{"id":1467,"date":"2007-11-17T00:20:23","date_gmt":"2007-11-17T04:20:23","guid":{"rendered":"http:\/\/www.prefblog.com\/?p=1467"},"modified":"2007-11-17T00:20:23","modified_gmt":"2007-11-17T04:20:23","slug":"november-16-2007","status":"publish","type":"post","link":"https:\/\/prefblog.com\/?p=1467","title":{"rendered":"November 16, 2007"},"content":{"rendered":"

Accrued Interest<\/em> wrote an interesting post regarding market volatility<\/a>, which is particularly timely in view of\u00a0kaspu’s question<\/em>\u00a0in the November 15 comments<\/a>.\u00a0He reviews the constant 1-2% moves in the market (“Sub-prime’s over!” “Sub-prime’s worse!” “Buy!” “Sell!”) and concludes that as far as day-to-day excess volatility is concerned:<\/p>\n

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So if the market isn’t manic-depressive, and fundamental buyers don’t tend to jump in and out of their investments from day to day, who really is moving the market and why?The answer is so-called fast money<\/font><\/a>. Mostly prop desks at the big dealers and some hedge funds.<\/p>\n<\/blockquote>\n

I will agree that these players have a big influence; but will note that sometimes “real money” accounts hire “hot money” traders and, for better or worse, a huge pension fund can be taking a completely speculative ten-minute position. Lots of pension funds are explicitly invested in hedge-funds, for example, so the taxonomy becomes a little confused.<\/p>\n

Other influences should not be disregarded. There are, for instance asymettric<\/s> asymmetric\u00a0rewards to stockbrokers: say that an issue that should be at $20 is trading at $18. After getting all their information and advice together, they are as sure of this as they will be of anything. But … say this thing is a pref that might default. If it goes to $20, they’ve made 11% on the investment and the client’s a little happier than otherwise. If it defaults, they lose the client. So they sell.\u00a0Asymettric<\/s> Asymmetric\u00a0and non-aligned risk\/reward profiles! If it subsequently defaults, they’ve got something to discuss with their clients for the next twenty years or so. If it subsequently goes to $20, they can simply emphasize how lucky the company was to avoid default and how no rational conservative investor would take such chances.<\/p>\n

I\u00a0myself have\u00a0had extremely frustrating discussions with clients who want to sell something because it has gone down. If they sell it, they won’t have to worry about it any more. End of analysis.<\/p>\n

Be that as it may, I think there’s some stuff left out of that; most notably that prices are set by the marginal buyer and seller. Royal Bank shares have a volume of what, maybe 2.5-million shares a day? The TSX<\/a> advises that 1,276,215,683 common shares are outstanding, so daily volume is, on average, about maybe 0.2% of outstanding. So if Royal Bank goes up 2%, we can say that this is because investors worth 0.2% of the company decided it was worth 2% more, but holders of 99.8% of the company didn’t change their minds. There is no reason why every single one of the 0.2% minority can’t be real money.<\/p>\n

It should be emphasized here that a great many models of efficient markets assume infinite liquidity – and infinite liquidity does not exist. If I’m a real money investor and I need to raise $10-million, the only things I can sell are the things I already own. So bang! there goes a $10-million sell order on the stock I choose and it may be expected that the price will go down, even though I haven’t changed my mind regarding that particular stock at all.<\/p>\n

Such things are called market impact costs, virtually ignored by academics because it’s hard to measure, hard to model, and because it contradicts the Holy Efficient Market Hypothesis. One can make a whole lot of money – and many, many, many players do make a whole lot of money – simply by selling liquidity to the marketplace, taking the other side of those trades.<\/p>\n

Accrued Interest<\/em> makes another\u00a0point with which I do not entirely agree -or, at least, that I feel deserves elucidation:<\/p>\n

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And of course, if XYZ is getting beat up, then other names in the same industry get beat up also. Maybe the buyer of protection on XYZ had a view specific to that company, but now there is momentum. Dealer desks will start buying protection<\/font><\/a> against related companies. Suddenly a whole sector is 30-50bps wider on no news.<\/p>\n<\/blockquote>\n

I have no doubt that in lots of cases the transmission mechanism is as silly as AI<\/em> describes, but there is a more rational explanation.<\/p>\n

Say I have a certain amount of my portfolio invested in Banks. At 9am I’m very happy about my portfolio, because it’s all in the cheapest bank, “A”. Without any news – or, at least, with no news I deem significant – Bank “B” starts diving. Quick! Update the valuation model! Yes! A swap is possible! Sell “A” and buy “B”! Thus, while acting as a strictly fundamental value investor, I am converting weakness in “B” to weakness in “A”.<\/p>\n

Anyway … there was a bit more clarification on the Fannie Mae accounting panic discussed briefly yesterday<\/a>. Fannie was so worried, they held a conference call<\/a>. From what I could make out – without having done any prep on this, you understand; the kerfuffle is over one table in a set of three filed documents each being 100-odd pages long – what happens is this:<\/p>\n