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DIALOGUES FROM THE HEDGE FUNDS MARKET WIZARDS {2012, JACK D. SCHWAGER}

This is another great book by Jack D. Schwager. We recommend to buy it and read it –But until then, here are some important quotes from the traders that are interviewed.

 

MORE: ◙ Paul Tudor Jones Tips | ◙ New Market Wizards 1993 | ◙ Market Wizards 1989

 

Colm O’Shea

 

■ Price movements only have a meaning in the context of the fundamental landscape. To use a sailing analogy, the wind matters, but the tide matters, too. If you don’t know what the tide is, and you plan everything just based on the wind, you are going to end up crashing into the rocks. That is how I see fundamentals and technicals. You need to pay attention to both to make sense of the picture.

■ Fundamentals are not about forecasting the weather for tomorrow, but rather noticing that it is raining today. The great trades don’t require predictions.

■ If you play roulette, you are in the world of risk. If you are dealing with possible economic events, you are in a world of uncertainty. If you don’t know the odds, putting a number on something makes no sense.

■ People love stable earnings, isn’t that great? I hate stable earnings. It just tells me the company is not being truthful.

■ The big mistake people make is to confuse liquidity with solvency.

■ In a bubble, the true believers will always win. You just need to make decent returns and wait until the market turns. Then you can make great returns. What I believe in is compounding and not losing money. All markets look li qui d during the bubble, but it’s the liquidity after the bubble ends that matters.

■ Markets don’t think, just like mobs don’t think. Why did the mob decide to attack that building? Well, the mob didn’t actually think that. The market simply provides a price that comes about through a collection of human beings.

■ My typical time horizon for trades is one to three months.

■ Having a positive skew is very important. It is not about being right all the time. Most good macro traders will be right only about half the time or even less.

■ You need to implement a trade in a way that limits your losses when you are wrong, and you also need to be able to recognize when a trade is wrong.

 

Scott Ramsey

 

■ I always want to buy the strongest and sell the weakest. Always.

■ I use the Relative Strength Index (RSI), but not as an overbought/oversold indicator; instead, I look for divergences between the RSI and look at the 200-day moving average and Fibonacci retracements. I particularly like to get combined signals, such as the approaching 200-day moving average and a 50 percent retracement. I will pay a lot of attention to that type of indicator combination.

■ Hope is the worst four-letter word for a trader.

■ It doesn’t matter whether you win or lose on any individual trade, as long as you get the process correct.

■ Trading is not a hobby. You need incredible dedication. Treat trading like a business. Keep a journal of your trades. If you make a mistake in the markets, write it down.

■ My challenge is to pick up on the subtle nuances of the various markets and to anticipate changes or accelerations in trends. I have found that by observing how the markets relate to one another, you can often detect when patterns of behavior change. A change in behavior is usually a failure of one or more related markets to confirm an existing move and serves as a warning sign. Since the 2008 financial crisis, market correlations have been extremely high.

■ In my opinion, the driver is usually the equity market. The typical stimulus-response pattern is:

Equities Up = Commodities Up = Dollar Down

The opposite price movements occur on “risk off” days.

 

Jamie Mai (Options Expert)

 

■ A necessary skill in private equity is the ability to kill bad deals quickly.

■ High conviction on an event path priced like a low-probability event is our Holy Grail.

■ Markets tend to over-discount the uncertainty related to identified risks. Conversely, markets tend to under-discount risks that have not yet been expressly identified.

■ Whenever the market is pointing at something and saying this is a risk to be concerned about, in my experience, most of the time, the risk ends up being not as bad as the market anticipated.

■ Options are priced lowest when recent volatility has been very low.

■ The single best predictor of future increases of volatility is low historical volatility. When volatility gets very low in a market, we consider that a very interesting time to start looking for ways to get long volatility, both because volatility is very cheap in an absolute sense and because the market certainty and complacency reflected by low volatility often implies an above-average probability of increased future volatility.

■ There is also an interest rate bet implicit in buying long-term options that can be quite interesting when interest rates are very low, as they are now. If interest rates go up, the value of the options can go up dramatically.

■ The common denominator in our trades is taking advantage of the fact that markets always price securities on the implicit assumption that changes from prevailing levels are equally likely in either direction, whereas in reality, idiosyncratic fundamental factors can make a move in one direction much more likely. The market always assumes symmetry, and you look for potential asymmetry. Our trades range widely in the probability of payoff, but they all share the characteristic of being priced cheaply relative to the perceived probability and magnitude of a win.

■ If the three-month implied volatility says that the price move that has just occurred was a three-and-a-half standard deviation event, we are going to like the odds of buying deep out-of-the-money options for a price move back in the opposite direction.

■ Option math works a lot better over short intervals. Once you extend the time horizon, all sorts of exogenous variables are introduced that can throw a wrench into the option pricing model.

 

 

Michael Platt

 

■ In this game, you want to be there when the great trade comes along. It’ s the 80/20 rule of life. In trading, 80 percent of your profits come from 20 percent of your ideas.

■ I like to know what the consensus view is because you really do make the most money when the consensus shifts.

■ Controlling correlations is the key to managing risk. We look at risk in a whole range of different ways.

■ Being long volatility is great protection against all scenarios.

■ I look at each trade in my book every day and ask myself the question, “Would I enter this trade today at this price?” If the answer is “no,” then the trade is gone. Most of the trades that I do stop myself out of, I stop out because of time rather than because of a loss. If I really love the trade and get strongly positioned, and then a month later, it still hasn’ t moved, alarm bells start ringing in my head. I think to myself, That is a really great idea you have, but the market is just not playing ball.

■ There are three things you need to make money in a market. You need a decent fundamental story, a good trend that looks like it will carry on, and the market handling news the way you think it should. Bull markets ignore any bad news, and any good news is a reason for a further rally.

■ Market makers know that the market is always right. You are wrong if you are losing money for any reason at all.

■ Market makers know the value is irrelevant in times of market stress; it’ s all about positions.

 

Steve Clark (Trading Stocks)

 

■ You can use charts to give you a plus or minus toward your view, but you can never start with the chart. To say that you can predict the future from past data is patently untrue. You can talk about percentage probabilities of what might happen next, but you can’ t go any further than that.

■ If you wake up thinking about a position, it’s too big.

■ Never stop asking questions. Speak to as many people as you can. Research every opposing opinion.

■ When everything lines up, you need to swing for it because in those situations, even if you are wrong, you probably won’t be wrong by that much. But if the position starts behaving in a way you don’t understand, you need to cut it because then you clearly don’t know what is going on. The market is telling you that you don’t know.

■ The market is not about facts; it’s all about people’s opinions and positions. Consequently, anything can be at any price, and anytime. Once you understand that, you realize that you need to have protective stops.

 

Martin Taylor (Trading Emerging Markets)

 

■ You have to be an expert in what you invest in. You need to understand why you are invested. If you don’t understand why you are in a trade, you won’t understand when it is the right time to sell, which means you will only sell when the price action scares you. Most of the time when price action scares you, it is a buying opportunity, not a sell indicator.

■ The true measure of a country’s balance of payments account is what happens to that country’s reserves.

■ On the long side, I like companies that are cheap relative to their sector, but where I expect positive earnings surprises during the next few years. So turning that around, ideally, I would like to go short companies that are expensive relative to their sector and where I expect profit warnings over the next few years. The problem is that these bad companies have the greatest risk of being takeover targets. The emerging markets are full of sectors where multinationals want exposure, and the only companies they can generally take over are bad companies. We only short bad companies that can’t be taken over because they are owned by the government or their own pension fund. If the company is owned by the pension fund, it will never be sold because the workers will be afraid that the acquiring company will sack 20 percent of the labor force.

■ There are multiple requirements for a trade to take place. Do we like the company? Is it cheap? Does it generate cash flow? Do we trust the management? Do I have confidence in my projections? Is the macro outlook favorable?

■ Once I have done the fundamental work and decided to buy a stock, I will first look at the chart before putting on a position. If the stock is very overbought, it won’t stop me from buying, but I will start with a small position because there is a larger chance of a correction. If instead I put on the entire position and then the stock had a large correction, I would feel terrible.

■ The core is always fundamentals. There is, however, one exception where a trade might be initiated because of charts. If a stock is extremely oversold—say, the RSI is at a three-year low—it will get me to take a closer look at it. Normally, if a stock is that brutalized, it means that whatever is killing it is probably already in the price. RSI doesn’t work as an overbought indicator because stocks can remain overbought for a very long time. But a stock being extremely oversold is usually an acute phenomenon that lasts for only a few weeks.

■ RSI is only useful in one direction, oversold. If the RSI is extremely oversold, I will then look at the fundamentals to see if whatever has caused the stock to be sold off that sharply is already discounted by the price. If it is, then I will buy.

 

Tom Claugus

 

■ We track a number of basic indicators to get a feel for the real economy. For example, rail traffic is up 2 percent for the year, and truck traffic is up 4 percent, which are not figures indicative of a contraction. Load factors on airlines are pretty good as well. RevPAR [revenue per available room] for hotels is up 7 percent. These are basic indicators you can look at that tell you the economy is just not that bad.

■ I am a reversion-to-the-mean thinker. We use standard deviation bands to define extreme readings. The argument is that you would have your maxi mum long position at the lower band and your maxi mum short position at the upper band.

■ At the lower band, we would be 130 percent long and 20 percent short. At the midpoint, we would be 100 percent long and 50 percent short. We are 50 percent net long at the midpoint rather than neutral because of the long-term secular uptrend in stock prices. At the upper band, we would be 90 percent short and 20 percent long, or 70 percent net short. Our net exposure will increase as the market goes down and decrease as the market goes up. We do similar calculations using the Nasdaq and Russell 2000 indexes and then derive a composite target exposure based on the relation between current prices and the price bands in all three indexes.

■ After determining the portfolio net exposure, we do a similar analysis by sector, trying to identify sectors that are cheap and sectors that are expensive. The relative valuations are only a guideline. It is critical to also examine the specific fundamentals.

■ The next part of our analysis is figuring out why a sector or stock is expensive or cheap, and do we see something that is going to change that? That is where we spend 90 percent of our time. I look for anomalies. When I screen quarterly earnings, I look for quarterly earnings that are up more than 50 percent or down more than 30 percent.

■ Our defining moment of a survival threat is being down more than 7 percent in a month and not knowing why.

■ You want to design a portfolio that will survive a 150-foot tidal wave. The number one risk factor for me is leverage. At the extreme levels, our net exposure is usually less than the net exposure of a typical mutual fund.

■ There are always some stocks that are going down. The interesting thing is that shorts are actually easier to find than longs. It is easier to spot a broken company than a good company. It is easier to identify bad management than good management.

 

 

Joe Vidich

 

■ There is no high for a concept stock. It is always better to be long before they have already moved a lot than to try to figure out where to go short. When P/E multiples get to 50, 60, or 70, you are in the realm of concept stocks.

■ In a bull market, prices open up lower and then go up for the rest of the day. In a bear market, they open up higher and go down for the rest of the day. When you get to the end of a bull market, prices start opening up higher. Prices behave that way because in the first half hour, it is only the fools that are trading [pause] or people who are very smart.

■ When the market closes near the high of the move, there will be some traders who want to sell near the high, and they will be sellers on the next day's opening.

■ If there is bearish news before the opening and the market does not trade down much during the first hour, it indicates that the smart money is not selling and that the dip is a buying opportunity.

■ What matters is the market sentiment, not public sentiment. I judge the market’s sentiment based on how the stock moves. If everyone is bearish because that’s what CNBC says, that is public sentiment, but if the stock gaps are higher after a conference call, that’s the market sentiment. What matters is the market sentiment, not public sentiment. I try to drown out the public sentiment.

■ There are two types of sentiment. There is the popular sentiment, expressed in the media, and then there is the sentiment that is expressed by the market. A stock being down after a good earnings report would be an example of negative sentiment.

■ When the SEC adopted fair disclosure in 2000, it meant that company conference calls had to be open to everyone. Information could no longer be controlled by the large brokerage firms who then funneled it out to the public.

■ The right way to manage risk is to monitor your positions and to have a mental point at which you reevaluate the position. The amount of room you would allow till that point would be different for different stocks. Every stock has its own risk profile. Some stocks could go down 50 percent, and it wouldn’t necessarily mean anything. But for a stock like Coca-Cola, you should be reevaluating if it moves 5 percent against you.

■ It is really important to manage your emotional attachment to losses and gains. You want to li mi t your size in any position so that fear does not become the prevailing instinct guiding your judgment.

■ To be successful in the markets, you have to be willing to change your opinion. Most people are not willing to change their opinion. You have to be humble about your ideas.

■ One of the best chart patterns is when a stock goes sideways for a long time in a narrow range and then has a sudden, sharp upmove on a large volume. That type of price action is a wake-up call that something is probably going on, and you need to look at it. Also, sometimes whatever is going on with that stock will also have implications for other stocks in the same sector. It can be an important clue.

 

Kevin Daly

 

■ I use Compustat and Zacks to screen their lists of U.S. and Canadian stocks.

■ The accounting for financial companies is quite different from that of non-financial companies, so I use different screens for each. For non-financial companies, I use some of the following:

1. Enterprise value/EBITDA
2. Price to free cash flow
3. P/E ratio
4. EV/EBIT (cap rate)

■ For financial companies and banks, I use some of the following:

1. Price/tangible book value
2. P/E ratio
3. Tangible common equity/total assets

■ I watch various economic statistics, including more esoteric data such as weekly rail car loadings. When the data points to a slowdown, I might reduce my exposure. If I am concerned enough, I may even move to almost all cash.

 

 

■ DIALOGUES FROM THE HEDGE FUNDS MARKET WIZARDS" {JACK D. SCHWAGER}

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