09/08/09
Circumstantial Theories on Markets Today
For some time now, I have been wondering if things really are what they appear to be in today’s markets. Any experienced trader can tell you markets do not behave like how they used to five years ago. The last six months of trading have been particularly unusual, even after adjusting for technical currents. Certain banks, regulators and media outlets appear to be working in concert to convince the public that the worst is behind despite little economic data to support such claim. The gap between what the powers that be would like people to believe and the abject reality that most Americans are living through has never been so wide; it almost makes you wonder if the other side is delusional or, even worst, they are knowingly lying to keep hope afloat and preserve civil order. My thoughts today are based on circumstantial evidences I have gathered from my trading, news flow, my understanding of this crisis, and my own deduction given all the information and the actors involved. Even if I had hard evidences to support my theories, it wouldn’t matter. Our Congress can’t even audit the Federal Reserve, curtail its incredible powers or enact any new and meaningful regulations to reign in on the financial service sector. In the end, the views expressed represent nothing more than musing thoughts that will attempt to make sense of a market that is no longer grounded in reality.
The extent of manipulation in today’s capital markets is vast, coordinated and unprecedented in scope because the stakes have never been so high. What began as a financial crisis among private banks has now mutated into a national crisis that threatens to tear apart the very fabric of this country. Massive amounts of private losses have been socialized without any consequence or new oversight of the failed risk takers. In this period of relative tranquility in capital markets, no efforts have been made to regulate or reform what is a deeply fractured and impaired financial system. Instead, the Federal Reserve has focused its energy on battling the liquidity bugaboo, which they believe is the culprit behind the market dislocation that began in 2007. The extent of manipulation in today’s capital markets has reached historic proportion. Its effectiveness is strengthened by the relatively light volume due to reduced number of major players to challenge Goldman Sachs’ dominance. One would hope the breadth and absurdity of manipulation today would force regulators to re-evaluate their original thesis of the root cause of this crisis and quickly take measures to correct them; this hope represents nothing more than wishful thinking. Our regulators have chosen to walk down the path of the dark side. Lies and deceits beget more lies and deceits, until that one day when the unvanquishable truth finally breaks free.
For those who are unfamiliar with the manipulators, they are officially known as the Plunge Protection Team (“PPT”). The group was created back in 1988 under Executive Order 12631, signed by President Ronald Reagan. The group consists of the Federal Reserve, Treasury, Securities and Exchange Commission and Commodities Futures Trading Commission. On October 6, 2008, the group released a statement that acknowledged their existence and the group’s intent to take measures to stabilize the capital markets. Although the law forbids this group from trading equities and futures directly, many traders believe PPT has established a symbiotic relationship with Goldman Sachs and perhaps some of the other leading investment banks. Through this special relationship, PPT can legally provide liquidity to these banks to manipulate futures and key stocks and sectors to prevent markets from breaking. In exchange, PPT banks are probably participating in some of the upside to these trades and are given implicit bailout guarantees should they teeter on the brinks of bankruptcy.
On a more general note, government intervention in capital markets is nothing new. Many countries have open policies to intervene in their currencies and national debt instruments when needed. Intervention in equities is not common as inflating stock prices rarely serves any national interest. But if anything, we are in a most interesting time. Higher equity prices have allowed banks and other levered companies to refinance their existing debts or issue new secondaries; had recapitalization not been possible, most of these failed and mismanaged companies would have had to file for Chapter 11 long ago. Manipulation persists today because people view the stock market as a barometer of the direction of this country. If stocks were to collapse again, it would be clear to everyone we are finished, reignite a crisis of confidence in our capital markets and lead to potentially uncontrollable situations in our nation. Policies to manipulate equities can not be made public because they may leave negative imprints and invoke skepticism among investors about the true values of their portfolios and consequently make the policies self-defeating; this is why PPT measures and activities must always be surrounded by bodyguards of lies.
Many traders today suspect PPT banks, led by Goldman Sachs, are actively manipulating markets to prevent another break that would lead to a crisis of confidence. Investors’ confidence and pervasive manipulation by PPT are the only factors holding up market these days, as fundamentals have not improved and the causes of this crisis have not been addressed. Some skeptics falsely argue that PPT does not exist because markets would never have collapsed to March’s low. This line of reasoning is deeply flawed and ignorant of market mechanics and technical currents that drive market trends. Markets collapsed down to March’s low because volume of real money exiting their investments exceeded volume of black boxes supporting markets using Federal liquidity. The sell-off earlier this year was also part of a natural cycle in market psychology and social mood as prescribed by Elliott Wave theory. There were also more banks and hedge funds prior to this year, which made manipulation less effective for extended periods. The bankruptcies of Lehman Brothers and Bear Stearns, the exiting of non-HFT proprietary trading businesses at certain banks and the closure of many hedge funds have eliminated groups that otherwise brought balance to the market and prevented firms like Goldman Sachs from dictating market trends through their abuse of conviction upgrades and indiscriminate buying in ES futures to support and nudge markets higher.
The presence of high frequency trading (“HFT”), which traders believe are the manipulative hands of PPT, account for over 70% of daily volume. Their presence has created an incredible surge in volumes in stocks and ETF’s over the last five years. Although I do not have the time to put together an empirical study of the change in volume due to HFT trading, I will use a few popular examples as illustrations. Back in the summer of 2004, the average 3-month volumes for SPY, QQQQ and GE were 41mm, 95mm and 21mm shares. respectively. Today, SPY’s, QQQQ’s and GE’s 3-month average volumes are 202mm, 112mm and 87mm shares, respectively. Please note GE’s shares outstanding are approximately the same now as they were five years ago at around 10.5mm shares. Such meteoric rise in volume by HFT does not provide liquidity as their defenders claim, but rather distort markets and puts retail investors at significant disadvantages.
As a trader, I know I have grown increasingly suspicious when looking at volume as most are not real in the sense that they no longer represent transactions between living, breathing human beings. On the PPT front, I believe these HFT have been colluding to 1) paint stability in shares prices to avert any panic sell-off and 2) reverse any market breaks given their disproportionate trading frequencies and capital bases. As readers know, this countertrend rally has been unusual in that the composure has been very controlled to the upside with few consecutive down days. Markets usually sell-off only after they consolidate for several days and it is clear that there are no more buyers or Bulls are exhausted. Even in the pullbacks, they are controlled and give back grudgingly, regardless of how far or fast markets have rallied in prior weeks. This reality was initially explained away as short covering and sideline money buying on dips. Although this narrative sufficed for the first three months of this countertrend cycle, it no longer provides a satisfactory account for the observed trading these days. Despite most institutional and retail investors being fully invested in today’s market, markets were somehow able to rally higher on Friday on worst-than-expected unemployment and claims numbers on Friday; this is on top of troubling retail sales report from the day before. In general, losses from the prior days are easily erased the next morning on a fraction of the previous days’ total volumes.
In the absence of enough major players in the US markets and any meaningful selling pressures by the longs, marginal buyers in the form of HFT have been able to hijack markets and take them wherever they please. Manipulators can simply push futures higher, either directly or indirectly, and force market makers to raise their bids and asks. Without real seller into higher prices or meaningful challengers to this manipulation, short covering becomes the only significant source of buying into higher prices. In many respects, today’s markets no longer need many real buyers to move higher; they only require that existing longs do not sell out of their current portfolios so volume is relatively light and manageable for these HFT to magnify price movements from short covering.
Why won’t the Bulls sell? There are two major reasons I can surmise. The first is emotional. Many people truly believe in green shoot. This group simply can not imagine markets heading any lower, despite what economic reports and data suggest about current market realities. These Bulls are so enamored with the idea that America is and will forever be the greatest destination for long-term investments that it has blinded them to any evidence that would suggest otherwise. These Bulls need to engage is self-reflection. If every reality about our markets today, including the health of our financial systems, corruption among our regulators and public officials, debt monetization, budget deficit, among host of other realities were true in any other nation, would they still be bullish on stocks in that country? I think economic realities should be very clear to Bulls in this exercise. The second reason why there have been few real sellers resides in the structure of the investment management industry. As a former industry insider, I can tell you the herd mentality on Wall Street is very real and powerful, as a vast majority of managers can not outperform the major indices and must resort to chasing to keep up with performance. This countertrend rally has caught many within the active fund management segment by surprise and has already put tremendous pressure on performance for 2009 for many managers. The trend since March’s low has been a steady assent with few pullbacks. Underperformers who did not initiate positions until later in the trend naturally feel compel to hold onto their longs so they do not miss out any further on performance. This pressure to keep up with the indices contributes to institutional investors ignoring valuation concerns and horrendous economic data. As long as stocks appear to be trending higher, these longs will not sell. This is why it is incredibly important that PPT creates an environment of low volatility to assuage any doubts about the legitimacy of this rally, saves markets every time they appear ready to break lower from overseas contagion or worst-than-expected data, counteract any gap downs at market open and put in bullish closing candles on the daily whenever possible, so as to preemptively avert or delay any planned liquidations among institutional investors.
Outside of their noble PPT responsibilities, HFT have been creating false technical set-up and patterns to lure in traders and retail investors for manipulative fixes. I’ve been noticing more technical set-ups this year that display textbook configurations with conforming indicators, only to break in the opposite direction or wick in both direction to stop out both longs and shorts. For a while, I had this eerie feeling that these HFT somehow knew my trades and my likely pain threshold. My suspicions were confirmed a couple months ago when news broke out that these HFT at Goldman Sachs apparently front-run millions of trades a day using a flash order mechanism that allows the firm to extract illegal early data. HFT computers are also situated on the floors of the exchanges, allowing them to capitalize on the laws of physics and virtually ensure they beat you to your own trades. Their massive database in addition to sophisticated algorithms created from inputs and insights from some of the greatest traders remind me of the chess AI program, Deep Blue. The greatest chess player in history, Garry Kasparov, can barely compete with Deep Blue these days, so what makes any pulsing trader believe they can beat these computers in the long-run? These black boxes have the finest understanding of investors’ sentiments, technical indicators, correlation, market data, chart patterns, and composure on top of being supported by the most sophisticated technologies and real time data feed. On average, I believe these capabilities trump the most experienced and savviest of traders and explain for the consistent and massive profits firms like Goldman Sachs rake in month after month.
Is liquidity today really worth it? Alan Greenspan believed so and his laissez-faire attitude to regulating market exchanges have allowed these predatory programs to blossom. But what is this elusive concept of liquidity that we keep hearing about? Liquidity is the free flow of assets, fiat money and credits in markets and is manifested in markets through volume. With increased volume, the theory goes, liquidity compresses bid-ask spreads and allows markets to transact without significant movement in prices and at minimal losses of value. Although this liquidity sounds wonderful on the surface, the question becomes what are its associated costs? The costs are quite substantial. Flash order mechanisms used by firms like Goldman Sachs and other investment banks have been used to justify the increase in liquidity markets have seen over the years. This flash mechanism, however, is nothing more than front-running ploys that are costly to every market participants. According to latest Q2 earnings report, Goldman Sachs was able to rake in over $100mm per day on 46 out of 65 trading days in Q2. The firm made at least $50mm a day on 58 out of 65 days in that period, which represent an incredible success rate of 89%. The firm suffered minimal losses on only 6 trading days. If these statistics belong to an online poker account, such numbers would suggest with high confidence that the account is engaged in some form of cheating; as no one in the history of risk taking can produced such magnificent returns when risk are assumed to be randomly distributed. If Goldman’s earnings report suggests anything, it is that in exchange for providing volume on the exchanges, majors firms can 1) siphon away billions of dollars a year from traders and investors and 2) maintain near absolute dominance in markets in the absence of panic selling. In short, trading is no longer an even playing field and, in many respects, is worst than taking shots at the casino given the cost, collusion and pervasive manipulation.
Although charts have broken in several key markets, this liquidity, or rather manipulation has so far prevented markets in the US from breaking. Markets have been trading in overbought territory since July with virtually no pullbacks. On August 19th, the Chinese markets sold off in an impulsive fashion and it became clear to investors worldwide that the charts for the Chinese markets were broken. Charts in several commodities also exhibited early symptoms of what the Chinese markets were going through. US markets naturally gapped down at the open the following day, but were miraculously saved by heavy and indiscriminate buying in the futures. The breadth of participation in the early reversal among individual securities was extremely weak that morning; one would expect this as the reversal was a result of manipulation and not real demand. Common sense would also leave one wondering why any real buyers would buy the open with reckless abandon when it was clear that the selling contagion from Asian markets would have pushed markets much lower and allow those buyers to get in at far better levels. This blatant manipulation received virtually no coverage by the media or financial press, as accomplices in the media later found inconsequential news during the day to justify the nonsensical reversal after the fact.