Five Reasons the Market Could Crash This Fall

With all this blather about “green shoots” and economic “recovery” and new “bull market,” I thought I’d inject a little reality into the collective financial dialogue. The following are ALL true, all valid, and all horrifying…

Enjoy.

1) High Frequency Trading Programs account for 70% of market volume

High Frequency Trading Programs (HFTP) collect a ¼ of a penny rebate for every transaction they make. They’re not interested in making a gain from a trade, just collecting the rebate.

Let’s say an institutional investor has put in an order to buy 15,000 shares of XYZ company between $10.00 and $10.07. The institution’s buy program is designed to make this order without pushing up the stock price, so it buys the shares in chunks of 100 or so (often it also advertises to the index how many shares are left in the order).

First it buys 100 shares at $10.00. That order clears, so the program buys another 200 shares at $10.01. That clears, so the program buys another 500 shares at $10.03. At this point an HFTP will have recognized that an institutional investor is putting in a large staggered order.

The HFTP then begins front-running the institutional investor. So the HFTP puts in an order for 100 shares at $10.04. The broker who was selling shares to the institutional investor would obviously rather sell at a higher price (even if it’s just a penny). So the broker sells his shares to the HFTP at $10.04. The HFTP then turns around and sells its shares to the institutional investor for $10.04 (which was the institution’s next price anyway).

In this way, the trading program makes ½ a penny (one ¼ for buying from the broker and another ¼ for selling to the institution) AND makes the institutional trader pay a penny more on the shares.

And this kind of nonsense now comprises 70% OF ALL MARKET TRANSACTIONS. Put another way, the market is now no longer moving based on REAL orders, it’s moving based on a bunch of HFTPs gaming each other and REAL orders to earn fractions of a penny.

Currently, roughly five billion shares trade per day. Take away HFTP’s transactions (70%) and you’ve got daily volume of 1.5 billion. That’s roughly the same amount of transactions that occur during Christmas (see the HUGE drop in late December), a time when almost every institution and investor is on vacation.

HFTPs were introduced under the auspices of providing liquidity. But the liquidity they provide isn’t REAL. It’s largely microsecond trades between computer programs, not REAL buy/sell orders from someone who has any interest in owning stocks.

In fact, HFTPs are not REQUIRED to trade. They’re entirely “for profit” enterprises. And the profits are obscene: $21 billion spread out amongst the 100 or so firms who engage in this (Goldman Sachs (GS) is the undisputed king controlling an estimated 21% of all High Frequency Trading).

So IF the market collapses (as it well could when the summer ends and institutional participation returns to the market in full force). HFTPs can simply stop trading, evaporating 70% of the market’s trading volume overnight. Indeed, one could very easily consider HFTPs to be the ULTIMATE market prop as you will soon see.

TAKE AWAY 70% of MARKET VOLUME AND YOU HAVE FINANCIAL ARMAGEDDON.

2) Even counting HFTP volume, market volume has contracted the most since 1989

Indeed, volume hasn’t contracted like this since the summer of 1989. For those of you who aren’t history buffs, the S&P 500’s performance in 1989 offers some clues as what to expect this coming fall. In 1989, the S&P 500 staged a huge rally in March, followed by an even stronger rally in July. Throughout this time, volume dried up to a small trickle.

What followed wasn’t pretty.

Anytime stocks explode higher on next to no volume and crap fundamentals you run the risk of a real collapse. I am officially going on record now and stating that IF the S&P 500 hits 1,000, we will see a full-blown Crash like last year.

3) This Latest Market Rally is a Short-Squeeze and Nothing More

To date, the stock market is up 48% since its March lows. This is truly incredible when you consider the underlying economic picture: normally when the market rallies 40%+ from a bear market low, the economy is already nine months into recovery mode. Indeed, assuming the market is trading based on earnings, the S&P 500 is currently discounting earnings growth of 40-50% for 2010. The odds of that happening are about one in one million.

A closer examination of this rally reveals the degree to which “junk” has triumphed over value. Since July 10th:

• The 50 smallest stocks have outperformed the largest 50 stocks by 7.5%.
• The 50 most shorted stocks have beaten the 50 least shorted stocks by 8.8%.

Why is this?

Because this rally has largely been a short squeeze.

Consider that the short interest has plunged 72% in the last two months. Those industries that should be falling the most right now due to the world’s economic contraction (energy, materials, etc.) have seen the largest drop in short interest: Energy -90%, Materials -94%, Financials -86%.

In simple terms, this rally was the MOTHER of all short squeezes. The fact that it occurred on next to no volume and crummy fundamentals sets the stage for a VERY ugly correction.

4) 13 Million Americans Exhaust Unemployment by 12/09

A lot of the bull-tards in the media have been going wild that unemployment claims are falling. It strikes me as surprising that this would be true given the fact that virtually every company that posted the alleged “awesome” earnings in 2Q09 did so by laying off thousands of employees:

• Yahoo! (YHOO) will cut 675 jobs.
• Verizon (VZ) just laid off 9,000 employees.
• Motorola (MOT) plans to lay off 7,000 folks this year.
• Shell (RDS.A) has laid off 150 management positions (20% of management).
• Microsoft (MSFT) plans to lay off 5,000 people this year.

So unemployment claims are falling, that means people are finding jobs right? Wrong. It means that people are exhausting their unemployment benefits. When you consider that there are 30 million people on food stamps in the US (out of the 200 million that are of working age: 15-64) it’s clear REAL unemployment must be closer to 16%.

And they’re slowly running out of their government lifelines.

The three million people who lost their jobs in the second half of 2008 will exhaust their benefits by October 2009. When you add in dependents, this means that around 10 million folks will have no income and virtually no savings come Halloween.

Throw in the other four million who lost their jobs in the first half of 2009 and you’ve got 13 million people (counting families) who will be essentially destitute by year-end.

How does this affect the stock market?

The US consumer is 70% of our GDP. People without jobs don’t spend money. People who are having to work part-time instead of full-time (another nine million) spend less money than full time employees. And people who are forced to work shorter work weeks (current average is 33, an ALL TIME LOW), have less money to spend.

Wall Street makes a big deal about earnings (earnings estimates, earnings forecast, etc), but when it comes to economic growth, sales are the more critical metric. Companies can increase profits by reducing costs temporarily, but unless actual top lines increase, there is NO growth to be seen. No revenue growth means no hiring, which means no uptick in employment, which means greater housing and credit card defaults, greater Federal welfare (unemployment, food stamps, etc), etc.

So how will corporate profits perform as more and more consumers become part-time, unemployed, or destitute? Well, so far profits have been awful. And that’s BEFORE we start seeing millions of Americans losing their unemployment benefits.

click to enlarge

With the S&P rallying on these already crap results… what do you think will happen when reality sets in during 3Q09?

5) The $1 QUADRILLION Derivatives Time Bomb

Few commentators care to mention that the total notional value of derivatives in the financial system is over $1.0 QUADRILLION (that’s 1,000 TRILLIONS).

US Commercial banks alone own an unbelievable $202 trillion in derivatives. The top five of them hold 96% of this.

By the way, the chart is in TRILLIONS of dollars:

As you can see, Goldman Sachs alone has $39 trillion in derivatives outstanding. That’s an amount equal to more than three times total US GDP. Amazing, but nothing compared to JP Morgan (JPM), which has a whopping $80 TRILLION in derivatives on its balance sheet.

Bear in mind, these are “notional” values of derivatives, not the amount of money “at risk” here. However, if even 1% of the $1 Quadrillion is actually at risk, you’re talking about $10 trillion in “at risk.”

What are the odds that Wall Street, when allowed to trade without any regulation, oversight, or audits, put a lot of money at risk? I mean… Wall Street’s track record regarding financial instruments that were ACTUALLY analyzed and rated by credit ratings agencies has so far been stellar.

After all, mortgage backed securities, credit default swaps, collateralized debt obligations… those vehicles all turned out great what with the ratings agencies, banks risk management systems, and various other oversight committees reviewing them.

I’m sure that derivatives which have absolutely NO oversight, no auditing, no regulation, will ALL be fine. There’s NO WAY that the very same financial institutions that used 30-to-1 leverage or more on regulated balance sheet investments would put $50+ trillion “at risk” (only 5% of the $1 quadrillion notional) when they were trading derivatives.

If Wall Street did put $50 trillion at risk… and 10% of that money goes bad (quite a low estimate given defaults on regulated securities) that means $5 trillion in losses: an amount equal to HALF of the total US stock market.

This of course assumes that Wall Street only put 5% of its notional value of derivatives at risk… and only 10% of the derivatives “at risk” go bad.

Do you think those assumptions are a bit… low?

Comments

[JosephN]

Wow, the fear mongering in this article is palatable.

Yes without program trading there likely would have been no bid during the crash and the country could now be in Great Depression II. However the liquidity added by HFTP insured there was a bid, thereby propping the market up long enough to for us to try and fix it. And while some people claim to think this is a bad thing, I just smell 'short' when I see articles like this.

The bottom line if the banks are manipulating the market, they are doing so to save themselves, the world economic system, and the rest of us to boot, almost certainly in that order.

Nothing to do but buy the banks and sit tight.

And if they don't then a war is coming to realign the political and economic world. Its easy to see, deficit spending on the military to pull out of an economic malaise is a time honored tradition right out of Imperial Japan or Nazi Germany and all the way back to the Roman emperors.

In which case, buy defense, sit tight.

Now that's fear mongering!

2009 Aug 04 08:23 AM

[azad]

An illuminating but bit scaring analysis. Probable but perhaps not possible, given the cautionery approach taken by all. But the recent euphoria about the stockmarket is certainly unsuatainable. Traders are once again luring people into a trap of greed and lunacy.

2009 Aug 04 08:25 AM

[Stez]

Enzio Von Pfiel was putting forward precisely this proposition on CNBC.

Take a wild guess how that was received.

He stated trading desks have made their money on the upside.
Now they will not be able to make such large sized gains here and the programs will be taking it to the downside and when they do it will be a violent sell off.

The idea was greeted with total bemusement.

October will tell the tale the key is not being the fish that got hooked.

2009 Aug 04 08:30 AM

[logicalthought]

>>I am officially going on record now and stating that IF the S&P 500 hits 1,000, we will see a full-blown Crash like last year.<<

LOL... Fortunately, when you wrote this, you followed Rule #1 of economic predicting: If you give them the price, don't give them the timing!

2009 Aug 04 08:41 AM

[Ed Zimmer]

What some call "fear mongering", others call "shedding light". By this analysis, HFTP's are generating income of 8.75 million dollars per day by gaming the system. Sort of explains the recent quarterly bank "profits", much of which were generated by trading, not banking. The small investor is wisely staying on the sidelines in this undertow and choppy current. Everyone wants things to improve, but too many are jumping on the green shoots bandwagon and singing "Happy Days are here again" when the roads are shot and the unemployed have taken the wheels.

Deficit Government spending is trying to fill the missing consumer portion of the GDP, a pothole patch at best, while banks buy US Treasuries to keep the scam going. Oil is up to $70bbl, the Dollar is trending downward from it's unsustainable and bewildering highs and yet inflation is still 'tamed'. Strange, that $4 extra value meal is now $5 thanks to the 70 cent per hour hike in the minimum wage. I hear the echos of the first President Bush with the words "there's no recession." We'll see if the magicians can keep things together into 2010 or if the audiance sees through the smoke and mirrors.

2009 Aug 04 09:11 AM

[User 118776]

Definately interesting. I'm in total agreement that the market has rallied too far and a lot of poor companies are rising on short covering - look at HOG...Terrible results, no end in sight to lower volumes, no pickup and the stock is 2X what it was a few weeks ago.....

2009 Aug 04 09:38 AM

[The Goy]

I think you left out the fact that the US government is going to seriously raise taxes next year, so selling is going to happen this year. I like the HFT information.

2009 Aug 04 09:59 AM

[Fruffing]

Nice post. In the spirit of "always a bull market somewhere," it'd be useful to hear your thoughts on what's actionable (other than SPX puts).

2009 Aug 04 10:05 AM

[David Braunstein]

I couldn't agree with you more. Great insights. Anyone long equities here is playing a game of Russian roulette. I'm amazed that computerized trading could be responsible for a 48% increase in this market without speculators coming back in. To me it reminds me of the market in 1997 to 1999 before the tech crash. A market driven by momentum investors. During that time growth stocks were king and value stocks trash. I often wonder if this market will be like that one given the tremendous amount of government stimulus in the economy. I don't disagree with your brilliant analysis, I just wonder if the crash will come this fall or the fall of 2011? Howver, no matter how you look at it, it looks to be a fool's rally and investors will likely be better off over the next several months holding high quality bonds or cash.

2009 Aug 04 10:58 AM

[Socialism cannot compete!]

# 1 seems like a straw man. Don't ya think big buyers use limit orders?

2009 Aug 04 11:01 AM

[CGP]

Interesting article, always good to hear a reasoned bear argument.

Can you provide #'s & PY comparatives on your volume argument?

See dshort.com/articles/20...

2009 Aug 04 11:22 AM

[Angel Martin]

What market ever had a crash that was not preceeded by a multi-year bull/bubble gains?

2009 Aug 04 11:26 AM

[Maxe Paul]

This one.


On Aug 04 11:26 AM Angel Martin wrote:

> What market ever had a crash that was not preceeded by a multi-year
> bull/bubble gains?

2009 Aug 04 11:37 AM

[doubleshortetf]

Why we're near the very top:

1. Goes up on bad news/numbers from MSFT, AMZN, AXP's poor numbers results couple of weeks ago.

2. The investment gurus and analysts who got blind sided by last fall's fall and March low (boy weren't they pessimistic) are now in unison as bullish as ever, even with heck of a run since March.

3. Bears are hiding and appear to be capitulating on short covering. One can say the bears were "early" smart money.

4. Russell 2k has been on a tear. Speculation or back to halcyon days are back?

5. CNBC has special on Dow 9k and Cramer is pounding the table with buys and the lemming retail and professional investors are piling in. So much for the lows we had in Oct/Nov and March.

6. And even Barron's sounding bullish sans Abelson?

7. Historically Sept is the worst month followed by Oct. Just around the corner.

My 2-cents is that we'll see 50% retracement to March low in Sept/Oct.

2009 Aug 04 11:55 AM

[contracontrarian]

"If Wall Street did put $50 trillion at risk… and 10% of that money goes bad (quite a low estimate given defaults on regulated securities) that means $5 trillion in losses: an amount equal to HALF of the total US stock market."

Any one particular Wall Street firm can lose everything they have or even more,but other Wall Street firms would earn the same amount at the same time,as they are on both sides of those derivative positions. Alltogether "Wall Street" can not lose money on their derivatives...

2009 Aug 04 12:10 PM

[conceptwizard]

Over at Zero Hedge, Tyler Durden did the math and figured that the recent 45% surge in the S&P 500 had nothing to do with the fictional economic "recovery", but was just more of the Fed's hanky panky. Durden noticed that the money that's been sluicing into stocks hasn't (correspondingly) depleted the money markets. That's the clue that led him to the truth about Bernanke's 6 month stock rally.

Zero Hedge: "Most interesting is the correlation between Money Market totals and the listed stock value since the March lows: a $2.7 trillion move in equities was accompanied by a less than $400 billion reduction in Money Market accounts!

Where, may we ask, did the balance of $2.3 trillion in purchasing power come from? Why the Federal Reserve of course, which directly and indirectly subsidized U.S. banks (and foreign ones through liquidity swaps) for roughly that amount. Apparently these banks promptly went on a buying spree to raise the all important equity market, so that the U.S. consumer who net equity was almost negative on March 31, could have some semblance of confidence back and would go ahead and max out his credit card. Alas, as one can see in the money multiplier and velocity of money metrics, U.S. consumers couldn't care less about leveraging themselves any more."

So, the magical "Green Shoots" stock market rally was fueled by a mere $400 billion from the money markets. The rest ($2.3 trillion) was main-lined into the market via Bernanke's quantitative easing (QE) program, of which Krugman and others speak so highly.

Wouldn't you like to know if Bernanke sat down with G-Sax and JPM executives and mapped out the details of this swindle before the printing presses ever started rolling?

2009 Aug 04 12:24 PM

[David Braunstein]

Dead wrong! Wall street firms and banks are the guarantors of derivatives contracts. They back those contracts by the financial insitution's credit rating. It is the customers of those brokerages and banks who are taking positions. It is a logical statement to say that all the customers of the financial institutions play a zero sum game, however, it is very posssible for one or more financial institutions to fail without another financial institution gaining anything.


On Aug 04 12:10 PM contracontrarian wrote:

> "If Wall Street did put $50 trillion at risk… and 10% of that money
> goes bad (quite a low estimate given defaults on regulated securities)
> that means $5 trillion in losses: an amount equal to HALF of the
> total US stock market."
>
> Any one particular Wall Street firm can lose everything they have
> or even more,but other Wall Street firms would earn the same amount
> at the same time,as they are on both sides of those derivative positions.
> Alltogether "Wall Street" can not lose money on their derivatives...

2009 Aug 04 12:27 PM

[TextBookHunting.com]

Agree with the most here. People have not learn much lesson from last recession! We will be doing same mistake again and again. We keep patching up the economy through stimulus, cash for clunkers etc. Long term it is going to have bad effects on US economy..

2009 Aug 04 12:42 PM

[MarkitWacha]

In this global environment, where most economies are not faring much better than the US, the safest bet is to bet against this government and others. How can you do this? Commodities. Their price doesn't lie, especially that of food and energy.

Long : DBC, with a 10% stop loss.

Long: SPY puts

Long: TBT

This charade can't last forever.

2009 Aug 04 01:21 PM

[Dave Wrixon]

Now what was it you said America makes these days?

2009 Aug 04 01:34 PM