Every once and a while, I sit back, relax, and think about *what is the market* to me and how to understand it better. Below is one of my thought about a subject as complex as the Market. What is the Market to you?
The market is like the invisible version of our natural environment. Many creatures live in the market assuming, often unconsciously, specific roles (species) in the “food-supply-chain” of the market: from global macro trader, liquidity provider, long term fundamental investor, value trader, momentum trader, arbitrageur, scalper, noise trader, etc. We are at once the predator of certain species and the prey for other species.
When certain imbalance in the environment occur, either triggered internally or externally, certain species are supplied more abundantly by mother nature. When this season come, the predator which most efficiently capture the bonanza will prosper. What these minority predator posses are tools to identify the arrival of the season, tools to capture the prey, and the wisdom to use these tools to position themselves close to the prey and capture them.
Like all things, season comes to an end as more predator comes forward to join the party. Eventually, the predator species grow too large that overall they should weakened to maintain a balanced ecosystem. Being late in the season and/or inefficient in catching, the late comer are not sufficiently nourished thus weakened and became easy prey for other species.
Like mother nature, which is regularly nourished by energy from the sun, the market is nourished by creator of money, our central banker. Just as it takes many life cycles before the sun energy nourish most creatures through the food chain, newly created money will take some time to nourish general market populations. Ironically, too much sun energy will destroy the whole ecosystem as everything is burned. So is the market.
Abundant supply of certain species tend to spread. If we see a bunch of game, chances are we will see a lot more of them nearby. Thus it helps to get hold of the map and see where the wind blows.
The main difference between us in the market and creatures in natural environment is the fact that we can choose what species to assume. In addition, we can also choose to join or leave the market at will. Both differences make the composition of species in the market ecosystem capable of changing dramatically. This causes the market to be relatively unstable with imbalances of various magnitude occurring every now and then.
For those skilled, every imbalance creates certain abundant food potential, given the right tools to know which season this is, the wisdom to assume what species, the tools to capture the prey, and the ability to execute the abundant prey.
While some tools are structurally more superior than others, it will not be effective on all seasons. Fastest leg of a lion won’t help him much if there is not much deer around. Similarly, most sophisticated momentum method won’t be of much use if there is not much momentum around.
I believe there are three basic form of reliable foods in the market: momentum, value (reversal), and volatility. These foods are created by actions of certain species in the market ecosystem. Momentum stems from tendency of market prices to trend. This perhaps originated from the fact that in all industry, eventually certain winners will emerge, acquiring the best talent, resources, and clients. In addition, institutional players might have a tendency to execute trades over longer duration due to their size. Short term Value (reversal) tends to occur after panic or forced selling. Volatility price (insurance) tends to get expensive as people get panicky and experience recent disaster. After long period of calm, however, volatility price tends to get depressed.
At any point in time, at least one of the three forms of reliable foods are abundantly created in the market place. Asness (2009), Value and Momentum Everywhere, has done an incredible job in documenting the prevalence of momentum and value effects in virtually every markets. He shows both momentum and value have positive expectancy and negative correlation, thus wonderful to mix. What is perhaps missing is prevalence of volatility mispricing and how to capture them using options strategies, and mix with the other two source of returns.