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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 Vics 10-year-old daughter, Kira
You couldnt win yesterday in doubles. Problem was your partner was too relaxed and just didnt want to win badly enough to reach for all the hard shots.
Same thing happened in my game. Thats 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 dont 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 theyre 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. Theres no way Im going to partner with others so smug about playing at a time like this. Ill wait and join them when theyre a bit more demanding of the market. Perhaps when that 19 moves up to 25.
Rules for the game
Lets use this loss to help you win next time you play squash by going over some of the things weve learned about your game. Its 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 trades not over until you have a round trip.
- A little deception is worth a lot of power. Keep shots under wraps. Dont tell others what your positions are or where your stops are. Theyll bury you.
- After your opponent hits a forehand, she doesnt have proper grip for a backhand. When the market rises in one period, its 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 youre a trader, dont 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. Dont buy positions that dont account for at least 2% of your assets or theyll 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; its 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. Its been down quite a few percentage points on all the indices, and at the close Im 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. Heres 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 todays 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 others pockets.
We emphasize again that the relation we have calculated is for the market and not for individual stocks. Furthermore, it doesnt 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 markets 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, Isnt 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 markets judgment as to the long-term course of future profits. Once you accept that axiom, its not surprising that theres 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 mlange.
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, its 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 Newtons 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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