What Really Drives Financial Markets?

Forget about anything you ever learned in economics. Prices in the markets are mostly driven by large financial institutions in their never ending search for profits.

To establish the viability of this claim, I would like to present some facts and figures. Being an Australian, I will use readily available data from the Reserve Bank of Australia and the Australian Bureau of Statistics.

According to these sources, approximately 6 million Australian residents own shares that are listed on the Australian stock exchange (ASX). This represents about 25% of the total Australian population and only includes those who privately own stocks; not those who invest through funds or other arrangements.

Those 6 million Australian residents hold about 15% of the total market capital. Another 35% is held by Australian institutional investors while the rest (about 50%) is held by overseas interests. We find similar patterns of stock ownership in most developed countries.

So we have a large numbers of individual retail traders and investors, controlling a relatively small percentage of the overall market, while a small number of institutional investors control the majority share.

Let us imagine a publicly listed company which we will call XYZ. Over the last few months its stock price has been falling and rumours are starting to circulate that they are experiencing problems.

XYZs bankers, who hold significant outstanding loans are understandably concerned so they initiate discussions with the company to determine its true position.

Far from being in trouble, it turns out that XYZ are on a solid financial footing and are expecting earnings for the current financial year to at least be on target and maybe even a little better.

XYZs bankers also have a trading department. If the banks loan department was to call a meeting with the trading department and tell them what they had just learned about XYZ, and the trading department was to use that information to profitably trade XYZs shares; that would constitute illegal insider trading.

The bankers however are protected from this dilemma by a legal entity known as a Chinese wall.

A Chinese wall is a virtual barrier between different divisions of a financial organization. Its purpose is to avoid internal conflicts of interest. This wall is a metaphor for ethical behaviour within an organization, but it would be naive to believe that sensitive information doesn’t leak across these walls.

Networking has always been a good way for individuals working for financial institutions to further their careers and many of these organizations are located close to one another in capital cities. At a local bar or coffee shop , outside of working hours, ‘privileged information’ is likely to be shared discretely between those in the know.

Even with information like this in hand, institutional traders are usually far too savvy to just jump in and start buying stocks in XYZ. Nor would they wait until just before an earnings report to take a big plunge. Such a move would be way too obvious and would quickly alert both the market and the regulatory authorities that something was going on.

They would be more likely to try and stimulate the existing rumours about XYZs weakness through their network of financial media contacts. Any sort of negative story associated with XYZ will do the trick.

Headline: ‘XYZ prices fall following terrorist attack’

This will do the job nicely. The reasons given for falling or rising prices in media reports are often ludicrous, but this doesn’t seem to matter.  It forms an association in peoples mind between bad news and falling prices and has the affect of causing existing stock holders to panic. It also drives away any who  may been thinking about buying.

To reinforce the story that the price of XYZ is falling, they may also wait until the market is quiet and sell a decent size bundle of stock. This process is commonly known as shaking out the weak hands.

Weak hands are the retail traders and investors like you and I who are holding XYZ stock and are already worried about the falling prices and rumours.

As retail sellers dump their stocks, the institutional traders start to cautiously buy. These days, most of this stealth buying is done using computer programs known as algo traders – algo is an abbreviation for algorithm. Algos generally do a better and more efficient job than human traders.

In some markets, particularly those based in London and New York, a significant part of this trading may be carried out using private exchanges known as dark pools. This is yet another technique that the institutional traders use to secretly accumulate large positions.

Another common trick is for the bank’s own research department to issue a ‘sell’ recommendation for XYZ as part of their routine investment advice to their retail trading and investing customers.

The fact that this information is contrary to what the banks own trading department are currently doing is neither a problem nor a conflict of interest thanks to the Chinese wall.

Some months later, if all goes to plan, XYZ issues their annual earnings report and it is better than expected particularly in the light of all the negative press the company has been getting.

The institutional trading process then goes into reverse. The institutional traders start pushing the markets up with a few large strategically timed ‘buys’.  Good news stories get associated with XYZs rising price and the banks investment department changes their advice from sell to buy. This starts a trend which the institutional traders may attempt to regulate to some extent as they lure more and more buyers into the market.

Meanwhile the institutional traders are slowly selling their large holding of XYZ stock at a higher price than they paid for them.  This process continues until the market tops out, perhaps many months later.

This game is played in all financial markets in many different ways. The underlying principle is about triggering psychological weaknesses in those they want to exploit.

The legality of what they do is often borderline. The institutions become very skilled at staying just on the right side of the law while exploiting every possible opportunity for profit.

There is nothing new about any of this. Around a hundred years ago a successful trader and market educator named Richard Wyckoff wrote several books describing this practice which has probably been going on since stocks were first traded in the coffee houses around London.

The individual retail trader or investor who understands how markets really work can attempt to profit from the situation by trying to recognise when the big players are buying or selling and following their lead. This unfortunately is a lot easier said than done.

The psychological processes that take place in our subconscious mind and drive our decision making are far more powerful than many give them credit for. Changing them requires a lot of work and determination. I call it developing a Traders Mind and if you have ever tried giving up smoking or losing weight you probably have some idea of what is involved.

While developing a Traders Mind is not an easy task there are effective ways to go about doing it. I plan to write about this in future blogs.

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