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Monday August 13, 2007 - 12:30:56 GMT
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Markets Misbehave. Certainty is fantasy!

Key News
• Inflation in China accelerated to the highest rate in more than 10 years. Consumer prices jumped 5.6 percent in July from a year earlier, after gaining 4.4 percent in June. (Bloomberg)
• In the “Dear Investor” letter category: Quantitative funds, which rely on computer models to make market bets, roiled the markets last week, with several such funds facing losses. Early this week, managers of several high-profile funds will start explaining themselves. (WSJ)
• The European Central Bank added emergency funds to the banking system for a third trading day and said money markets are returning to normal.  (Bloomberg)
Key Reports Due (WSJ):
8:30a.m. July Retail & Food Sales. Expected: +0.2%. Previous: -0.9%.
8:30a.m. July Retail & Food Sales, Ex-Autos. Expected: +0.4%. Previous: -0.4%.
10:00a.m. June Business Inventories. Expected: +0.4%. Previous: +0.5%.


"In physics, you are playing against God, who does not change his mind very often.  In finance, you are playing against God’s creatures, whose feelings are ephemeral, at best unstable, and the news on which they are based keeps streaming in.”

   E. Derman

FX Trading –  Markets Misbehave. Certainty is fantasy!

How many times have you herd this little piece of inanity uttered: “Markets hate uncertainty.”  I heard it said on Friday as I was “passing through” one of the TV “financial” shows on my way to the Home and Garden Channel—the only place safe on the dial for me.  Every time I hear that “uncertainty” phrase uttered, it just drives me nuts!

Why in the heck would anyone in their right, or wrong, mind ever think markets have certainty?  If they did, the quant funds wouldn’t be blowing apart right now.  If they did, we would have no such thing as a dynamic pricing system.  Market certainty is standing in line for eight hours for a loaf of bread in the old Soviet Union—you were certain nothing else was on the shelf, and certain the price would set by the state—that’s certainty for you! 

In his book, The Misbehavior of Markets, Benoit Mandelbrot summed it us this way, as he described what an alien being looking down on our markets might see:

“Our alien, seeing a planet obsessed by so illogical a system, quickly decamps.  But his observations of two forms of wildness remain: abrupt change, and almost trends.  These are the two basic facts of a financial market, the facts that any model must accommodate.”

Mr. Mandelbrot appears to be a very smart guy.  He knows a bit about math.  He has done groundbreaking work on the markets with his research on power laws (corn market) and fractal mathematics (a field it seems he virtually created).  If anybody could have found market certainty, he might be the guy.  Yet he hasn’t! 

The point is this: don’t ever enter markets expecting certainty.  Expect to be fooled.  If you work from that premise, all the rest is gravy. 

I was asked recently: What are my favorite books about the market and trading?  I boiled it down to my top six (couldn’t quite get to 5).  And one of them is Mark Douglas’ book, “Trading in the Zone.”  And the core reason this book makes the list is because Mr. Douglas makes it very clear there is no such thing as certainty in markets.  He lays out why it’s critically important to have the right mindset going into markets.  And he says, yes it’s important to do your homework and be disciplined.  But, don’t believe that this game is anything more than a probability bet.  The best we can do is “inch the odds of success ever so slightly” in our favor.  And when we do that, pull the trigger (make the trade). 

Some may argue about this.  But just think about it for a moment.  How many times have all the fundamentals lined up in your favor for a trade (a stock, bond, or currency), creating a great deal of “certainty” and yet you’ve been completely clobbered on the trade?  I’d dare say for me, too many times to count.  No matter how elegant the model, no matter how seemingly tight our inside contacts may be, we will always be fooled because there is no such thing as certain. 

Markets misbehave.  And sometimes they misbehave in a very big way.  And the time they tend to misbehave most is when the consensus thinks there is certainty, or near certainty.  For example of recent near-certainty groupthink: global growth is on track, China will continue to grow at 10% plus per year interrupted, interest rates will remain low, central banks don’t matter, on and on into infinitum.   It’s all the stuff that one can never forecast, yet we fool ourselves in to believing in certainty. 

Here’s something we have placed a higher probability on happening then not happening, and our probability, though not quantified, is very much closer to 50% than 100%. 

We think there could be at least a minor, and maybe a major, shift in expectations concerning the euro that could lead to a very playable correction.  The European Central Bank’s aggressiveness on the liquidity front would seem to suggest it may not be near as aggressive as expected on the rate hike front going forward.  Housing in Spain and Italy looks dangerously due for correction.  France is spreading its independent wings.  The euro, in its current form, has never really been tested yet, in terms of a major market “adjustment.” 

A key dollar alternative the euro—yes!  Any certainty monetary unions have weathered the test of time—no!

Jack Crooks


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