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Modern Trader - November 2017

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6 Power
10 Questions
Mark Cuban
Our mind on our money & our money on our mind
27 Timely
45th Anniversary
Trade Ideas
“Best Business Magazine”
— Niche Media Awards 2017
Fed Follies
& His
Tax Reform
& Trump
& Craft Beer
A Trader’s Love for
Burning Man
11.17 • issue 537
Robocops? Knightscope’s
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11.17 • Issue 537
Grant’s Interest Rate Observations
MODERN TRADER talks interest
rates, Fed policy and the great
unwind with James Grant.
Mark Cuban’s 10Q
Business, taxes, politics & Trump.
Mark Cuban Talks Investments
Cryptocurrencies, passive & private
Cryptocurrencies & Craft Beers
Grant’s look at bitcoin & beer.
The Cryptos are Creeping
Towards the Exchanges
Bitcoin is no longer a closed universe
comprised of digital geeks.
Markets, Politics, Modern
Trader & You
Results from our most recent reader survey.
Risk Factors
Knightscope, a robotics & software
company developing advanced crime
prediction and prevention technologies.
Raudys’ scientific approach.
Closing Tick
Yanking the tablecloth slowly:
Guest editorial from James Grant.
Cover by N E Torello
Folio Eddie Award: Best Single Article Business, Banking & Finance
(April 2017—The Banana Republic of Snapchat), Finalist • Folio Eddie
Award: Best Full Issue Business, Banking & Finance (January 2017—
Cannabis), Finalist • Min’s Magazine Media Award: Best Single Magazine
Issue (January 2017—Cannabis) Finalist • Min’s Magazine Media Award:
Best Cover Design Portfolio, Finalist • Nichee Award 2017: Winner Best
Business-To-Business Magazine Of The Year • American Society Of
Magazine Editors People’s Choice Award: Winner Best Political Campaign
Cover Of 2016 • Min’s Magazine Media Award: Best Feature Article (July
2015-Sell Stocks Now) Finalist • Folio Eddie Award: Best Editorial Full
Issue Business, Banking & Finance (July 2015—Premiere Issue) Finalist
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November 2017
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M o d e r nTr a d e r. c o m
We have been here through it all…
Commodities Magazine
& Financial Futures
Contracts Launched
Oil Shock
of 1973–74
Savings &
Loan Crisis
Latin American
Futures Magazine Introduced
Stock Market Crash
Asian Financial Crisis
FUTURES Magazine Introduces
Separating signal from the noise since 1972
Flash Crash;
Dodd-Frank Act
—the essential monthly journal
for professional investors &
active traders
Open Outcry Ending
Commodity & Financial Trading Floors
1848 – 2015
APRIL 2015
Hedge Fund & Private Equity News
11.17 • Issue 537
Daniel P. Collins
Managing &
Digital Editor
Yesenia Duran
Features Editor
Garrett Baldwin
Advance Auto:
The 40/125 forex trend
trading method
This former floor
trader keeps
returning to
Burning Man
Chart Patterns
Trading confluence of
chart patterns
If you like Zeppelin,
the Beatles,
& Hendrix…
Paper Trade
Systematic vs.
discretionary trading
Microdosing &
Stealing Fire
Lucinda Williams:
This Sweet Old World
Monetizing search &
funding moonshots
Google, notes & crude
Three outsourcing
Dogging the Dow,
debunking myths
Short interest
Real talk on business,
finance & politics
COT Ratio tips silver,
the Dow & the dollar
The Log-Log Parabola
Options Pricing Model
November: Trend
following tendencies
Trump’s Fed could
boost the buck
NACCO Industries –
Hamilton Beach =
40% upside
VESH: A different
inverse ETF
The collar portfolio
management strategy
Try decaf and write
Steven Lord
Murray A. Ruggiero, Jr.
Assistant Editor
Tamarah Webb
Creative Director
Nicholas E. Torello
Advertising Sales
Barry Weinberg
Financial Ad Solutions
Richard Holcomb
Non-Endemic Ad
Chief Content
Officer & Publisher
Jeff Joseph
Modern Trader
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Modern Trader
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We welcome your comments and suggestions at
Identification Statement: MODERN TRADER (ISSN0746-2468) is published monthly by The Alpha Pages, LLC at 107 W. Van Buren, Suite 203, Chicago, IL 60076. POSTMASTER
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November 2017
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6 Power
Industry insights from
28-year trading industry veteran
Dan Collins, Editor-in-Chief.
10 Questions
Mark Cuban
27 Timely
Trade Ideas
45th Anniversary
“Best Business Magazine”
Our mind on our money & our money on our mind
— Niche Media Awards 2017
rates &
the Fed
Fed Follies
& His
In a sense all major economic stories we
cover somehow relate back to the 2008
credit crisis; how it changed certain markets and how the reaction to the crisis by
major central banks altered the equilibrium
of the trading world.
This month is no different as we talk to
James Grant, long-term interest rate watcher and founder of Grant’s Interest Rate
Observer (see “Grant’s interest rate
11.17 • issue 537
observations,” page 26). Grant’s 2014
book: The Forgotten Depression: 1921:
The Crash That Cured Itself, highlights
what he sees as the appropriate response
2008 crisis, but points out that many of
to a major recession. While not all ecothose measures—near-zero interest rates,
nomic crises are the same, it is interesting
a huge Fed balance sheet due to endless
to look back and see that prior central bank
leadership took a different approach to such quantitative easing and negative rates in
some places— are still in place nearly a
an event. The U.S. Government balanced
decade later. He says the central bank
the budget and increased—not decreased
policies have overstayed their welcome
— interest rates in response to that crisis,
and added “Radical
which ended relatively
monetary policies beget
briefly and set the stage
All major
more radical monetary
for a period of substantial economic growth. In
economic stories policies.”
In “Yanking the
our conversation, Grant
somehow relate
joked that some current
back to the 2008
economists may be
credit crisis.
questions the Fed’s
surprised to know that
view that QE can be a
we are no longer in that
1921 recession since the Feds did not take positive force for the economy, yet the exit
from QE will not cause any problems.
that one-and-only route to exit it.
We also take a look at bitcoin and cryptoOn this point, Grant is not so orthodox.
currency mania this issue (see “The crypHe will accept—for argument’s sake— the
tos are creeping towards the exchangpoint-of-view many economists have made
es” page 40). Going back to our opening
that the U.S. Federal Reserve and other
thesis, it is hard to view the cryptocurrency
central banks needed to take strong and
trend occurring outside of the 2008 crisis.
extraordinary measures following the
Tax Reform
& Trump
& Craft Beer
A Trader’s Love for
Burning Man
Robocops? Knightscope’s
That shock surely was a key motivating factor to many cryptocurrency entrepreneurs.
It is a mania that can no longer be ignored.
The traditional investment world is asking
if they need exposure to bitcoin and there
is work being done to provide that access
through regulated derivatives products.
The Chicago Board Options Exchange and
others are looking to list futures and options
on cryptocurrencies. We get Grant’s and
Mark Cuban’s take on the space as well
(see pages 38-39).
Finally we have a discussion with Cuban,
the world’s most famous shark regarding
taxes and politics (see “Tax reform, politics, the market & Trump” page 36).
Daniel P. Collins
Send your comments, criticisms and suggestions to
November 2017
M o d e r nTr a d e r. c o m
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Real talk on business, finance, politics & alternative investments.
Powered by the Daily Alpha at
“On issue aer issue, it was like he
kept promising four-minute abs, or “Venezuela
is going to
even no-minute abs. Magic abs!”
That’s Hillary Clinton in her new book What Happened, an account of semi-truths
and misconceptions of reality by the former first lady and 2016 Democratic presidential
candidate. Clinton – to the horror of Democrats about to hit the campaign trail – is out on
a book tour once again blaming everyone and everything except herself and her lack of
policy ideas for her failure to win the 2016 election. This is rich considering that she was so
confident that she’d win the election that the Clinton’s purchased a house next door to their
residence in New York to house White House staff.
In the quote above, Clinton is carving knives for Sen. Bernie Sanders all the while
referencing the movie “There’s Something About Mary.”
She brings us back to the scene in the movie where the hitchhiker proposes “seven
minute abs” in which the stranger argues that he will make immense amounts of money by
shaving a minute off “Eight Minute Abs.” She argues that every time she pitched an idea for
the economy, Sanders would one up her with the same idea --- only bigger.
Of course, to get the reference, you’d have to remember anything about “There’s
Something About Mary.”
“I apologize to consumers
and our business
customers for the concern
and frustration this causes.”
Equifax CEO Richard Smith is sorry that his company is bad at what it does.
When it comes to completely screwing the American public, look no further than the
idiocy of modern credit reporting networks.
We’re living at the height of technological advancements, but our government still forces
Americans to identify themselves with nine-digit social security numbers and our birth
dates. Meanwhile, we have three credit reporting agencies that few Americans even understand. And while you might not want to know it, both your social security number and other
vital information about you is for sale right now on the dark web.
The entire structure of getting credit with easy-to-steal data points dates back to the
1930s, much like our retirement, banking and Social Security laws. So, add that to the list
of crap for Washington to hold meetings over in the next few weeks and then fail to resolve.
You cannot opt out of Equifax tracking you and collecting your data. When identity
thieves steal your information, banks and credit reporting companies like Equifax make you
have to prove yourself innocent in a process that can take years. Congress needs to let a
new system emerge.
Why is Bitcoin trading above $4,000?
Because no one wants to put up with identity theft on unsecure, centralized systems run
by companies who clearly don’t care about their customers’ security.
November 2017
a new
system of
and will
create a
basket of
to free us
from the
[U.S.] dollar.”
That’s a quote from Reuters
in a story on the embattled
Socialists’ effort to ditch the
petrodollar from international
markets. Some are predicting
that Venezuela is part of a
broader effort to destabilize the
U.S. dollar and untie it from the
global energy trade.
The irony is Venezuela is
attempting to pull away from one
of the most stable currencies
on the planet at a time that
inflation is well into the triple
digits. Rather than dollarizing, a
concept that could help stave
off total collapse, Nicolas
Maduro continues to prove he is
completely inept when it comes
to economics.
M o d e r nTr a d e r. c o m
“We’re not going to pass a single-payer healthcare bill
any time in the next few years. And so we need to have a
conversation about how we get there.”
That’s Sen. Chris Murphy, an advocate of single-payer healthcare, who will never have to suffer the experience of single-payer
healthcare because he works in Congress.
We’ve now moved to the point where unmitigated bureaucracy is the strategic goal.
Don’t worry… single-payer will work for two years, and everyone in the media will crow about how wonderful it is and how affordable and how easy and how little wait times are.
But wait for it, they’ll somehow blame the capitalists when the problems with wait times, high costs and endless regulations take
place as the path begins toward collapse.
Murphy is admitting that single payer was the goal all along. They were just waiting for the unsuspecting public to demand more
government in their lives.
Open Outcry
We receive a lot of feedback from our
readers. Not all of it is complimentary:
Your magazine doesn’t lie flat on the
table. When you take your hands away, it
closes up.
S. Stuart
Mesa, AZ
Subscriber since 1991
Stay out of politics and stick to trading.
We are a business and trading magazine, but politics has a major impact on
the economy and tax and regulatory
issues that affect markets. We address
this in greater detail in “The markets,
politics, Modern Trader & you.” page 42.
Keep up the fine work. Very much
appreciate the digital version.
C. Bennett
Wentzville, MO
Subscriber since 2002
Would like to see more interviews and
less on technical data, also would like to
be able to print articles from the digital
copy of the magazine.
We have recently moved our digital
edition to a new platform which allows
for articles to be printed.
Have a track record of the
recommended positions that are
suggested so the reader can tell if these
writers are the real deal or armchair
quarterbacks and posers.
N. Gravante
Brick, NJ
Subscriber since 1999
We agree. One year ago we began our
monthly Tracking Stock column (see
page 79) to provide full transparency on
the outcome of the trades and forecasts
published in our pages.
Start covering cryptocurrencies
E. Schall
Chester, NJ
Subscriber since 2012
Stay tuned. --We have regularly covered
the development of the blockchain and
cryptocurrencies and will continue to.
Including this issue (see pages 38-41).
Great Mag, keep it up and add as
much technical analysis as you can.
L. Bower
El Paso, TX
Subscriber since 2016
More interviews with successful
traders and hedge fund managers.
S. Lee
Los Angeles, CA
Subscriber since 2009
More technical analysis and more trader
interviews were the most frequently
cited reader suggestions.
The reader survey resulted in
hundreds of encouraging comments
from longtime readers and some new
Love the After the Bell section,
especially the whiskey.
Awesome magazine. Well done on the
D. Borowsky
Harrisburg, PA
Subscriber since 2015
Love the magazine - read it cover to
cover every month.
B. Leidt
Killingworth, CT
Subscriber since 2017
MT magazine has improved a lot over
the years. I’m impressed.
E. Chang
San Jose, CA
Subscriber since 1997
Been reading your magazine for over
30 years and in my opinion, it is the best
in the industry. Thank you all!
There is no other publication like it.
Keep up the good work!
H. Rudolf-Reckmann
Ringoes, NJ
Subscriber since 1981
We love our long-time readers. Thank
you for being with us through the years!
Daniel P Collins, EIC
Jeff Joseph, Publisher
Send your comments, suggestions and story ideas to
M o d e r nTr a d e r. c o m
Issue 537
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High conviction ideas from top traders, analysts & insiders
PSTG: Pure play
Q By Doug Busch
One of the strongest
bullish indicators is the
weekly ascending triangle
and upstart digital storage
provider, Pure Storage
Inc. (PSTG) is primed for
a breakout. PSTG is up
28% year-to-date and is
up 21% over last one-year
period. PSTG has admirable
earnings momentum with
back-to-back gains of 19%
and 9.3% in Q1 and Q2
2017. This comes after three
consecutive negative quarterly reports to end 2016.
The stock is higher in just
seven of the last 16 weeks
including gains of 28.2%
and 19.7% for the weeks
ending May 26 and Aug.
25. The $15 level serves as
strong resistance with no
weekly closes above it since
the end of 2015.
Recommendation: Enter
PSTG with a buy stop above
$15.20. Once this level is
breached, PSTG could challenge its all-time high above
$20 and would clear a long
weekly cup base trigger of
$20.70 dating back to its
October 2015 debut. Place
a protective stop at $14.
Doug Busch trades U.S.
equities using technical
analysis with an emphasis
on Japanese candlesticks.
M o d e r nTr a d e r. c o m
Source: ChartSmarter
This month in Trades
PSTG: Pure play
Chicago Bridge & Iron:
Turnaround brewing
Advance Auto:
Monetizing search &
funding moonshots
Google, notes & crude
Three outsourcing
COT Ratio tips silver, the
Dow & the dollar
VESH: A different
binverse ETF
Trump’s Fed could boost
the buck
The collar portfolio
management strategy
NC - HBB = 40% upside 21
Issue 537
Chicago Bridge & Iron:
Turnaround brewing
Q By Mike Dudas
Chicago Bridge & Iron (CBI) appears
strategically positioned in all its gas-facing
and downstream end markets, which should
result in 2018 being a turnaround year for
CBI. We find several catalysts to drive
shares forward during the next six months including projects tracking on a new schedule,
no additional project charges, progress on
cost- cutting programs and the achievement
of late-2017 booking targets. However, the
most important catalyst will be a successful
and lucrative sale of Lummis Technology.
Management appears confident of valuation and timeline targets. The last three-year
average earnings of the business (technology and engineered products) is in the
$220-$230 million range, and management
expects to achieve a minimum 10X multiple.
We believe strong competition could drive
a higher transaction multiple. The formal
sale process kicked off in mid-September.
Management indicated buyer interest has
been stronger than expected, with interest
from a variety of sources exceeding management expectations. The sale of technology
business for valuation in excess of $2 billion
should provide CBI with flexible financing
footing. Management plans to use the proceeds from an expected technology sale by
2017 year end to extinguish its entire debt
balance and to still have residual liquidity.
Management plans to use the proceeds
from expected technology sales by 2017 to
pay down the current $1.8 billion debt.
ects will be similar to that achieved to date.
Liquefied natural gas (LNG) markets
have been oversupplied for the last two
years, which management expects to eventually turn in a very sharp way. In management’s view, markets are going to turn from
being significantly inactive to being very
active. CBI management expects supply
deficits by 2021-22. CBI has already seen
the balance of power slowly shift away from
buyers. CBI is working on several projects,
in collaboration with companies such as
Exxon (XOM) and Qatar Petroleum, among
others and all of these projects have good
fundamentals. Even if only two or three of
these projects go ahead, that would be
The most
catalyst will
be a successful
and lucrative
sale of Lummis
pretty significant for CBI.
On the power front, CBI expects the
Engineering, Procurement, Construction (EPC) industry in general to be more
selective in pursuits. Continued efforts to
recapitalize its financial profile are leading
to the proposed sale of CBI’s most current
valuable asset; one not close to being
recognized in current valuation, a defined
overhead and operational cost reduction
program, and a move to emerging as a
global EPC/fabricated product vendor.
While there is risk of further costs to LNG,
projects remain and the cash burn could
increase, we believe the market’s valuation
and eventual worst case impacts as balance
sheet flexibility; CBI has the ability to execute the turnaround. We look at a 2018 CBI
post asset monetization, debt elimination
recapitalizing and restructured company
leveraging off a potential recovery in pentup downstream and LNG capital investment.
The degree to which management successfully implements plans to convert change orders, hold to project schedules, manage and
enhance operating cash during the second
half will allow a sharp recovery of at least a
portion of the significant valuation loss since
May (see “CBI due for recovery” below).
Our $20 price target reflects first half asset restructuring and a successful technology sale by year end.
Mike Dudas is an equity analyst for Vertical Research Partners.
The sell-off since spring of CBI has been overdone, and the positive fundamentals
should allow CBI to recapture a lot of ground.
Source: eSignal
Problem Projects
At its power projects, CBI has not witnessed labor productivity levels that it
usually sees in its direct workforce. As a
result, management has decided to not be
in the power market in those regions in the
foreseeable future, and rather be in markets
where management understands labor
productivity. Management has now taken
a conservative view and is assuming future
productivity at these problem power proj14
November 2017
M o d e r nTr a d e r. c o m
Advance Auto:
Q By Joseph Parnes
Advance Auto Parts, Inc. (AAP) the
provider of automotive parts, accessories,
and maintenance items for domestic/
imported vehicles, and industrial vehicles
has been given a “ticket to short,” due to
a 20% plunge in a singular trading day.
The Roanoke, Virginia-based company
founded in 1929 sells its products online
through and It serves do-it-for-me
and do-it-yourself customers, as well
as 5,062 independently owned stores,
branches and
approximately 1,250
Symbol: AAP
owned CarquestMarket cap: $7.24
branded stores in
the United States,
52-week high/low:
Puerto Rico, and the
U.S. Virgin Islands.
EPS: 5.52
Internationally it
P/E: 17.77
serves Canada,
Short Range: $95Mexico, the
Bahamas, Turks and
Cover Short: $69
Caicos, the British
Stop Loss: $116
Virgin Islands and
the Pacific Islands.
AAP’s 20% single-day plunge was
primarily due to its reported lower than
expected sales outlook for its Q2 2017. The
company’s profit fell 30% to $8.7 million.
It suggests that AAP is experiencing broad
industry sector headwinds where sales
for Q2 were flat instead of beating by an
expected 0.2%. To make matters worse,
this guidance was lowered by 1% to 3% in
same-store sales for the year. AAP’s adjusted earnings fell to $1.58 per share from
$1.90, leaving flat revenue of $2.26 billion.
AAP’s principle audience is comprised
of do-it-for-me and do-it-yourself customers.
The acceleration of new car sales in and
around 2010 has reduced AAP’s customer
M o d e r nTr a d e r. c o m
acceleration of
new car sales
in and around
2010 has
reduced AAP’s
customer base.
base in 2017 and in its 2018 projections.
Or another way of saying this is that AAP’s
inventory and maintenance services are
increasingly unfavorable to its customer
base as they are partially comprised of:
Batteries and battery accessories, belts
and hoses, brakes, clutches, engine
parts, exhaust parts, ignition components,
radiators, starters, alternators, tire repair,
fuel and oil fluids for engine maintenance;
which has little demand in a environment
of cars that are self regulating, computer
centric, and less prone to repair issues.
AAP’s stock price has plummeted to its
current low of $82.21, which marks its
lowest level since September 2013,
skidding consistently lower since its
2016 high above $175 (see “A rough
road”). AAP traded below its 50- and
200-day moving averages and continued
its retreat through mid-May 2017. This
led to a failed rebound above its 50-day
MA, followed by continued weakness
reaching its new low of $82.21. AAP’s
recent rebound challenging the $100
level is being carried out with little conviction. There is a difficult task ahead on
AAP’s horizon to fill the prior plunges, as
well as its capacity to meet its primary
resistance at $110, and its secondary
resistance at $115. AAP is on a seemingly long ride in the short lane.
The author has no position in AAP.
Joseph Parnes is an independent
RIA with more than 30 years of trading
experience. He specializes in short selling.
AAP has steadily declined for nine months.
Source: eSignal
Advance Auto Parts (AAP)
Issue 537
search &
Q By Christine Short
Equally loved as it is hated, Google
(GOOG), or Alphabet (GOOGL) if
you prefer, continues to put up strong
fundamentals while in the midst of
antitrust challenges and bad PR
regarding its diversity standards.
The tech behemoth can easily and
quietly ratchet its share of the search
market up or down by pushing more or
less revenue within a few percentage
points of growth. Currently, it’s estimated
Google owns more than 80% of the
search market. While they could easily
go out and capture the entire market,
they don’t due to regulatory worries of
Alphabet now
trades at the
highest trailing
four quarter EPS
and revenue
multiples of the
past five years.
being a monopoly. As it is, the company
was fined $2.7 billion this summer in
an European Union antitrust ruling that
found it favored its own services over
those of competitors.
After years of refusing to
their minority hiring
claiming their hiring
Estimize and Wall Street experts see continued
growth in Google’s future.
practice was a trade secret,
Source: Estimize
Google did begin doing so
in 2014, and the numbers
weren’t pretty. Three years
later the data still shows the
company is largely male and
white, and that progress has
been incremental at best. The
recent hire of a new VP of
diversity is hoped to help with
that issue.
Despite all this, the
company continues to report
strong fundamentals each
earnings season. In the last
November 2017
eight quarters (Q3 2015 through Q2 2017)
the giant has put up double-digit earnings
per share (EPS) growth in five quarters,
slowing more recently due to increasingly
difficult year-over-year comparisons.
Revenues have grown 15% or more over
the same time period, an incredible feat
considering this is a company with a
market cap of $650 billion. And there is no
sign of that slowing down with revenues
expected to stay in the double digits for
the next four quarters.
Of course the main engine of revenue
growth for Alphabet is through advertising,
which regularly sees year-over-year
growth in the mid to high teens (see
“Google growth”). Google investors have
started to see the advertising business as
a sort of technology REIT, knowing that
cash flow will remain strong each quarter.
Paid clicks have also remained strong this
year and as such the company’s cost-perclick continues to decrease.
These numbers need to continue to
be strong if they are going to justify the
high valuation. Alphabet now trades at
the highest trailing four quarter EPS and
revenue multiples of the past five years.
With those high multiples come very high
expectations of growth, which have been
mostly met over that period.
With strong ad revenues comes the
ability for Alphabet to invest heavily in
its “moon shot” investments such as
autonomous vehicles, fiber, virtual reality
and healthcare. Those businesses are
certainly the future of the company,
and in particular many are betting on
the giant to be the first to figure out
driverless cars, with all of the talent
they have working on that and other
projects. Alphabet’s cash position and
talent acquisition gives them the ability
to easily scale these moon shots and
develop them into stand alone multihundred billion dollar companies.
Christine Short, Estimize senior VP,
is an expert in corporate earnings
who produces content highlighting
Estimize data. @estimize
M o d e r nTr a d e r. c o m
Google, notes
& crude
Q By John Rawlins
The Cycle Projection Oscillator (CPO) is a technical tool that employs
proprietary statistical techniques and complex algorithms to filter
multiple cycles from historical data, combines them to obtain
cyclical information from price data and then gives a graphical
representation of their productive behavior. Other proprietary
frequency domain techniques then are employed to obtain the cycles
embedded in the price.
Google (GOOG) appears to have hit a plateau this summer and has drifted
sideways lower. The CPO is indicating that Google made a long-term bottom
in mid-August and began a long-term uptrend. The CPO expects a minor
correction in this rally by year end, but for Google to launch a much more
significant uptrend in 2018. A sell-off in December could present a strong
buying opportunity for Google before it begins a sharp rally that should last
through the first quarter of 2018.
Despite the added volatility of an active hurricane season, crude oil has
maintained a relatively stable range through the summer. The CPO is
showing crude entering a soft patch that could challenge its June lows
before bottoming out in mid-November. It then expects crude to turn higher
by year end, potentially testing high in the mid-$50 level. However, the most
dramatic action is expected in Q1 2018 when the CPO is calling for a strong
sell-off that could challenge the $40 level.
The 10-year Treasury note future has held an impressive rally this summer,
but the move has failed to regain the losses from the post-election sell-off
last fall. In fact, despite the impressive rally, the 10-year has only gained
in five months roughly half the ground it lost in the five-week post-election
collapse. Now the CPO is predicting the end of the current rally, and in a
big way. The CPO is forecasting a sharp sell-off in the 10-year that could
challenge the post-election move. If it doesn’t by Halloween, it will have
another chance in Q1 2018. The CPO is forecasting the 10-year to bottom
in early November, followed by a strong rebound to finish the year and an
even sharper down move in early 2018. A lot of opportunities as long as you
time it right.
John Rawlins is a former member of the CBOT with more than
30 years of experience in trading and research. He co-developed the
Cycle Projection Oscillator with an aerospace engineer. @cpopro1
M o d e r nTr a d e r. c o m
Issue 537
Three outsourcing buys
Q By John Blank
The 18-company strong outsourcing
industry is hot these days. It is ranked #3
out of the 265 industries that Zacks ranks.
In the last week of August the covering analysts made five positive earnings estimate
revisions and zero negative revisions.
In previous weeks, this ranking was
#52, #32 and #28. That tells you that
there is momentum to the jump in rankings
and that the outsourcing sector is in an
upward trend.
When a group of stocks is on a momentum run it is best to jump on or get out of
the way. Momentum is earnings estimate
revisions fuel and keeps the stock price fire
burning to new heights.
Nowadays, you hear of outsourcing a lot
in the business world. Why?
A July CIO magazine article attempted to
answer this question. It noted that the days
of low-cost commodity services are waning,
as IT organizations seek stronger strategic
partnerships with IT outsourcing providers
in an era of digital transformation.
Some of the key points included that
digital transformation is driving demand
away from compartmentalization and silos
of service delivery and toward frictionless
integration according to David J. Brown,
global head of KPMG’s Shared Services
and Outsourcing Advisory.
Enterprises are moving more workloads
to the public cloud, but continuing to
run certain applications in dedicated
private cloud environments for security,
regulatory or competitive reasons. So
they’re looking for providers that can
seamlessly manage and integrate their
hybrid cloud environments according
to Rahul Singh, managing director with
business transformation and outsourcing
consultancy Pace Harmon.
Steve Hall, a partner with sourcing
consultancy Information Services Group
noted that organizations are rapidly transforming to agile enterprises that require
rapid development cycles and close
November 2017
Top stocks in top-rated industries.
Source: Zacks
Top Zacks Industries with Stocks
Top Stocks
Office Supplies
Household Appliance
Building Products: Air/Heating
Publishing: Books
Consumer Products: Misc Staples
Insurance: Accident & Health
Machinery Tools
Semiconductor Equipment
Office Products
These three firms have seen significant gains to 2017.
Source: eSignal
coordination between business, engineering and operations. He stated, “Global
delivery requires a globally distributed agile process to balance the need for speed
and current cost pressures.”
Given what we have learned, here
are three Top Zacks picks to play this
trend: The Brink’s Company (BCO),
Broadridge Financial Solutions (BR)
and TriNet Group (TNET). These three
firms have been on fire, and as is usually
the case, the trend is your friend (see
“Trending” above).
John Blank is the chief equity strategist at Zacks. He covers the global
financial markets for
M o d e r nTr a d e r. c o m
A look at long-term trends of commercial interest in the
CFTC’s “Commitments of Traders” report.
Net Commercial Position
4 Week Net
Change +/-
Trend, SideTrader Momenways, Reversal
Q By Andy Waldock
Reversal -
Reversal +
Reversal -
Trend -
Trend -
Trend -
Reversal +
Reversal -
Reversal -
Reversal -
Reversal -
Reversal +
Trend +
Reversal +
Trend -
Reversal -
M o d e r nTr a d e r. c o m
COT Ratio tips silver,
the Dow & the dollar
There is a herd behavior of the speculative portion of the Commitment of Traders (COT) report that can currently be seen in silver,
Dow futures and the U.S. Dollar Index.
One of the primary tenets of COT analysis is that conflict between
the commercial and speculative traders typically resolves itself in
favor of the commercial traders due to better fundamental analysis.
There are several ways to measure the conflict as the COT report
provides the net and total positions of the categories measured as
well as the number of traders holding the outstanding positions.
Each of these metrics must be taken in context. For example, commercial traders in silver and sugar almost always maintain a negative
net position, showing that the commercial portion of these markets
is dominated by producers selling rather than processors buying.
Our favorite interpolation is our COT Ratio, which calculates the
ratio of long money vs. short money by trader group in each market.
We use it to determine speculative bubbles.
This spring, speculative traders were long silver more than 5 to 1.
Five to one has been the ceiling for silver over the last decade, except
for late 2009. Furthermore, the commercial traders set a net short record at the same time the speculators were trying to push the market
above $18.50. We use this scenario to generate a short trade as resistance builds against the speculative bubble. The trade is triggered
as the market collapses, while risk is limited to the recent peak.
The speculative trading position has evened out considerably,
now standing near even money. Just as importantly, the commercial
traders have repurchased more than 80K contracts on the summer’s
weakness. This leaves silver fundamentally balanced at current levels. This is typically indicative of a long-term bottom being formed.
Last month, speculators were long 8 to 1 in the Dow futures. They
are now long more than 11 to one. The small pullback in August was
insufficient to scare out the speculative bid. This is a classic example
of trend following herd behavior. Speculators are buying new highs,
rather than waiting for better prices. We expect this to end poorly as
there is little support above 19,000. Our discretionary COT model
has already produced a short sale signal and is using the August
high as the stop.
Speculators in the Dollar Index have been net long since June 2014,
and set the second most lopsidedly bullish COT Ratio of 12 to 1 late
this spring. Their only higher reading was 21 to 1in November 2008;
two weeks before setting a five-year high. The speculators have been
forced out of their longs on the market’s decline as predicted by the
commercial traders, and now hold a slightly net short position.
The COT Ratio is a visually intuitive way of aggregating multiple
data fields from the COT report. While it won’t predict the next
trend, it is very capable of predicting the next collapse.
Andy Waldock is a futures trader, analyst and founder of brokerage firm Commodity & Derivatives Advisors. He specializes in
analyzing the CFTC COT data. @waldocktrades
Issue 537
Trump’s Fed could
boost the buck
Q By Matt Weller
After an adventurous six-month period
from December to June, when the Federal
Reserve raised interest rates three
separate times, the U.S. central bank has
shifted into neutral in the second half of
2017. In essence, the stubbornly low rate
of inflation, combined with a lack of fiscal
support and a series of natural disasters,
has prompted Fed voters to tap the brakes
on interest rate normalization. Another
factor playing a role in the Fed’s inaction
is the potentially lame duck status of the
central bank’s core leaders.
By far the biggest cloud of uncertainty
hangs over the position of next Chair of
the Fed. Janet Yellen’s term as Fed chair
comes to an end in early February, and
based on her recent comments, the odds
of President Trump reappointing her are
The U.S. dollar has been in a steady decline since April.
Source: eSignal
The Fed’s caution about raising
interest rates has crushed the
dollar, especially with other
global central banks moving
toward tightening policy.
November 2017
Many market participants were
disappointed in Yellen’s lack of meaningful
commentary on the economy and
market policy in August’s Jackson Hole
Symposium speech. What she didn’t say
(i.e., not implying that the Fed was likely
to raise interest rates again this year)
definitely had a meaningful short-term
impact on the dollar, but it’s the topics she
did discuss that may end up having longerterm implications.
In her speech, Yellen laid out a
passionate defense of the benefits of
increased financial regulation in the wake
of the Great Financial Crisis, putting
her firmly at odds with President Trump,
who’s made rolling back regulations a
centerpiece of his presidency. Yellen noted
that additional regulations had had no
“readily apparent” adverse effects on the
economy and that “any adjustments to the
regulatory framework should be modest.”
Yellen’s non-conciliatory approach toward
the U.S. President’s agenda makes it less
likely that Trump will reappoint her to head
the central bank when her term expires.
Like most sitting politicians, Trump has
expressed a clear desire for low interest
rates from the U.S. central bank. In that
vein, former bank executives including
Gary Cohn from Goldman Sachs, Richard
Davis from U.S. Bancorp, and John Allison
from BB&T have been rumored as potential
candidates. In all likelihood, these financial
titans would mirror many of Yellen’s
characteristics; specifically, they all appear
to be pragmatic consensus-builders with
slight dovish leans when it comes to policy.
Where Cohn and company would differ
dramatically from Yellen would be in their
M o d e r nTr a d e r. c o m
outlook toward regulation. As dyed-in-thewool bankers, they would likely advocate
for easing financial regulations on small
lenders and scaling back the Fed’s annual
stress tests. Even if Trump opts for a
more traditional appointee like former
Fed Governor Kevin Warsh or Columbia
University economist Glenn Hubbard, a
bias toward deregulation is likely.
Beyond Yellen’s predicament, Stanley
Fischer, the august Vice Chair of the
central bank, recently announced his
resignation effective in mid-October, a
full eight months before the official end of
his term. It’s also worth noting that there
are three other open seats on the sevenmember Federal Reserve Board, giving
Trump and company plenty of latitude to
form the central bank around his vision
(assuming he has one and Congress
cooperates by approving his nominees).
So what would a dovish, deregulationfocused central bank mean for the
greenback? As we’ve seen so far this year,
the Fed’s caution about raising interest
rates has crushed the dollar, especially
with other global central banks moving
toward tightening policy (see “Dollar
daze,” left). On the other hand, decreasing
regulation can have a stimulatory impact
on economic growth, at least in the short
term. At a minimum, it’s hard to imagine the
next Fed Chair being any more cautious
than Yellen has been to date, even if Yellen
herself is able to defy the odds and get
reappointed to another term.
Moving forward, FX traders should keep
a close eye on the Trump administration’s
comments regarding the central
bank. After all, the temperament and
philosophies of the men and women in
charge of managing the economy will have
a far greater impact on the value of the
dollar than any individual economic report.
With traders’ expectations for any more
tightening from the Fed this year already in
the dumps, a change at the top of the U.S.
central bank could be just what dollar bulls
Matt Weller is a chartered financial
analyst and Senior Market Analyst for
Faraday Research. @mwellerfx
M o d e r nTr a d e r. c o m
Industries –
Hamilton Beach
= 40% upside
Q By Joe Cornell
NACCO Industries (NC) with a stock
price of $73 and market cap of $454
million (as of mid-September) recently
announced a plan to spin-off its
housewares-related business to NACCO
tax-free. Hamilton
Beach Brands
(expected to trade
as HBB) would
include a majority
of NACCO’s
current revenue,
leaving behind the
much smaller coal
business, The North
American Coal
Corporation. We
expect the spin to
take place prior to year-end.
American Coal (NACoal) mines and
markets coal for power generation and
steel production through developed
mines located in North Dakota, Texas,
Mississippi, Louisiana and Alabama. On
the housewares side, Hamilton Beach
Brands designs small kitchen appliances
such as bread makers, coffee makers,
blenders and juicers, while Kitchen
Collection (KC)
operates Kitchen
Collection and
Le Gourmet Chef
retail stores in
factory outlet and
traditional malls
across the United
States. This is not
the first spin-off
we have seen from
NACCO. Spin-Off
aficionados will
recall NACCO’s
2012 spin of Hyster-Yale (HY), a lift truck
and materials handling business.
Hamilton Beach Brands (HBB)
designs, markets, and distributes a slew
of small electric household appliances.
U.S. companies that have been
spun off from their parents
are beating the S&P 500 by
another wide margin this year.
Issue 537
The Spin-Off Research sum-of-its-parts calculation values the NC spin-off at $100.
Source: Spin-Off Research
Its portfolio includes blenders, can
openers, coffeemakers, air purifiers,
food processors, irons and toasters, sold
under the Hamilton Beach, Proctor-Silex,
Eclectrics, and TrueAir brands.
It also offers appliances licensed under
the Melitta and Jamba brands, and caters
to bars, restaurants and hotels with a
commercial lineup of drink mixers, glass
washers, and hair dryers. The Kitchen
Collection (KC) is a specialty retailer
that sells discounted cookware, bakeware,
small appliances, cooking gadgets,
gourmet foods, and decorative items to
consumers. It operates under the Kitchen
Collection and Le Gourmet Chef banner
through more than 300 stores, located
in factory outlets as well as retail malls,
dotting 40-plus states, as well as through
the Internet.
U.S. companies that have been spun
off from their parents are beating the
S&P 500 by another wide margin this
year, and a basket of them tracked by
Bloomberg surged to a record in late
August. The Bloomberg Spin-Off Index is
up more than 20% year-to-date (through
mid-September), vs. 12.2% for the S&P
500. One of the top performing among
them has been Ferrari (RACE), which
has raced 103% higher this year. Ferrari
was highlighted here (see “Ferrari – Fiat
= Accelerated Margins,” MT April 2016)
at about $35 per share. Spin-offs are
often overshadowed within a larger,
diverse parent, which can trade at a
discounted valuation because investors
do not necessarily want exposure to all the
disparate business units.
U.S. companies that have been
spun off from their parents are
beating the S&P 500 by another
wide margin this year.
November 2017
NACCO Sum-of-the Parts
Our estimated target price for NACCO
industries stands at $100 per share,
implying a potential upside of nearly 40%
from the mid-September price of $73
per share (see “Addition by subtraction,”
above). NACCO Industries (Stub) $32.
Hamilton Beach Brands
Holding Company (spin)
Consolidated Value Per Share
We value the coal business at $32 for
every NACCO share. This is based on
a 2018 estimate P/E multiple of 8X and
2018 estimate of implied EV/EBITDA
multiple of 4.8X. Our fair value estimate
for Hamilton Beach Brands (spin-off) is
$34 per share ($68 per NACCO share
based on a 2:1 spin ratio). Our Hamilton
Beach Brands valuation is based on a
2018 estimated EV/EBITDA multiple of
Joe Cornell is the founder and
publisher of Spin-Off Research, a
chartered financial analyst and author of
“Spin-Off to Pay-Off.” @spinoffresearch
M o d e r nTr a d e r. c o m
VESH: A different inverse ETF
Q By Matt Litchfield
In fact, VESH is very much a strategic
Eight years into arguably the second
beta fund built around the concept of
longest bull market ever, has made short
momentum, probably the most widely
selling seem less a “lonely” activity and
known and exploited market inefficiency,
more a “suicidal” one as tacking against
except its focus is obviously on capturing
the euphoria has been a career killer
negative rather than positive momentum.
leaving only a handful of exchange-traded
The fund is essentially two strategies, with
products (ETPs) to choose from.
50% of its assets in a monthly rebalanced
Our fund database shows 138 inverse
inverse S&P futures position that should
products, but taking away those levered
help keep the fund correlated with the
ETPs intended for short-term moves
broader market while the remaining 50% is
leaves just 57 names with total assets of
built around an immediately recognizable
$6.5 billion. Desperate times indeed for
traders who worry about equities potentially sector rotation strategy.
At the end of each month, the GICS
topping out, but the recent introduction of
(Global Industry Classification Standard)
the Virtus Enhanced Short U.S. Equity ETF
sectors comprising the S&P 500 are
(VESH) brings a novel strategy to one of
ranked by their trailing nine-month returns
the most challenged segments of the ETP
with the five worst performing sectors
market just when it needs it the most.
being singled out to be sold short using
Launched in late June, VESH is radically
futures contracts. While investors might
different than most of the inverse equity
sometimes wish for heavier exposure to
funds on the market beginning with its stated goal of outperforming a -100% of the to- smaller segments of the market, like energy
tal return of the S&P 500 Index when nearly stocks or utilities, the short positions are
weighted proportional to how much they
all inverse equity products are passive
funds that merely attempt
to deliver the negative perA BETTER SHORT
VESH has outperformed the S&P 500 and other
formance of a well-known
inverse ETPs since launching.
benchmark minus their fee.
That focus would make
VESH’s nearest competitor, the AdvisorShares
Ranger Equity Bear ETF
(HDGE) an actively managed product that shorts
individual stocks based on
bottoms-up stock research, a very different approach than most inverse
or bear market funds that
rely on futures (see “A better short”). While VESH
is also actively managed,
its strategy is laid out in a
rules-based fashion more
in-line with a strategic beta
fund, while employing a
more nuanced strategy
than larger inverse funds.
M o d e r nTr a d e r. c o m
Source: eSignal
make up of the S&P 500 to keep the
fund from developing unintentional sector
And despite lacking a long track record,
it’s easy to see the potential advantages of
such a strategy in a market where there remains a wide degree of dispersion between
sector returns, even as a 5% correction has
become a distant memory. Consider this
August, the S&P 500 delivered a relatively
flat, 0.31% return while beneath the surface
there was a 700-basis point performance
gap between the worst performing sector
(energy stocks of course) and high-flying
healthcare and utility names. VESH, with
its strategy of sector rotation and monthly
reconstitutions was able to deliver a solid
1.23% gain for August, outperforming the
S&P 500. The passive Profunds Inverse
S&P 500 Fund (SH) was down 0.21% in
the same period.
Finally, if that performance wasn’t
enough to put VESH on your watchlist, the
fund also has a relatively low management
fee of 55 basis points
despite being actively
managed and frequently
rebalanced. That low fee
puts VESH closer to the
majority of long-only, passive strategic beta funds
rather than existing short
strategies which usually
come with a higher price
tag. In fact, VESH’s fee is
substantially below both
actively managed HDGE
(175 bps) or passive funds
like SH at 89 bps, which
significantly reduces the
potential cost for investors
anxious to hedge their
equity exposure.
Matt Litchfield is the
content editor for ETF
Global at
Issue 537
The collar portfolio
management strategy
Q By Michael Thomsett
The problem for anyone in the market
is the threat of loss. Owning stock means
you risk a decline in the price, and this
is where some specific options-based
protective strategies are exceptionally
valuable. One such strategy is the collar.
The collar has three parts: 100 shares
of long stock, a short call, and a long
put. If the stock price rises, the call is
exercised and the stock is called away.
As long as the strike is higher than your
basis in the stock, your profit comes from
the option premium plus capital gains on
the stock and any dividends earned while
the stock was held. However, exercise
can also be avoided by closing the call or
rolling it forward, or by entering a buy to
close on the short position.
If the stock price declines, the short
call will expire worthless or can be
closed at a profit. The long put will grow
in value point for point with decline in
the stock once the put is in-the-money.
This strategy limits profit while putting a
ceiling on losses. So while it is not going
to create large profits, it does protect
you, hence collar.
The collar often is entered in stages.
For example, your stock rises and you sell
a covered call. However, the stock then
begins to decline. Rather than close the
call and sell the stock, you open a long
put to protect against the decline, should
it continue.
The collar has three parts:
100 shares of long stock, a
short call, and a long put.
The collar on Amazon locks in profits and limits losses.
Source: eSignal
The strikes of the typical collar are both
out-of-the-money. An example based on
100 shares and single option contracts is
shown in “Collaring Amazon.”
Amazon closed on this chart at
$967.54 per share. A collar opened at
this point would be designed to combine a covered call with a long put. This
accomplishes two goals: It generates
income from the call while paying for the
put. And the put hedges the downside
risk. As of this closing date, the following
options could be opened with expiration
in nine days:
SELL 970 call at bid of 8.55
(less $5 trading fee) = $850
BUY 965 put at ask of 9.20
(plus $5 trading fee) = $925
NET debit = $75
This trade accomplished the two
goals: Selling a covered call for income,
and using that income to hedge downside risk. The collar costs $75, which
is minimal considering its advantages.
Below the adjusted basis in the put of
$890 (strike of 965 less net cost of the
collar of $75), all risk is eliminated.
If the stock price as of expiration is
lower than the short call’s strike of 970,
it will not be exercised. If the price is also
above the put’s strike of 965, the put expires worthless. So this defensive trade
provides low-cost protection for $75. It
becomes valuable if and when the price
falls below the put’s net basis of $890.
In that case, every dollar of loss in the
stock is offset by a dollar gained in the
value of the put.
Michael Thomsett is the author
of 13 options books and has been
trading options for 35 years.
October 2017
M o d e r nTr a d e r. c o m
You could settle for 60 days
of free trades.
But you know better.
commission-free online trades
for two years
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MODERN TRADER talks interest
rates, Fed policy and the great
unwind with James Grant
Daniel P. Collins
James Grant has been watching interest rates for his entire adult life. After
serving in the Navy he earned a bachelor’s degree in Economics from Indiana
University in 1970 and a master’s degree in International Affairs from Columbia in
1972, before launching a career in financial journalism at the Baltimore Sun.
In 1975 Grant moved to Barron’s and took over its coverage of bonds, the
Federal Reserve and interest rates, just as the nation was experiencing its most
dramatic upheaval in rates for a generation. Grant would write a column on interest
rates for Barron’s until 1983 when he left to launch Grant’s Interest Rate Observer
with a mission “to see the present more clearly and to squint into the future more
Grant has written numerous books including three financial histories. His most
recent book: The Forgotten Depression: 1921: The Crash That Cured Itself, offers
a history of that event and, he argues, an alternative and better approach to dealing
with financial crises like the one we experienced in 2008.
November 2017
M o d e r nTr a d e r. c o m
M o d e r nTr a d e r. c o m
Issue 537
“Interest rates are prices, as
prices they are better discovered
than administered.”
Modern Trader: After approximately eight
years of a zero-interest-rate policy (ZIRP)
the Fed has begun raising rates. Did they
wait too long?
James Grant: Yes, I do think they missed their mark,
as we say on Wall Street. You know the central bankers
were quite confident that they could do what had never
been done before and then, when the time was right, to
undo it. But what they have discovered and certainly
what many investors have observed is that getting out
of these radical monetary gimmicks is not easy. It will be
interesting to see them try.
MT: How close are we to returning to a
normal Fed policy?
JG: I don’t think we are very close at all. The Fed
has been talking about returning to something more
or less normal since 2011. And it issued the outline of
a plan to reduce the size of its balance sheet in 2014.
The plan contained a simple escape clause that read:
“The committee is prepared to adjust the details of its
November 2017
approach to policy normalization
In light of economic and financial
developments.” So fast forward
three years to June 2014 when the
Fed issues an addendum to the
planned policy of normalization. But
this time, there’s nothing simple
about it. The essence is that if
something is amiss, the committee
would be prepared to revert to the
full range of its tools; including
balance sheet size and the like. So
I say that QE4 is one perturbation
away —whether it’s economic or
financial. Until the country decides
politically that it is time for a revamp
of our monetary methods and
thought processes, I think that
we are coerced to become more
and more abnormal at least in our
monetary ways. Radical monetary
policies beget more radical
monetary policies.
MT: Obviously that tool
shed is more crowded.
Talk about the long-term
impact of the extraordinary Fed policies
following the 2008 credit crisis?
JG: The intentions were good; the consequences
are likely to be adverse. Interest rates are prices, as
prices they are better discovered than administered.
We take that truth to be self-evident around here. We
call it Grant’s Interest Rate Observer, so we are kind
of sore that we have no interest rates to observe. The
consequences of these policies are innumerable,
and one of the more obvious is that when one part of
the world sports sovereign yields of less than zero,
including for the not so AAA credit of the nation
of Cyprus, those rates will inform sovereign yields
in other parts of the world through arbitrage. So
American rates are very much tied to what’s going
on in Europe and what’s going on in Japan. Every
month, according to Deutsche Bank, the world’s
central banks [account] for $175 billion in new credit
and that credit ripples through asset markets and
would not have been there except for these actions
of central banks.
M o d e r nTr a d e r. c o m
MT: Isn’t there more correlation
among interest rates now than
before the credit crisis?
JG: Yes. Years ago [English economic journalist]
Walter Bagehot was fond of saying — alluding to his
native England — John Bull can stand anything, but
he can’t stand 2%. What that meant was that very
low interest rates chew up speculation. They cause
the reallocation of capital and credit to places where
it might not otherwise go. These interest rates
provide the genesis for bull markets, and bull markets
being a little bit unnatural owing to the influence of
abnormally low interest rates. These bull markets go
a long way and then they come down a long way. So,
we have been at this in the industrialized world for
eight or nine years now? It will be a first in the history
of interest rates if these experiments end without
some sort of big bang.
MT: Wasn’t the idea that we were in a crisis
and extraordinary measures were needed?
That we would delay the pain until the
economy is in a better position to take it?
JG: It was a precedent that many people don’t know
about and [still] don’t know about, even after Simon &
Schuster published my book a couple of years ago on
the forgotten depression of 1920/21 (The Forgotten
Depression: 1921: The Crash That Cured Itself). I
hoped that the title would be obsolete after the massive
best seller-like sales, and the forgotten depression
would be well remembered. But it’s still forgotten. The
story of that depression is that in the face of a terrific
collapse in business activity, commodity prices, and
stock prices, the response of the Federal government
was to balance the budget, and from the point of view
of monetary affairs, was to raise, not to lower, the Fed’s
discount rate. And so, you have to ask Paul Krugman
and others how the country ever got out of that
depression [and] why aren’t we still in it?
But, in fact, markets did work. Liquidation was painful,
but truncated and within 18 months there was a bottom in
all markets and the 1920s proverbially roared. Ray Dalio
used the word beautiful to praise the Fed for its radical
interventions, but I would cite the experience of 1920/21,
as an example of a beautiful laissez-faire approach to a
very rough patch in the business cycle. So I don’t accept
MT: What is your opinion on how the Fed
handled the credit crisis?
JG: Well, I think they have overstayed their
welcome. We can agree to disagree about the
wisdom of the initial response, but let’s give them
the benefit of the doubt. Let’s say that the lender of
last resort function is a valid and necessary function
of central banks. What then do we say about the
persistence of these same policies,
along with economic recovery and
then expansion? This is a first, and
it’s not a wise precedent, it’s a quite
Interest rates have tended to move in long-term generational cycles.
worrying one. That might’ve been
Source: Business Insider/Bloomberg
obvious if one were to have uttered
it as we did at Grant’s early on in
the cycle, but now it’s become a
little bit controversial because all
the stuff seems to have worked
from the point of view of the owner
of a 401(k) account. You would be
hard pressed to get the average
investor to start finding fault with
what the central banks have done. If
it were this easy to create prosperity
through the massive injection of
central bank credit over the course
of this many years, we would have
learned this ages ago and all been
much richer than we are today.
M o d e r nTr a d e r. c o m
Issue 537
[that] these interventions are necessary even at the point
of maximum pain. But I’m prepared not to be dogmatic on
that point. Let’s say they are. But I don’t know any doctrine that holds [that these interventions are] necessary
or desirable five, six, seven, eight years after, and we have
yet to see [the central] banks extricate themselves from
what might yet prove to be a massive error.
MT: How do you expect the Fed to unwind its
balance sheet?
JG: Well they have told us what they intend to do.
When the time is right, the Fed will stop reinvesting a
portion of its maturing securities portfolio. Now this
portfolio is truly massive. I think the Fed owns 18% of
all the first mortgages in the country. It owns not quite
a quarter of all the Treasury securities in the hands
of the public. The question, of course, is being that
large a part of those markets, how will it get out. The
answer according to the Fed is ever so deliberately.
So it’s going to normalize its balance sheet stealthily
and deliberately by degree. And as it does that, it will
ever so slowly raise the funds rate. That’s the plan.
But notice the inconsistency in the theory. The Fed
was vocal about the benefits that QE would deliver.
Chairman Bernanke talked about the wealth effect
and how levitation of the stock indexes would induce
more spending and spending would induce more
activity. The trickling down of wealth from these rising
asset markets would do the trick. That was the plan.
Note what they don’t say about the exit. It will have no
deleterious effects. That’s the assertion. You won’t even
notice it. Paint drying. How could it have been bullish to
implement, and not be bearish [to] exit from it? I don’t
know how they plan to do this painlessly unless they
don’t do it. Which is my suspicion. The tip off is their
addendum, which I just talked about, where they have
now gone into some detail describing how they would
“The Fed ought to come out
and say …, ‘we are willfully
depreciating the currency
because the country is
overburdened by debt.’”
November 2017
reverse everything, [and] go into QE4.
Student waiters [used to] compete to yank the
tablecloth out from under [a table full of] china. The
person who never won that contest was the one who
pulled slowly. The Fed intends to pull slowly.
MT: Should they pull fast?
JG: I’m not sure what they [should] do. People ask
what is the way out? The way out is to own gold. But
that’s not the statesman-like approach to it. I simply
don’t know what the Fed should do. What the Fed
ought to do, is level with the country. We have been the
agents of a fabulous bull market, what we are in for is
something like the opposite.
MT: Chair Janet Yellen wants the Fed Funds
rate to return to more normal levels before
beginning to unwind. Is this the right approach?
JG: I don’t think either approach will be easy to
achieve. This country is now financed on ultra-low
interest rates. The Federal finances would be a little
less presentable if we return to the average American
interest rate which over the course of a couple hundred
years, is about 6%. We are about 300 basis points
away from that now. The Federal budget would look a
lot different at 6%.
MT: When the Fed initiated zero interest
rates, and followed up with a QE there
was acknowledgement that these were
extraordinary steps. Have they been
JG: Yes. I called up NYU Professor Richard Silla and
[said] I have read your magnificent history [on interest
rates]; tell me, in the 5,000 years that your survey
covers, have we ever foreseen substantially negative
nominal sovereign bond yields? He said no. It’s not
every day you have the privilege to observe something
that’s never happened before, but we were in that
position. These rates are new, but our attention spans to
historical precedent are necessarily truncated. Cyprus
is now borrowing at less than zero. That makes page,
like, 28 of the Financial Times of London and doesn’t
really get mentioned any place else. Yet it is a fact that
most of us find now kind of plain vanilla.
MT: Is there a chance the Fed will return to a
much less activist role?
M o d e r nTr a d e r. c o m
“It will be a first
in the history
of interest
rates if these
ended without
some sort of
big bang.”
JG: That ought to figure into someone’s political
platform. It is a juggernaut of a bureaucracy. We should
all live long enough to own a stock that performs as well
as the Fed has done. The Fed has only accreted powers
since the crisis that it curiously failed to anticipate. The
Fed was caught flat footed. And yet the consequence
of that shortcoming has been much greater power
and authority in the markets. The Fed is the one and
only bank of issue in the United States. It [also has a]
monopoly over monetary thought. There’s an intellectual
monopoly and a federally conferred monopoly, and the
Fed is a seemingly eternal organization. Well it’s not
eternal. The Congress has created it, the Congress
can trim its sails and that’s a political decision. But as
it is, the Fed is sailing on with ever-greater powers and
evermore intrusive presence.
MT: One of the reasons that the Fed has
been able to keep its balance sheet high is
the perception of low inflation. Are inflation
figures reliable?
JG: One of the things that I object to with respect to
inflation is the false precision that the indexes give us.
The number of assumptions and the number of arbitrary
decisions that go into the making of a price index like
the CPI or the PCE. How do you adjust for quality
improvements? How do you select the items that are
M o d e r nTr a d e r. c o m
present in the index? How do you adjust for seasonality?
All these things make a mockery of the idea that the
Fed is at 1.6% when it has to be at 2%. There’s nothing
like that precision to be had in the world of prices. The
second is [that way] back when the idea that a [sub 2%]
rate of inflation was a problem would have been received
with absolute disbelief. The Country was riven by rates of
inflation in the 1970s of 10% and up. Now we have a Fed
that insists on reaching a 2% rate of inflation and finds
it a problem when it is only 1.5%-1.7%. That is another
[example of people accepting as normal] what is truly
perverse and abnormal. There was a period of 12 to 13
months 1955/56 when the CPI never printed above zero.
Nobody paid any attention to it. For four consecutive
years in the 1960s the CPI never printed at 2% yearover-year, and that went unremarked. It might just be that
the amount of financial encumbrance in this economy
is so great that we need inflation of 2% or 3% just to
melt some of the debt away. But if that’s the case, the
Fed ought to come out and say it. It ought to say, ‘we are
willfully depreciating the currency because the country is
overburdened by debt. This is a moral question.
MT: What is the political underpinning of the
2% target?
JG: The idea of inflation targeting was pioneered
by the Reserve Bank of New Zealand many
Issue 537
James Grant’s four favorite shorts
Grant sees few opportunities on the long side, but pointed out
these potential shorts.
Q By James Grant
Kraft Heinz Co. (KHC): The Buffett- and 3G-blessed consumer
packaged-food manufacturer of brands such as Kraft, Heinz and
Velveeta, faces a secular decline in volumes due to changing consumer
tastes, increased cyclical competition in the grocery channel and Jeff
Bezos along with a highly leveraged balance sheet (four times net debt
to EBITDA). Despite these considerable drawbacks, Kraft Heinz is
highly valued (23X trailing adjusted earnings) and analysts insist that the
company will be able to expand margins; we doubt it.
Facebook, Inc. (FB): Facebook and Google command 20% of all
advertising sales. The Street predicts that these behemoths will grow
to half of the total ad market by 2020, at which point both companies
would exhibit the low growth and cyclicality of the overall advertising
market. Facebook looks fully valued even if everything goes according to
plan. However, fewer young people are using the iconic social network.
Restaurant Brands International, Inc. (QSR): The owner and
franchisor of Burger King, Tim Hortons and Popeye’s Louisiana Kitchen
is valued at 38.5X trailing adjusted earnings on hopes that revenues will
grow via international expansion. However, half of earnings and most of
earnings growth comes via the slow-growth Tim Hortons operations in
Canada. After years of squeezing franchisees, Tim Hortons owners are in
revolt. QSR’s valuation and balance sheet (over 6X net debt to EBITDA)
would suffer if Canadian operating profit slowed or declined.
Sprint Corp. (S): In 2015 the Sprint Corp. priced a single B-rated senior
unsecured 7.625% note due 2025 (quoted at $113.25 to yield 5.4%).
Priced for bankruptcy in early 2016, the 7.625% noted have rallied as the
company mortgaged its spectrum assets and generated positive free cash
flow in fiscal 2017 after slashing capital expenditures to the bone. Sprint
must catch up to its past underinvestment to remain competitive and there
is now less collateral backing the unsecured debt. Mobile telephony is
a highly competitive business—even chair Fed Janet Yellen blames cell
phones for dragging down overall inflation. Despite offering a free year
of service to customers who switch to the Sprint network, the company
reported a decline in subscribers in the quarter ending June 30.
years ago and it came to be seen as successful.
Academics did studies asserting that through
inflation targeting, stability in the overall economy
could be achieved and that the ideal rate they
determined was 2%. One academic study validated
another, but characteristically there is a lack of
imagination, a lack of peripheral vision in these
econometric studies. There’s an other-worldly
character to the discussions that the central bankers
engage in among themselves. They remind me of the
A students who always have the right answer, within
the framework that the professors gave them. It’s the
B and C+ students who go out and make millions of
dollars because they think outside that framework.
November 2017
MT: You have suggested that there is
more risk in the markets today than
people realize. Do you think investors
should be out of the market?
JG: Let me confess to writing for a living and not
investing for a living. But, what people who invest for a
living must do is invest. But now that you’ve asked me,
the question about whether you invest or hold cash,
rather liquid assets, boils down to this: Do you think that
the opportunities of the future are likely to be worse, or
better, or merely the same as the opportunities of the
present? And if you think they’re likely to be much better,
then it behooves you to have a fair amount of cash to
avail yourself of it because when those opportunities
come, what is wanted in the world is cash; what is next
wanted in the world is confidence. My approach to
investing and the investing approach [of] Grant’s, is that
cash is the default state. What is today’s opportunity
set and what is tomorrow’s likely to be? This of course
is not a guaranteed timing mechanism. Right now we
see the aforementioned 5,000-year first ever [negative]
bond yields. We see an important part of the world
supporting yields that has never been seen in the
history of organized markets. We see equity valuations
near the top of historical experience, we see realestate cap rates compressed; in short we see a lack
of interesting opportunities on the long side. What we
have been writing about is mainly opportunity on the
short side (see “Grant’s shorts,” right). If you believe,
as we do, that valuation is ultimately the determinant of
successful investment, we are inclined to hold a lot of
cash today and to bide our time.
MT: A lot of analysts believe tax reform
is priced into the market. What is the
market risk if meaningful tax reform does
not pass this year?
JG: This is a political question. You have to ask,
what is the likelihood of this Administration achieving
what it sets out to do. And negative interest rates in
Cyprus, are not the only 5,000-year first in the world.
Donald Trump is himself, a unique figure. Perhaps
we know him as the avatar of tail risk. With President
Trump nothing is exactly as it seems at first. So he got
elected in good part on what might have been kind of a
bi-partisan hope that come tax time we wouldn’t have
to go out and retain expert counsel to know what to
do. Simplify, broaden the base, wipe out deductions
M o d e r nTr a d e r. c o m
that make no economic sense and are merely the
pay-off for political favors. That was the program. Make
American corporations competitive in the world. But
as I see it, the President’s gone out of his way to make
the implementation of these appealing tax ideas very
difficult and indeed problematical. He’s at war with
Mitch McConnell. He’s now in a tiff with Gary Cohn.
And, I’m not sure that he can deliver on anything except
a fairly bland package of tax initiatives that may satisfy
the GOP’s need to hunt down something constructive
before the mid-term elections in 2018. But to achieve
anything more than the bare, necessary minimum would
have required the kind of political coordination that the
President seems intent on not having. So I’m a little bit
underwhelmed by the prospects of tax reform of any
meaningful kind.
MT: Is the market expecting more and how will
it react if it doesn’t get it?
JG: I’m not sure what will cause a correction. Time
and time again the market has seemed as bulletproof as
the president has himself. So it surely is not lost on the
bots and on the agents of artificial intelligence that the
political calculus is shifting. No doubt there will come
some correction and we financial journals will determine
what the cause was afterward. Maybe we’ll assign failed
tax reform as one of the primary causes.
as well as domestic ones, so it’s going to be an awfully
hard currency to displace. Not even Ethereum [is] up to
that. But, what’s happening in the world shows you what
may eventually happen. That is to say the tweets and
the habitual Naval collisions at sea, the bickering among
people who lead the majority party, the outright defiance
of presidential authority by some of the President’s top
advisors, including Gary Cohn and Secretary Tillerson.
These things don’t go unnoticed in the world. And at the
same time our political fortunes perhaps are waning, at
the same time Europe, of all places, is showing some
macro-economic strength. Mario Draghi might actually
“The Fed was vocal about
the benefits that QE would
deliver… How could it have
been bullish to implement, and
not be bearish [to] exit?”
MT: You wrote on the deficit, “We owe more
than we can comfortably repay, and it will
eventually stop.” You say this will happen
when the world loses confidence in the dollar.
Do you think that process is being accelerated
by this Administration?
JG: America’s standing in the world is not what it
ought to be and not what it has been at better times
in our history. But let me say this, by way of preface to
the idea that the dollar might come under suspicion.
And the preface is this, that reserve currencies have
more lives than a cat. The pound sterling ought to have
been kaput after the First World War, when Britain’s
career as the dominating world financial, industrial, and
military power came to an end. The sterling continued
to serve an important role as a reserve currency into
the late 1940s and into the 50s in the commonwealth
area. The dollar has the great attribute of habit behind
it. People habitually deal in dollars. The dollar is the
universal marker of value in international transactions
M o d e r nTr a d e r. c o m
Issue 537
generation-length cycles, certainly
in this country. They fell for 30
years until the year 1900, they rose
for 20 years until 1920, they fell
for 26 years until 1946, they rose
for 35 years until 1981 and they
have fallen persistently from 1981
until this very moment. Maybe the
bottom came in 2016? But you
asked where rates are going? Here
is my working hypothesis. I think
that sovereign rates bottomed in the
summer of 2016. That was a time of
almost a panicked drive into longerdated bonds, especially Treasuries.
We are embarked on a very long
cycle of rising rates. But if it goes
according to form, you’re scarcely
going to notice it for a long time. In
the great rising cycle of 1946 to
1981, it took 10 years, until 1956,
before Treasury yields went from
2.25% to 3.25%. Ten years for 100
basis points. Now the past is not
always prologue, but that’s my best guess for the next
35 years. After they end, will you please let my next of
kin know how right I was.
“There will come some correction and
we financial journals will determine
what the cause was afterward.
Maybe we’ll assign failed tax reform
as one of the primary causes.”
have to stop purchasing these tens of billions of euros
worth of securities every month. So yeah, it is worth
considering that the dollar might, some day, if not get
knocked off its pedestal; [get] taken down a couple
of notches. These musing are not to be confused with
anything having to do with a profitable trade. The ideas I
have just ruminated about are now very well distributed,
and people have watched the dollar go down 8.5% this
year and are pretty heavily overweight in the euro. For
the longer term, it’s at least worth considering that the
dollar could get some competition.
MT: What is your near-term outlook for
interest rates? Longer term?
JG: Can’t we talk about something else? I don’t know
would be the simplest and most honest response to a
very good question. To give you perhaps a non-answer
that might be worth something; these interest rate
cycles are kind of curious. No other asset moves the
way that interest rates move, or at least have moved.
They don’t have to do this in the future, but interest
rates, since the early 19th century, have moved in
November 2017
MT: What about gold?
JG: The price of gold can be thought of as the
reciprocal of the world’s faith in radical monetary
measures. The greater the faith in what the central
banks have been doing since 2007, the less interest
in gold. I take the sideways to downward movement
in gold since 2011 to be an expression of the world’s
acceptance of the policies to which we at Grant’s have
taken such exception. Believing as we do here that
central banks are all wet, that these interest rates are
artificial and ultimately dangerous and destabilizing and
the destabilization will focus attention on the error of the
central banks, we think that gold’s best days are ahead
of us. Gold is the money to which people will return to,
to a degree, when they become disillusioned with what
Janet Yellen, Mario Draghi and the others are doing.
And that point of disillusionment has not yet come, but
we believe it’s in the future.
M o d e r nTr a d e r. c o m
Mark Cuban is a businessman, investor, television
personality, professional sports franchise owner and
philanthropist. He is also one of the main “shark”
investors on the reality television series, Shark Tank,
but here he sits down and submits to our 10 questions.
Tax Reform,
the Market
& Trump
Q By Jeff Joseph
November 2017
1. Handicap the prospects for comprehensive
tax reform in 2017.
Mark Cuban: [There is a] 25%
chance it happens. And that 25%
only has a shot if they change the
approach. Old school approaches
to reforms of any kind don’t work
2. Do tax cuts stimulate economic growth?
MC: Minimally. There is so much
concentration of wealth right now;
there may be a significant percentage of those that would benefit who
wouldn’t change their investment
approach. The only real argument
for reform is for multinational companies who could move their entities
back to the USA or keep them here.
I don’t know how much of the economy it would impact.
3. Before the election you
told Fox Business that Donald
Trump’s tax plan could create
a horrible recession. What
do you think would be the
result of the abbreviated plan
MC: A 15% across the board [corporate tax rate] would be a disaster.
The deficit would explode. Since
the proposed plan doesn’t have
much meat to it, let me explain what
I would do.
I would take a page from Grover
Norquist’s tax pledge book. Rather
than trying to convince politicians
to vote for some plan based on
theories that we have no idea would
work or not, I would literally start
with the biggest, [most] profitable
companies and ask them what they
would commit to, in exchange for
getting an effective 20% or 25%
rate with zero cost for repatriation of
For [Fortune 500] companies it
would be easy to do the cash flow
projections based on any proposed
rate and know how much more cash
the company would have. I would
also [ask] them to commit some
percentage of that improvement to
M o d e r nTr a d e r. c o m
increasing wages and or benefits for the lowest paid employees
on their payrolls. I would ask them to spend some of that savings
to convert outsourced or contracted jobs to [pay] employees a
living wage. Then, I would work my way down the list of profitable
public and private companies and ask for their pledge to increase
wages. Then, I would add it all up [to] see if we can truly impact
the wage growth of working families.
I would then offer a five-year tax-free opportunity to startup companies with 25 or fewer employees that offer stock to all of their
employees. Obviously people will try to game the system. There
will be ways [developed] to counter that.
The more friction free we can make starting a business, the more
[businesses] will be started and [that greater] stock ownership
[will] reduce income inequality.
I would substantially reduce regulation of banks, [but only] if
they went back to being partnerships, and fraud was criminalized
to a far greater degree. If a banker can lose it all, they get a lot
more careful. But if they [can lose it all], they should face far, far
fewer regulations.
4. In 2012, you pitched this plan: “If it were up to me,
I would increase taxes and create metrics that trigger
declines. If the unemployment rate falls to 6% nationally and the Debt/GDP ratio declines to a specified
amount, we lower taxes.” Has your view changed?
MC: Somewhat. I think data driven rather than finite percentages
is a better approach. But it would still be too complicated and
make it harder to [pass a] tax plan.
5. You recently cited a blog post from 2008 in which
you pitched the intriguing idea of tax-free small businesses (staff under 25); “If we really want to stimulate
job creation in this country, take the same approach
to small business with 25 or fewer employees that we
take to Internet taxes. Outlaw them.” Do you believe
this proposal could attract wide support?
MC: I still obviously like the idea, but have no idea if it could pass.
I’m not a politician.
6. Among a number of likely financing mechanisms, we
expect to see a proposed lower cap on the mortgage
interest deduction. Perhaps from the current cap of
$1 million mortgages to $500,000 mortgages. Is this a
good idea?
MC: Good enough. We need fewer deductions.
7. Despite Gary Cohn’s recent statement that “simplification does not mean tax cuts for the higher end of the
bracket,” there is little uncertainty that Democrats will
attack any proposed reforms as “tax cuts for the rich”.
With wealthy paying the overwhelming majority of taxes, any broad tax reform will invariably provide benefits
to the top brackets. Will Democrats play the class war,
MC: I’m not a Democrat. You have to ask them.
8. Last year at SALT, you said of the president, “There’s
that guy who’ll walk into the bar and say anything to
get laid. That’s Donald Trump right now to a T. But it’s
M o d e r nTr a d e r. c o m
all of us who are going to get f*%ked”, more recently
you referred to him as the “Zoolander President” and
that his presidency was the equivalent of “political chemotherapy” on our nation. Are you contributing to the
coarse and divisive political dialogue or is this simply
our new normal?
MC: Coarse and divisive. No. This country was built on dissent.
If a leader can’t handle the heat, they shouldn’t take the job. And
realize, to 98% of America, politics is not top of mind. Most of
America knows far more about Beyoncé and Jay Z than they do
about what’s happening politically. Those of us who like to talk
politics or get involved can do just that. Have an opinion. Say
what’s on your mind.
Coarse and divisive is what you say when you don’t trust the
ability of the person you voted for to deal with the issues. If we
had confidence in him we would call all the media talk a circus or
sideshow because the work was getting done.
In a smaller way, owning or running a sports team is similar. One team is smart; the rest are idiots and the haters come out
and tell everyone how stupid you are. Could you imagine if as the
owner of a team someone said to stop talking negatively or in such
a harsh tone because it’s coarse and divisive? They would get
laughed at. Politics are a lot like sports. We keep score. We track
wins and losses. Your record is who you are. Not what everyone
says or shouldn’t say.
9. For many, including a significant portion of our
audience, the very notion of public service producing
career politicians is offensive. That same electorate
likely supported Trump as an outsider. What impact do
you expect that Trump’s election will likely have with
respect to future outsiders, businessmen, and other
non-political public figures?
MC: It’s not just your readers; I think it showed that voters don’t
trust politicians. That they will take anyone who commits to trying
a new approach with the hope it can truly help working families. I
think we learned that some of the rich and elites will vote their
pocketbook no matter what.
But, we also learned that middle-America and many working
families feel that they are forgotten. Trump talks a good game
about helping those families, but has done nothing and has only
theory from others that I don’t think he understands, to try to help.
If a future non-politician comes along with the leadership skills
that Donald Trump lacks, and the ability to truly help reduce the
stress and increase the wages of working families, they could win.
10. Do you believe the market is vulnerable to a correction if some material tax reform is not passed in 2017?
Is a correction likely regardless?
MC: No. I don’t think tax reform has any impact on equities.
Stocks have become a supply and demand play. The number of
public companies is dropping. People are moving money to passive funds. That means more money for [S&P 500] stocks.
More money going to fewer stocks means stocks go up over
the long haul. Now if there is a military action or some Black Swan
event, all bets are off.
Issue 537
Mark Cuban has never been shy with offering
up his opinion, particularly in the world of
investments. But when it was reported that he was
making investments in an initial coin offering after
calling bitcoin “a bubble,” we wanted to ask why.
Cuban discusses blockchain, active vs. passive and
public vs. private investing.
Mark Cuban
Q By Jeff Joseph
MODERN TRADER: You indicated
back in early June that you thought
bitcoin was in a bubble, and then you
made a major investment into the
space. What changed your mind?
Mark Cuban: I have invested in blockchain and a fund that invests in blockchain.
I’ve been a proponent of blockchain for a
long time. So nothing has changed. The
value of bitcoin is completely a function of
supply and demand.
MT: What are your thoughts about
the initial coin offering (ICO) craze?
Is the rush of capital into these tokens masking core issues of suitability and utility, or are they rewriting
the rules on startup finance?
MC: It depends on the ICO. I’m involved
in The integration of
our protocol into applications provides an
opportunity for app developers to generate
revenue and provide a better service. The tokens enable the service. When the offering
is driven by the application and opportunity
to deliver new and different and possibly
groundbreaking applications, like we think
is possible with Mercury protocol then I’m
a fan.
MT: Have blockchain applications
already eclipsed bitcoin as the real
disruptive element of the digital currency revolution?
MC: Without question. There will be
some amazing breakthrough applications
built on blockchain. It’s just a question of
what they will be and when.
MT: Where does cryptocurrency/
blockchain tech rank in terms of
“The value
of bitcoin is
completely a
function of
supply and
November 2017
technological game-changers?
MC: I don’t know as far as currency.
Blockchain can be a game changer at some
Active vs. Passive Investing
According to Morningstar, active funds saw
outflows of $285.2 billion in 2016; passive
funds attracted inflows of $428.7 billion. However, active investing remains
a bigger part of the market: $9.3 trillion
vs. $5.3 trillion. Over the last 10 years,
passively managed indexed investments
have handily beaten actively managed
funds, but during the first half of 2017, the
majority of active managers outperformed
their benchmarks (and consequently their
passive counterparts) in eight of the 12
Morningstar style categories.
MT: Do you believe investors should
own actively managed mutual funds
and ETFs? Individual securities?
MC: I think until we see more IPOs — a
lot more — passive [investing] is better.
There is too much money chasing too few
stocks. It’s far more likely that stocks will
continue to go up again based on supply
and demand. The number of public stocks
has fallen dramatically over the past 20
years; there are fewer than half as many
public companies, [and that number continues to fall]. This has to change first to make
active [investing] more attractive.
Public vs. Private
The JOBS Act opened up investment
access to private companies for non-accredited investors. Now, Reg A+ is bringing
these companies to market. In the past few
months, the first Reg A+ IPOs trading on
national exchanges have been launched:
Myomo, Inc. (MYO), Adomani (ADOM)
and ShiftPixy (PIXY) to name a few.
MT: How do you feel about the liberalization of non-accredited investor
access to venture and early-stage
MC: I like it. Reg A+ stocks aren’t early
stage. They just are smaller than the existing
public companies. Giving people access is
a good thing
M o d e r nTr a d e r. c o m
& Craft Beers
Q By James Grant
As to the arc of growth and decline in the
craft-money business, look no further than
the rise and fall of the craft-brewing business. According to Richard Schmidt and
Alex Walsh, analysts at Harding Loevner,
L.P., the growth of craft beer in the United
States over the last decade has been nothing short of extraordinary. In a $100 billion
plus industry that had been consolidating
for decades, craft breweries rose from a
paltry 3.4% market share (by volume) in
2006 to 12.3% in 2016. The surge was
so pronounced that, in 2016, a new craft
brewery opened in the United States every
11 hours on average. There are now around
5,500 U.S. craft breweries and, though
some of their names flout beer-branding
convention — Cellar Rats, Evil Twin, Rogue
Ales, Dogfish Head, Brew Cult, Hopping
Gnome and Wooden Robot are a few examples — they mean business.
And so do the colorful crypto-brands:
GameCredits, FunFair, NoLimitCoin and
Byteball. Intentions are admirable, but
prosperity can throw a curveball. Thus, new
craft breweries have cannibalized market
share from existing craft brands. “You don’t
say you’re a Fat Tire drinker, you say you’re a
craft-beer drinker” Schmidt writes. “That’s a
problem for Fat Tire. So while market share
of the craft-beer category has grown, the
share of most individual craft-beer brands
has been capped as that growth is shared
among a larger pool of competitors.”
Success has presented optical problems
as well. There is no such thing as a
powerful underdog; the bigger the craft
breweries became, the less like upstarts
they appear to beer consumers. Boston
Beer Co., Inc. (SAM), maker of Sam
Adams and, now the second-largest craft
brewer in the United States (after D. G.
Yuengling & Son, Inc.), has shown yearover-year declines in revenue in five of the
past seven quarters.
“While it may not be apparent to the
casual beer drinker,” Schmidt and Walsh
go on, “many craft-beer brands of the last
decade have been acquired by the big beer
giants, adding some of the movement’s
most recognizable names to their shelves
(Ballast Point, Blue Point, and Breckenridge
come to mind, and those are just the B’s).”
Probably, the Fed will never buy Bitfinex,
which makes the proliferation of craft
currencies that much more problematic for
the artisanal coin minters. What exactly can
cryptocurrency #866 offer that the existing
865 coins don’t already do? If new coins
continue to enter the market, might they
come at the expense of lower prices for
existing coins? Will ICOs that get too big
begin to appear like the very establishment
that cryptocurrency investors rebel against?
The incumbent issuers of fiat money pose
the bigger risk to digital wampum. AB InBev
S.A. (parent of Budweiser) is a formidable
competitor, but it doesn’t have the A-bomb.
Neither does it compile the Federal Register. In July, the Securities and Exchange
Commission ruled that ICOs may constitute securities offerings. Presumably this
means coin issuers might have to conform
to the standards of the securities markets
in issuing prospectuses and disseminating
audited quarterly reports. On May 25, Sen.
“What exactly can cryptocurrency
#866 offer that the existing 865
coins don’t already do?”
M o d e r nTr a d e r. c o m
Chuck Grassley (R. Iowa) introduced a bill
to require travelers crossing the U.S. border
to declare their cryptocurrency holdings.
The measure enjoys bipartisan support.
Canadian securities regulators are similarly
preparing to drop the hammer. Most unwelcome for ICO promoters was recent news
that the Israeli Securities Authority may take
a sterner look at new offerings. Cryptocurrency businesses have favored incorporating
in Israel for the very reason that regulation in
the Jewish state has been, “light touch.”
In September, China announced a ban
on ICOs, fitting a worldwide pattern. The
famous speculative proclivities of the Chinese people constitute only one source of
support for the home-brew money movement. China’s subsidized electricity costs
are another pillar of strength; an estimated
58% of all cryptocurrency mining occurs in
the People’s Republic of China. Seeming
to anticipate the September announcement
of Monday’s regulatory crackdown, ICOINFO, a Chinese platform for ICOs, shut
down on Aug. 31— temporarily management said, until the authorities’ intentions
became clearer. To take the government’s
announcement at face value, ICOINFO
might be a long time returning.
One force in the crypto-money movement
is the Friedrich Hayek–inspired vision of
competitive currencies. Thoughtful bitcoin bulls want to create an alternative to
governmental monopoly money, to invent
and perfect a monetary system undistorted
by state-directed manipulation. What an
observant bull is coming to see is that the
quantitative easing infected fiat system has
turned their imagined monetary Elysium into
a speculative pinball game.
The winners will be the sellers.
Courtesy of Grant’s Interest
Rate Observer.
Issue 537
Bitcoin and cryptocurrencies, while talked about frequently, has
remained a sort of closed universe comprised of digital geeks. But its
recent growth has attracted the attention of institutional players.
The Cryptos are
Creeping Towards
the Exchanges
Dimon, LedgerX, CBOE & bcause
Q By Daniel P. Collins
largest investment bank in the world felt the
asset and driven by exuberant market
In a mid-September interview with
need to address the rise in bitcoin. And it
behavior. There is no question that the
CNBC, JP Morgan Chairman and CEO
is not just JP Morgan. In late August, the
value of bitcoin at some point will go
Jamie Dimon referred to bitcoin as a
People’s Republic of China announced a
down—most likely dramatically, given its
fraud and said it was in a bubble. Dimon
ban on initial coin offerings (ICOs). The
sudden rise (it already has started)—but
compared it to the Tulip Mania of the
Chinese ban on ICOs caused a dip in
what we are seeing in the fall of 2017 is
mid-16th century. The news here isn’t that
bitcoin and a caution for short-term players
greater attention paid to an asset class,
Jamie Dimon thinks bitcoin is a fraud or
who may have jumped in at the wrong time.
cryptocurrencies, that has grown from a
in a bubble, it is that Dimon, head of the
So the question isn’t whether bitcoin is in
novelty to front page news.
largest investment bank in the world, was
a bubble, it is more about Dimon’s analogy
As we noted in the open, the head of the
on CNBC talking about bitcoin.
The 2017 explosive rally in bitcoin
is most likely a bubble—few markets
grow by a factor of 5x in nine months
Bitcoin values grew exponentially through 2017, but retreated in mid-September after
China outlawed them and Jamie Dimon talked them down.
without having a serious correction
(see “A nice run,” right). But many
people not knowledgeable about
investing misunderstand the word
“bubble.” Some people hear the
word bubble and think fad, but a
bubble simply means a euphoric rise
in an asset.
A bubble is an economic
cycle characterized by rapid
escalation of asset prices followed
by a contraction. It is created by a
surge in asset prices unwarranted
by the fundamentals of the
November 2017
Source: Coindesk
M o d e r nTr a d e r. c o m
buckets of customers to capture. Those
to the Tulip Mania. Many institutional
that have bitcoin and need to hedge that
investors are not willing to take that
exposure, and the broader universe of
chance and are dipping their toe in the
folks who simply look to gain access to
cryptocurrency world.
and speculate on innovative and emerging
This summer, LedgerX became the first
U.S. regulated exchange and clearinghouse markets.
“If you have bitcoin itself, you can pledge
for digital currency derivatives. LedgerX,
it to the clearinghouse, sell the swap
a New York-based institutional trading and
clearing platform for digital currencies,
received approval to operate a swaps
execution facility (SEF) by the Commodity
Futures Trading Commission (CFTC).
“Our focus is on derivatives contracts
that settle to bitcoin, so that a lot of our
customers who actually want to withdraw
the bitcoin for the clearinghouse can
actually go ahead and do things with it
afterwards.” says Paul L. Chou CEO and
co-founder of LedgerX.
Chou says LedgerX will start with vanilla
calls and puts on bitcoin itself and
plans to launch in early fall when
traders get back to work and trade in
Top 10 cryptocurrencies by market cap.
“The head of
the largest
investment bank
in the world,
was on CNBC
talking about
LedgerX is planning a slow
rollout but their goal is to provide
a broad range of derivatives on
cryptocurrencies. “In the beginning
the vast majority of demand will be
around call production on physically
settled bitcoin,” Chou says. “The
second category would be what
we call day-ahead swaps. This is
more of a linear product where you
are allowed to purchase a swap
and get physically delivered bitcoin
For LedgerX there are two main
M o d e r nTr a d e r. c o m
against it and receive dollars tomorrow,”
Chou says. “Whether you have to own it
depends on the style of transaction you
want to do. If you just want to purchase the
call option, then all you have to do is put
U.S. dollars at the clearinghouse. If you are
looking to sell a day-ahead swap, then you
have to put a bitcoin to the clearinghouse
before you can do it.”
The options offered at LedgerX are not
intermediated, they are fully margined.
LedgerX is not unique, though they are
the first to receive regulatory approval.
There are many exchanges in the works
with the goal of bringing the cryptocurrency
phenomena into an institutional structure
and help turn it into a ready for prime time
asset class.
In August, CBOE Holdings and Gemini
Trust Company, LLC announced an
agreement that provides CBOE and its
affiliates with an exclusive global license to
use Gemini’s bitcoin market data for bitcoin
derivatives and indexes. Gemini is a digital
asset exchange and custodian founded by
Tyler and Cameron Winklevoss that allows
customers to buy, sell, and store digital
assets such as bitcoin and [ethereum].
According to the announcement CBOE
plans to launch cash-settled bitcoin futures
on CBOE Futures Exchange in the fourth
quarter of 2017 or early 2018, pending
regulatory approval.
In the release Ed Tilly, CBOE Holdings
Source: bitconnect
Issue 537
all of their operating documents. But if
“The only things that are out there today
Chairman and CEO said CBOE’s history
there were futures and options on bitcoin
are spot exchanges for immediate physical
of innovation across multiple asset
and other cryptocurrencies listed on a
delivery,” Grede says. “Many of them
classes, “Makes us the natural choice for
regulated exchange, they could trade them
aren’t really exchanges, they are more like
the development and trading of bitcoin
right now.
dealers. The structure of the market needs
futures.” He added, “We look forward
Chris Tanger, a bitcoin trader and
more traditional exchanges, and in our view,
to responding to the growing interest in
software developer who also spoke on
needs regulation, and quite clearly CFTC
cryptocurrencies through the creation
the panel, said a big problem with trading
regulation. It would add a tremendous
of bitcoin futures traded on a regulated
bitcoin on listed exchanges is the lack of
amount of credibility and bring in the
derivatives exchange, with the many
a reliable index. Creating an index as a
institutional participation that really hasn’t
expected benefits that this brings.”
reliable settlement price for bitcoin and
been in these markets.”
Bcause, LLC, is a financial technology
other cryptocurrencies will be a challenge
Brian Kelly founder of BKCM Digital
firm founded by actual rocket scientists
for their listing. “It is the Wild West, but
Asset Fund, which offers investors
who were mining bitcoin and came up with
exposure to bitcoin and other digital assets, there is a lot of profit to be made in the
the concept of a derivatives exchanges
Wild West,” Tanger says.
agrees. Kelly, during a cryptocurrency
because there is no way to short
Another issue is that one of main tenets of
panel at a futures industry event in Chicago
cryptocurrencies or hedge their exposure
in September, said, “For [cryptocurrencies] bitcoin is that its trading is not centralized.
to them.
Tanger says that some of the current traders
to become a real asset class, it has to
Bcause has had an application to
may resist efforts to centralize trading and
be centralized. He was encouraged
become a futures exchange that will trade
settlement on a regulated exchange, but all
by CBOE’s announcement and added
bitcoin and other cryptocurrencies before
the experts on the panel agreed that that
that to have a major futures exchange
the CFTC for some time. “The centerpiece
would be necessary for cryptocurrencies
launch derivatives on bitcoin would lead
of the strategy is a CFTC-regulated
to take the next step to becoming an actual
to significant growth. He pointed out
derivatives exchange in cryptocurrencies,”
asset class.
that for hedge funds to be able to trade
says bcause CEO Fred Grede. “There are
Kelly would like to see one of the major
cryptocurrencies on the currently available
a lot of things that are happening in the
exchanges list futures on bitcoin but it
exchanges would require them to change
cryptocurrency space today. We are out
there talking to a lot of proprietary
trading firms [and] market making
firms who are also just starting to
get into this space,” Grede says.
On Sept. 15 bitcoin dropped below $3,000 and then rallied above $3,750
Source: CoinDesk
“Obviously the price of bitcoin has
attracted a lot of people; people
who you wouldn’t think of ever
trading this product.”
Expanding the Base
Bitcoin and other crypotcurrencies
have a loyal and growing following,
but now professional entities,
exchanges and brokerages are
asking themselves, “do we need to
be involved.”
Currently, bitcoin trades over a
series of spot exchanges. This is
fine for those early adopters and
risk takers who trade it and have
turned mining of bitcoin into a niche
business. But for cryptocurrencies
to become an actual asset class, it
must be available to the institutional
trading world in a form that they are
comfortable with.
”If you have bitcoin itself, you
can pledge it to the clearinghouse,
sell the swap against it and
receive dollars tomorrow.”
November 2017
--Paul Chou
M o d e r nTr a d e r. c o m
appears that LedgerX will be first to
market with its bitcoin swaps, which is also
targeting institutions and plans to launch
in early fall. “Our day-ahead swaps are
designed towards institutional customers
that do not yet have access to bitcoin
and are waiting for a [platform] that is
regulated like ours where they can put
U.S. dollars and receive the underlying
currency afterwards,” Chou says. “And the
second category is for people, like miners
for example, that have quite a bit of bitcoin
and are looking to sell some portion of it in
an institutional way to raise dollars for their
ongoing operational costs.”
Two Approaches
Bcause and LedgerX are taking two
distinct approaches, though Ledger X
plans to expand beyond swaps into more
traditional derivatives once it is established.
“Our primary customers right now are
going to be direct members. That would
be more of a disintermediated model,
[eventually] we are going to support an
intermediated transactions through Futures
Commission Merchants (FCMs), but in the
beginning all the larger institutions will be
[direct members]” Chou says. “Our initial
focus will be on institutional members that
have direct access. We will not have a retail
focus on day one.”
LedgerX will offer options that will allow
bitcoin holders to hedge and traditional
institutions to access price movement. “If
you are an institution that wants exposure,
you can purchase call options, day-ahead
swaps contracts and you can get exposure
that way and we will keep the bitcoin on
hand at the clearinghouse level for you so
you are not exactly taking delivery, it is like
a warehouse receipt,” Chou says. “If you
have U.S. dollars, you can either buy call
contracts or day-ahead swaps contracts
and get long exposure to bitcoin. There
are folks that only have bitcoins and want
to raise U.S. dollars, so what they can do
is place the bitcoin with the clearinghouse
and sell a call and receive the U.S. dollar
premium. If they don’t have any bitcoin they
will put up dollars.”
Grede says their target markets are
M o d e r nTr a d e r. c o m
“The structure
of the market
needs more
and in our
view, needs
--Fred Grede
both the millennials comfortable with
trading crypotcurrencies and the broader
investment and trading universe that is
intrigued by its growth and valuations.
“Whether it is the FCMs, market makers
or prop traders [we are seeing] increasing
interest in the product, but the market
structure that currently exists causes them
more operational headaches than they
are used to in the traditional exchange
markets,” Grede says. He adds that their
goal is to marry the traditional exchange
world with this new crypto-world. “That
would be the objective.”
He says that demand is even greater
outside the United States. “Bitcoin and
cryptocurrencies aren’t as popular in the
United States because we have a relatively
stable currency. If you go to China, if you
go to Japan, if you look at Malaysia [or] if
you look at Venezuela, the advantage of
these cryptocurrencies is [that] there is no
political risk,” Grede says. “Their utilization
is extremely popular in other parts of the
world. It hasn’t taken on as much popularity
in the United States because of the stability
of the dollar.”
Bcause is looking beyond bitcoin to the
broad cryptocurrency universe. “Bitcoin
is the obvious one to start with but [we
are looking at] the other cryptocurrencies
like Ethereum and Litecoin and there are
others. It is related to the actual size of the
market,” Grede says.
As a SEF, LedgerX is targeting more
of the current bitcoin traders. “The
customers we have on board range from
miners to other people in the industry to
actual trading shops that have extensive
experience in making markets in derivatives
across a wide variety of asset classes,”
Chou says. “It is going to be a healthy mix
of market makers, investors, speculators
and naturals. They can buy downside
protection or they also can do call
overwrites against existing inventory so
they can actually raise U.S. dollars.”
Bcause has not publically settled on a
clearing solution according to Grede. They
could look for clearing vendors or build
their own solution that could possibly utilize
blockchain technology. The firm is looking
at being a bridge between the traditional
exchange world and the less centralized
cryptocurrency world.
“You have to take a traditional
approach in order to satisfy the regulatory
environment. So that is step one,” Grede
says. “By the same token, however, you
have to be very much aware of the new
blockchain technology and how you
can implement that technology into your
structure. You have to be able to get the
regulatory approval. If it is too abstract, the
approvals will take longer.”
What is clear is that there is institutional
interest in the products. It is popular, and
it moves, perhaps too much (see “Bitcoin
margin call,” page 42).
Commodity Trading Advisor, Robb
Ross is interested, but holds no illusions.
“Bitcoin is a fad play much like Amazon
(AMZN), which has basically made little
money compared to its valuation, but look
at its stock returns. It was a fad play that
has made a lot of people money,” Ross
says. “Cryptocurrencies are the new fad
play. Now hedge funds and institutions are
getting into the game.”
Ross has concerns over liquidity. “With
some cryptos it can take days, I am told
from those who trade it, to get in or out of
a position. But with economies like Greece
and Venezuela having currency issues,
more people are looking at cryptos.”
Not only people, but people who
trade. And people who trade are always
interested in finding new things to trade.
Cryptocurrencies will be coming to an
exchange near you some time real soon.
Issue 537
Markets, Politics,
Modern Trader & You
Q By Jeff Joseph
MODERN TRADER surveys our readers frequently to
solicit opinions on market events and, most importantly,
learn how we can best fulfill our editorial objective of being the
essential monthly journal for professional traders and active
investors. We truly appreciate this engagement with our readers.
Our most recent survey resulted in a wide range of comments,
editorial suggestions, criticism, and insight into the mind of the
MODERN TRADER (See Open Outcry, page 11).
The most interesting insights from this latest survey touched
on the intersection of the markets and the current political
environment. History offers some interesting data points. While
we believe that in the long run, the market’s health is primarily
a function of interest rates, earnings, and economic growth,
with that the impact of presidents and their policies is often
overstated, some of the numbers are hard to ignore. The aggregate
common stock appreciation under the two terms of Presidents
Clinton, Eisenhower and Reagan were 171%, 148%, and 138%
respectively. Each president’s influence on the economy must
be viewed in a broader look at the economic environment they
inherited and the events of the day.
President Trump has hosted the best market performance for
a first-year president in more than 50 years with the Dow Jones
Industrial Average rising 7.4% in the first half of 2017. As of this
writing, stocks are up 19% since the election with the S&P 500
adding more than $2 trillion in market value and on the verge
of going 11 straight months without posting a monthly loss of
more than 0.1%. The last time that happened was 58 years ago.
Corporate bonds have also experienced a “Trump Bump.” While
his direct influence on investor optimism is unclear, as is the
sustainability of the rally (let alone his administration), prevailing
political environments are a tangible market variable.
Perhaps that is why our readers did not hold back on their
political opinions in our recent survey. Here is some of what we
learned about you:
You are a highly-educated and informed audience:
More than 47% of you have a Master’s Degree or a PhD.
Considering that 99% of our audience makes some or all of their
own investment decisions, it follows that you are highly informed
and consume considerably more news than the average citizen;
35% of you have a Bloomberg (or Bloomberg-like) news terminal,
and 87% rely upon business and finance print periodicals for their
market news.
MODERN TRADER’s highly-educated Republican-leaning
audience is an outlier, both statistically and regarding
the mainstream media narrative:
In the 2016 election, a wide gap in presidential preferences
emerged between those with and without a college degree.
College graduates backed Clinton 52% to 43%, while those
without a college degree backed Trump 52% to 44%.
Our highly-educated and well-informed audience overwhelmingly
supported Trump.
Those who did vote to elect President Trump are still very
of the new
Of our readers
Nearly half of MODERN TRADER
readers voted for Trump,
that voted for the
but with a 2-1 margin over Clinton.
president, 70%
Modern Trader Survey
have a favorable
opinion of Trump’s
performance thus
far; 16% of Trump
voters have an
unfavorable opinion
(see “How am I
doing?” right).
MODERN TRADER readers voted Republican in 2016
by more than a 2:1 margin:
23% acknowledged their presidential vote for Hillary Clinton vs.
48% for Donald Trump; 9% voted for the Libertarian ticket while
18% choose not to reveal their vote
(see “Showing your cards,” right).
November 2017
M o d e r nTr a d e r. c o m
But, our Trump-inclined readers are not tone deaf to the
administration’s unorthodox communications strategy.
We received hundreds of encouraging messages and suggestions
from Republican-voting readers intended for President Trump.
The overwhelming majority of the comments contained one simple
piece of advice for the new president. ”Stop tweeting.”
Stop using Twitter. Be our president.
A. Curran Jr
Woodstown, NJ
Think fast but be slow to speak (or tweet!)
M Dipaulo
Oswego, NY
Republican voters have an extremely unfavorable opinion
of the House and Senate:
An overwhelming 91% of Republican voters in last November’s election have a negative assessment of the performance of the House
and Senate thus far in 2017 (see “Throws the bums out,” below).
For the most part, our readers seem to understand where we are
coming from, and appreciate that our media perspective is outside
the “mainstream”…
Your magazine is the best out there. I do like the way you very
often take a contrarian viewpoint compared to the major media
and the typical talking heads.
G. Aul
Hot Springs, SD
Subscriber since 2015
Please keep the comments coming at openoutcry@, and thanks for reading.
Jeff Joseph
Cheif Content
Officer &
Despite an inability to move certain
agenda items and the persistence of
media questions over collusion with
Russia, Trump’s base is holding.
Source: Modern Trader Survey
On the whole, reader comments on our editorial were
overwhelmingly positive, but some readers questioned
the values (biases?) which form the basis of our political
Since you were so open with us, we will reciprocate.
Δ Political debates which influence the economy, the
market and investor sentiment will always be fair
game in our pages. They are implicit to our editorial
Δ Generally speaking, “social issues” fall outside of our
editorial domain. The exception would be where these
social issues may influence a market sector, such as the
impact of firearms legislation on the firearms sector, drug
legislation on pharmaceutical and marijuana stocks, etc.
Δ Sorry “snowflakes,” Modern Trader is not a “safe
While Republican voters appear willing
to give the President the benefit of the
doubt, the same can’t be said for the
GOP led Congress.
Source: Modern Trader Survey
space.” Our readers will invariably be exposed to diverse
perspectives that are contrary to their portfolios, as well as
their politics. We extend the same caution to “ditto-heads.”
There are two sides to every trade; we will continue to cover
political issues which impact the market and the economy
from various perspectives.
Δ If you wonder why the tagline on our cover changes
each month beneath the MODERN TRADER logo, we
blame Reason magazine. The venerable libertarian
publication uses the tag we would love to own: “free
minds and free markets.” The phrase underscores
MODERN TRADER’s advocacy and core values.
M o d e r nTr a d e r. c o m
Issue 537
Robocop meets Minority Report:
An Automation
& Security Play
Knightscope is a Silicon Valley robotics and software
company developing advanced anomaly detection
technologies intended to predict and prevent crime.
Q By Shruti Khetan & Jeff Joseph
and “mini-IPOs” of startups and several companies have raised
millions of dollars. Regulation A+ allows Tier 1 and Tier 2 offerings.
Under Tier 1, companies can raise up to $20 million each year from
institutional investors and main street (non-accredited) investors
provided they satisfy some state registration requirements. While
under Tier 2, companies can raise up to $50 million each year and
there are no state registration requirements to be satisfied. Due to
the registration hurdles with Tier 1, more companies are making
use of Tier 2, and succeeding. Under Tier 1, there is no limit to the
amount non-accredited investors can invest. However, under Tier 2,
a non-accredited investor is limited to investing the greater of 10%
of one’s annual income or 10% of one’s net worth excluding the
principal residence. Investors simply
self-verify their income or net worth
Knightscope CEO William Santana Li
by completing a form. This is a per-offering limit and not a per-investor limit.
MT: Walk us through the revenue
Modern Trader: Why Knightscope?
Knightscope is a Tier 2 offering.
William Santana Li: I was born in New York
WSL: We sign year-long contracts running
City, and my hometown was hit on 9/11. I am
Reg A+
dedicating the rest of my life to better securing 24/7, so loosely speaking at $7 an hour,
that’s about $5,000 of revenue per machine
People who invest in the future of
our country.
per month. That’s $300,000 of revenue over
a business or startup are generally
five years.
more likely to recommend the
MT: How many robots have you built
Because we have a couple different
particular company and create a
so far?
machines, our hardware material cost range
positive image of it. Apart from
WSL: We have built over 50 and we have 38
between 55,000 to $65,000. Basically, we
raising capital with fewer regulatory
of those machines under contract.
recover the variable costs in the first calendar
hurdles associated with a traditional
year and then second, third, fourth, fifth year
we’re printing money. Loosely speaking,
public offering, “mini-IPOs” under
MT: What is the value to the
that gives us about a quarter million dollars
Reg A+ help build brand awareness
of gross margin on each machine. We
and act as a marketing tool.
WSL: At $7 an hour, the clients get the
continue to add more and more value and
machine, the user interface, charge pad,
Companies have a greater potential
features so our client never leaves. We drop
charge box, data transfer, data storage and
of fundraising, as they can sell
a new software code every two weeks. New
all the maintenance, service and upgrades
hardware codes every four months. In short, a
securities to both accredited and
recurring revenue string for a service.
non-accredited investors. Since a
In a recent issue of MODERN TRADER we panned
Yayyo, a new Reg A+, pre-IPO, offering (see “J. Peterman is
pitching this IPO,” MT August 2017). But don’t get us wrong, we are
advocates of the liberalization of non-accredited investor access to
private offerings under the JOBS Act. Nevertheless, we caution our
readers that these private, often pre-revenue, early-stage companies
require more intense scrutiny and due diligence. Knightscope scores
higher that Yayyo (see “Trade or fade,” page 48).
Knightscope is one of the many startups in the recent past to
make use of the new Securities and Exchange Commission Regulation A+. Reg A+ became effective on June 19, 2015. It’s been more
than two years of allowing the public to invest in private companies
November 2017
M o d e r nTr a d e r. c o m
large number of people can invest, ownership is not confined in
the hands of a few and at the same time investors do not have as
much power as shareholders do in a typical private equity offering.
To enhance the offering’s marketing appeal, Knightscope
throws in some noise in the way of investor perks. Invest $999
(Bronze) and get a custom t-shirt designed by Knightscope. Invest
$10,000+ (Silver) and you also receive a replica toy model of one
of the security robots and an invitation to a media event. More
perks at $25,000+ (Gold), and if you invest $100,000+ (Platinum), the complete package including airfare to Silicon Valley for a
private tour of Knightscope’s headquarters, dinner with the Knightscope management team, your signature on a machine signed at
production and a professional family photo shoot with the K3, K5
and K7 series robots. Yes, Mr. Li certainly has a flair for marketing.
But more substantively, early-stage Knightscope and its robots
are very much in motion. On Aug. 15, Knightscope achieved a $10
million milestone in the Reg A+ mini-IPO preferred stock offering,
one of the most successful crowdfunding maneuvers in the history
of SeedInvest, its designated crowdfunding platform. This miniIPO is an addition to the prior raised $14 million+ in financing secured during their seed, Series A and B Preferred financings. The
CEO recently received an Upstart 50 Inventor Honor Award and
the company was nominated for Silicon Valley’s Best Tech Startup.
The company is very early in development, and in revenue, and
is far from profitability. It reported a total loss of $3,392,277
and $5,472,547 in 2015 and 2016, respectively. No matter
how promising the idea seems, it comes with challenges. The
security bots can be perceived as a cost over and above the
traditional security guards budgeted for. Another question is that
since these bots are available as a service and control will be
shared with Knightscope, will large companies in technologically
sensitive industries be comfortable with that arrangement?
A look into Mr. Li’s past reveals that he and a co-founder were
at the helm of failed Indiana startup Carbon Motors in 2013.
The local government gave Carbon Motors $7 million in grants
for a production facility that was supposed to bring 1,300 jobs,
but instead declared bankruptcy while owing another $21.7
million to private investors after the Department of Energy
denied the company’s application for $310 million in loans under
the Advanced Technology Vehicle Manufacturing program.
We investigated Carbon Motors expense records and did not
view the spending to be atypical of an early stage company in
business development mode. No red flag from our perspective,
as startups and serial entrepreneurs frequently fail, particularly
when nine figures of anticipated mission-critical investment
fails to materialize. Moreover, Li’s executive
history and accomplishments at Ford Motor
Company (F), building the world’s second
largest automotive recycler, give him the
leadership cred required to jockey this company
out of the gate.
There have been several bot mishaps. In
addition to the incident in the parking lot with
the drunken man knocking over a robot, a K5
security robot ran itself into a water fountain
Apart from raising capital
with fewer regulatory hurdles
associated with a traditional
public offering, “mini-IPOs”
under Reg A+ help build brand
M o d e r nTr a d e r. c o m
Issue 537
products are designed
to supplement the
work of security
professionals instead
of replacing them.
--William Santana Li
inside an office complex in Washington DC and was rescued by
human security guards. A year ago at Stanford shopping center a
K5 security robot bruised a child’s leg causing it to swell. While
these foreboding instances offer some humor and a glimpse of
The investment thesis
Trade or Fade
Maximum Offering Amount: $20,000,000
Funding raised to date: $25+ Million
Minimum investment: $999
Share Price $3.00
Key points:
• Over $1,000,000+ in signed contracts
• Security is a $500 billion market and a property crime
occurs every four seconds.
• Partnered with the two largest private security companies
in the U.S. (Allied Universal and Securitas)
• The Company is presently deploying its technology with
30 clients across eight states and three time zones and
aims to achieve its target for 100 machines under contract
by the end of 2017.
• First to market in commercializing autonomous technology in real world application with clients at scale; $7
per hour Machine-as-a-Service vs. $25 per hour human
security guards.
• Strategic investors include NTT DOCOMO, Konica Minolta,
Flex Lab IX, and NetPosa.
Knightscope is at the unique intersection of MODERN
TRADER’s two prominent investment themes: Automation and
robotics and cybersecurity. While artificial intelligence is still a
long way from creating robots that can become smarter than
their creators — and at this point they are merely facilitators —
William Santana Li believes that his revolutionary idea will take off
soon and every mayor across the country is going to be calling
Knightscope. He may be right. With the offering closing on 10
October 2017, Knightscope warrants a closer look by risk-
futures sitcom scripts, we hardly view these as red flags that
should deter investment consideration. We have very little doubt
about the ubiquitous proliferation of self-driving cars in the future,
but expect many accidents along the way.
November 2017
With no current direct competitors, Knightscope’s products are
designed to supplement the work of security professionals instead
of replacing them, and are suited to most environments that require
security patrol coverage. Globally more than $500 billion is spent
on security each year and Knightscope aspires to reduce this
spend. With Knightscope offering its bots at $7 per hour (all-inclusive), companies can save materially on their security budgets
while providing unprecedented situational awareness tools for the
security team themselves.
These bots make use of autonomous technology solutions and operate on a Machine-as-a-Service (MaaS) business model. Robotics,
predictive analysis, big data, autonomous technology, sensors and
software provide real-time data delivery to Knightscope customers.
With features including a 360-degree video for night and day, a twoway audio system, thermal imaging and data collection, Knightscope
currently has two running robot models in production and two more
on the way. The K3 is small, compact and maneuverable for indoor
use and the K5 is a larger robot for outdoor use. It is five feet tall and
weighs 400 pounds. With more than $14 million spent for research
and development and deployments, Knightscope is planning to
use the proceeds from the mini-IPO offering to develop the K7, a
four-wheel version of their ADM technology intended to operate in a
wider range of challenging terrains. The alpha engineering prototype
phase of the K7 multi-terrain machine is complete, and the beta
engineering prototype is underway. Later in August, the company announced the addition of a new robot to their portfolio of Autonomous
Data Machines; the K1. It includes concealed weapon detection
and radiation detection, for which the proof of concept prototype is
complete and work on the alpha prototype is underway. Both the K1
and K7 will begin shipping in 2018.
The bots are employed. Malls (Westfield), corporate campuses
(Samsung), and healthcare facilities (Dignity Health) are utilizing
them today and Knightscope counts contracts signed with more
than 30 clients in eight states and three time zones.
M o d e r nTr a d e r. c o m
L i f e , Lux u ry & t h e P u r s u i t o f H a p p i n e s s
The first Burning Man festival was held in 1986. “The Burn” has
since grown to 70,000 attendees as the essential annual mecca
for performing artists, cultural iconoclasts, and Silicon Valley icons
gathering in Black Rock City—a temporary city erected in the Black
Rock Desert in Nevada. In 2004 Larry Harvey, the festival’s visionary
and co-founder, detailed 10 principles meant to evoke the cultural
ethos that emerged from the event (see “10 principles,” right).
The rep of the desert festival has evolved from a playground for artists,
libertines, unicorns and sparkle ponies to become the must-attend event
for celebrities and the Technorati elite. Google’s Larry Page and Sergey
Brin have been coming to Burning Man consistently for well over a
decade. Jeff Bezos, Tony Hsieh, and Mark Zuckerberg have made
the trek. Elon Musk has declared that Burning Man is Silicon Valley.
Modern Trader’s editorial team was determined to provide our readers
a first-hand account of how Burning Man has become the Davos of the
dessert for venture capitalists and tech titans. But, our spouses would
not let us go. So we turned to one of our own, a former trader, to provide
us with his perspective on why he keeps going back year after year.
Why this former floor
trader keeps returning to
Burning Man
Q Photos & words by Alan Matthew from the Playa at Black Rock City, Day 4 of Burning Man, 2017
I spent decades as a commodity trader
on the floor of the Chicago Board of Trade
(CBOT). In 1975, I started work at the
CBOT as a runner and was extremely
fortunate to have had opportunities to work
with the best. Early on, I was an assistant
for Lee B. Stern who was one the largest
grain traders at the CBOT. After that a
wonderful guy, Leonard Eiseman, hired
me to work for Continental Grain Co.
Len assigned to me one of Continental’s
corporate memberships and in 1977 I
became a member of the CBOT. In 1983,
I went solo as a trader and enjoyed the
freedom and, flexibility it gave me to
explore the world’s different cultures. By
the mid-2000s electronic trading began
the end of the pits. At the same time, I was
going through a medical scare. After a few
years of a type of mental illness I decided
I had to re-invent myself and I jumped into
the deep end of the venture capital pool.
I always felt that adventure travel was the
perfect medicine for restoring balance after the intensity of the trading pits. Whether it was hitchhiking across Tibet in 1987
November 2017
M o d e r nTr a d e r. c o m
“. . . you
have to step
to find
Alan Matthew’s Bunny Car
(created by artist Michael
Conn) has been a fixture at
Burning Man since 2012.
Burning Man co-founder Larry Harvey wrote these 10 Principles in 2004
1. Radical inclusion: Anyone may be a part of Burning Man. We
welcome and respect the stranger. No prerequisites exist for
participation in our community.
2. Gifting: Burning Man is devoted to acts of gift giving. The value
of a gift is unconditional. Gifting does not contemplate a return
or an exchange for something of equal value.
3. Decommodification: In order to preserve the spirit of gifting,
our community seeks to create social environments that are
unmediated by commercial sponsorships, transactions, or advertising.
4. Radical self-reliance: Burning Man encourages the individual to
discover, exercise and rely on his or her inner resources.
5. Radical self-expression: Radical self-expression arises from the
unique gifts of the individual. No one other than the individual or
a collaborating group can determine its content. It is offered as a
gift to others.
6. Communal effort: Our community values creative cooperation
and collaboration. We strive to produce, promote and protect
social networks, public spaces, works of art, and methods of
communication that support such interaction.
M o d e r nTr a d e r. c o m
7. Civic responsibility: We value civil society. Community members who organize events should assume responsibility for public welfare and endeavor to communicate civic responsibilities
to participants, including conducting events in accordance with
local, state and federal laws.
8. Leaving no trace: Our community respects the environment.
We are committed to leaving no physical trace of our activities
wherever we gather. We clean up after ourselves and endeavor,
whenever possible, to leave such places in a better state than
when we found them.
9. Participation: Our community is committed to a radically participatory ethic. We believe that transformative change, whether in
the individual or in society, can occur only through the medium
of deeply personal participation.
10. Immediacy: Immediate experience is, in many ways, the most
important touchstone of value in our culture. We seek to overcome barriers that stand between us and a recognition of our inner selves, the reality of those around us, participation in society,
and contact with a natural world exceeding human powers.
Issue 537
| 51
or hiking in the Peruvian mountains or
drinking “the tea” with Amazon Shamans,
I always felt I had to get as far away from
the tensions of the trading pits as possible;
both mentally and physically. I loved trading
but I believed there was a bigger world
beyond the pits. Recently, I read the book,
“Stealing Fire.” Authors Steven Kotler and
Jamie Wheal focus on Man’s search for
“ecstasis,” the intersection between altered
states and peak performance, the optimal
state of consciousness where we feel and
perform our best (see “Stealing Fire,”
review page 57). As traders, we know
that place. There are times when it seems
every trade is a good one and the money
flows. We also know when it seems like
we’re so out of step with the markets that
our mojo is in serious question. My father
used to say to me, “Having money is one
thing, not having money is one thing. Having money and then not having money is a
whole other thing.”
Learning how to tune our focus towards
flow states is an industry. Stealing Fire
refers to what’s called “The Altered States
November 2017
Economy,” which totals out to roughly $4
trillion a year.
Burning Man has been the defacto
incubator for experiments in individual and
mass creativity. Burning Man is a cosmic
magnet attracting universal crowds from
around the globe. The Burn welcomes a
mixture of, A-list actors such as Johnny
Depp and Leo Dicaprio, technology stars
like Elon and Kimbal Musk, along with
Navy Seals, authors, painters and the top
electronic dance music DJs. Two years ago
Skrillex and Diplo were on stage together
at Opulent Temple. The world’s top artistic
and business talent comingle in an off-thecharts synchronistic play for one week a
year in the hostile desert environment. In
respect to Satoshi, I’ve read that, Bitcoin
was born at Burning Man.
To quote Albert Einstein, “We can’t solve
problems by using the same kind of thinking we used when we created them.” The
BUILDERS of Burning Man are the power
source behind the experience.
Ancient early adopters used meditation,
dance, and mind-altering substances to
empower themselves to see and understand the deeper connections of beliefs
and their consequences. From ancient
Greece to the jungles of the Amazon the
message is the same, you have to step outside yourself to find yourself. Only recently
has technology become available to scientifically measure consciousness, according
to Stanislav Grof author of “The Adventure
of Self-Discovery.”
My first “Burn” was in 2004 and I vividly
remember the sights, sounds, and the
thoughts racing through my mind. I rode my
bicycle through the streets and every few
minutes I’d announce, “That’s the craziest
fricking thing I’ve ever seen.” After repeating that a dozen times I made a personal
decision to suspend judgement and take
in the experience. It reminded me of the
first time I walked onto the CBOT trading
floors. Hundreds of people running around
screaming and yelling at each other. Grown
men in shirts and ties, smoking cigars were
acting out a no holds barred form of business: Radical self-expression.
The truth was I really didn’t want to go to
M o d e r nTr a d e r. c o m
“It reminded me of the first
time I walked onto the
CBOT trading floors.”
M o d e r nTr a d e r. c o m
Issue 537
“The world’s top
artistic and business
talent comingle in
an off-the-charts
synchronistic play
for one week a year
in the hostile desert
Sparkle Pony.
Burning Man. Dana Kennedy a reporter for
the New York Times invited me to go. After
researching articles about the Burn I said
no way, I’m not going out there, it’s not the
place for me.
Dana was persistent and she had an ace
up her sleeve. The year before, she and
I travelled to Venezuela and hiked up Mt.
Roraima. Mt. Roraima is the backdrop for
Sir Arthur Conan Doyle’s book, “The Lost
World.” As we camped and hiked Dana
read “The Lost World” and wrote an article
about our experience that she sold to the
Times. After she sold it, she told her editor
to reach out to me for photos that I took
documenting our adventure. The Times ran
seven of my photos along with her article.
Dana hooked me into going to Burning Man
telling me we could repeat the plan, her
article and my photos. That was her only
Burn and I’ve been back every year but one
since. It’s funny how things work out.
Camp mate and Engineer/Artist Richard
Wilks says his first thought in 2007 was,
“he walked into the bar scene from Star
November 2017
A “sparkle pony” is a
Burner who is underprepared for basic
survival but still managed
to pack two suitcases
full of fabulous outfits.
He or she expects the
community to take up the
slack because they’re just
so wonderful and drama
inevitably follows when
expectations are not met.
The 2017 Burning Man
reached a new milestone
with the volume and sophistication of art installations and camp engineering. Places included
a soap suds filled plexiglass shipping
container for cleaning off, and Alumina: a
huge, hour-glass shaped, interactive, visual
sound experience. The Playa is populated
with a large contingent of the baby boomer
generation that includes me. Also, more
children show up year after year and with
the creativity and freedom of expression
what generation will they morph into?
Many of them have watched Burning Man
explode in popularity. There are more and
more resources being dragged into Burning
Man, and it’s the age old question that gets
asked: “What’s the purpose in all this?”
The answer can be found in Stealing
Fire. “[Burning Man] is the single greatest
concentration of state-altering technology on the planet, designed by everyone
together and no one in particular.”
That brings us to the final and most
important category on our
assessment: the astonishing amount of innovation this event consistently inspires. Attendees
treat the playa as an
oversized sandbox-a place where ideas can
be dreamed up, tested out, and, as often as
not, shared freely with everyone.
I tend to go out earlier every year before
the event opens. The best parts are more
open and direct. I love to engage with the
workers, the builders and the ones setting
up the show.
The effort that makes Burning Man work,
is what attracts me back and there’s a synchronicity vortex that’s attractive to me. And
the truth is Sparkle Ponies don’t rule.
This year a 41-year-old man evaded
security and ran into the fire on Saturday
night’s “Burn.” He died shortly thereafter.
Alan Matthew, former floor trader,
is the CEO of the venture capital firm
Tribal Ventures LLC
M o d e r nTr a d e r. c o m
If Zeppelin, the Beatles, Hendrix
and Cream are on your playlist —
read on.
By Jeff Joseph
As daily observers of all market sectors, MODERN TRADER
often chronicles the evolution of the business of music, particularly
in the context of publicly traded entertainment companies and the
soon-to-be public music industry disruptors. The proliferation of
digital and streaming music platforms has certainly changed the
industry. The selection, immediacy and value of on-demand music is
great for music fans, but has resulted in less revenue margin for the
Lollapalooza rocks on
New York Times columnist Mike Errico noted in a 2016 story
titled: Touring Can’t Save Musicians in the Age of Spotify, that
record labels have followed the money in the contracts they offer
to recording artists. “In the pre-digital era, labels profited only from
the physical recordings they funded, but as that income began
dwindling, a new logic was applied to the artist-label relationship,”
Enrico wrote. ” Labels argued that by promoting the recordings they
owned, they were also promoting the artist’s career as a whole,
and were entitled to profit from the full spectrum of artist’s revenue
streams — the 360 deal, named for the totality of its coverage.
Artists today are not only touring more to make up for their own lost
recording-sales revenue; they’re also being compelled to by the
labels that also stand to profit. This makes it a great time to be a fan
of live music.”
While we appreciate all
music genres, the music of
rock legends like the Beatles,
Led Zeppelin, Jimi Hendrix and
Cream form our musical core of
MODERN TRADER’s demographics. As artists are indeed
touring more, it has never been
easier to see live performances
rooted in rock and roll, and contrary to popular opinion, today’s
proliferation of music festivals
are not just for the tweens and
Lollapalooza’s 26th lakefront
festival in Chicago this past
August illustrates this. Sure,
popular, hip-hop, rap, pop and
electronic dance music fills the
majority of the stages; but of the
170 performers over the four-day
lineup there was enough new
M o d e r nTr a d e r. c o m
and old-school rock and roll to soothe the savage sexagenarian
(see “Lollapalooza 2017 Rockers,” page 54).
The London Souls: New music for old souls
Our favorite performance at Lollapalooza this year was from
Brooklyn’s The London Souls. Fresh off a tour with The Who,
the Souls brought their classic rock roots to the BMI stage in a
soulful, hard-driving performance that was as memorable for me as
back in 2008 when Lolla headliner Radiohead went long on Fake
Plastic Trees along with an incredible light show, augmented by an
unrelated fireworks display in the distance.
The Souls killed in Chicago this year, opening with their take on
Little Richard’s “Lucille,” several songs from their eponymous debut
album and sophomore set Here Comes the Girls, as well as a
soulful cover of William DeVaughn’s “Be Thankful for What You’ve
Got”. The two-man Souls featuring Tash Neal (mostly guitar and
vocals) and Chris St. Hilaire (mostly drums and vocals) bring a big
banging sound and lot of heat to the stage.
And as it turns out, the unmistakable influences of the Beatles,
Zeppelin, Cream and Hendrix are at the core of The London Souls.
They are a band that rock and rollers need to know, so we caught
up with the Chris St. Hilaire to talk about his rock roots.
Modern Trader: How old are you guys?
Chris St. Hilaire: We’re both 31.
MT: Who’s writing the music and the lyrics?
CSH: Well we’re both doing both. When we first started, we
loved to just play together, and we’d just get together in a room and
come up with stuff or try stuff at shows that would turn into songs.
And then, as we grew as songwriters we started writing songs
individually and then presenting them. So Tash writes a lot of songs
individually and presents them and then I help finish them. I help
Issue 537
arrange them and add the parts and
harmonies and then we both go back
Chicago 2017
and forth on lyrics.
MT: Other than percussion, what
other instruments do you play?
CSH: We both play most instruments.
I play all the piano and keyboards that’s
on Here Come the Girls, and I play
about half of the bass. But we’re both
bass players.
MT: Who are your favorite
CSH: That is always a hard one to
answer. Every day I could pick five and
then the next [day] pick a whole different
five, there’s so many. One drummer
that had a huge influence on me is Max
Roach. And of course I listened to Mitch
Mitchell a lot when I was first learning
drums because my father’s a guitar
band for five years. She also plays with Maceo Parker. And
player and he showed me Jimi Hendrix and Jeff Beck. So Mitch
she’s just incredible. She’s a huge inspiration to me. In terms of
Mitchell was some of the first drums that I learned. Like the song,
Fire. Once I’d learned a bunch a Mitch Mitchell, I looked into who he female drummers, most people know Cindy Blackman and Terry
Lynn Carrington and Sheila E, and [people] like that. The sort of
listened to and started getting into jazz drummers. He was listening
celebrity, sexy female drummers. But Nicky in my opinion blows
to Max Roach and Elven Jones so then I started tracing it back to
most of them out of the water.
the source.
MT: Regarding the typical comparisons you guys
MT: More jazz drummers? Art Blakely among them?
CSH: Definitely, Blakey. He’s like one of the best, one of the most receive: the Beatles, Zeppelin, Cream, Hendrix, White
Stripes and the Black Keys; who is the greatest influence?
powerful drummers and band leaders of all time. Then I started
CSH: Tash and I identify most with the Beatles in terms of song
listening to funk drummers like Zigaboo Modeliste (Funky Meters)
writing and in terms and the interplay
and James Brown’s drummers like Jabo
between us…our vocal blends and
our harmonies. We just did a few
MT: How about rock and roll?
Cage the Elephant: The Bowling Green, KY
shows with The Who and that’s one
CSH: Charlie Watts, I love. And
brothers (vocalist Matt Shultz and guitarist Brad
thing that I had to remember, everyone
Ringo Starr. Those are the guys that
Shultz) brought it to the big stage at Lolla. One
thinks of The Who as just a big, ballsy
drummers, virtuoso drummers, always
of the best performances we have seen in years.
rock band. And they are, but the thing
hate on because they’re not the most
Jagger only wishes he had moves like Shultz.
that makes them really special, is
technical drummers, but in terms of
The London Souls: Raw and rocking. St.
they have this really beautiful, angelic
taste and in terms of coming up with the
Hilaire channels Bonham while Neal must be
intricate harmonies, that go along with
best parts that fit the song, and to be
the reincarnation of Hendrix.
everything, that bands like Led Zeppelin
the drummers in those bands. Like no
Muse: Their big anthem stadium filling sound
didn’t have.
one else could’ve done that. Could you
came out blazing, but torrential rains called their
MT: How about the White Stripe
imagine John Bonham being the Beatles
headlining act three songs in.
There’s not really a
drummer? It wouldn’t have worked.
Spoon: The Austin, Texas rockers played to
coming out of the
MT: What about the frequent
loyal fans pulling heavy from new hit release
Hot Thoughts. The last concert crowd we
White Stripes.
Bonham comarisons? You hear
saw this old was at a Dead concert. We felt
CSH: I wasn’t going to be the one
that quite a lot. Obviously you have
right at home.
to say it. I mean I get why people may
to feel good about that.
make that reference because they’re
CSH: Yeah, totally. Any rock drummer
thinking of the two. It’s the duo thing, and same thing with the
who’s doing what they’re supposed to should.
Black Keys, and when you actually sit and listen to the music, it’s
MT: Who would you call one of the more underrated or
really not coming from the same place we are coming from at all.
under-appreciated drummers, that’s performing today?
MT: What are the five albums that speak most to your
CSH: Nikki Gillespie is an amazing female drummer; she
musical roots?
plays in a band called The Nth Power. She was in the Beyonce
November 2017
M o d e r nTr a d e r. c o m
CSH: First, I’d have to say probably
Abbey Road, by the Beatles.
MT: That must have been a real
thrill for you guys when you recorded
your first album there?
CSH: Yeah, that was wild. That was
totally nuts. Man, that’s really tough, I
haven’t been asked that question. But I
would add Fresh by Sly and the Family
Stone, and Innervisions by Stevie Wonder,
Band of Gypsies (Jimi Hendrix) and Rubber
Soul by the Beatles.
MT: What about the business of
music? Where’s the money today for
you guys?
CSH: Mostly in touring. But even that
comes and goes. Where most of the
money is in licensing songs to movies and
MT: Do you two have a big goal? Is
there something special you want to
accomplish in the next couple of years,
either musically or professionally with
your business?
CSH: Musically I’d like to show people
what’s possible. People think of music
in boxes and they think a rock band is a
certain thing and they think that a blues
band is a certain thing and hip-hop is
a certain thing. We pull from so many
different places, and Tash comes from
a background where he grew up in the
church. And the music that his parents
were playing for him was either gospel
music, Motown, or he was listening to 90s
hip-hop. I come from a background where
it was rock-n-roll and old rhythm and blues.
We can continue to merge those two and
people who really get what we’re doing will
see that. So, one of the goals would be to
demonstrate that you can have a multitude
of influences, and you can have a voice that
encompasses all of that.
MT: Nobody accomplished that
better than the Beatles.
CSH: Exactly, that’s one of the things
I love about the Beatles. There were
so many different things musically.
Businesswise, I’d like to make a sustainable
living off of it. [LAUGH] That might not be
a very high goal. But I don’t think either one
of us are particularly materialistic. We don’t
want to have mansions and stuff. But it’d be
great to make a living off our music.
M o d e r nTr a d e r. c o m
book value
Stealing Fire:
How Silicon Valley,
the Navy SEALs, and Maverick
Scientists are Revolutionizing
the Way We Live and Work
By Steven Kotler, Jamie Wheal
HarperCollins Publishers
Published Feb. 21, 2017
304 pages
Microdosing is a new trend in Silicon Valley. A growing number of developers and
other tech professionals are taking small dosages of psychedelic drugs - typically
LSD or psilocybin (”magic”) mushrooms each morning to improve their productivity
at work. Mad Men protagonist Don Draper had it all wrong. With small fractional dosages, (typically about 10% of a dose, to avoid tripping) microdosers claim increased
creativity, proficiency in problem solving, better focus and less anxiety.
While tech visionaries such as Steve Jobs and Bill Gates famously experimented
with hallucinogenics, the practice has become more common in the past few years.
The proponents even have their own manual to the world of enlightened states..
“Stealing Fire” describes how Navy SEALs, Google developers, Silicon Valley
entrepreneurs, the United Nations, Nike, Red Bull execs, Burning Man devotees and
others are seeking the enlightened consciousness of “ecstasis” to increase collaboration, productivity and creativity in an altered state of mind.
The heart of “Stealing Fire” is focused on the pursuit of ecstasis, which it describes as heightened levels of inspiration and innovation. The four ways people
reach ecstasis is through: Psychology, neurobiology, pharmacology and technology.
In ecstasis we are so engaged in an experience that all of our senses are amplified to
the point that we forget ourselves.
The power of the Burning Man experience (see “Why this former floor trader keeps
returning to Burning Man,” page 50) is building a bridge between the extreme and
the mainstream. Burning Man is likely the largest and most bizarre U.S. gathering to
involve imagination, art, self-expression and self-reliance. The authors of “Starting
Fire” explore altered states of consciousness and how these states can fuel creativity, accelerate problem solving and improve decision making capabilities to gain a
formula for peak performance in life and career.
Plato described ecstasis as an altered state where our normal waking consciousness vanishes completely, replaced by an intense euphoria and a powerful connection to a greater intelligence. The final characteristic of ecstasis is “richness,” a
reference to the vivid, detailed, and revealing nature of non-ordinary states.
“Stealing Fire” references early studies that showed eight weeks of meditation training measurably sharpened focus and cognition. More recent studies have carved that
down to five weeks. Ecstasis only arises when attention is fully focused in the present
moment, where optimal potential can be unlocked and limitlessness can be obtained.
“Stealing Fire” is an articulate endorsement of the pursuit of ecstasis and flow and
their website ( is equally compelling. MODERN TRADER has
been in the business of forecasting, and following trends for 45 years. While one could
joke that some former floor traders had been at the forefront of macrodosing for years,
we expect microdosing will be a trend to follow in markets for years to come.
--Tamarah Webb
Issue 537
Music Musings & Reviews
Lucinda Williams
This Sweet Old World
Average – 96
Standard Deviation – 3.2
Albums are scored 1-100 and standard deviation
measures the album’s breadth of track appeal
In 1992, Lucinda Williams transformed
herself from primarily a songwriter
to a bona fide force in the singer/
songwriter country, Americana world
with Sweet Old World. On This Sweet
Old World her songs share traits with
Tennessee Williams’ plays in that they
oozed sexuality, recalled a recent
past, and seemed as if the world could
not quite have gotten by without their
words and insights as part of it.
Twenty-five years later, Williams has
reimagined and rerecorded this album,
updating the sound, production, track
list, and even some song titles and
lyrics. In the original recording, album
opener, Six Blocks Away, which like
much of the album, sounded like it was
recorded in 1992 with bright and crisp
production, gets a makeover as the
guitars and drums now match the gravel
and grit in Williams’ emotive phrasings.
Her voice now more accurately
captures the angst and anguish over a
man’s unrequited love who lives only
six blocks away, though he might as
November 2017
well be miles from her. Songs here
demonstrate why Williams’ song
writing is elevated from other radiofriendly country songs. Much of what
you hear on country radio depends on
a witty phrase, pun, or clever double
entendre, and describes first-level
emotion: Love, heartbreak or sadness.
Williams pens songs that go
deeper; they explore the emotional
underpinnings and rationale for these
emotions. Her characters aren’t
defined by the clothes they wear or
trucks they drive, but rather they
suffer from attachment issues and
get thrown in jail largely because they
were playing out the roles expected
of them by absent mothers and
abusive fathers, a far stretch from
a Body Like a Dirt Road. They are
literature rather than comic books.
This recording now brings these
characters a deserving, timeless
sonic palette that befit their depths.
— J Burr Vanetta @jvevanston
Big Thief
Benjamin Booker
The Clientele
Music for the
Age of Miracles
Penny & Sparro
Hiss Golden Messenger
Hallelujah Anyhow
Recommended If You Like
Whitney, Lucy Dacus, Mitski, Car Seat
Jimi Hendrix, The Black Keys, Gary Clark
Jr, Alabama Shakes
Asteroid #4, Galaxie 500, The Feelies,
Mercury Rev
Drew Holcomb, Johnnyswim, The Civil
Wars, Bon Iver
Wilco, Son Volt, Strand of Oaks, Jason
Isbell, Ryan Adams
M o d e r nTr a d e r. c o m
2 Portfolio
3 Outlook
4 Technical
analysis charts
5 TradeStation
Aistis Raudys, managing
member and principal
Firm: Automaton
Trading, LLC
Strategy: Short-term
diversified mean reversion
Location: Chicago/Vilnius
Bitcoin volatility
Q By Daniel P. Collins
The explosive increase in the value of bitcoin is the talk of
the trading world. Questions of how high it could go or whether
it was a bubble dominated business media at the end of the
summer and into September when traders returned from the
slow summer vacation period.
Bitcoin from Sept. 11 to Sept. 18
Source: Coindesk
M o d e r nTr a d e r. c o m
JP Morgan Chairman and CEO Jamie Dimon added fuel
to the fire by calling bitcoin a fraud and a bubble in a CNBC
interview in September (see “The cryptos are creeping toward
the exchanges,” page 40). This coming on the heels of China
restricting the trading of bitcoin created a top of sorts. During
the week of Sept. 11 through
Sept. 18 alone, bitcoin moved
from above $4,350 to below
$3,000 and then back above
$4,000 according to CoinBase.
Bitcoin hit is peak just shy of
$5,000 on Sept. 1. Its low for
2017 was $775.98 on Jan. 11
meaning that its value grew by
a factor of nearly 8x in less than
eight months.
Issue 537
GDP, CPI, Jobs Reports — right at your fingertips.
Economic Data from the Fed is now available right in thinkorswim®. With this advanced
feature, you can easily compare and analyze a wide variety of macro data to make more
informed trades.
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FRED® data, you are agreeing to be bound by the FRED® API Terms of Use, available at TD Ameritrade, Inc.,
member FINRA/SIPC. © 2017 TD Ameritrade.
Essential, time-tested trading strategies
Cutting your losses short and letting your
winners run is a common bromide of trend trading,
but takes a plan and the discipline to follow it.
The 40 /125 Forex
Trend Trading Method
Q By Billy Williams
succeeding in the market.
Surprise earnings, unexpected news events and unmet expecThis sound trading method will consist of instrument selection,
tations of company performance create an element of uncertainty
solid repeatable entry signals and exit signals that balances maximizthat cause many sleepless nights for most traders. Like an alligator
lurking under the water, there are many unexpected dangers of stock ing profits while retaining gains. Each of these has its own unique
contributions to the overall strategy, and lacking one or more of
market trading that lie just beneath the surface.
these legs will lead to failure.
Risk of ruin is the elephant in the room that most traders avoid
talking about, yet it remains a nagging concern; just one unexpected
price move and your ability to keep trading evaporates.
The Most Reliable Method
Yet, building a reliable strategy around the right tradAmong all trading methods, trend trading has proven
ing edges can help you avoid risk of ruin while increasitself the most reliable. The reason for that is that there
ing your chance of greater returns.
are underlying market behaviors in play that help susTrading Confluence of
tain its price movement.
Chart Patterns
First is “herding bias,” which means that if the market
The Realities of Trading
up then most of the traders will just assume
In trading, your goal is to catch large moves in an underSystematic vs.
and they will keep buying into it. If it’s
lying security while controlling your risk. To achieve that,
Discretionary Trading
then the majority of traders are likely
there are three things that you have to accept:
Huge moves happen, but they happen infrequently.
Freeze Driven
Coffee Bull?
As this goes on, it develops another bias called “conThe majority of your trades are going to break even
firmation bias.” As the market continues in one direcor lose.
Dogging the DOW,
tion, traders who assume it will continue will have their
Your focus should be to minimize the second point
Debunking Myths
assumptions validated by the price trend. The longer it
and increase your odds of success on the first point.
goes on, the greater the traders will feel validated that it
To help get around this, your strategy has to be built
Oil, Gas & the Log will continue.
around a series of edges that put the odds of success
Log Parabola
Options Pricing
It is a self-fulfilling prophecy that reinforces a trader’s
on your side.
belief about the current price action.
To customize this trading method to your own unique
The Three-sided Chair
you will need to tailor the edges that define it.
Imagine a three-sided chair designed to evenly distribute its weight on each leg. Each leg is critical for the
chair to remain upright and support the weight of the person sitting
Selecting Your Market
on it. However, if one of the legs isn’t designed right then it inTo avoid volatility, it helps to seek out underlying markets that expericreases the probability that it will fall apart. Remove one of the legs
ence greater predictability.
entirely and the chair will fail immediately.
The foreign exchange market has several currency pairs whose key
Like the three-legged chair, a sound trading method has to be built advantage is their price movement. Unless there is a huge monetary
around three distinct edges to have a better than normal chance of
or fiscal policy change that affects a nation’s currency, there
M o d e r nTr a d e r. c o m
Issue 537
| 61
Building a reliable
strategy around
the right trading
edges can help you
avoid risk of ruin.
is very little to knock its trend off course.
And, as long as you’re prepared for that possibility, there also is the chance of catching
the new price trend early on.
As for entries, smoother price movement
allows for price to confirm an entry into the
trend by simply riding its momentum in its
For exits, you can allow the currency pair
to reveal when the trend is over by trailing
your stops according to its daily price range,
allowing it stop you out. You also may test
different moving parameters depending on
your market or sector.
The 40/125 Forex Trading
Trend trading can experience spectacular
gains by capturing huge price moves, but
also can experience a long series of losses.
With trend trading, the 80/20 principle
applies where there is an unequal
distribution of gains. Losing 60% to
The 40/125 forex trading method was triggered in
April as MACD confirmed our entry.
Source: eSignal
70% of your trades with trend trading is
common. And even with that, a handful of
the 30% to 40% of your winning trades will
be responsible for the lion’s share of your
This presents a bit of a dilemma for the
average trader. If you have low trading
capital and/or low tolerance for pain of
losing then you’re at a disadvantage.
Making money and then giving it back can
be mind-numbingly tedious causing your
If the market moves in our direction, we can add to the position
once the market surpasses our initial risk level.
Source: eSignal
November 2017
enthusiasm for trading to dwindle. To help,
the 40/125 Forex Trend Trading Method
was designed to help you avoid being
papercut to death by trading losses while
still taking advantage of huge price moves.
A good example recently occurred in
the euro/U.S. dollar currency pair. The
EUR/USD was in a steady downtrend until
early 2017, but began a slow rebound in
Q1. By April the 40-day simple moving
average (SMA) was approaching the 125day SMA. On April 19, the 40-day SMA
crossed above the 125-day SMA signaling
a potential long entry. This was confirmed
by the Moving Average Convergence
Divergence indicator (MACD) crossover
on April 18, which acted as a secondary
confirmation. The trigger was the price
high of 1.0960 from March 27, which was
matched on April 25 (see “Euro trigger,”
above). The stop loss is set at two-times
the 14-day average true range (ATR), about
129 pips.
You can add to your long position to
enhance returns. In our euro example, price
traded back-and-forth in a range until the
currency pair gained more than its initial
risk, which set the stage for a potential
second entry. On May 16, the conditions
were met that would have allowed you to
scale in up to an additional half of your
original position. This gave you greater
reward potential magnifying your risk/
M o d e r nTr a d e r. c o m
The EUR/USD continued to trade higher reaching
1.182, for a potential gain of 920 pips per contract.
Source: eSignal
reward ratio if the trend continued (see
“Adding to a winner,” left. Your stop loss
would be adjusted to two times the current
14-day ATR.
Strategy Rules
To trade the 40/125 Forex Trend Trading
Method, place a 40- and 125-day SMA
on a daily price chart. Include a standard,
12/26/9, MACD indicator on the daily
price chart. Also include the 14-day ATR on
the daily price chart to calculate your stop
loss level.
For longs:
When the 40-day SMA crosses above the
125-day SMA a setup is signaled, if
The MACD crosses signaling an upward
trend at the same time, and
Price trades above a previous high, then
Enter the trade with two times the 14-day
ATR as the stop loss point.
For shorts:
When the 40-day SMA crosses below the
125-day SMA a setup is signaled, if
The MACD crosses signaling a downward
trend at the same time, and
position, you adjust your stop level, locking
in the initial profits or moving your stop to a
breakeven level.
The Danger of Apathy and
Trading Complexity
Price trades below a previous price low,
Enter the trade with two times the 14-day
ATR as the stop loss point.
Your stop loss should be adjusted daily
based on the two times ATR metric.
Once the trend gains your total risk you
can scale into a second position equal to
one half your original risk. If the trend continues then scaling in helps magnify the return
(see “Multiplying earnings,” above).
As of this writing, the trade is still viable,
and because we calculate the stop loss level
daily, the stop scales higher as the trade
accrues profits.
A Word on Scaling In
Huge returns are intoxicating, so if you’re
willing to risk a bit more to gain a larger
return, then consider scaling in to a winning
move. If your trade gains your initial risk then
you can scale in half your original position
to take advantage of a potential homerun.
It doesn’t always work out but the potential return can be far greater for the slight
increase in risk. Also, when you add to your
If you find yourself deviating from the
rules or changing the rules, then you’re
committing the sin of taking the simple
and making it complex.
M o d e r nTr a d e r. c o m
It’s worth mentioning that the biases of
herding and confirmation still pose as
much a danger to you as the other traders
who aren’t familiar with the term. Price
trends can result in a type of apathy on
your part as these biases seep into your
trading decisions.
While being aware of them is powerful
knowledge for exploiting forex price trends
it remains a double-edged sword. Finding
yourself under their spell will make it harder
for you to act when the exit signal comes.
You have to remind yourself daily of their
toxic effect, which is why some trend traders
act too slowly when the trend comes to an
end. The longer the trade goes in your favor
it makes it increasingly difficult to take the
appropriate exit.
In addition, the simplicity of the 40/150
method lends itself to another bias called
the “complexity bias.” This is a human
tendency to tinker with something that has
been proven to work with the goal of making
it even better or perfect.
This is why over-optimization is so common among system designers, who sometimes lose sight of the goal of designing a
robust trading method in favor of a mythical
Holy Grail.
If you find yourself deviating from the rules
or changing the rules, then you’re committing the sin of taking the simple and making
it complex. Worse, if you’re doing it in the
middle of the trade you’re setting yourself up
for unnecessary losses.
You might succeed every now and then
but eventually it’s going to come back and
bite you. It’s like running around in a dynamite factory with a lighted match; you might
survive but you’re still foolish for doing it.
Test and customize according to your
goals and to match your personality, but
execute with discipline without being blind
to your own biases.
Billy Williams is a 20-year
veteran trader and publisher of
Issue 537
Applying classic chart
patterns to current
trading opportunities
of Chart
Q By Suri Duddella
Chart patterns form purely as a result of
knowledge-based bias work in the markets.
The learned behavior of traders to buy and
sell above and below the key support and resistance levels or around critical price levels
(highs, lows, pivots) creates price barriers in
the form of trendlines or channels.
These barriers become action/reaction
lines and form geometric structures — chart
patterns. Successful pattern trading requires
the knowledge of chart pattern formation,
its arrangement and its market manipulation.
The recognition of patterns and their body
of knowledge and knowing how to react and
what to expect with certain patterns can
help a trader’s success.
What is Confluence?
Technical analysis is the study of behavioral patterns of various technical events. Confluence is when there is more than one
technical analysis concept coming together
at the same point in the market. Traders find
a setup that has multiple price concepts
from various non-correlated techniques
or multiple price-patterns that have found
a high probability trading opportunity and
there is a high chance of the trade working
out successfully. Finding a confluence could
eliminate noise when it comes to a validating
signal. When multiple ideas or events begin
to unfold, traders look for confluence to have
an edge before entering a trade.
Confluence can be found in all forms of
the markets: Price patterns, moving averages, pivots, support or resistance levels,
trendlines and Fibonacci levels. When some
or all of these tools meet at a single location
to form a unified event, it is considered a
point of confluence. Confluence trading is
simply combining more than one trading
technique or chart pattern or analysis to
increase trader odds of winning on a trade.
This is significant. As any technical trader
knows: Trendlines are broken, not every
pattern holds true, support and resistance
is broken and moving average crossovers
do not always signal a profitable trade. The
Confluence is when there is
more than one technical analysis
concept coming together at the
same point in the market.
November 2017
more technical tools that validate a move, or
simply confirm the significance of a price,
level the stronger that level is.
Patterns Confluence with
Price Levels
Here we will present a basic example of how
the confluence concept works with patterns
and price levels.
The confluence of various price levels
forming support and resistance zones
makes that support and resistance stronger.
Confluence zones from multiple pattern or
trade setups act as key areas for price-action. Trading solely with these price levels
may not be the best choice, but using these
confluence zones with pattern setups may
result in profitable trades. Here, we show
how these confluence price zones can be
anticipated and how to create ABC chart
pattern entries.
“Floor & Fibonacci pivots” (right) shows
an S&P E-mini daily chart with an ABC
bullish pattern and floor and Fibonacci
zone pivots indicators. The E-mini S&P 500
formed an ABC Bullish pattern from July to
November of 2016 with a long entry at 2088
and a stop at 2068. The first target zone is
2198 to 2233 and the second target zone is
2335 to 2408. A floor and Fibonacci zones
pivots (monthly) indicator is also plotted on
the same chart to find potential support and
resistance zones. A confluence target zone
for ABC bullish pattern targets and pivots
target zones is formed from 2365 to 2394.
ES reached its confluence target zone 2388
in March 2017.
Patterns Confluence
The confluence of technical indicators or
patterns is a great way to validate trends
and enter trades with confidence. When
similar chart patterns (continuous or reversal) form in multiple timeframes at the same
point, it indicates higher probability trading
opportunities. Here are examples in the
iShares 20+ Year Treasury Bond ETF
(TLT) in multiple timeframes and various
chart patterns to show the significance of
confluence trading.
A double-bottom pattern is formed
in TLT on a weekly timeframe from June
2015 to April 2017 with a long entry at
$119 and stop at $116 (see “TLT weekly,”
M o d e r nTr a d e r. c o m
The S&P 500 rallied thanks to multiple bullish technical
A double-bottom on this weekly chart is just one bullish
indicator for TLT.
Source: SuriNotes
Source: SuriNotes
This ABC bull pattern enhances TLT’s bullish outlook.
A double-bottom on this weekly chart is just one bullish
indicator for TLT.
Source: SuriNotes
right). The first target range is $134 to
$139. Also, notice an embedded Dragon
bullish pattern inside double bottom
pattern in January 2017.
“TLT daily” (right) shows a TLT daily
chart along with our proprietary trend
indicator eSIX. The trend indicator eSIX
uses non-correlated components to derive
the underlying trend. TLT made lower-low
swing prices from January 2017 to April
2017, whereas eSIX indicator made higherhighs, which signaled positive divergence
and a potential reversal in its downtrend.
M o d e r nTr a d e r. c o m
Source: SuriNotes
From April to mid-May, TLT also formed
an ABC Bullish pattern. The confluence
of TLT’s double-bottom pattern (weekly)
and the ABC bullish pattern with a strong
positive divergence signaled a long trade
opportunity. The ABC trade entry was at
$121.25 with a stop below $119.90 and
targets are $125 and $130.
“TLT 5-wave” (above) shows a daily TLT
chart with a confluence of a five-wave bullish
pattern along with the weekly double bottom
bullish pattern and the ABC bullish patterns.
A bullish divergence from the bottom of the
price and a five-wave pattern show a higher-high and a higher-low swings. Five-wave
patterns are similar to Elliott Wave patterns
with simple wave formations. A bullish price
channel is drawn on the five-wave pattern
to compute the target zones. The five-wave
pattern target zone is set at the top of the
trend-channel at $132 to $134.
Suri Duddella is a 20-year veteran
pattern-based, algorithmic trader and
author of “Trade Chart patterns Like the
Pros.” @surinotes
Issue 537
One of the first decisions a trader will
make is whether to follow a systematic
approach to trading or a discretionary
one. Here, in the first part of two, we
look at whether one style provides
superior returns over the other.
Systematic vs.
Q By Michael A. Dancey
Shown is the performance of the BarclayHedge Systematic and Discretionary
Traders’ Indexes as well as its risk metrics from February 1987 through May 2017.
Incentive and management fees have been deducted.
Source: BarclayHedge
Barclay Systematic
Traders Index
Barclay Discretionary
Traders Index
BH Systematic-Discretionary
50-50 Portfolio
Source: BarclayHedge data and PackHedge.
November 2017
Before delving into the world of trading,
a trader must decide on an approach to
seek profits from the market. Traders will
need to decide between a systematic
approach—one based on specific rules
that determine markets and entry and
exit points—or a discretionary approach,
which may include technical data and
rules but where the trader maintains the
final decision on a trade. Here we study
whether systematic or discretionary trading
styles yield superior performance results.
In examining this question, we will discuss
some of the basic characteristics of each
and how they relate to return drivers,
strategies, trade generators (fundamental
or technical) and sectors. Additionally,
we will analyze whether the benefits of
diversification extend to styles.
There are numerous variations of both
systematic and discretionary trading
strategies. Many strategies incorporate
both to varying degrees and could be
defined as a systematic strategy with
discretionary overlays or a discretionary
strategy with systematic overlays. The one
overriding difference between the two
styles is that systematic trading strategies
generate a definitive signal, whereas a
discretionary strategy allows the trader to
make the final call on price and time.
Most people’s perception of systematic
and discretionary trading may have been
more accurate 20 years ago. Nowadays,
systematic strategies are not just simple
strategies trying to exploit price and
time data. Most are an amalgamation of
trading rules that attempt to capitalize on
momentum, mean-reversion, carry, value or
other return drivers incorporated with welldefined risk management parameters.
Many systematic strategies now
incorporate fundamental data; some are
complex algorithms trying to capture noise,
such as high-frequency programs, or even
particular word groupings inputs from
social media. On the flipside, discretionary
traders are not simply traders trying
to capitalize on a “gut feeling” derived
from “divining” the fundamentals and/or
M o d e r nTr a d e r. c o m
The drawdowns of Systematic Traders Index are deeper and shorter. The run-ups
of the Discretionary Index are both greater and of longer duration.
Source: BarclayHedge
Run-up Analysis
Drawdown Analysis
Start Date No.
% Depth
Prior Peak
Prior Peak
Run-up Analysis
Start Date
Drawdown Analysis
% Depth
Run-up Analysis
Start Date
Drawdown Analysis
% Depth
price action. Most discretionary traders
have well-defined trading strategies that
assess and evaluate the supply/demand
fundamentals. Those that have the
wherewithal to survive for a reasonable or
long trading history invariably have specific
risk management parameters. Nearly all
Prior Peak
discretionary traders incorporate technicals
to enter and exit the market, to implement
risk management, and to varying degrees,
to confirm fundamental evaluations. One
caveat: A discretionary trader is more
apt to exit a position prior to his technical
parameters if the trade is not behaving to
Many systematic strategies now
incorporate fundamental data;
some are complex algorithms trying
to capture noise.
M o d e r nTr a d e r. c o m
price action expectations.
In this analysis of systematic vs.
discretionary trading we will examine
the BarclayHedge Systematic and
Discretionary Traders Indexes, the Barclay
BTOP50 Index, the Barclay Agricultural
Traders Index and the Société General
(formerly Newedge) Macro Trading Indexes
(Quantitative and Discretionary).
Let’s start with an examination of the
BarclayHedge Systematic Traders Index
and Discretionary Index. Not surprisingly,
the number of programs has grown steadily
in the period covered (February 1987
through May 2017) and now stands at
409 in the Systematic Traders Index and
at 106 in the Discretionary Traders Index.
BarclayHedge defines its Systematic
Traders Index as programs that make
decisions using automated systems in at
least 95% of cases. Their Discretionary
Traders Index includes programs that
make at least 65% of their decisions in a
discretionary way.
“Head to head,” (left) shows a VAMI
(value-added monthly index) chart and
a risk table of the two indexes. VAMI
is the growth in value of an average
$1,000 investment. VAMI assumes the
reinvestment of all profits and interest
As one can see, there is very little
difference in the returns of the two subindexes and 50/50 combination. This
is somewhat surprising given the major
differences in approach, the different
trade generators, the numerous strategies
and the number of markets traded by the
different styles. What this presents is
that the Discretionary Traders Index has
significantly higher risk-adjusted returns
as reflected by the Sortino Ratio. Given
the similar returns, this difference stems
from the greater volatility of the Systematic
Traders Index, particularly to the downside.
The Kurtosis numbers are huge and
deserve some study.
Kurtosis and skewness are statistics
that quantify the shape of a non-normal
distribution. The higher the kurtosis,
Issue 537
the fatter the tails and the greater the
probability of a wider distribution. For now,
let’s attribute the high numbers to the fact
that these are indexes rather than individual
programs/strategies. Skewness indicates
a propensity of direction of the surprise
(fat tails). What the kurtosis and skewness
statistics indicate is that all three have
extremely fat tails with a strong propensity
to surprise in positive returns with the
Discretionary Traders Index having the most
extreme numbers for positive surprise.
The correlation between the two indexes
is a relatively high 0.62. The degree
of correlation is high enough as not to
overcome the substantial difference in
risk-adjusted-returns between the two.
Consequently, 50/50 portfolio fell in
between the two indexes in risk-adjusted
returns but did yield the highest annualized
return by a small margin.
Despite the similarity in returns,
systematic traders have higher
volatility as noted the risk metrics (see
“Drawdowns,page 67). Broadly speaking,
one could describe the Discretionary
Traders Index’s returns stream as slower,
smoother and generally less volatile that the
Systematic Traders Index, though yielding
similar net returns. The result being better
risk-adjusted returns. The 50/50 Portfolio
did produce lower drawdowns.
A Deeper Dive
As we mentioned above, all systematic
strategies generate trades based upon
technicals, even those that incorporate
some fundamental data into their program.
While the vast majority of discretionary
traders generate trades based upon
fundamentals, most incorporate technical
analysis for entry, exit and risk management.
Both styles are practiced throughout all
time frames. Talking of particular strategies
and sector foci, there are areas of overlap
between the two where one style or the
other is the predominant approach. The
reasons for this stem from what return
drivers – carry, momentum, value, etc. – the
program is trying to capitalize upon, as well
A comparison of returns and risk metrics between the BTOP50 vs. the Agricultural
Trade Index.
Source: BarclayHedge.
Barclay BTOP50 Index
Barclay Agricultural Index
BH BTOP50/Agricultural
50-50 Portfolio*
*The 50/50 Portfolio is a hypothetical blend of the two Indices.
November 2017
as what is the most efficient or pragmatic
approach to do so.
For instance, there are practical reasons
why the majority of trend followers are
diversified and systematic. As mentioned
earlier, technical analysis is the trade
generator for systematic strategies. Trend
followers focus on exploiting momentum.
Many programs may have contra-trend
or mean reversion components but are
predominantly trend following. In general,
markets do not trend for the bulk of the
time. Trend traders typically take many
small losses hoping to catch a few good
trends that more than compensate for the
multitude of small losses.
Statistically, the odds improve when
applied to a greater number of markets.
It would be difficult to have a deep
understanding of, analyze and monitor the
fundamentals—whether supply/demand
or macroeconomic factors—of 25 to 75
markets. Hence, a systematic approach to
trend following in a broad array of markets is
the most proficient way to capitalize on the
return driver of momentum.
On the other end of the spectrum
are discretionary fundamental traders.
These traders immerse themselves in the
fundamentals of select markets — doing
deep dives on a wide array of factors.
Discretionary physical commodity traders
are a good example of this. Like other
fundamental traders, commodities traders
analyze a wide variety of fundamental
factors. The majority of discretionary hard
commodities traders seek to exploit the
return drivers of carry and relative value as
well as momentum.
Frequently, these are opportunistic in
nature. A major reason that these markets
lend themselves to this approach is the
more complex cost of holding these types
of asset classes. In addition to a financing
rate – the cost of holding a financial asset
— there are the costs of storage, transport
and insurance. Additionally, the benefit of
holding the asset — the convenience yield
— varies between market participants. Many
discretionary fundamental traders are niche
traders and focus on just one market or
market sector.
M o d e r nTr a d e r. c o m
The Agriculture Index had sharper drawdowns due to less diversification and
slightly lower returns.
Source: BarclayHedge
Jesse Blocher, Ricky Cooper and Marat
Molyboga explain why physical commodities
lend themselves to the fundamental
discretionary approach to trading in their
2015 white paper, Performance Persistence
in Commodity Funds.
They describe how commodity
traders have the opportunity to gather
more information from diverse sources
than equity traders and can apply that
expertise. They note how skilled traders
who understand the nature of data can
exploit overreaction to early production
forecasts and limited weather information
by exploiting more sources. They can also
find data on seed and fertilizer purchases
that provide them an informational edge.
The paper states, “In some ways,
commodity analysts may actually have
some advantages over equity analysts.
Publicly traded equities have significant
requirements for disclosure, but often the
most important information about customer
demand and supplier capacity is labeled
‘inside information,’ on which it is illegal
to trade. In contrast, commodity funds are
legally able to gather important information
about supply and demand, and deploy it in
profitable trades.”
The paper describes a number of
fundamental market factors in commodities
markets that underscore the importance
of being able to tap into a vast flow of
information. Consequently, physical
commodities provide unique opportunities
for a trader to gain a competitive edge via
fundamental analysis to capitalize upon
carry and relative value. The carry trade is
affected by the interaction between supply/
demand and the cost of holding the asset.
As opposed to a value play in equities,
relative value seeks to exploit mispricing
in relative values rooted in geography or
related commodities, WTI vs. Brent crude
oil, for example, or Soybeans vs. soymeal.
Big Systems vs. Small Ag
Given the value of fundamental information
in trading physical commodities, let’s compare the Barclay BTOP50 Index and the
Barclay Agricultural Traders Index versus
the same period (see “BTOP vs. Ags,”
page 68). Neither index has specific parameters for style, but the BTOP50 is composed of the 20 largest Commodity Trading
Advisors (CTAs) by AUM (two-thirds are
systematic diversified trend followers).
Technical analysis is the trade
generator for systematic strategies.
M o d e r nTr a d e r. c o m
The bulk of the 38 programs currently in
the Barclay Agricultural Traders Index are
discretionary fundamental traders.
The spread of the returns is greater than
the Systematic and Discretionary Indexes
but still minimal. The BTOP50 Index returns
are somewhat greater with very similar
volatility levels resulting in slightly better
risk-adjusted returns. The kurtosis and
skew statistics for the BTOP50 indicate
moderately fats tail with the moderate
propensity to surprise with positive returns.
The same for the Agricultural Traders Index
indicate very fat tails with a high propensity
for positive surprises.
The correlation between the two indexes
is 0.23. The 50/50 combination of the two
resulted in the return falling in between
the two but with the risk-adjusted return
significantly higher. The possibility for
positive tail events fell much closer to the
Ag Index, so a strong possibility of positive
returns exists.
After reviewing the drawdown data
from the BTOP50 and Ag index (see
“Big vs. small,” left), one can see that the
drawdowns of the Agricultural Index are
longer than the BTOP50 and moderately
deeper as well. Run-ups are also greater
and of slightly longer duration. The 50/50
portfolio significantly reduced drawdown
depth and duration relative to the two
individual indexes.
What is interesting is that the risk
metrics are dramatically improved by
combining these two indexes. This likely
due to the lower correlation as not all of
the components of the BTOP50 trade ag
markets, and those that do trade them
from a systematic technical perspective as
opposed to the vast majority of programs
in the Ag index, which trade from a
fundamental discretionary perspective.
In the second part of this series we will
look at the Société General indexes and
analyze what we have learned from all of
the data.
Mike Dancey, CAIA, is VP of
Institutional Services and Head of
Research at Managed Account Research
Inc. He consults on CTA selection, due
diligence, portfolio construction and
Issue 537
Coffee’s recent rally during an off-year
crop and hints of freeze hysteria are
producing elevated options premiums
and opportunities.
Coffee Bull?
Try decaf & write calls
Q By James Cordier
If you’re a mainstream investor used
to gauging price/earnings ratios or milling
through bond yields, selling options on
coffee futures may sound like launching a
trip to the moon. Soft commodities are also
sometimes referred to as exotics—most likely
named by mainstream investors more comfortable with familiar assets such as gold.
If you’re considering branching out
into the diversified commodities markets,
especially as an option trader, you don’t
want to avoid these markets. For it is in
these backwater food and fiber sectors—
away from the glow of public spotlight—
where fundamentally based opportunities
and large dislocations often exist. With the
2017 Brazilian harvest wrapping up and a
potentially record crop next year, a supply
burden should keep prices in check into
next year.
Brazil is the world’s largest producer and exporter of coffee
beans, and the main exporter of the Arabica variety that the
ICE Futures U.S. contract is based on.
Source: Hightower report
Here, we present just such a potential
opportunity in the coffee market.
The Seasonal Coffee Cycle
Brazil is by far the world’s largest producer
and exporter of coffee—in particular, the
higher quality Arabica coffee used to satisfy
the majority of the ICE Futures U.S. Coffee
futures contract. Thus, developments in the
Brazilian crop are key to forecasting coffee
prices (see “Coffee producers,” left).
In Brazil and the southern hemisphere,
coffee trees experience a bi-annual “on/off”
cycle. This means the trees tend to produce
more beans during “on” years and fewer
beans during “off” years. Thus, every other
year should theoretically produce a higher
yielding crop. As a trader, you should know
if the year you are in is an “on” or “off” year.
In addition, the coffee growth cycle has
three key seasons you should be aware of:
Flowering, growing season and harvest.
The coffee bean life cycle begins in October with flowering season. This is the most
critical time for the upcoming crop. As
the flowers drop off, they leave in place a
cherry. This cherry is what ultimately turns
into what we know as the coffee bean. The
number of flowers will determine how big
the upcoming crop will be; and the weather
will help determine how many flowers form
Cold weather talk, which
recently hit this South
American winter, can still
bring out the buyers in the
coffee market.
November 2017
M o d e r nTr a d e r. c o m
The summer (Brazilian winter) spike in coffee can
partly be attributed to fear of a freeze.
Source: eSignal
Despite a much lower change for a freeze, coffee prices tend
to rise in the South American winter and the flowering stage
for coffee.
through the next flowering season. Harvest
season also overlaps the Brazilian winter,
which is June-September. This can also
be a time for weather concerns as a harsh
freeze can hinder or damage the harvest
and/or hurt tree development for the upcoming flowering.
Knowing the seasons and the seasonal price tendencies for coffee can help
you better identify the best option selling
Source: Moore Research
Buy it All for a Freeze?
on the trees. As October is typically the
beginning of the rain season, it often coincides perfectly with flower formation.
However, if rains are late in coming,
worry, and, thus, prices can increase. It is
not uncommon to see a weather premium
building into prices during flowering
season. However, these can often be
trading opportunities, especially for call
selling, as prices can decline sharply when
the rainy season begins and flowering is
M o d e r nTr a d e r. c o m
Growing Season
This Brazilian growing season lasts from
November through March. During this period, weather can sometimes be a factor. But
in Brazil, it’s typically warm and wet. This
time is typically reserved for analyzing the
true size of the upcoming crop and keeping
an eye on its health.
The Harvest
In March, the Brazilian coffee harvest
typically begins and can last all the way
It used to be that coffee traders got excited
about going long coffee ahead of the Brazilian winter. A series of high-profile freezes
in the 1990s and early 2000s made this
an annual event. Coffee prices often
rallied even without any weather threat at
all, simply off of public participation in the
annual chance to strike it rich. If a freeze
decimated the coffee crop, the holders of
futures contracts would make a bundle.
But Brazilian coffee farmers grew weary
of spinning the annual roulette wheel.
Beginning in the mid-2000s, replacement
trees planted to supplant early frost losses
were planted further north, closer to the
equator in warmer climates. With up to
30% of Brazilian production moved all but
out of harm’s way, the freeze phenomenon
became less of a factor.
Seasonal tendencies show that despite
a lower potential for freeze, Brazilian
mid-winter from June through September
can often see a spike in coffee futures
(see “Coffee buying season,” left). A
secondary spike—and an opportunity for
higher premiums— can also occur during
flowering season in the Brazilian Spring
That doesn’t mean it went away entirely.
Issue 537
Cold weather talk,
which recently
hit this South
American winter,
can still bring out
the buyers in the
coffee market.
Fear of freeze, poor weather during the critical flowering stage and off
year production fundamentals has driven prices—and more importantly—
premiums higher.
Source: eSignal
Cold weather talk, which recently hit this
South American winter, can still bring out
the buyers in the coffee market. In fact,
weather buyers were a primary driver of the
recent 26% price surge in the coffee market (see “Something brewing,” page 71).
But the chances of a Brazilian hard freeze
causing significant damage to the coffee
crop have dropped substantially in the
last 10 years. Thus, weather rallies during
the Brazilian winter often can be shorting
opportunities and an exceptional time for
call writing in coffee.
the 2018 Brazilian coffee harvest at 5862 million bags. This due to an “on” year
in production as well as to a fair degree
of pruning done to trees this year, which
tends to help trees bear more fruit the
following year.
If the forecast is realized, 2018 will
be an all-time record for Brazilian coffee
Lastly, U.S. green coffee warehouse
stocks are now at all-time record levels –
largely overshadowing the bulls’ argument
of a 2017 global coffee deficit.
2017 Fundamentals
Freeze dried coffee rally
Coffee bulls made quite the big deal about
2017’s “off” year in the Brazilian production cycle. Yet estimates for the 2017 Brazilian harvest range between 49-51 million
bags of coffee. This is the largest “off” year
harvest on record and is only 4-to-6 million
bags shy of last year’s record 55 million
bag harvest.
That’s not the bull’s biggest challenge,
however. As of Aug. 1, the 2017 Brazilian
harvest was 80% complete vs. 76% at
the same time last year. As harvest nears
completion, the focus will begin turning
toward next year’s crop. By most accounts,
it’s expected to be a whopper.
While the numbers will come more into
focus after flowering, early estimates put
The bulls continue to tout the lower 2017
Brazilian coffee production and a 2017
global coffee deficit as reasons to buy the
market. Let them.
Despite this, 2018 is shaping up to be
an oversupplied year for coffee. In addition
to a potential record crop out of Brazil,
Vietnam—the world’s second largest producer—is expected to harvest 10% more
coffee next year than it did this last.
With seasonal factors now also appearing to shift in the bear’s favor, and call
premiums elevated after the July/August
rally, the time is right to consider layering
on short coffee call positions for early
2018 expirations.
Traders can stagger a series of short
November 2017
calls strikes above the early 2017 high of
$1.70. Self-directed traders can consider
the March 2.00 call on further rallies this
month (see “October showers bring March
flowers,” above). Target premiums are
$400 to $500 per option. There should
be strong resistance at the 2017 high and
March contract high before hitting the
psychologically important $2 level. Should
no such rally occur, traders can consider
moving out to the May contract where the
same strike currently offers premium in
excess of $550.
It would likely take an unforeseen and
substantial weather event to eventually
push coffee prices to $2 per pound. With
the end of Brazilian winter approaching,
the chances of such an event decrease
daily. Risk of loss, of course, is still present
in any trade and thus, risk parameters
should always be adhered to.
However, the current margin requirement
to premium ratio projects a 43% return per
option should the options expire worthless. That’s getting paid pretty well to bet
against the improbable.
James Cordier is author of “The Complete Guide to Option Selling,” and president and head trader of OptionSellers.
com, a wealth management firm specializing in option writing portfolios.
M o d e r nTr a d e r. c o m
Many traders avoid the 30 Dow
components based on long held
market assumptions. But are they
missing out on opportunities?
Dogging the DOW,
Debunking Myths
Q By Perry J. Kaufman
Analysts seem to look down at the
components of the Dow Jones Industrial
Average in every way imaginable. The
Dow components are an interesting
group because they have extraordinary
liquidity. At the same time, they are mature
companies. Conventional market wisdom
says that mature companies are unlikely to
grow as fast as newer companies, which
have unique products and more available
market share to capture.
Sometimes we submit to conventional
wisdom without looking at all the facts.
It is easy to decide, in advance, that the
gain probably won’t be worth the effort.
But the most valuable tool for a trader
is curiosity, and the desire to seek proof
rather than simply accept conventional
wisdom. An abundance of curiosity led
us to research whether buying or selling
the strongest Dow components, and
simultaneously doing the opposite with the
weakest, would yield an interesting result.
This simple approach to arbitrage should
reduce risk more than it reduces returns.
This research included a look at some
of the established strategies for the Dow,
and discovered the truth about them. The
period evaluated is from 2004 through
March 2017. While the Dow can be traced
back more than 100 years, results from
2004 are more relevant now.
What we discovered were multiple
myths regarding the Dow, as well as
some new approaches to trading its
Chart shows the returns from buying the weakest Dow components every
252 days since 2004.
Myth 1: Large Companies
Can’t Grow at the Same
Rate as Smaller or Newer
This is a difficult statement to prove or
disprove because smaller companies
can post great returns or they can fail.
Generally, we can say they have fatter
tails. We decided to compare the 30 Dow
stocks with the rest of the S&P 500 (see
“Dow 30 vs. broad market,” page 74).
When adjusted to 100 at the beginning of
2004, both the Dow exchange traded fund
(DIA) and the SPY performed nearly the
same. We can see that the Dow stocks
represent about 25% of the S&P total
capitalization, which still leaves enough
room to separate the performance of one
index from the other.
Our conclusion is that big companies
can perform as well as smaller ones. Of
course, it doesn’t hurt that Apple (AAPL)
is part of the Dow, and that some smaller
companies can implode, but if we allow
exceptions to every rule, there is no way to
draw any rational conclusion.
Myth 2: The Dogs of the
Dow Take Advantage of
The Dogs of the Dow was popularized by
Michael O’Higgins in Beating the Dow
(1992). In those rules, you bought the 10
highest yielding Dow stocks on Jan. 1 and
held them for the rest of the year. For the
period 1973 through 1989, that method
would have beaten the average return
of the Dow by 6.8% per year. However,
in 2017, the current thinking is that high
yields mean low returns. After all, why
pay shareholders a high yield when the
stock is soaring, like Apple? We’ll use the
concept that a high yield generally means
lower returns, and take an easier path
analyzing the Dow.
Buying the 10 Worst
Performers in the Dow
The Dow members are all substantial
companies. When they want to attract
more buyers they raise dividends. They are
always trying to improve their market
M o d e r nTr a d e r. c o m
Issue 537
The chart on the left shows the returns of the DIA and SPY from 2004; the chart on the right bottom shows the
percentage of Dow to S&P total capitalization by year.
share by introducing new products or
some new innovation. For those reasons,
it is possible that the worst Dow stocks
might rotate upwards in their returns.
“Contrarian approach,” (page 73)
show the results of buying the 10 Dow
components with the worst returns, then
rebalancing annually (every 252 days).
Based on a $200,000 investment, each
stock is allocated $20,000 and the
position size is $20,000 divided by the
price at the beginning of each year, a
simple way to get volatility parity.
The results show a drawdown of about
$30,000, or 15%, from 2008 through
2010, far less than the drawdown of the
whole market. Otherwise, the net return
was only slightly more than $15,000.
We can calculate the simple return as
$15,000/200,000 divided by 12 years,
or about 62 basis points. Not a return
we would like but could be useful when
viewed as a hedge.
The results of DIA and SPY show DIA
with a return of 7.65% and an annualized
volatlity of 17.8%, and SPY with a return
of 7.55% with an annualized volatility of
19.1%. DIA’s risk/reward ratio is 0.429
while SPY’s is 0.395. Both are far better
than buying the 10 worse performers
of the Dow. While we can’t speak for
the past, this period shows once a dog,
always a dog.
Buying the Strongest
Most of us have figured out that a highquality antique or painting is more likely
to appreciate in value than a bargain.
Buying a Da Vinci oil is going to be a
better investment than buying a portfolio
of Da Vinci ink sketches. The high-end
appreciates faster (and is more volatile)
than the low-end.
If we buy the strongest of the Dow
components rather than the weakest, we
get returns that are much more attractive,
and slightly better than either the full Dow
or the S&P. “Going top shelf,” (right) shows
two sets of results for buying the top Dow
stocks. On the chart on the left rebalancing
is done yearly, the chart on the right shows
rebalancing done monthly. The yearly
rebalancing shows more volatility and a
flattening of returns during the past three
years. Using a faster, monthly rebalancing,
returns far exceed both DIA and SPY, but
with a slightly larger drawdown during the
financial crisis of 2008.
Stocks that are performing well most
often, continue to perform well.
November 2017
These results shouldn’t be a surprise.
Stocks that are performing well most
often, continue to perform well. The idea
that a price is technically overbought
and should be sold, is nonsense. Look at
Apple, Amazon (AMZN) or Tesla (TSLA).
The biggest winners defy fundamental
analysis, except in retrospect.
Myth 3: You Can’t Arbitrage
the Dow
A relative-value arbitrage takes advantage
of divergence in prices of two related
markets. Given two stocks in the same
industry, one stock is relatively strong
and the other is relatively weak. This
often happens when, for example, one
retail company releases a good earnings
report a week before a competitor. The
stock of the first company jumps while
the other lags, for lack of news. A typical
arbitrage is to sell the first and buy the
second; assuming that the earnings
announcement of the second will also
be good and it will close the gap. But
the companies in the Dow are not in the
same business, so they have no reason
to move together. They would only be
similar in that they reflect the price
reaction to the general economy.
Given a ranking of stocks by historic
performance, if we believe that the stocks
that are outperforming can’t be sustained,
then we can sell the best and buy the
worst. But then we would always lose
money because the top stocks would
M o d e r nTr a d e r. c o m
Below shows the annualized volatility of returns for a strategy that buys
the strongest 10 Dow stocks using a 23-day linear regression.
way to reduce risk and avoid unnecessary
losses is to deleverage when risk gets
extreme. In this case, we define that level
at 90. Then whenever we are rebalancing
(every two weeks), we reduce our position
by 50% if the annualized volatility is
greater than 90. When volatility drops
below 90, we reset our full position on a
rebalance day.
Hedging at the Same Time
continue to outperform and the bottom
stocks would likely continue to have the
same problems that pushed them to those
levels. The worst stocks might not even be
moving, so they wouldn’t provide much of
an arbitrage, only a waste of resources.
We are then left with the conclusion that
the best performing stocks are most likely
to continue to outperform. That means
the worst performers are not doing as
well. We’ll base our strategy on buying
the 10 best Dow stocks, evaluated using
a 23-day (about one month) rolling linear
regression of returns. We’ll rebalance
every two weeks.
Reducing Risk Using
Having settled on the stock selection,
we now want to reduce the drawdowns.
We’ve already changed the rebalance
period from monthly to every two weeks,
which makes us more responsive to
change. We still evaluate the price
performance using 23 days. If we plot
the daily returns of our strategy (not the
prices), we can get the 20-day annualized
volatility, the rolling standard deviation of
the daily returns times the square root of
252 (see “A better way,” above).
We take risk seriously, and the simplest
We can do more. Because we have 50%
of our investment available above our
volatility threshold, we can now go short
the 10 worst performers in the Dow at the
same time we reduce long positions. We
don’t know that these worst performers
will move in the opposite direction, but we
do know that they will underperform. In
fact, the combination of reducing position
size using volatility, and hedging at the
same time using available funds, gives
enhanced performance (see “Improving
our model,” page 76).
The final method has a return of 15.7%,
a volatility of 24.28%, and a return-to-risk
ratio of 0.646. That’s twice the return
with a ratio about 50% better. It doesn’t
eliminate the drawdown during the 2008
financial crisis, but it shows good overall
There is Always a Better
Investors need to consider alternatives,
always seeking better returns at lower
risk. This article was intended to point out
The performance of buying the strongest 10 Dow stocks differs based on rebalancing. The chart on the left shows the
Dow strategy rebalanced yearly, the chart on the right is rebalanced monthly.
M o d e r nTr a d e r. c o m
Issue 537
Here are the results of our enhanced Dow strategy compared to SPY and
three simple, but sound, concepts: Buying
strength is better than buying weakness,
reducing volatility during periods of
extreme risk is a sound principle and
identifying strength and weakness can
be used to profit and reduce risk using
A strategic or tactical approach to
investing doesn’t need to be complicated
to be good and it doesn’t need to use
obscure markets or chase the latest fad.
Active management can generate the
same returns as passive investing with half
the risk. It’s your money.
Perry J. Kaufman is the author of
“Trading Systems and Methods.” He is
a trader and financial engineer.
The LLP option pricing model provides
insight to option traders that is particularly
helpful in the energy complex.
Oil, Gas & the Log–Log
Parabola Options
Pricing Model
Q By: Paul D. Cretien
The log-log parabola (LLP) options
pricing model has proven itself to be a
valuable measure for pricing and trading
options across all asset classes. Here
we will apply it across the energy futures
complex, specifically, crude oil, natural
gas, gasoline and heating oil.
If you take a look at “LLP options pricing
on Aug. 25, 2017” (right), it shows the information that is produced by the LLP model.
For each strike price on the options chain,
the model presents five unique metrics:
1. The predicted option price,
2. The dollar difference between the option’s market price and predicted price,
3. The slope (or delta value) of the options
price curve at every strike pride,
4. Upper and lower breakeven prices of
the underlying futures contract at expiration
for a delta neutral trade (selling the number
For each strike price on the options
chain, the [LLP options pricing] model
presents five unique metrics.
November 2017
of calls equal to an inverse ratio to delta)
offset by a long position in the futures contract, and
5. The option’s premium.
For each options price chain the LLP
model generates a formula that permits
forecasting a put or call price during short
time periods (several days) and makes it
possible for a comparison between the
market price and predicted price at each
strike price.
Parabola Curve
The LLP model depends on an option
price curve being a log-log parabola, thus
the LLP title. Predictive formulas are regression equations in which the independent
variable (on the horizontal or X axis) is the
natural logarithm of the ratio of the futures
price to each strike price, and the dependent variable (on the vertical or Y axis) is the
natural logarithm of the call or put market
price as a ratio to each strike price.
A trader who uses the LLP model need
not be concerned with calculations beM o d e r nTr a d e r. c o m
LLP pricing metrics for energy complex
cause these are completed by the
Microsoft Excel spreadsheet in a
convenient size: 27 columns by 42
rows. The only input values are the
strike prices and corresponding
put or call market prices in the
options chain. The user also inputs
the number of strike prices in the
chain — from 3 to 20. Three is the
minimum number because at least
three points determine a curve.
Restricting the number of strike
prices to 20 permits the model’s
results to be shown on one page.
In addition to the calculation of
a log-log parabola for the pricing
of options, the LLP model may
be useful in other applications in
which analysis of data results in
parabolic curves. Instead of converting data into natural logarithms,
the program can compute a parabolic regression formula based
on non-logarithmic input. In this way, LLP
provides a parabolic regression function.
The dollar variations from predicted prices for calls on crude oil, gasoline, heating/
diesel oil and natural gas are small considering the dollar value of each option point.
For example, the largest price variance for
gasoline calls on Aug. 25, 2017, is $1.66
The natural gas price curve has separated itself from the rest of the
energy complex.
M o d e r nTr a d e r. c o m
while the value of each option point
is $42,000.
Because of the relatively tight fit
between options market prices and
prices predicted by the regression formula, it seems safe to say
that options price chains may be
described as log-log parabolas.
Natural logarithms of the ratios
of an underlying futures price to
several strike prices are related to
the ratios of natural logarithms of
call or put prices to the same strike
prices by a regression formula that
describes a parabolic curve.
The LLP options pricing model
uses the portion of the parabola
that extends from the smallest call
or put price (for a call, the largest
strike price on the options price
chain, and for a put, the smallest
strike price on the chain). When
the price of the underlying futures
contract becomes equal to a strike price,
the predicted prices want to follow the
parabolic curve instead of becoming closer
to the option’s intrinsic value (the option’s
value if exercised in terms of the underlying
futures contract).
“Oil and gas ETFs” (left) shows the
current position of energy futures in August
2017. Three of the energies form a relatively
tight group between crude oil, heating/
diesel oil and gasoline. Natural gas at times
moves away from this group, which may
present excellent spread trade opportunities
when the variations become large — as they
did in February 2017 and later in July 2017.
The petroleum-natural gas spread appears
ready to close up again by fall of 2017.
The LLP model may be used to compare
implied volatilities of underlying futures
contracts. For example, “December 2017
energy call options” (right) shows the price
curves for crude oil, natural gas, USLD
Issue 537
The LLP model shows more volatility in natural gas.
Call and put prices converge near the current
futures price for March 2018 crude oil.
heating/diesel oil and gasoline on Aug. 7,
2017. True to its nature as a sometimes
outsider, natural gas futures are viewed by
the options market with the largest implied
volatility. More volatility is rewarded by the
options market with the highest price curve.
At the low side of implied volatility is
heating/diesel oil. Gasoline and crude
oil are close together in the center of the
options price curves and in terms of implied
A look at what the options market thinks
of crude oil futures is shown in “Crude oil
call options” (right). Ratios of call priceto-strike price are related to the futures
prices as ratios to the same strike prices for
expirations at December 2017, March 2018,
June 2018 and September 2018. The chart
shows the accelerating decline in options
values as the expiration date is approached.
By computing the differences be78
November 2017
The chart shows acceleration in the decline of price
as the expiration dates nears.
The LLP model can
suggest calendar
spreads in cases where
call or put options
may be over-priced or
tween market prices and the predicted
price curve, the LLP model can suggest
calendar spreads in cases where call
or put options may be over-priced or
underpriced. The predictable speeding-up of declines in price for options that
are closer to expiration may be part of a
calendar spread trading strategy. The LLP
model assists by continuously showing
the exact height and shape of the options
price curves, with the Delta slope value
computed at each strike price.
“Crude oil March 2018 puts and calls”
(right) shows put and call price curves
meeting at the point at which the current
futures price for March 2018 crude oil is
equal to the strike price. The LLP model can
suggest trades in which calls and puts are
used on opposite sides of buy or sell when
one or the other happens to be overpriced
or underpriced versus the predicted price.
Access to the LLP options pricing model
has been easy because it was a free Excel
spreadsheet download from Futuresmag.
com. You can find the model, which comes
with instructions for its use here: http://
spreadsheets.php. Select the LLP model.
Until market makers and individual traders
change the way they price put and call
options, the LLP options pricing model
will continue to provide information on any
option price chain. We have concentrated
here on energy futures and options, but the
model is just as useful for metals, livestock,
currencies, grains and softs such as cotton
and coffee. Give it a try!
Paul D. Cretien is a financial analyst
and case writer for a graduate school
of banking. He writes articles analyzing
futures and options markets.
M o d e r nTr a d e r. c o m
MODERN TRADER provides cutting-edge actionable market research
while holding analysts accountable. And, when we publish specific
recommendations, we also will let you know how we did.
This KITE soared
In our January 2016 issue, long-term analyst
Ronnie Moas reinstated a long recommendation
on Kite Pharmaceuticals (KITE) after the stock
dipped below $75.
“Recommending a name with no earnings and
a $2.5 billion market cap is unusual for us. KITE
deserves to be an exception,” Moas wrote.
Moas based his outlook on clinical results of
new chemotherapy treatments to treat specific
types of Leukemia, a strong cash position and a
commitment to R&D.
It was a great call. KITE breached $100 this
June and in late August, Gilead Sciences (GILD)
announced an all-cash deal to acquire KITE for
$11.9 billion at $180 per share, a 30% premium to
its prior close.
Below are the trade recommendations from our May 2017 issue along
with an analysis and grade on how they worked out.
Security or Sector
Joseph Parnes
American Express (AXP)
Value (as of
Apr. 1, 2017)
Michael C. Thomsett
Wells Fargo (WFC)
Natl. Commerce Corp. (NCOM)
Fidelity Southern Corp. (LION)
East. Va. Bankshares (EVBS)
Nasdaq Bank Index (KBW)
Euro FX
Dow Jones Average
AXP rallied roughly 10% after dipping to $75 in early April.
Wells Fargo traded in a range in the spring and early summer before dropping
10% in July and August.
NCOM rallied close to 10% in the spring and has traded in a stable range
LION has traded higher, but in an extremely volatile and choppy manner.
EVBS strengthened up until its planned merger into Southern National Bancorp
of Virginia (SONA). However SONA stocks dipped after the merger was
The CPO expected the KBW to drop in the spring before rebounding in the
summer and once again turning lower this fall. KBW did just that, though the
rebound was stronger than anticipated.
The CPO called for the euro to drop in the spring before a sharp rally. The drop
was shallow but provided a strong buying opportunity.
The Dow did drop in March & April, but resumed its bull move and made an
all-time high by the summer.
John Blank
John Rawlins
Matt Litchfield
ABA Community Bank Index
The small bank ETF, QABA, has dropped but in extremely choppy trade.
Abe Cofnas
Mexican peso (eww)
Chart Patterns
Suri Duddella
Goldman Sachs (GS)
Crude oil
77.31¢ per lb.
The peso based ETF, EWW, has shown continued strength, up roughly 10%
since April 1.
The megaphone reversal pattern provided a short signal at $247 and its profit
target of $225 was hit shortly after. However, the entry signal was initiated
prior to this issue hitting newsstands.
Crude oil dropped roughly 15% from April 1 levels, but in very choppy trade.
Traders would have had to take some heat to cash in here.
Cotton eventually traded more that 10¢ below its April 1 levels, but first spiked
more than 15%. A lot of heat here.
Corn rallied roughly 10% in the spring before dropping sharply in July and
Andy Waldock
Note: Forecasts are scored A (weakest) to AAAAA (strongest) based on actual outcomes.
M o d e r nTr a d e r. c o m
Issue 537
Looking for liquidity where it exists
Raudys’ scientific approach
Q By Daniel P. Collins
Aistis Raudys was introduced to the trading world
as a data scientist working in the asset management
department at Deutsche Bank in London. He holds
a PhD in Artificial Intelligence, which he earned from
Vilnius University where he now lectures. He also holds
an M.S. in Software Engineering.
Raudys would go on to take a position with Societe
Generale Asset Management in London. He worked within the group’s quantitative/systematic commodity trading
advisor (CTA) . “I was developing trading strategies; optimizing and calibrating them,” Raudys says. “At some point
I was not agreeing with how we approached the process.”
Raudys is a data scientist and says the scientific
approach calls for you to have proof that some trading
systems are working on unseen data.
“They weren’t doing it in the scientific way,” Raudys
says of his work with Soc Gen. “I wanted to approach
trading in a more scientific way. Build strategies and test
them on a completely unseen environment to see if they
still made money.”
So Raudys went out on his own and began building
trading systems, thousands of them.
At Soc Gen, he was working on building longer-term
technical systems that mainly built trend following strategies similar to what a lot of the big CTAs have done. On
his own, Raudys looked at much shorter time frames and
focused more on mean reversion strategies.
He began trading his system for friends and family in
Lithuania around 2008, and in 2014 launched Chicago-based CTA Automaton along with Thierry Rabut. The
He constantly tests the performance of these substrategies and selects 400 from the thousands he has
created based on testing results and their correlation to
each other. “Some strategies started working
after the 2008 credit crisis, so you run the
simulation and see they were not making money
before that and the market changed and some
Principles: Aistis
new market inefficiencies appeared which
Raudys, Thierry Rabut
can be used to make money,” he says. “I have
Strategy: Short-term
some strategies that had been working well
Mean reversion
until 2011 and then we had the European debt
Location: Chicago
crisis and they don’t work anymore. The market
is changing and you can see that with the
performance of different strategies.”
“You have a lot of different combinations of the logic, of
the markets and of the parameters—thousands of them but
I can’t trade all of them,” Raudys says. “I go into this big
pot of strategies and select [specific strategies] based on
performance and the correlation.”
The program, which holds positions from one to three
days is extremely active with 3,000 trades a month, or
roughly 9,500 trades a year per million. This makes execution vital to its success, and Raudys, a data scientist at
heart, has created an algorithm for that.
Raudys researched executions, looking at whether it
would be better to execute actively or passively? What
order types would provide the best execution? Should it
be aggressive and use market orders? Should it be very
passive and use limit orders?
“We did loads of computer simulations and realized that
if we can be as passive as possible, that limits slippage,”
Raudys says. So he built an execution layer that takes all
the trading signals and automatically sends the order to the
exchange matching engines in the most advantageous way.
“At the very bottom, the strategies send the order to
the execution layer and the execution layer; if it needs to,
matches the trades if they are offsetting each other ; if not,
it tries to execute them slowly, gradually and as passively
as possible,” he says. “It tries to use limit orders. In all our
compilations we calculated that it is more profitable this
way than jumping straight into the market.”
Raudys says that his scientific background allows him to
optimize his strategies in one day as opposed to a month
when he was working at large institutions.
“Because I implement everything fast and efficiently,
it allows me to do the research cycles quickly and test
different ideas faster than the other guys,” he says.
Raudys researched executions,
looking at whether it would be better
to execute actively or passively.
Diversified Program has earned 16.3% since its inception
and is up 8.65% year-to-date through August.
Automaton has six core strategies that include a trend
following, countertrend and mean reversion approach.
But he has literally created thousands of sub-strategies
he runs all of the time on 48 of the most liquid futures
“Each strategy can trade 48 instruments, Raudys says.
“We try different combinations to see which ones work
the best and then select the best ones to build a portfolio
[of live strategies].”
November 2017
M o d e r nTr a d e r. c o m
U.S. economic data & select global influences
November: Trend
following tendencies
Q By Daniel P. Collins
M o d e r nTr a d e r. c o m
Average %
Best & Worst October % Change
Issue 537
PMI Services | ISM Non-Mfg | Construction Spending
International Trade | Redbook | FHFA House Price | Richmond Fed
Consumer Confidence
GDP | EIA Petroleum Status | MBA Mortgage
Dallas Fed | New Home Sales
16 17 20 21
Bank Reserve Settlement | MBA Mortgage | Durable Goods Orders
Consumer Sentiment | FOMC Minutes
Redbook | Chicago Fed | Home Sales
Import and Export Prices | Housing Market | Philadelphia Fed
10 14
Leading Indicators | Home Sales
MBA Mortgage | Consumer Price | Empire State Mfg | Atlanta Fed
Kansas City Fed
PPI-FD | Redbook
Courtesy of Stock Trader's Almanac
*1950 **1971
Consumer Sentiment
Vital October Statistics
COMP. **
Wholesale Trade | EIA Natural Gas
Reserve Bank of New Zealand Monetary Policy Statements
MBA Mortgage | Bank Reserve Settlement
Consumer Credit | JOLTS | NFIB Small Business Optimism | Redbook
TD Ameritrade IMX | Treasury STRIPS
Employment | PMI Services | ISM Non-Mfg | International Trade
Bank of Japan Minutes
Chain Store Sales | EIA Natural Gas
Bank of England Policy Meeting | Reserve Bank of Australia Interest Rates
Construction Spending | PMI Manufacturing | ISM Mfg
MBA Mortgage
FOMC Meeting
Modern Trader Monthly Trading Calendar - November 2017
OECD Composite Leading Indicators
A major key to the performance of
the stock market in November is what
happens in the previous months. As
noted here, September is the worst
performing month for stock indexes
(see “Dog days give way to down days,”
MT September 2017) and October is
also a weak performing month with a
tendency for huge swings. As a result,
November performance has a low bar
and often benefits from corrective rallies.
However, in the major crashes over the
last 30 year —1987, 2000 and 2008—the
market continued sharp sell-offs through
November; so if we get an October crash,
there is a decent chance that there will be
no November recovery.
November is one of the best performing
months for the major stock indexes and
also the beginning of a strong multi-month
stretch across all of the stock indexes.
It is the month many technicians who
subscribe to the adage “sell in May and go
away” choose to re-enter the market.
November is the second strongest
performing month in the S&P 500 since
1950 and the third best month in the
Dow Jones Industrial Average (1950) and
Nasdaq Composite (1971).
This tendency has held up over the last
decade. Since the 2008 credit crisis crash,
the S&P 500 has been positive in six of
eight Novembers with the two down years
registering only marginal single digit losses.
29 30
Guest Editorial
Yanking the tablecloth slowly
Q By James Grant
Quantitative easing was bullish. On this, you have
had the assurances of former Federal Reserve Chair
Ben S. Bernanke as well as the ocular evidence of
rising stock prices, falling commercial real-estate
cap rates and tightening credit spreads. Now that
the Federal Reserve is supposedly ready to begin to
contemplate, even, perhaps, to implement, a plan for
reducing the size of its bulging balance sheet, will
quantitative tightening not be bearish?
The ocular evidence is still to come, but the official
predictions are in. Quantitative tightening will not be
bearish, Bernanke’s successors at the Fed insist. In
May, Patrick Harker, president of the Federal Reserve
Bank of Philadelphia, invoked the image of drying paint.
Janet Yellen has approvingly repeated it.
Torsten Slok, chief international economist at Deutsche Bank, begs to challenge such glib assurances.
How can it be, he asks, “that QE only has positive effects and reversing QE will have no negative effects?”
The bottom line, Slok goes on, “is that either QE
policies have an impact or they don’t. You cannot have it
“Either QE policies have an
impact or they don’t. You
cannot have it both ways, …
that’s like saying that you
will only see an impact on
the economy when you
lower taxes, not when you
raise taxes.” -- Torsten Slok
both ways, where a policy only has effects when it is carried out but has no effects when it is removed; that’s like
saying that you will only see an impact on the economy
when you lower taxes, not when you raise taxes.”
Meanwhile, combined monthly asset purchases by
the European Central Bank, the Bank of England and
the Bank of Japan continue in the neighborhood of
$175 billion, Slok points out. So the paint isn’t dry yet
— the central bankers are still slathering it on — and the
fight for yield continues.
November 2017
Among the bemused and grateful bystanders to this
central-bank-induced food fight is the single-B-rated
government of Tajikistan, which expects to issue $500
million or more of 10-year debt at a cost of 7½% to
8% (down from a projected 7½% to 8½% in July),
according to its lead underwriters, Raiffeisen Bank and
Citicorp. The per capita GDP of the Afghanistan-facing
nation tallies to $804.
When the central banks protest that, come time to
remove the “stimulus,” you will hardly remember that
it was ever there, we visualize someone attempting to
pull a tablecloth out from under a setting of crystal. In
accordance with the laws of inertia and friction, the
knowing trickster pulls down and fast. The uncertain
novice timidly will pull slowly, to the accompaniment of
breaking glass.
We wonder if the central bankers, disingenuously
protesting that quantitative tightening will prove a nonevent and slow to begin the process of withdrawal, do
not resemble the hesitant novice attempting his first
yank of the cloth.
James Grant is the founder of Grant’s Interest Rate
Observer. He has written numerous books including
three financial histories. His most recent book: “The
Forgotten Depression: 1921: The Crash that Cured
Itself” argues that an alternative approach to the
2008 financial crisis would have produced a better
M o d e r nTr a d e r. c o m
The Past 12 Months of MODERN TRADER…
Options’ Options: Binarys,
Weeklys, Volatility ETFs & more
The annual options review talked to the leaders of various binary exchanges and looked at the evolution of the product, provided
an in-depth look at Volatility as an asset class and explored the convergence of options and ETFs.
Special Stock Focus: Amazoned! Breaking it up is not that simple examines the online retailers threat to disrupting multiple
sectors and seven analysts provide their unique outlook on the stock’s future performance.
Special Reports Included: Chipotle: New Health Outbreak, New Short, Do Airline Stocks Have Room to Soar? The Big Equity Short,
Amazon’s Next Conquest, North Korean Tension and the Return of Risk-on/Risk-off, Trading Bearish Shark Patterns, Trading Social
Media Sentiment Indicators, The Bonus Trade, Trading Weather-driven Grain Markets, The Macallan Virtual Reality Cocktail & Save
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