The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

Markets have had the excited giddiness of a kid during the week before Christmas. Childlike, they cannot wait for the big day to arrive to open their presents from Santa.

Only the bearded dude isn’t a jolly fat guy in a red suit, he is an academician who is carrying not a bag full of presents, but an unconscionable burden.

This time last year, Ben Bernanke had some concerns: There was the fear of deflation, a decelerating economy, and asset prices acting squelchy. The FOMC decided to target stock prices with another round of quantitative easing — buying bonds — to keep rates as low as possible.

The markets quickly jumped — first in anticipation, than on the fresh flow of liquidity. $650 billion dollars puts an unnatural bid beneath equities, and the short side was a painful place for Hedgies to play.

QE2 ended June 30th this year, and market volatility has risen since. We already have QE 2.5 — rolling Fed repurchases as their short term bond holdings mature — but QE3 remains more doubtful. Not because its “treasonous“,^* but because it is failing to reach the “real” economy. The political situation within the FOMC makes it increasingly unlikely anything like a QE3 will be coming out of the Jackson Hole confab. Perhaps Santa Clause Ben Bernanke has something in his bag of tricks, but that looks like a long shot. Thus, we are set up for some disappointment.

The Fed’s focus on equity prices is the least of our concerns. The US is suffering from a long list of serious — but not unsolvable — problems that require intelligent, mature and potentially painful decisions

Can the US resolve these issues?

1) An excess credit problem, left over from the 2000s Housing boom and credit bubble — being solved v e r y  s l o w l y through deleveraging and passage of time;

2) Slowing economy and high unemployment (including increasing High School drop out rates creating a structural employment problem);

3) Crumbling infrastructure: Electric Grid, Bridges, Tunnels, Roads, Naval Ports, Airports;

4) Medical Costs that are double the rest of the industrialized world’s yet produces worse results.

5) Systemic deficits caused by unfunded tax cuts, unfunded entitlements, and a military bigger than the next 20 countries combined, (plus a lack of fiscal discipline);

6) A wholly dysfunctional electoral process, including corporate control of what was once a democratically elected legislative branch;

7) Increasing wealth and income inequality (Historically not a long term positive for social unrest and political legitimacy)

8) An overt hostility to empiricism and science (which helped create most of our wealth) and an embracing of “magical thinking”

9) An intellectually bankrupt political class married to outmoded, disproven, fantasy based economic ideas.

Note that the last of these is directly responsible for much of the prior 8 problems.

We need to distinguish between immediate concerns  — market crashes, unemployment, re-election — with the longer term structural problems facing the US.

The next 10 years can either be the end of the empire or a new healthier phase. The US has managed to reinvent itself every few generations. Its time for another such moment of reflection and redirection…

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* Won’t someone please explain the difference between monetary policy and seceding to Gov. Rick Perry?

Sound quality is awful — too hot — but its a great concept:

Hat tip Nicholas Teague

The latest adds to my Instapaper this very busy afternoon:

• Meet the man who will replace Jobs (Fortune)
• Buffett: The One-Man Blue-Chip Bailout Machine Strikes Again (Yahoo Finance)
• China’s Looming Debt Disaster (The Daily Beast)
• The run that brought Morgan Stanley to the brink during the crisis (Financial Post)
• Six lessons Japan can teach the West (Curious Capitalist)
• ‘MERS morass’ is hanging up negotiations on foreclosure settlement (Washington Post)
• The Illusion of Asymmetric Insight (You Are Not So Smart)
• China’s denials about cyberattacks undermined by video clip (Washington Post)
• Irene Aims at U.S. States Suffering Budget Cuts for Emergencies (Bloomberg)
• Top 10 great cars nobody is buying (Left Lane)

What are you reading?

Yesterday was a sad day for Global Macro Monitor with the announcement that Steve Jobs is stepping down as CEO of Apple.  We are one of his biggest fans.  The guy has created nothing less than a technological nation-state (see below).   A true superpower in today’s world of sovereign downgrades.

The question for the stock is does his retirement remove the  the uncertainty premium that has repressed its price or does it add more uncertainty surrounding the company’s innovative capacity?   We don’t know and will let the market decide.   Today’s action it appears they are voting for former.   Can they close it in the green today?

Given the spike in copper and oil (but not gold), perhaps its time to take a look this long term chart of commodities:

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Source: BLS, FactSet, J.P. Morgan Asset Management.
Data reflect most recently available as of 6/30/11.

Source: JP Morgan funds

Joseph Saluzzi (jsaluzzi-at-ThemisTrading.com) and Sal L. Arnuk (sarnuk-at-ThemisTrading.com) are co-heads of the equity trading desk at Themis Trading LLC (www.themistrading.com), an independent, no conflict agency brokerage firm specializing in trading listed and OTC equities for institutions. Prior to founding Themis, Sal and Joe worked for more than 10 years at Instinet Corporation, pioneers in the field of electronic trading, and at Morgan Stanley.

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We at Themis have been speaking about the effects of HFT on market quality since 2005. We especially feel that the Exchanges arm these traders as part of the for-profit exchange business model, and because of that have driven margin out of our equity markets.

Why is that bad? Think about the lack of IPO support. Think about all the analytical talent that used to analyze equities as investments, and how it has been replaced with mathematical talent to write code to scalp.Yesterday we all received news that Gleacher & Company is exiting the equities business period, just the latest example of how our equity markets have been ravaged and left barren by HFT and Exchange locusts. Sadly this Exchange/HFT/Data-provider Sausage Factory continues to be exported globally AND embraced.

The good news is that we have a letter for you to read that was recently sent to the Market Integrity Committee at the IOSCO (International Organization of Securities Commissions). Hopefully the letter will be read, reread, and posted in the foyer of the IOSCO, instead of being cast aside while globally HFT firms and Exchanges continue to pursue strategies of Regulatory capture and lobbying to entrench their perverted business models.

The last thing we need is for equities to become a barren wasteland globally, as well as the USA.

Read this letter. It is long. Print it out and read it later if you must, but please read it:

12 August, 2011

Mr. Werner Bijkerk
International Organization of Securities Commissions (IOSCO)
Calle Oquendo 12
28006 Madrid
Spain

Subject: Public Comment on Consultation Report: Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency

Thank you for the opportunity to comment on the IOSCO Technical Committee’s Consultation Report, “Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency” (“Report”).

The Report asks for public comment on the effect of technology, and of certain business models enabled by technology, on securities markets. The Report includes a particularly thoughtful discussion of so-called “high frequency trading” (“HFT”) firms and business models. My letter will address those firms and business models.

As the Report notes, the U.S. Securities and Exchange Commission published a concept release on the structure of U.S. equity markets in January, 2010. In April, 2010, I submitted a comment letter on the concept release (Subject: File No. S7-02-10). In that letter I discussed several facets of modern U.S. equity markets that deserved reform. My comment letter described factors responsible for increasing market volatility in recent years and also described ways in which long-term, fundamental investors were being disadvantaged by HFT firms, in some cases aided by the for-profit exchanges themselves.

In the letter I first described how U.S. market centers in the last 10 years had engineered “the replacement of formal and regulated intermediaries with informal and unregulated intermediaries” creating a “HFT-dominated market structure and business model that functionally replaced that of the 20th century exchanges.” I noted that “HFT firms invested in ECNs and exchanges, sat on their boards, and held considerable influence over their design and operation,” and took particular note of “an exchange that sells real-time data to high frequency trading firms telling those firms exactly where hidden interest rests and in what direction.”

Going further, I reported that “A HFT market making firm does not need to register as a market maker on any exchange” and that “market centers pay these firms for supplying liquidity and the liquidity they supply becomes part of the market center business models. ” Even registered market makers “have little or none of the regulatory oversight” they used to have, and “do not have any meaningful restriction on moving the market, they have no meaningful capital adequacy standards, no obligation to yield to customer orders, no meaningful obligation to maintain competitive quotes, no dealer position monitoring, nothing.” In consequence, “firms are free to trade as aggressively or passively as they like or to disappear from the market altogether,” and when markets face liquidity demands their behavior can “increase spreads and price volatility and savage investor confidence.” But that, importantly, “They still get valuable privileges if they register as market makers, and they promise in return to merely post any quote, and a penny bid can count as a valid quote.”

To the main policy point itself, whether HFT firms are the simple liquidity providers they claim to be, I wrote that despite what they might claim, HFT firms add liquidity only when it suits them, and that they cartwheel from supplying liquidity to demanding it when they spot trading opportunities or need to rebalance inventory, and that these trading practices exacerbated price volatility and directly contributed to the exceptional volatility of recent years.

Subsequent events soon illustrated all of these central points.

The Flash Crash

On May 6, 2010, U.S. markets suffered what’s become known as the Flash Crash. Equity markets lost $1 trillion in about 15 minutes, and hundreds of stocks and ETFs traded at penny bids. A significant contributing cause of the Flash Crash was that after partly absorbing a large seller’s position, HFT firms aggressively unloaded inventory in a cascading fratricide now sometimes called “hot potato” trading. After dumping inventory, many of these firms also then withdrew altogether from the market. As I later wrote in an invited comment for the FT Trading Room on FT.com, HFT firms “do it because they can. It doesn’t happen because of a computer malfunction. It happens because it is designed to happen. It is not a bug, it is a feature.”

One week after the Flash Crash, the New Jersey-based brokerage firm and market structure critic Themis Trading published a ground-breaking white paper called “Exchanges and Data Feeds: Data Theft on Wall Street” . In their paper, Themis described information leakage in certain exchange proprietary order book data feeds, practices almost entirely unknown to institutional investors and the public. As a consequence of the Themis paper, several market centers — but not all – in Europe and the U.S. stopped some of their most egregious practices. As for the preceding 10 years, when these feeds leaked trading details to HFT firms with impunity, regulators are unaccountably silent.

Several months after the Flash Crash, Andrei Kirilenko, the Chief Economist of the U.S. Commodity Futures Trading Commission, co-authored one of the most important empirical market microstructure studies yet published entitled “The Flash Crash: The Impact of High Frequency Trading on an Electronic Market” .

Kirilenko and his co-authors concluded that “High Frequency Traders exhibit trading patterns inconsistent with the traditional definition of market making,” directly contradicting long-standing HFT claims that they are nothing more than simple market makers or liquidity providers. He went on, “Specifically, High Frequency Traders aggressively trade in the direction of price changes,” contradicting HFT claims that they dampen volatility. And more, “This activity comprises a large percentage of total trading volume, but does not result in a significant accumulation of inventory. As a result, whether under normal market conditions or during periods of high volatility, High Frequency Traders are not willing to accumulate large positions or absorb large losses.” As for signaling behavior, that is, whether all of that HFT trading volume tells other traders anything useful at all, Kirilenko wrote, “Moreover, their contribution to higher trading volumes may be mistaken for liquidity by Fundamental Traders.”

And to the heart of the matter, whether HFT firms are healthy for the market, the very policy point HFT firms and their academic and regulatory co-religionists cite as justification for a decade’s worth of deregulation in the U.S. – deregulation that enabled and empowered these firms – Kirilenko wrote “when rebalancing their positions, High Frequency Traders may compete for liquidity and amplify price volatility.” He then points out that with inventory half-lives of about two minutes, HFT firms rebalance frequently throughout a trading day.

In stable markets, HFT firms do contribute liquidity and improve standard market quality metrics. Several academics have published studies showing a gradual improvement in several of these metrics in recent years. But their statistics are measured over months or years, and the disruptive and destabilizing trading practices of these firms are usually detectable only in episodes of transitory volatility, volatility which averages out in longer term studies. As an example of this kind of statistical artifact, fatalities from a plane crash will not move national mortality statistics a jot, but that is no consolation to the many victims.

HFT firms today rely on four legs to extract rents from the marketplace. As I wrote recently in a letter published in the Financial Times, these legs are privileged market access, privileged market data, destabilizing trading practices and deregulation.

Read the rest of this entry »

Jess3 has another wicked cool illustration:

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Source:
The Conversation Prism

Source:
Europe’s Headed For A Crisis, Says FT’s Gillian Tett
The Daily Ticker, August 24, 2011

All eyes are of course on the German stock market selloff as it seemed to come out of nowhere and a variety of reasons are being given, the one of a downgrade being particularly nonsense. The two legitimate reasons are firstly, the DAX is being used as a market to hedge against existing positions in other markets ahead of the decision on the part of France, Italy and Spain on whether to expand the short selling ban or have it expire tomorrow. The other reason is the confusion with what to do with Finland’s demand for cash collateral that the other 16 EU countries don’t have an agreement for. The news that the German Finance Minister saying that the deal between Greece and Finland was ‘off the table’ was out before the DAX opening but all we have to do is look at Greek yields to know that there is a big problem with bailout 2.

Another thought on the market weakness, while BAC investors are all excited about the Buffett investment and its helping to lift other bank stocks, why isn’t there concern that just 2 weeks after saying they needed no new external capital, they are selling 6% preferred stock? If Moynihan really didn’t need the money and Buffett really liked the company, Moynihan should have told Buffett to just buy the common shares in the open market.