Comments Off on High-Frequency Trading Finally Draws Some Scrutiny
I remember having a discussion with a friend, back in August of 2009, when I told him that he would soon hear quite a lot about “high-frequency trading”. It took a bit longer than I expected for that to happen. The release of the book, Flash Boys by Michael Lewis caused quite a stir. Many of the book’s harshest critics emphasized that what Lewis “exposed” was actually an old story. Much had already been written about high-frequency trading (HFT) years earlier.
In fact, here at TheCenterLane.com, I spent some time discussing that subject in the summer of 2009: here and here. I wrote about it on a few subsequent occasions in 2010: here, here and here. More important, in March of 2013, I discussed how HFT had motivated me to avoid using stop-loss orders because of the “mini flash crashes”, engineered by HFT miscreants.
Despite the cries of Wall Street apologists that Flash Boys was an “old story” which was no longer applicable to the present-day trading environment, Kevin Cook has written a few interesting things on HFT for Zacks Investment Research. Cook explains how HFT is being used right now as well as how to cope with this situation. I was particularly startled by Kevin Cook’s list of ten algorithm programs, which have exploited investors and traders with price behavior manipulation.
Although Attorney General Eric Hold-Harmless has promised to take action against HFT, I’m not holding my breath.
You can’t avoid reading about it. The stock market is sinking . . . Treasury bond yields are spiking . . . The TAPER is coming!
The panic began in the wake of Jon Hilsenrath’s May 10 Wall Street Journal report (after the markets closed on that Friday afternoon) concerning a new strategy by the Federal Reserve to “wind down” its quantitative easing program. The disclosure was carefully timed to give investors an opportunity to process the information and get used to the idea before the next opening bell of the stock market.
By the time the stock market reopened on Monday, May 13 – the first trading day after Jon Hilsenrath’s article – there was a surprising report on April Retail Sales from the Commerce Department’s Census Bureau. The report disclosed that retail sales had unexpectedly increased by 0.1 percent in April, despite economists’ expectations of a 0.3 percent decline. As a result, the Taper report had no significant impact on stock prices – at least on that day.
The Wall Street Journal report carried plenty of weight because of Jon Hilsenrath’s role as de facto “press secretary” for Ben Bernanke, as I discussed in my last posting. Since the WSJ article’s publication, there has been a steady stream of commentary about the threats posed by the Taper. Nevertheless, the word “taper” was never used in Hilsenrath’s article. In fact, the article included an explanation by Philly FedHead (and FOMC member) Charles Plosser, that the Fed has “a dial that can move either way”. The dial could be set to a particular level with either an increase or a decrease.
Regardless of whatever the Fed may have planned, the flow of commentary has focused on the notion that the Fed is about to taper back on its bond buying. The current incarnation of quantitative easing (QE 4) involves the Fed’s purchase of $45 billion in bonds and $40 billion in mortgage-backed securities every month. We are supposed to believe that the Fed will gradually ease back on the bond purchases – whether it might begin with a reduction to $40 billion or $35 billion in monthly purchases . . . the Fed will gradually taper the amount down to zero.
Despite what you may have read or heard about the taper, it’s not going to work that way. Beyond that, taper is not really an appropriate way to describe the Fed’s plan. In other words:
There was one thing Jon Hilsenrath did say in my interview with him on TV last night that I think is very important and clears up a big misconception. He explained that Bernanke himself will not be using the term “taper” that everyone else is bandying about. The reason why is that the Fed does not want to create the impression that one policy move will necessarily be attached to three or four others. In other words, suppose the Fed were to drop its rate of monthly asset purchases from $85 billion to some less number in one of the next meetings. This could be a one-off action with nothing else behind it, designed to temper the market’s expectations and gauge the effects.
I’d remind you that what Bernanke, as a self-styled “student of the Depression” fears the most, is a premature tightening a la FDR in 1937-1938, just as the nation was finally on the mend. If you think that this central bank, which has just spent the last six years patiently reflating the economy, is about to yank the rug out from under it at the last moment, then you haven’t been paying attention.
The wave of panic which followed Jon Hilsenrath’s May 10 article about the Fed’s plans for its quantitative easing program has yet to be calmed by Hilsenrath’s clarification about how the Fed’s new strategy is likely to proceed. As Napoleon once said:
“Men are Moved by two levers only: fear and self interest.”
We recently saw a demonstration of how important the quantitative easing program has been to investors. On Thursday, May 9, both the Dow Jones Industrial Average and the S&P 500 fell from intraday record highs during the last 90 minutes of the session. Philadelphia Federal Reserve president Charles Plosser announced that he would join forces with Kansas City FedHead Esther George to advocate attenuation of the quantitative easing program at the June 18 FOMC meeting. The news definitely spooked the stock market.
Friday’s report from Hilsenrath/Bernanke gave investors a chance to process what was being disclosed and to get comfortable with the idea that quantitative easing will not go on forever. The leak was obviously timed to provide a decent interval before the stock market opened again. There is no definite plan in place to end the quantitative easing program by any particular date, nor is there a planned date for the inception of the wind-down being discussed. Here is a bit of how Hilsenrath explained what is taking place:
Officials are focusing on clarifying the strategy so markets don’t overreact about their next moves. For example, officials want to avoid creating expectations that their retreat will be a steady, uniform process like their approach from 2003 to 2006, when they raised short-term interest rates in a series of quarter-percentage-point increments over 17 straight policy meetings.
Hilsenrath’s quote of Dallas FedHead Richard Fisher’s explanation of the plan was beautiful: “I don’t want to go from wild turkey to cold turkey“.
Bruce Krasting was the first to begin spreading panic and misinformation about Hilsenrath’s report. Here’s an example:
The Fed’s new plan is to taper off QE over the balance of the year.
Of course, the foregoing statement is completely untrue. Hilsenrath never said that. Does Bruce Krasting have his own source on the Federal Reserve Board, who is leaking secret information to him?
Perhaps we might see some of Bernanke’s foes initiate a Congressional inquiry into the “Tapergate scandal”. What did Jon Hilsenrath know and when did he know it?
For a long time, Hilsenrath’s role as Ben Bernanke’s de facto press secretary has been a subject of cynical commentary. Many have joked that Hilsenrath will replace Bernanke when he retires. At Bernanke’s press conferences which follow the FOMC meetings, I keep expecting to hear the moderator announce that the next question will come from Jon Hilsenrath of The Wall Street Journal . . . Hilsenrath would then take the microphone and say:
You know, Ben – that last question just reminded me of another matter which would be really important to these people . . .
Meanwhile, back in the real world, stock market investors are being confronted with the challenge of taking baby steps toward the idea of life without quantitative easing. At the same time – as Jon Hilsenrath explained – the Fed is attempting to reach a decision on when to begin such a tapering effort.
Since that time absolutely nothing has changed. In fact, the SEC has allowed the stock market to become an even more dangerous place for “retail investors” (mom and pop) to keep their life savings.
The use of “limit orders” has become a joke. The only reason for using a limit order is to let your enemies (the predatory traders) know the maximum extent to which you will allow yourself to be screwed on a trade. Since July of 2009, I have discussed the threat posed to retail investors by the use of High-Frequency Trading (HFT) systems. Computers – programmed with predatory algorithms – can engage in “computerized front-running” through the use of “flash orders” to force your own limit order to be executed at its most extreme expense to you. I discussed this situation in more detail on May 18, 2010.
I rarely use “stop loss” orders. They are used by investors to limit their loss if a stock price sinks. The investor specifies a stop price (based on a percentage of the purchase price which is the maximum amount the investor is willing to lose on the stock). If the stock eventually drops to the price in the stop order, the transaction is initiated and the order goes out to the exchange as a market order – to be filled at the best available price at the time. In other words, there is no guarantee that the order will be filled at the price specified in the stop order. In the “flash crash” on May 6 of 2010, many investors lost their shirts because their stop orders were executed and by the time the investors tried to repurchase the stocks, the prices rebounded to where they were before the flash crash. Worse yet, by the time their stop orders were actually filled, the stock prices had dropped tremendously. Not only did those investors lose money on the stop orders for no good reason – but many chose to buy back their stocks at the pre-crash prices. As a result, they lost twice as much money just because of an emotional attachment to the stock. (Emotional attachment to a particular stock is a bad investment habit.) Since that time, a number of “mini flash crashes” have been engineered by predatory traders on particular stocks, forcing investors off their positions to take losses, which ultimately benefit the predators, who use stealthy tactics to reap those profits without being caught.
Stock exchanges have explicit rules for canceling “clearly erroneous trades” and for triggering so-called circuit breakers that halt trading. None of the trades mentioned in this story met that criteria.
Generally, trades can be canceled if they fall 5% to 10% from the last trade, but the rules vary, depending on the market cap of a company and its trading volume.
Investors still have to notify the exchange within 30 minutes if they want their trade to be canceled.
And because many of the wild swings aren’t extreme enough to be considered “clearly erroneous,” individual investors may not even be aware that certain trades are being executed.
Although the article noted that “(t)he SEC continues to make changes to try to combat the frequency and impact of the mini flash crashes”, there is apparently nothing being done by the SEC to prevent the predatory engineering of those crashes. The SEC is apparently doing nothing to allow investors to unwind trades triggered by those crashes. More important, the SEC is doing nothing to track down and prosecute the culprits responsible for engineering and profiteering from these events.
Quantitative easing is back. For those of you who still aren’t familiar with what quantitative easing is, I have provided a link to this short, funny cartoon, which explains everything.
The first two phases of quantitative easing brought enormous gains to the stock market. In fact, that was probably all they accomplished. Nevertheless, if there had been no QE or QE 2, most people’s 401(k) plans would be worth only a fraction of what they are worth today. The idea was that the “wealth effect” provided by an inflated stock market would both enable and encourage people to buy houses, new cars and other “big ticket” items – thus bringing demand back to the economy. Since the American economy is 70 percent consumer-driven, demand is the engine that creates new jobs.
It took a while for most of us to understand quantitative easing’s impact on the stock market. After the Fed began its program to buy $600 billion in mortgage-backed securities in November of 2008, some suspicious trading patterns began to emerge. I voiced my own “conspiracy theory” back on December 18, 2008:
I have a pet theory concerning the almost-daily spate of “late-day rallies” in the equities markets. I’ve discussed it with some knowledgeable investors. I suspect that some of the bailout money squandered by Treasury Secretary Paulson has found its way into the hands of some miscreants who are using this money to manipulate the stock markets. I have a hunch that their plan is to run up stock prices at the end of the day before those numbers have a chance to settle back down to the level where the market would normally have them. The inflated “closing price” for the day is then perceived as the market value of the stock. This plan would be an effort to con investors into believing that the market has pulled out of its slump. Eventually the victims would find themselves hosed once again at the next “market correction”.
Felix Salmon eventually provided this critique of the obsession with closing levels and – beyond that – the performance of a stock on one particular day:
Or, most invidiously, the idea that the most interesting and important time period when looking at the stock market is one day. The single most reported statistic with regard to the stock market is where it closed, today, compared to where it closed yesterday. It’s an utterly random and pointless number, but because the media treats it with such reverence, the public inevitably gets the impression that it matters.
In March of 2009, those suspicious “late day rallies” returned and by August of that year, the process was explained as the “POMO effect” in a paper by Precision Capital Management entitled, “A Grand Unified Theory of Market Manipulation”.
By the time QE 2 actually started on November 12, 2010 – most investors were familiar with how the game would be played: The New York Fed would conduct POMO auctions, wherein it would purchase Treasury securities – worth billions of dollars – on an almost-daily basis. After the auctions, the Primary Dealers would take the sales proceeds to their proprietary trading desks, where the funds would be leveraged and used to purchase stocks. Thanks to QE 2, the stock market enjoyed another nice run.
This time around, QE 3 will involve the purchase of mortgage-backed securities, as did QE 1. Unfortunately, the New York Fed’s new POMO schedule is not nearly as informative as it was during QE1 and QE 2, when we were provided with a list of the dates and times when the POMO auctions would take place. Back then, the FRBNY made it relatively easy to anticipate when you might see some of those good-old, late-day rallies. The new POMO schedule simply informs us that “(t)he Desk plans to purchase $23 billion in additional agency MBS through the end of September.” We are also advised that with respect to the September 14 – October 11 time frame, “(t)he Desk plans to purchase approximately $37 billion in its reinvestment purchase operations over the noted monthly period.”
It is pretty obvious that the New York Fed does not want the “little people” partaking in the windfalls enjoyed by the prop traders for the Primary Dealers as was the case during QE 1 and QE 2. This probably explains the choice of language used at the top of the website’s POMO schedule page:
In order to ensure the transparency of its agency mortgage-backed securities (MBS) transactions, the Open Market Trading Desk (the Desk) at the New York Fed will publish historical operational results, including information on the transaction prices in individual operations, at the end of each monthly period shown in the table below.
In other words, the New York Fed’s idea of transparency does not involve disclosure of the scheduling of its agency MBS transactions before they occur. That information is none of your damned business!
Most investors have been lamenting the recent stock market swoon. The Dow Jones Industrial Average has given up all of the gains earned during 2012. The economic reports keep getting worse by the day. Yet, for some people all of this is good news . . .
You might find them scattered along the curbs of Wall Street . . . with glazed eyes . . . British teeth . . . and mysterious lesions on their skin. They approach Wall Street’s upscale-appearing pedestrians, making such requests as: “POMO?” . . . “Late-day rally?” . . . “Animal Spirits?” These desperate souls are the “POMO junkies”. Since the Federal Reserve concluded the last phase of quantitative easing in June of 2011, the POMO junkies have been hopeless. They can’t survive without those POMO auctions, wherein the New York Fed would purchase Treasury securities – worth billions of dollars – on a daily basis. After the auctions, the Primary Dealers would take the sales proceeds to their proprietary trading desks, where the funds would be leveraged and used to purchase high-beta, Russell 2000 stocks. You saw the results: A booming stock market – despite a stalled economy.
Since I first wrote about the POMO junkies last summer, they have resurfaced on a few occasions – only to slink back into the shadows as the rumors of an imminent Quantitative Easing 3 were debunked.
The recent spate of awful economic reports and the resulting stock market nosedive have rekindled hopes that the Federal Reserve will crank-up its printing press once again, for the long-awaited QE 3. Economist John Hussman discussed this situation on Monday:
At this point, the S&P 500 has achieved a cumulative total return of less than 10% since April 2010. Meanwhile, of course, there remains a great deal of faith in the “Bernanke put,” because even though it’s fairly obvious that QE has done nothing durable for the economy or the financial markets over the last couple of years, a hit of QE might at least be good for a few months of “risk on” delirium. If the American public can’t get thoughtful economic leadership, at least Wall Street’s speculative junkies can hope for a little taste of Q from Sugar Daddy.
One of the problems with QE here, however, is that it would essentially represent fiscal policy for the benefit of speculators, at taxpayer expense. To see this, note that the 10-year Treasury yield is now down to less than 1.5%. One wonders how Bernanke would be able to argue, with a straight face, that this is not low enough. Nevertheless, a 10-year bond has a duration of 8 years – meaning that each 100 basis point fluctuation in interest rates is associated with a change of about 8% in the price of the bond. So if you buy the bond and hold it for a full year, an interest rate change of of 1.5/8 = .1875, or less than 20 basis points, is enough to wipe out the annual interest and leave you with a negative total return.
* * *
“QE3 – subsidizing banks and bond speculators at taxpayer expense” – there’s a pithy slogan. That doesn’t mean the Fed will refrain from more of its recklessness (which will be nearly impossible to reverse when it becomes necessary to do so), but does anyone actually believe by now that QE would improve the economy, durably elevate risky assets beyond a few months, or materially relieve global debt strains?
Obviously, the POMO junkies have no such concerns. Beyond that, the Federal Reserve’s “third mandate” – keeping the stock market bubble inflated – will be the primary factor motivating the decision, regardless of whether those asset prices hold for more than a few months.
The POMO junkies are finally going to score. As they do, a tragic number of retail investors will be led to believe that the stock market has “recovered”, only to learn – a few months down the road – that the latest bubble has popped.
Regular readers of this blog know that I frequently discuss my skepticism about the true state of America’s economy. It gets painful listening to the “usual cheerleaders” constantly tell us about the robust state of our economy. The most recent Federal Reserve Beige Book serves as the Bible for these true believers. One need only check in on a few of the websites listed on my blogroll (at the right side of this page) to find plenty of opinions which run contrary to the current dogma that America is on its way to a full economic recovery.
My view is that the stock market has gotten way ahead of itself. Easy money has caused people to pile into risk assets as risk seeks return in a zero-rate environment. The real economy is nowhere near as robust as the increase in shares would have you believe. Moreover, even the falling earnings growth is telling you this.
Bottom line: The US economy is getting a sugar high from easy money, economic stimulus, and the typical cyclical aides to GDP that have promoted some modest releveraging. But the underlying issues of excess household indebtedness, particularly as related to housing and increasingly student debt, will keep this recovery from being robust until more of the debts are written down or paid off. That means the cyclical boost that comes from hiring to meet anticipated demand, construction spending, and increased capital spending isn’t going to happen at a good clip. Meanwhile, people are really struggling.
The hope is we can keep this going for long enough so that the cyclical hiring trends to pick up before overindebted consumers get fatigued again. Underneath things are very fragile. Any setback in the economy will be met with populist outrage – that you can bet on.
In the first two installments, I laid out the reasons why the U.S. economy, despite current strong consumer spending and the recent euphoria of investors over stocks, will weaken into a recession as the year progresses, led by renewed consumer retrenchment.
If my forecast pans out, the Federal Reserve and Congress may be compelled to take further action to bolster the economy.
* * *
Meanwhile, a number of economic indicators are pointing in the direction of a faltering economy. The Economic Cycle Research Institute index remains in recession territory. The ratio of coincident to lagging economic indicators, often a better leading indicator than the leading indicator index itself, is declining. Electricity generation, though influenced by the warm winter, is falling rapidly.
One of the most popular blogs among those of us who refuse to drink the Kool-Aid being served by the “rose-colored glasses crowd” is Michael Panzner’s Financial Armageddon. In a recent posting, Mr. Panzner underscored the fact that those of us who refuse to believe the “happy talk” are no longer in the minority:
no matter how you break it down — whether by party/ideology, household income, age, or any other category — the majority of Americans agree on one thing: there is no recovery.
But the fact that things haven’t returned to normal isn’t just a matter of (public) opinion. As the Globe and Mail’s Market Blog reveals in “These Are Bad Days for Garbage,” the volume of waste being created nowadays essentially means that, despite persistent talk (from Wall Street, among others) of a renaissance in consumer spending, people are continuing to consume less and recycle more than they used to.
Many people (especially commentators employed by the mainstream media) prefer to avoid “dwelling on negativity”, so they ignore unpleasant economic forecasts. Others appear trapped in a new-age belief system, centered around such notions as the idea that you can actually cause the economy to go bad by simply perceiving it as bad. Nevertheless, the rest of us have learned (sometimes the hard way) that effective use of one’s peripheral vision can be of great value in avoiding a “sucker punch”. Keep your eyes open!
Forget about all that talk concerning the Mayan calendar and December 21, 2012. The date you should be worried about is January 1, 2013. I’ve been reading so much about it that I decided to try a Google search using “January 1, 2013” to see what results would appear. Sure enough – the fifth item on the list was an article from Peter Coy at Bloomberg BusinessWeek entitled, “The End Is Coming: January 1, 2013”. The theme of that piece is best summarized in the following passage:
With the attention of the political class fixated on the presidential campaign, Washington is in danger of getting caught in a suffocating fiscal bind. If Congress does nothing between now and January to change the course of policy, a combination of mandatory spending reductions and expiring tax cuts will kick in – depriving the economy of oxygen and imperiling a recovery likely to remain fragile through the end of 2012. Congress could inadvertently send the U.S. economy hurtling over what Federal Reserve Chairman Ben Bernanke recently called a “massive fiscal cliff of large spending cuts and tax increases.”
Peter Coy’s take on this impending crisis seemed a bit optimistic to me. My perspective on the New Year’s Meltdown had been previously shaped by a great essay from the folks at Comstock Partners. The Comstock explanation was particularly convincing because it focused on the effects of the Federal Reserve’s quantitative easing programs, emphasizing what many commentators describe as the Fed’s “Third Mandate”: keeping the stock market inflated. Beyond that, Comstock pointed out the absurdity of that cherished belief held by the magical-thinking, rose-colored glasses crowd: the Fed is about to introduce another round of quantitative easing (QE 3). Here is Comstock’s dose of common sense:
A growing number of indicators suggest that the market is running out of steam. Equities have been in a temporary sweet spot where investors have been factoring in a self-sustaining U.S. economic recovery while also anticipating the imminent institution of QE3. This is a contradiction. If the economy were indeed as strong as they say, we wouldn’t need QE3. The fact that market observers eagerly look forward toward the possibility of QE3 is itself an indication that the economy is weaker than they think. We can have one or the other, but we can’t have both.
The economy is also facing the so-called “fiscal cliff” beginning on January 1, 2013. This includes expiration of the Bush tax cuts, the payroll tax cuts, emergency unemployment benefits and the sequester. Various estimates placed the hit to GDP as being anywhere between 2% and 3.5%, a number that would probably throw the economy into recession, if it isn’t already in one before then. At about that time we will also be hitting the debt limit once again. U.S. economic growth will also be hampered by recession in Europe and decreasing growth and a possible hard landing in China.
Technically, all of the good news seems to have been discounted by the market rally of the last three years and the last few months. The market is heavily overbought, sentiment is extremely high, daily new highs are falling and volume is both low and declining. In our view the odds of a significant decline are high.
Charles Biderman is the founder and Chief Executive Officer of TrimTabs Investment Research. He was recently interviewed by Chris Martenson. Biderman’s primary theme concerned the Federal Reserve’s “rigging” of the stock market through its quantitative easing programs, which have steered so much money into stocks that stock prices have now become a “function of liquidity” rather than fundamental value. Biderman estimated that the Fed’s liquidity pump has fed the stock market “$1.8 billion per day since August”. He does not believe this story will have a happy ending:
In January of ’10, I went on CNBC and on Bloomberg and said that there is no money coming into stocks, and yet the stock market keeps going up. The law of supply and demand still exists and for stock prices to go up, there has to be more money buying those shares. There is no other way in aggregate that that could happen.
So I said it has to be coming from the government. And everybody thought I was a lunatic, conspiracy theorist, whatever. And then lo and behold, on October of 2011, Mr. Bernanke then says officially, that the purpose of QE1 and QE2 is to raise asset prices. And if I remember correctly, equities are an asset, and bonds are an asset.
So asset prices have gone up as the Fed has been manipulating the market. At the same time as the economy is not growing (or not growing very fast).
* * *
At some point, the world is going to recognize the Emperor is naked. The only question is when.
Will it be this year? I do not think it will be before the election, I think there is too much vested interest in keeping things rosy and positive.
One of my favorite economists is John Hussman of the Hussman Funds. In his most recent Weekly Market Comment, Dr. Hussman warned us that the “music” must eventually stop:
What remains then is a fairly simple assertion: the primary way to boost corporate profits to abnormally high – but unsustainable – levels is for the government and the household sector to both spend beyond their means at the same time.
* * *
The conclusion is straightforward. The hope for continued high profit margins really comes down to the hope that government and the household sector will both continue along unsustainable spending trajectories indefinitely. Conversely, any deleveraging of presently debt-heavy government and household balance sheets will predictably create a sustained retreat in corporate profit margins. With the ratio of corporate profits to GDP now about 70% above the historical norm, driven by a federal deficit in excess of 8% of GDP and a deeply depressed household saving rate, we view Wall Street’s embedded assumption of a permanently high plateau in profit margins as myopic.
Will January 1, 2013 be the day when the world realizes that “the Emperor is naked”? Will the American economy fall off the “massive fiscal cliff of large spending cuts and tax increases” eleven days after the end of the Mayan calendar? When we wake-up with our annual New Year’s Hangover on January 1 – will we all regret not having followed the example set by those Doomsday Preppers on the National Geographic Channel?
Get your “bug-out bag” ready! You still have nine months!
On March 21, the Federal Reserve Bank of Dallas released a fantastic document: its 2011 Annual Report, featuring an essay entitled, “Choosing the Road to Prosperity – Why We Must End Too Big to Fail – Now”. The essay was written by Harvey Rosenblum, the head of the Dallas Fed’s Research Department and the former president of the National Association for Business Economics. Rosenblum’s essay provided an historical analysis of the events leading up to the 2008 financial crisis and the regulatory efforts which resulted from that catastrophe – particularly the Dodd-Frank Act.
While reading Harvey Rosenblum’s essay, I was constantly reminded of the creepy “JOBS Act” which is on its way to President Obama’s desk. Simon Johnson (former chief economist for the International Monetary Fund) recently explained why the JOBS Act poses the same threat as the deregulatory measures which helped cause the financial crisis:
With the so-called JOBS bill, on which the Senate is due to vote Tuesday, Congress is about to make the same kind of mistake again – this time abandoning much of the 1930s-era securities legislation that both served investors well and helped make the US one of the best places in the world to raise capital. We find ourselves again on a bipartisan route to disaster.
* * *
The idea behind the JOBS bill is that our existing securities laws – requiring a great deal of disclosure – are significantly holding back the economy.
The bill’s proponents point out that Initial Public Offerings (IPOs) of stock are way down. That is true – but that is also exactly what you should expect when the economy teeters on the brink of an economic depression and then struggles to recover because households’ still have a great deal of debt.
* * *
Professor John Coates hit the nail on the head:
“While the various proposals being considered have been characterized as promoting jobs and economic growth by reducing regulatory burdens and costs, it is better to understand them as changing, in similar ways, the balance that existing securities laws and regulations have struck between the transaction costs of raising capital, on the one hand, and the combined costs of fraud risk and asymmetric and unverifiable information, on the other hand.” (See p.3 of this December 2011 testimony.)
In other words, you will be ripped off more. Knowing this, any smart investor will want to be better compensated for investing in a particular firm – this raises, not lowers, the cost of capital. The effect on job creation is likely to be negative, not positive.
Simon Johnson’s last paragraph reminded me of a passage from Harvey Rosenblum’s Dallas Fed essay, wherein he was discussing why the economic recovery from the financial crisis has been so sluggish:
Similarly, the contributions to recovery from securities markets and asset prices and wealth have been weaker than expected. A prime reason is that burned investors demand higher-than-normal compensation for investing in private-sector projects. They remain uncertain about whether the financial system has been fixed and whether an economic recovery is sustainable.
To repeat what Simon Johnson said, combined with the above-quoted paragraph: the demand by “burned investors” for “higher-than-normal compensation for investing in private-sector projects” raises, not lowers, the cost of capital. How quickly we forget the lessons of the financial crisis!
The Dallas Fed’s Annual Report began with an introductory letter from its president, Richard W. Fisher. Fisher noted that while “memory fades with the passage of time” it is important to recall the position in which the “too-big-to fail” banks placed our economy, thus leading Congress to pass into law the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd–Frank). Although Harvey Rosenblum’s essay was primarily focused on the Dodd-Frank Act’s efforts to address the systemic risk posed by the existence of those “too-big-to-fail” (TBTF) banks, other measures from Dodd-Frank were mentioned. More important is the fact that the TBTFs have actually grown since the enactment of Dodd-Frank. Beyond that, Rosenblum emphasized why this has happened:
The TBTF survivors of the financial crisis look a lot like they did in 2008. They maintain corporate cultures based on the short-term incentives of fees and bonuses derived from increased oligopoly power. They remain difficult to control because they have the lawyers and the money to resist the pressures of federal regulation. Just as important, their significant presence in dozens of states confers enormous political clout in their quest to refocus banking statutes and regulatory enforcement to their advantage.
The ability of the financial sector “to resist the pressures of federal regulation” also happens to be the primary reason for the perverse effort toward de-regulation, known as the JOBS Act. At the Seeking Alpha website, Felix Salmon reflected on the venality which is driving this bill through the legislative process:
There’s no good reason at all for this: it’s basically a way for unpopular incumbent lawmakers who voted for Dodd-Frank to try to weasel their way back into the big banks’ good graces and thereby open a campaign-finance spigot they desperately need.
I don’t fully understand the political dynamics here. A bill which was essentially drafted by a small group of bankers and financiers has managed to get itself widespread bipartisan support, even as it rolls back decades of investor protections. That wouldn’t have been possible a couple of years ago, and I’m unclear (about) what has changed. But one thing is coming through loud and clear: anybody looking to Congress to be helpful in the fight to have effective regulation of financial institutions, is going to be very disappointed. Much more likely is that Congress will be actively unhelpful, and will do whatever the financial industry wants in terms of hobbling regulators and deregulating as much activity as it possibly can. Dodd-Frank, it seems, was a brief aberration. Now, we’re back to business as usual, and a captured Congress.
The next financial crisis can’t be too far down the road . . .
It has always been one of my pet peeves. The usual stock market cheerleaders start chanting into the echo chamber. Do they always believe that their efforts will create a genuine, consensus reality? A posting at the Daily Beast website by Zachary Karabell caught my attention. The headline said, “Bells Are Ringing! Confidence Rises as the Dow – Finally – Hits 13,000 Again”. After highlighting all of the exciting news, Mr. Karabell was thoughtful enough to mention the trepidation experienced by a good number of money managers, given all the potential risks out there. Nevertheless, the piece concluded with this thought:
The crises that have obsessed markets for the past years – debt and defaults, housing markets, Europe and Greece– are winding down. And markets are gearing up. Maybe it’s time to focus on that.
As luck would have it, my next stop was at the Pragmatic Capitalism blog, where I came across a clever essay by Lance Roberts, which had been cross-posted from his Streettalklive website. The title of the piece, “Media Headlines Will Lead You To Ruin”, jumped right out at me. Here’s how it began:
It’s quite amazing actually. Two weeks ago Barron’s ran the cover page of “Dow 15,000?. Over the weekend Alan Abelson ran a column titled “Everyone In The Pool”. Today, CNBC leads with “Dow 13,000 May Finally Lure Investors Back Into Stocks”. Unfortunately, for most investors, the headline is probably right. Investors, on the whole, have a tendency to do exactly the opposite of what they should do when it comes to investing – “Buy High and Sell Low.” The reality is that the emotions of greed and fear do more to cause investors to lose money in the market than being robbed at the point of a gun.
Take a look at the chart of the data from ICI who tracks flows of money into and out of mutual funds. When markets are correcting investors panic and sell out of stocks with the majority of the selling occurring near the lows of the market. As the markets rally investors continue to sell as they disbelieve the rally intially and are just happy to be getting some of their money back. However, as the rally continues to advance from oversold conditions – investors are “lured” back into the water as memories of the past pain fades and the “greed factor” overtakes their logic. Unfortunately, this buying always tends to occur at, or near, market peaks.
Lance Roberts provided some great advice which you aren’t likely to hear from the cheerleading perma-bulls – such as, “getting back to even is not an investment strategy.”
As a longtime fan of the Zero Hedge blog, I immediately become cynical at the first sign of irrational exuberance demonstrated by any commentator who downplays economic headwinds while encouraging the public to buy, buy, buy. Those who feel tempted to respond to that siren song would do well to follow the Weekly Market Comments by economist John Hussman of the Hussman Funds. In this week’s edition, Dr. Hussman admitted that there may still be an opportunity to make some gains, although the risks weigh heavily toward a more cautious strategy:
The bottom line is that near-term market direction is largely a throw of the dice, though with dice that are modestly biased to the downside. Indeed, the present overvalued, overbought, overbullish syndrome tends to be associated with a tendency for the market to repeatedly establish slight new highs, with shallow pullbacks giving way to further marginal new highs over a period of weeks. This instance has been no different. As we extend the outlook horizon beyond several weeks, however, the risks we observe become far more pointed. The most severe risk we measure is not the projected return over any particular window such as 4 weeks or 6 months, but is instead the likelihood of a particularly deep drawdown at some point within the coming 18-month period.
Economist Nouriel Roubini (a/k/a Dr. Doom) provided a sobering counterpoint to the recent stock market enthusiasm in a piece he wrote for the Project Syndicate website entitled, “The Uptick’s Downside”. Dr. Roubini focused on the fact that “at least four downside risks are likely to materialize this year”. These include: “fiscal austerity pushing the eurozone periphery into economic free-fall” as well as “evidence of weakening performance in China and the rest of Asia”. The third and fourth risks were explained in the following terms:
Third, while US data have been surprisingly encouraging, America’s growth momentum appears to be peaking. Fiscal tightening will escalate in 2012 and 2013, contributing to a slowdown, as will the expiration of tax benefits that boosted capital spending in 2011. Moreover, given continuing malaise in credit and housing markets, private consumption will remain subdued; indeed, two percentage points of the 2.8% expansion in the last quarter of 2011 reflected rising inventories rather than final sales. And, as for external demand, the generally strong dollar, together with the global and eurozone slowdown, will weaken US exports, while still-elevated oil prices will increase the energy import bill, further impeding growth.
Finally, geopolitical risks in the Middle East are rising, owing to the possibility of an Israeli military response to Iran’s nuclear ambitions. While the risk of armed conflict remains low, the current war of words is escalating, as is the covert war in which Israel and the US are engaged with Iran; and now Iran is lashing back with terrorist attacks against Israeli diplomats.
Any latecomers to the recent festival of bullishness should be mindful of the fact that their fellow investors could suddenly feel inspired to head for the exits in response to one of these risks. Lance Roberts said it best in the concluding paragraph of his February 21 commentary:
With corporate earnings now slowing sharply, the economy growing at a sub-par rate, the Eurozone headed towards a prolonged recession and the American consumer facing higher gas prices and reduced incomes, a continued bull market rally from here is highly suspect. Add to those economic facts the technical aspects of a very extended market with overbought internals – the reality is that this is a better place to be selling investments versus buying them. Or – go to Vegas and bet on black.
TheCenterLane.com offers opinion, news and commentary on politics, the economy, finance and other random events that either find their way into the news or are ignored by the news reporting business. As the name suggests, our focus will be on what seems to be happening in The Center Lane of American politics and what the view from the Center reveals about the events in the left and right lanes. Your Host, John T. Burke, Jr., earned his Bachelor of Arts degree from Boston College with a double major in Speech Communications and Philosophy. He earned his law degree (Juris Doctor) from the Illinois Institute of Technology / Chicago-Kent College of Law.