Has High Frequency Trading, Futures, Derivatives Etc. Rigged the Game Against Individual Investors? Not Really

U.S. and Developed Market Volume Dominated by High Frequency Trading

Tabb Group LLC estimates that High Frequency Trading, where trades are executed in milliseconds, accounted for about 53% of U.S. trading trading volume this year, down from 61% in 2009.. In 2006 it was 26% of the market, says Tabb. ModernNetworks IR LLC estimates that high-frequency firms are handling about 63% of U.S. equities volume, up from about 61% in July but down from last year’s 70% . In times of high market volatility, HFT can account for as much as 75% of trading in U.S. equities, such as August. About 80% of this trading is concentrated in 20% of the most liquid and popular stocks, commodities and/or currencies. Further, the S&P 500 VIX volatility index is almost perfectly correlated to high-frequency trading volumes. During such times of high volatility, institutional trading volumes shift to dark pools and exchange traded funds as institutions for less distorted places to execute.

Such rapid-fire trading was ostensibly responsible for the “flash crash” on May 6, 2010 in which Dow Jones Industrial Average plunged about 900 points—or about 9%—only to recover those losses within minutes. It was the second largest point swing, 1,010.14 points, and the biggest one-day point decline, 998.5 points, on an intraday basis in Dow Jones Industrial Average history. Declines in index futures apparently convinced traders a “cataclysmic event” was pushing down equities. The crash was called a “flash crash” because it came and went in an instant with apparently no lasting damage.

In a subsequent investigation by the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), the regulators found a market so fragmented and fragile that a single large trade could send stocks into a sudden spiral, and detailed how a large mutual fund firm selling an unusually large number of E-Mini S&P 500 contracts first exhausted available buyers, and then how high-frequency traders (HFT) started aggressively selling, accelerating the effect of the mutual fund's selling and contributing to the sharp price declines that day.

Basically, combined selling pressure from Algorithms, HFTs and other traders were instrumental in the market’s dysfunction. Lacking sufficient demand from fundamental buyers or cross-market arbitrageurs, HFTs began to quickly buy and then resell contracts to each other – generating a “hot-potato” volume effect as the same positions were rapidly passed back and forth. In a matter of minutes HFTs traded over 49% percent of the total trading volume, while actually buying a minimal amount.

This is not the first time that some new-fangled trading method or instrument has caused market disruption.

Black Monday 1987

Black Monday refers to a global market crash on Monday October 19, 1987. The crash began in Hong Kong and spread west to Europe, hitting the United States after other markets had already declined by a significant margin. The Dow Jones Industrial Average (DJIA) dropped by 508 points to 1738.74. By the end of October, stock markets in Hong Kong had fallen 45.5%, Australia 41.8%, Spain 31%, the United Kingdom 26.45%, the United States 22.68%, and Canada 22.5%. New Zealand's market was hit especially hard, falling about 60% from its 1987 peak, and taking several years to recover.

The culprit for this crash was supposedly un-controlled computer program trading. While the market crash was feared by some to be the beginning of a serious downturn, it turned out to be a short-term overshoot that barely showed up on the long-term charts. The same could be said for the flash crash, as prices quickly normalized after the aberration. Another common theory was that the crash resulted from a dispute in monetary policy between the G7 industrialized nations, in which the United States, wanting to prop up the dollar and restrict inflation, tightened policy faster than the Europeans. U.S. pressure on Germany to change its monetary policy was one of the factors that unnerved investors in the run-up to the crash. The crash, in this view, was caused when the dollar-backed Hong Kong stock exchange collapsed, and this caused a crisis in confidence. Yet despite all the talk about a possible depression, the S&P 500 by October 1989 was some 8% higher than the pre-crash high in August 1987.

Futures and Derivatives Driven Crashes

Failure of Barings Bank in 1995. Established in 1762, Barings was the oldest merchant bank in London before it failed in 1995 because of a blow-up in their Nikkei 225, JGB and Euroyen futures. Barings collapsed because it could not meet the enormous trading obligations established by Singapore trader Nick Leeson. When it failed, Barings had outstanding notional futures positions on Japanese equities and interest rates of US$27 billion: US$7 billion on the Nikkei 225 equity contract and US$20 billion on Japanese government bond (JGB) and Euroyen contracts. The huge nominal size of these positions is all the more astounding when compared with the banks reported capital of about $615 million at the time. Basically, Leeson tried single-handedly to reverse the negative post-Kobe earthquake Japanese market sentiment. While the Nikkei 225 fell over 28% mid-year, it rebounded 41% from these lows and ended 1995 on a positive note. Leeson’s bullish view on the Nikkei 225 would eventually be proven right, but his derivative/futures positions meant he ran out of time before market prices would prove him right.

Long-Term Capital Management. Before electronic, high frequency trading, the culprit supposedly was futures and derivatives markets as the tail that wagged the market pricing mechanism. Long-Term Capital Portfolio L.P., failed in 1998, leading to a bailout by other financial institutions under the supervision of the Federal Reserve. Here, off-balance sheet illiquid derivative positions with a notional value of approximately $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps and equity options. While the S&P 500 fell some 23% mid-year, it then rallied 36% by the end of 1998 and clocked in a gain for the year of 30%.

Longer-Term Impact of Black Swan Events

In his Black Swan theory, Nassim Nicholas Taleb describes;

* The disproportionate role of high-impact, hard to predict, and rare events that are beyond the realm of normal expectations in history, science, finance and technology.

* The non-computability of the probability of the consequential rare events using scientific methods (owing to the very nature of small probabilities).

* The psychological biases that make people individually and collectively blind to uncertainty and unaware of the massive role of the rare event in historical affairs

The moral of the Black Swan theory is that Black Swan events cannot be predicted, no matter how sophisticated the model, and that banks, other large financial institutions and trading firms remain very vulnerable to such hazardous events. Traders for years have been aware that the “tail” of a so-called normal distribution curve is fatter than theory would suggest, meaning Black Swan events happen much more often than leveraged investors assume.

While very disruptive in the relative short term, such futures, options, derivatives, swaps and algorithm-based high frequency trading do not change the longer-term fundamental (economic and corporate earnings) trends, although they can and do exacerbate and accelerate how fast markets react to shifts in perception regarding these trends.

The simple solution is to reduce leverage and second or third derivative (such as futures, options, CDS, etc.) exposure to Black Swan events, and to simply step to the sidelines and take a breather during times of high market volatility and try to figure out what the real trend of the economy and corporate profits is.

Japan Corporate Profits to Decline 2% in FY2011, Rebound Two Digits in FY2012?

A corporate profit survey by the Nikkei currently indicates ordinary profits for listed companies will decline 2.1% YoY in FY2011, but since April-June corporate profits were down 16.6%, corporate profits should see a second-have revival along with Japan's economy, with the manufacturing sector expecting a 30% rebound in the second half of FY2011. In addition, all corporate profits including the financials are expected to show positive growth of 2.5% YoY.

The sectors expecting two-digit YoY growth in ordinary earnings in FY2011 are;
Textiles/Apparel (+13.7%), Machinery (+10.8%), and Precision equipment (+22.6%).

The Nikkei 225 has been a roller coaster, falling 20.7% from a pre-earthquake high of 10,857, then rebounding to 10,138 (+17.8%) and then plunging almost 12% with the recent selloff in global equities. If the 2.2% GDP growth is a credible number for FY2012, aggregate corporate profits should also have a nice two-digit bounce after pulling out of a steep dive in first half FY2011 because of the disaster.

Thus the current level of the Nikkei 225 is more reflective of a double dip risk than follow-through on the post-quake recovery.

Heat Wave Bigger Problem for Kansai Electric than Tokyo Electric

Despite dire warnings of a possible shortage of electric power, TEPCO (9501.T, Reuters) now has electricity supply capacity of 55 mmKW versus peak demand of 46.8 KW, meaning demand is some 85% below capacity due to larger than expected savings on electricity consumption by companies and households in its service area. It even has enough spare capacity to wheel 2.06 mmKW of electric power to Tohoku Electric (9506.T, Reuters).

The supply demand situation for Kansai Electric Power (9503.T, Reuters) is not so rosy. Electricity demand is expected to reach 95% or more of capacity as companies resume production after the Obon holidays as companies within its service area have resisted calls to save on electricity. The electric train operators for example are reluctant to reduce the number of train runs, while companies like Sumitomo Electric plan to resume production levels as scheduled. Households in the Kansai region have also yet to save any significant amount of electricity consumption given the current heat wave. Consequently, Kansai Electric is asking Chubu Electric to wheel them power, but the amount is minimal as Chubu also has some unexpected plan shut-downs aside from the nuclear plant shutdowns.

Consesnsus Sees 32% Risk to 2.2% Japan GDP Growth Scenario for 2012

Japan's economy contracted 0.3% in April-June, or less than the consensus 0.7% Q-on-Q decline. Further the decline was actually milder than the 0.9% contraction in Jan-Mar 2011, the bulk of which was before the March 11 Tohoku disaster.

A survey of 15 economists in Japan by the Nikkei shows that all expect Japan's GDP to show positive growth in the current quarter (July-September), as supply chains are rapidly being repaired and industrial production is bouncing back. Further, personal consumption is returning and private sector capex is growing. Consequently, the consensus is for a 5.0% annualized GDP rebound in the July-September quarter, which will support 0.3% growth for FY2011 to next March, and 2.2% growth in FY2012--meaning Japan is now showing positive economic momentum even as the U.S., Euroland and even China economies sputter.

This however does not mean the risk of a double dip for Japan is zero. Economists put this risk at just under 20% for FY2011, but the risk grows to nearly 30% in FY2012, with the biggest potential negatives being, a) a double dip recession in the U.S., b) further appreciation in JPY, c) a slowing in China's economy, d) a shortage of electric power, e) further contagion in the Euro sovereign crisis and f) further delays in rebuilding the stricken Tohoku region.

Like their developed market peers, the rally in Japanese stock prices has hit a wall of worry regarding the U.S. economy, more sharp appreciation in JPY and a more pronounced slowing of China's economy, and the recent data for all three is not looking that promising.

Selloff Creates Bevvy of Dead Crosses

In July 2010 James Altucher was writing in the Wall Street Journal claiming the "death" of the dead cross, as he claims you lose money 72% of the time if you try to short the market when you see a dead cross (50-day MA drop below the 200-d MA). By his measurement, the Dead Cross has occurred on 29 occasions since 1955 and has resulted in an up market (by the time the Golden Cross was reached) on 21 of those occasions. If anything, he claims it’s a bullish indicator.

We aren't suggesting you sell dead crosses either, but a dead cross to us means a broken rally that will take months to repair at the earliest. Right now, the S&P 500, NASDAQ and Russell 2000 are showing dead crosses, as are European market ETFs like Belgium, France, Germany, Italy, Spain, Sweden and the U.K. Even though the Swiss Franc is the haven currency, the Swiss equity market is below its 200-day MA. Asian markets like India (dead cross in March), Shanghai (dead cross in June), Hong Kong and Australia. Malaysia have seen dead crosses, while Singapore and South Korea are trading below their 200-d MAs. Japan for obvious reasons saw a dead cross in May following the selloff from the Tohoku disaster.

Inside the S&P 500, the sectors under the most pressure are financials (banks, insurers and broker/dealers), basic materials, industrials and technology, while health care, consumer stables and durables, energy and utilities are not as damaged.

Note: By the way, in the original WSJ article, James Altucher mentioned RIMM as showing a dead cross at the time of the article. RIMM as everyone knows subsequently has plunged from $55/share to $25/share, or by half before bouncing, after the dead cross was shown. Hmm, looks like Mr. Altucher overstated his case.

WSJ: Death of the Dead Cross

China Economy Slowing "Significantly"

Bloomberg News is reporting the U.S. Conference Board believes China growth is slowing “significantly. ”China’s economy is cooling after the government raised interest rates and banks’ reserve requirements and extended curbs on the real- estate market, adding to concerns about the outlook for the global economy. Daiwa Hong Kong economist Kevin Lai says growth in China is actually slowing more seriously than the headline numbers suggest as trade volumes showed demand slowing “sharply” in China and the world. A slowdown in Hong Kong has highlighted the threat of another global slump as weakness in the U.S. economy and a debt crisis in Europe cap demand for exports. The city last week reported that gross domestic product contracted in the second quarter from the previous three months.

This will throw a particular monkey wrench in Japan's exports, as China is now Japan's largest trading partner. While Japan's April-June GDP was not as bad as feared, economists are skeptical about the strength of the recovery for the rest of the year, amid growing expectations of a global slowdown and worries about the possibility of delays to supplementary budgets for reconstruction, which will depend on how well the ruling Democratic party and opposition counterparts co-operate once a new DPJ leader and prime minister is elected in coming weeks.

The value of Japan's exports fell 3.4% in the first 20 days of July, according to preliminary data released by the Ministry of Finance. While the weakness is being attributed to the persistently strong yen, global PMI numbers tanked in July, meaning the Japan export slowdown is not just about a stronger yen.

Plexus Asset Management has an excellent review of GDP-weighted global PMI, which shows the global manufacturing industry tanked in July.



Japan's Slowdown Less Than Expected
Japan's Exports Fall in July
Global PMI Review

Ignore the Media Talking Heads: This Correction Isn't Over Yet

As global stock markets were tanking last week, storm clouds were gathering yet again over the world financial system, prompting a who's who of government leaders to assemble by phone. The flurry of calls were reminiscent of the emergency meetings during the 2008 financial meltdown. Presidents, finance ministers and central bankers dialed in, including German Chancellor Angela Merkel, on vacation in the Italian Alps and French President Nicolas Sarkozy from the Riviera. They were all eager to thwart calamitous day's trading in financial markets, as Europe's worsening debt crisis combined with a first-ever downgrade of U.S. debt by Standard & Poor's.

Signs of Renewed Stress in Global Financial Markets

European banks are relying more on the foreign exchange market to obtain dollar funding, as fewer investors are buying their U.S. short-term debt due to fears that the region's debt crisis is spinning out of control. In the euro/dollar cross-currency market, where a bank can swap euro interest payments with a lender for dollars, the three-month cross rate spiked to minus 84 basis points, the highest since the end of 2008 during the global financial crisis. This rate has doubled in three weeks, but it was still far below the peak of minus 300 basis points seen in the fourth quarter of 2008 when money markets froze after Lehman Brothers collapsed. Exacerbating the problem is U.S. money market mutual funds reducing their holdings of securities issued by European banks, which was increasingly seen as a flash point of increasing risk. Net-net, bank borrowing costs for dollars in other areas of the credit market have been climbing but increases have so far been modest.

But according to the International Finance Review, "options are rapidly running out for Europe’s ailing mid-tier banks as nervous creditors pull the plug on once vital sources of funding in response to growing sovereign contagion worries, sowing the seeds of an imminent liquidity crisis at the heart of the eurozone." "The closure of traditional credit lines is a clear sign that concern over European sovereign debt has infected the region’s banks. Many in the region are big holders of their respective government’s debt. According to the EBA stress tests published in July, the 90 banks it surveyed held a total of €326bn in Italian government debt, €287bn of Spanish public debt, and €215bn of French."

ECB Last Source of Liquidity

The ECB (European Central Bank) is now the last source of liquidity for many. Its member central banks provide unlimited repo financing against certain eligible assets.
Demand for that money has been picking up of late. Last week, the Italian central bank said lenders asked for €80.5bn of liquidity during July, almost double what it provided only a month earlier in a sign of banks’ deteriorating finances. Total use of the ECB’s main refinancing and long-term refinancing facilities – both part of the open market operations – are now close to €500bn, up from about €400bn in the spring. According to IFR, "If ECB eligible collateral runs out, banks will have little option but to sell off assets in a final fire sale, say bankers. That will depend on whether there are willing buyers for such assets, much of which were accumulated pre-2007 as retail, commercial and wholesale loans."

FT ALphaville reports there’s been quite a synchronized plunge in long-term Eurepo rates lately. This includes collateral drawn from Eurepo GC.

The German government no longer rules out agreeing to the issuance of euro zone bonds as a measure of last resort to save the Euro. The newspaper, traditionally close to Chancellor Angela Merkel's Christian Democrats (CDU), indirectly quoted the source adding: "In case of emergency, one would thus even be prepared to accept the introduction of a 'transfer union' and at the end of the day even joint euro zone bonds.

Welt am Sonntag, a German newspaper close to Chancellor Angela Merkel's Christian Democrats (CDU) quoting an unnamed source, "Without these euro bonds, it might no longer be possible to save the euro zone." "The path we've taken so far with multi-billion rescue packages for financially struggling states is beginning to reach its limits."

The ECB has responded with purchases of Italian and Spanish bonds, and Euro governments have initiated short selling bans. But the old fear is the ironic effect this has on sovereign CDS. Italian and Spanish bond yields are falling, but the CDS continues to blow out, apparently an indictment of the ECB’s bid to stifle sovereign volatility with its buying, or as a sign that markets are pressing French and German credit as underpinnings of the euro. ECB purchases might have pushed the hedging of sovereign risk back into the CDS market.

Political Fight Over U.S. Budget Ceiling Not Done Yet Either

According to MarketWatch, the conventional wisdom in Washington (especially inside the administration) holds that the next skirmish will come around Thanksgiving, when the so-called Super Congress of six Republicans and six Democrats have a deadline to make their recommendations about reducing the expected 10-year deficit by another $1.5 trillion. But the next budget brawl could come as soon as Oct. 1, when the new fiscal year begins. While the debt-ceiling agreement did produce a broad outline of how much the government would spend in the next fiscal year, there are no details of exactly which line items would be cut, which would be held constant and which would get increases. Contrary to what most people inside the Beltway believe, the level of spending agreed to in the debt-ceiling agreement is not binding.

Long-time budget observers believe it’s absolutely certain Congress and the president, the House and Senate, and Democrats and Republicans will all be fighting constantly over the budget during the next 18 months, leading to more political "crisis" and market volatility.


Reuters: Euro Banks are Scrambling for USD
IFR: Credit Taps Run Dry
FT Alphaville: European Collateral Crunch
Germans No Longer Rule Out Euro Bond Issuance
WSJ: Global Crisis of Confidence
FT Alphaville: CDS Basis Pain Trade
Next Budget Showdown Just Six Weeks Away

Talk in Japan of Selling U.S. Treasuries

When Japan's big insurance companies and other financial institutions were at their heyday, just a hint of selling U.S. treasuries conjured up images of a USD crash, plunging world financial markets and serious cracks developing in the unshakable U.S.-Japan postwar political alliance. In 1997, the suggestion by Prime Minister Ryutaro Hashimoto about selling Treasuries set off a Wall Street plunge until Japanese officials quickly jumped in for damage control and promised Tokyo had no such plans.

Thus Japan selling of U.S. treasury holdings has historically been considered unthinkable.

However, one spinoff political party, Your Party's Kenji Nakanishi is now openly suggesting that Japan gradually sell off its U.S. treasury holdings to help fund Tohoku reconstruction, as Japan's U.S. treasury holdings amount to JPY1 million per Japanese, meaning Japanese savers are at risk from U.S. treasury holdings without even knowing it. Further, Japan has few alternatives to raising taxes to fund reconstruction, which presents an unwelcome burden on the rest of Japan. Nakanishi said that Japan shouldn't sell all its holdings at once, but should reduce them by about ¥10 trillion each year, and earmark some of that money for recovery spending in the Tohoku region.Long-time critic of Japan's large U.S. treasury holdings, Naoto Amaki, is a writer and former government bureaucrat. He has long thought the time is ripe to start thinking the unthinkable. "Japan, with its towering public debt, is in no position to help finance America's deficit, especially after the March 11 earthquake and tsunami", he said, "Japan's finances were already in serious trouble. Now, we are literally being backed into a crisis of no return."

While still the second-largest holder of U.S. treasuries at USD911.0 as of June 2011, Japan actually holds only about 6% of total outstanding U.S. treasury securities, even though Japan and China combined hold about 50% of total foreign holdings, which are some 30% of total holdings of U.S. treasury securities. Japan's current holdings of USD911 billion are up from USD799.9 billion a year ago, while China's current holdings are USD1,185.5 billion, up from USD1,112.1 billion--i.e., both countries continue to increase their holdings of U.S. treasuries, while foreign governments in total hold some USD3,238 trillion, up from USD3,071.4 trillion a year ago.

But the biggest holders of U.S. treasury are actually domestic. For example, the U.S. Social Security Trust Fund holds about 19%, while the U.S. Federal Reserve has been monetizing U.S. debt under QE1 and QE2, and now holds over 11%. In addition, state and local governments and state/local government pension funds hold another 6% or so, while U.S. money market funds hold another 2%-plus.





Japan Times: Thinking the Unthinkable