I am going to start today’s post with a story. Forgive me for pulling a Bruce Springsteen and regaling you with a story about my glory days, but I think it is a great analogy for the problems in today’s equity market.
In the 1990s I was the stock index derivative trader for Canada’s largest dealer. Our group was in charge of making markets for both retail and institutional clients in the flagship equity index product called TIPs (which is different than today’s US listed TIPs which are Treasury Inflation Protected securities). I mainly worked on making markets for the upstairs institutional clients and executing index arbitrage, but one of our more lucrative side businesses was executing the index rebalances for the TIPs trust. The trust held the stocks which made up the index, but when there was a change, they couldn’t take the risk of not tracking the index, so they offloaded that risk to us. In those dark ages, there was no MOC (market on close) function, so the TIPs trust relied on us to guarantee the closing prices. This meant that we were responsible for executing the largest index trades in the marketplace.
The potential for gains, and losses, was huge. Although there were some other participants that had opposite index exposure who were trying to close the stocks against us, on the whole our position size meant that we had a considerable advantage.
One rebalance event there was a simple stock for stock merger with both stocks being index members. Back then the index providers didn’t calculate the implicit fair value price of the stock being removed from the index, but instead used the closing prices for both stocks on the last trading day.
Our firm was responsible for shorting something like 15,000,000 of acquiring stock and buying 12,000,000 of the target at the closing prices. If we could simply close the spread at $0.05 (stocks used to trade in nickels in those days… it was after eighths but before pennies), we could pocket $600k for very little work. If we could tick it at a $0.10, it would mean more than $1 million bucks. Somewhere between a nickel and a dime seemed like a fair price to me given that we were still taking a fairly large risk.
So I set about making a trading plan to put up a wall of stock to protect against the stock moving against us at the close. For the stock that was coming out, I layered the book with million share orders on the offer, and for the stock whose weight was increasing, I stacked a whole bunch of million share bids. This was of course all done in the frantic last few minutes going into the bell. Just to make extra sure that nothing else went wrong, we put in place our machine gun strategy.
The machine gun strategy was a computer algorithm we created which basically sent a barrage of small orders at the bell. Back then, on busy rebalancing days, the lag on the exchange was literally 30 seconds or a minute long, so you really never knew which orders were going to make it. This was always the nightmare scenario for all the risk we were taking. What if our orders didn’t make it to the exchange and the stocks closed $0.50 or $1 against us? We would be obligated to fill the TIPs trust and could lose $10 million bucks in a blink of an eye.
So between the layering of the book and the machine gun strategy, I thought I had it all under control.
But what I didn’t count on was my buddy at another dealer who also had the same exposure as us (he was getting long the target at the closing price and shorting the acquirer at the closing price). His position wasn’t quite as big as ours, but he was the next biggest trader out there.
Whereas my plan was designed to make sure we didn’t lose money (and hopefully make a little), he attacked it in a completely different fashion. He set about trying to push the spread as far as he could in his favour. So in the dying minutes of trading, he started wailing on the market, selling the target and buying the acquirer in quarter million chunks. Going into the close, the spread which had been trading at a nickel, managed to push out to a dollar with his frantic flailing.
My layered orders were moot because he had moved the market so far. But my machine gun algorithm kicked in… My buddy had pushed the market so far that there were basically no orders in the book at the bell. So when I went to tick the target on the bid, I moved it down $0.60 in one trade. The spread closed at an obscene $1.60.
That meant that we were going to make $19 million on our trade.
Instead of being happy, I was furious. The first thing I did was phone the dealer that I had sold the stock to down $0.60 on my machine gun order. I begged him to cancel the trade. Luckily he agreed. The trade was cancelled, the spread moved back to just a dollar discount. I had cost our shop $7 million on that one phone call. My boss was mad at me, but I didn’t care. This was just obscene and not right. My boss was going to have to be happy just making $12 million instead of $19…
The next thing I did was phone up my buddy from the other shop overhead and asked him what the fuck he was thinking. He was taken aback by my fury. He responded by asking me why I wasn’t happy to be making all this money? I told him because he was too greedy and he was going to ruin the game for everyone…
I have been meaning to write this piece for quite some time now, but then Thomas Piketty wrote this entire book on the subject of inequality and my droning on about it seemed a little too much like I was chasing the headline of the day.
But now that the Pikettymania has subsided, I want to take a moment to talk about inequality. I am not going to bother talking about what should be, I will leave that for the slick French economists. It’s not like I don’t have opinions about the right direction for our society and the economy, but really – who cares? My opinion is not going to change what is – which as a trader is all that you should really concern yourself with.
There can be no denying of the trend of a steadily decreasing share of the wealth for the average American. Have a look at this chart which measures labour’s share over the last few decades.
Labour Share</a> </div>
During the period between 1950 and 2000, there was a steady decrease, with a slight uptick going into the end of the decade. But the pace was quite gradual.
Ever since the dot com crash, that pace of decline has accelerated, with even the boom times of 2005/6 only causing the trend to slow down, not reverse.
All the while, the trend has been for the CEOs at the top to take more and more. Have a look at this table which shows the various CEO to average worker pay ratios throughout the world:
This ratio is symptomatic of the increasing inequality in America.
Now I don’t want to spend too long talking about who is to fault for this trend. Like most things in life, I am sure there is blame on both sides.
But at the same time, regardless of the cause, we have hit a point where it can’t continue. The 1% (actually more like the 0.1%) are simply being too greedy. They are going to kill the game for everyone.
I don’t know what the right ratio of inequality is. I haven’t bothered to read Piketty’s book yet, but I bet he thinks it is more equal than I do. Yet neither do I agree with the staunch free market hypocrites who claim that the market is going to sort it all out.
I have seen markets at work, I know they get it wrong all time. You can’t count on the market getting it right. Sometimes you need to say, “hey I know you are a private banking institution, but I don’t think giving $3MM loans to a waitress making $22k so she can flip McMansions is a good idea.” As a society, we also should be able to say, “it is ridiculous that CEOs are making 475 times the average worker pay.” Again, I am not sure about what is the right ratio, but I agree with the judge that says he knows pornography when he sees it. I know unjust inequality when I see it – and it is everywhere.
I am already veering too much into my opinion about policy instead of my opinion about the market. But in this case, they kind of go hand in hand.
We have hit a tipping point of ridiculousness. I see it, most of Wall Street sees it, and more importantly, the average guy on Main street increasingly sees it.
This year will mark the peak in inequality.
Some of the problem with inequality will be ameliorated by CEOs and other 0.1%’ers pushing less hard. They see the writing on the wall and will try to get out ahead of it. Some of it will be solved with higher taxes on the truly rich.
But the biggest way it will be solved is for that chart of labour’s share to stop going down and start climbing back up.
I know it is fashionable to talk about all the gloomy things that are happening to the economy. Yet amidst all this gloom, the labour market is slowly tightening up. Not only that, companies are paying their workers more.
Have a look at this great article from the NY Times:
Ikea plans to adopt a wage structure that it says will raise the average hourly minimum wage at its 38 stores in the United States to $10.76 an hour — a 17 percent increase.
Ikea, which will be announcing its new wage policy on Thursday, said it would not impose an across-the-board minimum wage for its stores, but would instead set a minimum for each store based on the cost of living in that particular area.
For example, the minimum wage will run from a low of $8.69 an hour at its stores in Pittsburgh and West Chester, Ohio, to $13.22 an hour at its store in Woodbridge, Va.
Ikea said that its new average minimum wage, $10.76 an hour, was $3.51 above the current federal minimum wage of $7.25 an hour.
The retailer’s decision was made as many low-wage workers and labor unions are pushing for an increase in the federal minimum wage and after Gap Inc. informed its employees in February that it would set $9 as the minimum hourly rate for its United States work force this year and then establish a minimum of $10 next year.
Gap said its new policy would raise pay for more than two-thirds of its 90,000 American employees, including those at Banana Republic and Old Navy, while Ikea said its new policy would raise the pay of about half of its 13,120 United States employees.
“This stems back to Ikea’s decision to create a better everyday life for our people,” said Rob Olson, Ikea’s acting president for the United States and its chief financial officer.
“We are of course investing in our co-workers. We believe they will invest in our customers, and they will invest in Ikea’s stores. We believe that it will be a win-win-win for our co-workers, our customers and our stores,” he said.
Ikea officials said its hourly wage will vary based on the cost of living in each location, using the M.I.T. Living Wage Calculator, which takes housing, food, transportation costs and taxes into consideration.
“The new minimum hourly wage structure will be a significant investment, but it will not increase Ikea prices,” the company said.
The retailer said its policy was a departure from determining wages based on local competitive conditions and was instead focusing on the needs of its workers.
Mr. Olson said that Ikea had been known for having benefits well above the competition, while having competitive wages. He noted that Ikea had a 100 percent match for the first 4 percent of pay contributed to 401(k)’s and then a 50 percent match for the next 2 percent. Separate from that, it has a bonus program for all employees and makes contributions to a new retirement fund.
Zeynep Ton, a professor at the M.I.T. Sloan School of Management, said, “Ikea is probably realizing that it’s hard to get the best out of their employees if their employees don’t earn enough to live on.”
The trend has clearly turned. It just hasn’t shown up in the data yet.
Everywhere I look, the minimum wage is being raised. Bit by bit, labour’s share of the pie is increasing.
As Herb Stein’s Dad famously said, “that which cannot go on forever – doesn’t.”
The trend towards labour taking less and less, with the elite few taking more and more has peaked.
This won’t be a one quarter blip, but a decade long trend that will surprise everyone.
I know it is very unconventional analysis, but that only make me all the more confident.
As for market implications… Have a look at this chart which shows the market capitalization of equities versus the GDP:
Then, ask yourself why the valuations are so high.
Could it be partly because corporate profits as a percent of GDP are also so high?
Corporate Profits as a percent of GDP</a> </div>
And if I am correct about labour gaining traction in the coming years, ask yourself how corporate profits as a percent of GDP is going to stay up here.
This chart is the inverse of the labour chart. In essence, the money has been funnelled away from the workers into the arms of the capital holders.
My money is on this trend reversing. But just remember, the end of peak inequality will not be good for financial assets. Don’t worry about whether this is good or bad, just worry about getting out ahead of it…