Saturday, July 30, 2005

Confessions of a Street Addict, Part II

In my last post I talked about Jim Cramer's Confessions of a Street Addict. Of course, there is an economics angle I also want to talk about.

How do hedge funds almost always outperform mutual funds and stock averages? A lot of it has to do with the fact that they can short stocks far more easily than can mutual funds, due to SEC regulations. Hedge funds can play both sides of the market and make money no matter which way the averages are going. Mutual funds are more closely tied to long positions in the overall market.

But a lot money that hedge funds make is from "trading gains." They don't just invest their $300,000,000 and sit on some solid growth potential. Their capital is in and out of the market minute-by-minute, second-by-second. In some sense they are day-trading with very large sums of money. But, as Cramer acknowledges, you can't beat the market averages consistently unless you have an inside edge. Insider trading is illegal - you can't know things about the company qua company - but you can find out whether large brokerage houses are going to upgrade or downgrade their rating on a particular stock. If you have $300,000,000 to trade with, you can do this by making trades with every broker in the city. Essentially you give brokers commissions on large stock trades in exchange for information. Tricky.

I also realized that there's a lot of variation in how the mechanisms of markets function. If you are in the market for a particular stock you can place limit orders or market orders. A limit order is of the form "sell X shares at $Y". This is written down in a list somewhere and if ever someone wants to buy some shares at $Y the trade is executed. A market order is more like "sell X shares at the highest possible price". The broker then looks at his list and executes a trade between you and the highest limit buyer. The "price" of a stock is then whatever the last price it traded at was.

But you don't have anything like this in, say, the market for milk. You go to the grocery store, see milk and milk's price, and decide whether or not to buy it. Perhaps you shop around to see who is offering the lowest price for milk. In the market for milk you don't really have the ability to issue a limit order saying "buy 1 gallon at $2". The price is the price. And grocery stores can't use a market order: "sell 100 gallons at the highest price". There's no bid price for milk, only an ask price. The institutions of trade are simply set up differently.

Thus it is easy for a hedge fund with $300,000,000 in capital to move prices around. It's very common to buy or sell upwards of 1,000,000 shares of some $30 stock. A move like that can't help but change the price of the stock. It is unlikely that someone is selling 1,000,000 shares of TDS at $30. You'll probably have to buy 100,000 at $30, 50,000 at $30.25, 75,000 at $30.50 and so on. Every such purchase moves the price up. Of course, hedge funds are fully aware of this and micromanage how they make large trades.

I submit two points. One is that there has to be more study of actual market mechanisms. Cramer is very skeptical of the theories of finance, like the Black-Scholes options pricing model. I tend to think that these sorts of things work pretty well in the long run but in the short run, where Cramer lives, they fail pretty miserably. Why? Because it seems clear (my second point) that even the much touted efficient financial markets are not, in the short run. There's market power: large institutional traders easily push prices around. There's not perfect information: hedge funds get "insider" information every day. Many markets in certain stocks are also fairly illiquid. Particularly with small-cap stocks you can get into trouble by not being able to find a buyer for shares you need to offload.

This area seems ripe for economic sociologists (if they working on it already, I have no idea.) Nonetheless, markets seem to pretty well in the long-run, as do the standard theories.

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