What You Must Know About Institutional Investors

The major institutional investors with tons of capital need liquidity to trade in the size that they want. They simply can't buy at the market like everyone else. There has to be enough people taking the other side of the trade, otherwise, no transaction can take place. For every buyer there must be a seller and vise versa.

So even though it seems like 100s of millions of shares of volume everyday is enough, if 100M extra shares wanted to get to work, they wouldn't find anyone to take the other side of the trade at the stocks current prices. Any inbalance of buying demand and selling demand will have to be settled by adjusting the price of the demand in order for any "trade" to take place. In other words, if the market will sell you 10M shares of a stock at $50, and you want to buy $20M, you only are able to buy $10M and after that you have to bid higher and higher until someone says... okay, I will sell to you at $55 or whatever.

This is what drives price, and "volume profiles" are often a clue of the market environment and what can come next.

Then there are even bigger players than the ins bond holders and the foreign exchange markets. There are currencies for trading goods and services, and then there is currency for "parking" capital to preserve value. The largest central banks will "park" their money in dollars because it is the world reserve currency. When they have difficulty finding demand for their local dollars, they switch to US dollar, to park it for safety. Basically the US dollar will always be allowed for trade by all countries as long as this remains.

But when it comes to the major global investors who participate in multiple asset classes, particularly in low liquidity markets, they require large DEMAND for either shares, or supply of shares (demand from shareholders of cash).

Now I bring this up because there also exists an interesting phenomenon. if there is a huge amount of volume and price drops below where it was where that volume existed, you now have a huge number of people underwater in their position. If there are no history of those wanting to buy at lower prices, there is likely to be more selling pressure UNTIL areas inwhich buyers IN SIZE are willing to pick up shares.

Take entire markets of gold represented by GLD, and bonds, represented by TLT. They once both looked like this.

 You could almost see what was coming.

Keep these lessons in mind when you look at any market. For example, lets look at the recent action in stocks.

Now it's even more powerful when you aren't just applying this understanding in isolation. Instead, you should look at it from the institutional investors point of view.

If I was them and I had bought the 2009 lows, I know that I could not get out without stocks dropping to dow 13500 and lower or DIA 135 and lower. There are conditions where it may be worth selling, but those are hard to envision from our perspective. However, what one can notice is that there may be some fear right now. The institutional investors may be looking ahead in the calendar. There are European elections September 22nd and the US is facing a budget deadline October 1st, lead by a group of extremes on both side, neither of which have shown any willingness to compromise.

I certainly would want to reduce my risk exposure leading into these events, but only to be prepared perhaps to buy significant weakness.

The problem with suggesting just that markets will sell off is that it lacks the answer "where will that capital go". Will the institutions park it in cash? Will they park it in commodities? Gold?  Treasuries? The bond market still looks weak, particularly if the US is at risk of being unable to met their demands.

I remain very worried about the political crosshair aimed at the hedge funds and investment banks as I don't think the banks will be getting a bailout if they trade with depositors money and so if that is the rumor, they may have to stop using depositor money to borrow with. Not to mention if interest rates are rising all those who borrow money to speculate in stocks may have to liquidate and deleverage stocks and treasuries. The shift in that case would be into short term liquidity. If the euro elections are a result that creates fear of the euro's future, there could also be a shift into the swiss franc (for they no longer could maintain the "peg" to it and would have to sell euros... see when George Soros was accused of "breaking the bank"), as well as the dollar (the only market with large enough liquidity to accommodate the demand)

But if the shift is into the dollar, the balance sheets which have dolar denomonated assets will gain. There will be plenty of companies that sell to the US consumer but also have international interests that will gain. Even those based in other countries that are able to borrow in Yen or euros and do business in dollars but pay them back in euros or yen will do very well. Those companies could also act as a proxy for Europeans to get long the dollar without being a foreign exchange trader.

If you understand how the global markets really work, there are new opportunities that you may not have considered.  If the elections perhaps pan out a different way, perhaps confidence will return into the euro and act as an area to hide from the US budgets. However, it is the euro that is structurally unsound and never going to be capable of being the reserve currency unless a central euro bond is made and individual country bonds are eliminated. All the bailouts that nations like Germany have done may end up "equalizing" the economies of europe and that may become economically viable at some point,but until then, there is too much incentive for countries to spend, promise nothing, and hope to get bailed out, and then because the rates are fixed to the euro, the yields will have to skyrocket in order for them to raise enough cash in euros. This creates tons of instability, and actually may be what triggers a lack of confidence in government debt around the world in the future. There have been bailouts, bail-ins, (selectively robbing large depositors via "taxes" that they never knew about when they made the deposits of cyprus) and austerity and taxation, you name it, they have tried it. Yet they find it so difficult to pay their obligations, and if they cut back on them, there are riots which kill tourism and economic growth. Eventually it will become too painful that abandoning the euro all together becomes a potential option. With even the threat/perception of that happening, there could be massive shifts of capital around the world.

Be wary of hype as those who have a vested interest in selling may pay for relatively small budgets and programs and funds to hype up the market so that they can get ou. If you see lots of hype, be the "smart money" and take the other side.

In this case, I think there is increased probability of a highly volatile move in major markets, but that it soon will sort itself out afterwards and provide tremendous opportunity. Due to the concerns of volatility, the retail investor may want to "reduce" position size of any area they are too exposed to.