What to expect as the markets reopen
The hours after U.S. markets reopen Monday are likely to be disorienting at best and extremely volatile at worst. One pro offers some perspective.
By Jon D. Markman
When U.S. stock markets finally reopen for business Monday, it’ll be more than just another day at work for professional traders around the country. The pros will plunge into a price-discovery process that is expected to be characterized by huge swings until much more is known about the extent to which real economic losses suffered by insurance, airline, property and retail companies on Sept. 11 will be offset by potential gains in construction, defense and technology infrastructure companies in the future.
Despite the many unknowns, professional traders of commodity futures are accustomed to shocks out of the blue that leave big gaps in prices. Whether it’s a hurricane that wipes out a large portion of the world coffee crop in Central America or a pipeline explosion that curtails deliveries of oil from the North Sea, pros have a game plan for reacting and trading amid deep uncertainty.
To learn how one veteran expects to trade the first day back at work, I talked to Linda Bradford-Raschke, a longtime trader of commodities, stocks and bonds. Made famous in the investment community when featured as a “Market Wizard” in a book by the same name a decade ago, she runs money for her own firm, LBR Group, out of offices in Boca Raton, Fla.
Look to overseas markets
Linda characterizes “price shocks” as violent gaps in price that are not predictable. Following a price shock, she expects to see much greater than normal trading ranges for both stocks and major indexes, gradually dampening over a five-day period and then flattening out significantly 20 days later.
She advises that both pros and individuals first try to subtract the cause of the price shock from their thinking and focus on the institutional trading environment that has reigned the past 18 months. It has been lousy. Major market players, she believes, are short the market and have made a long-term psychological shift to the belief that stock valuation levels need to gravitate back toward their historical means. If that’s true, she says, then even a 10% decline in prices at the open will not get stocks back to the historical mean, and any rebounds to the upside will be met by avid selling.
Linda assumes that the market will open down to an extent equivalent to foreign markets, or about 5% to 8%. That would put the Dow Jones Industrials Average ($INDU) at somewhere between 8,836 and 9,124 -- around the level of the April lows -- and the Nasdaq ($COMPX) between 1,476 and 1,559. She believes that this will not be true panic selling, however, because the emotional component of surprise is missing. Rather it will be a pragmatic reaction to the real, fundamental losses and prospective losses to property and sales, whether it’s lower buying at The Gap (GPS, news, msgs) in your neighborhood because you were glued to the television the past two days; a sharp decline in vacation travel that will crimp the airlines; or a sharp decline in retail commission revenue at stock brokerages as individuals step aside.
Sellers lie in wait
Next, market players know that the market can stabilize and rebound rather quickly as the Federal Reserve has made it tacitly clear that it would provide liquidity – a fancy word for very cheap money – to banks or brokerages who buy stocks and index futures in bulk. Essentially, the Fed will loosen its credit requirements and allow banks to take on greater than normal risk as buyers.
What happens next is a game of chicken played by many different players with different agendas as the psychology of uncertainty takes over. You’ve got Chicago pit traders who are going to make trades for five minutes, Fidelity Investments mutual fund traders who might try to liquidate big positions on every rally, and Morgan Stanley proprietary account traders putting money to work on every dip. All together, they make up the collective market that we will all see in action on the first day.
Linda believes that any rally that materializes off the initial low will fail because there are so many sellers overhead. There will be margin calls and mutual fund redemptions that will cause institutions to sell whenever possible, she believes. It’s easier to think about this in the context of individual stocks. There is little doubt that the airline business has suffered real economic losses, and will continue to suffer in the future from a fearful public. Who’s going to buy those stocks at lower prices? Linda says that the market “specialists” will buy them initially because it’s their job to maintain stability, but they will be happy to sell them up a buck or two. Buyers, she believes, are going to be pros trying to capture a short-term market inefficiency and will sell them back out for small gains.
Linda characterizes all of this as a “price discovery process” as market participants seek a new equilibrium level for the stock or market. A few notes from her playbook:
The one thing you can count on is that there will be euphoria on rallies and hope that the worst is over. On sell-offs back to the lows there will be despair that their markets won’t hold or ever go up again.
The first reactions in both directions tend to be the greatest.
After the initial plunge in price, don’t make a bet about what the price will do next. Expect it to move up or down from that first price, and then come back again.
Pros will wait for the first swing off the opening price to “fade” the next move – making what is known as a “counter-trend” trade.
To limit risk, traders should lower the amount of leverage, or margin, that they use and play for shorter durations.
The real test
Now let’s elaborate a bit. Let’s say you come into the market on the first day short a stock like insurance giant American International Group (AIG, news, msgs). She believes the first step down is the best time to cover, or buy back the stock and take profits. If you’re long AIG and it sells off, then you should wait for it to come back a bit in a rally. “The first rally will be the one to exit on, because it’s like a game of chicken,” she says. “Everyone waits to see how far a stock will move in one direction. As soon as the tape starts to turn, and the price starts to slow down – let’s say from $66 to $66.50 to $66.75 and then fluctuates around those last two prices and begins to roll back over, anyone who is long will take their profits and shorts will begin to try to push it in the opposite direction.”
What happens next, Linda says, is a series of tests. Tests to the upside and tests to the downside but increasingly in a smaller range. If the last sell off came at $66.875, then the next one will come at $66.75 and the next at $66.50. Swings will get smaller and smaller until everyone knows what the market price is, it achieves stability, and traders await new fundamental information.
While this kind of advice might apply mostly to pros, what about individuals? Linda recommends that an investor holding 300 shares of American International Group think about the prospect for rise in value of the dollar amount invested – not just the prospect for that precise company. “Rather than saying, ‘I have 300 shares of AIG but I think it will come back in two years,’ think that you have $22,000 in an investment. Can I get a better return on that investment in another company?”
Ultimately both individual stocks and the overall market will achieve a new equilibrium from the price shock, she believes, from which it will start a new trend. After the crash of 1987, she points out, a lot of stocks saw their lows the first week of the shock but it was two years before they recouped all their losses. She believes that eventually the bear market will just take its toll and volatility will decline dramatically, non-professionals will forget all about the stock market and the seeds of a new bull market will be sown.
And then it will be time for new rules, and a new outlook. |
