PERFORMANCE ANNOUNCEMENT

As Of: March 18, 2010

Prices Are Set At The Margin

Price may deviate from true value.

             In a free market, it is an economic fact that prices are set at the margin by the last trading pair. If one thousand buyers and one thousand sellers agree to a purchase and sale at price X, then X should be the quote for the market price. But if just one more buyer appears, and there isn’t a matching seller, then what happens? The market quote has to go up (to X plus some additional amount: X+Y) until either 1) the buyer decides the price is too high and he drops out, or 2) the price gets high enough to induce a new seller to come into the marketplace. So in spite of 1,000 buyers and sellers (2,000 people total) agreeing on a price of X, one additional trading pair can end up setting the quoted market price at X+Y.

             Of course this process can happen over and over. If one thousand buyers and one thousand sellers see the market quote of X+Y tomorrow and, in view of the fact that the market appears to be going up, agree to a transaction at that price, it is quite possible that one additional mismatched pair can set a new price of X+Y+Z. So we are confronted with the quandary of wondering if the real value is where the vast majority of people place it, or is it the quoted price set at the margin by a very small minority?

             This question is raised because the US stock market is going through a phase of rising prices set by short term traders in an environment of historically low volume. The data seems to imply that long term value investors are either fully invested and just going along for the ride, or not invested (and do not want to be invested) because they do not like current prices. In other words, we have very few buyers, but even fewer sellers; so the imbalance favors prices continuing to go up. Of course the question we really want to know is whether more buyers will be found as the market keeps going up, or will more sellers start to appear?

             If the economy grows and corporate prices go up, then owners of stock will tend to hold their positions and more buyers will probably present themselves. There will be an upward bias to stock prices. Knowing that at some future time sellers will appear and prices will go down, many stock owners place stop-loss orders to protect their profits. Other owners will purchase put options for insurance. Since stocks can gap down suddenly and skip over limit orders, stop-limit orders do not provide adequate insurance. Thus proper insurance requires a stop order that automatically converts to a market order if the stop price is hit. This can create a market that cascades downward as more and more stop orders are activated and sales are executed. As the market is dropping, the people who sold put options will need to protect themselves and typically this is done by shorting the stock. Thus, a simple shift of balance in which sellers outnumber buyers can turn into a torrent of new sellers, cascading stop-loss orders, short sellers, and margin calls that force even more selling. Did anyone say volatility? This is a classic example of a dull, slowly rising market suddenly going off a cliff.

             Pricing at the margin can also affect a falling market. For example, the residential real estate market may be essentially washed out in the United States; but as long as there is one more distress sale or foreclosure auction, prices will continue to drift down, even though the vast majority of sellers will not accept such a low price. When the distress sales finally dry up, the real estate market may slingshot back to more normalized pricing that reflects cost of construction and a balance between supply and demand.

             It is often said that all market knowledge is contained in the price; but during periods of economic stress and strain, this may not be true. When prices are set at the margin in a skittish, distressed, or thinly traded market, the price at any given time may diverge widely from the real value that is assigned by the majority of buyers and sellers. Low volume and low volatility is often taken as a sign of complacency. I can assure you, now is not a time to be complacent.