The 10th Man: Mean Reversion Monkeys

The buzz has been building on this trade for weeks. Clients, friends, people on Twitter, everyone I know has been waiting for a chance to pick the bottom in oil.

I’ve heard all this chatter on which triple-leveraged oil ETFs to use (I make a point of not knowing such things). They’ve been waiting for this opportunity since oil was at 80 bucks.

Interestingly, they could have shorted it when it was at 80.

Actually, they could have shorted it at 110.

Or 100.

Or 90.

Or 80.

Or 70.

Or 60.

Or 50. They could have shorted it at 50 and still made money.

But they waited this entire time, watching passively as oil plummeted over 60%, to play a 10-point bounce over the course of a couple of days.

Well, the mean reversion monkeys, as I call them, will tell you that they just made 20% in three days. Annualize that!

Problem is, it doesn’t work that way, because you can’t flawlessly pick every bottom. I was a mean reversion monkey once, and for every time I made 20% in three days, there were three other times I almost got carried out—like that time in 2008 when I tried top-ticking the Canadian dollar. That one was painful.

Have you ever heard of a CTA? CTA stands for Commodities Trading Advisor. It’s basically like a hedge fund that trades futures, but these guys are notorious trend followers. This is how John Henry, owner of the Boston Red Sox, made his money. They trade futures, they trade with leverage, and when stuff starts moving, they follow the trend. They don’t care what it is, or which way it’s going. The trend is your friend. There weren’t that many people who made money on falling oil, but the CTAs absolutely killed it.

Ever notice there’s no such thing as a CMRA? A Commodities Mean Reversion Advisor? That’s because they wouldn’t make any money.

The vast majority of traders and investors are mean reversion monkeys. I would place the number at well over 90%. Maybe 95%. You can make money as a mean reversion monkey, but not much. Basically, you are relying on your ability to scalp in and out of things continuously to make money.

And you wonder why average hedge funds only make 5-6% a year if they’re lucky. They cut short their losers, but they cut short their winners, too.

At the end of 2007, when I was still trading proprietarily at Lehman, I did an interesting exercise. I went back and looked at the P&L of every trade I did over the course of the year. I had one or two big winners, with small ups and downs everywhere else that all canceled each other out. If it weren’t for the one or two big winners, where I happened to bet big and let the profits run, I would have basically been flat for the year.

In fact, I think if you analyzed anyone’s portfolio, it would look pretty much the same. In a portfolio that’s up 10%, you’re going to have one or two huge winners, and everything else will be chopped salad.

The reality is that most people are only good for one or two good ideas a year. Maybe less.

So wouldn’t it make sense to put as much money in those ideas as possible?

Market Wizards

If you go back and read your Jack Schwager Market Wizards books, and read about all the stud traders, you won’t find one of them who would be buying triple-leveraged oil ETFs for a 10% bounce in oil. No. Those guys would have had the dominant trend right. They don’t care about the countertrend, because that’s not where the money is.

Trading with the trend is the only way to make meaningful amounts of money. All of Wall Street right now is doing a smug victory lap for their scalp in oil, but the funny thing about scalps is that people get greedy and, as trends often do, oil will make lower lows and people will find themselves sitting on losses instead of profits. Catching the falling knife requires so many things to go right simultaneously to work.

Have you ever met someone who has money all out of proportion to his intelligence? Someone who just goes around with a horseshoe up his ass? The guy that bought Apple at $50 and sold it at $700.

“So,” you ask this dude, “why did you buy Apple?”

“It was going up.”

It was going up. This is not someone who you think is particularly smart. But maybe he made $500,000 on this trade. And now he is long the iShares biotech ETF (IBB). How does he do it? How can someone so intellectually lazy be so rich? I mean, you spend hours staring at charts and watching oil tick for tick, and you timed the bottom perfectly, and you make… 10%.

The Magic of Compounding

Research has shown that owning equities with the dividends reinvested is about the closest you’re going to get to a sure thing in the markets. And your holding period needs to be long (like Buffett’s) so earnings/cash flows have a chance to compound.

I’m sure you’ve done that exercise where you were earning 3% interest in the bank and you want to see how it compounds over time, so you stick it in an Excel spreadsheet and do the math. Same thing. If you don’t give something a chance to compound, the odds of making a meaningful amount of money are very small.

Have you ever noticed that anyone who gained notoriety for being a day trader did so 15 years ago? There was no other time in history where you could literally make a living by cutting your winners short.

As for being intellectually lazy, well, there’s a difference between being smart and having a psychological need to prove you’re smart, or different. What’s wrong with holding IBB if you are making money? Seems easier than buying something that hasn’t had an uptick in months.

Like most sell-side guys, I was a mean reversion monkey back in the day. I’ve spent the last several years unlearning everything I had learned. Yes, investing is one of the hardest things in the world.

But shockingly, it doesn’t have to be.

Position: At the time of writing, Jared Dillian was short CAD

Jared Dillian