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 The idea that you are trading just one instrument or asset class is seemingly increasingly outdated in a global financial environment.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.