trader

To become a really great trader takes more than smarts; it also requires you to make a cold, hard assessment of your strengths and weaknesses. You have to know exactly what you can and cannot do, trade to what you can, and not let your weakness dominate. The following lesson from Warren Buffett should be instructive in this regard.

Back in September of 2008, Goldman Sachs was looking for a “stamp of approval” so the company turned to probably the most famous and respected trader in the world, Warren Buffett. Goldman agreed to pay Mr. Buffett an extraordinary rate of interest-10% a year on $5 billion worth of preferred shares.  Buffett however wasn’t satisfied with that-he insisted on obtaining warrants which gave him the right to purchase Goldman stock for $115 per share, about where the stock was trading at the time.  In fact, Buffett never would have gotten into the Goldman investment in the first place without receiving the warrants-they were a “kicker” on the deal that he absolutely insisted upon.

Buffett probably could have negotiated a better price for the warrants because remember, it was Goldman who came looking for Buffett, not the other way around. Here’s where it gets interesting.

As Mr. Buffett has often said, he’s a long term investor with no ability whatsoever to trade in the short term. But he doesn’t let his inability to trade in the short term (his weakness) get in the way of his long term trading ability (his strength). Within three months of making the $115/share deal, Goldman was trading at about $52, making the warrants virtually worthless because no one is going to exercise the right to buy something at a loss. Aside from that, the deal looked even worse because remember that Buffett never would have bought the preferreds without the warrants in the first place.

When Goldman sank to $52, Warren Buffett didn’t turn tail and run by cashing in his preferreds because they now were attached to worthless warrants. In other words, he didn’t let himself get stopped out of the trade. Why? Because Warren Buffett was trading to his strength-the long term; he wasn’t going to let a short term fluctuation (which he admittedly has no ability to trade anyway) interfere with what he knows to be his greatest abilities.

In the meantime, Goldman closed at about $162 on Friday, meaning that Mr. Buffett is up around 40% on those warrants. And he’s still getting paid 10% a year on his preferred shares.

What would have made this trade even more difficult for mere mortals is that his positions were played out all over the financial press. And although I don’t have the exact quotes, I distinctly remember an article on CNBC which postulated that the “old boy had lost his touch” when Goldman’s price was declining. Meanwhile, Buffett had warned during an interview that it always was possible (one could argue probable) that he might get things very wrong in he short term.

So, what are the trading lessons here? First, you always want to trade to your strengths. If you have a system that works for you, stick with it. If you don’t, get one that does. Second, if Warren Buffett is one of the world’s great traders, and he sometimes has to hold a trade at a loss in order to eventually become profitable, chances are that you and I are going to have to be able to do the same thing. Most importantly, don’t get into a trade if you aren’t willing to hold a loss and don’t get into a trade if having a loss is going to make you believe that your original opinion was wrong to the point where it forces you to close your position. Those are pretty high standards-it probably means that you’re going to have less trades but it also probably means that the ones you have will be that much more successful.

On a different subject, here’s why stabilization in U.S. housing along with rising equity markets are so vital to a global economic recovery.

U.S. homes prices lead the way because they’re the ultimate collateral for the $11 trillion of US home mortgage debt, a significant share of which is held in the form of asset-backed securities by foreigners. Some economists are now saying that prices appear to be stabilizing (even though they could drift a bit lower into 2010) due to the decline of inventory overhang being brought about by the sharp drop in the number of new homes coming onto the market.

Rising stock markets are a major contributor to global business activity in two major ways. First, rising share prices will lead to increased household wealth and spending. We’re seeing this happen in China, where a 50% increase in stock markets has led the way to a 30% rise in consumption on the part of consumers. Second, as the market value of existing corporate assets (proxied by stock prices) relative to their replacement costs grow, it will make economic sense for business to make new capital investment, a significant driver of GDP.

One factor that is likely to remain as a huge driver of improving equity prices is the continued policy of monetary expansion. During a Town Hall interview with PBS on Sunday night, Fed Chairman Bernanke retained the dovish outlook displayed in his Congressional testimony last week by implying that the emergency liquidity programs will be unwound only when there is certainty of economic recovery while reiterating his expectation of low inflationary pressure over the next couple of years. He also forecasted unemployment above 10% and suggested that the first half 2010 may not mark the peak jobless rate, meaning that at this time the Fed is not expecting to raise borrowing costs until well into 2010 and possibly later.

Fed Chairman Bernanke’s little stock rally, which was initiated when he announced on 60 Minutes that the Fed was “electronically’ printing dollars, has apparently come to an end (at least for now). As a currency trader and market observer, you’ll want to know why and the reason has to do with the most famous currency pair you’ve never heard of. Ready? It’s called…

S&P/USD

That the dollar moves inversely to riskier assets like stocks (and commodities as well) isn’t a matter of some kind of mystical correlation that can somehow “break.” The key to knowing this is to understand what really is happening when stocks (or commodities) appreciate, which is easy to see once you accept the existence of S&P/USD.

Look at it this way; when stocks go up, what are they going up against? The dollar of course. The same for goes for commodities because those are priced in dollars all over the world. Well, if these riskier assets have gone up, isn’t it than also true to say the dollar has depreciated. Absolutely. So when the market is buying risk, the dollar will tend to fall as a matter of due course.

What’s really interesting is that in the rare instance (like now) when the Fed is actively trying to devalue the dollar (because the economy is faced was the more serious threat of deflation), the Fed can create a stock rally just as Bernanke intended to do by admitting to the electronic printing of dollars on national television. Why? Because if you are convinced the dollar is going to depreciate, doesn’t that also mean that anything you can buy with it is going to be more expensive? Of course. And the convinced you become that the prices of liquid assets (like stocks and commodities) are going to rise, the more inclined you will be to buy them.

So what’s really happening in the current environment is that the Fed, through its actions and comments on the dollar (and on deflation/inflation which is the same thing) is pushing the market for riskier asset classes up and down. Let’s look at some recent action.

Bernanke’s rally pretty much fizzled out in the middle of May, but it got a temporary boost (about 4%) in the week following the last meeting on June 24 when members removed the deflationary concerns which had appeared in the April 29^th statement. But then something interesting happened.

On June 30, San Francisco Federal Reserve Bank President Janet Yellen expressed some deep concerns about deflation. “I’ll put my cards on the table right away,” she said. “I think the predominant risk is that inflation will be too low, not too high, over the next several years.”

Now, remember what we said; if the market is convinced the Fed is depreciating (creating inflation), riskier assets are going to be bought because inflation means their prices are going to rise (at least nominally). No one wants to hold cash if the potential for inflation is on the horizon, because cash is guaranteed to lose value in an inflationary environment.

Conversely, if inflation really isn’t a threat and the possibility of deflation exists, there’s no reason whatsoever to buy riskier assets. Afterall, your cash is guaranteed to increase in value in a deflationary environment because prices are going down!

In fact, in a deflationary environment you make more money simply by being a “lender” (keeping for money in the bank or in Treasuries). A little arithmetic will show you how this works.

Your real (inflation adjusted) rate of interest is equal to the nominal rate (what the bank is paying you) minus the rate of inflation or R = N – i.

Let’s say inflation is 3% and your bank is paying you a nominal 4% on your deposit. Your real (R) interest rate is the Nominal (N) rate minus inflation or R = 4% – 3% which equals 1%. In real terms you’ve only earned 1% on the money you have in the bank

Now, let’s say there’s deflation (negative inflation) of -2% for the year and your bank is paying you a nominal rate of 3% on your deposit. What’s the real rate of interest you’ve earned?

R = N – I or R = 3 – (-2) = 5%. In real terms, you’ve earned 5% on your deposit!

Now, if I’m guaranteed to earn a risk-free return of say 5%, and I think prices are going down, why in the world would I buy a riskier asset? In the hope that someday its price might go up? Hope is a bad rational for making a trade.

So, Ms. Yellen, with her deflationary concerns, helped kill the rally. She wasn’t alone however; the Fed, with its expert manipulation of the media via the pundits seen all over Bloomberg, started so make plenty of deflationary noises around the middle of May.

As a trader, there are times when you can put this to very good use for longer term trends (which really is where the money is made). If the Fed does start talking about inflation and making noises like it might raise interest rates, do yourself a favor and sell the dollar as you buy riskier assets like stocks and commodities.  But if they continue to talk about the risks of deflation, there’s little reason to sell the dollar or to buy riskier assets. Buy the dollar at that point because it will be in demand.

BTW, Thursday’s weak market action off the surprisingly good unemployment numbers, along with the subsequent decline of S&P futures overnight, bodes very poorly for stocks and very good for the dollar. I can hardly think of a more bearish sign for stocks than the market failing to rally on good news. Afterall, it the market can’t rise when the news is good…