money flows and the consensus

The early nineteenth century in Europe was deeply concerned with questions of truth and permanence.  The ponderings (using the term that describes the famous exchanges of Pinky and The Brain) of people like Hegel and Schopenhauer on these topics yielded us the (then) revolutionary ideas of the historical dialectic and the love-hate relationship.  The central idea is that nothing lasts forever, that movements contain the seeds of their own destruction.   One day, out of the blue, true and false change places.

It’s a commonplace that stuff like this happens in the stock market.  After all, the cliché is that the market makes the greatest fools out of the largest number of people.  What’s unusual about the equity world, however, is that the reversals almost always lead the economic changes that will confirm their validity, often by a long time.  Relative valuation explains part of this.  But over the past twenty years, what we in hindsight clearly see as bubbles were able to reach epic proportions and endure for years before reversing themselves.  So that can’t be the entire story.

I think the other piece to the puzzle is money flow.

I first noticed this early in my career as an analyst.  In the late Seventies and early Eighties, there was a dominant technical analyst on Wall Street.  The CIO where I worked, who had been one of the most successful equity investors of the Seventies, hung on his every word.  And it was true that this analyst had an uncanny ability to call even the smallest twist and turn to the S&P 500.

How did he do this?  He was, of course, in constant contact with his firm’s trading desks, so he knew what the firm itself and its customers were buying and selling.  Like any sell-side analyst a large part of his job was marketing, so he spent maybe half his time traveling and meeting with clients.

Clients were always willing, if not eager, to discuss their investment ideas with him, for several reasons:

–everyone likes to have opinions, and to educate and amaze others by giving them, so little coaxing may have been needed,

–as our analyst became more renowned, clients wanted to hear his opinions, and

–because the analyst met with most of the important portfolio managers in the country, he had a very good idea of what they were thinking.  Clients wanted to hear this as well.

I happened to be very interested in technical analysis in those early days (if you’ve read my other posts on technical analysis, you’ll know I concluded it’s most times probably more useful than phrenology, but not by much), so I watched this analyst very carefully.  I even attended a technical analysts’ convention or two, filled with strange characters wearing buckskin jackets, where he spoke.  His method had three parts:

–visit the largest asset management companies and by conversing with as many portfolio managers as possible, determine what the market’s consensus portfolio structure and investment strategy were,

–study price/volume charts and talk with the trading desks to try to figure out how fully the PMs had implemented their ideas, and

–when he determined that most PMs had carried out their investment plans, he would recommend the opposite strategy!

In the simplest terms, his philosophy was that when everyone had bought (or sold) a given stock or sector, then the only possible action left was for the market to sell it.  He just helped the process along.

I think this is as true today as it ever was.  It’s why it’s important at potential turning points–when, as now, a strong consensus has been in place for a long time–to watch the money flows and price action for signs that a reversal is taking place and what the new direction may be.  Flows can reverse very quickly, too.

What happened to our technician?  He came to a typical Wall Street end.  Clients eventually worked out what he was doing.  It didn’t help that as he became more prominent, he inadvertently began to talk about his method more than he should have.  PMs continued to meet with him, but they began to lie to him about their plans.

He ended up telling clients in mid-1982, as a new bull market was beginning, that this was a false dawn and they should sell heavily into the rise.  He was never the same after that.

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