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The Risk of Reward

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Welcome to the fourth quarter of 2006, where investors are rushing towards the light at the end of the tunnel.

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"Looking at the world through the sunset in your eyes. Trying to make the train to clear Moroccan skies." --Crosby, Stills, Nash & Young


Do you remember the scene in Young Frankenstein when the good doctor was sharing a sweet moment with his betrothed? As passengers rushed to the railroad, the two love birds tried to canoodle without wrinkling Elizabeth's taffeta gown. As the packed train pulled away from the station, a frustrated Freddy had to settle for the rub of an elbow.

The rub of an elbow.

Welcome to the fourth quarter of 2006, where investors are rushing towards the light at the end of the tunnel. What they may discover is that they're running straight into a sharp elbow.

There are four primary metrics that dictate equity action. Four legs, if you will, that make for a steady and profitable trading table.

There are technicals, which are littered with non-confirmations despite charts that are breaking out and "breaking news" each and every day.

There are fundamentals which, with notable exceptions such as Caterpillar, have served to validate the price action (Thomson Financial reports that, as of Tuesday, 74% of S&P companies beat earnings expectations).

There are structural elements, such as debt, the dollar, derivatives and liquidity.

And there is psychology, or the perception that dictates reality for the markets and the people who trade them.

While many traders have been schooled in one particular discipline, viewing these metrics in isolation is often a flawed approach.

Technical analysis, through the lens of a chart, dictates that stocks are "better" higher and "worse" lower. Fundamentals, as a function of the discounting mechanism of the market, is "best" at the top and "worst" at the bottom (and often lead to "value traps"). Structural elements, such as debt-induced liquidity, self-sustain until the point of exhaustion. And momentum, the process of gaming other people's motivations, rewards the herd until the sheep get slaughtered.

Assimilating these metrics, the current landscape doesn't seem as green as the sheen on our screens.

The early summer months were brutal for the bulls and, not surprisingly, the bovine focused their attention on risk as the market made a low.

Fast forward four months and 13% in the S&P. Talk on the Street has shifted squarely to reward. Who's making money, who's making more money and, most commonly, who's not making enough money. If we're to characterize market moves into three phases---denial, migration and panic--the current upside thrust is likely in the latter stages of that tri-fecta.

There's an old adage on the Street that says we should never short a chart we can't ski. That, for all intents and purposes, betting on the downside while the tape is on the chairlift is a losing proposition. I won't argue against that point as, through sixteen years of trading, I've come to learn that contrarian bets are a slippery slope in the context of conventional wisdom.

What I will offer is that, while everyone is at the lodge toasting to their gains, prudence dictates casting a glance at the bar bill.

Last week on Minyanville, I postured that the period between October expiration and the midterm elections could be a pivotal time for the tape. That, with performance anxiety manifesting into year-end, the mad dash to the finish line may take a detour that few folks expect.

The compression is surely building. As my friend John Succo recently wrote, and I quote, "Option selling is rampant as stock prices edge, grind and leap higher. This causes realized volatility to shrink. As volatility shrinks, "VAR" (Value At Risk) used by hedge fund managers, broker dealers, pension funds and insurance companies declines. When VAR goes down, managers feel compelled to increase risk for return. By increasing risk, they force asset prices higher and volatility lower. And around and around we go."

This dynamic is nothing new and, as any seasoned trader will tell you, it can last--and has lasted--longer than alotta smart cookies expect. There is intense leverage in the system, however, and while that's not a downside causation, it will most certainly exacerbate movement if and when a catalyst arrives. The question we must ask ourselves is: with conventional wisdom as it is, which is the path of maximum frustration? For my money, I wanna stay long volatility (option premium) and make the bet that volatility will significantly uptick into 2007.

Perhaps this monster market will slap on a tux and tails and sing a snazzy rendition of "Putting on the Ritz" into the New Year. I'll simply ask you to allow for the distinct possibility that the mindset of the masses, in its current iteration, is a tad abnormal.

Good luck today.

R.P.
No positions in stocks mentioned.

Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at todd@minyanville.com.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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