Taming the Lion. Richard Farleigh
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1.4 The markets can overwhelm government intervention
In September 1985 the world's biggest governments met at the Plaza Hotel in New York and reached an agreement: the US dollar was over-valued and needed to fall.
The effect was stunning. With the market aware of the new “official” preference for a weaker dollar, and some ten billion worth of dollars sold into the market by the governments as a show of force, the dollar dropped dramatically. In the following two years or so, it halved in value versus the other major currencies. An astonishing success for government policy.
However, this success was more of an exception than a rule. In fact, markets are normally too big to be bullied.
Countries of all sizes have often been tempted to try to dictate the value of their currency by intervening in the markets. Sometimes they want to lower a strong currency, but more often they want to prop up a weak currency. In some cases a falling exchange rate can be seen as an embarrassing assessment of political integrity and economic performance.
So governments enter the market with one thing in mind: to move the price. They buy or sell aggressively, and may add to the drama with a big announcement about government policy and commitment. The effect is immediate. Like a shark at a beach they cause widespread panic. Speculators and dealing rooms all over the world scramble to adjust their positions, and the media give the news top priority.
It was in the middle of one such episode a few years ago, when I had the idea to investigate the longer term effect of government intervention. The government was intervening aggressively in the Australian dollar market and there was a flurry of activity around me in the dealing room. Looking at the prices flashing on the screen, I wondered if the market reaction was very long lasting. Sure enough, my subsequent research showed that while falling currencies typically bounce after government action, in less than a month or so, they resume on their downward path and continue to weaken towards fresh lows.
So by spotting this pattern I had found a new, profitable strategy. Whenever the market had this kind of knee-jerk reaction to government intervention, I would bet against it, on the assumption that the bounce was only temporary. I was effectively backing market fundamentals versus the government.
The fact that even governments, with all their muscle, cannot reverse the market has always impressed me. It shows the depth and efficiency of the financial markets.
Keep that in mind when you think that the market price is wrong.
1.5 The market is strengthened by speculation
Over the years I have heard a great deal of criticism about speculators. It often pops up when markets or currencies are having a dramatic fall. Funny, speculation doesn’t seem to bother so many people when it’s pushing prices higher. Should speculators be ashamed? No, the fact is that the market needs them.
Speculators add important liquidity. I often invest in small stocks, which would not have much daily turnover if it were not for speculators. The longer term holders of these stocks do not buy or sell very often, so when I need to find a buyer or a seller, it is a great benefit to have speculators as they are much more active.
Speculators also play an important role in absorbing risk that others don’t want. Wheat farmers, for example, may sell their crop well before harvest at a fixed price for a future delivery date. That way, they can remove the risk that there is a bumper season and an oversupply that forces prices lower. The buyers may be speculators who are happy to take on that risk – without the speculators, the farmers may have no one to sell to.
You often hear criticism of speculation based on the flawed argument that it pushes prices to unrealistic levels. The thing is though, speculators are usually punished when they do this, because if they are wrong about real values, they are usually the big losers. The tech boom and bust, where perhaps it was speculators who drove prices to very high levels, is a great example. Most of them paid very heavily when market prices crashed to a fraction of the higher levels. Though what a great opportunity it was for the more savvy investors to sell near the highs.
So, speculation is usually only successful when it is in line with the fundamentals, and when it is pushing prices to a level that more closely reflects fair value.
George Soros and Black Wednesday
A great example of this is George Soros. He has been criticised because his massive selling probably caused the devaluation of the British Pound in 1992. In fact the resulting weaker currency and lower interest rates saved the UK economy, because they were more appropriate for the conditions at the time. The date (16th September 1992) is known as ‘Black Wednesday’ because the currency was pushed out of the European Exchange Rate Mechanism (ERM), but in my view it should be renamed ‘White Wednesday’. That day is one reason that the UK has only five per cent unemployment, while Europe, which stuck with cripplingly high interest rates for way too long, has about ten per cent. The feeling was that Soros was a greedy speculator who made a billion pounds in profit, but in fact it has proved to be a very cheap price for the British, because the lower pound - and the resulting lower interest rates - allowed for a big improvement in the economy. If the man in the street knew how things worked, Soros would be seen as a hero, not a villain!
For this reason, many commentators are naïve when they criticise these price shocks and the speculators involved. It can be better to have wild swings in currencies and other prices than lots of people losing their livelihoods.
It was a similar case in the late 1990s, when Malaysian Prime Minister Mahathir attacked currency speculators because they were pushing down the value of his currency. Again, speculation wouldn’t have worked unless there was a solid reason behind it. A few years later, the consensus is that the currency was too high for the economic conditions at the time.
The speculator is often just the messenger.
1.6 Respect the market not the experts
The power of the financial markets should be daunting, but many people are not deterred.
I have friends in Monaco who are amateur currency traders. They don’t have the same experience, resources, or the skill, of a George Soros. Nor do they follow the disciplined approach to trading that is recommended in this book. It’s completely crazy that they think they can win. Why do people underestimate the difficulty of making money in the financial markets? I believe there are two main reasons.
The first, which I will discuss here, is the experts in the media. The second is the widely held belief that many professionals are regularly able to beat the market. This I will discuss in the following Strategy. I won’t dwell on a possible third reason, which is that some people like to trade the market because they are gamblers. That usually ends with disastrous results.
‘Experts’?
The experts in the media promote the idea that markets are easier than they really are. A guy on TV or in the newspaper says that the price is going to do this and do that, and it sounds easy. The market can be beaten.
If the media put out a continual broadcast that the market has processed all the information and that the price is right, people would get the message. But they rarely say that. The message is that the behaviour of the market can be forecasted. It’s a persistent and seductive message, and people think ‘ah, I can have a go at that, I can make money out of that’. You can’t blame the average person for following what they read in the newspaper and what they’re being told on TV. However, many so-called experts are just commentators or analysts who often don’t have any track record and who often, to my ear, don’t even make much sense. Follow my advice below and listen critically, rather than just accept what you’re hearing or reading. You may be surprised to find that they’re not really experts.
Not that I blame the media for their financial guesswork. It can be very entertaining. But like a lot of gossip, the fact