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How Markets Work – 1

Most people struggle to become good investors.

They struggle because they never properly learn how financial markets work. They don’t understand why stocks, bonds and other financial assets go up at certain times times and why they go down at others.

If we don’t understand why markets go up and down we can never anticipate when they will go up and down? We must understand markets in order to correctly time our investment decisions.

Some writers claim financial markets cannot be timed. After reading this book it will be patently obvious to you that writers offering such a view do not understand financial markets.

Investing without an understanding of markets is like playing polo without knowing how to ride a horse or like scuba diving without knowing how to swim. It is essential knowledge.

Like any worthwhile activity, investing requires a proper foundation of knowledge. There are millions of small investors. Remarkably few even remotely understand how markets work.

Knowledge of how markets work is rare because nobody ever explains it.

To be sure, hundreds of books have been written on investment. However, none of these books offers a full and practical explanation of how financial markets work: Why financial markets go up and down and when.

This book seeks to rectify this remarkable oversight. This is the first book that truly explains how financial markets works to the small investor.

I have kept this book as short as possible. It is an introduction, not an exhaustive study.

Hopefully others will be inspired to expand and improve upon my efforts.

With the introductions complete, let’s get into it.

Three factors drive all of the major trends we observe in financial asset prices. These factors are growth, inflation and risk appetite.

The interplay between these three factors determines the price trends we observe across all financial assets.

Before we can identify how these factors impact financial markets, we must first learn how to measure them.

Every day financial markets digest a barrage of information on growth, inflation and measures of risk. This data impacts markets in the short term as the numbers are released. In the longer term, however, financial markets make very little use of this high frequency data.

Longer term financial market trends are linked to longer term trends in economic conditions.

If we wish to understand the true underlying link between financial markets and economic data we must ignore the noise and information overload of short term economic data

Growth is simply a measure of how much income and spending in the economy is expanding. With respect to growth, all markets really care about is how far away is the next recession — and whether growth is accelerating or slowing down. These are the only aspects of growth we need to measure. We don’t need all the detail that economists and the financial media like to offer us.

Inflation is a measure of how fast prices are rising in an economy.

Risk is a measure of the probability that borrowers will default. When it comes to risk, markets care whether interest rates are rising or falling. Rising interest rates increase the cost of servicing debt and so increase the likelihood that borrowers will be unable to repay their debts. All we need is to be able to measure the trend in interest rates.

Once you can see how these factors impact markets, you will quickly gain an instinctive understanding of how markets work. You will learn when US stocks are a low risk investment and when they are high risk. You will learn the conditions under which emerging markets offer a better alternative to US stocks. You will learn when high yield bonds likely to be a better investment than stocks and when it is advisable to stick to the safety of Treasuries. You will learn when it is essential to hold gold and when gold is almost certain to fall. You will learn to anticipate rising or falling oil prices.

Having learned the mechanics of markets, you will be better prepared for investment success.

Be warned, however. In real life financial markets are highly uncertain. Volatility obscures underlying markets trends. Investing is like flying a plane without instruments at night through a storm. One is never completely certain of the true of the

The art of being a good investor is about being able to make good decisions on a consistent basis. The best way to do this is to impose some simple rules on our decision making process. But,to ensure success we need an understanding of how markets work. This book will give you the building blocks to become a better investor.

One reason is that this can be a complex subject. It is difficult to explain nand really needs a book in itself. That kind of book might not sell as well as one offering to turn you into Warren Buffett within 24 hours.

Another reason is that very few books on investment are written by true market professionals — guys who have lived and breathed the markets for decades. Most are written by professional authors, self-appointed gurus, academics and guys who have traded for a few years. These writers might have interesting insights but will not possess the intuitive understanding one gets from working in markets over a lifetime. Would you read a book on hunting by a man who has never been to a forest? Would you read a book on the secrets of a good marriage by a lady who has only been married for five years?

Tthere are good books on investment written by experienced market practitioners. However, these books always assume that the mechanics of how markets work is known. Experienced investors have been in markets so long they have an instinctive understanding how markets work and, importantly, they assume everyone else does too. Unfortunately, life doesn’t work this way.

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This, then, is the first book to offer the individual investor a practical understanding of how financial markets actually work: Why different assets perform better at different times and how you can exploit this knowledge to invest.

However, I don’t want to give you the impression that investment is a cookie cutter exercise. It requires a lot of psychological strength. Becoming a good investor is mostly about developing the right mindset to be able to make good decisions. So, this book does not simnply plonk down the facts of how markets work. It attempts to present these facts as part of a bigger picture of understanding the whole investment process. As such, there is a little bit of wax-on wax-off in the way that this book develops an understanding of markets.

The good investor ignores noise and focuses on the forces that drive the long term market trends. These trends refelect the slow evolution of consensus market thinking and are the only aspect of the markets that have meaning and can thus be understood. Markets might act fast but in reality they think slow. Section 4 explains that the only way to properly understand how markets think is to slow them down so you can reveal the forces that cause market trends. This is the meat and potatoes of understanding markets — slow everything down

For the most part, markets only care about three things: growth, inflation and the cost of capital. But to trruly see how these three forces impact markets, you need to need to know how to look at growth, inflation and interest rates in the same way as the markets. Markets think about everything in terms of cycles: the growth cycle, the inflation cycle and the interest rate cycle. Once you know how to see these cycles, the mystery of financial markets melts away; the workings of the markets becomes mundane.

Section 4 introduces the three economic cycles and shows how they drive the relative performance of all asset classes such as stocks versus bonds, commodities versus property. Section 4 also shows how how the cycles drive relative preformance within asset classes such as the US dollar versus the euro, high yield bonds versus long dated Treasuries, emerging markets versus developed markets, or the financial sector versus the energy sector.

Everything, absolutely everything in markets that matters, can be explained with reference to the economic cycles in growth, inflation and the cost of capital.

To be sure, we can improve our assessment of the market condition by using other information on valuations, positioning and sentiment but these are secondary. They can help our market timing but not our understanding.

The fifth and final step to becoming a good investor comes when we accept that we cannot see the future. This observation might seem trite but with some investigation you will discover that the entire investment industry bases its investment decisions on some forecast or another. Even the investment process in this book is based on an expectation that fundmental forces that have driven markets in the past will continue to drive markets in the future. Value investors

worthless until it is applied. Section 5 explains the final layer of market understanding which is the knowledge of how we draw the three economic cycles into an investment process. Section 5 offers two investment strategies that exploit our understanding of the economic cycles, a $25,000 portfolio and a $100,000 portfolio. Either of these portfolios will outperform hedge and pension fund returns over the medium to longer term with low risk and minimal effort.

Hopefully this book will teach you how to look at financial markets with clarity. Without a sense of the fundamental forces that drive financial markets, they will always be confusing and it will be impossible to act with confidence. Without confidence one can never achieve control. Horror movies are only scary until we reach the point where we understand the nature of the evil our heros must confront. Once the evil is known, uncertainty dissipates and our heroes begin to gain control. At bthat point the movie loses its edge.

Of course many investors do proceed without understanding. Like victims in a horror movie, they willingly wander alone into darkened rooms. Small investors take this risk because they are focused on the promise of high returns (before even knowing what a good return is). This is understandable because most investment books are sold on the basis that anyone can “beat the market”. This is the marketing pitch that sells books. It appeals to people’s greed and it appeals the ego.

Books that talk about beating the market encourage novice investors to think they can be predators in a world they do not understand; a world where they lack basic survival skills; and a world where they are in fact the natural prey.

Investment is not about beating the market. This is an artificial concept. It encourages the idea that investing is a contest where we show ourselves to be smarter than the market. However this approach to investing put the ego at centre-stage and invites emotional thinking. Investing is not an intellectual challenge, it is a psychological challenge. It is a challenge to over-rule our emotions and it is a challenge to understand and invest in harmony with the natural rythhm of the markets. The only battle we fight when investing is with ourselves, not with the market. We are merely a part of the markets, like a fisherman is a part of the sea. An investor cannot beat the market any more than a fisherman can beat the ocean. It is a foolish, egotistical notion. Markets offer a return in the same way that the ocean offers fish. The wise investor simply gathers whatever bounty the markets provide.

Almost every book on investment ever written offers some scheme to “beat the market”. However, the truth is that investing has nothing to do with beating anything. And it has nothing whatsoever to do with being smart.

Investing, like hunting, is about understanding: understanding the environment and understanding your own limitations, what you can achieve in that environment.

Only when we understand the financial markets and our limitations within them, can we learn how to exploit their natural bounty. Investing is about learning to work with the financial environment, not against it.

Like nature, the financial world is capricious. Circumstances change. What worked last year, even yesterday, might not work today. The proficient investor must be humble. He must recognize his limitations. He must be willing to change. The proficient investor adapts to the ever-changing financial environment.

  • Why this book is unique:
    i. A good scuba diver must know how to swim. A good pilot must know how to navigate. A good investor must know how financial markets work;
    ii. This is the first book ever written for the small investor that properly explains, in simple terms, why markets go up and why they go down; why different asset classes perform better at different times; and how one should recognize and position for the different phases of the investment cycle;
    iii. This is the first book to offer an active investment method that is designed to overcome the psychological shortcomings of the individual investor. Like the safety on a gun, the investment system in this book is designed to protect you from your own foolishness;
    iv. Finally, this is the first book on investment to align the psychology and philosophy of investment with the true intent of the investment process, which is the attainment of freedom. As with all worthy pursuits, freedom is found not in the destination but in the manner in which one undertakes the journey.

We face two principal weaknesses when we invest: i) Other people often have superior information; and ii) We are all terrible at making decisions under conditions of uncertainty. The first problem is easy to fix, don’t compete where you are disadvantaged, but the second problem is deep. It is biological and has to do with the way our brains are wired. As a consequence, we all make a lot of mistakes when investing and we are forced to admit error far more often than we are used to in the normal course of our lives.

Chapters 5 and 6 illustrate how the principle of knowing the environment is applied to investing. In these chapters we get down to the business of explaining how financial markets actually work. The underlying mechanics of markets are comparatively simple. Growth and inflation drive markets but their influence cannot be seen at the normal speed and volatility of the markets. Both must be slowed down before their influence can be seen. Markets move in cycles and the influence of growth and inflation can only be observed in that cyclical context. This is an example of the value of patience.
Chapter 5 explains how inflation influences asset market returns while Chapter 6 reveals the influence of growth.
Once the process is slowed down, regular patterns emerge and the movement of financial markets becomes no more mysterious than the regular patterns that we associate with the changing of the seasons in nature.
After reading chapters 5 and 6 you will understand why asset prices go up and down, why returns are better in some years than others, why some asset classes perform better at different times, and so why it makes sense to hold different combinations of assets in different environments.
The more we understand how our financial environment works, the less uncertainty we face and the better our decisions will be. As we begin to link events to causes, patterns emerge and the apparent randomness of financial markets dissipates. By only focusing on the primary trends in growth and inflation, Grey Gull is able to ignore the noise and uncertainty of financial markets and focus on only that which is essential.
Once you can see the regular patterns at work beneath the noise and chaos of financial markets, you will quickly begin to appreciate the possibility of exploiting those trends. Chapter 7 explains to apply the principle of creating opportunity. In it we develop a set of rules to exploit the patterns observed in Chapters 5 and 6. These rules form the basis of the Grey Gull method of tactical asset allocation. By following these rules, and with a minimum of effort, you will achieve consistent long term investment returns that are as good as, if not superior to, most hedge funds.

Chapters 5 and 6 illustrate how the principle of knowing the environment is applied to investing. In these chapters we get down to the business of explaining how financial markets actually work. The underlying mechanics of markets are comparatively simple. Growth and inflation drive markets but their influence cannot be seen at the normal speed and volatility of the markets. Both must be slowed down before their influence can be seen. Markets move in cycles and the influence of growth and inflation can only be observed in that cyclical context. This is an example of the value of patience.
Chapter 5 explains how inflation influences asset market returns while Chapter 6 reveals the influence of growth.
Once the process is slowed down, regular patterns emerge and the movement of financial markets becomes no more mysterious than the regular patterns that we associate with the changing of the seasons in nature.
After reading chapters 5 and 6 you will understand why asset prices go up and down, why returns are better in some years than others, why some asset classes perform better at different times, and so why it makes sense to hold different combinations of assets in different environments.
The more we understand how our financial environment works, the less uncertainty we face and the better our decisions will be. As we begin to link events to causes, patterns emerge and the apparent randomness of financial markets dissipates. By only focusing on the primary trends in growth and inflation, Grey Gull is able to ignore the noise and uncertainty of financial markets and focus on only that which is essential.
Once you can see the regular patterns at work beneath the noise and chaos of financial markets, you will quickly begin to appreciate the possibility of exploiting those trends. Chapter 7 explains to apply the principle of creating opportunity. In it we develop a set of rules to exploit the patterns observed in Chapters 5 and 6. These rules form the basis of the Grey Gull method of tactical asset allocation. By following these rules, and with a minimum of effort, you will achieve consistent long term investment returns that are as good as, if not superior to, most hedge funds.

Right now people love passive investments because, believe it or not, the past 30 years have been in the best investment environment in history. Bond yields have continually fallen and, because of this, leverage has soared. Because of this real estate and stock prices in most countries have performed strongly. For the past 30 years, central banks around the world have gone out of their way to encourage people to take risk and to reward those who took on the most debt. In such an environment, passive investment could not help but succeed.

But this environment of explosive credit creation has its limits. It will not last forever and when it ends, passive investors will be destroyed.
Being passive, does not mean you are not making decisions. When markets are historically expensive, passive investing is a decision to lock in low returns at high risk. Similarly, avoiding risk when markets offer maximum return is a decision to lock in low returns.

There are times when it is foolish not alter one’s risk but this requires an understanding of how markets work and how to invest. In order to be able to act at the right time, one must be at least somewhat active. If one is passive and never follows the markets, one will never know when or how to lower risk?

“No battle plan survives contact with the enemy”
Sun Tzu

We now address the fourth principle of freedom, which is to know your environment.How do financial markets actually work?

We can make this question as complicated as we like because financial markets are enormously complex.However, investment is like war in the sense that once you begin to invest circumstances become very confused very quickly. Thus, as Sun Tzu suggests, there is not much point in having a complicated battle plan. It is better to have a simple battle plan that you can stick to.

Three key factors drive financial markets: (i) growth; (ii) inflation; and (iii) the level and rate of change in interest rates. Since interest rates are, in turn, driven by growth and inflation, they complicate the story enormously and I will leave them out of this discussion. I will address interest at another time.

Since the impact of inflation on financial markets is simpler than the impact of growth, I will deal with inflation first.

Inflation refers to the rate of change of the price of goods and services in the economy. Average prices are measured by indexes, the most widely known being the Consumer Price Index, or CPI for short. The inflation rate is the annual rate of change in this index. The faster the CPI is rising, the higher is the inflation rate. Deflation occurs when the CPI is falling.

This chart shows the US CPI inflation rate since 1960. I like to look at the inflation rate in comparison to the 8-year moving average. If the CPI is above this moving average, I say the inflation rate is running above trend and vice versa.

US-Inflation


Fig: Inflation versus 8 year average

Inflation rate has an enormous impact on financial markets. Inflation influences financial markets in three important ways:

  1. A higher inflation rate destroys value generally pushes up

A good investor anticipates the financial environment like a hunter anticipates his prey. An experienced good hunter does not wander aimlessly through the forest hoping to stumble on a buck. He knows a buck only ever wants food and water or it wants cover. He knows the home range of his buck; where it will like to feed; how far it will bed from water and from feeding areas; and he knows how to spot advantageous ground where his buck will likely travel or bed.
A hunter evaluates the risks and opportunities of the forest in exactly the same way as a buck would do. If a hunter thinks like a buck, he will know where the buck might be found.
Investors, like bucks, are simple creatures of habit. They only ever want returns (i.e. food) or they seek cover. These basic motivations mean they always react the same way the same way to the basic stimuli of growth, inflation and risk. Once we recognize this basic truth, it becomes easy to anticipate how markets will behave.
I must emphasize that none of this has anything to do with forecasts. Nobody can see the future and the GreyGull investment process does not use forecasts. We don’t forecast, we just focus on what we can see today.
At the risk of overdoing the analogies, investing is like sailing. You don’t sail a boat according to where you think the wind will be in an hour. You sail about according to where the wind is coming from now, and how strong the wind is now. What might happen in the future is irrelevant.
We invest according to present conditions only. To accomplish this take, we need tools to properly measure growth, inflation and risk. We don’t need to forecast these conditions we just need to know what they are now. If these conditions change, we change the portfolio.
You might think that this means we have to change the portfolio a lot but it doesn’t because the fundamental forces that drive markets are slow moving. That is the precise reason why markets trend. GreyGull invests to catch market trends. To do this well, we don’t have to take a view on what markets will do next; on how far a trend will run; or when a particular trend will turn.

  1. Understand how markets work
    Before we can follow investment rules, we must understand how financial markets work. By focusing only on the slow moving fundamental forces that drive primary market trends, we are able to identify clear and reliable patterns that repeat again and again. These patterns allow us to understand how markets work and allow us to invest in line with primary financial market trends.
    If this book achieves nothing else, I hope it gives the reader a clear understanding how financial markets actually work: why they go up and down; when they go up and down; and thus, when to invest in different assets and why.
    By far the best way to reduce the noise and uncertainty of markets is to understand how they work. Once you have this knowledge I guarantee you will begin to think of investing as being a natural activity, like farming or fishing than as some kind of intellectual challenge.
    Hundreds of books have been written on investment. It amazes me that none, not one, attempts to convey a knowledge of how financial markets actually work. This knowledge is not optional, it is elemental to investing. It baffles me. How can one possibly invest without understanding how markets work? It’s like scuba diving without learning how to swim.
    Existing books on investment are long on investment method but short on understanding. They mostly feed the ego. They promise small investors that they can be predators in a world where they are, in fact, the prey.
    This book begins from the assumption that people must know how financial markets work before they can make rational investment decisions amid the noise and uncertainty of markets.

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