The Big Lie: What Wall Street Does Not Want You to Know

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Trouble in Paradise

Kenneth Lay, Andrew Fastow, and Jeffrey Skilling of Enron
are the preeminent poster boys for corporate greed, but by
no means are the trio unique. In the back alley game of
“Fleece the Shareholder”, skilled competitors are abundant.
Dennis Kozlowski, Tyco's ex-chairman and chief executive,
showed some real creativity. Late last year Morgan Stanley,
always promoting an image of steady, conservative,
trustworthy values, agreed to pay $50 million to settle
federal charges that investors were never informed about
compensation the company received for selling certain mutual
funds. So much for protecting the little guy. Before that
the SEC settled with Putnam Investments, the fifth largest
mutual fund company, which allegedly had allowed a select
group of portfolio managers and clients to flip mutual fund
shares to profit from prices gone flat.

A
proposal that would force the SEC to give shareholders a
greater voice in selecting board members was defeated in
October 2004. Commissioner Harvey J. Goldschmid, an
advocate of the proposal, said “The commission’s inaction at
this point has made it a safer world for a small minority of
lazy, inefficient, grossly overpaid and wrongheaded CEOs.”
The ugly truth does not stop there by any means. Even the
venerable Fannie Mae is accused of fleecing investors. The
Wall Street Journal reports that the Justice Department
opened a formal investigation in October 2004, following
reports that the mortgage company may have manipulated its
books to meet earnings targets. This is after Fannie tried
to hinder an official investigation by refusing to provide
relevant information. Oddly, the Enron scandal ultimately
revealed Fannie’s alleged deception, when the energy
company’s collapse forced Fannie Mae to replace Arthur
Anderson with a new auditor.

When Good News is Bad

And that is the good news. The bad news is very bad indeed.
As an individual investor, you might begin to suspect the
game is rigged against you after hearing the recent spate of
charges and revelations. But the real problem lies not with
the illegal activity of a few high-profile rogue directors,
acting beyond the rather generous and forgiving rules of the
SEC. Instead, the frightening truth is that you have much
more to fear from what is done legally, with impunity, with
the official blessing of regulators.
I am a scientist by training, not a professional investor,
but I have a substantial portion of my net worth floating
about Wall Street in various stocks and mutual funds, mostly
in self-directed retirement accounts. I want to protect
those assets, so I naturally set out to learn more about
stocks, bonds, futures, and commodities. Like any
self-respecting scientist, I starting digging and
methodically researching the rules, regulations and
practices of Wall Street to get an objective picture how my
money was handled once I made a transaction. Early on I
concluded that the best way to make money was to take
control of trading decisions myself, so that I could
identify opportunities for the greatest returns without
looking through the artificial filter of a broker with his
own agenda.

I also found that institutional investors managing billion
dollar transactions or individuals working with grandma’s
“blue chip” stock all share something in common, regardless
of the method of trading or the size of the portfolio. All
depend on the fundamentally flawed notion that the future is
predictable. As a result, all are doomed to fail over time:
any attempt to predict the future is utterly hopeless, and
no amount of fancy arithmetic will change that immutable
fact of nature.

The futility of trying to foresee the future, however, has
not stopped traders from creating ever more sophisticated
methods that rely on predicting market movement. This
tragic flaw, this inability to recognize that the future
will never be predictable, is often masked by confusing
terminology and complicated math to create a comforting
image of some higher knowledge. But no matter how clever
the system or elaborate the math, the future simply can not
be foretold.

Oddly, while traders of stocks, bonds and commodities suffer
equally from the delusion that the future is knowable, the
pernicious effect of this myth is seen with greatest clarity
in futures trading. The world of trading futures,
therefore, will be the example explored in detail to expose
the depth and extent of the big lie. The lesson from
futures trading, however, applies universally to all
sectors.

Futures Trading

Traders fall into two distinct camps when it comes to
analyzing the market: fundamental traders and technical
traders.

Fundamental Traders

Fundamental analysis is a study of the principals of supply
and demand and the production and consumption patterns of
commodities, and how these relate to future market behavior.
The goal is to sift through fundamental economic data to
identify discrepancies between the inherent value of a
commodity and the current market price of that commodity. A
fundamental trader seeks to profit by buying or selling
during this period of discrepancy before the market catches
up to reflect the correct information.

Technical Traders

Traders in the second major camp rely on technical analysis,
which is a study of price behavior over time. Technical
trading attempts to foresee the future, an impossibility.
But hope seems to spring eternal, and so technical traders
have developed an arsenal of tools to predict market
direction.

The big gun in technical analysis is the bar chart, which is
a graph that represents market price changes over time.
Using the bar chart, traders evaluate historic price
behavior, seeking to identify any indicators that will
predict market movement in the immediate future.

The various patterns of peaks and valleys create “chart
formations” that analysts use to predict prices. Eighteen
basic signals and chart formations establish the basis for
technical analysis: trend lines, rounded bottoms,
consolidations, tops, bottoms, support, resistance,
retracements, reversals, head and shoulders, continuation
formations, triangles, coils, boxes, flags, pennants,
diamonds, and moving averages. The only signals missing are
tea leaves, scattered bones and eyes of newt.

A few of these chart formations, explained clearly by Russel
Wasendorf in All About Futures, are discussed below as a
means of illustrating how traders use analytical signals to
determine when and why to enter and exit the market.

The Trend Line

The simple theory behind this most popular analytical tool
is that market prices tend to follow straight lines. As
such, prices are almost always drawn back to the line if
they bounce off. Trends can be upward, downward or
sideways. Trend Liners believe that prices tend to cling
to straight lines because traders resist paying more for a
commodity than others are willing to pay. As long as prices
move up, for example, traders will continue to buy until the
trend appears to reverse.

The Rounded Bottom

This formation is perhaps the easiest to recognize, and many
traders believe that a rounded bottom is a strong signal of
an impending change in market direction. The formation
begins with prices gradually moving either up or down and
then gradually changing direction. The rounded bottom is
evident in the absence of an abrupt change in market
direction.

Head-and-Shoulders Formation

Considered by many to be the most reliable analytical tool
available, the head-and-shoulders formation has become
increasingly popular among traders as an indicator of a
sizeable market reversal. The pattern is developed from
three rounded bottom formations situated such that the
middle one is higher than the other two, both of which are
sitting at approximately the same level. The resulting
configuration resembles a person’s head and shoulders. The
formation indicates the end of an up trend in the market;
while the reverse head-and-shoulder formation indicates the
end of a down trend.

Sideways Channels – Trading the Breakout

This trading strategy involves looking out for markets that
appear to be trending in a horizontal direction. If a
market seems to be trading sideways, with the same tops and
bottoms along the way, it may be ready to break out of that
trend either up or down. The difficulty of course lies in
determining for how long the horizontal trend will continue,
and then predicting the direction of the breakout.

Triangle Formations

These formations are similar to sideways channels in that
the market being analyzed has been moving within a
relatively narrow range for a considerable time. The
difference is that in a sideways channel the upper and lower
limits of market movement tend to be parallel, whereas in a
triangle formation these areas converge until a breakout one
way or another occurs. Three types of triangle formations
are recognized: symmetric, ascending and descending.
Descending triangles develop when the higher price limits
converge toward the lower price barrier, which has tended to
stay flat. Symmetric triangle formations resemble sideways
channels except that their upper and lower price limits
continue to converge. Ascending triangles form when the
upper price limits tend to stay flat, while the lower price
limit converges upward.

The 1-2-3 Formation

The theory of this strategy is embedded in the belief that a
particular market will indicate a new trend in three steps.
When a market has reached a new 12 month high or low, a
trader begins to look for a 1-2-3 formation. The trader
labels the position of the high or low on the chart as point
#1. If the market rebounds from point #1, this theory
claims the rebound will only be of a certain magnitude.
When the limit of the rebound has occurred, this is labeled
as point #2. If the market then retraces itself back toward
point #1, but does not reach point #1 before reversing,
this new secondary low is labeled point #3. Once this third
point has been identified, the trader waits to see if the
market will move past point #2. If the market breaks out
from the second point, then the trader would enter the
market in the direction of the breakout (opposite of the
direction that the market was moving when it originally hit
point #1).

Simple and Weighted Moving Averages

Moving averages are the product of a mathematical analysis
of the market. Generally, the analyst selects a
pre-determined number of days to examine (usually four), and
then totals all of the prices for that time frame. A
division of this total by the number of days being analyzed
will yield an average. With each day going forward, the
first day is subtracted and the new day is added, thus
giving a new average. This is done for however many days
one chooses to examine. Once the moving averages are
calculated, the results are charted on a graph. Some
analysts calculate a weighted average using a formula that
places more value on the more recent prices. This strategy
is called a Weighted Moving Average.

The Big Lie

Software packages are available today that can assist with
culling through historical data. All of that is futile. At
the exact moment a trader enters the market, there exists
precisely a 50.000000% chance that market will move up or
down from that point of entry, completely independent of any
analysis that led the trader to enter at that point. No
amount of hand waving, and no amount of fancy math, will
change that reality. Denying that fact is the Big Lie.

Why is trading near the level of chance the death of a
system? To trade successfully, a trader must win enough to
generate earnings that exceed the costs of commissions,
slippage and losing trades, and this requires a wining
average greatly exceeding 50%. For every losing trade, you
must win another just to break even: that means two trades
for no gain, and all the cost of trading. If the third
trade happens to be a win, that means that 3 commissions,
slippage 3 times and one loss must be subtracted from the
win. Because of these downstream impacts of a loss, as a
general rule of thumb at least 7 out of 10 trades must be
winners to trade profitably. Not gonna happen.

To rely on any of these methods of analysis in making
trading decisions would be the height of folly. The hard
reality is that all of these analytical methods are down
right silly. They are the product of hope triumphing over
reason. Traders are desperate for anything that will give
them longevity and profit in the market in the face of
desperate losses. But all of these technical trend methods,
and fundamental methods as well, fail at a primary level,
and placing any hope in them is a form of financial suicide.
That 80% or more of traders lose is no surprise when the
majority place faith in methods that by definition can never
work over any extended period of time.

All is Not Lost

Yes, Virginia, there is a way out of this mess. Accepting
that the future can never be predicted requires a shift in
world view, one that rejects virtually every assumption
embedded in the current world of trading, and the leap may
simply be too great for many. But for those who reject the
big lie, step across to the other side, and realize there is
no leverage in tea leaves and eyes of newt, a tremendous
freedom and clarity await. Unshackled by false hopes,
trading becomes predictable and mechanical, freed from the
agony of watching the market move in the “wrong” direction
because in fact no prediction of market direction is
involved at all. The idea is to create a position in the
market that is truly cyclical, and therefore independent of
underlying market movement, and of known amplitude. How to
establish such a position is described in: A Simple Guide
to Astronomical Wealth. Go to www.tradetofreedom.com.