30-Apr-2006
Applying the "Rules of War" to the Market, from David Baccile

Bevin Alexander's "How Wars Are Won" details 13 rules for waging war. I'm just beginning the book and hope to provide a review when done. If it is anything like the short 10-page introduction, it will be a rewarding read. I will provide some quotes from the introduction and add some of my thoughts on how these rules of war may apply to the markets.

Both countries (France and the U.S.) tried to fight a conventional, or traditional war against the Vietnamese Communist forces, but the Communists insisted on fighting a guerrilla war. That is to say the Vietnamese used different weapons, and with those weapons they were superior. They, like the September 11 terrorists, eluded strength and struck at weakness.

The rule "eluding strength and striking weakness" is an old rule that all great warriors and commanders such as Napoleon have used to gain advantage.

How may such a rule apply to the markets? In the markets we are not matched against one great commander but many, many great commanders. Large Wall Street dealers with unmatched capital and sophisticated hedge funds both attract the brightest minds in the world to employ technology and methodologies to their advantage. In addition to this group, we are up against large money managers with teams of trained analysts and traders.

How do we, as smaller traders / investors, then elude their strengths and strike at weakness? First, we must identify the weaknesses and they - let's identify "them" as the Chair's "Market Mistress" - do not all share the same weaknesses.

Areas of Weaknesses for the Market Mistress:

1. Tied to a benchmark. Perhaps the second worst concept ever created was that of comparing performance to a benchmark (the first being CAPM). Most money managers are pleased if they can beat a benchmark every year by 100 - 200 basis points every year. They adopt rigid styles to keep them invested in a similar fashion to their chosen benchmark.
2. Short-term orientation. With some notable exceptions, Money managers, hedge funds and dealers focus on short-term success. When this short-term orientation is combined with a rigid style, the result is a flocking, or herding of managers within similar styles into the sectors and stocks that are "working" and out of those that aren't.
3. Success get punished. A money manager or hedge fund that performs well is then "rewarded" with a flood of new money as investors seek to garner their share of any prospective success of this talented manager. The additional funds, reduce the managers ability to capitalize on his advantage and the alpha is diluted. This leads to a fourth weakness.
4. Size matters. Successful money managers typically manage large sums which often limits their universe of potential investments. Liquidity constraints may keep a manager from investing in potentially fruitful areas.

Striking at the Weaknesses of the Market Mistress

Many reports and studies show that contrarian and small-cap strategies out perform in the long run. Both strategies strike at the weaknesses noted above. Contrarian strategies often take time to play out which requires the patience and confidence that many money managers lack - especially those "run by committee". Small and micro-cap stocks have gained popularity in recent years due to their strong performance - look at the Russell 2000 and you'd never know we experienced a major bear market in 2000 - 2002. By focusing on these two strategies, small investors can profitably strike at some of the Mistress's weaknesses.

The commander must evaluate every new situation with great care, and *then*choose the rule or rules he must employ to achieve success. The rules of war relate to solving specific problems as they arise, and are not general rules always to be applied to all situations. In fact, applying a rule in the wrong situation can lead to disaster.

Sound familiar? This passage seems terribly similar to the Chair's concept of ever-changing cycles. Trading strategies must be adapted to shifting market sentiment and the Mistress's ability to punish those that cling blindly to what has been working for them.

The general seeks a quick victory, not lengthy campaigns; extended operations exhaust the treasury and the troops. The commander attacks only when the situation assures him victory. By threatening in many directions, he seeks to disperse the enemy to defend everywhere. If defending everywhere, the enemy is weak everywhere. As water seeks the easiest path to sea, so armies should avoid obstacles and seek avenues of least resistance.

The Mistress works to disperse us, the enemy, by spreading market myths and useless information from global business new outlets. Once weakened, the Mistress attacks and scores victory. Counting is one of the ways to combat this strategy and break-thru the myths and other market noise. Statistical studies and deep financial analysis combined with rationale business sense is probably our best, if not only, defense against this method of attack commonly employed by the Mistress.

Another lesson learned from that quote might include the need to stay within your strength - or build-up new areas of strength *BEFORE* venturing off in different directions. Trading only when the advantage is solidly in our favor will help to ensure ultimate victory.