May 18, 2010

Global Statistical Arbitrage is No Snot Mark

Global Statistical Arbitrage is not nearly so good a name for a rock band as the one my lovely Karen quipped after cleaning the glass on a patio door where the cat presses her nose: Snot Mark.

Snot Mark is also a tempting description for what’s happening behind share prices and volume, at least at times. But Global Statistical Arbitrage is more accurate, and widespread.

It’s a term that can induce instant narcolepsy too, so we’ll make it interesting. The Nasdaq can be up, the Dow down. Your stock is up, your nearest peer, down. Overnight the Asian markets are up on “renewed enthusiasm,” while by mid-afternoon the following day Europe is down on “rising pessimism.”

It’s statistical arbitrage on a global scale. It can be confused for other things, such as investing, which it is not. Suppose you were buying and selling Robert Graham shirts and doing the same with off-the-rack Macy’s brand clearance shirts. Most times, the price difference between the two asset classes is constant, but slight differences in shirts, fabrics, times of day, and customer interest produce little gaps. It’s on those that you make your money.

To the observer, it would appear that a brisk business is being done. The Robert Graham shirts are really moving and that discount rack keeps clearing out. Ah, but little actual buying and selling is occurring since most times you’re procuring and dispensing the same shirts over and over, with little risk. I’m reminded of what a sharp Israeli client once said, no doubt borrowing it from a time-tested lexicon of smart observations: “We don’t confuse busy with productive.”

Arbitrage often gets people to mistake busy for productive. Arbitrage is the former. Traders weave currencies, futures and options, and global equities into an arbitrage model to capture small, quick price gaps. European banks are doing it. Classic institutional money managers are doing it. Broker portfolio trading schemes are doing it. The catalyst for the explosion of the high-frequency version is monetary intervention over the past two years. It distorts prices – creating a “Trader’s Paradise,” to borrow and twist that old rap song sung by Coolio and penned by Stevie Wonder.

By contrast, arbitrage is risky in markets without price controls or monetary intervention. If there’s no best bid or offer, no mandated one-penny spread between price points, how do you assess your arbitrage risk? You can’t. Yet the Synthetic Market Rip on May 6 is likely leading to more controls, more intervention. Arbitrage opportunity, and therefore risk of another synthetic rupture – if your market is dominated by intermediaries you don’t know its real value – increases. It’s going to happen again.

Solutions are simple. Remove price controls. Expand the supply of currency only when saved capital increases significantly, if at all. That way, the medium of exchange isn’t being used to correct gross failure but instead to match investment capital with opportunity.

And wait! There’s immediate good news beyond simple solutions. One upshot to arbitrage markets is that they winnow some wheat from chaff. We see stark market-structure differences between companies with tight messages and IR outreach adapted to market structure, and those doing the same old things the same old way.

Price is not the measure of solid IR. Sometimes great stories have extended gaps between the rational price and the noise from intermediaries. But real value returns as fulcrum. Knowing what’s productive in your trading and what’s just busy makes you cool in crowds of intermediaries. Alas, there’s a lot of busy right now, and not much productivity. Forewarned is forearmed.

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