Short-selling and Efficient markets

I have pondered over this question for some time now - 'Does short-selling make a market more efficient?' Or, to put it differently, 'Is short-selling a pre-requisite for efficient markets?' Here are my views on the same.

To answer the above question, we must first define 'market efficiency'. In my opinion, an efficient market is one where price discovery is solely based on the intersection of demand and supply functions. And any new information or event affects either or both of these functions, and hence results in the change in price. But as a whole, price is always arrived at by the demand function of the consumers and the supply function of producers.

In stock markets, the demand and supply functions are slightly complicated. The supply function is simpler to understand. During an IPO, its the standard supply function as in case of a manufacturing firm - higher the price, more the supply. As the valuations become richer, promoters supply more and more shares in the market. And as time passes, in a secondary market, the supply comes from prior period consumers (which were the demand function earlier). However, the supply side is still limited by the total amount of stock outstanding, and hence, has its upper-bound. It can always be estimated as coming from a single large firm with limited production - higher the price offered, more the supply.

Demand function, on the other hand, can come from anyone in the market place, and it has no upper-bound. However, it has a non-zero lower bound. So, there is always a positive demand, as well as a positive supply in a perfectly functioning markets. And it doesn't need 'short-selling' to function efficiently. In the worst scenario, there is no demand for the stocks, and hence, there is no trade in the market.

Now if short-selling is allowed, the supply function becomes as independent as the demand function. Everyone can become a supplier (that is, can sell the stock), and the upper bound on supply function disappears. Or, to look at it differently, now there is a possibility of a negative demand, and hence, must be matched by a positive demand. In falling markets where there is no positive demand, a negative demand if not met, can make a stock price nosedive towards zero. It will keep falling as long as it is matched by some positive demand. Hence, it can lead to quicker falls and higher volatility during the times of uncertainty.

Its a choice between a dry market with no trading (zero demand) or a highly volatile market with falling prices (negative unmet demand). And am not sure why the latter is better than the former.

Financial Crisis

The ongoing financial crisis is getting worse with each passing day. No one seems to have any clue as to when things would start improving. It has put some doubts over everyone's immediate future as well with their companies. Already, a couple of my friends have received the pink-slips, and I fear there is worse to come.

Just hoping that time would pass, and things would be normal again. These days, there is gloom all around. A lot of dreams, unfounded or grounded, have burst in recent times. And we are now in the process of realizing that Rome wasn't built in a day. Growth and development are slow process, and they happen over time. None of the economies move as fast as the stock or currency markets, and hence, there are crashes everywhere. Last few years were really a mad period in the world economic history where central banks around the world eased monetary policies, and credit was very easily available. Everything was made to appear rosy, and risk had disappeared from the world. The process of securitization had distributed to risk to everyone, and hence the crisis we find ourselves in has taken everything with itself.

There would be massive de-leveraging all around the world, and we can expect further crashes in almost all the asset classes. The emerging markets would be the worst affected, and there is a slight chance that it may pre-maturely end a lot of 'growth stories'.

Market Efficiency and Speculation

Much of the debate in recent few days has been about the massive amount of speculative positions in the stocks and other securities. People are blaming the short selling speculators for the demise of firms like Lehman Brothers, AIG, Bear Sterns, and many more. The argument is, even though the positions of these companies is sound in the long term, short sellers are putting undue pressure on the firms, and has resulted in forced liquidation.

I personally would think of these arguments as lame excuses. While not myself a supporter of naked short-selling to start with, I nonetheless believe that most of the firms which have fallen have fallen for the right reasons. If short-selling was to be blamed, and their balance sheet were sound, why would the senior debt holders in Lehman get only 8-9 cents per dollar as recovery? They ought to be making a lot more than this.

Short-selling didn't (or rather couldn't) have changed anything. At the low valuations at which Lehman Brothers or Bear Sterns was finally sold, the Management could easily have bought the firm with the personal pay-cheques. The fact that they themselves didn't do the same make the whole speculation argument seem hollow.

End of Road for US?

This would be the year of contrasts. The two biggest events of the year symbolize the same thing - US power may be waning, and something must be done very soon to save it.
Lets start with the first event - the great credit crisis. As has been said earlier, it was a game of musical chair being played by the banks, and thankfully, they always seemed to have a seat when the music suddenly stopped. Many corporations as well as a few banks have gone bankrupt in the last 2 decades, but the big ones got bigger. They became too big to fail. But in a complete turn-around, banks now find themselves caught in their own game. All are left with huge amount of sub-standard assets on their balance sheets, and with continuous fall in their market values, its a south journey for most of them this year. Bear Sterns has already been sold-off at throw-away prices, and Lehman Brothers may no longer exist after a couple of days. Nobody wants to make a guess on who would be next, but everybody in almost convinced that this is not the end of pain.

All the great institutions of US are performing badly. The big three of the automobile would may be struggling, and may meet the same fate as their banking counter-parts. The US is losing its hold over all the manufacturing sectors, and now with financial services, this may be the beginning of the service sectors as well. Already a large chunk of the these companies is being owned by Asian funds.

A marked phenomenon has been the interference by the US government and treasury in dealing with this crisis. The treasury tried its might to lend support to the sector, and extended a number of facilities earlier undreamt of. It was a great irony that the greatest proponent of Capitalism and free-market needed government intervention at the time when Socialist countries are turning towards Capitalism.

The second event that would define the year would certainly be the Beijing Olympics. From being described in superlatives all over the world, it was undoubtedly, the best ever sports event hosted on such a large scale. China showed its might to the world, and in the year where US and Europe are struggling with their economies and budget deficits, China spent more than USD 70 billion in preparation of the games. The move has paid-off handsomely, at least in an absolute sense. The world which was already witnessing an ailing giant saw a rising star as well in the same year. China brought an end to the US domination of the games, and in its typical manner. There was no star like Michael Phelps, or Usain Bolt. It was an effort by little known athletes, who together brought a giant to its knees. It was just another example of how socialism conquered the year.

What are the implications of these events for the future? They clearly shows us the divergence between the two big powers today. Whereas much of the money and energy in US has gone into preserving its institutions and survival, China has grown by leaps and bounds. For all the talks about recession and its severity, a country which spends all its year in fighting for survival and arranging bail-outs must surely be in a deep recession.

Trading is an Art?

I have often heard people saying that trading is an art, and not a pure science. Well, based on my little experiences, I can certainly say for sure its not an art. Whether its a science or not, I would take another year or so to make a view on.

When I say Art here, I mean a field where individual choices are different, and there is no way to judge two different entities. Two paintings or two works of music can both be good, and they might be incomparable to each other. Similarly, one can argue that even in trading there are different techniques used by different traders, and no one of them can be said to be superior to the other. Agreed to this, however, isn't it always about the output more than about the process?

Whatever be the technique employed by different traders, over a sufficiently long period of time, its a common measure that is used to judge who was better amongst them. Again, this measure can be flawed over the short term where luck and chance play a big role, and that is the reason why I have said over a sufficiently long time - around 10-12 years.

In my humble views, trading is much closer to science. All the successful traders have always been hardworking people, who keep a closer look at anything and everything happening in the world. I have seen/heard good traders working on the weekends to catch-up on the events of the past week, and get up to date with the world. They must study not just their own asset classes, but also what is happening in the other asset classes. At the minimum, one's view on interest rates and foreign exchange is a must, irrespective of the assets one trade. In the recent times, Commodities have acquired much more significance than in the past, and may truly end up becoming another big asset class. Its more a result of unrelenting efforts by the investment banks and hedge funds to bring it to prominence, and this is the first time we have had an oil shock after the derivatives got popular. It may have far reaching results a to how traders keep track of the world.

I'm yet to develop my own methods of trading, and that has more to do with the fact that I have not been able to zero down on the final asset class/securities that I would be trading. I have to make a choice between Equities and FX at the broader level, and between delta trading and volatility trading at the securities level. At the moment, I'm more inclined towards FX and Delta trading, and will be able to make a final decision by first half of 2009.

World Economy in Recession

I recently started working in an Investment Bank. And over the last one year, have had the opportunity to witness an event that may well describe our age. The credit-crisis have changed the shape of the world, and if not the Great Depression, this is at least comparable to the 9/11 attacks on the US.

Here are my learning from this recession:

1. Recession doesn't end very early, whatever be everyone's prediction about the state of the world markets, it does last for some time, sometimes for years. It may take us another 12 months to get to the end of the current one.

2. During recession, there are common themes which would always make money. One should be long the defensive sectors like FMCG, Pharmaceuticals, and be short the leveraged sectors like Real Estate, Banking, etc. Cash is king in these times, and sectors/companies with lower Debt/Equity ratios tend to outperform the rest.

3. At the onset of recession, rates usually move up - mostly caused by high levels of inflation. As recession deepens, central banks come into the picture, and start cutting rates. It might be a good idea to wait for rates to go up to 12-13% and then put some money into debt paper.

4. Oil and Gold perform very well during recessionary periods. One of the prime reason is flight to quality - these are commodities, and not paper certificates. Another reason is their link to inflation. Higher the inflation, higher the commodity prices. Hence, inevitably, most of the recessions are marked by rise in price of commodities.

5. Financial Sector is amongst the worst performers in a bad economy. The higher interest rates lead to de-leveraging, and lesser credit in the system. All this has negative effect of the banking system.

6. Big Caps always outperform the Small Caps, primarily because of the flight to quality syndrome. Another reason could be that during tightened credit conditions, small companies find it harder to raise debt, and their costs of funding soars higher.

7. Futures trade at lower premium (and even discounts) during Bear markets. This is simply due to huge shorting in index and stock futures by speculators as well as portfolio managers.

Tape Reading

Tape reading is a technique of reading the price action of the stocks, and infer something about the market activity in that name. In earlier days, expert traders used this to track strong buy or sell orders in a particular stock.

These days, the technique has become a little complicated, with millions of people having access to the trading terminals, and different software programs generating automated responses to certain events. However, as always, any astute trader can still devise his ways and means of reading the tape - which now may include in addition to price information on volume, open interest, put-call ratio and futures' basis.

I like this concept, and will try to get my hands on some literature on the subject.

First Trade

In the last post I had mentioned about my first trade, and the losses I made in it. As it turned out, those were just paper losses, and I actually got to close the trade at a profit.

Whatever, in the end, I just got out capturing a panic-moment in the market when the stock went down from -4% to -7% in a few minutes. The best thing about the current market is that everyone is scared, and it takes only a few moments for a stock to fall down. The best policy during these volatile market should be to capture the intra-day volatility.

Still, the lesson is learnt from the trade. Next time, would be a little more careful before shorting a stock. It was a lucky escape for me, and I would be doing more home work from now onwards.

First Trading Lessons

As I write this, there is a major turmoil developing in the world markets. Bear Sterns is already down the dump, being almost acquired by JPMC for as little as USD 240 MM. Lehman has had a bumpy ride on the last two days. Yesterday, it was down by more than 40% at one point in time, and today, its up by 35% on the back of positive returns.

Anyways, as people debate over the future of the financial firms, and these wall street barons, I have put on my first real trade. I am short on ABCD stock and have hedged that by being long on the index. ABCD was down yesterday, and I had made a small profit yesterday. However, today, it went up and up, and I have more than 4% loss for the day. I would wind up this position at 5% loss.

First learning from the trading:

1. Never short a stock which is backed by a strong promoter having large holdings. The promoter can stand at a price, and even when the whole market is falling, the stock may just stand at one price.