In my investment classes, I always stress to my students the importance of analyzing markets and building portfolios through four lenses:
- Fundamentals (relative valuation metrics, earnings cycles, macroeconomics, etc.)
- Technicals (support/resistance levels, moving averages, breadth, etc.)
- Sentiment (volatility measures, put and call ratios, CDS, etc.) and…
- Market structure
The latter element is, in my view, the most important, albeit the most difficult to research and forecast. Market structure is that comprehensive box that relates to the rules of engagement for all market participants.
Structure refers to the regulatory framework, such as what behavior legislators and regulators may want to push forward, but it also refers to the much more ethereal aspect of how such rules will be enforced and potentially “bent” in favor of certain investing classes.
To this point, think of High Frequency Trading (HFT) and how the combination of technology interests and for-profit exchanges has led to large structural changes in the markets with numerous distortions in the way the constant price discovery process now works. HFT is not the only example in recent history; the introduction of commodity-related Exchange Traded Funds has led to behavioral changes in the commodity markets due to the injection of a persistent long bias with retail characteristics in a traditionally institutional hedging market.
Historically we have also witnessed other major structural changes that have led to long bullish waves, such as rules in favors of equity investments as commonplace vehicles for retirement savings.
Understanding market structure will also force investors to research how the bigger players will align in the financial spectrum; this goes beyond following the smart money, such as hedge fund managers and corporate raiders, but more and more it has to do with fully understanding global politics and power plays. Today’s investor should spend more time analyzing Central Bankers speeches and Heads of States’ political realities rather than pouring over balance sheets and income statements.
The real truth is that the “1% of the 1%” sets the rules of engagement and while most investors do not have a seat at that very exclusive table, in order to be successful at the investing game you must work through an analytical framework that will take you as close as possible. One of the most significant realities of the unraveling of our financial markets since 2008 is that the rules of engagement are constantly being rewritten, putting any investor in a more complex situation than ever before. Structure is key but it is also now a fast-moving target. I believe that, to a large extent, this is one reason why traditional portfolio management approaches have failed miserably in this decade; as market structure became more negotiable and more unstable, it also became even more important, yet more difficult to predict, with the end result of undermining strategies established under the assumption of structural stability.
Successful investing in the next decade will require active political analysis and possibly an increased level of stakeholder activism in an attempt to be part of the rule-making process. Intense strategic geo-political analysis should also play a part in the construction of every portfolio. Legal expertise, now the domain of M&A and Distressed Securities traders, will probably become required talent for most money managers.
In conclusion, the world has become a lot more complex and unpredictable; successful investors will rise to the challenge by shedding old habits and stale formulas and embracing three-dimensional active analysis.