Market Structure and its relevance to Volatility

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In-depth conversation about value and volatility in the markets must first begin by addressing the world we live in today.  Whether you sit on the fence, or are passionately for/against the need for High Frequency Trading (“HFT”) in our markets, is beside the point. They exist today and we have/will just have to learn to co-exist, perhaps even adapt.

A chronicle of the history of the modern stock market can be best explained with books like Scott Patterson’s Dark Pools, while Michael Lewis’ Flash Boys, sheds even more light on prevailing practices within our exchanges post 2007.  Do yourself a favor and add these books to your amazon wish list.  Utilize these resources to learn as much as you can to learn about how we got to this present age of HFT.

How did it start, what allowed their existence?

Reg NMS is a U.S. financial regulation promulgated and described by the United States Securities and Exchange Commission (S.E.C.) as “a series of initiatives designed to modernize and strengthen the National Market System for equity securities.” The Reg NMS is intended to assure that investors receive the best price executions for their orders by encouraging competition in the marketplace.  It was established in 2007. Its aim was to foster both “competition among individual markets and competition among individual orders” in an effort to promote efficient and fair price formation across securities markets.

Intent vs. reality:

If we read the above the intent of the S.E.C., are alarm bells going off in our heads? I mean what could be malicious about the preceding statements? However, the world we live in is capitalistic and purely profit driven.  Despite the S.E.C.’s intent with those regulations, eventually market participants involved in HFT practices evolved their strategy to utilize:

  1.  Use of extraordinarily high speed and sophisticated programs for generating, routing, and executing orders.
  2.  Use of co-location services and individual data feeds offered by exchanges and others to minimize network and other latencies.
  3.  Very short time-frames for establishing and liquidating positions.
  4.  Submission of numerous orders that are cancelled shortly after submission.
  5.  Ending the trading day in as close to a flat position as possible (that is, not carrying significant, unhedged positions overnight).

It may surprise you to find out that “trading ahead of the market” or “front running” is entirely legal.

The S.E.C.’s perspective (2014):

“HFT typically exceeded 50% of total volume in U.S.-listed equities and concluded that, “by any measure, HFT is a dominant component of the current market structure and likely to affect nearly all aspects of its performance.”

That study goes on to find “there is great diversity among HFT trading accounts in terms of the aggressiveness of their trading. Some are highly aggressive and some are mostly passive. Moreover, the largest and most profitable HFT accounts are the ones that are most aggressive.” 

What we can ascertain today:

In an article on Vanity Fair, Michael Lewis explains his views a year after his book, Flash Boys went on sale.  “And since late 2007, as a study published in early 2014 by the investment-research broker ITG has neatly shown, the cost to investors of trading in the U.S. stock market has, if anything, risen—possibly by a lot.”

We can ascertain that increased volatility is not only prevalent but widespread in our markets today.  Whether the increase in this volatility actually serves a purpose is difficult to decipher.  All we know is that aggressive HFT’s are the ones that actually make money at the end of the day and their profits (perhaps even guaranteed profits) are influenced by their aggressive trading behavior.  This fact alone should make us all buckle our safety belts and be prepared for a bumpy ride.

As one Goldman Sachs executive, Brian Levine, put it, “Unless there are some changes, there’s going to be a massive crash”, he said, “a flash crash times ten”…”I think it’s a business decision. I also think it’s a moral decision.” (p. 238 – Flash Boys)

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Disruptive Companies & Their Impact on Value – UBER Example

Disruptive companies aren’t new.  These commercial entities tend to innovate and cater to customer needs in anticipation of their needs.  Who would have thought online dating could evolve to what it has now.  Who would have thought that mobile advertising could legitimately provide an alternate platform versus traditional t.v.  What would the world look like if there was a majority of  driver-less cars on the roads? What if drones could deliver our groceries and amazon purchases  and perhaps even registered mail?  “A disruptive innovation is an innovation that helps create a new market and value network, and eventually disrupts an existing market and value network (over a few years or decades), displacing an earlier technology.”

When we try and assess what value a potential disruptive company could be, we inherently have to start and assess where the business is in its life cycle and analyze the information available to us.  The potential impact of the probability of this company displacing earlier industry models is what we are essentially trying to figure out.

The Uber Example

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Uber is a venture-funded startup and transportation network company based in San Francisco, California, that makes mobile apps that connect passengers with drivers of vehicles for hire and ridesharing services.[1] The company arranges pickups in dozens of cities around the world.[2] Cars are reserved by sending a text message or by using a mobile app—the latter can also be used by customers to track their reserved car’s location.[3]

Aswath Damadoran – a finance professor at NYU’s Stern School of Business, published an article  for his own blog titled “A Disruptive Cab Ride to Riches: The Uber Payoff.”  Let’s start with the largest assumptions of his analysis and contrast that with another individual; Bill Gurley, a General Partner at Benchmark Capital and an actual investor in Uber.  Mr. Gurley responded to Mr. Damodoran’s analysis, in a blog titled “How to Miss By a Mile: An Alternative Look at Uber’s Potential Market Size

The largest point of contention is each individual’s take on (1) the size of the total available market (TAM) and (2) Uber’s likely market share.

Damodaran estimates that the global taxi and limo market is worth about $100 billion per year, but according to Gurley Uber isn’t just trying to displace the existing industry – he aims to illustrate a structured look at how traditional human car transportation can change as a result of today’s technology..

Here is Damodoran’s view on TAM and probable market capitalization.

My. Gurley offer’s his own detailed response and provides a reasonable and plausible argument that Uber’s market opportunity might be 25X higher than Professor Damodaran’s take.  Let’s keep in mind that Mr. Gurley is an early-stage investor has much more access to actual data than Professor Damodaran.

I highly recommend reading both blogs to try and figure out where each person is coming from, and what you think is actually probable.

The reason I want you to think about these views are because that’s what the markets are like. A confluence of diverging views with actual positions based on their respective forecast.   These views coupled with the forces of bid and ask size, determines price at any given point in time.

Business Enterprise Value

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The Intersection Between the Value of an Enterprise, its Earnings, and the Value of its Tangible and Intangible Assets