date 18 May 2022
The book The Man Who Solved the Market is an interesting, but at the same time a frustrating read. It explains how Jim Simons used sophisticated statistical tools to extract information about future price movements from price histories. A huge body of financial economic theory is predicated on the idea that this is simply not possible, and that securities prices follow a martingale process. A long time ago, I knew something about the rather complex theory of derivatives pricing that arises from this approach.
Anyway, the book focusses, like all popular books, on the personalities of the people involved, and avoids equations or really any mathematical discussion of how Simons did it. There is a huge literature and discussion of this topic on the Internet, but to me the important thing is that the widespread copying of these approaches by various hedge funds has resulted in valuations, in the sense that Graham and Dodd understood it, being completely irrelevant. For a lot of modern investors, a high P/E ratio is a buy signal. Well, as Graham himself said, in the short term the market is a voting machine, but in the long term it’s a weighing machine. The problem is that he didn’t say that the short term might persist for four decades.
My understanding is that modern (“AI”) and trend-following models are solving for slope in equities, not the endpoint. The problem is that momentum is reflexive. Soros was right: a rising price makes a stock more attractive to buyers (unlike the demand curve for a commodity, where the price elasticity of demand is always negative or at best zero). As more money flows to funds which use this trend-following approach, prices will rise as a consequence of limited supply and rising demand. Again, conventional economics with its static picture of supply and demand schedules doesn’t really work here.
This synchronized snowball effect of rising demand has resulted in exponential growth in prices of disruptor and lockdown-beneficiary stocks, like Peleton ($PTON). Except now the whole thing has gone into reverse. With no assets, no profits and shrinking turnover, it’s hard to see that the end for these stocks is other than delisting.
The only question is whether the effect will spill over to mainstream indexes, like $SPX. The FANG+ stocks are a big part of this index now. As investors de-lever, it’s hard to see the main index bucking the trend. If the flow into passive equity funds reverses, we are likely to see a vicious down spiral.
Most investors are instinctively long stocks, as they perceive that central banks will be incapable of stemming the money supply. Central bank are finding out now that a 2% (or 2.5%) inflation is harder to hit than they thought. In this environment, bonds are going to get smoked, so what’s left? So far gold has failed spectacularly to act as a hedge. My best guess is soft commodities, like corn, the demand for which will be minimally hit by a recession, but to be perfectly honest, I am far from convinced that agricultural commodity futures will not themselves be dragged down by the increasing cost of carry that will be imposed by central banks.
I missed making a note yesterday. Briefing had a decent summary.
Former President George W. Bush: “The decision of one man to launch a wholly unjustified and brutal invasion of Iraq. I mean of Ukraine.” pic.twitter.com/UMwNMwMnmX— Sahil Kapur (@sahilkapur) May 19, 2022
Seriously, you won’t get triggered by this.
𝐼𝑓 𝐼 𝑤𝑒𝑟𝑒 𝑎 𝑝𝑎𝑖𝑛𝑡𝑒𝑟— ♬ // ⓐⓡⓣ (@musicis4ever_) May 18, 2022
𝐴𝑛𝑑 𝑐𝑜𝑢𝑙𝑑 𝑝𝑎𝑖𝑛𝑡 𝑎 𝑚𝑒𝑚𝑜𝑟𝑦
𝐼'𝑑 𝑐𝑙𝑖𝑚𝑏 𝑖𝑛𝑠𝑖𝑑𝑒 𝑡ℎ𝑒 𝑠𝑤𝑖𝑟𝑙𝑖𝑛𝑔
𝑠𝑘𝑖𝑒𝑠 𝑡𝑜 𝑏𝑒 𝑤𝑖𝑡ℎ 𝑦𝑜𝑢…
© ɪɴɢʀᴇᴅ ᴋʟᴇʀᴋs pic.twitter.com/55Vk3737tf