In Integrated Macro Analysis Part I, we talked about 3-D Structures and General Conditions.
In this piece we cover the Market Tower, a metaphor for the profit-generating analysis process.
Think of a giant solar updraft tower in the middle of the desert. Except in our case, the goal is not to produce electricity but trading profits.
The value of the metaphor is in the integrated nature of the tower. You have to have all the vertical elements in order for the turbines to generate electricity (profit).
Let’s expand on the metaphor a little bit. Per Wikipedia:
“The generating ability of a solar updraft power plant depends primarily on two factors: the size of the collector area and chimney height. With a larger collector area, a greater volume of air is warmed to flow up the chimney; collector areas as large as 7 km in diameter have been considered. With a larger chimney height, the pressure difference increases the stack effect; chimneys as tall as 1000 m have been considered.”
In our metaphor the height of the tower, or chimney height, reflects the impact of “top down” alignment. The more support one can draw from the 10,000 foot view, the taller the Market Tower becomes.
Here are a few off-the-cuff examples of top down factors that would contribute to the height of a Market Tower:
- Central bank emphasis on currency devaluation favoring hard assets
- Emerging market demand impacting available grain supplies
- Deteriorating consumer credit increasing the demand for rentals
Meanwhile, the size of the collector area close to the ground represents the impact of “bottom up” fundamental inputs.
The stronger the micro-fundamentals of the individual security in question (or supply / demand dynamic in the case of commodities or currencies), the greater the amount of latent profit potential embedded in the trade.
A few examples of bottom up inputs that might increase the size of the collector area:
- An exceptionally strong balance sheet (for a potential long)
- An exceptionally leveraged and weak balance sheet (for a potential short)
- Robust earnings and modest or compressed valuations (for a long)
- Low quality earnings and stretched or inflated valuations (for a short)
In an actual solar updraft tower, the chimney and the surface-level collector area work together and in concert to generate power. Similarly, for an excellent high conviction trade, top down factors and bottom up fundamentals work together in the Market Tower to generate robust profits.
Stacking the Components
Furthermore, when thinking in terms of the Market Tower, one can “stack” or “layer” the various components of a high-conviction trading opportunity.
The most abstract, high-level concepts go at the top, with the elements becoming increasingly concrete and “boots on the ground” with each step down.
In practice it might look like this:
- Macro Climate: Credit Flows, Liquidity, Risk Appetite
- Valuation Risk, Geopolitical Risk, Broad Market Sentiment
- Major Themes, Catalysts & Drivers, Secular Trends
- Bellwethers and Indices: Bull or Bear? Emphasis long or short?
- “Pockets of clarity” for various sectors, industries, commodities etc.
- Odds of directional movement for a given theme or group
- Micro-level catalysts and drivers for a given theme or group
- Industry and valuation knowledge for a given theme or group
- Selection of individual names and trading vehicles
- Tracking, isolating and targeting various trade opportunities
- Integration, execution and management of actual trades
Once again, if you think of the above as a sort of “solar updraft tower,” you see that the turbines, which produce electricity, reside at the bottom level… but it is actually the ENTIRE STRUCTURE that is responsible for the desired outcome — profit!
Construction and Timing
Also note something else. It doesn’t matter where an idea BEGINS on the Market Tower… all that matters is that the FINAL RESULT is what’s integrated.
That is to say:
- A new Market Tower could have top down OR bottom up origins.
- The seed of an idea might start with bottom-up analysis of an individual security.
- Or, it might start with a high level observation regarding supply and demand.
- All that matters, in the end, is ultimate integration of the full structure.
- Wherever an idea starts, it always extends out in both directions.
- The ideas we get most excited about, and swing hardest at, are the ones with FULL TOWER SUPPORT.
Next — the Market Tower concept can also be useful in terms of identifying the timeliness of ideas. That is to say:
- Oftentimes an idea or trading theme will be “early.”
- By doing a “tower assessment,” we can see the state of readiness for an idea.
- Sometimes the pieces for a theme won’t be in place for action yet…
- But later on those pieces WILL be in place.
- So, for this reason, we maintain a warehouse of “partially built” Market Towers in our stable.
A Few Words on Price Action
Price action deserves some special attention, as it plays multiple separate roles:
Price action in and of itself is an important fundamental input. You get an idea of what is happening, from both a top down and bottom up perspective, via what Mr. Market is telling you. (With awareness that the message is not always be rational.)
Price action is a timing tool. As Stan Druckenmiller has said, “I never use valuation to time a market.” Valuation gives a sense of the potential behind a move, but price action determines when to pull the trigger.
Price action is a filtering tool. If you have a bullish or bearish opinion on, say, three different industry groups, price action may give you the green light to go ahead and act on one of those three, but to leave the other two alone. Once you have developed a roster of bullish and bearish opportunities based on your assessment of top down and bottom up fundamental inputs, price action then acts as a triggering mechanism for discerning when to go to certain names on your list, versus which names to leave in the stable.
Price action is a position management tool. Once you are in a trade, you still have an ongoing series of decisions to make. Should the size of the trade be increased or reduced? When to take profits? When to tighten stops? How to assess the opportunity cost of this trade relative to other positions (or potential positions) in the portfolio? Price action acts as a counselor and a guide in all these matters.
With all the above said, price action is not a standalone justification for action – at least not the way Mercenaries trade. Price action is always analyzed within the context of some greater level of awareness – hence the construction of the Market Tower for recognizing and implementing the highest conviction trades.
This may be a lot to take in at first. But at the end of the day, the skilled practitioner’s actions are fluid and intuitive. When the various elements are fully internalized and built into the natural structure of day-to-day routine, it all becomes second nature.
The conceptual process of constructing the Market Tower may also give you a better idea of what it means to say that skillful trading is both an art and a science – being hard to say where one starts and the other stops.
Still to come in Part III: Horizontal and Vertical Exposure!
Also in this series:
Integrated Macro Analysis, Part I: 3-D Structures and General Conditions
Integrated Macro Analysis, Part III: Horizontal & Vertical Exposure
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