Biderman holds the perspective that the stock market is a casino. In this casino, he sees the companies and funds as the house and the retail investors as the players. Similar to the real casinos, the players always lose to the house over the long run. The following is how he briefly describes his observations about the interaction between the house and the players during a stock market crash.
During a stock market bubble, investors practically clamor to buy stocks. At the same time as individuals and foreigners were pumping over $500 billion into U.S. stocks between November 1999 and August 2000, public companies and the insiders who run them were net sellers of $150 billion of new shares, net of cash takeovers and stock buybacks. Between June 2002 and March 2003, while individuals were heavy net sellers, public companies were net buyers of more than $50 billion of their own shares.
Public companies are perfectly willing to exchange shares of stock for cash during bubbles, since they know that once a bubble bursts, the cash they received for the new shares they sold will be far more valuable than the shares themselves. The opposite occurs during a bear market, when investors can hardly stand to even glance at their mutual fund and brokerage account statements. In the depths of a bear market, most investors want nothing more than to sell their stocks and retreat to the perceived safety of bonds and cash. Of course, public companies are more than willing to obliged them. Instead of selling new shares, as they would during a bubble, they buy back shares from investors at bargain prices, knowing the shares will be far more valuable than the cash they paid for them once the bear market ends.
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Do you notice a pattern here? Public companies and investors act in completely different ways when faced with the same market circumstances. While public companies (the house) buy low and sell high, investors (the players) buy high and sell low.
He opined that the retail investors have to know and even follow the house in order to beat market returns. To him, the real edge is found in discerning supply and demand, since this is how price is determined. He sees little value in fundamental or technical analysis in this aspect.
Easy said than done. How do you track the money flow in the stock market? This is where Biderman comes in to share his self-developed theory of liquidity analysis, which he has been using to publish his reports for fund houses.
There are 3 components.
L1 – Net change in the trading float of shares
This tracks the house’s transactions in stocks. It is bullish if L1 is negative because the supply of shares have reduced. There are 4 sub-parts that can be used to measure the change in supply. This is the most accurate indicator according to Biderman.
- New stock buybacks (bullish) – public companies can buy back their shares and reduce supply.
- New cash takeovers (bullish) – a case where a company is taken private. The number of shares in the market reduces.
- New offerings (bearish) – public companies selling additional shares and increase supply.
- Insider selling (bearish) – senior executives and major shareholders sell their personal shares.
L2 – Mutual fund flows
While L1 tracks the house, L2 serves to track the players. Due to the difficulty in tracking retail players direct investments in stocks, Biderman uses the mutual funds inflow and outflow as a proxy. More money flowing into funds is a bullish sign and the contrary is true. However, this is a lagging indicator to discern if a market is toppish and the players are wrong to pour money into the market.
L3 – Margin debt
An even lagging indicator is L3. It tracks the amount of leverage investors are assuming. Biderman observed that investors take on more leverage after a prolonged period of strong stock market returns. This indicator is useful to further prove that the players are wrong being aggressive in the market at the wrong time.
While the theory sounds logical, the availability and timeliness of data are concerns. Besides these, he acknowledged that investor psychology and exogenous shocks like terrorism are difficult to predict. Hence, Liquidity Theory, as with any other method or strategy, may not be accurate at times.
PS: Biderman devoted a few chapters about using liquidity analysis to build portfolios of ETFs and make buy and sell decisions. He catered for both conservative and aggressive investors.