Volatility Untruths and Skullduggery

by Chris Tate.

One of the most interesting things about times of profound volatility and investor uncertainty is that it seems to give free rein to idiots who spout all sorts of drivel about what you should do in the current market. Over the past few weeks I’ve collected some of the most inane things I’ve read and thought they’d make an interesting piece of education.

All in all, share prices aren’t just prices moving up and down, but a reflection of a company.

Actually the notion that this is true has been dying a natural death for sometime. Unfortunately the financial press don’t seem to keep up with the latest literature on the topic, so we get these endless platitudes rather than some form of true and useful analysis. Initially this would seem to be a logical statement – the problem is people are not logical and information flow through the market is lumpy at best.

Prices are not a reflection of the company but rather a reflection of the perceptions about a company. This is why financial analysis is somewhat akin to homeopathy. People believe in it, regardless of the fact that there is absolutely no evidence for it, whatsoever. It is also the reason the vast multitude of investors continue to make the same silly mistakes year after year.

The only way to tell what the market’s current perception of a given instrument might be is to look at the trend. Whilst the trend does not contain all knowledge about a given instrument, the trend does represent the current balance of sentiment regarding an instrument. Sentiment is vastly different from knowledge. Granted there is comfort to be found in believing you know something about the instrument you are trading. However, on balance, I would rather know whether the bulls or bears are in charge.

Edict 1

In tough times the only thing that matters is the trend. Knowing the trend will enable you to survive. Knowing the trend will also tell you when to leave. There is nothing wrong with not trading an overly volatile market.

Such a decision is a very important strategic skill which will keep you alive. If volatility gets too high by whatever measure you choose, this may be a signal to move to either shut down your equities system or move to a less volatile market.

One of the things that confuse traders and commentators alike is the relationship between volatility and trend. I will often hear the statement – “the market is exhibiting upward volatility” This is bollocks. Volatility is not trend and trend is not volatility. Volatility has no directional bias. In simple terms, if I have an instrument that is valued at 100 and it has a 30-day historical volatility of 20%, then my expectation is that sometime during the next 30 days, it will trade between 80 and 120. There is no indication given by volatility as to where within this range it might finish.

For example it might be assumed that with the continued fall in the US dollar that something like the US Dollar contract would display very high volatility. However, the evidence shows that this is not true and such a statement would be an example of confusing trend with volatility.

Well, they should think about what’s happening. I’m talking about economics as forecasting the future.

First a quick quiz.

Why did God create so many economists?

It raises the chance of at least one of them being right!

Milton Friedman and Eugene Fama put the standard model of economics as a financial tool for markets forward in the 1950s. The central tenet of such an idea is that stocks will over time move towards their true and proper value. This concept is founded on two ideas. Firstly, people have strong motivation to work out what something is worth. The motivation for doing so is to avoid the potential for loss. People would not pay too much for an instrument. For example, let’s assume you wander down to the local Milk Bar and discover that a litre of milk was $19. As a rational individual you would quickly form a view as to the value of a litre of milk and conclude that based upon your experience $19 per litre was too high.

The second point relates to point one. The markets act as collective information gatherers where all available information is pooled and then acted upon. In essence the market is a giant version of Google. Everything that can be known, is known, and is available to be known. Thus, any aberration in pricing is quickly extinguished by the markets collective knowledge of what something is worth. This ensures that there are no sudden swings or shocks to the market, or so the theory goes.

Unfortunately for modern economics, aka the dismal science, shocks have been hitting the market about once every decade. The problem is economists don’t seem to have noticed, as such, any contribution they might make to the subject is somewhat meaningless.

Traditional economics is based on the concept of equilibrium within financial systems. This equilibrium is maintained by the clean flow of information and rational responses by investors. This leads to post hoc rationalisations about why the market behaves in a given way. For example, you will often hear the expression “the market went down on profit taking”. Unfortunately such explanations are wrong.

In their recent paper titled Stock price jumps: news and volume play a minor role, physicists Armand Joulin, Augustin Lefevre, Daniel Grunberg and Jean-Philippe Bouchaud found no correlation between news items and the responses of stocks. They analysed the news feeds from both Dow Jones and Reuters (the major sources of information for financial analysts and journalists) and examined the correlation between hundreds of instruments and some 90,000 news items over a two-year period. Their conclusion was there was no link between jumps in instrument pricing and news items. Most changes were not directly attributable to any news item at all and the majority of news items caused no change in instrument pricing at all.

Edict 2

News is simply post hoc rationalisations to provide a story to people who need explanations and hand holding. In trading you don’t need a reason as to why something happened. You simply need to have the skills to realise that something has happened and a trading plan that deals with all eventualities.

Buffet’s motto of buying when others are fearful is beautifully displayed in his move into Goldman Sachs. This is a reflection of faith in the banking system and an investment philosophy everyone should follow.

Let me make this quite clear – you cannot invest like Warren Buffett. Nor can you invest like any other billionaire. They have access to markets and deals that you do not. Buffet is a corporate raider in the manner of Tiny Rowlands or T Boone Pickens. Do not let the folksy manner fool you, his deals are complex, aggressive and are often a reflection of complex derivative plays.

The foray by Buffett into Goldman Sachs (GS) is not a vote of confidence in the system, banking stocks, or the market. Nor is it a reflection of a given investment philosophy. It is nothing but self-interest. Let me also explain the GS deal because the above quote indicates clearly that most people don’t understand the deal. This is an extremely expensive and painful deal for Goldman Sachs because of the following:

  1. Goldman Sachs pays a preferred dividend to Berkshire Hathaway of 10% on the $5 billion invested. That’s $500 million per year direct to Berkshire. If you bought GS shares you would not participate in the same deal – Buffet has ensured he gets paid before anyone else does. I might also suggest that he has made certain that the US Treasury has given him an assurance that GS will not be allowed to fail.
  2. Goldman Sachs has the right to call on the preferred dividend to Berkshire at any time. However if they do they will pay a 10% premium in top.
  3. Buffet gets $5 million worth of warrants at a strike price of $115 – this is about 43 million shares. The warrants expire in 5 years time. If he went into the market to purchase the equivalent position it would cost about $1.5 billion and with GS at about $135, the $5 billion investment is actually around $3.5 billion. This means his net yield on the deal is closer to 17%.

Hands up those out there who think they could get a similar deal?

Edict 3

Play your own game – you cannot trade or invest like someone else. You need to find your own path and stick to it. I make no bones that this is actually quite hard to do and it takes time and effort.

Should you persevere and make the effort, the reward is one of not only financial freedom but also intellectual freedom. You are free to approach the world in your own way on your own terms.

The short selling ban

The fact remains, however, that the ban is real but only temporary, hence it is only an inconvenience and not a fatal blow to trading. In the meantime there are number of things we can do to get around it.

  1. Look at shorting sectors or indices.
  2. Equities can still be shorted via options and warrants.
  3. Look to other markets such as commodities or FX. Trading these is not as hard as is often portrayed. Although I will caution you that FX markets do have a tendency to not trend for significant periods of time.
  4. Take the next 30 days off – there is nothing wrong with recharging and getting your Christmas shopping done early.

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