The Prettiest Girl on the Floor

If markets are always right how come they are always changing?

Ben Stein

Ben Stein’s snarky observation in this Sunday’s New York Times, put a smile on my face and got me thinking about John Maynard Keynes. I’ve written about Keynes before noting that while he is recognized as the most influential economist of the 20^th century, few people realize that he was also one the greatest traders of all time. Unlike most pointy headed academicians, Keynes understood that markets - and for that matter all business activity - were controlled more by emotion rather than reason.

Rather than trying to construct complex mathematical solutions, Keynes produced a psychological model to explain the dynamics of the market. It is quite bittersweet to see the accuracy of his approach in light of the fact that so many “brilliant” quantitative hedge funds chuck full of “the smartest people on earth” relying on some of the most complex financial algorithms ever created, experienced double digit losses this month. One of the more famous of those funds, Goldman Sachs’ Alpha fund is located in the same building on Wall Street as our company and as I came in to work this week, looking at the signatures of Goldman traders on the building’s sign-in ledger I often wondered what they must be thinking now.

Perhaps they would have been better off reading a bit of Keynes who had a decidedly non-academic view on how the markets worked. Keynes likened the markets to a beauty contest. It was the traders job to find and identify the contestant that the majority of the audience would find the most beautiful. Setting the anachronistic sexism of the metaphor aside, let’s focus on what Keynes actually meant by this idea. Note that Keynes specifically emphasized that the trader should not judge contestants by the trader’s personal standards of beauty, but rather try to figure out how the crowd would make its choice. This was Keynes’ great insight into trading, teaching us that our view does not matter. Only the market’s opinion matters. As speculators it is our job to figure out how the majority will feel on any given day and then construct a trade based upon that hypothesis.

In the currency market, there was only one question to answer this week. Risk or no risk? Depending on how well you handicapped that question on any given day resulted in whether you won or lost. It was almost immaterial what currency pair you chose to trade. During moments of risk aversion yen rose and all other majors declined against the dollar and during periods of risk assumption the reverse dynamic ruled true. Fortunately we were correct in our assessment two out of three times catching EURCHF for 57 points and EURUSD for 52 points.

Indeed reduced to their Keynesian terms, the markets are actually quite easy to comprehend. “Understand the story, understand the trade,” is the catchy little phrase we often use in our trading seminars, It is, of course easier said than done. Stories can turn on a dime as unexpected news changes the crowd’s opinion. Still as traders this approach offers us the best chance for success. It also helps us to properly deal with losing trades. Instead of viewing those trades as some signs of our personal inadequacy we should accept them for what they really are – occasional mistakes in our ability to gauge crowd behavior. Looked from that perspective stops are then not some sort of moral transgressions but rather proper expressions of mature decisions making. After all, the key to being a well developed, grown up individual is our ability to accept mistakes graciously. Is there anything more pathetic and infantile than an adult man or woman who refuse to see the error of their ways throwing an emotional temper tantrum in the process?

If nothing else, Keynes “beauty pageant” model teaches us to not take the markets too seriously which in turn provides us the proper distance to make mature, adult like decisions with respect to each trade.

Have a great weekend.

We’ll be back next week with more trade ideas.

B & K

posted by BKTrader  # 8/26/2007 05:24:00 AM