Felix Salmon points toward an article written by Jim Surowiecki in the New Yorker this week on “ancillary markets” – CDS, futures, forex etc:
Even if these ancillary markets aren’t being gamed, the attention paid to them is out of all proportion to their informational worth. Because they are small relative to the elephantine U.S. stock and bond markets, it doesn’t take a lot of money to move them significantly, and since they have low margin requirements, speculators can have a big impact on prices while putting up only a little cash. Credit-default-swap contracts, similarly, are generally not that expensive, so fairly small investments can move prices noticeably. When U.S. stock-market investors take their cues from these other markets, the tail is wagging the elephant.
There are many assumptions underlying Surowiecki’s call, but the biggest of them all is perhaps the idea that the only market that counts is the (elephantine) stock market.
Certainly, that’s the one everyone knows about: the only one which features in the public imagination by any stretch and the one that dominates the media.
Stocks have become very graspable things. A stock is a part of a company. The company is owned by its stockholders. Companies do well, stocks do well, yada yada.
But ownership is as amorphous a market concept as risk. If a company issues bonds, for example, then should that company go to the Wall, those bondholders will have a better claim on ‘ownership’ than shareholders.
Why should shares be considered any less complex that credit products? Or, to put it another way:
I want to warn people about another derivatives sub-market, one that gets far less attention than the purportedly $36-trillion market (or whatever the current claimed number is) for credit default swaps. It is something called “shares”.
You may not have heard of them, so here is a description:
“A share is itself a derivative, composed of several underylings: capital value changes, dividends, an option that it might be taken over upping the price, and a set of entertaining variable tax consequences, since dividends and capital growth/loss are taxes quite differently from each other and for different classes of investor. [via Wilmott]
There’s an equity market industry – nay, a whole mythology – surrounding equities that belies the complexity – indeed the opacity – of equities.
Back though to Surowiecki’s point: that equity markets are central and more reliable than other markets, and shouldn’t be drowned by superfluous noise. Equity markets, in other words, are likely to give the best – that is, most accurate – prices.
Ann Rutledge of R&R consulting notes that the concept of fair market value “is as old as the 1587 edition of Blacks Law Dictionary” wherein it first appeared. Virtually unchanged, in the Merriam-Webster 1901, fair market value is:
…a price at which buyers and sellers with a reasonable knowledge of pertinent facts and not acting under any compulsion are willing to do business.
So we have two key issues: information and liquidity.
On the latter, equities win. Surowiecki is right in the sense that equity markets are very liquid, and so can be relied upon to give a degree of good pricing.
But who said those “ancillary” markets weren’t liquid also. Overblown numbers on the notional size of the CDS markets are paraded out in the media regularly. Underlying them is a huge number of trades going on, which means CDS markets are very liquid. For most of their history too, they have tracked bond prices quite well. Consider the below chart from Fitch, which measures the spread on a Globoxx CDS portfolio (50% CDX, 50% iTraxx) against a much longer dated Merrill Lynch index of corporate bond spreads:
Counting against the CDS markets, you might consider the huge role that structured products play in the markets. Unwinds certainly seem to be able to send spreads gapping out, as was the case in late October.
Equity markets though, have their own share of technically driven moves. The end of October was equally rough for the DJIA as it was for the CDX.The most recent bout of severe share price falls in the US has been almost universally put down to the unwinding of several large hedge fund positions or else the technical reversal of phenomena like the yen carry trade. For a more specific example of equity inanity, take a look at Volkswagen.
Onto the second pricing issue: information.
It has to be said: equity markets have proved themselves the least informed about the current crisis.
Indeed, perhaps that’s exactly why, as Surowiecki notes, they are paying so much attention to things like CDS indices and Libor.
There’s a good reason. If you own the bonds of a company, you’re privy to a lot more sensitive information than if you own the stock of a company. The general rule then is that credit markets see things coming before equity markets do.
And there’s a broader point. Structured finance has wrought huge changes on the corporation. No longer can we talk about corporate balance sheets as we once could. So many risks are now “off balance sheet” that the information equity markets have ownership of: cash flows, net figures and such, is largely bunk when it comes to assessing risk.
We’re all Enron now, in that sense. As a (somewhat parochial) example, consider the UK’s Punch Taverns, which we wrote about earlier today.
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Equity markets might be more liquid then, but they also have the least information – an equal component in the determination of fair value. And it would seem the charges against equity markets’ ignorance, relative to CDS markets’ illiquidity, are more serious.
Perhaps what’s needed is a new disclosure regime? One in which off-balance sheet risks have to be far more explicitly detailed in regulatory filings, for example?
Or perhaps its just that equities are a mugs’ game. Some rich people in equities make a tonne of money, some poor people lose a lot, and the rest just sit it out for the long term.
He belonged to the dreaded equity department, the sleepy backwater in which lurked such career stoppers as Equities in Dallas.
– Michael Lewis, Liars Poker
