Short-Term Trading is Still an Uncharted Game.

The question of what determines the value of a stock is abstract and nebulous. There are models based on the valuation of a firm’s assets and future earnings potential, but there are other important factors as well, such as supply and demand for a stock. Seth Klarman, successful hedge fund owner and author of a well-known book called Margin of Safety, provides an example of one factor that can affect stock valuation outside of fundamentals. In this example the price of a stock that has just entered the S&P500 shoots up dramatically, even though the fundamentals of the firm did not change when the stock entered the index. Klarman uses this example to show that there is opportunity to make money in the markets since stocks often dance around their fundamental or ‘true’ values. Investors can buy stocks when they fall below their ‘true’ value and wait until they are bought back up to equilibrium (of course, ‘true value’ is itself datable and investors may disagree on the best way to calculate true value and come up with differing estimates). According to Klarman, if you want to make above-average gains on a stock, you need to understand why it might be ‘undervalued’ or out of line with its true long-term true value.
The Modigliani-Miller theorem is a cornerstone of financial theory that explains one variable in the valuation of a firm: the capital structure (both Modigliani and Miller have received Nobel prizes). The Modigliani-Miller theorem states that, under an array of strong assumptions, the price of a stock will remain the same regardless of the firm’s capital structure. The capital structure of a firm is the ratio of debt to equity (if it has any debt at all) and reflects the firm’s decisions about how to finance its operations. This theorem was groundbreaking when it was first published because the phenomenon had never been easily observable, due in part to the impossibility of comparing two identical firms and the many assumptions required for the theorem to work. These core assumptions include: equal borrowing costs, absence of taxation, absence of bankruptcy costs, absence of agency costs, an efficient market, and the absence of asymmetric information. This theorem essentially operates in an economic vacuum to find the variables that would put the two identical firms in disequilibrium were they to use different capital structures. Imagine firm A and firm B. The first one is leveraged with debt and the second one only issues equity. According to Modigliani and Miller, the stocks of these two firms should appear identical to the investor. After all, the investor could purchase stock B and borrow debt himself, thus making stock B identical to stock A.
Outside of the economic vacuum the assumptions do not always hold. All of the assumptions I mentioned above can cause discrepancies in the theorem. For example, firms may borrow at cheaper rates than the average investor. It would therefore make more sense for a firm to leverage, lowering the expenses of the firm relative to those of investors. A firm that takes on debt is often able to engage in more projects and expansions than those without debt, making them more attractive as an investment (increasing the present value of future earnings). In the Modigliani-Miller vacuum, investors can borrow money and invest in a firm with an equity-only capital structure to simulate the returns of a firm with debt. If borrowing costs are not equal, however, this does not hold and firms with debt will have different share prices than firms without.
Another example is that taxes on debt (at least in the U.S.) are lower than those on equity, giving firms an incentive to take on more debt versus equity than they otherwise would. This may increase the probability of bankruptcy and, since bankruptcy costs do exist, may affect the current valuation of the stock price. Giving firms an incentive to take on more debt might encourage overleveraging and therefore affect the stock price (or it might not be, according to economist Tyler Cowen: http://marginalrevolution.com/marginalrevolution/2011/12/why-not-treat-debt-and-equity-the-same.html).
The way an intelligent investor might make money is by examining potential variables, some of the same variables that break the assumptions of the Modigliani-Miller theorum, that would keep a stock away from its ‘true’ value in the short or medium term. The evidence that this is possible is low, and many economists go so far as to say markets are so efficient that it is impossible. For example, is it really possible for someone to find a discrepancy in Apple’s share price that no one else in the market has accounted for and therefore baked in to the price already? To add to this issue, there are variables that may affect the short-term value of a stock that are still being researched. So it is possible that even if you do find good evidence that a stock is undervalued, there might be many more variables that will create noise and pressure on a stock to rise up and down that will drown out the one signal you found.
The Federal Reserve recently released a working paper titled Liquidity Risk and Hedge Fund Ownership that is related to the topic I’ve discussed (http://www.federalreserve.gov/pubs/feds/2011/201149/201149pap.pdf). This paper focuses on one such variable that can create noise and affect stock price outside of its fundamentals. Through empirical testing, the paper finds that stocks that are held by highly levered hedge firms (such as hedge funds) are more sensitive to changes in aggregate liquidity than comparable stocks held by other institutions. Stocks held by hedge funds also experience significant negative returns during a liquidity crisis. The reason is that during a liquidity crisis, when credit dries up, hedge funds are no longer be able to hold on to all their stocks due to demand for cash from creditors and investors. It is common for a hedge fund to borrow 20-30 shares of stock on debt for every share they buy with their own money. As a result they will be forced to sell assets in a liquidity crunch, putting downward pressure on the prices of the stocks they own, even though the fundamentals of the firms behind the stocks have not changed. Would this be an opportunity for someone else to buy the stock price up since it is now lower than its true value? Or was the stock price higher than the true value before due to the demand for it from hedge funds? Even if you can come to a proper conclusion to that answer, could there be other short-term variables that will have an even larger effect on the stock price? These are all important considerations for investors looking for ways to buy stocks below their ‘true’ value and hoping to profit from their rise back to an equilibrium price.

3 thoughts on “Short-Term Trading is Still an Uncharted Game.

  1. I think the largest determinate of short term movements are risk appetites. A way to think about this in a academic framework using CAPM to value a stock it’s the equity risk premium that is being continuously adjusted.

    Investors risk appetite can be viewed either very broadly (global GDP increasing then equities rise, vice vice versa) or narrowly ( firm specific earnings power).

    Market sentiment is very hard to quantify, but a huge driver. As investors assess the likelyhood of tail risk in this very uncertain environment it’s caused a lot of the volatility seen in equity indexes. If interested I’d look into a model called CONTEX that derives the expected price of the S&P based upon a number of inputs such as relative performance of credit, FX, and commodities.

    • Exactly, but it’s interesting how market sentiment can hurt or help some stocks more than others based on their cap structure and who holds their shares. Market sentiment that’s bad can hurt a stock that’s held more by hedge funds as I mentioned (as a simple example). How do you mean to differentiate Sentiment from beta factor? Thanks for your comment 🙂

      Ps: who is this? Unless you want to be anon 🙂

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