Muhamed Sacirbey
Along with mercantilism globally, is predation within financial markets ever more the defining characteristic?
Even the predators can become potential prey in today’s financial, currency and commodity, markets. Thus, predatory behavior can also be defensively driven. Market participants perhaps may believe that they are acting in a preemptive nature to avoid becoming the prey, or they may be running in packs, herds seeking profit but also safety in the security of numbers. Of course, some are simply driven by predatory opportunism with the hunter’s confidence fearing few consequences including from the regulatory environment. The recent recession has been considered transformational, particularly in the need for greater regulatory oversight and limiting the power of “too big to fail; however in terms of the increasingly primal nature of the financial and commodity markets, little seems to have changed in market participant behavior. This may foretell a return to the pitfalls of the past. If predatory market behavior, (including “bubbles”), was not the root cause of the recent financial market turmoil, then it was the impetus for even greater trauma.
Stalking the Financial Jungle
The consequences are that capitalism’s free markets have in fact increasingly taken on the characteristic of a financial jungle. Rather than traditional investors, various types of participants are stalking the jungle seeking out the weak and unaware frequently hunting in loose packs. The term “hedge funds” now includes a wide array of institutions with almost as many strategies of “investing,” and it would be inappropriate to simply place the focus on them as responsible for the transformation from free to predatory market behavior. Undoubtedly though the surge of new market participants generally labeled as hedge funds has dramatically altered the nature of how money is “invested.”
From “Too Big To Fail” to Dinosaurs
Many old line financial institutions focused on growth and size, but like plodding dinosaurs have been unable to compete with the variety of more agile new breeds. Some of the old dinosaurs have fallen prey, victim of outmoded survival strategies and the predation action of other market participants. The predators may be much smaller but more agile. Some may also be behemoths but effectively shielded from transparency. There is as likely to be cannibalism as predation from the new breeds.
The transformation is neither as dramatic or evident as from Dr. Jekyll to Mr. Hyde. Some of the old line institutions, traditional investment, merchant and commercial banks, perhaps even insurance and financial service firms have either mutated to adapt to the new environment and/or established their own affiliated “hedge funds.” Again, the relationships may not be fully evident and may go beyond cross-ownership interests to other forms of apparently symbiotic arrangements. (In at least some instances though symbiosis apparently turned predatory when some banks purportedly lent money to hedge funds only in turn to have such financial resources effectively employed as financial weapons to drive down the value of the lender through activity in short sales and/or credit default swaps markets).
Stampeding the Herd
Financial and commodity markets have been frequently moving in sharp, prolonged trends driven to “exhaustion.” The trend then frequently reverses in the opposite direction to another “exhaustion” point. During my MBA studies at Columbia University School of Business, the theory of free markets was taught upon the model that such are always tending toward a new equilibrium based upon the constant flow of information being then incorporated into mostly subtle price movements. Big price swings would result only on basis of transformative new information, perhaps a merger or dramatic change in profitability.
In today’s markets, the extended, if not necessarily always dramatic moves appear more the norm than exception. The reason for such moves frequently is not linked to any readily available new information regarding the company or asset. (Pattern is frequently evident in currency, commodity as well as equity markets). In some instances, subsequently it does become evident that price movements were triggered by “fundamental” change of circumstances in the situation of the particular enterprise, or perhaps industry as a whole. Leakage of “insider information” may be at the core, (bringing into question potential civil and even criminal violations of largely longstanding statutory and regulatory standards).
Frequently though it appears that price movements are triggered by the perceived redeployment of “investor” funds from one to another asset. In effect, a trend is initiated and the herd soon tries to recognize and follow the course set by the big money, regardless of apparent fundamental factors underlying such asset. The “smart money” is not necessarily smart nor even better informed but only has to have the market presence to establish dominance in the trend. While price movements that follow may be rationalized by “technical analysis,” the simple term of “the trend is your friend” describes the strategy and herd that follows.
Recent indictments of a few hedge fund managers accused of trading on basis of insider information may explain why in some instances the market overall has followed the trend initiated by some presumably “knowledgeable” investors. Certainly some hedge funds tend to not only walk but tout their talent in walking the fine line between the illegality of insider trading and the capacity to access unique if not outright confidential inside information. (Traditional analysts may take a complementary or secondary role in this “investing strategy”). However, in many if not most instances, money leverage is enough to stampede the trend in a particular direction. Then, to most savvy market participants, the successful survival strategy is to as quickly recognize the real trend, perhaps who is setting it and be early in and not last out as to maximize your profit but also avoid becoming the meal when the move is exhausted and perhaps dramatically reverses upon itself.
The Water Hole
Trends and thus opportunities tend to move from different real asset classes. Some asset classes as petroleum or food may be defined as necessities drawing both industry participants purportedly seeking hedging security but also pure financial players seeking maximum profit. Hedging perhaps may require on the other side of the trade a “speculator” who is willing to take the risk. However, speculators may become dominant in their role thus displacing more traditional industry participants as price setters, (who should be normally in better position to anticipate trends due to their proximity to production and demand). Also, speculators may be tempted to exacerbate volatility as a means to both secure higher margins for hedging costs and to move, stampede the herd in dramatic trends enhancing their position at the front.
The damage inflicted of course goes well beyond fellow investors. Consumers are hurt, particularly those least able to adjust to spiking prices. Producers can suffer as well though. Artificial, volatile and unstable prices are not a sound basis for investment and production schedules. Some have argued that speculation is really not at the core of recent volatility and price instability. However, the actual supply and demand fundamentals have not been reflected in many current prices.
Market Deeds & Sins: Will God and Karma Restore Balance?
In the end, the argument falls to: “while speculation may be the dominant force in today’s prices, in the long term, the fundamentals of supply and demand have to prevail.” However, this has come to sound more like a philosophical than functional rationalization depending on God and Karma to correct the injustice as well as the imbalance at some undefined future point. In the meantime, transformative profits are reaped today for some along with the damage inflicted upon the broader market and society.
Outright manipulation of prices perhaps is not a wide ranging problem, and it certainly may be difficult to evidence and to prove overt conspiratorial action. Speculation though produces similar results when a pattern of market behavior is established and even disciplined. Today’s predatory activity in the market place is more likely to rely upon concerted trends rather than covert arrangements.
Government and society did act to punish the likes of Bernard Madoff. However, the behavior addressed was the most egregious and obviously illegal, once uncovered. And as has been pointed out, while punished now, the illegality was not uncovered and prevented until it was too late in terms of the specific harm committed to Madoff’s investors and damage done to our collective confidence in our capitalist, free market system. The Madoff scam came on top of already severe erosion in confidence after predatory action and the near collapse of the housing and credit markets along with the bursting of various real asset bubbles.
The Death of “Buy & Hold?”
The longstanding advice to individual Americans investing their nest eggs and retirements had been to “buy & hold.” The underlying theory appears sound: a well diversified portfolio and asset appreciation will over the longer term reflect economic growth. However, some traditional advocates of this investment philosophy had already begun to question the broad validity of this strategy even before the crash. New enterprises not yet on the radar of most individual investors may reflect the greatest surge of growth and profit opportunity over any 5-10 year period, (as is most recently reflected by Google, Apple and some resource related companies). Most relevantly, market volatility could significantly impact long term returns depending on when you bought and particularly felt compelled to sell.
Historical Transfer of Wealth
Unfortunately even the success of the “buy & hold” strategy is predicated upon an individual’s ability to withstand the psychological and absolute risks associated with volatility, (particularly the type of sell-off witnessed during the 6 month period between the fall of 2008 and spring of 2009). Many adhering to “buy & hold” initially held on to assets that were experiencing at times dramatic price depreciation at least as reflected in daily posted market quotes. However, as the crisis continued over an extended period and neither the bottom nor recovery were readily evident, many individual investors found themselves no longer able to withstand the risk to their nest eggs and retirement futures. Either as a consequence of panic or simply trying to preserve the little of what was left for emergencies and old age, many sold at the most importune period. The result was a historically momentous transfer of wealth away from the savings and retirement accounts of the middle classes, only evident as real asset valuations are now being restored.
Only two questions remain, at least in the context of this article: How does an average investor with limited means keep from becoming the prey? Professional advice/assistance is helpful, but even then panic must be avoided. Much of the wealth lost during this crisis came from managed accounts that were being drawn upon, liquidated in panic.
Winners & Losers
Who bought up the real assets that were liquidated in panic? The answer to that question remains to become evident. However, it is not necessarily great news for either the US economic system nor the “buy & hold” average investor as the profitability of financial institutions is increasingly dependent upon trading, or more accurately speculative gain based on presumably naked risk taking.
While it appears that hard transaction costs have decreased and technological efficiency increased to the benefit of all investors, the consequences are much more convoluted. To each winning trade there is a counter-party. Practices have also evolved with technology and encroached upon the free markets in ways that bring into question the “level playing field,” such as “flash trading, ” (a practice by which big investors are provided the split second benefit to see what others may be placing in buy or sell orders, and thus beat the herd to the trade all through technological execution).
Should we be less concerned regarding how large Wall Street bonuses are and more on the conduct for which such are are rewarded? Wall Street may be more deserving of huge profits and the personal bonuses that go along with such when it plays the critical role of enhancing access to capital and overall efficiency. Some innovations over the last few decades, including mortgage and asset backed securities, some derivatives and hedging strategies have played a critical role in promoting the overall market and even egalitarian qualities regardless of certain excesses that have come to pass over the last 5-10 years. Broad benefits can be identified including from broadening and deepening the markets.
Capital flow must be allowed to follow both the industries and enterprises that offer the brightest future and opportunities, including profitability. Trading is an integral element of establishing a free market with the necessary depth for efficiency and timeliness. However, how much of trading in such opportunities, in real assets reflects a fundamental reassessment versus some more predatory behavior? Is it positive that investors are perhaps discouraged from seeing the opportunity over a multi-year time frame versus the hour, day or quarter? Trading and speculative functions can serve both a broad beneficial purpose, but they also can be readily transformed into predatory platforms. Mutually beneficial financial activities are still part of the spectrum and abundant but in terms of focus, profitability and personal compensation have already come or are increasingly under threat of being eclipsed by conduct that as frequently as not bears relative winners and losers in the moment.
