Part 3
Most coming events cast their shadows before, and it is on this that intelligent speculation must be based. The movement of prices in anticipation of such an event is called “discounting,” and this process of discounting is worthy a little careful examination.
The first point to be borne in mind is that some events cannot be discounted, even by the supposed omniscience of the great banking interests—which is in point of fact, more than half imaginary. The San Francisco earthquake is the standard example of an event which could not be foreseen and therefore could not be discounted; but an event does not have to be purely an “act of God” to be undiscountable. There can be no question that our great bankers have been as much in the dark in regard to some recent Supreme Court decisions as the smallest “piker” in the customers’ room of an odd-lot brokerage house.
If the effect of an event does not make itself felt before the event takes place, it must come after. In all discussion of discounting we must bear this fact in mind in order that our subject may not run away with us.
On the other hand an event may sometimes be overdiscounted. If the dividend rate on a stock is to be raised from four to five per cent., earnest bulls, with an eye to their own commitments, may spread rumors of six or seven per cent., so that the actual declaration of five per cent. may be received as disappointing and cause a decline.
Generally speaking, every event which is under the control of capitalists associated with the property, or any financial condition which is subject to the management of combined banking interests, is likely to be pretty thoroughly discounted before it occurs. There is never any lack of capital to take advantage of a sure thing, even though it may be known in advance to only a few persons.
The extent to which future business conditions are known to “insiders” is, however, usually overestimated. So much depends, especially in America, upon the size of the crops, the temper of the people, and the policies adopted by leading politicians, that the future of business becomes a very complicated problem. No power can drive the American people. Any control over their action has to be exercised by cajolery or by devious and circuitous methods.
Moreover, public opinion is becoming more volatile and changeable year by year, owing to the quicker spread of information and the rapid multiplication of the reading public. One can easily imagine that some of our older financiers must be saying to themselves, “If I had only had my present capital in 1870, or else had the conditions of 1870 to work on today!”
A fair idea of when the discounting process will be completed may usually be formed by studying conditions from every angle. The great question is, when will the buying or selling become most general and urgent? In 1907, for example, the safest and best time to buy the sound dividend-paying stocks was on the Monday following the bank statement which showed the greatest decrease in reserves. The markets opened down several points under pressure of liquidation, and standard issues never sold so low afterward. The simple explanation was that conditions had become so bad that they could not get any worse without utter ruin, which all parties must and did unite to prevent.
Likewise in the Presidential campaign of 1900, the lowest prices were made on Bryan’s nomination. Everyone said at once, “He can’t be elected.” Therefore his nomination was the worst that could happen—the point of time where the political news became most intensely bearish. As the campaign developed his defeat became more and more certain, and prices continued to rise in accordance with the general economic and financial conditions of the period.
It is not the discounting of an event thus known in advance to capitalists, that presents the greatest difficulties, but cases where considerable uncertainty exists, so that even the clearest mind and the most accurate information can result only in a balancing of probabilities, with the scale perhaps inclined to a greater or less degree in one direction or the other.
In some cases the uncertainty which precedes such an event is more depressing than the worst that can happen afterward. An example is a Supreme Court decision upon a previously undetermined public policy which has kept business men so much in the dark that they feared to go ahead with any important plans. This was the case at the time of the Northern Securities decision in 1904. “Big business” could easily enough adjust itself to either result. It was the uncertainty that was bearish. Hence the decision was practically discounted in advance, no matter what it might prove to be.
This was not true to the same extent of the Standard Oil and American Tobacco decisions of 1911, because those decisions were an earnest of more trouble to come. The decisions were greeted by a temporary spurt of activity, based on the theory that the removal of uncertainty was the important thing; but a sensational decline started soon after and was not checked until the announcement that the Government would prosecute the United States Steel Corporation. This was deemed the worst that could happen for some time to come, and was followed by a considerable advance.
More commonly, when an event is uncertain the market estimates the chances with considerable nicety. Each trader backs his own opinion, strongly if he feels confident, moderately if he still has a few doubts which he cannot down. The result of these opposing views may be stationary prices, or a market fluctuating nervously within a narrow range, or a movement in either direction, greater or smaller in proportion to the more or less emphatic preponderance of the buying or selling.
Of course it must always be remembered that it is the dollars that count, not the number of buyers or sellers. A few great capitalists having advance information which they regard as accurate, may more than counterbalance thousands of small traders who hold an opposite opinion. In fact, this is a condition very frequently seen, as explained in a previous chapter.
Even the operations of an individual investor usually have an effect on prices pretty accurately adjusted to his opinions. When he believes prices are low and everything favors an upward movement, he will strain his resources in order to accumulate as heavy a load of securities as he can carry. After a fair advance, if he sees the development of some factor which _might_ cause a decline—though he doesn’t really believe it will—he thinks it wise to lighten his load somewhat and make sure of some of his accumulated profits. Later when he feels that prices are “high enough,” he is a liberal seller; and if some danger appears while the level of quoted values continues high, he “cleans house,” to be ready for whatever may come. Then if what he considers an unwarranted speculation carries prices still higher, he is very likely to sell a few hundred shares short by way of occupying his capital and his mind.
It is, however, the variation of opinion among different men that has the largest influence in making the market responsive to changing conditions. A development which causes one trader to lighten his line of stocks may be regarded as harmless or even beneficial by another, so that he maintains his position or perhaps buys more. Out of a world-wide mixture of varying ideas, personalities and information emerges the average level of prices—the true index number of investment conditions.
The necessary result of the above line of reasoning is that not only probabilities but even rather remote possibilities are reflected in the market. Hardly any event can happen of sufficient importance to attract general attention which some process of reasoning cannot construe as bullish and some other process interpret as bearish. Doubtless even our old friend of the news columns to the effect that “the necessary activities of a nation of ninety million souls create and maintain a large volume of business,” may influence some red-blooded optimist to buy 100 Union; but the grouchy pessimist who has eaten too many doughnuts for breakfast will accept the statement as an evidence of the scarcity of real bull news and will likely enough sell 100 Union short on the strength of it.
It is the overextended speculator who causes most of the fluctuations that look absurd to the sober observer. It does not take much to make a man buy when he is short of stocks “up to his neck.” A bit of news which he would regard as insignificant at any other time will then assume an exaggerated importance in his eyes. His fears increase in geometrical proportion to the size of his line of stocks. Likewise the overloaded bull may begin to “throw his stocks” on some absurd story of a war between Honduras and Roumania, without even stopping to look up the geographical location of the countries involved.
Fluctuations based on absurdities are always relatively small. They are due to an exaggerated fear of what “the other fellow” may do. Personally, you do not fear a war between Honduras and Roumania; but may not the rumor be seized upon by the bears as an excuse for a raid? And you have too many stocks to be comfortable if such a break should occur. Moreover, even if the bears do not raid the market, will there not be a considerable number of persons who, like yourself, will fear such a raid, and will therefore lighten their load of stocks, thus causing some decline?
The professional trader, following this line of reasoning to the limit, eventually comes to base all his operations for short turns in the market not on the facts but on what he believes the facts will cause others to do—or more accurately, perhaps, on what he _sees_ that the news _is_ causing others to do; for such a trader is likely to keep his finger constantly on the pulse of buying and selling as it throbs on the floor of the Exchange or as recorded on the tape.
The non-professional, however, will do well not to let his mind stray too far into the unknown territory of what others may do. Like the “They” theory of values, it is dangerous ground in that it leads toward the abdication of common sense; and after all, others may not prove to be such fools as we think they are. While the market is likely to discount even a possibility, the chances are very much against _our_ being able to discount the possibility profitably.
In this matter of discounting, as in connection with most other stock market phenomena, the most useful hint that can be given is to avoid all efforts to reduce the movement of prices to rules, measures, or similarities and to analyze each case by itself. Historical parallels are likely to be misleading. Every situation is new, though usually composed of familiar elements. Each element must be weighed by itself and the probable result of the combination estimated. In most cases the problem is by no means impossible, but the student must learn to look into the future and to consider the present only as a guide to the future. Extreme prices will come at the time when the news is most emphatic and most widely disseminated. When that point is passed the question must always be, “What next?”
V—Confusing the Personal with the General
In a previous chapter the fact has been mentioned that one of the greatest difficulties encountered by the active trader is that of keeping his mind in a balanced and unprejudiced condition when he is heavily committed to either the long or short side of the market. Unconsciously to himself, he permits his judgment to be swayed by his hopes.
A former large speculator on the Chicago Board of Trade, after being short of the market and very bearish on wheat for a long time, one day surprised all his friends by covering everything, going long a moderate amount, and arguing violently on the bull side. For two days he maintained this position, but the market failed to go up. He then turned back to the short side, and had even more bear arguments at his tongue’s end than before.
To a certain extent he did this to test the market, but still more to test himself—to see whether, by changing front and taking the other side, he could persuade himself out of his bearish opinions. When even this failed to make any real change in his views, he was reassured and was ready for a new and more aggressive campaign on the short side.
There is nothing peculiar about this condition. While it is especially difficult to maintain a balanced mind in regard to commitments in the markets, it is not easy to do so about anything that closely touches our personal interests. As a rule we can find plenty of reasons for doing what we very much want to do, and we are still more prolific with excuses for not doing what we don’t want to do. Most of us change the old sophism “Whatever is, is right” to the more directly useful form “Whatever I want is right.” To many readers will occur at once the name of a man prominent in public life who seems very frequently to act on this motto.
If Smith and Jones have a verbal agreement, which afterwards turns out to be greatly to Jones’ advantage, Smith’s recollection is that it was merely a loose understanding which could be cancelled at any time, while Jones remembers it to have been a definite legal contract, perfectly enforceable if it had only been written. Talleyrand said that language was given us for the purpose of concealing thought. Likewise many seem to think that logic was given us for the purpose of backing up our desires.
Few persons are so introspective as to be able to tell where this bias in favor of their own interests begins and where it leaves off. Still fewer bother to make the effort to tell. To a great extent we train our judgment to lend itself to our selfish interests. The question with us is not so much whether we have the facts of a situation correctly in mind, as whether we can “put it over.”
When it comes to buying and selling stocks, there is no such thing as “putting it over.” The market is relentless. It cannot be budged by our sophistries. It will respond exactly to the forces and personalities which are working upon it, with no more regard for our opinions than if we couldn’t vote. We cannot work for our own interests as in other lines of business—we can only fit our interests to the facts.
To make the greatest success it is necessary for the trader to forget entirely his own position _in_ the market, his profits or losses, the relation of present prices to the point where he bought or sold, and to fix his thoughts upon the position _of_ the market. If the market is going down the trader must sell, no matter whether he has a profit or a loss, whether he bought a year ago or two minutes ago.
How far the average trader is from attaining this point of view is quickly seen from his conversation, and it is also true that a great deal of the literature of speculation absolutely fails to reach this conception.
“You have five points profit—you had better take it,” advises the broker. Perhaps so, if you know nothing about the market; but if you understand the market the time to take your profit is when the upward movement shows signs of culminating, regardless of your own deal.
“Stop your losses; let your profits run” is a saying which appeals to the novice as the essence of wisdom. But the whole question is _where_ to stop the losses and _how far_ to let the profits run. In other words, what is the _market_ going to do? If you can tell this your personal losses and profits will take care of themselves.
Here is a man who has done a great deal of figuring and has proved to his own satisfaction that seven points is the correct profit to take in Union Pacific, while losses should be limited to two and one-half points. Nothing could be more foolish than these arbitrary figures. He is trying to make the market fit itself around his own trades, instead of adapting his trades to the market.
In any broker’s office you will notice that a large part of the talk concerns the profits and losses of the traders. Brown had a profit of ten points and then let it get away from him. “Great Scott!” says his wise friend. “What do you want? Aren’t you satisfied with ten points profit?” The reply should be, though it rarely is, “Certainly not, if I think the market is going higher.”
“Get them out with a small profit,” I once heard one broker say to another. “If you don’t they will hang on and take a loss. They never get profit enough to satisfy them.” A good policy, probably, if neither the broker nor his customer had any real knowledge of the market; but mere nonsense for the trader who aims to be in the slightest degree scientific.
The fact is that the more a trader allows his mind to dwell upon his own position in the market the more likely it is that his judgment will become warped so that his mind is blind to those considerations which do not fall in with his preconceived opinion.
Until you try it, you have almost no idea of the extent to which you may be rendered unreasonable by the mere fact that you are committed to one side of the market. “In the market, to be consistent is to be stubborn,” some one has said; and it is true that the man of strong will and logical intellect is often less successful than the more shallow and volatile observer, who is ready to whiffle about like the weathercock at any suspicion of a change in the wind. This is because the strong man has in this instance embarked upon an enterprise where he cannot use his natural force and determination—he can employ only his faculties of observation and interpretation. Yet in the end the man of character will be the more permanently successful, because he will eventually master his subject more thoroughly and attain a more judicial attitude.
The more simple-minded, after once committing themselves to a position, are thereafter chiefly influenced and supported by the illusions of hope. They bought, probably, as a result of some bullish development. If prices have advanced, they find that the market “looks strong,” a good deal of encouraging news comes out on the tickers, and they hope for large profits. After five points in their favor, they hope for ten, and after ten they look for fifteen or twenty.
On the other hand, if prices decline they charge it to “manipulation,” “bear raids,” etc., and expect an early recovery. Much of the bear news appears to them to be put out maliciously, in order to cause prices to decline further. It is not until the decline begins to cause a painful encroachment upon their capital that they reach the point of saying, “If ‘they’ can depress prices like this in the face of a bullish situation, what is the use of fighting them? By a flood of short sales, they can put prices down as much as they like”—or something of the sort.
Such traders are suffering merely from youth, or lack of sound business sense, or both. They have a considerable period of study before them, if they persist until they get permanently profitable results. Most of them, of course, do not persist.
A much more intelligent class, many of whom are properly to be considered as investors, do not allow their position in the market to blind them so far as current news or statistical developments are concerned, but do permit themselves to become biased in regard to the most important factor of all—the effect of a change in the price level.
They bought stocks in the expectation of an improved situation. The improved situation comes and prices rise. Nothing serious in the way of bear news appears. On the contrary, bull news continues plentiful. Under these conditions they see no reason for selling.
Yet there may be a most important reason for selling—namely, that prices have risen sufficiently to counterbalance the improved situation—and they would see and appreciate this fact if they were in the position of an uninterested observer.
One of the principal reasons why investors of this class allow themselves to become confused as to the influence of the price level is because a bull market nearly always goes unreasonably high before it culminates. The investor has perhaps, in several previous instances, sold out at what he thought was a fair price level, only to see the public run away with the market to a point where his profits would have been doubled if he had held on.
It is in such cases that an expert knowledge of speculation is essential. If the investor has not this knowledge, and cannot obtain the dependable advice of one who has it, then he must content himself with more moderate profits and forego the expectation of getting the full benefit of the advance. But with a fair knowledge of speculative influences, he can fix his mind on the development of the campaign, regardless of his own holdings, and can usually secure a larger profit than if he depended merely upon ordinary business “common sense.”
The mistake is made when, without any expert knowledge of speculation, he permits himself to hold on in the hope of higher prices after a level has been reached which has fairly discounted improved business conditions.
Not one trader in a thousand ever becomes so expert or so seasoned as to entirely overcome the influence his position in the market exerts upon his judgment. That influence appears in the most insidious and elusive ways. One of the principal difficulties of the expert is in preventing his active imagination from causing him to see what he is looking for just because he is looking for it.
An example will make this clear. The expert has learned from experience, let us say, that the appearance of “holes” in the market is a sign of weakness. By a “hole” is meant a condition of the market where it suddenly and unaccountably refuses to take stock. A few hundred shares of an active stock are offered for sale. Sentiment is generally bullish, but there is no buyer for that stock. Prices slip quickly down half a point or a point before buyers are found. This, in an active stock, is unusual; and although the price may recover, the professional does not forget this treacherous failure of the market to accept moderate offerings. He considers it a sign of an “over-bought” market.
Now suppose the trader has calculated that an advance is about to culminate and has taken the short side in anticipation of that event. He suspects that the market is over-bought, but is not yet sure of it. Under these circumstances any little dip in the price will perhaps look to him like a “hole,” even though under other conditions he would not notice it or would think nothing about it. He is looking for the development of weakness and there is danger that his imagination may show him what he is looking for even though it isn’t there!