June 25, 2014

The Risk

On a hot Sunday 138 years ago today, Lieutenant Colonel George Armstrong Custer rode into the valley Native Americans called the Greasy Grass. The rest is history.

Speaking of unexpected defeat, wonder what ambush caused yesterday’s sharp market reversal? Here’s a ModernIR Rule: The day after a new marketwide series of options and futures begins trading is a leading indicator of institutional asset-allocation plans.

Options and futures expired June 18-20. The new series took effect June 23. Yesterday was Rule Day.  Counterparties including major broker-dealers hold inventory through expirations and these resets. If stocks then decline, they had too much inventory for demand-levels.

Now, one can blame bearish Dubai stocks or sudden weakness in the UK Sterling or something else. But this rule is consistently true: If there’s more money in equities, stocks rise because counterparties undershot estimates. The reverse? Counterparties dump inventory and stocks drop.

Is this dip the tip of the long-anticipated bear turn?  Right now, total sentiment by our measures doesn’t show that risk. But. Sentiment has consistently faded before offering investors a market-top for profit-taking, in itself a bearish signal.

Speaking of risk, Cliff Asness’s high-speed trading piece at Bloomberg is humorous and compelling. I admire the AQR founder for his smarts, success and libertarian leanings.

But I disagree on HFT.  Mr. Asness defends it, saying: “The current competitive market-based solution is delivering the product, meaning liquidity for investors, better and cheaper than ever. Moving away from this competitive landscape would be an invitation for incompetent central planning or rapacious monopolistic practices.”

The current stock market is called the National Market System. Is there a National Grocery System?  A National Gasoline System?  A National Clothing System?

The National Market System was centrally planned by Congress in 1975 and culminated in 2007 when the 500-page opus magnum Regulation National Market System defined how stock-trades would match, how they would be priced, how data would be shared and monetized and how exchanges would charge for access. It outlawed trading in sub-pennies but that’s since been reversed.

At our neighborhood weekend farmers market, 40% percent of goods on display aren’t borrowed, 30% of trades don’t occur in alleys, and the prices and supplies of what’s for sale are clear. Nobody is rushing up as you reach for potatoes at the Miller Farms booth to change the price by a penny, snag the spuds, and sprint them over to another produce booth with a better displayed price. That would be crazy.

To illustrate the problem another way, compare the NET CHANGE in institutional ownership reflected in your most recent 13Fs to total volume in the quarter.  The average we anecdotally observe is about two days’ worth of volume (63 trading days per quarter). That statistic says staggering volumes have shorter investment horizons than a quarter.

Not BRK.A, where net ownership change is routinely 50 or more days of quarterly volume. That’s 80-85% of quarterly volume tracing directly to ownership change. People hold it long-term. It’s the only stock we know with no HFT and bare statistical arbitrage. This is how markets worked when we were creating lots of jobs and companies.

Now suppose all the rest of the 3,680-ish public companies (a number that continues to fall) comprising the National Market System traded 250 times per day.  Million shares of daily market volume. Would market capitalization be the same – almost $24 trillion?

There’s the second problem. What happens if 61 of 63 prices – trades – disappear?  Well in BRK.A, nothing. In the market, you get May 6, 2010. The Flash Crash.

Arbitrage at 10-15% of volume is useful for correcting pricing and informational asymmetries. But when most prices reflect arbitrage there is ubiquitous price-uncertainty and colossal risk that most of them could evaporate for any random reason.

That’s in effect what happened late yesterday. Brokers shed inventory and HFT fled to avoid holding it.  How is this market helpful to long-term capital-formation?  No prudent person would continue living in a building engineers have determined could fall down at any moment.

This is reason 1,032,457 to move beyond tracking ownership-change and moving price-averages to understanding and measuring CENTRAL TENDENCIES in your market structure.

I’ve just shown you one – net-ownership change as a central tendency is about the worst possible indicator of what is setting your price.

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