Gambler’s of the World, Unite!

October 25, 2008

 

It may be a stretch to paraphrase Karl Marx’ Communist Manifesto, but hear me out.   As a full-time trader, I am often asked what the difference is between trading and gambling.  For years, I could not answer that question with any conviction.  I knew trading had to be better, because I don’t like gambling.  Then, years ago, out of necessity, I read a statistics textbook. 

 
I learned that casinos make money by ensuring that the odds of success are ever so slightly tilted in their favor.  For example, a typical roulette wheel has 37 slots, 1 through 35, 0, and 00.  By picking a number among these 37 choices, you have a 1 in 37 chance of winning.  However, your payout, should you win, is only $35 for every dollar bet.  Over many, many bets, the casino can expect to be a net winner because every $37 in bets, on average, will only pay out $35, assuming all numbers are equally likely to be landed upon.  The house keeps the $2 "edge".

 

Trading is Different

On the other hand, trading is different than gambling in that you constantly strive to put the odds in your favor, rather than in the house’s favor.  If you find a way to do this, then over many, many trades, you should be a net winner.  The reason most traders lose money is that they think it is easy, and don’t realize that the deck is already stacked against them.  You unstack it by doing your homework and trading judiciously.

 

There are innumerable ways to put the odds in your favor in the markets.  There is no free lunch, and you’ve got to work hard to find an edge that distinguishes you from the rest of the market participants.  The most common methods to achieve this are with fundamental and technical analysis.  Other approaches include studying historical economic data, comparing currencies among world nations, and finding relationships among data that no one has published before, to name a few. 

 

To make money, traders put their research into action.  If you think XYX is undervalued (a fundamental edge), or is strongly oversold (technical edge), you buy it.  You know that eventually the rest of the market should recognize what you’ve discovered, and buy the stock up to where it should be.  If you are right, you make money.  Over many trades, you will be wrong sometimes, too.  With proper money management, and by constantly trying to put the odds in your favor for any given “bet”, you will be a net winner.  It takes years for the average person to consistently be able to do this, but it can be done.

 

A Brave New World

Then, they go and change the rules.  I’m not talking about the bailout package or the short-sale ban.  Not the uptick rule, or the nationalization of the banks.  I’m talking about what used to work, doesn’t.  This market has changed the way it operates, although I’m convinced this is temporary.  Oversold becomes more oversold, and undervalued stays there.  The edge that you think you have does not exist right now, and that is very dangerous.  This is as close to pure gambling in the stock market as I have ever seen in my 10 years of participation.

 

When this volatility started, about a year ago, you heard several professionals talk about how this is a “traders market”.  That was true, and as a trader, I’ve done very well all year.  The problem is that over the past couple of weeks, you don’t hear that as much.  Even traders can’t find an edge in such illogical times.  It’s frustrating.  This market is not fun to trade right now.  Although I am still successful and making money, I consider it to be pure luck lately.

 

The bottom may or may not be near, but what evidence can one point to for determining that?  Fundamentals say that the S&P is trading at a forward P/E of 11, below its historical average.  The E, earnings, is questionable, and could drop hard if estimates are revised downward, as is likely. 

 

The technicals say we are oversold, but that has been the case for several weeks.  One example is the Percent of Stocks Above the 40 Day Moving Average.  For decades, the market has had a significant bounce when this value dropped to 10%, as it did this past July.  Today, that value is 2.5%.  It dropped below 10% on October 2, and has stayed there for 17 straight trading days.  The last time the indicator was this low was October, 1987.  It lived sub-10 for 27 days in a row during that time.

 

What about Forex?  The dollar has been very strong against the Euro and British Pound, but there’s no positive reaction in the US markets.  The general consensus is that those currencies are in worse shape than our own, so on a relative basis, the dollar wins.  Not exactly a tradable situation.

 

Class Struggle

Much of the recent sell-off is being blamed on “Hedge Fund Redemptions”.  That sounds so fluid rolling off the tongues of market reporters, that we aren’t aware of why it matters.  That’s what I’m here for.

 

Hedge funds are legal entities that trade in the open markets.  They have almost no reporting requirements, and can buy or sell large positions in stocks, commodities, etc. with almost nobody knowing what they are doing.  Hedge funds are only open to wealthy individuals and institutions, such as pension funds.  These multi-billion dollar trading outfits made huge bets in commodities such as oil, gold, grains, and related stocks (agriculture names, energy, etc.).  Hedge funds also bought large positions in the S&P futures and other common stocks.

 

When customers get nervous about the markets, they call their hedge fund (or fund of funds manager, sort of an “in between”, slimy character), and ask for their money back.  They want to “redeem” their shares, and get their money.  To prevent this sort of inconvenience from happening too often, hedge funds only allow redemptions during certain periods, written into the bylaws of the hedge fund agreement.

 

Many hedge funds have a redemption cycle which ends in October.  I’ve heard that as much as 75% of hedge fund holdings fall into this time frame.  As the customers demand money back, the funds need to sell out their positions in the open market, causing giant down days, like we’ve seen.

 

Another impact on the recent market is through margin selling.  Very large insider share holders are being sold out of their positions because they borrowed on margin against the collateral of the stock price.  When the stock goes down enough, the broker will sell the stock to get his loaned money back.  This is a margin call.

 

So, as far as I can surmise, the small trader, like most all of us here, is currently at the mercy of the wealthy hedge fund and insider share holder.  From Part I of the Manifesto:

 

The bourgeoisie, wherever it has got the upper hand, has put an end to all feudal, patriarchal, idyllic relations. It ... has left remaining no other nexus between man and man than naked self-interest, than callous “cash payment” ... for exploitation, veiled by religious and political illusions, it has substituted naked, shameless, direct, brutal exploitation

 

Of course, Marx and Engels were describing the exploitation of the working man by the wealthy.  When the wealthy sell out and cause a 40% drop in the markets, is not the working man’s 401k the victim?

 

Historic Price Action

Finally, all the volatility got me thinking about whether this type of market pattern has ever happened before.  Specifically, I wanted to know if we had other periods where the absolute value of the daily market swings, in percentage terms, was this high.

 

Using data back to 1915 for the Dow Jones Industrial Average, I calculated the daily price percent change for every trading day.  I then took the absolute value of this change, and calculated a 5-day moving average.   Using the 5-period average, how many times has the market averaged a 5% or more daily change for the whole week? 
 
Out of 23,552 trading days, this has happened a whopping 39 times, or 0.17% of the time.  This means that for the trailing 5 days, the average close on the Dow has been at least 5% up or down.

 

When did this happen?  Surprisingly, all occurrences are congested around specific periods:

 
 Year      Occurrences
 1929, Oct and Nov  10
 1931, Nov  5
 1932, Feb, Aug, Oct  5
 1933, Apr, Jul, Dec  9
 1987, Oct  6
 2008, Oct  4
 
The first 29 times all happened at the start of and during the Great Depression.  The next 6 during the great crash of 1987.  The final four in mid-October of this year. 

 

As if the daily whip-saw movements didn’t convince you that we are in highly unusual times, perhaps my little study, above, will.  This is uncharted territory for most of us, but eventually this will end.  The opportunities created right now are truly once in a generation, but the pain of waiting out the uncertainty can be almost unbearable. 
 
Forget any real trading for a while, as we have entered into the world of casinos and back-room poker games.  We are now gamblers, but at least we are all in it together.
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