Thursday, April 8, 2010

Why We Need a Stop Loss


My favorite piece from Zen literature.

Master Caotang Qing said:

    The fire that burns a meadow starts from a little flame, the river that erodes a mountain starts drop by drop. A little bit of water can be blocked by a load of earth, but when there is a lot of water it can uproot trees, dislodge boulders and wash away hills. A little bit of fire can be extinguished by a cup of water, but when there is a lot of fire, it burns cities, towns and mountain forests….

When people of old governed their minds, they stopped their thoughts before they came up… Therefore the energy they used was very little while the accomplishment they reaped was very great.

- Zen Lessons, translated by Thomas Cleary, Shambhala Books, Boston

I don't think I can say it any better than the Master said. So I will just shut my trap and let you meditate on it.

Tuesday, April 6, 2010

Confirmation pouring in: We are in the middle of a commodities boom and a dollar flood


I did not expect confirmation of my yesterday's views so early. Of late, confirmation has generally been arriving pretty soon for what I have been observing. On NIFTY breakthrough (Violent and Brief), it took the market barely one day to cross the long held resistance.

There is sporadic evidence emerging for the hypotheses I proposed yesterday (Recovery : Final Confirmation, Twin Deficits and Rising Inflation). Broadly, my argument is on the following lines.

  • Recovery in the West has been underway for some time and now we are seeing final confirmation of the same.
  • At the same time, this confirmation is of little use, mainly because what brought the recovery is going to be a massive drag from here on.
  • The large US budget deficit is also going to create a massive trade deficit. This means:
    • Higher purchases of US treasuries by foreign governments; this will fail to absorb the entire trade deficit.
    • Additional dollar supply flooding the market; since there is no penalty for the US for letting the world slosh in its money. Exactly one year ago, I was ranting about the same thing and why China and even EU want piece of the action (Of Triffin's Dilemma and China's Ambition). It is funny how an old rant can seem new sometimes.
    • Commodities on fire; the dollar flood is going to simply push commodity prices out of the stratosphere.

A cursory glance at Bloomberg page today brings the following news.

Rise in Treasury Yields Slowed as Currency Reserves Grow Fastest Since '08

Oil Surges to 17-Month High on Signs of U.S. Economic Growth

Copper Advances to Highest Level Since August 2008 on Recovery

Financial journalism tends to put a spin on everything. Right now the spin is 'recovery'. Well, there is another explanation that is far simpler; dollar flood. And then there is the Euro flood that is almost as big. And then, there is the Pound flood that is the biggest of all in relative terms (just measure the relative sizes of the budget deficits to the economies). The "gainers" of this not-so-hard earned money, on the other side, are also easy to identify. Export powerhouses like China (who incidentally refuses to let the currency appreciate) and commodity dependent economies. Japanese yen is around 93 (you can bet the Japanese are not very happy about it but will keep quiet because it will rise to probably sub-80 levels if they let it go free), Australian dollar is heading towards parity again and Brazilian Real is at 1.76. The evidence is all over the place.

To avoid confirmation bias, am still looking for that one bit of contradicting news which can disprove the hypotheses. If you come across something, please do throw it in.

Monday, April 5, 2010

Recovery : Final Confirmation, Twin Deficits and Rising Inflation


Much has been made of the recent job growth numbers out of the US. They are a very positive sign of course. But what does it augur from markets' point of view?

Not very much, not at least from the US markets' perspective. Here is why. In any typical recovery, most of the indicators start registering a positive long before growth starts showing up in job numbers. As an indicator, growth in jobs is probably the one that lags the farthest behind. The reason is not difficult to see, no matter how rosy the outlook starts becoming, you will always want to check twice before you add those extra workers to your payroll. If you have any doubt, you will most likely opt for paying overtime or other such temporary measure.

Hence, the value of the indicator is in confirming that a recovery has actually taken place. Yes, it makes not a very convincing confirmation since the number has been positive only twice. But if you are waiting for further confirmation, you are already way behind the curve.

It does not augur necessarily well for the US stock markets. Much of the move has already happened and there are major challenges going forward. The toxic assets that caused the problem in the first place are still stuck somewhere in the system. The large stimulus, even though it drove the recovery, is going to be a major drag in the form of fiscal deficit in the US.

For emerging markets, there are many positives though, particularly for India. India came out of the shock with relatively little 'stimulus' and whatever has been provided has been rolled back. Fiscal position is looking good. Hence, the growth is solid. Furthermore, even financing crunch (due to lack of liquidity) is likely to ease, as explained below. All looks well for Indian market, except that inflation is going to be a complete pain.

Rising liquidity

Huge budget deficit in the US is going to drive a huge trade deficit too (they are two sides of an equation, no matter how much hot air US policy makers blow, there is no way you can eliminate one without eliminating the other). Which means the world is going to get inundated in dollars too. Whether you like it or not, a dollar flood with continuously falling interest rates is inevitable over next one year. Some of it will go back to the US as Central Banks buy US treasuries, some of it will simply be funded by excess money supply. Such is the prerogative of those supplying the reserve currency of the world.

Commodities again

No turning back the commodity inflation cycle from here. Once again, the rollicking days of ever rising commodity prices are here. That is likely to be the situation for next one year. If you bought some of those metal stocks here when they were going cheap, you are going to be rich pretty soon! Jokes apart, we are looking at a repeat of the late '70s here, nothing less.

Friday, April 2, 2010

Violent and Brief


So we did have a dip from the 5300 levels afterall (Waiting for the Breakthrough) on the NIFTY. Nothing very surprising there. The market has bounced back from its minor correction (if you want to call it that). We are back on the gates of the 'zone de résistance' and things might get stuck here again.

Or they might not. I do not know whether the bearish side of the market has had its fill of adventure or not. If not, we will see another skirmish. But at some stage (possibly in this very move), the zone is likely to be overrun.

And it is likely to be overrun in a big way. This is not the first time that this level is working as a major resistance. Post the Lehman dip, this level has alwathings might get stuck here again.

Or they might not. I do not know whether the bearish side of the market has had its fill of adventure or not. If not, we will see another skirmish. But at some stage (possibly in this very move), the zone is likely to be overrun.

And it is likely to be overrun in a big way. This is not the first time that this level is working as a major resistance. Post the Lehman dip, this level has always held. It was not broken during the post election rally, held out once again against medium term trend and is proving tough to breach for the medium term trend move.

The strong resistance means that a break is likely to be fairly forceful and swift when it happens. There is a lot of pressure built up that is likely to be released when the breach comes. All the doubtful bulls sitting on the sidelines will jump in at the sight of a convincing breach and that will make the move quite sudden.

For those salivating at the thought of making a quick buck in the move, here is a sobering thought. Given that a large chunk of the market is now dominated by robo-trades, there is no way exact timing of the move can be predicted. Going aggressively long has its risks, as you can get caught in the 'sucker bet' downmove generated by automatic algorithms. At the same time, there is no telling when the market may make a sudden breakout. In all likelihood, it is going to be a very violent affair, and a very brief one. Given the nature of trading in the market, it may be over before you can say "gotcha!!!"

Thursday, April 1, 2010

A Questioning Mind


Yesterday's piece cited one recent piece of research that insists there are specific 'centers' in the brain that control temptation. Also, 'stimulating' those centers somehow seemed to alter the level of temptation subjects could bear. Does it mean we should snap electrodes to our heads to stimulate our brains before sitting down in front of the trading screens?

The answer to that brings us to another important trait that makes a successful trader, a questioning mind. On the face of it, the research seems innocuous and straight forward. But it might not be. There are too many give-aways. The first one is the intent to produce a 'drug' that can help you control temptation. I won't even get into the ethics of doing this. The other is the fact that there could be a much simpler explanation for the phenomenon observed. We all know (thanks to a movement that took this principle to the height of stupidity) that the right side of the pre-frontal cortex processes information holistically while the left side processes sequentially. So it is not hard to imagine that stimulating the 'holistic' side will help you thwart temptation while working the sequential, 'next step only' side will drive you right into its clutches.

This is too simplistic, of course. As simplistic as the right-brain left-brain movement, which incidentally made the assumption that 'using your right brain' was a simple matter of shutting down half of your brain (a truly "half-brained" approach). Let us not even get there. But the moot point is that you can avoid questioning 'given wisdom' only at your own peril.

The same applies to investing also. "Very well known" you would say, "tell us something new". Well, the new thing is that 'cultivating the questioning mind' is something different from what it is made out to be. What does not matter is how many questions you raise, because simply raising questions is not enough. What matters is what questions you are asking and what you are willing to accept as an answer.

The importance of asking the right questions and framing has been explored long ago by behavioural finance pioneers Tversky and Kahnemann. Those who are interested in the area would enjoy their brilliant work and how ingeniously they separated the motivations at work layer by layer. In most of the cases, path breaking conclusions look extremely simple in hindsight, though getting to those solutions to begin with might have been extremely hard (due to orthodoxy, 'given wisdom', etc.). The beauty of their work is that most of what they say is so counterintuitive that even today it never fails to startle. To come up with answers that are counterintuitive yet startlingly true, not only against the 'given wisdom' of the time, but still amaze three decades later requires a rare quality. A truly questioning mind.

More will follow.

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