Fear the Computer-Driven Sell-Off
Last week the stock market experienced a rapid sell-off, something most investors didn’t think could happen. However, since the Great Financial Crisis, computer algorithmic-trading programs have slowly made their mark on the stock market. Today, approximately 70% of all trades are computer controlled, with some experts indicating the total is much closer to 90% of all trades. These computer programs trade in milliseconds, much faster than any human trader could hope to do alone. With retail investors, institutional investors, pension funds, hedge funds and nearly everyone else heavily invested in stocks, the stock market is now at the mercy of the machines.
There isn’t a day that goes by where I don’t hear how much stocks are going to continue to rise over the next couple years, yet I continue to wonder where all this new money is going to come from. It seems as if most people have forgotten what happened back in the Fall of 2007, and with computer programs dominating the stock markets, the market can fall much faster now than it did back then.
In the summer of 2007, the economy was firing on all cylinders. The Federal Reserve was raising the Federal Funds rate to cool off the economy and to ward off inflation. The once red-hot housing market was slowing a bit, but optimism remained high as homeowners and investors continued to speculate that housing prices were going to rise indefinitely.
Even the stock market was in on the action as it reached a new all-time high in October 2007, mostly due to corporate share buybacks. On an annualized basis, in the third quarter of 2007, corporations bought an unprecedented $700 billion worth of their own stock back, after buying a record-breaking annualized $600 billion in the second quarter of 2007. It seemed as if the good times would never end.
By the end of October 2007, things changed a bit. The Fed stopped raising the Federal Funds rate and even lowered it from 4.75% to 4.50%. This move was mostly due to Lehman Brothers, who was struggling after the closure of its subprime lending unit, BNC mortgage, in August 2007. The S&P 500 was falling and by the end of November 2007, it was down 10% from its all-time highs. Corporate share buybacks fell to an annualized $500 billion which was still a very large number.
Nobody felt the economy was about to enter a recession or that the stock market had seen its best days. After all, corporations were continuing to buy their own stock and had pledged to continue buying in the years to come. The S&P 500 rallied 8.5% but stock prices never made it back to their peak. Not even the annualized $500 billion of corporate share buybacks were enough to push the stock market bears back into hibernation. It was becoming clear; the Fed’s monetary tightening had gone too far, and the economy was about to crumble from all the debt created in the prior eight years.
The reason the stock market fell in October 2007 is the same reason we have seen it fall this month. The Fed has been tightening monetary policy for nearly three years, most investors are over-weighted in stocks, and corporations are the last marginal buyer of stocks. Even with all the corporate share buybacks, the stock market shouldn’t have fallen. Until you realize, just like today, corporations are barred from buying their stocks back in the five-week period preceding their quarterly earnings announcement.
As of Monday, October 15, 2018, we corporations will enter a two-week period of peak blackouts. A peak blackout period is when most companies who have been buying their stocks back will be barred from repurchasing, leaving the stock market to stand on its own. When the largest marginal buyer goes on vacation, and everyone else is fully invested, there’s nobody else left to keep the market propped up. However, unlike 2007, today we are at the mercy of the computers.
The stock market is dominated by several forms of computer algorithmic trading methods, many of which I am familiar with and others I don’t know exist. The most visible of the computer trading programs are called the “algos” who trade the markets at all possible hours of the day. The algos were designed with machine-learning technology that allows them to read and interpret the news and then trade accordingly. Any rapid move in the markets following a press or earnings release are done by the algos. Very little is known about how much money these machines control or who owns them. All we know is they can make large, rapid moves across multiple markets simultaneously.
Following the algos are the High-Frequency Traders (HFTs) who scalp pennies per trade by front-running buy and sell orders. The HFTs provide the impression of liquidity in the markets by creating fake trades on the exchange to make it appear there are buyers and sellers. Unlike the algos who take a position in the market, HFTs only front-run trades and, by design, should not be holding any positions once the markets close for the day.
HFTs can stop providing liquidity when a flood of orders, mostly sell orders, are placed. The reason some stocks seem to rapidly plummet in a matter of minutes following an announcement is because the algos enter a large number of sell orders that cause the HFTs to stop providing a market in that stock.
Next in line are the CTAs, which trade based on price levels. The CTAs follow a formula that dictates how much they buy or sell based on the closing price of an index. As far as I can tell, CTAs primarily trade futures-contracts, which means they don’t trade individual stocks. When an index closes above or below a certain level, the CTAs will begin buying or selling the following day. Due to the large number of contracts the CTAs can buy or sell, they can rapidly move the market up or down.
Last on the list are risk-parity funds, which adjust their portfolios between stocks and bonds based on the VIX volatility index. When the VIX rises, risk-parity funds shift their allocation to bonds, and when the VIX falls, risk-parity funds shift their allocation to stocks. Generally, their trading is done after market close, just like mutual funds, when the computer programs adjust their portfolio weightings based on the closing value of the VIX. While there may be more, there is at least $1 trillion of direct investor money in risk-parity funds, with another $2 trillion of indirect money tied to the movement of risk-parity funds.
Earlier this month, when the corporate share buybacks began to fade as the blackout window began, liquidity from the market dried up. Liquidity is a proxy for how much money is in the market looking to buy should prices fall. With most investors already in, there isn’t much liquidity. As the stock prices began to fall as corporates entered their blackout period, key prices levels were breached that caused the computers to sell.
The CTAs were the first to start selling across the S&P 500, Nasdaq-100 and Russell 2000. Sensing weakness in the market, the algos also started selling causing prices to further fall. The HFTs also joined the party by front-running the sell orders, which caused stock prices to fall even faster. As volatility rose, the risk-parity funds also started selling. All this selling caused leveraged investors to get margin calls since cash levels in brokerage accounts are at the lowest level in history. As investors received notifications to bring their account balances in line with the margin requirements, many chose to sell, as they only have 24 hours to satisfy a margin delinquency.
The risk in the current market is the computers. As the Fed continues to raise the Federal Funds rate and reduce the size of their balance sheet, liquidity in the markets and asset prices fall. This downward pressure on stock prices eventually leads to the computers selling. When the computers sell into an illiquid market where there aren’t many buyers, prices can fall very quickly. So quickly, as we saw last week, the computers sold past their trigger points which led to more selling. When one computer model starts to sell, it can quickly cause other computer models to sell, which can lead to a feedback loop.
The S&P 500 recently peaked in late September. Based on all of the available data, I believe the computer algorithmic traders were fully invested in stocks or close to fully invested in stocks. When everyone is invested in stocks that want to be, it’s hard to see how the stock market can go too much higher without more money coming in. To put this in perspective, corporate share buybacks this year have been around $850 billion, and the stock market comparatively marginally set new highs.
When it comes to investing, the best way to make money is to buy low and sell high. Sometimes investments that are low go lower. When that happens, investors can either buy more or wait. Markets always cycle. When investors buy stocks after all the computer trading programs have already bought, the risk is being caught in the downdraft when the computers start selling. An ideal move would be to buy after the computer programs have sold, in the hopes the computers will resume buying, to have a margin at the next peak when the computers start selling.
For the time being the computer trading programs are still heavily invested. There is one asset class that happens to have a shiny yellow color to it, where the computer trading programs are at their maximum short-level. In this case, looking for a bottom before the computers buy back in is a wise move. For those chasing the stock market higher, the computers trading programs are their biggest risk.
With the Fed tightening, the government borrowing at record levels and financial conditions tightening, it’s only a matter of time before all the computers start simultaneously selling. For those who have money to invest when the selling stops, they will find themselves with an opportunity to buy stocks at very low levels.
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Daily Market Briefs
- Thoughts from the Weekend
- What happened to the stock market on Monday?
The major U.S. stock indices tried to fight to get back over some of their key moving averages but ultimately closed below them. Foreign stocks sold off in overnight trading as global liquidity dries up. Treasury yields were mostly flat as short-sellers were unable to drive yields any higher.
The S&P 500 fought to stay over its 200-day moving average but closed below it. The 200-day moving average is significant, as a close over it indicates last week’s move down was a short-term correction.
Based on the recent data on the positioning of the CTAs, more selling should occur tomorrow. To make matters worse, the S&P 500 closed below the top end of its bull-market channel, suggesting prices are going to drop again. The next line in the ascending bull-market channel is around 2,860, which if hit, would lead to another round of selling by the CTAs.
The Nasdaq-100 bounced off its 200-day moving average but found sellers throughout the day. With Netflix reporting earnings tomorrow, any bad news could send the Nasdaq-100 below its 200-DMA. The DJIA tried to move above its 100-day moving average but also failed. The Russell 2000, which is trading well below its 200-day moving average, found some buyers today but faded some of its gains going into the market close. Today’s price action is not a sign of strength.
September’s retail sales data came in at +0.1% month-over-month, which was below analysts’ expectations of a +0.6% print. Adding concern to the data was the huge drop in restaurant data, which showed a massive -1.8% month-over-month in restaurant sales. Many Americans spent their tax money on fuel, movies and eating out, so this is a major potential leading indicator that the tax cut has passed through the economy. If the tax cut has, this is not good news for retailers going into the holiday shopping season.
Physical gold and the large gold miners lurched higher but failed to close over their respective 100-day moving averages. Today’s move is indicating the beginning of a bull-market rally for gold and the miners. Bulls want to see prices fall to confirm the lower supply zone or the 50-day moving average. Bears want to smash prices well below either point. Should either occur, it will set up a buying opportunity.
If gold tries to move up to its 200-day moving average, don’t be surprised if it takes a hard reversal. Rallies begin when the price of a security crosses upwards through its 50-day moving average and is confirmed when prices retest and hold their 50-day moving average. Our opportunity is coming!
Agricultural commodities moved higher as prices closed over their 100-day moving average. I believe we are seeing the beginning of a bull market in the agriculture space. There was a triple price bottom, followed by an upward movement through their 50-day moving average, which was followed by a successful retest of their 50-day moving average. This is exactly what the beginning of a rally looks like.
- What happened to the stock market on Tuesday?
After being unable to trade over its 200-day moving average, the S&P 500 “gapped” above it at open and continued to move higher all day as the equity short-sellers were flushed out. Trading volumes, while higher than they have been, were not high enough to suggest today’s move higher was due to a large number of buyers.
The DJIA closed over its 100-day moving average, where it has been struggling lately, the Nasdaq-100 is still in between its 100- and 200-day moving averages and the Russell 2000 remains well below its 200-day moving average.
Despite the big move in stocks, Treasury yields fell on the day as today’s new 2-month Treasury auction saw a huge number of buyers bidding for a piece of the action. Most of today’s bidders were domestic buyers. Trading volumes on Treasuries have been dropping, which is a sign the short-sellers are likely exhausted. Look for the Treasury bulls to step in soon to push yields lower. I have a hunch the last jump in Treasury yields were due to the CTAs going ‘max short,’ but I don’t have any evidence to validate that.
Industrial production numbers came in at +0.3% MoM for September, which beat analysts’ expectations of a +0.2% MoM gain for the fourth month in a row. Wage growth is tied to industrial production growth, so workers should be optimistic for higher wages in the future.
Physical gold and the gold miners made another attempt at their respective 100-day moving averages and were rejected. This is setting up a retest of the 50-day moving average, which if confirmed, is a bullish signal. I also happen to know the CTAs are ‘max short’ gold right now and I happen to know where their first trigger point is.
- What happened to the stock market on Wednesday?
U.S. stocks started the day in the red, but buyers came to the rescue to push prices higher. Investors continue to believe that U.S. stocks are a safe haven and are immune to any economic downturns. While in the short-term such views can be accurate, stock prices have always fallen during every economic downturn.
The business cycle isn’t dead, and this cycle will come to an end. The only difference is investors haven’t learned their lesson about buying stocks at ultra-high valuations. One would think the last two recessions would have taught investors that, but perhaps this time is different.
Housing starts fell -5.3% MoM and housing permits fell -0.6% MoM. The housing market is a big generator of new money into the economy, so when housing slows, so does the economy. Mortgage applications fell -7.1% last week to their lowest level since 2000. Since new loans create money into the economy, falling mortgage applications support my opinion that the money supply will continue to decelerate and eventually contract.
Keep in mind, 17 out of the past 21 monetary decelerations led to a recession and every contraction in the growth rate of the money supply has triggered a recession. Mortgage applications are a leading indicator of where the economy is headed and are also indicating long-term interest rates will fall.
The Federal Reserve released their minutes from their last meeting which indicated they are likely to take the Federal Funds rate above the “neutral” rate. The neutral rate is where interest rates and the economy are balanced. This means the Fed believes the economy is running too hot and needs to be cooled off again. Investors responded by buying stocks and selling bonds, which they should do the exact opposite.
Stocks were mostly flat on the day after recovering their early losses. Treasury yields were up slightly. Both physical gold and the gold miners fell, which means a retest of their respective 50-day moving averages should be in the near future. A successful retest of their 50-DMAs should be considered bullish. Agricultural commodities were down a touch on the day.
The EIA reported a sizeable build in crude inventories with a small decline in gasoline inventories. The market has used rising oil prices as an excuse for rising bond yields, as rising oil prices are considered inflationary. With refineries closing down for maintenance, oil inventories should have fallen and gasoline inventories should have fallen even more.
- What happened to the stock market on Thursday?
One might think a -3% drop in the Chinese stock market, which is now down -30% from it’s January highs and at the lowest level since November 2014, might give U.S. investors a reason to back off their bullish bets. Despite the high correlation between the U.S and Chinese stock markets, U.S. investors eagerly continued buying this morning as the weight of the Fed’s balance sheet unwind continues to pull global asset prices down.
The Fed’s balance sheet and the Chinese stocks market are in sync and at some point, the U.S. stock market will find its way down as well. After Tuesday’s big rally, investors are being forced to defend their positions by selling what little bonds they have left to buy stocks.
Yields jumped in overnight trading and immediately ran into a wall at market open. As yields have started to fall, it’s clear the “Smart Money” is completing its rotation out of stocks and into bonds. Treasury yields have failed to reclaim their recent peak which is a sign there aren’t many sellers left or the buyers have reached their quotas. Either way, this is a signal that yields may have reached their cycle peak.
Equity bulls face a second headwind, which is the S&P 500’s 200-day moving average. In a bull market, the 200-DMA is a sign of support. In a bear market, it’s a sign of resistance. On Tuesday the bulls pushed the S&P 500 back over its 200-DMA, but if it fails to hold that a second time, look for the sellers to emerge. Not far below that is where the next round of selling occurs by the CTAs.
The Atlanta Fed posted its third-quarter GDP estimates which showed inventory accumulation is likely to represent more than half of third quarter GDP growth. The economy doesn’t need inventory accumulation, it needs sales. Should this hold true going into the holiday season, look for the economy to fall flat on its face as wholesales drop prices to clear inventories. This is another indication that we aren’t seeing money-price inflation, but cost-push inflation that is being rejected by consumers.
With seconds to spare the S&P 500 closed just over its 200-day moving average as all major indices erased their gains from earlier this week. Treasury yields were down slightly on the day. Physical gold, and the gold miners, both tried valiantly at their 100-day moving averages but failed. Agricultural commodities check in with their 100-day moving average and close a touch below. Early rallies can involve repeated confirmations against their moving averages, so another test of their 50-day moving average may not be out of line.
Tomorrow is options expirations day, so look for volatility to increase and stock prices to fluctuate. Bulls need the S&P 500’s 200-DMA to hold, while the bears want to see prices close below.
- What happened to the stock market on Friday?
The M2 money supply has fallen back into the danger zone. On a year-over-year basis, the growth rate of the money supply is 3.5%, back where it was just as the tax cuts were passed. Historically when the growth rate of the money supply falls below 3.7% YoY, all our economy experiences are recessions and depressions.
The three-month rate of change in the money supply also rapidly decelerated to 0.76%. The last time the three-month rate of change in the money supply fell that quickly was back in August 2009 when the Federal Funds rate was 0% and we had Quantitative Easing 1. I expect the three-month rate of change to go negative within the next four weeks as the Fed continues to tighten. This will be the first recession in a very long time where the money supply will outright contract. Those recessions historically have been the worst.
A hedge fund manager pointed out that when there is a big one-day move in the market by retail investors followed by a plunge the following day or two, it is the “Smart Money” entering the final phase of selling, which is called the distribution phase. As I suspected, the “Smart Money” has just about completed their rotation out of stocks and into bonds, just as the money supply contracts. Unless this time is different, a contracting money supply will cause stocks to fall and bonds to rise.
Existing home sales continue their decline for the seventh month in a row with a -3.4% MoM print for September. Sellers continue to raise prices despite slower sales, as the median home price is up 4.2% YoY. The economy is clearly showing it cannot handle higher interest rates and higher home prices. One or both will have to give.
The S&P 500 closed below its 200-day moving average for the third time in the past seven trading days. Again, this is not normal behavior in a bull market. Stock prices should be rebounding off its 200-DMA and moving higher. Consider this a warning sign.
The Nasdaq-100 continues to trend lower towards its 200-DMA and the DJIA closed below its 100-DMA. Treasury yields moved slightly higher on the day, but buyers came in to absorb those who are still selling. Selling continues to weaken, which will shift the tide to the bulls soon.
Physical gold and the gold miners continue to get rejected at their 100-DMA. A retest of both on their 50-DMAs is in the cards. There is a nice amount of volume showing price support below their 50-DMAs, which should be confirmed at some point in the near future. A buy upon confirmation will be getting in early.