"Get 'Em While You Can"

I spoke to a dealer who is on the front lines of equity derivatives trading yesterday and the very first thing he told me was that everyone now thinks markets are going to rush to new all-time highs, so the battle cry is "buy before it's too late". Pundits are already suggesting that smart money should get right back into the yen carry game, embrace risk, etc. Oh my, how quickly panic is transformed into greed... This vertiginous emotional roller-coaster is well known to yours truly, having observed it amongst speculators many a time.

Managing the rebound after a plunge like the recent one takes significant skill in market-making, particularly in dealing with the real money sell orders that come in mixed with the hot money buys. The skill consists of downplaying the importance of the sell orders in relation to the buys when arriving at the prices that cross the tape. It is not easy, but market makers are helped by the fact that real money investors usually place "limit" orders, whereas hot money always goes for "at market". The trick is to slowly work the "limit" sell orders, executing them against carefully controlled bids, while causing the "market" orders to be executed at once - as requested - but at ask prices that are immediately widened out. In this way prices jump more than the balance of buy-sell orders would suggest and specialists and market makers can usually recoup what they lost on the way down. Everyone is satisfied, except for the "market" buyers who see their fills come in higher than they expected. But they are usually so hot under the collar, they are still happy. (There always has to be a "sucker" in a "sucker rally", no?)

I vividly remember my first encounter with a NYSE specialist (the important members on the floor posts who make markets in stocks). The firm I worked for at the time had brought him in for one of our formal training sessions. He was impeccably dressed and groomed and while the head of training introduced him and explained his function on the floor as part antagonistic, part helpful to our customers' and firm's interests, he stood with his hands clasped and calmly scanned the audience. When the introduction was over he cracked a wide smile and let four Dracula teeth show through his grin - everyone burst out laughing and the point was well made: his function was to make a profit for himself, first and foremost.

He proceeded to hold a short simulation of how order execution takes place on the NYSE floor, with our hapless selves as floor brokers for our firm instructed to execute various market, limit, stop, etc. orders and himself in his usual role of specialist. We got.. whomped, to put it mildly. It was a very worthwhile initial lesson in how markets really work. There have been many more lessons since - I taught some of them myself.

Anyhow, what I am trying to say is be extra careful of wide price swings. "Real money" pros don't crash headlong through an ice cream parlor window, if all they want is a second scoop of vanilla. When the store is being trashed by a bunch of hungry yahoos, they are perfectly content to step out and wait until they all go away. The result of real money pulling sharply back can be best observed in the primary market, i.e. the issuance of new securities, which has now slowed down dramatically. Various announced but unfunded LBO deals can't sell bonds and plans from private equity funds to go public are being "delayed".

Finally, how about a top Swiss banker as commentator? Jean-Pierre Roth, the head of the Swiss National Bank (the country's central bank) had this to say: "We're certainly not at the end of the story. There are question marks surrounding the development of the American economy. Something unbelievable happened. People who had neither income nor capital got credit with very attractive conditions. Now reality is striking back".