By Chris Ebert

The stock market has been compared to many things over the years; a casino, an ocean, a flock of birds. A couple of years ago it was compared to a swimming pool full of algae right here at zentrader. Those analogies are all very apt, but perhaps now more than ever the stock market is looking like a childish game of musical chairs.

Musical Chairs

musical chairsImagine a group of children playing a friendly game of musical chairs. Whatever the number of children, there are enough chairs to seat every child but one. An adult then plays some music as the children walk, skip or dance their way around the row of chairs.

For most, it is a lot of fun. Then, suddenly, the music stops. Anyone left standing when the music stops will be ostracized, thrown out of the game and left to watch silently from the sidelines. Almost immediately everyone finds a seat, except for one child.

The game is very similar to a stock market approaching a Bear market, including the propensity for the game to be rigged.

Unfair Games

In an ideal world, the game is not rigged; the adult controlling the music has no vested interest in the outcome of the game. In an ideal game all players have an equal chance of finding a seat when the music stops.

Now imagine that the adult controlling the music has some outside relationship with one or more of the players, for example a teacher running the music while the teacher’s pet is one of the players. It doesn’t take too much manipulation for the teacher to give the teacher’s pet an advantage.

All that is necessary for the teacher to give the teacher’s pet an advantage is to ensure that the music doesn’t stop at a time when the teacher’s pet has no chair available at arm’s length. It’s easy to do. In fact, it would be difficult for spectators to prove that any manipulation had taken place.

The stopping of the music often seems almost random, thus attempting to prove that it was not random is a monumental task. Beyond trying to prove it, his type of manipulation can be so subtle that it sometimes goes on without anybody noticing.pet

A group of schoolchildren might never know that their game of musical chairs had been rigged from the start. To them the music seems to start and stop at random. The same can be said for traders and investors in the stock market. Stock prices can appear to move at random… even when they are being intentionally manipulated.

Any large central bank, for example the Federal Reserve, the European Central Bank or the Bank of Japan can easily manipulate one or more stock markets. This is true even when monetary policy of these institutions is shown to the public under the guise of transparency. In reality such transparency does no more to prevent manipulation of the market than does the teacher standing in full view of the classroom as she manipulates the game of musical chairs.

If a central bank stands to profit from delaying or accelerating its monetary policy, it will have a vested interest in bringing about either such delay or acceleration, respectively. A promise of transparency merely pushes the bank to find plausible economic reasoning to justify either a delay or acceleration.

Anyone can find data to justify an action, just as it is possible to find data to refute almost any claim. Just look to any court case and this phenomenon will be visible. All a central bank needs to do is favor the data that supports its intentions while minimizing attention to data that does not. The bank then sets the appropriate policy – all the while appearing completely transparent to the public – with the intention of creating profit for the bank itself, or for an entity the bank considers to be a friend.

Look at the schoolteacher. She certainly looks impartial. She doesn’t appear to have an axe to grind. She seems to have the student’s best interests at heart. Yet the teacher’s pet has somehow never lost a game of musical chairs. Fishy? – Yes. Proof of manipulation? – Doubtful.

If it goes on in an innocuous place as a child’s classroom, it’s almost certain to be going on in a dog-eat-dog world of the stock market.

Corrupt Games

federal reserve buildingManipulation by a central bank is one thing; but what would happen if the players of the game were free to manipulate it as well. Imagine if the schoolteacher were to leave the room and allow the students to continue to play the game of musical chairs in her absence.

Now, the person in control of the music might have several vested interests in the outcome. Perhaps he has several close friends in the game. It is not unreasonable to expect he’d prefer those friends are never left without a chair. So tempting would it be for these friends to conspire to ensure that they never end up the loser, each looking out for the others to ensure they all have a chair within reach.

Banks, large mutual fund managers, hedge funds, individual billionaire investors – any one of them might be in control of the music at any given moment. Any one of them might be looking out for so-called friends. Every one of them is likely to have a vested interest in the outcome.

These entities are free to ensure that they benefit when the music plays, and they benefit when the music stops. Their friends will also benefit as well. It’s all well and good for those in the good-old-boys club. The profits keep coming in for those with the most influence over the music. Friends of the influential are raking in profits as well.

There is only one problem – each time the music stops, the number of chairs decreases. Each time there is a major pullback in stock prices, someone loses his chair, and probably his shirt.

End of the Game

When the stock market starts to get bearish, those doing the manipulation – those controlling the music – will often find themselves with fewer and fewer players. Individual investors and traders, retirement savers and the like have one thing in common: they can only take so much. When they start to talk like Popeye “That’s all I can stands and I can’t stands no more” these folks start to disappear from the market.

When the music keeps stopping, when stock prices tumble every month or every week, more and more folks are forced out of the game. Eventually there comes a point at which the vast majority of participants remaining are the big guys; the banks, the mutual funds, the hedge funds and the billionaires.chairs

Let’s face it, when the evening news on TV starts the broadcast with headlines of the Dow losing 500 points or 1000 points in a single day, it’s not the kind of market that attracts the average individual. It’s also not the kind of market that tends to attract investors from other countries.

When things start getting bearish, the only folks left in the game are those that either can’t get out because they are somehow trapped, or those individuals who thrive in adverse conditions – short-sellers and the like.

The longer the bearishness persists, the fewer the chairs remain, until at some point there are very few players and very few chairs. That point often coincides with the start of Bear Market Stage 7.

Despite all the friendly collusion, all the times the music stopped without causing major damage to the remaining players, there simply has to come a point at which there are so few chairs remaining that players realize that one or more of them will be kicked out the very next time the music stops. Despite all the friendly bonds, no player can continue to trust any others because the others’ survival depends on another’s demise.

Imagine the simplified example in which the majority of the stock market comes under the control of a handful of hedge funds, a couple of big banks, a few billionaires, and some very large mutual funds. Imagine the distrust that brews between these folks when it becomes apparent that one of them is not going to survive the next sell-off in stocks. That is what happens when they realize they have pushed the market into Bear Market Stage 7.

For a time they may avoid Stage 7, And no one can blame them for wanting to avoid it. Not even the most heartless hedge fund manager is likely to find comfort in watching a colleague’s demise. But it is difficult to avoid Stage 7 when such few players remain in the game.

OMS 01-31-16

Poor economic news can cause a sell-off at any time. Such a sell-off can be the straw that breaks the camel’s back – the straw that brings Stage 7 into being. When Stage 7 begins, all the remaining players will look for their chairs and not everyone will find one. That’s when the bottom will fall out of stock prices. That’s when the real damage gets done.

There is one hope for avoiding Stage 7 – a miracle. If global and domestic economic developments somehow undergo an amazing transformation towards a Utopian bliss, it is conceivable that Stage 7 might be avoided entirely. Absent that, the game of musical chairs will get tougher and tougher until all the remaining players turn on themselves, bringing about the very demise they attempted to avoid. Thus the default is for Bear Market Stage 7 to show itself in an all-out bloodbath very soon, unless there is some sort of miracle.

 

* Option strategies referenced above are analyzed for profit or loss on expiration day only and are opened using an at-the-money strike price, 4-months to expiration, using options traded on a broad-based ETF such as $SPY (NYSEARCA:SPY)

The preceding is a post by Christopher Ebert, Chief Options Strategist at Astrology Traders (which offers subscribers unique stock-trading perspectives and options education) and co-author of the popular option trading book “Show Me Your Options!” Chris uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to OptionScientist@zentrader.ca

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