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Friday, August 28, 2015

Do Computers Dream of Algorithmic Capitulation?

Financial Review

Do Computers Dream of Algorithmic Capitulation?

DOW – 11 = 16,643
SPX + 1 = 1988
NAS + 15 = 4828
10 YR YLD + .02 = 2.19%
OIL + 2.71 = 45.27
GOLD + 8.30 = 1134.80
SILV + .08 = 14.70

The week roared in like a lion and left like a lamb. For the week, the Dow gained 1.1 percent, the S&P rose 0.9 percent and the Nasdaq added 2.6 percent. Go figure. Panicked selling on Monday and Tuesday gave way to a rush to buy on Wednesday and Thursday.  And for many investors, it was just too much. Equity funds saw $29.5 billion head for the exits, the largest weekly outflow on record. On Tuesday, investors pulled out $19 billion, the biggest single day for outflows in the past 8 years.  Some traders would call that “capitulation”, a sign of a bottom in the markets.

The chaos of this week’s markets appeared to hit smaller investors especially hard, leaving yet another dent in their stock market confidence. The Monday flash crash resulted in smaller investors being locked out of their online accounts. Strange glitches appeared. Exchanges spit out the wrong prices for widely held funds. For example, the SPDR S&P Dividend ETF dropped 33% in 15 minutes, then shot right back up 30 minutes later, while the stocks tracked by the ETF never fell that far.

The QQQ, which tracks 100 of the biggest Nasdaq stocks, dropped 17% in a matter of minutes. The shares of the 100 companies that make up the PowerShares QQQ did not drop 17 percent. There is about $2 trillion held in 1,411 exchange traded funds in the US. Monday’s flash crash raised an interesting question: how difficult would it be to liquidate those ETFs in a period of stress?

The crash also raised questions about whether the exchanges offer a fair playing field. You probably already know the answer. So far we have heard next to nothing from the Securities and Exchange Commission. What we really saw was a market failure. A playing field heavily tilted toward High Frequency Traders and tilted away from the average investor. Some traders see the outflows as capitulation, but most Mom and Pop investors likely just rode it out; if you own Starbucks, you probably did not sell when it dropped 26%; first you probably didn’t realize it; second, you probably couldn’t log on to trade it.

And so most of the outflow can likely be attributed to the institutional investors and algorithmic traders; those folks, or maybe we should say “those machines”. Gillian Tett of the Financial Times wrote: “these machines are being programmed to link numerous market segments together into trading strategies. So when computer programs cannot buy or sell assets in one segment of the market, they will rush into another, hunting for liquidity.”

In Asia: Chinese shares rallied for a second day and the yuan gained the most since April on speculation authorities took several more steps to prop up equities. During this week’s wild ride, China became the epicenter of a global selloff, with a five-session crash starting last Thursday triggering steep losses in U.S. and European stocks – only to be followed by surges. The Shanghai Composite index closed the session up 4.9%, paring its loss for the week to just over 10%.

So far the situation in China has not lead to credit contagion, just volatility that spread globally. Of course the really big risk of extreme volatility in the markets comes from the possibility that the High Frequency Traders and the market makers and their algorithms just freeze up; and we saw some of that on Monday. Then the circuit breakers kicked in, and things normalized. But here’s where it gets tricky. When all those ETFs couldn’t figure out pricing, it was really a pretty simple problem; check the prices of the stocks in the basket, recalculate, and then reset the prices. Remember that ETFs are a very basic form of derivatives; a fund derived from the valuations of a basket of stocks.

For every market and every index, there are derivatives, and most of them are much more complex than a simple basket of stocks, and they are still largely unregulated. Remember back in 2008, when the derivatives trading unit of AIG collapse? AIG executive Joe Cassano had the famous quote that is was difficult to imagine “a scenario within any kind of realm of reason that would see us losing a dollar in any of those transactions.” And then of course, AIG collapsed when its credit default swaps defaulted and the financial world learned that they couldn’t cover their bets, and the government came to the rescue with a $180 billion bailout for AIG.

Now you may think that this problem was cleaned up following the near global financial meltdown of 2008; Dodd-Frank reform was supposed to make derivatives trading more transparent, but that didn’t happen. Wall Street firms successfully lobbied to have a huge loophole inserted into the Dodd-Frank Act that enables them to evade regulations on swap agreements. Now traders and firms can shift the location of the swaps to places like London and avoid the oversight that was supposed to be provided by Dodd-Frank. The trading affiliates of the largest banks remain largely outside the jurisdiction of U.S. regulators, thanks to a loophole in swaps rules that banks successfully won from the Commodity Futures Trading Commission in 2013.

The U.S. derivatives market has shrunk but remains large, with outstanding contracts worth $220 trillion at face value. And the top five top banks account for 92 percent of that. US banks are still trading derivatives as vigorously as ever. But their trades, booked through London affiliates, do not carry any credit guarantees, meaning that when the next credit contagion hits, they won’t be forced to pay off; meaning that all the financial institutions that purchased derivatives as a hedge against extreme volatility, kind of like what we saw on Monday; they don’t actually have insurance.

The final read of consumer sentiment was revised lower for August, to 91.9 from a preliminary tally of 92.9 and a July reading of 93.1. That was the first reading since the market turmoil.

Total incomes rose 0.4 percent in July for a fourth month.  Consumer spending increased 0.3 percent in July, matching the prior month’s gain. Because spending increased less than incomes, the saving rate rose to 4.9 percent from 4.7 percent. Today’s Commerce Department report also showed inflation remained tame. The personal expenditure index, or PCE, increased 0.1% from the prior month and was up 0.3 percent from a year earlier. The core price measure, which excludes food and fuel, also rose 0.1 percent from the prior month and was up 1.2 percent from July 2014, the smallest year-to-year gain in four years. Inflation hasn’t reached the Fed’s 2 percent goal since April 2012.

So what’s on the menu at Jackson Hole? The Federal Reserve’s annual economic policy conference kicked off late last night, and will run through Saturday. Fed policymakers have, in the past, used the conference to telegraph changes in monetary policy. In the past couple of days, we have heard from NY Fed President William Dudley, who seems split between hiking or waiting; KC Fed President Esther George is predictably hawkish; Minneapolis Fed President Narayana Kocherlakota is predictably dovish.

With Fed Chair Janet Yellen skipping the conference we probably won’t hear anything definitive, traders will be watching for signals about the likely timing of an interest rate increase from Vice Chairman Stanley Fischer. Today Fischer was playing it close to the vest, saying the Fed is watching the situation in China, but also acknowledging that the US economy has shown signs of strength.

There is little doubt that the Federal Reserve’s efforts to prop up the stock market since the 2008 financial crisis through monetary stimulus measures, like buying up government bonds and other assets, better known as quantitative easing, or QE, helped fueled one of the longest bull runs in history. But those who predict a cratering of the market with the cessation of QE have, so far, been proven wrong. At most, the market rally slowed, but it did not crater. The market anticipation of the end of QE, a taper tantrum, was far worse than the actual end of QE. We may be seeing something similar now.

And while QE and Zero Interest Rate Policy were certainly important parts in the market recovery from 2008, they were not the only parts, and it is probably misleading to make a direct connection when trying to gauge where the S&P 500 is headed or why it might go in a particular direction. In short, an interest rate hike in the not-too-distant future is not off the table.

Crude prices were up again today after bouncing back from six-and-a-half-year lows on positive U.S. growth numbers, recovering equities markets and reports of an emergency OPEC meeting. On Thursday, oil saw its biggest one-day bounce since 2009 with North Sea Brent and U.S. light crude rising more than 10%, tacking on 6.3% today. WTI crude posted its first weekly gain in nine weeks, ending its longest losing streak since 1986.

Carl Icahn has set his sights on mining company, Freeport-McMoRan. The stock surged almost 30% after announcing plans to cut spending and production, and lowering its 2016 capex budget by 29% from its $5.6B estimate issued in July. After the closing bell, Carl Icahn disclosed an 8.46% active stake in the company, sending shares up another 10% in after-hours trading. In a new 13D filing, Icahn said he plans to engage with Freeport McMoRan management and may seek board seats.

“For the first time ever, one billion people used Facebook in a single day – one in seven people on earth,” – that according to a blog post from CEO Mark Zuckerberg. With 1 billion users this past Monday, the 12-year-old company has become an online community that is bigger than the population of every country on the globe except China and India. Facebook has 1.49 billion average monthly users, and said it had an average of 968 million daily users in June.

I guess we really are all in this together.

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