The way to learn

Learning to trade is not very different from learning any other discipline. It takes a lot of efforts and finding the right teachers. At some level of experience, the best teacher for you will be you, but before such level is reached having someone to show you the direction of least resistance is priceless.

For example, in his early years, one of the most notorious composers ever –  Mozart, imitated and mimicked the work of others. From their lessons, later in his life, he gradually builds his own unique style. This is a common path to success in music. Common path to success in trading.

In music first you learn the notes. Then you try to replay other guys’ compositions until one day you start to compose in your own unique style. In trading, first you learn the basics of supply and demand, some common market anomalies and basic market psychology. Then you read about other, already successful, people’s methods and try to mimic them until one day you become experienced enough to create your own style of trading that satisfy you financial and personal goals best. These are three different levels of expertese in each field and they should be mastered in the mentioned sequence.

Open your eyes

Seth Godin has an interesting article on finding the one, who can really help you. Very thoughtful and a must read.

“People in charge can rarely help you, because they are rarely (truly) in charge. Billionaires can’t help you, either, because they have their defense force fields on full strength during meetings like this. In fact, the person who can help you the most is almost always someone who doesn’t appear that powerful on the surface.

Remember, it’s not just that they can help you. It’s that they want to help you. Famous people qualify in neither category.

So, who is it? Hint, it’s not the Wizard of Oz or the Pope or Barack Obama. It’s someone not famous, someone who actually makes things happen and someone who actually cares. Think hard… Got it?”

Step by step…

1. Create a clear, concise method that will serve you to find trading ideas. A method consist of simple to implement consecutive steps based on market anomalies. A method should be derived from your trading goals and it always incorporates in itself money management techniques for capital preservation.

2. Use those trading ideas to create a plan of action.

3. A plan of action usually consists of two or more scenarios. For example if X happens, I will go with trading idea A; if Y happens, I will go with trading idea B. We create different scenarious, because we can’t control the market. We forecast what might happen and plan how we will react if certain event or a process happens.

Having a clear method helps you to be consistent and disciplined in finding new trading ideas. Creating a plan helps you to profit from your trading ideas. It assist you to focus on your goals.

The curious case of crude oil

Last week’s production cuts and further weakening of the dollar were not able to offset the expectations for slump in demand and crude oil fall to four year lows. OPEC claims that the severe decline is not based on fundamentals and it is pure overreaction. If they truly believe that the current price of crude is unfairly cheap, let step up and start buying oil futures as every self-respected company would buy its shares in a similar situation. Such behavior might seem extreme, but it will have better appreciation impact on oil futures than production cut.

During the last three weeks we experienced a small rally in many commodity related industries. All, except oil. The demand was highest for Gold. If smart money is truly expecting an economic recovery in 2009, it would be buying crude, not gold. Bidding up gold and treasuries is a sign of fear and uncertainty. It reflects a perception of higher risk. It is a desperate move aiming to save some of the purchasing power of the current wealth, which is devastated by FED’s favorite sport – dollars printing.

In the end of last year I wrote a post about crude oil, trying to explain that too high price of the black gold will be devastating for oil producing countries in long-term perspective. First, an extreme price of oil gives people an incentive to invest in alternative, more energy efficient technology. If a human being is motivated to achieve something, sooner or later, it succeeds. Second, high oil price changes people’s habits. They find a way to consume less and tend to stick to this newly found behavior even when the economy starts to recover. At the brink of extremes, people change.

It is fair to point out that OPEC didn’t and doesn’t have a major impact on crude futures. It is well known fact that they were bid up by financial institutions. Disregarding that, oil producers liked the thickness of their wallets and said that they can’t impact the price of oil. Why do they think that they will be able to do it today? They became complacent and didn’t think about the long-term ramifications of high oil price for their economies. Oil was found about 100 years ago and it was adopted as energy source, because it was cheap and efficient. Once those variables change the whole equation changes. People go and find a better alternative.

Earlier this year Bank of Kuwait came up with a report, revealing the break-even price of crude for the different oil producers. It claims it is $17 per barrel for Kuwait, $30 for Saudi Arabia, $33 for Canada and much higher (in the lower 40s) for many others. All small numbers that should suggest that at the current level of crude, many countries should stop producing. I don’t believe these numbers. Oil producing nations have sold profitably its products at even lower prices during the last several decades, even when inflation is taken into account. I would like to see a similar report for break-even prices from an unbiased entity.

What strikes me the most is not the break-even prices, but the claims that many oil producing nations have based their 2009 budgets on $70, $80 and even $95 per barrel. If for a moment we assume that this is true, countries like Venezuela, Iran and Russia are in big trouble. Not only many projects will be postponed (scratched), but their cash reserves will evaporate faster than a glass of water in a dessert. Extreme budget deficits will affect substantially the living standards of their citizens and it won’t be surprising to witness cases of massive civil disobedience. Ironically, political destabilization in any of the major oil producers will lead to far more efficient appreciating shock on oil futures than any coordinated cuts. An extremely low price of oil will lay a solid foundation down for its fast appreciation in a 3-5 years horizon, as an extremely high oil price caused what we are currently witnessing. Remember that for the next 20 years oil will most likely remain the cheapest and most efficient source of energy.

Assuming that the current short-term trend of weakness in crude oil continues, which industries would be the biggest benefactors? The fist groups that come to mind are Airplane carriers and trucking companies, which bottom line should get a boost from cheaper oil. So far there is no sign of that happening. Oil is only one variable in their EPS equation. The current decline in their input cost is more than offset by a decline in their output – people travel less often, companies sell less; less packages need to be transported.

The only industry that currently should thrive in an environment of low oil price is Gold mining. Not only crude accounts for substantial part of its expenses, but gold has been outperforming everything else this year. If this trend continues, and there are no signs that it will end any time soon, gold mining companies’ EPS should get a nice boost. Higher EPS growth often leads to higher stock prices. Certainly EPS is not the only factor that affects price. It is actually of secondary importance when put next to investors’ confidence. A simple way to measure confidence is through P/E ratio. It is self-evident that recession hits investors’ confidence big time. Often a rise in bottom lines of solid companies is offset by general lack of confidence.

The dangers of deflation

In long-term perspective there are two scenarios for the global economy: severe deflation and strong inflation, as they might come one after another in this order.
Severe deflation will mean further shrinking of consumption, unemployment in the double digits. More downside for commodities. Oil might take the elevator to the lower 30s. If this happens, we might see another 30-50% decline in the stock markets, as soon as next year. Earnings expectations are still elevated and negative earnings surprises in the coming quarter might shave the Dow with razor number 6. Many emerging countries will default on their credit following the example of Ecuador last Friday – a dangerous practice that usually leads to tightening of the credit markets, which hurdles economic growth. Severe economic crises around the world might lead to forced change of governments and a revival of nationalistic political systems. No country is insured against the unsatisfaction of the crowds. Countries which have enjoyed higher economic standards during the last decade should be particularly aware of sudden economic slump. People seem to be motivated more by the thought of losing something that by the thought of gaining something of equal value. James Davis states that we are most likely to find revolutions at a time when a period of improving economic and social conditions is followed by a short, sharp reversal in those conditions. Thus, it is not the traditionally most downtrodden people – those who have come to see their deprivation as part of the natural order of things – who are especially likely to revolt. Instead revolutionaries are more likely to be those, who have given at least some taste of a better life. When the economic and social improvements they have experienced and come to expect suddenly become less available, they desire them more than ever and often rise violently to secure them. For instance, it is little recognized that at the time of the American Revolution, the colonists had the highest standard of living and the lowest taxes in the Western World. According to historian Thomas Fleming, it wasn’t until British sought a cut of this widespread prosperity (by levying taxes) that the Americans revolted.
The other, and ironically the preferred path, is inflation. The US government desperately is trying to inflate the economy, trying to prevent Great Depression number two from happening. The financials injections in the economy will lead to severe weakening of the dollar. People, who keep their money under their mattresses or in low interest savings’ account will get poorer. The only way to offset the decline in the purchasing power of your dollars will be to be invested in the stock markets, which are supposed to rise during periods of inflation. Commodities will renew their upward spiral.