Are Equity Markets Broken?

28th May '12 by Edward Croft

8 comments 3727 reads

I just wanted to share some of my weekend reading on the impact private equity markets, index investing and HFT are having on the public equity markets. The net impact of many recent trends are clear - higher correlations across stocks, overvaluation of e.g. S&P 500 stocks due to indexing, the difficulty for active managers to outperform, risk on/risk off trading and so on.

At some point I'll put together a more structured piece on the topic but before I do I just wanted to ask if anyone else had any good reading material on the matter. If you do let me know in the comments below.

The general thesis is that stock markets are increasingly being viewed as 'dumb money' by the smart money on the side... used to 'exit' investments by private equity / VCs (rather than to raise money), or scalped daily by smart hedge funds / high frequency traders. The question is - is there anything left on the table for investors in funds? - and the ultimate question - if you do invest in equities what's the smart way to do it ?

A few links.

IPOs & Equity financing

I wrote about this last week but there are some great articles around the web on the same subject.

Felix Salmon on How the IPO Market is Broken
Felix Salmon (Wired) - for high tech companies going public sucks
Business Insider - The Way Companies are Getting Financed is Completely Changing
Neil Collins - FT 26th May (offline only?) "Oh no! those greedy banks have done for our IPOs"

Index & ETF Investing

There are lots of fantastic articles at psyfitec.com and alphaville and I could list many but the best on the index investing bubble is here - Hubble, Bubble, Index Trouble

HFT

FT Alphaville and Zero Hedge are among the champions of exposing high frequency trading and its impacts. But a brief summary of the implications for the layman can be found at The Reformed Broker.

Any thoughts / links appreciated.

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marben100

28th May '12

Hi Ed,

In reponse to your plea, I'd like to draw your attention to the following: http://ftalphaville.ft.com/blog/2012/05/24/1014581/the-death-of-equities-again/

When everyone is declaring, "equity markets are broken" or "money can't be made investing in equities", I read that as the perfect contrarian signal to be heavily invested in mispriced equities (which I am - but with some index put options, just in case ;0)).

My firm view is that it is bad mistake to look at "equity markets", as one homogenous asset class. Yes, in the short term, the algorithmic strategies you describe tend to cause correlations, and the good gets marked down together with the bad. However... if one looks beyond a timeframe of a few months, such matters are an irrelevance. Investors would be much better served by remembering Buffett's adage, which I have found to be indubitably true: "In the short term, equity markets are a voting machine, but in the long term they are a weighing machine.". Patience is one of the most important attributes for investment success.

I get my exposure to a variety of asset classes through equities:

Commodities via e.g miners/oils
Real estate via REITS or similar vehicles
Private equity (which it is also a mistake to lump together as one asset class, as PE managers' strategies can vary widely), via an investment trust.
Emerging markets via investment trusts, ETFs or equities heavily dependent on them.

etc

I really fail to understand why populist commentators lump all these disparate asset types together under the daft label "equities" - except because it appeals to an ignorant public. The only commonality they share is that they're traded on a stock market, making them conveniently liquid.

Regards,

Mark

Asagi

I think there might also be a more 'social' rather than technical angle here but I am unsure if you want to explore that.

Look at how private ownership of shares has declined in the last 50 years.

Companies are massively disconnected from the people that have a beneficial interest in owning them, can capitalism work effectively in those circumstances i.e. when beneficial owners don't get a say?

Asagi

Edward Croft

I totally agree with you Mark and have read the blog post you mention! But it was Keynes who also stated that 'Markets can remain irrational for longer than you can stay solvent"!

I am less concerned for the fates of value oriented stock pickers with long time horizons than I am for the general public who are invested in generally inflated and abused big liquid index trackers and ETFs.

There's an interesting thought in one of those articles that talks about how the cult of equity ownership is changing given the increased flow of information in the internet age. Many companies just don't need to go to the public markets given that there's so much equity financing available from other sources nowadays. A worry for investors in public markets is that they just don't get the opportunity to invest in early stage growth ventures in this new model of equity financing, but are force fed bloated IPOs whenever private equity wants an 'exit'.

Interesting times !

On that note Asagi - have a read of this...

http://menmedia.co.uk/manchestereveningnews/news/business/s/1532933_shareholder-blasts-morson-23m-management-bid

Shareholders furious about the Morson management buyout bid... management buyouts are good signs that stocks are cheap.

If anyone has any stats on the level of management buyouts in this environment I'd be interested?

emptyend

There's an interesting thought in one of those articles that talks about how the cult of equity ownership is changing given the increased flow of information in the internet age. Many companies just don't need to go to the public markets given that there's so much equity financing available from other sources nowadays.

I find this quite an interesting paradox. We habitually think of the communication and research facility of the internet as being "empowering" for the individual investor - but in fact I wonder whether all it has done is accelerate the movement of markets away from the public gaze and the cauldron of comment - and into unregulated hedge funds, private equity, dark pools etc etc......where only "those in the know" are able to operate effectively. The hoi polloi are shut out of "the action" every bit as effectively as they were before the internet and market transparency offered the chimera of hope for empowerment.

Market structures have changed to allow rich and powerful entrepreneurial types to continue to flourish at the expense of the rest of us - the only difference is that we can now clearly see that we are being legged over by "the smart money".

It seems to me that these changes have largely come about because of a failure of regulation. Unregulated/under-regulated hedge-funds could easily have been strangled at birth by regulation - but instead those (in the large banks and other institutions) who were best placed to do so simply decided not to - as they could see money-making opportunities for themselves. (nb - that may not now be the case, post-crash, as they are being forced to exit or recapitalise those business areas). Similarly, whilst dark pools emerged as a result of institutional (aka global investment bank) whingeing about high commissions charged by the LSE, there could have been a regulatory pushback against the dark pools - forcing share trading to concentrate on single exchanges (as it used to). We would then have greater depth and liquidity being transparently available on an even-handed basis to all market participants....rather than having chunks of the market depth creamed off by the big global players.

So.....I'm in complete agreement with this:

The general thesis is that stock markets are increasingly being viewed as 'dumb money' by the smart money on the side... used to 'exit' investments by private equity / VCs (rather than to raise money), or scalped daily by smart hedge funds / high frequency traders. The question is - is there anything left on the table for investors in funds? - and the ultimate question - if you do invest in equities what's the smart way to do it ?

In an ideal world, I would impose greater restrictions on hedge funds (one of which would be to make 2+20 commission structures illegal) and I would force liquidity back to a single, highly transparent, marketplace for each stock. And I would limit the size of private equity funds within the same group to perhaps £2-3bn. There is a serious need to force markets back to the level-playing field that currently exists only in theory!

If that doesn't happen, then I'm going to continue doing what I've been doing.....which is to try to pick a small number of stocks that I think I understand better than the street and to run a very highly focused portfolio. It seems clear to me that there has been a substantial reduction in the benefits of diversification, especially in the risk-on/risk-off correlated trading that we've had for the last few years......so anyone who takes a traditional view of diversification is IMO simply "paying protection money" to the racketeers who really run things. That may seem a tad over-dramatic in the way I put it - but if you think about it for a while, it isn't quite as far from the truth as one would wish it to be.

Isaac

ee,

I've been reading your posts as long as I've been invested in Soco - I've always concluded that your a very smart man.

Interesting post,

If that doesn't happen, then I'm going to continue doing what I've been doing.....which is to try to pick a small number of stocks that I think I understand better than the street and to run a very highly focused portfolio.

Do you think you understand the business of BG. and Lloyds better then the street? How?

Cheers

29th May '12

The operative word was "focused". "Focused" doesn't mean holding one or two stocks to the exclusion of all others.

Those two are c 1% of the total, combined. Both, IMO, have strategically-important positions in particular markets (albeit that the Lloyds Banking (LON:LLOY) dominance of the domestic High Street seems unlikely to pay off anytime soon). Lloyds Banking (LON:LLOY) is also relatively less exposed than most of its peers to the problems with the Euro (a point that is frequently overlooked).

9th Jun '12

Almost every wealth manager I know is now focused on 'asset allocation' strategies rather than picking stock portfolios as it's so easy for them now to just buy ETFs in any style. The growth of the ETF industry as shown below is quite astonishing.

But the influence this is having on stock returns (and stock pickers) is more and more important. The following chart is quite astonishing. 50% of the daily moves in the average stock are now driven by the greater market impact.

The great 'stock pickers' of former eras have all stumbled in this landscape - Anthony Bolton, Bill Miller etc. But Andrew Lapthorne in a recent Soc Gen note put it clearly:

But with great pain can come great opportunity. The contrarian view, of course, could be that this may be the very best time to be a fund manager. The problem will be in educating the providers of capital (those who continuously ask about tracking error and worry about short- term performance), that perhaps things need to be done a little differently going forward. If everyone is hugging the benchmark, then concentrated portfolios with massive tracking error will be the future.

Are Equity Markets Broken?

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Edward Croft

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