Cut Through Market Chaos

Cut Through Market Chaos

2016 was a turbulent year that defied the attempts of many to predict where it was headed next.

January 2016 started off ugly and led many analysts to state that the market would finish lower for the year. Instead, the Dow Jones Industrial Average tacked on a healthy 11%, and the S&P 500 added 9.5% in 2016.

The Federal Reserve was calling for four interest-rate hikes. We got one.

The media talking heads and experts said that there was no way Brexit would go through. It did.

Few — beyond our own James Dale Davidson and Jeff Opdyke — called for Trump to win the presidency. He did.

Every day, it seems as if the world is defying our expectations and moving away from the “normal” that we once knew. That’s why it’s become even more critical to be able to come at the market with a systematic approach that removes emotions and biases so you can profit no matter what surprise awaits us in 2017.

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That’s why we added a new member to our team with a very unique background who will give you that needed edge when trading in 2017…

At the end of 2016, Michael J. Carr, CMT, joined the Banyan Hill team, bringing his expertise in developing systems to find great trading opportunities in the market regardless of the conditions. He graciously agreed to sit down with me to chat about his background, approach to the market and outlook for 2017.

Jocelynn: Thanks for joining me today, Michael. Now, I’ve got to start with a strange question. I keep hearing this story that at one time, you were the guy with your finger on the BIG RED BUTTON that could launch a full-scale nuclear missile attack. Is this true, or are the guys from the marketing team just pulling my leg?

Michael: I wasn’t the guy with my finger on the button — my job was to relay the message from the president to the missiles if that day ever came. As you can imagine, it takes a complex system to do that, and I had my fingers in those systems.

If something happens, the military holds a conference call where the president is told about what’s happening and has to make a decision. The decision needs to immediately reach all of the nuclear forces whether they are on airplanes, in submarines or missile silos scattered around the Western United States.

My job was to make sure the message reached the person responsible for launching every single weapon. I had a short amount of time, measured in seconds, to be sure everyone got the right message, so it was an exciting job.

Part of the excitement was the reality that there was no room for error. If I made a mistake and the message didn’t make it to the right people, there would be no way to fix the problem. Everything had to work exactly as expected, so I learned how to ensure failure was not an option. That’s a lesson I’ve carried over into my second career in the financial markets.

Jocelynn: That seems like quite a leap from calculating and coding missiles to stock trading. What caught your interest with trading?

Michael: I realized I would need to make a living after I left the Air Force, but I also learned in the Air Force that I didn’t enjoy spending time in long meetings. In thinking about retirement, I realized the “magic of compound interest” could help me earn a living trading.

Retirement planning, according to most financial planners, usually means investing for 40 years and compound interest turning that money into millions of dollars. Their math is correct, but I realized their underlying assumption was deeply flawed. There’s nothing magical about 10% a year. Compounding can unfold over any time period. I realized if I compounded small gains quickly, I could avoid having to get a job that required me to sit in meetings every day. The only way to do that was through trading.

Cut Through Market ChaosNow, I also realized trading is difficult. Rather than flying by the seat of my pants, I wanted to develop a computer program to deliver consistent results. I found the ideas for my program in the missiles I was working around.

The chart shows the ideal trajectory of a missile. It goes up, turns down and then crashes. If all goes well with a missile, the crash is actually the most important part. For investors, the initial phase, the “goes up” part, is the most important part.
You can see from that chart the initial part of the trajectory determines how far the missile goes. I saw a connection with the stock market. I wanted to find a way to buy stocks that were going up and were likely to deliver additional gains. Then, I needed a way to sell when they turned down to avoid that crash.

Through research, I found the best way to do this was with relative strength, a concept that is also known as the momentum anomaly to the efficient market hypothesis.

Jocelynn: How would you describe your approach to trading and the stock market?

Michael: My approach is disciplined.

Working with missiles, I learned that mistakes happen when you do something “different, dumb or dangerous.” The Three D’s are deadly in the military, and I believe they kill profits in the markets. To avoid the Three D’s, I use a quantitative investment strategy.

Quants rely on computers for signals. There is no discretion in my approach. The indicators and system drive the decisions. This eliminates the emotional responses that cost investors so much money. It also tells us what to expect based on historical data.

Jocelynn: Do you have a specific stop-loss strategy you like to use? Technical levels or a set percentage?

Michael: As you know, Jocelynn, I’m a Chartered Market Technician and active in the professional organization that administers that designation. My involvement in the Market Technicians Association has given me access to a variety of people who work on Wall Street. This is important because I’ve talked to market makers, the people who stood on the floor of the exchanges and executed orders. Now, that function is automated, but it works exactly the same way — their job is to execute orders, and if you have a stop in the market, they believe it is their duty to fill your order. They admit that the market will turn around when all the stops are filled, and that means your stop is almost guaranteed to lose money. Your loss is their gain, so the danger of stops is never going to be eliminated.

To avoid that, we need to avoid stops. I manage risk by knowing the probability of success of each trade I take, accepting only high-probability trades and using a moderate amount of diversification.

The exact number of positions to hold is driven by a quant model and can vary from zero to 10. When we have a low probability of making money by buying stocks, we hold no positions. That’s actually the best way to manage risk, according to my research.

Jocelynn: Any thoughts on what investors can expect for 2017?

Michael: We should expect buy-and-hold investors to experience the thrill of victory and the agony of defeat over the next 12 months. I expect a great deal of volatility in a market that is perfect for trading. By trading, we should be able to benefit from the upside in the market and preserve gains while the buy-and-hold investors suffer losses as prices dip.

I believe there will be a “deep dip” later this year, probably a crash-sized decline of 11% or more. But I also see a lot of gains before then and am looking forward to capturing profits using my quant system. I will be going into more detail on my expectations for 2017 in my first article for the Winning Investor Daily.

Thanks so much for your time today, Michael. I can’t wait to see how you tackle the market in 2017!

Regards,
Cut Through Market Chaos
Jocelynn Smith
Sr. Managing Editor, Banyan Hill Publishing