The following is from The Philosopher in Drobny’s classic The Invisible Hands (emphasis mine):
Some people can trade markets using only numbers, prices on a screen but this approach does not work for me. The numbers have to mean something — I have to understand the fundamental drivers behind the numbers. And while fundamentals are important, they are only one of many important inputs to the process. Just as a Value-at-Risk (VaR) model alone cannot tell you what your overall risk is, economic analysis alone cannot tell you where the bond market should be.
Let us use an interest rate trade around central bank policy as a straightforward example to illustrate my process. Economic drivers will create the framework: What is the outlook for growth, inflation, employment, and other key variables? What will the reaction of the central bank be? We then build a model of the potential outcomes of these economic drivers, weighting them according to probabilistic assumptions about our expectations. We look at what the central bank could do in each scenario, comparing this with market prices to see if there are any interesting differences. When differences exist, we then think about what can drive those differences to widen or converge.
It is important to note that a key element to this exercise is the fact that what other people believe will happen is just as important as the eventual outcome. A market is not a truth mechanism, but rather an interaction of human beings whereby their expectations, beliefs, hopes, and fears shape overall market prices.
A good example of this psychological element can be seen in inflation. At the end of 2008, U.S. government fixed income was pricing in deflation forever. At that point, the only thing of interest to me was the question of whether people might think that there could be inflation at some point in the future. Quantitative easing made it easy to answer this question affirmatively, because there are many monetarists in the world who believe that the quantity of money is the driver of inflation. Whether they are right or not is a problem for the future — what is important to me is that such people exist today. Their existence makes the market pricing for U.S. long bonds completely lopsided. Such pricing only makes sense if you are a died-in-the-wool output gapper who believes that when unemployment goes up, inflation goes down, end of story. Market prices reflect the probability of potential future outcomes at that moment, not the outcomes themselves. Some people do not believe in the output gap theory of inflation, and these people believe that pricing for U.S. bonds should be somewhere else. Because these two divergent schools of thought exist, it is possible that market sentiment can shift from deflation to inflation and that pricing will follow.
One way to think about my process is to view markets in terms of the range of reasonable opinions. The opinion that we are going to have declining and low inflation for the next decade is entirely reasonable. The opinion that we are going to have inflation because central banks have printed trillions of dollars is also reasonable. While most pundits and many market participants try to decide which potential outcome will be the right one, I am much more interested in finding out where the market is mispricing that skew of probabilities. If the market is pricing that inflation will go to the moon, then I will start talking about unemployment rates, wages going down, and how we are going to have disinflation. If you tell me the markets are pricing deflation forever, I will start talking about the quantity theory of money, explaining how this skews outcomes the other way. Most market participants I know do not think in these terms. The market is extremely poor at pricing macroeconomics. People always talk about being forward-looking, but few actually are. People tell stories to rationalize historical price action more frequently than they use potential future hypotheses to work out where prices could be.
Beauty contests… Playing the player… Second level thinking… Viewing markets as a range of reasonable outcomes… These are points we write about over and over. And that’s because the overarching concept is so important and yet so misunderstood.
Let me give you an example.
Your average retail trader (and even most “professionals”) read in the paper, magazines, blogs, etc. that Europe is on the brink of collapse. Deutsche bank is teetering on insolvency… populism is rising… the UK is leaving… it’s all going to hell in a handbasket.
They think to themselves, “Man, Europe is in trouble. I need to short some European banks and sell the euro.”
But those playing the game at the second level and above read the same articles and come away with a completely different train of thought:
Bearish sentiment on Europe is really reaching a zenith… Every market pundit and blogger is railing about how bad Europe is… Bearish positioning is extremely one-sided as there’s definite market consensus… Which means this narrative is likely baked into the price as everybody who’s going to sell has already sold… And if the public narrative is this bearish then the central bankers will be too… So they’ll err on the dovish side for the foreseeable future… Which means that the entire market is standing on the wrong side of the boat… I need to buy Deutsche call options and go long the euro.
The first level thinkers are part of the herd and the second level thinkers are the wranglers anticipating where the dumb herd will swing to next.
First level traders believe trading is about correctly predicting the future. They are wrong.
Successful trading is about understanding prevailing market expectations.
Understand the narrative and you can understand the key drivers. Understand the key drivers and you can identify the fulcrum point of the narrative (the data point that if changed, will force a new narrative to be adopted).
Then you take this understanding and closely watch how reality unfolds in comparison to expectations, all while keeping an eye on divergences (mispricings) that create asymmetric trade opportunities.
Here’s the Palindrome (George Soros) on the topic (emphasis mine).
There is always a divergence between prevailing expectations and the actual course of events. Financial success depends on the ability to anticipate prevailing expectations and not real-world developments. But, as we have seen, my approach rarely produces firm predictions even about the future course of financial markets; it is only a framework for understanding the course of events as they unfold. If it has any validity it is because the theoretical framework corresponds to the way that financial markets operate. That means that the markets themselves can be viewed as formulating hypotheses about the future and then submitting them to the test of the actual course of events. The hypotheses that survive the test are reinforced; those that fail are discarded. The main difference between me and the markets is that the markets seem to engage in a process of trial and error without the participants fully understanding what is going on, while I do it consciously. Presumably that is why I can do better than the market.
Understand that the things you read in the paper, see on Twitter, or hear on TV, are all popular knowledge — in game theory this is knowns as common or mutual knowledge. The more widely known the information, the more likely it’s already been discounted by the market.
Markets lead the news… not the other way around.
Truly understanding this and applying it is how you become an effective contrarian. And operating as an effective contrarian is the only way you can win in the game of speculation.
If you want to learn how to become an effective contrarian, then check out our Trading Instructional Guide here.