid a (very small – given my stop) loss. Let us have a look at the chart again. When the squeeze got rejected for the second time – was there any significant level on the chart broken? No! ITUS barely sold off four cents and quickly recovered. The price action at this point did not invalidate my entry at all. I have to say it once more. It is 1000 times better to exit with a (small) loss at a point when your trade idea has been invalidated than to exit with a minuscule profit just to make a profit. It does not matter if my win rate is only let´s say 30% as long as my winning trades are much larger than my losing trades. Traders do go broke taking profits after all and missed opportunity cost is a cost too – as we see in this case and further down too.

Lesson learned, I have to include different time frames and stops invalidating my trade idea for my trade plans.

I really had hoped not having to write about the next trade and actually did not pick up my “pencil” until the market close just in order to avoid the painful reality. While I could have earned more on a more appropriate ITUS trade, the next trade, the next missed opportunity, makes me want to attribute myself an IQ of 80. GLNNF is just the perfect breakout out of its resistance at 30 cents.

Already on Thursday, I was watching this stock. However, when it was clear that it would not break out during this session, I promised myself to watch it again on Friday. And boy did it break out on Friday. Since I like to buy these OTC breakouts at the end of the day, speculating for the morning gap up, I had not clearly articulated my plan for a morning break out. This led me to being sitting at the sidelines thinking at many points “let it just come back to X and I´ll enter”. Well, obviously it did not only not come back but went as high as 38 cents from its breakout level at 30 cents – more than 20% of appreciation. If this follows the pattern on Monday, and I bet it will, it will gap up and offer even better returns. Let us see – I clearly deserve this lesson and hope I have learnt it.

Best,

Nils

On Overvaluation and Extreme Losses

So, just how overvalued are current equity markets and more importantly when the markets finally crash, what will be the magnitude of this crash?

Universa Investment´s Chief Investment Officer Mark Spitznagel set out to answer this question already in 2011 in the white paper “The Dao of Corporate Finance, Q Ratios, and Stock Market Crashes”. Even though the “likely” crash has not occurred for 6 years, his analysis is very compelling and may be worth keeping in mind while watching our current surroundings.

It is all about valuation

The start of Spitznagel´s analysis goes back to business valuation and revisits one of the most famous equations in Finance. The Gordon Dividend Discount model states that the value of a company equals it´s future expected dividends discounted at a appropriate cost of capital. Thus, we have.

where D(1) are next period´s dividends, WACC is the appropriate weighted average cost of capital and g is the growth rate of dividends.

Since it is more appropriate to use free cash flows than dividends, we replace dividends with

Free Cash Flows = “Net Operating Profit less Adjusted Taxes” * ( 1-Rate of investment (IR))

Additionally, the grow rate can be approximated by the product of return on invested capital (ROIC) and invested capital (IR).

g = ROIC * IR

We arrive thus at

And since the net operating profits less adjusted taxes are themselves a product of invested capital and return on invested capital, i.e. NOPLAT = ROIC * IC we arrive at.

The last equation shows us the relevant force in valuation. It is all about the ROIC – WACC spread. According to basic reasoning and based on economic concepts one would expect this spread to disappear. If ROIC exceeds the WACC “greedy” capitalists will rush into the market, thereby pushing the ROIC lower. The opposite holds if WACC would be to exceed return on capital. Therefore, we generally can expect these two measures to converge. Indeed, empirically in the U.S. both ROIC and WACC have been at a value of around 8%.

So, where are we at? At this point we can say that if Value/IC is high this tells us nothing but that ROIC currently is higher than WACC. Since the growth rate appears both in the numerator and the denominator, we may neglect it.

The Q ratio and expected returns

Our measure of Value/IC which is entirely driven by the ROIC – WACC spread is essentially the same as the Q ratio, which is expressed as total equity over the total net worth of the company (assets and debt are netted). Below the development of the Q ratio between 1900 and 2011 is displayed.

Source:  Spitznagel, “The Dao of Corporate Finance, Q Ratios, and Stock Market Crashes”, Universa Investments

We may observe that the average Q ratio value is 0.7 for the given time frame. This indicates that at a reading of 0.7 WACC = ROIC. Even though one would expect a Q ratio of 1 to bring equilibrium, we may explain this feature by the fact that net worth of firms consistently has been overstated, i.e. invested capital has been overstated and depreciation understated.

So how can we use Q ratios to forecast returns? Well, first of all it may be interesting, even though it should be intuitive, to note that the lower the Q ratio (the more undervalued the equity markets) the higher the expected returns. This is displayed in the figure below.

Source:  Spitznagel, “The Dao of Corporate Finance, Q Ratios, and Stock Market Crashes”, Universa Investments

We have it! The Q ratio seems to work very well when forecasting expected returns. What is even more astounding however is the impact of the Q ratio on the left tail of the return distribution. Spitznagel states

“Insofar as the Q ratio is also able to expose the magnitude of that implied spread [ROIC – WACC] as well as perhaps of implied growth rates, where material, it should not be surprising that it in turn indicates susceptibility to shifts from any extreme consensus. And such shifts of extreme consensus are naturally among the predominant mechanics of stock market crashes.”

Therefore, let´s have a look at the effect on the left tail.

Source:  Spitznagel, “The Dao of Corporate Finance, Q Ratios, and Stock Market Crashes”, Universa Investments

The picture seems pretty scary. 50% and 20% of returns are expected to occur below the returns indicated in each bin based on the Q ratio. The left tails are a lot fatter the higher the Q ratio. Therefore as Spitzagel notes:

“While overvaluation is murder on mean returns, as one should expect, it is even worse on risk.

[…]

At current valuations (Q = 1.04) – and if this 110- year relationship continues – there is an expected (median) drawdown of 20%, and a 20% chance of a larger than 40% correction in the S&P500 within the next few years. Should valuations remain elevated (that is, if no large correction materializes), these probabilities continually reset; this makes an eventual steep drawdown from current levels highly likely.”

The sharp correction thus far did not occur and at the time of writing the Q ratio hovers around the 1.038 level. Does this mean that we are headed for a crash? Well, it is not easy to answer this question. Distinguishing between causation and correlation is at times a difficult task. However, the theory behind the basic valuation formula seems very compelling and even if we cannot forecast the future one may conclude that larger drawdowns have become increasingly more likely in recent years.

Best,

Nils

Weekly Recap: 11.09-15.09

Dear L.,

This was a more quite week but there were still some interesting opportunities. So let´s have a look!

Last week I wrote about DCTH and DRYS and possible bounce opportunities. Well, it did not work out very well to be honest.

DCTH just continued selling off.

DRYS however, offered a very small bounce opportunity. On Monday morning it opened weak, found support however and then “squeezed from the mid 2.3s to a high of 2.50 – admittedly a small move.

What we did get however where three dip buying opportunities on HOMR – as we had anticipated before.

On Tuesday, NLNK bounced nicely.

Given that it has experienced 5 consecutive red days, I will be watching this for a bounce next week too. However, with a market cap of $286 million and a share price of around $12.6 it definitely is not the optimal setup.

What I will be watching closely is NSRPF for a break out of its $4.5 resistance.

That´s it already for this week. Let´s see what next week will offer.

By the way. From Wednesday onward, I will be able to trade again. Thus I will be able to test my hindsight bias tactics first hand.

Best,

Nils

Weekly Recap: 04.09 – 08.09

Dear L.,

One of the benefits of writing these weekly recaps, including my watchlist for the upcoming week, is that it limits (to some extent) my tendency to rely on hindsight bias. Based on my favorite patterns I put stocks on my watchlist and “clearly” articulate what I expect to happen. Sometimes it works out and sometimes it doesn´t. Since I do not write this post daily, new stocks show up every day that come onto my watchlist which I do not write about before the week starts. But at least when reviewing my previous week´s forecasts I have to face reality to some extent.

This week was one of the weeks were my patterns did not work out the way I had anticipated and thus we have to talk about it. Don´t worry though. There will be a lot of hindsight bias regarding stocks that popped up on my radar during the week.

For NBEV I had anticipated a bounce play. Well, it did not happen. Liquidity dried up and even though the stock is higher priced, thereby still being liquid in $ terms, this play once more strengthened my view that the bounce play works better for stocks in the $1-2 range.

The next stock on my watchlist, PYDS, was such a lower priced share. Anyway the bounce did not happen.

For FSNN, the pattern played out to some extent. After three red days we had the typical morning sell off followed by an upwards trend. When the morning high broke FSNN spiked a little bit.

The same goes for LINU. However, the pattern appeared after five consecutive red days and thus very late. Already on previous days the pattern seemed to materialize. Consequently, I would have entered at these points and lost on these trades. Anyway, on Friday the pattern was perfect. Weak opening, LINU grinding up and when the high at $1.33 broke it spiked up to around $1.5.

Now let us have a look at the hindsight bias play.

PULM bounced this week after two days of selling off. The pattern took longer to work out but we see that once more the opening level of the stock was the crucial one. Once this was broken short sellers covered and PULM spiked.

Let us have a look at the plays for next week.

Already on last week´s watchlist, HOMR keeps on grinding up. I am waiting for the crash and the dip buying opportunity.

OTC stock ACBFF is getting close to its resistance level at $2.2 and I am watching it for the breakout.

For both DCTH and DRYS the pattern is not super convicting but considering their charts, there may be the opportunity for a bounce play. They are worth watching.

Let´s see how the week turns out.

Best,

Nils

 

Weekly Recap: 28.08 – 01.09

Dear L.,

As so often in the recent past, this week offered a lot of great trading opportunities which I want to tell you about.

Let us first have a look at the two stocks that were on our watchlist at the end of last week.

First of all I have to admit that SQNS should not have on the watchlist. I was betting for the bounce play but the liquidity was just not there anymore. Therefore, even though it bounced on the daily chart, the setup did not work out in this case.

For GBTC the situation looked quite differently. Fueled by Bitcoin appreciating more and more, it broke out of the previous highs at $780 on Tuesday and went as high as $931 on Wednesday. What a nice breakout! Of course, holding GBTC overnight would have exposed the buyer to Bitcoin´s volatility. Since this crypto currency trades 24/7, a depreciation could result in a gap down the next morning.

On Thursday GBTC even went higher, reaching a high of $1064! But what I want to show you is what happened on Friday. On Friday we encountered the third pattern that I want to focus on. Even though it occurs less often and is risky if implemented inefficiently, it offers great returns. This is the famous morning dip buying pattern. On Friday, GBTC opened slightly higher. Then it failed to spiked and subsequently crashed from around $1020 down to $760 in less than half an hour – what a move! What is more interesting however is that in the following minutes GBTC was able to bounce back $100 to $860 and it even went as high as $920 later before selling off again. As I said, the pattern is not easy to play and it is like “catching a falling knife” but the profit opportunity is great on the other side too.

After the dip buying pattern let us have another look at two stocks following my other two favorite patterns. Thursday once more brought a perfect bounce play pattern. UNXL had spiked from 5 cents on Monday to as high as 16 cents on Tuesday. On Wednesday the sell off followed. Then on Thursday the pattern was just perfect. UNXL sold off in the first minutes but then found support. When it took out the high of the day at 10.5 cents it subsequently spiked to almost 13 cents in the next quarter of an hour. The fact that UNXL has a market capitalization of only $8.7 million dollars made this setup even more likely to work out due to the limited supply of shares. Thus, when shorts had to cover and momentum buyers came in to buy, supply & demand dynamics made UNXL appreciate very nicely.

And then between Thursday and Friday we had a another very nice OTC breakout play. On Thursday LQTM broke out of the previous highs at 33 cents, closing the day at 34.2 cents. As the pattern “predicts” LQMT gapped up to 35 cents on Friday and reached its highs at almost 40 cents.

For the coming week there are some very very interesting patterns setting up too. Talking about the dip buying pattern , I am quite confident that the OTC stock HOMR will offer this setup in the not so distant future. This stock clearly is manipulated and keeps on grinding upwards. This results from promoters sending out e-mails and other advertisement to retail investors, persuading them to buy into this “great opportunity”. One day, HOMR will gap down or fail to spike. This is when all the stop loss orders will kick in and HOMR will crash. I hope to be there to buy the dip. When will this be? I don´t know. HOMR may very well keep on grinding for a few more weeks. But I am very confident that it will crash sooner or later.

Next we have a bunch of anticipated bounce play:

LINU has sold off for two days now after doubling. On Tuesday this very well may bounce.

PYDS had its first red day on Friday. Ideally this sells off some more on Tuesday before bouncing on Wednesday.

The pattern is less convincing for NBEV but it is still worth watching it.

The same goes for FSNN. But this too is worth watching.

Let´s see how next week plays out.

Best,

Nils