What You Should Be Reading #17: June 2022

How Markets Work

Markets seldom behave the way you anticipate them to, one way to look at how the markets work is an equilibrium system. There are two types of investors in this model, optimists and pessimists. The market price reflects an equilibrium at which both parties are happy. In short, the price represents all the expectations and information in the market.

The above model works well in many situations but falls short in several ways. One, it doesn’t explain why there is so much trading, and second, it doesn’t account for tail events.

A better model of markets understood by most is of the market participants is an evolving ecosystem. In this, there aren’t just two types of investors. There are multiple; fundamental investors, technical trades, liquidity traders and market makers, each trading according to their interpretations.

It’s interactions between these players that drive the behaviour of the markets, rather than the actions of players themselves. These interactions create feedback in the system that can lead to extreme market movements as market participants imitate each other to varying degrees.

"When interactions between these players are taken into account, a complex system emerges, more akin to a biological system than a mechanical one. Each player operates under the guidance of two different functions – a cognitive one and a manipulative one.

Market participants observe the market and transact according to their mandate, whether it’s growth or relative value or some other style. That’s their cognitive function. But they also affect the market through their actions – that’s their manipulative function."


Where does the wealth go when asset prices go down?

If you ever switched channels on your television from one news channel to another, then you might have come across these lines at least once, “2 lakh crore investors’ wealth is wiped off!” or “Markets continue to bleed and investors lose 1 lakh crore for 3rd consecutive day” and you might have wondered who lost this money and where did it go? Well, you’re not alone and the short answer is: It didn’t “go” anywhere. It just vanished. It stopped existing.

Wealth isn’t a physical property of the Universe itself. It’s just how much humans value stuff like stocks, crypto, bonds, houses, or gold.

There are different ways to determine the value of an asset. To cite an example, to value a company’s shares there is something called mark-to-market accounting. Suppose there are 1 million total shares of Noahcorp and only 1000 shares are traded on any particular day. Now suppose that the 1000 shares that DO get traded go for $300 a share. Mark-to-market accounting means that we value all 1 million Noahcorp shares at $300 a share, including all the ones that never get traded. So the total value of all 1 million shares of Noahcorp — which is called Noahcorp’s “market capitalization” or “market cap” — is $300 million. But this method doesn’t hold good for real estate. The best example is your own house which is different compared to another property, and the sale price of other houses doesn’t automatically tell you how much your own house is worth.

Does this mean that everything is “fake”? Not entirely, but a little bit. The reason for this is something called “price impact”. In the earlier example if some entity holding all the non-traded shares (999,000 shares off 1 million) are sold at once then the price of $300 a share won’t hold up. The price would probably go way down. This is because, in real life, asset prices aren’t determined only by fundamental value, but by supply and demand as well. When these shares are sold in the market, it increases supply by 1000x which will tank the price.

Does this mean that the wealth numbers are fake again and you are thinking, why don’t we calculate wealth as the amount of cash you COULD get if you DID sell?

Well, the answer is: Because we can’t. We just don’t know. The only way to find out price impact is to actually sell. So we can’t really calculate how much cash people could get from selling all their stock or all their Bitcoin because we don’t actually have any way of knowing how much it is in advance.

Noah Smith takes you through this question in a very simplistic way in this article.


Risk of another recession?

As we approach the second half of 2022, we are looking at a recession risk. To fight inflation, the US Federal Reserve just hiked interest rates to their highest level in decades.

In simple terms, a recession is a drop in economic activity that can be mild or severe. As of today, nothing has changed. Everything remains the same, the spending, there hasn’t been much news about job losses, and still no real effects on businesses. We haven’t felt the heat yet. However, among all the other events starting with Covid, the geopolitical worries, and recent lockdown announcements in a few countries. A recession might be called on by the US Fed.

Can the US and other economies survive these interest rate hikes? I think we should simply wait and watch. Here’s an article explaining how high is the risk of another recession.

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The pressure with the rise of Index funds and ETFs

Index funds off late have been highly popular with the extraordinary cost effectiveness in comparison with actively managed funds. Funds with weak or average past performance see a small fraction of inflows while funds with strong past performance receive a large fraction from investors. Interestingly, with the rise of index funds, the inflows of investments have become less dependent on past performance. A small but very interesting paper.


You’ve probably heard the term “bull market” & “bear market” a lot lately and you also probably know what it means.

Bull market: Prices rise.

Bear market: Prices drop.

But why are animals involved in all this?

There are multiple theories for the terms’ origins. One is about how they kill: bulls slaughter their enemies by thrusting upward with their horns, while bears swipe down with their claws.

Another popular theory dates back to a proverb about not selling a bear’s skin before you’ve caught the bear.

In the 18th century, when someone sold something they didn’t own, hoping they could buy it later at a lower price, people would say they were a “bearskin jobber” who “sold bearskin.” That’s where the “bear” came from, as for the “bull” the first known instance of the market term “bull” popped up in 1714, as a direct result of the term “bear”.

These terms were further popularized after the South Sea Bubble. A financial crash in 1720 involving the South Sea Company, is said to be the world’s first financial crash, the world’s first Ponzi scheme, a financial crash so disastrous that even Isaac Newton succumbed to it and lost as much as £40 million of today’s money in the scheme. The ongoing cryptocurrency mania is being compared to the South Sea Bubble, where impossible promises on returns are made for something that is clearly overvalued. This article explains what actually happened in 1720 which made the trading company worthless despite its once-rising stocks.


Not Financial Advice

In today’s era of technology and ease of access, information is abundant and easily available and it has become ever harder to distinguish between what is genuine and what is false. In the world of investing too, there is no shortage of advice, but not everything is genuine. Most of it is driven by narratives to such gullible people in, and people do get sucked into this time and again. Below image is a nice interpretation of this.

“Most of the time, someone saying that you have to invest has a financial interest in having you invest. Because having you invest will make their price go up. And if you don’t invest, that price will probably go down.

Good investments outperform regardless of promotion. Poor investments outperform because of promotion.”

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What to listen:

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