Did the Retail Investor Just Show His Hand?

By: Henry To | Tue, Nov 8, 2005
Print Email

Dear Subscribers,

We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. For now, we are completely neutral and in cash. Since the latest market bottom in late October, the market has quickly become overbought. Because of this and because of the fact that we are now in the late stages of the cyclical bull market (which began in October 2002), caution is now extremely warranted. The market continues to be very divergent in nature, and combined with the fact that the Fed is continuing to tighten (the Feds rate is projected to have a 90% chance of hitting 4.50% by January of next year), this author does not recommend committing substantially on the long side. Last week, we stated that we were looking to in a 100% long position in our DJIA Timing System. That view has now been scrapped. No new signals as of now.

In last weekend's commentary, we discussed today's modern concept of risk assessment and how it is practiced and how it should be practiced in today's stock market. In my conclusion, I stated: "Given the 5000-year recorded history of humankind, it is amazing to note that our understanding of modern finance and our concept of risk is still in its infancy. Consider the fact that our modern perception of probability theory did not emerge until the 17th century, and that other theories such as the Modern Portfolio Theory did not begin to be studied until the early 1950s ... This author has argued that today's most sophisticated tools are nowhere near adequate to measure the risks inherent in such financial instruments as equities, as many real-world risks are still impossible to quantify ... As stock market participants, it is imperative that we are able to put the risks in perspective in each of our investments. Like I have mentioned above, the ability to quantify risk is not totally dependent on one's IQ - even though there is somewhat of a correlation. In a complex world and in today's information age, it is the ability to simplify each potential investment and filter out all the unimportant information - as well as minimize the number of real-world variables that we need to guard against. Blind diversification by buying the S&P 500, for example, does not minimize your risks in any way if one has not done the necessary research."

Diversification in itself is not enough - just witness the many investors who preached the buy-and-hold concept and who bought the S&P 500 in March 2000. Many of them had forgotten their intentions to buy and hold by late 2002. In order to suppress one's emotions, minimize risks, and achieve above-average investment returns in the long-run, one must do the necessary research, as well as consistently review and research one's findings. In addition, an investor must find the investments that suit one's temperament, as well as in areas where you possess an edge (see "The Mean Reversion Way of Making Money"). This is easier said than done - as you must also take the time to learn about yourself as well as to learn about your potential investments.

Before this author makes an investment or takes a position in the financial markets, I always try to make sure that most, if not all, variables are lined up on my side. In addition, I also try to buy undervalued assets or seek the mean reversion trade. That is, even if things don't turn out the way I anticipate - the intention is to not to lose too much even if I had erred. In Warren Buffett's words, having a "margin of safety" is imperative.

Let's now imagine a game of cards. It really does not matter if one is a high roller or has the best card-playing skills out of every other player in the casino. Once other players know your hand, you are pretty much "finished." Readers can find many examples when it comes to playing cards, but let's discuss a couple of relevant examples in the financial markets:

  1. The demise of Long-Term Capital Management: When John Meriwether, the founder of LTCM, called Vinny Mattone (his first contact at Bear Sterns, which cleared trades for LTCM) and told him that the fund was down by 50% by the end of August 1998, Mattone replied: "When you're done by half, people figure you can go down all the way. They're going to push the market against you. They're not going to roll your trades. You're finished." In the midst of trying to raise capital, LTCM had also revealed bits and pieces of their highly secretive portfolio. Sure enough, banks such as Goldman, Morgan, Salomon, and Merrill started closing out the same trades that LTCM had put on - not just to attack LTCM, but to save themselves. Meanwhile, LTCM could not close out any of their trades. With their huge positions, there is just no way the market could have taken their orders should they choose to sell.
  2. The near-collapse of Enron in October 1987, when a pair of rogue traders of Enron Oil put on a short position in crude oil in early 1986 - in a period of generally rising oil prices. By the summer of 1986, oil was trading at nearly $10, but it proceeded to rise to over $20 a barrel in July 1987. When Ken Lay and the Enron management team found out about the 84-million barrel short position, it was nearly too late, since Enron was approximately $1 billion down at that particular point in time. Fortunately (or unfortunately, as the demise of Enron in 1987 could have saved a lot more tears and heartache down the road), Mike Muckleroy (the head of Enron's liquid-fuels division and an experienced commodities traders) and a small team of traders went to work and managed to ultimately salvage the situation. Quoting "The Smartest Guys in the Room": His [Muckleroy's] only hope was to bluff his way out of his dilemma; if other traders knew what trouble Enron Oil was in, they were likely to bid the price of oil even higher, then demand payment. To fool them, Muckleroy pretended that Enron had crude oil in hand; he even bought some to sell into the market. The bluff bought him time. Within a few days, oil prices began to decline. Or at least they fell enough that Muckleroy and his team were able to close down Enron Oil's positions, reducing the damage to the company to around $140 million. That still hurt, but it was no longer life-threatening. "If the market moved up three more dollars Enron would have gone belly up.." Muckleroy later said.

Such scenarios had been played out many times in history, such as when Arthur Cutten tried to corner the corn markets knowing that Jesse Livermore had an illiquid short position of ten million bushels (Jesse Livermore ultimately came up with an ingenious way of getting out of his short position). In early 2001, J.P. Morgan Chase, one of Enron's largest bankers, already had a short position in Enron stock to the tune of approximately $300 million - which was one of the five largest short positions the firm had in North America. Morgan subsequently continued to add to its short positions on the way down.

In other words, revealing one's hand in the markets is usually a death sentence - especially if one usually does not have the ability to ride out those positions. Such is the case usually with the positions of retail investors - who are inherently emotional and who usually has the least ability to hold on to a position - which leads to the heart of today's commentary.

In various posts on our discussion forum, I had discussed the prevailing bearishness on the homebuilders. In scanning various message boards around the web, one cannot help but notice that many retail and amateur "investors" are now shorting the homebuilders - fully convinced that the housing bubble will collapse with the increase in the both the Fed Funds rate and the 30-year Treasury rates. Before I go on, however, I want to emphasize this: This author is not advocating our readers to go long the homebuilders. There is no question that the best (and the least risky) gains in the homebuilders are now behind us. Sure, some of the better homebuilders may double from here, but the downside risks definitely outweigh the upside risks.

No, this author is actually more interested in the direction of the long bond going forward. In going short the homebuilders, many of the amateur "investors" are fully convinced that long rates can only head higher from here, citing the latest upticks in the ECRI's Future Inflation Gauge, the CPI readings, and the scheduled 2006 cost-of-living increase for Social Security payments (the highest since the 1991 increase). No doubt, these concerns are legitimate, but this author feels that too many retail investors are now in the high inflation camp for comfort, and given that the Fed has shown no signs of slowing down the Fed funds rate hike, it is time for bond bears to be cautious here. This is highly obvious when one takes a look at the Commitment of Traders (futures) report for the 30-year Treasury bond:

More follows for subscribers...


Henry To

Author: Henry To

Henry K. To, CFA

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

Copyright © 2005-2009 MarketThoughts.com

All Images, XHTML Renderings, and Source Code Copyright © Safehaven.com