October 30, 2007

First Principles

Technical Analysis of Stock Trends by Edwards and Magee is as close to the sacred book of technical analysis as it gets. In it, one can find such gems as:

1. The market value of a security is determined solely by the interaction of supply and demand.
2. Supply and demand are governed at any given moment by many hundreds of factors, some rational and some irrational. Information, opinions, moods, guesses (shrewd or otherwise) as to the future combine with blind necessities in this equation. No ordinary man can hope to grasp and weigh them all, but the market does this automatically.
3. Disregarding minor fluctuations, prices move in trends that persist for an appreciable length of time.
4. Changes in trend, which represent an important shift in the balance between supply and demand, however caused, are detectable sooner or later in the action of the market itself.

October 25, 2007

Rapid Cycling

Trading has not exactly been an easy ride lately as the market is trying to find some sort of a bottom to its latest bout of weakness. The market is going through one of those bipolar phases when it can't decide if bad news (and there are plenty of them) is good news (the Fed will keep cutting rates) or if it is so bad it can't possibly be good no matter what (a recession will be impossible to avoid). In psychobabble, what we have these days is not only bipolar disorder (formerly known as manic depression) but rapid cycling bipolar disorder.

Yesterday was a case in point. The morning news was uniformly disastrous, even by current standards. Merrill Lynch announced results that were even worse than the worst case scenarios and this despite the fact that the investment bank had done its best to prepare everyone for the worst. Housing data also came in worst than expected, a tour de force considering that it is now generally accepted that the housing situation will get a lot worse before it gets better. And finally, to add insult to injury, one of the rare sectors that had been reporting good earnings, the Internet sector, saw one of its illustrious members (Amazon) disappoint. All this added up to a relentless swoon that took the Dow down 200 points.

And then, after an obligatory test of the key 13,500 level, the Dow retraced the entire 200 points, egged on by rumors that the Fed would pull yet another trick from its hat and cut its discount rate a few days before it cuts its Fed Funds rate. And so the future is shaping up as a fierce battle between the Fed and the recession monster. The market will be counting points and reacting accordingly. No end in sight to the rapid cycling.

October 15, 2007

Kurtosis

The Black Swan is making me want to know as much as possible about statistics so I've been reading the statistics volume in the CFA1 reading material (not that I ever intend to take the CFA exam....actually I'm signed up for the December exam but will not take it for I am not and will not be ready....it's the accounting part that made me give up).
From what I understand, kurtosis is the statistical measure that tells us if a distribution is more or less peaked than a normal distribution. A leptokurtic distribution is more peaked than normal which I take to mean that it is fat-tailed. The normal distribution is a better approximation for U.S. equity returns for annual holding periods than for monthly returns which have very large excess kurtosis and are thus leptokurtic. My questions are: 1) Isn't the reason annual returns appear mesokurtic (normal-like) is that there isn't enough data to analyse? If we had 1,000 years of market data, wouldn't the distribution of annual returns turn out to be leptokurtic after all with many years of extreme returns? 2) Has anyone computed the kurtosis of daily, hourly, minutely, etc... returns? Does the distribution get more leptokurtic as we reduce the interval? If that's the case, it would explain why it is easier to make money trading off a 30-minute chart than off a daily chart, wouldn't it? More extreme/unexpected moves mean more trading opportunities. It would also mean that all the financial theories (which are based on the assumption that returns follow some sort of normal distribution) do not apply when we look at small intervals.

October 12, 2007

Free market OR free investors?

Isn't it interesting that the main champions of free-market thinking are also the ones who promote theories that have as their main underlying assumption the rational investor?
A rational investor is a predictable investor (very useful for modelling). A predictable investor, by definition, is not a free investor since freedom means freedom to invest in an irrational, self-destructive way. As behavioral finance has shown time and again, most investors do behave in a non-optimal way most of the time.
One must wonder how accurate a model assuming lack of freedom in investors can be at predicting future investor behavior in a free market.
You can't have it both ways: a free market with captive, predictable investors. Either the market AND the investors are free or they're not.

October 11, 2007

Truly fascinating article on Niederhoffer on the New Yorker's website. It seems like he blew up yet again. Fatal flaw? Greek tragedy? It seems Nassim Taleb was right when he specifically predicted this would happen as Niederhoffer is constitutionally incapable of comprehending the concept of Black Swan. He's basically picking up nickels in front of a steam roller.

October 7, 2007

Bonkers

Reading Alan Abelson's rantings and ravings about how the market is bonkers etc..., it occurred to me that he (among many others) is falling prey to a very common fallacy: he is confusing the stock market with the economy, the same way others are confusing a stock with the underlying company. He is in his role saying there is a disconnect between the level or the direction of the stock market and his appraisal of the current state of the economy if it's his opinion. But he is totally missing the point when he derives from that opinion that the stock market is wrong.
The stock market is never right or wrong, it just is. Sometimes it discounts things, sometimes it's late factoring things in and sometimes it's adjusting right along the perceived economic realities. Add to that the fact that those perceived economic realities turn out to be wrong most of the time and you have a situation where judging the market's sanity by comparing it to where we think the economy is heading is pure madness. And doing it every week on the first page of Barron's, week in week out is bonkers.
Having said that, I very much appreciate Abelson's wit, style, cynicism and refreshingly outside the box thinking.

October 5, 2007

Ebullient bullion continued

As a quick update to a previous entry concerning GLD, the gold ETF, once the 68 resistance was taken out it was only a matter of time before the all-time high at 72.26 was history too. Point and Figure charting is saying: stay all in, even better things are on the way.
On a totally different note, wasn't neat how the employment numbers came in weak a month ago perfectly on cue for the Fed to justify its electrifying 50 bp rate cut but then, wait, we learn today that it was all a big mistake, the numbers were actually just fine and the ones this month are great. Does that mean the Fed is going to take back its easing action? A 50 bp rate hike at the next meeting? More seriously, the Fed can now build a good case for leaving rates unchanged and not get too much grief from the market shrills.
On yet another subject, I'm reading The Black Swan, Taleb's second oeuvre and as expected it is teaming with ideas. As in:
we tend to underestimate the likelihood of black swans before they happen and overestimate that likelihood after they happen. More on this later.

October 1, 2007

Peter Boockvar, equity market strategist at Miller Tabak says:
"The market won't go down until it disabuses itself of the notion that the Fed can do anything."
But he also cautions against the possibility that "we're rallying ourselves out of a rate cut".
Well, what if the economy were OK all along and the 50 bp cut were all gravy, a pure gift to the market. Another cut or not would not matter much in that case except to the market's slope of ascent.