For anyone who has gone through traditional schooling and then moved into the “real world” it becomes pretty clear, pretty quickly that theory rarely plays itself out in life the way it does in a textbook.
Few other areas of study and vocation are more enveloped with theory than financial markets and money management. With each passing day I become more and more convinced that most theory surrounding the markets is wrong and people managing money based on those theories are just waiting to get slaughtered.
Last Thursday’s response to the ECB meeting debunked a couple of core theories surrounding the markets.
In traditional economic theory, information is treated as a generic item and the investor is treated as generic and rational. Neither of these assumptions is accurate. Anyone who has traded a day in their lives knows that people are not rational.
As for information, this generic approach implies that all types of information impact all investors equally. This assumption is flat out absurd.
The market is made up of all different types of investors with varying time horizons and varying goals. A piece of information has different impacts depending on your time frame and what your ultimate objective is for investing in the market impacted by the information.
If this assumption about information was true, there would be no stability in markets. The market remains stable because different time horizons value the same information differently. Market stability relies on the diversification of the investment horizons of its participants.
Markets become unstable and illiquid when market participants all have similar time horizons, like when long-term investors become short-term traders.
Liquidity is not the same thing as volume. Liquidity is the balancing of supply and demand within a given market. This illiquidity played out last Thursday in a number of markets that traded lopsided in response to the ECB not increasing their easing actions as much as expected, no market was more impacted than the Euro.
A quick note about market stability. Generally people associate a market instability with a dramatic decline in a given market. However, market instability occurs when the ability to trade at a given price, decreases dramatically when a majority of market participants are either buying or selling based on the same time frame. Market instability can occur in markets that are rallying just as it can occur in a market that is rapidly declining.
The extreme moves, up and down, across a number of markets occurred because investors across various time frames became short-term traders and acted irrationally.
How can I say they acted irrationally? Market participants were positioned in assets based on the belief that the ECB would increase the duration, magnitude or both of their current easing program. While most participants were disappointed with the extent to which the ECB expanded its program, the fact remains that they did, in fact, expand their easing policy. So, based on being disappointed, a large number of market participants re-allocated their portfolios.
There is no surer way to the poor house than to trade your portfolio based on “market expectations” and how a particular data point or central bank statement measures up to that expectation. Of course, expectations being met, exceeded or disappointed can move markets for a couple of days but its not what moves markets over several months to years. This gives those of us who are able to stay above the fray an opportunity to use participants irrationality on a day like Thursday to better position ourselves for what we know is to come.
In the case of the ECB and the Euro, we know that the ECB is on a path to further burn the Euro, whether or not the ECB did as much as the market wanted last Thursday or not. If information is generic and people are both generic and rational then markets wouldn’t be capable of moving they way they did last Thursday.
Keep in mind, that any act, be it an economic data point or a central banking action, gives birth not only to an effect but a series of effects, like a loaf of bread. Only the first of these effects, the heel, is immediate and seen. The other slices – effects - unfold in succession. Thursday’s market action was based on the immediate effect of market participants reacting to the fact that ECB didn’t throw everything and the kitchen sink at more easing.
Market participants were focused on the heel and traded accordingly.
It's critical to have the ability to keep the whole sequence of slices of time rather than arbitrarily focusing on the very first slice, or effect. To gain an edge over other market participants, you have to look beyond the obvious immediate effect and anticipate what's to come in the middle slices.
How do you apply this type of framework to the Euro? The first step is to ask yourself what is happening currently.
Did the ECB statement or actions taken change your perspective on where ECB monetary policy is headed over the next 6 months? No it didn’t. The ECB eased further and then Draghi came out the next day and did everything in his power to reverse the markets reaction to the statement. He went right back to his "whatever it takes" posture, and said that not only is "QE there to stay", but could be "calibrated" if needed and the ECB can use "further tools" if needed as there is "no limit" to the "size of the ECB's balance sheet."
What more do we need to hear? Draghi is talking the burning currency talk and the ECB is walking the walk. This doesn’t mean that Thursday was the ideal day to initiate new SHORTs. The speculative positioning was so lopsided to the SHORT side in the Euro that a short covering rally could last up to a couple of weeks as traders choose or are forced to cover their positions.
What it does mean is that you should view any rally in the Euro as an opportunity to initiate new SHORT trade ideas and not view it as a shift in sentiment and a reason to go LONG. So, while Thursday’s action saw a lot of SHORT positions covered and some LONGs established, there was also a fair amount of SHORT exposure added.
Does that make sense? If you're adding LONG exposure on Thursday, you’re focused on the heel and not the fresh slices in the middle. The LONG Euro trade initiated at Thursday’s close has you risking $1 to gain $1.70, if the Euro can trade back to $1.16. Oh and you are trading against monetary policy.
The SHORT trade has you in line with the ECB and risking $1 to gain $3, if the Euro trades to parity. By focusing on the middle slices, you can use today’s price movements based on investors focus on the heel to position yourself for bigger gains.
Opportunity comes when the public’s perception of an event diverges from the actual probabilities. The higher probability is that the Euro trades to $1.00 before it trades back to $1.16. Our emotions get in the way of being able to get clarity in some of these situations.
The more we can understand this quality, the better we can gain insight into other market participants by gauging their perceptions and reactions across time. This allow us to use the present as a means for opportunistic exploits in the middle slices.