My unpublished (100,000 word) book “The Financial Jigsaw”, is being serialised here weekly in 100 Issues by Peter J Underwood, author
Last week we looked further at the possible failure of markets and the likely effects. Everyone has their own ideas on how this is going to play out. Here is another set of scenarios which I came across last week: https://news.goldcore.com/ie/gold-blog/where-will-the-pending-financial-crisis-originate/ . There is plenty of investment advice here in order to prepare for the coming financial crisis, so worth it’s a read in my view. Here is the link to last week: Issue 36
We continue to look at how markets function, the risks involved and, using some thought experiments, hope to convey an understanding of the basic operations of markets in general.
CHAPTER 7
Markets
“Interest is the difference in the valuation of present goods and future goods; it is the discount in the valuation of future goods as against that of present goods.”
Ludwig von Mises: “Planning for Freedom”
Everything is determined, the beginning as well as the end, by forces over which we have no control. It is determined for the insect as well as the star. human beings, vegetables, or cosmic dust, we all dance to a mysterious tune, intoned in the distance by an invisible piper.
Albert Einstein
Trading in financial markets bears a high risk factor
The risks for traders in the markets are really quite forbidding because good results rely on good information and there is never enough information to guarantee positive moves for the trader.
Charts and projections abound and, in the electronic internet age, some would say there is too much information which adds to confusion. Perhaps a quote from a well-known book from the 1940s about trading will illustrate how this nerve-racking occupation has remained so tenuous even today. Robert Edwards and John Magee are authors of the ‘Bible of Technical Analysis’ which tells all about using charts to judge market movements. In 1948 they wrote ‘Technical Analysis of Stock Trends’ and the words therein remain a caution even today:
“It has often been pointed out that any of several different plans of operation, if followed consistently over a number of years, would have produced consistently a net gain on market operations. The fact is, however, that many traders, having not set up a basic strategy and having no sound philosophy of what the market is doing and why, are at the mercy of every panic, boom, rumour, tip, in fact, of every wind that blows. And since the market, by its very nature, is a meeting place of conflicting and competing forces, they are constantly torn by worry, uncertainty, and doubt. As a result, they often drop their good holdings for a loss on a sudden dip or shakeout; they can be scared out of their short commitments by a wave of optimistic news; they spend their days picking up gossip, passing on rumours, trying to confirm their beliefs or alleviate their fears; and they spend their nights weighing and balancing, checking and questioning, in a welter of bright hopes and dark fears.
Furthermore, a trader of this type is in continual danger of getting caught in a situation that may be truly ruinous. Since he has no fixed guides or danger points to tell him when a commitment has gone bad and it is time to get out with a small loss, he is prone to let stocks run entirely past the red light, hoping that the adverse move will soon be over, and there will be a ‘chance to get out even,’ a chance that often never comes. And, even should stocks be moving in the right direction and showing him a profit, he is not in a much happier position, since he has no guide as to the point at which to take profits. The result is he is likely to get out too soon and lose most of his possible gain, or overstay the market and lose part of the expected profits.
On the other hand, if you have satisfied yourself that the charts are, for you, the most dependable indication of the probable future course of stock prices, then you should follow explicitly the signals given on your charts…according to the rules and modifications as your experience dictates. But while you are following any set of rules and policies, follow them to the letter. It is the only way they can help you.
If you do this…all of this means that you will have peace of mind. You will (a): never be caught in a situation where a single stock commitment can wipe out your entire capital and ruin you; (b) not find yourself frozen in a market that has turned against you…so that you cannot use it in the reversed trend to make new and potentially profitable commitments; and (c) make your decisions calmly, knowing exactly what you will be looking for as a signal to take profits, and knowing also that your losses, at the very worst, will be limited to a certain definite amount. You will take losses and you will make gains. In neither case will you have to take your notebooks home and lie awake worrying. You will have made certain decisions. If developments prove you were right, you will, at the proper point, take your profit. And if it turns out that you were wrong, then you take your comparatively small loss, and start looking at a better situation, with your capital still largely intact, liquid and available.”
Market performance should be an indicator of the health of an economy
The performance of all markets is an essential measure of the financial health of an economy because if markets are improving (going up in price) this indicates a growing economy and is generally considered a good sign for the country; the opposite is negative for growth which is the stormy waters that economies have floundered in since the crisis of 2008. One way to illustrate the workings of markets is to use an old favourite of mine, the thought experiment.
Imagine, if you will, a five mile long, rising street lined with market stalls on each side selling a vast array of produce and services. The market has been in existence for many years and the people walk around viewing offerings and bargaining for prices as the underlying demand and supply alters over time.
Psychology is a large part of the decision-making process and also laziness comes into it too because people are reluctant to travel very far on foot in order to examine the whole market and obtain complete information. They may not know what is going on in the more remote parts of the market and they have also failed to notice the innovation of a new and improved transport method.
You, however, have a massive advantage: you have spotted the innovation of a bicycle by which means you can travel much faster than the others and obtain much more information very rapidly giving you a significant advantage over your competition.
You start at the bottom of the street and notice that a stall is selling apples for £5 per kilo but obviously you are unable to discover the price at which he buys them. Noting this sale-price information you pedal fast and furious five miles to the top of the market where there are fewer participants. Here another trader is selling apples, but for much less, £3 per kilo because at the top of the market there are fewer buyers and therefore less demand.
You ask the trader what he will sell apples for in bulk, say, 100 kilos, judging that the first trader would be buying in this quantity, at least, given that apples are a perishable product and he has relatively rapid stock turn.
You strike a deal at 33% discount (a normal wholesale rate), buying apples at £2 per kilo and obtain a contract to purchase (and deliver) for delivery in three days’ time to the address of the first trader.
You scoot down the hill, covering five miles quite quickly, and calmly engage the trader in conversation about supplies of apples, indicating that you have 100 kilos for sale. You have already calculated that the normal wholesale price for this market equates to maximum 50% of the sale price, £5, (that is: 100% ‘mark-up’ on cost price– which is £2.50 or 50% profit on the retail sale price of £5 – I will leave the reader with the math), trust me, it is correct. [Note; competence in quick mental arithmetic is a major requirement for any successful trader]. Thus we know that £2.50 is likely to be the trader’s current buying price.
You now negotiate the sale of 100 kilos of apples for a price of £2.25 per kilo, a saving of 0.25p per kilo for the trader, close the deal assuming quality and other parameters being equal, and an acceptable ‘sample’ having been agreed.
All you need to do is exchange your contract for the sale agreement and request delivery in 3 days. This is a classic ‘win-win’ situation which all good trades engender. The trader is making £25 more profit and you have made £25 clear in less than an hour without moving, storing, insuring or delivering the physical apples; it’s all done on paper and with little effort or expense. This is known a ‘arbitrage’.
Nice work if you can get it! Perhaps the reader would like to speculate on the short-comings, risks and possibilities of failing to make a profit because this is where experience and expertise are needed to ensure a successful deal. There are many lessons to be gleaned from this experiment.
To be continued next Saturday
