Jul 2007
Few players take into consideration the principle of ever-changing cycles of results. The would-be professional player must always understand that the form moves away from the public's knowledge.
- Robert L. Bacon, Secrets of Professional Turf Betting
Nobody goes there anymore -- it's too crowded.
- Yogi Berra
In The Stuff of the Madding Crowd, we talked about cognitive biases, hard-wired genetic tendencies, and the ubiquitous "weapons of influence" that bombard us all on a daily basis.
In this follow-up we'll progress from part to whole, taking a macro view of crowd behavior in markets. (Quick side note: in the discussion to follow, "the public" and "the crowd" are synonymous. For all intensive purposes, they are the same thing.)
Now let's dig in with "the principle of ever-changing cycles," first introduced in Robert L. Bacon's Secrets of Professional Turf Betting in 1956.
The opening quote from Bacon is profoundly important, and well worth repeating here:
Few players take into consideration the principle of ever-changing cycles of results. The would-be professional player must always understand that the form moves away from the public's knowledge.
Bacon is very insistent on this point. To make sure it is hammered home, he repeats it in various ways:
...if the public ever did get wise to the facts of life, the principle of ever-changing cycles of results would move the form away from the public immediately.
The public can never catch up to the form -- or the game ceases.
Strong words indeed. But what exactly is Bacon talking about? How does one interpret "the principle of ever-changing cycles?" What does it mean to say that "the form moves away from the public's knowledge"... and that the public can "never catch up?"
To grasp Bacon's point, it helps to understand the nature of parimutuel betting. Wikipedia explains:
Parimutuel betting (from the French language: pari mutuel, mutual betting) is a betting system in which all bets of a particular type are placed together in a pool; taxes and a house take are removed, and payoff odds are calculated by sharing the pool among all placed bets.
The parimutuel system is used in gambling on horse racing, greyhound racing, jai alai, and all sporting events of relatively short duration in which participants finish in a ranked order.
At the race track, the payoff for any given wager is determined by betting patterns on the whole. After the race, winning bets are paid off by losing bets (minus taxes and the house take). Because wagers are not spread around equally, some bets pay better than others.
Say, for example, that Coal Miner's Daughter is the runaway favorite to win a race. If the majority of punters put their money on Coal Miner's Daughter, the payout on those bets will be quite low. With so much money on the favorite, the remaining balance of the betting pool is small.
In contrast, say that Cousin Jethro is the opposite: a beaten-up old glue bucket that would need a miracle just to place.
If Cousin Jethro suddenly runs the race of his life and takes first, anyone who wagered on him could receive an astronomical payout relative to what they bet... funded by that large pool of dollars incorrectly wagered on Coal Miner's daughter. A key takeaway here is that the losers always pay the winners.
To rephrase, parimutuel systems work like this. Popular or "crowded' bets pay less, because there are relatively few punters leaning the other way; uncrowded, unpopular bets pay more, because more folks get caught out when the unexpected happens. (And rain or shine, the house take its cut.)
Though respectable white-shoe types are loath to admit it, the markets function very much like a parimutuel system. Commissions, slippage, and research costs represent the house take. Valuations are determined by public sentiment, as expressed by how much the public is willing to bet. The more the crowd likes something, the lower the odds of paying a reasonable price for it; "sure thing" bets are often lousy, because of the minimal reward in comparison to risk.
Value investors understand this principle intuitively. It's along the lines of what Benjamin Graham talked about when he said, "In the short run the stock market behaves like a voting machine, but in the long run it is a weighing machine." One could argue the art of value investing is about consistently backing unfavored and mispriced horses over the course of hundreds of races.
Traders also routinely exploit the market's parimutuel tendencies; they simply use a different set of tools and time frames to do so. For example, consider Victor Sperandeo's description of "tide watchers," from his excellent book Methods of a Wall Street Master:
Since tide watchers make up the bulk of floor traders on the exchanges, it is in the best interest of the speculator and investor to be aware of their potential impact on the short-term price trend. They can easily drive the price of a particular stock or commodity up or down several points in the short term, with nothing but their own interactions creating the movement.
For example, suppose that floor traders on a stock exchange observe that offerings for XYZ are light and that declining prices don't result in any significant liquidation. If this pattern continues, they might conclude quite reasonably that there is very little interest to sell XYZ. The logical thing for them to do is pick up the stock at any sign of weakness -- to buy the stock at what they perceive as short-term bargain prices -- and test the market.
This is not unlike race track strategy. Say a young thoroughbred named Seven Dewey has lost his last few races; as a result, the betting public has gone a bit sour on Dewey. Or maybe that same public is just ignoring Dewey... maybe they are all busy drooling over Coal Miner's Daughter, who just won her eighth race in a row.
If Dewey is a decent horse, odds are his results will pick up again. That makes Dewey a good bet when his comeback prospects are sufficiently mispriced. When good traders sell strength and buy weakness, they are challenging the betting line in similar fashion -- going against the short-term odds consensus.
Even as it changes, the game stays the same. As floor traders slowly go extinct, they are being replaced by hedge fund jockeys and computer algorithms that apply the same ebb-and-flow strategies. The parimutuel dynamic works across all time frames and all methodologies... from ‘quantitative finance' players who trade in and out every few seconds, to swing traders who hold from weeks to months, to value investors who hold from months to years.
To beat any type of parimutuel system, a few key elements apply:
1) You must be able to identify ‘good bets,' i.e. potentially mispriced asset situations, with a reasonable degree of accuracy.
2) Your methods must be profitable enough to overcome the "house take" (frictional costs).
3) Your skills must be competitive relative to other operators in your timeframe. (Predators tend not to eat each other, but often compete in terms of food source.)
As a side note, some may argue that the stock market is not a true parimutuel system, because it is not a zero sum game. Over long term periods where more money flows in than out, where companies create value-add, and so on, it is theoretically possible for all market participants to profit. (The picture is further muddied by the dynamics of wealth creation, the finer points of capital inflow vs. outflow, and myriad other subtle points.)
While worth noting as an aside, these caveats are not all that critical to the parimutuel analogy. Your humble Consilient Investor editor has participated in more debates than he cares to admit on the topic of equities and zero sum; through trial and error, he has hit upon the following all-purpose response.
The stock market is a zero sum game for anyone seeking above average performance.
In other words, the desirable side of the bell curve has a limited number of seats. It is the bottom half of the class that makes the top half possible; without one you couldn't have the other. In a "winner take all" or "winner take most" type of game, the dynamic is even stronger. If 80% of the profit goes to 20% of the players, middle-of-the-pack results aren't worth the effort!
Those who don't care about outperformance -- the ones who could care less about beating their peers -- are thus more likely to index than to bother playing the game. "Average" is attainable via passive strategy; those who participate actively, for the most part, are playing to win a top spot in the relative performance rankings.
Therefore, when talking about the activity of trading and investing, it seems reasonable to move forward under the framework of zero sum. (Minus sum actually, after frictional costs are considered; but we'll hold off on that rabbit trail for now.)
In Part II we will dig deeper, to further explore what Bacon really meant with his semi-cryptic statements.
Still to come: why the crowd is not always wrong; why the crowd is wrong by definition at turning points; reflexivity and volatility; the logistics of mass movement; more.
