Behind the Trade

We were in King Soopers and they were out of lemons.

For those of you elsewhere in the country and world, King Soopers is a Kroger-run grocery chain and I’m sure you’re thinking as I did when I first saw one, “Who names a store King Soopers?”

I bet you’re also thinking, how do you run out of lemons? Answer: deliveries hadn’t arrived. We take for granted that stuff will be on the shelves. Having lived a year in Sri Lanka in college, where oftentimes there wasn’t anything on the shelf because no shipments had come, I grasp limited liquidity.

When stocks rise in price, we figure there must be more buyers than sellers. When they decline, the opposite must be true. You laugh, yes. But how do shares get on shelves in the first place?

A long time ago, there were just a couple stores, like the New York Stock Exchange, owned by the firms who stocked the shelves – literally. Brokers had books of business comprised of owners of shares. In 1792 under a buttonwood tree in lower downtown New York City one May day, 24 brokers agreed to confederate, recognizing that pooling business would create a marketplace. The NYSE was born (next week it becomes a subsidiary of derivatives market The ICE).

Today, where’s the store? Who’s got the lemons and how do they show up on shelves? The answer in a sense is that today’s stock market is the opposite of Walmart. It’s many tiny stores connected by a giant distribution network. It’s a “fragmented market,” where no one carries all the products or enough supply to meet needs.

Imagine if you could swoop away from Aisle Nine in the stock market, where a blue light is flashing above canned goods, and back through those mysterious swinging doors at the rear of all grocery stores that always had me wondering as a kid, “What’s back there?”

The answer is the warehouse is back there. If canned goods are on sale in the grocery store, it’s because of oversupply. Prices are slashed to move the product so the supplier and the store can both reduce inventory.

In the stock market, there are few of your shares available most times. For a broker to carry shares, it must commit capital. Inventory is expensive. Most only stock the “products” in high demand because those sell fast – like Apple, Microsoft, and so on.

Brokers called wholesalers or interdealers have as their primary business the “warehouses” of the market. Increasingly, this is the domain of fast traders like Two Sigma, Citadel and RGM, which build models and algorithms to shift inventory around.

When there’s a run on a product, wholesalers may corner the supply and start allocating it, which drives up prices. At other times they’re caught with too much inventory in a stock that suddenly experiences stalling demand and they dump it to reduce risk.

In a sense, a large majority of market activity is just logistics, not buying and selling in the investment sense. Indexes and ETFs are major consumers of products but they constantly rebalance. Around these mighty whales are the remora fish, high-frequency traders, the suppliers moving inventory to profit on fluctuating demand (apologies for mixing metaphors). This interaction accounts for something near 75% of all market volume by our measures.

Bottom-up investors are grocery shoppers in a marketplace where prices are set by logistics. The marvel of this system is its almost preternatural capacity to anticipate fluctuations – a technologically developed sense that’s so good you’d think it must be inside information. But it’s not. These firms build tremendous predictive models.

But the downside is that no investor really knows the true supply of any product in this market. Are there lots of lemons or did I just buy the only one in the whole distribution system? In this construct, a proper assessment of value versus growth investment is elusive. It’s the most massively intermediated market the world’s ever seen (other than the US economy).

Everybody knows that if you want a good deal you eliminate the middle man. Except in this case that would mean bare shelves, or overflowing ones – and neither is good. Think about that next time you buy some lemons.