After an amazing week of whipsawing market action, we explore why trading was so erratic and conclude that the days of fearless dip-buying and trust that “The Powers That Be” can support the markets may be coming to a messy end.
(Excerpts from Stock World Weekly)
The S&P Downgrade
Standard & Poor’s downgrading U.S. debt from AAA to AA+ after the close last Friday contributed to Monday’s steep selloff. (See Stock World Weekly, Dungeons & Downgrades) But instead of the downgrade of U.S. debt leading to lower Treasury prices and higher yields, as might be expected, the reverse occurred. As we noted in Stock World Weekly, July 31, High Stakes Histrionics:
“AAA status or not, the investing world does not have many alternatives to U.S. Government debt. Joe Weisenthal of Business Insider argued that a downgrade of the US AAA rating wouldn’t result in much of a change at all… ‘There’s just nowhere to fly to in a flight to quality.'” (The #1 Reason Not To Fear A Ratings Downgrade)“
“Investors feel confident that they will be repaid with interest. They are not the least bit worried about a credit downgrade. Nor should they be in the short run. There simply is no alternative to the Treasury market to absorb investible funds. Everything in this world is relative and in that respect, investors still believe that the US is a better bet than anywhere else.” (Lee Adler of the Wall Street Examiner)
Two more years of ZIRP
Trading was wild on Tuesday, with the afternoon release of the FOMC minutes, and the anticipation that the Fed would announce a third round of quantitative easing (QE3). Instead of bestowing QE3 on the stock market gods, the Fed took an unprecedented step of explicitly stating a specific duration for keeping the federal funds rate at 0 to 0.25%. (FOMC Minutes) Lack of an explicit promise for QE3 initially pulled the rug out from under the market, but the drop almost instantly reversed as a strong wave of buying lifted the Dow about 600 points off the low. Veteran trader Art Cashin commented,
“A key to the reversal to the downside was the Fed’s own language. They admitted they had misjudged the economy. It was growing slower and more limply than they had estimated…in the next 30 minutes stocks plunged… Then a strange thing happened. The media types began to talk about the spectacular rally going on in the bond market. My pal, Rick Santelli, pointed out that the yield on the 10 year Treasury had plunged to 2.04%. That could put mortgages under 4%.
“It looked like the Fed had done six months work in 60 minutes. The shorts began to cover. It quickly turned into a stampede as wave after wave of electronic buy orders swept over the floor… One of the most frenetic and bizarre trading sessions that I can recall.” (Cashin: If you Missed the Cuban Missile Crisis, Yesterday Was Pretty Crazy Too.)
What fuelled this rally? According to Jesse of Jesse’s Cafe Americain, the Exchange stabilisation Fund, part of the Treasury, may have been involved. Jesse wrote in an email correspondence with Ilene, our editor: “Robert Rubin said they could do their job best by buying SP futures to stabilise the markets, rather than let them fall and then have to clean up afterwards. When the markets are short term oversold, it does not take much to spark a brief rally, which is often the perfect environment to attempt an intervention.” (Federal Open Market Committee Pledges Monetary Easing Through 2013 If Required)
Ilene asked Lee Adler of the Wall Street Examiner whether the Fed’s extended ZIRP would affect his analysis of the money flows. Lee’s research into the Fed’s and the Treasury’s activities – the money flows – provides invaluable information for formulating an overall market outlook. Lee replied,
“What the Fed says it will do with interest rates has no effect on my analysis. Interest rates generally play no role. I’m interested in the quantity and flow of liquidity. Keeping rates at zero will not prevent crashes, and will cause other dislocations. This happens when you fix the price of anything.
“People forget that interest rates are a two edged sword. For every dollar in interest that someone does not have to pay, that’s a dollar that someone isn’t receiving and consequently can’t spend. It can also force a liquidation of principal. Zero interest rates are deflationary without offsetting money printing.
“It’s very bearish. Case in point, Japan. They’ve been doing it for 20 years and their economy refuses to grow, and people are even refusing to procreate. People who cannot earn a fair return on their assets behave rationally. They stop producing assets, and they stop having children.”
Assessing the market landscape after last Tuesday’s mega moves, Stoneleigh of The Automatic Earth observed,
“Whereas most commentators treat markets as being driven in some kind of rational fashion by external events, we have concentrated on the irrational endogenous dynamics and the role of sentiment in creating the perceptions that drive positive feedback loops – either virtuous or vicious circles. Sentiment, and therefore perception, can change very abruptly, with far-reaching effects. The events of this past week or so have been a prime example.
“The rally of the past two and a half years continued longer than we had anticipated, but on balance of probabilities it is now over, and we are entering the next phase of the credit crunch – the period where a majority begins to appreciate what a credit crunch really means. The first phase, from October 2007 to March 2009, was little more than a mild introduction for many, although even that was enough to push a large number of casualties silently over the edge.” (Over the Edge Lies Fear).
High Frequency Trading
During the turmoil of the last two weeks, the stock market’s fastest electronic firms boosted trading threefold, stepping up strategies designed to profit from volatility, according to one of the electronic firms’ biggest brokers. Wedbush Securities is the largest broker supplying bids and offers on the Nasdaq Stock Market. In a telephone interview with Bloomberg, Gary Wedbush, executive vice president and head of capital markets at Wedbush, explained that the increase in the electronic firms’ trading from August 1 through August 10, compared to their 2011 average, surpassed the 80% rise in equity volume, showing that high-frequency trading made up more of the market during the recent stock market selloff. Mr. Wedbush reported,
“‘We’re seeing a tremendous amount of high-frequency trading. Their business is a trading business, and volatility creates far more opportunities. Some of their algorithms and automated systems are trading two, three or five times as many shares as they would have in a more normalized volatility environment.’
“The role of high-frequency firms in periods of market swings has come under scrutiny since the May 6, 2010, crash that briefly erased $862 billion from U.S. share values. In contrast to their behaviour this month, the traders and other professional investors were said to have withdrawn bids as the 2010 sell-off worsened, according to a Sept. 30 report from the Securities and Exchange Commission and Commodity Futures Trading Commission.” (High-Frequency Firms Tripled Trading as S&P 500 Plunged 13%, Wedbush Says)
Dave Fry, publisher of ETF Digest, shared his thoughts on High-Frequency Trading:
“The market is putting on a show better than Marx Brothers’ A Day at the Races. One day bulls hate HFTs and the next they’re saviors. You can’t have it both ways and the action is getting downright silly. It’s completely dominated by HFTs. So, let’s see if I’ve got this week right so far: -635; +430; -520; and +423 for the DJIA. Who can push these kinds of results? HFTs are the only reasonable answer.
“In the end this volatility and manic behaviour is a massive turnoff to Main Street. The powers that be (TPTB) are pulling out all the stops to thwart action they don’t like. Margin requirements were raised on gold because rising gold prices are a Bronx Cheer to the Fed, Treasury and Administration… Meanwhile, Sarkozy is having another date with Merkel to make sure they’re on the same page with regard to bailouts. She’s become very unpopular in Germany given the Germans will carry the lion’s share of the bailouts. And so it goes.” (HFT-Driven Mayhem Tops Marx Brothers: Dave’s Daily)
The Black Debt
The European “Black Debt” crisis is now spreading beyond the smaller member countries and beginning to affect pillars of the Eurozone such as Italy and Spain. France, too, is worrying investors even though its AAA rating was reaffirmed.
Dr. Michael Hudson explains how the bailout process is being rigged against the general public. He writes,
“A bailout, like any other government expenditure, is a tax. Someone must pay all this money. And it is unfair to tax the broad population to pay for a special interest. Instead of being a progressive tax policy, bailouts enable bad behaviour by the financial elite, sticking taxpayers with the cost.
“Bailouts are unpopular among Europeans who see them as a tax being paid by the population as a whole to financiers at the top of the pyramid. These bankers have lived in the short run, taking large risks of capital for short-term gains to outperform their rivals. It is a game that most individuals have not played with their own savings, and they don’t think that governments should compensate banks for taking these risks.
“The bonds in question are held largely in German and French banks in Europe, and by U.S. banks. Germans are especially angry by reports that U.S. Treasury Secretary Timothy Geithner intervened in opposition to the insistence of Germany’s chancellor, Angela Merkel, that bondholders should take a loss on their irresponsible investments. News reports say that as many as half the troubled securities are held by U.S. money market funds or subject to derivatives gambles. So it is not only European banks that are being bailed out, but also risk-taking U.S. speculators…
“Banks bought these bonds to earn high rates of interest; they took a risk, and now the taxpayers will pay. This is morally repugnant.” (German Taxpayers Willingly Subsidise Bankers)
Looking ahead, we anticipate more turmoil in the Eurozone. Phil is heading into next week “cashy and cautious.” For more, including several trade ideas for next week, take a FREE trial to Stock World Weekly here >