February 1, 2011

The World Rocks and Markets Roll

Memo on a 70-point swing: Saturday we hiked the red rocks at the Denver Front Range’s Roxborough Park. It was 62 degrees Fahrenheit. This morning it was ten below zero.

Last Friday I was in Dallas (seventy-five degrees warm) for a trading panel discussion at the NIRI Dallas-Fort Worth chapter. Also Friday, the Market Structure Map from last week on artificial liquidity ran courtesy of Joe Saluzzi at the Themis Trading blog, and at Welling@Weeden, Kate Welling’s respected letter at Weeden & Co. (many thanks to both generous hosts). Today against a rocking backdrop of geopolitical unrest, rising global inflation, commodity uncertainty and cold winter weather, US equities are rolling.

Talk about wild temperature swings. Higher prices are nice. We loved them in home values too five years ago. There is no better way to be cool in the IR chair than riding a hot stock. And most times, your executives think your share price is undervalued.

But don’t you wonder, just a teensy bit, how come the prospect of the Suez Canal disappearing into a dark pool isn’t mildly sobering? We had four clients up 5-7% today, five down a little, and the vast bulk up equal or better than the market. Really?

The old adage was “for every buyer there must be a seller.” On the floor of the NYSE, the old specialists ran a book and monitored the crowd and committed capital now and then to smooth temporary imbalances. By the way NYSE companies, you lost another source of trading information last week when identification was removed from order flow hitting floor booths. It’s just liquidity now, a commodity.

“Artificial liquidity” is trading volume that does not exist of its own accord. It’s paid to be there. Mercenary shares. Traders and market makers can get them from anywhere, so long as the need for them does not move outside defined parameters (this is partly why exchanges and regulators want to control the movement of every security with circuit breakers). You can get 100 shares of anything, anytime, anyplace. Why do you think the average trade size today is close to 100 shares? In some massively machine-traded stocks, you can always get 500 shares because there are always five trading systems with 100 shares available.

Where does this mysterious equity ether come from? Over there. Literally. For instance, the Nasdaq’s “rebate,” or payment for order flow, (all approved by the SEC, as is every rebate, so we can’t just blame the exchanges) encourages selling at the Nasdaq and buying at the Boston Stock Exchange, another Nasdaq property. A trader goes over there and buys and offers the shares here. If shares move back and forth, it generates transactions and data for the exchange, which drive revenue, and it supports the ebbing and flowing demand on algorithms.

That seems good. But in essence, markets about 80% of the time now only need either a buyer or a seller, not both. How? If I buy 100 shares at the Boston Exchange, I’ll take them from somebody’s standing order. If I buy 200 now, I will alter all the behaviors, and machines will begin plucking shares from various points and pockets and places, and offering them in front of my order. And those shares could pass through eight machines that are not buyers or sellers at all, but intermediaries. So for eight of ten trades there was only one purpose – moving the shares.

Multiply the effect. What you see are liquid markets with low volatility. What you get are markets in which prices have been manufactured by machines. And this is what we’re getting right now. Part of it is because there is a vast sea of dollars, and dollar-denominated markets are best right now, so machines manufacture liquidity ahead of demand.

This works so long as nothing sloshes mercenary shares outside defined parameters, causing them to quit. But it also means that most times prices aren’t set by real buyers or sellers.

As humorist Dave Barry would say, “We are not making this up.”

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