November 17, 2009

How Do You Know What’s Real?

We’ve gone and done it.

We’re moving the Market Structure Map to a blog, to invite comments (so please comment!). Don’t worry, we’re not about to start tweeting. But I do like the interactivity at the blog. We’ll dual track with the email awhile, then move to alerts about the weekly post.

In the Michael Jackson movie “Just Do It,” the legend is backed by a cadre of dancers in one scene, who, through “green screen” technology are replicated so that it appears to viewers to be a vast dancing army.

Vast Dancing Army would be a good name for a rock band. And Green Screen might be at work in the equity markets. Is trading real, or replications that create an illusion meant to mimic reality?

It’s an important question. Ben Bernanke said yesterday:”We use our interest rate tools to try to meet our mandate — full employment and price stability.” A tagline on the European Markets WSJ update today read: “Traders said stock-market sentiment remains positive, buoyed by rising faith in a global economic recovery.”

The Fed can’t prestidigitate jobs, resulting in full employment, or magically materialize price stability reflective of balanced supply and demand. It can only toy with monetary tools to produce a facsimile of that outcome in the behavior and availability of money. Markets can only reflect whatever factors affect the behavior of money.

So, do markets reflect rising investment and production, or just a facsimile thereof? And if so, what’s that mean to your stock price a week or a month or a year from now? These are the questions that matter to IR. Alas, monetary factors, and the traders’ responses to them, carry more weight at the moment than your business fundamentals.

Here’s an example. On November 12, we saw a marketwide hedge reset in equities. Quite literally, it was a seismic ripple through every shape, size and form of equity. Institutions use risk-management systems and software to modulate risk relative to economic factors and monetary policy. These systems use the same data, so the effects are similar. And they invariably happen ahead of options expirations, occurring this week.

Electronic trading is initiated to rebalance mixes of securities. Not just equities, but other instruments ranging from debt to treasuries, to commodities (which can now be traded daily in Exchange Traded Commodities vehicles), and currencies (which can also be traded in ETCs). So on Nov 12, these assets were tweaked. On Nov 16, when LEAPs – long-term market futures – converted, institutional asset managers did not renew their portfolio insurance at the same levels, and instead put some money into equities.

Boom, the market shot up. We saw the same thing around LEAPs expirations on July 13. It’s eerily similar.

The question is: what’s real? Is this a response to fundamentals, or a reaction to monetary policy?

The data tell us it’s a Green Screen. We’ve seen aggressive fundamental money in the markets recently. But on the whole, volumes are muted. Electronic volumes were way up – but part of that is risk management and part is money that’s been on the sidelines and is now desperate to make up for lost time before year-end.

On the whole, the stuff that’s given us 60% gains in the market this year – hedge fund traders and gigantic prime programs using free money – is shifting out of the markets. Goldman Sachs, we’ve noticed, is trimming volumes on its trading desks. There is a dearth of “commission recapture” execution, or trades that occur in response to research. Active money hitting markets on electronic platforms is tactical, not strategic.

We follow data. The data suggest that there’s less here than meets the eye.

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