Lessons From A Trading Diary

13 January 2008

If I hadn’t made money some of the time I might have acquired market wisdom quicker.

- Jesse Livermore

The ING Philippine Equity Fund, despite its size, was beating the index in the first half of 2007, until the subprime crash hit, prompting it to switch gears and pursue a modified strategy.

For the largest institutional equity fund, to shift from Food and Banking to Mining, and to double Communications exposure, such changes didn't happen overnight, but over a dynamic process that took 12 volatile months. Unlike the retail investor, institutional fund managers will always worry about liquidity in their decision making. As Paul Garcia, who runs the ING Philippine Equity Fund, says, "It is difficult to move when you are bigger than the market's turnover."

This suddenly brings to my mind the Observer Effect Principle (also related to the Heisenburg Principle) in my high-school physics class: the act of observing an object, changes the properties of the object being observed. In trading, this is similar to the problem of size for institutional funds. Reflecting on the 12 month movements of the ING Fund against market action, I find it difficult to determine whether the fund was moving in response to the market action, or was it the market moving in reaction to ING's (and other funds') trades?

This is really an important context to consider: in drawing lessons from what the fund did in response to the market developments, am I really deciphering real investment "solutions" to crisis situations, or am I just tracking what funds are likely doing during such events, so I can later trade hoping to anticipate their moves?

I'll leave that question hanging for a moment so I can proceed.

Apart from the obvious industry groupings, seems institutions like ING view our stock market in with the following groupings in mind (which overlap each other in a number of cases):

Large Caps (e.g. TEL, ALI, AC, BPI) — Essentially the PSE Index
Key Factors: Liquidity, quality, priority
Defensives — are composed of:

Telecoms (TEL, DGTL, PLTL, GLO)
Consumer Food (JFC, URC, SMC) and SM
Utilities and Power (MWC, FGEN, FPH, EDC, MER, BPC, AP)
Media (ABS, GMA7)
Key Factors: General economic conditions, consumer growth and spending

Cyclicals — are composed of:

Property (ALI, MEG, RLC, FLI, SMPH etc.)
Banks (BPI, RCB, MBT, BDO, etc.)
Construction and Related (DMC, EEI, CMT, HLCM, etc.)
Key Factors: Interest rates, money supply, exchange rates, OFW remittances

Mining (PX, LC, AT, GEO, etc.)
Key Factors: Metal Prices, emerging foreign demand (China, Australia)
Others

With a framework like this, the fund's aggressive focus on telecoms may suggest continued faith in the general economy, but by shying from other consumer sectors like Food also suggests that the fund does not expect completely rosy economic conditions (business margins for telecoms are higher than food margins–so are more resilient). The moves regarding Power is more a play on the deregulation of the sector.

Cyclicals, especially banks are being avoided, due to the exchange rate and interest rate volatility.

Mining is a new focus, which is odd considering the relative illiquidity of the sector compared to the others. For a large fund to position aggressively in Mining means that the liquidity risk is at least balanced by the business prospects of these speculative companies. The sky high prices of Gold and other precious metals relative to 12 months ago may also be a strong argument to pursue the mining angle.

That covers the broad strokes. Now about the finer tactics:

In a market crash: quality names are favored due to liquidity. This was a consistent move in the 3 market routs experienced in 2007 (Feb, July, November). So it's a fairly good probability that the first to recover from any market downturn (i.e. the first that institutions will pick up) are the large caps. Any window-dressing also benefits quality names first.

During successive market rallies, the institutions try to get into some cash, which they keep around to deploy aggressively during market crashes. This is a contrarian style, which is borne out of the need to manage liquidity due to the usually large size of fund transactions. For a large fund, the act of buying will move prices up, so evidently the best time to be buying without sacrificing entry cost, is when the market is falling. Vice-versa for selling.

In times when a fund is forced to sell down along with the market, funds try to make up for opportunity cost by buying back those same shares later at lower prices–a crude short-sell. Again liquidity is a factor here, and very often the choice candidates will be the highly liquid large-caps, which also supports the "bounce" argument earlier.

Now going back to my earlier question: am I really learning anything new about the market or am I just spread betting the actions of the large funds? In an earlier Financemanila EB, where FMers met CKP for the first time, Mr. CKP imparted some advice that is relevant to this question:

"We should not trade against each other. We should patiently accumulate our stocks, and then unload when the foreign are buying at several prices higher."

The mining sector is the usual suspect here, since it is a sector that has very little institutional and foreign participation until now. Great profits were made in 2006 and 2007 when institutions started buying aggressively into mining stocks, allowing retail investors to dump their holdings from depressed prices.

Outside of mining, if ever there is a truism to be had in this case: the clearest market signals (and best opportunities) seem to be where institutions are in agreement about the prospects for that sector, so you will have many funds either buying up the stocks (e.g. Mining, early 2007) or selling down (e.g. URC, MER, FLI, late 2007). In cases where the big boys are in disagreement, prices will generally go nowhere (e.g. EDC).

A final word about this project which I'd like to leave to the reader is this: often the small trader relies on some form of analysis or lead-in to form their outlook about the market action. The top methods people on Financemanila seem to rely on are:

The movement of foreign markets like the DOW, futures, and metal prices
The economic factors (e.g. rate cuts, inflation, exchange rate) that drive the above
Technical analysis
Fundamental analysis (especially foreign broker research)

In considering one's outlook, one ought to remember that regardless of any analysis, what REALLY moves prices is order flow. Who is buying, who is selling? Who is buying BIG, and who is selling BIG. In most of these cases, it is the institutionals who will be moving your stock. The basic question now is, do the institutions agree with your analysis? Will you be buying ahead of them?

Cheers and Happy Trading in 2008!

~ Mark T. Market

Online References and Readings:

Paul Garcia, Manager of ING Philippine Equity Fund
http://www.iht.com/articles/2007/07/09/business/sxfund.php

Investment Company Association of the Philippines
http://www.icap.com.ph

Trust Officers Association of the Philippines
http://www.uitf.com.ph

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