Just Blame Fred

Wow, what a whirlwind of news we’ve all heard over the past couple of weeks! Merrill Lynch, Lehman Brothers, AIG, and who’s next?

All this squabbling over ecomomic growth problems. All this scrambling to “fix” the problems. All the politics being flung around by Obama and McCain over who’s to blame. All the people on “Main Street” staring like deer in the headlights. All the talking heads making crazy pronouncements of impending doom and gloom. All the other financial institutions scrambling to “protect” themselves from being the next major jaw-dropping headline. All the investors, traders, fund manager, market makers on wall-street shooting worthless tokens — whoops, I mean stocks — back and forth to each other in a never-ending zero-sum Ponzi scheme of Ages.

And yet, a true understanding of what’s really going in is so simple even a 5-year-old can grasp it — if you know where to look and how to understand the results.

And so, let me impart this wisdom to you.

The first requirement is that you understand that, dollar for dollar, the stock markets are a zero-sum game. This is a rather tough concept for some to grasp, and I can appreciate that because all the hype you hear about stocks and the related financial instruments tend to hide this plainly obvious fact from you: that every dollar you make on the stock market comes out of someone else’s pocket, and every dollar you loose goes into the pocket of another trader/investor/what have you. That is the definition of “zero-sum”. When you add up all the gains and losses of the entire system, you come up with zero. Get that? Good. Now for my next pearl of wisdom.

If you look at the stock market over time, it indeed looks complicated. A price rises, a price falls. One company rides to success; another goes down in flame. Traders shoot tokens back and forth to each other representing these companies. And when I say “trader”, I mean anyone who dabbles in the exchange of stock tokens on the stock market, directly or indirectly. Long term, day trader, guy in the pit. The distinctions really don’t matter in the long run as you will soon understand.

Now, I will show you something, a simple something. It’s a chart. It’s derivation is not complicated at all, and anyone in the world can pull this same information and understand it, including a 5-year-old. Brace yourselves. Here it comes.

Now, notice that this is the NYSE chart — a calculated average of all stocks traded on the New York Stock Exchange. Notice that this is yearly data going from 1970 to the present (2008). The “candlesticks”, as they are called, show at a glance how the prices shifted for that period. Since this is a yearly chart, a candle represent price movement for the entire year. If the candle is hollow, it means the price ended higher at the end of the year than it began. Red candles mean the price ended lower for that year. The “stick” part of the candlestick represnts the highs and lows of price movements for that year.

Now you are probably thinking, “so what?” Even this chart shows what looks like a general rise in the NYSE, even though that last candlestick looks meanincing (it represents the year to date movenent of this year– 2008). But there’s more to this chart if it hasen’t caught your eye already.

Yes, the bottom part of this chart is where the real story lies. It represents trading volume. The vertical bars are color-coded for the years they represent — a black bar means the candle above ended at a higher price; a red bar means the year ended at a lower price than it began. But that’s not important. The important thing is the trend in volume itself, and it’s relationship to the price movements.

You will note that from 1970 to 2002 the volume has been increasing almost exponentially. Afterwards, you see a leveling off in volume. In fact, this is the first time the volume has been level since 1987. And you will note that the volume now is much higher than it was back in 1987.

And if you haven’t figured it out by now, let me tell you what that 5-year-old can understand once you tell her.

You will recall my quip about zero-sum games earlier. Now, what does the zero-sum game really mean to you as a trader? Come on, think about it! Even a 5-year-old should be able to figure this out!

Ok, if you still didn’t catch on, it means simply this: You, the trader/investor/whatever you are, are a fool for buying a token with no intrinsic value. The only thing you can do with this token, once bought, is to sell it again. And what do you look for when you sell it again, being the fool that you are? Exactly. You need to find a greater fool than yourself to take it off your hands at a higher price than you bought it! That’s right! You only make out if you find a greater fool than yourself.

And so fear sets in if you cannot find a greater fool than yourself and trading is going on below your strike price. Your only options is to go into a “hope and pray” mode and hope greater fools flock back into the market, or to sell it off and take a hit, hopefully advoiding an even nastier hit if you would be so foolish to hold on to this worthless token longer.

Now with that pearl of wisdom, let’s take a look at another chart — NASDAQ.

You see — not suprisingly — the same characteristic volume trend — a near exponential rise until 2001, then a levelling off. You can directly relate the volume to the number of “fools” in the market, and the volume no longer increases exponentially anymore for one simple reason: You have run out of grater fools!!!!!!!!

Is that surprising? I mean, the population on this planet is a finite number, and the stock market has grown far faster than the population can. What that ultimately means is that you MUST run out of greater fools. What happens after that? The prices will shift about chaotically. Confused investors will all scratch their heads wondering why the old tried and true approaches of the past don’t work anymore. Any such foolishness as “being in it for the long term” is to be laughed at, and you can plainly see why if you look at these charts.

During the 20th century, as prosperity spread to more and more of the population, more and more people were drawn into the stock market, either directly as “investors”, or indirectly through 401Ks, mutual funds, IRA accounts, and the like. All their foolish stategies were really predicated on the notion that there will always be greater fools to take the market higher and higher. That there will always be an exponential increase in volume. That the supply of money is infinite. That, in point of fact, the zero-sum game that is the stock market is not really a zero-sum game. That the money is not really coming at the behest of the loss from someone else, that this Ponzi — or pyramid — scheme can continue forever.

The 5-year-old is now laughing at you.