A market ripe for a fall

Last Thursday the market experienced a sudden air pocket, with the S&P index temporarily dropping by over 100 points. In real-time, it certainly looked as if a crash were underway. At the low point, a record one day intra-day loss was recorded. As is now known, a mixture of errors and glitches contributed to the situation, and it is also known that several HFT (high frequency trading) firms simply stopped trading after the DJIA had fallen by 500 points. Apparently, some of these firms have a rule to withdraw when 'disorderly market conditions' pertain.

 

Let us be clear beforehand, the stock market was more than ripe for a sell-off. In the weeks leading up to the late April high numerous sentiment indicators went to rarely seen extremes. Especially equity option traders (both large and small) had begun to buy more and more call options for several weeks while refraining from buying protective puts, and various polls (such as Investor's Intelligence) showed an increase in bullish opinion on a par with the bullish consensus seen at major market tops in the past. Lastly, the mutual fund cash-to-assets ratio fell to a new all time low, clocking in at barely above 3% in March. This particular datum is in fact a major medium to long term bearish indicator, and a strong warning that the secular bear market is likely to continue and enter its next phase of liquidation.

 


 

CBOE equity put-call ratio

The CBOE equity put-call ratio – click on chart for a larger version of the image

 


 

II poll

The Investor's Intelligence poll – at the end of April, over 55% of advisors were bullish, and less than 20% bearish. This is a very extreme reading – click on chart for a larger version of the image.

 


 

MF cash-to-assets ratio

The mutual fund cash – to assets ratio – a new all time low of 3,4% as of March 2010 – click on chart for a larger version of the image.

 


 

This surfeit of bullish sentiment was certainly aligned with the trend, but that trend had become very stretched. The stock market has been strenuously overvalued for quite some time (more on the stock market valuation issue in a follow-up post). Insiders have been selling hand over fist since the summer of 2009, with nary any buying detectable. In short, the market was in a situation where a period of abrupt and large losses was likely to occur soon. In the trading week prior to the mini-crash, volatility suddenly picked up, a classic pattern of distribution.

 


 

SPX-3 months

The SPX prior to the mini-crash: A pattern of distribution. – click on chart for a larger version of the image.

 


 

Bulls made the same erroneous assumption that preceded the 2007-2008 decline: namely that the market's capacity to ignore any and all potentially bearish fundamental news for a while was a sign that these developments 'didn't matter'. A plethora of articles in the financial press suggested for instance that the sovereign debt crisis engulfing the Euro-area could be safely ignored by investors – in some instances it was even argued that the bearish developments in Europe would be bullish for financial assets in the US. This is of course utter nonsense.

 

 

Trading systems go haywire

As mentioned above, several HFT firms ceased trading during the market crash in medias res. As the Wall Street Journal reports:

 

 

 A number of high-frequency firms stopped trading Thursday in the midst of the market plunge, possibly adding to the market’s selloff. Tradebot Systems Inc., a large high-frequency firm based in Kansas City, Mo., closed down its computer trading systems when the Dow Jones Industrial Average had dropped about 500 points, said Dave Cummings, founder and chairman of the firm. Tradeworx Inc., a N.J. firm that operates a high-frequency fund, also stopped trading during the market turmoil, according to a person familiar with the firm. Mr. Cummings said Tradebot’s system is designed to stop trading when the market becomes too volatile, too fast. “That’s what we do for safety,” he said. “If the market’s weird, we don’t want to compound the problem.” Tradebot says it often accounts for about 5% of U.S. stock-market trading volume. The withdrawal of high-frequency firms from the market didn’t necessarily cause the downturn, but could have added to it, some market experts say. A number of high-frequency firms closing down in the midst of a sharp market drop can “widen markets out substantially,” said Jamie Selway, managing director of New York broker White Cap Trading.

 

 


 

intraday view of mini crash

An intra-day chart of the mini crash – each candle represents 3 minutes – the period when the bids were suddenly pulled is clearly discernible – click on chart for a larger verion of the image.

 


 

Procter and Gamble

An intra-day chart of venerable Dow stock Procter & Gamble – n.b. this is considered a 'defensive stock' – another crash lasting 3 minutes and reversed just as quickly – click on chart for a larger verion of the image.

 


 

 

According to this Wikipedia article on quantitative trading strategies, HFT recently accounted for more than 70% of all trading volume on US stock exchanges. Does it matter when these firms stop trading and pull all their bids? You bet it does. In discussions with several friends in recent months, I have dubbed this phenomenon the 'fully automated crash' (FAC). My argument centered on several aspects of the market structure. For one thing, the claim made by HFT firms that they have effectively replaced the 'specialist system' and by providing liquidity have actually helped to keep the market stable, never sounded credible to me. These firms use algorithms for trading, designed to arbitrage away what are often tiny price differences. My question was always: What if all of these algorithms want to sell at once, with none of them bidding for shares? Is that an unthinkable situation?

We now know that it can indeed happen. In addition, there are other quantitative trading strategies employed by dedicated hedge funds in the market, most of which use some combination of technical analysis and empirical historical data to determine which trades to execute.

The most salient fact about these quant strategies is that none of them have anything to do with 'investing' in the classical sense of the term. While every system is slightly different from its peers, the main inputs of these systems still tend to increase the herding effect – this means that e.g. favored stocks or commodities will see their trends magnified, adding to the 'normal' herding effect observed in financial markets, and eventually exaggerating the overvaluation of these assets. The other side of the coin is that when a sudden market decline happens, all these systems will sell or attempt to short the market at once.

Once again, apart from systems that use mean reversion as their major input, this will lead to a 'bidless market' and exacerbate declines. The final point to consider are the option markets. Since the crash of 2008, overall trading volume in the stock market has steadily declined. At the same time however, open interest in the option markets has raced from record to record. The increases are by no means small, as you can see when looking at the press releases of the CBOE, the major options exchange in the US.

Consider now how option writers protect themselves against adverse market movements. The most prevalent strategy is referred to as 'dynamic delta hedging'. Delta in options terminology is also fittingly known as the 'hedge ratio' – it compares the price change in the underlying security to the corresponding price change in the derivative. The objective of dynamic delta hedging is to become 'delta neutral' if adverse price movements endanger the position of an option writer. In practice, these strategies are also executed by algorithms, whereby for instance the writer of a naked put will go increasingly short the underlying security if the security falls and threatens to slice through the strike price of the written put.

Conversely, the writer of a naked call will go increasingly long the underlying security if it rises and approaches and eventually breaches the strike price. These strategies are adapted to various parameters such as the premium received by the options writer, but essentially they all aim to offset risk by taking a position opposite to the options position – and they do it dynamically. Naturally, this form of dynamic hedging will then also magnify price movements, especially when these price movements are very large and many strike prices with large open interest are sliced through in a short period of time. Given that trading volume in equities has steadily trended down, while options open interest and trading volume has trended steadily higher, the potential for dynamic delta hedging to exacerbate both sudden and large up and down moves in the market has increased markedly.

 

 

Panic of the machines

Considering the prevalence of quantitative trading strategies in today's marketplace, human emotion, which has been the main driver of market movements in the past, has at least in part been superseded by the 'greed and fear of machines'. Naturally, the computers doing the trading do not have emotions – that is precisely the reason why quant strategies have become so popular in the first place. It is held that they remove the human error factor from securities trading, by maintaining cold, pre-programmed objectivity in all situations.

This conviction is a close cousin to the conviction back in the late 1980's that 'portfolio insurance' using S&P futures to protect a basket of stocks dynamically with a likewise fully computerized procedure, could in fact insure stock portfolios against losses. Instead the combination of portfolio insurance and program trading (a form of arbitrage between stock index futures and the underlying baskets of stocks) combined to produce the biggest one day market crash in history in 1987.

Any market in which a specific trader has 'become' an overwhelming percentage of the positions in this market is bound for problems. HFT and other quant strategies are a form of trading that effectively transforms the many different firms engaging in it into a single entity, due to the strong similarities in the strategies employed.

After all, the algorithms used by the black box community have been programmed by humans, all of whom work with the very same set of historical data to come up with effective trading rules that can be back-tested and thus legitimized. Instead of eliminating human error, the computerized strategies are in fact multiplying it, by dint of all of them reacting in virtually the same manner to a given set of inputs. And so the machines are perfectly capable of reciprocating the mindless greed and equally mindless panic that characterize the emotion-laden trading of mere humans, and in fact, it appears that they are capable of exaggerating both.

 


Conclusion

Without a doubt, quantitative strategies are here to stay. There is growing investor demand for funds employing systematic strategies, and the marketplace has reacted to this growing demand by supplying ever more sophisticated systems that are on the whole highly successful. The panic of last Thursday will likely lead to new regulations and restrictions aiming to blunt the impact these strategies have on the market, but it can be safely predicted that not a whole lot will change in principle – the exchanges would be up in arms if any putative restrictions to electronic trading strategies were deemed too onerous, as they create a good slice of the exchanges' income.

Given that a huge sub-industry has evolved in the hedge fund industry and the CTA (commodity trading advisors) space that revolves around systematic strategies, there are now sizable vested interests that would be threatened by such regulatory action. Besides, we have empirical proof galore that as soon as one potentially market-destabilizing practice is curtailed (such as the curbs on program trading introduced after the 1987 crash), other strategies with similar characteristics will soon take their place. In any case, the market demand for such strategies will only continue to prevail as long as these strategies work as advertised. To wit, portfolio insurance died a sudden and quiet death after the 1987 crash.

There was no need to curb it – the market itself curbed it, by proving spectacularly that it didn't work. So far, most quant strategies seem to work just fine, hence demand for them is bound to continue to be strong. However, investors and traders need to be aware of the potential impact these strategies can have on the market. We may well one day wake up to a market dislocation unlike any other witnessed in market history to date.

A final point I wish to make is that in Thursday's trading another lesson was taught yet again: in a panic situation, when trading volume explodes and prices fall at great speed, the infrastructure that is supposed to handle transactions is prone to failure. It suddenly takes ages to get confirmations of trading executions, and as the many in the meantime 'busted' trades reveal, posted bids and offers can fail to reflect reality. For instance, Accenture (AGN) and several other stocks and ETFs at one point traded at plainly absurd prices (AGN went from about $45 to 1 cent in the space of a few minutes).

In other words, if you are exposed to a lot of risk, don't fool yourself into thinking that if anything untoward happens, you will be able to 'get out in time'. As always, market liquidity disappears just when it is needed most, and the backbone of our famed electronic trading spaces is less resilient and reliable than is generally assumed.

Charts by: StockCharts.com, schaeffersresearch.com, sentimentstrader.com.

 


 
 

Emigrate While You Can... Learn More

 
 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke

   
 

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • Speculative Blow-Offs in Stock Markets – Part 1
      Defying Expectations Why is the stock market seemingly so utterly oblivious to the potential dangers and in some respects quite obvious fundamental problems the global economy faces? Why in particular does this happen at a time when valuations are already extremely stretched? Questions along these lines are raised increasingly often by our correspondents lately. One could be smug about it and say “it's all technical”, but there is more to it than that. It may not be rocket science, but...
  • Speculative Blow-Offs in Stock Markets – Part 2
      Blow-Off Pattern Recognition As noted in Part 1, historically, blow-patterns in stock markets share many characteristics.  One of them is a shifting monetary backdrop, which becomes more hostile just as prices begin to rise at an accelerated pace, the other is the psychological backdrop to the move, which entails growing pressure on the remaining skeptics and helps investors to rationalize their exposure to overvalued markets. In addition to this, the chart patterns of  stock indexes...
  • India: Still the Fastest Growing Large Economy?
      India’s Currency Ban - Part X It has now been four months since Narendra Modi declared about 86% of monetary value of currency illegal. Linked here is the last in my series of updates, which was written soon after the deadline to deposit the demonetized currency. Most of the banned currency was eventually deposited, making a mockery of Modi, who had claimed that unaccounted money would not reach the banks.  Perhaps 3% of the cash never reached the banks.   A cunning plan...
  • Gold Sector: Positioning and Sentiment
      A Case of Botched Timing, But... When last we wrote about the gold sector in mid February, we discussed historical patterns in the HUI following breaches of its 200-day moving average from below. Given that we expected such a breach to occur relatively soon, the post turned out to be rather ill-timed. Luckily we always advise readers that we are not exactly Nostradamus (occasionally our timing is a bit better). Below is a chart of the HUI Index depicting the action since the January...
  • They're Worried You Might Buy Bitcoin or Gold - Precious Metals Supply and Demand
      Bitcoin Mania The price of gold has been rising, but perhaps not enough to suit the hot money. Meanwhile, the price of Bitcoin has shot up even faster. From $412, one year ago, to $1290 on Friday, it has gained over 200% (and, unlike gold, we can say that Bitcoin went up — it’s a speculative asset that goes up and down with no particular limit).   Bitcoins are a lot less tangible than this picture implies, but they are getting a lot of love recently...
  • Welcome to Totalitarian America, President Trump!
      Trump vs. the Deep State If there had been any doubt that the land of the free and home of the brave is now a totalitarian society, the revelations that its Chief Executive Officer has been spied upon while campaigning for that office and during his brief tenure as president should now be allayed.   Image adapted from the cover of “Deep State #5” - depicting an assassin from the future   President Trump joins the very crowded list of opponents of the American...
  • Boosting Stock Market Returns With A Simple Trick
      Systematic Trading Based on Statistics Trading methods based on statistics represent an unusual approach for many investors. Evaluation of a security's fundamental merits is not of concern, even though it can of course be done additionally. Rather, the only important criterion consists of typical price patterns determined by statistical examination of past trends.   Fundamental considerations such as the valuation of stocks are not really relevant to the statistics-based trading...
  • The Long Run Economics of Debt Based Stimulus
      Onward vs. Upward Something both unwanted and unexpected has tormented western economies in the 21st century.  Gross domestic product (GDP) has moderated onward while government debt has spiked upward.  Orthodox economists continue to be flummoxed by what has transpired.   What happened to the miracle? The Keynesian wet dream of an unfettered fiat debt money system has been realized, and debt has been duly expanded at every opportunity.  Although the fat lady has so far only...
  • Why the 21st Century Sucks - Turtles All the Way Down
      A Truly Sucky Century BALTIMORE – What an awful century! Worst we’ve ever seen. Household incomes are down. Employment is down, with 7 million people in the U.S. of working age without jobs. Productivity growth is down. GDP growth is down – to only about 0.5% per capita last year. Even life expectancies are down. Drug overdoses are up. Suicides are up. One out of every eight children lives in a family getting food stamps. One of out every eight adults takes psychoactive drugs...
  • Searching for Truth
      Heresy or Truth? RANCHO SANTANA, NICARAGUA – In the fifth century, Christian scholars counted 88 different heresies. Arianism. Eutychianism. Nestorianism. If there was a way to “offend” God, they had a name for it. One group of “heretics” argued that there was no such thing as “original sin.” Another denied the trinity. And another claimed Jesus was not divine. Which one had the truth?   Depiction of the first Council of Ephesus in 431 AD, convened by Emperor...
  • Gold and the Fed's Looming Rate Hike in March
      Long Term Technical Backdrop Constructive After a challenging Q4 in 2016 in the context of rising bond yields and a stronger US dollar, gold seems to be getting its shine back in Q1. The technical picture is beginning to look a little more constructive and the “reflation trade”, spurred on further by expectations of higher infrastructure spending and tax cuts in the US, has thus far also benefited gold. From a technical perspective, there are indications that the low at $1045.40,...
  • Off the Beaten Path in Mesoamerica
      Greeted by Rooster There’s an endearing quality to a steadfast rooster call at the crack of dawn when overheard from a warm country farmhouse.  There’s a reassuring charm that comes with the committed gallinaceous greeting of daybreak that’s particularly suited to a rural ambiance.  The allure of a morning cock-a-doodle-doo somehow falls flat in all other settings.   Good morning everyone! Before meteorological forecasts were available on TV and smart phones, people...

Austrian Theory and Investment

Support Acting Man

Own physical gold and silver outside a bank

Archive

j9TJzzN

350x200

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com