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Posted 11/30/2000
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The Speculator
A swingin' Gestalt theory to rock your stocks
In search of a new guide to market psychology? We propose Swing Systems 100, based on the idea that stocks tend to bounce around round numbers. It tests well, but execution will take patience and nerve.
By Victor Niederhoffer and Laurel Kenner
The market's broad swings this year were framed, and perhaps predicted, by holidays.
On the eve of the new millennium, the S&P 500 ($INX) closed at an all-time high. Then, as people began to worry that perhaps Dow 40,000 wasn't inevitable, bearish emanations from the Federal Reserve, hedge-fund managers and doomsayers carried the market to a 6.2% decline through Memorial Day.
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After Memorial Day, people developed a more optimistic view, and the market rallied 10% to Labor Day.
By Labor Day, it was time for a swing back to negative psychology. In addition to the old negative factors, there was a new one: uncertainty about the outcome of the election. The S&P 500 Index declined 12% to Thanksgiving.
Since Thanksgiving, the S&P 500 has been little changed.
The markets' seemingly blind rushes to and fro belie the calm in the U.S. economy and underscore their link to swings in psychology. Gross domestic product, personal income and inflation statistics have been remarkably stable. Earnings are up and interest rates are down.
For things to switch course, people are going to have to go from a negative mental state to a positive one. These switches tend to happen around holidays and beginnings of months -- and, we suspect, elections. As we go to press, we can see some light. An NBC News poll released Tuesday indicates that, by a 4-to-1 margin, Americans believe Texas Gov. George Bush won Florida. No way is the invisible hand of government stasis going to allow the public's will to be subverted, especially while the stock market is in the doldrums.
Markets, after all, are far from random, chaotic places. Like it or not, it's absolutely clear that what's been influencing every move of the market every minute for the past month are the relative prospects of Bush vs. Gore, with the former bullish and the latter bearish.
So, we're ripe for a change.
Ready for a new Gestalt
The early 20th-century Gestalt psychologists developed some theories on perception that we find pertinent in explaining why vivid events tend to create a frame of reference.
They noticed that people organize complex visual fields into coherent wholes, or gestalts, rather than seeing unrelated elements in isolation. And when organizing a gestalt, people like a focus. Recall the famous picture of the vase set off by profiles -- impossible to see both at one time.
The Gestaltists came up with a series of laws to describe how people arrive at perceptions, some directly applicable to the stock market:
The law of proximity. Elements close to one another in space or time will be perceived as groups. Market application: Investors paint an entire picture out of a few anecdotes and switch systems accordingly, thereby continually cheating themselves of the opportunity to get an edge and make a profit.
The law of continuity. A string of items will indicate where the next item in the string will be found. Market application: A string of declines, a string of earnings warnings or a series of rallies gather momentum.
The common fate principle. Items that move or change together will be seen as whole. Market application: Companies in an industry tend to suffer or benefit from the miseries or good fortunes of the outliers.
The law of closure. Parts of a figure that are not presented will be filled in by the perceptual system. Market application: Need we say more?
Even as the price-to-earnings ratios of many tech stocks approach that of value stocks, our readers are not likely to take advantage of the fact that it is darkest before the dawn, or heed our prediction that there should be a spectacular rally in the markets starting by the end of December. So we turn instead to an application of Gestalt psychology: the importance of round numbers.
Round numbers -- 100, 5,000, 10,000 -- have a tendency to attract attention, orders and trades. Thus, the common effort to price items at $9.90 rather than $10.00, and the tendency of your friendly gas attendants, in the rural areas where they still exist, to top out your gas to exactly $10 or $20.
The IBM roller coaster
The attraction of the number 100 is particularly relevant right now. Take IBM (IBM, news, msgs), the traditional technology bellwether. IBM has been seesawing below 100 when the market looks bad, and above 100 when the market is good.
Since Oct. 17, when IBM reported third-quarter sales that fell short of estimates, the stock has crossed the 100 barrier on five occasions.
By buying at the close on the first day that IBM fell below 100 -- and selling and going short at the close of the first day that IBM rose above 100 -- the speculator could have made four successful trades out of four, with an average profit of $3 a turn.
Round trip on the IBM Express
| Trade Date | Buy/Cover | Sell/GoShort | Profit |
| Oct. 18 | $95.50 | ||
| Nov. 2 | $102.00 | $6.50 | |
| Nov. 9 | $99.50 | $2.50 | |
| Nov. 17 | $102.00 | $2.50 | |
| Nov. 21 | $98.50 | $3.50 | |
| Current | $97.88 | -$0.63 | |
| Profit | $14.37 |
The tendency to oscillate around 100 or alternatively, as we like to think of it, for 100 to have a gravitational attraction, seems to be generally true of stock prices.
To tap into this phenomenon, we looked at each of the companies in the S&P 500 as of June 30, 2000. We found six companies that were selling for between 90 and 110, and thus were reasonable candidates for Swing Systems 100: Comverse Technology (CMVT, news, msgs), IBM, Johnson & Johnson (JNJ, news, msgs), Eli Lilly (LLY, news, msgs), Mercury Interactive (MERQ, news, msgs) and Sun Microsystems (SUNW, news, msgs).
In all, there were 34 trades with a total profit of 150 points. Assuming round-trip costs of 25 cents a trade for bid-asked spread and commissions (these are all stocks with huge market values, and the spread is normally 6 cents), the total profit is 148 points, or about $4.25 a round trip.
The average trade takes about one month to complete, so that's 4.5% a month.
The average variability of the individual trades is 8% per completed trade, and with 34 trades, we can have a reasonable degree of certainty that the results weren't due to chance variations alone.
System takes some nerve
One major caveat: During several of these trades, the maximum loss exceeded $50. It will take much staying power, diversification and internal fortitude to stay with a system like this, even if the results in the next period are as good as we found in our test.
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In addition, a caveat of our own: A system like this tends to work when the S&P 500 is in a narrow range. Since June 30, the S&P 500 has fallen from 1,454 to 1,336, an 8% decline. But had there been a decline of the likes of 1987, many of the longs would have been creamed.
This system takes small profits and is afflicted with long waiting times when it's not profitable, during which unrealized losses can be staggering.
We would also point out that this is a system that appears to work for S&P 500 companies. It is quite likely that it would not work for Nasdaq 100 ($NDX.X) companies. Here are the current candidates from the S&P 500 that are between 90 and 110. (We'll leave in the ones that also happen to appear in the Nasdaq 100).
S&P 500 candidates for Swing 100 trades
| Company | Nov. 27 close |
| Veritas (VRTS, news, msgs) | $106.00 |
| PerkinElmer (PKI, news, msgs) | $104.06 |
| Cardinal Health (CAH, news, msgs) | $101.13 |
| Minnesota Mining (MMM, news, msgs) | $99.25 |
| IBM (IBM, news, msgs) | $98.44 |
| Broadcom (BRCM, news, msgs) | $97.56 |
| Johnson & Johnson (JNJ, news, msgs) | $97.38 |
| Merck (MRK, news, msgs) | $91.63 |
| Loews (LTR, news, msgs) | $94.88 |
| PE Biosystems (PEB, news, msgs) | $93.88 |
| Progressive (PGR, news, msgs) | $93.69 |
| WellPoint Health Networks (WLP, news, msgs) | $93.50 |
| Comverse Technology (CMVT, news, msgs) | $93.38 |
| Exxon Mobil (XOM, news, msgs) | $93.13 |
| Sanmina (SANM, news, msgs) | $93.06 |
| American Int'l Group (AIG, news, msgs) | $92.69 |
Taking all considerations and caveats with one another, however, we are partial to the system. We plan to implement it ourselves, initiating only from the buy side. In other words, we'll buy if the stock falls from above 100 to below 100 and sell when it returns -- but we'll never hold a short position. We'll let you know how it goes.
At the time of publication, Victor Niederhoffer owned Sun Microsystems. Laurel Kenner did not own any of the equities mentioned in this column.
MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.