Shareholder Rights | Market Depth And Liquidity - Macro Concerns!

31st Oct '13 by emptyend

2 comments 17169 reads

Gillian Tett in the FT has a very interesting piece this morning.

Briefly it is about the concern that liquidity in many emerging markets is illusory - and there is a severe risk of a sharp reversal at some point:

.....as money has rushed into emerging markets in recent years, this has created an image of abundant liquidity. But this image may be dangerously illusory, some policy makers fear, as one of the little-noticed ironies of the 2013 financial system is that there may now be fewer – not more – shock absorbers in the markets than there were before 2008......

The key issue at stake, as Mark Carney, Bank of England governor, indicated in a speech last week, is the question of who makes markets in a crisis. Before 2007, when the investment banking world was expanding at a breathless pace, dealers held large stocks of emerging market assets on their books. But since 2008 these inventories have shrunk more than 70 per cent, according to central bank estimates, due to the introduction of the Volcker rule in America (which restricts proprietary trading) and increases capital charges for banks to hold risky assets.This has undermined the ability of dealers to supply trading liquidity in some asset classes.

My bold and large typeface!

I think this is a really really important issue!

Where is the "back bid" for the assets in your portfolio?

The new regime for banking may have made the payments systems and other commercial banking more secure - but it has made parts of the investment banking and securities trading space very much riskier.......

......and, importantly, we won't know how much riskier and which bits have been most affected until some external shock gives us a "live test" of the post-2008 regime!

I think the macro environment is very much riskier than the average punter seems to think these days......

It is a very macro issue, of course - but that doesn't mean it can just be ignored. Perhaps the trade here is to get long of vol?

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emptyend

31st Oct '13

I'm extremely concerned about the fragility of the current market system. The lack of a 'back bid' is v. clear to me. We've seen flash crashes, and fragility ripples all across the systems in recent years. A cataclysm could v. easily happen - we should all read loads of Taleb and keep our fingers crossed.

I don't think that Taleb will help much. Knowing that something may well happen won't help protect from the consequences, especially in these days of high frequency trading (aka spawn of the devil!)

There's a generation of investors who treat momentum as more fundamental than the fundamentals - the tail kinda now wags the dog - but that momentum money can disappear in a flash.

Yes that is the case - and it is certainly very worrying!

Over 25 years ago now, I remember writing a very long letter to the FT about the dynamics behind the 1987 crash - and pointing out that the root cause of it was so-called "portfolio insurance". This relied on continuous delta-hedging....and the people (institutions!!!) who had bought insurance simply loaded up on the long side in the belief that their downside risk was protected.

As we discovered in 1987, if the market is closed unexpectedly due to a Friday hurricane, then you get a serious market discontinuity - and the "insurance" product proved to be anything but..... ....because the investors who bought it got unexpectedly-bad fills.

For your interest, this was the letter the FT published on 16th January 1988. I've emboldened the point that you and I are both making now - and which I have made at regular intervals over the last 25 years!!

The frenetic covering of short dollar positions in the FX markets last week appears to me to have at least one factor in common with October's equity market crash namely that many fund managers try to delay important asset reallocation decisions until the very point when the market turns.

Such a pervasive emphasis by fund managers on market timing has a much more serious effect on market stability than any of the mechanisms or processes used to control or operate in the markets. This forms the basis of the principal lesson to be drawn from the events of the last six months.

The reasons for this phenomenon are complex. They include rapid dissemination of information, concentration by fund managers on short-term performance against indices or competitors and the subordination of fundamental analysis to (so-called) technical analysis.

All these help well-informed fund managers feel comfortable about following their friend the trend - but get out quickly when the turn comes. Unfortunately, circumstances can conspire to make the turn apparent to everyone in the world at almost the same moment resulting in a market where buyers overwhelm sellers or vice versa.

Thus the UK's hurricane of October 16 combined with a sliding New York market between October 13-16 to ensure that London was dominated by sellers on October 19 - taking the FTSE 100 down 269 points (11.7%) even before New York opened to news of fresh trouble in the Gulf.

Similarly, last week's surprise appearance of the world's central banks buying dollars was also not a change in fundamentals, but certainly provided at least a temporary realisation that the dollar was not an automatic sale, as it rose more than 7% in three days.

Why did so few fund managers sit back last summer and switch from equities to gilts (which then yielded more than three times as much, with real returns of over 6%)? Why did they generally fail to conclude (before the central banks) that a dollar which had halved in value over the last 33 months (including a 17% fall in the last five months of 1987) was beginning to look a little cheap, especially when the US trade volume data suggested that the next few months will see big improvements in the nominal trade deficit?

It is the fund managers who must take the blame for the losses of their investors - after all, it is they who are paid to distinguish price from value, selling when price exceeds value and buying when value exceeds price.

It is quite wrong for such professional advisors to blame the marketmakers; a marketmaker's capacity to absorb stock without cutting price is not only limited by his capital but, more importantly, also by his judgement on whether the stock can be sold at a higher price within a reasonable time. It is not his job to bale out investors caught in a one-way market created by their own collective folly.

It is also wrong to blame the stock index "arbs" - but right to blame the widespread use of stock index futures for "portfolio insurance", which exacerbates the extent to which the markets can move in one direction without a major reversal. It is wrong to expect markets to be "liquid" enough to enable investors to escape the consequences of investment decisions which were not fundamentally sound.

Many people have "invested" in recent years in the expectation of a quick capital gain. They did not assess value, but merely relied on a greater fool to take them out at a profit.

The clear message for the future is that investors and their fund managers must be responsible, prudent and independent assessors of value in deciding asset allocation policy. They must justify their decisions with reference to fundamental value, not trends, charts or fashions. They must accord the preservation of capital a higher priority than the maximisation of potential returns.

Fund managers must be instructed to do this by the trustees of the funds they manage and individual investors must think before leaping on to passing bandwagons. Allocating assets on the basis of fundamentals can be extremely rewarding: one dollar-based fund manager of my acquaintance showed gains on a half equity/half bond funds of 62.2% in 1986 and a further 19.5% in 1987 (a compound return of 22% p.a., even in sterling terms). The more people invest on this basis, the more quickly the global market will find solid support and rebuild confidence.

Finally, a cautionary note. Statistical distribution theories suggest that, for markets to be fairly valued, at least some people must think them sufficiently undervalued to continue to invest heavily. Hands up everyone who thinks that London residential property or the Tokyo stock and property markets are very cheap. I hope there are some, or we shall see further misleading stories of financial "collapse" appearing in the "popular" press.

And this is an extract from my letter published in the FT on 4/2/1999 (my bold again):

Sir, Lex (January 29) is seeing the wrong parallel between the role played by programme trading in the 1987 crash and the role which trading on the internet could play in a crash today.

The root cause of crashes is always the same: liquid markets sometimes aren't! And the greater the market power of those who think the market is liquid and the more they depend on market liquidity, the bigger the crash will be when it comes.

On the other hand, the greater the fear of a price crash (and the less influence any group of sellers has on the broad market), the less likely a crash becomes.

In 1987 "portfolio insurance" products led to significant market power in the hands of a few "mechanical" hedgers who were absolutely reliant on liquidity; the disruptions of the previous week and the lack of circuit-breakers helped create the downside momentum. There was no special news event. Since then, the only comparable dynamic in a crash was the one in autumn 1998 when a relatively small number of highly leveraged players became "mechanical" forced sellers of collateral.

Of course if I'd had Taleb's mathematical training and his willingness to turn unpopular thoughts into a series of books, perhaps a few more people might have paid attention to my various witterings* ;-)

rgds

ps......

* I discovered another of my witterings in the FT, from 27/11/1998 whilst I was looking for those above. This is what I wrote then, on the topic of banks:

Sir, Peter Martin's observations on the role of banks ("A long goodbye", November 24th) could have been made more pointedly. Unless banks are prevented from position-taking, either by their shareholders or by regulators, they will continue to try to deploy their balance sheet to maximise absolute returns.

This is ultimately not a sustainable source of profits, since the capital made available by their ability to leverage will always tend to drive them towards risky assets which are vulnerable to step-changes in valuation.

Recent volatility in markets will therefore tend to get worse until the market begins to withdraw capital from such "banking" activity. Meanwhile, banks generally seem to be neglecting lower-return service businesses which nevertheless can generate sustainable income.

This problem is at its worst in wholesale markets. Shareholders, or regulators, should be pressing banks to be more transparent about the way they make money in their wholesale businesses. Most banks can make money in wholesale markets only by position-taking or by service provision to their customers; they should be forced to reveal which, in more detail. The quality of their earnings is crucial information, so that the market can discount them at the appropriate rate. The present obfuscation of their true underlying income sources is in no one's long-term interest.

....little did I realise back in 1998 just how little both the markets and the banks' boards actually understood about what was going on. And it took 10 years of growth - and commensurate growth in ignorance - for the shit to finally hit the fan for the banks!

Market depth and liquidity - macro concerns!

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Emptyend

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