Saturday, 16 May 2009

Putting prices up on Wall Street to have a sale

Equity price behavior violates the simple theory of supply and demand so beloved by classical economics. Under the normal assumptions the demand for anything is functionally related to price with the expectation that lower prices will lead to greater demand and higher prices will lead to less demand.

Wall Street practitioners realized many years ago, that the appetite for stocks, especially on the part of the "general public" was in fact in contradistinction to this simple economic theory.

When Wall Street wants to hold a sale it puts its prices up.

The above is what I shall call the Enigmatic Markets Hypothesis or EMH - not to be confused at all with an alternative theory about how markets work with the same acronym. I hope the reader will indulge me the following rather cynical explanation of how this works, in general, and whether it can be relied upon to work in today's more stressed financial environment.

When markets are in the doldrums, the first phase of the EMH arises from the so-called "smart money" buying at lower prices and by steadily increasing their bids until eventually broader constituencies within the market become ever more receptive to the notion that this is a good time to start buying stocks. This positive feedback loop then begins to take on a momentum of its own creating a nicely circular and increasing enthusiasm for stocks.

A lot of the techniques that are deployed in support of the 21st century version of the EMH involve one group of asset warehouse/market makers engaged in relative value and sector rotation strategies with other groups of asset warehouse/market makers to provide the appearance of liquidity and a general and sustained uplift to the most visible and widely reported barometers of the appeal of stocks - the daily reports of increases in the Dow Jones Industrials Average and the S&P 500.

In terms of the larger goal of the EMH, the market makers are, of course, ultimately not in this to "distribute" to each other - but on a short term basis the movement back and forth through algorithmic trading maneuvers is what creates the chimera of a positive and liquid market - a nicely combustible mixture. The next phase of the EMH requires the contribution of talking heads, ranging from Wall Street analysts to freelance bloggers and traders talking up their books . The spark to get the party started again is then usually provided by the more congenitally optimistic as well as the well paid touts in the financial media who begin to talk about green shoots and a nascent bull market.

Even more reminiscent of Alice Though the Looking Glass is that the different warehousing specialists could just as easily be within the same firm and on the same trading desks performing their sleight of hand through the wonders of financial engineering. Algorithmic stratagems are constantly re-calibrating long/short ratios and other arcane portfolio management strategies to ensure that while the overall trend of the market is upwards - designed to captivate the attention of the "average investor" and engage him or her with a fresh enchantment for the markets - this is the EMH temptress - the degree to which the movement of price reflects any genuine accumulation of equities is back firmly in the peculiar world created for Alice by the febrile imagination of Lewis Carroll.

At this point the baton is passed to the popular media who, seduced by the temptress (or at least under instructions to be so seduced by their proprietors) take over the narrative with headlines in the mainstream press and broadcast media about exciting percentage increases in stock prices and great prospects for further increases - the general public's appetite to get on board and enjoy the ride up in prices provides the liquidity necessary for the smart money to begin the process of distributing the stock that they have been "warehousing" at lower levels to those whose motivations to buy even more stocks are driven by even higher prices.

Just as an aside it's worth recalling that, owing to the recent capital market "difficulties" the carrying of inventories and the warehousing of them is essentially risk less to the major market makers and comes with minimal financing costs courtesy of the vast array of government programs and safety nets.

I have two cautionary concerns on whether the type of "asset marketing" which lies at the heart of the EMH being practiced by the big inventory/warehousing players - Goldman Sachs (GS), Morgan Stanley (MS), etc- will continue to work in the current environment.

1. Large sections of the general public are now permanently "out of the market" and given current levels of indebtedness, anxiety and outright suspicion of the integrity of the institutional framework surrounding markets - they are likely to remain out of the market for the forseeable future. Collective investment vehicles for the general public, mutual fund managers and pension fund managers, are not sitting on huge amounts of cash with a steady inflow of new funds to deploy in the market. Parenthetically I would suggest that it is not fundamental to the reservations being expressed here whether there is a huge surplus of cash on the sidelines - all part of the bullish narrative - or not. According to this recent article a graphic illustrates that according to the author:
Cash as a proportion of mutual fund assets has never been lower
2. The current market feels as though it is critically poised in regard to the recent EMH campaign and the suspicion is that there are not enough punters prepared to succumb to the temptation to take a chance again. If "average investors" are not being enticed back into this market in droves because of widely based, cultural disaffection with equities, then those very same EMH strategies which have been exhibiting an upward tilt - as the appearance is being created that risk appetite is replacing risk aversion - may now be starting to develop a downward tilt as the sector rotation dynamics, which are at their core, revert back to a more defensive posture. Even though the market makers have their inventories well protected on the downside they don't really want to be seen to be holding some really dodgy stuff when the music stops playing again.

If the recent rally in equities is running out of steam, this will surely bring into focus again questions about how much patience those who are holding equity positions in the large inventory/warehousing merchants, will have as they contemplate how long it will take before another ramp up of EMH, perhaps requiring further embellishment of the financial cosmetics, regains its traditional allure.

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