depends on the instability of thesnow bank. This is also true of the audio feedback in the first example:The screech continues even after the speaker stops talking. A small beginning effect is magnified into a large one by the structure of the system; this is one of the main discoveries that has come out of the newscience of chaos. The phenomenon is often colorfully described in chaostheory by the phrase “how the flapping of the wings of a butterfly in SanRafael can give rise to a hurricane over Texas.”The stock market, too, has feedback loops. A single news item maytrigger the initial selling, but then selling begets more selling, and themovement takes on a life of its own. Here, however, the source of the underlying instability can be complex. For now, I will say that its sourceseems to lie in the group emotions of investors and the magnitude anddistribution of investors’ profits or losses.Older stock market models downplayed these feedback loops. Theyheld that these types of price distortions are quickly erased by large, rational investors, who neutralize them by bringing prices back to fairvalue. However, it was chaos theory that demonstrated that these typesof distortions can be much more powerful than previously thought andtherefore not so easily dismissed.My work indicates that feedback loops alone seem to be able tocause price movements of up to 25% or more. This is an important conclusion and I want to state it clearly: The stock market can become unstable at times and undergo price movements of up to 25% or more,for no pressing economic reason. However, I have also found that afeedback-loop movement does not last much more than 13 weeks maximum in a decline and about 26 weeks on an advance. These movementscan be followed by another three months of stabilization.The best example is the 1962 crash. This crash, illustrated in thegraph in Figure 2.3, lasted 13 weeks. The market declined more than25%, and there was no economic reason for it, which frightened investors and analysts even more and made the feedback action (selling outof fear) worse. The field of technical analysis attempts to understand
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FIGURE 2.3 The 1962 stock market decline was a 25% movement that seemsto have been nearly 100% feedback. There was little, if any, economic reason toexplain it.
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what causes these instabilities and how to distinguish a stable from anunstable market. The study of economic factors is incapable of locatinginstabilities because the cause of the extreme movement is not found ineconomics. After the 1962 crash, the market made bottom, stabilized,and started on a 3-year advance to new highs.The idea is not new that stock market price movements often exhibitcharacteristics similar to those in physical systems with feedback loops.Many people have fitted feedback loops into their ideas and many models allow for it. What is somewhat new is the discovery that these loopscan sometimes grow much larger than academics originally assumed,but this finding has been incorporated into the newest models. However,it is my opinion that even with these allowances, current theories stilldon’t model the stock market correctly—something important is missing.I believe what they’re missing is that feedback in the market is not oneloop but three separate loops. The market’s price action is a manifestation of the concurrent and overlapping action of all three loops. Thisidea becomes clearer after examining a concept that I call the time intention of the trade.
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A NEW STOCK MARKET MODEL
THE TIME INTENTION OF THE TRADEI believe that understanding and then categorizing investors by what Icall the time intention of the trade helps illuminate stock market pricemovements and is fundamental to understanding any stock marketmodel. It is interesting that Wall Street has no real definition of this concept. The term investor’s time horizon (the period through which a person can invest before he or she needs the money) is close but not reallythe same. Time intention of the trade means that an investor has a clearidea of the expected length of time between the purchase date and thesale date of an investment even before the investment has begun.In truth, the stock market is not one investment activity but the sumof many, each categorized by the time intention of the trade. For example, some investors try to predict and profit from short-term price movements that last from a day to a few weeks: They buy today with theintention of selling in a few days. They live in a very small time world,where hours often seem like years. In that world, a sharp 2-day sell-off isa bear market and something to be avoided. Then there are intermediateterm investors, who focus on price movements lasting a month to manymonths. Their time world or scale is much larger. The third category isthe long-term investor, who focuses on movements of many months to afew years.Each of these investment activities, defined and categorized by thetime intention of the trade, is a legitimate investment activity in its ownrealm. I am not attempting to evaluate whether an investment strategyapplied to any one period is more correct than another—I simply acknowledge their existence and effects. The price movements we seeevery day and all the activity that makes up the daily tape is the sum ofall the different time worlds going on concurrently. Wall Street has always talked about short-, intermediate-, and long-term traders, but theconcept has never been seen as a fundamental and illuminating idea.When its importance is recognized, and the idea of unstable markets
The time intention of the trade is the time—measured in minutes,days, weeks, or months—between the start of a transaction and itsintended conclusion. It is a clear statement of the expected durationof the investment.
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due to feedback loops is also considered, a realistic model for stocksemerges.I distinctly remember the event that brought this to the fore in mymind. In the summer of 1973, I was visiting the floor of the Pacific CoastStock Exchange on Spring Street, Los Angeles. I struck up a conversation with the floor specialist in Alza Corporation. The day’s trading wasover, he was wrapping things up, and I said something like, “The market’s starting to look pretty good.” He disagreed and said he was nervous.We talked a little more, but the conversation was strange. Every time hesaid something, I became puzzled. When I said, “Well, with the marketso oversold . . .” he curtly interrupted with a disagreeing look and said,“What do you mean oversold? It was up 15 points yesterday and 20points today [those were big moves back then]—the market is extremelyoverbought.”I went silent as I realized why we hadn’t been communicating: Wehad been discussing two completely different things. Although we hadexperienced the exact same stock market each day, we had experiencedit differently; we were thinking and living in two completely differenttime worlds.At that time I was interested in the intermediate-term movement ofthe market. Since stocks had been declining for 4 months, it was oversoldin my world. The specialist, however, was involved in every trade of theday. He was focused on the minute-to-minute fluctuations. To him themarket was overbought; it had gone up 2 days in a row! He was so far removed from what was happening in the intermediate term that it didn’texist for him. It’s like an elephant and an ant walking around on the samehill. The ant is walking into a small crevice of the hill and that crevice isall it sees. The elephant doesn’t even see the crevice, only the big hill.The ant can see only the crevice, while the elephant focuses on the characteristics and shape of the hill—yet they are experiencing the same hill!As I drove home, I couldn’t get this realization out of my mind. Whathit me as the important point was that all these different investment activities, categorized by the time scale of interest, existed together coincidental in time, seemingly independent of one another. It was a mistaketo think that short-term trading was unimportant and that long-term investing was the only important area. With feedback loops, price action inone time frame can magnify and affect another.Although this idea was to find its way eventually into my model of themarket, it had a more immediate and useful application in solving a paradox I had noticed. As mentioned earlier, in 1974, market technicians
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were using specialist data (buys, sells, and short sells) to forecast longterm market moves. If my insight here was correct, however, this couldn’t be—the specialist wasn’t interested in and didn’t act in that timeframe. Nonetheless, the indicators developed using specialist data had afantastic record of correctly signaling major long-term tops and bottoms.How could they be so successful? I’ll explain how in Chapter 5.Short-Term Trading Is ImportantYou might think that short-term trading is less important than long-terminvesting. However, if you look at the amount of money invested by shortterm traders (e.g., specialists, floor traders, day traders) you find that itrepresents about 30% of daily volume or more, and this is a rather largepercent. You might say, “Yes, but these traders produce short-term pricemoves that last a day or two and can be ignored.” Wrong! Here is wherechaos theory and the power of feedback loops show that short-termtraders may be able to trigger a movement that can carry on for weeks.Each group of investors, grouped by the time intention of their trading, can generate feedback-loop movements in that time frame. For example, short-term traders can become nervous and produce extremelyfast, but short-term, price changes. Certain instabilities can also exist inthe minds of intermediate-term traders that, when triggered, can produce extremely fast intermediate-term price changes. Finally, instabilities can exist in the minds of long-term traders that can influencelonger-term price changes.Long-term trader instability is much less important than the first twobecause the mechanism behind the feedback loops lies in emotional reactions of the participants, and it is difficult to hold an emotion and reactto it over a long period. In fact, I have never seen a feedback-loop decline last longer than 13 weeks. On the other hand, positive feedbackloops—instabilities that drive prices higher than economics justifies—seem to be able to carry forward to extremes for up to 6 months.The Market’s Three Feedback Loopsand the 1987 Crash: A Feedback Loop DeluxeThe feedback loop of the stock market is not one loop but three. Investors grouped by the time intention of their trading (short, intermediate and long term) and reacting to price movements of a certain size in
THE TIME INTENTION OF THE TRADE
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FIGURE 2.4 The 1987 stock market crash was a feedback loop deluxe. Programtrading accentuated stock price movements, which triggered the feedback loopsof all three time domains—short, intermediate, and long term—in one day.Regulations on program trading that were created after the crash, called collars,were intended to help keep program trading from ever acting as an extremefeedback trigger again.360
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their time domains, can generate a feedback loop for that domain. Thesethree time worlds act somewhat independently of one another, as separate domains, but at times they influence one another. The 1987 crash,in which programmed trading magnified price movements out of all proportion, was an example of all three feedback loops being triggered simultaneously.The 1987 crash, shown in Figure 2.4, caught everyone by surprise,including me. There was no fundamental economic problem to trigger it.Selling, magnified by programmed trading, triggered an underlying instability that in turn created more instability, and down the market went.The boards of governors of the major exchanges know the theories aboutfeedback loops and emotional selling, and after the crash, they set upprice and program trading limits to prevent the bleed-over effect fromhappening again.
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A NEW STOCK MARKET MODEL
The Advisor Frozen in the TV LightsFor a long time, I’ll be remembered in the Los Angeles area as thestock market commentator who was on the air early Monday morning, October 27, 1987, at the local financial station and who becamea little rattled trying to explain what was happening. I’m not a professional announcer, but I appeared on television once a week tooffer my investment opinions. My normal routine was to jot downsome notes in the car on the way to the studio and put them in mytop pocket so I’d have something interesting to tell viewers on myfirst update. The notes covered something I read about the marketover the weekend. I usually did the first market commentary 15 minutes after the market opening and, with a foggy Monday morningmind, counted on these notes to get me through. Later, I wouldassess the market and the news background for more currentobservations.At the studio, I put on my microphone and sat down in front ofthe large number board; I was to be on in 2 minutes. I immediatelysaw that the Dow Jones was down 140 points (that would be 600points today) and it had been open only 15 minutes. I asked the cameraman what was going on. He didn’t know. I took my microphoneoff, ran over to the general manager, and asked him what was goingon. He said, “I don’t know—you’re supposed to know.” I said, “You’reright.” I ran back to the board, put on the mike as the lights and camera came on, and I gave my usual pleasant, “Good morning.”I started to go over the market statistics, beginning with thenumber of advancing and declining issues. As I recall, it was something like 1,400 stocks declining and 7 advancing. The amount ofadvancing volume was so small it wasn’t even registering on theQuotron board. I almost stopped and said that the Quotron boardwas broken, but I wasn’t sure, so I just kept going. Near the end,when I would normally start thinking about what I was going to say,my mind went onto to my notes. I realized with horror that theywere completely useless. What was I going to do, just ignore all thisand talk about some irrelevant observation from the weekend? I didn’t know the cause of the crash—maybe some terrible national eventhad occurred to trigger it.
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Suddenly, the dreaded thought came that I had nothing to say.I froze. When the camera returned to me, I simply stared ahead,sweating and speechless, for 10 seconds. Eventually I said somethingin a squeaky, panicked voice and it was over.It took me about a half hour to calm down and compose myself.When I came back for the next update, I said the decline looked likea selling climax. I was right, but the bottom was 4 hours and 400points (another 15%) away. Neither I nor anyone else had ever seena one-day market decline so severe.
Feedback Loops and Market NewsInvestors usually estimate the importance of an economic news item bywhat happens to the market after the news is released. What seems to bea minor news item can act like the bird in the example of the avalanche—as a trigger—setting off an unstable market and thereby causing a hugeprice movement way out of proportion to the importance of the news.Therefore, when a strong feedback-loop move is in play, it is very hard toevaluate the real import of any news. Is the market reacting because theeconomic news is really that bad, or has an instability just been triggered?During these moments, investors can become very confused. Theywake up in the morning and hear some news that doesn’t seem too bad.As they watch the market begin a major sell-off, seemingly way out ofproportion to the news, they might think, “Boy, did I figure that wrong!I must be missing something important here.” No longer confident inwhat they know, they often join the selling, deciding to sidestep the market until they can figure it out again. Sometimes they have missed something important, but often they have just failed to understand thefeedback-loop mechanism in stock prices.Investor uncertainty can work in another way—analysts and themedia can start inventing economic reasons to explain what is in truthonly a strong feedback-loop price movement. Although the 1987 crashwas really just an extreme feedback loop, for months afterward manypeople were convinced we were heading into a severe recession. Theyneeded a strong economic reason to explain what had just happened, but
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having nothing available, they started inventing ideas. Articles began appearing on the cover of the Wall Street Journal tracing the outline of the1987 crash against the 1929 crash, predicting severe economic problems.There was nothing to support the recession theory, however, except themarket crash itself. Eventually, the market did recover, as investors regained confidence and there was no recession.Understanding that feedback loops exist all by themselves is a majorstep to understanding some large stock price movements. It doesn’tmake the loss of money any less painful or the uncertainty any less, butit can help you understand what you are up against. It can also open upa person’s mind to consider other factors besides economics when forecasting in unstable markets.
AMFLY
The Time Intention of the Trade Clarifies Many Things
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Besides bringing some clarity to the structure of the market’s feedbackloops, the time intention of the trade, which is really an effort to compartmentalize investors by their time focus, helps clarify many confusing areasof investing. For one, knowing the time intention of a trade helps clarifythe type of financial information an investor or speculator will study.Although it might seem trivial and something everyone should know,it is seldom addressed. The question is very simple: “What type of information should you study if you want to correctly time the market?” Thisquestion can be posed, but can’t be answered until we know the time intention of the trade. This is because you use different tools and considerdifferent information depending on the expected period of your investment. Short-term traders usually study some type of technical analysis,whereas longer-term investors usually study the economic picture of acompany (you’ll learn about these two types of information in Chapters3 and 4).Without knowing the time intention of a trade, an investor doesn’tknow what to study. A great deal of trader and investor confusion stemsfrom this one vital point. Without clear definitions of the time frame, investor activity often becomes illogical. For example, an investor decidesto buy a stock because of long-term earnings growth. When the pricedrops 10% in two weeks, she decides to sell, although the stock’s earnings prospects haven’t changed at all. She bought the stock based ondata that predicts long-term movement and then sold because of dataused to trade shorter-term movements. This investor had not clearly defined the time intention of the trade.
THE STOCK MARKET MODEL I USE
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Another reason the time intention of the trade is so important has todo with the concept of stock market predictability. The efficient markettheory says that the market is random and unpredictable, like the flipping of a coin. In my experience (and that of many others), the market isnot always random but is sometimes predictable. The model presentedin the next section allows for this.If you accept that the market is sometimes predictable, you must askan important question: “How long does it stay predictable before it slipsinto its normal random and unpredictable state?” Another importantquestion is “When the market does become predictable, what size andtime duration of price moves does it usually predict: short, intermediate,or long term?” Shouldn’t an investor’s time intention of the trade matchthe time scale over which the market seems to be predictable?It is my conclusion, supported by a study discussed in Chapter 5, thatstock market movements lasting from 3 to 6 months are the ones that arerelatively predictable. Only under unusual circumstances can longerterm movements be predicted with a high degree of certainty.
THE STOCK MARKET MODEL I USEYou are now ready to see the model that I believe is a closer representation of the real stock market than any other. Before you do, however, onefinal piece is missing. There must be a term for fair value.A major feedback-loop movement, even though it can cause an advance or decline of 25% or more for no economic reason, should not beconfused with a bull or bear market. In my opinion, to be called a bull orbear market, a movement should have some long-term economic reasonbehind it and should last at least 9 months to a couple of years. Becausefeedback loops can’t last more than about 13 weeks maximum (with upto another 3 months of adjusting to it), real bull and bear markets areusually composed of a sequence of feedback-loop movements. The market goes from unstable to stable, where it sits for a while, until deteriorating or constructive economic forces bring about a new instability,which leave it vulnerable to the next triggering event. There is always aneconomic or financial reason behind a movement of that duration.Any accurate model of the stock market must contain economic factors, and they must be of primary importance. Technical analysis aside,long-term stock market movements do reflect financial and economic
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conditions, and markets do move up and down long term because ofperceived changes in the economic picture. In my model, the term thatrepresents this economic factor is the term for fair value. To symbolizefair value, I use the mathematical expression D/I, where D stands for dividends and I stands for interest rates. (This term is more fully explainedin Chapter 3.)The complete model is shown in Figure 2.5. According to the model,stock prices equal a fair value modified and stretched by the action of thethree somewhat independent feedback loops of three time domains. Thismodel, with its inclusion of the feedback loops, opens the door to a sometimes predictable market. These four factors have a dynamic interplaythat ultimately causes the wiggling price movements you see in stockcharts.
FIGURE 2.5 A schematic of the stock market model I use. The price of a stockequals a fair value (D/I) modified and stretched by the action of three somewhatindependent feedback loops of different time domains.
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MARKET PREDICTABILITYThe efficient market theory says that the future course of stocks is unpredictable, like the flipping of a coin: The chances of being right at anygiven time are 50 : 50. From my experience, this is true most of the time.At other times, however, it is not true, and the market is highly predictable. When I say that the market at certain times is predictable, Imean that the odds of correctly forecasting market direction are at timesbetter than 50 : 50.How can this be, since there is no way to know the unexpected economic news that drives the market? Because those feedback loops aresometimes very predictable. It may be impossible to predict the nexteconomic statistic, but I believe it is sometimes possible to know whena market has become unstable and when a feedback loop might betriggered.How do you describe or define an activity that is completely unpredictable some of the time and at other times somewhat predictable? Isthere any analogy with some system whose predictability ebbs and flowsfrom random to somewhat predictable? Yes, there is. My analogy mightmake you uncomfortable at first, but keep in mind that it’s only anexample of a system with changing odds; no other relationship withthe stock market is implied. The analogous situation is the game ofblackjack.In blackjack, there are certain odds, say 52 : 48, that the house willwin. However, the odds aren’t fixed at those numbers; they average 52 :48. At times, the odds are even greater in the house’s favor, and at othertimes, the odds go the other way and favor the players. This is true because the initial odds of 52 : 48 depend on the ratio of the number of 10cards to non-10-cards in a standard 52-card deck. If, in the first deal, adisproportionate number of 10-cards comes out, the ratio shifts for theremaining deck. This is the essence of card counting—trying to determine when a deck is out of balance in favor of the bettor. With the stockmarket, it is a much more difficult proposition (Figure 2.6).Suppose that a similar situation exists with the stock market. Assumethat the stock market is usually a 50 : 50 proposition, but at certain timesthese odds shift and the direction of prices becomes more predictable:60 : 40, for example. What do you look for to see that the market is nowin your favor, that it is more likely to go either up or down? This is a very
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FIGURE 2.6 A schematic diagram showing that the stock market is usuallyrandom and unpredictable but at times shifts into periods when it can becomevery predictable.
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Somewhat predictable markets (odds better than 50%)appear sporadically and for short periods. They are bestlocated using contrary opinion.
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important question and one that I try to answer in the remainder of thebook.Before we go forward, let’s take a look at one of the greatest tradersin American stock market history, Jesse Livermore. After 50 years oftrading, he reached a similar conclusion regarding the predictability ofthe stock market.
Jesse LivermoreJesse Livermore was one of the great stock speculators of WallStreet. Legend has it that he made four million-dollar fortunes overa trading career that lasted 50 years, from 1890 to 1940. His firstjob at age 12 was posting prices for customers who were placingbets in a local stock market bucket shop. Soon he was placing bets
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himself and winning. In a few months, he had earned $1,000. Hebecame so successful that all the bucket shops banned his activities.He then began speculating in stocks and eventually became successful at that, too. Stock speculation was the only job Livermoreever had.Over time, he matured from a short-term tape reader to a speculator who planned his operations based on longer-term economictrends. He made his first million in 1906, which also saw the start ofa massive credit crunch and stock market decline that he foresaw.After losing some of his nest egg in three short positions taken a little too soon, his fourth short position was right on target, eventuallyyielding him millions in profits as the market crashed. He bought theshares back at the bottom of the market and acquired the name ofBoy Wonder.Many books were written about him, the most famous being the1917 Reminiscences of a Stock Operator, by Edwin Lefevre. It may bethe most well-known book ever written on the subject of stock speculation, and it’s still in print today. In his own book, How to Trade inStocks, Livermore said, “One cannot be successful by speculatingevery day or every week. There are only a few times a year, possiblyfour or five, when you should allow yourself to make a commitmentat all. In the interim you are letting the market shape itself for thenext big move.”He lost most of his money in the 1929 crash and never reallymade it back in the heavily regulated environment that followed.
Now that we have defined the model I use to understand how stockprices behave, the next few chapters explore the two disciplines—technical and fundamental analysis—that are used to study the two components of the model. Technical analysis is concerned with the study ofstable and unstable markets, including the three feedback loops. Fundamental analysis is the study of the D/I term that defines fair value. Thefirst subject under consideration is the fair value term and the theory behind it.
3Fair Value: The Theoryof Stacking the Money
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s discussed in the first chapter, the accepted efficient marketmodel concludes that stock prices are essentially random and unpredictable. This presents us, however, with the amusing pictureof thousands of people on Wall Street trying to do everyday what awidely accepted theory says can’t be done—predict stock prices. Thenew model for stock prices, presented in the last chapter, I believe ismore accurate and much closer to the ideas most traders have aboutstocks, and allows for a stock market that can sometimes be predicted,thus saving Wall Street the embarrassment of contradicting itself everyday.Figure 3.1 shows this new model, which says that the price of a stockequals a fair-value term modified and stretched by three feedback loopsworking over three time domains. Fair value is represented symbolicallyby the term D/I, where D stands for dividends and I for interest rates. Ifyou think dividends no longer have meaning in today’s stock market, youshould pay close attention. Throughout this chapter, you will see whydividends and interest rates are so important, or at least should be, tostock prices.A major bull or bear market—or any price movement lasting longerthan nine months—always requires an economic reason for its occurrence. A long trading range market like the one I’m expecting should last
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FIGURE 3.1 In this stock market model, the price of a stock is a fair-value termmodified and stretched by the action of short-, intermediate-, and long-termfeedback loops. The term for fair value is D/I, which is symbolic. It is really thesum of a long series of fractions, in which each fraction is a future dividenddivided by an increasing power of the current interest rate (D divided by I ).
a number of years, so the reasons for it are fundamental, not technical.To understand what the economic factors might be, you need to learnmore about the fair-value term of the model.
FAIR VALUEThe theory behind the fair-value term in the model is simple. It is an oldtheory that says that the current price of a stock should exactly equal thepresent value of all that company’s future dividends. This chapter explains the theory and how it applies to today’s stocks. Your initial reactionmay be that this statement can’t be true because you know many companies that have never paid a dividend and yet still have a stock price.
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Nevertheless, as you will see, the model still holds. As we explore theidea behind D/I, you will learn how stocks with no current dividend canhave a theoretical stock price.
WHY FAIR VALUE THEORY IS NOT WELL KNOWNI must confess that I studied the stock market for more than 20 years before I knew what fair value was or that there was even a formula for it. Ifound it much easier to study technical analysis. I was more interested inintermediate-term price movements lasting about six months and Ifound that technical, not fundamental analysis seemed to work better forforecasting prices in that time frame. I also found most of the instruc-
Bridging the Math ProblemPeople who haven’t studied mathematics often have strange ideasabout it. Many think that scientists work long hours on complicatedequations looking for some deep formula that contains a great truthof nature, yet this is far from what they really do. Most scientistsdon’t think in terms of mathematics; they think in terms of conceptsand use mathematics only to test these concepts. In real life, mathematicians and physicists often get very sloppy with their calculations,doing quick tricks that would upset a strict math teacher. These scientists have come to know that mathematics is really only a tool (anda marvelous one) to obtain insights into how things work. They arefamiliar enough with the tools of their trade (math symbols) thatthey know when to be exact and when they can be sloppy and stillget a close answer.The famous physicist Richard Feynman used to revel in his ability to explain very complicated physics theories without using anymathematics while not losing any of the theory’s truths. He could dothis since he had learned that real insight usually stands on the otherside of the mathematics. This typically comes after immersing oneselfin the mathematics, then finding the two or three core ideas that
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come out of it. He would pull these out, bypassing the mathematics,and show the reader how simple it all is.Feynman’s book called QED (Quantum ElectroDynamics) demonstrated how everything we experience in the universe can be explained by the act of combining, in an infinite variety of ways, threebasic actions. Behind all the math lay that simple truth. Amazing.The average reader, hearing only these simple truths and notseeing any complex equations, often thinks he or she is getting thecheap explanation—the great truths must lie somewhere deep insidethe math. But this is not so.The same is true on a much simpler scale about the fair value ofstocks. It is usually presented in complex mathematical form, whichhas confused