CFD investors need to manage leverage

The Australian regulator ASIC is finally investigating the disclosure of Contract for Difference (CFD) market makers. This action is well due because customers are not being adequately prepared for trading CFDs. It is really a form of high-stakes gambling. Unless you know what you are doing there is a strong chance of losing a lot of money.

My advice to clients investing in CFDs is to use them as if you were investing your own money, i.e. on zero leverage, and then slowly increase your leverage in increments as you become accustomed to the product. When many people do is:

1. Abuse this market leverage and are never comfortable trading with it, so they overtrade

2. Abuse the leverage and set stops, and always find that they are being stopped out, ie. mostly losing trades

3. Not using stops and losing great amounts on trades, particularly if they have been enthralled by an earlier big gain.

------------------------------------Andrew Sheldon www.sheldonthinks.com

An inflation-fighting investment strategy

You might be asking yourself what your strategy should be in these times given the prospect of inflation. Clearly inflation makes it harder to make profits, so if we are concerned about inflation, then there are certain types of investment we should be consider over others. I would make the following points:
1. Bonds: People like to place money in bonds because they are considered safe. I would discourage investing in long-dated bonds because inflation is going to erode the value of them in future.
2. Property: Property is of course a tangible asset class so we would normally expect property prices to rise with inflation. This is however not true if the property market is over-leveraged, as it is in most Western countries. The exceptions are Japan and the Philippines. In these countries you can safely buy property. In Japan particularly the yields on property can be particularly good in suburban areas. In Western countries, its harder to find low-priced property because the bubble swept most markets. I would restrict your investments for a few years until inflation has knocked a few highly-geared home owners out of the market, whether because of rising interest rates or a job loss. Rural property makes the most sense in depopulating towns, unless there is some fundamentals reason to buy elsewhere.
3. Shares: Stocks will initially benefit from a little inflation because it helps raise balance sheet asset values whilst liabilities remain the same. The problem however is that eventually demand is crimped by higher interest rates, resulting in a market-value collapse. The exception is of course precious metals stocks.
4. Derivatives are a more risky form of investment in a credit crunch. You might be thinking that we are through that phase of the market, but there will be still one further credit crunch in a few years when inflation really bites. In these circumstances derivatives which carry a counter-party risk are not a good idea. You can use derivatives like CFDs as a minor part of your portfolio, but don't get silly.
5. Cash: It is silly to sit on cash because it will be eroded by inflation, and its not safe. Better to buy tins of canned food or cereal for a few months if you are fearful. At least the price of foodstuffs will rise in value (as long as it is not perishable).
6. Precious metals: You can certainly buy precious metals and store them in a safety deposit box, or but Exchange Traded Funds. Just make sure its safe, and you know what you are buying. Read the fine print. Some of these ETFs are leveraged into derivatives. You need to know those things. The best entry is silver, gold, platinum, palladium. Palladium is particularly low at the moment.
7. Business: There are things you can do to improve your business. If you have a good position in the market I would recommend investing in cost-reduction expenditure. Apart from being a deduction from income, it will place your business in a stronger position to whether any downturn. But you need to be confident that you can whether the recession. If you are marginal now, I'd be reluctant to invest more.
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Andrew Sheldon www.sheldonthinks.com

Investment Strategies

There are 2 ways you can look at investment
1. Big picture perspective: This is where you look at the macro-economic setting, the state of global capital markets and develop a micro-economic framework that reconciles with your global perspective. This is otherwise referred to as a top-down analysis.
2. Specific investment focus: This is where you reflect more on the merits of a range of particular investments, and allocate your funds accordingly. This is referred to as a bottoms-up approach to stock picking.
3. Holistic or synchronised perspective: The best approach is to consider both, or to integrate both approaches.

Prior to 2002 I really did not have the understanding of global financial markets to understand how all the elements of the market came together. I think it took me about 4 years of reading material to really develop an understanding of the macro-economics that drive markets. In recent years its become apparent to me that so many financial journalists, even economists just dont have a clue.

I would suggest that you really need to know the commercial parameters that drive corporate decision making, and well as the factors that drive markets. It might take you a while, but managing your investments by the age of 40yo is likely to become just as important as managing your career, and managing it well could make the world of difference.
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Andrew Sheldon www.sheldonthinks.com

Misconceptions - Risk vs Return

One of the misconceptions I learned in university economics courses was that there was an inverse relationship between risk and return. The assertion was made on the premise that people would demand a higher level of return to offset a higher 'perceived' risk. There is some merit in this statement, but another factor strikes me as pertinent - the quality of the perceptions assessing market value. Consider that there are mining analysts, but they only get paid to research major stocks, so they can therefore only recommend researched stocks. There is thus an information gap. The implication is that not every market participant has a good understanding of all stocks, and some small stocks might be totally off the radar of brokers. Thus not all participants perception of the market is equal. One persons 'perception of risk' is not the same as another person's because their knowledge and experience is different. There is always a story that is poorly understood, or is just outright ignored because the market was not open to the story. This has a lot to do with personal focus, though I would discourage you from having such a fixed loyalty to one sector.
A mining analyst confronts a much smaller risk than a novice investor. A disciplined analyst has a far better understanding than an analyst whom cuts corners. An investor who has a critical mind has a better likelihood of success (or less risk) than an investor who just accepts what they have read. An investor who listens to others opinions before acting on his own, an investor who researches his stocks, and similar companies has a better risk-reward profile than an investor who doesn't. An investor who is emotion or risk-averse is likely to act on distorted thinking, and will perform worse than a trader who systematises their trades, thus acting in a mechanistic fashion.
The implication is that there is a great deal that you could be doing to reduxe your risk exposure in the market apart from listening to others when they say its too risky. In fact some of the best trades are when people are telling you to stay out of the market.
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Andrew Sheldon www.sheldonthinks.com

Trading systems - Are they any good?

Several years ago I looked at trading systems. For the uninitiated, trading systems or so-called 'black box' solutions are software packages that include algorithms to analyse market trends with the intent of spitting out stock recommendations. Most such systems use daily end-of-day

trading data from the stock exchange to give you those signals. They might even give you the tools to help manage your portfolio. In fairness, these tools are no different from the tools that traders use, though I would make the following points: 1. Such indicators are typically lagging indicators - they tend to get you in & out of the security too late. 2. They drop the context - you might think that noise, but it might be pertinent info 3. These systems were developed in the previous boom. They have not really been tested over bear markets 4. Unless you are trading short term, they are likely to be unhelpful over the next 5 years, since this will be a period of flat earnings - that is a succession of falls and rallies, but flat overall.

Why the 'buy & hold' strategy is flawed

I was having a discussion with a guy on a Japanese bulletin board www.gaijinpot.com - a useful reference if you are going to Japan. His argument was:

[QUOTE=Gaijin 06] I disagree with your assertion that the buy and hold strategy has had it's day. I fundamentally disagree with this as no amount of technical analysis nor fundamental analysis can accurately predict market highs or lows.

My response is that you must have fundamental or technical reasons for buying a security. On what basis can you buy a security - if not based on fundamental or technical reasons, better still a combination of both. There is utterly no reality to the 'buy & hold' strategy. You might as well have been throwing dice. The strategy worked marvellously for the last 20 years because markets, credit and globalisation was growing. But as we know, cycles go up & down. The problem is that people have been on a good think as far as 'easy money' is concerned, that they think 'this cycle is different', that our central bankers have conjured up this magnificent system which allows you to make endless profits. These 'true believers' will be the last to sell in the panic, and sadly at the bottom. They have lost perspective. Its a reality that the biggest transfer of wealth occurs during economic downturns, not to mention the biggest destruction of wealth. Thats destruction of wealth is more pernicious than the monetary loss because its changing people's consumption patterns from optimism to pessimism. Thats why crashes hurt. But people forget the pain, and a great many have not felt it. They think the Asian Currency Crisis was bad. :) The central banks just pumped money into the economy. There is no solution to prevent inflation. Monetary discipline (prevention) is the only cure. Thats why the central bank strategy of targeting 'low inflation' is really just fluff because the government measures inflation and its setting policy on symptoms which lag rather than preventing the cause.
This economic expansion is based on the pernicious creation of credit on a scale as never before. There will be a crash and it will be bigger than any other precisely because there is so much credit. Thats not to say that economic prosperity was a total distortion. There was real gains in productivity, there was the creation of factories and so forth, but to a large degree your propensity to spend has been driven by easy money, and that will eventually be curtailed by rising wages. There is already inflation, its just financial markets have no interest in seeing it as long as you dont see it. And you have no interest in seeing it as long as your house is increasing in value by $20-50K per year, offering tax cuts, or you are gainfully employed. We are all told that oil and food prices are not good measures for the CPI because they are volatile/seasonal, so they are excluded (nevermind that they have a seasonally adjusted index), but it has suited politicians to include rent because you ensure high vacancy rates by building houses. It suits them to include qualitative fudge factors to lower 'real prices' because your hard disk is 100x faster, never mind that thats a productivity benefit (double counting) or that you might not even use the capacity. But it is true that less metal is being used to make a CPU - yet metal prices are up 400% regardless.
Credit creation arises because commercial banks have the capability of creating money through debt creation. Money was once an asset in itself - under the gold standard. Now its a claim on others incomes in the form of tax receipts, which dont even pay the US interest on its federal debt, and private debt is only partially backed by assets, which includes 'dubious assets' called debt securities, which are claims on others, based on their ability to pay. In some cases these are protected by derivatives, which are securities which protect your downside, except the fact that their counterparty has unlimited exposure, and his security is even more 'dubious assets' called debt securities. It might comfort you that their institutional exposure to these financial instruments is balanced, but the problem is, not all counterparties are of equal standing. It was only 5 years ago that the Bank of International Settlements (BIS) even talked about regulating derivatives. Its not discussed, but the major players in derivatives are the some of the same players (the likes of J.P. Morgan, Goldman Sachs) that own the Federal Reserve - that private bank that most people think is the US government.
Many economists believe inflation can be controlled by demand management...by simply raising rates. But the serious rise in interest rates in the 1980s by Fed Chair Paul Volcker disproved that. Volcker did it because he came to realise there is no escaping inflation because its not a demand-phenomena, its a monetary one.
There are reasons why markets go up, and there are reasons why they go down. Its difficult but not hopeless. I pick markets all the time...sadly I dont follow my own thinking on a great many occasions because of 'flawed psychology'. But thats the end of that 'session'. I can demonstrate it to you on this website.
Charts provide the best guide for investors and traders. They will not tell you which stock will offer you the best entry, but they will give you a powerful tool for entering and exiting the market. But you need to watch them, and ACT when your tool suggests you sell. There is a problem with using charts in that often they are 'lagging' signals, which is why I prefer chart patterns than the indicators like Moving Averages (MAV), Bollinger Bands. The reason I dont want to lag is that I dont want to miss out on upside and the possibility of an announcement-driven recovery. Corrections are quick - I think you need to use short term charts for short term decision making. Perhaps use a volatility index to gauge when you should use a short or long term chart trading solution.
My experience is that charts give you very good basis of picking direction - better than pot luck. The challenge is watching them if you are busy. And you must apply the discipline of applying them. If I expect the market to move in a certain direction based on fundamentals, take a position, but if the charts prove you wrong, follow the charts until they prove you are right, or your fundamentals appraisal is changed. Some times when the charts are coming off a very long term uptrend which has alot of support, I get very excited and maximise my exposure. But a time will come when that long term trend will be broken, and it will be convincingly so. Thats why its good for you to know when those turning points are coming, and thats why it would be good for you to focus on those 'critical moments' because alot of professional traders managing alot more money than you will be. The best way to handle these situations is to have good charting software and to use alerts to monitor your stocks and important indices. But always look at your reasons for buying and the charts before you sell, and focus on short term charts in those critical moments....if you can. If you can't because of work commitments...its a negligible setback in your long term performance and much better than the 'buy and hold' strategy that sees you wearing the losses that institutions will be selling into. You need only appreciate that the institutions that tell you to 'buy and hold' are the ones selling to you.
You can take the emotion out of trading by setting and acting on the basis of price alerts set on the basis of chart patterns. Follow your strategy though...dont procrastinate. You can always change your strategy later for 'good reasons'. :)
There will be a few surprises like a few months ago when the Dow broke resistance after establishing a new high. It defied my expectation, but as a result of selling I was cashed up when the charts told me it was about to recover, so I profited greatly from a lower weighted average price. You dont loose your shirt. You dont need to predict highs and lows, just change when the trend changes. eg. A lower low signalling downtrend.
Long term charts dont always provide a good indicator, so its useful to watch shorter term charts. If you have the time, learn about candles and how candle patterns can actually signal changes in trends, eg. Engulfing candles, hangman, etc. Understand chart patterns like flag structures and ascending wedges. You dont need to know fundamentals, but it helps a great deal. Because bad news can wipe 30-70% off the value of a company in minutes because of bad news that cant be determined from chart patterns. eg. A poor result from drilling, a law suit against the company for price manipulation or the withdrawal of a takeover. Thats why its better to have both skills. If you dont, then you need to diversify, and even if you have special insights, its probably prudent to diversify because you will make mistakes, or things you are not told are wrong, or there are things you can't possibly know. If you know what you dont know, then you will sell before it can impact on you. eg. If a company is drilling a project and there is an anticipation of good results, sell before the results are due.

The 'buy & hold' strategy works fine during economic expansions with growing leverage, but in the 1930s, 1950s and 1975-85, equities long term went nowhere for decade-long periods, as profits were eroded by inflation, or because there was excess capacity in the economy. During these periods the 'buy & hold' strategy did not work. Advisors like to recommend it because its easy to sell because it worked for the last 20 years. But in these periods of poor equity market performance my strategy of taking trade gains on the basis of charts was able to deliver investors good profits because their were periods when equities offered a 20-30% gain on average. Thats why you need to keep an eye on trend changes. Look at commodities, they were down for 15years. You need only use a simple chart pattern to give you entries and exits. When you see a commodity moving above a 10-year previous high - thats significant. Gold just broke a 27-year high, so we can expect it to move up much higher. Its not convincing yet, but the upside is huge, the downside is 5%. If I'm wrong and gold doesnt go up, then you take your small loss. Move onto the next opportunity. Maybe the move in gold will come 6mths later. Fine! Take a new position when the charts suggest. You wont profit on every position, but you will do well overall. Was it a short term change of trend or was it a long term trend change? The best buys are based upon long term trends, but when they break, the rally is going to be greater. Now sugar prices are showing positive signs. Precious and agricultural commodities are the flavour of the month.