Playing In The Stock Market Casino

As an investment advisor, I’m not supposed to admit that stock investing amounts to gambling. The industry line is that if you invest in good companies or mutual funds, keep a long-term perspective and ignore the dips along the way, everything will turn out fine. For a long time I tried to ignore that little voice in my head that said “something’s not right.” After all, stocks have outperformed all other asset categories over the last 100 years, the stock market always recovers from crashes, Warren Buffett is a buy-and-hold investor. Most of the conventional wisdom and rules-of-thumb have a sizable element of truth or they never would have become so widely popular and embraced, but something still doesn’t seem right.

There is an ugly side of investing that creates that uncomfortable feeling. According to market data put together by Kenneth French at Dartmouth College, large cap stocks have experienced drops of 25% or more about 10 times over the last 85 years. That averages once every 8.5 years, although there are some long stretches where there were no steep drops and other stretches where they came in clusters. If you started investing shortly after a market drop (say, 2002) your investments performed significantly better than if you began your investment life shortly before a drop (2000 for example). The Nikkei-225 index (Japan) is currently down about 75% over the last 22 years, which has ruined the retirement plans of an entire generation. Of course, Japan’s problem was an over-heated real estate market, multiple recessions, excessively high debt, and an aging population. That could never happen in the U.S. Finally, it is very difficult to invest like Warren Buffett. Goldman Sachs has never offered me perpetual preferred stock with a 10% yield. I also can’t afford to buy a business, install the management, and hold them accountable for superior performance.

The truth is that investing in stocks is a gamble regardless of your timeframe. The best fundamental indicators can be rendered meaningless by hedge funds doing flash trades with super computers or a change in governmental policy that alters the rules of investing (see General Motors). Like any casino, someone has the “edge.” In Las Vegas, the edge in every game belongs to the house, which means if you play long enough the house will eventually take your money. With respect to stock investing, you may not actually lose your money, but if you play long enough you will eventually experience a significant down market that will take back a chunk of your wealth. As an average investor, you do not have the edge. Hedge funds can have an edge by front-running stocks with flash trades. Politicians can have an edge by legally using inside information. Warren Buffett can have an edge by taking advantage of deals that are not available to normal people. The average investor is on the other side of these trades and is completely exposed to the whims of the market.

An Example: Covered Call Strategy

To demonstrate what the lack of an edge looks like, let’s use a typical Covered Call option strategy, which is becoming very popular as investors look for sources of income and additional yield. A Covered Call strategy involves buying shares of stock and selling Call options to generate additional income. A typical position might look like this:

Buy 100 shares of Apple stock for $450/share

Sell a $475 Covered Call option contract for $9.20/share

In this example, the Covered Call option will expire in 75 days. If Apple stock stays flat for the next 75 days, the investor will pocket $9.20/share for an annualized return of 9.9%. If Apple shares rise above $475 on the option expiration date, the investor keeps the $9.20/share and participates in another $25 of share price appreciation for an annualized return of 36.0%. If Apple shares fall, the sale of the option provides $9.20 of price protection, so the investor would not start losing money until Apple drops lower than $440.80. The argument for this strategy is that selling Calls provides additional income in a flat or rising market, and some amount of downside protection in a falling market. It’s the best of both worlds. So why would a casino take the other side of this trade?

Let’s consider the risk profile for this Covered Call position. As the stock price rises, the short Call position loses value at an increasing rate until it is falling at the same rate that the stock is rising. As the stock price falls, the value of the short Call gains value, but is capped at $9.20/share (the price collected for the Call when it was sold). The net effect of combining a long stock position and a short Call position is that profit resistance increases when the stock price rises, and protection decreases as the stock price falls. In other words, if the stock price happens to skyrocket you will have limited profit potential, and if the stock price drops sharply you will have almost unlimited loss potential. This is exactly the kind of position the market wants you to have because the edge is clearly on the side of the market.

The Market Maker’s Side Of The Trade

The job of a Market Maker is to provide liquidity to the market by accepting buy and sell orders for stocks and options, thus “making a market”. A Market Maker must always protect his (or her) account by closely controlling the potential loss. If his account blows up because a stock moves in the wrong direction or an unexpected catastrophic event crashes the market, his job is over. The secret to survival when your career is based on trading stocks and options day in and day out is to tightly limit potential losses and maintain an edge on the market. It’s that simple, and it’s the same philosophy as any casino in Las Vegas.

A successful Market Maker is not going to have a portfolio full of Covered Call positions with limited upside and unlimited downside, but he may take the other side of the trade. Let’s consider what that would look like.

Sell 100 shares of Apple stock for $450/share

Buy a $475 Call option for $9.20/share

The combined position described above is a little better from a probability standpoint. If the short stock position loses value due to the stock price rising, the potential loss is limited by the rising Call option value. If the stock price falls, the short stock position gains value and the option price approaches zero, creating an increasing profit potential. You may recognize that a position with limited risk from rising prices and almost unlimited profit from falling prices is exactly the description of a Put option, and in fact, the opposite of a Covered Call position is a synthetic Put. If you’re still following this, you’ll realize that a Covered Call is therefore the same as a short Put option, which most people would immediately recognize as being very risky.

There is still a problem with this position that a Market Maker would not like. If he guesses wrong and the stock price moves higher he loses money, even if it’s a limited amount. If nothing else, it just doesn’t feel good to lose money, so let’s improve the position by adding another Call option.

Sell 100 shares of Apple stock for $450/share

Buy two $475 Call options for $9.20/share

With the improved position above, the odds of making money are greatly increased and the market edge has shifted in our direction. If Apple stock crashes, we make a lot of money due to the short stock. If Apple stock soars, the 100 shares of short stock cancels out one of the Calls, but we are still left with a Call option that will make a lot of money. However, if the stock doesn’t move, the options will gradually lose time value and we will eventually lose the amount we paid for the options. Therefore, we still don’t have the edge, but we also aren’t holding the sucker bet of a Covered Call (i.e. short Put). Actually gaining a positive edge requires adjusting the position from time to time in order to capture value in relatively modest price moves in the stock, while maintaining the potential for big gains. This goes beyond the scope of this article.

Improving Your Chances

If you decide to try your luck at Black Jack and the extent of your knowledge is that the objective of the game is to reach 21, the dealer will probably take all of your money in fairly short order. The best way to play Black Jack is to be the dealer. The second best way is to learn the subtleties of the game, memorize the odds for any given combination of cards, and have an enormous capacity to keep track of what cards have been played (i.e. count cards). If you do this well enough, the casino manager will conclude that you have captured an edge and will promptly kick you out.

The best way to invest is to have the clout and wealth of Warren Buffett, or the resources and special privileges of a hedge fund, or become a U.S. Senator. The next best thing for most of us is to learn to recognize when we are giving away “edge”. Although most of us do not have the time and resources to invest exactly like a Market Maker, there are techniques we can utilize to avoid handing over a sizable portion of our money to the market on a regular basis.

In a casino, you can’t beat the odds forever. The same is true with investing.

Will History Repeat Itself? Examining the Stock Market Crash of 1929 and Economic Indicators of 2013

The end of World War 1 brought a new era into the United States; an era of enthusiasm, optimism, and confidence. This was a time when the industrial revolution was in full swing and new inventions, such as radio and airplanes, made anything seem possible. Capitalism was the economic model and nothing but good times seemed to appear on the horizon. It was this new era of optimism that enticed so many to take their savings and invest in various businesses and stock offering. And in the 1920s, the stock market was a promising favorite.

The Biggest Stock Market Boom in History

Even though the stock market is known for volatility, it didn’t appear so risky in the 1920s. The economy was thriving, and the stock market seemed like a logical investment strategy.

Wall Street quickly attracted a lot of investors. As more people invested, stock prices began to rise. The sudden spike in price first became noticeable in 1925. And then between 1925 and 1926, stock prices started to fluctuate. 1927 brought a strong upward trend, or bull market, which enticed even more people to invest. By 1928, the market was booming.

This booming market completely changed the way investors perceived the stock market. No longer were stocks viewed as long term investments, rather a quick way to become rich. Stock market investing had become the talk of the town, from barber shops to parties. Stock market success stories could be heard everywhere, newspapers and other forms of media reported stories of ordinary people – like teachers, construction workers, and maids, quickly getting rich quick off the market. Naturally this fueled the desire among the general population to invest.

Many newcomers wanted in, but not everyone had the money. This in turn led to what is known as buying on margin. Buying on margin meant that a buyer could put down some of their own money, and borrow the rest from a broker/dealer. In the 1920s, a buyer could invest 10-20% of their own money and borrow the remaining 80-90% to cover the stock price.

Now, buying on margin could be a risky endeavor. If the stock price dropped below a certain amount, the broker/dealer would issue a margin call. This meant the investor needed to come up with cash to repay the loan immediately, which often meant selling the underperforming stock.

In the 1920s, many people were buying stocks on margin. They seemed confident in the booming bear market, but many of these speculators neglected to objectively evaluate the risk they were taking and the probability that they might eventually be required to come up with cash to cover the loan to cover a call

The Calm before the Financial Storm

By early 1929, people across the country were rushing to get their money into the market. The profits and road to wealth seemed almost guaranteed and so many individual investors were putting their money into various companies stock offering. Sham companies were also set up with little federal or state oversight. What’s worse – even some unscrupulous bankers were using their customers’ money to buy stocks – and without their knowledge or consent!

While the market was climbing, everything seemed fine. When the great crash hit in October, many investors were in for a rude awakening. But most people never noticed the warning signs. How could they? The market always looks best before a fall.

For example; on March 25, 1929, the stock market took a mini-crash. This was a mere preview of what was to come. When prices dropped, panic set in throughout the country as margin calls were issued. During this time, a banker named Charles Mitchell announced his bank would continue to make loans, thus relieving some of the panic. However, this wasn’t enough to stop the inevitable crash as fear swept across the nation like a raging wildfire.

By spring of 1929, all economic indicators pointed towards a massive stock market correction. Steel production declined, home construction slowed, and car sales dwindled.

Similar to today, there were also a few reputable economists warning of an impending, major crash. But after several months without a crash in sight, those advising caution were labeled as lunatics and their warnings ignored.

The Great Summer Boom of 1929

In the summer of 1929, both the mini-crash and economists’ warnings were long forgotten as the market soared to all-time historical highs. For many, this upward climb seemed inevitable. And then on September 3, 1929, the market reached its peak with the Dow closing at 381.17.

Just two days later, the market took a turn for the worst.

At first, there was no major drop. Stock prices fluctuated through September and October until that frightful day history will never forget – Black Thursday, October 24, 1929.

On Thursday morning, investors all over the country woke up to watch their stocks fall. This led to a massive selling frenzy. Again, margin calls were issued. Investors all over the country watched the ticker as numbers dropped, revealing their financial doom.

By the afternoon, a group of bankers pooled their money to invest a sizable sum back into the stock market, thus relieving some panic and assuring some to stop selling.

The morning was traumatic, but the recovery happened fast. By the day’s end, people were reinvesting at what they thought were bargain prices.
12.9 million Shares were sold on Black Thursday. This doubled the previous record. Then just four days later, on October 28, 1929, the stock market collapsed again.

The Worst Day in Stock Market History

Black Tuesday, October 29, 1929, was the worst day in stock market history. The ticker become so overwhelmed with ‘sell’ orders that it fell behind, and investors had to wait in line while their stocks continued to fall. Investors panicked as they couldn’t sell their worthless stocks fast enough. Everyone was selling and almost no one buying, thus the price of stocks collapsed.

Instead of bankers attempting to persuade investors to buy more stocks, the word on the street was that even they were selling. This time over 16.4 million shares were sold, setting a new record.

Stock Market Freefall

Without any ideas on how to end the massive panic that gripped society, the decision to close the market for a few days was made. On Friday, November 1, 1929, the market closed. The market reopened again the following Monday, but only for limited hours, and then the price of stocks dropped again. This continued until November 23, 1929, when prices appeared to stabilize. But the bear market was far from over. During the next two years, stock prices steadily declined. Finally, on July 8th, 1932, the market had reached its lowest point when the Dow closed at 41.22.

In 1933 Congress Introduces the Glass-Steagall Act

In the midst of a nationwide commercial bank failure and the Great Depression, Congress members Senator Carter Glass (D-VA) and Representative Henry Steagall (D-AL) inked their signatures to what is today known as the Glass-Steagall Act (GSA). The GSA had two main provisions; creating the FDIC and prohibiting commercial banks from engaging in the investment business.

The Glass-Steagall Act was eventually repealed during the Clinton Administration via the Gramm-Leach-Bliley Act of 1999. Many financial professionals would have you believe the Glass-Steagall’s repeal contributed heavily to the financial crisis of 2008. And despite hard lessons once again learned, little was done by congress to restore public confidence and to reinstall safeguards or re-in act the Glass-Steagall Act. The lobbying pressure is just too much to overcome. Just like before the crash of 1929, again, there is no firewall between the major banks and investment firms and with little federal oversight. It’s a house of cards ready to fall once again.

However, Noble Prize Winner, Joseph Stiglitz of the Roosevelt Institute, had this to say:

“Commercial banks are not supposed to be high-risk ventures; they are supposed to manage other people’s money very conservatively. Investment banks, on the other hand, have traditionally managed rich people’s money – people who can take bigger risks in order to get bigger returns.”

The truth was that when the Glass-Steagall Act was repealed, it brought investment and commercial banks together for a profitable outcome. There was indeed a market for this style of high returns that required risk taking and high leverage. While some believe that repealing the GSA was a contributing factor of the 2008s financial crisis, one can’t help but wonder if the agency was actually hindering the competitive advantages of financial firms.

Allen Greenspan on Irrational Human Behavior in the Stock Market

Allen Greenspan, former Federal Reserve chairman stated in his new book, The Map and the Territory, they did all the economic mathematical calculations during his tenure, but failed to take into account irrational human behavior patterns triggered by strong emotions of fear and panic or desire for gain, which apparently run rampant in the stock market. The flip side of that is euphoria that can drive the market up to unrealistic highs, like now.

Since the financial crash of 2008, Greenspan stated he has been thinking a lot about bubbles. He has been trying to figure out why he along with so many other economic forecasters didn’t see the housing bubble that caused the crisis. Today, another housing bubble exists in China far greater in magnitude than any other country, and according to economist, Harry Dent, it’s a ticking time bomb poise to create economic havoc around the world when it detonates.

The Approaching Baby Boomer Retirement Bubble (2013 – 2015)?

Consider that 401(k) retirement plans are relatively recent platforms. They were first introduced in the early 1980’s and have primarily been funded by the baby boomer generation, which has driven stock prices to current levels.

As of 2013, baby boomers are retiring at the rate of about 10,000 per day. In most cases this means they are no longer working, or contributing to their plans and will be withdrawing from their 401(k) plans, likely already rolled over into Individual Retirement Plans. Could this massive retirement wave put us on the forefront of a record-shattering stock market correction as the last of the baby boomers move into retirement?

High-profile world economist, Harry Dent, most famous for his predicting Japan would suffer a financial correction lasting over a decade; has been publishing this research for years. He not only carefully analyses economic data, but demographic data as well.

Dent’s theory of a “baby boomer retirement wave” presents a disturbing reality. With 10,000 baby boomers spending and cashing in on their retirement accounts every day, these numbers suggests that the U.S. is heading down a dangerously similar slope as Japan years ago.

Dent’s research shows that when consumers age, their spending patterns change. For example; when baby boomers were starting families, they spent more and the economy flourished. When their children grew and left home, the boomers starting spending less, which led to a decline in the economy.

The same thing happened in Japan, when the working-age population peaked in 1995.

Dent predicts by 2015, we will see a similar scenario here in the United States, when there is a disproportionately high number of older people and a much smaller population of young productive people. With fewer people working and a larger segment of the population in the older age bracket, taxes will most likely have to increase for all segments of our population

Indeed the financial devastation the stock market crash inflicted on the economy in 1929 is almost unthinkable. A great majority of people lost their entire savings. Businesses went bankrupt, and peoples’ faith in banks was shattered. Some people jumped to death off of high rises after they lost their savings and were wiped out financially. Some banks went broke also, and people lost the money they had deposited in banks.

Banks foreclosed on numerous businesses and family farms. You couldn’t buy a job! Soup lines formed in major cities because no one had anymoney, there were no jobs to have, or money to feed themselves or their families. Fights broke out due to the anger and frustration and dire circumstances.

While certain regulations have added a layer of protection since then, like the federal deposit insurance of accounts up to $100,000. the stock market keeps its risky reputation. The truth is that another crash of a similar magnitude could be right around the corner as the baby boomer generation moves into retirement. The smartest thing an investor can do now is simply understand the shift that the market and economy is going through in order to profit from it.

Alternative Asset Classes Gain Popularity in Spite of Sluggish U.S. Economy

When institutional investors and billionaires like Warren Buffett start adjusting their portfolios and start selling various U.S stock positions it’s wise to pay attention. They are careful financial analyst and try to project and re-position themselves at all times. And, they are usually far ahead of the market in doing so. Even more important is finding out just what alternatives they’re using to grow their wealth. For example, Buffett has a thriving company, Berkshire Hathaway, and likes to add stability to his portfolio buying Life Settlement contracts, (an alternative asset class) for a total of $400 million dollars’ worth.

Major brokers and financial institutions generally don’t offer their clients information on these types of investment alternatives, and for a variety of reasons. In fact, less than 15% of financial professionals are even familiar with this asset class.

Since Life Settlements are insurance contracts with no ties to the market or economy, they offer individual investors a strategy to avoid a stomach turning stock market roller coaster ride and unpredictably of their hard earned dollars by offering double digit returns year after year.

As an investor, you can’t control the market or economy, but you can control your own personal economy.