Tuesday, October 28, 2008

Turning Points: how trends are born and how they die

There are a lot of lessons to be derived from the recent market events. In this post I want to focus on two that have to do with identifying turning points. At the risk of making post too long, I'll put them together since they are very interconnected.

Turning points are in effect change of the trend. Thus, it's important to look into what maintains trends and what causes them to end.

Lesson 1. What causes trends to end, or pendulum effect.
System when pushed hard and far enough, pushes back. The harder and farther has it been pushed, the harder and farther does it push back.
This concept is well described and explained in a brilliant book The Fifth Discipline: The Art & Practice of The Learning Organization .
We all witnessed how, during oil stunning rally, all kinds of higher and higher targets were assigned - 150, 200, 300. Part of those predictions that is related to what we discuss is this: there were explanations to those targets and to continuing rise of the price, that cited all kinds of equations, how much oil is out there and can be extracted per day, and how much oil per day is consumpted and needed. Projection of the growth in both parts of equation led to a conclusion that supply and demand ratio will inevitably cause further price rise. Were those equations correct? Sure - if you accept the fact that system will not push back. But it will (and it did) - in a form of slowed down consumption (caused in no small part by the very cause of imbalance in the system, fast and hard oil price rise), in a form of developing other energy sources (yet to materialize to really meaningful degree). Similar predictions put food prices above the clouds, and failed in a similar fashion. Similarly, rapid increase of predators in a certain area eliminates their very food base and leads to banace restoration when predators start dying of starvation. Similarly, explosive expansion of a particular company often undermines its growth perspectives and requires contraction to regroup and find the way to evolve in a more mature fashion. Similarly, overheating of a certain area covered with water leads to increased evaporation and forming of clouds that cool the area off. Finally, to return to the markets, similarly excess of buying leads to exhaustion of buyers and eventual trend reversal. Similiarly, abundance of short positions leads to short squeezes. This phenomenon is known as "becoming a victim of own success". It's also known as reversion to the mean. Nothing exists in vacuum - everything is a part of the bigger system, and when a certain element of the system gets out of balance, there will be parts of the system that push for balance restoration. Thus trends are being born when a certain element upsets the system, and trends reverse when system pushes back.

Lesson 2. What maintains trends, or inertia effect.
Markets tend to overshoot any reasonable targets on both sides.
This phenomenon is well known as well, but somehow rarely taken into account at the time. When oil started showing signs of cooling off and reversal, very few people called for such seemingly far away (at the time) targets as 80 and below. When NASDAQ started running in 1998, no one could even think of such heights as 5000 - and similarly, when it reversed in the spring of 2000, no one could imagine that it could drop as low as it did. "Market can stay irrational longer than you can stay solvent" - sounds familiar in light of recent events even to those who never heard this sentence, doesn't it? If you want to see the most recent example of this, look no futher than at intraday chart of UAUA for two days, Oct 16 and 17. It would reach all reasonable targets, and still continued to go to unreasonable, and then some more, and then a lot more. This phenomenon takes care (which in market terms means deprives of profits or causes losses - cynical, I know) of those who trade on "obvious" as they see the obvious - which is usually how the majority sees it. "Deprives of profits" part is materialized when profits are being taken where reasonable targets are reached - and market advances well beyond reasonable, leaving those who took their profits in the dust. "Causes losses" part is materialized when countertrend position is being initiated at reasonable targets (shorting oil on the way up at 80? 90? 110? Going long on thwe way down at 120? 100?), and market overshoots those targets and stays "insane" long enough to cause desperation or margin calls.

Failure to take into account and to balance against each other both of these principles leads to severe misreading of the market. Try to analyse what caused billion-sized losses in Pickens energy fund, and you will see how this works. Having made immense amounts of money in oil, where such mis-calculations came from? From misreading the system as a whole first, thus believing in endless price rise? From underestimating the inertia on the downside move, thus multiple calls (and according actions or luck of such) of "oil will never lose $100" kind? You will see numerous examples of miscalculations of this kind in analysis and trades of many around you, and possibly in your own. Hopefully, this overview will help you recognize the fallacies in thinking and balance these counteracting principles in the future.
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