Whenever people agree with me I always feel I must be wrong. - Oscar Wilde
A few weeks ago we highlighted how Value-at-risk models can exacerbate movements in various markets, even ones seemingly unrelated. Since then, this has become the topic du jour, as different pundits catch on to the fact that something is not quite right in today’s financial markets. It’s not that stocks are going down – stocks have been going up and down for hundreds of years. Going down is good. It resolves periodic overvaluations, and creates opportunities for those that have cash or new money to invest. It cleanses the markets of its occasional excesses, and there will always be excesses. But smart investors, who have been around for awhile, are sensing that something is amiss. When Art Cashin, one of the best writers on markets I’ve read, is worried about “another Lehman event,” as he stated on TV last week, I pay attention. So why all the angst?
This is a complicated question. As I set out to write this week’s Miller’s Market Musings, I kept getting dragged down different paths, all of them legitimate, and all of them somewhat inter-related. But writing about them all would make this piece a lot longer than I like these Musings to be, so I will explore them in more depth in this week’s Stockpicker newsletter. You can get a copy of it for free by emailing me at email@example.com.
Some cause happiness wherever they go; others whenever they go. - Oscar Wilde
A proximate cause of the recent volatility according to a subset of the financial press, particularly the talking heads on CNBC, is that a large part of the Street is out on vacation. I’ve heard this explanation for market drops many times in the well over 20 years I have been working on Wall Street, and I am convinced that this is simply not true. I’ve worked on the sell-side and the buy-side, and only once have I walked into the office or the trading floor and been like man, where is everybody? The one time I can recall this happening was the Blizzard of 1996, when New York was basically shut down. I was young and dumb and figured eh, I’ll go in, what’s a little snow? I lived in the West Village, and when I finally made it to our offices in the World Trade Center, I was literally one of about 6 people there. So I can see why volume was low that day. But who are these people that are a) so powerful that they move markets all by themselves – or, thought of differently, are so powerful that they calm markets by their mere presence and b) why are they on vacation all the time. I mean, I go on vacation occasionally, but even then I check the markets at both the open and the close and am able to monitor all my positions, in real time, from my Ipad and phone. If I was “the” person moving markets, the person able to arbitrage away the market mispricings and provide liquidity and dampen volatility, I’d like to think that not only would I be diligent and pay attention to markets, even from the Hamptons or St. Tropez, but that I’d have a few employees whom I trusted watching after things for me. You know, in case things happen that provide us the chance to make some money. Like a market selloff. And if things got interesting, and I do think the markets are quite interesting at the moment, and I was the person responsible for moving markets, I’m pretty sure I’d have spent the money on a nice computer and internet connection at my house in the Hampton of my choosing and be able to do the things that I do from there.
So I’m not buying the vacation argument. The U.S. isn’t Europe. We don’t go away and do nothing for a month. We take a long weekend, we go away for a week, but if you go to the places where people like to vacation, you’ll see lots of people still on their computers and their phones. Is this healthy? I don’t know, probably not, but that’s how Wall Street works, and you don’t get to be the man behind the curtain by leading a healthy and balanced life. You get to be the man behind the curtain because you’re willing to work harder and longer and sacrifice things, like your vacations. Sure, at the end of the movie the Wizard is revealed to be old and sad and not that powerful, but for the time he’s the Wizard, he’s the man, and he likes it, so he does it. And the Wizard of the market has a good internet connection on vacation.
To understand the driver of the recent market volatility, I think we need to understand the cast of characters in this movie. Markets have changed, and what we used to think of as the “investor” really has changed. In the 1800s, markets were dominated by syndicates of related investors who would sometimes corner markets, manipulate them, and profit from them at the expense of somewhat less sophisticated “punters”. In the 1920s, markets became dominated by speculators trading on extremely thin margins who resembled the momentum investors of the late 1990s. They mostly disappeared in the Crash of 1929, to be replaced by more sober investors like the great Paul Cabot, who founded State Street. As the markets churned through the aftermath of the Great Depression, they became slightly more institutionalized, and a diligent and smart investor like John Neff or a young Warren Buffett could thrive on the inefficiencies.
A little sincerity is a dangerous thing, and a great deal of it is absolutely fatal. - Oscar Wilde
The institutionalization of the stock market in the U.S. in the 1980s was initially a good thing, as an element of the guesswork involved in picking winners and losers was squeezed out. Peter Lynch and other star stock pickers became as well known to the investing public as sports figures were to sports fans. The lingering inefficiencies in the market, mainly due to a lack of easy access to data and information, were mostly removed with the advent of the internet and the widespread availability of financial data. Now, a database of comparable company data that used to take reams of analysts month to build can now be bought for a few hundred dollars, and be searchable and screenable in ways that were literally unimaginable 25 years ago. Today’s active stock picker has more fundamental data available to her than the head of research at a large investment management did at a fraction of the cost. This should have created greater understanding about the true value of a business, as estimating current and future cash flows becomes easier and more widely dispersed. But a funny thing happened along the way. This dispersed information and computing power led to the rise of a two parallel universes of investors who do not make judgments about the value of companies and their securities, but instead simply use the prices of those securities and/or the variability of those prices to judge their value and riskiness. Here is where the market’s structural weakness resides, in funds that have gotten too large relative to their strategy’s capacity. A parasite only survives so long as it doesn’t kill its host.
A man who does not think for himself does not think at all. - Oscar Wilde
The “Chicago School” refers to a group of professors that came up with the Efficient Market Hypothosis and effectively set in motion the odd market movements we are seeing today and will continue to see in the future. These professors basically stated that all information is immediately reflected in security prices, so there is no advantage to be gained from studying companies or markets. One can simply take a security’s price, at face value, as being correct at all times. This has generally been proven to not be the case, as all information isn’t generally known, some information is hard to ascertain, and some information requires judgement and experience (along with investors willing to give the manager sufficient time and variability in returns to extract this return – but that is a story for another letter) to understand. But unfortunately this idea, however misguided it may be, found a champion in Vanguard, which built one of the largest investment firms in the world based on this idea. Vanguard’s simplistic notion is that since the average investor can’t beat “the market” (whatever that may be defined as), then the average investor shouldn’t try. The only differentiator is cost in the Vanguard world. This is based on some really shoddy statistics (of course the average investor can’t beat the average investor by definition, just like the average person can’t outlive the average person, but that doesn’t mean that eating well and getting some exercise are fruitless endeavors either) and lazy thinking (why use market capitalization except that it is easy?), but nonetheless it has come to define a world called Index investing that has come to increasingly drive markets. Index investors don’t think. They take perverse pride in not thinking. Thinking is bad, it leads to bad decisions, and anyway, it’s not necessary – just define a “market” and then replicate that market. Simple, easy, done.
One of the many lessons that one learns in prison is, that things are what they are and will be what they will be. - Oscar Wilde
Except that there is a problem. When the parasite, aka, the world of index investors, was small, it didn’t really matter that it was relying on a flawed Efficient Market Hypothesis because it was “good enough” and the money invested in related strategies was small enough to not really matter. It was truly a parasite along for the ride. But the index fund industry forgot that eventually it will kill its host if it grows too large relative to the host. Trillions of dollars now reside in index funds and their related products, Exchanged Traded Funds (ETFs). ETFs are index funds on steroids, because while an index fund only needs to worry about inflows and outflows once a day, ETFs are constantly adjusting their holdings based on supply and demand during trading hours. Again, when the parasite was relatively new and small, the host market didn’t really notice them. They added volume but, critically, not much volatility. But as ETFs have come to be an asset class in and of themselves, somewhat removed from the underlying assets, the feedback loop has been reversed.
Whereas once upon a time, the value of the underlying companies determined the price of the ETF, increasingly today it is the trading supply and demand for a particular ETF that is moving the underlying securities. I see it all the time – all the components of say, the Alerian MLP ETF (AMLP) or the KBW Regional Bank ETF (KRE) will rise or fall together. A change in an investment firms’ allocation to an “asset class” will immediately ripple across all the stocks or bonds in the ETF, regardless of whether or not all the stocks and bonds deserve to be treated the same. The defining characteristic of how their securities will behave in the short-term is now almost always their sector and their market cap, not their product or prospect for future success or failure. Absent the 4 times a year when companies report their earnings (in which case fundamentals do determine the near-term stock movements), the day-to-day movements in stocks have become more synchronized. Correlations are up because the driver of prices over short periods of time is simply money flows into an ETF. As index funds and ETFs have become the investment of choice for many investors, price movements within sectors have become more homogenous, and securities in them are more correlated to one another.
However, I believe that the weird feedback loops markets are experiencing lately is because all financial markets are now tied to one another as a second parallel universe of investor – the “risk-parity” investor, has garnered more assets under management. These investors look at asset classes, like foreign bonds or emerging market equities or currencies, as just things to be modeled and leverage applied to based on expectations for future returns and volatility. I read an article last week where the head of a firm with hundreds of billions of dollars in risk-parity investments said, effectively, that his firm doesn’t make judgments about securities individually, but only about asset classes and their theoretical returns and the variability of those returns. They then lever up the asset classes with lower expected volatility to get to a “market” level of volatility, and they then do this across asset classes globally. Which led me to ask myself – if everyone is now an indexer, or a derivative of an indexer (ETF) who assumes that the prices being generated by the other indexers, none of whom actually thinks about things like the businesses these companies are in, or their values, or what the possibility of disruption to the business is, then who is driving the bus? In other words, who’s deciding what these companies are worth now that the parasites have taken over their hosts?
Consistency is the last refuge of the unimaginative. - Oscar Wilde
After initially being alternately annoyed and scared by the realization that multi-billion dollar businesses have been built on top of a faulty foundation and then new, even more fragile businesses have been built on top of them, I’m now quite happy that this has happened, because while it has made my job much more frustrating on a day-to-day basis (“Why is that stock down 4% on no news?), it is also creating many more opportunities for intelligent, rational, and most important, active fundamental investors to make money over time. I believe that we are nearing, if we haven’t already reached, a tipping point in markets in which the parasites have become the hosts, and the prior hosts can now become the parasites (in a good way of course, because I’m one of them), feasting off of the market disturbances that are occasionally created by these feedback loops and VAR model driven selloffs. Index investors and their risk-parity cousins have become the hosts for a new version of parasite (fundamental, active investors who are not benchmark huggers) that takes advantage of these dislocations to buy great companies at distressed prices. The opportunities that await those that are flexible enough to take advantage of them will be tremendous.
This week’s Trading Rules:
Support: 191, 188/189, then 183.50/184.
Resistance: a lot at 197.50/199, then 201 and 205.
Positions: Long and short U.S. stocks and options, Long SPY Puts.
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