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The Speculator
10
rules to squash the market competition
To win at the speculator's
game or on the court, you have to be tricky and quick. These tips
will improve your chances.
By Victor
Niederhoffer and Laurel Kenner
An open letter to Vic’s 10-year-old daughter,
Kira
You couldn’t win yesterday in doubles. Problem was
your partner was too relaxed and just didn’t want to win badly
enough to reach for all the hard shots.
Same
thing happened in my game. That’s why I moved to the sidelines.
Investors are saying they are very happy with the current market
risk. When they are happy, they willingly buy at high prices and
don’t demand much in the way of earnings in return. So you can
expect to get as little return if you play along with them by buying
when they’re happy as you could by playing with a partner who is
just having fun.
The way I can tell when the market is happy
with the current risk is by looking at something called the CBOE
Market Volatility Index, or VIX ($VIX.X).
It measures market players’ sentiment about which way the market
will move in the next year; the lower the number, the more bullish
the market. Right now, the VIX is at 21, up from a four-year low of
19 on March 28. There’s no way I’m going to partner with others so
smug about playing at a time like this. I’ll wait and join them when
they’re a bit more demanding of the market. Perhaps when that 19
moves up to 25.
Rules for the
game
Let’s use this loss to help you win next time you
play squash by going over some of the things we’ve learned about
your game. It’s funny, because even though they seem unrelated, I'll
bet many of the same things that will help your game will help me
with mine.
- Get ready before you serve. For a trader, that would
mean, get in early before you trade and make a plan.
- Never assume the point is over or stop to admire a shot you
just hit. The trade’s not over until you have a round trip.
- A little deception is worth a lot of power. Keep shots
under wraps. Don’t tell others what your positions are or where
your stops are. They’ll bury you.
- After your opponent hits a forehand, she doesn’t have
proper grip for a backhand. When the market rises in one
period, it’s vulnerable to a decline in the next.
- Set up so you can hit to all four corners. Diversify
your investments into at least four positions and leave some in
reserve.
- Never relax during the point. If you’re a trader, don’t
take trips when you have a position on. If you must travel, close
out your positions.
- Hit power shots with abandon but return quickly to the
middle of the court. When you feel sure about a position, take
a meaningful amount, but after you cover or sell, focus
immediately again on opportunities as they tend to rotate from one
field to another.
- Stay close to the ground with a low center of gravity.
Be sure that your positions cannot be toppled by evanescent moves.
- Return all the soft shots hard or your opponent will get up
to them. Don’t buy positions that don’t account for at least
2% of your assets or they’ll become too frivolous and random in
their effect.
- Play every day and write the lessons down. Keep a
record of your trades and how the market moves each day, as I and
my employees have been doing each hour of every day for the past
25 years.
By the way, lots of people think speculators are
not nice guys, but in truth, they play a very important role in the
world. My good friend, Ross Miller, explains my job like this to his
15- year-old daughter:
“The forces of nature need no assistance to bring the world
into balance: Water always seeks its own level without any help
from anyone. In the world economy, traders play the role of the
natural force that helps markets to operate more efficiently.
Traders notice when prices are too low in some places (then they
buy those goods, helping to drive up the prices) and too high in
other places (then they sell goods, helping to drive down those
prices). For a time, traders may profit from the imbalances that
they discover; it’s a kind of finders' fee granted to them by the
market system. However, as other traders discover these
imbalances, competition among traders reduces the profit as
markets come back into balance. The return to balance eliminates
that profitable trade, and so the trader needs to find other
market imbalances in order to make his living. Only people who are
clever and constantly on the lookout for opportunities can make a
living as traders. Hey, did you know that the Latin verb for 'look
out' is speculare, which is why traders like Vic are also
known as speculators?” So you can see, Kira, that you have to be
tricky and quick to speculate. Few but your dad would be crazy
enough to look at squash to get trading ideas -- and that gives us
an edge.
P.S. Sometimes after traders violate these rules and
relax too much, something happens to make them pay attention. If you
have a good partner, and she lets you down, it's good to give her
another chance. That's how I feel about the market as I write on
Wednesday at the close. The market is paying quite a bit of
attention and is looking very risky. It’s been down quite a few
percentage points on all the indices, and at the close I’m giving it
another good chance by playing very heavily from the long side. I
would suggest you give your partner another chance, too.
P/E ratios and random
success
Our column on the lack of correlation between
broad-market P/Es and broad-market returns generated considerable
feedback of an educational and revealing nature. Much of it was the
hostile kind of name-calling and ad hominem arguments that
result when sacred cows are manhandled. Here’s one from a "Mr. TB":
“One can conclude that you are long, you lost lots of money, and are
holding on till death do you and your money part.”
The funny
thing about that is that we have actually been leaning and trading
quite heavily from the bearish side, as today’s column and our
Market Dispatch item published Monday morning made quite clear.
But who can blame the bears for being vigilant in stamping
out what they consider to be bullish propaganda? Of the millions of
analysts’ recommendations tabulated by Bloomberg during the past
five years, almost 25 to 1 have taken the bullish vs. the bearish
side. Similarly, can one tune in to any message about stocks without
anticipating a celebrity spokesman for a brokerage house touting his
interests? Much of the criticism hurled at us stemmed from down-home
observations such as this one from Howard Nelson, who says he
invests only in low P/E stocks; “To invest in a stock with greater
than 20:1 P/E ratio, I have to believe that there will be a
significant growth in earnings for the company or enough hype that
the pyramid will grow and I will have good enough timing to get out
with a profit.”
The problem is that even if true and
persisting, not due to chance and not counterbalanced by similar
anecdotes from the growth boys, that would still not invalidate the
finding at the aggregate level. Statisticians call the mistake of
jumping from conclusions at the individual stock level and
generalizing them to the total the “fallacy of composition.” It is a
variant of an everyday fallacy like this: “If a person who picks the
pockets of another person is better off, then we are all better off
if we pick each other’s pockets.”
We emphasize again that the
relation we have calculated is for the market and not for individual
stocks. Furthermore, it doesn’t indicate that the higher the P/E,
the lower the expected return. It merely indicates that no matter
what the past P/E, the future expected return is the market’s
long-term advance of some 9% a year, including dividends.
One
of our readers, the libertarian actuary Dick Sears, who oversees the
Gilder Technology Web site wrote in with what seems to us the best
explanation for the phenomenon, and we will be sending him a cane
accordingly. He points out, “Isn’t it typical that the pundits would
assume that they know better than the market? The reality surely is
that whatever the P/Es are, they reflect the market’s judgment as to
the long-term course of future profits. Once you accept that axiom,
it’s not surprising that there’s no correlation . . . within the
broad expectation of 9% to 12% a year, and with myriad exceptions
for individual stocks, where some know better than others what the
future holds, the markets as a whole will always be random from here
on out.”
Yes, precisely. And all we would add is that the
confounding effect of interest-rate moves -- which generally are at
their nadir and most bullish when the economy and earnings are
weakest -- is a key factor in mixing up the mélange.
A cool market insight
If there is one
insight that Laurel Kenner and I have learned from writing 400
columns together during the past three years, it’s that knowledge
about investments exists in diffuse and dynamic niches that vary in
their accuracy over time, place, industry, approach and market
cycle. While our own knowledge tends to be in fields like squash,
piano or counting, we feel we are pretty good at spotting an eagle
when we see it. One contribution came in last week from statistician
Martin Knight that is at once so brilliant and so deep that we feel
we must share it. It explains a most important insight about
trading.
“I have an analogy to share that goes with your
attempts to relate the laws of physics to finance and your work on
the principle of ever-changing cycles,” he writes. “It seems to me
that market inefficiencies obey Newton’s Law of cooling: the greater
the inefficiency, that is the greater the difference between actual
and face value, the more flow there will be across it. As market
inefficiencies are exploited, the market will tend to equilibrium
over time just as temperature will tend to level out in a room, but
new inefficiencies (heat sources) will turn up to create new
flows.”
Laurel Kenner is on vacation.
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