We Study Billionaires - The Investor’s Podcast Network - TIP204: Momentum Investing Strategies w/ Dr. Richard Smith (Business Podcast)

Starting point is 00:00:00 You're listening to TIP. On today's show, we bring back our good friend, Dr. Richard Smith. Richard is an expert in momentum investing and is the founder of Trade Stops. He's an alumni of Berkeley and has used his background in statistics and mathematics to model normal and non-standard momentum trends in financial securities. Since Stig and I are avid users of his momentum service to augment our own value investing approach, we are always thrilled to have him on the show and talk about the current. trends and ideas. So without further delay, here's our interview with Dr. Richard Smith.

Starting point is 00:00:36 You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. All right, welcome to The Investors podcast. I'm your host, Preston Pish, and as usual, I'm accompanied by my co-host, Stig Broderson. As we said in the introduction, we have our good friend, Richard Smith with us today. So Richard, welcome to the show. Preston, it is great to be here and really excited to be with you, Stig. All right. So Richard, Stig always wants to ask this first question, especially when we have people that were talking about current market conditions and kind of where they were seeing things going. So he cannot wait to ask you this question. So Stig, go ahead and

Starting point is 00:01:30 fire away. I think quite a few of listeners already familiar with you, Richard, because you were on this show here back in late March. And at the the time you were talking about which sectors you saw a strong momentum trend. And you mentioned three. I know I'm really putting you on the spot here, but you mentioned consumer discretionary, financials and technology. So quite a few of us are curious to hear like what has happened since. Did your prediction hold? Well, I think I got two out of three. Consumer discretionary and technology have both outperformed the S&P 500 since we last talked. I think they're up about 13% and 12% respectively.

Starting point is 00:02:13 Finanials have flatline. They're up about 4% versus about 10% for the S&P 500. So two out of three ain't bad, huh? No, I don't think it's too bad. I'm going to put you on this spot here even more because now that you had two out of three, I'll ask another tricky question. So we are in the middle of August, 15 August here. And what kind of lucrative momentum trends are you seeing right now?

Starting point is 00:02:42 And it could either be in individual stocks or it could also be in sectors. Yeah. Well, there's a couple of areas that I'm excited about. One is small cap stocks. So one of the things I've been looking at is market capitalization. And back in kind of the early part of the year, right, when we had the correction back in February or so, I got really worried about large cap and industrials. I was very struck by the fact of how well midcaps and even better small caps we're doing.

Starting point is 00:03:15 So I think small caps have probably the strongest momentum in the market right now. And I think there's a kind of viable economic reason for why that might be the case. I think they are less threatened by all the trade war concerns that are going on around the world globally right now, a little more domestic focus in the small cap stocks. So small caps is an area of the market that I am very personally attracted to right now. You know, it's an overlooked sector of the market, right? And it's really a unique section of the market that we have an opportunity to dig into ourselves and to invest in that a lot of the bigger institutional players can't really maneuver in that in that small cap space. So small caps is one area of the markets that I'm really excited about.

Starting point is 00:04:01 So, Richard, when you say small cap investing, how do you recommend people step into that type of investment? Do they buy individual companies, buy ETFs? Give us an idea what you're talking about here. I think that the retail investor has an opportunity to really look into individual small cap stocks. So, of course, there are ETFs, you know, there are ways to invest in small caps broadly. I think finding a good source of small cap ideas and then applying some of the strategies that we'll probably be talking about today like momentum and volatility to individual small cap

Starting point is 00:04:41 ideas is where I'm personally very interested myself. Could you be a bit more specific in terms of perhaps even like put some numbers on? Like so what is the strong price momentum by your definition? What should we be looking for? I came up with a proprietary. momentum indicator a few years ago. It's a moving average type of indicator. It tends to be a little longer moving average, but it is unique for each asset that I apply it to. Okay, so it's not just a 200-day moving average. It's not just a 50-day moving average. We actually look for the moving average

Starting point is 00:05:19 that has the best bounces off of trend. Okay, so when a kind of price falls down, hits the trend line, and bounces back up. That's what I'm really looking for. So I want to see strong bounces off of the trend. So I actually will analyze, you know, quantitatively, a range of moving averages for every different asset in our database and look for the moving average that has the strongest bounce off of trend. So those tend to be a little longer, say, between 100 and 300 days.

Starting point is 00:05:53 And that is also overtrading is one of the, biggest reasons that individual investors tend to underperform the markets. You know, it's so easy to just click a button and make a trade today, you know. And we always have this urge to do stuff, you know, to fix things. And, you know, as Jesse Livermore, I think it was said, you know, the investor that can be right and sit tight is going to be more successful. Let's talk more about those different ranges. For most people who would then go into stock investing, before they discover value investing,

Starting point is 00:06:31 which is really like the foundation of where Preston and I are coming from, most people would go into trading. They start looking at those moving averages and suddenly, you know, candlesticks charge and whatnot, and suddenly it becomes a bit more complicated. They are looking at should it be like 10 days? Some people would say that or 20 days. And then Richard, you come here on the show and you talk about two. 200 days moving average and you talk about a longer hole in a period. So could you talk to us some of the advantages and disadvantages there are to those two approaches,

Starting point is 00:07:04 just like the extremes, if you want to put it like that in training? Yeah, I mean, so just taking a step back for a minute, I am a big believer in a moving average strategy. And the main reason is because it is a, it's an improvement over the behavioral biases that all investors bring to investing, right? We think we can go into the markets and make, you know, shoot from the hip decisions about what to do that somehow we're smarter than the markets. And it's just, it's not true, right? You have to get run over by the markets a few times before you go, man, that just doesn't work. And I don't want to do that again, right? So I think what a moving average strategy does at its most basic level is it lets us behave better in the markets more consistently, right?

Starting point is 00:07:51 and behaving consistently following a system is going to put you in the minority of market participants, right? So that's how I see it. And I think that is so important. And it reflects back to sort of my personal journey, you know, into getting where I am today. I started by advocating a 25% trailing stop strategy, right? It's a mechanical strategy for individual investors, you know, sell when the stock falls 25% from its high. don't sell if it hasn't. And I was just amazed how when I would apply that to portfolios,

Starting point is 00:08:26 newsletter portfolios, individual investor portfolios, I would almost always see improved performance. What I eventually figured out why is because of a insidious bias that we bring to every investment decision we make. And two Nobel Prizes have basically been awarded for this in economics now, the first two Daniel Conneman and then Richard Thaler, right? We are risk. seeking when we're losing. So we want to take more risk when we're underwater. We want to put more money into these positions. We want to double down, try to get back to break even. But we are risk averse when it comes to our winners, right? So we get up 50%, 100%, and we start to feel like, oh my God, I better take those profits off the table before I lose them. That is a incredible bias that

Starting point is 00:09:13 that, you know, seeps into every investment decision that most individual investors make, and not just individuals, professionals, too. And so a simple strategy, like a 25% trailing stop strategy, reverses that. It makes you risk averse with your losers and risk seeking with your winners. So those are the kinds of things that I've come up against personally as an investor, that I think these quantitative strategies, even like a simple trailing stop strategy or a simple moving average strategy, have alpha for individual investors because of the behavioral biases that we bring to the market. Let's take a quick break and hear from today's sponsors.

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Starting point is 00:14:22 own a business forever. So we're curious about your personality and why you implemented this kind of investing. Well, I'm a mathematician by training. So I'm attracted to quantitative strategies, right? I'm running a business. I have three kids that are still in school. You know, I'm married. I don't have time to be watching the markets on a day-to-day basis, you know.

Starting point is 00:14:47 I actually, and I believe that, you know, watching prices flicker during the day is bad for your wealth and bad for your health, you know, unless you're a day trader, right? And I think that the best way to do that is to focus on a little longer time horizon than most people are focused on. I think there's this kind of push to the shorter term timeframes because it's more exciting. You can stoke more greed and fear and the media can really grab your attention on a constant basis, you know. And I want to tune all that out. A lot of my work is about, you know, figure out how much noise, you know, you have to put up with in order to be in the markets and then make sure that you're ignoring that. And then noticing kind of when it's not noise, when it's moved beyond just noise, right?

Starting point is 00:15:33 So my goal is to tune out as much noise as possible. But have my ear open for when it's signal and not noise. Oh, yeah, I absolutely love that you say that. It kind of reminds me whenever we're talking to Guy Speer and he was talking about how one of the most valuable personal traits is really to stay sane. It's not about like doing all those amazing stuff. It's actually more about not doing all the stupid stuff. I totally agree, man. I totally agree. Let me take one step back and just share another sector of the market that I'm excited about personally, and that's the energy sector. So I see a lot of strong momentum in the energy sector right now. Energy for me is something that is kind of particularly interesting. It's been beaten down for years. You know, it's really just starting to show positive momentum now. And I think the energy sector is a very exciting area of the market right now.

Starting point is 00:16:26 So whenever you talk about going into the energy sector, are you then looking at the price momentum of the various stocks? Or are you more looking at, for instance, something like the oil price that has really been soaring and then saying, well, that's the underlying factor anyway. In the case of energy, I'm looking at both. Oil has had positive momentum now for at least a year, probably 18 months. And that's a trend that I've been all over since the beginning. and it's an area of the market that I really get excited about in part because I used to be oil used to be my total nemesis when it came to, you know, investing and speculating. And it was because oil was a lot more volatile than I realized, right? So I have this indicator that I call the volatility quotient or the VQ. In oil, you know, it's typically like 30% on average. You don't think for a massive commodity like oil that it's,

Starting point is 00:17:23 can swing around 30% in a year just because of noise in the market, right? But it does. So once I understood how volatile oil was and that it wasn't something that you could basically kind of short-term trade, that really helped me out in terms of being able to understand the oil markets better. So oil's been on a nice uptrend, has had good momentum for 18 months. That has started to transfer into energy stocks itself, so XLE. I look at the spider sector ETFs to kind of understand the sectors of what's going on in the markets. XLE has great momentum right now. And I think if you drill down into XLE, you find the individual stocks that are in the XLE. Very interesting pick. And let's talk about momentum investing in a potential bear market. I think to a lot of investors

Starting point is 00:18:17 out there, they might think it's kind of odd. I would be speaking to a momentum investor about a bear market. But you brought up like whenever we saw the drop of 10% or whatever it was back in February. What does your indicator tell you about what happened back then? I'm sure that's something that was on your radar. And is there ever a point where you would simply start shorting or are you just like not long in that period? I do still have a concern about kind of large caps and industrials. in the U.S. stock market right now. My momentum indicators told me that they, you know,

Starting point is 00:18:53 the S&P 500 and the Dow fell more than they should have fallen just based on normal noise in the market. And I use volatility to define noise here. So I've been kind of very cautious about large caps for a while. You know, obviously the bottom didn't fall out of the market, right? and the S&P 500 is actually hasn't made new highs yet, but it's getting close. But I still saw strong momentum in the NASDAQ 100 and in the mid caps and the small caps of the market. So I really didn't see the market breaking down as a whole. You know, I think momentum is starting to return to the market overall in spite of what we've seen for, you know, the past week, right, with some prices falling. I'm not a big believer in shorting myself.

Starting point is 00:19:39 It's not that I'm not a big believer in it. I'm not that comfortable with it personally, Stig, you know, to me, going to cash is my form of shorting, right? So I will look for indicators, you know, when I see the market starting to fall apart across, you know, all market capitalizations, all sectors, I will be looking to go to cash. And basically going to cash is my form of shorting the markets. So let's talk about volatility. Whenever you read up on stock. investing. There's all these write-ups about volatility and the importance of not having too much volatility. And I'm always referring here to value investing, which is really like the core here

Starting point is 00:20:22 of most of our listeners. Because they've been brought up with volatility and to some extent is good. You know, volatility means that you as a value investor by doing fundamental analysis, K going to say, it's undervalued, I can buy, it's overvalued, I can sell, especially if it's out in the extreme. So for you, is volatility good or bad? And how do you optimize your portfolio accordingly to volatility? Yeah. Great question. And I think this is a really interesting area for investors to be looking at. So I kind of stumbled upon volatility as a way to help me in my investment decision making because I started out with trailing stops. And so initially, my interest in volatility was to find the optimal trailing stop that I could use on any stock.

Starting point is 00:21:16 Okay, so I was using 25% trailing stops as a strategy. And I was like, well, it doesn't make sense to use a 25% trailing stop on all stocks, you know, if I'm investing in a small cap energy company or I'm investing in Walmart or Johnson and Johnson, those are totally different stocks. So I used volatility and I came up with this volatility quotient that I call it that was an optimal trailing stop loss strategy to use on any stock. But when I saw that number for each of the stocks in my database, it started to change the way I thought about my investments and changed the way my subscribers thought about the investments. So just to see like Johnson and Johnson, Walmart, 12%, a small cap energy stock, 50%. It was like, whoa, what does that mean? Right? So that was very

Starting point is 00:22:03 interesting to see those numbers and go, oh my God, you know, that stock has a 50% volatility quotient, 50% VQ. Maybe I shouldn't put half of my portfolio into it, you know? Because, and again, we tend to want to put more money into the stocks that we're most excited about. The stocks that we are most excited about are the ones that have great stories. The reason they have great stories is in part because there's a lot of speculative, you know, fervor around the opportunity, right? And you can really spin a good story when you basically don't know what's going to happen. So I found this measure of the volatility quotient to really help me understand kind of how much noise or how much uncertainty I had to put up with for the stock if I wanted to be invested in it.

Starting point is 00:22:53 And so it became something bigger than an optimal trailing stop strategy. for me. It was like, man, that's 50%. Do I really want to be in a stock that's essentially got that much uncertainty or that much noise? And what I found in my back testing is that if I allocated my capital, so I was putting the same amount of money into, taking the same amount of risk on each opportunity based on volatility, that automatically helped me to put more money into the less volatile opportunities and put, I like to say, just the right amount of money into the more volatile opportunities and more speculative opportunities. And a big part of that for me is about being able to sleep at night, you know? So I love the idea of, you know, swinging for the fences

Starting point is 00:23:37 on some small cap speculative opportunities, but you got to put the right amount of money into it so that you can still sleep at night so that you can be in that stock for the long run to actually capitalize on the opportunity that's really there, right? So just as a simple illustrative example, if I may, you know, a stock with a 50% volatility quotient, if you want to risk $1,000 on that stock, you can put $2,000 into that stock. If that $2,000 investment falls 50%, you're down $1,000, right? On the other hand, if you have a stock like Walmart or Johnson and Johnson that's a 10% volatility quotient stock, you can put $10,000 into that stock.

Starting point is 00:24:20 If that $10,000 investment falls 10%, you're a $10,000. down $1,000. So this is a much more advanced strategy for the individual investor than I think, you know, most of us have considered before. You know, it's not necessarily a mechanical strategy as I see it, but it's a great place to start to consider, you know, how are you deciding about how much to invest in different opportunities? Kind of my focus on volatility, I will say one more thing, which I've found, you know, you mentioned kind of volatility going up being a good thing. I think that can be a good thing. And recently I've been exploring something that I call kinetic volatility or kinetic VQ.

Starting point is 00:25:02 And it basically means like when a stock has gotten above its historic average volatility, that can be a really interesting sign when you have positive momentum combined with a kind of extra volatility. If you can start a positive uptrend with good momentum and you've got this kind of extra volatility or extra noise or worry that you can measure in the stock, that extra worry can really fuel a new uptrend that can be more enduring than a typical uptrend. So that's an area that I've been personally exploring and seen some pretty compelling evidence that it's a cool strategy. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. risk and regulation are ramping up, and customers now expect proof of security just to do business.

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Starting point is 00:29:00 be found in the income fund fund's prospectus at fundrise.com slash income. This is a paid advertisement. All right, back to the show. Yeah, that sounds very interesting and a very, in a different approach to volatility than I heard from, from other people who are trading the market. So, Richard, Stig and I want to ask you about a certain investor. His name is Bill Miller. For people not familiar with Bill Miller, he was the former chief investment officer at Lake Mason. He managed something like $60 billion or something while he was there. He now runs his own fund. It's called Miller Value Partners. And the reason we want to talk to you about Bill Miller is when we had them on our show, Stig and I were both very surprised to find out that

Starting point is 00:29:47 Bill disclosed to us that he always follows up a value investing approach by looking at the momentum trends of the price action as well. So we want to ask you, are you the inverse Bill Miller, meaning you're starting with this momentum approach, but then do you go back and look at the fundamentals before you conduct a purchase? Yeah, well, first of all, Mr. Miller is full of surprises, huh? He surely is.

Starting point is 00:30:18 Coin and price action, and yet everybody thought he was just a deep value investor. So kudos to Mr. Miller for looking into all the things that might really work, right? On the value side, for me, I just don't really have the stomach to be a deep value investor myself, you know. But I do value fundamentals, but I really look to other people to make sure that I have an element of value in my investing strategy. We're both interested in billionaires. Yep.

Starting point is 00:30:54 So one of my strategies is to sort of limit the universe of stock ideas that I'm choosing from to the universe of what the world's greatest investors are choosing from, right? So if you take, you know, 10, 20 of the world's greatest investors and you just kind of aggregate what's, you know, what they're invested in, you can come up with, you know, a list of a couple hundred stocks, two or three hundred stocks. And in my mind, those stocks have been vetted for value by the world's greatest investors. So I would like to take that universe of opportunities that have a value bias to them and then apply my own kind of quantitative strategies to that smaller basket of ideas.

Starting point is 00:31:43 So personally, when I've tried to do value investing, I've gotten caught in the value trap you know, more times than I care to admit and ridden a stock down to just unacceptable losses. Oh, we all tried that, Richard. And then I just don't have the, you know, the 10 and 20 year, you know, time horizon patience of a Warren Buffett, you know. So I think my attention span is a little better than, you know, maybe the average millennials, you know, I'm more Generation X myself. I think we've been having a deteriorating attention span now, you know, through the generations. So anyway, my sweet spot is, you know, holding a stock for 18 months to, you know, maybe

Starting point is 00:32:26 five, six years max. That's what works for me. I think that's an interesting kind of time range for a lot of people in the world today that aren't necessarily, you know, that are interested in investing but aren't necessarily going to, you know, be Warren Buffett. So now I'm really going to poll you here, Ricketts, because I'm putting you on the spot here again. You know, we talked about this interview back and forth, and then we settle on today for various reasons. And this is coincidentally 15th of August, just the day when the 13F filings

Starting point is 00:33:00 have been released, which is basically if you are, and as you mentioned in the US and you manage for more than $100 million, then you will need to disclose that once a quarter. So the market opened 33 minutes ago. So I'm really putting you on a spot. here, but have you seen anything like pub up for this 13F round or for the previous one that's really just very interesting, both in terms of value and in terms of price momentum? The data is still very fresh, Stig. I haven't done the deep dive on it that I ultimately intend to do. The one easy one here for me is the fact that Warren Buffett is buying more Apple.

Starting point is 00:33:40 and I think that is a really great lesson for individual investors to hear because you see, you know, Apple is at all-time highs. It's just past the trillion-dollar market cap and Buffett continues to buy it. And I think so many of us who, you know, get involved in the markets succumb to the very unfortunate idea that, oh, it's at all-time highs, I can't buy it here, right? And so seeing Buffett continue to pile into Apple, you know, it just crushes that mindset, you know, that you can't buy at new highs. You know, look at what he's been doing. He's been accumulating it for a couple of years now. And then, you know, brus through a trillion dollar market cap and he's still buying it. So I think that's a great lesson for individual investors to, that we can take from investors like Buffett.

Starting point is 00:34:32 I also have done a little bit of analysis on the kind of what the billionaires are doing overall sector-wise. So I have a little bit of data on that so far. It looks like they've kind of backed out of the consumer discretionary sector a little bit. So that was one that I had talked about back in February, kind of cut their position there by about 15 percent or so, really increase their position in industrials and in energy and in materials. So those were smaller, you know, parts of their portfolios overall. But the biggest increases that I'm seeing are in industrial. which is interesting because the industrials have been so beaten down, especially the Dow and energy as well, which is a sector that I'm pretty excited about right now.

Starting point is 00:35:19 I'm really curious about your response here to the next question. You know, we've been talking about Warren Buffett quite a few times here in this episode, but also really, wow, four years in the making here of TIP. Really like someone we should follow. So we're always looking forward to him disclosing what Bercia Halloway buying, four times a year. Whenever you follow the financial markets, you can also observe that we are not the only people who are following what Buffett is doing. It's very common that the stocks that he would load up on, they would go up and price quickly. How do you, how do you as a trader,

Starting point is 00:36:00 I don't know if the time horizon then, because a lot of it happens within the day, if that's the too short period for you, but like, how do you factor that into your decisions that you would have these four times a year, then you almost know before the market opens that there's a good chance that they might go up in price. I would ignore that. And what I've found is that digging into the 13F data, the information that you can get has value six months, 12 months, 18 months out from when the events take place in the investor portfolios.

Starting point is 00:36:35 even think about, you know, the 13F data that's coming out yesterday or in the last couple of days, you know, like I said earlier, one of my favorite approaches is to kind of narrow down my stock selection universe to a couple hundred, you know, two or three hundred different ideas. I just don't think it's that useful to look at what's happening, you know, 48 hours after this data is released. I think looking three to six months out, you know, from like looking back at what what happened in the 1Q data is actually, you know, there's still a lot of alpha in there. And it's not where most people are looking, Stig. Most people are looking at, oh, my God, you know, they just release the data, what's happening, right?

Starting point is 00:37:16 So it's hard to find alpha when you're looking in the same place as everybody else. Yeah. That's a good point. So, Richard, you absolutely come to the table with just a wealth of experience and knowledge. and I'm sure during that period of time, you have made plenty of mistakes along the way. So I'm excited to hear your response to this question. If you could go back in time and give yourself any piece of advice for trading or momentum strategies or what have you, what would you tell yourself? Don't sell your winners.

Starting point is 00:37:53 The gentleman that I learned about trailing stops from is Dr. Steve Sugarwood. and so he publishes a newsletter, great newsletter. It's called True Wealth. He has a great track record. And I was studying the 25% trailing stop strategy, and I went back and looked at his performance when I applied a mechanical 25% trailing stop strategy exit, exit strategy to his recommendations. And I found that it significantly improved his performance. And I was like, well, why it, how could that be?

Starting point is 00:38:26 I know he uses a 25% trailing. stop strategy. And it was because he wasn't using the trailing stop strategy to stay in his winners, right? So because that bias that I mentioned that we are risk averse when we get profits and we start to want to pull those profits off the table, you know, sticking with your winners and, you know, experiencing what I call irrational profits instead of irrational losses, you know, you know, that's saying that the markets can stay irrational longer than we can stay solvent, right? Well, let that market irrationality work for you, okay? Like let your profits defy your wildest expectations instead of letting your losses defy your wildest expectations. You know,

Starting point is 00:39:09 so you get some 10, 20 baggers in your portfolio instead of 80, 90 percent losers in your portfolio. So being able to really stick with what's working like Buffett and Apple and buying more of Apple, that is probably the single biggest change in my own behavior. as an investor that I think has made me a more successful investor today than when I got started 20 years ago. Well, Richard, thank you so much for coming on the show. We just truly value your input. I've been personally using trade stops for quite some time now, and I can honestly say that I don't execute any buy or sell of any stock without first checking the momentum metrics that I

Starting point is 00:39:50 find on your platform. So it's really an honor for me and Stig. I know he also uses the platform. to have these conversations with you. So thanks for making time for us and coming on the show. So before we go, Richard, I'm sure people listening this might be interested in learning more about you and your Trade Stops platform. So give them a handoff where they can learn more about you. We have a special page set up for your listeners at Trade Stops.com forward slash tip. So anyone who's listening to this podcast can go to Trade Stops.com forward slash tip. learn a little bit more about kind of how our tools can apply to the type of investing that you guys like to talk about and also get a special offer for your subscribers.

Starting point is 00:40:37 Awesome stuff. Well, Richard, thanks again for joining us. We really appreciate your time. Hey, guys. I love spending time with people who are serious about helping individual investors. That was all I pressed on the hat for this week's episode of The Investors. We see each other again next week. Thanks for listening to TIP.

Starting point is 00:40:56 To access the show notes, courses or forums, go to theinvestorspodcast.com. To get your questions played on the show, go to Asktheinvestors.com and win a free subscription to any of our courses on TIP Academy. This show is for entertainment purposes only. Before making investment decisions, consult a professional. This show is copyrighted by the TIP network. Written permission must be granted before syndication or rebroadcasting. P-R-B!

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We Study Billionaires - The Investor’s Podcast Network - TIP204: Momentum Investing Strategies w/ Dr. Richard Smith (Business Podcast)

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