Intellectually I knew there were two forms of market participants already: price-sensitive “investors” and price-insensitive “traders”. The former buys low and sells high, and has a process for determining why they are doing so. The latter sells low and covers lower, or buys high and sells higher. Both are entirely legitimate ways to make returns in any market, but it’s important to distinguish between them; who you listen to and surround yourself with will inform your market view and trading positions. When the stock market opened for its “Black Monday” on August 24th, those selling were “traders”, whether they want to admit it or not. They didn’t care what level prices were at, just that they were going down. “Get me out, NOW!!!” Those who were in buying blue chip, mega-cap, high quality secular growth stories at 10 or 20% discounts to that day’s close? They were investors. More on this below, but when you’re in a crash, make sure that you’re not trying to inform investing decisions with a trading perspective; just as harmful is trying to manage risk by making trading decisions that need to show positive PnL in the short term from an investing perspective. I saw and talked to lots of folks doing both on Monday, but the ones that were able to distinguish between investing and trading made some pretty amazing trades; the key was keeping them separate.
Investing from an investing perspective: “CVS is down 20% on the open, I don’t care what’s going on, I’m buying it, that price is too low.”
Trading from a trading perspective: “ES [S&P 500 futures] is down 2.5% and the US is just walking in with no good news in sight, it’s in a multi-day breakdown, I’m short into the equity market open.”
Both of these trades made money Monday, but on very different time frames and for very different reasons.
Understand when markets aren’t working; dislocations create opportunity.
Most investors in most modern markets have something in common: a pretty good assurance that during a typical day, they can buy and sell securities at very low cost. That’s one simple definition of “liquidity”. Monday markets were not liquid, but many investors on both the institutional side (high beta hedge funds liquidating positions, quant strategies under pressure, long-short funds reducing gross exposure) and the individual side (RIAs receiving direct instructions to liquidate client portfolios, day traders frozen with indecision, stop-loss execution from brokers at market) thought they could be. Oops. The result was historic dislocations of 5, 10, 15 and 20% from any reasonable estimate of “fair” value, on any time frame. For example, a friend was able to buy and S&P 500 tracker ETF over 10% below where a more liquid product was trading, simply because the ETF he saw had a specific imbalance between sellers at any price and buyers that cared about it. “I don’t see how this trade stands; how can I, an individual, be arbitraging this easily?” Sometimes markets stop working, and when they do there is massive, massive opportunity. I’m proud of friends and colleagues that were able to take advantage of that dislocation Monday and am glad I got to see the consequences of it for those who were on the other side.
Have a buy list.
To take advantage of dislocations, you need to know what to look for. In the example above, my friend simply knew how big a dislocation was by seeing it on his screen. In other examples, I saw people backing out cash and calculating forward PE at ludicrous multiples in real time. Others simply had lists of stocks they liked, took one look at prices, and said “I’m a buyer here.” If you’re active in financial markets, I think you should have a list of stocks, or other assets, with “no matter what is happening, I’m a buyer here” prices. Those prices should change over time, but you never know when opportunity is going to strike and it’s a fantastic way to be opportunistic.
Of course, to buy stocks you like, you need capital. Monday showed me the value of cash, both as a hedge against volatility and as “ammunition”. Having seen the action I did, I’ll be very unlikely to ever run a fully invested book the rest of my life. Doing so is effectively selling an option on panic, as it exposes your entire portfolio to illiquid conditions and prevents you from lifting offers when stocks are forced on sale.
Professional risk managers work two ways.
Fiduciary and non-fiduciary managers of capital have an obligation to be the cool head in the room with respect to the assets they care-take. Sometimes arguing against selling everything at the open, at market, is managing a kind of risk for a client that can’t be managed via financial market instruments or strategies. Not all clients will listen! And past a certain point, there’s only so much a risk manager can do to argue against panic. But if you can do it, you can save your clients a lot of pain that was visible in yesterday’s market open.
Falling knives can be caught, but the PnL can’t matter initially.
Last one here. “Catching a falling knife” can work. But you need to expect losses in the future after doing so, and be okay with that. There were a lot of knives caught the last few days in global equity markets, and price action this morning is positive; I hope folks that were able to take advantage of cheap fills make good returns. I think most will! Not before more volatility though. It should be no surprise to anyone if global markets make new lows before we march higher again (and sorry Zerohedge Mob…May’s highs will be taken out at some point again in the future, whether it’s a week, a month, a year, or a decade from now). I have no idea whether we will or not, and don’t mean this as a prediction; yesterday was a massive shakeout and markets are historically oversold by any reasonable measure so it’s likely we get a bounce here but there’s no way to know what will actually happen, and those that bought should be ready for some short-term pain.
Courtesy of GeorgePearkes