President and CEO of Acernis Capital Management Inc., which may hold long or short positions in securities mentioned in this article.
An old investing rule quoted by Warren Buffett advises to be "optimistic when others are fearful, and fearful when others are optimistic."
But what if you are one of the "others?" Here's an example.
One old, reliable market indicator is the ratio of bulls to bears. When it falls below a certain low level of pessimism, it has often been a sign that the market will "soon" rise (although "soon" can mean weeks, or even months). It's fairly low right now, after the August massacre.
So is the market a buy? Maybe – or maybe not.
For years, such contrarian "sentiment" indicators worked well, but this was B.I. (Before Internet), when there was a lag between information and action. Today, such indicators are computed in real time, then sit right alongside your e-trading buy/sell button.
So, how can you (and everyone else, including automatic trading algorithms) act contrary to an indicator that says you (and they) should act opposite to what all of you have just done? That mind-twister isn't meant to make you cross-eyed, but rather to point out that there are profit opportunities in this foolishness.
First, a brief history. In 1987, based on a bit of half-baked finance research, some portfolio managers came up with an idea: As the market fell, they would protect their portfolio against further decline without selling, by buying put options; if the market fell more, they'd just buy more puts, continuously. The market's capacity to absorb this activity was unlimited, the assumption went. And so the idea was adopted by many, and soon became the norm.
But who would the portfolio manager buy the puts from?
Ah yes, from a willing broker. And why would the broker take on the risk of a market fall? Why, the broker would, of course, protect himself immediately by shorting a lot of stocks as a hedge. However, because the broker had sold a lot, to hedge, the market declined more, and so the portfolio manager bought a few more puts – which of course made the broker short more stocks, which in turn made the market tank more, which required more puts. You get the idea. This process, also known as dynamic gamma hedging, became a vicious feedback loop, since the basic assumption behind the half-baked research was dead wrong. The market did not have an infinite capacity to absorb such selling. And so on Oct. 19, 1987, the self-reinforcing selling action kicked the Dow into a black hole – 24-per-cent deep.
Since then, many rules and safeguards have been put in place to prevent such a recurrence. And yet, we just saw another such mini-event – a 10-per-cent hole between Aug. 20 and 24, 2015 – and for a very similar reason, though in a modern garb. Much of today's stock trading is done by algorithms ("algos"), which buy and sell automatically. In August, the algo of a giant American hedge fund with more than $100-billion (U.S.) in assets, sold ETFs short as the market fell, to hedge its falling portfolio.
The brokers naturally sold short the underlying stocks to hedge themselves against the ETFs they had just bought from the fund. But this, of course, knocked down the prices of the ETFs behind these stocks, and so the hedge fund's algos sold more ETFs short, which kicked the underlying stocks further down.
It was a near-repeat of the 1987 stock-dump, on autopilot. And like then, after the market tanked, it bounced, then tanked again and rebounded again … Not surprisingly, the bulls/bears ratio remains in the dumps. But it's rising a bit, and you can almost feel the collective sense of relief as portfolio managers let go of their bearishness and begin buying, because – that's right – the indicators show that everyone else (except them) is still bearish.
Or is the decline really over? It very well may be, just as it eventually was in 1987. But probably not, since the same giant U.S. hedge funds still use dynamic hedging algos. What happened in August can happen again.
Why am I telling you this? Not to scare you, but to show you an opportunity. You see, algos are dummies; they never talk to live management and don't sleuth the fundamentals. But you can. And if you do both, and use these to estimate the real value of a company, then divide it by the number of shares, you'd know exactly what a stock's true value is. Algos won't know, and never will.
So if you discount this real value by your required return, and put a buy order at this price, GTC (Good Till Cancelled), you can then wait to be filled. And if you aren't filled because the stock never got there, so what? It didn't cost you anything. But if one day, a dummy algo goes gamma-hedging and crazily drives the market into a temporary hole, your cheap purchase will be a gift.
It's like they say in poker: If you don't know who's the "fish" at the table, you are it. But in this case, the "fish" are the algos, which sell perfectly good stocks whose value they don't know, just because they've been told to short into a falling market and hang the consequences.
If you do your homework, you can take their money, just like you can do it to real people who haven't done their homework and sell you stock gems cheap. That part hasn't changed – and never will.