Category: Best Of

1. Perceptions affect prices and prices affect perceptions

I believe that market prices are always wrong in the sense that they present a biased view of the future. But distortion works in both directions: not only do market participants operate with a bias, but their bias can also influence the course of events.

For instance, the stock market is generally believed to anticipate recessions, it would be more correct to say that it can help to precipitate them. Thus I replace the assertion that markets are always right with two others: I) Markets are always biased in one direction or another; II) Markets can influence the events that they anticipate.

As long as the bias is self-reinforcing, expectations rise even faster than stock prices.

Nowhere is the role of expectations more clearly visible than in financial markets. Buy and sell decisions are based on expectations about future prices, and future prices, in turn are contingent on present buy and sell decisions.

2. On Reflexivity

Fundamental analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values. One provides a static picture, the other a dynamic one.

Sometimes prices change before fundamentals change. Sometimes fundamentals change before prices change. Price is what pays and until expectations change, prices don’t change. What causes expectations to change? – it could be change in fundamentals or change in prices. So what I am saying is that sometimes prices could be manipulated to change expectations, which will fuel further price momentum in a self-reinforcing way.

3. “Once a trend is established it tends to persist and to run it’s full course.” – Sentiment changes slowly in trending markets (up or down) and extremely fast in choppy, range-bound markets.

4. “When a long-term trend loses it’s momentum, short-term volatility tends to rise. It is easy to see why that should be so: the trend-following crowd is disoriented.”

A surprising countertrend pop or drop reminds investors of the risks involved and all of a sudden the fear of losing (giving back gains) becomes bigger than the fear of missing out. This is the beginning of the end of the established trend. It doesn’t end here, but it is a damn good spot to consider closing positions and moving to something else. The distribution/accumulation stage is in full force.

5. Markets are not always right. Market is a good discounting mechanism most of the time, but not always. There are times when animal spirits run supreme and emotions overshadow reason. Market constantly discount events that haven’t happened yet. As a result they will often discount events that will never happen.

How good are markets in predicting real-world developments? Reading the record, it is striking how many calamities that I anticipated did not in fact materialise.

Financial markets constantly anticipate events, both on the positive and on the negative side, which fail to materialise exactly because they have been anticipated.

It is an old joke that the stock market has predicted seven of the last two recessions. Markets are often wrong.

Often? How often? Do you have the balls and more importantly the pockets to fade them. Market could remain irrational longer than most people could remain solvent.

6. It doesn’t hurt you what you don’t know, but what you think you know, when it ain’t so

Participants act not on the basis of their best interests but on their perception of their best interests, and the two are not identical.

7. On Bubbles

“Boom-bust processes are asymmetric in shape: a long, gradually accelerating boom is followed by a short and sharp bust. Consequently, most of the credit contraction can be expected to occur in the near term.”

Currency movements tend to overshoot because of trend-following speculation, and we can observe similar trend-following behaviour in stock, commodity and real estate markets, of which Dutch Tulip Mania was the prototype.

8. On Manipulation

I want to buy $300 million of bonds, so start by selling $50 million. I want to see what the market feels like first.

9. On how to be selectively active

The trouble with you, Byron [Byron Wein – Morgan Stanley], is that you go to work every day [and think] you should do something. I don’t, I only go to work on the days that make sense to go to work. And I really do something on that day. But you go to work and you do something every day and you don’t realise when it’s a special day.

Today, $PCYC reached another multi-year high, which brought its YTD gain to a little over 300%. Its impressive performance is not what matters here. What is more important is that it left plenty of clues along the way that it was a major winner in the making.

While $SPY and $QQQ were in a free fall in mid-May; while almost every single stock was obliterated, $PCYC stood firm. Not only it stood firm, but on May 16/17 it was literally the only stock that broke out to new 10-year highs on above the average volume. It takes a lot of buying power and conviction to move a stock to major new highs when the indexes are down 2% for the day and the protection of capital is everyone’s main priority. What happened after the market turned back up in June and July? $PCYC doubled.

Another example. On May 3rd, $ELLI broke out to new all-time high after reporting strong earnings. At exactly the same time, the market was rolling over and it went into a 10% deep monthly correction. What did $ELLI do in the meantime? It went sideways, quietly being accumulated while almost everything around it was falling apart. True market leaders form bases during market corrections. Once the market snapped back, $ELLI resumed its upward gallop and went up another 65% in a couple months.

This equity selection method works even better when a whole group of stocks from the same industry exhibit relative strength. For example, take look at the price action in fertilizer stocks near the end of June – the time when the whole country was hit by a record heat and it became clear that the drought will substantially reduce this year’s grain crop. The market, which is a forward looking mechanism most of time, quickly discounted the drought by bidding up fertilizer stocks. Most notable was the relative strength on June 25, Monday: $SPY gaped down and finished the day lower. Fertilizer stocks ($CF, $MOS, $POT…) gaped up and finished the day above their opening print. Most of them went up 15-20% from there.

The above mentioned examples are not isolated cases. They happen all the time, several times a year. Only this summer, we saw similar group price patters in newspapers and refiners stocks. Relative strength is one of the most reliable equity selection methods.

1. As long as no one cares about it, there is no trend. Would you be short Nasdaq in 1999? You can’t be short just because you think fundamentally something is overpriced.

2. All markets look liquid during the bubble (massive uptrend), but it’s the liquidity after the bubble ends that matters.

3. Markets tend to overdiscount the uncertainty related to identified risks. Conversely, markets tend to underdiscount risks that have not yet been expressly identified. Whenever the market is pointing at something and saying this is a risk to be concerned about, in my experience, most of the time, the risk ends up being not as bad as the market anticipated.

4. The low-quality names tend to outperform early in the cycle, and the high-quality names tend to outperform toward the end of the cycle.

5. Traders focus almost entirely on where to enter a trade. In reality, the entry size is often more important than the entry price because if the size is too large, a trader will be more likely to exit a good trade on a meaningless adverse price move. The larger the position, the greater the danger that trading decisions will be driven by fear rather than by judgment and experience.

6. Virtually all traders experience periods when they are out of sync with the markets. When you are in a losing streak, you can’t turn the situation around by trying harder. When trading is going badly, Clark’s advice is to get out of everything and take a holiday. Liquidating positions will allow you to regain objectivity.

7. Staring at the screen all day is counterproductive. He believes that watching every tick will lead to both selling good positions prematurely and overtrading. He advises traders to find something else (preferably productive) to occupy part of their time to avoid the pitfalls of watching the market too closely.

8. When markets are trending up strongly, and there is bad news, the bad news counts for nothing. But if there is a break that reminds people what it is like to lose money in equities, then suddenly the buying is not mindless anymore. People start looking at the fundamentals, and in this case I knew the fundamentals were very ugly indeed.

9. Buying low-beta stocks is a common mistake investors make. Why would you ever want to own boring stocks? If the market goes down 40 percent for macro reasons, they’ll go down 20 percent. Wouldn’t you just rather own cash? And if the market goes up 50 percent, the boring stocks will go up only 10 percent. You have negatively asymmetric returns.

10. If a stock is extremely oversold—say, the RSI is at a three-year low—it will get me to take a closer look at it.8 Normally, if a stock is that brutalized, it means that whatever is killing it is probably already in the price. RSI doesn’t work as an overbought indicator because stocks can remain overbought for a very long time. But a stock being extremely oversold is usually an acute phenomenon that lasts for only a few weeks.

11. If you don’t understand why you are in a trade, you won’t understand when it is the right time to sell, which means you will only sell when the price action scares you. Most of the time when price action scares you, it is a buying opportunity, not a sell indicator.

12. Normally, I let winners run and cut losers. In 2009, however, as a result of the posttraumatic effects of going through the September 2008 to February 2009 period—talking to clients who are going out of business and seeing 50 percent of your fund redeemed is all very wearing—I got into the habit of snatching quick 10 to 15 percent profits in individual positions. Most of these positions then went up another 35 to 40 percent. I consider my pattern of taking quick profits in 2009 a dreadful error that I think came about because I had lost a degree of confidence due to experiencing my first down year in 2008.

13. As an equity trader, I learned the short-selling lessons relatively early. There is no high for a concept stock. It is always better to be long before they have already moved a lot than to try to figure out where to go short.

14. Do you know what happens in a bull market? Prices open up lower and then go up for the rest of the day. In a bear market, they open up higher and go down for the rest of the day. When you get to the end of a bull market, prices start opening up higher. Prices behave that way because in the first half hour it is only the fools that are trading [pause] or people who are very smart.

15. Now that you have switched from net long to net short, what would get you long again? – Buying. If all of a sudden stocks stopped going down on bad news that would be a positive sign.

16. Lots of companies screen as being “cheap.” I think that it’s easy to avoid value traps. The trick is to stay away from companies that can’t grow their cash flow and increase intrinsic value…As Buffett says, “Time is the enemy of the poor business and the friend of the great business.”

17. If I wrote a book about a strategy that worked every month, or even every year, everyone would start using it, and it would stop working. Value investing doesn’t always work. The market doesn’t always agree with you. Over time, value is roughly the way the market prices stocks, but over the short term, which sometimes can be as long as two or three years, there are periods when it doesn’t work. And that is a very good thing. The fact that our value approach doesn’t work over periods of time is precisely the reason why it continues to work over the long term.

18. The institutionalization of the market has shortened time horizons—it has reduced the window of time managers have to outperform. Most managers can’t wait for two years for an investment to work. They have to perform now. Their institutional and individual clients appear to demand it through their money flows.

19. The single best-performing mutual fund for the entire decade was up 18 percent a year, on average, during a period when the market was flat, yet the average investor in that fund lost 8 percent. That is because every time the fund did well, people piled in, and every time it underperformed, people redeemed.

Source: Schwager, Jack D. (2012-04-25). Hedge Fund Market Wizards. John Wiley and Sons. Kindle Edition.