Secrets of Professional Stock Market Speculation

One of the best books we've ever read on stock market speculation was actually written about betting on horse races. The book is "Secrets of Professional Turf Betting" by Robert Bacon. It has been out of print for decades, but used copies can be obtained via www.barnesandnoble.com. 

Most people who bet on horse races not only lose money, they lose much more money than they should lose based on chance alone. What this means is that someone making purely random bets on horses, or an untrained chimpanzee betting on horses, will, over a long period of time, lose the track's 'take'. The 'take' is a fixed percentage, usually in the 10%-20% range, that is extracted by the track (or jockey club) out of the total amount of money bet on each race. The remaining 80%-90% is paid out to the winning bettors. In other words, if the track's take is, say, 15%, then someone who selects horses based on random guesses alone would, over a long period of time, be expected to lose an average of 15% of the amount of money they bet each race day. However, the average member of the betting public actually loses 33%-100% of the money they outlay over the course of each racing day. It is almost as if they are trying to lose!

While the vast majority of people lose money at the races, some betting professionals consistently win. These professional bettors generally do not have inside information or any resources that are not readily available to members of the public. Nor is it usual for them to be highly educated. So, how do they win? Since the public is usually so wrong that it manages to lose far more money than it should, it stands to reason that those who are able to consistently win do the opposite of what the public does. As Robert Bacon puts it, "These professionals win because they know the "inside" principle of beating the races, the same principle that must be used to beat any speculative game or business from which a legal 'take', house percentage, or brokerage fee is extracted. That principle is: 'Copper' [bet against] the public's ideas...at all times!" 

This principle certainly applies in the stock market and is the reason we spend a lot of time analysing sentiment indicators. If our analysis of sentiment indicators is 'on the mark' then we will know what the collective mind of the public is thinking and can, at the appropriate time, do the opposite. There is, of course, added complexity in the stock market, or any financial market for that matter, since there isn't a fixed pool of money that is distributed at fixed points in time based on a set of clearly-defined rules. There is, therefore, a critical timing element in the financial markets that is not present when betting on horses (as the speculators who 'shorted' absurdly-priced internet stocks during 1998 and 1999 discovered to their detriment).

In horse racing, betting against the public involves the identification of "overlays". These are situations where the odds assigned by the public (the odds at which a horse runs are determined by the amount of money bet on that horse relative to the amount of money bet on the other horses in the race) are longer than what the odds should be. In other words, where the risk/reward ratio is in favour of the bettor. For example, if a professional determines that the correct odds for a particular horse are 2:1 whereas the public's betting puts the horse at 10:1, then the professional has identified an "overlay" and may decide to bet on that horse. If the professional determines the correct odds to be 2:1 and the horse is quoted at 2:1 then the professional would certainly not bet on that horse because, in such a case, the likely upside and the likely downside are the same. 

This leads us to another important difference between the consistent losers (the public) and the consistent winners (the professionals). Most race-going members of the general public will bet on every race, whereas the professionals will only bet on those races in which they have identified an attractive overlay. This might result in the professional only betting on 2 or 3 races during a 10-race day. If there are no attractive overlays in any of the races then he/she will place no bets on that day. 

The principle of only putting money at risk in cases where there is an attractive overlay applies perfectly to stock market speculation. An "overlay" in the stock market would, for example, occur if the stock of a company is dramatically under-valued based on the cash that it is currently generating or is likely to generate in the future (the market value assigned by the public is low compared to the company's intrinsic value). In such a situation a long-term speculator (also known as a 'value investor') such as Warren Buffett might decide to buy the stock. He does so because he knows that the stock price will eventually return to its intrinsic value and he doesn't really mind how long he has to wait for this to happen. For a short-term speculator a suitable overlay might occur, for example, as a result of a period of panic selling that sets the stage for a sharp rebound. Whether you are a long-term speculator (investor) or a short-term speculator (trader), it is important not to act unless you can identify an attractive overlay, that is, unless the risk/reward is heavily in your favour. This means there will always be periods, sometimes lengthy periods, when you should do nothing. 

Another factor contributing to the public's losses in the game of horse racing, and in all speculative endeavours, is something called "switches". According to Robert Bacon it's not the races that beat the amateurs, it's the switches. Whereas the professionals develop a plan and stick to the plan the amateurs are continually changing (switching) such things as the types of bets they make, the amount they bet on each race, and the way they select horses. For example, an amateur might try Method A for a while and when it doesn't appear to be working switch to Method B. As soon as he switches to Method B, Method A starts to win. Not wanting to make the same mistake again he decides to stick with Method B, but Method A continues to win and Method B keeps losing. After a while he can't stand it any longer so he switches back to Method A, just before Method B hits a winning streak. 

Most speculators in the financial markets will have experienced the frustration wrought by switches, that is, they will at some point have been coaxed by a market to switch strategies at exactly the wrong time. One difference between the winners and the losers is that the winners have figured out a way to avoid the switches. An important part of this 'avoidance' is to only ever speculate in those instances when you have identified, via a thoroughly-tested method, an attractive overlay.

From the perspective of a stock market speculator the most important chapter in Robert Bacon's book is the one that deals with the "principle of ever-changing cycles". We will discuss this principle in the next Weekly Update.

The US Stock Market

The September-11 Effect

Next week is the anniversary of the Sep-11 terrorist attacks and the following week is the anniversary of the waterfall decline in the US stock market that occurred in response to the events of Sep-11. It is possible that nervous anticipation associated with these anniversaries will keep the stock indices under pressure for the next 1-2 weeks. However, markets seldom do what most people are expecting them to do or are worried they might do. In particular, anniversaries of major market declines often cause considerable trepidation as they approach but just as often turn out to be 'bear traps'. This is especially true on the first anniversary of a terrible event when the devastation of the previous year is still fresh in the minds of most market participants.

A good example of how markets often respond to 'anniversary angst' occurred in 1988, 12 months after the stock market crash. In 1987 the market peaked in August, began to decline during September, then crashed in mid October. In 1988 there was a lot of anxiety as the months of September and October approached. The huge losses suffered the year before were still at the forefront of most traders' minds and many were fearful that the market would crash again. However, during September and October of 1988 the market moved higher in almost straight-line fashion. In fact, a significant pullback did not occur until November when the danger was perceived to have passed. The below chart of the S&P500 Index shows what happened between August of 1987 and December of 1988.

The impending September-11 anniversary might turn out to be a similar bear trap, with the decline that so many people are worried about not starting until the danger is perceived to have passed. With the market having just reached an oversold extreme, no doubt partly due to nervousness associated with the Sep-11 anniversary, this appears likely. It also meshes with our forecast for another rally prior to the start of the bear-market's next downward surge. 

Current Market Situation

From the e-mail alert sent to subscribers prior to the start of trading on Wednesday: "With the market having moved from being 'heavily overbought' to 'heavily oversold' we are now at a point where either an upward reversal occurs or the market completely falls to pieces and collapses below the July lows. We expect the former, although we certainly wouldn't be taking any profits on put option positions at this time. With or without a rebound to new recovery highs over the next few weeks there is a good chance that the stock indices will trade well below their current levels before the end of this year."

Below are two charts that illustrate what we mean when we say the market had become "heavily oversold". The first chart shows the amount of money in Rydex bear funds relative to the amount of money in Rydex bull funds. Notice that the bear/bull ratio had, as at the close of trading on Tuesday, moved higher than where it was in late-July (shown as a new low on the chart since the scale is reversed). This indicator suggests that people were more bearish early this week than they were when the stock indices were bottoming in July. The second chart shows the percentage of NASDAQ100 stocks that are trading above their 50-day moving-averages and the percentage that are trading above their 20-day moving-averages. As at the close of trading on Tuesday these percentages had dropped to levels typically associated with short-term lows. 

Although short-term sentiment indicators just hit levels that reflect widespread fearfulness, there are very few long-term bears. As discussed in last week's Interim Update the vast majority of people remain very bullish as far as the long-term prospects for US stocks and the US economy are concerned. Wall St strategists and analysts, as a group, have also remained steadfastly bullish in the face of the relentless downtrend. This bullishness in the face of horrible price action is especially evident amongst the analysts at the major Wall St firms who follow the semiconductor sector. The stocks in this sector have been slaughtered over the past 12 months, yet during this period not one of the Wall St analysts was officially bearish on the sector. The Semiconductor Index dropped to a new multi-year low on Wednesday before rebounding, but there are still no bears amongst this group of analysts. Not one. When the ultimate bottom is reached they will all be bearish.

The market rallied on Wednesday as it should have done following the panic selling that occurred on Tuesday. It would, however, have been more bullish if the market had dropped sharply on Wednesday morning prior to rallying. As it turned out, Wednesday's action was indecisive and left open the possibility that the recent lows will be breached before a multi-week rally begins.

The Nikkei

Up until this week the Japanese Nikkei Index had remained above last September's low, but earlier this week it broke decisively below major support defined by the September-2001, February-2002 and August-2002 lows (see chart below). This prior support will now become resistance.

The US and Japanese stock markets have been moving with each other since the beginning of last year with the Japanese market usually leading at important turning points. The Nikkei's breakdown therefore provides further evidence that the July lows in the US stock indices were not long-term or even intermediate-term bottoms (as if we needed any more evidence!). 

Following a breakout a market will often move back to 'test' the breakout. As such, a bounce in the Nikkei to around the 9500 level some time during the next few weeks would not be a surprise.

Commodities

Commodity prices in general have been strong over the past few months. However, the price of one of the most important and economically-sensitive commodities - lumber - has recently been very weak. In fact, lumber futures have fallen by around 30% since March.

Below is a weekly chart of lumber futures. The behaviour of the lumber price over the next several weeks will be an important 'tell' regarding the economy and the demand for other economically-sensitive commodities such as copper. In particular, a break below support in the $200-$220 range would be a very bearish development. 

Gold and the Dollar

Current Market Situation

Regardless of what the sentiment indicators were saying we wouldn't be giving the benefit of the doubt to the stock-market bulls in the short-term if the US Dollar's price action did not have short-term bullish connotations. After all, the stock market is experiencing its most severe bear market since the 1930s and we don't have records from the 1930s to show us just how 'oversold' a market can become in such circumstances. When there are no historical benchmarks to go by (no relevant ones, anyway, because a parallel to the current situation has never occurred during a period when sentiment was objectively measured) the risks are much greater or, at least, less quantifiable. At the moment, however, the US$ appears to be consolidating ahead of another push higher (see the daily chart of the September Dollar Index below). A daily close above 108.50 would suggest that the Dollar Index was on its way to our 111-112 target for this counter-trend rally. Note - a daily close below 105 would negate the short-term bullish argument.

Below is a chart comparing the gold price and the Swiss Franc. Our view is that the rebounds in both the SF and gold that began in early August are counter-trend moves within on-going corrections. This is the interpretation that makes the most sense to us based on price action, inter-market relationships and sentiment indicators. Note that the gold price has been leading the SF since the beginning of this year, so we shouldn't be surprised if gold bottoms and begins heading higher before the SF completes its correction.

Below is a 6-month chart of the Amex Gold BUGS Index (HUI). Anyone who didn't take profits on gold stocks during May/June and subsequently regretted it has just been given another good opportunity to do so. There is a reasonable chance that the gold price and the HUI will spike a bit higher in the short-term, but the rebounds from the July/August lows are now 'long in the tooth'. We expect that most of the major gold stocks will hold above their July lows during any pullback over the next few weeks.

Chart Sources

Charts used in today's commentary were taken from the following web sites:

http://stockcharts.com/index.html
http://www.decisionpoint.com/
http://bigcharts.marketwatch.com/