Beat the markets with data-driven strategies instead of faith-based “analysis”

Are you sick and tired of financial media, investment research firms, and traders that are great at sounding smart (“look at our smart macro and technical charts!”) without actually being smart (i.e. outperform buy and hold in the long run)?

Following their advice and conventional strategies leaves investors and traders worse off than “dumb” buy and hold in the long run! The market crashes that they successfully predict and avoid don’t even make up for the market rallies that they miss!

Here’s the S&P 500 Total Return Index vs. the HFRI Fund Weighted Composite Index, an index that tracks the performance of 1400 hedge funds net of all fees. As you can see, almost all the outperformance came in the 2000-2002 and 2007-2009 bear markets. From 2009 – present, hedge funds have lagged the S&P badly.

Conventional investment and trading strategies rely on too much dogma and faith-based “analysis”, such as “a breakdown below the 200 daily moving average must be bearish for stocks!”

How much of this dogma is actually true?

Reality: a lot of it is false, and we can prove this with data.

Most of what Wall Street and the media promotes as “analysis” is not much better random guessing. In the words of Warren Buffett, no better than a monkey throwing darts at a chart in the long run.

That’s why over the past 10 years, many professional traders and hedge funds have consistently underperformed buy and hold. Their faith-based “analysis” is no better than a coin toss. They believe in conventional investment strategies and conventional “wisdom” just because everyone else believes in it. Monkey see, monkey do.

It’s not that coin-toss analysis “never works”. It works 50% of the time. Which is no better than a monkey throwing darts at a chart.

How to outperform in the long run

Don’t use financial dogma to “guess” where the market will go next.
Don’t trade the news.

We let data, facts, and quantitative models tell us where the market will most likely go next.

Investing and trading is about probability. Use probability to your advantage. The market usually (but not always) goes according to its most-probable direction. Over the long run:

Those who consistently trade with probability on their side will outperform.
Those who consistently trade against probability will underperform.

Hence, the optimal investment strategy is to:

Consistently bet on the side that probability favors.
Incorporate quantitative risk management rules in case a low probability event occurs.

My journey

I’m Troy Bombardia, founder of Fundamental Capital, the investment strategy and research firm behind Bull Markets.

I worked in my family’s hedge fund from 2008-2017. We increased our capital by 40x during that period, which is an average annual return of 44%.

By 2014, I noticed a very interesting pattern in the U.S. stock market:

The average professional trader and hedge fund underperformed buy and hold for most of the prior 10 years. This shouldn’t be happening if conventional investment and trading strategies actually worked, as the experts and gurus claim!
Research firms and financial gurus only highlighted their accurate market calls. But when you look at the number of times they were wrong, they’re no better than a 50-50 coin toss!
Most research consisted of charts. Meanwhile, no one bothered to backtest and see exactly how useful those charts were for predicting tops and bottoms! (The problem with charts is that the human eye tends to see what it wants to see, which is confirmation bias).
Investment and trading professionals are great at producing complicated, smart-sounding research. But when they apply their “award winning proprietary research”, their results are worse than buy and hold. What sounds smart ≠ what’s actually smart

What were they doing wrong in the U.S. stock market? After a lot of research, our findings formed the basis of our values. Values are important because they determine how we consistently work towards our mission.

Our mission

Help regular investors and traders to systematically make as much money as possible and as consistently as possible.

Value #1: Use clear, quantitative models

Clear, quantitative models allow investors and traders to backtest their strategies and know EXACTLY how well a strategy works over time (average annual return, max drawdown, volatility, etc).

No more “guessing” and hoping that strategies preached by “gurus” actually work.
No more marketing hype.

There are 3 trading methods, ranked from what we believe to be best → worst

Discretionary trading (worst)

Discretionary trading is anything related to charts and individual “trade ideas”. The key phrases that define discretionary trading are “it looks like” and “I think”.

The stock market’s valuations are very high. It looks like the dot-com bubble all over again!
It looks like copper is leading the stock market down.
The stock market today looks just like 2007
PMI is falling, global trade is slowing down. I think the macro picture is terrible right now!

Traders then bundle up their discretionary outlook into individual “trade ideas”.

Short stocks right now.
Long gold right now.

So what’s the problem?

At any given point in time, there are countless bullish factors and countless bearish factors. There will never be a case in which the factors are 100% bullish or 100% bearish. How do you reconcile the bullish and bearish factors? How do you decisively know which factor is more important than the other?
There is too much guessing involved. For example, a common discretionary outlook is “valuations are too high. Bearish!” This is silly, because the trader never bothers to ask “when valuations were this high in the past, did the stock market keep going up or down over the next 3 months, 6 months, 1 year, etc?”
Discretionary traders rely on charts, which are prone to recency bias. This results in recency bias-riddled market “analysis” such as “the last time the S&P fell below its 50 day moving average, it collapsed -20% in the next 3 months” and “the last 2 times the yield curve inverted, the stock market fell -50%”. Recency bias overestimates the probability that a recent event will occur again.
A trader who relies on “trade ideas” will forever be a slave, stringing together trade idea after trade idea. There’s no systematic train of thought. There isn’t always an ideal trade idea in the stock market. Most underperformance comes from underinvestment. So when you don’t have an ideal “trade idea” and sit on the sidelines, the stock market may very well keep going higher. Hence underperformance.

Most discretionary market outlooks are no better than a 50/50 guess. We have a Guru Tracker that looks at various trading experts’ discretionary market predictions over the years. Long story short, 95% of these “experts” have track records that are no better than a monkey throwing darts at a chart. Once again, sounding smart ≠ actually being smart (outperforming). Don’t believe most of what you see or hear.

Quantifying your discretionary outlook (better)

Quantifying your discretionary outlook is better than using a pure discretionary approach because you eliminate some of the guessing.

“The stock market’s valuations are very high. It looks like the dot-com bubble all over again!” turns into → “when valuations were this high in the past, did the stock market go up or down over the next 3 months, 6 months, 1 year?
“It looks like copper is leading the stock market down.” turns into → “historically, does copper actually have a statistically-proven leading relationship with the stock market?”
“The stock market today looks just like 2007” turns into → “what is the correlation between today and 2007?”
“PMI is falling, global trade is slowing down. I think the macro picture is terrible right now!” turns into → “when the PMI fell to this # in the past, did the stock market go up or down over the next 3 months, 6 months, etc.”

This is what we do in our free market research: quantify popular discretionary outlooks and stop guessing how bullish or bearish XYZ factor is.

In other words, studying market history helps us challenge our thoughts and biases.

However, quantifying our discretionary market outlook is still not good enough because it doesn’t address other problems we mentioned:

At any given point in time, there are countless bullish factors and countless bearish factors. How do you reconcile the bullish and bearish factors?
You cannot keep stringing together disconnected “trade ideas” because there isn’t always an ideal trade idea.

End-to-end trading models (best)

End-to-end trading models solve the various problems listed above:

Models reconcile various bullish and bearish factors into a clear BUY or SELL signal. There is no ambiguity.
There is no guessing involved. There is nothing more honest than an equity curve that slopes up to the right and outperforms buy and hold.
There is no recency bias. We build models based on at least 40 years of historical data. The more historical data, the more robust a model is.
There are no individual and disconnected “trade ideas”. Every trade is merely carrying out the actions that a proven system prescribes.

Quantitative traders have other big advantages over discretionary traders:

Discretionary traders spend most of their time doing market analysis and coming up with “trade ideas”. There is little time left to improve their thought process and improve their returns
Quantitative traders spend most of their time improving their thought process and strategies. Hence their returns improve over time. Quantitative traders simply follow their model, regardless of their personal biases.

If a quantitative trader wants to incorporate a certain factor into his model, he simply needs to ask 1 golden question

Can I develop a set of rules that can encapsulate this information that leads to systematic, actionable trading decisions that outperform buy and hold over time?

Value #2: Focus on the medium-long term

The stock market’s short term is harder to predict because there is a lot of randomness in the short term movements. The short term is heavily impacted by random events and factors that one cannot consistently and accurately predict without 20/20 hindsight. The stock market’s medium-long term is much easier to predict because it follows the fundamentals of the stock market (i.e. the economy).

On any random day, the U.S. stock market’s short term outlook is mostly a 50-50 bet. But as time goes on, the stock market has a higher and higher chance of going up.

Value #3: Combining fundamental analysis with technical analysis in a systematic way improves performance

While most of Wall Street uses fundamental analysis, most independent traders use technical analysis.

Both approaches have their advantages and disadvantages. Combining the 2 approaches = higher returns than only using 1 approach.

Everyone knows what technical analysis is. There are thousands of books devoted to this subject.

But understanding the stock market’s fundamentals is the tricky part.

Corporate earnings and the stock market move in the same direction in the long run.

As corporate earnings increase, the stock market goes up in the long run (it’s a bull market).
As corporate earnings decrease, the stock market goes down in the long run (it’s a bear market).

However, it’s the U.S. economy that drives corporate earnings in the long run.

As the U.S. economy improves, corporate earnings increase.
As the U.S. economy deteriorates, corporate earnings decrease.

This is why we focus on the U.S. economy to predict the U.S. stock market’s medium-long term direction. The economy drives corporate earnings, which drives the stock market.

The S&P 500 and real GDP have a 0.92 correlation from 1947-2018

This chart demonstrates that the stock market (S&P 500) rarely makes big declines (bear markets, which are 40%+ declines) outside of recessions.

*Recessions are in grey, bear markets are in orange. This is a log scale chart.

Recessions + above-average valuations = bear markets (40%+ declines)
Recessions + below-average valuations = “big corrections” (15-30% declines)

Everyone knows if the stock market is “overvalued” or “undervalued” right now. The most basic of valuations indicators will tell you that (e.g. Tobin’s Q, Shiller P/E)

But it’s the predicting economic deterioration part that is difficult, which is what our models do.

Some people say that “the stock market leads the economy”, while others say that “the economy leads the stock market”. Both of these camps are right, but each camp is only telling you half of the story.

The stock market leads the “economy”, as defined by GDP. As you can see in the above picture, the stock market tops (bear markets start) before recessions begin. However, GDP is a lagging economic indicator.

Certain LEADING economic indicators (e.g. Initial Claims, Housing Starts, Heavy Truck Sales) lead both the stock market and the economy.
The chain of events usually look like this: Leading economic indicators start to deteriorate. Then the stock market tops. Then GDP turns negative, resulting in a recession.

That’s why we use leading economic indicators to predict the stock market’s medium-long term direction. The leading economic indicators will start to change directions before the stock market makes long term tops and long term bottoms.

Economic expansions and equity bull markets DO NOT die of old age. As you can see from the following chart, the U.S.’ economic expansions over the past 150+ years have lasted longer and longer. There is no such thing as “an economic expansion MUST end after X number of years”.

Temporary deviations between the stock market and economy are technical in nature. Our models and indices can predict some of these deviations.

But if the stock market and economy start to move in opposite directions, the stock market will eventually move in the same direction as the economy.

Value #4: Stress test and simplify

We prefer models that are backtested with more historical data over models that are backtested with less historical data. For example, models with 70 years of historical data are more robust than models with 20 years of historical data. More historical data allows the model to be stress tested against different market environments and gives us a more accurate reading of the model’s true performance over time.

We generally won’t use models that are backtested with less than 40 years of data.

We also prefer models that use fewer indicators.

Use too few indicators, and you risk relying on a single Holy Grail that can fail
Use too many indicators, and you risk curve fitting your model

In general, we prefer models’ whose indicators do not exceed the mid-single digits.

Value #5: Stay open minded

We are willing to change all of our previous values as we learn and improve, AS LONG AS the new things we learn stand up to the light of data.

For example, right now our best trading models combine fundamental analysis with technical analysis. But perhaps we’ll one day discover that the best trading models only use technical analysis. We remain open to that possibility, but we will only accept it is our new “truth” if we can find the data and facts to support that claim.

Our trading and investment models

We developed quantitative models for trading and investing in the U.S. stock market.

The Medium-Long Term Model is our most complicated model. It generates an average of:

14.7% a year when traded with SPY (for investors)
30% a year when traded with SSO (for traders)

*SSO = S&P 500’s 2x leveraged ETF

We have other investment and trading models that yield an average of 10-25% a year when traded with $SPY. These models outperform the S&P 500 in the long run, which generates an average of 7-8% per year.

Armed with our models, an investor or trader can significantly outperform in the long run with smaller drawdowns than buy and hold.

Why multiple models?

We provide multiple models in the Bull Markets Membership Program.

So why produce multiple investment and trading models? Why not just recommend 1 model to members?

Because there is no such thing as a Holy Grail in the financial markets. Every model has its advantages and disadvantages.

Some models have higher returns. These models also have higher drawdowns.
Some models have lower returns. These models also have lower drawdowns.
Some models perform better in trending markets.
Some models perform better in choppy markets.

There is no “best” model. The model that is most suited to each person depends on their own personal preferance, risk tolerance, etc.

We explain each model’s advantages and disadvantages. By laying it all out, our members can pick the model that best suits them.

Our attitude in the markets: we are cautious optimists

This website is called Bull Markets because the big money is made from investing in bull markets and sidestepping bear markets. It isn’t made from blowing every single risk or “worry” out of proportion.

Pessimists always sound “smart” because humans respond stronger to loss than to gain (Daniel Kahneman won the Nobel Prize for proving this). Why is pessimism so popular?

Optimists tell you that the world’s major problems will eventually get solved. While this seems stupid (especially if you’re reading this in the depths of a recession), it is the reality. On a multi-decade basis, the world continues to get better and asset prices continue to climb.
Misery loves company.
Pessimism grabs your attention. Optimism requires slow growth. Pessimism requires CRASH AND BURN. So while good things take more time (not as sexy or headline-grabbing), bad things happen more quickly.
Pessimism sounds like someone is trying to save you. This isn’t true. The only way permabears make money is from selling their message to other gullible pessimists. If permabears actually traded on their own advice, they would lose 90% of their capital within a decade.

While pessimism sounds “smart”, optimists generally outperform in all aspects of life.

Just look at the Forbes 500 list.

How many permabears are there?
How many doom-and-gloom billionaires are there?

Matt Ridley wrote in his book The Rational Optimist:

If you say the world has been getting better you may get away with being called naïve and insensitive. If you say the world is going to go on getting better, you are considered embarrassingly mad. If, on the other hand, you say catastrophe is imminent, you may expect a McArthur genius award or even the Nobel Peace Prize.

The same applies to the stock market.

If you say that “stocks will go up 20% next year”, you will be called reckless, ignorant of risk, blind, etc.
If you say that “stocks ‘could’ go down -30% year next year”, everyone will reach out to you and congratulate you for being so savy and aware of risk. (Never mind the fact that anything ‘could’ happen. Probability is more important than possibility.)

If you know nothing about the stock market, just know this. The stock market goes up more often than it goes down. Be a cautious optimist and ignore the permabears.