Last Thursday’s short lived intraday 1000+ point market dive and subsequent recovery, a “Flash Crash”,  raises some big questions on the stability and quality of our electronic market system.

The new age of technology and computers was heralded on Wall Street with the computerization of the market exchanges. Conversely, the NYSE was seen as being antiquated with their manually managed open call system where a human market maker determined the prices of the bid and ask of stocks.

Yet, the May 6 debacle showed that we may have gone too far too fast. The 20 minute cliff dive seen is still being investigated as to what caused it. So far it is believed to have been triggered by a CitiBank trader who mistakenly executed a billion dollar sale over the intended million dollar execution. This allegedly triggered a chain reaction among all the automated trading systems who read the market activity as a big sale trigger.

Now CitiBank is denying that they had anything to do with it, and the other problems that occurred certainly can’t be blamed on them. For all we know, someone could have hacked into the system like in the movie WarGames and played “Stock Market Crash” instead of Global Thermal Nuclear War.

The market dive was interesting in that it was done on low volume- not a big volume dump that would truly indicate widespread panic selling. Other big problems was stocks were being mispriced at either pennies or over a hundred thousand dollars. Regardless of what triggered it, there was a definite error in the system as the markets went haywire.

There was one market that didn’t go haywire – it was the believed “antiquated” NYSE who still has humans setting the market prices for their stocks. They saw the aberrant pricing and decided to slow down the trading action while the they checked the validity of the stock prices. The meant that trades were not being executed instantly, but had a delay of 30 seconds or so. The other electronic markets traded past the NYSE and ran with the given prices. This resulted in the NYSE being the only market that was still open during that time that maintained sanity in their stock pricing. They were also the first to decide to cancel any automated orders that were part of NYSE (ARCA) that happened with the erroneous pricing.

The news may be playing it down, but what happened that day was a SERIOUS malfunction of the US automated trading market, and could have had grave consequences on the worlds economies. During that time, it looked like the market was on its way to completely collapsing, and any one witnessing that would be inspired to sell and keep selling. There were also stop loss orders that would have been triggered taking people out of their positions at the lows of the day. This unfortunately adds more tarnish to the US financial system, which already has a black eye from the dubious actions of the major investment banks which are being blamed as the primary cause of the current Great Recession. If our market stability comes into question, it would gravely impact international money coming into America, not to mention our own security and peace of mind.

Canceling all the trades that occurred with crazy pricing was the right thing to do, as this wasn’t triggered by real world events, but an error in the system. If the trades were allowed to stand, that would mean that people would have lost and made money based on a computer error which would seriously undermine the security and safety of our markets. It would be like a bank making an error with their accounts giving some people more money and taking away money from others, and then saying it was going to let those errors stand. That bank wouldn’t be in business much longer if they went that route.

It also shows you the limitations of our current computer technology. Without a human mind in the system to evaluate the validity of the trade during volatile times, the market was more than willing to trade at whatever prices it received. With the myriad of worldwide financial news being taken into consideration, there are just too many factors to consider to think a computer can be programmed to take all of these into account and come up with a sound judgment – our technology is no where close to that.

You can be sure that more regulations are on the way to bring more stability to the markets, which is a good thing. An error like the one we experienced will most likely be triggered again on perhaps an even bigger scale unless proper checks are put into place. The current checks are not enough- the first built in market slow down is only triggered at a 10% intraday market drop. We were close to that, but didn’t hit that number. Perhaps that number should be reduced to a lower number like 5% or 7%. Our current checks are now only meant to slow down a falling market, so there is nothing stopping the market from being bid up to the moon in one day with no forced time outs- this doesn’t sound very safe either.

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As you can see, the market literally falls off a cliff and then rapidly recovers much of the loss. That’s an incredible amount of volatility!

Here’s what it look like on the S&P 500:

As this was going on CNBC had live video of people rioting in Greece over the govt approved austerity measures as they try to climb out of their debt problem.

Just remember as you see these countries in financial turmoil, that much of the damage was caused by them having toxic CDO assets that went worthless. This is the gift the big investment banks have given to the world….yet you still have folks trying to justify their existence instead of scaling them back.

This super-sized whipsaw most likely caused big casualties in the market today. All those who had stop loss orders placed most likely had them triggered as the market plunged. It’s never fun to get stopped out of a position, only to have the market reverse and go higher. The market got me to cough up some shares before the real dive happened – thanks heaven I pulled the plug early!

The next set of victims were day traders- the human ones. The market moved so fast that if you weren’t fast enough, you were likely to either get burned on the way down, on the way up, or from both sides. I made a few mistakes and got singed here too. I’m sure a few folks manages to capitalize and make some money if they timed it right.

The third set of victims were the robot day traders. What ever triggered this dive (they are still investigating) took everyone by surprise and the machines just exacerbated the moves as their algorithms went with the flow. I’m sure some auto trading machines fared very poorly.

The only folks who escaped that whip were the ones ignoring the market. Of course, the aren’t completely unscathed as the market still ended the day with over 3% losses.

UPDATE:

NYSE (ARCA) and NASDAQ have announced that the are canceling ALL trades that happened during the plunge/whipsaw for stocks that were more than 60% off were they were trading before the big moves. Not sure how this will be tallied in…

Apparently the latest track is that some traders fat fingered an execution and instead of executing a million trade sell, he triggered a BILLION execution instead.

No Country for Old Men…or Humans

Now there is talk about more regulations needed to control the level and timing of trading. With hyper fast trading, computers can now process and work on over 1000 bid/offers per second. There’s no way humans can compete with that on the short term. Manual trading gets safer the farther out you go in the time line as you have the longer term trends to support you.

Now everyone is getting worried again after months of “happy times are here again” complacency.

To be ahead of the game, all one can really do is stick to technical and trend analysis. Don’t base your decisions on the news or emotions, but keep them in mind in the background. The long term trends should be the primary markers to show you whether to be buying or selling.

It’s is interesting that turmoil in Greece can send sink our markets as well. It just shows you how connected we are. Don’t you find it strange though that when Greece first announced that had problems several weeks ago, the market shrugged it off and moved higher? This is why you can’t trade solely on news.

As I’ve said in ma prior post, fundamentals ALWAYS catch up to the market eventually despite the market’s willingness to ignore it for an extended time. This market is to be traded – buy and hold is high risk at this time.

Since the March 2009 market ultra lows, the market has been on a high octane tear moving ever higher. The Dow has recently moved past 11,000 reaching 19 month highs. The Dow has also enjoyed eight straight weeks of gains, giving it the longest winning streak since January 2004. The Nasdaq is also having an eight week winning streak and a third of the S&P 500 companies are at 52 week highs.

All bearish analysts are left in shock and awe as the market surges continually upward.

With all this market euphoria, shall we proclaim that the worst is behind us and that good times are here again?

If you’ve been reading my blog for any length of time, you’d see that I’ve been on the bearish side of the market.  I’ve also talked about a bipolar market that acts as if either everything is good or everything is horrible with no moderate in-betweens.

Okay, so am I guilty of being a “perma-bear”, one who remains bearish regardless of what the market does and has an eternally gloomy outlook? I hope not because I can’t stand perma-bulls or perma-bears as you can’t trust what they say since they’re always one-sided.

Anyway, here’s my take on the market – we have a complete disconnect between the market technical data and longer term fundamental data. In short, I’m technically bullish on the market but long term fundamentally bearish. Here are my reasons:

Case for the Technical Bull:

One just needs to look at the ever climbing market for that. You can’t argue with the market’s upward movement. Companies are also seeing improving bottom lines from the lows of 2008/2009.

Case for the Fundamental Bear:

Does it make sense to you that the market has gone straight up in a “V” type recovery as if all the problems have been resolved? Have things improved that much so soon? Here’s what we are still dealing with:

1) Decades high unemployment – shedding employees will give big business employers boosts in productivity and better profit margins in the short term, but on the long term will see decreased demand and declining revenue as there are less people with buying income.

2) Crushing debt – In the aftermath of the market melt down, several cities and states are suffering with budget shortfalls. Services are being cut across the board which include fire, medical, and police services. There are municipalities that are in danger of declaring bankruptcy.

Debt problems go beyond the state level. The US Federal Deficit is well over $12 trillion dollars and climbing fast. Spiraling out of control debt will have negative implications down the line with higher taxes along with reduced services and benefits. The US dollar will also be under devaluing pressure which means the likelihood of rampant inflation along with higher interest rates. We’ve seen $4/gal gas…$5/gal and $6+/gal are real possibilities if inflation takes off.

The US isn’t the only country dealing with a huge debt problem. I’ve written about the financial crisis in Dubai  and predicted that other cities and countries may also be in danger of defaulting on their debt. Since that time, Greece has moved into the spotlight of being in danger of default. This begs the question as to what other cities/countries are on the ropes, but hiding it for now? A default of a major country can have severe economic and currency impacts.

Yet despite all these real problems, the market continues to ignore them and power upwards.

One thing we know for certain is that while the market may ignore fundamentals for quite a while, it will ALWAYS respond to it eventually. The only question is WHEN. Don’t expect the main stream media to give you any advance warning….they never do.

Knowing this, the question becomes how does one invest in this market, or if they even should?

I would say yes, one can invest, but one needs to have a short term outlook, meaning being ready to move your funds to safer harbors if the market starts an extended decline. The higher the market climbs in the face of all these headwinds,  the greater the risk that we are moving into yet another bubble.

The main point here is to avoid going into zombie “buy and hold” mode as this could be the worst time for it. It’s best to use technical analysis for determining when to buy or sell.

As you may recall, I discussed market behavior when October employment numbers were released:

The unemployment numbers were higher than expected and the national unemployment rate rose to a high of 10.2%, to which the market responded by rallying and moving higher. The reason given by financial main stream media was higher unemployment means interest rates will likely be kept low for a longer period.

So in their Bizzaro universe, higher unemployment is reason to celebrate in the stock market.

Now there has to be two sides to every equation, which means that if the jobs number showed lower unemployment, the market move should be negative (higher interest rates), right? Well, my Bipolar Market Theory predicts that the market will move in a certain direction independent of any new information.

Now last Friday the jobs number was much lower than expected- only 11K jobs lost for the month and the national unemployment number dropped to 10%

How did the market respond? Well if you guessed it went down since this means interest rates will be going up, you’d be wrong. The market instead rallied to make another new high for the year and ended positive for the day. The financial media, as expected, linked the rally to positive signs of the recovery taking place, forgetting all about interest rates.

So in summing up we have the following:

1) Higher unemployment triggers a market rally.

2) Lower unemployment triggers a market rally.

3) The financial mainstream media will try to make both situations seem logical and expected.

From this we can conclude:

1) Bipolar market theory has been verified.

2) Financial main stream media are basically idiots and should never be looked at for insight.

3) The market isn’t trading on fundamentals at this time, which makes it equivalent to Wyle E. Coyote running off of a cliff and not falling because he hasn’t realized it yet. Technical analysis is best suited for use now and one needs to be alert to any signs of bipolar market sentiment shifting. Once the sentiment shifts negative, you will see the market continue to fall regardless of news in the same fashion as it did going up.

Before I show the video, a little set up is needed…

Here’s the low down on bailed out company AIG. When a company is in serious financial trouble, one of the first things they do is try to renegotiate the debt obligations to their lenders….as in pay them 60 or 70 cents on the dollar rather than the full value amount, known as “par value”. The lenders may not like to take a loss, but they are motivated to negotiate because the losses could be far greater if the company goes bankrupt. Anyway, that’s what normally happens- but it didn’t with AIG. The Fed bailed out AIG and paid 100% of their debt (par value) to the lenders…..all with US taxpayer money and more debt. So basically AIG allowed other banks to engage in risky counter-party investments that went bust- and US citizens get stuck with the bill. So AIG and their lenders get the benefit of only gains and NO RISK of any losses. This, my friends, SUCKS and is NOT what capitalism is about.

This video starts in where Bunning is talking about the AIG bailout having no negotiated cuts to lenders:

Notice how Bernanke tries to weasel out by saying he was “powerless” to do anything and that the lenders had the upper hand. This is hogwash. If AIG went belly up, the lenders would have got squat, and had NO leverage. This is yet another example of Bernanke making excuses instead of taking accountability for his mistakes….that is, if you want to call this a “mistake”. I think this was a deliberate move in favor of Wall Street cronies.

Here’s the longer version of the video to see the full verbal smack down given to Bernanke:

Sen. Bunning (R-KY) to Fed Chair Bernanke: ‘You Are the Definition of Moral Hazard’

With the dollar weakness, gold and the other commodities continue to trend higher.

This kind of dollar decline/gold appreciation can’t be good for the economy in the long run and certainly threatens any hope of a timely recovery.

I wonder if the US Govt (Bernanke/Geithner) will continue to watch the dollar sink and do nothing while gold continues to make new record highs on an almost daily basis?

Although you could have easily missed it with all the news about Tiger Woods and his auto accident, or the White House party crashers taking up the majority of the air time, there was some very interesting financial news the past week.

Dubai, the play city for the wealthy, has run into financial problems due to plunging real estate values and has asked its creditors for a delay in its debt repayment schedule. Okay, so the fact that Dubai is in danger of defaulting on their debt and facing bankruptcy is just the first part of the interesting news.

The next part, which I find even more interesting, is the fact that none of the other United Arab Emirates (UAE) initially stepped up to “save the day” and even stated that they wouldn’t be stepping in for any bailout. How about that? Forcing Dubai to take responsibility for their own debt problems – what a novel concept!

Could that be a lesson for how the US and Europe should regard corporate debt problems? It would seem it’s a lesson they still aren’t ready to learn as the financial markets responded by falling last Friday and the major complaint/question repeated over and over again by the talking heads on financial and news media was “why wasn’t the UAE going to bail Dubai out?”

This type of mindset angers me to no end. How is it that banks and corporations feel they are entitled to special consideration and being bailed out for the “good of the markets”, and yet these same banks show little to no mercy for their own individual customers like homeowners who fall behind on their debt payments. Their level of hypocrisy knows no bounds, and is a clear example that the harsh realities of accountability don’t appear to apply to rich corporations. It disgusts me.

Meanwhile, the news media would rather keep you updated on fluff news like Tiger Woods, and White House parties instead of news that could actually have an impact in your life. This is why you should NEVER depend on the news for advance warning- by the time it’s becomes “worthy” of their attention, it will be too late to do anything about it.

Here are some of the questions you should be asking about the Dubai situation since most news media isn’t doing it:

1) How does this affect me or my investments?

Just because Dubai is half a world away is no guarantee that their actions have no global impact. The failure of US investment bank Lehman Brothers last year should make that very clear.

2) Could this crisis impact my country?

All investors in Dubai could be impacted – which includes many international banks and investment firms. How much have these corporations loaned to Dubai- which translates into how much of their capital is at risk?

3) What does this say about the remaining “systemic risk” out there?

Think Dubai is the only city-economy in dire straits? Think again. Could there be other cities or nations on financially shaky ground?

4) Why does the news ignore this story for the most part?

You can find news on Dubai if you’re on the financial news network or online service, but good luck finding it on regular TV news, where they would rather compete with Entertainment Tonight or TMZ, rather than give you useful information.

5) How does this affect overall market risk in general and risk to my investments in particular?

By effectively gauging risk, you will be ahead of the curve in keeping your long term investments safe from severe market turmoil.

Friday, 27 November 2009

*** Attention Bulls ***

*** Attention Bears ***

It should be obvious by now that the market will often behave independently of what the current market forces and economic conditions are. This can leave one at a loss for how to engage such a market rationally while still limiting the level of risk.

On the Bullish side:

Many of those who have subscribed to “buy and hold” have been burned badly as the market plummeted. Parts of the market has bounced back from the March lows, but other segments are still languishing.

On the Bearish side:

Many shorting or expecting the market to collapse have been stymied by the continued run up from the March lows with no sign of weakening. Anyone attempting to short this market has most likely been in a losing campaign.

In both the bullish and bearish scenario’s listening to the news would not have helped you make sound decisions in the short term as there has been a mix of both positive and negative information, and not only that, the market seems to ignore the information most of the time.

In my research, I’ve found that the best way to invest in this market is to accept that fact that the market is bipolar, meaning its normal state isn’t rational- either everything is great, or everything is rotten.

The next step is read the current financial data and make your own projections where the market “should” be going. You’ll have to determine this yourself as the news always presents conflicting information and will only confuse you if you don’t have a good grasp of the current state of the economy. This will tell you where the market is headed eventually- and here, the key word is EVENTUALLY- it could take some time for this to happen so consider it an “extended forecast”.

The last step is to understand “Trend Line Analysis” and “Support and Resistance” areas specifically as well as the art of technical analysis in general. You will need to know this area in order to determine when to buy or sell.

So putting it together, we have three main components to achieve success:

1) Accept the market is irrational (Bipolar)
2) Determine the “extended forecast” of the market.
3) Know Trend line and Technical Analysis

This is how you put them together for more successful investing experiences:

Knowing the “extended forecast” of where you think the market is headed will be invaluable for your long term (at least 1 year or more) investments. It will provide you with an early alert on whether you should be adding to your position or reducing it and moving it somewhere else. If done right, you should be able to avoid being caught in major market crashes as well as keeping your assets in stronger investments.

For short term trading/investing, knowing where the market is headed with your financial extended forecast information won’t be as helpful due to the bipolar nature of the market. The market has the uncanny ability to keep moving in one direction regardless of the current financial conditions. There is also an abundance of automatic computer trading going on which makes decisions on other things besides current news. The media, looking to explain any market movement with current news only adds to the confusion and you wind up with ridiculous “can’t lose” scenarios. Here’s one example:

The national unemployment numbers for October went up to 10.2%, which was higher than expected, but the market was seemingly unaffected and rallied. The financial news media stated that the market rallied because that higher unemployment number means interest rates will remain low. This makes no sense as the negative of a higher unemployment rate is of a higher magnitude that the positive of lower interest rates. Now on the other hand, had the unemployment number been lower than expected, the market would have rallied and the media would have proclaimed that it was due to signs that the recovery was taking hold, ignoring the interest rate angle altogether. Therefore no negative scenarios exist in this case that would result in a negative market move. This makes no sense in a rational market, but behaves as expected in a bi-polar market.

The way around this situation in the short term is to focus primarily on technical analysis (TA) instead of the news. If TA dictates the trend is up, go long. If TA points down, go short. In each case include a protective stop loss trigger as a risk limiter. This technique should keep you on the right side of trades in the short term while you’re waiting for your long term forecast to come to pass.