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If Price Insensitive Buyers Become Sellers, Will The Entire Market Collapse?

Tyler Durden's picture




 

One narrative we’ve been building on for quite some time is the idea that both stocks and bonds have been propped up by a perpetual bid from price insensitive buyers. Put simply, it really doesn’t matter how overvalued something is if your primary concern is something other than maximizing your return on investment. 

Take corporate buybacks for instance. Both equity-linked compensation and the market’s tendency to focus on quarterly results at the expense of the bigger picture have compelled corporate management teams to develop a dangerously myopic strategy that revolves around tapping corporate credit markets for cheap cash and plowing the proceeds into EPS-inflating buybacks. Whether or not this is the best use of cash is certainly debatable but when the goal is to manage earnings and appease stockholders, that doesn’t matter, and indeed, companies have an abysmal record when it comes to buying back shares at levels that later prove to be quite expensive. 

In America, the price insensitive corporate management bid simply replaced the monthly flow the market lost when the Fed - the most price insensitive of all buyers - began to taper its asset purchases. Of course QE in all its various iterations playing out across the globe, is price insensitive buying taken to its logical extreme. With the ECB’s PSPP for instance, limits on the percentage of an individual issue that NCBs are allowed to own apply to nominal amounts meaning that, to the extent NCBs can buy bonds at a premium to par, they can effectively buy fewer bonds than they otherwise would have and still hit their purchase targets. In other words, if you overpay, it’s easier to stay under the issue cap when supply is scarce in eligible paper. So in some respects, the more EMU central banks pay for the bonds they purchase, the better

In Japan, the BoJ has amassed an elephantine balance sheet full of ETFs and because one cannot classify stocks as "held to maturity", Haruhiko Kuroda’s equity plunge protection is effectively a self-feeding loop - that is, the more stocks the central bank owns, the more it must buy in order to protect its balance sheet from the damage it would suffer were equities to sell off. 

And then there are banks, mutual funds, and pension plans which for various reasons (regulatory and otherwise) are forced to accumulate assets at otherwise unattractive prices. 

The question in all of this - and this may indeed become one of the most important considerations for market participants once every DM central bank bumps up against the Sweden problem - is this: what happens when the price insensitive buyers behind the inexorable rise in financial asset prices become price insensitive sellers?

Here with more on that question and more, is GMO’s Ben Inker:

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From GMO

Price-insensitive sellers

The last decade has seen an extraordinary rise in the importance of a unique class of investor. Generally referred to as "price-insensitive buyers," these are asset owners for whom the expected returns of the assets they buy are not a primary consideration in their purchase decisions. Such buyers have been the explanation behind a whole series of market price movements that otherwise have not seemed to make sense in a historical context. In today’s world, where prices of all sorts of assets are trading far above historical norms, it is worth recognizing that investors prepared to buy assets without regard to the price of those assets may also find themselves in a position to sell those assets without regard to price as well. This potential is compounded by the reduction in liquidity in markets around the world, which has been driven by tighter regulation of financial institutions, and, paradoxically, a greater desire for liquidity on the part of market participants. Making matters worse, in order to see massive changes in the price of a security, you don’t need the price-insensitive buyer to become a seller. You merely need him to cease being the marginal buyer. If price-insensitive buyers actually become price-insensitive sellers, it becomes possible that price falls could take asset prices significantly below historical norms.

Monetary authorities

The first group of price-insensitive buyers to confound the markets were, arguably, the monetary authorities of emerging countries, who in the 2000s began to accumulate a vast hoard of foreign exchange reserves. These reserves, which served to both protect against a recurrence of the 1997-98 currency crises and to encourage export growth by holding down their exchange rates, needed to be invested. The lion’s share of the reserves went into U.S. treasuries and mortgage-backed securities, causing Alan Greenspan and Ben Bernanke to muse about the conundrum of bond yields failing to rise as the Federal Reserve lifted short-term interest rates in the middle of the decade. I have to admit that from a return standpoint, those purchases were ultimately vindicated by the even lower bond yields that have prevailed since the financial crisis. But just because the position turned out to be a surprisingly good one, return-wise, doesn’t mean that these central banks were acting like normal investors. Their accumulation of U.S. dollars had nothing to do with a desire to invest in the U.S., in treasuries or anything else, but was rather an attempt to hold down their own currencies. 

Developed market central banks

The financial crisis itself created the second group of price-insensitive buyers, developed market central banks. Quantitative easing policies by a wide array of central banks have had the explicit goal of pushing down interest rates and pushing up other asset prices. While one can argue that the central banks were anything but price-insensitive in that they cared quite deeply about the prices of the assets they were buying, they certainly were not buying assets for the returns they delivered to themselves as holders, and their buying has been driven by an attempt to help the real economy, not an attempt to earn a return on assets. Since 2008, the sum of the U.S., U.K., Eurozone, and Japanese central banks have expanded their balance sheets by over $4 trillion USD, as shown in Exhibit 2. 

At the moment, the most active central banks in the developed world have been the European government bonds.

Defined benefit pension plans

Considerations of profit and loss on their portfolios are seldom at top of mind for central bankers, making them obvious candidates as price-insensitive buyers. But regulatory pressure can push otherwise profit-focused entities in similar directions. Successive tightening of the regulatory screws on defined benefit pension funds, particularly in Europe, have forced many of them into the role of price-insensitive buyers of certain assets as well. 

Risk parity

Another group of price-insensitive investors are managers of risk parity portfolios. These portfolios make allocations to asset classes not with regard to pricing of assets, but rather their volatility and correlation characteristics. Their price-insensitivity comes out in a couple of ways. First, as money flows into the strategies, they are levered buyers of bonds and inflation-linked bonds in particular. Like most strategies, if the money flows out, they are forced sellers of a slice of their portfolio. Second, unlike many other investors, they will also tend to buy and sell based on changes in volatility. As the volatility of an asset falls, these strategies will tend to lever it up further, and as the volatility rises they will sell. Given that low volatility tends to be associated with rising markets and high volatility with falling markets, this gives their buy and sell decisions a certain momentum flavor. If bond prices are moving up in a steady fashion, they will tend to buy more and more as volatility falls, and in a disorderly sell-off that sees yields and expected returns rise along with rising volatility, they will sell the assets due to their higher “risk.” In fact, rising volatility in bond markets could cause a general delevering of risk parity portfolios, causing them to sell assets unrelated to bonds in order to keep their estimated volatility stable. With hundreds of billions of dollars under management in risk parity strategies and large holdings in some of the less deeply liquid areas of the financial markets such as inflation-linked bonds and commodity futures, it is easy to imagine their selling in unsettling markets under certain circumstances, such as a repeat of 2013’s "Taper Tantrum."

Traditional mutual funds

While the levered nature of risk parity portfolios may cause them to punch above their weight in potentially disrupting markets, in the end it isn’t clear that they are more likely to cause trouble than the managers of traditional mutual funds.

The mutual funds are at the mercy of client flows. As money has flowed into areas such as high yield bonds and bank loans, they have had little choice but to put it to work, and given their mandates, prospectus restrictions, and career risk, they are largely forced to buy their asset classes whether or not they think the pricing makes sense. But to an even greater degree, when redemptions come, they have no choice but to sell. This is nothing new. But what has changed is the extent to which mutual funds have seen large flows into increasingly illiquid pieces of the markets, particularly in credit, where bank loan mutual funds are 20% of the total traded bank loan market and high yield funds make up another 5%. That may not sound particularly large, but almost half of that market is made up of CLOs, which are basically static holders of loans. This makes the “free float” of the bank loan market perhaps half of the total, and should the bank loan mutual funds sell, there are not a lot of investors for them to sell to.

This is particularly true given the changes to the regulatory landscape for the dealer community. Banks are much less likely to take bonds and loans on their balance sheet for any length of time in the course of their market-making activities.

Conclusion

The size of the price-insensitive market participants is impressive. Monetary authorities and developed market central banks have each bought on the order of $5 trillion worth of assets for reasons that ultimately have nothing to do with earning an investment return on them. Regulatory pressures have caused pension funds, insurance companies, and banks to do likewise. While it is somewhat harder to put precise numbers to the size of these investments, it seems a safe bet that the total is in the trillions as well. Other investors are in analagous positions for different reasons, as strategies such as risk parity and the exigences of life as a mutual fund portfolio manager push such investors to also buy assets for reasons other than the expected returns those assets may deliver. To date, these investors have tended to be buyers, and given their lack of price-sensitivity, they have pushed up prices of assets beyond historically normal levels.

At the same time, a natural buffer for many markets against a temporary imbalance between buyers and sellers, the dealer community has been forced to significantly curtail its activities due to the regulatory regime. So if circumstances cause these price-insensitive buyers to turn around and become price-insensitive sellers, there are not a lot of candidates to take the other side. 

Be prepared for the possibility that some of the same assets that have again and again risen to prices that many investors said were impossible show more downside volatility than investors have bargained for. 

Full letter (.pdf)

 

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Sun, 08/02/2015 - 17:19 | 6382572 Headbanger
Headbanger's picture

Oh no..

It'll just float downward like a rock.

No worries..

Ooops... There I go again with that "Bubble of Pessimism" again..

 

Sun, 08/02/2015 - 17:20 | 6382591 Winston Churchill
Winston Churchill's picture

Those stocks will fly like a brick.

Sun, 08/02/2015 - 17:24 | 6382603 symtex411
symtex411's picture

a rock in a vacuum

Sun, 08/02/2015 - 18:01 | 6382718 oklaboy
oklaboy's picture

I thought bubbles floated?

Sun, 08/02/2015 - 18:15 | 6382745 gimme-gimme-gimme
gimme-gimme-gimme's picture

Step 1) Use PPT

Step 2) If that fails take a page from China and make selling illegal and arrest institutional sellers/hedge fund owners who sell anyhow.

Step 3) Have a huge exit fee tax of about 90% on institutional sellers.

Step 4)Government force pension funds and 401k to buy equities

Step 5)Call a national state of emergency, deploy the national guard and freeze any elections until said state of emergency is over (like war on drung and war on terrorism, etc...)

Step 6) General population is ordered to Keep Calm and Carry on or be tossed in FEMA camps! 

 

 

Sun, 08/02/2015 - 17:23 | 6382585 FatuousTwat
FatuousTwat's picture

The answer is no. Because there is no market when all stocks are owned by central banks.

They will never sell.

Sun, 08/02/2015 - 17:21 | 6382593 knukles
knukles's picture

And if financial debacles cannot be saved by additional stupidity, The EU will just tax it!

http://www.spiegel.de/international/europe/plans-for-euro-zone-tax-take-...

 

Seriously!  The NWO Lives    Roddy Piper was Right!  FUCK the EU!

Sun, 08/02/2015 - 17:22 | 6382594 BullyBearish
BullyBearish's picture

Proof...previous leaders experiencing 10-20% declines in one day...pump it up, hand off to bagholders, step it down to load up the shorts, REPEAT ALL THE WAY DOWN

Sun, 08/02/2015 - 17:29 | 6382615 booboo
booboo's picture

Set Phasers to disiniggerate.

Sun, 08/02/2015 - 17:34 | 6382624 Chuck Knoblauch
Chuck Knoblauch's picture

If Trump wins, they will sell.

But he wont.

Sun, 08/02/2015 - 17:42 | 6382652 Sudden Debt
Sudden Debt's picture

I had a drink with a few friends saturday where we talked about the risk of a crash.

Funny thing, everybody has made profits and the economy wasn't doing that bad either these last few months before the summer. So nobody believed the possibility of a crash.

And that's just like 2001 and 2008. People will actually be shocked. Haven't seen that one comming. Wasn't the economy growing?

Just look at 2008 to know how this one will play out, a week of nightmarish crashes.

And in that week, when the world commes apart, this time, I'll take it all out as fast as I can.

And with what I can't get out in a week will be used to buy monster boxes.

Sun, 08/02/2015 - 18:58 | 6382861 Angus McHugepenis
Angus McHugepenis's picture

Sudden Debt:

Thought I would step into this thread for one last time.

I'm based in Canada (Alberta) and see the oil biz collapsing daily along with the CDN dollar. The CNC guy next to my buddy's shop is very slow, and he's one of the survivors in this. He has better skills and a deeper bank account than most of his competitors, and he can ride out another year until all the other "shops" who he competed with are gone. Many are already gone.

We happened to run into a plumber that did a shitload of work up in Ft. McMurray and is qualified to manage the operations at the big producers. He says it's a Ghost Town up there now. He said you couldn't find a seat at the local Earl's restaurant not long ago but it's no problem getting a seat now.

Should be a shitload of cheap ATV's and various other toys available on Kijiji and Craigslist soon... most of them abandoned, simply left behind for the taking. And that means a shitload of loan defaults.

Now, I gotta go back to being Galt.

Sun, 08/02/2015 - 17:57 | 6382702 BoPeople
BoPeople's picture

As to the first question: Yes!

But banks are the most price insensitive buyers because all of their money is created out of thin air with zero work.

Why would the banks all of a sudden be sellers when they have been the buyers of last resort for decades? They need the system to continue so that they can live like (fiat) kings.

Sun, 08/02/2015 - 18:05 | 6382729 Clowns on Acid
Clowns on Acid's picture

It will be a controlled demolition....sound familiar?

Sun, 08/02/2015 - 18:16 | 6382748 knukles
knukles's picture

Oh, I get what you're getting at!
Price insensitive selling just like the hits on gold by the tons at the opening in the wee hours of Asia when there's nobody else around?

Sun, 08/02/2015 - 18:24 | 6382774 buzzsaw99
buzzsaw99's picture

please. ain't nobody selling diddly.

Sun, 08/02/2015 - 19:45 | 6382999 CHC
CHC's picture

The Fed is a prime example of a price insensitive buyer.  They could care less since their money is just digital money - it doesn't exist, it's created by a couple of key strokes.  When shit hits the fan and everything starts falling - they won't jump in and sell - they don't have any "sweat equity" to begin with - they're insensitive (bastards) either way - up or down. 

Sun, 08/02/2015 - 21:03 | 6383209 fowlerja
fowlerja's picture

Oh no...

Has my yin just  changed to yang... and I was faithful to buy on all the dips on the way up...

Sun, 08/02/2015 - 21:11 | 6383231 g speed
g speed's picture

did he mention HFTs ---they seem to be profitering on price movement but not the price level--that is whether it is a good investment or not--  

Mon, 08/03/2015 - 01:28 | 6383844 q99x2
q99x2's picture

The entire market is not going to collapse because it is now legal for the central banks to purchase every corporation that is publicly traded until they own the entire world.

 

Bitchez.

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