Diary of a Financier

Philosophy, Quantum Physics, and a Look Past the Horizon

In Dissertation, Existential on Mon 9 May 2011 at 08:24
  • Trading flaunts the complex machine that is the human mind.
  • I find trade ideas by identifying compelling valuations & stories, but I open positions after I’ve rejected the null hypothesis and waited for the technical entry point.  I stick to my process, and sometimes I just have to pull-over to let a swerving market pass me by.
  • We’ll look back upon the Fed’s inaugural press conference as the flap of a butterfly’s wings that altered the Market’s trajectory.
  • Changing the fundamentals for the first time since Fed easing began, expected inflation gave way to [persisting] actual deflation, and now no policy action stands to offset it.

Every morning, I envision the trading day and weeks ahead.  I derive my outlook, the standard deviations from my expectation, and the outlier scenarios.  Having internalized where my portfolio stands today, I visualize where I would position us given the trajectory of any outcome.

Capital markets activity really flaunts the powerful machine that is the human mind. A trader’s mind before the open is like a Prius at a stop light: it’s inaudibly running, but the batteries are recharging for when the light turns green.  I literally stockpile mental storylines within my RAM; I tag every conceivable outcome with a quantitative probability, a qualitative annotation, and a maze of contingencies.  I’d expect the inside of my head to look like a little girl went Cat’s Cradle on an NCAA March Madness bracket.  When the opening bell rings on the floor of the NYSE, snoozing cash market tickers suddenly light up on my screen, and my mind goes “real time”–dynamically storyboarding & calculating.

In my business, I just need the tiniest of an edge, the smallest advantage to stack the odds in my favor.  I know what I’m looking for in a trade.  I do my own research first.  I read news and others’ research next–not looking to pad my argument, but rather to negate it.  I turn to the charts to learn the flow, find a setup, a confirmation, an entry point, and exit points.  By the time I’ve entered a position, I’m not sure what the future holds (nobody is), but I am sure that the probability of an adverse outcome is statistically insignificant.  In a sense, I haven’t proven my hypothesis as much as I’ve rejected the null.  I’m then able to hedge out the probability of Type 1 error in another pocket of the portfolio.  (This high-level redux makes me sound like more of a statistician than a behaviorist, but I suppose I mesh the two.)

In the movie Bull Durham, Crash Davis (Kevin Costner) launches into one of my favorite diatribes about baseball:

You know what the difference is between hitting .250 and .300?  Twenty-five hits a year in 500 at-bats is 50 points. OK? There’s six months in a season, that’s about 25 weeks. You get one extra flair a week–just one–a gork, a ground ball with eyes, a dying quail–just one more dying quail a week and you’re in Yankee Stadium.

That’s why losing trades shouldn’t discourage. The difference between a flat year and a blockbuster year is not your infallibility or a propensity to “get out at the top.” Worst case, the market is a random walk. Like a coinflip, you yield as many winning trades as losing. (Like a coinflip, the losers can even disproportionately outweigh the winners no matter how big your sample size.) But you let your winners ride and cut your losses short, and one breakout trade is all you need for abnormal returns. Yes, don’t get discouraged because your win percentage is sub-.500, because your process skews the odds in your favor–a duality between risking a little and rewarding a lot.

Inevitably, you still go through periods where your mind swims in Jello.  Your brow grows heavy under the weight of your throbbing frontal lobe, and your eyeballs just feel like they’re being clutched in a gentle trash compactor.  Even through the ups & downs of the past years, I’ve never faced a losing streak that’s turned my book into a multi-car pileup. I have often come to standstills in mental gridlock.  I have occasionally pulled-over to let traffic pass me by. Sometimes I just can’t find a position supported by significant odds; sometimes I just can’t find confirmation patterns in any chart.  These are often times in which the markets move so quickly and chaotically that my mental processes overload–the Cat’s Cradle in my head gets tangled.  Further, these are often times in which the Market shows its sensitivity to initial conditions.

It’s a property of the natural world dubbed the Butterfly Effect by Edward Lorenz, who asked,  “Does the Flap of a Butterfly’s Wings in Brazil set off a Tornado in Texas?”  Given an arbitrarily small perturbation of its current trajectory, the Market’s future behavior may differ significantly.  Since Friday’s market left my mind entangled thus, I took the weekend to ask myself if the properties of this market ripple were any different than those of Summer 2009, January 2010, (the big one) Spring 2010, and early March 2011.  Although I’m sill revisiting those moments-in-time to complete the puzzle, I’m deciphering that the trajectory of today’s Market has indeed been agitated.

The Fed’s lenience was the catalytic accelerator for the S&P 500 bounces post bellum (Lehman).  After the bounce out of January 2010’s dip, we were reminded not to fight the Fed.  (We played virtuoso through every subsequent dip.  We rode Gold to the tippity top, we let go to let Silver drop, we were all over the precious metal/commodity slop.)  Here today–resting on the bottom of another SPY crater–I’m changing that mantra because inflation expectations pivoted from Weimar to no mas the day before this Market slipped.

We’ll look back upon the inaugural Federal Reserve press conference (April 27, 2011) as the irritant. I agreed with Ben Bernanke that inflation expectations are what matters most.  I’ve asserted that actual inflation wasn’t alarming; rather, inflation expectations contributed to the reflexive feedback loop that pushed commodity prices higher.  Vindicating me (along with Mr. Bernanke’s snide “transitory” word choice), commodity prices crashed back down overnight.  No CPI or PPI number lent credence to a fundamental spur.  No supply/demand reports either.  It was all inflation expectations all along.

The loss of inflation fear is this market’s last leg.  When deflation was all the rage in 2009, the Fed embarked on a liquidity campaign for the ages.  That rained “confidence” on the Market.  When actual deflation yielded to perceived inflation sometime in 4q2010 (after QE2), commodity & equity Markets went into overdrive.  Now, we’re losing the liquidity and the inflation drivers.  I’m also being vindicated for doubting Mr. Bernanke’s persuasion that it’s not the frequency of Fed purchases, but the size of the Fed’s balance sheet that counts:

This is an interesting thesis which will be tested come June.  At that time QE2 will end and the ‘frequency of Fed purchases’ will drop to nil.  My gut reaction is that the expectation of continued purchasing drives the market higher, something idle maintenance cannot achieve.  If this market were to consolidate for too long a period, complacent traders would grow dangerously anxious.  Further, using history as a guide, I’ve noted that while bonds have reacted to action (like purchases), equities have reacted to anticipation (like the announcement of QE1′s end 3/31/10 or Mr. Bernanke’s famous Jackson Hole speech 8/21/10).

I find the force of expectations a lot more powerful than anything to the contrary… because there is nothing to the contrary.  No Fed, no Treasury, no FNM/FRE policy to counterbalance the crummy sentiment.  For the first time in this modern rally, the fundamentals have really changed.  Deflation was the threat throughout because of housing’s disproportionate share of the economy.  The Fed/Treasury were there throughout to offset that threat. But deflation still remains, and no policy stands to oppose it. The fundamentals have indeed changed with this flap of a butterfly’s wings.  The policy response remains the critical contingency.   (It’s so blatantly obvious to me that given the outsized risk of deflation from housing, policymakers need not even debate whether or not to intervene.  They need not even debate where or how to intervene.  Real Estate.  That’s it.)  We’ll bounce out of this crater again (next resistance for SPX at the 1361 52-week high close from May 2), but if the market keeps swerving, I’ll just pull over to let traffic pass me by.

–Romeo

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  1. […] 5/9- Ben Bernanke’s inaugural press conference as the Butterfly Effect changing the market’s trajectory/fundamentals. […]

  2. […] I get a good idea for my odds of success, and I compile enough data to disprove my theory’s null hypothesis.  By “success,” I don’t mean I’ll just making money in a stock; I mean […]

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