Monday, May 10, 2010

Why Didn’t We Buy?
Did the Game Change?

As by now, you and practically every other stock market oriented person on the face of the earth knows, that after a significant market decline earlier in the day last Thursday, starting a little after 2:30 in the afternoon and lasting for about for 43 minutes, stock prices collapsed with 997 points on the Dow Jones Industrial Average disappearing.

A Strategic Question

What caused this calamity? At this point, no one has produced conclusive evidence as to the specific cause or causes. My concern is much more strategic than what was the immediate cause of the decline, (which to me is similar to focusing on the assassination of the Archduke that started World War I, rather than the irreconcilable differences between Germany and its neighbors). My concern is why I and others did not buy at the depressed stock levels. While I won’t be able to be definitive for some time or perhaps ever, I do have some thoughts to share with this blog community.

Lead-up to May 6, 2010

Recently the bulk of the trading in many institutionally-favored securities has been driven by proprietary trading desks and other professional traders including some hedge funds, not by investors. In response to calls from investors and some dealers, regulators have been determined to reduce the monopolistic power of the New York Stock Exchange and NASDAQ. They permitted, (some may say encouraged) alternative trading sites and procedures to come into being. The institutions now have many places to trade.

This market dispersal in turn creates the problem that traders must find the natural other side of the order they wish to execute. One of the techniques they choose to use is to divide their orders. Prior orders of 10,000 or more shares were given to a single broker or dealer to execute. In traders’ search to find volume on the other side, block trades have been replaced with many multiple 100 share orders, placed rapidly through a number of different market sites. Because of the difficulty involved in executing these trades, some institutions reduced their participation in the visible marketplaces. In the partial vacuum which was created, traders saw an opportunity to get between natural buyers and sellers and earn a spread. To find these partial vacuums they employed statistical techniques using various types of algorithms developed by PhDs from universities like Caltech and others. They were, in effect, mining the flow of information captured in prices. To avoid the “Black Swam” effect of something occurring beyond the expected, with a stroke of a computer key they could cancel all their below-the-market buy orders, which was what I believed happened Thursday afternoon.

An Inflection Point?

More disconcerting was the absence of large value stock buyers on Thursday. In last week’s blog I shared my brief notes from the Berkshire Hathaway annual meeting. I saw a number of well known value fund managers at the meeting and I am sure that there were others there also. In theory, these managers always weigh price and valuation points as well as trends. With stock prices plummeting to levels that had not been seen for many years, why did they not rush in and commit all of their reserves? Tumultuous days in the market are often deemed to be inflection points. Was there some new vital information that caused a change in the valuation system used by these managers?

Market Intelligence

On Wall Street you don’t have to actually have superior information, you just need to act as if you have it. For many years when he was chair of the Federal Reserve Board, the market thought Alan Greenspan had better information than others because of his background as an econometrician. We now know, sadly, that his information, especially on housing, was not particularly accurate. Nevertheless, at that time, market practitioners tried to tease out the implications of his supposedly superior information.

Foreign Exchange Trading on May 6

Early on Thursday there was much concern as to most of the Mediterranean economies and the fate of the euro. There was a euro-yen trade early in the day which some took as significant. Up to that particular time most did not look to the yen as a safe-base investment currency. Did this trade suggest that the Chinese government’s attempt to safely cool-down their economy was working? Or did this mean that the rise of the US dollar against the euro was, in effect, causing the Chinese yuan to appreciate and thus reduce some politically sensitive trade imbalances? Was something else of significance occurring, causing sound, value-oriented investors to withhold their support from previously favored stocks?

A Non-Political Observation

From my standpoint a further complicating event happened this weekend. I am not making a political statement, but an informational belief. The good citizens of Utah chose not to re-nominate Senator Robert Bennett. Losing his knowledge as to how the markets work will be unfortunate for the country and particularly for investors. Next year’s Senate will have a lot to do with major regulatory changes that are likely to come.

Did the Game Change?

How should an investor, particularly a long term investor who uses mutual funds and hedge funds, react to Thursday and its aftermath? I suggest that some wise managers will be searching for the implications of this possible inflection point. If a number of successful managers start to do things differently, then I think that Thursday was important and our strategies should be adjusted. At this point I am weary of managers that think what happened was just an aberration. Be particularly careful until after the election.

What do you think?

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