The Stock Surfer

Randomness Thoughts From A Bear

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I am growing more bearish by the day. More on that in a minute.

Because of my honeymoon, I was able to pry myself away from the daily market banter and reflect on my general market strategy. Although my time away didn't help me in the Strategy Lab contest, I think the bigger picture ideas that enlightened my brain will help me be a better trader in the long run. (I also realized that the time I was spending on the contest was taking away from my quest to make money in the real world--I'm putting a stop to that!) Here are a few of my reflections, heavily influenced by my beach reading, Fooled By Randomness by Nassim Taleb. In any order:

* Our minds want to see cause and effect in randomness. You see this every day in the market headlines. "Dow falls on recession worries." "Oil rises on Nigerian violence." Cause--Effect. The journalist wants to write a coherent story, and our mind wants a linear explanation. The problem is, there so many factors at play--buyers and sellers with their own perspectives, companies with agendas we can't see, governments with competing priorities--that we can't possibly identify a single cause. This doesn't mean there is no cause and effect, it simply means we must be skeptical of the simplicity and aware of uncertainty.
* We make our decisions out of emotion and try to explain them with reason. Taleb talks a lot about this, and how difficult it is to make a truly rational decision. As much as we try, we tend to act first and talk about it later. This is not necessarily a bad thing, but can lead to delusions. When we make good choices we like to credit our genius, when we make bad choices we blame our emotions or the weather.
* It's the size of the gain that matters, not the frequency. You can be right on the market 80% of the time, but if you lose all your money when you're wrong it does you no good. Taleb's style is to be right rarely, and make a lot of money when that happens. I'll no doubt hear more about this in his other book, The Black Swan.
* Most information is meaningless. The amount of information thrown at us is increasing every day, but is it making us smarter? Which data points or expert opinions should be trusted? Avoid CNN for a few days, and see if your life suffers.
* Price fluctuations always show volatility, but only occasionally show a meaningful move. This is similar to the cause-effect fallacy. If we watch a stock in real time, we see it go up and down within a certain range very rapidly. This is often little more than volatility with a number of random causes. A guy could be selling because he is moving to Australia, or buying because he typed in the wrong ticker symbol. We simply don't know, and should avoid reading too much into simple price fluctuation.

So how will this help my trading? I'm not completely sure, but I keep coming back to the theme of risk-reward. This year I've been focused on risk management, but have not always been aware of the reward side of the equation. Sometimes, even if it's likely that I will be wrong on a trade, I may want to attempt it simply because the reward will be high if I'm right. Conversely, I may want to avoid the easy trade that will not make me any money even if it works. In addition, I want to learn to avoid getting pushed into or out of trades due to meaningless bits of information or tiny price fluctuations.

Now then, why am I bearish? The rally since Bear Stearns Day has taken the market back to around 1400 on the S&P, which appears to be a significant technical level. I would be foolish, after what I just wrote, to give a firm reason for the rally. From a psychological perspective, my best guess is that investors were relieved that the financial system would not collapse, and shorts have been covering. But I am very skeptical of interpreting this move as a signal that the economy is in good shape and a bear market has come and gone. Doesn't the housing bubble/credit crunch have broader implications than a quick recovery would suggest? I think so. Interest rates can't go much lower. The dollar, if it strengthens, will create a headwind for the bright areas of the market (commodities and exports). Deflation could be the real "flation" to worry about.

On a risk/reward basis, I'm looking to short financials (SKF), short oil and gas (DUG), and short real estate (SRS). And I'm open to being wrong.

[Posted simultaneously on my personal blog.]