Wednesday, February 27, 2013

Choose Your Rationalization . . . | The Big Picture

Choose Your Rationalization . . .

By Barry Ritholtz - June 22nd, 2012, 7:53AM
Yesterday’s ugliness has the pundits looking at numerous explanations, correlations and motivations for what was the causation of the 2+% market sublimation.
All those “-ations” leave out the most important one: Rationalization. For that is what all of these tales actually were.
Consider the following “causes” trotted out for the move:
-Federal Reserve failed to deliver QE3
-Global economic slowdown
-Moodys downgrade of banks
-Spain/Greece/Italy (choose up to 3)
-Commodity bear markets
-Euro currency concerns
-Middle Eastern unrest
-US Election jitters
-All of the above
I have a different view:
The day-to-day action is nearly all noise. It contains a surprising degree of randomness, but its not as totally random as some academics would have you believe.

The I-O market is a mixture of Iv chaos and Bi randomness. 

Why? Sometimes we see price continuation, leading to distinct trends. This is often acted on, reflected in the trading behavior of both Momentum traders and Trend followers.

They are the Iv side of the market looking for momentum or energy while the Bi side is looking for positional or time based factors. The trend can then grow to a ceiling and the crash to a floor. 

Occasionally, a move in either direction gets over-extended. Hence, Contrarians and Sentiment watchers try to anticipate the counter-trend reaction move.

Arbitrage can work by the assumption of a normal price and changes from this are improbable aberrations. If the stock goes up they might bet it is not a trend or momentum, instead they short the stock expecting it come back to its normal value. They might also expect this trend to hit a ceiling and then crash back down to the normal price. 

Third, the market internals can shift, become aberrational. Technicians try to discern what this is telegraphing behind the scenes in the activities of the biggest institutions as they impact the stock supply demand battle.
Or not.
All of these cross currents described above are hardly reliable guide posts. They occasionally provide a modicum of insight, but just as often lead to confusion. Typically, they make day-to-day trading exceedingly challenging. The shorter your timeline, and the greater your assumptions, the far less reliable your investment strategies become.
The exception, ironically, are those folks who measure their holding periods in fractions of a second. High Frequency Traders (HFT) — a/k/a “cheaters” — mostly know the outcome of their trades in advance, courtesy of the information provided to them by the exchanges. Their high probability front-running is not available to ordinary investors, from  whom their profits are derived.
What investment decision have you rationalized today?

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