Financial Review

Do Computers Dream of Algorithmic Capitulation?

Sinclair Noe — August 28, 2015

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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.

FINANCIAL REVIEW

Dow Up, Oil Down, Quit Your Job

Sinclair Noe — November 13, 2014

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

DOW + 40 = 17,652
SPX + 1 = 2039
NAS + 5 = 4680
10 YR YLD – .02 = 2.34%
OIL – 2.79 = 74.39
GOLD + .20 = 1162.90
SILV – .01 = 15.77

Record high close for the Dow Industrials.

The Nasdaq Composite hasn’t seen record highs since the spring of 2000, when it closed at 5048, which is just 368 points, or about a 7% move from here. If you were unlucky enough to have bought the PowerShares QQQ exchange-traded fund, an ETF that tracks that top 100 non-financial stocks in the Nasdaq, on March 10, 2000, you’d still be in the red on that investment.

Tech companies are once again in a leadership role. While Microsoft, Apple and several other tech leaders of today are trading at higher prices than 15 years ago, Intel and Cisco are still well below their 2000 peak prices. Of course the largest company in market cap is Apple at $660 billion. Apple shares have surged more than 40% so far this year, creating more than $160 billion in market value for shareholders, which coincidentally is about the same market cap as IBM, which was once considered the big player in tech. Today, Microsoft passed Exxon to become the second largest company in terms of market capitalization. Exxon has a market cap of $400 billion; Microsoft is worth $408 billion. Exxon’s declining fortunes can be tied directly to the price of oil.

Have you stopped by a gas station in the past few days? I did. I paid $2.78 a gallon. Gas prices have been falling for the past 48 days, and the nationwide average is now $2.92 a gallon, the lowest since December of 2010.

Crude oil prices were down again today after OPEC said demand for its oil will drop next year, and Saudi Arabia remained silent about a possible cut in production. There is another OPEC meeting in 2 weeks, and it is possible that OPEC members Venezuela and Nigeria will cut production, but today the Saudis merely reiterated their policy of stable global markets as they rejected rumors of a price war.

Global demand for oil from OPEC, which pumps a third of the world’s oil, will drop to 29.20 million barrels per day (bpd) next year, almost a million bpd less than what it currently produces. Oil production around the world has been strong in recent years. A boom in the US has pushed domestic production up 70 percent since 2008. At the same time, demand for fuels is growing more slowly than expected in Asia and Europe because of weak economic growth. The US economy is faring relatively well, but more fuel-efficient cars and changing driving habits are keeping domestic gasoline demand low.

Meanwhile, the International Energy Agency says the 30% drop in oil prices over the past 4 months will damage the US shale oil boom and cause supply problems down the road. The low prices could deter investment in production, which will eventually hurt supply. Deutsche Bank said recently that 40% of US shale oil production scheduled for 2015 would be “uneconomic” if prices drop below $80 a barrel; that might be what the Saudis are hoping for. It may be tough to shake out those domestic producers; technology has advanced dramatically.

Meanwhile, oil stocks, shares in oil companies, have not taken the same hit as oil. Sure Exxon-Mobil and Chevron are off their highs, but they have rebounded from mid-October lows; just not as much as the rest of the market. Oil broke a very important level of support at $80 a barrel, which is now the new level of resistance; and the next level of support is $75, broken today. Oil is now extremely oversold but almost nobody seems to think it will go much lower from here; and if it does, there will undoubtedly be production cuts. Of course, the contrarian in me says that nobody is expecting oil to go lower, so it probably will. The point here is nobody knows, so let the market tell you.

Today, the Energy Department revised its outlook for gas prices, saying the average price for gas in the US will be below $2.94 a gallon in 2015; that implies oil prices won’t move above about $84; that forecast included a few caveats about production and possible supply disruptions. The EIA also slightly lowered its prediction for growth in U.S. oil production because lower prices will force some drillers to cut back. Production is expected to reach 9.4 million barrels a day in 2015, down from a previous estimate of 9.5 million barrels per day. Still, that would be an increase of 4 percent over this year and the highest domestic crude production since 1972.

Still, $2.94 a gallon is a 44 cent drop from the outlook issued just a month ago; and that’s 45 cents a gallon less than the average price paid this year. And that works out to about $60 billion in savings. It’s almost like everybody will be getting a raise.

Lord knows we need a raise. This is the first “recovery” where median household income has dropped, and continues to drop. The unemployment rate has dropped to 5.8%. Jobs are coming back but wages aren’t. Every month the job numbers grow but the wage numbers go nowhere. Most new jobs are in part-time or low-paying positions. They pay less than the jobs lost in the Great Recession. And wages are less predictable. Most Americans don’t know what they’ll be earning next month and two-thirds are living paycheck to paycheck. When that is the case, workers who have a job tend to stay on the job, even if the wages are stagnant.

That may be changing. The Bureau of Labor Stats published the Job Openings and Labor Turnover Summary, or JOLTS, for September. There were 4.7 million job openings on the last day of September, down slightly from 4.9 million in August. But more employees quit their jobs: 2.8 million in September compared to 2.5 million in August. These are voluntary separations. This means workers have confidence they can leave their job for greener pastures. The number of job openings are up 20% year-over-year compared to September 2013. Quits are up 16% year-over-year.

It’s definitely good for wages. The unemployment rate comes down, but wage growth lags behind. When labor markets finally begin to tighten and the economy nears full employment, that’s when wage growth accelerates. And we are starting to see a shift in attitudes. Consumer confidence has been firming. More Americans are working, more people are changing jobs, and gasoline prices are down; so even if workers haven’t seen an increase in the paycheck, they have more money to spend, and that might fire up more consumer spending.

We are wrapping up earnings reporting season. Today, Walmart posted diluted earnings per share came to $1.15 in the third quarter, narrowly beating estimates of $1.12 a share, and above the $1.14 it booked in the same quarter last year. Total revenue for the quarter grew 2.9 percent from the previous year, to $119 billion. Same store sales were up for the first time in 2 years.

This has been another strong earnings season and US companies are now sitting on mountains of cash. Capital Economics and Audit Analytics figures companies now have $1.9 trillion in cash held in the US, and $2.1 trillion in cash held offshore.

A follow-up to yesterday’s news of $4.25 billion in fines for a half dozen banks involvement in rigging the foreign exchange markets. I know that sometimes it sounds like we repeat the news. The rigging of Forex markets sounds a lot like the rigging of Libor markets or derivatives markets, but the thing that really makes the Forex rigging a bigger problem is that it happened after all those other manipulations. The Forex investigations ran through October of last year. And that means there was absolutely zero deterrent impact from the billions of dollars in fines for Libor, or all those other fines. Did managements really not know, or even suspect, something was wrong? Did they just turn a blind eye? Or did they just not care?

In a rational world, the customers would move their business to firms with higher standards. That is not going to happen because investment banking is almost a closed shop. The six firms involved in the settlement are five of the biggest banks in the world. Clearly billion dollar fines have not altered bad behavior. No doubt criminal convictions would concentrate minds on the trading floor and in the executive suites. Maybe we should rethink the idea that banks have some inalienable right to control foreign exchange markets or interest rate markets with reckless abandon. Six years after the financial crash, some of the world’s biggest banks are still out of control. In other fields, firms with shoddy practices fear the loss of their license to operate. Big banks don’t, but should. At the very least, it should be time to consider suspensions; a six month ban on foreign exchange trading; maybe a three month ban on bond trading. That would shake things up, for the better.