“I am not superstitious, but I avoid situations in which I continually lose.” -Barry Greenstein, Ace on the River
I led an article with this quote before, but I consider it so key to understanding the markets that I’m going to blatantly re-use it. The topic I want to discuss is the “rigging” of the markets. As far as I can tell people have been complaining about rigged markets as long as there have been markets to rig. The complaining seems to go on at a constant background level, but my perception is that the volume has picked up since the crash of 2008. The nominal target of the whining changes over time. In the 80s it was brokers, “boiler rooms”, and program trading. In 2008/9 is was bailouts and the Plunge Protection Team. Recently everyone’s bitching about quantitative easing and high frequency trading (HFT). Five years from now it will be something we haven’t heard of yet. At every turn the market is rigged.
If you want to succeed as a trader, you absolutely must not participate in this sob fest. The market is in fact rigged. Actually it’s rigged in two specific ways that I’ll discuss in a minute. Every villain I listed above is merely a symptom of one of two. But there are good economic reasons that the market works the way it does – namely that the alternative is worse. More importantly, as a trader this rigging process is not your enemy. It’s your window into understanding the machinations of the market. In other words rigging is your friend – it’s senseless to complain about the very thing which will make you money once you understand it. The very act of complaining will blind you to learning about the structure of the market.
Before I can explain to you how the market is rigged, we need to agree on exactly what I mean by the market being rigged. The easiest way to do this is to envision an “un-rigged” market. Arguably such things exist only in econ textbooks, but we can still talk about them. I propose the following definitions:
An un-rigged market is what would result if you put the fundamental suppliers and consumers of a good together and let them do whatever deals were consistent with their long-term interests without interference from speculators, government policy, regulators, market rules, or other outside entities. Over the long term the market participants would set their production/consumption levels based on the prices in the market.
Market rigging is the process by which a real market deviates from this ideal. The difference in prices, transaction volumes, and long term production/consumption levels between the observed market and the hypothetical market are measures of the magnitude of the rigging.
I think these definitions, while technical, correspond directly to the conventional meaning. Those complaining about market rigging seem to envision an alternate market where people who “need” to use it get together, enter into mutually beneficial long term deals free from outside interference. So if we’re talking the stock market it would look something like this:
- The selling participants would be companies wishing to issue shares and long term investors wishing to exit their positions.
- The buying participants would be long term investors wishing to enter positions and companies wishing to re-purchase their stock.
- They would get together and do deals whenever their buy and sell prices overlapped (perhaps using an auction market).
Now we can discuss how the market is rigged. The first way is what I’ve termed macro rigging since it occurs at the large scale of public policy and government. There infinite variations of macro rigging, but the policy goal is always the same:
Macro rigging is the collection of policies designed to increase overall production.
In other words, the government and society as a whole wants there to be more stuff. More companies with more stock. More food. More bonds. More houses and mortgages. More money. More valuable real estate. More employment. More energy. More of everything. Now don’t get me wrong – the policies used to implement this desire are not always effective. Economics is still the dismal science, and the law of unintended consequences frequently bites us in the ass.
One consequence of this more-more-more approach is the business cycle as we currently understand it. In order to spur growth, both government and private entities extend credit which in turn creates both demand and capital to build supply. The result is increased production and consumption. The further this process goes, the more debt all parties take on. Eventually the resulting leverage causes an otherwise small disturbance to turn into a market crash and both the produced goods and means of production tend to change hands to less leveraged firms/people at bargain prices. Then the cycle repeats.
Now, given the inevitability of the crash, you might wonder why public policy is always in favor of more. Part of this is short sighteness, but there is also a good long term economic reason: after the crash, the stuff is still there. It’s just that someone else owns it and it’s priced cheaper. In other words boom-bust cycles can create incredible long term wealth. The agriculture boom of the 1920s in the US produced huge amounts of farming capacity. The crash of the 30s transferred that capacity to less leveraged hands, but the capacity remained. The 70s/80s agriculture boom-bust cycle had the same effect. That’s why to this day the US has excess food and is a huge net exporter. Hell, our poor people are obese. Similar patterns have played out in other markets – the housing boom of the 1990s and 2000s likely has created a situation where we will never be short housing in the US again. There are too many houses, too much supply apparatus, and too few people to fill them.
So what does macro rigging mean for the trader? Several things. First, it means that over the long term it doesn’t make sense to short the industry of any developed country that’s not currently being destroyed by a war. It can make sense in the short term if there appear to be pricing irregularities or a very strong trend, but you have to remember the market is rigged to go the other way. Everyone is working against you. Central bankers will ease the money supply (which is murder on shorts). Firms will create new business. Congress will pass stimulus measures. Production will grow. In the end you’re going to lose. So don’t play that game. We’re now over three years into the current bull market, and there are STILL people who are whining that the market is going up. Because it’s rigged of course. And that’s true – the market got from where it was in March of 2009 to where it is now via TARP, bailouts, quantitative easing, and 0% Fed Funds. But given that it’s rigged to go up, why weren’t you long? You can be pretty sure the people who are whining now either were short or flat. Oops! They should have let the rigging work for them.
Let’s step away from the arena of government policy and look at markets themselves and their day to day operation. It turns out that real markets don’t work anything like the hypothetical un-rigged market described above. A real market is not just a meeting of producers and consumers. That’s a trade show. What makes a market is the presence of a speculator who will both buy and sell the good in question at any time and in meaningful quantity – even if there’s no intrinsic supply or demand right that instant. Such a speculator is called a market maker because without one there’s no guarantee you can complete a transaction – you don’t have a market. Large, robust markets have several major market makers. This brings us to the second form of market rigging, which I have pompously termed
The Fundamental Theorem of Market Structure:
All markets have pricing behavior and rules such that the primary market makers make money.
I’ll explain why this is so fundamental in a minute, but first I’ve got to convince you it’s true – hopefully an easy task.
Consider what would happen if the market makers were not profitable. Eventually they would get sick of losing money and stop making a market. In other words they’d pull a Barry Greenstein and avoid a situation where they continually lost (you knew that quote would come up eventually). When the market makers quit, that’s the end of the market. So just by knowing that a market continues exist, you can deduce that the market makers behind it must be profitable most of the time. That doesn’t mean that they must be profitable every second of every day. But overall, they make money. QED.
Now, what’s so fundamental about this? It tells you how to analyse markets and learn to make money from them! When looking at any market, you can just assume the market making is profitable. Then you look at the transactions in the market and see how price behaves to make that the case. This lets you understand how market pricing works. From that you can generate trades which are also profitable – in essence selectively mirroring the behavior of the major market makers.
Now this isn’t quite as easy as I made it out to be. The process of determining which transactions involved the major market makers and which were with other speculators (eg trend followers) or real suppliers/consumers is not easy. There’s a lot of art and science involved. But the fundamental theorem of market structure gives you the intellectual framework you need to get started.
So once again we’re in the same situation. The market is just as rigged on a small scale as it is on a large scale. And on the smaller scale that rigging is economic necessity – without it there would be no market. More importantly the market is rigged in a way that allows us to profit as speculators which a very good thing assuming you like profit. So embrace the rigging, because as a speculator it’s your best friend.
Soon I’m going to start a series on short term trading as a counterpoint to the long term speculation series. The fundamental theorem of market structure will play a central role. Stay tuned…