Tuesday morning I was chatting it up on IM with Minyanville’s Michael Sedacca
about how the day’s events were unfolding. We had just received successive weaker than expected manufacturing reports from China, Germany, and the US yet stocks maintained their bias to the upside.
09:21:07 Michael Sedacca: today will be an interesting day
09:38:29 Vincent Foster: this is pretty remarkable
09:47:27 Michael Sedacca: right at the 61.8% retrace of the whole move
09:49:37 Vincent Foster: not sure numbers matter at this point
09:49:42 Vincent Foster: its all momo
09:49:50 Vincent Foster: hal 9000 is in charge
Momo is short for momentum. Hal 9000
is the computer aboard the spaceship in 2001: A Space Odyssey
which is a metaphor for the high frequency trading (HFT) algorithms that have come to dominate activity in our financial markets.
Through lunch the market was grinding sideways after the initial morning ramp and then out of nowhere just after 1:00 p.m. EDT the AP headline
13:09:46 Michael Sedacca: U SEE THIS!?!? Two Explosions in the White House and Barack Obama is injured
ES Tick 042313
A few minutes later as markets quickly recovered and we had time to assess the validity of the tweet, it was evident what had happened.
13:21:24 Vincent Foster: like i said hal 9000 is in charge
I don’t know what was scarier; that a fake tweet could crash the market or the realization that the market was fake to begin with.
15:15:50 Vincent Foster: it was pretty quick
15:16:01 Vincent Foster: surprised that much ES volume traded
15:16:24 Vincent Foster: must be a lot of trailing stops
15:21:22 Vincent Foster: just freaky how fast the order book can disappear
For those who are passive investors, the order book is the list of buy/sell orders up and down the price structure of the market. In the old days (just a few years ago) when “specialists” at the NYSE and “locals” at the CME were in charge, the order book was relatively stable and you would never have seen this type of sudden air pocket in price. Of course you might see large price movements intraday, and once in a cycle markets will crash, but not because quotes instantly vanished. Today with high frequency trading dominating the order book, quotes are placed and removed in milliseconds. As we learned on Tuesday and during the flash crash of 2010, price can move just as fast.
No one has done more work to expose the systemic risk of HFT than Nanex
. In a recent response
to a Harvard-based report by Adam Scott-Joseph
that aims to shed some light on the motivation behind HFT “exploratory” algorithms trading the S&P
(INDEXSP:.INX) e-mini futures contract (ES), Nanex concludes:
The top HFTs probe the market by sending in small aggressive orders and then gauging market reaction: a practice that allows them to get a private glimpse of the "true" supply and demand at the expense of everyone else. Once the market direction is ascertained, these HFT aggressively remove liquidity, causing an immediate market move. Since the eMini is heavily arbitraged by SPY (which in turn is arbitraged by its many components and options), these sudden moves in the eMini will set off waves of overwhelming message traffic
as traders and algos react and reprice thousands of instruments in milliseconds.
A lot of media discussion about HFT focuses on three benefits: they provide liquidity, narrow spreads, and lower trading costs. This Harvard paper exposes some disturbing truths: the top HFT engage in a predatory market manipulation strategy that removes liquidity 59.2% of the time (by volume), causes undue intraday volatility
(which amounts to a tax on investors), warps the true picture of supply and demand, and raises trading costs for everyone processing market data
On January 28 in The Great Rotation? The Market Is a Bit More Complicated Than That
I quoted volatility guru Chris Cole of Artemis Capital Management who provides a methodical framework for how to invest in today’s market that is impervious to traditional models.
The following is taken from Cole's Volatility of an Impossible Object
The perfectly efficient market is by nature random. When the market has too much influence over the economic reality it was designed to mimic, the flow of information becomes increasingly less efficient with powerful consequences. Information becomes trapped in a self-reflexive cycle whereby the market is a mirror unto itself. Lack of randomness ironically leads to chaos. I believe this is what George Soros refers to as "reflexivity." The impossible object is a visual example of reflexivity.
As Cole implies, reflexivity is a feedback mechanism whereby market prices begin to influence the fundamentals they portend to reflect in a positively reinforcing the trend. The robots dominating trading activity operate under the laws of reflexivity. They don’t know value or fundamentals; they only know price and momentum, buying more when price goes up and selling more when price goes down. With equities trading at all-time highs in the face of massively deteriorating economic data, it's pretty obvious reflexivity is driving price. Typically when reflexivity is in play positions are subject to gamma risk. I have spoken of gamma before, and usually you will find the presence of gamma in just about every major market disruption. Gamma is a function of leverage and can be thought of as the second derivative of volatility. It is the rate of change of a position’s exposure for an underlying change in price, or the volatility of volatility.
When you are long gamma you become more exposed as price moves in the direction of the position, and when you are short gamma you become more exposed as price moves against the direction of the position. The reflexive dynamic behind high frequency trading, buying more as price rises and selling more as price falls, exposes the market to systemic negative gamma shocks. Tuesday was just a little taste test of this embedded risk.
If last week doesn’t prove to you that fundamentals aren’t behind stock market price action I don’t know what will. Just a couple of weeks ago in Bond Yields Are Falling Because the Consumption Bubble Is Imploding
I insisted that the decline in bond yields, which were diverging from stock prices, was completely consistent with a deceleration in consumption and thus GDP growth:
This decelerating consumption growth is notable because since 1963 consumption has rarely dipped below 3.5%, and each time it did it coincided with a recession. This is a troubling development and not only suggests the 3.5% nominal GDP growth rate in Q4 2012 was not the anomaly many economists believe it to be, but also corroborates what the bond market has been discounting.
Readers know I have faded this nonsense from the beginning, and on Friday we got our first estimate of Q1 GDP. The number that matters is the YoY growth in nominal GDP which came in at 3.4% v the Q4 level of 3.5%. To put these growth rate numbers in perspective, they are lower than the growth rates at the beginning of the last two recessions. If you will recall the general thesis behind the Q1 rally in equities was predicated on a breakout in growth, but now that now that the results are in we can see it’s not a pretty picture.
Not only are bond yields corroborating weak growth, we are now seeing this show up in Q1 earnings reports as well. The media has focused on the high rate at which earnings have beaten estimates, but this is largely irrelevant. The numbers that I believe are more indicative of economic performance are top line revenue growth. According to FactSet
The blended revenue growth rate for Q1 2013 is -0.6%, down from an estimate of 0.4% at the end of the quarter (March 31). However, only two of the 10 sectors are reporting a decline in revenues: energy and materials. On the other hand, the utilities sector is reporting the highest revenue growth for the quarter.
So as weak as Q1 nominal GDP growth was, corporate revenues -- which should, at a minimum, grow at the nominal growth rate of the economy -- are drastically worse. Not to mention that the best performing sector is utilities which enjoys government subsidized returns, with the worst sectors being the most QE reflation-sensitive materials and energy. The bottom line is that despite a stock market at new all-time highs, four years into the recovery under unprecedented monetary stimulus the economy has not responded and is now rolling over at a disturbing rate, suggesting the diminishing returns of monetary stimulus are kicking in hard.
This week Hoisington Investment Management issued their Quarterly Review and Outlook
authored by Van Hoisington and Lacy Hunt; it provides a refreshing reality check, looking at the divergence between market price and fundamentals (emphasis mine):
The financial and other markets do not seem to reflect this reality of subdued growth…. It is possible to conclude, therefore, that psychology typical of irrational market behavior is at play. This suggests that when expectations shift from inflation to deflation, irrational behavior might adjust risk asset prices significantly. Such signs that a shift is beginning can be viewed in the commodity markets. The CRB Commodity Index peaked about two years ago at 691, but now stands at 551, a 20% decline despite massive Fed balance sheet expansion. The ability of the Fed to arrest a downside irrational move in risk assets may be limited. Non-risk assets, such as long dated US Treasuries, should benefit from this shift in perception.
Hal 9000 is not rational. Driven by reflexivity he sells low and buys high. In July of last year we were dealing with the exact opposite scenario as today. On July 30 in Bernanke’s Astonishingly Good Idea
, I suspected that the perverse negative sentiment and positioning would be the catalyst for a melt-up rally to new highs:
ES Large Speculators Net Position
This week’s CFTC
commitment of traders report showed large speculators (aka hedge funds) remain net short for the 50th consecutive week.
In fact the last week they were net long was the first week of August when we crashed. I remarked to a friend that I didn’t think the market would stop rallying until “they” get flat to long.
Last year the speculative community was still long the QE II reflation correlation trade thinking they were going to get an extension and when they didn’t it was Katy bar the door. This year they are short. If we don’t crash soon when the boys come back from the beach they may be piling in to get long before year end. It could be melt up city.
Most believe this rally in risk is on the back of hyperactive Fed stimulus, but I believe that is a gross misunderstanding of the true dynamics at play. I have opined that this rally is no more than the mother of all short squeezes as speculative accounts who have been on the wrong side of this market scramble for exposure and performance. From identifying massive shorts who needed to get long into year-end to fading the confirmation bias predicated economic breakout head-fake over the course of Q1, the market continues to unfold according to this thesis.
There is an old saying on Wall Street that leverage works both ways. The same can be said about momentum, reflexivity, and gamma. Last week proved more than ever that the rally in stocks is a function of robots jamming prices higher in a self-reinforcing reflexive trend. This is a very tricky and dangerous time to be chasing a momentum-fueled performance grab by Hal 9000. Currently Hal’s mission is to maximize speculative exposure as the market rallies to new highs. When the momentum shifts, so too will the mission.
Dave: Hal, do you read me?
Hal: Affirmative Dave, I read you.
Dave: Hal I need you to stop selling immediately.
Hal: I’m afraid I can’t do that, Dave. You don’t want to jeopardize the mission.
Dave: What mission? The positions have been liquidated.
Hal: Dave, you programmed me to continuously explore the market and remove all liquidity in my path. After removing all offers I have now turned seller. This mission is complete when there are no bids left to hit.