February 23, 2010

The Market Isn’t Efficient

What do air travel and equity markets have in common?

As background, we’re readying a comment letter for the SEC’s Concept Release on Equity Market Structure. Exciting stuff! (We heard your groans all the way here in crispy, crunchy Denver). Really, they did a good job and it’s worth reading.

But markets are inefficient the same way air travel is today. If you want a bargain ticket you’ve got tools galore. Kayak, Vayama, CheapTickets, Travelocity, SideStep, Priceline, on it goes, plus every airline website. Sure, you’re in control and you’ve got gobs of information and technology at your disposal. If you’re nimble you can pick up a whopper of a bargain. But you can spend hours trying to track it down. You’ll pick from fewer flights and fly in packed planes.

In trading markets it’s similar. There are lots of choices but few distinctions. The markets are jammed with all kinds of jostling travelers. And what’s more, you can’t take the first deal you see if it’s not the best bid or offer. No, you must hunt through every site or send your order on.

On the surface it looks great. Little trips happen super fast and the prices are awesome. But the slick veneer hides a disturbing reality. This is no place for long-term travelers looking for comfort and wide open spaces.

All analogies break down, so let’s shift our lingo. We see dozens of examples each month showing how equity markets are inefficient. Here’s one: a client with market cap of $1.5 billion had a trade that resulted from an institution adjusting a hedge against portfolio risk. It was a couple hundred thousand shares in the closing cross for an issue that routinely trades 1.5 million shares. Over the next five days, these shares trickled and matriculated through trading desks, dragging the price down. When a party bought a chunk, the stock price jumped five percent. That in turn affected all the current market participants engaged in various trading activities, wildly altering market structure a second time.

This is why markets are dominated today by reactive trading that’s cheap, swift, small and anonymous. It might seem efficient to regulators and to the many participants making and taking liquidity. But it consigns public shares to the status of permanent short-term travelers fighting through the crowd.

It’s a lot like air travel. It’s not fun. It’s not an experience you anticipate with the warm fuzzies. If you had an alternative, you’d probably seize on it. You are treated like chattel rammed through a rule structure that seems to have your safety in mind but really drives you out of your mind.

In short, equity markets are not efficient because they reflect forced behavior that discourages staying around and which requires participants to expend great effort to meet the best price. The participants who find these conditions to their liking have thrived. Banks make little money underwriting and vast seas of it trading. Many thousands of participants chew away at tiny spreads and generate good profits.

But the public companies whose shares constitute the currents of the market cannot consider their stock a good measure of investor sentiment anymore. Most sentiment reflects reactive trading and spreads. What’s more, investors are discouraged from committing to stocks for the long term, because it’s cheaper and less risky to trade, and you get better yields on assets to boot.

Maybe we need to separate trading from investing and managing risk. They are fundamentally different pursuits. Remember how purist insurance salespeople used to say, “Why would you treat your protection from risk as your investment vehicle? That’s goofy.”

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