Wednesday, July 4th, 2012
Courtesy of the author, we present to our readers the following excerpt from Dark Pools: High-Speed Traders, AI Bandits, and the Threat to the Global Financial System, by Scott Patterson, author of The Quants. Part 1 can be found here.
Haim Bodek thought practically nonstop for days about what the trade-venue representative had told him that night at the New York party.
The way that the abusive order types worked made him think back to a document he’d been given by a colleague that summer as he researched what was going wrong at Trading Machines. The document was a detailed blueprint of a high-frequency method that was said to be popular in Chicago’s trading circles.
It was called the “0+ Scalping Strategy.”
Bodek suspected that there might be a link between the order types and the strategy.
Riffling through his files, he quickly found it. While the document didn’t say which firm used the strategy, he’d been told by the colleague who’d given it to him that one of the most successful high-speed firms employed it, or something closely akin to it. Due to the sophistication of the strategy, he’d guessed from the start that it was probably written by a Plumber.
There was another giveaway that it had originated in Chicago, where Bodek had worked for several years at Hull Trading: “scalping.” To a trader, scalping didn’t mean the same thing it meant to most people—a suspicious-looking guy peddling tickets for a sporting event or rock concert outside a stadium. In trading, scalping was an age-old strategy of buying low and selling high—very quickly. It was a common practice on the floors of futures exchanges that populated the Midwest—the Kansas City Board of Trade or the Chicago Mercantile Exchange. The 0+ Scalping Strategy was apparently a futures-trading technique that had been transformed into a computer program.
Bodek started reading. Page two of the document laid out the purpose of the 0+ strategy. “Simple Goal: use market depth and our order’s priority in the Q to create scalping opportunities where the loss on any one trade is limited to ‘0’ (exclusive of commissions).”
He paused at that. Essentially, the author of the strategy was saying that its primary goal was to never lose money—the loss on any trade was “0.” In theory, this could be done through a scalping strategy. By being first in the “Q”—shorthand for the queue in which orders are stacked up, like theatergoers waiting in line for their tickets—the firm could always get the best trade at the best time.
But what happened when the firm didn’t want to buy or sell? Bodek kept reading.
“GOAL RESTATEMENT: use the market depth and our order’s priority in the Q to create scalping opportunities where the probability of a +1 tic gain on any given trade is substantially greater than the probability of a –1 tic loss on any given trade.”
Aha, Bodek thought, market depth. That was a reference to the orders behind this firm’s orders, the other theatergoers waiting in line. The 0+ trader is assuming that his firm is so fast and so skilled that it can almost always get priority in the trading queue—be the first to buy and the first to sell. The depth behind it, the other orders, is the rest of the market.
The author is saying I always want to win (or rather, I never want to lose). His probability of winning—a +1 tick—is “substantially greater” than a –1 tick loss.
The rest of the market—suckers like Trading Machines or every- day mutual funds—was insurance. Under the next heading, called SIMPLE PREMISES, the exact meaning of what insurance meant was spelled out.
“If we have sufficient depth behind our order at a given price level, then we are effectively self-insured against losing money. Why? If we get elected on our order, we could immediately exit our risk for a scratch by trading against one of the orders behind us.”
In other words, if the 0+ trader buys a stock (gets “elected”), and his algos suddenly detect that the price is likely to fall—they can see a large number of sell orders stacking up in the trading queue—he can flip and sell to the sucker standing behind him, resulting in a “scratch” (no gain and no loss). He can do this because his computer systems can “react fast enough to changing market conditions . . . to ‘always’ achieve, in the worst-case, a scratch or a cancel of our orders.”
It was the Holy Grail of trading. The 0+ trader was describing a strategy that effectively never lost. The rest of the market protected it whenever the firm’s algorithms detected the slightest chance that the market was moving against it.
It’s brilliant—and diabolical. A firm that has found a strategy that is virtually guaranteed to win on every trade has discovered a hole in the market. Trading is all about taking risk, but this author was describing a virtually riskless trade.
The situation confronting Bodek and other investors not using the 0+ strategy was challenging, to say the least. It was like driving a car down the freeway, and every time you tried to speed up, another, faster car was in front of you. No matter how many tricks you pulled, this car (a 0+ symbol stamped on its hood, of course) was always leading the pack. The only time you could get around it—when it would suddenly hit the brakes and vanish in the crowd behind you—was when a Mack truck was speeding right at you. Worse, the 0+ trader was the Mack truck!
The upshot: Regular investors, the suckers using those stupid limit orders, buy high and sell low—all the time.
The game had changed. Bodek became increasingly convinced that the stock market—the United States stock market—was rigged. Exchanges appeared to be providing mechanisms to favored clients that allowed them to circumvent Reg NMS rules in ways that abused regular investors. It was complicated, a fact that helped hide the abuses, just as giant banks used complex mortgage trades to bilk clients out of billions, in the process triggering a global financial panic in 2008. Bodek wasn’t sure if it was an outright conspiracy or simply an ecosystem that had evolved to protect a single type of organism that had become critical to the survival of the pools themselves.
Whatever it was, he thought, it was wrong.
Tags: Bandits, Blueprint, Chicago Mercantile Exchange, Circles, Colleague, Computer Program, Dark Pool, Dark Pools, Excerpt From, Futures Exchanges, Futures Trading, Global Financial System, High Frequency, Kansas City Board, Kansas City Board Of Trade, Plumber, S Trading, Scott Patterson, Sophistication, Stock Market
Posted in Markets | Comments Off
Monday, July 2nd, 2012
Courtesy of the author, we present to our readers the following excerpt from Dark Pools: High-Speed Traders, AI Bandits, and the Threat to the Global Financial System, by Scott Patterson, author of The Quants.
In early December 2009, Haim Bodek finally solved the riddle of the stock-trading problem that was killing Trading Machines, the high-frequency firm he’d help launch in 2007. The former Goldman Sachs and UBS trader was attending a party in New York City sponsored by a computer-driven trading venue. He’d been complaining for months to the venue about all the bad trades—the runaway prices, the fees—that were bleeding his firm dry. But he’d gotten little help.
At the bar, he cornered a representative of the firm and pushed for answers. The rep asked Bodek what order types he’d been using to buy and sell stocks. Bodek told him Trading Machines used limit orders.
The rep smirked and took a sip of his drink. “You can’t use those,” he told Bodek.
“You have to use other orders. Those limit orders are going to get run over.”
“But that’s what everyone uses,” Bodek said, incredulous. “That’s what Schwab uses.”
“I know. You shouldn’t.”
As the rep started to explain undocumented features about how limit orders were treated inside the venue’s matching engine, Bodek started to scribble an order on a napkin, detailing how it worked. “You’re fucked in that case?” he said, shoving the napkin at the guy.
He scribbled another. “You’re f*-ked in that case?” “Yeah.”
“Are you telling me you’re f*-ked in every case?” “Yeah.”
“Why are you telling me this?”
“We want you to turn us back on again,” the rep replied. “You see, you don’t have a bug.”
Bodek’s jaw dropped. He’d suspected something was going on in- side the market that was killing his trades, that it wasn’t a bug, but it had been only a vague suspicion with little proof.
“I’ll show you how it works.”
The rep told Bodek about the kind of orders he should use— orders that wouldn’t get abused like the plain vanilla limit orders; orders that seemed to Bodek specifically designed to abuse the limit orders by exploiting complex loopholes in the market’s plumbing. The orders Bodek had been using were child’s play, simple declarative sentences sent to exchanges such as “Buy up to $20.” These new order types were compound sentences, with multiple clauses, virtually Faulknerian in their rambling complexity.
The end result, however, was simple: Everyday investors and even sophisticated firms like Trading Machines were buying stocks for a slightly higher price than they should, and selling for a slightly lower price and paying billions in “take” fees along the way.
The special order types that gave Bodek the most trouble—the kind the trading-venue rep told him about—allowed high-frequency traders to post orders that remained hidden at a specific price point at the front of the trading queue when the market was moving, while at the same time pushing other traders back. Even as the market ticked up and down, the order wouldn’t move. It was locked and hidden. It was dark. This got around the problem of reshuffling and rerouting. The sitting-duck limit orders, meanwhile, lost their priority in the queue when the market shifted, even as the special orders maintained their priority.
Why would the high-speed firms wish to do this? Maker-taker fees that generate billions in revenue for the speed Bots every year. By staying at the front of the queue and hidden as the market shifted, the firm could place orders that, time and again, were paid the fee. Other traders had no way of knowing that the orders were there. Over and over again, their orders stepped on the hidden trades, which acted effectively as an invisible trap that made other firms pay the “take” fee.
It was fiendishly complex. The order types were pinned to a specific price, such as $20.05, and were hidden from the rest of the market until the stock hit that price. As the orders shifted around in the queue, the trap was set and the orders pounced. In ways, the venue had created a dark pool inside the lit pool.
“You’re totally screwed unless you do that,” the rep at the bar said. Bodek was astonished—and outraged. He’d been complaining for months about the bad executions he’d been getting, and had been told nothing about the hidden properties of the order types until he’d punished the it by reducing the flow he send to it. He was certain they’d known the answer all along. But they couldn’t tell everyone—because if everyone started using the abusive order types, no one would use limit orders, the food the new order types fed on.
Bodek felt sick to his stomach. “How can you do that?” he said.
The rep laughed. “If we changed things, the high-frequency traders wouldn’t send us their orders,” he said.
* * *
Tags: Bad Trades, Bandits, Dark Pool, Dark Pools, Excerpt From, Global Financial System, Goldman Sachs, High Frequency, Ked, Launch, Quants, Riddle, Runaway Prices, Schwab, Scott Patterson, Sip, Stock Market, Stock Trading, Suspicion, Ubs, Undocumented Features
Posted in Markets | Comments Off
Friday, May 25th, 2012
May 24, 2012
Managing Director of Trading and Derivatives, Schwab Center for Financial Research
- Sometimes understanding the past can help you with your forecasts.
- Pattern repetition can lead to potentially more reliable forecasting.
- Study and learn from history, but we recommend that you don’t base your trading strategies entirely on history.
Does history really tell us anything about today’s market? Trading has certainly changed from the day of brokers trading in the streets to today’s high-frequency traders. Indeed, the trading environment of yesteryear is as foreign to modern-day markets as a horse and buggy are to a Formula 1 race car.
And yet it often seems that the more things change, the more they stay the same. We often find that we rely heavily on past performance (or more specifically, past data) to forecast the future, because history has shown that past patterns often re-emerge, and quite frankly, history is all we have.
As both an active trader and a market analyst, I spend quite a bit of my time looking for market patterns. Then I watch to see if things play out the same way this time. The belief that patterns repeat themselves is essentially the foundation on which technical analysis is based.
While I’m not strictly a technical trader, I think it’s unwise to ignore technical indicators. Because whether or not I believe technical analysis has merit, as long as market participants take action based on technical events, these events are worth watching.
Taking this into consideration, what makes a pattern noteworthy? The answer is repetition—or how many times it has occurred in the past with the same or a similar result.
Golden Cross and Death Cross
In the world of technical analysis, one of the most frequently discussed patterns is the Golden Cross—when a 50-day simple moving average (SMA) crosses up through a 200-day SMA. This is often seen by technical traders as a sign of a continuing bullish market.
The opposite of a Golden Cross is known as a Death Cross—when a 50-day SMA crosses down through a 200-day SMA. As you might imagine, this is most often seen by technical traders as a sign of a continuing bearish market.
But do they work? To find out, I looked at S&P 500® Index (SPX) data from 1950 to the most recent Golden Cross (January 31, 2012) to see what typically happens following these events.
Since 1950, there have been 31 Golden Crosses and 32 Death Crosses. The average return for a long position on the SPX going forward one year from each of these signals was 3.8% for the Death Cross and 10.2% for the Golden Cross. So interestingly, the Death Cross signal wasn’t actually bearish, just less bullish for the one-year period following the events observed.
Looking at more recent history, the results are pretty similar. Since 2003, there have been five Golden Crosses and five Death Crosses. The average return for a long position on the SPX going forward one year from each of these signals was 8.5% for the Death Cross and 9.2% for the Golden Cross. So again, the Death Cross wasn’t actually bearish, just slightly less bullish.
The chart below depicts all of the 50/200 SMA crossover points for the past four years.
- The yellow line is the 50-day SMA and the pink line is the 200-day SMA.
- Notice how the crossovers never signal the start of a bullish or bearish trend, but rather the continuation of a trend.
Crosses in Action
Source: StreetSmart Edge®.
Now, let’s say that since 2003 you had gone long only on the Golden Cross and short only on the Death Cross. Here’s what would have happened:
- For the five bullish signals since 2003, the average return on the SPX going forward from each Golden Cross until each Death Cross was 8.6% (so a long position would have gained 8.6%).
- For the five bearish signals since 2003, the average return on the SPX going forward from each Death Cross until each Golden Cross was 0.0% (so a short position would have essentially broken even).
- The most recent Death Cross was August 12, 2011 and while that is typically seen as a bearish signal, if you look at this period until the Golden Cross of January 31, 2012, the SPX actually gained 12.3%.
- Since the most recent Golden Cross (January 31, 2012), the SPX has gained about 5% (as of this writing), although it has only been a few months.
Technical patterns aren’t the only events that re-emerge in the markets. Cyclical patterns can also occasionally provide insight into what the future holds. While investors should never base trading decisions strictly on cyclical patterns, the statistics associated with them are often interesting to discuss. Here are a few that I’ve found to be particularly noteworthy:
- Thirteen of the last 17 year-end rallies continued into January. Most recently, for example, SPX gained about 0.9% in December 2011 and about 4.3% in January.
- The fourth year of a bull market (e.g., 2012) is typically much stronger than the third (e.g., 2011). According to data compiled by Standard and Poor’s Equity Research, the average third-year bull-market return for the SPX is 3% vs. 13% for the fourth year. The SPX returned 0% in 2011 and was up about 10% this year as of this writing.
- Presidential election years have been positive 12 of the last 15 times. They have an average return of 6.6% (and that includes the 38% decline in 2008). If you exclude the 2008 election, the average return jumps to 9.8% and then election years would be positive 12 of the last 14 elections. The other two losing election years were 2000 (George W. Bush) and 1960 (John F. Kennedy).
The chart below shows the start (green vertical line) and finish (red vertical line) of each presidential election year since 1950.
- The three down years (1960, 2000 and 2008) are identified with a red box.
Stock Market Action in Presidential Election Years
Source: Schwab Center for Financial Research.
Now, let’s take a look at the (sometimes) annual pattern often referred to as, “Sell in May and go away.” Like so many other patterns, this “rule” appears to have historical merit. It seems like the market often begins to wind down around Memorial Day and then does not pick back up until around Labor Day.
I looked at SPX performance from 1950 through 2011 for the 68 trading days preceding the Labor Day holiday (basically June, July, August and the first week of September). Here’s what I found:
- The SPX had an annual gain in 45 of those 62 years.
- But the period from Memorial Day to Labor Day (about 68 trading days) was only positive in 41 of those 62 years.
- During this 62-year period, the SPX increased from 16.66 to 1257.60, which was an average annual return of 7.22%. Note: To find out the annualized return we use the formula below.
- However, the average return for each yearly period between Memorial Day and Labor Day (68 trading days) was only about 1.1%.
So while 68 trading days represents about 27% of the approximately 250 trading days each year, the period between Memorial Day and Labor Day accounted for only about 15% of the total average annual returns. In other words, this tends to be a historically underperforming period of time.
Sometimes statistics can imply patterns that aren’t quite as repetitive as they appear, so below is a list of the 10 most bearish years for the Memorial Day to Labor Day period going back to 1950. While there is definitely a small bias toward negative action in more recent years, it is not as skewed as some might expect.
As shown in the chart below, sell in May and go away was a pretty good strategy for three of the last four years. But in 2009, the year the bear market ended and the SPX rose 23% overall, this strategy would have missed out on about an 8.5% gain during this period of time.
Summer Market Activity During the Last Four Years
Source: StreetSmart Edge®.
An area of the market that has garnered a lot of attention in the past few years is volatility. One of my favorite statistics in the area of volatility relates to the CBOE® S&P 500 Volatility Index (VIX). According to my calculations, the VIX has closed above 40, exactly 167 times since it was created in 1993:
- 95% of the time, when the VIX closed above 40 on a given day, the market was higher exactly 12 months later. The average gain was more than 31%.
- Only 5% of the time, when the VIX closed above 40 on a given day, the market was lower exactly 12 months later. The average loss was less than 10%.
In 2011, the VIX closed above 40 on 11 days between August 8, 2011 and October 4, 2011. The average level of the SPX between August 8, 2011 and October 4, 2011 was about 1,170. So from a strictly historical perspective, there could be about a 95% likelihood that the SPX will be higher than Q3 2011 by Q3 2012, perhaps sharply higher.
Looking at this data a slightly different way, because historical spikes in the VIX were concentrated in just seven specific periods of time, it may make more sense to view the results if you simply went long the SPX1 on the day of the very first spike above 40. If you did, the results would have been as follows:
- From August 31, 1998, the 12-month return was 37%
- From September 17, 2011, the 12-month return was -15%
- From July 22, 2002, the 12-month return was 20%
- From September 19, 2002, the 12-month return was 22%
- From September 29, 2008, the 12-month return was -3%
- From May 7, 2010, the 12-month return was 20%
- From August 8, 2011 to the time of this writing, the return has been approximately 15
The chart below shows the seven periods above. The green lines represent gains over the next 12 months; the red lines represent losses. The pink line represents the inverse of the VIX and the black line shows the SPX. The red line at the bottom illustrates the equivalent level of 40 on the VIX. Since the VIX is mapped inversely, any time the VIX closed above 40, the pink line will be below the red horizontal line on this chart.
Seven VIX Spikes
Source: Schwab Center for Financial Research.
No strategy, statistic, research or historical pattern can consistently predict the future. But experienced traders study history anyway because they know that while, “History doesn’t always repeat itself, it often rhymes.”
For additional information or for assistance with other trading strategies, please contact a Schwab Trading Specialist at 800-435-9050.
Brokerage Products: Not FDIC Insured – No Bank Guarantee – May Lose Value
The Charles Schwab Corporation provides a full range of securities, brokerage, banking, money management and financial advisory services through its operating subsidiaries. Its broker-dealer subsidiary, Charles Schwab & Co., Inc. (member SIPC), offers investment services and products, including Schwab brokerage accounts. Its banking subsidiary, Charles Schwab Bank (member FDIC and an Equal Housing Lender), provides deposit and lending services and products. Access to Electronic Services may be limited or unavailable during periods of peak demand, market volatility, systems upgrade, maintenance, or for other reasons.
This site is designed for U.S. residents. Non-U.S. residents are subject to country-specific restrictions. Learn more about our services for non-U.S. residents.
© 2012 Charles Schwab & Co., Inc, All rights reserved. Unauthorized access is prohibited. Usage will be monitored. (0512-3478)
Tags: Death Cross, Derivatives, Formula 1 Race, Golden Cross, High Frequency, Horse And Buggy, Market Analyst, Market Participants, Market Patterns, Race Car, Repetition, S Market, Schwab, Sma, Taking This Into Consideration, Technical Indicators, Technical Trader, Technical Traders, Trading Strategies, Yesteryear
Posted in Markets | Comments Off
Friday, March 9th, 2012
Paying Heed to Peripheral Cues in Portfolio Construction
by Vineer Bhansali, PIMCO
- The availability of high-frequency information, technological advances in electronic trading and the dominance of government and regulatory policy factors made the world since the crisis of 2008 a risk-on/risk-off environment.
- In January 2012, S&P 500 implied correlations began to fall. It appears that stocks are beginning to take a bit more of their individuality back so that other assets don’t move in lock step.
- Investors may benefit from a focus on policymakers, relative value opportunities, hedging potential left tail events, and diversification.
This article was originally published in Pensions & Investments online, www.pionline.com, on 5 March 2012.
A fascinating fact whether you are a tennis fan or not: The time it takes for a professional player to perceive, process and respond to a serve from another player is longer than the time it takes for the ball to travel the distance from the server to the receiver.
How can a player return a serve when it takes a longer time to process the information than it takes for the event to happen? Put another way: How do you return a serve that you can’t really even see? (My own response time after a long day’s work is close to 250 milliseconds – try your own hand at a site Humanbenchmark.com – so I would miss a pro-level serve every time, guaranteed.)
The answer in large part is about anticipatory cues. Via many years of practice, a pro learns how to “read” the slightest variations in foot placement, ball toss – even head movement – to position and start to react in advance of the actual serve. Paying attention to peripheral indications and patterns of behavior of an opponent is a well-tested way to improve reaction time and get ahead of the actual event.
Can anticipatory cues help investors? We believe the answer is yes if you know how to watch for them and then use the cues to guide portfolio construction.
Some scene setting is in order: Market participants have access to much of the same information, especially in highly efficient and liquid markets. The availability of high-frequency information, technological advances in electronic trading and the dominance of government and regulatory policy factors made the world since the crisis of 2008 a “risk-on/risk-off” environment in which high correlations between asset classes are seen at times of market turmoil. In such a world, the ability to time betas – i.e., exposures to systematic risk factors – can be more important than security selection. But the peripheral information – the “signal in the noise” – is where the cues are.
In Figure 1, we see that the implied correlation of stocks in the S&P 500 rose for most of last year, but beginning in January of this year correlations began to fall. It appears that stocks are beginning to take a bit more of their individuality back so that other assets don’t move in lock step. It is no surprise that this fall in correlations is accompanied by falling volatility across the board, especially for indices such as the S&P 500.
We have seen correlations fall across and within most other asset classes, too, as the world romances a recovery and falling macroeconomic volatility. Investors slowly, tentatively seem to be taking on a little bit of idiosyncratic risk, as illustrated by falling correlations between certain issuers in the credit markets. (Whether or not this is a good thing remains to be seen.)
So if an investor is aware of the peripheral cues of falling correlations across some important asset classes and risk factors, can he or she then position to make important decisions for portfolio construction?
1. Pay attention to the signals sent by policymakers: Like the tennis server, the gentle opponents of the market participant today are central banks, policymakers and regulators. Their cues, such as liquidity provisions, selection of particular entities (nations and banks) as survivors or failures, are important cues on where the ball will go. More critically, changing signals in the language of pre-commitment to low rates for the next few years (latest Fed extension is to 2014) will provide the necessary cue to reposition portfolios for a higher rate environment. If policy risk factors end up receding into the background, low correlations could become more the norm.
2. Continue to focus on relative value: If correlations continue to fall, participants will likely gravitate towards alpha opportunities, i.e. opportunities that are not simply bets on the direction of systemic risk factors. Relative value opportunities across assets and within assets will likely begin to drive investment returns rather than beta. Market timing will become less important than doing your homework on valuation. Active and smart-passive management that uses security selection expertise will likely beat out pure-passive management in an environment full of relative value opportunities.
3. Hedge Tails: Falling correlations can turn on a dime if there is an accident. In a multi-modal world, markets and participants are exposed to accidents without warning. Lower correlations across assets can turn higher and without warning. Given the low levels of volatility and implied correlations, it has become much less expensive to hedge the fat left tails using systemic hedges. One eye on alpha and one eye on cutting the left tails could add up to much better peripheral vision than both eyes on beta.
4. Diversify: When correlations are high, it is hard to find diversifying assets. When correlations fall, the innate differences in securities allows the free-lunch offered by diversification to work its wonders by providing more optimal mixes of assets. This may result in lower risk for the same expected portfolio return, or higher return for the same expected risk. However, to do diversification properly one needs to focus on the underlying risk factors, not simply on the assets.
The importance of paying attention to cues such as the ones discussed here, however crude, may allow one to get ahead of the pack. These cues provide a powerful set of tools for the creation of more robust portfolios designed to handle today’s market uncertainties, while taking advantage of the possible turning tide of investment opportunities.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
The correlation of various indices or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.
The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. The CBOE S&P 500 Implied Correlation Index is the first widely disseminated, market-based estimate of the average correlation of the stocks that comprise the S&P 500 Index (SPX). Using SPX options prices, together with the prices of options on the 50 largest stocks in the S&P 500 Index, the CBOE S&P 500 Implied Correlation Index offers insight into the relative cost of SPX options compared to the price of options on individual stocks that comprise the S&P 500. It is not possible to invest directly in an unmanaged index.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. This material is published by Pensions & Investments, www.pionline.com. Date of original publication 3/5/2012.
Tags: Correlations, Diversification, Electronic Trading, Foot Placement, Heed, High Frequency, Individuality, Paying Attention, Pensions Investments, Peripheral Cues, Policy Factors, Portfolio Construction, Professional Player, Reaction Time, Regulatory Policy, Relative Value, Response Time, Technological Advances, Tennis Fan, Value Opportunities
Posted in Markets | Comments Off
Tuesday, October 18th, 2011
Welcome to the Machine: High-Frequency Trading Domination
- Market volatility has spiked, starting with 2010′s flash crash and culminating in this year’s wild August, bringing asset-class correlations up with it.
- High-frequency trading and the use of leveraged exchange-traded funds (ETFs) are the primary culprits, but the impact isn’t all bad.
- What are regulators doing and saying about the phenomenon?
The Flash Crash of 2010. The wild week in August when Standard & Poor’s downgrade of US debt hit. Triple-digit last-hour moves becoming the norm. Turbocharged high-frequency trading firms are in the crosshairs of investors and the Securities and Exchange Commission (SEC). But are they really to blame? Over the past couple of months, it’s become apparent that this new type of institutional trading is a big concern of individual investors—and it’s a hot topic at client events at which I’ve spoken, so here’s my take:
High-frequency trading (HFT) is a program-trading platform that uses high-speed and ultra-powerful computers to transact a large number of trades at very fast speeds. HFT uses complex algorithms to analyze multiple markets and execute orders based on market conditions.
Trading speeds are measured in milliseconds (thousandths of a second), and even more recently in microseconds (millionths of a second) and nanoseconds (billionths of a second). The twinkle in technologists’ eyes is picoseconds (trillionths of a second) in a “race to zero.” The goal, of course, is to make a (typically) small profit on each trade.
HFT firms are usually trading their own capital and rarely hold positions overnight. Some try to add “alpha” (outperformance relative to a benchmark) by using unique trading strategies, while others are more passive—often just trading the spread between a bid and an offer price.
Dominating trading volume…
According to several sources, including TABB Group, Aite Group and Thomson Reuters, HFT now accounts for between 55-75% of trading volume on average, with some days even higher. You probably remember the second week in August when the market had one of its wildest rides in history. I certainly remember, as I was on a vacation that turned into a non-vacation.
…and elevating volatility
On August 8, the Monday after S&P downgraded US debt, the Dow Jones Industrial Average fell by 635 points. Volume on the New York Stock Exchange was the fourth highest on record. TABB estimates record profits of $60 million that day for HFT firms. The bottom line is that any time trading firms are making millions while the majority of investors are either getting killed or simply watching market action with horror, it’s going to generate attention.
Pros and cons
The proponents for HFT claim that it brings more liquidity to the market while keeping transaction costs low via narrowing bid-ask spreads, and a recent study by the Capital Markets Cooperative Research Centre of Australia supports that view. But there are plenty of studies that refute the aforementioned benign characterization of HFT.
One such study was completed last November by Yale Professor X. Frank Zhang, who found that “HFT is positively correlated with stock price volatility” and that it’s “especially strong for the top 3,000 stocks in market capitalization and stocks with high institutional holdings.” Zhang’s most condemning find is that “the positive correlation between HFT and volatility is also stronger during periods of high market uncertainty.”
You can see the latest increase in volatility in the chart below.
Source: FactSet, as of October 14, 2011.
You can also see the unprecedented increase in asset class correlations, for which there’s a longer history than volatility, in the chart below.
Source: The Leuthold Group, as of September 30, 2011. Average 60-month correlation of monthly changes in S&P 500 with monthly changes in: Morgan Stanley EAFE, Gold, CRB (Commodity Research Bureau) Raw Industrials, 10-Year Treasury, one-Year Treasury-Bill Rate, Broad Foreign Currency Index.
Volatility and correlation are related
In times of high market volatility, stock movements tend to be more correlated and the link has grown increasingly strong since the mid-2000s. That was when regulatory reform encouraged financial exchanges to switch from floor-based trading to electronic trading.
Two things have happened since then that are coincident with the emergence of trading-platform fragmentation and HFT. First, as noted, volatility and correlations have both been higher. Second, the slope of the volatility/correlation curve is steeper, meaning that a rise in volatility today has a more pronounced impact on correlations than in the past.
HFT seems to have reduced bid-ask spreads (and thus transaction costs) in less-volatile times, making markets work more smoothly. But it appears to have done the opposite in more-volatile times, adding to market stress and amplifying volatility.
Diversification is dead …
This increase in correlations is throwing for a loop the notion of diversification in investors’ portfolios as a way to minimize risk in volatile markets. If all asset classes are moving in tandem, the power of diversification is lost. This is the reason for the now-popular characterization of market action over the past several years as “risk-on/risk-off” trading, and HFT has undoubtedly been a factor in this phenomenon.
…long live diversification!
I’m often asked about this relatively new highly correlated market and whether it’s a fixture of the future or a fluke of the unique environment we’ve been in since the financial crisis erupted three years ago. I lean toward the latter view and still believe that investing based on longer-term fundamentals will still be rewarded, and that diversification is not dead.
One of the things that high correlations do bring is the opportunity to find mispricings amid coordinated movements. It’s simply the case that the fundamentals are very different among the riskier asset classes, and within asset classes among individual securities. When everything’s moving in tandem, investors can look for securities, industries, sectors or asset classes whose movements aren’t justified by underlying fundamentals. It may not be a strategy with an immediate reward, but should serve investors well in the longer term.
HFT and ETFs
The other facet of HFT dominance is its use of certain vehicles, notably ETFs. I’m a regular reader of TheStreet.com articles written about or by Doug Kass, founder and president of Seabreeze Partners Management. He opined recently on HFT firms’ use of “leveraged” ETFs in particular, and it caught the attention of my friend Andrew Ross Sorkin, who penned an article on the subject in The New York Times.
Leveraged ETFs give investors the opportunity to bet on a basket of stocks, commodities or an overall index and have become very popular vehicles for traders generally and HFT firms in particular. It’s estimated there’s about $1 trillion invested in leveraged ETFs. Their attractiveness to HFT users comes from the fact that investors can bet long or short and leverage the bet, while also moving in and out during the trading day to lock in gains (or limit losses, which can be substantial). There are also “inverse leveraged” ETFs that go up when the price of the basket of goods goes down and vice versa.
Doug Kass calls these leveraged ETFs the “new weapons of mass destruction” as they’ve “turned the market into a casino on steroids.” Leveraged ETFs have to rebalance their holdings each day to remain properly weighted, and they do so by buying and selling millions of shares within minutes. If a leveraged ETF made money that day, it has to reinvest the proceeds and leverage them again to remain balanced. This helps to explain many of the very wild, very large late-day swings we’ve seen in the market.
The view that HFT firms and their use of leveraged ETFs have wreaked havoc on markets has not gone unchallenged, though. William Trainor, a professor at East Tennessee State University, studied market volatility at the beginning and end of market days and concluded that ETF rebalancing had little to do with it. But Andrew Ross-Sorkin did his own (informal) poll of fund managers and virtually all agreed with the Kass view about both leveraged ETFs and the magnification of their impact from the use by HFT firms.
SEC et al. taking a look
In the meantime, I’m often asked whether there’s any official scrutiny of the practices of HFT firms. In fact, US and European Union (EU) securities regulators are looking into whether ETFs and their use by HFT firms amplified August’s wild swings in the market.
SEC officials are honing in on leveraged and inverse ETFs specifically, part of a broader look by regulators into exotic trading vehicles and HFT. In early September, prompted by August’s market action, the SEC voted to open up a public dialogue about the use of derivatives by mutual funds and ETFs, among other things. The Dow Jones Industrial Average swung by at least 400 points on four consecutive days that month for the first time in its 115-year history. And as previously noted, many HFT firms posted huge profits during that volatile time. Expect to hear much more in the coming months from the SEC.
Across the pond, the EU is considering listing “specific examples of strategies using algorithmic trading and high-frequency trading” that should be banned outright and punished by regulators as market manipulation.
Layering, stuffing and spoofing
The Brussels-based commission is targeting “layering,” in which traders place large orders they have no intention of putting through, and “quote stuffing,” in which investors seek an advantage by delaying data feeds. “Spoofing,” in which market participants try to trick other computers into making decisions that can be exploited for profit, would also be banned.
Steps are already being taken to stem abuses. Regulators in the United States and the EU have recently fined traders for using computers to gain advantage over slower investors/traders by illegally manipulating prices. They’re also weighing new rules for HFT, with an international regulatory body to make recommendations to global leaders over the next few weeks. Even the HFT industry itself is cooperating, believing that although the majority of HFT is legitimate and lowers costs, it’s in favor of policing the market to quell manipulation and support market stability.
The hoped-for benefit of this increased scrutiny and action is confidence among traditional investors in markets and the belief that we can all again play on a relatively level playing field.
Investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.
Some specialized exchange-traded funds can be subject to additional market risks. Investment returns will fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost.
Leveraged ETFs seek to provide a multiple of the investment returns of a given index or benchmark on a daily basis. Inverse ETFs seek to provide the opposite of the investment returns, also daily, of a given index or benchmark, either in whole or by multiples. Due to the effects of compounding, aggressive techniques, and possible correlation errors, leveraged and inverse ETFs may experience greater losses than one would ordinarily expect. Compounding can also cause a widening differential between the performances of an ETF and its underlying index or benchmark, so that returns over periods longer than one day can differ in amount and direction from the target return of the same period. Consequently, these ETFs may experience losses even in situations where the underlying index or benchmark has performed as hoped. Aggressive investment techniques such as futures, forward contracts, swap agreements, derivatives, options, can increase ETF volatility and decrease performance. Investors holding these ETFs should therefore monitor their positions as frequently as daily.
Diversification strategies do not assure a profit and do not protect against losses in declining markets.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Copyright © Charles Schwab and Company, Inc.
Tags: Charles Schwab, Chief Investment Strategist, Commodities, Crosshairs, Culprits, Exchange Traded Funds, Gold, High Frequency, Hot Topic, Individual Investors, Institutional Trading, Liz Ann, Market Volatility, Microseconds, Powerful Computers, Securities And Exchange Commission, Senior Vice President, Thousandths, Trading Platform, Trading Strategies, Unique Trading, Welcome To The Machine
Posted in Commodities, ETFs, Gold, Markets | Comments Off
Wednesday, September 7th, 2011
Video giving you insight on HFT, The Fund Manager Sucker, Quote Stuffing and Co-Location.
Thursday, September 1st, 2011
The crusade against High Frequency Trading which Zero Hedge started well over two years ago, is now coming to an end. Reuters reports that U.S. securities regulators have “taken the unprecedented step of asking high-frequency trading firms to hand over the details of their trading strategies, and in some cases, their secret computer codes.” As everyone knows, the only thing of value within the sub-penny scalping HFT universe are the odd nuances in computer code. Which is why its supreme and undisputed secrecy is sacrosanct. As soon as anyone, especially a regulator, has a whiff of understanding how any given algorithm works, it becomes the equivalent of collapsing the wave function: observing the HFT theft-scalping duality in action eliminates the Schrodinger equation associated with any simplistic algo and collapses its “wave function” to a worthless series of ones and zeros. Said otherwise, this is the end for HFT.
More from Reuters:
The requests for proprietary code and algorithm parameters by the Financial Industry Regulatory Authority (FINRA), a Wall Street brokerage regulator, are part of investigations into suspicious market activity, said Tom Gira, executive vice president of FINRA’s market regulation unit.
“It’s not a fishing expedition or educational exercise. It’s because there’s something that’s troubling us in the marketplace,’‘ he said in an interview.
The Securities and Exchange Commission, meanwhile, has also begun making requests for proprietary algorithmic trading data as part of its authority to examine financial firms for compliance with U.S. regulations, according to agency officials and outside lawyers.
The requests by SEC examiners are not necessarily related to any suspicions of specific wrong-doing, although the decision to ask for it can be triggered by a tip, complaint or referral.
It’s all in the code:
Trading code is a high-stakes secret for high-frequency firms that battle each other to earn razor-thin profits on tiny price imbalances in the market. Such firms can make thousands of trades per second and provide much liquidity to the market.
High-frequency trading is estimated to be involved in more than half of all U.S. stock trading. Regulators have said the algos behind such trading were a factor in the flash crash, but that they did not cause it.
Carlo di Florio, who heads the SEC’s Office of Compliance, Inspections and Examinations, said the agency started asking firms for proprietary algorithmic trading data over a year ago, and has since more broadly incorporated such requests into its risk-based exams.
Most of the algo-related requests, he said, have been made to hedge funds that use quantitative trading strategies.
Although some lawyers and industry sources have said the SEC has asked for the actual computer code itself, di Florio said such a request is “very rare.” Instead, most of the time the SEC has been asking for research papers containing sensitive information about trade reasoning and proprietary formulas.
Luckily once the HFT scourge is over, it will finally return the market to a normal state of liquidity and volume, not the current churn of rebate paying stocks (all 10 of them in a universe of 5000). Yes, some liquidity may be lost. But what remains will set the basis for a return to true efficiency.
After this momentuous victory against the “robots”, the only event that could possibly top it, would be extrication (by force or otherwise) of the Chairsatan and his globalistic central planning cohort from capital markets.
At that point the stage for restoration of normalcy will finally be set.
In the meantime we will take it: one day at a time… until the war is finally won.
Tags: Agency Officials, Algorithm Parameters, Algorithmic Trading, Computer Code, Duality, Educational Exercise, Financial Industry Regulatory Authority, Fishing Expedition, High Frequency, Ones And Zeros, Proprietary Code, Reuters Reports, S Market, Schrodinger Equation, Secret Computer, Securities And Exchange Commission, Trading Strategies, Unprecedented Step, Wave Function, Whiff
Posted in Markets | Comments Off
Monday, August 29th, 2011
What Is the CBO Seeing (or Smoking?)
The End of the World, Part 1
Who Will Rescue the Rescuers?
The Problems of Debt in the Eurozone
Thoughts on Jackson Hole
Some Thoughts on Getting Older
Fine, then. Uh oh, overflow, population, common food, but it’ll do to
Save yourself, serve yourself. World serves its own needs,
listen to your heart bleed – dummy with the rapture and
the revered and the right, right. You vitriolic, patriotic, slam,
fight, bright light, feeling pretty psyched.
It’s the end of the world as we know it.
It’s the end of the world as we know it.
It’s the end of the world as we know it and I feel fine.
R.E.M. song from 1987
It’s not really the end of the world, but to read some of the analysis and data over the past week, it’s hard not to wonder if it’s not the beginning of the Endgame at the very least. There is more to cover than I can really do justice to, but we will just start. We HAVE to look at the US data first (briefly) and then on to Europe, where it will may be the end of the euro experiment, depending on two voting populations. Can you spell “Banking Crisis,” gentle reader? A nod to Bernanke’s finger-pointing speech, some links on the scourge of high-frequency trading, and we end on a positive note about the Boomer generation growing older. And, I answer the question that is burning in your brain: “How many years of US corn production will China’s dollar reserves buy?” Write your answer down now. This letter may print out longer than usual, as there are plenty of charts. Let’s skip the “but firsts” and jump right in.
What Is the CBO Seeing (or Smoking?)
Last week I finally stopped being wishy-washy (with my 50-50% chance of a recession call) and said the US would be in recession within 12 months. And suggested that you consider moving to the sidelines your longer-term equity investments, except your conviction stocks. (I have some of those in the biotech space and simply intend to buy more if the prices go down. But remember, I am looking out ten years and expect an eventual bubble, so I don’t care if I am early for some of my high-risk money.) Stocks typically go down about 40% or more in a recession. David Rosenberg estimates that we have seen 27% of a typical bear-market move, so that would suggest the possibility of another 30% downdraft (give or take).
None of the data this week makes we want to change my opinion on recession. Rich Yamarone (Bloomberg Chief Economist) and I traded emails as we got new data this morning, comparing notes. He does better charts than I do, so we will use his. (I hear, by the way, that he is being addressed as Lord Vader in the halls of Bloomberg. Come to think of it, his voice is rather raspy.)
As he points out, when GDP year-over-year drops by more than 2%, we have always had a recession. So with today’s second-quarter revision (first revision of many) down to just 1% (technically 0.99%, but we are among friends here), where are we? At 1.5% year-over-year. Here is the chart:
The normally bullish staff at economy.com gave us this rather dismal paragraph tonight as a summary to the week:
“The last week of the summer brings a rare Northeast hurricane and a heavy load of data that will show the economy running close to stall speed. Second quarter GDP was revised down to 1%, and the slight improvement in growth we expect for this quarter assumes no new financial shocks. Upcoming indicators for August will bear the mark of steep declines in stock prices. The employment report will be the headliner; nonfarm payrolls are expected to rise just 30,000, and the unemployment rate likely will tick up 0.1 percentage point to 9.3%. We think the ISM manufacturing survey dipped into contraction territory for the first time in two years, and auto sales and consumer confidence likely also fell during the month. There will also be significant interest in the minutes of the August Federal Open Market Committee meeting, especially given Chairman Ben Bernanke’s omission of details regarding policy easing options in his Jackson Hole speech.”
Ugh. More on the Bernank later.
The Michigan Consumer Sentiment number was just awful. It dropped 8 full points (which is huge for this index) to 55.7. The index has fallen nearly 20 points in three months. In the chart below, note the close previous correlation between sentiment and GDP. Which do you think is more likely to happen: sentiment to rise or GDP to fall?
Unemployment claims are back up over 400,000, to 417,000. If the employment gain is really just 30,000, that bodes poorly for any recovery. So, exactly how does that square with the recent Congressional Budget Office (CBO) projections? Quoting:
“CBO expects that the recovery will continue but that real (inflation-adjusted) GDP will stay well below the economy’s potential—a level that corresponds to a high rate of use of labor and capital—for several years. On the basis of economic data available through early July, when the agency initially completed its economic forecast, CBO projects that real GDP will increase by 2.3 percent this year and by 2.7 percent next year. Under current law, federal tax and spending policies will impose substantial restraint on the economy in 2013, so CBO projects that economic growth will slow that year before picking up again, averaging 3.6 percent per year from 2013 through 2016.”
Let me work you through the numbers. We grew at less than a total of 1.4% for the first six months of 2011. To get to 2.3% as an average for the year, we would need to grow by (back of the napkin) 3.2% for the last half of the year. We could reduce the deficit by a lot if we could sell what these guys are smoking to engender such optimism. I think demand would be strong, especially on Wall Street. (Note: these are the same people that told us in 2000 that all government debt would be gone by 2010. Just saying.)
Their projections are likely based on assumptions about recoveries from past recessions. But since 1945, all recessions have been business-cycle recessions. We are now in a deleveraging/balance-sheet/post-credit-crisis recession for which we have no modern analogs, except maybe Japan. And that hasn’t turned out too well, as in, two decades of going nowhere. Yet we are applying the same methodology (massive debt and deficits along with zero interest rates) that did not work there, and will soon bring Japan to ruin.
We have a fundamentally different economic scenario than at any time for the last 66 years. Why then should we expect the same outcome? EVERY indicator (employment, GDP, ISM, sentiment, etc.) is far below its average result two years after the official end of a recession. That should speak volumes.
So why does what the CBO says mean anything? Because Congress is making projections for future deficits, based on what appear to be wildly optimistic assumptions. That means future deficits are likely to be worse than expected. If we enter recession, as I expect, then revenues will be down (as unemployment will be up and profits down) and expenses will go up. That de minimis deficit reduction currently being negotiated by the “Gang of 12” will disappear in a cloud of smoke and maze of mirrors. This will mean that more pain in the terms of future spending cuts and/or tax increases will be needed. (I know a fair number of congressional staffers read this letter. Please pay attention here – your bosses need to be given a“heads up.”)
If we are in for a slow-growth, Muddle Through decade, then the deficit projections by CBO are dismally off. Get the spreadsheets. Factor in slower growth and higher unemployment and two recessions by the end of the decade (typical for the aftermath of a banking/debt crisis), and see what those deficit projections look like.
Given the large amount of data coming next week, as the month ends, I will stop here and get back to the US next week.
The End of the World, Part 1
In trying to decipher Europe it is hard to know where to start, but let’s begin with some assumptions:
For the euro to survive, one of two things must happen. Either the Germans (and the Dutch and Finns and French) decide to back the concept of some sort of eurobond financing of the balance sheets of the peripheral countries, OR there need to be massive write-downs of insolvent-country debt and the various countries need to backstop their banks, because bank losses will be massive.
The former needs buy-in from German voters. Polls show Germans are against the idea of eurobonds by something like 5-1 (75% against, 15% for). (More on Germany below.) The latter option assumes the peripheral countries will lose access to the private bond markets, thus forcing sudden and enormous austerity (read Depression levels or worse). Will they simply throw in the towel and leave the euro on their own, remaining in the free-trade zone but with their own currencies, much as Denmark, the Czech Republic, or Sweden are now? Or opt to suffer and remain in the euro?
Germany could decide not to back the peripheral country debt, and leave the Eurozone. But this would be painful for Germans. If you think the Swiss franc trade is crowded (and way overvalued) because people are looking for a safe haven, what would a new Deutschmark look like to investors? Switzerland is a country (and one of my favorite in the world, so no slight intended – I will be in Geneva for my birthday in October) of just over 7 million people, only somewhat larger than the population of the greater Dallas-Fort Worth, Texas area where I live (although with much better weather!).
Germany, on the other hand, is the world’s 4th largest country by GDP, with a population of over 82 million. It is well-run and respected. The new mark would climb to far higher levels against the remaining euro countries and other currencies, which for an export-driven nation would not be very helpful. Mercedes and BMWs cost a lot now (and don’t forget tool parts and other things Germany excels in making). Double the value of your currency in a short time? Watch your market share drop. Painful is perhaps an inadequate word.
So, what to make of the remarks this week by respected German leaders? Let’s fire up a few quotes here (http://www.telegraph.co.uk/finance/financialcrisis/8720792/Germany-fires-cannon-shot-across-Europes-bows.html):
“German President Christian Wulff has accused the European Central Bank of violating its treaty mandate with the mass purchase of southern European bonds. In a cannon shot across Europe’s bows, he warned that Germany is reaching bailout exhaustion and cannot allow its own democracy to be undermined by EU mayhem.
“ ‘I regard the huge buy-up of bonds of individual states by the ECB as legally and politically questionable. Article 123 of the Treaty on the EU’s workings prohibits the ECB from directly purchasing debt instruments, in order to safeguard the central bank’s independence,’ he said. ‘This prohibition only makes sense if those responsible do not get around it by making substantial purchases on the secondary market,’he said, speaking at a forum of half the world’s Nobel economists on Lake Constance to review the errors of the profession over recent years.
“Mr Wulff said the ECB had gone ‘way beyond the bounds of their mandate’ by purchasing €110bn (£96.6bn) of bonds, echoing widespread concerns in Germany that ECB intervention in the Italian and Spanish bond markets this month mark a dangerous escalation.’” (London Telegraph)
Who Will Rescue the Rescuers?
From the same article: “The blistering attack follows equally harsh words by the Bundesbank in its monthly report. The bank slammed the ECB’s bond purchases and also warned that the EU’s broader bail-out machinery violates EU treaties and lacks ‘democratic legitimacy’. The combined attacks come just two weeks before the German constitutional court rules on the legality of the various bailout policies. The verdict is expected on September 7.”
Yet“Nobel laureate Joe Stiglitz told the forum that the euro is likely to fall apart unless Germany accepts some form of fiscal union. ‘More austerity for Greece and Spain is not the answer. Medieval blood-letting will kill the patient, and democracies won’t put up with this kind of medicine.’ ”
His solution? Germany will either have massive banking losses (see below) or assume some debt. Why give up the dream of a united Europe over a few trillion and your credit rating? Yet (Ambrose Evans-Pritchard writing in the Telegraph):
“Marc Ostwald from Monument Securities said Germany is drifting towards a major constitutional crisis. ‘This has all the makings of the revolt that unseated Helmut Schmidt [in 1982], and indeed has political echoes of the inefficacy of the Weimar regime,’ he said.
“Mr. Wulff said Germany’s public debt has reached 83pc of GDP and asked who will ‘rescue the rescuers?’ as the dominoes keep falling. ‘We Germans mustn’t allow an inflated sense of the strength of the rescuers to take hold,’ he said.
“ ‘Solidarity is the core of the European Idea, but it is a misunderstanding to measure solidarity in terms of willingness to act as guarantor or to incur shared debts. With whom would you be willing to take out a joint loan, or stand as guarantor? For your own children? Hopefully yes. For more distant relations it gets a bit more difficult,’ he said.”
The final option is for the peripheral nations to eschew austerity and leave the Eurozone, launching their own currencies again. This would mean long and painful bank holidays and massive losses for European banks and local citizens, depending on how many countries left. And the lawsuits would last for decades – nothing short of a full-employment act for lawyers all over the world.
And Merkel was not helped by her own Labor Minister, Dr. Ursula von der Leyen. Rather than simply hand over further loans to Athens – money many Germans believe they will never see again– Dr. von der Leyen suggests Berlin should ask for collateral. Gold, preferably. From the Irish Times:
“One month after euro zone leaders agreed a bailout reform package, and a month before the package goes to vote before national parliaments, a senior German minister appeared to be calling for a renegotiation.
“On an aircraft back from Belgrade, a thin-lipped chancellor Angela Merkel reportedly told advisers: ‘I’m going to have to have a word with Ursula.’
“Even before she landed, German officials were in full damage limitation mode, working the phones and issuing statements denying the minister spoke for the government. ‘This is sub-optimal,’groaned a senior government source. ‘No one is amused.’ ”
Some back-bench minister? Hardly. Dr. von der Leyen, a 52-year-old mother of seven, is one of Dr. Merkel’s most ambitious ministers and one of two names regularly mentioned as a possible successor.
But she only reflected a rather contentious Bundestag meeting this week, in which one after another representative voiced opposition, invariably noting that the voters disapproved.
Of course, none of this is helped by Finland negotiating a side collateral deal as part of their conditions for approving their portion of the next loan to Greece. And a chorus of countries have jumped on that wagon. How do you explain to YOUR voters that the Finns got actual in-the-bank collateral and you got nothing but Greek promises? But if everyone gets collateral, the whole deal will fall apart. What’s the point if you give back a large chunk of your loan? It just means you need even more!
The Problems of Debt in the Eurozone
Let’s look at some charts. This first one is the amount of principal debt in terms of GDP from July 2011 to July 2012 (plus budget deficits, in red) needed by ten European countries. Note that France and Italy are well over 20%! Source: Peterson Institute of International Economics (hat tip, Simon Hunt!)
“From the same report this chart illustrates how Germany could become the banker for the Euro Zone. The question is will it? The question will be more clearly defined in September when Germany’s Constitutional Court will rule on the legal complaints against the Euro Zone rescue packages. If the comments being made by the Bundesbank and by the country’s President are a hint as to the outcome of the court then a negative ruling is a real risk. Who then will take the losses?” (Simon Hunt)
Note in the chart that Germany holds the largest percentage of net debt.
Claims of Euro Area members from netting of Euro System cross-border payments (in billions of Euros):
And then there are the interest-rate issues. Rates were rising rapidly in Spain and Italy until the ECB stepped in. Everyone knows Greece, Ireland, and Portugal are on life support and cannot get debt on their own. The ECB inserted an IV into Spain and Italy and started them on a slow drip. The real question of the moment is, can they get off that support and stand in the markets on their own? The answer a few weeks ago was starting to look like “No.”
And look at the massive growth in ECB lending to Italian banks, which are getting shut out of the “normal” market. It has literally more than doubled in a few months:
Credit spreads at French banks are blowing out. Review how much France has to borrow in the next 12 months, in the first chart. Then look at their deficit-to-GDP (above 10%, according to Charles Gave) and realize that there is no reason why S&P should not downgrade them as well. How do they cut spending? Taxes are already at 50% of GDP. Wealthy French have voted with their feet by moving away.
The list of country woes is long in Europe. Massive unemployment in Spain and Portugal. Deficits everywhere. Voting populations in both creditor and debtor nations are upset.
It is only a matter of time until Europe has a true crisis, which will happen faster – BANG! –than any of us can now imagine. Think Lehman on steroids. The US gave Europe our subprime woes. Europe gets to repay the favor with an even more severe banking crisis that, given that the US is at best at stall speed, will tip us into a long and serious recession. Stay tuned.
Thoughts on Jackson Hole
Jackson Hole often provides fireworks and significant speeches. Bernanke came up with neither this week, which I think is a good thing. But he did forcefully point out that the Fed has done about all it can do and that the forces of civil government need to step up to the plate with credible actions. It was as close to finger pointing as a Fed Chairman can do, and parts of the speech actually sounded as if he was trying to channel his inner Richard Fisher (Dallas Fed President). Basically, he said the Fed has done what it can with as easy a monetary policy as is possible and prudent. Quoting from Joan McCullough’s remarks on the speech:
“Yeah, the Fed underestimated the severity of our ills and so this recovery is gonna take longer than expected. But underneath it all, the US still has the capability of generating growth. Here are the precise words with which he threw responsibility back at Congress and the Administration; he starts out kind of slow:
“ ‘… Notwithstanding the severe difficulties we currently face, I do not expect the long-run growth potential of the U.S. economy to be materially affected by the crisis and the recession if – and I stress if – our country takes the necessary steps to secure that outcome.’
“Just in case they didn’t understand that they had just been handed the baton, he continued with this:
“ ‘… most of the economic policies that support robust economic growth in the long run are outside the province of the central bank.”
“With this closing castigation cum zing:
“ ‘… Finally, and perhaps most challenging, the country would be well served by a better process for making fiscal decisions. The negotiations that took place over the summer disrupted financial markets and probably the economy as well, and similar events in the future could, over time, seriously jeopardize the willingness of investors around the world to hold U.S. financial assets or to make direct investments in job-creating U.S. businesses.’ ”
As I said, for a Federal Reserve Chairman, that is as close to reading the riot act as you are going to get.
Some Thoughts on Getting Older
I turn 62 on October 4 while in Geneva. I don’t feel that old, and hope I don’t look it, but the birth certificate verifies the age. I should note that my mother turned 94 last week and is still quite active. I was talking with a Rice University classmate (of ’72) and old friend, John Benzon, who has recently retired from Price Waterhouse and is trying to figure out what “Act 2” will be. I realized that when we graduated, we had barely lived 1/3 of the lives we now have.
So with that on my mind, two items hit my inbox today. The first was from Lance Roberts of Streettalk Advisors. The San Francisco Fed did a report recently that suggested that we aging Boomers will be a drag on the stock market as we sell to support our retirement (shades of Harry Dent!). From the report:
“The baby boom generation born between 1946 and 1964 has had a large impact on the U.S. economy and will continue to do so as baby boomers gradually phase from work into retirement over the next two decades. To finance retirement, they are likely to sell off acquired assets, especially risky equities. A looming concern is that this massive sell-off might depress equity values.”
You can read his short piece and the link to the Fed piece at http://www.streettalklive.com/financial-blog/253-boomers-are-going-to-be-a-real-drag.html.
I am not so sure, though. I think the Boomer generation is a little different from previous generations. I remember going to my grandmother’s in my early years, when my aunts and uncles were the age I am now. Even though active – and most lived well into their 90s – they had a far more sedentary lifestyle than many Boomers do today. Boomers are more active and, whether for financial reasons or simply because they don’t want to retire (that would be me!), they are going to work longer than previous generations. In fact, the only cohort that has seen their employment rates rise is workers over the age of 55! Good for them (although tough on my young kids, who need those jobs).
Then I got this picture from Jon Sundt, the president of Altegris, a close friend, and my business partner. He is 50, at the tail end of the Boomer Generation. This is a wave he caught at the Mentawai Island Chain, 80 miles off the coast of Sumatra, Indonesia. He goes there every summer. They go into the middle of the Indian Ocean to find these large waves. And it is mostly Boomer surfers. (I’m not sure how much I like the guy who’s responsible for a large part of my monthly cash flow taking these risks, but that’s another story!)
Go to a gym or running trail: it is not just kids out there any more. There are lots of people my age where I work out. Some of the trainers are over 50! We all have friends who are pushing the envelope – climbing mountains, biking, etc.
And the new biotech that will come out within the next five years is going to offer cures for many of the things that kill us sooner than we simply wear out. Cancer, Alzheimer’s, sclerosis of the liver, viruses are all on the short target list. I was talking about this with Scott Burns, noted author and long-time newspaper columnist (and a long-time friend). He calls it “catastrophic success”in his next book, as living longer is a “success,” but it makes our collective pension, Social Security, and Medicare problems even worse. Maybe MUCH worse. I smiled and told him there are worse problems than living longer. I intend to be writing and traveling for a few more decades.
And as my Dad used to say (he made it to 86), “God willing and the creek don’t rise” I intend to do 62 pushups on October 4th, which will be a personal best. I can’t do much about getting older (I will be very disappointed if I do not get a whole lot older!), but I don’t have to go quietly into that dark night. And neither do you, gentle reader. So, make sure you are around to read my musings a whole lot longer, as well. If you hang around long enough, you will even see me turn bullish! It won’t be that long, I promise. It will seem like just a few weeks from now.
And while I was having lunch with Scott, he asked me the question, “How many years of US corn production would the dollar reserves of China buy?” I mused, maybe 40. Wrong. It is only 12. And that is just corn. Not soybeans, wheat or rice or cattle, hogs or chickens. Think about that and stand back in awe at the productivity of the American farmer.
It is time to hit the send button. I stupidly forgot to save this letter and had an unexpected “hard” crash. I thought I lost almost the entire e-letter; but checking the Web, I found a back door to the temporary files where most of it was still store, so only lost a few hours re-creating it – but now it is late, 2 am). That means this letter might not be there Saturday morning, and for that I apologize. Have a great week!
Your looking forward to the next third of this life analyst,
Tags: Banking Crisis, Bonds, Cbo, Corn Production, Endgame, Equity Investments, Firsts, Gentle Reader, Gold, High Frequency, India, Jackson Hole, Jump Right, M Song, Mauldin, Pric, Rapture, Recession, Rescuers, S Finger, Scourge, Sidelines, Term Equity
Posted in Bonds, Brazil, Gold, India, Markets | Comments Off
Friday, August 26th, 2011
Following credit market charts can be a much better source of insight into the health of the overall markets and economy than equity markets, unless of course you’re a high frequency trader. Equity markets have failed to indicate the most current and previous recessions; in fact, if anything, equity markets have been in a state of denial. Credit markets have, on the other hand, a much better track record, and have been signalling economic softness for many months.
Even while the equity market celebrated the Fed’s stimulus via QE, the credit market has and remains soberly focused on reality, remaining as one facet of a supposedly free market system that cannot be manipulated so easily.
When the economy weakens interest rates fall resulting in less demand to switch to a fixed rate, thus falling swap rates.
Rates already at multi year lows have really rolled over recently as the economic data has deteriorated at an accelerated pace.
With rates so low it speaks volumes to the structural problems within the US economy as monetary policy has done nothing to fuel growth.
Rates for both financial and non financial are at multi year lows and have been trending lower since June of 2010 another sign of a weakening economy as the need for commercial paper falls.
Tags: Credit Markets, Economic Data, Economy, Facet, Fixed Rate, Health, High Frequency, Insight, interest rates, Lows, Market Charts, Monetary Policy, Pace, Qe, Recessions, Slowdown, Softness, State Of Denial, Stimulus, Swap Rates
Posted in Markets | Comments Off
Monday, July 11th, 2011
Don’t Miss Your Chance to Catch a Bull Market
By Frank Holmes and John Derrick, U.S. Global Investors
Many people missed the market’s enormous appreciation during the latest equity bull market because they were late to the game or chose to sit on the sidelines. The sideline is a crowded place these days as investors have been reluctant to fully embrace equities.
Household savings for the past 12 months totaled $711 billion, the highest level ever recorded in dollar terms. You can see from the chart that’s roughly double the amount of savings recorded following the Tech Bubble. In fact, household debt-to-savings ratios are currently at levels so low, they’ve not been seen since the mid-1990s.
If you’re one of the people on the sidelines who has been debating whether to get your feet wet in today’s market—now could be your chance.
After peaking in late April, the S&P 500 Index declined for nearly seven-straight weeks before bouncing sharply last week. J.P. Morgan research says the seven-consecutive-week losing streak was an extremely rare occurrence during bull markets, only occurring once before in March 1980. That year, the market rallied 15 percent over the next three months.
Historically, summer’s arrival has been good for the market. J.P. Morgan analysts researched the S&P 500’s performance during the June-August period over the last 111 years. They discovered that markets have risen 3 percent on average during this period, with pretty high frequency of up years (roughly 60 percent). During bull markets, which we believe we’re currently in, the S&P 500 averaged 5 percent with up years 77 percent of the time.
However, recently there have been some notable divergences from historical norms. The S&P 500 rose 11 percent from June through August in 2009, but lost 4 percent in 2010 over the same time period.
One reason we think the market will rise during the second half of 2011 is that sentiment has grown pervasively negative in recent weeks. The American Association of Individual Investors (AAII) survey of investor sentiment, a popular contrarian indicator, showed 77 percent of individuals were bearish in June, one of the lowest readings since the beginning of this bull market in March 2009, according to J.P. Morgan.
Citigroup research also showed the pendulum has swung too far toward negativity. Their Panic/Euphoria Model, a proprietary combination of nine facets of investor beliefs and fund manager actions, gauges the mood toward the market. Overly bullish territory (Euphoria) generally signals a market correction is on its way, while a recovery arrives when sentiment is overly pessimistic (Panic).
Market sentiment fell into a “panic” at the end of June, which is a good sign for investors. Citigroup says there’s roughly a 90 percent chance markets could move higher over the next six months—and a 97 percent chance over the next year—according to historical data. On average, the market bounces 8.9 percent the following six months and 17.3 percent the following year.
Tags: Bull Markets, Dollar Terms, Frank Holmes, High Frequency, Household Debt, Household Savings, J P Morgan, John Derrick, Losing Streak, Mid 1990s, Morgan Research, Norms, Rare Occurrence, Ratios, S Market, Same Time Period, Sideline, Sidelines, Straight Weeks, U S Global Investors
Posted in Markets | Comments Off