Creating the Strategist (1/11)

Part 1. Creating The Strategist

To fully understand and obey rule #1 of CRI's 2 rules of investing you must understand what it is
you are actually doing in the market. Very much like the auto mechanic or the surgeon, if you
don't know what you are doing, you are basically dooming yourself to failure. As the saying
goes, from knowledge comes wisdom. To that end, no matter how large your account size, in
the end we are all 'students of the market.’ Make no mistake, no one will ever fully understand
the markets. The market is constantly in a state of flux where acceptable ratios often are
stretched to meet current conditions. Having said that, there are ways to both identify and then
take advantage of imbalances within our capital markets and that is what this part of the course
is all about.

Building a strategic plan - understanding capital markets and creating a 'rational' strategy

● Building a plan for success (30 minutes)

○ To plan or not to plan
○ What does a good plan look like?
○ How to use this information

● A brief overview of the capital markets (1-2 hours)

○ Stocks
○ Bonds
○ Commodities
○ Currencies
○ How to use this information

● Money Flows (1-2 hours)

○ Simple example (the money flow game)
○ Demographics
○ Proxies
○ How to use this information

● Investor Sentiment (1-2 hours)

○ Fear vs. Greed
○ Proxies
○ How to use this information

● Rational Investing (1-2 hours)

○ Fundamental Analysis
○ Technical Analysis
○ Intersection / Overlap
○ How to use this information
 Creating the Strategist (2/11)

Building a plan for success

Introduction:
Historically, traders have often been likened to wild-west gun shooters, wielding buy and sell
orders like pistols and gunning down opponents right, left, and center. Ironically, really good
trading is as far from that as you could imagine. Indeed, our number one objective as
traders/investors is to always be able to fight another day. Appropriate risk levels will be
discussed in detail elsewhere, but for the purposes of this section of the course, we must simply
understand that we don't do anything without a tactical plan (short term trade execution) and
that plan must adhere to our strategic (overall objectives) plan. Once you 'buy in' to this concept,
the entire investment process becomes very mechanical, quite predictable and ironically
enough, kind of boring.

'The only thing we have to fear is fear itself'

As traders/investors we really are small business owners where managing risk is our first priority
(sustainability) and growth (profit) come secondarily. But as small business owners too, we must
be able to manage emotional responses in the face of adversity. While in a calm state (which
hopefully we are in while reading this) making rational decisions seems quite simple. Making
those same decisions in the face of either euphoria or sheer panic is not the same. Sadly, it is
more a question of managing yourself when things go 'wrong' versus how you act when things
go 'right' which will ultimately dictate your success or failure. So the question then becomes, are
there any ways to prevent such situations from arising? Interestingly, if you have a preset plan
as to what you are going to do should various scenarios play out, it not only forces you to act,
but the existence of the plan itself makes the entire decision making process much more
manageable – and as small business owners, that's exactly what we want. When you reduce
anxiety around a decision making process, not only do you make better decisions, but the fear
of making those decisions diminishes too...as they say – nothing breeds success, like success.

So we have decided to make a plan. What should it include?

First and foremost, we need to understand that our plan is literally a living document. It will
constantly be changing over time and should never become stagnant. It will almost take on a
personality in itself. The reason why? Because it really is just reflection of the architect of the
plan. It is us and interestingly, as we change as investors over time, so too will the plan. Along
with basic personal profile information, the plan should include both strategic (over all) and
tactical (short term attack) elements. Tactical plans are discussed in detail later, but for the
purposes of this section of the course, we shall concentrate on who we are strategically. This
process of self identification will take some reflection and shouldn't be taken lightly. Sometimes
the answers to strategic and tactical questions are painful to openly admit. But as they say, the
truth will set you free.
 Creating the Strategist (3/11)

So, Strategically, who are we? Where do we want to go? What kind of capital do we have to
work with? Do we have any preconceived notions about investing? Do we have any horror
stories from our past that may dramatically affect our 'rational' analytical ability? Do we have a
plan?

Sadly, past experiences often dictates our perception of reality. If we felt pain at one point from
one particular source, we will be reluctant to even look at that same source of pain again.
Subconsciously, our minds tag certain triggers with labels, and once a label has been tagged to
an associated trigger, it’s next to impossible to change it. While I am certainly not here to teach
psychology, as good traders/investors we must understand how significant having a positive
psyche is to performance, but we must also be able to openly admit what may be holding us
back. Why do we fear certain things? Are those fears rational? Are there ways we can plan to
remove (mitigate) those fears from our day-to-day lives?
 Creating the Strategist (4/11)

A Brief Overview of the Capital markets

Introduction:
Capital itself is nothing more than the accumulation of assets. Capital is simply a monetary
representation of accumulated wealth. Modern day 'capitalism' as we know it is the result of a
process that has been well underway for more than 500 years. Routed in Northwestern Europe,
the evolution of the use of capital has taken many strange and interesting turns. From being
centrally controlled to market-based driven, capital has consistently found new and innovative
ways of being utilized. As we transition from an industrialized society to technology based one,
capital has found remarkably new avenues to fuel growth. Interestingly too, the velocity of that
utilization seems to be growing at an exponential rate - welcome to the information age!
Please refer to Appendix 2.a

Commodities ​(roughly $500 billion):

Considered 'hard' assets, commodities have historically been considered a store of value.
Because of their relative scarcity and unique properties, various commodities have risen and
fallen in value over the ages as societies place greater and lesser value on the particular
product. Aside from the value of knowing what the price of a hard asset at any particular
moment in time is, trends in commodity prices are important to appreciate too. There are some
commodities today that are themselves used as both a benchmark for the value of money (gold)
and others that are used as a benchmark for economic activity (copper).

Bonds ​(roughly $90 trillion):

In simplest terms, bonds are promissory notes and were the first formal way for capital to
participate in 'capitalist type' endeavors. Arising through early Mercantilism, loaned capital would
be paid back in full at a later date with a premium. Should the promissory note fail to be repaid
on time, bond holders were the first in line to lay claim to the assets of a venture in the event of
bankruptcy. Even today, bonds trade at a premium or discount depending on the likelihood of
that promissory note being paid back in full. Since we have such faith in our banking system,
government guaranteed bonds carry the highest premium while personal debt carries the
greatest discount. Make no mistake, there is no such thing as an absolute guarantee and even
modern day governments can fail on their financial obligations.

Stocks ​($30 trillion global equity market cap.):

Under the 'equity' classification, stocks are nothing more than a bet on a particular company or
venture. They represent the current market perception of what something is worth. Stock
owners can be paid a premium of ownership (dividends) and may buy and/or sell their shares
on the open marketplace, but the actual asset itself is has no intrinsic value. The value that is
derived from stock ownership is the belief the underlying asset will get more valuable over time.
That growth may come from a number of different sources but simply put, without the perception
of growth (or even the perception of potential growth), stock prices can stagnate or even retreat
very quickly. Additionally, a stock's current market price and actual 'value' can deviate wildly
 Creating the Strategist (5/11)

based on sentiment. That fact can both work for you and against you as investors. Sadly, most
poor investments don't come from buying undervalued assets but from buying assets grossly
overvalued.

Currencies ​($4 trillion / day):

The international foreign exchange market simply dwarfs all other asset classes. At more than
10 times the size of the global bond market, 50 times the size of the global equity markets and
at least a 1000 times the size of all commodity markets combined, the foreign exchange market
is the final arbiter when it comes to market proxies. The modern day concept of a currency is
actually relatively new. Historically, counties 'pegged' the value of their currencies to a hard
asset, such as gold, in an effort to both establish value in the trading unit and in an attempt to
stabilize prices. As of 1971 that all changed for the western world. We now live in a world of 'fiat'
currencies. At that time, it was decided currencies would no longer be based on hard assets but
would rather free float against each other in a mutually controlled basket of trading partners.
The only thing backing most modern day currencies is the belief in the underlying governments
backing them. This policy is well and good if the cooperating countries maintain relatively sound
fiscal policy. Should the market lose faith in the underlying government due to prolonged
internal imbalances, the value of the currency relative to its trading 'pairs' can fall dramatically
and inflationary pressures can quickly get out of control.
 Creating the Strategist (6/11)

Money Flows

Introduction
Over the course of 30 plus years working and trading/investing, I have heard of many analogies
for the market and money in particular. The one that has stuck out to me as the most accurate
came from a gnarly old VSE broker. His heyday was through the 1970's and he loved making
references to that era. One reference in particular stood out to me, and still does to this day.
“Money is never really created or destroyed.”​ Rather, it sloshes around like a lava lamp from
one end of the investment spectrum to another and back again. Imagine ​a rectangle on its side
that is suspended at the midpoint and slowly rocks back and forth. ​The lava slowly flows from
one end and then back to the other, never making the same pattern or taking the same course
twice. This is a really important concept to understand: there are always two sides to every
trade, and money (and economies) simply flows from one area to another. It just goes to where
it is wanted and most needed.

The power of demographics

The exercise we have just done hopefully will have demonstrated the significance that
imbalances within societal demographic structures can create. In essence, we have just walked
through the 'baby boomer' generation's life cycle. Through their early years, companies that
catered to that market emerged, such as McDonald’s, Proctor & Gamble, and Tide. Through
their peak earning years, lifestyle names blossomed like Ralph Lauren, BMW, and Holt
Renfrew. And finally through their senior years came Merck, Johnson & Johnson, and Pfizer.

Influences on governments
Demographic forces can have far-reaching and profound effects on economies. Since
governments are nothing more than a reflection of the underlying society, public policy is
especially at the mercy of those forces. Ideological aims are often sacrificed in the light of
economic realities. The ultimate danger for a society is when you get into a situation where
there are far more people dependent on public sources of funding than there are workers to
fund those projects. Indeed, during those periods of time, public policy can and does get pushed
to extremes.

Implications going forward

From an investment perspective, knowing and understanding how demographic bubbles will act
through their life cycle (and where one is at any given moment relative to that cycle) is critical to
sound asset management. You must go with the flow, not against it, for long-term success. Is it
easier to swim with the current or against it? From a personal perspective, I find the trades that
go with the higher time frame trends are so much easier than trades that go against that higher
time frame trend. For example, given our newfound understanding of demographic influences, it
is now easier to understand why interests rates are low and the trend has been down. Bets on
rising interest rates have literally been like sailing into the wind.
 Creating the Strategist (7/11)

Investor Sentiment

'You should be selling when they are yellin' and only buying when they are cryin.'

Introduction
I was once told many years ago, “to make money, you simply have to buy when others are
selling and sell when others are buying.” On balance, that statement is very true. However, the
risk tolerance needed to handle short term market 'noise' is often far greater than most people’s
threshold for pain. Indeed, I have personally seen analysts who stick to their guns and get fired,
only to be vindicated a very short time later. Imbalances within the capital market can persist for
great lengths of time. They often result in what we call bubbles, and those bubbles are very
painful when they burst.

Fear vs. Greed

Having now been through what I would consider three​ ​asset bubbles, the ​Seven Tigers of Asia,
Dot.com and US Housing market, ​I have not only seen individual investors lose self control but
significant fund managers too. Investor sentiment does not get euphoric because people are
losing money, it gets that way because people feel it's an easy way to make even more money.
One could argue that these bubbles develop out of the relative cheapness of money. That
cheapness of money often leads to greed, which ultimately feeds on itself. Long time Fed
watchers are apprehensive to say ​'three steps and a stumble’​: should the US Feds raise the
cost of borrowing three consecutive times, the market (stock prices) will often times take a
tumble. The point I am trying to make is that while it is in your best interests not to get involved
(or swept up) in manic peaks, it is far easier said than done. The general public always gets
swept up in manias. I still hear stories of people with garages full of Beanie-babies. Ironically,
most often it is the shrewd investors who are actually selling into those manic peaks, not buying.
This is where the real value of an investment plan comes into play and what ultimately
separates the amateurs from the professionals.

So the question becomes, are there any ways for investors to literally steer their portfolios clear
of potential bubbles or of bubbles that are actually underway? Additionally, are there ways we
may actually be able to take advantage of those short-term market anomalies? Ironically, the
answer to both questions is yes. Since there are tools to identify potential bubbles and even
ways to take advantage of them, the question then becomes, can you create a plan around your
desires (whether to participate or not) and will you have the discipline to stick to your plan when
it tells you to act?
 Creating the Strategist (8/11)

Sentiment Indicators

Demographically Speaking
From a long-term perspective, the demographic cycles are roughly 35 years in duration. Our last
cycle turn was the 'greed peak' that was represented by the Dot.com bubble of 2000. Using one
proxy, the Dow/Gold ratio, we clearly see that our next cycle turn should be a 'fear peak' and
should occur somewhere around Q3'17. Having been through two in my lifetime, and as an
adviser through the last 'greed peak', I can tell you they are violent and the stories that surround
these events can border on the ridiculous.

Too bullish or too bearish

Based off of a short-term perspective, are there any tools available to measure Investor
sentiment over the short to medium term, like 6 months to a year? The short answer is yes there
are various technical tools available to both measure over extension and actual fundamental
events that are indications that prices may be pushed too far. Briefly, a few of those indicators
include:

● Technical
○ Bullish percentage of broader market
○ Momentum
○ Put/Call ratio & Volatility index

● Fundamental
○ Significant insider transactions
○ Analyst overconfidence
○ Large institutional participation
 Creating the Strategist (9/11)

Rational investing

Introduction
So what is rational investing, you ask? A relatively new term in the investing universe, rational
investing attempts to combine the strengths of both fundamental and technical analysis to try
and find investments with high upside potential & relatively low risk.

According to Wikipedia (link) "​...many technical analysts reach outside pure

technical analysis, combining other market forecast methods with their technical
work. One advocate for this approach is John Bollinger, who coined the term
rational analysis in the middle 1980s for the intersection of technical analysis and
fundamental analysis....​"

Fundamental analysis (FA)​: The study of the perceived value of an asset from the
balance sheet's point of view. From either a top down (macro) or bottom up (micro)
perspective, the fundamental analyst looks to find imbalances that suggest the price of
an underlying asset is not reflective of its underlying intrinsic value. Popular measure
include Price/Book, Price/Sales and Price/Earnings. Building a list of fundamentally
appealing criteria is a very personal process and is the focus of an entire part of this
course. It should not be taken lightly, however, it should not be feared either.

Technical analysis (TA)​: The study of price itself has its roots much further back in
time than fundamental analysis. There are records of Japanese rice farmers using
charts to forecast price as far back as the fourteenth century. Technical analysis also
encompasses ratio/spread analysis as well as indicator & volume analysis. I personally
am a fan of harmonic price pattern analysis in which price never moves from just point
A to point B. rather price moves in a point A to point B to point C to point D pattern.

Historically, these two camps don't really like each other. Call it professional hubris or
whatever, one often ridicules the other. From my personal experience, fundamentalists
believe technical analysis is 'too easy' while technicians of technical analysts believe
the fundamentalists live in the clouds. Another great analogy I once heard goes
something like this. ​“Imagine two people driving down the road in a car. The passenger
has the map out and when given the opportunity to look out the window, sees blue sky
out on the horizon towards the destination. The driver, on the other hand, has two
hands gripped firmly on the wheel and is anxiously following the broken road and
desperate to avoid the potholes along the way.”

What if they agree?

Aside from personal bias, a simple question arises from this debate. What happens if
you find situations where they both agree on direction? The answer is simple – very
high probability of success. Remember that magic 66% from rule #1 of CRI's two rules
 Creating the Strategist (10/11)

of investing? Using a rational approach to investing takes that number well above 75%
and even higher. Interestingly too, having a rational understanding of why you are
invested makes the process of seeing that investment to fruition much easier, too.

Investing is almost boring

A good trading/investing plan is in itself a lot of fun to construct. Ironically,
implementing and monitoring the plan is very boring. For example, for stocks,
seasonally there is a time to be buying (tax loss selling season) and a time for selling
stocks (tax refund season). This implies one should only be interested in doing a stock
transaction twice in a year. Sadly, many make great capital gains through that
seasonal window only to give a good portion (if not more) back through the remainder
of the year. From personal experience as a broker, I have watched many good plans
slowly deteriorate over time due to impatience and/or complacency. Good investing is
boring and requires few transactions – indeed, the fewer the better. Money grows
slower then grass sometimes and that is just the way it is. Having a plan, a rational
plan keeps you on track and focused through those boring and/or tempting periods.