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March 13, 2007
Heh Diddle Diddle
Hey diddle diddle,
The cat and the fiddle,
The cow jumped over the moon,
The little dog laughed to see such fun,
And the dish ran away with the spoon.
The above nursery rhyme may be nonsensical, but it sounds good. Welcome to Wall Street-speak…
John Hussman further questioned the theory “that Wall Street operates on a well-defined base of knowledge” in his latest commentary ‘The "Money Flow" Myth and the "Liquidity" Trap’.
On ‘Money Flow’:
Dear Wall Street analysts and financial reporters – when investors purchase a stock in the secondary market, the dollars that buyers bring “into” the market are immediately taken “out of” the market in the hands of the sellers. It is an exchange. This is why the place it happens is called a “stock exchange.” The stock market is not an air balloon into which money goes in or out and expands or contracts that balloon. Nor is it a water balloon that is expanded by pouring in “liquidity.”...
On ‘Liquidity’:
The phenomenon that's being called “liquidity” is nothing more than a combination of fiscal irresponsibility and risk blindness, and will ultimately prove itself to be the time-bomb that it is when investors begin to “re-price” that risk.
While nothing that Mr. Hussman says is inaccurate, he nonetheless made some less than rounded comments, some of which are worth discussing.
For Every Buyer There Is A Seller
Mr. Hussman’s statement that “The stock market is not an air balloon into which money goes in or out and expands or contracts that balloon” leaves much to be desired. After all, while someone may buy peaches/sell grapes and then call it a day at a fruit market, they are much more likely to buy and sell stocks over extended periods of time. Thus, it should be acknowledged that since participation levels in the equity markets are usually of a long-term duration that these ‘levels’ can be seen as expanding and contracting like a balloon.
Adding to the ‘participation’ distinction it should also be noted that when stock prices are rising the markets have a tendency to attract more participants. In this regard, the story that every transaction has a buyer and seller misses the point, which is: if the ‘sellers’ are making money on their transactions they are likely to keep their capital working in the equity marketplace.
Cash does not ever find a “home” in a secondary market. Every time you hear the phrase “investors are putting money into…” or “investors are taking money out of …” or “money is flowing out of … and into …,” it is a signal that the speaker is unable to distinguish a secondary market from a primary one.
I sincerely doubt that every analyst that floats speculations about money flows is incapable of comprehending the buyer/seller mechanics of the secondary market. Rather, what Hussman is apparently missing is that when Wall Street deploys the buzzwords in question they are often times talking about ‘flows’ in the context of mutual funds, ETFs, hedge funds, and other investment vehicles. Wall Street is correct in that the money investors ‘put in’ to say equity funds can play a key role in determining stock market prices because these flows can help determine the amount of capital participating in the marketplace.
To summarize, the amount of participants in the equity market follows “out of and into” tendencies, and these tendencies can and do play a role in determining price trends. As for Hussman’s focus on market mechanics, for every scalped ticket to a hot rock concert there must be a buyer and seller as well, but this knowledge doesn’t give us any insight to why those U2 tickets just sold for $700 when the face value was only $150.
As for the ‘liquidity’ points made by Hussman (although they are spot on) the ‘participation’ factor should be remembered. To be sure, with so many different asset classes performing so well in recent years, it is obvious that overall investor ‘participation’ levels are way up (i.e. there are more precious metals investors than in say 1999, more REIT investors than perhaps ever before, more art investors, etc.) Thus, what Wall Street does is attempt to harness the forces these ‘participation’ bubbles may unleash. For example, a popular Street’ speculation last year was that since real estate prices will stop rising money will move out of real estate and into equities. Yes, since there must be a buyer for every seller of a house, the speculation that money can move ‘out of’ real estate makes no sense. However, the unspoken assumption was that participation in the real estate market would flat line while gaining in equities.
Conclusions
Below is a chart that comments on market ‘liquidity’. Without attempting to define the liquidity animal, can you guess when U.S. stock prices broadly peaked in 2000?
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If you guessed March 2000, correct! And to think, you did this without a single market transaction being known…
“Prices are not driven by the amount of money that buyers “put in” or sellers “take out” (as those dollar amounts are identical). Prices are determined by the relative eagerness of the buyer versus the seller.”
Even though Wall Street flippantly and incorrectly uses the terms ‘liquidity’ and “money flows” to comment on every gyration in the marketplace, Mr. Hussman threatens to take semantics to the other extreme by breaking down these terms into intelligent modes of thought. Quite frankly, there is no intelligent way to describe thousands of fund managers being obligated (whether they are ‘eager’ is questionable) to throw money around in the markets.
Maybe when, and if, the markets start losing a few participants they can be regarded as an animal that obeys the laws of fundamental analysis. Until then record high margin debt levels, high/peaking turnover ratios, and the fact that there is little sidelined capital still available to flow into the equity rotational party suggest that liquidity forces will start being depressed heading into the seasonally weak consumption period beginning May (or so someone on Wall Street might say). It doesn’t really matter that most of what I just said is nonsensical if broken down, because at the end of the day it sounded good and will be read by ignorant and blissful equity participants – something Mr. Hussman is most certainly not.
“I am increasingly losing confidence that Wall Street operates on a well-defined base of knowledge. Instead, I am struck by the number of platitudes and false constructs that seem to dominate the investment management industry.”
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