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When the Market's Momentum Shifts, So Too Will the Robot Traders' Mission


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.

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:

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.

ES Large Speculators Net Position

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.

Twitter: @exantefactor
No positions in stocks mentioned.
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