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In Secret #6. we discussed the almost impossible task of pre- dicting futures and stock prices. However, out there are some methods that will improve your ability to predict the future; in other words, crystal balls that work sometimes. We live in a prob- lematic world where there are no sure things, but there are ways to bend the odds in your favor where you are right about the fu- ture more often than you are wrong.

We are in the midst of a technological revolution. In the next two decades computers will probably become more intelli- gent than humans. This is due to the fact that microprocessors’ speed doubles every eighteen months and has for the past thirty years. The explosion in technological development will accelerate as the computer becomes more intelligent.

Forecasting techniques that have developed due to this rev- olution include neural nets and genetic algorithms. These tech- niques are only possible with high-powered computers, which are now even in the home.

Neural nets use a methodology similar to how our brains work and identify patterns in data that cannot be identified by the naked eye.

Genetic algorithms is an evolutionary process similar to how we evolved from microorganisms over millions of years. With super fast and powerful computers, the evolutionary process can be replicated on the computer.

One company, Ward Systems, has trading systems software that use neural nets and have developed a specific software that may give you an edge. We also have experimented with neural nets in predicting stock index moves and have formed systems that predict market moves about 60% of the time. Nevertheless, because even neural nets can only have a small porthole on the future, this still tells us that the markets approach randomness.

Besides, these artificial intelligence tools, such as neural nets, do require a lot of work and a lot of continued retraining to implement.

Furthermore, even with these futuristic techniques for pre- dicting the markets, when too many people use these methods and millions of dollars are poured into this process, the markets will become even more efficient and the future less predictable.

You may be able to develop a system that finds a peep hole on the future, but that could take a lot of work and continued re- tuning of your system.

Here, again, the advantage of options trading comes through; you don’t have to predict the future.

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Secret

11

MAVERICK

INVESTING

To truly predict what the markets will do in the future, you need to look at the field of psychology and group behavior.

Since the start of the NYSE, it is well known that specialists who make a market in listed stocks make a lot of money each year. Why? Because they are forced to buy stock when prices are falling and sell stocks when prices are rising. Their job is to make a market in a stock, which means they must buy stock when everyone wants to sell and sell stock when everyone wants to buy. This forces them to be on the other side of the crowd. Emotion- ally they prefer not to be in that position. In fact, when the mar- ket is falling, they would prefer to be also sellers. The specialists in a sense have been forced to be contrary investors in the very short term. Consequently, in the end they are the winners.

Markets at times tend to move to extremes. When they do, you have a chance to stack the odds in your favor and improve

your odds of predicting future price moves. The problem is that when markets move to extremes, you, like everyone else, emo- tionally don’t want to take an opposing position. Despite this aversion, ironically, the best time to buy stocks is when there is blood in the streets and when in the pit of your stomach, you feel the world is about to end.

Markets tend to overshoot and undershoot their true value and at times become irrational as we saw in the internet crash in 2000. Here it is easy to predict the future, if you have the guts to go against the psychology of the crowd.

However, to be a successful contrary investor or maverick investor, you must be patient and wait for the real extremes. Buy when there is a lot of fear in the market and sell when there is a lot of euphoria and greed in the market. You also must control your greed in the midst of a bull market and control your fear at the bottom of the market.

One indication of whether the stock market is near a bottom is the CBOE Market Volatility Index (VIX). This index measures the implied volatility of the S&P 100 Index Options and, as a re- sult, is a good measure of the fear in the market.

When implied volatility is high, options are expensive. This is because when there is a lot of fear in the market, investors buy put options, forcing put prices up, making options more expen- sive, and the VIX measures how expensive options are. The higher the VIX, the more fear there is in the market.

The index moving above 35% suggests that we are near a market bottom. (There is one exception to this rule. If the market

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is really volatile, the VIX should be high to reflect that volatility. Then the VIX will not be as predictive.)

Knowing how fear and euphoria work in the market and using it for you rather than against you is a self-discipline you have to acquire. Emotionally as well as intellectually, you have to prepare yourself for the game.

M A V E R I C K I N V E S T I N G

Secret

12

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