Sheep among wolves, or wolf among sheep?

I caught the movie "The Wolf of Wall Street" last week, starring DiCaprio as Jordan Belfort, a New York stockbroker who ran a firm selling securities. The show is excellent, entertaining and filled with eye candy. More blatantly, it highlights the potential conflicts of interest in broker-client relationships, and this concerns you whether you are a stock speculator, property investor or forex trader in Singapore.

Broker-Client Relationships

For stock brokers such as DiCaprio in the movie, the more clients transact, the higher the broker earnings through commissions. These transaction costs add up for the investor and can negatively impact the investment performance of a portfolio. Unless high frequency trading or stocks rotation is part of your portfolio strategy, one should always minimize transaction occurrence as much as possible.

While the movie instills our suspicions in brokers, it is no question that brokers play an important role, providing information and convenience to investors, as well as liquidity to capital markets. And they deserve to be compensated fairly. The best brokers who build sustainable careers in their respective industries have their clients' best interests at heart, even though there is always room for misalignment.

How to Reduce Trading Costs?

One possible way to avoid incurring excessive trading commissions from overtrading is to only buy during recessions. Even though recessions only happen once in a blue moon, purchasing an asset during the downturn can also be extremely profitable, assuming of course that markets recover. As Warren Buffett warned, “You pay a very high price in the stock market for a cheery consensus.” In other words, if everyone agrees with your investment decision (in a bull market), then it’s probably not a good one.

Baron Rothschild, an 18th century British nobleman and member of the Rothschild banking family, is credited with saying that “the time to buy is when there’s blood in the streets.” This refers to an economy that is dismal, stock markets are red, fear is at its highest, and people are losing their jobs.

How do we identify such periods of "oversold" periods?

In his 1978 book, New Concepts in Technical Trading Systems, J. Welles Wilder introduces the Relative Strength Index (RSI), which is a momentum oscillator that measures the speed and change of price movements. RSI oscillates between zero and 100. Traditionally, RSI is considered overbought when above 70 and oversold when below 30.

We have plotted the 9 period RSI to a variety of asset classes below. The top portion of each chart shows the price of the asset in blue. The RSI is plotted in the bottom portion, oscillating around the horizontal green oversold line of value 30, and the horizontal red overbought line at value 70. When prices go below the green oversold line, markets are oversold and one can expect a bullish move to ensue. For ease of visual recognition, we plot vertical green lines whenever the RSI indicates an oversold period. All graphs below are sourced from Bloomberg.

FSSTI Singapore Index 15 Year Graph

The Straits Times Index saw oversold periods around 2001 and 2008, which were followed by equity market rallies. Right now the RSI value is 42.4134, not yet below 30. It will be interesting to see the next time the STI becomes oversold as it only occurred twice in the past 15 years.

S&P 500 Index 15 Year Graph

This trading indicator is not limited to local markets, as we see successful oversold signals on the S&P 500 Index as well. S&P was oversold around 2002 and 2008, which was followed by a bull run. Unlike the Singapore markets however, S&P is currently at overbought regions with the RSI value at 71.1775. Some traders may be getting ready to take profit during such times.

DBS 10 Year Graph

The previous 2 examples were equity indices; what if we apply this concept on a particular stock? The 9-period RSI seems to have identified 2 larger oversold periods successfully on DBS, once around 2008 and more recently around 2011.

Gold 15 Year Chart

The previous 3 examples pertained to stocks; what if we take a look at Gold's trading chart? The oversold periods are even rarer, with the first occurrence around 1999, and gold has been pretty much in a bull run since then, with more instances of RSI above the center line value of 50, than below. It is interesting to see Gold oversold in 2013 as well, could this be the start of another run up?

SGDUSD 15 Year Graph

What about foreign exchange markets? The above chart plots the same indicators on the Singapore/US Dollar chart. Forex traders who held Singapore dollars against the USD saw oversold periods around 2001, and the Singapore currency has been strengthening ever since. Good news for all of us in Singapore!

Singapore COE (Category B Above 1600cc) 10 Year Graph

In the final chart, we take a tongue-in-cheek look at something close to every Singaporean's heart - COE prices. This is a 10 year graph of COE category B above 1600cc prices. COE prices were "oversold" after the financial crisis in 2008, and more recently around 2013. Thereafter COE prices increased. Perhaps drivers can wait for COE prices to be "oversold" before buying their cars?

Challenges of Recession Investing

In an ideal case scenario, investors can reap huge returns by only buying during recessions, when prices are at or near their cheapest. However, this poses challenges because:

1. Many people are impatient and are not able to wait years for an opportunity. Human psychology prefers many small gains over a long period of time, as opposed to no activity followed by one sudden gain. Trading frequently with incremental profits boosts an investor's confidence but incurs higher trading costs.
2. Many investors are already invested before the market crashes, often buying in during the bull run which Warren Buffet calls "cheery" markets. So when stock markets tank, they are already incurring losses, and the last thing they want to do is invest more. The Golden Rule of trading is to cut losers and let winners run. But investors caught by a stock market tank do the reverse, often holding on to losers and hoping they can make back what they lost on paper.
3. There is much fear and uncertainty during recessions and sell downs, and nobody is certain that markets will recover. So it takes courage to buy when no one else is buying.

Back to the Movie

I will conclude with what to me was one of the most impressionable scenes from the movie "The Wolf of Wall Street". When Belfort first joined as a rookie stock broker, he was taken out to lunch by Mark Hanna, his new boss at LF Rothschild. Here is the scene:

Hanna: "Name of the game, move your money from your client's pocket into your pocket."

Belfort: "And if you can make a client money at the same time it is advantageous to everyone, correct?"

Hanna: "No." "Nobody knows if a stock is going to go up, down, sideways or in circles. You know what a fugazy is?"

Belfort: "Fugazy: it's a fake."

Hanna: "Fugazy, fugazy; it's a wazi, it's a woozy, it's ...... fairy dust."

In the same scene Hanna said: "First rule of Wall Street, nobody, and I don't care if you're Warren Buffett or Jimmy Buffett, nobody knows if a stock's going up or down, or ..... sideways, least of all stock brokers. But we pretend to know."