Posts Tagged ‘Negative Impact’

The Dark (Pool) Truth About What Really Goes On In The Stock Market: Part 3

Friday, July 6th, 2012

Courtesy of the author, here is the last excerpt from the excellent Dark Pools: High-Speed Traders, AI Bandits, and the Threat to the Global Financial System, by Scott Patterson, author of The Quants. To read the previous excerpts, see here and here.

Haim Bodek rushed out the front door of his home, jumped in his all-black Mini Cooper, and sped to the train station in downtown Stamford, thrash metal pounding from the car’s speakers.

It was the morning of March 25, 2011, his last day on the payroll of Trading Machines. Bodek was scheduled to give a speech later that afternoon at Princeton University, at a conference called “Quant Trading: From the Flash Crash to Financial Reform.”

He was running late. He hadn’t written his speech yet, so he banged it out on his laptop on the train to Princeton.

It was hard. He wasn’t sure what to say. He’d grown so cynical about the market that he’d become convinced that massive reform was required. But he didn’t know if he should be the one to spearhead changing the rules of the game. He worried about his career, whether the new elite at the high-speed firms and exchanges who’d built the market’s digital plumbing in the past decade would attack him and make it hard if not impossible for him to build another trading operation. He had a wife and three young children to support, and he was out of a job. The role of market-reform gadfly wasn’t high on his list of priorities. But his creeping belief that the market had been hijacked kept bugging him, like a bee buzzing in his face. And it wouldn’t go away.

In his talk, Bodek went halfway in calling for major changes. He spoke about the structural issues facing the options market, the evolution of algorithmic trading, and the negative impact stock market structure changes were having on the options industry. There was no mention of toxic order types or 0+ scalping strategies. He wasn’t ready to take on the whole system—yet.

Bodek knew his complaints sounded like excuses for failure. Critics would say he couldn’t take the heat. But he was convinced there was more to it. Exchanges and high-frequency firms had been working hand in glove to design a system that gave an advantage to the speedsters. The speed traders had been working closely with the electronic pools for more than a decade, from Island to BRUT to Archipelago. They’d pushed for more speed, for more information, for new exotic order types. And the pools complied willingly.

It all added up.

In Bodek’s eyes, there was nothing implicitly wrong with what had happened—at least at first. The relationship between high-speed firms and exchanges was in ways beneficial for all investors, he thought. The Bots pushed for better execution. That made the markets better for everyone.

But a problem developed. High-frequency trading became so competitive that on a truly level playing field no one could make money operating at high volumes. Starting in 2008, there had been a frantic rush into the high-frequency gold mine at a time when nearly every other investment strategy on Wall Street was imploding. That competition was making it very hard for the firms to make a profit without using methods that Bodek viewed as seedy at best.

And so a complex system evolved to pick winners and losers. It was done through speed and exotic order types. If you didn’t know which orders to use, and when to use them, you lost nearly every time.

To Bodek, it was fundamentally unfair—it was rigged. There were too many conflicts of interest, too many shared benefits between exchanges and the traders they catered to. Only the biggest, most sophisticated, connected firms in the world could win this race.

One apparent consequence of this hypercompetitive market was its fragility. Because high-speed traders were now competing for wafer-thin profits, they’d grown incredibly pain-averse. The slightest loss was unacceptable. Better to cut and run and trade another day. The result, of course, was the Flash Crash. It was an algorithmic tragedy of the commons, in which all players, acting in their self-interest, had spawned a systemically dangerous market that could threaten the global economy.

Bodek knew he’d made mistakes. He’d wasted months trying to hunt for a bug in the code of the Machine, when the problem was actually abusive order types.

Then he’d started using the order types himself to protect his firm from the abuses. But it felt dirty. He’d become one of the bad guys. One of the tipped-off insiders. Kill or be killed. He didn’t like it, but it had become a matter of survival.

It was not how the market should work. Investors should be re- warded for their intelligence, for being able to make accurate pre- dictions and take risk—not for knowing the location of secret holes inside the plumbing (or, worse, creating the holes).

That was Bodek’s biggest complaint: The Plumbers had won.

Finally, Bodek became determined to reveal what he believed was a corrupt insiders’ game that came at the expense of everyday investors. Was it outright collusion? He didn’t have enough hard information to know for certain. But he believed the exchanges were locked in cutthroat competition, not only with one another but with the dark pools and the internalizers like Citadel and Knight. It was a dynamic that went all the way back to the late 1990s when Island, Archipelago, Instinet, and other electronic networks were engaged in a kill-or-be-killed Darwinian struggle. That struggle led to massive innovation and changes and, to be sure, benefits for nearly all investors.

But something else had changed along the way. The competition had become toxic. The exchanges’ backs were against the wall, and they’d made a deal with the devil at the expense of regular investors.

And so in the summer of 2011, he decided to explain it all to federal regulators. He hired a major law firm to help him use his understanding of toxic order types he’d gained from his exchange contacts while at Trading Machines, combined with the details of his understanding of high-frequency strategies he’d learned from the 0+ Scalping Strategy document, to lay out a road map. The road map detailed his argument that high-speed traders and exchanges had created an unfair market that was hurting nearly all investors.

Were the regulators listening?

Tags: Bandits, Dark Pool, Dark Pools, Digital Plumbing, Excerpt From, Gadfly, Global Financial System, March 25, Market Structure, Mini Cooper, Negative Impact, Options Market, Princeton University, Quant Trading, Quants, Rules Of The Game, Scott Patterson, Stock Market, Structure Changes, Train Station
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Hatzius On The Three Reasons The Recovery Is Overstated

Tuesday, March 20th, 2012

Economic Surprise Indices have been rolling over for a month or two now. The trend of US macro data has also disappointed in a period when it would be expected (empirically) to accelerate. However, taken anecdotally or cherry-picked managers can find plenty of ammunition to support the to-infinity-and-beyond Birinyi forecast (though often it relies on the most manipulated and adjusted government provided time-series). Overnight’s concerns on China show just how quickly confidence can be upset but Goldman’s Jan Hatzius sees three main factors for why their GDP-tracking estimate is weakening already (more like 2% than 3-3.5% growth) and that we are seeing slightly softer data already. The end of the inventory cycle, the pulling forward of demand thanks to the warm weather aberration, and the already clear impact on consumption from higher gasoline prices will likely shift from an overstated economic trajectory to more muddle-through or worse for Q2 onwards.

Goldman Sachs: Sticking With Sluggish

The US economic data over the past few months have clearly outperformed expectations. Our current activity indicator (CAI) is running at 3.5% in February given the data in hand so far, and is tracking 2.9% for the first quarter as a whole. However, we expect the numbers over next 2-3 months to slow to a pace that looks more consistent with a 2% overall activity growth pace rather than 3% or even 3.5%.

1. Warm weather has pulled forward activity.

Some of the recent strength in the CAI is likely to reflect the exceptionally mild 2011-2012 winter. To be sure, there are some areas where mild weather has a negative impact on economic activity, such as utilities output and perhaps some retailers that sell seasonal goods. But this is likely to be offset by areas where the impact is positive, as construction and other outdoor activities decline by less in not seasonally adjusted terms than the seasonal factors “expect” and this gets translated into a large seasonally adjusted increase. Overall, we found that the weather has contributed an estimated 0.3 percentage points to the 2.9% annualized growth rate of the CAI in the first quarter so far (see Zach Pandl, “Growth Impact of a Mild Winter,” US Daily, March 1, 2012). The impact on a more comprehensive measure of activity that includes both the CAI and GDP would be a bit smaller, perhaps 0.2 points, as GDP is probably less weather-sensitive.

2. The inventory cycle has helped.

The pickup in inventory accumulation from -$2 billion (annualized) in the third quarter to +$54 billion in the fourth quarter contributed 1.9 percentage points to the Q4 growth rate. Moreover, inventory accumulation seems to have picked up a bit further in the early part of the first quarter, judging from the Commerce Department’s book-value inventory numbers for January as well as the ISM manufacturing survey for January/February. This suggests that inventories may still be making a positive growth contribution for the time being. But while we are not close to a situation where inventories start to look “heavy,” a further positive impact in coming quarters is not likely.

3. Gas prices are starting to cut into real income.

Gasoline prices rose sharply in January and February. Using weekly data from the US Department of Energy, they are now up 9.1% from their end-2011 level on a seasonally adjusted basis, with most of the increase likely to show up in February and March on a month-average basis. According to our models of the link between gasoline prices and growth, such a hit might take 0.3-0.4 percentage points off real GDP growth over the subsequent year. Moreover, using monthly data on the link between gasoline prices and consumption, we find that the impact becomes visible about 1 month after the initial hit, so this would imply that the impact would show up in March and April.

There may be some early signs of deceleration in the data.

The data surprises have indeed turned a bit less positive in recent weeks, although it is too early to say definitively whether this is noise or a more lasting shift. In March so far, our US-MAP scoring system for the economic data relative to consensus expectations has averaged a slightly negative reading, despite the better-than-expected February employment report. Of course, some of this just reflects the fact that consensus expectations have caught up with the better data. However, there are also some faint signs in the more forward-looking indicators that the tone of the data may be shifting down a notch. In particular, the new orders indexes of the February ISM, March NY Empire State, and March Philly Fed survey all fell moderately.

Our bottom line is that there are several reasons to believe that the recent data may have overstated the strength of the US economic data. For the first quarter as a whole, our current best guess is that a broad measure of activity growth that puts most of the weight on the CAI but also some weight on the GDP bean count is currently running at a 2.6% pace; we believe that this might overstate true growth by perhaps 0.2 percentage points because of weather, so that the second quarter is likely to understate growth by 0.2 percentage points (for a “swing” of 0.4 percentage points); the end of the inventory cycle might take a couple of tenths off growth; the impact of the gas price increase might take another few tenths off growth; and we may be seeing some signs of softer growth in the most recent data already. All told, we believe that the numbers are likely to slow to a pace that looks much more consistent with a 2% rather than a 3% or even 3.5% growth pace through the end of the second quarter.

Tags: Aberration, Ammunition, Anecdotally, Birinyi, Economic Activity, Economic Data, Gasoline Prices, Goldman Sachs, Growth Pace, Inventory Cycle, Macro Data, Mild Weather, Muddle, Negative Impact, Q2, Seasonal Factors, Seasonal Goods, Time Series, Trajectory, Warm Weather
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Investors Await Additional Clarity Around Europe (Doll)

Tuesday, October 18th, 2011

Investors Await Additional Clarity Around Europe

by Bob Doll, Chief Equity Strategist, Fundamental Equities, Blackrock

October 17, 2011

Last Week: Stocks Jump on Receding Fears

For the second consecutive week, stock prices moved sharply higher as investors welcomed the news of progress in addressing the European debt crisis and also took some solace in improved US economic data. For the week, the Dow Jones Industrial Average climbed 4.9% to 11,644, the S&P 500 Index advanced 6.0% to 1,224 and the Nasdaq Composite jumped 7.6% to 2,668. Other risk assets, including commodities, also experienced gains last week, while safe-haven assets such as US Treasuries struggled.

Europe: Progress Being Made, but Uncertainty Persists

As last week’s market gains attest, the direction of the financial markets remains highly dependent on the degree to which politicians and policymakers can create a solution to the European debt crisis. Currently, markets are putting a great deal of faith in the possibility that such a solution will come to pass even though the efforts have fallen short before.

At present, policymakers are attempting to engineer a “ring fence” around banks and troubled sovereign nations in an attempt to limit the contagion from a potential restructuring of Greek debt. Any such plan that is created will be subject to the competing interests of a number of parties and as a result, plans and policies will likely not be as bold as many investors would like. In any case, however, the policies that are put into place should help reduce the risks associated with the crisis.

It is impossible to accurately determine whether the worst of the crisis has passed or whether we have only begun to see the negative impact of the region’s debt problems. It does seem, however, that the crisis may have passed an important turning point since policymakers appear more aware of the need for a broad-based bank recapitalization than they were several weeks ago. Details will remain elusive as the policies are being created, but we should see some additional clarity in the coming weeks. We are hopeful that the funding measures and improved liquidity will help stabilize the European debt crisis.

US: Improvements Becoming More Solid

Within the United States, we have been seeing some modest but real improvements in the economic data. On the heels of a better-than-expected September labor market report, initial jobless claims fell slightly last week, reflecting some additional (albeit small) improvement in the employment picture. Retail sales figures, which were quite anemic for much of the summer, also showed some better results in the most recent readings. On balance, it appears that the economy has been less weak than feared and considerably better than surveys and sentiment have indicated.

One wildcard affecting the economy is the political backdrop. We have been suggesting for some time that the economy would benefit from some more supportive fiscal policies, but action on that front has remained elusive. The jobs program that President Obama has been proposing has not seen much progress, but at a minimum, we do think that some sort of extension of current unemployment benefits is likely. The broader issues of the large federal budget deficit and longer-term changes to taxation and spending policies remain a drag on sentiment, and we are not expecting to see significant clarity on this front any time soon.

On the earnings front, it appears that corporate America is headed for yet another strong quarter. It is possible, in fact, that the third quarter could be the best on record in terms of earnings per share. In addition to closely watching reported earnings and profits, investors are heavily focused on the commentary and forward guidance that is part of the earnings releases. We are not expecting corporate managements to be overly optimistic about the future, but we are looking for signs that they believe the worst of the economic slowdown has passed.

Markets: The Trading Range Persists, For Now

Equity market sentiment swings have been ferocious over the last several weeks. Two weeks ago, it looked like stocks were poised to significantly break below the bottom of their current trading range (between 1,100 and 1,250 for the S&P 500) and we are now nearing the upper end of that range.

For the time being, we expect that markets will remain in their trading range as the downside macro risks compete with attractive valuations and strong fundamentals. Should we continue to see progress and improved clarity around the European debt crisis, however, stocks could be poised for improved longer-term performance.

About Bob Doll

Bob Doll is Chief Equity Strategist for Fundamental Equities at BlackRock^® a premier provider of global investment management, risk management and advisory services. Mr. Doll is also Lead Portfolio Manager of BlackRock’s Large Cap Series Funds. Prior to joining the firm, Mr. Doll was President and Chief Investment Officer at Merrill Lynch Investment Managers.

Tags: Bob Doll, Commodities, Contagion, Debt Crisis, Debt Problems, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Economic Data, Nasdaq Composite, Negative Impact, Policymakers, Recapitalization, S Market, Safe Haven, Second Consecutive Week, Solace, Sovereign Nations, Stock Prices, Strategist, Treasuries
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Mohamed El-Erian: Navigating the Multi-Speed World

Wednesday, May 18th, 2011

Mohamed El-Erian, CEO and co-CIO of Pimco, undeniably is one the world’s brightest investment minds. His comments on the secular economic outlook make for particularly interesting reading.

His bullet-point summary is as follows.

Balance sheets, both across and within economies, are still out of equilibrium. We expect advanced economies will face sluggish growth and persistently high unemployment over the secular horizon. Emerging economies will achieve higher growth but face recurrent inflationary concerns.

We do not expect policymakers to boldly address structural problems. By targeting negative real interest rates, they will pursue financial repression that undermines the “real return” contract that savers expect.

Secular baseline portfolio positioning should minimize exposure to the negative impact of financial repression, hedge against higher inflation and currency depreciation and exploit the heightened differentiation in balance sheets and growth potentials.

El-Erian concludes his very thoughtful article with the paragraphs below:

“With the world continuing on its bumpy journey to a new normal, there certainly is a lot happening in the global economy that is of direct, and unusual, relevance for markets and for the way we position your portfolios. This is the nature of multi-year re-alignments, especially when they take place concurrently at both the national and global levels. They are messy and uneven; they turn parameters into variables; and, especially when it comes to policies and politics, they change the balance of benefits, costs and risks (to use a phrase from Fed Chairman Bernanke).

“These re-alignments become even more interesting when multi-speed growth, inflation, and credit dynamics are in play – as is the case today. Critically, they also become much more complex when the related balance sheet repairs proceed in a slow and uneven fashion.

“Expect us to do our utmost to continue to analyze well these multi-year, multi-speed dynamics; and to properly reflect them in everything that we do for you – from secular investment positioning to the design of investment solutions, and from client servicing to business management.

“The world will remain an unusually fluid place. By looking forward and retaining our culture of “constructive paranoia,” we will strive to ensure that your portfolios benefit from change, rather than fall victim to it.”

Click here for the full interview.

Sources: Bill Gross, Pimco – Secular Outlook, May 2011.

Tags: Alignments, Balance Sheets, Bullet Point, Currency Depreciation, Differentiation, Economic Outlook, Emerging Economies, Equilibrium, Fed Chairman, Financial Repression, Global Economy, Global Levels, Investment Minds, Mohamed El Erian, Negative Impact, PIMCO, Return Contract, Sluggish Growth, Speed World, Thoughtful Article
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John Taylor: “The Nice Risk Rally Since The First Half Of 2009 Is Ending” And Will Be Replaced By A “Scary Descent”

Friday, May 13th, 2011

In the last two years, one of the most accurate predictors of both long and short-term trends has been FX Concepts’ John Taylor, whose April call for a EURUSD peak of 1.4925 was almost to the dot. Which is why he is either about to cheapen his predictive record by being wrong, or the days of the rally are ending. In a statement very comparable to that from Jeremy Grantham released a few days ago, Taylor tells Bloomberg that: “the rally in higher-yielding assets is coming to an end with Europe’s sovereign debt crisis resurfacing, growth sluggish and banking systems unsteady. “This is the end of the nice slow moving risk rally that has lulled us pleasantly to sleep since the first half of 2009,” Taylor, chairman of New York-based FX Concepts LLC, said in an interview. “This warning is worthy of a brass band and bright lights as the other side of this low volatility rally will most likely be a scary descent that will have a very negative impact on markets. Our statistical models say we are about at the end of the road for risk.” Taylor gives a deadline to his prediction: “Higher-risk assets, such as equities, the euro and emerging market currencies, have either peaked or will do so by end of July.” If Taylor’s previous predictive record is any indication, it may get volatile soon. On the other hand, his forte is FX not stocks, and many other forecasters have been burned (or should have been) at the stake of predicting capital markets in a time of central planning.

From Bloomberg:

Higher-risk assets, such as equities, the euro and emerging market currencies, have either peaked or will do so by end of July, according to Taylor, who manages about $8.5 billion and uses statistical models to help predict future movements in assets. Global investors have tempered their optimism about the U.S. and world economies and plan to put more of their money in cash and less in commodities over the next six months, a Bloomberg survey released today found.

FX Concepts, whose returns last year were the company’s best since 2006, reaped gains in the first half of 2010 betting on a slide in the euro against the dollar and then profited by its rise the rest of the year. At present, the fund is short the common currency, which means it will profit if it declines.

Taylor, who predicted several times since 2010 that the euro will eventually fall to parity versus the dollar, boosted returns by wagering on short term swings higher in the shared European currency. FX Concepts, in a Jan. 27 note, said the euro would move higher in a medium-term trend and in April predicted the currency was poised to reach a technical target of $1.4925.

Taylor had some choice words for Europe:

“There is absolutely statistically no way that Greece can survive,” said Taylor, who just returned from France. “There is a one in 10,000 chance; if the Germans give Greece their money to pay back their debt then they’ll be fine. But there is no way Germany will do that.”

Greek government bonds fell today, pushing the two-year note yield to a record high of 26.77 percent. The bonds have lost investors 11 percent this year.

“As the spread of Greek two-year debt goes absolutely crazy over German, it means that at some point we are going to have to have a crisis,” said Taylor, whose Global Currency fund gained 3.33 percent last month. “And I think it’s very soon.”

Tags: Banking Systems, Brass Band, Bright Lights, Capital Markets, Commod, Debt Crisis, Emerging Market, Forecasters, Global Investors, Jeremy Grantham, John Taylor, Negative Impact, Optimism, Rally, Sovereign Debt, Stake, Statistical Models, Term Trends, Volatility, World Economies
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ECRI Index: Signaling Slowdown, No Recession Yet

Friday, May 13th, 2011

The closely-watched smoothed growth rate of the ECRI Weekly Leading Index (WLI) for the week ended 29 April came in at 6.7% or 0.8% lower than the previous week.

Source: Dismal Scientist.

In previous articles I argued that the S&P 500 index is perhaps the most important constituent of the ECRI WLI, as evidenced in the graph below, where my calculated smoothed growth rate for the S&P 500 is plotted against that of the ECRI WLI.