July 7, 2010

How Quants Find Value

Prior to the 4th of July you might have heard us jeer, “That’s about as exciting as Iowa.”

Passing through last weekend, we had to concede that Iowa was in fact a place of surpassing and bucolic beauty, with its rolling corn-planted hills and manicured farms. The heartland at Independence Day reminded us that this land of ours and yours is jeweled.

Anyway, we’re a day late this week because it’s a long way from Bratenahl on Erie to the banks of the Platte.

Speaking of eerie, your management teams must be wondering what caused stocks to cross chasms today to the upside. Do you think investors suddenly decided stocks were cheap? To paraphrase Saturday Night Live…really?

No, today is why every corporate IR professional should develop a rudimentary grasp of market structure. The way of the world now in trading markets is more like the movement of tides than the patient fashioning of edifices. To do your job with purpose and ease of mind, it’s helpful to know when the tide turns. We said last week that stocks should benefit from a return of capital after the 4th of July. We saw surging proprietary trading by liquidity providers July 1-2, indicating that software systems expected money to arrive this week.

How do software systems find bargains where investors don’t? They look at different data. To explain, let me tell you a story. Yesterday, we traversed the plains in Kansas from Fort Riley to the Colorado border and west to Denver. Once, that area belonged to the southern Cheyenne tribe. For history buffs like me, it’s living history, crossing that grassy canvas. The Sand Creek massacre site is southward. Battles were fought with the legends of the Cheyenne people at Beecher’s Island and Summit Springs just north of I-70.

The plains people had a narrow, rational worldview. Life revolved by seasons on a finite patch of earth. It worked in predictable fashion. It wasn’t possible for most of them to study different data and reach new conclusions. Now suppose you could sweep up and away in Google Earth fashion from the trace remains of Fort Sedgwick, west of Julesburg township (which the Cheyenne twice looted and burned), and observe continents and hemispheres. What’s happening on the Smoky Hill River isn’t quite so important now.

Trading software sees continents and hemispheres. If it’s summer in Patagonia, it’s time to ski Aspen. By the same token, the movement of money and trading liquidity isn’t limited by individual financial performance, but by where the sun shines and where the skiing’s good – so to speak.

How long will it last? No one knows these days, but the tides move fast. We suspect we could hang ten till July 21. The cool, contemporary IRO won’t try to control the seasons or tides. But it’s good to know about them so you can prepare, enjoy the autumn colors, and abide with a sense of purpose and ease. It beats the agitated uncertainty that can linger when you don’t know what’s over the next knoll. And it certainly beats becoming an archaeological curiosity.

All analogies break down. So let’s finish with a more mechanical explanation. Trading systems can incorporate multi-dimensional data, including the supply and demand of currency, derivatives and stocks. That data is often quicker to imbalances than are rational bottom-up investors looking for intrinsic disconnects between market valuations and financial metrics.

We are not in Iowa, or Kansas, or Fort Sedgwick, anymore.

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