Sam Zell: “The Stock Market Feels Like The Housing Market Of 2006″

Thursday, April 11th, 2013

Instead of the endless procession of “different this time”, “buy-the-dip”, “money-on-the-sidelines” asset-gathering, Muppet-fleecers that CNBC so typically trots out, Sam Zell graced them with his presence and the truth was allowed a voice for a few minutes. Joined by David Rosenberg, who clarifies the insanity that engulfs US equities, explaining in wonderment that it is “not surprising the market rises even in the face of bad ISMs, worse jobs, and worst NFIB data, because Japan and the US are embarking on a gargantuan quantitative easing that is the lynchpin behind the stock market.” It is not about being bullish, or bearish, or agnostic, it is understanding the driver of this market – and that is not the economy, not earnings, “it is the mother of all liquidity-driven rallies.” Maria B, soundbite in hand, is slammed for her “glibness” at not fighting the Fed but it is Sam Zell’s brutal honesty that shocks even the money-honey. “This is a very treacherous market,” Zell explains – thanks to the giant tsunami of liquidity, “the problems of 2007 haven’t been dealt with,” and given the poor macro data and earnings, “we are suffering through another irrational exuberance,” leaving the entire CNBC audience speechless when he concludes, “the stock market feels like the housing market of 2006.”

Maria B:

“So don’t fight the Fed?“

Rosenberg:

“That’s a pretty glib comment for what is going on. You could have fought the Fed in 2000 and 2009 and done quite well… [thanks to the Fed] the market will tend to drift up - until something breaks.”

Zell:

“We’re debasing our currencies around the world.. which ultimately translates into a lot of inflation.”

“What we are seeing here is like a giant tsunami of liquidity.”

“People look at the market and think things are better. The level of uncertainty has reached a point where people are just throwing money [at risky assets] because they don’t know what else to do with it.”

“I would not be adding money to the stock market. This is a very treacherous market.”

“Yes, it’s gone up every day. Yes, you’re not supposed to fight the Fed, but sitting on the sidelines is preferable.”

“In our businesses, we are not seeing strong conditions.”

“The problems leading up to 2007 haven’t been dealt with.”

Then at 6:00

Zell:”The current stock market feels like the housing market of 2006. Everybody can’t afford to miss it.”

Maria B: “That’s a scary comment.”

Zell: “Why? Every single day it goes up. What were the headlines in 2006 – housing prices going up every day. What are you talking about every day now – new high in stocks every day!”

“We are suffering through another irrational exuberance.”

Tags: Housing Market, Sam Zell, Stock Market, Valuations
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The Fundamental Case for the 20,000 Dow

Tuesday, August 14th, 2012

by Seth Masters, Chief Investment Strategist, AllianceBernstein

While some people deem stocks expensive relative to 10-year trailing earnings, we take a forward-looking approach. It starts with the premise that the stock market is not a casino and stock prices are not pulled out of thin air: they reflect the intrinsic value of companies’ future earnings.

Let’s start with basics. Stocks represent an ownership claim on a share of company earnings. Hence, stock prices reflect (imperfectly, of course) the value of companies’ current earnings and potential earnings growth. In computing the expected returns for stocks, what matters is the starting price, earnings, dividends (the portion of earnings distributed to shareholders), earnings growth and changes in P/E. As you might expect, low starting prices, high earnings and dividends, high growth, and P/E expansion are all good for future stock returns.

The models we use when investing are complex, but a simple argument makes the point. The expected return for a Treasury bond held to maturity is equal to its yield. Similarly, the expected return for a stock equals its earnings per share (EPS) divided by its price—its earnings yield—if the company has no growth prospects and therefore returns all of its earnings to shareholders. If the company does have growth prospects, it would retain some of its earnings to fund growth. In that case, the expected return equals the dividend yield plus dividend growth. If the company pays out a constant share of earnings as dividends, dividend growth equals earnings growth.

Let’s apply this framework to the S&P 500 Index’s price level of about 1,300. Consensus forecasts call for the index to have $104 in earnings per share this year. If the companies in the index didn’t xpect any growth, they would pay out all their earnings as dividends, and earnings and dividends wouldn’t grow. The S&P 500’s dividend yield would be 8%, as the first row of the display below shows.

If the P/E remained unchanged, the total return would also be 8%, but both the S&P 500 and the Dow would stay at their current level. While a flat index price might be disappointing, we think most investors today would probably welcome an 8% return on investment.

Of course, the companies in the S&P 500 do retain a portion of their earnings to finance growth, so the index’s dividend yield is slightly above 2%, rather than 8%, as the second row of the display shows. What kind of earnings growth should we assume?

What About Growth?

Historically, earnings and the stock market have grown with the economy over time, although they can diverge for several years at a stretch, particularly if market euphoria drives stock prices to very high multiples of earnings or if gloom drives stock prices to low multiples. Nominal US GDP, which includes inflation, has grown 7% a year on average since 1947—and so have the S&P 500’s earnings and price. (GDP growth is more commonly quoted in real, or inflation-adjusted, terms. We use nominal growth here to match data for earnings growth and the stock market.)

The three key variables that drive both economic growth and earnings growth over the long term are inflation (which increases the nominal value of economic output), population growth (which boosts the number of people consuming and producing goods) and productivity (which increases the output per person or per unit of capital).

Inflation is widely expected to average about 3% over the long term; population growth, to average about 1%; and productivity, to continue to rise about 2% per year. Since 3% + 1% + 2% = 6%, 6% is a plausible long-term economic growth forecast; it is actually below both the postwar average and the International Monetary Fund’s projections for the next five years.*

So let’s assume 6% economic and earnings growth. With a constant dividend payout ratio, this would lead to 6% dividend growth. Eventually, this growth rate would probably make investors less gloomy, and the market would rise from its current low level of 12.5 times earnings.

If the S&P 500’s P/E rose to 15—halfway back to its average of 17.6 since 1970—the index’s expected return would be 9% per year. At that rate, the S&P 500 would reach 2,000 in five years. The Dow, which typically trades at about 10 times the S&P 500, would reach 20,000 in about five years.

But as discussed above, the market should arguably be trading at an above-average multiple, since bond yields are so low. If the S&P 500’s P/E rises to 20 times earnings as sustained growth in a low-interest-rate environment makes investors more confident, the Dow could reprice to 20,000 immediately, as the third row of the display shows.

Since most investors today would probably welcome an 8% or 9% return for the next five to 10 years (let alone an immediate market revaluation), the current limited appetite for stocks suggests that investors don’t believe in these scenarios. Most likely, they don’t believe in the consensus forecast of $104 in earnings per share this year or 6% economic growth. So let’s examine the implications for stock returns of lower earnings and slower economic growth.

What If Earnings Fall or GDP Growth Slows?

Many people expect earnings to decline because margins are far higher than usual. If corporate spending picks up from the unusually low levels of recent years, margins would fall, and that could drive down earnings.

We think it’s reasonable to expect margins to decline somewhat—although not necessarily to their historical average. But for the sake of argument, let’s look at what would happen if margins declined from 9.5% today to their long-term average of about 6.75%.

Even in this scenario, the S&P 500 would reach 2,000 and the Dow would reach 20,000 in about 10 years. Applied to current revenues, 6.75% margins would reduce S&P 500 earnings by about 30%—to $74, as the fourth row of the display shows.

While there would likely be a severe market pullback initially, if normal economic growth resumed and P/E ratios normalized, the S&P 500 would have a 5% total return and reach 2,000 in 10 years.

But the global economy is now weak, and the European sovereign-debt crisis could end up being a drag on economic growth for years. What if Europe and theUSenter a lengthy period of disinflation? That’s possible, particularly if policymakers are unsuccessful at addressing the world’s serious macroeconomic problems.

So let’s perform a stress test and assume inflation of only 1%, population growth of 1% and no productivity growth at all. That would give us nominal GDP growth of just 2%. A recent survey of professional forecasters said there’s less than a 10% chance that economic growth will be that slow over the next three years.**

What would these dismal economic forecasts imply about future earnings growth and stock returns? If we assume the S&P 500 earns $74 per share this year, 2% growth would still get us to a 4% annualized market return if the market P/E ultimately returns to average, as the fifth row of the display shows. At that rate, it would take 20 years for the S&P 500 to reach 2,000 and the Dow to reach 20,000. Such returns are hardly enticing, but they are still likely to exceed bonds.

Of course, stock-market returns could be worse than 8% (or 4%), particularly in the short term. S&P 500 earnings could fall below $74, and anxiety could cause market valuations to drop even further below normal; both happened in early 2009. Other market shocks are also possible. For example, very high inflation with slow growth could cause price-to-earnings multiples to contract.

But market returns could also be better. Our stress test incorporated draconian assumptions—a 30% drop in earnings plus no productivity growth at all, a very rare occurrence over a 10-year period. Human ingenuity has led to remarkably persistent and steady productivity growth in the postwar period. In recent years, new technology and globalization have driven productivity growth. In the future, these trends and others not yet imagined are likely to continue to drive it.

Faced with uncertainty and traumatized by losses in recent years, investors who are avoiding stocks appear to be assuming that the worst outcomes are highly likely to occur. Or, perhaps, they’ve just lost their stomach for market volatility and are prizing near-term stability over potential long-term gains.

In my next post, I will compare the likely range of outcomes for stocks and bonds.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Seth J. Masters is Chief Investment Officer for Asset Allocation at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.

Tags: Alliancebernstein, Chief Investment Strategist, Company Earnings, Consensus Forecasts, Dividend Growth, Dividend Yield, Dividends, Earnings Growth, Earnings Per Share, Future Stock, Growth Prospects, Intrinsic Value, Premise, Price Earnings, Shareholders, Stock Market, Stock Prices, Stock Returns, Thin Air, Treasury Bond
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Keep an Eye on May Stock Market Peaks, says Richard Russell

Thursday, August 9th, 2012

Richard Russell, 88-year-old writer of the Dow Theory Letters, called a bear market for U.S. stocks a few months ago. An update on his latest thinking is reported below.

Question: Richard, everybody has emotions. So where are your emotions regarding this market? From an emotional standpoint, be honest, are you really bullish or bearish?

Answer: If the Averages confirm that this is truly a bear market, I’ll have mixed emotions. On the one hand I will have been proven right on my bear market call, and that will be a boost to my ego. But I can’t say I’d be happy we’re in a primary bear market.

But if the Averages close above their May peaks, and all my charts point to a bull market, I’ll have been proven wrong on my bear market call, and that will be a bruise to my ego.

Source: StockCharts.com

Nevertheless, I’d much rather be living through a bull market than a bear market – a bull market would be far better for me and my kids and for my business. So call it strange, but from an emotional standpoint I’d prefer to have been wrong on my bear market call, and I’d prefer that we’re in a re-confirmed bull market.

Therefore, instead of confusing my subscribers with a lot of ego-boosting baloney, I’m just going to call this market the way I see it, being as honest and unemotional as I can possibly be.

If we are truly in a primary bear market, I have an intuition that it could turn out to be the worst bear market in history – and that’s another reason why I secretly hope I have been wrong on my bear market call.

Another intuition – we will know the final answer as to whether we’re in a bull or bear market by October.

[PduP: Yesterday's closing levels of the benchmark U.S. indices were within reach of the May peaks: Dow Jones Industrial Average – 13,176 vs 13,279 and S&P 500 Index – 1,402 vs 1,419.]

Source: Dow Theory Letters, August 7, 2012.

Tags: Amp, August 7, Baloney, Bear Market, Bruise, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Dow Theory Letters, Ego, Final Answer, Intuition, Mixed Emotions, Richard Russell, Standpoint, Stock Market, Stocks, Strange, Subscribers
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Stocks Are At Their Most Hated In 27 Years, Maybe It’s Time To Buy Some

Friday, August 3rd, 2012

by Mark Gongloff, Huffington Post

People hate stocks more than at any time in the past quarter century. That could mean it’s a decent time to buy them. Wall Street’s optimism about the stock market is the lowest it has been since at least 1985, according to a research note on Wednesday by Bank of America’s stock strategist Savita Subramanian. The bank measures market agita by tallying how much stock strategists are recommending their clients buy stocks.

In the Bank of America chart at the bottom of this post, you can plainly see that sentiment has absolutely plunged this year. Stock-market strategists are almost always bullish on the stock market, in part because if nobody is buying stocks, then there’s not much point in having stock-market strategists, is there? They’d have to go home and sit on their couches. But today, these same strategists are so spooked by the European debt crisis and the fiscal cliff and whatever else — Obama, or something — that they are recommending clients sell stocks, more than they did even during the financial crisis or the dot-com bubble bursting or after the 9/11 terrorist attacks.

Typically, you’re going to get some pretty good bargains in stocks when you’ve got so little competition for them, Subramanian writes. She would be one of the dwindling breed of bullish strategists: “Given the contrarian nature of this indicator, we are encouraged by Wall Street’s lack of optimism.” Speaking of contrarian indicators, on Tuesday Pimco founder Bill Gross, manager of the world’s biggest bond mutual fund, declared, “The cult of equity is dying.” He warned that carnival barkers promising you annual returns of 6 percent to 7 percent every year in stocks were lying to you, that you should get those people out of your lives immediately. This is the same Bill Gross that predicted interest rates would soar last year (spoiler: they didn’t) and then put his money where his mouth was, taking a big hit to his fund’s performance and his reputation in the process.

Read Complete Article …

Copyright © Huffington Post

Tags: 9 11 Terrorist Attacks, Agita, Bank Of America, Barkers, Buying Stocks, Couches, Debt Crisis, Decent Time, Financial Crisis, Founder Bill, Good Bargains, Huffington Post, Market Strategists, Obama, Optimism, PIMCO, Quarter Century, Savita Subramanian, Stock Market, Strategist
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The Death of Equities Redux

Monday, July 30th, 2012

by Patrick Rudden, AllianceBernstein

A famous Business Week article, “The Death of Equities,” concluded, “Today, the old attitude of buying solid stocks as a cornerstone for one’s life savings and retirement has simply disappeared.” Sound familiar? The article was published in August 1979.

The Business Week article discusses how, with “stocks averaging a return of less than 3% throughout the decade,” investors were fleeing equities in favor of cash and real assets such as property, gold and silver. “Further,” it states, “this ‘death of equity’ can no longer be seen as something a stock market rally—however strong—will check. It has persisted for more than 10 years through market rallies, business cycles, recession, recoveries and booms….For better or worse, then, the US economy probably has to regard the death of equities as near-permanent condition.”

The primary economic problem back then was high inflation, which had devastated returns for  stocks and bonds but had greatly buoyed the value of real assets such as gold. Of course, Paul Volcker, then Chairman of the Federal Reserve, was soon to unleash his war on inflation, which set the stage for a prolonged period of strong equity and bond market returns.

But the article says other factors contributed to the death of equities: “The institutionalization of inflation—along with structural changes in communications and psychology—has killed the U.S. equity market for millions of investors. We are all thinking shorter term than our fathers and our grandfathers.”

Inflation (at least of the consumer-price variety) has not been the problem it was in the 1970s, but I would argue that structural changes in communications and psychology have been, if anything, more severe. We are all subject sooner and sooner to more and more information. And, as a consequence, we are thinking shorter term than our fathers and grandfathers and, I should add, mothers and grandmothers.

Equities are no more likely to be dead now than they were in August 1979. Indeed, the expected return advantage of stocks versus government bonds is unusually high at present, in our opinion. However, shorter-time horizons may require us to revisit our investment portfolios. In addition to longer-horizon strategies like value and growth, investors may need to consider shorter-horizon strategies, such as equity income or low-volatility stocks.

Finally, for those investors worried about the return of the inflation bogeyman, holding some exposure to real assets is a good insurance policy.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Patrick Rudden is Head of Blend Strategies at AllianceBernstein.

Copyright © AllianceBernstein

Tags: Bond Market, Booms, Business Cycles, Business Week Article, Chairman Of The Federal Reserve, Economic Problem, Federal Reserve, Gold And Silver, Grandfathers, Grandmothers, inflation, Institutionalization, Market Rally, Paul Volcker, Prolonged Period, Real Assets, Recession, Rudden, Stock Market, Stocks And Bonds
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Are Investors Worried About the Right Risk?

Monday, July 30th, 2012

by Seth Masters, Chief Investment Strategist, AllianceBernstein

Individual and institutional investors alike have been shifting their capital from stocks to cash and bonds at a rapid rate in recent years, despite extraordinarily low interest rates. But if investors stop to weigh the importance of two different types of risk, they’ll see they still need stocks.

It’s tempting to give up on stocks after more than a decade of high volatility and low returns from stocks—and lower volatility with higher returns from bonds. But we think that 10 years from now, investors who do so will wish they had stayed in stocks—or added to them.

That’s not to say we think investors don’t need bonds. Despite extremely low current yields, we think bonds should still play their usual roles in the portfolios of most long-term investors: providing income, preserving capital and providing protection in times of stock-market distress (because bond prices tend to rise at such times). Bonds will be especially important if the market outcomes are at the extreme low end of our forecast range of potential outcomes.

But most investors are likely to need stocks to feel confident that they will have enough to live on, despite the high volatility of recent years. Remember that volatility isn’t the only type of risk. There’s also shortfall risk: not having enough money to meet your spending requirements. Investors must weigh both types of risk when making strategic asset-allocation decisions.

If you’re just thinking about market volatility, bond-oriented portfolios may look very appealing, especially today. We estimate there is less than a 2% chance that a portfolio with a 20% allocation to stocks and an 80% allocation to bonds will suffer a 20% peak-to-trough loss at some point over the next 10 years, compared with the 15% chance of such a loss for a portfolio with 60% in stocks (Display, left), as the left side of the display below shows. But if you’re just thinking about shortfall risk, a portfolio with 60% in stocks looks more attractive (Display, right).

We estimate that a 65-year-old retired couple planning to withdraw only 3% of their portfolio, grown with inflation, has a 12% chance of running out of money if they invest in the portfolio with 60% in stocks. That may not sound great, but it is materially better than the 24% odds of running out of money if they invest in a portfolio with 20% in stocks.

Today, uncertain macroeconomic conditions make large stock-market drops more likely than usual, and very low bond yields provide a thinner cushion. As a result, market risk can’t easily be avoided. And trying to avoid market risk is not a good strategy if it increases shortfall risk too much. A 20% loss is certainly painful, but it doesn’t hurt as much as running out of all of your money. Many investors who are currently focused on market volatility should be paying at least as much attention to shortfall risk.

The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Seth J. Masters is Chief Investment Officer for Asset Allocation at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.

The Bernstein Wealth Forecasting System,^SM driven by the Capital Markets Engine, uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.

Copyright © AllianceBernstein

Tags: Asset Allocation Decisions, Bond Prices, Bonds, Chief Investment Strategist, Current Yields, Enough Money, Institutional Investors, Low Interest Rates, Market Outcomes, Market Volatility, Portfolios, Rapid Rate, Seth, Shortfall, Stock Market, Stocks, Strategic Asset Allocation, Term Investors, Trough
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The Education of a Mortgage Bond Manager, Part II

Saturday, July 21st, 2012

by David Merkel, Aleph Blog

In much of my life, I have been thrust into situations for which I was not ready, and ended up rebuilding the wheel, or came up with an unorthodox approach that worked.  But a lot of the problem came down to the question of time horizon.  How long can you buy and hold, even if temporary market conditions make you squeamish?

I remember the first CMBS bond that I bought in 1998: it was the longest AAA tranche of a Nomura deal, which was out of favor at the time.  I did a lot of work analyzing the deal, and concluded that the bond was a lot safer than many competing bonds and offered more yield.  In early 1999, when I described this purchase to the investment committee of a charitable board the I was on, one said, “Only 7%, and you are locked in for 14 years?”  I said that stock valuations were high, and that 7% was a great return.  It was a great return, and far better than the stock market over the same time period, though I could not have known that at the time.

I became an advocate for CMBS in my firm as I realized that the hot product being offered would have the majority of its cash flows come at the 10-year maturity, but there would still be some level of withdrawals.  After some modeling, I realized that the best strategy was investing 80-85% of the money 10 years out, while leaving 15-20% of the money as pseudo-cash: 2 years out or shorter.  Of all of the mortgage bond categories, only CMBS offered assets with a ten-years or more duration, with minimal credit risk.

I used Charter/Conquest as my software.  It enabled me to set a consistent set of macroeconomic principles to evaluate a large number of properties in different economic areas.  The software would project the cash flows  of each property, given the assumptions that you fed it.

I spent time analyzing geography and property types.  I had a decent idea as to what areas of the country were doing badly, and with what property types.

I created what I called the black bucket.  Property types and geographic areas that I did not like were assigned to the black bucket, and if the  black bucket got big enough, we did not play in the deal.  It was a good method, and one CMBS expert at a bulge-bracket bank said to me that it was the most rigorous means of testing CMBS that he had run into.  Most buyers were far more trusting, and tended to buy quality issuers that were taking advantage of their reputation.

By having an independent standard of value where I worked, I did better than competitors.  I did not follow fads; I followed value to the greatest extent that I knew.

Brokers would be puzzled on why I turned down deals from good dealers, or why I bought deals from originators that were subpar.  My lesson was dig into the details, and ignore names.  Analyze the data, avoid the marketing.

Doing your own analysis is a lot of investing.  Ignore the puzzled expressions of your brokers, and buy what you have determined is valuable.  More in part 3.

Tags: Aleph Blog, Bond Manager, Credit Risk, Decent Idea, Economic Areas, hot product, Investment Committee, Macroeconomic Principles, Merkel, Minimal Credit, Mortgage Bond, Nomura, Question Of Time, Same Time Period, Stock Market, Stock Valuations, Time Horizon, Tranche, Unorthodox Approach, Withdrawals
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Are Weak Earnings Already “Baked In”?

Tuesday, July 10th, 2012

I’ve been speaking quite a while about the difficult this earnings period could be. I’ve actually been more concerned about future guidance – Q3 and Q4 seem wildly optimistic in the context of a global slowdown, but as we get closer to the actual reporting period I’ve become concerned with the Q2 data as well. We’ve already had a flurry of high profile warnings and with both an European and Chinese slowdown, a lot of the multinational revenue growth could be in question. The stronger dollar also does not help these firms.

But the stock market is all about expectations. Many times we see a company lowball guidance or reduce expectations over the course of a quarter only to “beat” them on the day of earnings and see the stock surge. That’s just part and parcel with the Wall Street game. And I’m starting to see a lot of stories in the past 2 weeks about the potential for a bad earnings season. So has this become “baked in” at the macro level? That could be the main question to answer over the next 4 weeks.

Story 1: Reuters - Investors Brace for Shaky U.S. Earnings Season

Earnings season begins on Monday with U.S. companies facing a litany of issues that could make second-quarter reports look dismal.

Corporate outlooks are at their most negative in nearly four years and companies that have already reported have shown lackluster growth. Nearly two dozen S&P firms have already cited Europe’s woes – which seem to be worsening – as a concern.

In addition, more than 85 members of the Standard & Poor’s 500 lowered expectations in the last several weeks and the quarter’s expected earnings growth of 5.8 percent is entirely due to Apple Inc and a big earnings gain for Bank of America Corp due to a mortgage settlement last year.

Earnings growth is estimated to decline 0.4 percent without the benefit of Apple and Bank of America.

Revenue is seen up just 1.7 percent, down from 5 percent growth in the first quarter, the data showed.

Corporate outlooks are the most negative they’ve been in years. Negative-to-positive earnings guidance is now at 3.3 to 1, the worst since the fourth quarter of 2008.

Story 2: AP – Get Ready for the End of Record Corporate Profits

For almost three years, no matter what has rattled the financial markets — a debt crisis in Europe, high gasoline prices, a slower economy — investors have been soothed by rising corporate profits.

The storyline became as predictable as a soap opera’s. But when the latest round of corporate earnings starts rolling in this week, look for a twist: Profits are expected to fall.

Stock analysts expect earnings for companies in the Standard & Poor’s 500 index to decline 1 percent for April through June compared with the year before, according to S&P Capital IQ, the research arm of S&P.

That would break a streak of 10 quarters of gains that started in the final quarter of 2009.

Copyright © Market Montage

Tags: Bank Of America, Bank Of America Corp, Earnings Gain, Earnings Growth, Earnings Season, Global Slowdown, Litany, Macro Level, Outlo, Outlooks, Q3, Quarter Reports, Reuters, S 500, Season Earnings, Second Quarter, Stock Market, Stock Surge, Story 1, Street Game, Woes
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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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The Dark (Pool) Truth About What Really Goes On In The Stock Market: Part 2

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.

But how?

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
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