Sal Marvasti's  Instablog

waThis article attempts to investigate a special situation where private retail investors can act in tandem and stop being the group collectively known as the "sub-par investors" in academic research. Without going into econometric modeling, we intend to illustrate how this could become possible; hedge funds can be burned not just by other hedge funds but by swarm tactics. A little like the tiny locust versus the big farmer with his shepherd dogs. I hope you can learn something from this illustrative fantasy "what if" scenario, where the dumb money becomes the smart money. To illustrate my point I will look at one individual stock AMD (AMD) which has consistently had over 20% of its shares shorted in recent times. Apple (AAPL) could also be a nice candidate for this type of analysis. However, AMD is smaller and easier to influence so we will stick with AMD in this example.

Hedge funds typically squeeze private investors with better research and internal market forecasts combined with large market moving short/long positions. It is no wonder why many private investors fail to make overall profits in the stock market ( Barber-Odeon ). It is very hard to consistently produce profits by buying individual stocks even ones which survive and prosper. Since mid last year certain fundsincreased short positions on AMD . For details you can see Nasdaq, but keep this fact in mind:

In financial markets, there is an adding up constraint. For every buy, there is a sell. If one investor beats the market, someone else must underperform. Collectively, we must earn the market return before costs. The presence of exceptional investors dictates the need for subpar investors. With some notable exceptions, which we describe at the end of this section, the evidence indicates that individual investors are subpar investors.

(Barber-Odeon, UC Berkley research paper)

Short Interest on AMD slowly drops (Dec - Feb 2013)

Let us look at a simple setup. On average there are at least 10 million AMD shares changing hands per day. The majority of this trading is done by institutional / systematic trading funds, as research has long shown (LBS paper). Thus, let us assume only a quarter or 2.5 million of these shares per day are being bought by private retails investors, in the tune of 1000 shares each. That means approximately 2500 retail investors per day. Over one quarter that is 3 months, we have 60 working days. Lets us assume on average, each quarter there are at least 150,000 new private investors who have a long interest in the stock in question. This new group, organizes to link up with 100,000 retail investors whom are already invested in the stock. Together they devise a new scheme to manage risk and make gains. You should note that because

..... risky stock is in fixed supply, it must become less attractive in the presence of institutions to clear markets. So, the stock market Sharpe ratio decreases, and its volatility simultaneously increases, relative to the benchmark economy with no institutions. (Basak-Pavlova, London Business School Research)

Retail investors swarm tactics can make use of this fixed supply of risky stock (short or long it does not matter) to increase the expected return on the stock, thus increasing the Sharpe ratio in way that is transparent to the market at large. This hypothetical group of private investors, we assume, are contrarian and have bought AMD at 10% below consensus estimates right around when the shares are at a high short ratio (>20%). That means in today's climate we assume they bought AMD at less than $2.50 (the current consensus estimate is $2.75 according to NASDAQ). Knowing that the hedge funds are short AMD, these private investors, in tandem go out and purchase AMD products to the tune of an average of $300 each, buying something they previously had not planned to purchase but do not mind having (e.g. AMD tablet, GPU card or RAM). Each investor, then persuades just 2 other people to also buy $300 of AMD products. Let us also assume that 60% of this money reaches AMD as revenue. So AMD receives an extra $540 (from 3 people) * 250,000, or $135 million revenue.

AMD's expected break even quarterly revenue is about $1.3 Billion since last year's announced restructuring (SA article). In other words, if the private investors band together and buy product, AMD could receive a 10% boost in unexpected revenue. This translates into profits if AMD reaches the $1.3billion break even point. As a results, EPS, in the following quarter, could beat all consensus estimates by +10% thus forcing a revaluation of the market price, potentially as a growing stock. The stock then could explodes and hedge funds attempt to limit their risk by closing their short positions and options. The point I am trying to make is that hedge funds extensive market research would have been in vain as the market for AMD products had grown due to these unforeseen "swarm" events.

Consensus Recommendation for example stock AMD

(Source Nasdaq)

Now consider what happens to the share price of a moderately shorted AMD when it beats estimates significantly, like in December 2010 when it gained market share and beat EPS estimates by over 10%. AMD rose from $6 before Christmas 2010 to $8 just after results. So these investors could expect a 33% return over a 4-8 week time frame. If this holds true, then these investors would have made $825 on an average $2500 investment for 1000 shares ignoring transaction costs, and would have spent $300 on AMD products. In total they would have made $525 profit and would have gotten the AMD product for free. After the short squeeze, the funds would have lost and the private investors would have gained. The reason is simple, no amount of research or market survey would have shown up the unpredictable actions of the private investor swarm. Lacking resources, private investors can move markets if they act in concert. Rather than wait for Bloomberg to run a story "Company XXXX recovers" sending the shares flying, can't we create the news? In the age of peer to peer computing and retail blogs, this may yet become possible.

Risk management would also be part of this swarm strategy, that is why buying at a price below consensus estimates is important. It mitigates risk of such action. Analyzing the risk of such tactics is fodder for a future article.

Your thoughts and ideas always welcome.

Disclaimer: Unless stated otherwise, these views are not the opinion of any of my present or past employers. In addition, we take no responsibility for your gains or losses if you follow our advice. Please speak to a financial advisor if you are unaware of the risks inherent in algorithmically traded markets.

Our contracting company as a separate business is now providing quantitative modeling and risk management reports. Please contact reports@technoorconsulting.co.uk for details of in-depth risk models and pricing if you are interested in a more quantitative angle to your investments.

Will the world finally face up to China ? Export to china is far more expensive duty wise than import from china. At some point this trade balance will need to be addressed. It is why I am short USD.

The BIC Group (Paris:BB) duly notes the decision taken recently by the European Union Commission not to renew the anti-dumping tax on lighters of Chinese origin.

The objective of this anti-dumping tax, set up in 1991, was not to protect the European lighter industry, but to put an end to unfair competition from lighters of Chinese origin. Its non-renewal justifies the actions of those who have been fraudulently circumventing the tax for more than 20 years, and will obviously favor Asian lighter importers who already hold more than 70% of the European market in volume¹.

(bicworld.com)

In Europe it is important to note.

• Chinese manufacturers pay only 2.7% custom duties when entering the European market while European manufacturers are subject to 25% custom duties when entering China.

BIC is a world leader in stationery, lighters, shavers and promotional products. For more than 60 years, BIC has honored the tradition of providing high-quality, affordable products to consumers everywhere. Through this unwavering dedication, BIC has become one of the most recognized brands in the world. BIC products are sold in more than 160 countries around the world. In 2011, BIC recorded net sales of 1,824.1 million euros. The Company is listed on "Euronext Paris" and is part of the SBF120 and CAC Mid 60 indexes. BIC is also part of the following SRI indexes: FTSE4Good Europe, ASPI Eurozone, Ethibel Excellence Europe, Gaia Index and Stoxx Global ESG Index.

¹ : BIC estimates - total European pocket lighters market (flint and piezo)

There are plenty of articles on Herbalife (HLF) since the Ackman vs Icahn war broke out. In this article, I would like to take that sustainability debate one logical step further and apply it to the market in general. Why does it matter if growth is achieved via duping people into being distributors or through retail sales? A sale is sale after all. The reason, as you may have guessed is that getting paychecks based on distributor recruiting is not sustainable, in the long run.

Herbalife's discrepancy in accounts between distributor stock and actual retail sales came into public view last year, with Einhorn's questions. Many articles are now not challenging the pyramid nature of Herbalife like MLMs, but they claim it is sustainable. From a former distributor's perspective, Herbalife, at a minimum, is at fault here for obfuscating accounts. How would you like a blue chip stock if it assumed all stock including the ones warehoused by its own distributors are "sales". As a shareholder you would be furious. In this article, we will raise serious questions, which we hope either readers or future researchers can answer. Our questions are the equivalent of Einhorn's questions but asked of the economy in general. If you want to believe everything is rosy and good, don't read any further.

Modern capitalism is pyramidal in nature: the ones on the top always make more money with less effort. So what makes Herbalife different? Not because Herbalife is a pyramid, because if that is the reason to short, then go ahead and short the entire western markets. The problems is you will have to buy back at some point, a point well made by Terry Allen for Herbalife.

A pyramid schemeis a non-sustainable.....primarily for enrolling other people into the scheme, rather than supplying any real investment or sale of products or services to the public. Wikipedia

How could I compare modern (fiat currency) markets to pyramids? Because, the unifying key is potentially unsustainable growth. A pyramid scheme relies on increasing growth using lies which in turn make the pyramid unsustainable. Modern capital markets rely on growth to prevent stalling and deflation or stagflation. The problem is, in a finite world, there cannot be a continuous increase of resources and consumers providing the engine of growth till infinity as we live on an earth that is limited in nature. A pyramid scheme thrives as long as it is growing very fast. For pyramid schemes growth in sales, could be retail or they could be just enrolling many new distributors. Similarly, if the economy cannot continuously have more and more consumers and raw materials, it cannot "grow". Without growth, and with greater than inflation market returns the high net worth individuals and companies will end up owning the entire market. Think about it, if you had $100 invested in the year 1750 at risk free interest rates 5% above inflation you could be sitting on 874 Trillion dollars in todays money. Clearly someone at that time could have had $100, but no one today has this kind of money. Thus, we can conclude risk free gains 5% above inflation have simply not existed.

How Can Markets Be A Pyramid?

Anyone outside the billionaire's club, if you think a little, get much less from working than the top 10% earn from sleeping in the Bahamas. Interest from a good dividend portfolio with low risk, on $10 million could be up to $300K / annum above inflation which is much more than many could earn working 60Hours per week. In modern competitive economics, the super rich are supposed to be the entrepreneurs. But that is not necessarily the case. Current economic policy has multiple similarities with a pyramid scheme:

1- The chances of an average aspiring entrepreneur are slim

2- Working for corporations will never make you that rich

3- The harder you work the faster the economy grows, which in turn means the faster the billionaires assets grow.

So, the question is, are we also sitting on a pyramid scheme about to collapse? This has been an interesting thought that has occupied my mind for a while. After doing more research, I came to the following conclusion: Interest significantly above inflation and growth is simply not sustainable. If it was, the current economy would be unsustainable, similar to a pyramid scheme. Let's see if my theory holds any water.

Tax Distortion in Markets

Without the distortions caused by economic law (mainly tax advantage of debt), the market cost of equity should be equal to expected inflation. Before you try to argue otherwise, study Modigliani-Miller theorem and proof. There is little benefit to debt, if it was not for the unfair tax laws. And this debt distortion creates strange markets. In addition, the abundance of resources allows for growth (steady reduction in resource prices while money supply keeps growing). Once this resource abundance is no longer there, and growth approaches zero, this can only mean that real market cost of equity must be equal to inflation, otherwise, at some point the rich will simply own the entire economy. Have we reached that point yet? We won't even pretend to know that answer, however, it does not look to be too far off.

Market Return Higher Than Inflation?

Without getting into too much numerical detail, how can we see if the market is a pyramid? Can we compare the expected market return to the expected inflation?. The problem is international markets make it harder to calculate where the growth comes from and what is the market rate of return. Being based in Europe, we decided to take a multi country approach. Taking the European share index, and by considering the Local Capital Asset Pricing Model (LCAPM). It is the most common way to estimate the cost of equity between multiple countries. The LCAPM defines the cost of equity as:

E(K(i,x)) = R(x) + Beta(i,x)*(Rmarket(x) - R(x) )

where R(x) is the risk-free rate in country x ; Rmarket(x) is expected return on the market in country x; and Beta(i,x) is the sensitivity and responsiveness of returns on investment i to returns on the market in country x . The LCAPM is theoretically sound. It validly assumes that investors cannot diversify away country risk.

While the academic literature indicates that global integration has increased, emerging markets remain largely segmented (Bekaert 1995). .... integration has reduced the cost of capital, the reduction is small .... (Pace.edu paper)

Consider Europe

We will look closely at Europe as a whole since it is both segmented and uniform; it has had a duty free trade system in place for many years. How have European shares faired relative to inflation and the risk free return? With risk free European yeilds of 1% , much less than inflation, money in bonds, in Europe, is now losing value unless you take risk.

My argument is that Inflation(X) must equal the weighted average cost of equity for each country (E(K(i,x))) in a free trade zone, if the economies are on a sustainable track and not growing. Otherwise, there is a shorting opportunity in equities. Since, if the cost of capital is greater than inflation and there is no growth, the billionaires (i.e. lenders) can end up owning the entire economy with nothing left for the middle classes. Let us look at some numbers to see if there is such a danger.

European Inflation

click to enlarge)

The European area inflation on average is 3.37% based on 2011 data. So what has been the average equity returns over that period? It has been 3.98% if you use MSCI Europe index. With the European area GDP growth being about 0.2 percent, that leaves a euro area inflation plus growth of 3.57%. Compared to the MSCI Europe index, that just about right. Looking at historic data, the real world equity growth seems to somewhat mimics inflation in the longer term. Short term there it always overshoots or undershoots. So we might have a sustainable pyramid after all. Do not go shorting the markets, at least not yet.

Conclusion

Despite sharing some characteristics of a pyramid scheme, modern growth based interest economics appears to be more stable, as long as expected returns are close to inflation. Initially apparent comparisons with pyramids may not be valid because of the economies ability to change track and penalise savers. Thus, on average, stocks will be expected to give lower returns than in the past, if our arguments are correct; if the developed market returns are much higher than inflation we would have a shorting opportunity. That is because unlimited growth is unsustainable. We showed this with some basic analysis of Europe showing average market returns recently being close to average inflation. This analysis does not work on an individual country basis since both inflation and return are global; companies on an exchange in Paris also do business globally. Which is where the theory of LCAPM comes in.

In other words, while capital markets and the concentration of wealth have an eerie similarity with pyramid schemes, current inflation/return statistics across large trade areas, appear to show that the current distribution is sustainable as long as we do not have unrealistic returns in the market portfolio (e.g. the European share indexes) . With current risk free rates below inflation, it seems we are on a wealth destroying track for savers, as a necessary evil. Going forward, given the growing populations and living standards and dwindling resources, investors should expect market returns in the developed world to be much less than they were historically. It is prudent to be cautious when investing in markets for the foreseeable future. Unless the elements of rapid growth (perceived limitless of resources) return, a lower standard of living is inevitable to make the current system sustainable. In the long run, that may be a good thing.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.