Computers do not have psychology

In previous posts, I discuss equities investing or stocks using technical analysis (TA) to guess the market (see here, here, here and here). One common form of TA is known as Elliot Wave Principle (EWP) which depends on the collective psychology of investors charting price patterns over time into 5 distinctive waves. Over the last couple of years as I have dabbled in stock investing I have attempted to use EWP unsuccessfully with the New York Stock Exchange indexes. EWP came to my attention in the 2007-2009 crash as the price action followed the 5 waves. If it was true then, it must be true just a few months later? I have come to the conclusion that TA including EWP is not very effective at the current time in US stock markets because of how the market's composition has changed even in a brief period. It has to do with investor psychology (or lack of) and other outside influences.

I will give a brief history of how the US stock market changed over the last couple of decades. In 2001, markets began to trade stock in $0.01 increments in a process known as decimalization. Prior to this, all stocks were traded in fractions of (n/16) fractions of dollars. One advantage of fractions was the fact stock brokers with ask and bid prices at the increments. The slight (n/16) difference between the bid and ask price was the amount a stock broker could make buying and selling blocks of stocks for customers. The second innovation was the market switched to partially computerized operations in NYSE operations and is fully computerized in the NASDAQ market. In a nutshell, the pits with traders buying and selling stock are gone. The price action mostly occurs within a giant computer.

This "modernization" of the markets led to new kind of investment strategy, computerized trading at a quick speed. Basically, picture supercomputers directly connected to the exchange computers through a high speed Internet connection. Why would anyone do that? It is capitalizing on the same trade strategy as day traders. Buy and sell millions of stock simultaneously of just a few pennies of profit and the pennies turn into hundreds of thousands of dollars quickly. Add in the ability to trade put in quotes and cancel transactions before they are processed, one has quite a money making strategy. This process is known as high-frequency trading (HFT).

How does this influence TA? As stated before, TA is based upon investor psychology and the desire to hold stock over various lengths of time from hours up to years. Traders make buys and sells in a response to price movement creating the distinctive TA patterns. HFTs buy and sell stock within a matter of seconds. HFTs can even move millions of stocks down to milliseconds time frames! The HFT responds in a near instantaneous, mechanized manner to stock movement. The resulting trade psychology does not appear on the stock price charts. If HFTs were a small minority in the stock community, it would not directly influence TA. This was partially the case during the 2007-2009 crash with HFTs being ~40 % of the market's participants. EWP traced out the 5 distinctive waves. Currently, HFT represents ~60 % of all trades made on the US exchanges and can account for ~70 % on light trading days. Since this represent the majority of trades, the price action is not driven fully by investor psychology making TA less effective. I believe TA is useless over short periods of time.

One other factor distorting the markets are US government authorities. The government's stimulus and various Federal Reserve programs (TARP, TALF, POMO and etc) are putting money into investors hands in indiscriminate, unequal ways. The "free" money ends up being investing in the market in unorthodoxy manners.

The aha moment I had last night was using TA to avoid these unwanted outside influences into the markets. The only market to my knowledge that is too large ($100s billions per day) for authorities to significantly manipulate are foreign exchange markets (FX). These markets are based upon converting money into different currencies worldwide and HFTs would also have no interest in these markets. What FX markets can follow using TA are carry trades and whether investors are seeking risk or are seeking a safe haven for their investing.

The stock market casino

One institution that has significant amounts of mythology and lore surrounding it operation is the US stock market. Wall Street has made many a man wealthy. These wealth generating stories are legends. What no one really talks about is about those who lose money and are often bankrupted by the same institution. In a prior post, Baseball cards as equities, I give a brief analogy describing stock trading as an ongoing auction. What is important is stocks have no value except what an individual is willing to pay and in the end, it is a zero-sum game.

As the market has been plunging over the last week and a half, it caught me by surprise on Tuesday with a sudden drop. That is the nature of the casino. I am guessing most stock owners are in a bloodbath at the moment. This gives me a chance to outline three kinds of investors on Wall Street.

Investor #1, The Insider
The insiders are professionals who either play stocks/bonds as a profession or are extremely wealthy individuals who have the inside track to corporate America. This group is the smallest consisting (guessing here) of at 0.1 % or 1 in 1000 investors. I guess they own 15-20 % of all stocks and bonds though. This group will always make money in the end because they have the knowledge and power to manipulate individual stocks. Insiders know when a big time news event is going to happen even before a public announcement. One fictional character who fits this category is Gordon Gecko in the 1987 movie Wall Street. The majority of all profits reside in this elite group. We define this group as those who know what is occurring.

Investor #2, Experienced, Successful Traders
This group of traders do not have the inside track as The Insiders do, but they have an idea of how Wall Street works. This group consists of smart hedge funds, individual traders and those at big bank trading groups. They consist of about 10 % of all investors. They probably have 15-20 % share in total assets. This group makes money most of the time. Since they lack advanced insider knowledge, they also lose on many trades. One subcategory of this group are high frequency traders (HFT). This subgroup uses high speed supercomputers to beat the market. What is even more interesting, HFT represent ~80 % of all trades made on the New York Stock Exchange. HFT are what control the majority of stock movement in modern stock exchanges. We define this group as those who know that they do know what is occurring.

The initial two groups outlined above are known as the smart money. They make money off of stocks and bonds. Who do they make money from? The following group, the dumb money.

Investor #3 Retail Investors and Inexperienced Traders
This group of traders represents the majority of investors. It includes all of those who put money into mutual funds, 401ks, IRAs, day traders (yes, day traders) and the majority of part time traders. This largest group of investors is fed the normal "fundamentals" and "over the long run stocks are the best investment" advice. Unfortunately, this is not the case because the stock market does crash. Crashes wipe out a significant amount invested in this group. As I previously stated, stocks are worth only what someone is willing to pay and they do not have an intrinsic value. The "fundamentals" advice is just smoke and mirrors to convince the average Joe to invest. Smart money knows these stock truths and avoid crashes. The lost dumb money proceeds ends up going to the smart money. We define this clueless group as those who don't know that they don't know.

Baseball cards as equities

Most Americans know of that sports fanatic who seriously trades baseball cards. I had a little interest in these things when young. Recently, I am had an idea using these sports memorabilia items as an example to explain the general operation of the stock market. First, I will define why stocks and baseball cards have any value.

Baseball card value is dependent upon a collector's desire to own the card. Rarity, nostalgia and the desire to complete a collection often add to a card's value. The actual card has no inherent economic value except what a trader is willing to pay.

Stock shares are portions of a business. Companies sell shares in initial public offerings to raise money. The owner of a share(s) owns a small portion of that company. Most shares are traded publicly on stock exchanges and these are known as public companies. We are going to focus on public companies for simplicity sake in this analogy. The only value a stock has except the listed price on an exchange comes from dividends. In most cases, dividends paid are on the order of a few percentage of a stock's listed value, not the main factor leading to ownership. Excluding dividends, the actual stock has no inherent economic value except what a trader is willing to pay.

Back to the baseball card analogy, we are going to have a giant conference where all of the biggest traders congregate to trade in auctions. The purpose of the auction is for buyers and sellers to get the best price for their cards. It determines a fair value for cards in the auction at that given point in time. English auctions (most common type in the US) work in a simple manner. An auctioneer will start announcing to the crowd a price or ask for a card. In the crowd, investors will start bids increasing the ask price of the card. When the ask price no longer increases, the bid and ask match. The auction for the given card is over and the card is sold to the bidder from the seller at the agreed price.

Alternate the scenario a little and the stock market basic operation will be represented. Picture the baseball card traders ditching their day jobs and trading baseball cards full time? Everyday, the same baseball card is traded at an auction. The mechanics of the auction change as follows:

1) The beginning ask price of the day is the ask/bid price from the previous day.

2) Bids can now take card price in both directions. Price can increase and decrease.

This is similar to the bidding found in stock markets, except this occurs for millions of shares (cards) hundreds of times per individual stock daily. Total stock exchanged on a market is on the order of a few billion daily. The stock market is nothing more than a complex auction house to trade stock between investors buying and selling stock. Stock markets themselves have no inherent value, the participants have the capital and stock. Participants are where a market's value lies.

This analysis covers stock market basics. It does not take into consideration advanced trading strategies such as shorting stock, options and day trading to name a few.

Driving with the rearview mirror

One source of continuous fascination is the stock market. Why not? Put in a little money, it grows, and in the end profit without labor. How can you not like that! Billions of dollars is exchanged on the world's stock exchanges daily. Stock markets exist as an easy way for companies to raise money through a collective public ownership. Of course, the market operation is much more complex.

The psychology behind this money for nothing concept supports the main market drivers, fear and greed. Everyone who has struggled to make a dollar and put it into an online brokerage account understands this. They love when the market goes up and make money. Optimism pushes buying, the market rises. They absolutely hate when the market goes down with money evaporation. Pessimism leads to selling, the market craters. In the end, the market is a sentiment machine driven by the various kinds of investors summarized by this site.

Excluding day traders, two main kinds of investors exist: fundamentals and technical. Fundamental trading is based upon the idea that a stock is worth a certain value according to corporate size and revenues. Profitable companies are worth more than unprofitable entities. The other investors are technical traders and their trading is dependent upon derived indicators. Some of the best known indicators are:
Moving Average Convergence-Divergence (MACD)
Fast and Slow Stochastics
Relative Strength Index
Bollinger Bands.
The basic concept behind all of these indicators is to identify the point at which a stock changes momentum, i.e. stops going down in price and begins to appreciate.

The movement of the markets has thousands of traders everyday bidding prices up and down. Buying and selling stock. One school of thought has stock market movement being random. Looking over years of stock market data, patterns appear. Typically in upward movements followed with an occasional sell off forming a wave pattern. Personally, I believe the day-to-day patterns are random, but over time patterns do exist. Technical trading is supposed to clue an investor into these patterns identifying momentum changes. Honest traders admit they are lagging indicators or tools that tell investors when to buy (or sell) after the momentum has already changed. I agree, but another serious issue that is a fly in my ointment is these indicators all use past data. What happened yesterday, may not necessarily happen tomorrow. Yes, the indicators show stock price going up. If another disaster like 9/11 hits New York, will the indicators show this. NO!!!!!! As we discussed earlier, the market tends to be a sentiment indicator. One frustrated mutual fund manager has heart burn from his favorite Indian restaurant may drive down a stock. The indicators will not pick this up until it is too late. I think the best analogy is driving down the road using the rearview mirror instead of looking through the windshield. That crash ahead is pretty rough.