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Pricking Bubbles 102

March 24, 2000
Name of module:     Pricking bubbles 102
Course requirements:     Growing Bubbles 101
Market Psychology 102
6 months experience as a day trader
Reference materials:     These course notes
Speeches of Federal Reserve Board Chairmen
Extensive NYSE market data (10 minute intervals)
Description:     This is an extra-curricular module that is recommended to all students who intend to follow a career in Government with the intention of reaching the top of the pyramid, or who aspire to sit on the Federal Reserve Board or to become staff members to the House or Senate [a change from the previous version, which mentioned the SEC, in response to comments from a reader, Jonathan S. Thanks.]



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Lecture 2     Alternative strategies available to a Crash Prevention Team (CPT)
Introduction:     Of levers

In the first lecture we discussed the danger bursting bubbles hold for all Authorities in power. Politicians in particular get highly upset when they find themselves with the fall-out of a Market Crash – which is how Bubbles end – in the form of a Depression.

If it happens during their Administration, they lose the next election. When the party in opposition wins the next election, 4 years are far too little time to haul the economy back onto an even keel out of the Depression that followed, so that they in turn lose the next election. Then their opposition gets the credit for the recovery that begins to take place., while they have to face the prospect of at least two terms out in the cold.

It is therefore desired by all parties in the political spectrum to avoid playing the game of musical Administrations, which can be done by preventing a Market Crash.

For the man in the street the effects of a Market Crash are typically quite severe, more than just changing one seating place for another. For many it could mean exchanging one address for another, where the second is often fleeting and frequently left in a hurry.

One problem in trying to hold the Bubble aloft is that the weight of funds in the market in a mature Bubble is enormous. When that massive weight starts off on a downward course, total collapse into a Market Crash can only be prevented by a correspondingly large force. Since such a force is absent the market and, even if one could find the resources somewhere to halt a threatening descent into the abyss, their employment would attract attention and some awkward questions.

The solution to this problem can be found in a saying by Archimedes, the old Greek philosopher. In a statement that reveals an insight almost as startling as his well known "Eureka" discovery while lying in a bath tub, Archimedes said, "Give me a lever long enough and a fulcrum on which to rest it, and I will move the Earth." The question is which lever to use and how to adjust the fulcrum to best effect – task that should not be impossible as even Wall Street doesn't measure up to the weight of the Earth.


Prior to the 1987 Market Panic – almost a Market Crash, but the latter was prevented by a sudden and massive increase in liquidity, which at that time worked well, as it did again in 1998, because consumers were not nearly as over-borrowed as they are at the start of the year 2000 – futures played a relatively small part in all equity markets. Since then the situation has changed dramatically. Open positions in the futures and other derivatives and the daily turnover in nominal value on futures and options markets by far exceed the action in equity markets all over the world.

While not strictly what Archimedes meant by a long enough lever and suitable fulcrum, the derivatives markets do make available a force that might be massive enough to counter any inclination by equity markets to descend rapidly into the depths from where they had risen so steeply during the past few years of the Bubble, i.e. to Crash.

The objective of a CPT is not to push equity markets to new highs, but merely to prevent the kind of sell-off that could trigger a Panic on those days when some Bad News have become known or are expected to become known during the trading day. Prices of most leading stocks are already in the stratosphere and any significant increase in the major indices would only make a Crash more likely later and also make its effects even more ruinous on the sheeple who have borrowed heavily in order to increase their positions.

Futures on the major New York market indices offer the advantage that they trade 24 hours per day on the Globex market, which means that manipulation of the futures could take place before trading opened in New York. If the popular S&P500 futures, for example, could be maneuvered to show a substantial premium when US equity markets open, it might just ignite a feeling of optimism among investors and thereby trigger enough of a buying spree from the opening bell to prevent a subsequent sell-off.

Two strategies in using futures

Two possible strategies exist for the use of futures to prevent a sell-off on Wall Street when it is known the risk for this to happen exists. The first is to pre-empt the market action on the NYSE and the second is to halt and then correct the incipient sell-off as the market first falls and then hesitates to seek direction – something that happens almost invariably after the Dow Jones has fallen 100-150 points from the opening.

The first strategy is to enter the Globex market as buyers of S&P futures before US markets open. By pushing the S&P future well above fair value, anticipation of a strong open on the NYSE can be established. When trading later begins, buying support from those market players who believed the action on the Globex futures market will soften the effect of any eager sellers coming onto the market. In this way, the threatening sell-off can be tempered, if not completely eliminated.

A second strategy would be to wait for the market to complete the initial leg of the sell-off, before coming in to first support and then ramp the S&P future. This method has some important psychological and financial advantages over the first strategy – that of preventing the initial sell-off on the NYSE or cushioning it as much as possible by ramping the S&P future in after hours trading, prior to the open.

Psychological advantages of the second strategy.

American sheeple (i.e. consumers who also trade actively in equities) have been strongly conditioned over the past 5-6 years or so to believe that a stock market can only move in one direction, over a sufficiently long time span – where the latter is usually about a week, and rarely exceed a month. With corrections against the long-lasting rising trend always temporary and seldom longer than a week, these have given 'bottom fishers' (or 'dipsters', i.e. traders who enter the market vigorously as buyers after the Dow Jones has suffered a temporary decline) occasions to make substantial profits within a very short span of time. Even intra-day weakness of 100-150 points often offer such an opportunity.

Because of this conditioning, the reaction of the market to Bad News is generally quite limited. The reason can be found in the way sellers react when the Dow Jones has fallen more than say 100 points. (For more detail refer to Market Psychology 102 under Herd Behaviour). Because sellers have learnt the lesson that corrections are temporary and that intra-day falls of about 125 points often offer good speculative buying opportunities, the supply into the market soon dries up when the market falls steeply on the open.

If the news was Bad enough, the Dow could slip to more than 200 points in the red, but at that point sellers will become very nervous. Just the slightest sign that speculators are 'buying the dip' and most active sellers will disappear off the trading screens with almost the speed of the internet, to sit back and wait for the much better prices they know will be obtained later the day.

Trying to support the market on an anticipated weak day through a ramp of the futures before trading opened is like St George taking on the dragon without sword and asbestos suit – the odds are stacked heavily against it. At the opening bell sellers swarm all over the market, all trying to get out with as small a loss on the previous close as possible. With market sentiment so negative, nobody except hardened futures traders are even looking at the futures market, so that the premium over fair value has little effect on most market players.

On the other hand, if one should climb in and start buying futures only when the Dow Jones has fallen substantially from the opening bell and is beginning to consolidate, much of the earlier over-supply has been taken up, while remaining sellers have reached a state of nervousness that extends beyond mere nail-biting. Just a suggestion from the market that the 'dipsters' have been activated and the sellers will run for cover as fast as the internet allows them to do so.

This is the time when determined buying of the futures will have the most effect.. Many intra-day arbitrage positions will be unwound, thereby adding to the resurgence in the Dow. Soon the market is back on even keel, with demand strong across the Big Board.

It is clear from this discussion that the second strategy is superior to the first alternative when measured against the amount of effect one could expect from any intervention and also from how much clout has to be employed to achieve any significant effect.

Financial advantages of the second strategy

Use of the first strategy requires sufficient purchase of S&P futures before the NYSE opens to effect a significant premium over fair value and to keep the premium high once the market falls on the open. Except under rather rare conditions, this is likely to demand a relatively large amount of funds.

A negative point in this strategy is that a falling Dow and strong futures market just at the opening of trading present opportunities for arbitrage. Arbitrageurs will sell 'expensive' futures and purchase 'cheap' baskets of S&P500 stocks, locking in the differential above fair value to be realised later at a suitable time, when prices of S&P futures prices and the S&P500 index have returned to a fair relationship.

While arbitrage will offer some support for equities, to keep on supporting the futures market in the face of a falling NYSE and a flood of futures selling by arbitrageurs will need a strong stomach and very deep pockets. Even if the strategy succeeded partially and cushioned the decline in the Dow – i.e. engineering a soft landing for the day – the risk of substantial losses to the Crash Prevention Team (CPT) is very real.

On the other hand, if, according to the second strategy, the CPT only enters the market in support of the futures when the market has already plunged quite steeply after the open, the risk of large losses is mimimised if the intervention happens to be unsuccessful in its objective, i.e. reversing the weaker trend of earlier in the day.

If the action is successful and the market does rebound in pursuit of the futures, the earlier purchases of futures contracts can be carefully off-loaded into the strong demand that has developed, and so result in a jolly good profit for the CPT.

A CPT using the second strategy successfully actually becomes self-funding. This means that with the second strategy the CPT can afford to be much more aggressive in their intervention, since success will safeguard and even augment the funds available to them.

Assignment 1      Mid term
Students must analyse the available market data (10 minute intervals) from July 1999 through to February 2000 for any evidence that one or the other of these strategies were in fact used during this period of time. If such evidence of intervention is found, students have to examine and discuss the success of such efforts.

(Hint: To identify the presence of strategy 1, search for days when the S&P futures were well above fair value during overnight Globex trade, closely followed by a weak opening on the NYSE. What happens next on those days will reveal the efficacy of this strategy – if in fact evidence of its use is found. Strategy 2 requires much more detailed screening of the data. Attention is drawn to days when the Dow fell more than 100 points from the open, equivalent to say 12 points on the S&P500. Once the NYSE started to consolidate, the data for the S&P500 futures must be analysed to determine whether a resurgence in the futures prices led a recovery in the Dow, if any.)

A third strategy

It can be anticipated that if evidence of these strategies being used is found in the data, the results achieved by such intervention are likely to be unexciting. If the first strategy was used at all, any success at all is quite doubtful and it would soon be replaced by the second strategy, where both the timing of the action and the effectiveness of the available funds are improved.

The reason for a lack of sufficient success lies in Archimedes' observation. S&P futures are really a rather short lever in terms of the effect these exert on the NYSE as a whole and the 30 stocks in the Dow Jones in particular. Even a switch to the Dow futures is not likely to offer much improvement of the S&P futures. Using futures for the purpose of intervention is like using a shotgun to hunt hippo or elephant. Sure, you'll score a hit, but the result will be minimal in terms of the desired effect.

While many pure equity funds do not care too much about what happens on the futures market, a good proportion of individual investors and traders – particularly of the day variety – are probably oblivious of the existence of derivatives. The effect any changes in futures prices has on these market players at best resemble the slight itch a hippo or elephant experiences on being hit on the rump by a load of bird-shot.

Such indifference makes for a poor lever with which to engineer the market.

A more effective solution can be found if academic rigour is applied to what is known of the behaviour and perceptions of market players. It is known that different factors have different effects on the various types of people who are active in the markets. Long term investors, for example, pay much more attention to interest rates than day traders, who believe that nothing Greenspan does or say can have any effect on a position that is held for only 27 minutes. If, of course, they are aware of Greenspan's existence at all.

Investors would also be more aware of what the PE ratios of their purchases are. To many day-traders the concept of a PE is completely foreign; most of their purchases lack the earnings needed to calculate a PE and a good number even lack any sales whatsoever. What they consider important is what the price has done over the past 60 minutes, or the probability that the posting of a suitable message on a chat forum would raise the price 7.5% or better over the next 20 minutes.

Careful reading of the material presented in Market Psychology 102 will reveal that the single most important driver of market sentiment on a global scale is a factor derived from the NYSE – the Dow Jones Industrial Index.

It does not matter that most objective observers will find it quite ridiculous that investor behaviour and market trends can be dictated to by an index of only 30 stocks, even if these are among the corporate giants of the global scene. The Dow exerts an influence out of all proportion to even the market capitalisation of the 30 stocks used in that index. And it does so universally, for all practical purposes.

This fact is a godsend for a CPT. It means that if the Dow Jones Industrial Index can be steered into a desired direction, changing direction of the S&P500 and Nasdaq becomes a matter of routine, just like turning a steering wheel to take a corner or make a U-turn.

Methodology for the third strategy
The timing of the intervention is the same as for the second strategy. To have most effect, the action is initiated just when the Dow first settles down after a steep fall on the open, or shortly after.

That is when sellers pause to take stock and when the bottom fishers are waiting for a sign to climb into the bargains. Determined buying on a selective and sustained basis, by continuously taking out the offers on one or two selected stocks among the Dow 30, soon has the Dow Jones-index ticking higher at a constant rate of 2-10 points/minute. It won't be long before sellers of other Dow stocks react by withdrawing from the market, thereby helping the recovery. Then it won't be very long before the Dow turns positive and begins to show solid gains.

At some point, when the Dow has made it clear that the plunge is over, dipsters will pile into the bargains among the S&P500 and Nasdaq stocks and then the whole market is in a feeding frenzy. The S&P500 and Nasdaq Composite indices start to rise and also move into the black. Wall Street is on the move, all the Bad News is forgotten and Goldilocks is laughing her heart out. And so too is the CPT, of course, if one exists.

This methodology can be used time and again, provided that on each occasion the CPT selects those Dow stocks that at that moment in time provide substantive motivation for the sudden and sustained buying interest. The reasons to explain what the market did can be almost any piece of news that has just become known about one or two of the Dow stocks. In the absence of any real hard news, a suitable hint to the popular financial media can set the talking heads off on a tangent that should provide an after the fact explanation for the market action.

Risk inherent in the third strategy
Perhaps the single biggest problem with this strategy is that, to use Archimedes' terms, the lever provided by the Dow is too long, and the fulcrum placed too far back. It should prove very difficult indeed to use this lever with any finesse.

The effect rapid changes in the trend of the closely watched Dow has on the stock market as a whole is substantial. Any upward reaction in one or two Dow stocks after a steep fall would trigger the conditioned reflex among traders and investors; when they all react, the Dow will be roaring up, up and away – to be followed by the rest of the stock market.

The advantage of the long lever is that even if the Dow plunges 300 points at the open or soon after, it would actually be quite easy to halt and reverse the slide, even to the extent of sending the Dow Jones steeply into positive territory for the day. The problem is that the dividing line between successfully halting a threatening collapse and starting another lasting explosion of irrational exuberance is exceedingly thin.

The objective of a CPT and its SLE's is to engineer a soft landing – one that will offset the negative effects of the so-called wealth effect, but without precipitating a Crash that wipes out much of the accumulated wealth of 40 million American households. The last thing a CPT would want to do is send the market off into the wide blue yonder and a new string of all time highs.

The primary objective remains to prevent a steep fall in the Dow that could precipitate a Market Crash, yet to do so without inviting new comments on irrational exuberance.

An ideal would be to halt any steep fall and begin a recovery, but to give slack again the moment that market reacted sufficiently to introduce some stability. If the Dow Jones could close lower by 300-400 points per week, so that investors have ample time to adjust their financial positions to the lower value of their investments, a target in the vicinity of say 7500-8500 points could be reached without creating any turmoil in the markets.

A further refinement of this strategy would then be to intervene if the Dow feel steeply during morning trade, in order to prevent panic taking hold. Yet, if the plunge started during the afternoon and was not too severe, it could be left alone to run its own course and to contribute to the objective of a gradual lowering of the Dow.

Archimedes would applaud the efforts of a CPT if it used the heavy leverage of stocks on the Dow Jones index to engineer a soft landing from the current market Bubble. It would be a first for slow bubble pricking if these efforts are successful and he would feel that he has contributed to the success of slow deflation of the Bubble of the 90's.

This is of course a lecture in market theory and it is up to the students to determine whether reality presents any evidence that this theory has been turned into practice.

Examine the available data (10 minute intervals) from the different markets to search for evidence that the third alternative has found application in practice.

If such evidence is found, analyse and describe the effects the intervention had on the market. Extend the analysis to identify any instances of irrational exuberance following intervention. Did such irrational exuberance follow through into a new bull market, or was it a temporary effect of the intervention?

Provide a motivated answer, irrespective whether you could identify examples of actual intervention or not, to the question if a CPT could successfully engineer a soft landing for Wall Street as a matter of course.

(Hint: Search out those days when the Dow Jones feel steeply at the open or during morning trade; then examine the nature of any recovery, with specific attention to one or more of the Dow stocks that led the recovery quite aggressively. Compare your findings with those cases where the fall in the Dow started later in the day



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