I sit here on a Saturday morning reading the papers, and I’m in disbelief at what I’m seeing. Terms that have never seen their way outside of finance textbooks, are now not only in the Wall Street Journal, but are even in the New York Post (killing any future enjoyment I’ll ever get from this paper). “Reversion to the Mean”, “Quant Funds”, “Statistical Arbitrage” and other terms never before seen in news print are now only a few pages from pictures of Paris and Nicky Hilton leaving the Playboy Mansion Midnight Summer Night's Dream party last weekend. And what’s even more amazing is that Paris is being portrayed as one of the better people in the world whereas the people at Goldman Sachs (and many other big Wall Street firms and funds) are now the bad guys. The real bad guys!

First, if you use or follow our research and trade our methods you know I’m guilty of both trading quantitatively and trading by applying the now mainstream words “reversion to the mean”. I’ve been publishing reversion to the mean research for more than a decade, and in one way or another, thousands of past and current customers and readers of our research apply this style of trading. And, as of today (Saturday August 11), our accounts' overall performance for the year is still comfortably in the green, in spite of the fact that Paris Hilton is a better person than me, (and anyone else who believes that quantitative trading and reversion to the mean is the better way to make money from the markets).

Yes, the Goldman Alpha Fund is down big, as are many other quant funds. And the people running these funds are smart people, probably a heck of a lot smarter than me, (and in spite of what the NY Post say, they’re even smarter than Paris). But in reality, not all quants are bad. And no, reversion to the mean is not a flawed strategy. In fact, statistically it’s one of the very few trading styles that can be quantified and shown to have decades of consistent edges.

So what went wrong so quickly for so many of these funds?

I don’t have the answers nor do I think anyone yet knows the full answers. But my guess is when the final story is written (this time a few pages after a Lindsey Lohan story), the culprit will be the same one who has ruined so many other great traders and fund managers over the years. It’s the leverage -- excessive leverage. So maybe their strategies didn’t work for a month (we had a drawdown too but Friday’s upside moves in many of our positions took care of a lot of the pain and then some). So there’s no way a multi-strategy fund should lose 26% of its value (or 50% of its value as the former Harvard guys did) if leverage wasn’t being used. And I’m not talking about 2x leverage. I’m talking leverage of 5x, 10x and even 20x times which makes even the slightest wrong move look monstrous.

In early May I wrote an article which was intended for our site, Yahoo! Finance and a few other sites. After nearly completing the article I decided not to publish it. Why? Because I don’t enjoy publishing negative things and after I was done writing the analysis, I felt the analysis was just too negative. In hindsight, I wish I had posted it. What I wrote was what I was hearing and seeing over and over again in discussions with people. That the outsized gains that were being made by these funds over the past few years was due to a low volatility environment which rewarded the use of high levels of leverage. I’ve been in this game for 26 years and if you do anything that long, you start seeing signs that tell you when things are neither sustainable nor rational. How can so many guys taking 20-25% of the gains plus another 2-4% for management fees net 40%+ a year when the stock market rises 3% in 2005 and 14% in 2006? They’re either the smartest people in the world and they have models which are truly unbelievable (certainly possible). Or they have lots of small edges, take these edges and leverage the heck out of them and then assume volatility is dead forever (I actually heard this “volatility is dead” comment quite a few times, especially earlier this summer).

So of course what happens? Wall Street is a highly competitive environment and when everyone else is making money doing things like this, why be the only idiot not doing the same (1998-2000 all over again)? Lever up, make 1% edges look like 10% edges and attract billions in capital. And it worked for 2-3 years…until the last month.

Now that the background for “what happened” has been set, lets move to the important things…what should we do and how can we potentially prosper from this?

Five ideas for the start of a summer week:

1. You can ride this out. That’s what we did and are doing (and fortunately we had one of our best days ever on Friday). It’s standard policy for us. We trade reversion to the mean. We trade looking for extreme moves on stocks, especially to the downside and then when the stocks snap back we sell into the rallies. In my opinion, it’s the best way to gain alpha, and our models go back more than a decade. On Thursday our accounts went down. The good news was that at that time the declines were normal. The bad new news was that the market could still decline and it would still be normal. On Friday we saw (and if you follow our research you saw the same in your accounts) a handful of stocks we had positions in rise over 10% during the day. It was reversion to the mean at its best-something we’ve been publishing for years. We’re not always that smart and in no way do I think we’re smarter than other professionals in this industry. The only difference with us is we rarely use margin, we’re patient (maybe too patient) and we make small bets when things get way out of the norm. The downside to this approach is that we often have high cash positions when markets are quiet. But when they move like they have recently, edges get bigger and opportunities to make money start popping onto the screens. Again, it’s never perfect but in my opinion, it’s the best way over the long term to trade.
   
2. You can stand aside. Possibly this is the prudent thing to do. But, you’ll miss the snap back. It is unlikely the market is going to move up a few points a day until it makes new highs. When it snaps back, it’s likely going to be violent. The shorts will cover first and when the coast is clear the big funds will step in. Standing aside let’s you live to play for another day (or maybe even put you in the position to buy lower should the sub-prime mortgage situation get worse). But again, you’ll miss the move-the move that has the potential to be one of the better ones for this year. Only you know what’s best for you.
   
3. Lessen the leverage until volatility (the VIX) drops. You’re getting a 2-1 bang for your buck already versus a few months ago. Why? Because volatility has doubled. What does this mean? It means that prices are basically moving at double the rate they were a few months ago. Therefore a $100,000 in the market a few months ago is now acting more like $200,000 today. The leverage that killed off all those very smart leveraged funds killed them because of the added volatility. Therefore you don’t need to be on margin today. In fact, the prudent thing to consider is lessening your position size so you’re again trading at equal levels where you were earlier in the summer.
   
4. Watch Goldman Sachs (GS | Quote | Chart | News | PowerRating). As Goldman goes, so goes the market. They’re the benchmark today. If Goldman goes up, the market is going to quickly follow. But (and this would be the perfect scenario) if Goldman and the market decouple (meaning Goldman drops and the market rises), we’ll likely have a rally that we may not see again for years. If the market gets to the point where it says “forget Goldman, I’m going higher anyways,” then we’ll be off to the races.
   
5. Look at the VIX Options. The VIX Options have exploded in volume. They’ve become the go to product to hedge and to bet on volatility. Right now the VIX is at 4-year highs. Longer term puts (especially the ones in the high teens to low 20’s) will potentially provide healthy double digit returns if order is restored to the world (and I do believe that it will, just like it was in 1987, 1998 and 2001). I’m conducting two conference calls this week on trading the VIX Options. If you would like to listen, click here for more details.

Two Studies

Let’s now finish with two sets of studies we ran this weekend. Again there are no guarantees of future performance but hopefully we can look at this market in a sensible historical sense. I like to look at both price and also the VIX. Price tells us where we stand based upon recent movement; the VIX tells us how much fear there is in the marketplace. Both are excellent indicators when used correctly. And when they are properly combined, they help give us a clearer picture of what the future may bring.

1. This has only been the fifteenth time since 1995 that the SPX has dropped 2% or more 3 times within a month. Of the 14 times it’s occurred before, 13 times the market was higher one month later. The average one month gain for all times was +5.10%.
   
2. The VIX has been stretched (on a closing basis) 50% or more above its 50-day MA only 21 times since 1995. The market has closed higher 20 of those 21 times one month later. The average gain has been 4.88%. Incredibly the VIX has now closed 50% higher than its 50-day MA three more times since late July, the last one being last Thursday.

One caveat to the above, there are things going on in the world today that no one has even seen before (including never being seen before by Federal Reserve Chairman Bernanke and Treasury Secretary Paulsen). This is a Black Swan caused by the unwinding of sub-prime mortgages and their derivatives - a first in history. Therefore prudence is advised. But, if things do go back to order, we’ll look back years from now and say that the summer of 2007 was one of the more exciting times the market has seen. And we may also say that it created one of the better opportunities of our time.

Have a great week trading!

Larry Connors is CEO and Founder of TradingMarkets.com, and CEO of Connors Research, a financial markets research company.

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