For the Birds

Did you know the Caribbean is full of brown boobies? 

The blue-footed brown booby, about the size of a seagull.  We’re just back from sailing St Martin and St Barts, where the critters of both sea and sky delighted.

Unlike the stock market, apparently, which has gone to, um, the birds. 

By the way, best food in the islands?  Grand Case on St Martin. It’s French. Need I say more?  On our boat, we had French food, French wine, French chef.

It’s a wonder we left. I gained five pounds. You can see it in the photo, aboard our catamaran in St Barts (more trip photos if you’re interested).

Tim and Karen Quast aboard Norsegod in St Barts Harbor (courtesy Tim Quast).

Back to stocks, we should have expected cratering markets because fundamentals have deteriorated dramatically.

Oh no, wait. They haven’t. 

Zscaler (ZS), which has been crushing expectations every quarter, is up just 6.7% the past year now after rising over 500% the past five years. It’s down 33% the last six months.

Philip Morris (PM), which is not growing, is down 7% the past five years but up 8% the past six months.

The popular explanations for why these conditions exist have reached such shrieking insanity that I might be forced to return to the sea.  And French food.

First, let’s understand how stocks go up.  Not the “more buyers than sellers” version but the mechanics. 

There is demand.  It can come from investors, traders or counterparties. Active investors buy opportunity, Passive investors buy products – growth, value, etc. Traders chase arbitrage (different prices for the same thing). Counterparties buy or sell to meet or mitigate demand for derivatives like options.

When all converge, prices explode. 

And there are compounding factors. Many investors now prefer Exchange Traded Funds (ETFs), which don’t increase the SUPPLY of stocks, just the DEMAND for them.

And traders buy or sell short-term prices with connection only to previous prices, leading to spiraling short-term gyrations.

And derivatives as both implied demand and supply magnify moves.

Are you with me still? Think this is for the birds?

The Tetris of the stock market, the arranging of these blocks, distorts perceptions of supply and demand and fosters absurd explanations.

And over time, it erodes realized returns.  All the toll-collectors – money managers, ETF sponsors, trading intermediaries, stock exchanges, counterparties – get rich.

As of yesterday, the Nasdaq is up about 6.5% annually since March 2000, before taxes and inflation and without respect to risk premia. Tech stocks move 3.5% intraday daily.

You see? Daily price-moves are more than half the average expected pre-tax returns. That’s because of what happens when all the Tetris blocks start falling.

Here’s how. Active investors stop buying equities. Passive investors slow allocations and see redemptions.  Speculators stop setting prices. ETFs have to redeem shares so compounding demand is suddenly replaced by a vacuum. Implied demand via derivatives vanishes.

And prices implode.

This is how the DJIA drops 800 points in a day.

And we haven’t even talked about short volume.  The SEC permits intermediaries to create stock when no real supply exists to satisfy it. That is, they can short stocks without borrowing.

That works great on the way up as it provides supply to rising prices that would otherwise go unsatisfied. On the way down, we become aware that the implied demand in created stock just doesn’t exist.

So, Tim. What can we do in this market?  

You can’t control it.  We could fix it if we stopped letting shilling Fast Traders set prices and create stock.

If we junked the continuous auction market and returned to periodic auctions of real demand and supply. No real buyers or sellers, no prices.

And stock markets should actually compete by offering separate “stores” that aren’t connected electronically and forced to share prices. As it is, markets are just a system.

Alas, none of this will happen anytime soon.

So.

We can continue as companies, investors and traders fooling ourselves that fundamentals drive markets.  Or we can learn how markets work. The starting point.

Otherwise, we’re like somebody reading the opening line today. “Did he just say ‘boobies’?”

I was talking about birds.

We need to understand the topic. The market (ask us, we’ll help).