CHG Issue #142: What's the Frequency, Kenneth?

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The foundation for quantitative analysis is prices that update frequently. Charles McGarraugh has this theory he calls asset duration in which he posits that the power of feedback is inversely related to the frequency of realization of information. When I traded CMBS there were often times a bond wouldn't trade for weeks or even months and then it would appear on a BWIC and you had to put price talk on it and provide a bid for the bond. This market structure makes you consider a lot more things when valuing a security than what is typically covered in quantitative finance these days.

For example, if I bought the entire issue of any particular bond that made me the only one setting the price of that bond. I couldn't realize the value of that bond until maturity, but in the meantime I was the one setting the price so I had the ability to set the narrative, absent any news. I wasn't as subject to the whims of the market because I was the only one that could trade that bond; no one could sell that bond because I wouldn’t let them borrow it and no one else owned bonds to sell. I could offer the bond at any price and determine my profit and the only constraint was convincing another investor that my price was a fair price. Now, I might be forced to sell that bond due to a margin call or quarter end, and when I did I was subject to the market's determination of value at that moment; my ability to set the narrative was degraded by my need for liquidity in that moment.

A similar dynamic exists in venture capital and private equity. In VC a startup raises money at a valuation that is determined by a minority of investors and the ultimate goal is to sell the company to the broader market at a much higher valuation, which is due not only to the performance of the company but also the broader market appetite for such a company. The VC is not subject to a lot of feedback in the meantime, absent company performance and the funding rounds it needs to complete to continue to fund operations. In Private Equity the reverse happens where a PE manager buys a publicly traded company and delists the stock. In this case the manager is acting like I would have in the case of buying the entire issue of a bond. They take the company off the public market and reset the narrative around the company as well as improve the performance so that they can resell it later at a higher price.

To this point we have demonstrated how we have large investment strategies that are based on this idea of the frequency of the realization of information. Our aim today is to connect the worlds of quantitative finance and the less-liquid worlds of fixed income, VC, and PE through the idea of asset duration. In this exploration we are continuing our investigation of the different ways that time plays an important but underappreciated role in the financial markets and the interplay of liquidity, frequency of/time to realization of information, and the importance of value.

It is often remarked that the stock market is not the economy. We can similarly ask if price is the best representation of value? If I am the only market maker in a security is my determination of price the best indication of value? The price I offer the security to you is the price that you can buy it for but value depends on intrinsic and extrinsic qualities. If my price is too low that would be recognized as value, but that is a superficial analysis because it presupposes that one knows the actual future value. To get to the heart of this requires a reframing of the question. Value is abstract while price is concrete; and the real question is what is the price I can realize after making the investment.

The realization may come from a fundamental outcome such as the company paying off the debt or defaulting (intrinsic value) or it may come from selling the security to another party (extrinsic value). Financial markets enable the later and greatly expand the universe of outcomes for any investment by enabling us to sell our investments to others. This is the greater fool theory and it demonstrates how value can depend on the liquidity of an investments. In this case value is the price you realize when you exit the investment, however this can have very little to do with the true intrinsic value of the investment. Therefore we find that more liquid investments can have a weaker connection to intrinsic value because of the ability to sell to others.

A determinant of liquidity is the frequency of realizing a price for an investment. There will always be a larger number of buyers and sellers for a bet where the payoff is immediate and a smaller number for bets where the payoff is further in the future and less certain. This will naturally make a shorter term investment more liquid than a longer term one. We see in the markets today how short term rates swing more violently than long term rates as market expectations for Fed policy are more prone to change than the long term expectations for growth and inflation.

Another determinant of liquidity is how abstract value is; the more concrete value is the more liquidity there will be as market participants have greater confidence to buy and sell around a known value. Fed policy is an unknown and therefore makes the short term market more vulnerable to large price swings because there is less certainty and fewer market participants willing to defend any price level as the true indication of value.

However, it is also possible that liquidity is determined by the importance of value. When the frequency of realization is low there is more time for the imagination to take hold and stir the passions of the majority. As people increasingly spot an opportunity to enrich themselves in the latest innovation the mind creates a future that is increasingly distant from the present. The value of the object of such speculation matters little, only the extent to which the imagination can dream up a future price that is much different than today’s. As the price rises or falls it stirs the passions of the majority to the point where the whole body of society is engaged in buying and selling the investment and liquidity is increased. We are witnessing this today with artificial intelligence and the impact on Nvidia and Microsoft.

Charles McGarraugh says the weighing machine of the market operates at different wavelengths. When the frequency of realization points is low (aka low liquidity or longer duration of realization) the stories you can tell about the investment are more powerful. A present day result of this is how value has become increasingly meaningless in our highly liquid, modern financial markets especially concerning new technologies that have the ability to exponentially change society.

...we're a society that knows the price of everything and the value of nothing. -Sean Illing, Vox

We have theoretically shown how liquidity and the importance of value can be inversely related and this theory can also be proven out empirically: In the liquid markets we find an almost singular devotion to price over value. The advent of quantitative finance has degraded the importance of value so much that it is almost entirely forgotten and subordinated to other interests such as volatility and correlation, which are both derivatives of price. The primary job of a portfolio manager today is to build a diversified portfolio not necessarily a value-laden portfolio. Indeed, the value factor has underperformed the market for many years now while growth and momentum, both price-dependent factors, have outperformed. Value has become meaningless as the ability to build a portfolio based on volatility and correlation in liquid markets creates the opportunity to be entirely indifferent towards value. If one investment goes up and another goes down you have a well-diversified portfolio; it matters not if either company creates value, it only matters how their securities move. The ability to scale this (liquidity) is the enabling force behind the degradation of the importance of value.

There was an interesting thought experiment on X last week that contrasted the price and value of a bet on the flip of a fair coin. The experiment asked where the bet would trade in the market(price) and I suggested it could easily trade through fair value because of the potential for securing future order flow from that seller. If the seller was willing to sell a favorable bet than I would be happy to pay through fair value as a loss leader to secure more profitable volume in the future. In this case we have a very clear idea of value and a short time frame to the realization of that value, but even in that simplified case there is theoretical and empirical justification for price detaching from value.

We recently discussed edge in the lending business and how many lenders try to scale their operations but find it more difficult than expected. This provides further empirical evidence demonstrating how price often trades indistinct from intrinsic value. Lenders routinely make loans through their cost of capital either because they don't have a handle on their OPEX or they must print volume, regardless of its profitability, to keep their operations going in the hope that they can manage into profitability in the future.

We have shown that value is increasingly meaningless in today's financial markets however, while this may be true in practice it is not true in principal. Just because I can sell an investment to another fool today does not mean fools will always be around. Price and value can diverge for long periods of time but they always converge around the maturity of the asset. The longer that window, the more opportunity for divergence but we have seen that shorter windows also afford opportunities for large divergences. The fools who engage in unprofitable activities will eventually go bust over time as the system naturally corrects comes into balance. It is in this window where the criticisms of markets are given space to grow. Opponents of the markets point to the divergence between price and value, as represented by a billionaire financier, and say the system is broken because of that unfair and inequitable outcome. However, over time luck is just that, a random outcome, and only true value rises to the top in the end.

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