How markets really work

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Many do not understand how markets work.

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The majority think financial markets are all about the news. As usual the majority has got it wrong! As with all great lies there is an element of truth in this and you can see it happen. News comes out and the market jerks around as if something has happened but this is only a small part of the story.

The actual determinant of market action is buying and selling, this ultimately governs price, so if we want to understand markets we need to focus on this factor. Here are a few of the factors affecting buying and selling:

• Availability of cash

• Positions already in place

• The economy

• Feel good/feel bad – ie human psychology

• News Flow

The market is many things but I think the best description is a “maelstrom of human psychology” and although this describes the experience the market is also a machine governed by fairly strict rules and as we examine the factors that affect buying and selling these rules will become clear.

The first factor is how much cash an investor and investors at large have to invest.

In good times, as in the run up to 1999 and 2007, investors had plenty of cash and a good slab of that made it into the market propelling prices higher. All pretty clear and simple. But the next factor is vital. If an individual investor already has a substantial holding in a particular stock, let’s take Apple as an example, then he is less likely to buy more, especially if that stock increases in value and starts to form a disproportionate part of the portfolio.

But it is more fundamental than that and the fact is every time somebody buys a stock the market gets weaker!

Now this is a fairly controversial statement plus it is totally contrary to the mass perception and is also totally counter intuitive, but let’s look at the facts. If an investor holds no shares in Apple Inc then he has the potential to buy the stock and as the stock price increases it exerts a hypnotic influence on investors at large to buy the stock backed up by all the feedback from other investors they talk to saying how much money they are making.

So whilst the investor holds no stock in Apple he can still be viewed as potential positive for the stock because he may buy it. But consider what happens when he has bough it. Firstly that potential positive is no more but, more importantly, the potential positive has reversed into a potential negative because now he may sell the stock. So price may have increased as that investor, and possibly others, buy the stock but the market has weakened because all those buyers who had the potential to buy now have the potential to sell.

Now take this to its logical conclusion. The stock continues to rally and as it does so the hypnotic effect on the psychology of investors becomes irresistible and more and more investors buy the stock. Usually at this point there is not a cloud in the sky adding to the euphoria and greed that pushes investors to buy at silly prices – they may not seem silly at the time but looked at in the cold light of day away from all this emotion, that is exactly what they are.

So the buying continues and the positive potential, measured by those who do not own the stock but may buy, dwindles away to be replaced by the negative potential, measured by those who hold the stock but may sell. Plus a lot of these are “weak” holders meaning they bought at silly prices and are very vulnerable to a pullback.

Now you may quite correctly say, but there is only a fixed amount of stock in the market surely there are still the same number of holders? To answer this consider the investor who sold Apple at, say, $200 on the way up. I would answer that he or she is very unlikely to be a buyer at $500+. OK, very few investors act rationally as they are too hyped up with emotion, and in fact it is the investors who overcome this issue who make all the money. So if an investor is acting rationally when he/she sold at $200 there is no way he/she would buy at $500, unless something fairly major had changed and this is unlikely. But if he/she had been acting emotionally, which is more likely, it is also unlikely he would buy at the higher price as it would mean admitting he had been wrong to sell at the lower price and people hate to do that!

So a point is reached where the negative potential becomes overwhelming and the stock starts to fall. Very often there is no “news” of import to justify this but market pundits hate that and start to scratch their heads and play the game I call sticking the news tail on the market donkey – a game that is played blindfold which aptly describes their blinkered view of how the market works.

So, even though the fall happens because “everyone” has bought the man/woman in the street listen to those he/she considers experts who, basically, fill him full of pap based on some obscure news item these experts think has caused the change!

It is my view that the factors stated above are the major determinant in the timing of the major moves in stocks and stock markets – the major determinant in bull and bear markets!

But the economy has a large effect as it determines how much cash is in the system and thus how much investors have to invest.

What of Government policy? This is not completely irrelevant but generally the less a Government does, the better – a factor I believe applies to pretty much every area in which the Government gets involved other than its primary duties such as law, defense, the police etc. When it comes to a market a free market which is properly self regulated wins hands down on every occasion and the price mechanism itself looks after most problem areas but Governments can put many spanners in the works.

For example a Government may decide to ban short selling (a practice whereby traders open short positions before they buy the stock) because they feel stocks are going too low. Such action shows such a level of ignorance that it is very depressing. Such action is most often followed by sharp downside action where the market is said to have “no bottom” and the logic is clear. I said above that every time an investor buys the stocks it weakens the market because he has the potential to sell. The reverse holds true when a short seller come along and such action strengthens the market (whilst very possibly driving price lower) because they have the potential to buy. In fact these guys provide a floor, they provide a bottom, because as price goes lower they will start buying.

It is when you ban short selling that the market truly has “no bottom” and this is a clear case of fear (the fear of falling markets) creating the very thing that is feared – a common occurrence which is why we should never be swayed by fear. In fact when it comes to the economy the Government is really in the position of a surfer. They do their best to look good surfing the waves but have as little control over the waves of the economy as a surfer does over the waves of the sea. Again they can most certainly screw things up but business is best left to businessmen who will make the most of the opportunities.

Certainly the worst excesses of such businessmen need to be controlled and that is a proper function of Government – but it always goes far to far bowing to various pressure groups and creating mess and muddle in the process.

This trend of too much Government is why we in the West are now in such a non-competitive situation as compared to the new economies in the East not burdened by excess Government, excess welfare, and excess taxes. If we study history it is when Government gets too big that empires decline and, finally, fall.

The British Empire peaked in the 19th Century and I would say the US is now in the peaking process. The mantle will undoubtedly pass to the East. I am writing this in Bangkok and I have no doubt this will be one of the leading cities in the world within the next ten or twenty years – in fact if you want to invest in property you should certainly consider Bangkok as one possibility. Right now, at the end of 2012, there is some political risk with an aging monarch, but I cannot see anything really halting growth in this area.

This leaves two final factors to consider. One is news flow, what many consider the prime determinant of market action. I consider it almost entirely irrelevant most of the time. As I said at the beginning of this section news does affect short term action as traders react to the latest news flash but this means nothing really. News is mainly concerned with the economy and a single issue of a particular economic indicator, especially when “fudged” by the various Government agencies and seasonally “adjusted” etc etc. What is important is the trend of such indicators over time but a single release does not show that. Certainly there are significant news items, such as an earthquake, 9/11, interest rate hikes, fiscal cliffs, etc., etc., but, important as these are, they do not usually change trends although they may mark the their beginning or end or the start of such.

From the trading standing although news may not be important in the grander scheme of things it can be critically important when it comes to shorter term trading – in fact I have developed trading systems based entirely on news items (see my books BINARY TRADING and TUNNEL TRADING).

One particular aspect of news is that it can lead to sharp knee-jerk action and this can all too easily knock out trading positions if stop losses are in place close to market action, and, in some cases, not so close – this is anther area we will be looking at in more detail later in this new book but is one good reason why a trader needs to know when news comes out even if he/she has little interest in what the news might actually be (which is my basic position!).

Whilst news flow may be the least effective of our factors; human psychology is definitely the most important. If you agree that the markets are a maelstrom of human psychology, and I believe this is indisputable (but as with everything I write, it is open to reasoned analysis and discussion), then clearly human psychology is what it is all about. Ultimately information comes into our brains (our three brains – see Chapter XX) and it gets processed. This can then result in action either, impulsive, emotional or thoughtful depending on which brain is dominant and effective at that time. 99.9% of market action is dictated by this process and so human psychology holds sway. But there are also algorithms at work, aka trading robots, which are created by human psychology but are then let loose to work on their own within pre-set limits.

The “flash crash” in May 2010 (aka the crash of 2:45 – http://en.wikipedia.org/wiki/2010_Flash_Crash ) is an example of their work and it is interesting, if not rather alarming, that these emotionless robots seem capable of producing more erratic action than massed humanity at its least rational!

I hope this brief but fairly in depth look at what markets are gives you some insight into what you are dealing with. It is certainly fascinating and I could write a lot more just on this single aspect, I have not even mentioned “auction process” above which some see as a fundamental aspect of a market, indeed I would agree!

The above is an extract from my new book THE WAY TO TRADE BETTER!

TRADING TRIANGLES is still available for less than £5 at http://www.amazon.co.uk/Trading-Triangles-triangle-patterns-ebook/dp/B00AHXYNOO/ref=sr_1_1?s=books&ie=UTF8&qid=1356409452&sr=1-1 (5***** reviews!!)

For free information and reports please email jptt@aweber.com

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Comments

  1. Old China Hand says:

    Great book. As a professional engineer who is also a pilot I listened to Bloomberg TV(US desk) handling the Boeing Dreamliner teething issues and it really came across as to how the majority can get it wrong, as John Piper says in this excellent publication.

    To listen to Bloomberg’s talking heads you would have thought that the roof had fallen onto Boeing as a company, yet when checking the news in more detail I found there had been some issues but the plane had not been grounded. In engineering asset management this is called the bath-tub curve, where the birth of a new product has teething problems as does a very old asset – hence the shape of the asset intervention curve. All major new engineering asset births go through this phase.

    Of course if you want to short the stock then lots of “bad news” made worse by half truths and lots of spin gets you some bear action.

    Great to hear one voice in the wilderness telling it the way it really is.

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