She Moves In Mysterious Ways

How many different ways can a market move?

At first glance, the answer seems binary: Markets can move in one of two directions, up or down. Work out (or just guess) the direction and it is off to the Hamptons.

Think about it for slightly longer, and be slightly less flippant, and you might realise that markets can move in three directions: up, down or sideways. The market is not always trending, and can spend considerable periods of time without any real direction (see Josh Brown on Middles).

That is true, but still unsophisticated.  It matters what timeframe you are talking about: a market could be downtrending intra-day, stuck within a 4 week congestion range that is part of a multi-year bull trend. When discussing the market condition, it is important to identify the time-frame under consideration.

It also matters whether the market is moving steadily or violently i.e. if it is volatile or calm. Market volatility is not constant, and that can have a considerable impact on your psychology and success.

Within any given timeframe, I identify six ways that a market can move:

  • Up in a steady manner
  • Down in a steady manner
  • Sideways in a steady manner
  • Up in a volatile manner
  • Down in a volatile manner
  • Sideways in a volatile manner

Each of these market conditions feels very different to trade. Different trading strategies perform better or worse under different conditions. Markets with higher volatility are harder to trade: even if you call a trend correctly, there is a higher chance that you will be whipsawed out of your position. It is hard to make any money at all in steadily sideways markets, while mean-reversion and range-trading strategies can work well in volatile but ultimately directionless markets.

Sometimes you will hear different markets classified by their “usual” behaviour e.g. commodities “tend to trend strongly”, stocks “tend to mean revert”. Different assets are viewed as more volatile or riskier than others. Just as important, though, is recognizing that all markets cycle through the six different states over time: Soybeans might be more volatile than Treasury Bonds overall, but it is just as interesting that Soybeans were more volatile in June than they were in April. Volatility is nothing if not cyclical.

It is important to know how your trading strategy and style works under each type of market action. It is unlikely that your personality will be equally comfortable trading all different market conditions. Perhaps you can design some filters that sit you out when conditions are unfavorable to you, or perhaps you just have to accept that there will be a series of losses until the wind starts blowing your way.

Market movement is more subtle than simply “up or down”, and volatility is itself volatile. I normally avoid metaphors like the plague, but the wind is not always blowing from the same direction, nor at the same speed.

Taking The Red Pill: All Fundamental Data Is Wrong

All fundamental data is wrong in some way. Some of it is incorrect, some of it is published by people with a vested interest, and some of it is lies. I am not angry about it, but I think we should face the sometimes harsh reality provided by the Red Pill.

Let us start with company-provided information. If the history of public corporations tells you anything, it is that anything a corporation tells you should be treated as a lie. Sometimes it is deliberately misleading, sometimes it obscures the truth, and sometimes it just lies to your face. If you do not believe me, then I point you to some of those who were caught: Enron and Lehman Bros stick in the mind, but the list is long.

Do not kid yourself that these are the rogues in an otherwise healthy bunch: every public corporation twists and tortures their information to meet their objectives. In a previous life I was a company auditor, and I can attest that there is plenty of scope for maneuver within the law. In a Barron’s interview, forensic accountant Howard Schilit put it like this:

Here is how the auditors look at the world: They think of themselves and their legal liability issues first; if it’s in the rule book and disclosed, you are covered. Second, they think of their clients. The client asked them to do something, and they want to please the client. A very distant third is they may occasionally ask: How does this look from the perspective of the investor? Investors would be astounded if they realized that this is how the party that is supposed to protect them views the world.

Similarly, the New York Times reported on an investigation by the Public Company Accounting Oversight Board that reviewed multiple audits performed by ten different auditing firms. All of those firms were reported to have performed audits that were unsatisfactory and flawed.

Some data is clearly to be more trusted than others: anything a CEO tells you is not even worth a pinch of salt, whereas tax returns are probably more reliable (not because no-one ever lies on their tax return, but because the consequences of doing so are reasonably high, and there is at least a chance of being prosecuted). But the evidence is overwhelming that company executives have a vested interest in portraying as positive an image of their company as they can, and that they can and do lean on all sorts of levers to manipulate the data they present to you.

Trusting the data a company gives you is like believing what Saudi Arabia tells you about their oil reserves, or what North Korea tells you about their nuclear weapons: it might be in the ballpark of True, but it undeniably comes from someone with a vested interest in the outcome. Company data also carries the material risk of missing information: what they tell you might be true, but what they choose not to tell you is important as well.

It is difficult to believe data released by government organizations either. The US Government and the Federal Reserve have a vested interest in persuading you that unemployment and inflation are lower than they actually are. They might not be deliberately falsifying the figures a la Argentina, but there are more subtle institutional pressures to chose assumptions and methodologies than systematically underestimate certain measures.

Just as pertinent are the revisions. Fundamental data is often revised. Corporations restate their earnings. GDP and employment figures are adjusted materially months later. If data can be revised long after the fact, it makes little sense to base investment decisions on the originally announced variable.

Every computer programmer knows that if you input garbage, you output garage. Doing analysis based on discounted cash flows, or price/earnings multiples or supply/demand components is all well and good, but if you cannot trust the data, you cannot trust the output it produces.

I am not one of the Black Helicopter crowd that sees conspiracies at every turn. I believe that Armstrong walked on the moon, that Oswald shot Kennedy and that earthquakes are generally caused by shifting tectonic plates rather than the CIA*. My skepticism regarding fundamental data does not come from a dark and bitter place, but rather from a frank and honest acknowledgement that data is prepared and released by people and that people tend to act in their own self-interest. Even honest, well-intentioned people are humans, and humans are susceptible to spinning bad news as good and lying by omission.

I use fundamental analysis every day. It can be an important part of the trading process. However, I treat all fundamental data with a strong pinch of cynicism, a healthy sense of skepticism and a highly-refined BS Detector. When placing my own money at risk, I think it is better to see the world as it is, rather than how I might want it to be.

* I think that people are attracted to conspiracy theories because they find comfort and security in the  notion that someone is in charge, rather than accepting that most things happen due to random chance.

The Fisherman And The Hypothesis

I have done some fishing. Not much, but some. My father-in-law has done a whole bunch, and from the stories he tells me fishing is a lot like trading. Because it is not about landing a fish with every cast, it is about tolerating lots of nibbles in the anticipation of landing the big one.

For the scientific fishermen among you, you can also think of trading as hypothesis testing. Each trade entry is an hypothesis, a proposed explanation for a phenomenon. You are hypothesizing that a market is about to move in a particular direction. It is pretty testable too: the market will tell you pretty quick if your hypothesis is correct. Or not.

Fishermen and scientists are wrong a lot. As a trader, you should expect to be wrong, to be wrong often, and occasionally you will be spectacularly wrong. Michael Jordan has a fabulous perspective on the subject:

I’ve missed more than 9,000 shots in my career. I’ve lost almost 300 games. Twenty six times, I’ve been trusted to take the game-winning shot and missed. I’ve failed over and over and over again in my life. And that is why I succeed.

Searching for the winning trade is a process of casting, failing and re-casting until the fish is hooked. The successful fisherman will cast and fail more times than the novice fisherman who gives up and goes home early. The successful trader will lose more often than the unsuccessful trader, precisely because the unsuccessful trader does not stay in the game.

Tim Harford describes how a complex problem can be resolved by an approach that incorporates a willingness to experiment:

The process has three components: First, try lots of different things; Second, make sure the experiments are at a small scale so that when things go wrong, it’s not a catastrophe; Third, make sure there’s a reliable way to tell the difference between success and failure.

Besides being pretty much the opposite of how government works, this concept is directly applicable to trading: Try lots of different things, make sure that all the things you try are small enough to not blow you up if they go wrong, and check regularly to see if these things are working.

Regular readers of this blog will know that I am comfortable with failure. I fail everyday, more than once. But that is okay because it is part of a process of progression. Seriously trying for success requires exposing yourself to the risk of failure. Expecting to succeed without experiencing failure is naive. Experiencing failure is fine, as long as it is part of a process that leads to success. The fisherman knows that, and so does the successful trader.

Market Move Through Pain

There are all sorts of things that move markets: shifting fundamentals, technical pivots, valuation changes, macro events, market sentiment, news flow… But in my experience the most extreme market moves are about pain, and nothing else. Valuation and long-term analysis flies out the window as the margin clerks run amok and the market searches for liquidity.

The answer to the riddle of market direction can often be answered by asking, “Where is max pain?” (If your answer is, “In Sao Paulo, searching for redemption”, then you have been playing too many video games). The market will tend to move in the direction that causes most pain for most people.

I have been in the room where experienced, intelligent, wealthy traders have said “I believe our fundamental analysis, but this is too much pain. I have to exit the position.” This is after days and weeks of saying “The market will prove us right eventually. It doesn’t matter where the market goes in the meantime” and even “I’d love the market to go against us, because then we can add more”.

If you read my post on the Averaging Down Clown, you will know how I feel about that last statement. But the point here is a broader one about being clear about your ability to stay in a position. It is very good practice to decide on a stop-loss point before you enter a trade, and to stick to it. Deciding on how and when to stop out after you enter a trade is much more difficult, since you will have all sorts of emotional difficulties and hang ups to deal with.

In some ways, it is the job of the market to seek out the weak longs and weak shorts, and to test their resolve. There are certainly trading professionals whose business model relies on this: in all time frames from HFT to weekly and monthly patterns, there are traders who will attempt to “run the stops”, to find pain and to force people out at the worst possible moment. Even if there is not someone explicitly doing that, markets seem to move in that manner anyway.

Have you ever stopped out at the bottom of a move and had the market trade right back up? I have, many times. It is incredibly frustrating. You say “Oh man, I can’t believe I stopped out at the bottom. If only I could have held on a little longer.”

But here is the thing: you have the logic the wrong way around. You did not stop out at the bottom. It was the bottom because you stopped out. If you had not stopped out, that would not have been the bottom: the market would have kept on moving against you until you stopped out. It was searching for the pain of the weakest, and today it was you.

Markets move through pain. Work out how much pain you are willing to take before you jump in. Be honest with yourself about how much pain you could tolerate and expect the worst, since the market will test you just when you are least able to cope. Otherwise, you run the risk of being half an hour into the poker game, still wondering who the patsy is.