The Invisible Hand
Self-interest may play larger role in markets than many realize.
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Have you come here for forgiveness?
Have you come to raise the dead?
Have you come here to play Jesus
To the lepers in your head?
- One (U2)
There is nothing like losing all you have in the world
for teaching you what not to do.
- Reminiscences Of A Stock Operator (Edwin Lefevre)
One of the important themes of Adam Smith's Wealth of Nations was the concept of "the invisible hand." Without making a value judgment that it was good or bad, Smith argued that people will act in their own self interest.
It is also thought that Smith used the term "invisible hand" in referring to the idea of balance: self-interest is not always necessarily good, but neither is it all bad. In addition, Smith promoted the idea that an "invisible hand" indicates the capacity of the market to correct what may seem to be disastrous situations without government intervention. Just as Smith's theories indicate supply and demand derive a "natural price" and seek equilibrium, likewise the financial markets attempt to seek their own equilibrium despite interference and agendas from outside forces.
Despite "outside hands" running interference, seeking to shape larger social and economic outcomes that Adam Smith argued ultimately leads to inefficiencies and actually impedes progress, the market's financial waters seem, remarkably, to rise and fall to their own natural levels at their own given time.
Often, handicapping the time and the price of these "natural levels" may seem rather esoteric and obtuse. However, if the typically more than transitory causes and effects of "value" lay in scientific metrics of fundamentals alone, we would not have a market: prices would fluctuate narrowly around a concentric center of universality of opinion as to the underlying worth of a company. There would be little need for the auction market per se if value was consecrated by science more than art and emotion.
Granted the dynamics and economics of companies and nations change, but not to the degree represented by the not-infrequent flare-ups in volatility seen in the market place: 10%-plus moves in individual issues in a single day, sometimes up and down 10% or more in a day?
To be sure, on Wall Street value, like beauty, flies in the eye of the beholder and is "tick-deep": the silk purse of value in the morning is the afternoon's pig in a poke. The market turns on a dime but few traders can.
One season's 'growth at any price' mantra is the next seasons value at no price. Whether trading or investing, speculation on whatever timeframe you endeavor goes from excess to excess, regardless of whatever measurement of value you may use. This cycle from one extreme to the other, from a stock being overloved to falling on ill repute has at its root the supply and demand of sentiment, the ebb and flow of confidence. Understand what determines individual and crowd psychology and the behavior of the market won't seem so mysterious.
What it is that drives the cause and effect of crowd behavior and the cycles of psychology to come close to echoing the movements of the market more than any model or indicator I am aware of? Indicators are more descriptive than predicative.
For example, the December 3 issue of Barron's featured an interview with Don Hays of Hays Advisory Group. He pointed to an indicator maintained by Emergent Financial that tracks the five-day moving average of insider buys and sales on the Russell 3000 index. A move above 25% has seen some good buying opportunities in the past such as in 2004, 2005, late 2006, as well as early and mid 2007. In early December, it was running at 70%, an indication that corporate insiders were buying at the highest rate in the last four years. He also pointed out that treasury yield and the S&P 500 12 month forward earnings yield were in a favorable relationship. The earnings yield based upon the next twelve months earnings yield was about $103 in early December. Compared to the yield of the ten-year Treasury note, stocks were about 42% undervalued. Or so it seemed. The market had been that inexpensive only five other days in 28 years.
Yet we all know what happened in January. Perhaps portfolio managers who bought into the above and the idea of a Santa Clause rally collided with the rhythm of the "Algorithm Boyz" who held on to the some of their beloved momentum darlings until the bell rang in 2008 and then kicked them out the door. Be that as it may, things could have gone the other way given that stocks were so inexpensive and corporate inside buying strong. Something else must have been or must be going on. If you want to catch fast moves in the market it seems that it is important to identify when the big money is buying into a premise that doesn't pan out.
Additionally, in early December, the AAII poll of sentiment indicated a prevailing bearish complexion. At the time, the total of those expecting a correction added to those that were outright bearish equaled 70%, the third highest reading in 2007.
Despite the combo of ample liquidity, sharply bearish sentiment, and historically inexpensive valuation precedents, a rally did not materialize: just the opposite happened as a waterfall decline played out.
Clearly, something else is or was going on. Was it the sign of the bear? Was it cyclic influences exerting? Perhaps it is that the invisible hand of crowd behavior that became so impressed with the ability of the market to backhand the ogres of credit through the second half of 2006 that the hand that fed was bitten by the bear.
Be that as it may, it is normal for markets to lead economic data by six months, give or take. However, despite this month's one-year anniversary of the beginning of the winds that became the sub-prime cyclone and despite a 100-year credit hurricane, major indices held above key levels until early January. As Joe Granville says, "The market has its own internal clock."
So, the larger question arises: where the markets normally reflect economic realities, are the markets now themselves magnified by credit derivatives and trillions of dollars sloshing around in Sovereign Wealth Funds ruling the roost, creating the current economic realities?
If so, more than before, it will be important to look for the fingerprints of the invisible hand of cycles in determining the natural price and time of the markets: the supply and demand of sentiment.
Strategy: The S&P played out pretty much as anticipated on Friday with key support at 50% of the recent range at 1338/1340 acting as equilibrium and a fulcrum for the index to bounce closing right at the 135 Spyder strike on Friday's option expiration. In the process, the S&P recaptured the pivotal 20 DMA on the important weekly closing basis. Follow-through above last Thursday's reversal high of 1368 suggests the test of the February reaction high is underway.
Live Angle, A, runs from the November 20 low through the January 10 top. Live Angle, B, runs from the January 9 low through the February 1 high. Trendline, D, runs from the October 11 high through the October 31 high, through the December 11 high to 1450 S&P. Trendline, C, runs from the December 11 high, through the December 26 high to 1406ish, coinciding with Live Angle, B. Leg, 1, from the January low was 120 – 126 points in eight trading days. A symmetrical leg, 1, up from 1317, 2 = 1437 to 1443.
After following through from Thursday's reversal, the S&P carved out a 1st hour low, A, and broke out of the morning range, B, only to fail. However, when another test of what I offered was the key to Friday's action or 1338 / 1340 held again, the index turned up to close on the high of the session.
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