Don’t any of the academic studies consider the stock price trend before a number’s release?
No, they only look at whether a number beats the consensus expectations. Although this is still useful information, by considering other factors, such as the price trend in the stock before the release of the earnings report and the magnitude of the difference between reported earnings and expected earnings, you can significantly increase the probabilities of a successful trade.
For example, if I crossed a street without looking, I could decrease my chances of getting hit by a car by crossing at 2 A.M. instead of midday. That would be analogous to the information these academic studies use—it is worthwhile, but there is lots of room for improvement. What if I listened when I crossed the street? That would reduce the odds of my getting hit by a car even more. What if I not only listened, but looked one way? My survival odds would increase further. What If I looked both ways? I would increase my chances even more. That’s what we’re doing in our analysis. We are trying to increase the probabilities of a trade being successful as much as possible.
Therefore, as an example, I assume that if a stock moved down before a positive earnings surprise, it increases the probabilities of a bullish market response.
Absolutely. If a stock goes down before a report because of negative expectations and then there is a positive earnings surprise, there will be shorts who have to cover, new investors who want to buy, and a completely undiscounted event. In this type of situation you can get a tremendous response in the stock.
But won’t the stock gap up sharply after earnings are reported and eliminate the profit opportunity?
The stock price will go up, but usually it will not fully discount the change. That is one of the problems with the efficient market hypothesis. The market doesn’t discount all information instantaneously.
What happens when you put on a position before a report because you anticipate a better-than-expected figure and the actual number is worse than expected or vice versa?
We just get out, usually right away. We make lots of trades, and I make mistakes all the time. Every day I come in and get humbled [he laughs].
The whole Street focuses on events that provide catalysts; what gives you the edge?
Our whole focus is looking for catalysts. It’s not just part of our strategy; it is our strategy.
How do you decide when to get out of a position?
One thing that has been tremendously helpful is the use of time stops. For every trade I put on, I have a time window within which the trade should work. If something doesn’t happen within the time stop, the market is probably not going to discount that event.
What is your balance between longs and shorts?
Our net position averages about 40 percent net long and has ranged between 90 percent net long and 10 percent net short. A typical breakdown would be 50 percent long and 10 percent short, with the remainder in cash.
That’s a pretty large portion to keep in cash.
We have a dual mission: to make money for our investors and to preserve capital. Keeping about 40 percent in cash acts as a performance stabilizer.
How are you able to trounce the index returns while keeping such a large portion of your capital in cash?
We look at our business like a grocery store. You can get leverage in two ways: by taking on larger positions or by turnover. Just like a grocery store, we’re constantly getting inventory in and moving it out the door. If we have a piece of meat that’s going bad, we mark it down to get rid of it.
Typically, how long might you hold a position?
On average, about two to four weeks.
What percent of your trades are profitable?
Just over 70 percent.
Do you use technical analysis?
We use technical analysis not because we think it means something, but because other people think it means something. We are always looking for market participants to take us out of a trade, and in that sense, knowing the technical points at which people are likely to be buying or selling is helpful.
Do you use the Internet as an information source?
The main thing I use on the Internet is TheStreet.com. I like Jim Cramer’s running market commentary. This Web page is one of the best Internet resources available to the ordinary investor. One thing I would caution investors about, however, is paying attention to chat rooms, where the information can be very tainted because people have an agenda.
Are there trades that have provided valuable lessons?
Hundreds. When you order business cards, you get a huge stack of them. I hardly ever hand out any business cards because I am not in marketing. Instead, I use the back of my business cards to jot down trade lessons. For any trade that I find instructive regarding market behavior, I’ll write down the stock symbol and a brief summary of what I think I learned from the trade. That’s how I developed and continue to build my trading model.
I believe that writing down your trading philosophy is a tremendously valuable exercise for any investor. Writing down your trading ideas helps clarify your thought process. I can remember spending many weekends at the library writing down my investment philosophy: what catalysts I was looking for; how I expected them to affect a stock; and how I would interpret different price responses. I must have accumulated over five hundred pages of trading philosophy. Frankly, it was a lot of drudge work, and I could only do it for so long in one sitting. But the process was invaluable in developing my trading approach.
What other advice do you have for investors?
One of the benefits of having been a retail broker is that I got to see a lot of people’s mistakes. Based on this experience, the most important advice I can offer investors is: Have a plan. Know why you are buying a stock, and know what you are looking for on the trade. If you just take a step back and think about what you are doing, you can avoid a lot of mistakes.
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Masters’s approach can be summarized as a four-step process:
1. Learn from experience. For any trade that is instructive (winner or loser), write down what you learned about the market from that trade. It doesn’t make any difference whether you keep a trader’s diary or use the back of business cards, as Masters does; the important thing is that you methodically record market lessons as they occur.
2. Develop a trading philosophy. Compile your experience-based trading lessons into a coherent trading philosophy. Two points should be made here. First, by definition, this step will be unachievable by beginners because it will take the experience of many trades to develop a meaningful trading philosophy. Second, this step is a dynamic process; as a trader gathers more experience and knowledge, the existing philosophy should be revised accordingly.
3. Define high-probability trades. Use your trading philosophy to develop a methodology for identifying high-probability trades. The idea is to look for trades that exhibit several of the characteristics you have identified as having some predictive value. Even if each condition provides only a marginal edge, the combination of several such conditions can provide a trade with a significant edge.
4. Have a plan. Know how you will get into a trade, and know how you will get out of the trade. Many investors make the mistake of only focusing on the former of these two requirements. Masters not only has a specific method for selecting and entering trades, but he also has a plan for liquidating trades. He will exit a trade whenever one of the following three conditions are met: (a) his profit objective for the trade is realized; (b) the expected catalyst fails to develop or the stock fails to respond as anticipated; (c) the stock fails to respond within a predefined length of time (the “time stop” is triggered).
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Update on Michael Masters
Masters managed to maintain his profitability during the first two calendar years of the bear market, albeit at more moderate levels, but three-quarters of the way through 2002, he seemed in danger of experiencing his first losing year. Since the start of
2000 through September 2002, he was up 13 percent. While this return may not sound all that impressive and is far below his previous pace, it is worth noting that during the corresponding period, the S&P 500 was down 45 percent and the Nasdaq plummeted 71 percent.
What is your view of the current market?
It has all the earmarks of a classic bear market. The Nasdaq during the past couple of years looks very similar to the Dow from late 1929 through 1932.
Why are you comparing the 1929 Dow to the current Nasdaq as opposed to the current Dow or even the S&P 500?
Just because they look very similar on the charts.
What are the implications of that comparison?
The implications are simply that the percentage price declines could end up being very similar. During 1929–1932, the Dow declined nearly 90 percent. At the recent lows [July 2002], the Nasdaq had fallen nearly 82 percent from its March 2000 peak. Of course, another near 8 percent decline measured relative to the peak would imply another 40 percent plus decline measured relative to the recent low. I don’t necessarily believe we need to match the 1929–1932 bear market since current economic conditions are obviously far better than they were in the Great Depression. But then again, in terms of the average annual price rise, the 1990s bull market was more extreme than the 1920s bull market.
What are your long-term expectations for the market?
I think the indexes will maintain a broad trading range, much like we experienced in the late 1970s. We will probably see bullish phases where the market rallies by 30 percent or more, but these will likely be followed by one-to two-year bear markets.
From an investor’s perspective, it almost sounds like you are anticipating an average annual return near the dividend yield for the next five to ten years.
I think that’s probably a reasonable estimate. I don’t think you’ll get much more than that.
Well, that’s a fairly bearish outlook. It certainly implies significant underperformance relative to the market’s long-term average of near 10 percent per year. What makes you so negative?
It’s primarily a reversion to the mean argument.
In other words, the excess on the upside was so extreme that we are probably facing a long-term period of underperformance.
Yes, that’s my assumption. Although I believe Fed efforts to avoid deflation—a stance made more likely by the experience of Japan in the 1990s—will lead to earnings growth, this improvement will come at the expense of higher inflation and reduced multiples. The net result should be close to a wash for long-term equity prices. Commodities, however, will probably do very well over the long run because the Fed has no choice but to inflate.
Of course, if you are right, it implies that bonds, which are at long-term highs, will trend lower over the long run. The irony is that many people who have been burned in the stock market and are seeking “safety” in the bond market will probably compound the damage by losing money in bonds. *
Yes, if you’re placing money in bonds as a long-term investment, you are essentially betting that we will repeat the Japanese experience—that is, that the Fed won’t be successful in avoiding deflation—which is not a bet I would make.
How is trading in the bear market different from trading in the bull market?
The symmetry between the euphoric bull market of 1999 and this year’s unrelenting bear market is quite amazing. In 1999, a company announcement that it was expanding its business to the Internet would be sufficient to propel its stock price $20 higher overnight. This year, a Wall Street Journal story about a company’s accounting is enough to trigger a near instantaneous $20 decline in the stock price. So you are seeing the same type of crazy price moves, except they are on the downside instead of the upside. The fear in 2002 is just as intense as the greed in 1999. The analogy is that long positions are now subject to the same type of sudden large irrational adverse price moves as short positions were in the 1999 bull market. However, just as in 1999, I believe the current situation will be temporary.
What advice would you have for investors at this juncture?
I think the only way you will make money in the U.S. stock market over the next ten years is by adopting a contrarian approach. Whenever there is panic in the air, as there was in July 2002, you have to be a willing buyer, even though you may not want to be. Then if a year later, prices have rebounded and optimism appears to be returning to the market, you will have to get out. In other words, if you can do the opposite of what people around you are doing, you should be able to make good returns.
The contrarian approach went out of style in the 1990s because people just wanted what was hot. But if you go back to the 1960s and 1970s, the only way to make money was to be a buyer near the lower part of the trading range and a seller near the upper part of the range. I believe we are facing a similar situation over the next five to ten years, or longer.
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JOHN BENDER
Questioning the Obvious
If John Bender is right about options*—and, given his performance, there is good reason to believe he is—then virtually everyone else is wrong. Bender asserts that the option pricing theory developed by Nobel Prize–winning economists, which underlies virtually all option pricing models used by traders worldwide, is fundamentally flawed. This contention is not just a theoretical argument; Bender’s entire methodology is based on betting against the price implications of conventional option models. Bender places trades that will profit if his model’s estimates of price probabilities are more accurate than those implied by prevailing option prices, which more closely reflect standard option pricing models.
Bender has maintained a surprisingly low profile, in view of the large sums of money he is managing and his excellent performance. His fund did not show up in any of the industry databases I checked. As was the case for the majority of interview subjects in this book and its two predecessors, I found Bender through networking with industry contacts.
Bender graduated with high honors from the University of Pennsylvania in 1988, receiving a degree in biophysics. During his summers as an undergraduate, Bender held several scientific jobs, including positions at Livermore Labs and the Marine Biological Laboratories at Woods Hole. Although he liked science, he was disenchanted because the career scientists he observed were forced to spend much of their time seeking grants instead of doing research. At the same time, he became intrigued with the markets and saw that they provided a challenging application for his analytical skills.
Bender began trading his own account after graduation, but he had only a few thousand dollars of risk capital. After a year, he was able to raise $80,000 in financial backing. He traded this account from August 1989 through March 1995, averaging a compounded annual return of 187 percent during this period, with only three losing quarters, the worst being an 11 percent decline.
After taking a sabbatical, Bender launched his fund in August 1996, with returns over the subsequent three and a half years averaging 33 percent. Although still quite respectable, you might wonder what caused this steep decline in returns relative to the performance in his personal account in prior years. The answer is very simple: leverage. For the fund, Bender reduced his leverage by a factor of approximately 4 to 1 (which because of the effect of monthly compounding reduced the annual return by a greater amount), placing a strong emphasis on risk control. To date, the fund’s worst decline from an equity peak to a subsequent low has been only 6 percent. In addition to managing hundreds of millions in his own fund, Bender also manages an undisclosed allocation from the Quantum fund, for which he trades currency options.
It is quite common for Market Wizards to use a portion of their substantial trading profits to support favorite charities or causes. I found one of Bender’s uses for his winnings particularly noteworthy for its originality, long-lasting impact, and hands-on directness in mitigating a problem before the opportunity for action disappears: He is buying up thousands of acres of the Costa Rican rain forest to pr
otect this area from destruction by developers.
A day before leaving for New York City to conduct interviews for this book, I learned that Bender was scheduled to be in the city at the same time. Since he lives in Virginia, which is not near any of the other traders I planned to interview, it seemed convenient to arrange a meeting on our mutually coincident visit to New York. The only problem was that my schedule was already booked solid. We decided to meet for a late dinner. To simplify the logistics, Bender booked a room at my hotel.
We met in our hotel lobby before leaving for dinner. It was an extremely warm summer evening. Bender was wearing a suit and tie, while I had considered substituting Dockers for jeans a sufficient concession to being dressed for dinner. Bender, who had made the reservations, expressed concern whether I would be allowed into the restaurant dressed as I was and suggested calling to make sure. I assured him that I usually did not encounter any problems because of my casual dress. He seemed almost disappointed when this proved to be the case. As the evening progressed, I became aware that Bender was clearly uncomfortable in his suit and tie, which was obviously atypical dress for him as well, and somewhat envious of the fact that I had gotten away going casual. His large frame seemed to strain in his more formal clothes.
The interview was conducted over a wonderful multicourse meal in a sushi restaurant. We left nearly four hours later, just short of midnight, when we suddenly realized that we were the last remaining diners and that the staff was milling about impatiently, waiting for us to depart. We took a brief break upon returning to the hotel, I to visit my orphaned wife, who had accompanied me to the city, and Bender to check on trades on the Tokyo Stock Exchange in which his firm is a heavy participant. When we met again in the hotel lobby fifteen minutes later, Bender was wearing shorts, a sloppy T-shirt, and a look of relief at having been freed from his suit and tie. The interview finished at three-thirty in the morning as the second of my three-hour tapes rolled to an end.
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