A Few Random Thoughts

These are some random thoughts I have been putting together following the events of last week.

1. Markets move from manic to panic within a few sessions. Those who still cling to the outdated notion that humans are rational assume that when markets transition they do so in an orderly fashion. The thinking is that there is some form of interregnum of indecision as the market battles to decide whatever the dominant narrative is. In reality what happens is the bulls bugger off and the bears take control very quickly.

Consider the chart below of the Shanghai Composite; you can see the trend changed very quickly. One day the bulls were in charge and the next day they weren’t

Traders have a tendency to marry their positions and cannot let go when things have changed. Change acknowledges that initial position was wrong in the face of the new conditions. Ego defensiveness dictates that people act in a manner that preserves the ego and admitting that things have changed and you need to alter your opinion runs contrary to defending your ego.

2. If some reaction is good then overreaction is even better. One of the things I have found interesting is the extraordinary overreaction of our market to the crisis in Greece. I could even raise the point that the Europeans overreacted since this crisis is four years old –the events of the last few weeks were not unexpected, nor was there any new information. We had no reason to respond at all, the entire Greek crisis is a solely regional event involving a third world country that through poor economic management and profligacy has sent itself broke.  We have seen third world countries default on debt before and historically Greece has made someone of a national past time out of it. So I am surprised that everyone else was surprised.

This overreaction has been in no small way fueled by breathless media hype about the impending end of the world. Media reporting by its very nature is short term in focus and lacks any form of context. This lack of context makes every single event seem as if it is immensely catastrophic in its own right.  I have written before about how this panicked narrative is designed to elicit an emotional response – which is the last thing you want in a trader.

3. Volatility is good – bullshit it is. This is the frequent theme of people who do not understand the difference between trend and volatility. They are completely different and people who confuse them would obviously have trouble telling the difference between an orange and a Wankel rotary engine – the difference is that extreme. Traders to be profitable require a trend that persists over time. The key word here is persistence. This means you can have long trends with low volatility, you can have long trends with moderate volatility, you can have long trends with high volatility. You can even have downtrends with low volatility – a point that confuses the living daylights out of people who think that downtrends are always accompanied by high volatility. The point is that you need longevity and I could go on endlessly about Hurst Exponents and the like but all we need is consistency.

4. History tells you everything. One thing I have noticed about traders is that many are poor students of the market. Therefore, they are confused and surprised by events as they unfold because it is the first time they have encountered them, either in person or as a function of their study. One of the good things about longevity in the market is that you get to see a lot of things happen. I have been a market participant through the following –

• The 1987 crash,
• The 1989 mini crash – this was a heart stopping moment after 1897.
• The Japanese asset price bubble giving way in 1992. WTF happened to the Japanese century?
• George Soros and other speculators caused Britain to drop out of the European Exchange Rate Mechanism in 1992 (I was sitting in a friggen airport  lounge at the time trying to make the best of the primitive technology we had at the time)
• The 1997  Asian Economic Crisis of 1997 – third world countries go bust all the time so why was Greece a surprise.
• The 2000 Dot Com Bubble and Burst
• September 11
• The GFC of 2007-2008
• 2011 Flash Crash
• And every tiny market perturbation and hiccup over the past three and a bit decades….

The point being that history gives you perspective because there is nothing new. Much of the writings about Greece and China convey the tone that this is the first time that this has ever happened. Politicians being incompetent and consumed by hubris and markets overcooking themselves have been happening forever and will continue to happen. You need to learn about history to get a clear sense of where these events sit in the spectrum of idiocy that is human irrationality. As such there are a series of books you should have in your library.

1. Manias, Panics, and Crashes: A History of Financial Crises by Charles P Kindleberger
2. Extraordinary Popular Delusions and The Madness of Crowds by Charles MacKay
3. This Time Is Different: Eight Centuries of Financial Folly by Carmen M Reinhart
4. Irrational Exuberance by Robert Shiller
5. The Misbehaviour of Market by Benoit Mandelbrot