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Thought Piece

Tail Wags the Dog

Markets are constantly discounting the future. This is like a bookie updating her line, evaluating the health report of the home team. Market participants generate wealth not only through the long-arc creation of value (i.e., underlying ownership stakes in businesses), but also through arbitraging the oscillation of that collective discounting. Arbitrage is the oil that greases the system. It would be like numerous bookies competing to update their lines right after an injury report for a quarterback hits the newswire. The bookies are paid to update their lines with information that reflects reality, so investors can put on intelligible risk. In this sense, markets act as a prism into reality. In another sense, they form their own realities. This is especially the case in periods of visceral emotional response.

Think about a supply / demand decomposition governing the price of a good. Econ 101. Classical economics tell us that these competing forces allow us to find equilibrium. Now take a panic shopper at a wholesale warehouse, frantically searching for toilet paper or hand sanitizer. In these situations, prices don’t impact demand the way we are trained to think of homo economicus. This is well documented, with phenomena such as Veblen goods. The whole idea behind Veblen goods is their price signals their value, rather than being a point of evaluation versus an intrinsic value. The classic example would be a luxury good that might sell more if priced more. The key is to form a brand supporting the collective recognition of value. Hence, these companies spend extravagantly on advertising and design. The tail wags the dog. Returning to our frantic shopper, price increases (or gouging) of consumer staples are not denting demand. If anything, demand will foment, as consumers digest that increase as a signal of scarcity, further amplifying panicked buying (and unfortunate hoarding).

And so here we return to markets. Their function as a medium for the weighing of intrinsic value is facilitated by their profiting on arbitrage. For structural reasons too long to get into, that arbitrage has grown shaky, leading to disruption of an orderly market function. We see this in portions of the markets traditionally supported by bank prop desks. Without it, market structure is being tested as a facilitator of market making. The Fed knows this and has stepped in with full force to buttress the building blocks. They’re doing so not only through rate adjustments, but also through open market purchases and dollar swap lines.

With the relative dysfunction of certain basic forms of arbitrage, we are seeing panic across evaluators of risk, as their weighing duties are now being overridden by daily speculative fears. It’s hard underwriting investments when 15 minutes into the close can move markets double digits. These two feed off each other in symbiotic ways during good times and potentially parasitic ways in periods of tumult. We find ourselves oscillating on a daily basis at levels which belie sense. This reflects the havoc that constant no-filter coverage feeds into our ability to digest information. It is the weapons-grade zeitgeist. This is the tail wagging the dog.

What we’re left with is a dynamic that divorces itself from the healthy discounting of intrinsic value. This divorce can be hard to perceive, and I wouldn’t characterize it as pervasive. Even in this chaotic time, there is some sensibility in market gyrations. Sectors and balance sheets most vulnerable are seeing the most drastic moves, and perhaps rightfully so. And yet, it’s there. The overriding force of daily moves is clearly being driven at the aggregate, or macro level. Markets gap down on Sunday night futures, rip up after a press conference, fall back down as tone, clarity, and leadership are being digested. Correlations rise spectacularly on these moves. To us, this reflects evaluators of risk stepping into the panicked role of arbitrage. This is the tail wagging the dog.

What I am increasingly sure of is that the cacophony is 90% noise and isn’t worth tick by tick attention. While it may seem cavalier to say after markets move limit up/down, we think it is the truth too often discarded within the speculative frenzy. We’d encourage investors to start with the long-term and work back to the breaking news. It is a clarifying perspective for an otherwise unorderly environment.


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