The Book-To-Price Effect In Stock Returns Accounting For Leverage There’s Something Hiding Behind the Numbers

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There’s Something Hiding Behind the Numbers

When you step into the financial market today, you’re exposed to volatility that has little or nothing to do with the sub-prime mortgage crisis, a burst real estate bubble, or the resulting U.S. economic meltdown that’s all over the front pages.

The innocent market player is always exposed to sudden inexplicable peaks and valleys, with no rational explanation for why the market went up on a day when it should have gone down, or down on a day that it should have gone up. “The market is a discounting mechanism,” pundits will say, as they point to the old adage, “buy on the rumor, sell on the fact.”

But rogue traders like Nick Leeson, Yasuo Hamanaka, Brian Hunter and most recently Jérôme Kerviel, will whisper in your ear what your broker may never admit: Funds that flow through the market sometimes come with a hidden agenda. These four trigger-happy rogue traders were more concerned about hiding losses under the rug than entering “short” or “long” orders a split second after the GDP numbers were released so they could profit from the fundamentals” of the markets.

Of course, you cannot pin every uncommon increase in market volatility on the actions of a rogue or trigger-happy trader. The point is that, despite conventional wisdom, relying on traditional market “fundamentals” falls far short of what’s really happening. You cannot grasp the true intentions of buyers and sellers just by reading colorful trend charts, or find the true fair market value of a financial asset just by plugging discount rates, risk premiums or annualized growth rates into a formula.

Sophisticated institutional trading

Below the radar, trillions of dollars pass through intricate financial trading strategies developed by math PhDs, IT nerds and financial engineering wizards. These strategies allow sophisticated institutional and individual traders to scout the globe at electronic speeds every second of every day. When it comes to trading, these sophisticated traders have a lead on you and – more to the point – can afford to lose what you can’t.

Using color-coded Reuters or Bloomberg screens, they find the tiniest little market opportunity, leverage to the hilt and multiply returns by 10, 20 or even 50 times. Wins or losses on such trades exacerbate daily fluctuations in the market, pushing market trends up or down. The paths these market trends follow impact a company’s ability to raise capital, as well as the cost of debt for corporations and individuals.

These trends not only affect decisions to engage in capital expenditures, but the wealth consumers can accumulate. These and other factors affect the economy at large, and contribute to an expansion or recession. If you look deep enough you can uncover faulty programmed hedging strategies (such as the Long Term Capital Management case in 1998 and the programmed trading that precipitated the market crash of 1987). And of course, trigger-happy traders who, oops, sold the option to buy one million shares of a particular stock when the order read to buy. Plus, there are rogue traders that keep on adding to a position, with no intention beyond covering their gambling scam with a financial institution’s proprietary funds.

The net effect of sophisticated programmed trading, innocent mistakes or trigger-happy rogues is to create “noise” in the information that markets use to discount the price of financial assets. As Richard Bookstaber explains in his book A Demon of Our Design, it’s all about the supply and demand for liquidity and strategies that profit from the availability or scarcity of such liquidity.

When you buy a stock, whether you know it or not, you are directly or indirectly entering the “twilight zone” of leverage; derivatives and liquidity hedges will affect your return. This drives home our main point about the complexity of the markets and why you cannot bet on the “investment” theme Wall Street has hammered down everyone’s throat for years. The truth is, from Wall Street to Main Street, it’s all a speculation.

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