Tuesday, February 14, 2006

Exam Questions I Would Like to Ask

When I eventually tire of playing this game, I've always fancied having a go at teaching. I'd finally have a good excuse to wear that tweed jacket hanging in my closet. Maybe even a colourful bow tie. Okay, NOT a bow tie else I am confused with that smug weenie, Tucker Carlson. And there are of course the oak-paneled rooms, the genteel debate, LBV port and ubiquitous other drink. (Bob Jones & Brigham Young U. excepted). Not that anyone would be silly enough to actually let me teach. But if perchance they did, one of my courses would be called "Fallacies of Finance & the Real-World Questions Stock Brokers & Financial Planners are too Ill-informed to Answer or Even Ask". It would be contentious to say the least. And it certainly wouldn't fly at any Economics Department that Fidelity or the Johnson family was endowing (at least if the Trustees had a say). For they would find it embarrassing to be responsible for the revelation of some of the stock market's dirtiest little secrets - one that might undermine public confidence, and shatter long-held illusions of fairness (not to mention offending their benefactors). For these are keystones of capitalism. Indeed, if this course were to be taught at all, it would be appear in the University's Course Directory in small-font italics, in a place where those of upstanding moral fiber rarely visit. It would be relegated to the red-light district equivalent of academia where those that did speak of it would only do so in hushed and disapproving tones.

The class would be rife with brain-teasing discussions and test questions that were NOT on the CFA Level III exam, nor likely to have been discussed by one's Ivy-league finance professor. For example, my mid-term might contain questions resembling something like this:

You've acquired a line of a smaller-cap stock, and you're trying to ramp its share price up (for obvious reasons of reputation & bonus/performance fees to buy your Ferrari or Humveek, etc.). Assuming you possess no reliable material non-public information, is it better to:
(a) be "Steady Eddie" & consistently buy more stock every day at higher & higher prices?
(b) "Go for the Gusto" and buy larger amounts with more marked impact, but only on selected meaningful days?
(c) Employ "Fear & Surprise" tactics by jamming it up hard, but do it randomly & less frequently (like Torquemada's Spanish Inquisition)
(d) Don't buy any more, but Hope & Pray for Divine Intervention.

Wow. So many degrees of freedom! Where does one start? First, what's the co's characteristics? Index membership? Expectations?, Short interest, amount of long margin or levered punters? It's Growth? Value? Momentum? Capital structure? "Quality"? Management acumen and integrity? Insider buying & selling? Prior return patterns? Speculative value (hidden assets, greenmail potential, net cash, cancer research, or solar cell research)? Ownership and float? Risk? Issuance of derivatives (options or CBs)? Borrowability & loan fees? Analyst following? Periodicity (Is it January or November)? Is anyone else operating in it, or likely to have an axe? That's for starters. One might also consider What's the objective - double it ? Triple it? More....?!!! How big a line does one have? Is it levered? How stable is YOUR capital or margin? How BIG are you (possible resources)? How diversified is your portfolio? What's the timing - a swing trade? A quarter? A fiscal year? Almost forever (e.g. Cap Research/Cap Guardian)?. As needed for "portfolio performance enhancement" purposes? Are you worried about the MOF? SEC? SFA? SFO? FSA? Is your compliance officer a weenie? Are you concerned about Exchange Regulators or the SIA (ha ha ha, only kidding on the last two). Whew. Decisions decisions. Even a good neural net would begin hemorrhaging.

Here are some hints to get the discussion going:
(a) Steady Eddie is an effective way to suck the punters in. Being 10 to 15% of daily volume (on the buy-side) will go a long way to insuring relative outperformance and the stock and endowing it with "alpha" (assuming it has reasonable characteristics & metrics and doesn't "suck"). There is no need to do anything dramatic (though on quiet or half-day sessions you can have some fun at low expense by buying everything in sight). From time to time, you'll encounter some short-term counter-trend selling and shorting, but if you keep to the plan, most will cover quickly and get squeezed out. The smart ones will certainly be able to see your resolve and will go away (for a while). Eventually you'll have taken out enough of the discretionary sellers to have your way with the price. About now, the, Libertarian trend-following crowd and/or the naive electronic herd will discover it and pile in. Use them to lighten up because by now you've probably achieved enough price appreciation to benefit your relative performance or achieve your mark. Of course you'll have to "get out a some point" without being beaten to a pulp but we'll discuss how to that that later.

(b) "Going for the gusto" has the advantage of being more economical. This is used by people who're cheap or who have probably bitten off more than they chew and want to conserve their bullets, or by those specifically looking for periodic mark-to-market performance and bang-for buck benefit from the money they've spend. The biggest advantage is that you spend less money buying up a stock that, in all honesty, you don't really want to own (especially at higher & higher prices), and in all probability after a period of time is overvalued and increasingly tempting for those itching to take a plunge on the short-side. The downside is that, like a burglar in winter, you've left some rather obvious tracks. Shorts will see your tracks, label you "a pretender" and lock-n'load. But that's not all. With Spitzer looking for fresh-kill in pursuit of high office, anything of dubious fiduciary integrity may be scrutinized - including the million shares you bought into the close on March 30th to move the price 7%. And the price of getting busted (or even accused) for a supposed fiduciary is not unlike a very very painful rectal itch. Not that getting your hand caught in the cookie jar has historically been fatal (it hasn't!) except in rare Alberto Vilar-like cases) where schizophrenia, cross-dressing serious, or vulgar theft are involved). Anyone from PBHG, Putnam, Baron or countless others will confirm that Sing-Sing is highly unlikely. In the end, though this method is not without some minor merit especially for the cavalier, but with the attendant risks it's probably more "penny-wise and pound foolish".

(c) Torquemada was horrible, brutal, but effective. There are virtually no Goldbergs or Cohens left in Iberia. Working randomly and in size is effective and helps prevent the market parasites from gaming you. You see, "Fear & Surprise" screws with their heads (and their strategies). You jam it up, and counter-trend sellers will see it. They wait. Watch carefully. Them it looks safe. So they drop some stock. The price drifts lower, they are confident they've made the right trade. Then, before they cover, like tasmanian devil, you let it rip and take it up 10 or 15%! The shorts are dumbstruck, bitter, kicking themselves for being greedy and are now looking to cover flat or at loss just to save their gonads. Afterwards, sellers see a tape that makes looks enticing to sell, but everytime they plunge they get hosed, so like a poisonous toad that wears bright day-glo colours to warn-off his would-be predators, so too does fear, surprise and randomness confuse people who otherwise might "get in your way" and make the operation more expensive and less profitable. Eventually you'll have to get out, and face the music, but in the end the only thing that really matters is average price, average price, average price.

(d) Since it is my observation that "market justice" (note: an SM & TM registered by Cassandra Does Tokyo)) which I would define as "things doing what they fundamentally "should" do, in the time frame that one expects that they will" is less prevalent than "things doing what things do (typically on account of the largest marginal investor)". Though chaotic, it's not complete chaos, but rather reasonably large amounts of noise with subsets of momentum in precisely the places where one might rather they weren't. This state of affairs is quite perplexing for amateur and professional investors alike. So where does prayer come into it? Well, if THIS is the product of intelligent design, then the "Deity in Charge", "Universal Architect" or who or whatever, must be one savagely sadistic supreme entity with one very twisted sense of humour. Given this reality, relying upon an appeal to her/its/his compassionate side to influence the future economic outcome of one's operation seems, IMHO, to be rater sub-optimal (not to mention a waste of time).

FOR EXTRA CREDIT: (bonus prize being a genuine vintage Made in Japan "Kewpie Doll"): In the operation described above, What do you do when you run into a real [and apparently large] seller?
(a) See how price sensitive he is
(b) Puke
(c) Take him out
(d) Hope & Pray for Divine Intervention
(e) Telephone Nick Leeson for advice
(f) none of the above
(g) all of the above
(h) both a & b

Sample Answer (I invite you all to take a stab): A Democrat would test the waters, get touchy feely and see how price sensitive the seller is. An Ayn Rand Libertarian would understand the implications of a large seller, decisively place a tight sell stop, and wait to see which way the wind will blow. But a real man, one with "cojones" the size of a Texas Republican for example, would throw caution to the wind, irrespective of the odds and costs and "take him out". Or try at least. Kind of like what the US has done in Iraq.

Of course what is described above is theatre. But like all good theatre, it's based upon kernels of truth. As such, comments from the real-world are encouraged.

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