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Stock Market Investing, The Case for Spitting into the Wind

Stock-Markets / Stock Markets 2012 Mar 13, 2012 - 07:13 AM GMT

By: Money_Morning

Stock-Markets

Best Financial Markets Analysis ArticleShah Gilani writes: You've heard the expression "You don't spit into the wind," haven't you?

Well, it's true when it comes to trading and investing, too. You keep the wind at your back, and you don't give up easy profits by bucking the trend.


That's all well and good, so long as the wind is coming from a discernible direction. I prefer a warm southwest breeze myself. That's why I live where I live (in Miami).

But we have no control over the many ill winds that blow over our investing horizons.

The best we can do is stay aware of subtle shifts in directional changes, and watch out they don't strengthen into hurricane-force monsters.

I've been cautiously (too cautious, I admit) bullish since October, and I remain optimistic that stocks have enough momentum to try and push through important psychological barriers - such as 13,000 on the Dow, 1,375 and 1,400 on the S&P 500, and 3,000 on Nasdaq.

That doesn't mean we won't see a correction first. Or that last Tuesday wasn't a tiny correction in and of itself.

But 30 years of hardcore trading, and catching every major move in that long time span (no, I hardly ever pick the exact top or bottom, but I have come close) has taught me to go with my gut, to know when I "blink" that it means something.

And lately, I'm starting to "blink" more and more...

I'm getting the feeling that something's wrong, and, somewhere, the eye of a terrible storm could be forming. There's nothing out there that I've read (and I read a lot), or heard, or come across in any research, either quantitative or fundamental, that articulates what this nagging feeling is that's hanging over markets.

So, it looks like I'll have to be the one to put it out there.

But first let me be clear. I'm not spitting into the wind here. I'm still going with the path of least resistance.

What I am doing is presenting the backdrop of what people have lost sight of as they look front and center on the investing stage.

Am I saying the eye of a hurricane is forming? No. I'm saying it already has formed.

I'm saying keep buying cautiously and keep raising your stops as markets go higher, if they do. I'm saying keep watching these developments with me.

Things change, and this brewing storm could dissipate, but it could also turn really ugly, really quickly.

If the storm strengthens, and that's my bet, have a fail-safe plan to get out of speculative long positions, a plan to selectively add to core positions on the way down, and a plan to put on short-side positions that will make you a ton of money if I'm right.

Okay, ready?

Here's where the winds have shifted...

Where the Winds Have Shifted
Structural changes in markets worldwide have occurred. Electronic trading has changed everything.

In the old days, there used to be market-makers. (I was a market-maker on the floor of the CBOE and an over-the-counter "OTC" market-maker.) The job of market-makers is to make a two-sided market in a stock or other instrument. In other words, you have to be willing to buy at a posted price and sell at a posted price, your posted price.

Specialists on the New York Stock Exchange are the best examples of market-makers. Back in the day, when all orders for a stock that was only traded on the NYSE came down to the floor, the specialist in that stock kept a "book" (it used to be an actual leather book) on that stock. In it were all the buy and sell orders from all over the world. In addition to keeping the book, the specialist also made a market, meaning he or she could set their own price inside the public's quoted bids and offers to narrow spreads and transact for their own accounts. As they traded the stock they were specialists in for themselves - they still are.

Then electronic trading took hold.

Instead of just one place where one stock was traded, there are now many different exchanges or electronic platforms where stocks are traded.

The need for market-makers has disappeared as individual traders put their own buy or sell orders down wherever they want, or where their trading platforms direct them (in most cases).

In other words, there are no market-makers keeping fair and orderly markets. Bids and offers coming into electronic venues from across the globe constitute what the market is (the bids and offers) for any instrument.

At the same time that electronic trading was growing, decimalization replaced the system of trading stocks in sixteenths and eighths of a dollar. Now everything trades in one-penny increments.

The combination of electronic trading and decimalization decentralized trading and made it much more volatile.

Essentially, the unintended consequence of changing basic market structures scared off long-term investors looking for stability... and replaced them with a frenetic trading crowd that now includes non-professional (though they think they are) day-traders and non-professional speculators who tend to jump onto trends (usually as they are peaking) once they are the hot new game in town.

Of course, these non-professionals are a drop in the bucket compared to the "professional" crowd that has exploded to get into the very lucrative game of trading volatility.

Keep in mind: Volatility is anathema to investors, but manna from heaven to traders.

Into this mix of structural changes, we have to add the hugely popular and massively traded derivatives universe. Most individual investors will never touch these instruments directly, but they are constantly affected by them, one way or another.

So we have a market that moves on thin volume, because investors are more inclined to be traders, ourselves included.

Skeleton Market Tends to Get Crushed

As spreads have narrowed because of decimalization and electronic trading, so have time horizons for holding stocks and reasons to hold them.

What we have are rising markets based on short-term assumptions that are not underpinned by long-term investors willing to add to core positions if markets correct.

Because the market structure now resembles a skeleton, as opposed to a fully complemented living organism, overhead weight or sideways winds can crush it or blow it apart.

Innumerable research reports and white papers (they will make you blue in the face if you read them all) support exactly what I'm saying -- that markets are a shell game these days.

Here's the latest support for what I'm telling you.

How is it possible that less than $1 billion flowed into domestic-stock mutual funds since the beginning of 2012, but the value of Wilshire 5000 index (an index as broad as they come) rose by $1.5 trillion?

Where is the increase in value (share prices) coming from if there is no meaningful capital flow into stocks?

Starting to get my fear?

As speculators go after stocks, they take smaller and smaller bites of what's being offered for sale. That's because there are not a lot of sellers. There aren't a lot of sellers, because there aren't a lot of long-term holders in the first place.

The sellers that present themselves (especially short-sellers) aren't offering a lot of stock. So, if you want to buy, you take what's offered, and step up and take the next higher price, and so on, and so on. You might end up buying not a lot of stock, but you might have moved the price up a good bit. Everyone sees that, and thinks, great, stocks are rising.

But, where's the beef?

ETFs have added to the speculative fever. But, again, what are ETFs other than mutual funds that trade like stocks? And where has the $16.4 billion that's gone into ETFs since December gone? Mostly into bond funds, believe it or not.

What I'm worried about is that this shell game faces a headwind that shatters the illusion of huge numbers of investors holding onto core positions. They aren't.

When a macro event happens -- and one will -- will speculators, hedge funds, and high-frequency traders step in at lower levels perceiving value? Will investors come off the sidelines and finally get involved? Or will they climb on board this rising shell game, only to get spit out when the day of reckoning comes?

Massive liquidity has floated speculation for the past three years. We'll see what happens next.

As far as Greece goes, PLEASE, don't be fooled.

Tuesday's sell-off was about Greece not getting its bond swap. It got it. Now, good luck with that... On Thursday, I'll tell you the truth about what really happened and what's going to happen next over there. It ain't pretty.

So, for those of you looking to jump onto Europe's gleaming prospects now that the Greek debt crisis is resolved, go ahead. Just don't spit into the wind when it comes.

And the wind is stirring.

[Editor's Note: If you're looking for some sound advice on the direction of the markets then you need to read Shah Gilani's Wall Street Insights & Indictments newsletter.

As a retired hedge-fund manager, Gilani opens the doors on Wall Street's private money club -- where his experience and knowledge uniquely qualify him as an expert on the markets.

Bull market or bear, Shah knows how make money in any market.

Please click here to find out more about Shah's free newsletter.]

Source http://moneymorning.com/2012/03/13/the-case-for-spitting-into-the-wind-at-least-for-now/

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