Wednesday, August 31, 2011

Bad News Is Good News.

Headline news from AP; “Dow up for a fourth day, turns positive for 2011”. But what changed from the beginning of August? Have we solved all the structural problems or have the sovereign debt crisis in Europe been solved? Or for that matter, have the capital adequacy requirements of the European banks been met? Nothing of that sort has happened and yet we have a mini bull run.

This Bull Run is based on few things:
             Month end window dressing.
             Hope that QE3 is coming.
             Hope that Obama Administration will socialize the mortgage and housing mess and thus the insolvent banks will be saved.
             Hope that some sort of stimulus package will be worked out.
             The economic indicators and news are so bad that actually it is good news for the Banksters because it means more free money.

Any one of these hopes can materialize and the market can continue to go up to new heights but the timing does not seem right. If the market continues to go up, then the Fed will not inject liquidity. For that to happen, TPTB (The Powers That Be) have to create panic. So my wild guess is that we will see renewed volatility again and most likely the lows of August will be revisited or broken. Without that panic, they are not going to get more free money.

Hope is not a good investment strategy. Tomorrow being the 1st of the month, there will be lots of new fund allocation and possibly the last day of the prices going up till October. The sentiments have become overtly bullish and the put call ratio has reached a new high which is flashing red light. The COTS report is indicating that it is time to get back in cash. And possibly Gold will make a run for new high before the correction.

Tuesday, August 30, 2011

Overbought Markets, confusing signals and Keynesian stupidity

First the Keynesian Stupidity.
Is there any provision to take back the Nobel prize?
The governments of the world thought that they can stop all recessions just by pumping in more money, printed out of thin air. Bubbles replace bubbles and pop ups are messier.

The stock markets continue to go up and Gold jumped more than $ 30 just by the whisper of QE3 in the minutes of the Fed meeting. The markets are overbought and corrections, even if limited, is due any time. May be tomorrow.  There is no clear trend, just HFT confusion.

In that confusion, NASI gave a buy signal.

How much to act on this signal is big question. In the past, this signal has been quite good. So again, no clear trend. I am expecting Euro to continue moving up, after a brief spell of weakness. If that happens, we might see the general stock market also move up.

But move up or down, it is a market for day traders. Investors better stay away.

P.S.: A very nice short clip from BBC;

Algorithms are smarter than people

On the topic of algorithmic trading, I recently posted on some evidence documenting the benefits it brings to markets -- more liquidity, lower spreads and trading costs, etc. On a related topic, Ole Roleberg at Freakynomics has a nice post reviewing some of the evidence that automated decision tools actually make better decisions that real people when confronting many different kinds of problems. As he notes,
There’s a host of studies showing that human judgment is poor at synthesizing and weighting a large number of different types of evidence, and that simple, statistical models can outperform humans on tasks such as predicting recidivism, making clinical judgments (psychiatry and medicine), predicting divorce, predicting future academic success, etc. (for an entrypoint to this literature, see here for a blogpost I found that has some good quotes from J.D. Trout and Michael Bishop).

I guess the point is that algorithmic trading can be good or bad depending on the algorithm – and that the danger it brings is more if the ecology of trading algorithms active in a market is of a kind that could create cascading ripples destabilizing the market: One set of algorithms lowering the price of a set of stocks, triggering another set of algorithms to sell these stocks to avoid loss, triggering another set of… and so on.
This is precisely the point I've made before about the dangers of algorithms -- it's not one algorithm that might blow things up, but potentially explosive webs of feedback running between many.

But I think the superior performance of algorithms at making decisions is itself quite striking and not generally recognized. The article to which Rogeberg links makes the following all-too-plausible remark:
Training of large numbers of experts by universities has probably had the perverse effect of increasing the number of people running around making highly confident but wrong judgements. But the tendency to not notice our errors and to place excessive confidence in our subjective judgements is something that all humans suffer from to varying degrees.
One final interesting read -- again thanks to Rogeberger for pointing this out -- is a profile in The Atlantic of Cliff Asness of the quant hedge fund Applied Quantitative Research. AQR was one of the hedge funds involved in the infamous "quant meltdown" of August 2007 which was driven precisely by a positive feedback loop, in the case one which caused a violent de-leveraging among a number of hedge funds using similar strategies and invested in similar assets. This is one of the few cases in which we have a pretty good quantitative model explaining how these kinds of feedback loops emerge essentially in the same way violent storms (or hurricanes) do in the atmosphere -- through ordinary processes which create the conditions in which explosive events become virtually certain. In the profile, Asness describes the dynamics behind the quant meltdown, which weren't as complex, mysterious or irrational as many people seem to think:
He told the New York Post that he blamed the sudden losses not on AQR's computer models but on "a strategy getting too crowded ... and then suffering when too many try to get out the same door" at the same time.

Monday, August 29, 2011

Pavlov Rang the Bell

Excerpt from Stock World Weekly

Last week we wrote in To QE3 or Not to QE3, “The biggest hope for the markets may be another round of quantitative easing. Investors and traders have been carefully listening to the words of Fed officials, looking for clues of an impending announcement for QE3. Such a move might be bullish for the markets, at least in the short term.” On Friday, Ben Bernanke gave his much anticipated speech in Jackson Hole, Wyoming. He expressed mild optimism for the U.S. economy and did not explicitly announce a third round of quantitative easing. 
Bernanke acknowledged that while the housing market is bad, and the current rate of unemployment is unacceptably bad, the economy is not in terrible shape and can grow normally again. However, the U.S. government and European governments are going to need to get actively involved. For as Bernanke put it, “most of the economic policies that support robust economic growth in the long run are outside the province of the central bank.” 
Taking Congress to task for the game of chicken they played with the debt ceiling, Bernanke declared, “The country would be well served by a better process for making fiscal decisions. The negotiations that took place over the summer disrupted financial markets and probably the economy as well, and similar events in the future could, over time, seriously jeopardize the willingness of investors around the world to hold U.S. financial assets or to make direct investments in job-creating U.S. businesses.” Paul Dales, senior U.S. economist at Capital Economics commented, “[Bernanke] appears to be saying that the Fed has largely played its part and that the politicians need to step up their game.”
The market initially sold off, but soon recovered as people realized that more easing is likely on the way.
While Bernanke didn’t promise to announce QE3 at the September Fed policy meeting, he dropped enough hints to make the markets respond as if he had done so. The response of the market makes sense from the perspective of Pavlovian conditioning. First you ring the bell, then you give the food. After some repetition, all you have to do is ring the bell to make the subject salivate in anticipation of the food. While Bernanke may not have served the QE3 food to the hungry markets, he did “ring the bell” by dropping broad hints about how the Fed is “prepared to employ its tools as appropriate to promote a stronger economic recovery in a context of price stability.”
So Bernanke laid the groundwork for justifying more easing at the Fed’s September policy meeting. That meeting had originally been scheduled for one day, but was expanded to two days so members could enjoy a “fuller discussion” of their options. St. Louis Fed President James Bullard pointed out that adding a second day to the September meeting would allow more time to review easing options. “If the economy is weaker and the inflation picture moderates, we could consider more action. The call is much more difficult this year than last year. We have a much different inflation situation than last year.” 
Bernanke was probably telegraphing to the market that some form of QE3 would be announced in September. As Bruce Krasting surmised, “This is a heads up to the insiders that more monetary gas is in the works. The stock market’s first reaction to today’s nonevent was to sell off hard. But after the word got around that this was just a delay (and a short one at that) stocks caught a bid. Basically, the plan by Bernanke to leak his intentions worked..." (My read on the speech
Commenting on the media’s response to Bernanke’s speech, Phil wrote, “What more can the guy say – they WILL do what they can – we DO have problems that the Fed is able to address. They think inflation is under control, but unemployment is too high and liquidity needs to be improved. How can someone read this and not conclude QE3 is coming?...CNBC has stopped saying no QE3 and is now saying that Bernanke has ‘kicked the stimulus can into September.’ I guess enough people finally pointed out to them how ridiculous they sounded saying that there was no QE3 in that speech.” 
Bruce Krasting made the point he felt obligated to repeat - and we agree:  "I flat out hate that this Fed is conducting monetary policy through leaks, a wink and a nod and innuendo.
“It feels like we should just put up a tent, because a three-ring circus is what we are getting nonstop. And Bernanke is the strong man in the middle ring.” (My read on the speech
As reported by Zero Hedge, Jeff Snider of Atlantic Capital Management wrote, “His statement spoke volumes without saying anything. Yes, he disappointed the hardcore debasement enthusiasts called stock investors, but only at first. In between the lines of what he did say, it was crystal clear: Chairman Bernanke wants to do more QE. ‘Want’ is not really the right word because it doesn’t really go far enough into Bernanke’s canon. I think it is abundantly clear he believes the Fed needs to do it as soon as operationally possible... 
“He said QE 3.0, without really saying it.  The markets, seeing the enlarged schedule for the September meeting and interpreting the likelihood of heavy discussions, have gotten the message. Stocks threw off the daily mortal struggle that is life as Bank of America and bid for the QE future that is now September (good riddance to August apparently). Gold prices followed on those expectations of a resumption to the willful and wanton dollar destruction that QE purely represents.
“If the Chairman can influence a major market rally without ever having to face the growing dissent within the FOMC ranks, then his speech has proven to be a stroke of genius.  That is the essence of rational expectations, making others believe you have magical powers so that they do your bidding without any actual work or direct engagement on your part.”  (Bernanke In A Box)
Not everyone expects QE3 to be delivered at the September meeting. According to Diane Swonk, chief economist at Mesirow Financial Inc. in Chicago, “The move to a two-day meeting means [Bernanke] will work to build consensus. They will end up with QE3, but probably not in September. They will edge closer to it in the September statement.” (Bernanke May Seek Consensus on Easing)
Regardless of what eventually happens in September, expectations for more easing have now been established. The markets may now rise in Pavlovian anticipation of more free money from the Fed (or fall less than it may have otherwise). 

Click here for a free trial to Stock World Weekly

Sunday, August 28, 2011

The Next Twelve Months.

As the days of summer draw to a close, we are filled again with uncertainty about the future. The scares of 2008 have not been erased from the minds of the investors and we are constantly looking over our shoulder to watch out for the double dip recession. But 2011 is not 2008. The central bankers have learned their lesson or so you would think. Perhaps they are better prepared in terms of addressing the crisis, but they still do not understand how to solve the crisis on a permanent basis. Much of the crises of 2011 are actually fiscal crisis and credit crisis. To solve a fiscal crisis with a monetary tool is not only ineffective, but a complete waste.

The threats facing the world economy today are ironically the things which were responsible for the progress for much of last 40 years. The globalization of trade and interdependent nature of the economies. The Keynesian theory of growth followed by the world governments, which depend on debt to deliver prosperity. The desire of the politicians to hang on to power by providing or promising to provide everything to everyone. And of course, the growing power and greed of the “Bankers” to manipulate the political class and engage in excessive speculation.

In the USA, from the period of dot com bust, till date, the political class and their henchmen in the Fed, have created bubble after bubble by borrowing and injecting liquidity in the system. There was no job growth, no real income growth, only an illusion of prosperity, created by simply inflating asset prices. Stock markets went up and up, house prices went higher forever, fooling the mass that they are far wealthier and they need not save or produce anything. Only one country in the western world has bucked this trend. That country is Germany. But there also they were fooled by megalomaniac politicians, notable among them Mr. Helmut Kohl. Helmut Kohl, a post world war 2 politician, who grew up in the guilt of wars, wanted to become a world statesman and thus pushed for the creation of a unified Europe and Euro. While Euro has helped German export machinery to a great extent, it has also tied Germany to other profligate countries in Europe and its periphery that do not have the fiscal or work ethics of Germany.

So in 2011, we are faced with two headwinds not one. The economic powerhouse of the USA is slowly turning to recession again and Sovereign defaults in Europe is a real possibility and banking crisis in those “soon to default” countries is going to explode sooner than expected.

For all the news of BIRC countries who will take us to economic salvation, these countries cannot even save themselves, let alone the world. China and India are just other developing countries, who will soon turn to emergency market from emerging market, when the markets in the USA and Europe dries up and protective barriers start to come up. Make no mistake, politicians will install protectionism to appease their vote bank and the globalization that we know will be a thing of the past. When the unemployment rate hits past 10%, who do you think the politicians will blame for the loss of jobs? They won’t take any blame themselves. They will sure find scapegoats and the easy ones that too.

Anyway, let’s just look at the real GDP figures of USA.

The 1st revision of the 2nd Quarter GDP figure stands at barely 1%. So year on year we are below 1.5% and the 3rd quarter is not going to be pretty either.  Normally, consumers get the feel of economy better and earlier than the sale-side economists in the big banks. So the following chart says.

The GDP and Consumer sentiment have mostly walked together. So what can we expect here? GDP following the sentiment or sentiment climbing up?

And then we have glorious politics. The presidential election of the USA in 2012. With the bitter partisan divide that we have seen so far, the slash and burn method employed by the Republicans, and their pledge to make Obama one term president, we can be sure that they will do anything to turn the voters away from the incumbent president. What better way than to sabotage the economy.  Historically, the 3rd year of the presidential cycle is the best in terms of stock market returns and the 4th year is the worst.  You can read it here;

When we combine all these three, we can be almost certain that a recession is in the cards by 2012. Stocks typically go down 40% or more in a recession, but this one is going to be a depression, not just our garden variety recession. In addition to the negative economic growth in the USA, we are going to have sovereign default in Europe and possibly a banking collapse there as well.(More on that,later)  All these toxic combinations will lead to massive balance sheet contraction and we are looking at an uncharted territory 12 months down the line. In short-term, I think we might still re-test the lows of August or might even go below it, before the Fed is forced to tip its hand with more liquidity. If that happens, it will consistent with the script of 3rd year cycle and also the fact that when January of a 3rd year of a presidential cycle has been positive, 90% of the time, the stock markets in that year have ended in positive territory as well.  

That is another reason, I am not expecting the bottom to fall off yet, but we are not far from the cliff either.

If you like this macro economic analysis, invite your friends to read it and follow me on twitter. bbfinanceblog

Wednesday, August 24, 2011

Au Revoir Mr. Jobs.

Today’s headline stories are:
·         Steve Jobs Steps down and
·         Gold and silver starts correction.
For the first news, I do not have many comments except wishing Steve Jobs good luck and good health. He has singlehandedly turned around Apple and made the company what it is today. Many things can be said about Apple but no one can deny the fact that it is the most valuable company in USA just by market capitalization alone.  We need to wait and see how it will affect the stock price tomorrow. But nothing or nobody goes on forever. So “ Au Revoir” Mr. Jobs. Well done Sir.

The second news was about the sharp decline in Gold and other precious metals.  
From ETF Digest; the sharp decline in the price of gold was “the result of the Shanghai Gold Exchange raising margin’s the second time this month Tuesday late, the impending options expiration on the COMEX Thursday which generally leads to chaos, a much overbought market and, let’s face it, Bernanke doesn’t want continually rising gold prices to embarrass him Friday. (BREAKING NEWS: After the close the CME raised gold margins by 27%! This must have been leaked to other exchange members. Options traders at the COMEX will feast on this and this is another reason markets are broken and corrupt.)

I am borrowing another chart from the master chartist Chris Kimble regarding gold;

Please continue reading here:

Efficiency versus stability


I had an opinion piece published today in Bloomberg Views looking at the relationship between market efficiency and stability, a topic which hasn't received much attention in the economics literature until recently. The point of the essay was to explore two distinct recent studies which suggest that adding more derivative instruments to markets tends to make them less stable, even if they do push markets toward the ideal of market completeness and efficiency.

I wanted to make available here some further technical information on the two studies I mentioned, but as publication arrived very quickly and I've been pressed with other deadlines I haven't yet managed to write the post as I wanted. However, I can at least offer some information with the idea of updating it very shortly (later today, Thursday 25 August).

I've given some extensive discussion of the first study I mentioned, by economists William Brock, Cars Hommes and Florian Wagener, in an earlier post.

The second study by Matteo Marsili is quite technical and relies for parts of its analysis on ideas and techniques imported from physics. I will tomorrow try to give some simplified discussion of the gist of this argument. What makes this particularly fascinating is that it works fully within the confines of standard general equilibrium models, and examines how market stability should evolve as the market approaches the ideal of market completeness. Agents are assumed to be fully rational, there are no problems with asymmetric information, etc. Even here, however, Marsili finds that the equilibrium becomes more and more unstable as the ideal is approached. Efficient markets are also unstable markets.


Marsili's argument is one he has been developing in a series of papers (with various co-authors) over several years. This paper from last year offers what is perhaps the most concise argument. It looks at a market with informed (fundamentalist) traders and non-informed (noise) traders, and shows, first, that the market becomes efficient as the number of informed traders grows. They are assumed in the model to have different kinds of private information about market outcomes, and the market becomes efficient, roughly speaking, once there are enough traders to cover the space of outcomes so all private information gets aggregated into market prices. The paper then introduces a non-informed trader -- a chartist or trend follower -- and shows that this trader has a maximum impact on the market precisely at the point at which it becomes efficient. The conclusion is very much against standard economic thinking:
[The results suggest} that information efficiency might be a necessary condition for bubble phenomena - induced by the behavior of non-informed traders...
Another paper from two years ago approaches the problem from a slightly different angle. This study looks explicitly at how the proliferation of financial instruments (derivatives) provides more means for diversifying and sharing risks and takes the market to an efficient state. However, it finds that this state is what physicists refer to as a "critical state", which is a state characterized by extreme (essentially infinite) susceptibility to small disturbances. Any small noise stirs up huge fluctuations. Again, efficiency trails instability in its wake. As the paper asserts:
This suggests that the hypothesis of Arbitrage Pricing Theory (the notion that arbitrage works to keep market in an efficient state) may not be compatible with a stable market dynamics.
This paper also makes the important point that market stability really ought to be thought of as a public good because well functioning markets do help everyone. But like most public goods, private individuals acting in their own interests will not likely provide it.

Finally, the paper I discussed in the Bloomberg article is from last year and analyses a model set up specifically so as to include the finance sector. It is very much akin to standard general equilibrium models, and includes essentially two components:

1. There are investors who aim to take their current wealth and preserve it (or make it grow) into the future. They do this by investing in various instruments provided by a sector of financial firms. These investors are assumed to be rational and have full information and they invest their wealth optimally over the set of possible investments.

2. There are financial firms who create the investment instruments and take on risks in supplying them. They also act optimally, and they hedge their risks by trading between themselves. Again, the firms are rational and have full information.

Marsili then studies what happens to this world of investors and financial firms optimally making decisions as the number of different financial instruments grows. The first result confirms expectations -- the financial firms are ever more successful in hedging their risks and they can provide the financial instruments more cheaply. Investors can therefore invest more effectively. The market becomes efficient.

But there are also two unexpected consequences. As Marsili describes them,
As markets approach completeness, however, two "unintended consequences" also arise: equilibrium portfolios develop a marked susceptibility to idiosynchratic shocks and/or parameter uncertainty and hedging engenders divergent trading volumes in the interbank market. Combining these, suggests an inverse relation between financial stability and the size of the financial sector...
In other words, the character of the optimum portfolios for both the investors and the financial firms becomes hugely sensitive to tiny shocks to the economy. As the efficient state is approached, these agents have to work ever harder to adjust their holdings to remain in the optimal condition. The market only remains efficient through an ever faster and more vigorous churning of investment positions. This shows up in the hedging done by the financial firms, where the volume of trading required to remain optimally hedged actually becomes infinite as the market reaches efficiency.

All three of these papers show much the same thing -- efficiency bringing instability along with it. But this latter paper may be the most interesting as it shows directly how the size of the financial sector also naturally explodes as this efficient-unstable regime is approached. The effect sounds suspiciously like what has happened in the past 30 years or so with massive growth in the financial industries in most developed nations.

What I find really remarkable, however, is that all of this comes from the very models that economists have been using for a long time to make arguments about market efficiency. Why did it take a physicist to look at what happens to stability at the same point? This seems bizarre indeed.

Tuesday, August 23, 2011

Have Markets Reached Bottom?

Nothing happens in small measures in stock markets anymore these days. Either DOW goes down 400 points or it goes up 400 points. The question that is in everyone’s mind; “ do we have a tradable bottom”? Let us read on to find out.

Given the fact that HFTs and ALGOs rule the market, in short term the markets are ruled by irrationality not economic fundamentals. I would like to draw your attention again to the Russle chart I showed few days ago. Does it look similar? If it does look similar, that is because we are in a similar situation.
Please continue reading here;

Monday, August 22, 2011

Goldman and BRIC Theory Bull*hit.

Among many jitters in the stock market, today it was hammered hard by the news from GS that the vampire squid has hired a high profile Washington based lawyer to defend its chairman from the possible perjury charges for lying to Congress. I am not sure if we should laugh or cry. After all, it may be all noise without any meaningful action. But we can be assured that lots of backroom posturing is going on and there will be more market volatility. The stock markets today are a giant casino run by the Banksters.  They always win.

Market’s hope is being built on coming QE3 expectation but I think the market will have huge 
disappointments there. I do not think the Fed is going to come out with any additional bond buying program now. But if we step back a while from the five minute chart and daily churning and look at the big picture, we can be sure that central banks of the world have almost run out of bullets to inflate the bubble.

Please continue reading here:

Sunday, August 21, 2011

The next credit crisis -- in education?

From The Atlantic comes a chart showing an incredible rise in the level of student debt over the past decade or so. The total outstanding debt among US students has grown by a factor of more than five over this period.

 Daniel Indiviglio brings out the crucial point to appreciating just how explosive this rise has been. The figure shows two curves, red for student loan debt, blue for overall household debt. The latter itself went through a rather explosive growth from 1999-2008, yet doesn't come close to matching the rate of growth in student loans:
See that blue line for all other debt but student loans? This wasn't just any average period in history for household debt. This period included the inflation of a housing bubble so gigantic that it caused the financial sector to collapse and led to the worst recession since the Great Depression. But that other debt growth? It's dwarfed by student loan growth.

How does the housing bubble debt compare? If you add together mortgages and revolving home equity, then from the first quarter of 1999 to when housing-related debt peaked in the third quarter of 2008, the sum increased from $3.28 trillion to $9.98 trillion. Over this period, housing-related debt had increased threefold. Meanwhile, over the entire period shown on the chart, the balance of student loans grew by more than 6x. The growth of student loans has been twice as steep.
The number of students has remained more or less constant over the same period. Indiviglio goes on to ponder what happens when the bubble bursts, but there isn't an obvious endgame.

The disturbing thing is what lies behind this sudden expansion; it isn't the high-minded aim to make education possible to ever more people but the chance to make an easy profit on loans guaranteed by the US government. An earlier article in The Atlantic documented fast rises in tuition as universities aim to suck up their share of the easy credit, and of course there's been an explosion in for-profit college companies such as the Education Management Corporation. That company appears to be to the education bubble what Countrywide was to the housing bubble -- a facilitator pushing clients into loans regardless of need, solely to make a profit. As the New York Times recently reported, the Justice Department has joined in a suit against Education Management Corporation, charging it with defrauding the government " illegally paying recruiters based on the number of students they enrolled." Get 'em signed up regardless of need or ability to pay. Sound familiar?

As the NYT article noted,
For-profit schools enroll about 12 percent of the nation’s higher-education students yet receive about a quarter of all federal student aid; their students account for almost half of all defaults. In general, these institutions get more than 80 percent of their revenues from federal student aid. 
Good money to be made here, apparently. So you may not be surprised to hear who's behind the Education Management Corporation. According to the NYT, it is 40% owned by Goldman Sachs.

Recession or Depression?

It is now almost given that we are going to have economic downturn. Except the Fed and Obama Administration, everyone is pretty much sure that we are going to get a double dip. For people on the main st. we never left recession in 2008 in the 1st place.

Question is, are we going to be in recession or in a worldwide depression?

From Wikipedia; “In economics, a recession is a business cycle contraction, a general slowdown in economic activity. During recessions, many macroeconomic indicators vary in a similar way. Production, as measured by gross domestic product (GDP), employment, investment spending, capacity utilization, household incomes, business profits, and inflation all fall, while bankruptcies and the unemployment rate rise.

Recessions generally occur when there is a widespread drop in spending, often following an adverse supply shock or the bursting of an economic bubble. Governments usually respond to recessions by adopting expansionary macroeconomic policies, such as increasing money supply, increasing government spending and decreasing taxation.”

So what we have here?  We all know that GDP growth is below 2% in USA and almost 0 in most parts of Europe. In Japan it is negative. Only growth we still see is in the fantasy land of China and in some developing countries like India and Brazil. But we should be fools to believe anything coming out of China at face value. Before we go any further, let us understand what is GDP. It is C+I+G+Net Export. C is the consumer spending. I is investment by industries. G is spending by government and Net export is difference between export and import.  We also know that there has been no growth in real wages for the last 10 years. Consumers have been spending by borrowing, using home equity or some other form of bubbles created by the Fed. That ATM has now been turned off. Industries are sitting on piles of cash and not investing because they do not see any increase in sales in future.  Net export is negative in USA and in most European countries. We are helping the Chinese to come out of the swamp by purchasing all the junk from them and creating jobs there. In return they are now able to give lectures to America how it should live within its means.

Friday, August 19, 2011

No Help For Small Business

Let me indulge in some shameless self-promotion. Our new look business web site is now ready. So henceforth all market blogs will be written and posted in the blog of our company website;

We are basically small business consultants and one of our major operations is offering off-site accounting and bookkeeping function to small businesses. We offer to save up to 50% of the current cost in accounting and bookkeeping function. Just think, even if a small business owner saves $ 10,000 in cost, s/he would have to generate sales of over $ 100,000 to generate that much profit otherwise. It is the small business which makes America tick. People are surprised to know that US Economy is by no means dominated by big business. Yet the big business gets most of the tax cuts and favorable policies, simply because they have the money to lobby to the politicians.

These small business account for almost 60% of the workforce and yet the government makes the life of the small businessmen/women difficult with innumerable rules, requirements and bureaucratic hoops. The financing to small business is always a problem and there are times when we have seen small business owners pawn their personal assets to make the payroll. If these people survive, America will survive. 

Continue reading here;

Thursday, August 18, 2011

Coping with chaos -- with false certainty

I was looking today for a paper -- allegedly published in Science earlier this year -- reporting the results of a re-run of the famous Robert Axelrod open competition for algorithms playing the Prisoner's Dilemma. In that competition, the simple TIT-FOR-TAT strategy -- start out the first time cooperating, and then afterward do whatever your opponent did in the preceding round -- won out easily over much more complex strategies. The twist on the new competition (as I've been told), is to allow copying strategies so players can explicitly mimic the behaviour of others they see doing well. Apparently, some very simple (mindless) copying strategies won this new competition, showing how blind copying can be a very effective strategy in competitive games.

But I must have had the wrong reference, because I didn't find the paper in the 8 April 2011 issue of Science. I'll track it down and post on it soon -- this kind of thing obviously has huge implications for strategies used in financial markets, where copying may well out-perform allegedly more sophisticated techniques. But I stumbled over something else in that issue of Science that is worth mentioning, even if briefly (as I don't have access to Science and haven't yet been able to read the full paper).

The paper is entitled Coping with Chaos: How Disordered Contexts Promote Stereotyping and Discrimination. It reports the results of experiments in which two psychologists, Diederik Stapel and Siegwart Lindenberg, tested how the level of environmental uncertainty might influence the tendency of volunteers to make judgments on the basis of simple stereotypes. They took advantage of a rail strike in Utrecht -- during which train stations became much more littered and disordered. Here's the abstract (at least):
Being the victim of discrimination can have serious negative health- and quality-of-life–related consequences. Yet, could being discriminated against depend on such seemingly trivial matters as garbage on the streets? In this study, we show, in two field experiments, that disordered contexts (such as litter or a broken-up sidewalk and an abandoned bicycle) indeed promote stereotyping and discrimination in real-world situations and, in three lab experiments, that it is a heightened need for structure that mediates these effects (number of subjects: between 40 and 70 per experiment). These findings considerably advance our knowledge of the impact of the physical environment on stereotyping and discrimination and have clear policy implications: Diagnose environmental disorder early and intervene immediately.
This is interesting in this limited context of discrimination and how the orderliness of physical environments might influence it, but the effect described seems in fact to be far more general -- it reflects a human longing for order and simplicity whenever faced with too much uncertainty. On the same point, another notable study from 2008 (also in Science) by Jennifer Whitson and Adam Galinsky showed how uncertainty and loss of control makes people more likely to see fictitious patterns in random data. In brief, they had a set of volunteers plays some competitive games in which they could influence how much the volunteers felt in control. For example, they could induce feelings of loss of control and uncertainty by eradicating any link between the players' actions and the outcomes. Then they tested these people on totally random data sets (some looking like stock market time series) to see how much they would perceive fictitious patterns in the random data. Those primed more strongly with the "loss of control and uncertainty" feelings were significantly more likely to see patterns where there were none -- grasping, apparently, for some kind of order in a perplexing world. The paper is available in full at the link I gave above, but here's the abstract:
We present six experiments that tested whether lacking control increases illusory pattern perception, which we define as the identification of a coherent and meaningful interrelationship among a set of random or unrelated stimuli. Participants who lacked control were more likely to perceive a variety of illusory patterns, including seeing images in noise, forming illusory correlations in stock market information, perceiving conspiracies, and developing superstitions. Additionally, we demonstrated that increased pattern perception has a motivational basis by measuring the need for structure directly and showing that the causal link between lack of control and illusory pattern perception is reduced by affirming the self. Although these many disparate forms of pattern perception are typically discussed as separate phenomena, the current results suggest that there is a common motive underlying them.
This seems to fit in very well with the experiments of Stapel and Lindenberg. It reminds me of what Nietzsche said long ago:
"Danger, disquiet, anxiety attend the unknown — the first instinct is to eliminate these distressing states. First principle: any explanation is better than none.”
 Indeed, this seems to be a very general topic on which a great deal is known from psychology. Galinsky's web site lists a forthcoming article which appears to be a review of sorts. I look forward to reading that.

Also worth a read is this feature in Wired, which discusses some related experiments. Curiously, the article quotes Christina Romer, the former chairwoman of President Obama’s Council of Economic Advisers, on economic uncertainty and it's influence on the opinions of "respected analysts" about where things are going. This was from December 2010:
One sign of heightened macroeconomic uncertainty is that the forecasts of respected analysts are all over the map. According to the Survey of Professional Forecasters conducted by the Federal Reserve Bank of Philadelphia, the difference between the highest and the lowest forecasts of unemployment a year from now is about twice as large as it was before the crisis. And forecasters’ reported uncertainty about their longer-run forecasts has shown no sign of improving over the last year. If professional forecasters are unsure of the future, businesses and consumers certainly are as well.
Then again, this spread in forecasts is a healthy thing. Things were by no means "more certain" before the crisis, it only seemed that way to an army of "respected forecasters" who found comfort in saying pretty much the same thing as everyone else.

Wednesday, August 17, 2011

Market Analysis and Outlook, August 17th.

Yesterday was an extremely busy day for me. We are giving a new look to our official web site and it took all my time.

Coming back to the market, it does not look good at all. The market opened strong but closed weak.
There is huge resistance around 1200 level in SPX. May be people are selling the rally. I think it is time to get back in cash by Friday, which is the OPEX. Historically August expiration has been bullish lately, DOW up seven times in a row. But I think the upward momentum is losing steam and the lows will be retested.

The Franco-German joint statement was possibly the 1st indication that France will save its skin when push comes to shove. Their joint statement made some demands regarding fiscal stability and sovereign policy, which only few in Europe can match. There is no mention of Euro-Bonds. The irony is that Germany fought two world wars to win over what is Europe. Now they effectively control the rest of Europe and they did not have to fire a single bullet.

My favourite chartist  Chris Kimble has this chart to share.

The similarities between 2008 and 2011 are eerily similar. But the market has to churn in that grey rectangle area few times, before it can roll over. I do not see any chance of the indexes going up without any further stimulus from the FED. That seems highly unlikely today, unless the market tanks a good bit and all the highly popular (13%, no less) leaders in Washington lose half the value of their portfolio. Then there will be a bipartisan call for action and we shall see happy days again, even if for a short while.

Monday, August 15, 2011

Market Analysis, 15th August.

The price action of the market makes news. This was evident today. The economic data was bad and normally when the Empire manufacturing index is negative for three consecutive months it signifies recession.
But bad news is good news for the super computers that control the markets. Markets are up three days in a row on decreasing volume. That is quite understandable. After the panic, retail investors do not have the stomach yet to go long. If anything they are selling into the rally. That is the whole idea of the panic. Buy cheap and then sell high. Very soon, 200 DMA will be overcome and once again greed will overtake fear. Wash, rinse and repeat.

If 2008 was memorable for bank failures and credit crisis, 2011 / 2012 will be remembered for sovereign debt crisis and of course bank failures. This time the bank failure will come from Europe. French banks are particularly vulnerable. It seems banks like Society Generale has a leverage of 50:1. How long before it blows up? The trouble was evident last week but France banned short sale of bank shares for 15 days. So the problem has been hushed up for now.

So the market rally today because TPTB (The Power That Be) wanted it to go up. Today was a major accumulation day. So we can expect a red day tomorrow or a very small green. But the rebound is not over yet. I expect the SPX to rebound between 1250 -1300. 61.8 % of Fibo. Retracement is 1270 and 200 DMA is 1280.

If you believe Elliot wave mumbo jumbo, then we are in wave 4 up and it should be followed by wave 5 , testing the lows. Most likely reason, Banksters will create panic for QE3.  

I think we shall see more disturbances by the end of the month or even before and markets will retest lows.  

Sunday, August 14, 2011

The Coming Hard Landing of China.

China is a success story told many times over. It’s economic miracle has been the stuff of folklore. There are investors out there who think that China will keep growing forever. The commodity speculators love China. Be it oil price or copper, any spike in price in any commodity is attributed to the insatiable demand from China. But behind the obvious, there is another story. For those who are willing to question the fairy tale story, it is time to short China.

Let us start by looking at the socio-economic model of China. The communist party of China has ruled the country with iron hand for over from 1949. The political elite of China want to avoid any social unrest and upheaval at any cost. They have an unenviable task.  They have to provide enough work, food and shelter to the millions of ordinary Chinese. Being a command economy means there is no free market. The local purchasing power is insignificant compared to the western world. In order to create work and alleviate poverty, the leadership decided to take the route of growth by export.

Today China is the manufacturing powerhouse of the world and the single biggest factor in the growth has been low labour cost. Companies from all over the world shifted their production base to China to take advantage of the cheap labour. With the result, western civilization lost jobs. But most of the wages that a Chinese worker gets is at a level that is just sufficient for survival. Millions of rural poor migrate to bigger coastal cities in search of work and live in deplorable conditions. The worst part of the deal is that the companies that produce goods for the world do so at a very low level of margin, average 4% to remain competitive. And now every country is trying to grow out of poverty through export. Irony is, not every country can be net exporter, and someone has to be net importer as well. And consumers in western civilization do not have the capacity anymore.

China imports all the raw materials from other countries, iron ore from Australia, energy from Middle East, and machinery from Germany and produce goods to export. When the world demand for the cheap Chinese goods plummet, as it will with the slowdown of the global economy, what will happen to the export oriented growth model?

After 2008, China decided to kick start its economy through construction. And they found it is the easiest way to keep people employed while projecting a growth of GDP. But creating assets which does not give income does not actually create sustainable growth. When, not if, the world economy slows down in the coming months and years, the available capital to continue such useless construction projects will come to a halt. Already millions of homes and cities are lying vacant across China. As if the sub-prime housing crisis is being played all over again in China, but in a much greater scale.

Over the last 40 years, there has been a growing middle class in China who are well educated and are demanding. Since the currency is pegged to US dollar, the QE in the USA is exporting inflation to China in the form of higher food cost. And unlike in America, food cost constitutes over 40% of the average household expenditure in China. So inflation is rising in China and China is now battling hard to control the price rise. This is causing huge social unrest and the Communist Party is uneasy about it. As a result, we are seeing a slow rise in the value of Chinese Yuan vis-à-vis US$. But this cuts both ways. While a rising Yuan will help reduce the cost of imported foods, it will reduce the profit margin of the exports and make them uncompetitive. More so in today’s weak demand situation where the exporters do not have the leverage of negotiating higher prices.

There are talks about the huge Chinese holding of US debt and the threat they possess to US Economy. Actually it is the other way round. China has no option but to invest in US treasury and if they don’t, they would not be able to keep their currency down and be totally uncompetitive. If they want to sell the massive holding of the US Treasury bonds, they would push the prices down and lose money.  So again, China is caught in a no win situation there. With the money fleeing Europe, there is no shortage of demand of US Treasury, at least for now. So US do not need China, as much as China needs US.

The demographics are another factor to be worried about China. With one child policy strictly followed by the party for so long, the average age of the population is growing and the country is graying. Moreover, because Chinese parents prefer boys to girls, there have been systemic abortions of girl featus on a large scale for a very long period of time. With the result, the ratio of man and woman has been totally skewed. In some places there is one woman for every two men and poor migrant workers cannot get wife for the love of their life.

Central command always fails. The asset allocation in central command economy is not based on efficient use but what the party leaders think best. And few people cannot decide what is best for millions. Corruption is rampant and so are the red gift bags. Even the death penalty does not deter the local authorities much. The end result is something other than desired.

The bubble is about to burst along with the global debt deleveraging and the popping  sound will be heard loud, far and wide for many years to come.

Friday, August 12, 2011

Volatile Markets.

Continuing on my theme of yesterday, the basic question we should ask is; who is/are controlling the stock markets?  For answer just look at the price movement of DOW this week;

Monday, August 8, 2011 = -635
Tuesday, August 9, 2011 = +430
Wednesday, August 10, 2011 = -520
Thursday, August 11, 2011 = +423
Friday, August 12, 2011 = + 125
Net effect                       = -177

Never before we have seen such wild swings and it can only be attributed to HFT and Algo trading by the big black box traders. The same too big to fail banks which now control the Wall St.

The same old “too big to fail banks” who are in bad shape again. GS, down from $ 175 to $ 116. City, down from $ 51 to $ 29, Bank of America, down from $ 15 to $ 7, JPM, down from $ 48 to $ 36. The situation is same with the European banks.  The 2008 crisis was started by these big banks and it is only after 2 trillion dollar liquidity injection, they survived and got back their swagger.  Bonuses and six figure salaries continued based on speculation. But underneath, the assets in the books continue to lose value. Mortgage loses and legal claims from fraudulent COD and MBS keep mounting. Income from trading operations continues to shrink because retail investors flee the market. Traditional loans to Main St. are not growing and so the traditional banking incomes are not growing either. Only thing that is still keeping them alive are the free money from the Fed and the speculation that they do with the free money.

Now that Fed has stopped the flow of free money, these too big to fail banks are feeling the pain. So they are creating the volatility and panic. I think they will force another round of QE and they do not want the retail investors to be around when the QE 3 comes.

Only fly in the ointment of that plan is that money is fleeing Europe. That is where the fire has started already. All these money fleeing Europe has to find a parking place and so far they have gone to the bonds, pushing the 10 year rate to historic low. But in the next two weeks, some of that money will flow through to equity as well, pushing the stock market higher.

The boyz know that public memory is short and in two weeks we will forget this panic and talk about new highs. I think that is when they will strike again. They will not stop unless the Fed comes out with QE3 and when that happens, they don’t want Main St to be there.
 Have a wonderful weekend folks.
PS. Now MSM has picked up the theme. Here is one from CNN.

VIX to September 11 levels

By way of Moneyscience, Nicholas Bloom notes that the VIX -- the so-called fear index -- has spiked to the same level it reached just after 9/11 (not quite as high as during late 2008):

What this means for the future is uncertain -- it is a measure of uncertainty, after all -- but Bloom suggests, by analyzing 16 previous episodes of similar spikes, that a short recession is very likely, as economic growth generally follows some level of coherent confidence, and that is obviously lacking:
I have studied 16 previous uncertainty shocks – events like 9/11, the Cuban Missile Crisis, the Assassination of JFK – and the only certain thing about these is they lead to large short-run recessions (Bloom 2009).

When people are uncertain about the future they wait and do nothing.
  • Firms do not to hire new employees, or invest in new equipment if they are uncertain about future demand.

  • Consumers do not buy a new car, a new TV, or refurnish their house if they are uncertain about their next pay-check.

The economy grinds to a halt while everyone waits.

I cannot attest to the reliability of the statistical analysis (16 events is quite few, after all), but the conclusion would hardly be surprising.

Thursday, August 11, 2011

Bipolar, Manic Depressive Stock Markets.

Last night before heading off to sleep, I checked the futures and it was up 2%. In morning before trading started futures were down 1%. At the end, the stock markets closed the day about 5% high. What changed from yesterday or day before? What is this manic depressive stock market doing? How the retail investors are supposed to trade in this market. And the headlines that follow each rally or sell-off are adding to confusion. Just read note that said "risk appetite gained because... US Jobless Claims came in 5k below forecasts." Anyone really believe that?   And only people who are in control are HFTs and Algos.

Yesterday I wrote about an interesting statistics. “In the 3rd year of presidential cycle, when the 1st week of January and the whole month of January is positive, history shows that probabilities are 90% that the year will end in positive territory. “ So there is a chance (9 out of 10 times) that the year will end in a new high. But that can happen only when there is more liquidity pumping from the Fed. Even after this 15% sell-off, the Fed, in its last meeting did not come out with any new QE3. May be it was too early after the just concluded QE2. So what is next? I think the Banksters may rally the market for a while, and then we see another round of massive sell-off which will force the Fed with another round of free money. Makes kinda sense.

The market cannot survive on its own. The structural problems which led to the financial crisis in 2008 are all there, only they are worse. The assets values in the books of the banks are less than they were in 2008.There is no job growth, no income growth, consumers are stretched thin. Only thing that has grown is debt. It has grown not only in USA but all over the western world and the law of diminishing return has set in. It cannot sustain any further.  If you notice, each round of monetary injection is giving less and less result. We have already gone back to the level of pre QE2. The interest rate cannot go down any further. And Bond market is saying that depression is here. There are no “Growth” folks. At one end of the spectrum we have power hungry greedy manipulative Banksters and uber rich who want more and more. On the other side we have welfare addicted free loaders who could not care less about job and prosperity so long their daily quota gets filled by government dole. The subprime mortgage problem started with Bankers knowingly giving loan to people who could never pay back and people taking the loan knowing well that they would never pay back.  Who is to be blamed for the mess we find ourselves in? The society as a whole is sick with speculation and getting rich quickly. And what we see today in the stock market is just a manifestation of this sick society. Stock market do not reflect economy nor it is an instrument of growth of capital.

Where does all these ranting and raving lead us anyway? It all boils down to the matter of debt. The world governments have over $ 40 trillion in recorded debt and 10 times that much in unrecorded debt. Just ask Goldman how governments of the world hide their debt. Do the governments of the world have enough money to save all the broken banks and keep them on life support for ever? At least Japan has done it for over 3 decades. But at what price? Today the Japan’s debt is 200% of its GDP and the Nikkei 225 now stands at less than 9000, far from its lofty high of 38000. And Japan is in depression for last 3 decades. Magnify this to USA and Europe and only thing that you can expect is deep decade long depression and DOW somewhere between 2000-4000.

Short term, I expect to see some tradable bottom and Indexes may well attempt 50DMA or above by end of the month. May be the stock markets will end the year at a higher high but it does not matter unless you are a day trader or speculator. For average retail investors, it is time to be careful. 

Looting -- history does repeat itself

Writing at, Yves Smith of Naked Capitalism offers a rather depressing but illuminating wrap up of the utter failure of the SEC or the US Justice Department to do almost anything to punish the perpetrators of massive fraud in the run up (and after) the financial crisis. It's a sobering analysis of the world we live in, which isn't (for most of us) the world we thought we lived in until a few years ago:
For most citizens, one of the mysteries of life after the crisis is why such a massive act of looting has gone unpunished. We've had hearings, investigations, and numerous journalistic and academic post mortems. We've also had promises to put people in jail by prosecutors like Iowa's attorney general Tom Miller walked back virtually as soon as they were made.

Yet there is undeniable evidence of institutionalized fraud, such as widespread document fabrication in foreclosures (mentioned in the motion filed by New York state attorney general Eric Schneiderman opposing the $8.5 billion Bank of America settlement with investors) and the embedding of impermissible charges (known as junk fees and pyramiding fees) in servicing software, so that someone who misses a mortgage payment or two is almost certain to see it escalate into a foreclosure. And these come on top of a long list of runup-to-the-crisis abuses, including mortgage bonds having more dodgy loans in them than they were supposed to, banks selling synthetic or largely synthetic collateralized debt obligations as being just the same as ones made of real bonds when the synthetics were created for the purpose of making bets against the subprime market and selling BBB risk at largely AAA prices, and of course, phony accounting at the banks themselves.
The article goes on to document how what is happening now isn't actually too different from what happened following the Crash of 1929, and how much of the problem has been engineered by the increasing influence of economics in law, specially through efforts to limit regulators' powers and the potential liabilities of corporate managers.

This is an old, familiar story. I think the best analysis is still in the brilliant 1993 paper (stimulated by the Savings and Loan Crisis in the US) by George Akerlof and colleagues entitled Looting: The Economic Underworld of Bankruptcy for Profit. Below, enjoy the final two paragraphs:
The S&L fiasco in the United States leaves us with the question, why did the government leave itself so exposed to abuse? Part of the answer, of course, is that actions taken by the government are the result of the political process. When regulators hid the extent of the true problem with artificial accounting devices, when congressmen pressured regulators to go easy on favored constituents and political donors, when the largest brokerage firms lobbied to protect their ability to funnel brokered deposits to any thrift in the country, when the lobbyists for the savings and loan industry adopted the strategy of postponing action until industry difficulties were so large that general tax revenue would have to be used to address problems instead of revenue raised from taxes on successful firms in the industry-when these and many other actions were
taken, people responded rationally to the incentives they faced within the political process.

The S&L crisis, however, was also caused by misunderstanding. Neither the public nor economists foresaw that the regulations of the 1980s were bound to produce looting. Nor, unaware of the concept, could they have known how serious it would be. Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better. If we learn from experience, history need not repeat itself.
That was 1993. Alas, history has repeated itself and didn't take too long to do so.

Wednesday, August 10, 2011

SPX 400 Anyone?

The Fed did not come up with more free money, yet. So where do we go from here?

I strongly believe that what we are seeing is the beginning of the end of debt super- cycle. All the prosperity and growth of the last 40 years are largely based on massive debt which resulted in speculation and hubris.
The question going forward is whether we will have inflation or deflation.  My thinking is more towards deflation. But Governments of the world are trying their best to pump in more money. And it is a losing battle all the way.  Oil has already in 80s and other commodities are on the way down. All the money printing has only resulted in increase in the price of foods all over the world. People in developing world are finding it more difficult to put food on the table and that is causing a great social unrest.

Closer to home, London is burning. One of the reasons of the riot is social disconnect by a large part of the unemployed youth. The unemployment rate among the youth of colour is over 25%. How long before that social unrest reaches our shore?

Will the emerging markets save the world? I doubt it. China and its economy is a mirage and I will be writing a detailed report on the coming hard landing of China. India and Brazil would be happy to survive and keep its own population fed. India, at least is not an export dependent country and so the effect of the coming world crisis will be less on India, as we saw in 2008. The emerging markets will soon become emergency market.

The gyration of the stock market from May onward is a process of forming a top. I was hoping that we will see a new high before we plunge, but I was wrong. Now I think we should be lucky even if we get back to 1300-1350 level in SPX. Unless we have a definitive QE3, there is no way the share markets are going to hold up.

One piece of interesting statistics. In the 3rd year of presidential cycle, when the 1st week of January and the whole month of January is positive, history shows that probabilities are 90% that the year will end in positive territory.  The only way I see that happening is if we sell of hard between September and October and Fed ultimately comes out with QE3 to inflate the asset prices.

Price actions of the last 3 days show that the market is taking a breather. The force of selling has reduced somewhat. It can either break down from here and go to 1000 or shoot up. Rest of August is going to be interesting.  But 2012 will definitely be the worst to come. Stock market historian and CLSA consultant Russell Napier says that S&P will go to 400. Watch the video. Sobering thoughts indeed.

Algorithmic trading -- the positive side

In researching a forthcoming article, I happened upon this recent empirical study in the Journal of Finance looking at some of the benefits of algorithmic trading. I've written before about natural instabilities inherent to high-frequency trading, and I think we still know very little about the hazards presented by dynamical time-bombs linked to positive feed backs in the ecology of algorithmic traders. Still, it's important not to neglect some of the benefits algorithms and computer trading do bring; this study highlights them quite well.

This paper asks the question: "Overall, does AT (algorithmic trading) have salutary effects on market quality, and should it be encouraged?" The authors claim to give "the first empirical analysis of this question." The ultimate message coming out is that "algorithmic trading improves liquidity and enhances the informativeness of quotes." In what follows I've given a few highlights -- some points being obvious, others less obvious:
From a starting point near zero in the mid-1990’s, AT (algorithmic trading) is thought to be responsible for as much as 73% of trading volume in the U.S in 2009.
That's no longer news, of course. By now, mid-2011, I expect that percentage has risen to closer to 80%.

Generally, when I think of automated trading, I think of two activities: market makers (such as GETCO) and statistical arbitrage high-frequency traders, of which there are many (several hundred) firms. But this article rightly emphasizes that automated trading now runs through the markets at every level:

There are many different algorithms, used by many different types of market participants. Some hedge funds and broker-dealers supply liquidity using algorithms, competing with designated market-makers and other liquidity suppliers. For assets that trade on multiple venues, liquidity demanders often use smart order routers to determine where to send an order (e.g., Foucault and Menkveld (2008)). Statistical arbitrage funds use computers to quickly process large amounts of information contained in the order flow and price moves in various securities, trading at high frequency based on patterns in the data. Last but not least, algorithms are used by institutional investors to trade large quantities of stock gradually over time.
One very important point the authors make is that it is not at all obvious that algorithmic trading should improve market liquidity. Many people seem to think this is obvious, but there are many routes by which algorithms can influence market behaviour, and they work in different directions:
... it is not at all obvious a priori that AT and liquidity should be positively related. If algorithms are cheaper and/or better at supplying liquidity, then AT may result in more competition in liquidity provision, thereby lowering the cost of immediacy. However, the effects could go the other way if algorithms are used mainly to demand liquidity. Limit order submitters grant a trading option to others, and if algorithms make liquidity demanders better able to identify and pick off an in-the-money trading option, then the cost of providing the trading option increases, and spreads must widen to compensate. In fact, AT could actually lead to an unproductive arms race, where liquidity suppliers and liquidity demanders both invest in better algorithms to try to take advantage of the other side, with measured liquidity the unintended victim.
This is the kind of thing most participants in algorithmic trading do not emphasize when raving about the obvious benefits it brings to markets.

However, the most important part of the paper comes in an effort to track the rise of algorithmic trading (over roughly a five year period, 2001-2006) and to compare this to changes in liquidity. This isn't quite as easy as it might seem because algorithmic trading is just trading and not obviously distinct in market records from other trading:
We cannot directly observe whether a particular order is generated by a computer algorithm. For cost and speed reasons, most algorithms do not rely on human intermediaries but instead generate orders that are sent electronically to a trading venue. Thus, we use the rate of electronic message traffic as a proxy for the amount of algorithmic trading taking place.
 The figure below shows this data, recorded for stocks with differing market capitalization (sorted into quintiles, Q1 being the largest fifth). Clearly, the amount of electronic traffic in the trading system has increased by a factor of at least five over a period of five years:

The paper then compares this to data on the effective bid-ask spread for this same set of stocks, again organized by quintile, over the same period. The resulting figure indeed shows a more or less steady decrease in the spread, a measure of improving liquidity:

So, there is a clear correlation. The next question, of course, is whether this correlation reflects a causal process or not. I won't get into details but what perhaps sets this study apart from others (see, for example, any number of reports by the Tabb Group, which monitors high-frequency markets) is an effort to get at this causal link. The authors do this by studying a particular historical event that increased the amount of algorithmic trading in some stocks but not others.The results suggest that there is a causal link.

The conclusion, then, is that algorithmic trading (at least in the time period studied, in which stocks were generally rising) does improve market efficiency in the sense of higher liquidity and better price discovery. But the paper also rightly ends with a further caveat:

While we do control for share price levels and volatility in our empirical work, it remains an open question whether algorithmic trading and algorithmic liquidity supply are equally beneficial in more turbulent or declining markets. Like Nasdaq market makers refusing to answer their phones during the 1987 stock market crash, algorithmic liquidity suppliers may simply turn off their machines when markets spike downward.

This resonates with a general theme across all finance and economics. When markets are behaving "normally", they seem to be more or less efficient and stable. When they go haywire, all the standard theories and accepted truths go out the window. Unfortunately, "haywire" isn't as unusual as many theorists would like it to be.

** UPDATE **

Someone left an interesting comment on this post, which for some reason hasn't shown up below. I had an email from Puzzler183 saying:

"I am an electronic market maker -- a high frequency trader. I ask you: why should I have to catch the falling knife? If I see that it isn't not a profitable time to run my business, why should I be forced to, while no one else is?

You wouldn't force a factory owner to run their plant when they couldn't sell the end product for a profit. Why am I asked to do the same?

During normal times, bid-ask spreads are smaller than ever. This is directly a product of automation improving the efficiency of trading."

This is a good point and I want to clarify that I don't think the solution is to force anyone to take positions they don't want to take. No one should be forced to "catch the falling knife." My point is simply that in talking about market efficiency, we shouldn't ignore the non-normal times. An automobile engine which uses half the fuel of any other when working normally wouldn't be considered efficient if it exploded every few hours. Judgments of the efficiency of the markets ought to include consideration of the non-normal times as well as the normal.

An important issue is to explore if there is a trade-off between efficiency in "normal times" as reflected in low spreads, and episodes of explosive volatility (the mini flash crashes which seem ever more frequent). Avoiding the latter (if we want to) may demand throwing some sand into the gears of the market (with trading speed limits or similar measures).

But I certainly agree with Puzzler183: no one should be forced to take on individual risks against their wishes.