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5 Secrets of Wall Street

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December 09, 2011 - 5 Secrets of Wall Street - By Zacks Investment Research

By: Kevin Cook

Investing can be a jungle, a battlefield, even a nightmare if you don't follow sound principles of diversification and risk management. The good news is that in the age of the Internet, the self-directed investor has been given access to the research, tools, news flow and execution speed of the professionals.

The bad news is that the business of investing still has its own unique unwritten rules that can trip you up if you're not careful. I could list a dozen or more ways that equity portfolio managers, analysts, hedge funds and brokers "rule the Street." You could call them "secrets" because when you listen to a pro talk about how he or she is making money on a particular stock, they don't tell you this part.

Today, I offer you five of my favorite secrets...

Secret #1: They Have to Buy

What is the business of institutional investors who manage other people's money? It is to deploy that capital. Lots of different equity portfolio managers have mandates and performance benchmarks that create certain behavior, such as being fully invested even when the market is peaking.

I am not even addressing how analysts or brokers work on the Street to facilitate this business. I'm just talking about fund managers having a bias to buy stocks, not short them. How strong a force is this bias? Trillions strong. The creation of employer-sponsored retirement savings plans has been one of the biggest contributors here.

The combined assets of the nation's mutual funds increased by $606.5 billion, or 5.5 percent, to $11.661 trillion in October, according to the Investment Company Institute's [ICI] official survey of the mutual fund industry. It is their business to put this capital to work, mostly in equities.

On top of this money ear-marked for equities, there is over $2.8 trillion in money market funds, and another $2.6 trillion is sitting in various bond funds. This is all "cash on the sidelines" that could help PMs do their primary job: buying stocks.

While they "have to buy," we enjoy the freedom to control our investment cash and decide what to buy and when.

Secret #2: They Don't Have to Sell

In this secret, I exaggerate (only slightly) to make the point about the pain tolerance of the aforementioned groups whose job it is to buy stocks with other people's money. It's easy to watch stocks lose 30, 60, even 90 percent when it's not your money.

Do you know what the greatest risk is for a fund manager? It's not losing money or clients. It's underperforming their benchmark (most commonly either the S&P 500 or the Russell 2000). So if stocks are peaking and then turn down, who knows if it's the top? What if the index surges higher again?

For the most part, they can handle the 20% downturn. But they can't miss the last 10% of upside, especially if they've struggled in their stock-picking at all that year and are at risk of underperforming their peers or benchmark. When you understand at what points in the year fund managers are likely to feel "underinvested," you can take advantage of their fear and greed.

Secret #3: Sector Rotation

This one is simple: money doesn't leave the markets, it just moves around. Especially when interest rates are near zero. Especially when equities still offer the best risk/reward overall compared to other asset classes.

And this one also has quite a bit to do with the economic cycle. During the early expansion phases, it's good to be in "cyclical" sectors such as industrials, materials and energy. As the cycle starts to approach its peak, money will move back out of these areas.

But lately the moves seem hair-trigger in nature. The media loves to call it the "risk on/risk off" trade. With fast-money hedge funds taking short term positions in cyclical stocks, commodities, currencies and ETFs, risk on/off is a very accurate way of describing the "light switch" nature of this trade flow.

Just keep in mind that while the momentum players, who are using lots of leverage in their risk taking, have to move in and out fast, there still exists a longer, slower approach to economic cycle investing that you can benefit from. Knowing where we are in the cycle and which sectors are trending accordingly can put a tailwind behind your investment ideas.

Secret #4: Technology, Liquidity & Speed Rule

Speaking of hedge fund momentum players, this secret explains why they move markets and make so much money doing it. It also explains why you have to work harder & smarter to beat the pros.

I call the world of professional day traders one of "total immersion, instant access." Pro traders are swimming in rich information networks, amid oceans of research, and surrounded by analysts who can summarize it all for them instantaneously. They also have amazing technology, tools and systems to help them quickly capture a majority of high-probability trading opportunities.

Of course, the extreme bad behavior on one end of this spectrum can't be ignored either. Raj Rajaratnam may be going to jail for his insider antics, but there are dozens more who probably should and won't because they either covered their trail or have some influential protection.

It's sad but true. The lines between "inside" information and "exchanging ideas" are pretty gray on Wall Street among the pros. When I traded interbank FX, there was often a trade to be made when someone knew what someone else bigger was doing. My trading desk always seemed to find out too late because we weren't as "plugged in." But I knew it was going on at the big banks.

Then there are the automated traders, the "algos." Algorithmic trading has overtaken markets in many ways. It's not that the machines rule. It's more that they have entrenched themselves by providing constant streams of liquidity that almost can't be matched by human traders.

And the technical "model" funds - essentially, computer programs that use price and volume formulas to trade - will never stop inventing new systems to capture market swings. They run stocks up and they run stocks down, without regard for fundamentals, or sanity.

But while sharks abound in Wall Street's waters, we can profit using their same tools and tactics.

Secret #5: Risk Management Isn't a Science

Speaking of super models, one of the most dangerous ever didn't walk a fashion runway, but it did earn its creators a Nobel Prize. The Black-Scholes option pricing model is "dangerous" because it ushered in the era of derivatives.

Not that there's anything wrong with derivatives like options and futures. But other complex financial engineering - like the kind that spawned the sub-prime housing bubble and subsequent banking meltdown - can be very dangerous indeed.

Why? Because they are all based on some variation of the same quantitative methods used in Black-Scholes. Specifically we are talking about standard deviation and the bell curve.

And these quant tools offer Wall Street the illusion of control and safety. If you can measure the past, and its variations, you can model the future. Sounds simple enough. And it sounds so objective and scientific without appearing to offer precise predictions.

But we all know "past performance doesn't guarantee future result." So how does Wall Street get away with using standard deviation to measure risk? Because it offers such a tangible, numbers-based approach to describing the world.

"Don’t worry," the quants say. "The statistical volatility (risk) is only X."

The problem is that standard deviation was invented to measure the variation in physical phenomena like the anatomy of animals, the composition of rocks and the structure of matter. Nature has an order, and science is all about discovering it, measuring it and classifying it so that we can make predictions that work.

Markets meanwhile are anything but natural physical objects that can give us reliable "standard" measurements. Markets are social beasts with unpredictable "wild randomness" as Nassim Nicolas Taleb calls it his book The Black Swan.

So the next time that some Wall Street quant or analyst tells you he has carefully defined the risk of a particular investment according to its "variance" in his model, tell him you'll be happy to trade it with his money.

What does all this mean to us? While some on the Street would have us believe that markets are efficient and rational, they are actually more subject to bubbles and shocks. And that spells opportunity for traders who can exploit the emotional extremes of optimism and pessimism.

How to Apply These Secrets for Short-Term Profits

Of course, most investors don't have the time or knowledge to trade like the big fund managers. But it's possible to track and even anticipate where they're moving the money. In that way, you can catch small market swings near the bottom or top and ride them for quick, substantial profits.

To get them, I'm directing the new Zacks Tactical Trader, a private investor group that goes long or short with stock, ETF and options moves. If this approach interests you, be sure to look into it right now. The number of investors who share the moves must be limited, and demand to get into the service has been tremendous. The deadline for entry had to be moved up to midnight, Saturday, December 10.

Click now for details about Tactical Trader >>

Good Investing, Kevin Cook

Kevin, a Senior Stock Strategist at Zacks, is a recognized authority in global markets. A former market-maker in the $4-trillion-dollar-a-day world of interbank currency trading, he developed the ability to track the movement of money, and trained his reflexes to take advantage of it. Today he directs the new Zacks Tactical Trader, providing commentary and recommendations.

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