April 20, 2017
What We’re Reading This Week
I suppose it is not possible for me to go this week without writing something about United. After all, it was in the news AND it is a publicly traded company AND occasionally I write about the legality of ETFs. Faithful readers will know what I mean about the “legality” of ETFs but here is a quick primer: There are some people that think ETFs violate multiple facets of antitrust laws. The idea here is that these laws exist to stop one big company from doing whatever it wants through a monopoly. If there is only one company in an industry then people cannot give their business to another company and investors cannot purchase stock of a competitor if they do not like said big company.
In today’s marketplace the former seems to less important than the latter as most companies prioritize shareholders over customers, at lease to the extent that they can get away with it. It is a balancing act. For instance, customers do not like it when they buy a car from you and pieces of it stop working. They really do not like when those faulty parts result in their death. But shareholders also do not like it when car companies have to replace a bunch of car parts for free. Then, later, shareholders do not like it when customers die. Therefore, it is a real catch 22 for automakers. Really, for anyone with obligations to shareholders.
Back to United. On a recent flight, the airline found itself needing to bump four passengers from the flight. United was short staffed at the destination airport and the four passengers would be replaced by four united employees. This is common in the industry and most airlines can find customers to give up their seats willingly for some form of compensation. After the first attempt to find volunteers the airline will select passengers and offer them higher forms of compensation. In this case, it was $1,000. Of the four, three willingly accepted the money and left the flight. One man was not willing to give up his seat and he was subsequently forcibly removed from the plane. There were viral videos, public outcry, and stock losses. This will continue to be in the news until people get bored and another person is abused by some other company, or maybe until a bank gets caught doing something bad.
What interests me is the stock price. According to Morningstar, eight of the top twelve investors in United also own American Airlines stock. The data on Delta and Southwest is similar. That is because the top holders of United are Mutual Fund Companies. Most people do not own United stock directly; they own it through an intermediary like a fund or ETF. Therefore, if you own United you lost a little at first but then gained a little, closing the day down 1.13%. If you owned United through a fund like the S&P 500, your fund airline positions ended the day positive by roughly 1%. That is because American, Delta, and Southwest were all up. They were up due to first quarter revenues. As it relates to the PR battle United faces and the subsequent loss of customers, most of United shareholders do not really care. If people stop flying United and start flying Delta, United’s largest investors will still make plenty of money, because they also own Delta stock! Maybe some large individual investors will mind but those top twelve funds own almost 15% of the stock collectively. That may sound like a small number but it really is not. One, it is just the tip of the iceberg in terms of shareholders that own multiple airline companies. Two, there are plenty of firms on the institutional side that are in the same position. Take Warren Buffet’s Berkshire Hathaway who owns 9.20% of United stock. Fortune calculated Buffet’s airline holdings that day and found he was up about $104 million.
If you believe that current market environments work to create efficiencies by changing corporate behavior through shareholder penalties then what is happening here is relevant. 20 years ago, fines and penalties could be imposed on United and they would directly affect shareholders who would then put more pressure on United to change. Sure, shareholders are currently still affected by what is happening to United, they just care a little less because it affects them a little less. Do indexes create monopolies by removing pressure on individual companies to be more competitive? Personally, I wonder if the person in charge of removing the passengers from the United flight is thinking, “I should have just offered that guy $2,000.” It certainly would have been cheaper for the company.
I have talked a little about Flash Crashes in the past. This occurs when a security or multiple securities’ prices drop dramatically, very quickly. The cause is typically something small, then exacerbated by black box and high frequency trading. Most recently, in 2014 two mini crashes were reported.
Algorithm based trading, mutual funds, ETFs, and hedging are all designed to reduce volatility in the market. All of these things existed (in one way or another) have existed for decades. However, they are becoming more and more prevalent today. It is easier for traders to use computers to design algorithms and automate trades. Hedging strategies are becoming more profitable. 20 years ago, very few people were invested in ETFs, today investors put more than $3 trillion in ETFs.
One theory espoused by bankers and traders suggests that while these tools work, they serve to create and intensify these flash crashes. The article focuses on hedging and why it creates a feedback loop that calms markets while potentially creating an environment that will amplify sudden drops in the market. I have often considered the US stock market to be one of the most efficient mechanisms in the world. It will go up and it will go down. Regardless of how much people attempt to flatten out volatility, it will find a way to correct itself.
As I have said before, it is becoming increasingly hard to invest in the market individually. My grandfather could invest in a stock and research its financial position and corporate vision. He never had to worry about spoofing algorithms precipitating a 1000-point drop in the DOW over 15 minutes.
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