Archive for September, 2012

This Is Progress?

Friday, September 28th, 2012

Economic growth for the second quarter of 2012 officially has been revised down to 1.25%, which is below the lowest previous estimate.

In an effort to stimulate the economy, the Obama Administration and the U.S. Congress have added $6 trillion to the federal debt, with annual deficits exceeding $1 trillion.  The Federal Reserve Board meanwhile has announced its third round of quantitative easing, on top of Operation Twist.

Yet the unemployment rate remains over 8% and, as we stated earlier this month, could be as high as 19% if you take a true and accurate count of everyone who is not working.

Since the current “recovery” began, real income for the average American has dropped 5.7%, and while inflation as a whole remains in check, the price of essentials such as oil and food has soared.  At least we can credit quantitative easing with taming deflation!

This all sounds pretty gloomy, but cheer up.  Alan Krueger, who chairs the President’s Council of Economic Advisors, says “we’re making progress.”

It’s All Relative

Progress, of course, is relative.  It’s true that the free fall that began in 2008 created the worst economic conditions we’ve encountered since The Great Depression, but in the past the rule has been the greater the recession, the greater the recovery.

Not so this time.  Cumulative growth for the past three years has been just 6.7%, according to the Congressional Joint Economic Committee.  In comparison, the average for all 10 post-World War II recoveries is 15.2%.

In other words, the economic growth we’re experiencing is well under half of what it has been historically after past recessions, even though it should have been among the best periods of growth ever, given the severity of the recession.

Worse still, we can look forward to the long-term impact of today’s failed economic programs.  Someday, the debt we’ve accumulated will have to be paid back.  And quantitative easing may keep the country’s debt payments manageable today, but it weakens the dollar and boosts inflation.

And sooner or later interest rates could rise to the point where our current tax revenues will not be enough to pay the interest on our debt, let alone support government programs.

So what do we do when the current economic programs produce the same results as they have in the past?  Prepare for a multi-trillion dollar stimulus package?  QE3, the third quantitative easing program is open ended and can last as long as The Fed wants it to last, so at least we don’t have to worry about QE4.

Set Our Markets Free!

Friday, September 21st, 2012

In the not-too-distant past, the stock market rewarded entrepreneurs who worked hard and had innovative ideas.

Today, the market is driven primarily by two things:

  • Monetary policy.  The Federal Reserve Board’s quantitative easing programs drive stock prices higher by making other securities less attractive.
  • Computers.  High-frequency trading (HFT), which is conducted by proprietary trading desks at big banks and private hedge funds, uses computers to make trading decisions and execute trades based on perceived pricing inefficiencies.

These two factors already dominate the market, but they are becoming even more dominant.

This past week saw Japan join the U.S. and Europe in seeking to jumpstart its economy with an asset-purchase program.  The U.S., of course, announced QE3 last week and that announcement was preceded by a European Central Bank (ECB) announcement of a round of bond buying that called “an act of desperation.”

It used to be that company fundamentals drove share price.  Well run companies were rewarded with higher share prices.  Now, political appointees and computers determine share prices.

The key to improving employment and helping the economy is simple – set our markets free!

The Truth about High-Frequency Trading

Friday, September 21st, 2012

We’ve been critical before about high-frequency trading.  While regulation sometimes makes matters worse, it’s encouraging that he U.S. Senate Committee on Banking, Housing and Urban Affairs held a hearing this week to discuss potential regulation of computerized trading.

While it is unlikely to take action anytime soon, testimony given at the hearing was enlightening.  Here are a few excerpts:

David Lauer, Market Structure and HFT Consultant, Better Markets, Inc.:

“The sophistication of your trading strategy is no longer a defining characteristic of its success, rather the number of microseconds that it takes your software to react to a piece of market data has become one of the most important factors of success in the HFT industry.”

“The traditional mantra of the high-frequency trading industry is that HFT has helped to decrease trading costs by providing tighter spreads and lower volatility. One of the oft-cited studies in support of this claim was authored by employees of RGM Advisors, LLC, a prominent HFT firm. Another study was done by an employee of Credit Suisse, a major proponent of HFT. However, an increasing number of independent academic papers have demonstrated the opposite:

– the structural inefficiencies present in the market have created a massive misallocation of resources into technology that provides no social benefit, and structural deficiencies in market structure have allowed for nefarious or accidental actions to disrupt the market.”

“The increasing fragmentation of the marketplace and the advent of pay-for-order-flow deals have led to a phenomenon called adverse selection. This means that profitable trades (from a marketmaking perspective) never reach the market. Retail and institutional order flow pass through a gauntlet of internalizers and high-frequency trading desks, which pick off any profitable order flow before it ever reaches the public market. While these orders are filled within the NBBO, meaning that the originator of the order is no worse off on that particular order, market quality as a whole suffers. Natural buyers and sellers are virtually nonexistent under this structure, and the majority of the volume on the exchanges becomes ‘toxic flow’ an industry term for orders that nobody wants to interact with.”

Larry Tabb, CEO, The Tabb Group:

Have the high-profile computer trading failures over the past year, such as the recent trading problem at one firm that sent stocks sharply higher and then lower over a period of minutes, discouraged ordinary investors from participating in the stock market?  Have these failures and recent volatility with initial public offerings discouraged companies from taking advantage of the capital markets?

Of 260 market professionals surveyed by the Tabb Group two weeks after the recent Knight Trading meltdown, 34% rated their confidence in the markets as being either poor or very poor.  That’s up from 15% following the “Flash Crash.”

According to Tabb, HFT is just one of many factors, including “the long-term trend of decreasing equity ownership, a reduction in IPOs and lack of trading volume across virtually all financial products.”  Consider the other factors he cites:

The election – going back over previous election cycles from 1950, third-quarter equity trading volume during election years is down an average of 17% compared to the first half of the year. In non-election years, it is down only 4%. Volume in the fourth quarter during election years is down 5% from the first 3 quarters, while fourth-quarter volume during non-election is only down 3%.

Washington unease – the debt ceiling, the fiscal cliff, tax rates, and credit rating downgrades have investors uncertain about how to plan for the future.

Regulations – with Dodd Frank and many European regulatory initiatives in the works, it is hard for financial institutions to know how to plan.

Sarbanes-Oxley – raises the cost of becoming a public company.  This was addressed in the JOBS Act for smaller organizations.

Research settlement/research business model – Because of the Spitzer Research Settlement, it becomes harder to fund equity research, and without equity research (even biased research), it becomes harder to discover opportunities in smaller companies.

Basle III – new capital requirements increase the cost of capital, and with interest rates so low it is hard for banks to generate an adequate return. This makes it harder for banks to provide capital to the market.

Europe – with the Euro zone threatening to break up, investors do not know how to react or invest.

Risk on-Risk off/high correlations – with all of the macro risk in the market, investors are not investing in companies, they are investing in sectors and geographies via ETFs. So investors are not worried about

Coke or Pepsi or Ford or GM, they are worried about US or China, technology or health care. They are then using ETFs to express those strategies. Because ETFs are generally index-driven, they don’t buy undervalued assets and sell overvalued assets – they buy all the assets in an index in relation to the weighting of stocks in the index. Those trading strategies then drive the correlation of assets within the index toward 1.00.  Instead of one stock appreciating and the other depreciating, both begin to move in the same direction.  This hurts single-stock investors who then switch their investing strategy away from single names to trading sectors, or global macro themes.

Low interest rates – with interest rates so low, and declining over the past 30 years, at some level it becomes more beneficial to borrow money instead of issuing stock and diluting owners’ capital.

Demographics – baby boomers are retiring and want to secure their retirement by moving assets out of equities into fixed income or into savings accounts

Bank consolidation – with bank/broker/investment bank consolidation, the fees generated on smaller IPOs become immaterial. As banks get bigger, they need bigger transactions to move the dial.

Private equity – is tapping institutional money to invest in private companies because the return on public companies is so low and interest rates are so low. Tax treatment of PE firms may also play into this.

Going For Broke

Friday, September 14th, 2012

So The Fed is “all in.”  QE3, the third round of quantitative easting, will continue until the unemployment rate drops to an acceptable level.

The implication is that buying bonds will improve the unemployment rate, which has been over 8% for a record 43 months.  Yet if unemployment remained high after QE1, QE2 and Operation Twist, why should QE3 be any different?

The unemployment rate, of course, is bound to drop sooner or later.  When it does, will The Fed take credit and claim that QE3 is the reason?

Granted, this round of QE is different from the others, as The Fed will be buying $40 billion worth of mortgage-backed securities a month.

Added to existing bond buying, that will come to $85 billion a month through the end of the year.  If unemployment doesn’t drop, the Fed said it will buy even more bonds!

So we’ve come full circle since 2008, when the financial system nearly went bust by … investing in mortgage-backed securities.

Consumers Might Spend – If They Had Any Money

Friday, September 14th, 2012

Bond buying will pump money into the economy and reduce long-term interest rates, which are already at historic lows.

Theoretically, this will give consumers a greater incentive to spend their money now.  Or it would, if they had money to spend.

The Fed announcement comes on the heels of a Census Bureau report that annual household income fell in 2011 for the fourth straight year to $50,054, which is the level it was at in 1995.

In addition, of course, many Americans are currently living off of their unemployment benefits.  As we reported, many Americans have given up looking for jobs.  The deficit between the number of jobs created and the number of jobs shed exceeded 200,000 in August alone.

While the reported unemployment rate dropped from 8.3% to 8.1% in August, if those who are underemployed and those who have stopped looking were included, the real unemployment rate would be about 19%, according to The Wall Street Journal.

And, of course, bond buying will increase inflation.  Many Americans, who are barely subsisting, will need to find a way to spend more on food and gas.  So, tell me again, how is this helping the middle class?

When a Lower Unemployment Rate Is Bad News

Friday, September 7th, 2012

Want to reduce the unemployment rate?  Stop looking for a job.

More than 300,000 workers dropped out of the labor force in August, while employers added just 96,000 positions.

In the bizzaro world of Washington, D.C., that cut the unemployment rate from 8.3 percent to 8.1 percent.

Now if we can only get a few million people to stop looking for work, we can achieve full employment!

The Other QE

Friday, September 7th, 2012

It’s not QE3, the Fed’s highly anticipated and much discussed quantitative easing program, but the European Central Bank’s (ECB) bond buying program is having a similar impact.

Stock markets worldwide rose announced its bond-buying program yesterday.

Bond buying is Wall Street’s version of crack … it costs money and has a negative long-term impact, but it creates a temporary euphoria and makes everything seem just find for the those who want to live in the moment.

As The Wall Street Journal put it, “we suppose the good news is that it isn’t as sweeping as it might have been.”

To receive money from the ECB, countries that want help must first apply to the eurozone’s bailout fund.  Countries that receive assistance must consent to reducing government spending and debt.

In reality, though, countries like Spain, Italy and Greece are under pressure from citizens who don’t want austerity.  They’re protesting in the streets of Spain because the government would like to reduce their generous benefits … and politicians who want to survive had better take heed.

The program also has the potential to send bond yields soaring, not to mention causing higher inflation.

Conversely, one reason the markets responded favorably is that the program reduces the risk of a Eurozone break-up – at least for now.