Are markets efficient?

Are markets efficient? No. But just because there are temporary mispricings doesn’t mean that it’s possible to take advantage of those trades. Furthermore, those mispricings can stay in place for quite some time and there is nothing you - as an individual participant - can do about it.

Still, two of my favorite podcasts this week shed light on the concept of market efficiency so let’s delve deeper into this concept.

Over at the Market Huddle podcast the founder of Falcon management and without a doubt one of the smartest traders around (although he would be the last person to toot his own horn). A few months back Jim was on Kevin’s podcast and laid out a brutally persuasive argument for EUR/USD volatility. At that time FX was so slow moving that it wasn’t unusual for the pair to crawl a whopping 10 pips over a 10 hour time frame. Needless to say, supply chain disruption, war in Ukraine and skyrocketing inflation changed that in a heartbeat and Jim’s trade paid out in spades. 

His new idea is that inflation is likely to be much stickier than we think and he is effectively betting that rates will rise above 5% and beyond. But the details of the particular trade are less important than what Jim has to say about what really makes markets move. 

Jim believes that prices do not adjust until an idea becomes “common knowledge”. For example, anyone with even a rudimentary understanding of epidemiology would have been aware that COVID was going to be a serious public health problem as early January of 2020. Certainly by mid February, as  the pandemic began to spread to the US shores, investors should have turned cautious. But it really wasn’t until the end of February that market panic began to set in and it wasn’t until March of 2020 that it reached a fever pitch. That flip from blase disinterest to once-in-a-century scare was very quick mostly because COVID was such an all encompassing story.  But often the gap between personal realization and “common knowledge” can take months, years, even decades to close which is why it's important to realize that just because something is obviously mispriced it does not mean that you can make money on it.

Closed End Funds

Closed end funds have been around for decades. They are basically stocks that hold other securities as their assets - similar to mutual funds or ETFs. But because of their corporate structure many closed end funds are quoted at a discount to their net asset value and that mispricing can persist for decades because unlike with ETFs there is no quick and easy way to arbitrage the difference. You effectively have to force the management of the closed end fund to sell all the assets and redeem the shares for cash or convert the fund into an open end fund. It’s impossible to do that as an individual investor so the inefficiency can persist for years until a large player like Boaz decides to take an interest in the fund and force the management to do a conversion. ( Note to Reddit Army - this could be your next strategy  to stick it to the man)

SPACs

A SPAC as Boaz explains it is basically  a lockbox of Treasuries with a free call option embedded. The rules of the SPAC are such that you can always “put” the shares back to the company at $10 par plus whatever yield you can collect before the deal closes. As long as you purchase SPAC shares under $10 your risk is minimal, although you may tie up your capital at low yields for a considerable period of time and thus suffer an opportunity cost. Still, if you look at SPAC trade as essentially a cash equivalent transaction with a lottery ticket attached you have a chance to exploit an interesting market dynamic and this one is actually pretty accessible to individual investors.

Carry Free Tail Risk

Insurance always costs. In fact one of the reasons why few individual investors hedge their stock portfolios is because the cost is prohibitive. At minimum it costs 10% of the notional to hedge a stock portfolio for a year. Do that for a few years and you won’t have much of a portfolio left. By contrast it only costs about 1% of notional to insure your house – which is why most people have house insurance but few have stock market insurance. 

But what if you could purchase protection essentially cost free? That's what Boaz was able to do in the credit derivative space when he noticed that the price of credit insurance for AAA stocks like McDonalds was exactly the same (about 25 basis points) as the price of insurance for much lower quality credit like the company that owned the SABRE reservation system. So he sold the equivalent amount of Mcdonalds risk and bought SABRE protection taking advantage of the mispricings. During the pandemic McDonalds credit risk was able to remain steady while SABRE CDS blew out to 500 basis points effectively making him 10 times his money for zero net cost.

But this trade was by no means guaranteed. If by some freak of nature COVID jumped to cattle  and maybe even turned into a more deadly strain there would be a de facto consumer boycott of Mickey D’s wreaking havoc with the short leg of the trade. Or maybe COVID once hitting the US shores would have mutated within days  into the far less ominous Omicron B strain and global travel would have resumed within months. These are of course far fetched scenarios, but the point being that this inefficiency played out only because the risk paths followed the original thesis and that’s not always so.  

London Whale

One of the most interesting market inefficiency trades that Boaz did was the London Whale trade where he noticed that there was a major discrepancy between the benchmark and a certain very similar index of high yield bonds. Without going into too much detail Boaz was able to sell the overpriced index against the benchmark taking advantage of the mispricing. But here is the kicker. Boaz publicly disclosed this trade idea at a JP Morgan investor conference - the very firm that was overbidding the value of the secondary index well above its actual worth. The thesis was straightforward. The math was pretty simple. It was just a matter of addition. Anyone who followed Boaz’s idea could have taken advantage of the trade. And yet for six months this discrepancy held! 

Eventually JP Morgan lost $6 Billion dollars on that position and Boaz made out like a bandit, but the very fact that this massive mispricing was allowed to exist not for days, not for weeks, but for months is proof positive of Jim Leitner’s idea that market inefficiencies will only correct when they become “common knowledge”.

Are markets efficient? Of course not. Can we profit from that fact? That’s a whole different story.