May 11, 2010

The Market Fits Like a Sock

The late standup comedian Mitch Hedberg said: “A severed foot is the ultimate stocking stuffer.”

I’m not sure that’s funny. But it segues to the stock market. So let me tell you a story about a severed foot in a sock.

Nets have been cast wide to discover what went wrong in the markets last week. There were hearings today before the House Subcommittee on Capital Markets. There have been wringing regulatory hands. Scott Patterson postulated in the Wall Street Journal that a Black Swan waddled through, courtesy of a tail-risk-timed futures bet by a Santa Monica hedge fund.

Looking at client data, the reason why the mystery cannot be solved is because there is no mystery. Our conclusion about trading on May 6-7 after studying prodigious data: In the absence of value and real buyers and sellers, machine-driven markets may collapse. This indeed is tail risk or a Black Swan – severe divergence. But markets functioned as machine markets will, and it was nobody’s fault.

Here’s why. High-frequency systems generally furnish shares and hold no positions. When they trade with each other, the trend of the crowd – general market sentiment – is magnified, be that fear or greed. High-speed trading systems don’t represent a thoughtful search for value; they’re the other side of the trade. Period. And if high-speed systems are BOTH sides of most trades, market reactions can be extreme.

This is how Accenture can briefly trade for a cent. Registered market makers put in wide bids and offers so they can transact between. If you intend to trade inside the best bid or offer, you might, for a $50 stock, set your offer at $100 and your bid at $0.01. If your bid suddenly becomes the only one and some panicked body enters a market order to sell, the trade will execute at one cent. Blaming traders for getting out of the market is like excoriating the signal man on the track for stepping away from in front of the train.

Most days, there is no trend. There is continuous reaction by speculative systems to actions from risk managers and investors. Passive, high-frequency market-making is speculative no matter what anyone says. It’s trading for trading’s sake. Period. When speculators encounter markets devoid of actual buyers, sellers, or risk managers, extreme bids and offers set prices. And the Dow drops 1,000 points in minutes.

We’ve been saying since 2008 that the market is a synthetic construct susceptible to a giant tear in the continuum. Regulators and even the exchanges are looking in the wrong place for answers. Rather than asking who screwed up, we should be saying, “Holy cow. The foot in the sock is severed.”

For a brief, terrifying period on May 6, we stared cold truth in the face: Nobody saw widespread value, even as the market dropped 1,000 points. That should wake us up.

Our markets don’t have any clear value. There is something radically wrong when liquidity is the only thing propping them up. Here’s an analogy: picture four people at a card table. One has a large stack of dollar bills. The other three are poised. Each time the one lays a dollar on the table, the other three slap to grab it and the fastest keeps it. When the dollars stop coming, the game dies.

Now consider what happened yesterday. Markets popped back when Europe devalued its currency. That’s what pumping $1 trillion worth of Euros into the system is. When markets respond favorably to devaluation, prices reflect inflation, not value.  Our global market and economic construct is predicated on liquidity in place of value. Sooner or later you run out of liquidity and the whole thing crashes down. No amount of printing and dumping more into the system is ever going to fix it.

That’s the bad news. There’s good news too. We saw vast disparity in client data. There was no discernible pattern, because it was, to quote funny man Jeff Foxworthy, “pandelerium.” But here’s the interesting thing: we saw strength in the market structure of clients with firmer commitment from informed money. Value matters. Resilience stems from value in the eye of a beholder, not from automated quotations.

We’re at what Barack Obama would call a teachable moment: The sustainable basis for healthy, vibrant markets is the infinite variety and intelligence of the opinions of buyers and sellers transacting with currencies of constant value.

If we want our IR jobs to count for more again, our governments must stop this insane, insatiable stream of liquidity from central banks. Yes, it would hurt for a bit, but imagine the grand and verdant vistas of value beyond the shadowy valley. We’re all in this muddy liquidity puddle together, be it with Yen, Euro, Dollar, Sterling, Loony or whatever.

Let’s put our foot down about this. Or we’ll be left with a severed one in our stocking. Again.

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