The Stock Market And Chess: How The Game Works And Who Is Moving The Pieces

by: Husky Financial

"Like the alchemist of old, forever searching for the philosopher's stone, the analyst today never stops looking for stronger moves to prevent the defender from establishing equality." - Savielly Tartakower

If you equate the market to a game of chess, an investor or trader is always faced with the challenge of not only assessing the "board" as it looks in the present, but also anticipating the future moves of his or her opponent. Looking at the current state of the market, and, in turn, the global economy, we see a conflicting story that is currently polarizing market participants in an unparalleled way.

The market seems to be at a major tipping point, in which case there will be a clear-cut, long-term "winner" and "loser" in the battle of animal spirits. On the contrary, there also exists a strong possibility we remain range-bound for an even longer period of time, bouncing, for example, from 1000 to 1400 back to 1000 again in what would be a classic-example of "cat-and-mouse" in chess; an investor's nightmare and a trader's dream.

With the news loop of today's financial media outlets running 24/7, feedback cycles are often self-fulfilling prophecies, and the market is moving in major ways on "news" alone. A continuous cycle of bad news and fear mongering will scare the retail investors (or trigger the HFT machines) into a fit of selling and panic.

On the contrary, if all we see are positive headlines about how the Dow is headed to 20,000 and Apple is on its way to $1,000 a share, people begin to buy anything and everything in order to make sure they don't miss out on the "sure gains" that are set to come. This positive feedback cycle can cause the market (SPY, DIA) to move higher in a violent fashion, as we witnessed in both October 2011 and January- March of 2012.

Since the market found a bottom in 2009, it has rebounded significantly, up almost 100% from the lows before this latest sell-off. However, it has not been a smooth ride, and depending on what time you bought in and how easily you were scared out, you could have easily lost your shirt (or entire wardrobe) in one of the numerous broad market sell-offs over the last two-and-a-half years. The self-fulfilling prophecies mentioned above were largely apparent in the last twelve months, shifting from negative in Fall/Winter of 2011 to positive for the Spring of 2012 and back to negative for Summer 2012.

Now back to our chess game… We must constantly make reads; not only what hand the market is currently showing us, but what has yet to play out. Based on what I'm currently seeing, those who are short the market right now are long the immediate failure of Central Banks. That is because at this point in time, it is largely the central banks "moving the pieces" of the market. Nearly every asset class, from equities to commodities (GLD, SLV) to currencies (UUP, EUO) and treasuries (NYSEARCA:TLT), is moving based on the current (and anticipated future) monetary decisions of central banks.

There is also a chance that many shorts are playing the game of cat-and-mouse mentioned above, riding the market all the way down to their ideal range "bottom" before piling in on the long side and riding it back up. Rise and repeat. Playing to the downside is a dangerous game because when shorts get burned (also known as squeezed), things get ugly fast.

This is due to the fact that those with short positions traditionally have a briefer intended holding period than those who are long equities, so the rush to cover creates massive moves to the upside, whereas sell-offs tend to be more gradual as the longs are not as quick or impulsive to exit their underwater positions. This is important to keep in mind when you are betting on major moves to the downside, either shorting equities or going long volatility (TVIX, UVXY).

The role and duty of the central banks are not to ensure that the stock market goes up. They understand there is a correlation between their decisions and the movements of equities, but they also know that these relationships are largely causal. This means that there is a cause, for example a monetary policy implemented by a central bank, and an ensuing effect that occurs as a consequence of the first action, which in the example could be equities going up or the purchasing power of a currency going down.

The only outlier may be the Bank of Israel - which almost perfectly timed a short-term market top with the decision to invest 2% of its $77 billion in reserves ($1.5 billion) directly into US equities, including a large chunk of Apple (NASDAQ:AAPL). This was not a causal relationship, but a direct injection of capital into specific securities.

However, for the most part, the duty of Central Banks is to ensure the strength of the banking system, moderate price stability and inflation, and do their part to facilitate and contribute to the health of their sovereign economies. If they are successful, the stock market will take care of itself, and we could see a return to the long-term uptrend the market has experienced since the early 30s. If they fail, there is a possibility that a global financial collapse of unprecedented proportions could unfold.

Thanks to the high correlation that exists between asset classes these days, the global economy is only as strong as it's weakest links. These days, the focus is on Europe, which is running into problems dealing with it's own weak links - mainly Spain, Greece, and Portugal. Although those three countries represent the 13th, 38th, and 49th largest GDPs in the world, they lack the ability to print their own currency to inflate themselves out of a recession and have forced the EU to (try) to come to their rescue without dragging the rest of the member nations down with them.

Looking at the rest of the picture, there are concerns about the sustainability of the US economic recovery and the slowing growth in emerging markets. Then you have the geopolitical risk sprinkled on top, with major elections taking place all across the world this year. When elections take place, things tend to get ugly. When a political party has their back against the wall, logic and concern for their constituents takes a back seat.

For a recent example of this, look at the immaturity and classlessness of both Democrats and Republicans in the debt ceiling debate last August, as they placed political agendas in front of the well being of the country, and brought the country to the brink of default. Remember that whether it's in politics or the stock market, when the masses are polarized and pitted against one another, they lose a handle on seeing the truth and coming to logical conclusions.

CNBC just aired its latest special "Markets in Turmoil", while Goldman Sachs (NYSE:GS) sees the potential for a U.S equities bear market in 2012. The bears are out in full force and the market influencers (Central Banks, Politicians, Investment Banks) have their backs up against the wall.

So what is left in the pieces?

Well, quite a bit. To start, high-grade sovereign bonds (often seen as the Risk-Off play) do not have much lower to go before you start paying them to take your money. With inflation pegged at just under 2% this year, the yields are already negative real, meaning they are not even enough to cover the decrease in purchasing power from inflation. Bernanke knows this. He is in no rush to ease because he does not need to.

Europe has some bazookas left, and still has some drastic "last-ditch" moves that could be enough to seal victory for the bulls, who would then declare "Check." in a nervous, skeptical tone, as they understand the odds for victory are still currently favoring their opponent in the short-run. Eurobonds would go a long way in showing that the EU is serious about maintaining both sovereign unity and fiscal stability. It is crucial yields can stay cheap enough for banks to borrow at rates low enough "make the spread" and allow themselves to get a solid footing before Basel III comes knocking.

In the mean time, continue to assess what the market is telling you not just in the present, but what has yet to unfold. Understand what techniques and resources exist that continues to allow market influencers (aka the chessmasters) to counter any sudden gain or loss of control on the global economy, and in effect, the global equities markets. Prepare for both the good and the bad, and plan to the best of your abilities, what actions you will take in the event that the market starts to make a clear move to either the upside or downside.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.