Bloomberg View columnist Matt Levine always does a great job making sense of the complicated world of investment banking, hedge funds and credit.
Last week, he tackled a February working paper from Nathan Swem of the Federal Reserve — Information: Who Gets There First? — that explores how valuable information is disseminated on Wall Street. The paper argues that analysts help hedge funds market their best ideas to other investors.
That may appear like a shocking, or at least cynical conclusion. But it’s not going to come as a huge surprise if you know anything about Gilded Age super-trader Jesse Livermore. The subject of the 1923 investment classic Reminiscences of a Stock Operator, Livermore understood the internal machinations of Wall Street all too well. Face value is a mug’s game.
After comparing the “timing of information acquisition,” Swem concluded that hedge funds get important information first and build positions. As the news seeps out, sell-side analysts at brokerages change their published ratings, at which point hedge funds often reverse trades.
Levine, characteristically, connects more dots:
“The simple model here is: The hedge funds are good at finding undervalued stocks, so they do, and they tell the analysts, and the analysts write up reports, and the stocks go up until they are fairly valued, and the hedge funds sell them and move on to the next trade. It’s an efficient market, but one that relies for its efficiency on hedge funds (who are actually making investment decisions) rather than on research analysts (who aren’t). This is perfectly reasonable!”
Many retail investors are not going to like that conclusion. They may very well be angry. After all, it implies hedge funds have an advantage. That anger is wasted.
I have worn a lot of hats in my professional career in finance: Reporter, editor, inventor, hedge fund manager and research publisher. I have learned that things on Wall Street are rarely what they seem. My observations have led me to energetically pursue truth, and try to harness its clarity.
The quest led me to Jesse Livermore.
Livermore was the original hard-core trader, but also a seminal truth seeker that made him a rags-to-riches icon in the early 1900s. For him, the trickery by the elite was not an impediment; it spelled opportunity.
Almost in unison, Wall Street analysts are now telling investors to pile into cyclical stocks because the Trump economy will bring much faster growth. It’s a compelling argument. Prospects for reduced regulations and lower corporate tax rates have been seen as bullish for earnings growth. And some of the Street’s biggest names — including Apple (AAPL) and Facebook (FB) — have soared.
Yet there is a cloud on the horizon: Hedge funds, as a group, are selling. A recent report from Credit Suisse Group AG, based on its prime brokerage accounts, reveals hedge funds have been selling banks and materials stocks like copper.
It might be simple profit taking. After all, those sectors have had their best run since 2013. But it’s likely something bigger. Bloomberg reports hedge funds are worried about the pace of economic improvement. Benjamin Dunn, president of Alpha Theory, advises funds with $6 billion in assets. He sees a lot of skittishness because the hard-economic data is lagging despite the ramp-up in consumer sentiment. The turmoil in the White House over Russian ties, and the Federal Reserve’s determination to hike short-term interest rates in the face of rising inflation metrics will not help.
If this seems confusing, just remember the conclusion of the Federal Reserve paper: The smart money gets the best information, and acts early to sell its inventory to retail investors before the truth is widely dispersed.
I know what Livermore would do because I’ve developed algorithms based on his seminal work. He would agree with the findings of the Fed paper, as he pioneered the same approach a century ago: Turn brokerage recommendations upside down before use.
Best wishes,
Jon Markman
