How to Value Stocks in Modern Barren Equity Landscapes
We remember studying how to value stocks when we were young men. Ahhhh the good old days: P/E ratios, PEG Ratios, Sharpe Ratios, The Web-Clicks Count Method, the Ben Graham Formula, the Jim Cramer Ratio, and of course… the Take-My-Brother-in-law’s-Guess-and-Divide-by- 2-Method.
Those days are long forgotten. To quote from one of the best financial minds on The Street, Samantha Bee of Jon Stewart’s Daily Show:
“We’ve all heard that the way to make money in the stock market is to invest in a company you believe in and hold on to that stock. Well, there’s a name on Wall Street for people who do that: SUCKERS! These days making money is all about the action… and the faster the better!”
Although we haven’t been able to bring ourselves to invest in this new High Frequency Trading thing, we have been moving closer to the day on which we shall embrace it. Well, today may be that day! We now have an investing Formula!
There is a new research paper out of Ryerson University’s Ted Rogers School of Management, written by Godfrey Cadogan, titled Trading Rules Over Fundamentals: A Stock Price Formula for High Frequency Trading, Bubbles, and Crashes. We learned of this paper from reading a blog posting on All About Alpha, which did a nice job dumbing it down for Brooklyn guys:
Cadogan takes it as evident that “high frequency traders quest for alpha, and [that] their concomitant trade strategies are the driving forces behind short term stock price dynamics.”
His formula, then, is as follows: S(t, ? ) = S(t0) exp (?tt0 ?x(u, ? )?x(u, ?)dBx(u, ?))
Cadogan is claiming that if trading in the underlying stocks is dominated by HFT, then the movements of a stock price index (S) can be predicted by the exposure to (?x) and the volatility (?x) of E-mini contracts, which serve as a proxy for the strategies of traders seeking to control exposure….It shows how if volatility is above a historical average the price of S can enter “an exponentially downward spiral if volatility continues to increase,” because the HFT strategies become “phase locked,” each feeds off of the others’ efforts to reduce exposure to that downward move and compounds it.
Other writers have contended that the dysfunctional character they attribute to HFT is the result of its speed advantages over non-HFT players. In Cadogan’s view, though, the problem is the interaction of HFT with HFT, not with non-HFT players.
Well anyways, we have the paper downloaded now, and our weekend is now spoken for. (Sal can digest it while driving with his parents to Florida!)