2) Long Equity Managers
3) Fundamental Hedge Funds
4) Short-term Equity Traders
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From the “Invisible Hand” to the “Rational Actor”, the “Electronic Herd”, or just the monolithic “Market”, we tend to think of asset prices as being driven by a uniform force. In reality, there are many different types of investors and traders who push and pull prices in myriad ways. The battle between these actors creates inefficiencies and profitable opportunities. I’ll discuss the most important market players and how their actions create distinct waves in asset prices. A rough estimate of the relative trading volumes:
When these investors pour money into the market, the result is an indiscriminate rally that will lead to the overvaluation of some weak companies that are simply getting swept along. This causes the market truism, “a rising tide lifts all boats.” Over a 5+year horizon, their contributions will be influenced by the public attitude towards stocks and bonds in general. For example, for 20 years after the great depression, the American Public believed that stocks were inherently risky and unsuitable for most investors. Over a 10+ year horizon, contributions are also greatly influenced by demographics. As more Americans near retirement age, net investment into the stock market as a percentage of income will decrease. It’s also worth noting that passive investors are still relatively geographically isolated; American investors drive American stock market prices, and German investors drive German prices.
Over the long term, the valuation of a large country’s stock market is primarily determined by passive investors. To take advantage of opportunities created by the passive investor, we want to identify when they make poor choices. The simplest example is the passive investor’s exaggerated response to crisis. During a major war, recession, or natural disaster, public sentiment is likely to become extremely pessimistic. If the market has already sold off by as much as you think appropriate for the actual risks, it’s time to prepare for a contrarian trade. Similarly, we know that a young country with a growing economy will have a tremendous tailwind from a continuous flow of new earnings into the equity market. In the absence of a crisis, stock prices are likely to continue to rise regardless of valuation. As long as valuations are not obviously too high, we can ride the tailwind.
2) Long Equity Managers