the world’s largest financial services firms, Eric contributed a wealthof experience with the Market Profile, and provided guidance in developingconcepts that would resonate with other senior officers of financial servicesfirms.CBOT Market Profile® and Market Profile® are registered trademarksof the Chicago Board of Trade (CBOT), which holds exclusive copyrights toboth. The views expressed in this publication are exclusively those of theauthors.
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It is not necessary to change. Survival is notmandatory.—W. Edwards Deming
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y first car was a used ’49 Chevy. We could pull it into the garageand change the plugs, set the timing, clean the carburetor and beon our way. Back then, it was relatively easy to understand enginesand how to keep them running smoothly. Today, if someone asked me toexplain the first thing about what’s happening under the hood of my car, Iwouldn’t have a clue.There’s a parallel between that Chevy and my first excursion into theworld of investing. When I became a stockbroker in the late sixties, mychoices were pretty simple: common stocks, preferreds, a few warrants,limited over-the-counter options, U.S. government treasuries, municipalsand corporate bonds, and cash. While there were mutual funds, they wereextremely limited and many brokerage firms discouraged brokers fromselling them to customers.The financial markets have moved from simple to complex at a rateof change that is impossible to fully grasp. This accelerating complexityhas been multiplied by the Internet explosion, global expansion, and myriad other factors, leaving individual traders and investors bewildered andgrasping at narrow fragments of the larger picture, or subscribing to thebeliefs of supposed experts who promise clarity and shelter from the information maelstrom. It’s no wonder that the current financial atmosphere isone of continual change and uncertainty.In his landmark book, The Structure of Scientific Revolutions(Chicago: University of Chicago Press, 1962), Thomas S. Kuhn examines1
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the way change realigns the “received beliefs” of any given community; because a community’s participants define themselves according to the ideasthey share, they often take great pains to defend those ideas. In fact, it’s notuncommon for this defensive posture to result in the active suppressionof new theories that undermine reigning assumptions. Therefore research,Kuhn writes, is not about discovering new truths, but rather “a strenuousand devoted attempt” to force new data into accepted conceptual boxes.In short, change threatens the very terms with which we identify whowe are (and how we invest our money).But history has proved that in all things stasis never lasts—eventuallyan anomaly arises that is so compelling it cannot be ignored or dismissedas a “radical theory.” Inevitably, the anomaly unseats the norm, resultingin a paradigm shift in shared assumptions. These shifts, as Kuhn describesthem, are nothing short of revolutionary.Paradigm shifts force a community to reconstruct its foundation of belief. Facts are reevaluated. Data are examined through new lenses and, despite vehement resistance by those who refuse to let go of outdated ideas,the old paradigm is overthrown. A new community is established, and the“radical theories” are accepted as the new normative establishment.The cycle of change begins again.How important is change? Think about the many powerful institutionsand intrepid individuals that once lead the fray and who are now long gone;those who recognize change early can take advantage of change, those whocan’t overturn their past beliefs get left behind. That pattern repeats itselfendlessly in all human endeavors.In The Tipping Point: How Little Things Can Make a Big Difference(Boston: Little, Brown, 2000), Malcolm Gladwell defined the way peoplereact to change by classifying them on a spectrum:innovators : early adopters : early majority :late majority : laggardsWe are going to show you how to use market-generated informationto identify and adapt to change before your competitors—once the majority recognizes that change is occurring, all assymetric opportunity is lost.This book challenges you to be an innovator, to overturn (change) manyof the assumptions that now guide your perception of economic and market conditions. You may be faced with information that runs counter tothe prevailing beliefs of those whom you have trusted for guidance. DanielKahneman said it best: “Resistance is the initial fate of all new paradigms.Often this resistance is strongest among the institutions responsible forteaching and upholding the status quo.”To begin, we address change in the financial markets from the broadest perspective, which is from the point of view of investors who operatein the longest timeframe. But it is important to note that this same process
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occurs for traders/investors of all timeframes—those who capitalize onfive-minute price swings, day traders who make several daily decisions,short-term traders who hold positions for several days, intermediate-termtraders who track bracket extremes, as well traders who hold their positions for several months or even years.What we are addressing, across all timeframes, is how change occurs.We believe that the financial markets—and therefore all participants,businesses, and industries dependent on the markets—are at the vortex ofa truly significant change. Over the coming years, investors, traders, portfolio managers, financial advisors, pension consultants, and even academicswill all have to pick their spot on the spectrum of change . . . and win orlose because of it.There is no single key driver behind the change we’re experiencing.Rather, a series of developments—some connected and some not—overthe past 30 years have created the evolution that is now underway. Thebalance of this chapter introduces these events and their implications onthe financial markets and those who operate within them (traders, portfoliomanagers, advisors, etc.). To help you visualize the following discussion,S&P 500 Large Cap Index ($SPX) INDX155015001450140013501300125012001150110010501000950900850800750
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FIGURE 1.1 Events shaping market and investor behavior: S&P 500, 1965 to2004.Source: Chart courtesy of StockCharts.com.
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Figure 1.1 illustrates several key developments of recent market history inthe context of the U.S. equity market.
THE CREATION OF ERISAThe first serious change in the modern financial services business tookplace in the early seventies, partly as a result of the U.S. bear market thatculminated in October 1974. Leading to the trend’s nadir, equity valuationhad decreased by approximately 40 percent (see Figure 1.1), the bond market had dropped an equivalent amount, and there was an estimated 35 percent decline in purchasing power. It should come as no surprise that innovation flourished under these extreme conditions; change demands the surrender of security, and in 1974 the very notion of security was cast in doubt.Not surprisingly, new government regulations designed to protect employees’ hard-earned retirement funds followed closely on the heels ofthis cataclysmic plunge. Enter ERISA (Employee Retirement Income Security Act), enacted in 1974 and designed to protect employee pensions.While performance measurement had got under way in the 1960s, ERISAincreased focus on return relative to risk, which jumpstarted a new era ofcorporate accountability.While this new accountability was clearly needed, ERISA was concerned more with the process by which pension-investment decisions weremade, rather than with the investments themselves, which had the effect ofushering in an industry that focused on asset allocation, manager selection,and performance evaluation. Pension funds began to exercise more prudence when selecting money managers, hiring consultants to assist themin meeting their fiduciary responsibilities. The pension-consulting industrybegan to boom.On the surface, ERISA had many positives—it improved diversificationand disclosure and promoted standards that enabled investors to better understand and compare investment performance. However, lurking belowthe surface was a negative that would take years to fully reveal itself: manyof the processes implemented as a result of ERISA served to stifle innovation and creativity in the investment management business.
THE RISE AND FALL OF RELATIVEPERFORMANCEThe push toward improved diversification and process transparency resulted in managers developing extremely specific approaches to investing(see Figure 1.2). In turn, consultants needed improved ways to judge how
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LargeCapGrowth
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FIGURE 1.2 Typical U.S. equity styles.
individual managers were performing relative to the market, and relativeto each other. Consultants initially used broad markets indices to gaugeperformance. However, as more and more specialty managers began to appear, benchmarks began to evolve and, as with all change, these evolutionsbecame increasingly complex. Specialized market indexes were employedto gauge performance. Categories were formed so that managers couldbe compared against their peers. Consultants pigeonholed asset managersinto distinct styles so they could more easily monitor their activity andfire them (or not hire them) if they didn’t fit neatly into preconceived categories. Over time, this forced many money managers to become highly specialized, focusing on individual styles like growth or value, which in turnwere further broken down into large-cap, mid-cap, and small-cap strategies, as well as a host of other variations.Throughout the Great Bull market that began in 1982 and ran for almost 20 years, managers that attempted to be creative and innovativesometimes found that their ability to raise assets diminished—even if theyhad stellar track records—because they no longer fit within a convenientcategory.The perceived institutional need to compare performance to peers andmarket benchmarks resulted in most of the focus being on relative performance, rather than absolute performance. (In short, “relative return” hasto do with how an asset class performs relative to a benchmark, such asthe S&P 500. “Absolute return” speaks to the absolute gain or loss an assetor portfolio posts over a certain period.) The relativistic approach to evaluating performance proved to be a boon for asset managers, in that theycould now focus on constructing portfolios that had only to equal or perform marginally better than market benchmarks—regardless of whetherperformance was positive or negative.Relativism provided a windfall for asset managers, in that it oftenmasked poor absolute performance; an asset manager with a negative
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return could still win the Boeing pension fund simply by outperformingpeers and benchmarks! As long as performance was measured on a relative basis, the money management industry continued to raise significantassets (upon which fees could be charged). While this wasn’t so detrimental during the rising markets of the time, the relative-performance crutchdid little to prepare managers to compete in the less certain markets thatfollowed the end of the great bull market in 2000.The tide would soon turn: Once it was clear that the market was nolonger going up, clients would begin to demand that their managers domore than simply match the market.
THE FALL OF THE GREAT BULLCoupled with an extended bull market, the enactment of ERISA had theeffect of codifying modern portfolio theory (MPT) in the eyes of the majority of investors and investment managers. (In a nutshell, MPT emphasizesthat risk is an inherent part of higher reward, and that investors can construct portfolios in order to optimize risk for expected returns.) For fiduciaries, the concept of controlled risk through diverse asset allocation iscertainly appealing. When markets are “behaving” (as they were for nearlytwo bullish decades) the return, risk, and correlation assumptions used togenerate asset allocation analyses tend to sync relatively well with marketactivity; a trend is predictable as long as it continues. In this environment,modern portfolio theory became the comfortable thread that held the financial markets’ complex patchwork quilt together. Within this model, asset managers that performed well on a relative basis within a single, easilyidentifiable style could consistently raise assets. Once they stepped awayfrom their advertised style, however, their opportunities became limited.An unfortunate result of this phenomenon was that this narrow, restrictiveenvironment tended to limit the growth of asset managers’ skill base. It’sdifficult to understand how talented, competitive individuals allowed themselves to remain locked into one specific management style for so long,especially when that style had clearly fallen out of favor. I saw managersliterally go out of business rather than change their investment approach.As the great bull began to show signs of strain and the equity marketsbegan to behave with far less certainty (no longer trending up). It becameapparent that the relativistic, MPT-driven business model embraced by traditional asset managers—one in which money was managed on a relativebasis, track records were marketed based on relative performance, andperformance was measured in relative terms—was plagued by significantweaknesses.
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Alexander M. Ineichen of Union Bank of Switzerland (UBS) estimatedthat total global equity peaked at a little over $31 trillion at the top of thebull market, falling to approximately $18 trillion at the 2002 low—a declineof approximately 42 percent. As during the 1974 period, the investmentcommunity reluctantly began to embrace change in order to cope with thedivide that opened between the objectives of traditional money managersand the needs of their clients.One of the prime causes for this divide was that MPT depends on “reasonable” assumptions for each asset class. Implicitly, this requires a verylong-term view; investors must plan on holding their investments for a longtime in order to reap the desired rewards. Unfortunately, when marketsfailed to cooperate toward the end of the bull market, it became evidentthat most individuals and institutions have a vastly different perspective ofwhat “long-term” means, especially when short-term performance is on theline. During times of market stress, the correlations between asset classesoften fall apart, which often results in unexpectedly poor performance.
THE RISE OF ABSOLUTE RETURNThere appears to be a dearth of insight into how investors respond whenthe shorter timeframe delivers significantly different results than was advertised and expected for the longer term. But there is no lack of evidencethat long-term-minded investors, when confronted with unexpectedlypoor short-term results, tend to liquidate their holdings at precisely thewrong time.As the markets became more volatile and uncertain, traders andinvestors who had broken free of the relativistic herd, embracing anabsolute-return philosophy, continued to produce positive returns at atime when the majority of traditional asset managers were posting consistently negative returns (along with the market). Because absolute-returninvestors measure themselves against the risk-free rate, rather than relative to a market index, they must be more flexible and nimble. They musthave the ability to employ a much broader arsenal of investment strategies in order to achieve their goal of delivering consistently positive performance. This group can employ all styles across all capitalizations. Theycan also short securities, which creates even more opportunities and enables portfolio managers to exploit both overpriced as well as underpricedsecurities.The end of the great bull served as the catalyst for a much more adventurous and entrepreneurial environment. In today’s atmosphere, it’s harderfor the traditional money management firms to hold on to talented traders
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and portfolio managers, as the financial rewards for stepping out solo canbe extremely large for truly capable individuals. The firms that want to survive and prosper in the absolute-return milieu must adapt and find new incentives for attracting and retaining such innovators. An article in a leadingU.K. newspaper, the Observer, reported that Dillon Read Capital Management, the new hedge fund unit established by UBS in 2005, earmarked $1billion in bonuses for its first three years in business to ensure that it continued to attract and retain successful traders. When the article appeared,there were only about 120 employees in that unit, which would work out,on average, to about $3 million per employee. It’s no wonder that we continue to see a steady exodus of portfolio managers from the traditionalasset management firms toward those organizations that offer more challenging opportunities in the new world of absolute return.
SUCCEEDING IN AN ABSOLUTE RETURNMARKET ENVIRONMENTFollowing a strong rise or bubble, markets historically remain withinbracketing ranges for many years. As most equity markets peaked in early2000, we are in the fifth year of a bear market at the time of this writing.Although the term “bear,” in this context, is misleading, it is more useful tothink of current conditions as indicative of a “consolidating,” “trading,” or“bracketing” market. The high-to-low range of a consolidating market offers excellent opportunities for traders who are adaptable enough to tradethem. John Mauldin, in Bull’s Eye Investing: Targeting Real Returns ina Smoke and Mirrors Market (Hoboken, NJ: John Wiley & Sons, 2005),states that the shortest bear on record is eight years, with the average being 16 years. During these periods, it seems as if the market’s actions areguided by some shrewd NFL offensive coordinator—just when it looks likethe market is going long it pulls up short, jukes left and rolls right, leavinga pile of stunned investors in its wake.Consolidating markets are tricky. Just when you think you’ve got themfigured out, you end up the wrong way on a big move and you feel likeyou’ve been betrayed by everything you know. Many traders begin to thinkof the market as a cunning adversary who tries to foil their best-laid plans,or perhaps a tempting siren, bent on luring them to the bottom of theirbank accounts.In a long-term bull market, or a “relative-return market,” you can succeed by simply staying fully invested and matching the market’s steadyrise. In a bear, or consolidating market, such as the one we’re in now,savvy traders seek to identify and profit from mispriced securities, both onthe long as well as short side of the market. Achieving “absolute returns”
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FIGURE 1.3 Absolute vs. relative return market conditions: S&P 500, 1965 to2004.Source: Chart courtesy of StockCharts.com.
(returns that consistently exceed the risk-free rate, regardless of marketdirection) requires skill, self-knowledge, an understanding of market andinvestor behavior, and trading maturity. The point here is that the relativeand absolute approaches exist at opposite ends of the spectrum, and bracketing market conditions reward absolute-return investors—those individuals who are concerned with the value of their portfolios at every point intime, not just at some predetermined maturation (see Figure 1.3).If history continues to repeat itself, as it has for the past five years,then the 20-year bull run will fade farther into the past, and a substantiallydifferent approach to market understanding will be required to consistentlysucceed.It is worth noting here that Mind over Markets, the first collaborationbetween these authors, was written in the middle of the great bull market,when most investors had already climbed aboard the relative-return train.The theories and practices prescribed in that book are as applicable today as they were then—there is still unexpected volatility in bull markets,and Mind over Markets provided a detailed treatise on taking advantage ofsuch volatility. Since the great bull, market mechanics and human behavior
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have not changed, although much around them has. With the proliferationof hedge funds, for example, there is more short-term momentum trading,which means that markets tend to move faster and go further once a movement has started.But bull or bear or bracket, markets always conform to the fundamental dictates of time, price, and volume. We’ll revisit some of the principlesset forth in Mind over Markets within new context in this book.
PURE, UNBIASED INFORMATIONAs you have already surmised, the volatility of consolidating markets isgenerally far greater than that experienced in bull markets. This increasedvolatility provides both risk and opportunity. Traders who are ruled bytheir emotions (or led by nearsighted analysts) will continue to chase upward swings and bail out on downward swings, which results in temporarily mispriced securities, as well as the financial destruction suffered bythose who get whipsawed. This progression between bracket extremesprovides prime opportunities to take advantage of fleeting discrepanciesbetween price and value.Markets in Profile is in large part dedicated to explicating this phenomenon in the clear light of market-generated information—not the deluge of hype and conflicting information that serves only to fuel the emotional panic behind most market movement. Those individuals who havethe trifecta of market experience, self understanding, and skill can avoidthe classic “panic in/panic out” whipsaw and take advantage of those whodon’t. Absolute-return investing is a zero-sum game, with a few highlyskilled professionals taking from those who run, generally terrified, withthe pack.Who are those few? They are investment professionals with the experience to take a long-term view while capitalizing on short-term inequities inmarket structure; those who understand their own foibles, so they don’t fallprey to the slings and arrows of doubt, anger, and fear; those who have thediscipline to focus solely on relevant, market-generated information whilethe data explosion rages on around them.Market-generated information is the pure, unbiased information thatcomes directly from the market itself. Structuring and interpreting thisinformation is an excellent way to get a truly objective opinion aboutwhat’s driving market movement, as it’s based solely upon real order flow.Market-generated information represents a composite of all available information at any given moment—from macro and micro. And by organizingthis information using the CBOT’s Market Profile, you can monitor market
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MMMMLMPLMPLMPLMPCHLMPCHLMPCHILMNPCHILMNPCHILNPCHILNPCGHILNPBCGHILNPBCFGHIKLNPBCFGHIKLNPBCFGHIKLNBCEFGHIJKLNBCEFGHIJKLBCDEFGIJKLBCDEFGIJKBCDEFGIJKBCDEFGJKBCDEFJBDEFJBDEFJBDEBDEBDBDDDDDDD
FIGURE 1.4 A market proﬁle of a market in balance showing symmetry in marketstructure.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
structure in real-time context, which enables you to recognize paradigmshifts in equilibrium. When there is symmetry to market structure (asshown in Figure 1.4), which manifests itself in a traditional bell-shapedcurve, then there is generally a balance between good opportunities andbad.
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BBBBCBCBCBCCCCCCCCCDDDDDDDJDJDJDJDFJDEFIJDEFIJDEFHIJNDEFHIJKLNDEFGHIJKLNDEGHIJKLMNDEGHIJKLMNDEGHKLMNPEGHKLMNPEGHKLMNPEGHLMNPHMHMHMMM
FIGURE 1.5 A market proﬁle of a market moving out of balance, showing asymmetric opportunities.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
When the market profile becomes asymmetric (as shown in Figure 1.5),then there is a lack of balance, which results in opportunities to distinguishfavorable (and unfavorable) investment opportunities.Structuring and reading market-generated information via CBOT’sMarket Profile is about identifying opportunities where risk is considerably
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less than the potential reward. Asymmetric opportunities are often causedby irrational human behavior, such as the herd instinct that pushes priceaway from value. We’ll delve more deeply into using the Market Profile tooland behavioral finance (often referred to as neuroeconomics) in later chapters. The point is that having a reliable, objective information source becomes more important every day. Markets continue to exhibit overwhelming, ever-increasing complexity, driven by growing diversity, globalization,technological advances, an increasing numbers of participants, and almostlimitless outside factors that result in constant change. The remainder ofthis book is about how you can better understand and interpret the mostobjective source of information—the market itself.
PEOPLE CHANGE MARKETS, MARKETSCHANGE PEOPLEChange is the beating heart of this book. Markets in Profile addresses thenature of change as it relates to markets and market participants of everytype and timeframe, from macro to micro, from large institutions to investors who hold positions for decades and traders who roll with the market’s daily vacillations. Everything in this book is equally applicable to individual traders, money management organizations, the proprietary tradingunits of major financial organizations, and all the newly formed alternativeinvestment shops.For all market participants, the financial world has changed dramatically in the last two decades. This change can work to youradvantage—most practitioners have either failed to recognize this change,or, more likely, have chosen not to adapt, blinded by the assumption (or thedesperate hope) that what has worked in the past will continue to work inthe future.Your second, and more important advantage, is that despite the astonishing rate of change in the investment world, the fundamentals of marketactivity are just as they have always been: price and volume move over timeto facilitate trade in the pursuit of value. It really is that simple.It is the belief of the authors that in order to better manage risk, youmust first understand the ways in which people change markets, and theways in which markets change people. We will endeavor to investigate thenature of change, starting with a general discussion of perceived paradigmsand culminating in a close look at the specifics of securing favorable tradelocation in the active, endlessly changing market.On a final note, Markets in Profile is also about addressing what couldbe your greatest adversary: yourself.
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Information
There are relatively simple changes in the presentation and structuring of information that canmake a big difference in how much of an impact itmakes.—Malcolm Gladwell, The Tipping Point
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n Chapter 1, we discussed the central role change plays for all market participants. We suggested that people change markets, and markets change people. Let us now turn our attention to information—thebyproduct of change, the ubiquitous evidence that change is, as they say,the only constant.Information has no power until someone acts on it. There are as manyresponses to any given piece of information as there are humans who receive it; we all find ourselves somewhere on the long continuum between“leader” and “follower,” in every endeavor. To illustrate the importance ofthis concept, consider what would happen if you were to simultaneouslyshare a perfect investment idea with five different people. One of those fivemight act immediately, without requiring further evidence, while each ofthe remaining four would act in successively later time periods, waiting tosee proof that the idea was, in fact, generating profits. The diffusion model,made popular by author Malcolm Gladwell in The Tipping Point: How Little Things Can Make a Big Difference (Boston: Little, Brown, 2000), wouldlabel each of these individuals as innovators, early adopters, early majority,late majority, or laggards. These five archetypes can help us better understand the way the various timeframes’ interactions influence the market’sauction process. We’ll discuss this interplay at length in a later chapter, but15
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