In Search of the Perfect Investment

Richard Russell argues his normal bearishness. Could he be right? For my take, he’s missing five factors:

1. The vast amount of cash sloshing around earning bupkash (yiddish for nothing) and looking for a home.

2. The U.S. dollar is looking fantastic, relative to other alternatives.

3. Much of the bad news is known and presumably has already been priced in.

4. Corporations have cut back and their earnings are rising.

5. Skirts are rising, some to absurd heights. Isn’t life wonderful.

Comments my friend, Pete Rawlings, “If you’re bearish for years, ultimately you’re right. Then you’ll be a genius.”

From Russell’s latest newsletter:

June 2, 2010 — Is it a bear market? June 1 (Bloomberg) — The biggest monthly drop in the Standard & Poor’s 500 Index since February 2009 is ratifying Mohamed El-Erian’s prediction for a new normal of below-average returns. Analysts say not so fast.
Combined price estimates from more than 2,000 forecasters tracked by Bloomberg show the S&P 500 will rise 27 percent in the next year, the fastest projected rate since February 2009, data compiled by Bloomberg show. The rally above 1,350 will be led by industries most tied to the economy, according to analysts who boosted individual share projections by an average of 0.9 percent in May, the 14th straight monthly increase. Russell Comment — Yeah, I think it’s a bear market. But the average of 2,000 professional forecasters remain bullish and are looking for substantially higher prices.
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I want to go over the three psychological phases of a primary bear market.

The first phase is the one where the bear market wipes out the optimism and excitement which existed at the preceding bull market’s top. I believe we are in the first phase of the bear market now.

The second phase of a bear market is usually the longest phase. This is the phase where it gradually dawns on stock holders that business is deteriorating and that we are moving into hard times. I believe we are now close to the second phase.

The third phase of a bear market is the “throw ’em in” phase where stocks are sold for no other reason than that the sellers need to raise cash. During the latter part of the third phase, blue-chip stocks will sell “below known value,” and dividend yields on top-quality blue-chip stocks will climb above 6% or more. Investors will turn black-bearish, and we will hear opinions such as “This is the end of capitalism,” and “The nation may not survive.” As a pure guess, I think that if or when the Dow breaks below its March 9, 2009 low of 6547.05 (and I think it will) that will mark the end of the second phase of the bear market and the start of the third phase.

I’m aware that many of my subscribers are sceptical of my warnings regarding the years ahead. The generations since the end of World War II have never experienced hard times. I’m aware that it is difficult to envision what you have never experienced. If I have one unusual talent, it’s the ability to envision vast change.

Here’s one item that I have not discussed. The great primary bull market started in 1980-82 and lasted to 2007. That represents a period of 27 years of generally rising prices, over-consuming and debt-building. Most bear markets tend to last one-third to one half as long as the preceding bull market. On that basis, this bear market may have years to go. If, as some claim, the bear market started in 2007, that would mean that the bear market is less than three years old. It’s absurd to think that a 27-year bull market can be corrected in less than three years.

Question — Russell, almost every analyst and economist now seems bullish regarding the market and the economy. How is it that you can take a stand directly in opposition to the great majority of analysts and economists? If your bearishness proves to be correct, what could the other people in your field be missing?

Answer — My answer to the question above is that the other analysts just have not done the work. And they don’t have the experience. They still don’t really understand that the stock market and the current economy are two separate items. The fact is that these people don’t really believe that the stock market discounts the future, regardless of what’s happening in the present.

In my business, you have to have done the work. You have to have a knowledge of the “internal” and “external” markets. You have to realize that the external market inevitably follows the internal market. You have to be able to read the internal market. But above all, you must accept the fact that the stock market is disinterested in current news and that the function of the stock market is to discount the future.

I liken the stock market today to a man who looks healthy, eyes shining, full head of hair, rosy cheeks, broad chest, but he’s suffering from cancer of his stomach and his pancreas. In other words, he’s a dead man walking. That’s the way I view today’s stock market.

One more item — in order to do what I do you must be totally obsessed with the stock market. Your life has to be one long learning process. You have to have studied almost every facet of the stock market that’s available. You have to able to detect or sense change. You have to know which technical items to believe and which ones to throw out. In short, you have to be what I call a “stock market maniac.” There are average doctors, there are good doctors, and there are great doctors. What make the rare great doctors? My answer is — damned if I know. Maybe it’s an instinct, maybe it’s an obsessive personality.

When I was 8 years old, I had a severe mastoid infection. My mom’s sister had died of a mastoid infection. Therefore, my parents were frantic. My parents took me to the top children’s surgeon in NYC. The surgeon refused to take the case. Why? He thought I was too far gone — the surgeon didn’t think I could live. He just didn’t want another dead child on his record.

My parents found another surgeon. His name was Sigmund Manheim. Manheim was an original. He refused to split fees and was barred from practicing at Mt. Sinai Hospital in Manhattan. But Dr. Manheim took my case anyway. I was sent to Doctor’s Hospital in Manhattan. Dr.. Manheim was obsessed with cleanliness. He would not let the nurses change my dressings. He insisted on doing everything himself. Dr. Manheim probably saved my life. My parents treated him as though he was a God. Sigmund Manheim was a great and dedicated doctor. I probably would have died had it not been for Dr. Sigmund Manheim.

I’ve lived through a lot of stock markets, but I have to call this one “diabolical.” It’s diabolical because it’s playing with the minds of the optimists. This bear market is like a cat playing with a dying mouse. The market opens higher, the Dow, which everyone watches, opens higher by 70 points. The bulls utter a sigh of relief. Then near the close, the smart money throws in the towel, and the Dow drops 100 points. “The market looked good all day,” sighs the bull, “and then some whacko dumped stocks at the close. Maybe some trader pressed the wrong button or something, tomorrow should be better.” The bear grins and sits back on his haunches. Time for a little rest.

The Dow has been down five out of the last six weeks. It’s severely oversold. Therefore, a dead-cat bounce should not be unexpected. But with Selling Pressure so high, and my PTI close to breaking down completely, anything can happen. But who cares if you’re OUT of the stock market. If you’re still in, you’re not taking me seriously. Hey, I’ve tried my best to get everybody out. What do I do next?

The chart below from the Chart Store shows the steady decline in the percentage of S&P stocks holding above their 200-day moving averages. Deterioration in the “internal market.”

When is it “irrational exuberance?” After housing imploded it was fashionable among economists (especially government ones) to argue that that you can’t predict irrational exuberance.

My take is simple. Check out chart. If it suddenly goes parabolic, you know it’s about to burst.

A friend says he has a better indicator. Towards the end, prostitutes were giving up their old profession and becoming real estate brokers. (This is true.)

Here’s another irrational exuberance. I would not be speculating in Vancouver houses — no matter how much I love that wonderful city.

Canadian real estate prices have been rising across the board, but some regions are going wild. The chart above comes from the Real Estate Board of Vancouver. Check out the price trend for single detached houses, the top line in red. Some houses appear to have almost tripled in value since 2000.

Fast, Loose, and Out of Control. High frequency trading from the latest Newsweek.

Trading billions of shares in the blink of an eye has made stock markets more responsive—and volatile—than ever.
by Matthew Philips of Newsweek, June 01, 2010

On April 26, the Dow Jones industrial average stood at 11,205, up nearly 70 percent since its low in March 2009. While there were bumps along the way, the ride from 6,500 to 11,205 was generally smooth and steady. But the placid markets were about to get hit by a tsunami. When it became evident that Greece’s financial woes might spark a Europe-wide sovereign-debt crisis, the waters began to churn. The Dow lost 214 points on April 27 and posted triple-digit moves on 13 of the next 17 trading days. Worst was the “Flash Crash” of May 6, when the Dow lost 998 points in a matter of minutes, only to rally more than 600 before closing down nearly 350 points.

Suppressed for much of the recovery that began in the spring of 2009, market volatility has come roaring back. On May 21 the VIX, which measures the volatility of the S&P 500, and is also known as the “fear index,” spiked 25 percent. Who is to blame? Many analysts have fingered high-frequency traders, computer jockeys who plug complex trading algorithms into superfast computers and scour the markets for tiny price differentials. By trading vast amounts of stock at warp speed, as many as a billion shares a day, high-frequency traders gobble up fractions of cents at a time. The more volatile the market, the easier it is for them to make money jumping in and out of stocks across exchanges.

Markets become volatile when liquidity dries up—in other words, when people can’t trade stocks when they want, at a fair price. “High-frequency traders thrive off volatility, because when liquidity is in short supply, it becomes very profitable to provide it,” says Manoj Narang, founder and CEO of Tradeworx, a hedge fund and high-frequency trading firm in Red Bank, N.J., that trades an average of about 80 million shares a day. “On days with big movements, in the realm of triple digits, we make a lot of money.”

High-frequency traders, who on the whole have maintained a low profile, say that because their frenzied trading provides liquidity, they help markets run smoother, improving the environment for all investors. But combine the speed at which they operate, the outsourcing of decision making to computer codes, and an almost complete lack of regulation, and this shadow market can fuel and exaggerate volatility. Speed traders argue they actually tamp it down. Nonetheless, politicians and regulators are starting to get nervous. “I’m afraid that we’re sowing the seeds of the next financial crash,” says Sen. Ted Kaufman (D-Dela.), arguably D.C.’s most vociferous critic of high-frequency trading, or HFT.

Within weeks of taking over Joe Biden’s seat in early 2009, Kaufman, a Wharton M.B.A. and longtime aide to Biden, was pushing for stringent financial reforms. Last August he focused on HFT, urging the Securities and Exchange Commission to take a “ground up” review of the entire electronic-market structure. “We’re dealing with something highly complex and completely unregulated,” he told NEWSWEEK in March. “The last time we had that mix, with the practitioners telling us, ‘Don’t worry about it,’ things didn’t end well. The time for ‘trust us’ went out the window a long time ago.”

High-frequency traders may have become the new villains of finance. But their computer-driven methods, which now account for upwards of 70 percent of all U.S. equity volume, aren’t going away. To a large degree, fundamental investment strategies—i.e., buying and selling stocks based on a company’s performance—have taken a back seat to algorithms hunting for inefficiencies. And the practice is beginning to spread from the U.S. stock market into new areas (Europe, Canada, Brazil, India) and asset classes (bonds, futures, currencies). Assuming the financial-regulatory-reform bill forces derivatives onto exchanges, high-frequency traders will no doubt trade them too. And every day, things are getting faster. Four years ago, executing a trade in a millisecond (one thousandth of a second) was considered fast; now the top firms are trading in microseconds. That’s one millionth of a second.

The last few weeks have been the biggest bonanza for HFT firms since the crash of late 2008 and early 2009, when the Dow bucked and thrashed its way down to its 6,500 low on March 9, 2009. While most long-term investors lost their shirts during the Great Panic of 2008, high-frequency traders posted huge profits. “That was the Golden Goose era,” says Narang, whose HFT shop launched in March 2009 and just finished its most profitable month.

HFT firms haven’t exactly helped their public image. Paranoid and reclusive, they’ve cloaked themselves in secrecy in the name of protecting their black boxes—those trading codes they spend so much time perfecting. They almost never talk to the press and disclose as little as possible about how they operate. No wonder they’ve joined short sellers and vulture investors in the pantheon of perceived market malefactors. “As a group, we’ve fallen into a trap by erring on the side of secrecy,” Narang says. Concerned by all the bad press surrounding his speed-trading brethren, Narang has become the public face of the industry—appearing on CNBC and PBS, and letting reporters tour his offices (nothing but 20-something physics Ph.D.s in jeans staring at computer screens). “The public is skeptical as it is,” Narang says. “Secrecy is equated with doing something bad.”

Most people had never heard of high-frequency trading until last summer, when the FBI arrested Sergey Aleynikov, a Russian-born Goldman Sachs computer programmer. Agents nabbed him as he got off a plane at Newark airport and charged him with attempting to steal the bank’s algorithmic trading code. A flurry of press coverage followed—profiles of Aleynikov, front-page stories about how some of the new electronic exchanges that have sprung up in recent years were allowing speed traders to peek at other people’s orders before executing their own. The finance blogosphere turned Aleynikov into a sort of cult hero, a cyber-era Robin Hood stealing from the most notorious bank in the world.

The incident sparked an immediate backlash against HFT. The SEC launched an investigation. So did its British equivalent, the Financial Services Authority. New York Sen. Chuck Schumer threatened legislation in the absence of regulation. Two Democratic members of the House, Ed Perlmutter of Colorado and Peter DeFazio of Oregon, proposed a quarter of a percent transaction tax on all stock trades. The bill went nowhere. New York Times columnist Paul Krugman likened the practice to a form of tax on second-class investors who lack rocket-ship computers.

In their defense, speed traders say their actions make the markets more functional and fair to typical investors. To fully understand this, you have to go back a decade, to the birth of HFT in September 2000. That month, then–SEC chairman Arthur Levitt, eager to push the market into the digital age, ordered exchanges to implement “decimalization”—i.e., allowing stocks and options to be listed in one-cent increments rather than 12.5-cent ones. Before decimalization, if you wanted to buy a share of IBM between $117 and $118, you had only eight options: $117?, $117¼, $117½, etc. It’s the job of an exchange to match a buy order with a sell order. The price difference between the two is called the spread. Before decimalization, the tightest spread was often still 12.5 cents. Today, it’s rarely more than a penny.

Tighter spreads were good news for your average man-on-the-street investor, but spelled serious trouble for market makers, the individuals and firms that facilitate trading by quoting both a bid and a sell price, and who pocket the spread as their profit. Prior to decimalization, this was relatively easy. Twelve and a half cents is a veritable football field in which to find a profit. But the combination of decimalization and the advent of new electronic exchanges where buyers and sellers could meet one another directly made life difficult for market makers. Some traditional Wall Street firms folded their market-making desks, while the survivors doubled down on technology and speed.

As a result, trade volume exploded. The average daily volume of equity shares traded in the U.S. zoomed from about 970 million shares in 1999 to 4.1 billion in 2005 to 9.8 billion last year. Simply put, these volumes make U.S. equity markets the most liquid in the world. Investors can buy or sell stocks instantly, and at a fair price, thanks largely to HFT. This was never more evident, and crucial, than during the market plunge of 2008 and 2009. As long-term investors rushed to sell millions of shares, high-frequency firms were there to buy them, risking their own capital and earning a tiny profit along the way, literally fractions of a cent per share.

The problem is that, unlike the market makers at the New York Stock Exchange, most high-frequency traders have no obligation to help maintain an orderly market. And during the Flash Crash, many speed traders simply turned off their machines, including Narang. Rather than wading into the frenzy, and possibly propagating the crazy price declines to other stocks, he turned off his codes and traded out of his positions. “We realized that the prices we were seeing were erroneous, and we did not want to have our trades broken,” he says. (Exchanges ended up breaking some 19,000 trades.)

With fewer people willing to buy all those sell orders, prices crashed. When the NYSE shut down its computer-trading operation for about a minute, handing things over to human traders on its floor—a vestige of the old system—order flow was forced onto less-populated electronic exchanges. The sell-off gained speed as stop-loss orders were triggered once prices fell a certain amount, and many large institutional investors dumped stocks by the truckload. As liquidity dried up, volatility went through the roof. Speed traders that stayed in the game had record paydays. “We would’ve made a killing if we’d kept trading,” Narang says.

It is precisely this ability to profit amid widespread carnage that has aroused the attention of regulators. Many have come to see high-frequency traders as nothing but digital piranhas, creating feeding frenzies that send the market into violent swings for their own profit. Still, the first wave of regulation to come after the Flash Crash hasn’t been aimed at speed traders but at the exchanges, which 10 years after going electronic are still largely a patchwork of cobbled-together systems. So far, high-frequency traders have emerged unscathed. Experts like Ben Van Vliet, a professor at Illinois Institute of Technology, believe big computer traders like GETCO and TradeBot will one day become something akin to electric utilities: entrenched, highly technological industry players with virtual monopolies on the market.

Like utilities, though, HFT may soon be regulated. As this prospect increases, speed traders are taking a page from the more established players on Wall Street. In March, Narang began meeting with SEC commissioners to try to “enlighten” them about HFT. “I am more optimistic that regulators will not do irrational things than I was a couple months ago,” he says. The real worry is whether markets, and the machines that increasingly drive them, will do irrational things.

This would be funny, if it weren’t so sad.

Marriage.

The wife and I were sitting around the breakfast table one lazy Sunday morning.

I said to her, “If I were to die suddenly, I want you to immediately sell all my stuff.”

“Now why would you want me to do something like that?” she asked.

“I figure that you would eventually remarry and I don’t want some asshole using my stuff.”

She looked at me and said: “What makes you think I’d marry another asshole?”

Harry Newton, who went to a fantastic Dave Rawlings concert last night and got home at 1:30 AM, way after his normal sleepy time.