… and anyone can tell. You think you know me well. But you don’t know me.
-- Ray Charles
Why do markets organize themselves as they do? What is the significance of the market trends of recent history? Professional transactions are rapidly dividing themselves into two categories: markets for owners and markets for traders. And assets themselves are also gravitating into these two camps: assets for owners and assets for traders. Assets for owners are becoming less generic, and riskier – hence more important. Assets for traders are becoming generic and less risky – hence less important. But this is a desirable development.
Assets for traders are the subject of transactions in the publicly traded stock markets and the futures markets. Assets for owners are the rest. There has always been a difference between the professional owner and the professional trader. And the markets which serve them meet different needs.
The explosion of information available to the trading public has had several interesting effects on market awareness of constituent's needs. It has encouraged firms to distinguish themselves between innovator and old-line boring cash cow, on one hand. The evidence is most clearly seen in the effect on business school graduate job search. Once single-mindedly interested in working for a Wall Street firm; graduates now seek to land jobs in Silicon Valley. The reason is simple. Wall Street profits by identifying existing value; Silicon Valley creates value where there was none. Wall Street makes millionaires. Silicon Valley makes billionaires.
On the other hand, the information explosion has stripped has-been, cash cow firms of their earlier prestige. The big, publicly held companies, the bread-and-butter of trading, have been reduced to proclaiming their primary attraction to be selling their assets for cash and returning this cash to stockholders in the form of dividends and buy-backs. In other words, their primary product is cash.
Markets for traders.
The quintessential market oriented toward Wall Street and the identification of value is the futures market. Futures markets have gained greatly in prominence over the past 40-odd years, for reasons that are poorly understood.
It is more reasonable to believe that the world’s futures traders determine cash prices, in the big, price-risky markets that traders love than to make the out-of-date supposition that it is the other way around. The assets in high-volume spot markets have become holographs of the futures market reality. Participants in both markets use the same raw material, supply and demand for the instruments in question; but a trader with a strong belief about the coming change in the price and the desire to place a serious bet on that belief is most likely to place her wager in the most liquid market. And for the big-volume markets, that market is futures; second, ETFs.
Consider the two most successful futures markets, the S&P e-mini futures, and the Eurodollar futures. S&P e-mini does no real damage to the principle that the futures price is a forecast of spot valuations since the S&P index is a value-weighted average of spot prices. The S&P contract is the combination of many spot prices, determined with weights that vary daily, which makes the determination of spot S&P values from futures prices near-impossible. Thus, the S&P spot markets may well dominate futures prices in a way single-instrument contracts cannot. The futures trader has no other way to directly estimate S&P 500 valuation other than estimates of the index formed during the day.
But is that arithmetic fact really the way the market works? Or do futures traders and ETF traders dominate the volume of stock trading so thoroughly that individual stocks are simply swept into their currents, wiggling like fish to modify their path within the general market flow? If so, the arithmetic calculation of the indexes is no more than an after-thought. The relative weight of buying and selling sentiment is everything – a sentiment best expressed in the futures market. What index calculations really do is divide the market tide into separately estimated eddies and currents.
And Eurodollar futures are an even less likely to be dominated by Eurodollar deposit values. LIBOR, the putative Eurodollar spot rate, is a fiction. Consider the construction of LIBOR, by LIBOR rate providers. What is a LIBOR rate provider? A designated employee of a rate-providing bank. A rate-providing bank is a bank identified by the Bank of England, then required to submit a price on a kind of wholesale deposit that most of these banks no longer actively trade. In other words, LIBOR has become a myth. My guess – rate providers look at futures prices to figure out their daily submissions. If so, the cash market price is directly determined by futures market transactions. Backward. Yet Eurodollar futures are by far the largest futures market. The revelation of the past few months that the futures price is a forecast of a mythical interest rate has had no effect whatever on futures trading volume. LIBOR futures rates decide themselves. The deposit rate that they supposedly estimate is really an afterthought.
Should futures prices determine spot prices?
This futures-price-determines-cash-price phenomenon makes more sense than might be thought. Futures markets typically have far greater volume than any of the cash markets they serve. This is the product of futures traders’ historical understanding of the role of futures – futures exist to form consensus prices, not to exchange property. And the consensus is the product of the broadest possible market participation.
Traders’ markets will all eventually adopt the technology of futures markets. Why? Futures were the first markets to self-consciously configure themselves to cater to value determination at the expense of ownership transfer. They did this by becoming volume machines.
Volume is what makes a market a good source of broad market opinion. Every significant market has either a time or a locus where prices are more “real” – real in the sense that market participation is both greater and more diverse. Seasoned traders understand the value of volume concentration. Futures exchanges do several things to increase this participation: 1. Each important commodity or security is traded in only one venue. 2. Transfer of ownership is not important to transfer of value – value gains and losses are transferred at least once daily; transfer of ownership occurs seldom; for most traders, not at all. 3. A futures exchange focuses on relatively few instruments. 4. Listing of futures contracts is not a factor in futures exchange revenue, so illiquid futures contracts die quickly and anonymously.
There are other market customs designed to concentrate volume. For example, market conventions such as orders placed in advance of the close or the open. Bottom line, there are markets for traders and markets for owners. The past five years have witnessed the polarization of these two groups.
The difference between what is valued, and how it’s valued.
Ownership control of a property is what is valued. Transactions are how value is determined. Transactions happen for two basic reasons – transfer of ownership of property and its prerogatives now, and the ability to command ownership later by wealth accumulation now. But if there is a way to distinguish traders from the rest of us; the difference is that traders are interested in the control of value at the expense of ownership. The effect of this trading psychology is, predictably, that markets tend to segregate themselves into markets for an ownership clientele and markets for a value control clientele, traders.
This separation has mixed effects on those who wish to exert the prerogatives of ownership. Quintessential owners walking among us are Elon Musk [Tesla (TSLA)]; Travis Kalanick, (UBER); and Jeff Bezos, Amazon (AMZN). For them, the point of ownership is the transformation of a firm or industry. For a trader, the point of ownership is to enjoy the fruits of knowledge of the future superior to that of the average investor. Control of the property itself is an unfortunate, expensive, side effect for a trader.
Elon Musk typifies the attitude of professional owners toward professional traders – or as owners would have it, Wall Street. He thinks, quite reasonably, that Wall Street gets in the way of value creation because the Street is focused on value collection.
An owner, by nature, values her property differently from the market. A trader, presented with the possibility of buying something built by an owner, is happy to be convinced by the owner of the superior value of a property (say, Tesla shares) but has no interest in any related plot development. A trader wants to see the business plan, broken down into an Excel spreadsheet complete with anticipated revenues. And that’s it. The trader grabs the spreadsheet, makes her investment, then shouts the news. If the market salutes, that ends the trader’s interest. The rest, as far as she is concerned, is drama. And risky drama at that. What if the dreamer is poor at execution? A trader won’t hang around to find out. Flip those shares and move on.
Publicly held shares are for traders; privately held shares, for owners.
Commodities, money market instruments, and widely held common shares are instruments tailored toward the interests of professional traders. Privately held stocks, most corporate long-term debt, and niche markets like Silicon Valley startups, are the domain of professional owners.
Both markets cater to the interests of their constituency. Professional owners may, in the fullness of time, seek to “cash out.” Once the owner’s “story” has become more-or-less accepted, the owner’s guidance ceases to be unique. As owner creativity becomes common coin, plenty of professional managers “get it” now. It’s time for the professional owner to go public, and let her creation join the herd of firms living off the spoils of their earlier creativity in the public markets.
The pivot of smaller firms toward private shares and the pivot of wealthy investors toward private investment suggest that investors get it. The public markets are becoming less risky, hence less likely to produce serious opportunity. It’s not a bad thing. Most investors belong in the safer publicly held marketplace.
Entrepreneurship is never about the obvious. Hence it is inherently dangerous. Nor is the public marketplace an appropriate place for that kind of risk. With the financial theory of the benefits of diversification well-and-truly absorbed into market consciousness through the efforts of academics such as Markowitz and Sharpe, and professional advisors such as John Bogle, the public markets are becoming increasingly generic, and the character of risk in this market, changing. It is less a place for speculating on specific future developments; more a place for speculating on the future itself.
No investment is without risk. But life itself is a bet. And for the average investor, investing should be about collecting on the bets she has already made – her society, her country, her world, its resources, and their productive use.
Disclosure: I/we 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.