Investing versus Trading

"Business is the art of extracting money from another man's pocket without resorting to violence." - Max Amsterdam

This week's blog is very near and dear to my heart.  When I began in this business over 20 years ago I was an investor through and through.  The only way to invest was through hard work.  Start with a detailed analysis of a company, drill down into the numbers to find hidden value, interview management to make sure that nothing was missed and if the stock was still cheap relative to the results from my analysis then I would load up on the position.  If the stock dropped lower I would confidently add to my position and then wait patiently for the rest of the market to discover my hidden gem and take it to my target price.  Once there I would offload.

Of course I would keenly await the quarterly reports and raise or lower my expectations based on management comments and the reported numbers and guidance.  I would hold positions for months if not years and normally I would be rewarded for my effort.  Time, effort and patience were virtues and a formal education in analysis was important.  Do your apprenticeship with a financial consulting firm or one of the major investment banks and you had a ticket to riches.

This all changed with the NASDAQ bubble and the advent of massive computer power.  I clearly remember during the NASDAQ bubble in 1999 a technical trader friend of mine asking which positions I held.  After our discussion he took five minutes to evaluate each of these technically and purchased a few of the names on their "breakout".  He proceeded to buy more and more as the stocks moved higher and then exited near the top for a massive profit.  I was amazed that anyone could base millions of dollars on a technical chart.

Over the years since I have become a keen advocate of technical analysis mainly because the market has changed so much that it almost makes financial analysis worthless.  Certainly there is a place for financial analysis but it is more and more likely to be found in private equity funds than in Wall Street hedge funds.  Traders have taken over the market and seek to gain an edge not by superior financial analysis but through superior speed and cheaper price of execution of a trade.

Traders seeking an edge try to sit right next to the market (literally) to get a millisecond advantage over the competition that is sitting a thousand miles away.  This is all that they need.  Company stocks are unknown only tickers are relevant and price to earnings ratios are replaced with stock price momentum.  This is why you have situations where high priced stocks just keep on going while lower priced stocks do not move. 

This is all very good and well but it has turned Wall Street into a glorified casino.  The authorities are turning a blind eye to all of this as they are all making money.  The average daily volume of stocks traded has almost quadrupled over the past decade while the market value of the Standard and Poors 500 (the largest 500 companies listed on the United States stock markets) has not moved.  Money is being made by charging a fee for each share traded.  Meanwhile investors are not being rewarded for this greed and are in reality the chicken fodder.  Give us your money so we can pay ourselves fees and you can receive a negative return on your money.

This has to stop and is going to end badly.  While everyone is making money no-one will turn their attention to these market practices.  The downside is that just as the computers are pushing prices higher, at some point when the market bursts they will drive prices lower and in a hurry.  At this point Congress will look into the problem but by then it will be too late.  Thousands of investors will have lost their shirts but this time hopefully Wall Street will be made to pay.

Protect yourself by moving out of the market and looking for opportunities elsewhere.  For those of you with a conservative edge I would advise that you take a long hard look at your overall portfolio and try to find a decent yield in a low yield environment.  As I mentioned to a friend of mine the other day, it is better to get out now and protect against a 50% retracement than to try to catch a 10% increase in the market.  Things are skewed to the downside so look to exit and wait patiently for the bottom.  It will come and you will be rewarded, just like the old days.