Millisecond mayhem

The terrifying Flash Crash of 6 May 2010 has long dropped out of the news. The news cycle more of less ended with the release of the SEC's final report on the event in October of last year which concluded that...well... the event got kicked off by a big trade in E-Mini Futures by Waddell and Reed and played out in two subsequent liquidity crises exacerbated -- and crammed into a very short time-sale -- by high-frequency traders. In essence, the report concluded that A happened, then B happened, which caused C to happen, etc., and we had this Flash Crash. What it didn't explore is WHY this kind of this was possible, WHY the markets as currently configured should be prone to such instabilities, or WHY we should have any confidence similar things won't happen again.

I'm not sure what triggered my interest, but I had a quick look today to see if any similar events have taken place more recently. Back in November of last year the New York Times reported on about a dozen episodes it called "mini flash crashes" in which individual stocks plunged in value over a few seconds, before then recovering. In one episode, for example, stock for Progress Energy -- a company with 11,000 employees -- dropped 90% in a few seconds.  These mini whirlwinds are continuing to strike fear into the market today.

For example, this page at Nanex (a company that runs and tracks a whole-market datafeed) lists a number of particularly volatile events over previous months, events in which single stocks lost 5%, 17%, 95% over a second or five seconds before then recovering. According to Nanex, events of this kind are now simply endemic to the market -- the 6 May 2010 events simply seems larger than similar events taking place all the time:

The most recent data available are for the first month and three days of 2011. In that period, stocks showed perplexing moves in 139 cases, rising or falling about 1% or more in less than a second, only to recover, says Nanex. There were 1,818 such occurrences in 2010 and 2,715 in 2009, Nanex says.

 A few specific examples as reported on in this USA Today article:

•Jazz Pharmaceuticals' stock opened at $33.59 on April 27, fell to $23.50 for an instant, then recovered to close at $32.93. "There was no circuit break," says Joe Saluzzi, trader at Themis Trading, because Jazz did not qualify for rules the exchanges put in place after the flash crash for select stocks following extreme moves.

•RLJ Lodging Trust was an initial public offering on May 11. It opened at $17.25 its first day, then a number of trades at $0.0001 took place in less than a second before the stock recovered. The trades were later canceled, but it's an example of exactly what is not supposed to happen anymore, Hunsader says.

•Enstar, an insurer, fell from roughly $100 a share to $0 a share, then back to $100 in just a few seconds on May 13.

•Ten exchange traded funds offered by FocusShares short-circuited on March 31. One, the Focus Morningstar Health Care Index, opened at $25.32, fell to 6 cents, then recovered, says Richard Keary of Global ETF Advisors. The trades were canceled. "No one knows how frequently this is happening," he says.

•Health care firms Pfizer and Abbott Labs experienced the opposite of a flash crash on May 2 in after-hours trading. Abbott shares jumped from $50 to more than $250, and Pfizer shot from $27.60 to $88.71, both in less than a second, Nanex says. The trades were canceled.

 Apparently, according to the Financial Times, something similar happened just over a week ago, on 9 June, in natural gas futures.

I haven't seen anyone who has explained these events in some clear and natural way. I still see a lot of hand waving and vague talk about computer errors and fat fingers. But it seems unlikely these tiny explosions in the market are all driven by accidents. Much more likely it seems to me is that these events are somehow akin to those dust devils you see if driving through a desert -- completely natural if rather violent little storms whipped up by ordinary processes. The question is what are those processes? Also -- how dangerous are they?

The best hint at an explanation I've seen comes from this analysis by Michael Kearns of the University of Pennsylvania and colleagues. Their idea was to study the dynamics of the limit order mechanism which lies at the mechanical center of today's equity markets, and to see if it is perhaps prone to natural instabilities -- positive feed backs that would make it likely for whirlwind like movements in prices to take place quite frequently. In other words, are markets prone to the Butterfly Effect? Their abstract gives a pretty clear description of their study and results:

We study the stability properties of the dynamics of the standard continuous limit-order mechanism that is used in modern equity markets. We ask whether such mechanisms are susceptible to "Butterfly Effects" -- the infliction of large changes on common measures of market activity by only small perturbations of the order sequence. We show that the answer depends strongly on whether the market consists of "absolute" traders (who determine their prices independent of the current order book state) or "relative" traders (who determine their prices relative to the current bid and ask). We prove that while the absolute trader model enjoys provably strong stability properties, the relative trader model is vulnerable to great instability. Our theoretical results are supported by large-scale experiments using limit order data from INET, a large electronic exchange for NASDAQ stocks.

The "absolute" traders in this setting act more like fundamentalists who look to external information to make their trades, rather than the current state of the market. The "relative" traders are more akin, at least in spirit, to momentum traders -- they're responding to what just happened in the market a split second ago and changing their strategies on the fly. Without any question, there are indeed many high-frequency traders who are "relative" traders -- probably most. So mini-flash crashes -- perhaps -- are merely a sign of natural instability and chaos in the micro dynamics of the market.

Bond Market has called the bluff of Europe.

This morning we work up with the wonderful news that Greece has been saved. Mom and Pop have made up and have given a nice photo-op. The “non default, default”  event was conjured up by the Politicians of Europe in the style of Prof. Dumbledore.  For a brief few hours we were transported to Hogwarts, the mystical and magical land. And then, poof! The magic went out of the window. The Bond Market called the bluff, lie and farce of the European politicians.

Let’s start with Greece.

Two year yield was near 30%. Not a sign of confidence, eh?

May be Ireland was doing better?

But last we saw, it was over 11%

We would probably have better luck with Portugal.

But no such luck, the rate was nearing 11%.

How about Spain?

Hmmmm, getting near 6%. What the bond market is seeing that we are missing?

But nothing to worry. Core Europe is fine.

Really?  Let’s look at Italy.

But if it is so fine, how come the rate there is near 5%.

The pompous fool of Trichet and Sarkozy is giving media show and gaining some more time for the Banks of their country, France. I don’t think they really care about Greece or united Europe or Euro, I think they are concerned with their jombi banks which are definitely going to go bust along with Greece. By the way, banks in France will be affected more badly than the banks in Germany when the time comes.

I also think, Merkel agreed to go along with Sarkozy for now because Germany have set September as their date of reckoning and the banks in Germany need some more time to withstand the catastrophic effect of the Greece default.

But the Bond Market and the Stock Markets called their bluff. The S&P 500, which went up 10 handles in the morning with the news of the “Non Default”, gave up almost all its gain for the day and at some point, was on the verge of going negative. Only some last minute monkey job saved the day for option expiry. The investing community knows a default when they see one.

I hate to say, “I told you so”, but I did tell you in the morning don’t believe this rally. It was running on empty.

Real steps on banking reform?

Don't want to get too wildly optimistic. When it comes to banking regulations, disappointment always lies just around the corner and everything important happens behind the scenes. But a couple things today give me some cautious hope that regulators interpreting the new Basel III banking rules may actually take some real steps to curb systemic risks -- they may even take the structure of banking network interactions into account.

First, Simon Johnson gives an excellent summary of recent developments in the US where banking lobbyists seem to have been caught flat-footed by recent steps taken by Federal Reserve governor Dan Tarullo. I hope this isn't just wishful thinking.

The banks are apparently pushing four key arguments to explain why it's a really horrific idea to make the banking system more stable, and why, especially, the world will probably end quite soon in a spectacular fiery cataclysm of the biggest and most well-connected banks are required to keep an additional few percentage points of capital. Johnson dissects these arguments quite effectively and suggests, encouragingly, that regulators at the Fed, charged with interpreting Basel III, aren't convinced either.

Elsewhere, this Bloomberg article suggests -- and this really surprises me -- that the measures under consideration would...

.. subject banks to a sliding scale depending on their size and links to other lenders.

Now this is an interesting development. Someone somewhere seems to be paying at least a little attention to what we're learning about banking networks, and how some risks are tied more directly to network linkages, rather than to the health of banks considered individually. The density of network linkages itself matters.

Research I've written about here suggests that there's essentially no way to safeguard a banking system unless we monitor the actual network of links connecting banks. It's certainly an encouraging step that someone is thinking about this and trying to find ways to bring density of linkages into the regulatory equation. I hope they're pondering the figure below from this study which shows how (in a model) the overall probability of a banking failure (the red line) at first falls with increasing diversification and linking between different banks, but then abruptly begins rising when the density gets too high.


The implication is that there's likely to be a sweet spot in network density (labeled in the figure as diversification, this being the number of links a bank has to other banks) from which we should not stray too far, whether the big banks like it or not.

A Stock Market rally is coming today.

So Greece has been saved while we were sleeping!

Germany and France apparently agrees on the common ground and there will now be another bailout package of $ 150 billion. No haircut for senior / private investors. And so the S&P futures are already up 12.5 points one hour before the open. A rally is coming today. Isn’t that a perfect world!

I have already said in my blog that we should expect the Stock Markets to go up on Thursday and Friday. How did I know? Did I have a dream or vision? No, but I am getting a feeling of the pattern of the manipulation in my head.

But I said that the low is not in yet and don’t believe in any bull$hit rally. There was not enough panic in the market for the market to go up. There was no gut wrenching despair and talk of share market crash. Everybody was expecting a bounce and bounce we are getting. Now everyone cannot be correct at the same time. To quote from one of my favorurite blogger Rohan from Australia:                                                                   ” if everyone has the same opinion, and has entered into the same trade in anticipation of that opinion playing out, then no-one is left to ‘buy’ or ‘sell’ to deliver the outcome that is the expected by the consensus opinion.”.

I think the stock markets will go up substantially today, not because the problems of the world have been kicked down for few months, but because the manipulators have to kill maximum number of puts and calls and so they have to pop the market today. Today might be a perfect opportunity to close all the longs and go on the short side of the market. 

I am expecting a lower low in the coming week.

Till “Debt” do us part.

The Stock markets in USA, reached their bottom only two years ago.  It was June 2009 when S&P 500 reached a low of 666, Dow reached a low of 6470. Two years hence S&P reached a high of 1370, Dow reached a high of 13870. They doubled!

So the factors which caused the stock markets to collapse in the 1^st place have all been sorted out, correct? Otherwise how come such a parabolic gravity defying moves?  But then we are shocked to see that unemployment is still above 9%. We are shocked. Even after spending over US $ 2 trillion, what we have to show for? Only the wealth effect in the stock market and commodity speculation. Sad but true. So what is driving the stock markets? For answer let us look at the following picture.

It is the huge amount of leverage built up on margin , helped by QE1 and QE2 , that has encouraged the investors, speculators and yield hungry pension funds to pile on to the long side based on the mantra  “ don’t fight the Fed”.  Margin levels are almost at the same level where they were in 2008.

But debt on debt does not help growth of GDP. If you have read the excellent book, “This time is different” by Reinhart & Rogoff, you know that after the debt has reached a certain percentage of GDP, it actually reduces growth and leads to default. Reinhart & Rogoff have given numerous examples from the last 700 years of various countries, where Countries have defaulted because they took on excessive debt. And we see that happening in Greece, Ireland, and Portugal and in so many other places. Japan has become a country in perpetual deflation for the last 3 decades and most likely the same situation awaits us here. The similarities between USA and Japan are too much to ignore, but that is a discussion topic for another day.

When the going was good, Greenspan was giving away free money and creating another bubble, all these banks and speculators have borrowed and invested, rather speculated on various assets, whose value today is less than half of what it was initially. Thus there is debt destruction or balance sheet contraction. Even the two trillion US Dollar that helicopter Ben has pumped in the system in the last 2 years, have not been able to increase the money  supply in the system because the banks are busy repairing their balance sheet to the extent they can. They are now holding approx. US Dollar 1.5 trillion in their cash reserve and hoping that when the sushi hits the fan now, they would be able to survive.

The problem facing us is not inflation, in spite of the money pumping because everywhere the value is getting destroyed, be it home equity for the individuals or loan portfolio of the banks. The powers that be have tried to fight this with more debt and it is failing. And they know that they are facing the demons of deflation.

Now we go back to the chart at the top. When deflation finally hits the shore, when the contagion from Europe catches up with USA and the dominos fall, the margins will be called 1^st and this time there will not be anyone to re-inflate it again. According to Russell Napier, the S&P 500 will reach 400 at the end of the true bear market. If such a situation should arise, all the castles of sands will be washed out to sea because:  the final bear market stage "is caused by distress selling of sound securities, regardless of their value, by those who must find cash market for at least a portion of their assets."

Low is not in yet.

I have mentioned in my morning post that today would most like be a green day. So it was. And I expect a big jump tomorrow and possibly on next Monday as well. But do not read much into these counter trend rallies because the next week may not be pretty. The low is not in yet.

Profit from the "End Game".

Yesterday, one of the protesters in Greece was carrying a placard with a sign that their Prime Minister, George Papandreou was "Goldman Sach’s employee of the month". Now that’s a good insult. If the Greeks can get it, understand it that they have been screwed tight by the Banksters, why can’t the Americans, Irish and people in similar situation?

I have mentioned before, that it is a question of when not if Greece will default. Nobody can survive with 160% debt to GDP, when the economy is shrinking and you don’t have the control of money in your own hand. One way to default would have been to devalue the old Greek currency, but that option is not available today.

Today the question is, is the end is now or will they be able to kick down the can for some more time. Knowing the politicians, they will try to kick the can to infinity and the effort is on in earnest.

Reuters, reports, Germany now "wants the deadline for a second Greek rescue package to be pushed back to September, reflecting the problems Europe is having hammering out the details, EU and banking sources said on Thursday."

One EU source told Reuters that German Chancellor Angela Merkel and Finance Minister Wolfgang Schaeuble favored a delay.

"The argument goes: We don't know what to do, let's buy more time," the source said, adding that Berlin had its customary backing from the likes of the Netherlands, Finland and Slovakia.

A high level German banking source also told Reuters Berlin was targeting September as the point at which all the problems could be solved.

The euro reached 1.4080 by 8.30 AM but is now rallying back above 1.4141. The US Dollar index which was above 76 in early morning has now come down to 75.74. All these are happening in the last one hour, indicating that the end has been pushed down for some other day. Reading between the German official statements, they are saying that their Banks will be ready to absorb the shock of the Greek Default by September. I think Germans are now ready for the default eventuality, they always were and being methodical and systematic people as they are, they have now fixed a date and time for the inevitable.

Meanwhile, jobless claim has come out and it is below expectation. Something to spin around for a higher stock price in the US Markets. Yesterday was a major distribution day (NYSE down Volume: NYSE up Volume >= 9) and the day after a major distribution day is usually a green day. Unless something happens that is beyond the control of the manipulators. And going by the Option Pain results, they will try to push the markets up today and tomorrow.

But the selling is not over yet and will not be over till next week at the earliest. They want to create panic and are almost there. Yesterday Barron’s screamed about “Bull Run” being over. Times had an article about weak economy. NY Times ran something similar. So one last time they want to buy cheap and by September will sell it back high. If we can ignore the talking heads of the televisions and MSM, if we can do just the opposite of the recommendations of the likes of Cramer, we should be OK. It is not difficult to see through their broader plan; the immediate timing may vary a bit. In the end, we might be able to profit from that end game.

Amen.