Thursday, November 15, 2007

But how am I to know the good side from the bad?

Academics and other investment outsiders often marvel at the volatility of investment markets. The truth is that economic fundamentals, either with a specific company or the market as a whole, just don't change very much from day to day, or even month to month. Why is it that markets rise and fall so significantly every day?

Mass media reports on the stock market are very deceiving to the average reader. Today, with the Dow falling over 100 points, media reports from the USA Today and Washington Post blame "credit worries." If the Dow rises 200 points tomorrow, the headlines might read "subprime fears recede." We've seen such headlines during strong rallies several times this year. I've often wondered how the average reader interprets these kinds of reports. One day the market is worth 1% less because of housing problems, the next day its worth 1% more because... Housing isn't so bad? Put together these stories read like traders showed up at the NYSE one morning and thought "Holy shit, the housing market is bad. Sell! Sell!" Then the next day the same traders show up for work saying "Well, it really isn't that bad. Buy! Buy!" This view of the market has it as a sort of impulsive manic-depressive.

But of course, that's not really how it works. Academia would like you to believe that the market is made up of rational buyers and sellers. In their model world, the market for securities is based on rational estimates of fundamental value. Prices rise or fall because market participants re-evaluate value: if an owner of a security finds the price has risen above his view of fundamentals, he sells. And the opposite is true of buyers. Where buyers and sellers meet, through the magic of the invisible hand, the market has rationally set the price.

Of course, that's not how it works either. Unfortunately, this view cannot explain the volatility. We know that its common for a stock to rise or fall by 1-2% every day, often with no news at all. Same goes for credit spreads, futures contracts, swap rates, etc. These things move all the time for no fundamental reason.

The reality is that fundamental investors don't change their view on fundamental value much from day to day. Even when there is news on a company or on the economy as a whole, normally no single piece of news will change someone's mind about an investment. For example, if I'm bearish on rates because I expect inflation, I'm not likely to change my mind because CPI
prints low one month. If I'm long AT&T stock, I'm not likely to sell just because they have a mediocre earnings report. Normally fundamental investors have a longer term investment thesis, and therefore short-term events usually don't change the longer term view.

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. Mostly prop desks at the big dealers and some hedge funds. One way to think about these traders is that they're trying to front-run the fundamental investor. But since it isn't immediately clear where the fundamental investor will buy or sell a given security, they are left guessing what every piece of news is worth.

But remember, they don't actually care what any security is actually worth. It doesn't matter. Only that they can get in at a certain price and get out at a better price. This is why securities sometimes seem to operate on momentum. Someone wants to buy XYZ CDS at 100. Someone offers at 110. That's lifted. Now someone thinks it's a good short, so they offer at 120. That's
lifted. Suddenly traders start to think someone has a buying program on, so now there is momentum. The next offer is 130, and it just keeps going until they stopped getting lifted. All that could easily happen in a thin market with no fundamental change in the company.

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 against related companies. Suddenly a whole sector is 30-50bps wider on no news.

The same momentum can last for a long time. Because once its clear there are traders looking to short a name, the CDS becomes very one sided. See the ABX.

Now here is the rub. You can't know when the front runners are actually right, and when they are just pushing the market around. Recently we've talked a lot about MBIA, FGIC, and AMBAC on this blog. All three have seen their CDS spread pushed around quite a bit. The media and other commenters have remarked that the bond insurers are trading like they are junk-rated, which is an undeniable fact. Some have gone so far as to calculate the odds of bankruptcy. Others have commented that the CDS are not indicative of fundamentals.

The reality is that securities can and do trade far from fundamentals, especially thinly traded markets like CDS. But its also true that sometimes the market is right, even when it seems to be trading far from fundamentals. See the ABX.

So how can you know when fundamentals are changing versus just technicals? You really can't. I'm not sure where I'm going to come down on AMBAC just yet. But suffice to say where the CDS are trading won't influence by analysis. If you are a long-term investor, you really shouldn't worry about technicals. Trying to time technicals is a good way to lose a lot of money. Trying to graft fundamental meaning on technical movement is a good way to be completely wrong. As the Buddha said, "Know well what leads you forward, and what holds you back."


Anonymous said...

the cds trader's guide to making money:

1) wait for market to be a bit jittery
2) buy a load of protection on a credit
3) talk to a few of your friends on the hedge fund side, get them to lift some other dealers on that name
4) send round to all clients something negative on that name
5) once clients have seen your negative article AND get reports from other dealers that some hedge funds have been buying protection on that name, they will try and buy it from the dealers that don't seem to havee been involved yet
6) offer out your cds at a higher level than you bought it
7) lift the street once in a sloppy manner at a high price (optional)
8) dumb clients come in and pay up to buy the cds since rest of street is wary on offering it out while situation uncertain.

repeat as desired!

i love thin markets.

Anonymous said...

Really enjoyed today's post, particularly the conclusions in the final paragraph.

I think members of the public who pay attention to the markets without being actively involved (I'm not talking about a bit of PA trading here) do indeed tend to hold market participants in some contempt and frequently it stems from this daily noise. I like to blame the media because, well, because I enjoy blaming the media, but also for their preference for taking Fact A, then taking Fact B then sticking the words "because of" between said facts.

Anyway, keep up the good work.


Anonymous said...

I think the key question for the monolines is do the current levels of CDS spreads hurt their business. I can't believe a rational muni buyer in this market is going to pay anything for a AAA wrapper. Seeing that we have massive defaults coming down the pike I can't see the CDS spread normalizing anytime soon? So how can they stay in business? What am I missing?

Accrued Interest said...

I think you have to realize how wacky the muni market is. Many buyers NEED a AAA rating. Now what I suspect will happen is two things:

1) Issuers will stop doing deals without underlying ratings. Right now there is a severe penalty for insured bonds without underlying ratings.

2) Insurers will do more business with revenue issuers and less with GO issuers compared to now. So their muni book will decline in quality. This will force them to keep more capital on hand, although whichever insurers survive this will already have to had increased their capital reserves anyway.

Eyal Bar said...

I think something's missing in your post. Over the past few years, there has been a system which incentivized smart people to start their own hedge funds and dedicate their days to generate alpha for clients. This has produced a sort-of efficient market, a very quiet low-volatility reasonably-priced market, albeit with a twist of complacency & undervaluation of credit risk. In that market, market action became trustable. When a company's CDS, bonds or stock declined, you knew there's probably trouble brewing. This was the case for example in early 2007 when the subprime wholesalers started seeing their stock decline sharply. We saw much more of this and recently it has hit the credit insurers. The thing is, maybe everything has gotten so wacko now that a decline in stock or a rise in CDS premiums doesn't mean anything. I don't know but I still - very marginally - tend to fall on the side of those who believe we are in the 2nd/3rd inning of "credit Armageddon".

Karl Smith said...

As an academic I would say that you can think of it as two markets.

A real money market based on fundamentals that responds essentially in the way that the models expect accept with relatively large transaction costs that mean a move doesn't occur unless there is a significant change in fundamentals.

The there is a low transaction cost fast money market which is, as you say, trying to guess the next move in the real money market.

A large fraction of the fast money play is zero sum, but that is made up for by the times when its beats the fundamental market to the punch.

They can both be modeled as rational agents the difference is in the transaction cost - which is really related to time and effort spent analyzing information.

Accrued Interest said...


I'm not here to claim the market is inefficient, just that it can be. Obviously something is up when CDS widen substantially, somebody thinks something is up. But it might be that some one expects real money accounts to panic. OR it might be that there is something worth panicing about. You can't know which it is when you're in the middle of it.

Take a look at Capital One spreads in 2000-2002. They're still around. Or Tyco. Or Time Warner. There were others from back then that I'm not remembering I'm sure.

Anonymous said...

What a great post!

Anonymous said...

The markets may be efficient some of the time, but anyone who says they are efficient now has forgotten the key characteristics needed for them to be efficient.

First and foremost, markets need to have a large number of INDEPENDENT participants, each making their own independent evaluation of a security.

Most Wall St houses (and the hedge funds they spun off) are incredibly clique-y. Far more so than any high school you went to. They all went to the same prep schools, the same colleges, they belong to the same golf clubs / social clubs. They all sit around trading floors exchanging Bloombergs with the same group of people they have been talking to for years.

Wall Street "research" has become a total oxymoron. Mostly, you have the same group of perma-bulls spewing out the same market color they always have.

The traders all use the same Bloomberg, CQG, Reuters, whatever data. They plug the same data into models that have various blinking lights, but underneath the hood are all materially the same thing. So they all reach pretty much the same conclusions, at pretty much the same time.

There is no diversity of opinion, which is just another way of saying this market is not made up of millions of independent bets -- its basically two or three bets, even if they happen to be put on by a couple dozen dealerships and their hedge fund offspring. Even those 2-3 bets aren't all that different.

This is not an efficient market. It is at best an oligopoly. It is dysfunctional no matter you cut it

Anonymous said...


You really need to start a blog. If you need any help, post an e-mail address that you have created anonymously (so that you don't get your identity thefted) and plenty of people will help.

Eyal Bar said...

I'm not saying markets are efficient, I'm saying that between, say.... January 2004 and January 2007 they were MUCH more efficient than at any other time.

Anonymous said...

It has been a very interesting time for the monolines indeed. I remember talking to a dealer two weeks ago, about the real possibility of one of the more "in the news" names, starting to trade with points up front. After today's marks, who knows? the headlines keep pushing this stuff tighter......