High Frequency Trade causes mayhem & opportunities

Financial history will ultimately narrate whether the global stock market plunge on Monday and early Tuesday was the selling climax of the nasty 2011 bear market. 

The best news following the worst tumble since  the 2008 to 2009 stock market collapse was the resilience of Asian markets on Tuesday. They first plunged and then recovered, giving hope to Europe and the US. A relief rally was in prospect ahead of the Federal Reserve Board’s meeting and expected soothing statements and monetary tinkering.
The best measure to end the rout would be tight regulation of high frequency funds that have created havoc in the markets, but don’t hold your breath. Wide market gyrations damage investor confidence. Some more liquid asset managers and individual investors have been bargain hunting, only to find that their stocks were down by 3 to 5 per cent within minutes, if not seconds. These investors could be described as brave, reckless, shrewd or foolhardy, depending on how events pan out.
 
The media has concentrated on declines that have taken place in the past fortnight, but the US and Europe peaked in the spring of this year, while Asia tended to reach their tops at the end of 2010. The extent of the declines show that investors have experienced a nasty bear market that has carried some financial and other stocks—regardless of the state of their businesses– to lows that were seen during the 2008 to 2009 market depression. From its 2011 peak to its low point on Tuesday morning European time, France’s  stock market had plunged by a whopping 30 per cent, Germany by 28 per cent, Hong Kong and Australia by 25 per cent, UK by 23 per cent, the US S&P index by 22 per cent and Japan by 21 per cent.

After such a decline equity values, on average, have improved considerably (see table). Earnings yields—the inverse of the price earnings ratio—are well above bond yields and dividend yields are also higher. Low bond yields illustrate that investors purchasing US Treasuries (despite the downrating), German, French and UK sovereign bonds, are fearful of deflationary recession. Economic indicators, however, point to a “growth recession” at worst i.e. a sharp slow down, but still positive growth. There is thus an argument that global equity markets are already discounting that event, although there is a danger of a China implosion and global business sentiment deterioration following the stock market crash. The good news is that oil, other energy prices and commodity quotes are at last falling. That will help cut inflation and reduce raw material costs.

Values Stocks against bonds

Market

Earnings Yield % Dividend yield % 10 year bond yield
US S&P 500 6.5 2.3 2.3
UK 9.3 3.4 2.7
Germany 9.9 3.4 2.3
France 9.2 4.1 3.1
Japan 7.1 2.2 1.0
Australia 7.7 4.7

4.5

Sanguine advisors and disenchanted investors

A few weeks ago the majority of sanguine asset managers and brokers  ahead of their summer holidays, were advising investors to buy.  Economic factors overhanging markets that began to range trade in a nervous way were the European debt crisis, a political logjam over the US’ debt for many weeks and fears of a downturn in the US and Europe. Over confident professionals persuaded investors to buy equities and risk assets such as commodities despite the worst of all worlds, notably the stagflation of high unemployment and inflation. Now on Bloomberg and CNBC many are pontificating that people should have higher levels of liquidity and place money in sky high gold, the Swiss franc, Australian dollar and bonds to keep safe. Others have downgraded their end year equity forecasts after the horse had already bolted. A new index should be plotted, notably the extent of disenchantment with the so called experts!

Technical factors that have aggravated the downturn

There have been several technical factors in the market that have caused the dislocation in a world economy that is still growing, albeit at a slower pace. Despite the market noise and loud mouth financial news presenters the world is not experiencing credit crunch and solvency crisis of late 2008 and the consequences of the Madoff fraud.

The main technical factor which has caused good stocks to slump with the bad is the disturbing growth of high frequency funds causing what has been an effective equities flash crash. These funds make trades in nano seconds buying and selling and arbitraging shares against a variety of indices. Thus as indices fall they sell the constituents and such is their speed that they are invariably ahead of asset managers and well before the individual investors trying to manage their portfolios. Their actions in equity, currency and bond markets, have proved to be highly controversial and regulators have been criticised for not curbing their activities. Joseph Saluzzi of Themis Trading, a US institutional  broker, has warned in several in depth papers that there should be greater control over these controversial automated trading system funds.  The playing field has been slanted in their favour and hurts long term investors, Mr Saluzzi opines.

Hedge funds that go long and short in equities, bonds, currencies and commodities have been whipsawed and their results have been poor. As a result investors have been withdrawing funds, forcing them to sell into a falling market and accentuating the downward momentum.
Illustrating the panic, hedge fund manager Barton Biggs, who last week called U.S. equities a “strong buy,” said that he had cut risk in his billion plus Traxis Partners LP hedge fund when the market crunched in the past few days. He was quoted as saying in Bloomberg: “I’ve taken some risk off, and I hate to do it, I think it’s probably the wrong thing to be doing…. I don’t understand now what’s going on…I suspect that we’re now into a high-frequency trading, momentum-driven cascading downturn. And I want to get out of the way of it.”

The final technical factors have been sales of exchange traded funds that have forced good and bad stock constituents to slide and the break down in charts causing technical analysts to advise selling. Charts, however, depict oversold levels.

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