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Peter Atwater: An 'Oligopoly in Confidence' Puts Global Markets at Risk


This time it is different -- the stakes are much higher.

This time is different. Or at least that's what equity strategists and social-media titans would lead you to believe. To them, 2014 is definitely not 2000 all over again.

Rather than fight them, I thought I would instead go along with them this week and focus on some of the many ways current conditions are so very different from what they were both 14 years ago, at the peak of the dot-com bubble, as well as in 2007, just before the banking crisis.

For example, today's equity markets are dominated by the post-2000 growth in both futures contracts, particularly the e-minis, and ETFs. E-mini average daily volume in 2000 was just 67,820 contracts versus 1,510,352 last year. On the SPDR S&P 500 ETF Trust (NYSEARCA:SPY), average daily volume in 2000 was under 8 million shares. Last year, the average daily volume was 122 million shares. The average NYSE trading volume, by comparison, for 2000 was 1.04 billion shares versus 2.6 billion shares in 2007 and 1.4 billion shares in 2013. The 2013 figure also includes the NYSE ARCA and NYSE MKT volumes.

While none of these statistics are likely to have been much of a surprise, I think they convey how profoundly different the drivers of equity prices are today from a decade and a half ago.  For many individual stocks, price action is often far more dependent on what is happening in the trading of a related index futures contract and/or its sector or index ETF.  We now have a market of baskets, not individual names. One futures or ETF buy or sell has the potential to cause hundreds of underlying transactions. Furthermore, we have a market of baskets underpinned by high leverage invisible to most retail investors.  Rather than standing next to Post 9 discussing individual company names, CNBC would do its viewers a much greater service by discussing what futures traders and e-mini investors are thinking. Today, they are the market. 

The past 14 years have also brought with them the consolidation of futures and equity exchanges, major retail and institutional brokerages, and money-management firms.  Purchase, sale, trading, and clearing volumes are concentrated among far fewer major players than they were in 2000 and 2007. (Without question, whatever distinction existed 14 years ago between banks and investments has been completely erased. Today's largest banks have become the model of the integrated financial institution envisioned by the repeal of Glass-Steagall.)

Trade-order entry, too, has changed significantly.  Thanks to smartphones and tablets, today's market participants have untethered access to real-time information and trade execution.  Markets are mobile. There are no perceived barriers to execution. None.

In fixed income, the yield on the 10-year Treasury was near 6% in 2000. In 2007 it was near 5%. Today it is under 3%. Credit ETFs, which didn't exist in 2000 and were nascent in 2007, are large buyers of fixed income securities today, particularly high-yield bonds. Depending on the measure you use, the spread between Treasury yields and junk bonds is at or near a historic low today.

On the political front, Congress had an approval rating above 50% in 2000 (and reached an all-time Gallup high of 56% in 2001).  In 2007, the approval rating was 27%. Today it is 12%, just above its record low 9% reached last fall. Last year Congress passed a record low 55 bills versus 180 in 2007 and 410 in 2000.

In 2000, the US government had a budget surplus of $236 billion. In 2007, it had a deficit of $161 billion. Last year the deficit was $1.1 trillion.

In 2000, the Federal Reserve's balance sheet was roughly $500 billion in size. By 2007 it had reached $800 billion. Today it is $4.1 trillion.

Finally, in 2000, Gallup economic confidence was +30. In 2007 it was +10. Yesterday it was -18.

To be clear up front, my concern today is not the next dot-com bubble collapse nor is it the next credit-market collapse, but rather what happens if we simply begin to get some kind of meaningful market correction here and now. 

From a systemic resilience perspective, today's starting conditions are very different from both 2000 and 2007; and based on what I see, the market's confidence underpinnings, for lack of a better term, are far more fragile than they were at either of the past two market peaks.

Looking at our current condition, the nation's fiscal and monetary abilities that were perceived to have cushioned the 2000 and 2007 market drops might better be characterized as weaknesses.  When you think "source of strength," Washington doesn't exactly come to mind.  What's more, even if they wanted to come to the rescue of the markets, Dodd-Frank imposes plenty of limitations on what Congress and the Fed can now do.

Then there is the systemic piping itself. To these eyes, the entire "high liquidity offered by exchange-traded products" promise (offered to institutional and retail investors alike) could easily become an outright lie given not just the absolute size of the largest players but the instantaneousness by which the entire market can now move.  And I particularly worry about this with regard to the e-mini futures market.  All I hear today is how liquid the contract is. Given the contract's growth trajectory, of course it is liquid. No one today seems to be worried about how a meaningful shift in sentiment in the e-mini would impact market prices.

As I look at the markets, what we have today might best be described as an oligopoly of confidence in which the mood of just a handful of the world's largest investors matters more to price than anything else. A line of retail investors rushing for the exit and causing panic is not my major fear. Today, I am more concerned that a single large investor could create discontinuous markets; as the system moved, would it be able to accommodate others in size?

While some may discount the reference, I think that we got a good preview of this scenario last year in the fixed income market as Pimco struggled to deal with redemptions.  As news about the firm spread, its redemption spiral impacted market pricing for all.  The elephant couldn't get through the door. (And had Bill Gross not suspended "nonessential" trading, the price consequences could have been even worse.)

Today, equity investors believe that the exchanges, particularly the futures exchanges, offer 24/7 liquidity.  In a world in which no single investor matters, that may be the case, but that condition clearly doesn't exist today. Given our current weak confidence underpinnings, trouble within a "mega" asset manager/hedge fund could easily shake the market.

Admittedly, the existing circuit-breaker system should slow the drop. What is not clear, however, is how retail investors and the media will interpret the broad-scale application of circuit breakers given current confidence levels.  In this environment, rather than cooling nerves, a market suspension could just as easily draw additional sellers in. Even five and a half years out, the failure of Lehman Brothers still looms large to many investors. 

Finally, there is the "Fed-compliant" nature of the market today. A decline in confidence/markets could also raise doubt as to whether the Fed really caused the market rally in the first place. To mix metaphors, if the king really doesn't have clothes, the jail break could be enormous.

Peter Atwater's groundbreaking book "Moods and Markets" is now available on Amazon and Barnes & Noble.
"Peter Atwater brilliantly provides a framework for understanding both the socioeconomic hubris that led to the great credit bubble of the past decade and the dark social-psychological hangover that has resulted from its collapse. In so doing, he offers an invaluable guide to what promises to be a very difficult and turbulent period ahead as we experience what he calls the "˜me, here, and now' behavioral tendencies of the post-crash world."  --Sherle R. Schwenninger, Director, Economic Growth Program, New America Foundation

Twitter: @Peter_Atwater
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