An arbitrage opportunity?

John Cochrane writes,

A perpetual inflation worrier, I habitually confront the fact that bond prices don’t signal inflation. I am forced to point out that they never do — interest rates did not forecast the inflations of the 1970s, nor the disinflation of the 1980s. And I say inflation is unforecastable, a risk like a California Earthquake.

But for once there does seem some inflation risk in asset prices.

These are option prices. The main forecast remains subdued inflation. But these option prices are pointing to a larger chance that inflation does break out.

1. I assume that what the option market is screaming about inflation is “I don’t know!” Some folks think that inflation will be close to zero, and some think it will be above 3 percent.

2. But if there are more worries about inflation priced into the options market than into the bond market, this might suggest an arbitrage opportunity: be a seller of options, where inflation risk is priced high, and be a buyer of inflation-indexed bonds, where inflation risk is not priced as high. Adjust your hedge dynamically as needed.

Brokers and dealers

In the WSJ, Alexander Osipovich writes,

The practice, in which high-speed trading firms pay brokerages for the right to execute orders submitted by individual investors, has long been controversial. Some say it warps the incentives of brokers and encourages them to maximize their revenue at the expense of customers. Supporters, including many brokers and trading firms, say it is misunderstood and helps ensure that investors get seamless executions and good prices on their trades.

In theory, there are two types of market-makers in securities markets: brokers and dealers. A broker connects a buyer and a seller. A dealer buys some securities from a seller, holds them in inventory (maybe for just a few seconds), and then sells them to a buyer.

Most real estate transactions are intermediated by brokers. The broker finds a buyer for your house, and then you pay a hefty commission to the broker.

From time to time, an entrepreneur will try to operate in the real estate market as a dealer. The company offers to buy your house, with the intention of turning around and selling it. Instead of charging a commission, the firm tries to buy your house at a price somewhat below the price at which the firm expects to sell it. You save the commission, but chances are you do not get full price for your house.

It sounds to me as though the “payment for order flow” model is one in which brokers hand off customer orders to dealers. The dealers pay for the order flow because they are efficient at doing what they do, so they make more profit if they have more business. The dealers supply liquidity in the market. This enables the brokers to allow customers to trade without commissions.

Some retail investors also supply liquidity. If you target a stock at a particular price, but you don’t care when you get it, then you place a limit order. You supply liquidity, and you make it easier for brokers and dealers to do their job.

On the other hand, if you want the stock right now and you don’t care what price you pay, you are a demander of liquidity. If I am trying to arbitrage the options market by writing a call option and buying the stock, then I am going to demand liquidity. I don’t want those trades to take place at different times.

My guess is that the action in GameStop involved a lot of traders who were demanding liquidity. Amateurs buying call options and bidding up those option prices, leading arbitrageurs to want to write calls and buy the stock with rapid execution in order to arbitrage and discrepancy between call option prices and the price of the underlying stock.

The cost of operating as a dealer rises when prices become volatile, because your risk of keeping an inventory of shares goes up. This increased cost has to be passed on to traders in volatile stocks. The zero-commission model may not necessarily be sustainable in those cases. Shutting down trade for the retail investors seems like a bad solution, though. Charging a commission would be better.

When someone proposes something like “Ban short-selling!” or “Ban paying for order flow” I suspect that they are either are shilling for a trade group that stands to benefit from such a regulation or that they are just posturing without any sense of what sort of Chesterton fence they may be tearing down.

Grumpy on GME

John Cochrane and Owen Lamont discuss the GameStop situation. “You do not have a robust, liquid market.” In a liquid market, any investor (or group of investors) faces a very elastic demand curve if he wants to sell and a very elastic supply curve if he wants to buy. Cochrane and Lamont offer several possible reasons for the inelastic supply in this case, but they do not push any one explanation in particular. Their understanding is incomplete, but I trust it more than others.

EMH and GameStop

A reader emails,

It seems to me that even if markets are only semi-efficient, then the trading curbs imposed by Robinhood and other firms should not have had an adverse impact on GME’s share price.

1. I do not believe that financial markets are efficient. When GameStop stock goes up or down by double-digit percentages on days when there is no news about the underlying business, then either you have to concede that the market is not efficient or else concede that the Efficient Markets Hypothesis is just word salad without meaningful implications.

2. A stock market in which any particular trader or group of traders can manipulate the price is not a good market either in theory or in practice.

3. I meant what I said about the Wall Street riot being more significant than the Capitol Hill riot. I don’t watch television, which is why the Capitol Hill riot did not make a big impression on me. If you were around a TV during the O.J. Simpson chase, you will probably never forget it. But in the grand scheme of things it was not important. That’s my view of the Capitol Hill riot–compelling TV, minor event.

But as of right now, the stock market looks ridiculous. There is an economic theory, most clearly articulated by James Tobin, that when a firm’s share value rises that is a signal that it should expand. That theory implies that GameStop should be undertaking a massive expansion of its business. Nobody believes that.

Conspiracy or kludge?

The unfortunately named Anthony Denier says,

in reality, what’s going on is that there is a two-day settlement between if you buy the stock today, those brokerage firms that you bought that stock on have to fund that trade with the clearing central house called DTC for two whole days. And because of the volatility of stocks, DTC has made the cost of the collateral of the two-day holding period extremely expensive.

…So the brokerages or the clearing firms have to go into their own pockets to do it. And they simply can’t afford the cost of that trade clearance. That is the reason why these stocks are coming off. It has nothing to do with the decision or some sort of closed room cigar– smoke-filled cigar room of Wall Street firms getting together to the dismay of the retail trader. This has to do with settlement mechanics of the market.

Pointer from Tyler Cowen.

This reminds me that back in the housing market collapse a lot of the foreclosure paperwork was flawed. This was not some conspiracy on the part of lenders to improperly foreclose on homes. It had to do with the mismatch between the mortgage securities market, where the lender of record could in some sense change in seconds, and the antiquated housing title system, where records are stored at a county courthouse, often in paper format, with a cumbersome process for updating that could take. . .almost forever.

I would bet that the two-day settlement delay in stocks is as anachronistic as the real estate title system. When you have a system that wants to be instantaneous but incorporates a process that hasn’t been updated in decades (or longer), this is what you get.

Once again, I am violating one of my norms, which is not to pile into the latest news. But here goes:

1. This seems like partly a Charles Kindleberger moment. In Manias, Panics, and Crashes, he adapts the Minsky model to major historical financial manias. Kindleberger’s thesis is that when there is a major shock that shifts a lot of wealth to a particular population, manias can ensue. The tulip mania is the classic example.

Over the past twenty years, we have seen a massive shift of wealth toward the tech sector and finance. Then the virus hit, accelerating these trends. Then the government printed enormous amounts of paper wealth as “stimulus.” All of this was enough to fuel asset bubbles.

2. This also seems like partly a Martin Gurri moment. Individual investors were participating in the financial equivalent of the Capitol riot. Some of them do not care whether or not they make a profit–they are in it for the schadenfreude.

In fact, I think this is an even more severe blow to American prestige than the Capitol riot. The U.S. can station enough troops in DC to convince the world that Congress cannot be invaded so easily. But there is no straightforward way that I can see to reassure investors of the integrity of the market.

Right now, large investors are scared of what small investors can do, and conversely. How do you ease the fear on one side without increasing the fear on the other side? How much does the market rally of recent years depend on small investors, and what sort of reversal could we see if those investors bail out because they believe that the system is rigged against them?

A bad bet of mine

A reader reminds me that three years ago, I wrote,

I’ve got $100 that says the market cap of Amazon is lower on July 31, 2020 than it is today.

Spectacularly wrong. Since then, Amazon revenue has roughly doubled and its profits and market cap have roughly tripled. (As I read charts. I could be mis-reading them. Check me.)

The P/E ratio for Amazon has stayed at roughly 150. If it had fallen below 50, I would have won my bet, despite the growth in revenue and profits at Amazon.

At some point, the P/E ratio has to come down to earth. I lost my bet because this has not yet happened.

Inflation risk

Alberto Cavallo writes,

By April 2020, the annual inflation rate of the US Covid index was 1.06%, compared to only 0.35% of the equivalent CPI (all-items, US city average, not seasonally adjusted). The difference is significant and growing over time, as new social-distancing rules and preferences prevent consumer spending in categories that are experiencing deflation, such as transportation, and induce more expenditure in food and other groceries, where prices are increasing over time.

This is one reason that TIPS or other inflation-indexed bonds may not hedge well against inflation. Official measures may not pick up the rise in the cost of living.

Anti-fragile Arnold hates this bailout

As reported by the WSJ,

The $100 billion Term Asset-Backed Loan Facility is a reprise of a program launched in 2009 that enabled investors to buy bonds linked to consumer and business debt using money borrowed from the Federal Reserve. The central bank and other supporters say the program, known as TALF, helped unfreeze credit markets vital to the workings of the economy.

If it works as intended, TALF will jolt the market into reviving the issuance of new bonds, which spreads risk to investors and allows lenders to continue making loans. On the other hand, the Fed could face criticism for helping to super-charge returns for some of the biggest investors at a time when millions of Americans are losing their jobs as a result of the coronavirus pandemic.

In short, at a time when ordinary individuals and small businesses are getting only partial relief, these Wall Street activities will get a complete bailout. Moreover, this rewards the kind of behavior that Anti-fragile Arnold hates: financial engineering that results in privatized profits and socialized risks. Continue reading

Stock buybacks

[Note: askblog had an existence prior to the virus crisis. I still schedule occasional posts like this one.]
A commenter asks,

Could you write an explanation of the financial / economic logic behind stock buybacks, vs. lowering debt and/or paying out dividends?

My cynical view is that 90 percent of financial strategy is either tax minimization, regulatory arbitrage (coming up with instruments to comply with the letter of regulations while violating their spirit), or accounting charades (complying with the letter of accounting rules while disguising reality).

In the case of stock buybacks, I lean toward tax minimization. I suspect that stock buybacks are the most tax-efficient use of surplus cash.

If you reduce debt, the corporation will pay more in taxes, because the interest payments on the debt were tax deductible. Incidentally, this is a pet peeve of economists, because it provides an incentive for high leverage. I think that the best thing to do is get rid of the corporate income tax, which is best describe as a swiss cheese that is mostly holes. But the holes all distort behavior in some way.

If the corporation pays me a dividend, that is ordinary income to me for tax purposes. If the corporation instead buys back stock, the income I get comes from a higher share price, which I can hold until it is taxable as a long-term capital gain.