Saturday, August 16, 2008

Financial Markets: Harder, Faster, Not Necessarily Better or Stronger



It's been a tricky environment for sector relationships since the July bottom. The U.S. dollar has turned sharply higher, particularly against European currencies; commodities have fallen significantly; U.S. stocks have bounced; and the shares of emerging markets have lagged. You couldn't ask for a more thorough unwinding of themes from earlier in the year. Just in the last few days, we've seen housing stocks break out to multiweek highs (bottom chart), while energy shares languish near their lows (top chart).

Once these themes unwind, they go further than one would expect from a normal correction, shaking out large numbers of participants. Conversely, those who catch the turn in themes can make significant money in a relatively short period. While in London, I read an interesting piece in a financial publication that noted that the sharp down move in gold was initiated and sustained almost entirely in the futures markets by large participants who were trading an algorithmic relationship vis a vis the U.S. dollar. Gold may be classified as a commodity, but it trades as a currency when these algorithms dominate.

All of this makes it difficult to be a classic trend follower or a fundamental, longer-term participant waiting for relatively undervalued assets to return to (or overshoot) their fair value. The normal way of trading those approaches is to wait for markets to confirm your views and then gradually add to positions as the markets move your way. When themes unwind, however, such a money management scheme almost ensures that a trader will be running the greatest risk just as markets reverse.

I'm not sure there's an easy answer to this dilemma. Either you stick to long-term views and prepare yourself for considerable noise and retracement, perhaps by hedging markets that have moved sharply in your favor, or you supplement your longer-term core positions with more active trading to lighten up risk as markets have moved your way and add risk on the large pullbacks. Either way, the investor is prodded to become more of a trader if for no other reason than money management. You can't afford to be scaling into positions just as markets are ready to make violent turns.

For the more active, shorter-term market participant, it's a different challenge. The idea that you are trading just one instrument or asset class is seemingly increasingly outdated in a global financial environment. You may choose to express your market views through a single instrument--an potentially inefficient way of deploying capital in a literal world of alternatives--but to not know how your instrument is affected by others is to run the race for returns with at least one leg tied. Many stock market moves, for instance, are intimately tied to what we're seeing in the U.S. dollar, commodities, and interest rates. Trading without awareness of those relationships leaves traders in the dust when those markets turn, taking stocks with them.

Does this mean you have to become a macro-economic fundamental trader? I don't think so. It does mean, however, that the playing field has become wider and faster as increasing capital chases a finite number of markets and market relationships. The speed with which you manage positions and the breadth of markets you track change as a result. Many failures that I'm seeing and reading about among traders are the result of experienced traders trading new markets in old ways. The traders that are thriving are broad of vision, fleet afoot; they've adapted to changed realities.

It all reminds me of changes in communication technology. Back in the day, the letter sent by parcel post was a primary means of communication. With the advent of the telephone, communication became more immediate. Now, some people continue to rely on telephones. Others ground their communication in email. Still others are instant messaging and text messaging. Yet others are joining multiple communities and aggregating instant communications across them. Harder, faster, better, stronger? I'm not sure of all those Darwinian consequences of shifting markets, but recent markets *are* different: not only in their extent of change, but also in their rate. And they leave few countries for old men.
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9 comments:

Brandon Wilhite said...

There's also the speed of change among the relationships. Over much of the last two weeks the relationship between the dollar and these other markets has been very tight (with the dollar leading), but in the last few days it seems to have loosened again. However, it could easily tighten up again (although imo it appears we're starting to rest a bit). Also, I know there have been several periods in the last few years where it hasn't been the dollar that was in control, but rather it was the stock market that was in control, or even other markets.

The people who are old school fundamental traders especially seem to not 'get' these markets, at least when it comes to USD. For some reason, they want to trade it as if it were a fundamental stock play, but they totally ignore how people are *actually* trading it. Maybe if you take a long enough view, just going on the fundamentals will work. However, I think that there were plenty of people who were surprised that USD continued to strengthen this week, because it contradicted their fundamental view.

I don't know that I'd consider myself 'fleet of foot,' but I do know that I have been up in the middle of the night numerous times in the last few weeks in order to adjust positions intraday. Luckily, I have a very supportive spouse, whom I consider to be my greatest asset. Again, just my thoughts, but I would say that it's almost a necessity to be able to do this if you're going to trade these markets well.

BW

upsidetrader said...

Dr Brett,
In case you missed it, there is a nice piece with Ari Kiev in http://www.traderdaily.com/ I thought you and your readers may enjoy it enjoy

upsidetrader

The Mechanical Trader said...

The Euro/USD chart has recently completed a classic sell formation; it has been a foregone conclusion the Euro would plunge in regard to the USD, imo.

I'm bearish on all US equities for several years; Institutions in the futures market are selling recent rallies; a classic confirmation we're still in a long term downtrend, imo.

Marc said...

Hi Brett,

There's also a speed of information difference that has continued to increase. Handheld devices bring instant news and today's bloggers are the new Wall Street Journal.

I've stopped watching TV and instead have a dozen "news" blogs that I read all through the day. Even free quotes are realtime now. It seems everyone is in a hurry and I think this is causing bubbles to form and burst even faster.

Cheers,
Marc

The Mechanical Trader said...

Hey Brett;
re; "All of this makes it difficult to be a classic trend follower or a fundamental, longer-term participant"

In light of the globalization of markets, and the entire 1st World being wired with instant communication and powerful decision-making tools (computers & software) -- would it not be logical to face the fact that "holding many financial instruments long term" is no longer viable?

I think of the time (I wasn't around then) that the buggy whip manufacturing sector had to face reality that the Model T was the new transportation mode and the horse was not a viable business model - until gasoline hit $4 a gallon - LOL.

I see the index futures as perpetually being in violent trading ranges or smooth trends - either one is not conducive to profitable long term positions as a general rule.

What are your thoughts about this, from a Phd standpoint?

Regards,

Stuart

Brett Steenbarger, Ph.D. said...

Hi Brandon and Marc,

Good points re: the speed of change variable; thanks for the comments. More money chasing more relationships creates quicker and more violent reversals, it seems. This represents opportunity for those who can adapt, but it raises challenges for those who would rely upon long-term historical data to develop trading systems.

Brett

Brett Steenbarger, Ph.D. said...

Hi Stuart,

I do think there are long-term moves in markets (e.g., bull market in emerging markets, commodities), but the noise factor has increased greatly.

Brett

Viet said...

Thanks for this posting. The financial markets are scary.

GS751 said...

I think some of the crowded trades are becoming unwound and we will see some hedge funds report bad numbers in the next couple of weeks. The long energy, short financials, short the dollar trades all got pretty cramed. In these markets I find it helps me a lot to take a more long term view.