A strong sign of long-term investors returning

One of my favorite ways of viewing market behavior was provided by Edgar Peters. He is both a professional investor and an author who wrote a book called “Fractal Market Analysis.” In the book he says that there are two types of market participants: short term and long term investors. On any given day or during any given week there is news flow that can serve as the cause for either selling or buying behavior. Short-term investors are much more sensitive to news flow than long-term investors. Why? Because long-term investors understand and accept that many fluctuations are going to happen over the length of time they own a business, but so long as the overall trend is upward they are content to continue to invest or be invested.

The differences between the two type of investors, short and long, result in an interesting dynamic. Namely, when there is short-term bad news and short-term investors want to sell, they depend upon the long-term investors for liquidity. That is, the short-termers sell to the long-termers with the long-termers providing the cash. Assuming that this happens, then the markets remain fairly stable. But what happens when long-term investors get panicked and switch from a long-term focus to a short-term focus? Who then provides the liquidity? The answer is that hardly anyone steps up to buy. This imbalance, a preponderance of sell orders and a pittance of buy orders, has only one resolution: falling prices. Thus, one of the ways you can evaluate the health of a financial market is strong evidence of long-term investor participation. And that is exactly the point of today’s posting.

The Wall Street Journal today is reporting that over $85 billion has been raised by the banking institutions subject to regulators’ bank stress-tests. That is a gigantic number. While it pales in comparison to the amount of TARP funds, that $85 billion comes from private sources, not taxpayer sources. That means that private investors are $85 billion interested in the very banking institutions most at risk and that were responsible for the debacle that is the current “credit-market-bubble-popping” recession. Because these banks are largely selling shares to raise the money, that means that there is tremendous amounts of dilution of current shareholders taking place. Dilution means that the size of the pie of the bank has not changed, but now there are many more pieces of pie being handed out. It can take many years for earnings to overcome the effects of dilution. So clearly these providers of $85 billion of capital are not short-term investors, but very likely long-term investors. Look at the way this relates to Edgar Peters’s model I described above. Long-term investors are returning.

Because of the return of the long-term investors I would expect that the financial markets are going to stabilize and we will see less and less downside volatility. My prediction is that we have definitively seen the financial market bottom for the current economic cycle. Amen!

Jason