Debunking False Investment Assumptions (w/ John Bollinger & Tom Thornton)
TOM THORNTON: Hi, I'm Tom Thornton with Hedge Fund Telemetry. Today on Real Vision, I have one of my heroes, a technical hero, John Bollinger of Bollinger Capital Management, and the founder and creator of Bollinger Bands. John, thank you for being here in New York City. JOHN BOLLINGER: Thank you for having me on. TOM THORNTON: I know a lot of people are very excited about this interview. First time on Real Vision and I'm thrilled because I'm a technician and you have one of the best indicators. It's so many use. We've had this conversation earlier about how you developed your indicator, and it's a creative process that I think is rather unique. Also, it goes back before computers, so why don't you talk a little about that. JOHN BOLLINGER: I started right at the juncture of hand driven analysis and computer driven analysis. Of course, we had things like HP calculators and such like that to aid in the process but when I started, we mostly calculated indicators by hand, we kept trading butters, big like accountants pads with row of dates and times down one side and rows of prices and various instruments we were interested in, and then the various indicators and we didn't calculate many indicators because it took a long time. One of the benefits of doing that is we got to know those indicators intimately. We really understood how they behaved in different phases of market action. As we made the transition to computers, that knowledge gave an advantage to those who then were able to take advantage of the of the speed and power of computers, because we knew what to tell the computers to do. Today, people will walk up to a computer and they want the computer to answer questions for them, but we drove it the other way. We wanted the computers to do work for us. TOM THORNTON: That's fascinating. The basis of Bollinger Bands is trend and volatility. JOHN BOLLINGER: Absolutely. TOM THORNTON: Tell us a little about your indicators, you have three you mentioned to me that you use as your secret sauce. JOHN BOLLINGER: I don't know if it's a secret sauce, it's pretty public, but I use Bollinger Bands which are a type of trading band that is driven by volatility. It's the defaults are a 20-day moving average and the upper band is two standard deviations of the same data that you use to calculate the moving average plotted above and then the same interval plotted below. Those bands, like all bands, many types, Donchian bands, percentage bands, Keltner bands, etc., they all answer the same question. They all answer the question as to whether prices are relatively high or relatively low. You can then use that information to create trading systems and defined trading approaches. When I started, we had an assumption about volatility. We thought that volatility was stable, like the sky is blue or the house is white. For example, we thought IBM's beta, which is a measure of volatility, was 1.1 and that was it. We calculated once it a year using five years of weekly data because we didn't think that it changed much. I was an option trader so I was very lucky I had an early computer. One day, I copied a formula for volatility down a column of data, and I saw that was changing a lot. We have been searching for a way to automate the changes in trading bands because we would mostly use percentage trading bands in those days. As the regime change, you'd have to tighten the bands or expand the bands. When you did so, you'd let emotions into the process. If you're bullish, you draw the bands to present a bullish picture. If you're bearish-- so I really wanted to avoid that. I was looking for a way to automate the setting it with the bands, and I saw volatility changing so like, aha, that might be it. It turned out that it was exactly the right way to make trading bands adaptive. TOM THORNTON: The aha moment? JOHN BOLLINGER: Yeah, exactly. It earned a Nobel, not for me, it earned a Nobel for Robert Angle about 10 years ago. The Nobel Committee recognized how important that observation of volatility was volatile was, he did work on inflation in the very early '80s and it was exactly the same time that I did my work on Bollinger Bands. What it was is that was in the air, people were beginning to question those assumptions and it's that questioning process that's so important. TOM THORNTON: That leads me into something that I think is really important right now. There's a lot of assumptions, things that people "know" in the markets these days, and I have a list of six of them that I thought we could discuss, and you can give me your opinion on things that people just assume are the standard. Let's go right into indexing. JOHN BOLLINGER: Well, just to start with, my idea is to question everything. I think that that's what everybody should do. You should look at all these ideas that are out there and question everything. For instance, indexing has byproducts that people don't really recognize. The more you index, the more you weld the prices of all securities together. If you start indexing something like the OEX, which has 100 stocks in it, when you buy or sell that basket, you move all 100 at the same time, that's what I mean by welding them together, but now, you start indexing the S&P 500 and it's 500 stocks, you start indexing the Russell 1000, 2000 or 3000 and you're really indexing the whole market, just gluing the whole thing together. Out of that, did comes a destruction of diversification. That's one of the things that I think people should be questioning, is the benefits of this diversification. We've seen, as we saw in the 2006, '07, and '08 period, when the market came under real pressure, correlations for virtually all investable assets merged on one. What we mean by that is that everything went down together, even things that weren't supposed to because professionals, when they come under pressure, if they can't sell what it is they need to sell, they sell something else, they sell whatever they can sell. TOM THORNTON: Diversification was another one that people say it's great to be, you got to be diversified. It works well when everything is going up but when it's going down, like you said, correlation. It's all together and there's nowhere to hide. JOHN BOLLINGER: Right. That's really, I think, a byproduct of this mania for indexing. The whole thing was 10, 15 years ago, the idea was that if you just invested in the market, if you just bought the S&P 500, you were entitled, entitled to earn 8%, 9%, 10% a year for the rest of your life just for the act of having indexed. Well, we all know the market doesn't actually work that way. We came into circa 2000 and an entire generation of people who are facing retirement over the next 10 or 15 years, the baby boomers made that assumption. They bought those index funds, and they said, aha, if I go up at 8% per year for the next 15 years, I'm going to have everything I need to retire. Well, the market didn't cooperate. It went sideways for 15 years, and so it didn't deliver virtually any returns, well, it did deliver a little bit of dividend income, but it didn't get delivered the 8%, 9%, 10% that many people had promised that they would earn if they indexed. These assumptions, I think they're very dangerous and it's very important that we question them. Very easy to say, index and you'll be safe, but it's a bigger question than that. TOM THORNTON: Well, one of the things that you see on TV and you hear from everyone, the market's having a great year, but if you go year over year, and here we are in the end of October. If you go back a month, the S&P was basically flat for a 12 -month period. Your concern with indexing is if things go sideways, or let's say they go down, that's a large risk for the average investor. Now, the average investor another thing, ETFs are safe. JOHN BOLLINGER: Well, yeah. One of the things that indexing has done and I don't think people realize yet and it's the same story with ETFs is it's made stock picking more attractive. The market's going sideways over the past timeframe as you suggested, there were many opportunities in the individual stocks to make it better than market return and many professional managers, many hedges and many just ordinary investors, people who still thought about investing in individual stocks rather than in indexes or funds of various sorts, they were able to do very well over the past year, but on average, the returns just weren't there. I think there's a really good aspect ETFs. The ability to buy like individual sectors or very specialized pieces of the market and experience that return chain that ETFs can offer, I think that's a fabulous opportunity for investors and if they go after that wisely, I think that that can be a tremendous benefit, but this panacea idea, buy the ETF and you'll be okay, well, not so much. TOM THORNTON: Well, there's another thing, too, that on assumption, liquidity is great in the market. JOHN BOLLINGER: Well, yeah, liquidity is great in the market, isn't it? But it's only great until it's not great as we saw in-- as we saw so clearly in the 2006, 2007, 2008 sequence. There were times when you really couldn't sell anything. It just wasn't possible, they were not fit. It seemed like a very liquid market because the volumes were there, but the volumes were created by people engaging in capitulation. I don't think people normally think of capitulation and liquidity in the same breath, but I think they should. The idea that liquidity will be there when you need it, I think that that's probably a false idea and that you ought to be ready to field some defense when the going gets rough. Before the going gets rough that is, and I think this idea that market timing is somehow not a reputable idea. I think that's crazy. I think you have to engage in market timing, you have to recognize times when the risks are increasing, and the dangers are building up, especially in these days with all this index going on, and all these securities welded together. TOM THORNTON: Yeah, I would agree 100% with your thoughts on the sectors because sectors will rotate and that's a natural thing throughout the year. You'll see technology go up and go down. You'll see the energy market especially is a very good one. I think that's really important and I'm a market timer as well so I 100% agree. JOHN BOLLINGER: Yeah. I don't understand why market timing is in disrepute. I think it's an in central discipline. I don't think that that means that you buy everything by 100% today, and sell 100% tomorrow, which is what some people think market timing is, but I think good market timers recognize when risks are increasing and some money ought to be taken off the table or as we often say on the street, we already got a little closer to home. TOM THORNTON: Yeah, exactly. Okay, one other thing that I have thought about, and it's an important day today because of the Fed's meeting, don't fight the Fed. JOHN BOLLINGER: Well, that was one of Marty Zweig's two big maxims, don't fight the Fed and don't fight the tape, both of which in their time, they were perfect. They described the best set of behaviors in relation to market that could be imagined. In this last interest rate cycle with zero interest rates, I think that don't fight the Fed part of it is been called into question in a pretty dramatic way. We found in certain environments that falling interest rates are, in fact not a good scenario for stocks and that, in fact, rising interest rates might be a good scenario for stocks. That's the opposite of the perceived wisdom. It has also done a lot of damage to academic theory. For example, what is the Sharpe ratio when interest rates are zero? TOM THORNTON: You can't calculate it. JOHN BOLLINGER: I think these are very challenging times in which you need to look at the realities of the marketplace and keep yourself tuned to them. Another example is this has been a very bad news year. We've had tremendously volatile news, good, bad, etc., virtually continuous news cycle of stuff that upset people, made people uncomfortable, made people unhappy yet on balance, the market's done okay through this. You couldn't have convinced anybody say five years ago then if we went through this news cycle, stocks would actually be trying to break out which is what they're doing now. You would have thought that it would have created a bear market. TOM THORNTON: That's been this ping pong battle over the 50-day moving average back and forth with tweets and everything. Okay, let's talk a little about current times right now. What do you think of some markets, like the US markets, do you have anything to talk about, rates? JOHN BOLLINGER: Well, there's a whole bunch talk about. A lot of people are trying to hide in bonds right now and bonds have the worst risk reward ratios that you can imagine. What's the upside for buying a bond now? You get a couple percent income and if rates continue down, seems highly unlikely since they're near zero to start with, you get a tiny bit of capital appreciation. If rates rise just to historic norms, and you say own a 10-Year Treasury, you're going to be looking at a 50% decline in the value of your capital. The potential reward in bond is very small. The risk should inflation reignite, I guess nobody believes that we'll ever have inflation again, which means that it will be a show up tomorrow morning, but if inflation's reignite, these bond portfolios that are bought at interest rates of 1% and 2% and 3%, when we go to interest rates of 5%, 6%, 7%, 8%, those portfolios are going to be destroyed. My whole has always been fine, trades where the risk and reward ratios are in your favor for example, with Bollinger Bands, you make a W bottom in relation to the Bollinger Bands. You can put on trade, you can risk a relatively small amount with a defined potential, nothing guaranteed about it but it's defined potential. You can put on a trade with risk and reward criteria are in your favor and the odds of success are also in your favor because you go back and test it and say, well, this trade worked 66% of the time which is to say two out of three times and I risk a few percent, 4% or 5% on the downside and maybe the reward's 10%, 20% so you have a decent success rate and you have a decent risk reward ratio. That's positive for investors. That's the thing that you can actually make money with over the years and keep volatility down the opposite, which is what bonds are now where risk is huge and reward's tiny. I think that's suicide. I understand that that there's a perceived safety-ness in bonds but I think we ought to question that assumption. It's one of those assumptions. TOM THORNTON: Yeah, absolutely. The other thing that makes me just crazy is its capital appreciation, what bond investors have achieved this year and nice dividend paying-- JOHN BOLLINGER: George, life that in. TOM THORNTON: Buy stocks for nice high dividends so when you have the stock market yielding more than the bond market and bond investors are trying to get capital appreciation, it's whacky. JOHN BOLLINGER: That was a holy grail set of indicators, the bond stock ratios and such like that, both for quality and for high quality bonds, for junk bonds, for low price stocks, for high price stocks, so on and so forth. There's a whole basket of the of those indicators, and they worked for years and years and years. But in the zero interest rate environment, those indicators are moot. They just-- I don't know what they mean in this environment, but they don't mean what they used to mean. It's not to say that they're not worthwhile, that they're not generating information, but it's not the information that they used to generate. If you try to operate those on the old rules, you're going to get your clock cleaned, but there may in fact be uses for that information in this new environment. I just haven't explored that. TOM THORNTON: Well, the Fed in a few hours from now, and when everybody watches it, they'll know they cut or they cut another 25 basis points, is it just mindboggling to you that they're cutting rates at S&P 3000 all-time highs, low unemployment? JOHN BOLLINGER: It's not so much mindboggling that they're doing that. What's mindboggling is the sequence of rate rises that preceded this which were totally unnecessary. Their excuse was that, oh, we want to get rates up to a point so that we have some ammunition should we need it. Really? Is that the way you run monetary policy? We want to make sure that we got a stack of bullets here and that's not-- I did not think that that was the job of the Fed. I think that that sequence of rate rises forced them into this sequence of decline, and I agree with you, they should not be in the situation of having to cut rates into a very high valuation environment. I think the latest GDP indication we just got is 1.9%. That's not negative GDP. Those aren't recession numbers. That's not back to back negative quarters of GDP, which is what the Fed ought to be fighting with lower rates. TOM THORNTON: Right, and unemployment at 3.50%, and it's just really. JOHN BOLLINGER: 10, 15 years ago, my thing that I argued was the most important thing was not the unemployment rate, but the total percentage of the US population that was working, the employment rate. That had declined dramatically for many years and then went to a static record. That's now rising. As you point out, 3.50% unemployment, but you can look on the other side of that, and that number looks very good as well, after a long time where that number looked hopeless for the future. More and more people being employed as a percent to population, I think that's a very positive trend. I don't think anybody's talking about that. TOM THORNTON: Yeah, I think you're right. Well, I want to wrap it up with a question on what you think is the most pressing issue right now for investors in the market? JOHN BOLLINGER: Well, I think the most pressing issue is the same issue that it always is, it's discipline. We've too many people invest in an undisciplined manner, but have to have a rigorous rational approach to investing and we have to employ it come whatever the market does. I think that these assumptions that we should index or somehow, that we don't have to take responsibility for investing. The typical man or woman out there has a job. They may have probably have a partner, they might have a family that they're trying to put together a future, so they're generating some income and they're putting into savings. Well, investing is part of their job and they need to realize that. You have two choices, either you can do it yourself or you can pay somebody to do it for you, an investment manager. You can examine their track record and their discipline and what their ideas are and see if it suits you and to suit your approach. But this idea that somehow that they're just returns, that they come to you from the fact of investing. Not so much. It's work. It's a job and it has to be done and has to be done with discipline. TOM THORNTON: It's going to get harder out there. JOHN BOLLINGER: Yeah, I think it will. These are extraordinary times. This is a zero interest rate environment that we're in. We've never seen anything like it before. We have to really pay very close attention to what's happening. There are real risks out there, but there are real opportunities out there. I'm not a Cassandra in any way whatsoever. I'm actually very bullish on equities here. I think stocks are going to do well for quite a while, at least into the end of the year and early into next year. I'm not a Cassandra. I just think that we need to do some work. TOM THORNTON: Well, I'll leave it at that. John, it was great to meet you. Thank you for coming on Real Vision. Everyone, I just want to say thank you for having me. I feel honored to interview John and we'll see you again soon.