Part 6 (1/2)
While the D-Mark was consolidating along with sterling in Hl1990, the Yen was still heading down sharply (into May, anyway), and the Swiss franc took over the leaders.h.i.+p of the pack, followed in May by sterling.
The rationale in the case of the SF lay in the perception that the Swiss National Bankas governor Lusser really was determined to reverse the weak franc policy of his predecessors and raise Swiss interest rates to whatever level might be necessary to support the currency a”despite the resentment against high mortgage rates and the price in terms of raised cost of living. Then, come Iraqas invasion of Kuwait, the SF, being already seen as the strongest of the hard currencies, got an added s.h.i.+ne as a ahavena currency for funk money from Arabia. The resultant rise in the Swiss unit drove the DM down to quite near 80c by September.
The rationale for the poundas surge from May onward was of course the idea of sterling joining the ERM* , the exchange rate mechanism of the EMS* a” plus the perception, clearly endorsed by Margaret Thatcher herself, that if the pound did enter the ERM it should do so at a higher level, rather than a lower one.
In both cases, there was no shortage of detractors who ridiculed both the rise in the currencies and the rationales for them. In instances of this sort, it usually pays to let price action be our guide. We have to distinguish two sorts of players a” the crowd and the heavy money. When price moves with the crowd, we can sit out the hand and look to go contrary. But when the media and the crowd sing one song and the price moves another way a” the consensus which is not confirmed by price a” it makes sense to follow price.
However, you had to see these rationales early on a” before the crowd saw them. If you donat see the rationale early ,donat play. Just donat play a” like Jim Rogers.
The rationale followed cla.s.sic lines in the case of the Yen, which had attracted heavy speculative sales against the D-Mark and other currencies. In the course of 1989, the DM had risen from around Y73 to peak at Y95. In the process, sentiment against the Yen had gone about as far as it could go a” to the point of arevulsion*a , as CB called it. The stage was thus set for a major comeback in the currency. The clincher was a further rise in j.a.panese interest yields during the summer, reducing the differential with American yields to zero by August.
Going for it
What we are always looking for is the aset-up conditionsa for major currency moves. And in August, we finally had all the set-up conditions for a major acatch-upa in the Yen. Sentiment had pa.s.sed from revulsion to uncertainty; and at this point, the least show of strength was liable to challenge the perception of the trend, and change it at a stroke from down to up. Moreover the Yen was acting remarkably well in the face of a soaring oil price. With the s.h.i.+ft to a zero-yield differential with the dollar, all the pieces fitted.
DOLLAR FN YEN 1989 TO 1990 (Source: DalastreainJ Such moments call for commitment. There are no certainties in financial markets: but there is conviction. More exactly, there is a scale of confidence, with conviction at one end and something more like hope or wishful thinking at the other. When we have conviction a” when all the pieces seem to fit a”then we have to go for it. We have to commit ourselves, for this act of commitment is as much an essential ingredient of success in trading as risk-control. What we say when we commit ourselves is: athis position can lose, like any position. We must have a contingency plan for getting out economically. But itas an exceptionally good position and itas not going to lose.a And when all the pieces fit, we should bet our final stake straight off, in my view .That way we bet most when the odds are best, i.e. when the risk is lowest.
You may find that difficult to swallow a” and itas not a course of action that is recommended by most pundits, though it was in the end the one recommended by Jesse Livermore. Most futures traders recommend building up positions if and when they seem to go right. That apyramidinga approach may make sense for systems based on price a.n.a.lysis. But it doesnat make sense for CBas system, for the following reasons.
The situation where all the pieces fit is one which can only be recognised with hindsight. For nine tenths of the time we are watching the markets and seeing probabilities s.h.i.+ft around the place. Sometimes nothing fits, sometimes most of the pieces seem to be in place; and we never know whether all the pieces are going to fit until they suddenly do. In other words, most of the time, we are wandering about in the darkness or under thick cloud; and weare not absolutely sure whether the sun is going to s.h.i.+ne, let alone when. Ideally, perhaps, we would just do nothing so long as the sun is not s.h.i.+ning. But that might mean we would have to be inactive for months. And this just isnat realistic for those of us for whom currencies are a business or a pa.s.sion or an occupation a” or even an occupational hazard.
The solution would seem to be to keep our bets small a” on a scale of 10, we might bet just 2 a” until the suns.h.i.+ne actually breaks through. But when that happens, we go for it with maximum exposure a” 8 or 10 out of 10. The Yen in August 1990 was a suitable case for such treatment. Even then, knowing when to get in was one thing: staying in, and knowing when to get out was another.
Formula for Getting out
This move in the Yen was discussed in Chapter 1. And if you remember the story of Old Partridge (page 46) you will have got the message about staying in: we must not alose our positiona so long as the reason for holding it is still intact. The little hesitation around Y137 by no means challenged our reason for holding the Yen, which was to do with its need to acatch upa with the reality of its changed yield equation: our catch-up target was Y120.
That target was arbitrary , but the rules for getting out are not quite so arbitrary. Aside from an underlying rationale, our reasons for opening a position always include a polarised picture in our 4 sentiment gauges. If our a.n.a.lysis turns out right, we shall always see some degree of reversal in the polarisation of sentiment. Two times out of 3 we are rewarded with a completely opposite picture: the oversold currency becomes overbought; the overbought currency becomes oversold.
Every case will be different, but the rule for getting out holds: what matters is not how close to the final top or bottom we get out a” thatas mostly luck: what matters, as noted, is that we have a rational formula for getting out which is worked out beforehand. We can set a date: we can use a crawling stop: we can set a price target: we can use a combination of these methods. But deciding the formula beforehand is the thing.
Cross-rate games*
The end of the 1980s and the early 1990s witnessed some large fluctua-tions in the Yen against the Europeans and in the SF and pound against the DM a”in the cross rates, in short. In some instances there was a visible ra-tionale at play, particularly with the Yen. This was the big move by the j.a.panese life insurance companies to reduce the enormous hedges* they had against the dollar risk in their US bond portfolios: when the dollar was perceived to have stabilised in 1989, these hedges made no sense.
During the first stage of the Yenas marked relative weakness, when the dollar was generally strong a”the sharpest move was in the Yen/$ rate a”and this was the right and logical play for performance seekers. This is not said with hindsight: CB forecast the Yen would be athe weakest of the currenciesa in PROSPECT 1989. When the European currencies began to rally in H21990 and the Yen carried on weak, the DM/Yen cross-play was a much better speculation, in the event. But was it foreseeable that the Yen would be a better sale against DM than dollar? This CB did not foresee, nor did one see any a.n.a.lysis to that effect before the event.
There were brief windows when relative strength in sterling and Swiss franc against the D-Mark seemed to coincide with a solid rationale. But in most instances, and for most of the time, I think these cross-rate trends were, and may continue to be, creatures of fas.h.i.+on a” self-feeding from a more or less chance initial price trend. In such a situation, you are forced to fit your time-frame* to the lowest common factor in the market. Itas a matter of taste. But they will surely continue to be popular with professionals, when they are at a loss to forecast the dollar.
CHAPTER ELEVEN.
aTeach us to to care and not to care. Teach us to sit stilla.
T.S. ELIOT.
Acurrency fund adviser had two accounts. He lavished great care on his flags.h.i.+p account, which had a good record. The other one took little of his time. It was an individual account, whose owner was not concerned with the week to week or even month to month evolution of the account.
One day the adviser decided to do an a.n.a.lysis of the two funds. As he had expected the number 2 account, which was more highly leveraged, had a better record. But he was quite unprepared for the extent of the difference. Over the brief study period of 15 months, the flags.h.i.+p account was up 35%, and the maximum adrawdowna was 11.5% from monthly peak to trough. Meanwhile the number 2 account was up 92%, with a maximum drawdown of just 9.2%.
The two accounts had been run on a similar basis. The only difference lay in the att.i.tude of the account adviser to the two accounts. On the flags.h.i.+p account, the adviser lavished daily care, with frequent adjustments to the risk level; he was acutely conscious of each monthly reporting date; he was deeply concerned about drawdown*; and he kept a careful tally of the value of the account. With the number 2 account, he was barely conscious of the account value and made few changes, typically dealing only at multi-week intervals.
The difference in the performance of the two accounts was not luck. It reflected a phenomenon which has been noted and observed by a number of expert fund advisers. The phenomenon is not easy to put into words: worry doesnat help performance; being careful does, but being full of care does not; caring about doing the right thing helps, but caring about being right doesnat; nor does caring about money. The crowd worries, cares about being right and cares greatly about money.
The thing we must be absolutely clear about is the crowdas inherent tendency to be wrong in financial markets. Crowds are not noted for understanding and clear thinking. In fact they are deluded and mad, according to Charles Mackay (Popular Delusions and the Madness of Crowds), But thatas not the prime reason for their inherent wrongness. Itas to do with the price mechanism of free markets. The crowdas partic.i.p.ation makes the price movement so it has to be diametrically wrong at the extremes a”inherently. And that applies to all extremes, to greater or lesser degree, i.e. short, intermediate and long-term extremes. In zero-sum games like the currency markets, the crowd has to lose over both years and decades. It loses to players who play differently from the crowd.
The crowd loses, If you are part of it, you lose.
As readers know, Currency Bulletinas approach to a.n.a.lysing the currencies a” its method a” is essentially anti-crowd. We look where the crowd is not looking for an underlying rationale for the direction of the main trend. And we use a series of contrarian* sentiment indicators designed to orient us in the opposite direction to the crowd. This method has worked well, and it is timeless so it should always work. The method is OK. If we can have confidence in it and can apply it, we shall win.
But as the great traders constantly remind us, being able to have confidence in a method and to apply it consistently, hence winning, depends on our mental att.i.tude. So long as our mental att.i.tude is that of the crowd, we wonat make it. And but for the grace of fortune or our own determination, we are members of the crowd. Who is the crowd made of but you and me and the rest? If you cut us, do we not bleed?
Well, who is the crowd made of a” the trading crowd, that is? Or more precisely, who dominates it? The Joker (the mischievous spirit of the marketplace) determined that the leaders of the crowd be the people most of the crowd aspire to be. Of above average intelligence; good at their lessons; possessed of highly a.n.a.lytical minds; plausible; conforming. The kind of couth, clean-cut individual that appeals to members of the investment committee, because he (she) resembles them or incarnates the image they have of themselves. Such are the people who run the management funds, bank trading desks, trust departments and economic advisory sections, at the major financial inst.i.tutions.
Their (our?) mental att.i.tudes and thought patterns tend to follow along similar lines, which have been programmed by their upbringing. Letas consider three forms of programming which are common to all of us.
1) The first happens before the age of about six. The founder of the Jesuits, Ignatius Loyola (1491-1556), is linked with the saying: agive me a child till heas 7 years olda and I will show you the man.a (There are varying versions). The theory is that the beliefs and character of individuals can be set in stone by their programming in the early years of life. And since the work of Freud and the psychoa.n.a.lysts, this notion has become more or less the conventional wisdom. As a Freudian psychoa.n.a.lyst by formation, the brilliant American psychiatrist Dr Eric Berne* came up with a theory of personality which he called atransactional a.n.a.lysis*a (TA).
In a nutsh.e.l.l, Eric Berne believed that our personalities include three parts. Each of us has: a Parent, which consists of a system of beliefs received from our parents or whoever was looking after us from birth to the age of roughly six; a Child, which is the child we were at 6 years old; and an Adult, which is the part of us that responds rationally to the facts presented to us. Each of these can be called aego statesa, meaning acoherent systems of feelings which motivate a related set of behaviour patterns.a When our Child takes over, it dictates a certain behaviour pattern, and when our Parent or Adult takes over, they dictate different behaviour patterns.
Caricaturing grossly, the Child is impulsive (playful, petulant, intuitive, impatient, whimsical); the Parent is all pre-judgement (rule-bound, conventional, bigoted, occasionally sage); and the Adult is the computer (rational, a.n.a.lytical and independent).
The voice of the crowd equates with the voice of the Parent Think back to occasions in the past when you were confronted by an experienced salesperson a” a car dealer, say, or an insurance salesman, or a perfumery saleswoman a” and you bought something you didnat want; and consider whether your mental state and behaviour wasnat that of a child before a parent. Smart companies teach their sales-people to take the adult role when they donat do it naturally. Think also of the occasions when prescriptions you inherited from your childhood came between you and freedom to choose the right answer. The voice of the crowd, incidentally, would equate with the Parent. So does the voice of the arisk-committeea meeting in your mind which decides youave been naughty, so you close out a perfectly good position.
Berneas theory fits the findings of Dr Wilder Penfield, the famous American neuro-surgeon. In open-brain operations carried out in the 1950s, Dr Penfield made some remarkable findings a” operating with electric probes on patients who included epileptics. On stimulation of the temporal lobes of his subjects, whole tracts of experience from childhood and later years would sometimes come bubbling out. I say experience, because it wasnat so muchmemory as actual aplaybacka of awhat seems to the patient to be present experience.a Penfield concluded that the playback was a areproduction of what the patient saw and heard and felt and understooda at the time of the original experience. Such childhood arecordingsa cannot be erased, it would seem. They are with us forever.
Following in the footsteps of the original psychoa.n.a.lysts (Freud, Adler, Jung et al), Dr Berneas theory of personality developed largely from observation. As its name, transactional a.n.a.lysis, implies, it provided an explanation for the common transactions that take place between two or more people and it lent itself to group therapy rather than the a.n.a.lystas couch. Hence by the time Berne died, in 1970, transactional a.n.a.lysis had been tried out and seen to fit in tens or even hundreds of thousands of case studies in and outside California (where Berne practised).