Searching for a Source of Blame

The recent pullback in the market has left many searching for answers. Many market participants have been caught by surprise. How could we have had such a swift and forceful pullback?

Instead of asking questions like:

• What could we / I have done differently?
• What did we / I miss?
• Was our / my exposure level appropriate?
• Did we / I appropriately manage the risk involved?
• At what point was the thesis wrong?

Statements are being made:

• This is all because of HFT
• This is all because of congress
• The Fed hasn’t done enough
• This is all due to technical analysis: ”That strange language is being spoken more forcefully on Wall Street these days. It is the language of technical trading, which is helping to drive recent wild gyrations in stock prices.”
• This is all due to trading: “Wall Street no longer views the stock market as a means to invest in companies that they believe are undervalued based analysis of a firm’s earnings and growth potential. Instead, it has become a sort of game. The objective is to find ways to buy or sell stocks and make a quick trading profit.”

As I’m sitting here typing this, I can’t help but wonder how any of those remarks help going forward. How are they going to prevent you from ending up in a similar situation in the future?

There’s a million ways to take a look at the market or come up with ideas to take part in the market. Some people make decisions based on tips, follow investment letters or fund allocations, some are merely guessing, others invest on emotion, some pour over financial statements, others are contrarian and some use technical analysis.

There I said it… technical analysis. Technical analysis isn’t some voodoo magic or some all in wonder fail safe. It simply helps you analyze market prices. There’s a million different forms of technical analysis. It’s all based on price. Whether you look at moving averages, support & resistance levels, chart formations, indicators of any sort (be that MACD, Stochastics, etc)… these are all based upon price.

What’s all the big fuss about price? Well for one, as Brian Shannon likes to say, price is the only thing that pays. At the end of the day, everything else is irrelevant. Price is the final determinant of an asset value. When we buy, we are anticipating higher prices. When we sell, we’re anticipating lower prices.

It doesn’t matter what school of thought you come from. Every market participant is speculating on prices. The value investor attempts to purchase an asset in hoping for it’s price to rise. The momentum trader buys higher prices in anticipation of even higher prices. A premium seller anticipates that prices will revert to the mean. The contrarian sees too many people on the same side of the equation and fades the current move. The trend follower buys pullbacks in the expectation that the trend continues.

Who is to say which one of these is the correct way to speculate? Not a single one of them is 100% accurate. No school of thought can make sense of every price move. Each has its upsides and its pitfalls.

Why the attraction to technical analysis?

• Information quality and availability are not equal, especially in the market. The research reports you have access to aren’t on the same level or available to you at the same time as they are to large funds. These research reports may also be biased. It’s a well known fact that most analyst recommendations on Wall St are skewed to the upside. Even when you look at regularly scheduled market releases, there are earnings reports that are leaked & subscriptions to obtain economic data ahead of the public release (i.e. Chicago PMI). We live in the information age, yet we have unequal access to data.
• Markets move on more than just fundamentals. There is and always will be an emotional component. These emotions are factored into prices and as above, price is the only thing that pays.
• Technical analysis is the equalizer. Anyone can pull up a chart. Just about every broker available to the public has some sort of a charting platform these days. If not there are many other alternatives out there including: FreeStockCharts or Stockcharts.com. Prices are equally available.
• Technical analysis has been around for hundreds of years (Japanese Candlesticks of the 17th Century, Charles Dow in the Early 1900s). It began gaining more acceptance in the 1970s.
• Computers have greatly accelerated technologies of charting. In the beginning charts had to be hand drawn. Even if you look back to the 90s there were few options and charting platforms were obscure and pricey. These days you practically have free access through your broker or other sources (as above).
• Buy and hold is a strategy… for secular bull markets. We are in a secular bear market. The market from 1982 to 2000 is an entirely different environment than the one we’ve been in since 2000 until now.
• The trust factor. Building upon the previous points: you have the option of basing decisions on information readily available to you or simply trusting someone else. I don’t know about you, but there are very few people I would trust with my money, especially my life savings.
• Technical analysis isn’t the holy grail. No matter what school of thought you come from success in the market is largely based upon 2 things: discipline and risk management. When technicals are applied properly, they simply help to execute those 2 principles.

Take a look at this chart from the year 1900. It plots the 50 day moving average of price percentage changes on the Dow (courtesy of Bespoke Investment).

Are things volatile now? You bet. Have we had instances like this before? Sure. Take a look at the years involving the Great Depression.

Do you suppose they were blaming day trading or technical analysis for those large daily moves back then?

In all seriousness, the Great Depression has many similarities to the Great Recession. I’m not going to go into great detail here, but I’ll list some obvious parallels:

• We’ve recently exited a period of high growth and are now in a period of low growth.
• We’ve recently relied on extensive government support (QE1 & 2, government stimulus, etc), and are now attempting going through a period of austerity.
• We’ve recently had a period of very low unemployment and those have dramatically risen.
• There are a number of other concerns such as possible bank runs.

The net sum of all these is uncertainty (What’s going to happen to consumer spending with unemployment running out? Will the private sector be willing &/or able to make up for the shortfalls in decreased government spending? Will GDP continue to slow? Will we have more downward revisions? Can we trust our government to do the right thing? What is the right thing? Has the Fed run out of bullets? Is Societe Generale going to go under? Will that trigger a domino effect? Are the French and other Europeans going to intervene in time? Will Bank of America be around tomorrow? Is China still running too hot? How does our aging population play into all of this? Is the US Currency still a trusted investment?). Uncertainty brings fear and volatility.

When things look terrible one day and there’s hope for recovery the next, you can bet these bring large price moves. There are people who have just sold in fear and others who don’t want to get left out so they buy in a panic. On Monday we were digesting concerns with the S&P downgrade of the US Credit Rating. On Tuesday the FOMC Meeting announcement was over-analyzed with people clinging on to hopes of QE3. On Wednesday everyone was afraid of Societe Generale being the next bank to go under. Thursday comes and these fears dissipate. We have better than expected jobless claims data.

Want an explanation for all the volume? Everyone is currently involved in the market (large funds, the retail crowd, and those that are normally partaking in the market). There’s a lot of new information to process and when large funds have to make instant decisions on positions, forced selling or large purchases can really move the markets. In addition, many market participants were complacent about a possible pull back.

Speaking of large funds (mutual funds, hedge funds, sovereign wealth funds, endowment funds, etc!)… another thing that amazes me is how people would rather trot around on the Titanic. The buy and hold crowd seems to be more up in arms about the pullback than anyone else, but they clearly have other options. Large funds typically scale in and out positions over long periods of time. They just have to. They are too large to simply go on the market and purchase 100s of millions of shares all at once. Main street participants don’t have to be subject to this problem. They can react with the quickness of a speed boat… if they choose to.

Let me finish by saying this: I feel terrible for those who were over exposed to this move down. I know many people on Main Street who were caught flatfooted. I’m sure there were many traders that tried to buy too soon or were dragged on the way down as well. But ask yourself this, what good does it do to search for someone to blame? Why not learn from the incident and adapt?

In every other aspect of life we do what we can to adapt. With our jobs we’re learning new skills and information, creating new products and helping our companies become more competitive. With our friendships we learn more about those that we care for. We continue to seek better sources of technology: be it a nicer TV, a faster computer or a cell phone with more features. Yet, somehow in the markets (a zero sum endeavor & the most competitive arena on earth) we expect to be force fed and for things to remain the same? Now how does that help us remain competitive in the long run?