Almost everything you have ever been told about the world's stock markets is wrong.
Almost everything you have ever assumed about the world's stock markets is also wrong. You probably believe that share prices go up and down due to classic 'supply and demand' laws. You probably believe that over time, the world's stock markets will go up because of increased economic production, or inflationary pressures. You probably believe that your broker, though undoubtedly a parasite, makes his money reasonably fairly by charging you an honest declared spread between his bid and offer price. You might even be laboring under the delusion that 'fundamentals' or 'interest rates' drive price.
Wrong, wrong, wrong and wrong.
So where's the proof, I hear you squeal. OK, here we go.
Market Makers and their Role
Markets are composed of players of all sizes (including you and me!), the most important of whom are 'Market Makers'; firms who have an obligation to quote a price on particular securities whatever the overall market is doing. Brave of them, I hear you think - imagine having to buy Enron as it plummeted. Surely they ended up with most of that worthless stock in their own portfolios? Er, no. So where did it go then? Patience, little investor.
Get something straight in your mind now - although these market makers would like you to think that they are simple 'middle men', buying from Fred and selling to Joe, while pocketing the spread between those two prices in an honest, upfront sort of way, the truth is rather more devious (not to mention complicated). The real tool that market makers use to create their own profits is embedded within that sentence. The spread. I hear you think, "I have no problem with them charging a fee for their service - everyone has to make a living, and it's only a few percent after all! ". Wrong again! The whole concept of a 'spread' allows a market maker to control the market in the same way that a shepherd controls a flock of witless sheep.
How the Market should work
Imagine that a market really IS controlled by the laws of "supply and demand", and rises and falls due to the imbalance between external buyers and sellers (you and me) competing for, or shunning certain securities. In this wonderful la-la land, market makers really don't care what the market does, as they make their own money from the spread. And a nice profit is is too. But hang on - isn't there any way to make MORE money from these investing sheep? Of course there is.
How the Market really works
To lubricate their transactions, market makers need a supply, or inventory of the securities they support. This can either be real certificates, or via a process called 'stock lending' (don't worry about THAT one yet - it basically means they borrow stock or "pretend" they have it). Once you have an inventory of stock, and the concept of 'spread' (or 'edge'), a marvelous opportunity opens up. The average price at which a market maker accumulates a security and the average price at which he distributes it are going to be different. Add this to the fact that the market maker sets the price tick by tick, and boom! A license to print money. Observe closely, this is a good trick.
Let's play Chicken
I, as a market maker, decide (for no real reason, or perhaps because there has been some trivial news about them) that stock in ABC Corp is my plaything today. I don't have much of an inventory in that particular security, so what do I do? Mark up the price so external holders will sell me some? No. I mark the price DOWN. Oof. Some external parties see this as a buying opportunity, and as I am a market maker, I am obliged to sell them the security at the new, lower price, meaning I am even shorter on that security.
Sounds mad, doesn't it? But it doesn't matter, because I mark the price down again. And again. And I keep on doing it till I hit the stops of external parties who are long, but weak, or the limit orders of people who are short. As a market maker, I know where these stops and limits are. I own the book, after all.
Ordinary Joe Public mostly think the market follows the laws of supply and demand, follows trendlines or fibonaccis etc, which means they all tend to put their stops in similar places ('resistance' anyone? 'support'? That's right, it exists!). This is a game of chicken, really, and YOU will ALWAYS crack before ME (the market maker), because I can take the market to zero, or to the moon. You have to meet a margin call.
So now I am a market maker who has a LOT of supply of ABC Corp, which has fallen significantly in price. Looks like I'm holding a plum, doesn't it? What do I do next?
So what does a market maker do?
...That's right. I mark the price up. And I QUICKLY mark it up to the point at which the current price is ABOVE my average purchase price. So voila. I'm in profit. In a fairly big way. All I need to do now is unload this stock to you over a period of time at a price above my average, and I am rich. You, of course, sold it to me on the way down, and are regretting it because it is probably already way above where you exited (strange isn't it, how the market seems to 'hunt your stops', and then reverse?!) If I do this right (and it is an art form, for which successful brokers get paid multi-million dollar salaries), I create the illusion that the market is totally random, and is being driven by YOU, whereas I am simply a fee paid middleman, facilitating your activities. Even worse, I give you the vague impression that you are actually pretty good at it, and if you can only get your stops a little more accurate, you will stop losing money!
As I mark the price up, external parties start to worry they will miss out on this growth, and begin an ABC Corp buying frenzy, allowing me to unload. Everyone is happy. Most of the investing public are sitting on unrealized (imaginary) assets, while I am converting worthless shares into hard cash.
So, I have made a real, cash profit. You are sitting on an unrealized paper profit. We are all happy. Until I repeat the process and stop you out. Again. Are you getting the picture yet? In fact, once I have built a little momentum in a particular direction (long OR short) I can let you prolong it, settling simply for my spread profit. I know that eventually the run will peter out, and then I can force it the other way, easily dislodging those who took a position too near the end of that particular phase.
Let me paraphrase. When the market is zooming up madly, market makers are actually selling (usually stock they don't own!) in preparation for a subsequent managed fall, during which they can buy it back for less (i.e. make a profit). When it is crashing down, they are actually acquiring stock, in preparation for the process of selling it back to you at a higher price (i.e. make another profit).
Does it EVER behave according to supply and demand?
So how do you, as an external investor, determine whether the market is being 'sheepdogged' by the market makers, or is actually moving under the real influence of normal supply and demand? Slope. Key to a market maker being able to effectively set his average price is the speed with which he marks it up or down. For example, when squashing prices downwards, if the market maker lets the process take too long, he will accumulate stock at too high an average price, making it hard for him to reverse out at a profit. He needs to buy it at an average price nearer the low than the high. Speed is of the essence. That is why a typical day on the DOW (for example) consists of a wild rally or fall, followed by a gradual retracement, then perhaps another wild flurry of activity. Most action during the day happens in very short time periods. Now you know why.
Obviously, one of the reasons this is an art form to the market maker is that it requires a mind in tune with the thoughts of the general public in order not to 'kill the golden goose'. If a market maker is too blatant in these cash raids, the public, while not actually understanding the process, might stop playing due to the '5 times bitten' syndrome.
Long Term Rising Markets
The process works just as well either way, i.e. long or short. So why, I hear you ask, does the market generally seem to continue to rise over time (on average)? Economic growth, inflation, etcetera, undoubtedly play a part, but from a market maker's view, keeping the long-term trend up is important because it "keeps the public in the game". If everyone is convinced that long term the market will outperform property or other investments, they will keep trying to invest, no matter how often a market maker raids their account and smacks them round the back of the head with a wet flounder. This is the reason why stock markets will continue to outperform any other sort of investment over the long term - if it didn't the market makers wouldn't have anyone to suck on, and until other investment types also have a super class of manipulators, things won't change. From their own perspective, they would prefer it to wobble around a set middle, so they could cream you up and down, with little thought involved - this would enable them to hire less expert staff and cut their costs.
OK, so what about Bear Markets?
You just keep asking these hard questions, don't you? The phenomenon of bear markets is reasonably straightforward, and is basically a question of timescales. Markets are fractal - that is, without any time clues, the movements of price look remarkably similar at any resolution, from a single day up to yearly charts. Different players work to different timescales. A bear market just happens to be an occasion when a long-term element needs the markets to fall again, so they can re-supply. The more cynical among you might argue that extreme preceding bull phases mean that a standard bear jerk off is needed to restore any semblance of credibility to the game, and there may indeed be some truth in that. The more niave among you may argue that world economic cycles cause these phenomenon, in which case, the very best of luck in your trading!
Is it possible to 'get on the same side' as the market makers...
and thus win big? Of course it is. Getting right sided with the market makers takes a little practise, but is well worth the effort, because then YOU can parasitically ride THEIR efforts!
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