Friday, February 16, 2018

Maybe It's Time To Dispense With the Trope of "Market Fundamentals".

Jim Paulsen, market expert with the Leuthold Group LLC, believes the turbulence in the market isn't over by a long shot (WSJ, 'Business & Finance', 2/11). Those starting to breathe easier after last week's volatility had better buckle themselves in for more - and also reconsider the somber reality that this market is supported by "fundamentals" - an  ambiguous catchall term designed to baffle with bullshit.

Charlie Farrell – CEO of Northstar Investment Advisors LLC – put the current stock market behavior and its basis in perspective in his recent Denver Post Business column (p. 1K, Feb. 11):

What makes bull markets so dangerous is they are not supported by fundamental growth, they are supported primarily by investor enthusiasm. When something causes this enthusiasm to wane, as it did last week, markets decline. The important point is that they eventually decline to the fundamental valuation supported by earnings

And so, in the biggest bull market ever -  lasting from 1980 through 1999 - we saw “70 percent of the price gains from investor enthusiasm”. This set the stage for fifty percent of those gain to be given up in the ensuing bear market. That the current market is overvalued beyond its alleged fundamentals is well known which is why Farrell delivers this advice (ibid.):

If you need funds any time in the next five years, consider keeping those funds out of the stock market . You can instead do something simple like a savings account, a CD or high quality bonds.”

That advice is not intended to help you get rich but to ensure you don't end up a relative pauper, i.e. dumpster diving after half your disposable income is left in the crapper or having to work 10- 15 more years – eating sardines and fried dandelions each day - to reach a nominal retirement.

A popular trope about the stock market peddled by assorted finance pundits- such as CBS'  favorites Melanie Hobson and Jill Schlesinger – is that you can remain in the market with confidence, 'cause the “fundamentals” are still at work. Don't believe it for a nanosecond. The only “fundamentals” at work in the current Bull (or what I call “bull shit”) market are: ridiculous leverage, and flash trading to game ordinary investors. In the right conditions both have contributed to the volatility we've seen in the past week.

In another Sunday D. Post piece, 'Robots Have Hijacked The Market', p. 1D), Steven Pearlstein informs us:

Pay no attention to the volatility these financial wizards assure us. It's just a little technical correction. The fundamentals of our otherwise sound economy will soon reassert themselves. The truth is that the market is as irrational and divorced from fundamentals on the way up as it is on the way down. More so today as a result of the high frequency trading strategies of the Wall Street wise guys. What we've watched this week is “herd” behavior on steroids.”

Pearlstein goes on to point out that only “10 percent of trades are made by real live humans”, with 40 percent originating out of index funds or exchange traded funds (ETFs) and the remainder – 50 percent flash trades.

In such a “robot to robot” environment of “circular logic”, he argues, “fundamentals are as irrelevant as the volumes are enormous”. Worse, the multiple trades – often in the millions and lasting microseconds each take only minutes – and are done with borrowed money. This is where the leverage aspect enters.

This is as a result of the Fed's cheap money, low interest policy - which means the same flash trade investors (mainly hedge funds) are emboldened to borrow most of what they need to buy shares. According to Pearlstein:

the low interest rates allow hedge funds to borrow $4 or $5 for every one they put at their own risk.

He goes on:

When prices start to fall rapidly the funds are forced to sell their positions to pay back the banks and brokerage houses, driving down the price even further. Selling begets yet more selling. Investors rushing to cover short positions, or to sell underwater options before they expire run into a similar dynamic.”

Worse, what happens in one asset class can affect all others, as I warned about in an earlier post (Feb. 6th), e.g. with asset classes moving in lockstep setting the stage for a multiplier effect.

Another aspect of flash trading that bears scrutiny concerns the tiny time advantage- called a “latency” - enjoyed by the flash traders. In this latency (see e.g. WSJ:   'CME Defect Aids Speedy Traders', Feb. 13th, p. B1) a firm receives private confirmation of its trade before it is reported over the public feed. This applies to the CME Group Inc. for which a system defect is “yielding rich profits for ultrafast firms at the expense of ordinary investors.."

Though a CME spokeswoman claimed (ibid.)  it had “dramatically decreased the latency” she also admitted that “private confirmations were still arriving first in some cases”

This ought to be disturbing for anyone plowing money into Maul Street, especially after author Michael Lewis' book “Flash Boys”,  where he exposed the workings of flash trades and how they benefit the flash traders.

In the case of the CME Group latency defect, the typical delays to its public data feed are “measured in microseconds or millionths of a second ….much smaller than they were five years ago” But still (WSJ, ibid.): “the flaw can yield hundreds of millions of dollars in profit a year in profit to flash traders.” This according to Quantlab Financial LLC, an electronic trading firm.

The WSJ piece goes on (p. B2) to note there are various ways to exploit this latency flaw. One concerns so-called “canary orders”, which are small buy or sell orders- say for one or two contracts. In other words not large at all in scale but which nonetheless can be used to detect large trade that can move the market. (Think of the "canary in the coal mine" - when it croaks you know methane gas is around.)

How would this advantage work in practice? The WSJ piece gives this example (ibid.):

If oil futures can be bought for $60.01 and sold for $60, a trader could place a small order to buy at $60 which would join a queue of similar buy orders at CME. If the trader gets a message saying his or her buy order was filled, that could signal that a large seller is at work and the price is about to tick down to $59.99. The trader could then quickly sell at $60 to take advantage of the expected move.”

So let's get our perspective straight: Here you are faithfully putting money into your 401(k) each month,  expecting to earn a bit for your retirement security, and just microseconds before your fund or funds tank the flash traders learn about it and get to dump the component stocks before you can get to a phone. Fair? No, but that's the only fundamental now at work in this overvalued, over leveraged market.  As WSJ columnist James Mackintosh (Business & Finance) poses the quandary for all investors ('A Historical Tie Breaks, But Trouble Still Lurks', p. B1, Feb. 10):

"The question facing investors is whether they should dismiss the 10 percent drop in the S&P from its  high hit in January, or whether it's indicative of deeper troubles ahead?"

Perhaps the more germane question to ask is: If you are an ordinary, e..g. little guy investor, do you believe the possible trouble ahead is tied to flash traders in large hedge funds betting on volatility, or simply the downstream risk of potential inflation?

My best advice? If you plan to remain in this volatile market and buy "on the dips" like the gurus advise,  just be sure you have enough disposable income to sustain deep losses over time, especially in case of a crash.  Bear in mind that a mutual fund that drops in share price from $20 to $10 has suffered a 50% loss. But for that $10 stock or fund share price to return to $20 it must gain 100%, or double. This may take not just two or three years, but more than TWENTY! 

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