Fan of the Market
Vol #97: September 16th, 2022
The NFL season is now officially open, and 184 million fans have something to be excited about.
I’m not necessarily one of them, but the only thing I enjoy more than a pun is a stroll down meme-ory lane.
The photo needs no text, it’s just good ole Rob Lowe at a football game with an NFL cap on. He’s not supporting the Cowboys or the Giants, he’s just a fan of football.
The Brat Packer is simply there for the experience. Soaking in the energy of the crowd, the stadium food calories, and the rhythmic moving of the chains, he’s ambivalent on the outcome, and just wants sport.
I sympathize with this feeling about not just football, but about finance broadly. I am a fan of the market. I don’t have a favorite stock, but I love the stock market.
Markets are a system of rules designed to govern the transfer of assets, securities, and tokens. Ideally these rules create a level and transparent playing field that allows for information and capital to freely flow towards the most efficient resources.
The devil of how this actually works is market microstructure, where the real geeks meet. What is the correct amount of exposure time for a block order? What fees should be charged to customers on exchanges? Are orders in the pit “public information”?
Setting those rules appropriately is a win for everyone. When the field is right sized, and the appropriate pass interference rules are interpreted, it sets up the potential for stunning plays.
How to get ahead is constantly changing and evolving. Quarterbacks were smoking during halftime of the first Super Bowl, and today they track every milliliter of their VO2 capacity.
Financial markets attract creative and competitive participants because the spoils are so rich. The lore of great investors contains a strong element of David vs. the market Goliath, traders armed only with wits and a bit of capital. Bring some popcorn, these stories unfold every day.
When “High Frequency Trading” first started to peek into equity markets, it was a level step improvement in how trading was done. Previously you made money in stocks from off the record conversations with the CFO, now the private conversations were with exchange or dark pool reps who knew the secret order types to let you queue jump and pick off retail orders.
Kidding aside, the market quality improvement from HFT is notable. We now have significantly tighter markets, and customers get cheaper executions at a lower spread. The race to lay the straightest fiber between the CME data center in Aurora, Illinois and the NYSE’s facility in Mahwah, New Jersey improved the user experience for everyone that buys a single share of stock.
Advances in share trading algorithms mean market makers in options can provide tighter prices for customers because their delta risks are better managed. The game keeps evolving, and improvements in one corner of the market can raise the tide for the whole ecosystem.
This is a feature of markets, not a bug. They are so powerful that the very forces that create and allocate opportunities are the ones that consume and eradicate those same opportunities. Watching this happen is exhilarating and intellectually stimulating. The creativity of market participants to find an edge never ceases.
One of the dominant themes for active observers of the options and equities markets today is the impact of dealer positioning on the market. The theory goes that if you can reliably estimate what kind of position an options dealer (market maker) has, then you can predict how their risk profile will change as the market moves. Knowing their change in position alongside their risk constraints (staying delta neutral), gives a lens into potentially significant hedging flows that drive the market one way or another.
At best this indicator gives an idea of what one piece of predictable flow is going to do. There are however a multitude of variables both within the dealers position and across the overall market, to get much more than a probabilistic estimate under certain conditions. But sometimes that’s all you need….
To the extent that this works in predicting short term market moves, it probably won’t work for very long. The model will have to keep changing. Alpha is ephemeral, and today’s nugget is tomorrow’s lead weight.
It’s a process, and not a feat. Charlie Munger reminds us that markets are voting machines in the short term, but a weighing machine in the long term. You don’t watch football for the score, you watch it for the game. True fans want to see how each play unfolds, the decisions and triumphs that led to the final boxed result.
A good football game zigs and zags between favorites, and markets find their true value through under and overestimating, sometimes irrationally so. After the CPI number this past week, we saw a repricing of equity indices that lopped 5% off the value of well diversified baskets of stocks. Forty percent of CPI comes from Owner’s Equivalent Rent, which tends to trail housing prices by 12-18 months. The high in house prices was over a year ago in June 2021. Inflation is a real problem, but did a rounding error’s significance in a lagging indicator really change future valuations by trillions of dollars?
We love it when underdogs win in sports, but (most of us) hate it when 2, 3, and 4 standard deviations happen in the market. I too cringe when I have to open up the accounts after a day like Tuesday, but I can steel myself with the knowledge that volatile pricing in public equity markets is the daily penance for long term value capture.
Stock pickers are great. Giants fans are great. Markets are better for everyone because individuals and institutions buy and sell different stocks. I’m a fan of watching these markets work, and allocating appropriately.