Robert Fisher has two passions: chess and stock trading. Because he’s good at one, he’s also good at the other, and today, he’s about to make a lot of money because he sees the whole stock market chessboard and thinks many moves ahead.
Robert’s gambit will be to buy a thousand shares of Northwest Airlines. Why? Because minutes ago, the King of the Friendly Skies, United Airlines, announced that it would purchase a very valuable pawn, U.S. Air. This will make United the largest air carrier in the world—and truly a King.
Upon the news, traders immediately begin scrambling to buy shares of U.S. Air, but Robert knows that most of these “checker players” will wind up paying far too much for their shares in the resultant speculative bubble—and many will lose money.
Meanwhile, Robert immediately understands that such a strategic move by United is a clear attempt at a monopolistic checkmate of rivals like Delta and American. Robert also knows that as a purely defensive response, Delta and American will now be forced to quickly look for acquisition targets of their own. That’s why Robert immediately buys 2000 shares of Northwest Airlines, the likeliest purchase target.
Over the next two weeks, Northwest’s stock jumps first from $24 to $28 and then to $35 as American Airlines does indeed make a fat offer. That’s when Robert exits the trade. He walks away with a lovely macrowave windfall of $22,000. Meanwhile, the U.S. Air speculators who only got in after U.S. Air stock had gapped up from $25 to $49 are now getting clobbered as the price sinks back from its $49 peak to $40. God, Robert loves this game!
The goal of macrowave investing is to maximize gains for a given risk level while minimizing losses and preserving capital. To achieve this goal, the macrowave investor must understand these eight principles, which are the foundations of macrowave investing.
1. Speculate but never gamble.
2. Distinguish clearly between market risk, sector risk, and company risk. Use the principles of macrowave investing to diversify and minimize these risks.
3. Ride the train in the direction it is going. Go long, short, or flat as the situation demands.
4. Ride the appropriate train. Don’t limit your perspective to the stock market. Learn to observe, and perhaps even trade in, the bond and currency markets as well.
5. Macroeconomics is the most important determinant of a bullish or bearish market trend, and the trend is your friend. Never buck the trend.
6. Within the stock market, different industry sectors react very differently to good and bad macroeconomic news. The macrowave investor buys strong stocks in strong sectors in up trends and shorts weak stocks in weak sectors in down trends.
7. The stock, bond, and currency markets likewise react very differently to macroeconomic news. The macrowave investor knows that movements in one market can often presage movements in others and watches each of these markets carefully.
8. Don’t play checkers in a chess world. Macroeconomic events affecting one particular company or sector invariably have spillover effects that wash over other companies, sectors, or markets. To see these effects, the macrowave investor must become a chess player, looking as many moves ahead as possible.
Let’s look now at each of these eight principles from the macrowave investor’s point of view.
Do you wish to gamble blindly in the hope of getting a great big profit or do you wish to speculate intelligently and get a smaller but much more probable profit?
JESSE LIVERMORE, REMINISCENCES OF A STOCK OPERATOR
The macrowave investor speculates but never gambles. The distinction between speculation and gambling is a very important one because over time it clearly draws the line between consistent winners and inevitable losers.
The gambler inevitably loses because he takes risks when the odds are against him. Buying a lottery ticket or playing roulette or dropping coin after coin into a slot machine are all forms of gambling. To take these kinds of risks is to bet against the House.
The gambler keeps taking such risks because of the occasional exhilarating big wins that buck the odds. However, the laws of probability eventually must catch up with him—no matter how lucky he may be on any given day. This is because, over time, the House never loses. This is the “gambler’s ruin.”
In contrast, the speculator only takes a risk when the odds are in his favor. That means the speculator only plays on a field that is tilted in his favor—not the House’s favor. Moreover, he never risks more than he can gain, and he never risks it all on one bet.
Poker is one form of speculation. Trading in the stock market is another. Gary Bielfeldt beautifully explains the relationship between these two speculative pursuits in the classic book Market Wizards.
I learned how to play poker at a very young age. My father taught me the concept of playing the percentage hands. You don’t just play every hand and stay through every card, because if you do, you will have a much higher probability of losing. You should play the good hands, and drop out of the poor hands, forfeiting the ante. When more of the cards are on the table and you have a very strong hand—in other words, when you feel the percentages are skewed in your favor—you raise and play that hand to the hilt.
If you apply the same principles of poker strategy to trading, it increases your odds of winning significantly. I have always tried to keep the concept of patience in mind by waiting for the right trade, just like you wait for the percentage hand in poker. If a trade doesn’t look right, you get out and take a small loss; it’s precisely equivalent to forfeiting the ante by dropping out of a poor hand in poker.
The remaining seven principles of macrowave investing are essential in helping you distinguish between profitable speculation and gambler’s ruin.
Not diversifying is like throwing your lunch out the window. If you have a portfolio and are not diversifying, you’re incinerating money every year.
VICTOR NIEDERHOFFER
The macrowave investor knows the critical differences between market risk, sector risk, and company risk. By a careful adherence to the principles of macrowave investing, she knows how to diversify and minimize these risks.
Market risk revolves around the basic question: Is the stock market going up, down, or sideways? In this regard, market risk involves the purest kind of macroeconomic risk. This is because market trends are, by and large, determined by emerging macroeconomic news and conditions. A broad case in point is the Asian financial crisis of 1997–98. When it first hit, virtually every stock market around the world suffered a meltdown. Similarly, when the U.S. Federal Reserve announced a large increase in interest rates in the year 2000, both the Dow and Nasdaq markets fell precipitously on the news.
The macrowave investor knows that the best way to minimize market risk is to adhere to macrowave investing principles 3, 4, 5, and 8. Principle 3, being able to go long, short, or flat, and principle 5, never bucking the trend, allow the macrowave investor to constantly turn market risk in the direction of a reward. Principle 4, being able to trade in all markets—stocks, bonds, and currencies—provides the opportunity to further diversify across different broad markets. Finally, by anticipating spillover effects into other markets according to principle 8, the macrowave investor is always seeking to stay one step ahead of any indirect market risk—she does not play checkers in a chess world.
As for sector risk, it is any kind of event that affects a specific industry or sector. For example, when the American president and British prime minister jointly declared that rivals in the race to discover new genes should share their results, the biotech sector plunged dramatically. The clear regulatory risk was an implied threat of some future restrictions on patent rights for those companies charting the human genome. Similarly, any time the OPEC oil cartel announces an increase in oil prices and a cutback in production quotas, fuel-intensive sectors like the airlines, autos, and utilities are all exposed to increased energy cost risk that can translate into lower profits and stock prices. Or when Cisco warns of dropping sales, every company that would be considered a supplier or beneficiary of Cisco begins to fall as a result. Or when a new technology comes out for broadband communications, such as wireless high speed or DSL, then cable modem providers fall off sharply.
Now here’s the larger point, and it is one of the most important ones we will share in this book: Sector risk typically accounts for at least 50 percent and perhaps as much as 80 percent of an individual stock price’s movement. That means that when a semiconductor stock like Applied Materials or Intel goes up or down, much of the movement results not so much because fortune and fate are smiling or frowning on the particular companies; rather, these movements are largely attributable to what kinds of macroeconomic and microeconomic forces are bearing down on the semiconductor sector as a whole.
It follows that when the macrowave investor buys individual stocks, he is always aware of sector-level risk. For example, a portfolio consisting of Ivax, a drug stock, Cisco, an Internet infrastructure stock, Schwab, a financial sector stock, and Enron, an energy sector stock, is a portfolio that clearly diversifies sector risk. However, a portfolio featuring Motorola, Nokia, Qualcomm, and Vodaphone—all of which operate in the same wireless telecommunications industry—does not diversify sector risk but merely company risk. In essence, you are not holding four positions but merely one.
And what is the nature of company risk? It may involve management risk—the chief operating officer of Ask Jeeves unexpectedly resigns and throws the company into turmoil. It might involve regulatory risk—a Microsoft finds itself in the gun sights of a trust-busting Department of Justice and its stock value is slashed in half. It might involve a natural disaster—a severe blizzard disrupts the flow of raw materials to a General Motors factory. Or it might involve unfavorable news coverage—Barron’s publishes an article questioning the valuation of Cisco, and its stock plunges.
As a rule, the macrowave investor prefers to minimize company risk in one of several ways. One option is to trade at the sector level. For example, instead of buying Linear Technologies, which is a semiconductor stock, he might buy an index share stock like SMH that represents the semiconductor sector. Better yet, he might basket trade. That is, if he wants to open a position in semiconductors, he might buy three or four leading semiconductor stocks like Intel, Broadcom, Micron, and Xilinx, and then exit one or more of the stocks that perform least well over time while maintaining his positions in the others.
In this regard, when the macrowave investor does trade or invest in a specific company, he will carefully look at fundamentals such as earnings-per-share growth, the price-to-earnings ratio, and market capitalization. He will also look at the technical characteristics—is it overbought or oversold? Is it near a key support or resistance level? Has it just hit a “double top breakout”? Most importantly, he will never speculate in a stock without first carefully checking the latest news on the wire services about the company as well as its earnings announcement calendar.
What is the biggest misconception the public has about the marketplace? The idea that the market has to go up for them to make money. You can make money in any kind of market if you use the right strategies.
TONY SALIBA
Except within the professional trading elite, virtually all traders and investors favor the long side of the market. That is, most traders and investors limit their bets to buying stocks in the hope that the stocks will rise. The macrowave investor, however, is just as likely to go short or flat when the situation demands it.
To sell short is to bet that a stock, a market sector, or a broad market index is going to fall in value. Mechanically, selling short involves selling a stock that you do not own. How can you do this? Well, all major stock brokerage firms maintain an inventory of stocks that you can effectively borrow to offer for sale. Thus, if Cisco is selling at $100 a share and you believe that it is going to fall, you can short-sell it at $100. Then, if the stock falls to, say, $95, you can cover your short by buying the stock in the market at $95 and putting it back in the brokerage firm’s inventory. In the process, you’ve made $5 a share.
As for going flat, that can simply mean moving out of the market into cash. Alternatively, it can mean neutralizing your position with an offsetting transaction that doesn’t necessarily take you out of the market, but effectively takes you to net neutral until conditions once again dictate net exposure in one direction. For example, you can hold 1000 shares of the same stock both long and short. Then, when you feel like you know which direction the market is trending, can close out one of those positions. During this time, you would be flat, even though you were not holding an all-cash position. Going flat typically is the best strategy when the markets are trading sideways and the macrowave investor can read no clear signals as to which way the market is likely to turn. In such a case, going either long or short in the market would simply be gambling, which would be a violation of our first macrowave investing principle.
In this regard, you can take this idea to the next level by discussing strategies involving the writing of options in order to exploit a sideways market for the purpose of capturing time premium. There are several tax strategies that also come into play here. For example, suppose you’ve been holding a stock long for seven months, it’s up 45 percent, but if you sell it, you have a big tax hit. At the same time, however, you don’t want to hold the stock while it moves against you 15 percent. In such a case, you can write some covered calls, then close the options position out when the pull-back is over, and use the profits earned from the options transaction to immediately roll into additional shares of the underlying position.
Almost without exception, the stock market turns down prior to recessions and rises before economic recoveries.… Since stocks fall prior to a recession, investors want to switch out of stocks into Treasury bills, returning to stocks when prospects for economic recovery look good.
JEREMY SIEGEL
Just as most nonprofessional traders and investors typically go long, the vast majority also focuses singularly on the stock market. However, in at least some circumstances, this isn’t always the appropriate train to ride. Indeed, under certain circumstances, the bullet express train to Profit Land might be the bond or currency markets.
One such timely circumstance for moving into bonds from stocks is offered up by the quotation leading off this principle by the esteemed Wharton professor, Jeremy Siegel. But it is not just these broad cyclical turning points that the macrowave investor can exploit.
To see this, suppose the Federal Reserve uses a series of interest rate hikes to aggressively fight inflation. This is likely to drive stock prices down. In this case, a macrowave investor might want go short in the stock market. However, there is a catch here known as the up-tick rule which can make going short with individual stocks very difficult. (Note here, that I will talk about the benefits of using so-called “exchange-traded funds” to get around the up-tick rule in a later chapter.)
The up-tick rule was instituted by the Securities and Exchange Commission to promote stability in the markets. It dates back to the days of the Great Depression and the stock market crash of 1929. It basically says that you can’t short a stock that is falling in price; the clear intent of this up-tick rule is to prevent short selling from driving a stock into a death spiral. Because of the up-tick rule and because, as we will discuss further in principle 7 below, the bond, stock, and currency markets sometimes move in opposing directions, it is important for the macrowave investor to be able to ride the appropriate train when the situation warrants.
For example, an easy money policy by the Fed might buoy stocks, but such a policy can also send ripples of inflationary fears through the bond market and knock prices down. Similarly, while stock prices typically fall on the expectation of higher interest rates, the value of the dollar may well rise. That’s why a very experienced macrowave investor can often realize a much greater profit on inflation news by placing a futures bet in the currency market. But be very careful here about an important market misconception.
Although technically the dollar is supposed to rise with rising interest rates, the prospects of a slowing economy sometimes can far outweigh the increase in demand caused by marginally higher rates. As a result, investors may begin to switch out of dollar-denominated assets when expectations are for a recession. And once interest rates start to come back down, the dollar begins to rise because of capital inflows to dollar-denominated assets, even though technically the dollar should fall with falling rates.
The broader point is that just as the macrowave investor must be able to go short and flat as well as long, he should also be able to trade in markets other than the stock market, for this will prove to be a valuable skill at key times. However, even if you prefer not to trade in the bond and currency markets—it is complicated, risky, and time-consuming—it is still very important to observe the behavior of these markets because movements in one market can often presage movements in others. This is a point we shall return to discussing principle 7 below. But first, let’s see why the trend is your friend.
Even turkeys fly in hurricanes. As the wind subsides, the turkeys stay on the ground.
KEVIN MARONI
If you stick around when the market is severely against you, sooner or later they’re going to carry you out.
RANDY MCKAY
On any given day, the stock market can only go in three directions: up, down, or sideways. Over time, these daily movements help define a trend. For example, the chart (see Fig. 5-1) of the Nasdaq Composite Index shows various different trends over a 12-month period.
FIGURE 5-1 Bullish, bearish, and sideways markets.
For example, in September and October, the Nasdaq basically traded sideways, moving up some days and down some days but always staying within a clearly defined trading range. But then, between November and March, the Nasdaq rode a sustained and very bullish trend upward. For most investors, this was a great ride while it lasted. Indeed, even weaker stocks were buoyed by the updraft because, as Kevin Maroni’s trenchant quote tells us, “Even turkeys fly in hurricanes.” Note, however, that things turned very choppy in March. Then, from the end of March until the end of May, the trend was clearly down and bearish. At that point, the market trend went back into a mostly sideways pattern.
Now, it should be obvious just from looking at the chart why it’s so risky to short stocks during a bullish up trend or to buy stocks in a bearish down-draft. Indeed, to do so is to engage in gambling against the odds, and it is a violation of our first macrowave investing principle. As to precisely why the odds are against you when you try and buck the trend, consider this: In an upward-trending market, stock price advances typically lead stock price declines. In other words, the prices of more stocks are going up than down. In contrast, in a downward trending market, declines typically lead advances.
Knowing this, let’s get out our stock market dartboard and play a little game. The game is to throw a dart at a list of the Nasdaq 100 each day and then make a trade on the result. If the advance-decline line and trend are up and you are buying, you’ve got a better than 50–50 chance of making money. Perhaps this is why even the most inept of investors can make money in a rising market and perhaps also why numerous Wall Street wags have observed: Never confuse brains with a bull market.
But wait. Let’s introduce one more subtlety here regarding our dart board analogy. Specifically, let’s talk about the relationship of market breadth to the market trend. There are times, quite often in fact, when the market is advancing, but breadth remains negative. In other words, even though the broad indices are moving up, there may be more declines than advances. In this case, you would lose at the dart game. Accordingly, looking closely at the degree of market breadth is critical to accurately measuring the health of any advance. For example, several times in the early months of 2000, the market was surging but breadth was very poor. This negative breadth kept the bullish macrowave investor on guard and protected.
Now, having convinced you to never buck the trend, let me also suggest that the only time you should break this ironclad rule is when the macroeconomic signals are clearly telling you that the trend is about to reverse. But be very, very careful here. One of the few things that virtually all professional traders seem to agree on is that only the luckiest and smartest are able to catch a trend change right at its beginning. My favorite quote on this subject comes from the classic Reminiscences of a Stock Operator. So take these words of the legendary Jesse Livermore to heart:
One of the most helpful things that anybody can learn is to give up trying to catch the last eighth—or the first. These two are the most expensive eighths in the world. They have cost stock traders, in the aggregate, enough millions of dollars to build a concrete highway across the continent.
The early investment birds who were buying interest-sensitive sectors such as the utilities four months ago and the technology stocks a month or two ago have already been switching to sectors that should be early beneficiaries of recovery. They have been buying the automakers, even as those behemoths have been slashing their payrolls and their dividends.
THE FINANCIAL POST
Within the stock market, different industry sectors react in different degrees—and in some cases in different directions—to good or bad macroeconomic news. While technically, this is macrowave investing principle number 6, it really is, in many ways, principle numero uno. This is because by thinking about the market in terms of its individual sectors, the macrowave investor is able to exploit his or her greatest opportunities for profit making and profit taking.
Perhaps the best way to see this is by example. Let’s go back in time, then, to April 13, 2000, the day before the latest data on the Consumer Price Index are about to come out. Because you’ve done your research, you know this will be a key report: If the report shows any signs of significant inflation, the Federal Reserve will almost certainly hike interest rates by another 25 basis points—and perhaps even 50 points. Because you’ve done your research, you also know that the market is expecting a mild CPI number. However, you believe that the market is overly optimistic and is refusing to acknowledge increasing signs of inflation that are quite visible in the economy. At that point, you decide to make a trade on an unexpected inflationary spike. But what trade would you place?
Table 5-1 provides one possible answer to that question. It shows several stock market sectors that have typically reacted most sharply to unexpected changes in the Consumer Price Index. In the case of an unexpected rise in the CPI, these sectors fall sharply and vice versa. But exactly why is it that these particular sectors are so reactive? The quite intuitive answer is that all of these sectors are very interest rate–sensitive. Indeed, for each of these sectors, higher interest rates directly raise the price of industry products such as mortgages, loans, and margin interest. And of course, when a product’s price rises, fewer products are sold. That means lower profits and when profits fall in a sector, stock prices can’t be far behind.
TABLE 5-1. Some Sectors That React Strongly to CPI News
More broadly, the kind of sector information in Table 5-1 provides macrowave investors with a very clear strategic direction. In this particular case, the macrowave investor could have made any one of a number of trades in anticipation of unexpectedly bad CPI news. For example, she might have shorted a weak stock in the banking or brokerage sectors. Alternatively, a more defensive play might have been to simply go flat. That is, she could have simply closed out positions in any stocks in any sectors most vulnerable to a large price drop on bad CPI news.
A typical move in U.S. stocks might start like this. The U.S. bond market goes up.… The dollar follows. The U.S. stock market immediately rises because of the increased value of U.S. earnings with the lower interest rates. Then high-grade copper, a primary industrial metal, moves up in anticipation of greater investment spending. The Japanese stock market drops because U.S. assets are now becoming more attractive to foreigners. But this makes gold decline because inflation is likely to be lower with a strong dollar. With inflation down, something has to be less attractive. It is time for meats, grains, and soft commodities to recede because there will be less purchasing power left for them. But if European and Japanese assets are going to decline, soon they will pull down the U.S. stock market. And the cycle will be ready to reverse. All this in a minute or two, 10 or 12 times a day.
VICTOR NIEDERHOFFER
You can’t help but love Victor Niederhoffer. He’s the Crown Prince—and sometimes Clown Prince—of macrowave thinking. In this regard, he can also be spectacularly wrong. For example, in 1997, Niederhoffer suffered a legendary blow-up when he bet against George Soros in the Thai baht. His guess was that the U.S. markets would bounce back from the Asian crisis, but he was dead wrong. Nonetheless, the underlying point of his quote is an important one. The stock, bond, and currency markets—as well as commodity markets and financial markets all around the world—react in different degrees to good and bad macroeconomic news and can move in different directions from one another. Table 5-2 illustrates this point once again for the stock and bond markets using the case of the unexpected spike in the Consumer Price Index that occurred on April 14, 2000.
TABLE 5-2. How the Stock and Bond Markets React to Inflation
From the table, we see that from the close of the markets on the day before the CPI news was released to the close of the markets on the day of the release, the Dow fell by almost 6 percent while the Nasdaq composite fell by almost 10 percent. Of course, this drop is very intuitive—bad news moves the stock market down.
But what about the bond market? Here we see that yields on the 30-year, 10-year, and 5-year instruments all went down. This means that bond prices actually went up on the inflation news because bond yields are inversely related to bond prices. This actually seems like a very counterintuitive result. After all, if there is an unexpected spike in inflation, this must raise the probability that the Federal Reserve will raise interest rates. And when the Fed does this, bond prices must fall. But at least on April 14, they didn’t.
So what exactly is going on here? Well, if we look at the actual intraday movements of bond prices on April 14, our counterintuitive paradox is easily resolved. In fact, bond prices did fall sharply on the morning of April 14 on news of the inflationary spike—just as one would predict. However, as this news also began to pummel the stock market, investors began to stampede out of equities into the safer haven of bonds. This flight to quality dramatically increased demand for bonds and bond prices began to move back up. And by the time the market closed, bond prices were indeed up for the day while bond yields were down.
In this case, then, there were two competing effects for the macrowave investor to sort out. One was an interest rate effect pushing bond prices down; the other was an equity effect pushing bond prices up. At least in this case, the net effect on bond prices was positive.
This example not only illustrates how complex macrowave logic can be, it also illustrates why the Wall Street game is much more one of chess than checkers—which leads us to our last principle.
A good speculator builds his position from a single base linked to a long, flexible chain of trades. Here’s a hoary old favorite that emerges once or twice a year and is good for a trillion or so of outright trading on each round. The dollar’s going to be weak because the government’s going to keep interest rates down so jobs will be good when the election comes. The mark will be the chief beneficiary, so let’s buy it. Strong markets will create demand for German bonds and stocks. Let’s buy some of those also. Pressure will be put on the pound and the lira to keep pace. Sell them and their stock and bond markets. The whole support system might entangle, which will be bad for Mexico. Sell the peso and, while you’re at it, sell the Indian global depository receipts short and calls on Telemex on the CBOE.
VICTOR NIEDERHOFFER
Behind Niederhoffer’s humor, there is again an enduring truth: Macroeconomic events affecting one particular company or sector invariably have spillover effects that wash over other companies or sectors or markets. In this regard, far too many nonprofessional traders and investors are playing checkers in a chess world. Unlike the macrowave investor, they do not look many, many moves ahead on the board. As a result, fine opportunities are missed.
One example of an opportunity that wasn’t missed is offered up by our fictional chess player cum stock trader in the example that led off this chapter. In that example, Robert Fisher clearly saw the whole chessboard. He knew that the United Airlines–U.S. Air merger would immediately put pressure on United competitors like Delta and American to get bigger as well. That’s why Robert immediately opened a position in acquisition target Northwest Airlines even as other checkers players in the market wound up fighting among themselves over a piece of the U.S. Air pie.
Another example of a spillover effect was offered up at the beginning of this book. When the U.S. Department of Justice sued Microsoft for antitrust violations, the savvy macrowave investor immediately opened long positions in Sun Microsystems and Oracle—the Microsoft rivals most likely to benefit from the news.
The broader point here is simply this: View the market as a giant chessboard and look as many moves ahead and across as many sectors as possible. As a practical matter, this means identifying the many spillover effects of a macroeconomic event and then quickly acting on this information. As a practical matter, this also means doing methodical research. As the old Chinese proverb says, “Chance favors the prepared mind.” In a macrowave investing context, this means first and foremost familiarizing yourself with the major sectors of the economy and the strong and weak companies that make up these sectors. It is to this task we now turn.