Chartists
That sort of profit potential began to attract many ordinary people to the study of technical
analysis at a time when it was based on hand-drawn charts and manually computed indices.
Its early practitioners were dubbed chartists and viewed as the 'lunatic fringe'
by the established investment community. Jim Slater once described them as, "shabby
little men in dirty raincoats".
Early technical analysis
was a crude, inscrutable process more akin to crystal-ball gazing than a science. An analyst
would produce a graph of a share price going back anything from a few months to several years,
which, to anyone outside the craft, would look like a squiggley line. And that's all it was.
Of course, they were meticulously drawn with multi-coloured pencils on fancy logarithmic paper,
but after one had stared at fifteen or twenty such charts, they all began to look more or
less the same. Just boring, squiggley lines. The old school could be excused for dismissing
those early protagonists with their incomprehensible jargon - head and shoulders,
drooping necklines, double-bottoms, triangles, rectangles, wedges, gaps and pennants - as
complete lunatics.
Traditional investment decisions were based on
fundamental analysis. It relied on the study of company earnings, sales, growth,
management and other tangible factors that might havean impact on future dividends.
It was the realm of the bowler-hatted City professionals - accountants, stockbrokers,
bankers and economists. The very thought of a novice out performing them armed only with
a squiggley line was anathema. I was once told by a prospective employer, "What's
the use of a map that only tells you where you've been and runs out before your next step?
You could walk over a cliff and it would only tell you about it after you'd hit the ground."
I did not get the job.
In the 1960s, no City institution would admit to such folly as using
charts although their use had already caught on in America where several chart-by-mail services
were thriving.
In parallel with the spread of technical analysis, a new theory
appeared to muddy already turbulent waters. Its adherents called themselves 'random walkers'.
Joel Stern, then vice-president of one of America's biggest banks, visited London to inform
members of the fledgling Association of Chart and Technical Analysts thatthere was no such thing
as a trend and that all price movementswere completely random and unpredictable. I listened
carefully but a few of our members heckled him vociferously. The argument continues to this day,
but his ideas would have put us all out of a job. What bank would have employed analysts to select
investments at random? Eventually, the markets grew to accommodate and then depend on technical
analysts.
By the mid-1970s, computers and information technology had begun
to change the world of high finance and technical analysis. Atrend that would culminate in
the frenetic trading environmentof the last two decades where markets and technical analysts have
become each others means of survival. The first step along that road was the pioneering work of
J. M. Hurst, whose book, The Profit Magic of Stock Transaction Timing, was to technical
analysis what Relativity Theory was to Physics. It added powerful, computerised numerical-analysis
to the technician's repertoire. Even so, the City of London's largest stockjobber - with a turnover
exceeding General Motors and IBM put together - employed just four technicians in an obscure
research department producing hand-drawn daily charts from prices copied from the Financial Times.
Stock-Index Futures
At about the same time, nearly eighty years after Charles Dow had invented them, it became possible
to trade stock averages. The advent of stock-index futures contracts cleared the way for
the multitude of index and formula based contracts and derivatives that are available today.
Suddenly, the traditionalists were faced with securities that were simply too difficult or impossible to
quantify with their old fundamental techniques. They found themselves dealing in markets that were
driven by technologically sophisticated speculators - millions of them - who knew or cared little of
fundamental reality. The markets had become global. Those who had the righttools - telecommunications,
computers and fast technical software - were'skinning alive' the die-hard fundamentalists still
poring over their accounts ledgers and slide-rules.
More and more traders discovered that technical analysis could
cope with fast moving markets, indeed, it gave them an edge. Anyedge on a multi-million dollar
trade was better than a loss. They discovered that computer-based technical analysis could resolve
minute-by-minute trading action. It was but one small step tofeed electronic trading statistics from
the exchanges into a computerand read the buy/sell signal off the screen a fraction of a second later.
The computer could do this with hundreds of contracts trading on dozens of exchanges across the globe.
A task no human brain could rival.
Dow Theory has twelve basic tenets or rules. They are so simple, each can be
stated in a single sentence. The first rule was the basic assumption - the philosophical justification
for the entire theory. Four others were merely amplifications of the remaining seven 'essential' rules.
Today, technical analysts are called 'rocket scientist' and their systems are so complicated that even
senior investment bankers cannot understand them. There is a simple reason for this and it is clearly
stated in Dow Theory's first tenet: The Averages Discount Everything.
It is fairly clear, in retrospect, that the originators of Dow
Theory did not realise that it would become a victim of its own
first principle. Not long after it was popularised, it ceased to work. The market had discounted it!
Most technical analysts- those who trade, not those who sell it to the public - understand that a
winning system must remain a secret system. This is especially true in the futures and derivatives
world which is a zero-sum game. It does not create wealth - it merely shifts it around amongst the
players. For every winner there is a loser.
The futures and derivatives markets offer the erstwhile speculator
the possibility of turning a few thousand into many millions (positive or negative) in a very short
space of time. Every speculator's Holy Grail is the trading system that produces consistent
profits - fast! So great are the rewards that almost any effort is justified in its pursuit.
Anyone who had developed a winning system would guard its secret
with their life. To tell anyone how it worked, even one's employers, would be courting disaster.
Just as stockjobbers jealously guarded their own 'book' on the floor of the stock exchange - knowledge
is power. It is quite possible that Nick Leeson's personal trading system was never completely revealed
to his employers, especially if he was developing it on the fly. More importantly, it is highly
probable that it would have been kept secret from Leeson's fellow traders in Singapore. This could well
explain why Leeson and his wife were so deeply involved in the back-office. Anyone with access to his
trading records might be able to deduce his system. That person could walk into a rival firm and write
his own ticket on the back of Leeson's established trading success. Certainly, Barings' senior management
would have wanted to protect such a valuable asset. Regulators and human nature do not always coincide in their objectives.
Around three years ago, I spoke to Teddy Clark at Barings about a position
as senior technical analyst. The firm was offering an annual salary of £220,000 and more perks
than I would care to mention. A friend, a former president of a technical analysts'association,
had given me the lead along with copies of the bank's employment contract and its memorandum and
articles of association. I was not satisfied that my systems would remain my property. I passed when
Clark insisted that disclosure was company policy.
Last LaughFew of today's traders have heard of Dow theory, their only
qualification seems to be the possession of balls. Almost anyone can create a new trading system using
an optimisation program and historical price data. A new system will always be a little more complex
than the one before, but modern software has virtually automated the process. It looks easy, but Dow
Theory's first principle always has the last laugh. As soon as a system starts to take serious
money out of the market, the market discounts it. Common sense tells us that it has to be that way,
otherwise the first person to create a winning system would soon win all the money in the world!
The 'trick' is to keep optimising, adjusting the system's parameters
to offset the market's reaction to it. This can lead to a significant extension of its life expectancy,
but each new optimisation pushes the system a little closer to the envelope. Its risk-reward ratio
climbs geometrically for reasons enshrined in Dow Theory. Until rule number twelve is invoked:
A Reversal In Trend Can OccurAny Time After That Trend Has Been Confirmed.
Optimisation during a trend reversal usually leads to financial
disaster. In futures and derivatives, a tiny mistake is amplified a thousand-fold.
The result is a blow-up.
In the old days, speculators were protected by the twin devils
of fear and greed - the gambler's emotions. Computers do not know fear or greed, they do not have any
common sense, either. Anyone trading off a screen soon loses touch with reality and common sense.
The squiggley line rules.
Nick Leeson's superiors knew exactly what he
was doing, although it is now clear that none of them knew what they were doing!
Peter Baring's first instinct was to save his own backside by crying conspiracy! Leeson
reacted by throwing away his bullet-proof vest, a full and wide-ranging indemnity within his contract
of employment, and threatening to implicate his superiors in criminal activity through the publicist,
Max Clifford. I faxed a note to Clifford warning him that the establishment would never bring Leeson back
o stand trial in England and offering to help Nick invoke his'irrefutable' defence. Clifford did not
respond and Leeson's allegations were the next day's headlines.
ForecastLeeson is about to be set-up as the fall-guy of the century.
One does not need to study a squiggley line to forecast that not one senior Barings executive will
attend his trial in Singapore, even if they can be subpoenaed. The measures put in place by Barings
senior management to fool its auditors and deceive banking and exchange regulators will be portrayed
as evidence of Leeson'sown attempts to deceive its higher echelons.
He will be tried alone, in a foreign country, without a single
material witness or shred of evidence to prove his version ofthe biggest futures blow-up in British banking history.
Imagine what would have happened if Barings's futures trade had succeeded?
Barings would have made profits of tens, perhaps hundreds of millions. That was the expected outcome.
Is it conceivable that it would have allowed its auditors to tell the world that it had done so by
risking almost a billion pounds on a naked futures punt? More than the bank's entire capital, in
contravention of every banking and exchange regulatory rule in Britain and Singapore? Is that a
credible scenario? Of course not. The famous error account and bogus client accounts were in place
to launder those highly speculative profits and disguise their source from the auditors.
Nobody at Barings appears to have studied Dow Theory. If they had they would have remembered the
full text of its first principle:
The Averages Discount Everything (except "Acts of God") -Because they reflect the combined market activities of thousands of investors, including those possessed of the greatest foresight and the best information on trends and events, the averages in their day-to-day fluctuations discount everything known, everything foreseeable, and every condition which can affect the supply of or the demand for corporate securities. Even unpredictable natural calamities, when they happen, are quickly appraised and their possible effects discounted.
Barings, by failing to discount the ultimate squiggley line - the
seismographic trace of the Kobe earthquake - found itself discounted by the market: £1 for lock,
stock and a barrel of laughs!
© Copyright P Koupparis 1995. All rights reserved.
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