Weekly Economic Update 12-08-2017

The Magic Levitating Market

Today the stock market appears to effortlessly rise as if there isn’t a worry in sight. Any bad news that causes stocks to fall is quickly reversed within minutes or days. Volatility has been crushed to historically low levels giving the average investor the confidence to take more risk than they should. Based on the stock market alone, one could infer that this country is on the cusp of the biggest economic renaissance in decades. While the economic data continues to refute the notion that the economy is about to boom, the stock market magicians are creating the biggest illusion of all – that the next Bull market in stocks is here to stay.

After the Great Financial Crisis of 2008-09, the rules for the stock market exchanges would change. Regulators decided that investors should pay the lowest price for a share of stock, meaning buy or sell orders had to be routed to the exchange that had the cheapest offering price. Since there were only a few stock exchanges, this new law seemed to be very consumer friendly. Shortly thereafter transaction costs would start to fall, making it cheaper to buy and sell stocks. While this all sounds good, what few people do know is that their trade information is being sold to and front run by High-Frequency Traders (HFTs).

High-Frequency Traders are computer algorithms that provide liquidity in the market, but what they are really doing is scalping fractions of a penny off every trade. When a trade is placed, that trade should route to the stock exchange with the lowest offering price. If that exchange doesn’t have enough shares to complete the transaction, the balance of the trade is then sent to the exchange with the next cheapest offer. As an investor, this should make perfect sense – the rules were changed to make sure the public receives the lowest possible offer for a trade. However, this law opened the door for scalpers to come in and exploit the law.

Now when a trade is placed, that information is sold to one or more High-Frequency Traders. The High-Frequency Traders then front run the transaction by getting to the exchange ahead of your order and buying it for you. By the time your trade arrives, the High-Frequency Trader then sells those shares that it just bought microseconds earlier to you for a fraction of a penny higher. This might not sound like a very lucrative deal, but when you can scalp a fraction of a cent from millions of trades per second, it’s very lucrative. It’s not just lucrative for the High-Frequency Traders, but for everyone involved — except the public. If you think that large institutional investors or hedge funds are immune to this scalping, they aren’t. Everyone is paying more.

To put this in perspective, imagine standing in line at the box office waiting to buy a concert ticket. As you reach the box office, someone jumps the line to buy the tickets you want and then sells them to you at a slightly higher price. Not only are you paying more, but each person who follows is also paying more and this process is repeated for each person in line.

Normally stock prices rise on demand when there are more buyers than sellers, but what High-Frequency Trading does is create the illusion of higher demand which leads to higher prices. Each successive investor is paying more than they should. If each person is paying an additional mark up, then the market can rise on a small number of buyers. Hence, creating the illusion of a rising stock market with a small number of buyers.

Now you know why in a rising equity market how High-Frequency Traders can accelerate a rise in stock prices by making every successive buyer pay a higher price than the previous buyer. Since the Great Financial Crisis, trading volumes have fallen while stock prices have risen, lending evidence that the High-Frequency Traders are manipulating the market. In a down market, High-Frequency Traders will do the opposite, and front-run the sell order which will cause the seller to receive a lower price than they expected. The biggest fear isn’t that High-Frequency Traders will front-run sell orders, but that High-Frequency Traders will choose to stop front-running trades during the next Bear market.

Over the past couple of years, the Federal Reserve (Fed) has made numerous mentions that High-Frequency Trading is the biggest risk to the stock market. High-Frequency Traders provide liquidity to the markets by front-running trades, but if they stop providing that liquidity, then there’s nobody left to take their place. Through the advent of High-Frequency Trading, the normal market makers who provide liquidity in down markets have been made obsolete. While I do not have an exact number, there are very few market-makers left, meaning the Fed’s fear is well-founded. Nobody knows whom, if anyone, will be left to step in to arrest a large sell-off.

There have been numerous instances where High-Frequency Traders have stopped front-running trades on specific stocks and during those instances, stock prices have fallen straight down – some stocks as much as 30%+ in a matter of seconds. Nobody knows what will happen during the next Bear market because High-Frequency Trading didn’t exist prior to the Great Financial Crisis of 2008-09, but one can assume that High-Frequency Traders will accelerate the next downturn.

High-Frequency Trading accounts for approximately half of all trading volume in a given day. This is frightening once you realize that trading volumes are already abnormally low and that half of that volume is due to front-running by High-Frequency Traders. All this does is lend further evidence that the stock market has been run up to absurdly high levels by computer programs pushing prices higher and higher.

The story behind High-Frequency Trading is much deeper than this short essay. If you’re wondering if High-Frequency Trading is sanctioned by the regulators, exchanges and dealers – yes, it’s completely legal. The exchanges have even rewritten their code to be High-Frequency Trading friendly by creating bogus order types that allow High-Frequency Traders to spoof real orders to confuse the custodians who are sending in trades! The number of exchanges increased, and they have been strategically placed outside of Wall Street to make sure that the High-Frequency Traders can win the race when trades are routed in between the various exchanges. Through High-Frequency Trading, custodians, dealers, and the exchanges have found a way to make more money than they ever have by legally selling your trade information to allow High-Frequency Traders the ability to front run trades.

Since the Great Financial Crisis of 2008-09, the rules of the stock market changed. In the past, you could ride the market up and try to sell at the first sign of the Bears coming out of hibernation. Between the High-Frequency Traders, the machine-learning algorithmic traders, the risk-parity fund, the volatility targeting funds and the short volatility trade that I detailed last week, there is a real possibility that the next Bear market will crush the stock market in a matter of days. Some experts believe it may not even take that long. Unfortunately, the regulators have done nothing to protect the average investor, who believes the Federal Reserve will just print money to keep pushing asset prices higher.

That logic remains flawed as central banks have tried to prevent every major Bear market since the Great Depression and haven’t succeeded once. Nevertheless, investors are taking a huge amount of risk in a market that has the stage set to annihilate itself in a very short period of time. Anyone who thinks their financial advisor will be able to react quickly enough will likely be wrong. The Fed won’t have time to save the markets because some experts believe that if this unwind begins, that investment banks (who are tied into the banking system) may fail in a day. The Fed may be too busy putting out infernos to worry about the public.

At the end of the day, investing is a function of risk and reward. As markets go higher, the risks increase, but the public perception is that a rising market has less risk. No matter what you believe, the Fed is actively shrinking the money supply. As the money supply falls, so will asset prices and as that happens, the world will see first-hand if the leverage that is holding the stock market up is solid or if it’s just a house of cards like it has been in every previous recession.

Video Topic of the Week – Payrolls

Nonfarm payrolls continue to print strong numbers, but wages aren’t following. Tune in this week to hear my thoughts on what’s going on in the labor market.

Chart of the Week – Credit Card Debt

Consumers are borrowing heavily to keep the economy running. How long will they be able to continue doing this in the absence of wage growth?

Portfolio Shield™ Update

The December rebalance went smoothly and the strategy remains fully allocated to equities. Depending on how the bond market moves in December, the bond allocation should be coming back soon.

The December investment detail report is linked below.

Work slowly progresses on the momentum strategy. I had a couple projects come up at the office that required my immediate attention, but those are done for the moment. I ran into a roadblock on how to interpret the data into an investing strategy – it wasn’t working. Visually I could look at the charts and identify what I wanted to happen, but when I ran the backtest on the data, it wasn’t coming out the way I hoped. There is a big enough lag in the data where it misses the early and late part of the momentum swings.

After taking a few days off from the project, which helped, I was able to visualize the solution in an entirely different way. After sketching it out, the next approach looked good. As it turns out the Portfolio Shield™ data validated that this new approach should work. I pulled some data to run a quick test and the results were very positive. More to come on this!

Weekly Broad Market / Economy Commentary

The day after the tax package passed the Senate the stock market started showing signs of weakness. While the passage of the bill is not guaranteed, in its current form or otherwise, the public continues to pour money into the stock market despite obvious warning signs that risk assets are in a massive bubble. Money flows show that the public just can’t get enough risk assets, which is interesting because there still aren’t any signs of Wall Street’s elusive “blow-off top.” Perhaps the media can start selling the infrastructure bill that is coming next year as a reason to buy now. Even though Japan has passed nearly 30 infrastructure bills in the past 30 years and their stock market is nowhere near its 1990 high.

What I find more interesting is that as of November, global industrial production is starting to fall, and nobody seems too concerned. Maybe people think that a dip in industrial production is transitory, but to me, it’s a sign of the drain in dollar liquidity. As the Fed drains liquidity, it should show up in places where there are lots of dollars, which would be Asia and then the broad economy. It doesn’t come as a surprise to me that the global economy is slowing – with less money circulating, it should slow down.

The Fed is set to meet next week at what will be Janet Yellen’s last meeting before handing the role of Chairman off and while opinions vary, I believe the Fed will likely hike rates in December. Wall Street has given the Fed a green light to hike, plus there is now growing concern that the labor market is getting too hot. Yes, you read that correctly. Six months ago, the labor market was weak, but now it’s getting too hot. I can’t make this stuff up!

If there’s one part of the stock market that’s following the money supply, it’s precious metals. Gold and silver have been falling, which as many of you know, is something I have been waiting for. Given the massive buildup of credit, it’s reasonable that during the next recession there will be a huge collapse in credit and the money supply, which will be a boom for precious metals. The gold and silver mining stocks are fast approaching my target buy points – I have several. I’ll cover this in more detail in the video and in the charts.

For now, the public is driving the stock market, because the public buys the most at the peak and the least at the bottom. The problem with this market isn’t just that it’s overvalued, it’s all the computer-controlled algorithms that will lead to what will likely be the fastest sell-off in history. Unless you think you can out-trade the computers when things turn, the prudent move remains to catch the countertrend. If gold does half of what I think it can do, it alone will be one of the best investments of this decade.