EXCLUSIVE: Investor James Altucher Discusses the Edge in Today’s Market

I’m sure many of you know that James Altucher is incredibly active in the financial blogosphere, publishing his own blog–The Altucher Confidential–and writing everywhere from TheStreet.com to the Wall Street Journal to a daily links post at the DailyFinance.  He is equally active in the investment space, where at times he makes intraday trades while always investing for the longer term.

Recently I had the chance to talk with James about his trading and investing to learn a little more about where the edge is in today’s market…

Elliot Turner:  When did you start day trading and what appealed to you about it?

James Altucher:  I started day trading during the dot.com boom and it appealed to me because of the enormous amount of money that’s simply made going long stocks in the morning and selling later in the day.  Every day I wake up in the morning and I’m grateful for my two kids and my wife and then I get on my knees and I pray for another 1999 because that is just heaven for day trading.

Elliot: Do you think the market structure today has hurt the edge of the day trader or do you think that it’s more a function of less volatility and less exuberance with regard to equities?

James: Well, there’s a lot of volatility in markets right now. I think the problem for day traders now is that you don’t have as many retail investors in the game.  When all you have are institutions, prop traders, and hedge fund traders, and not as many retail investors there are ultimately less people to take money from.

Elliot:  That last statement evokes a comparison of the day trader to the market’s parasite or leech trying to extract money off of others. Is that correct?

James: Yes, because what you want in an ideal world is to be a good trader. In order to be good a day trader who makes money, but not a great day trader, you need a lot of bad day traders. So, you need people who are pouring money into the market that you’re now taking out.  A great day trader, on the other hand, can make money in any environment and do so against the institutions, but to be mildly good you also need some bad.

Elliot: And you recently wrote the Eight Reasons Not to Day Trade and last of your eight was that it’s impossible. Is that a new thought? Is that something that you’ve always felt about day trading?  And, if not, when did you come to that conclusion?

James: It’s a new thought because I’ve definitely made a lot of money day trading.  In the past, I’ve day traded for hedge funds and for myself. Overall, I’ve done very well in day trading. It’s a new thought that I’m not alone in thinking.  You see it coming from the prop firm world as well, with firms like Schonfeld laying off traders. First New York, a classic prop firm has also started to switch business models by going into the hedge fund business. All the banks are trying to figure out what they should do with their prop trading divisions, in part because the environment is changing so rapidly.  It’s getting to be much harder to find an edge in day trading.

Elliot: And about the banks leaving the prop business. Do you think it’s reading too much into recent events to conclude that the banks are willingly leaving the business because it’s just not as profitable as it was in the past? Or do you think it’s purely because of the regulatory structure in Fin-Reg?

James: A little bit of both. It’s still very profitable for the banks and banks have edges that normal human beings don’t have. They have access to various pieces of order flow from the exchanges, high frequency trading, and technology and executions skills that normal humans don’t have. So, it’s a function of both the law and it’s become harder to scale up profits right now.

There’s only so much money you can take out of the market and when not a lot of money is poured in and there are mutual fund outflows every day, day trading stocks becomes a lot harder to do.

Elliot: Are you a believer in the efficient market hypothesis?

James: No, definitely not.  I am a believer that the market is largely efficient but there are anomalies that exist and happen all the time. The challenge of any trader or investor is to find those anomalies, and to exploit them while they work.  When they don’t work is when a trader must look for a new edge.  Those who are capable of adapting are exactly the ones who make for a good trader over the long run.

Elliot: I’ve been thinking about the efficient market theory and how it relates to day trading’s role in the market.   One of the conclusions that I’ve been drawn to is that there’s a distinction to be made between price efficiency and value efficiency. Over time, markets have become far better at finding price efficiency but there’s an increasing amount of value inefficiency today.  As a direct result of this increasing price efficiency the day trader’s margin of success has eroded substantially. Do you agree with that conclusion?

James: I think that’s definitely true. Let’s take a stock like Intel. How are you going to really day trade Intel? What kind of edge can a day trader have on a stock that billions of dollars are traded on everyday? Something like Intel is probably priced pretty efficiently. The company has a hundred analysts looking at it, every mutual fund in the world is looking at it and so too is every hedge fund.  Overall, Intel is one of the most widely owned stocks. So in a stock like that, it’s going to be very hard for a day trader to trade it on a daily basis.

In contrast, smaller cap stocks are going to have more of both price and value inefficiency because they used to be covered by a whole tier of investment banks that are simply out of business today.  These smaller firms could not survive the economic turmoil of the last few years.  At the same time, a whole tier of hedge funds — the small $50-100 million funds — have gone out of business for the same reason even though by and large hedge fund access has grown.  The market segment that used to trade and invest intelligently in small cap stocks is not there anymore.  As a result, you can find inefficiencies on small cap or micro-cap stocks and that’s why the best traders I know stick to that domain.

Elliot: One of the key points of the efficient market hypothesis is that active investors in aggregate can’t beat the market.  As the theory goes, there isn’t really a way for an active investor to get an edge above the performance of the market after you take into account fees, taxes and the coefficient of risk. Do you think today it is far harder for a day trader to beat the market in terms of overall performance or do you think that there’s still an edge to be gained in active day trading management?

James: I think that’s two different questions. Day trading by itself has nothing to do with the efficient market hypothesis.  It does to an extent because day trading won’t exist when the market is totally efficient, but when the efficient market hypothesis was conceived in the 1960s, commissions and taxes were much greater than they are now and there was no such thing as a day trader. There were still investors succeeding year after year, like Warren Buffet, but since the rise of day trading, day traders had to deal with the additional problem that markets tend to go down during the day and up overnight.

Since 1992, if you bought the open and sold the close everyday (and assume no commissions) you actually would have lost money between then and now—during a period where the stock market has gone up something like 500%.  In that time span all the money made has been overnight from gaps upward.  Overall, U.S. markets were gapping up more than they were gapping down.  As a day trader, you have a current flowing against you even before commissions are added into the equation every day.

In addition, right now there are not enough day traders active in markets to make it an interesting game for most people.

Elliot: Do you think some of that has to do with the emergence of high frequency trading and the price inefficiency in the market moving towards ever shorter time frames?

James: Absolutely.  Even when a mid cap stock moves up or down 15 cents in a short time frame, high frequency programs head over to arb the spread. There are so many different arbitrage strategies happening on every single stock during the day that for day traders you can’t just jump in the middle to try and beat the computers.  For example, take any random ETF other than the SPY or QQQQ.  There’s usually an arb algorithm in between the bid and the spread, and another program that is trading a basket of the underlying securities against the ETF itself.

These programs keep spreads very tight on any ETF making it very hard for any day trader to find an edge. In addition to the challenges of competing against mathematical programmers all day, day trading has the psychological battle to contend with. There is a gambling component built into it and 80% of the gambler’s battle is fought against the self. Clearly you need a really good psychology to be a successful day trader.

Elliot: Let’s take a step back from day trading for a second.  You’re also active as a longer-term investor. Do you subscribe to a particular theory of investment?

James: I’m more of a value investor.  I particularly like small cap stocks, because I think that’s where the real value inefficiencies are.  In general, I like stocks that can move up regardless of which direction the market moves in. Overall I try to find investing situations where I feel the odds are greatly in my favor. For instance, I do a lot of investing in private companies in addition to publicly trade stocks. Right now I have lot of angel and VC investments.

Elliot: This summer, when everyone was incredibly uncertain, cautious, and bearish, you made the bold call that now is the time to buy stocks.  That was a prescient call and something that was a real contrarian point of view. Is it still time to buy stocks today or has that time passed?

James: It’s absolutely time to buy stocks.  Let’s look at the last time Ben Bernanke printed up a trillion dollars.  It was basically in the beginning of ’09. The market went up extremely fast.  So, what’s going to happen this time? The market will still go straight up because you can’t fight the Fed.  I don’t care what number is announced—let’s not fool ourselves—he’s going to print up a trillion dollars and that trillion dollars has to go somewhere.  A lot of that will inevitably end up in the stock market.  Even if only a portion of it does, that will make stocks go straight up again.

Elliot: Over the summer you put a target of 1,500 on the S&P 500. What’s the timeframe on that prediction and how did you come up with the 1,500 number?

James: I came up with 1,500 by looking at analyst’s estimates on earnings for next year. On average, they estimate that the S&P 500 companies will earn $94.  Give those earnings a roughly 15-16 P/E ratio and you have the index in the 1,500 range.  I think analysts are under promising and over delivering now in order to look good.  But, even discounting that number and assuming the analyst are all wrong and earnings are flat year over year, interest rates are so low that the Fed model has grossly undervalued the stock market. You can make a legitimate argument for S&P 2,500 right now. Let’s not go crazy, because I’d like to see it at 1,500 before anything else.  While I don’t claim to be a prophet, I do see the S&P at 1,500 by the end of next year.

Elliot: If you had a pool of capital right now that had to be deployed in the market, let’s say one million dollars for round number’s sake and you had the choice to do with it as you pleased, would you invest the capital for the longer term or day trade?

James: Well, I do manage money like that and am faced with the choice every day and I choose to invest for the longer term horizon. Sometimes I do make day trades though, when I think there is a clearly justifiable risk/reward setup, but day trading is not the best way to allocate that capital.  My recent article is Eight Reasons Not to Daytrade, and I wrote that largely because I don’t think day trading is a valid career choice.

That doesn’t mean that I don’t think there are opportunities during the day that aren’t worth exploiting on occasion, but in general I am a longer term investor—and the longer the better.  If you could find companies with great valuations, good long-term demographic trends behind them and good co-investors then there is reason to invest.   For instance, a company that’s taking advantage of an aging Baby Boomer population that has a cheap valuation, and Warren Buffet recently bought shares, then I know it’s probably a pretty safe bet for me to make.

If a stock has each of those qualities, then the stock will probably do well in the long run even if in the short run I go through hell. Goldman Sachs (NYSE:GS) towards the end of 2008 is a great example of this.

Want More? See why Elliot Turner sold his Gold >>