The Importance of Market Structure

In my investment classes, I always stress to my students the importance of analyzing markets and building portfolios through four lenses:

-         fundamentals (relative valuation metrics, earnings cycles, macroeconomics, etc.)

-         technicals (support/resistance levels, moving averages, breadth, etc.)

-         sentiment (volatility measures, put and call ratios, CDS, etc.)

and…..

-         market structure.

The latter element is, in my view, the most important albeit the most difficult to research and forecast.  Market structure is that comprehensive box that relates to the rules of engagement for all market participants. 

Structure refers to the regulatory framework such as what behavior legislators and regulators may want to push forward but it also refers to the much more ethereal aspect of how such rules will be enforced and potentially “bent” in favor of certain investing classes. 

To this point, think of High Frequency Trading (HFT) and how the combination of technology interests and for-profit exchanges lead to large structural changes in the markets with numerous distortions in the way the constant price discovery process now works. HFT is not the only example in recent history; the introduction of commodity related Exchange Traded Funds lead to behavioral changes in the commodity markets due to the injection of a persistent long bias with retail characteristics in a traditionally institutional hedging market.

Historically we also witnessed other major structural changes that lead to long bullish waves such as rules in favors of equity investments as commonplace vehicles for retirement savings.

Understanding market structure will also force investors to research how the bigger players will align in the financial spectrum; this goes beyond following the smart money such as hedge fund managers and corporate raiders but more and more it has to do with fully understanding global politics and power plays.  Today’s investor should spend more time analyzing Central Bankers speeches and Heads of States political realities rather than pouring over balance sheets and income statements.

The real truth is that the “1% of the 1%” sets the rules of engagement and while most investors do not have a seat at that very exclusive table, in order to be successful at the investing game you must work through an analytical framework that will take you as close as possible.  One of the most significant realities of the unraveling of our financial markets since 2008 is that the rules of engagements are constantly being rewritten putting any investor in a more complex situation than ever before.  Structure is key but it is also now a fast moving target.  I believe that to a large extent this is one reason why traditional portfolio management approaches have failed miserably in this decade; as market structure became more negotiable and more unstable, it also became even more important yet more difficult to predict with the end result of undermining strategies established under the assumption of structural stability.

Successful investing in the next decade will require active political analysis and possibly an increased level of stakeholder’s activism in an attempt to be part of the rule making process.  Intense strategic geo-political analysis should also play part in the construction of every portfolio.  Legal expertise, now the domain of M&A and Distressed Securities traders, will probably become required talent for most money managers.

In conclusion, the world has become a lot more complex and unpredictable; successful investors will rise to the challenge by shedding old habits and stale formulas and embracing three-dimensional active analysis.

Are Financial Markets Doomed? MF Global Bankruptcy Strikes at the Core of Markets

Happy families are all alike; every unhappy family is unhappy in its own way. LeoTolstoy, Anna Karenina, Chapter 1

In a bull market everyone is happy, the sky is the limit and we all feel like “wunderkinds”.  We see cracks but we disregard them as insignificant, we may notice incompetence and malice but the show must go on.

Then the inevitable moment of reckoning occurs, bull times turn into bears and the sky is suddenly not limitless but heavy and suffocating.  Disasters like the Lehman moment in 2008 happen and great destruction touches society at its core.  The only silver lining, you may think, is that something must be learned and that things can only get better from here.

Fast forward to the fall of 2011 and “enjoy” the MF Global moment.  The bankruptcy of this once powerful derivative broker may not have, so far, scared markets as much as Lehman but to the eyes of the careful analyst it is actually much more dangerous and systemically insidious.

MF Global had been around for more than 200 years facilitating commodity trading around the world; in some exchanges up to 80% of the volume was attributed to MF Global. This changed recently when disgraced ex New Jersey Governor Jon Corzine was chosen to run the firm.  Eighteen months later, MF Global is bankrupt thanks to a series of actions that make Lehman look like child’s play. 

Corzine levered up the firms’ capital to a ratio as high as 40 to 1 in risky bets on European sovereign debt.  Sounds like 2008 all over again? Weren’t we going to fix the leverage issue with banks? I guess not.  Corzine also levered his political capital to intimidate regulators in order to have rules changed or kept in his favor.  Doesn’t it sound very familiar again? But additionally, the MF saga really strikes a deadly blow to financial markets: while no formal indictments have been put forward yet, it is clear that $600 million of customer segregated funds have been lost, stolen, vaporized (you pick your favorite).  In commodity trading, customer funds are fully segregated from the bank capital to ensure safety in cases like bankruptcy.  It is the cornerstone of the brokerage industry.  The CFTC, the commodity regulatory body, is supposed to oversee this process and the Chicago Mercantile Exchange (the largest derivative exchange in the US) is responsible for managing this process as well.

Almost three weeks after the filing of MF Global bankruptcy, customers of the bank still have their accounts frozen (only open positions were transferred to new brokers with a percentage of minimum margin needed to hold the exposure) and there are questions whether they will recover 100% of their funds. 

Even though customers are not part of the bankruptcy dynamic since their funds are outside of the bank’s balance sheet, the Trustee in charge of the process is holding everyone hostage.

If our financial markets cannot guarantee safety of funds deposited with brokers or banks, our economic system will fall into a dark medieval state that will impoverish all.  Liquidity will dry up, spreads will widen, prices and volatility will become intolerable.  While it is clear that the system of incentives in Wall Street continues to push at best risky behavior and at worst illegal activities, our regulators and legal system continue to abdicate their responsibilities.

This is very serious as people’s faith in financial markets cannot be broken once again.