Investment update 5 February 2018

Last week in the markets

Over the past week Australian shares were up 1.2% while small company shares were up 0.4%. Shares in developed countries fell 3.4% with the US market down 3.9%. Shares in emerging markets were down 3.3%. The Australian dollar fell 2.2% to 79.31 US cents. The Australian 10 year bond yield decreased to 2.83% while the US 10 year bond yield increased to 2.84%. The oil price fell 1.0% to 65.45 US dollars per barrel.

Information and Trading

If you’ve ever overheard people excitedly swapping share tips then you may have contemplated share trading. The question can be re-framed as follows: can additional returns be found beyond that which investors receive by being ‘passively’ exposed to the market (invested in an index product for example) and if so how?

Information about particular companies is ‘impounded’ through trading. Amazon’s recent interest in Australia’s grocery market is negative for Wesfarmers (Coles) and Woolworths (Woolies). And news like that and the analysis that follows brings about swift trading, selling in this case, until the information is impounded.

There is a paradox well-known to finance academics called the Grossman-Stiglitz paradox: if the market is efficient and all available information is reflected in share prices then no trader has an incentive to expend resources to gather information. So, how then did the information come to be reflected in the price? A paradox!

This suggests that if there’s money to be made from trading, beyond that which comes from investing for the long term, then it’s likely a result of gathering new information about many companies quickly, trading swiftly, and getting out once the broader trading community updates its thinking. This is the space of institutional traders and hedge funds. Informational edges, comprehensive analysis, speed and scale are everything in the competitive space of trading.

So let’s bring this idea into the kind of experiences we have every day.

Imagine two adjacent coffee shops, Café Stable and Café Shifter. They sell identical flat whites in identical cups, have the same customer-focussed smiley staff, and possess the same menu. Café Stable charges $3.00 for a flat white but Café Shifter makes a game-changing move and lowers its price from $3.00 to $2.50. What will happen? Once people see the price change (new information) and begin to take advantage, the news will spread and Café Stable will be forced to drop its price to $2.50. Coffee fans faced with a choice of these two cafés would again be indifferent – back to ‘same-same’.

This contrived example is a demonstration of the ‘law of one price’ – identical products or services should command the same price. So why is it that the prices of everyday items (cheese, muesli, capsicums) seem to differ in our major supermarkets from week to week?

Let’s consider how you would take advantage of the price discrepancies in Coles and Woolies. After drawing up your list of necessary items you would need to obtain the price lists for Woolies and Coles. This may not be easy as typically shops promote their specials, and not their standard prices. So you would need to visit Coles first, write down their prices and then head to Woolies and buy items there if they were cheaper, and then head back to Coles to buy the remainder.

You would need to make three supermarket visits, use two rewards cards, clear the checkouts twice, and place the items in the boot of your car twice. If the shops are not close together then some additional travel time and petrol would be involved. All of this takes valuable time, time that could be spent on more interesting pursuits, and requires resources (petrol). If you are feeding a family of ten, possess a large pantry and have a lot of free time then perhaps this is worthwhile, but for most of us this much work to save a few dollars might not be worth it. Time is money – and time is in short supply.

So back to our question: can you make additional returns trading stocks? There is no definitive answer here but Café Stable, Café Shifter and our supermarkets suggest this answer: Perhaps - if you have the resources (staff and technology, news feeds and data scraping tools), comprehensive analytical skills, a true informational edge, high trading speeds, low trading costs, time, and can act on a scale to make such an investment worthwhile. Something to consider when you next pop a flat white in your chosen trolley’s cup holder.

Signing off

Sean Anthonisz | Senior Quantitative Analyst

Past performance isn't necessarily an indicator of future performance.

Data sourced from Bloomberg.