Audacity had one of its better month’s performance in August adding to what has been a very strong year for the Strategy. This has been followed by a reversal in fortune in the early part of September.
In what appeared to be a couple of quiet days of trading on Monday September 9th and Tuesday the 10th (and on Wednesday but to a lesser degree) there was the biggest rotation of winners turning to losers and losers turning to winners that has occurred in the markets over the past decade. This market behavior resulted in meaningful losses for Audacity.
Our Investment Strategy
In simple terms, the investment strategy of Audacity is to be long stocks (profit when they move higher) that have been performing well and short stocks (profit when the move lower) that have been performing poorly. The idea is that the trends generally continue which has proven to be the case from our research dating back to 1963.
Monday and Tuesday’s Market Environment
There were one-day reversals of winners and losers in the market on Monday and Tuesday that was the most extreme of the past 10 years. When longer-term winners immediately turn into losers, such as occurred, this is not good for Audacity because we tend to be long these stocks. Furthermore, when longer-term losers immediately turn into winners, such as also occurred, this is even worse for Audacity because we tend to be short these stocks. That’s what happened Monday and Tuesday and, to a lesser degree, on Wednesday as well. The following graphs illustrate such reversals.
As the accompanying graphs show, generally we have long positions that have been in longer-term upward trends and short positions that have generally been in downward trends. On Monday and Tuesday these longer-term trends immediately reversed as illustrated in both graphs on the far right side resulting in losses for Audacity.
The below table provides some examples of actual holdings in Audacity and how they performed prior to Monday and then on Monday. As you will see, the long positions, those we want to continue going up so that we profit, had all performed very well prior to Monday but then reversed. One example from the top half of the table showing sample long positions is Boston Scientific up +23.8% during the prior 12 months then on Monday falling -4.1%.
In the lower half of the table are sample short positions, those we want to continue declining in value so that we profit. You will see they had all been performing poorly during the prior 12 months and then reversed on Monday. One example is Abercrombie & Fitch down -17.4% during the 12 months prior to Monday and then reversing with a gain of +10.4% on Monday.
It's Not Broken, It Just Sometimes Happens
Although Monday and Tuesday were both two of the most extreme one-day flip flops of winners and losers that has occurred during the past 10 years, we have seen times during the past 10 years that have been similar. Furthermore, our research on Audacity going back to 1963 shows there have been many times when there have been one-day flip flops that were meaningfully more extreme than we just experienced.
The bottom line is that these market environments happen periodically and to varying extremes, most often they are not good for our short-term performance, but they have always been short-lived and we go on to enjoy great long-term returns from Audacity. There is nothing to suggest this time will be any different.
That said, sometimes these challenging circumstances last a couple of days and sometimes, to a lesser degree, they go on for a couple of weeks. It’s impossible to know how long this downward trend will last or how long it will take to fully recover but, again, every bit of history and research suggests our patience will be rewarded.
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Additional Research and Commentary
As with all investment strategies, there are a variety of market environments that can impact the performance of certain stocks. An example is an environment of falling interest rates which would have a meaningful impact on the performance of banking stocks. Another would be a high inflation environment that would meaningfully impact gold and real estate stocks.
Any given market environment though does NOT explain ALL of the movement of any given securities. There are always stock and sector specific circumstances that will further influence performance. A given market environment though can often explain a lot…it’s the backdrop for individual security performance.
I’m not sure there is such a thing as a “normal” market environment but there are certainly things we can say tend to occur more often than not. One of those is that stocks that have recently performed well tend to continue to do so and vice versa. This is important to our Audacity Strategy.
As discussed earlier in this blog, September 9th and 10th were days when the leaders, those stocks performing best the past 12 months, reversed course dramatically. The same was the case for the past laggards…they became the days’ winners. This is a market environment that can explain a meaningful amount of the performance of Audacity.
Details About My Research
To put the market behavior on September 9th and 10th into perspective, I did some extensive research. I focused on the 500 stocks in the S&P 500 because all of the long positions and most of the short positions are S&P 500 stocks. For every day I did the following:
- Calculated the 12-month performance up to the prior trading day for every stocks in the S&P 500 (for example, for September 9th I calculated the 12-months returns up to Friday the 6th)
- Calculated the one-day % change for the given date for every stock (for example, the one-day % change on September 9th when doing research for September 9th)
- Ranked the 500 stocks by their 12-month performance (from #1 above) from best to worst
- Calculated the average one-day % change (from #2 above) for the 50 best performing stocks (we will call these the “Winners”) based on their prior 12-month performance (this tells us how the prior best performing stocks performed on this one day)
- Calculated the average one-day % change (from #2 above) for the 50 worst performing stocks (we will call these the “Losers”) based on their prior 12-month performance (this tells us how the prior worst performing stocks performed on this one day)
I ran the above calculations for every day from July 1, 1963 to September 10, 2019.
There were two important things learned from this research. I focused on the one-day % changes of the prior 50 best performers (“Winners”) and the prior 50 worst performers (“Losers”). The difference between these two groups’ performance is very meaningful to our Audacity performance as is the performance of the Winners alone. The following table shows some results from this research.
On September 5th you will see the Winners, those 50 stocks that have performed best during the prior 12 months, on average had no change while the Losers rallied an average of +3.2%. Generally speaking, this is not good for Audacity because our longs positions, represented by the Winners, produced no gains and our short positions, those represented by the Losers, rallied +3.2% causing us losses (shorts going up in price results in a loss).
Again, no market environment will explain all of the performance of a given strategy or security but it provides a backdrop that can have a meaningful impact. September 6th is an example where this research explains little or nothing as the Winners and Losers did not move much but our Audacity experienced a decent gain.
As the table shows, September 9th and 10th were both very similar in nature with the prior Winners on average falling sharply on both days and the prior Losers on average rallying on both days. The difference in performance of the Winners and Losers on the 9th was -5.8% which was the biggest one-day difference during the past decade. Prior to the 9th, the biggest difference was -4.5% on November 29, 2017 which was a day Audacity lost -9.5%. Note that for the full year of 2017 Audacity produced one of its best annual performance of the decade…these short-term downturns very often happen in the midst of a long-term move higher.
Although September 9th was the most extreme difference in performance of the Winners and Losers since 2010, there were 67 days in our research back to 1963 when there was a more extreme difference. The biggest one-day difference was -17.0% while a total of 18 days were in double-digits. Interesting to note is that the vast majority of the biggest one-day performance differences occurred during major bear markets and sometimes just before or just after a major bear market. This is of particular note since we are not in a bear market today but we experienced a couple of back-to-back extreme one-day performance difference. I’m not exactly sure what this means but I’ll be doing more research on this.
An equally important finding from this research was the impact of the performance of the Winners alone. Let’s forget about the Losers and the difference for now and only consider the Winners. When there is a day that the Winners experience a significant average loss, our Audacity Strategy is nearly certain to experience a meaningful loss. This can be explained by the fact that Audacity most often has more money invested in long positions than short positions combined with the use of leverage.
An example of the importance of the Winners’ performance is just a few months ago on June 4th. Although the difference between the Winners and Losers was -2.3% (relatively significant), the Winners were +1.2% and Audacity posted a gain. Consider that the difference of -2.3% on June 4th is not all that much different than the difference on September 5th in the above table when Audacity was meaningfully down. The difference of these two days is that the Winners were higher on June 4th, helping Audacity, while on September 5th the Winners were lower and compounded the challenges for Audacity.
My research clearly shows a quick flip flop of winners and losers presents a challenge for the performance of Audacity. Furthermore, a meaningful drop in just the performance of the winners is also tough. September 9th and 10th were a combination of both. Audacity performed just as would be expected in such an environment…disappointing for sure but just as expected.
The data does show these environments do not last long but they can go on for more than just 2-3 days. We can only hope this is over! Regardless, it will pass and we have every reason to believe Audacity will continue to climb higher and deliver great long-term returns.
Thank you very much for your trust and confidence. I absolutely hate poor performance but I recognize that every great investment strategy goes through such periods. Our research says we should expect this so, to some degree, anything different would be concerning!
As always, please let me know any questions or comments.