A matter of faith
In the age of information overload, the biggest problem facing anyone, especially analysts, is to make sense of the endless streams of facts and figures pouring in from every side. One of the simplest, but most effective, ways of doing so is by looking for trends. If the same phenomenon keeps recurring daily, weekly or monthly – depending on the kind of data and the frequency with which it is reported – then you know something significant is occurring.
Using that yardstick, it is now undeniable that there is a major problem in the American equity market –for that matter, in most global equity markets. This problem has little or nothing to do with prices. Rather, it goes much deeper to the very heart of the market. The most obvious expression of this malaise is the steady decline in the overall volume of trading, with a growing share of the trading that is being done now concentrated in a small group of shares and executed by a steadily-shrinking group of traders – mainly the largest investment houses, hedge funds and a few other financial institutions. The flip side of this development is that the general public is less and less involved in trading shares.
The data regarding the size and even the relative composition of trading are readily available. The downsizing has been underway since the crash and has become more severe this year, irrespective of the market’s price action – it made a high in April and has been volatile since then — confirming that it is not price levels that are driving this phenomenon. Things have reached the point where a day in which total volume on the ‘Big Board’ – the New York Stock Exchange – now exceeds one billion shares is considered to be a relatively good day, where last year this would mark a very slow day. Nor is it possible to continue blaming ‘summer doldrums’ or any other seasonal whim for this state of affairs.
In response, trading firms have started laying off staff and even reducing the scale of their activity. One firm reportedly said this week that it would stop trading between 11am and 2 pm, a period in which trading has become so sluggish that the market seems almost moribund. This type of response, even if logical from the firm’s point of view, will serve to make matters worse for the overall market, creating a “bar-bell” trading day in which the action is concentrated in the opening 30-60 minutes and in the final hour.
But it’s not just trading. The real proof that something very fundamental is amiss is to be found in the amazing behavior of the investing public in the area of mutual funds. Data on flows into the various classes of funds are published weekly and these have been telling a clear story. For the last twenty successive weeks – a phenomenon not merely unprecedented, but previously unimaginable – the public has been pulling money out of equity funds. In tandem, but in far largest amounts, money has been pouring into funds invested in bonds, including government, corporate and even municipal bonds. This general trend also traces back to the crash, but the strong rally since March 2009 did not impact it. If anything, the public is becoming more determined to move away from equity and into bonds.
An economic/ financial analysis of the relative prices of these asset classes could make a very good case that this behavior is not smart, and may be entirely irrational. But that’s just the point – it probably has little to do with economic analysis and nothing to do with rationality, as defined by economists and measured by finance-specialising MBA graduates. Instead it has everything to do with the irrational factors that underlie financial markets and drive much of the behaviour in them. Classically, these factors are hope, fear and greed, and it is plain that hope has been hammered and fear is rampant. Nothing else can explain the extent of the move from shares, the instrument of hope, to bonds, perceived (wrongly) as stable and solid investments and hence as the right place for scared people to be.
But beyond the cycle of hope-greed-fear is something even more basic, namely faith. Investors must have faith in key elements of the system: that their orders will be fairly executed; that the markets will function smoothly, with adequate liquidity to allow buying and selling at or near quoted prices; that the financial reports of the companies they invest in are valid and meaningful; and that the government and its agencies are on their side and will protect their interests against the huge financial institutions that dominate the markets. Over the three-plus years since the crisis began, the faith of many investors in all of these has been eroded or shattered completely. That is why people are streaming out of the equity market, to the supposed safety of bonds, where they expect to get some modest return – and their money back, come redemption time.
Whether that faith will be vindicated or will in its turn be destroyed will become clear over the next 12 months. But for the equity market, the damage runs very deep. The cult of the equity took two generations to develop, until it reached its maniacal climax in the late 1990s. Since then, equity investors have suffered a ‘lost decade’ and with it have lost their faith in the market. This will not be quickly or easily restored – nor can that process even begin until the big players and the regulators accept that the system is badly broken and that it is they who must lead the effort to regain the trust they have squandered.