The trajectory of the stock market over the last 14 months has brought me to the point where I am almost without words to explain the inordinate risks investors are exposed to today. Even those who are optimistic about the future are angry that we can't even get a modest pull back that will allow them to commit some money to the market. Those in the bull camp - if one were honest - are just as stunned at the steep ramp trajectory of the stock market today as are those less optimistic bears.
What's occurred in the last 15 years is a major transformation in the nature of markets and leaves us with little in the way of useful analytical tools to attempt to discern where markets might go over the course of the next few years. What's different today than in times past you ask?
Well, fiscal and monetary policy for one. Also the advent of banks as THE major player in markets with the repeal of Glass-Steagall. Add to that the HFT algos that shove bank money into the market in an aggressive manner at even the slightest hint of a pull back. And then there are the dark pools that hide large scale orders from public view.
Perhaps the most disconcerting change in the dynamic of markets today though is the blatant manipulation of the markets by HFT algos (high frequency trading algorithms). The chart below reflects an incredibly short time frame - 1/3 of a second - and most of the quotes are fake but they still move the market. The chart is from Nanex and appeared in a Business Insider article - What It Looks Like When A High Frequency Trading Algo Bombs A Stock With Fake Quote.
Understanding what you are looking at in the chart below is not as important as understanding the impact this type of "fake quote" has on price. Here is how the author of the article explains it and the chart appears directly below the explanation:
To buy a stock you must quote the right price. The "right" price is known as the National Best Bid and Offer (NBBO) and is determined, of course, by the market's demand for a stock.
Quote the right price, and you can buy. It's as simple as that.
Until it's not.
Nanex, a Chicago-based market research firm, sent us a chart that illustrates what can stand in a trader's way when they're trying to quote the right price.
What's happening below is a snapshot of 1/3 of a second of one stock's life while it's being bombed by a high frequency algorithm. One thousand quotes are firing off at this stock, the SPDR BofA ML Crossover Corp Bond ETF, every tenth of a second and then canceling, so no trades are actually being executed.
Those are fake quotes.
The thing is, the market sees those quotes as demand anyway, and it changes the NBBO. So every triangle you see there (color coded for what exchange they're appearing on) is a quote that is impacting the price (NBBO).
The gray background shows how the price is dipping up and down. According to Nanex CEO Eric Hunsader, those black spaces you see (showing a change in price) are happening in intervals so fast that this chart can't even catch them.
"It happens all the time," Hunsader told Business Insider. "It crowds out legitimate prices... it's like SPAM. Maybe one of these guys is a legit offer but there's no way of knowing."
Perhaps an easier way to understand the manipulation of markets today is to look at a 5 minute chart:
The price movement in the red boxes are counter trend movements. They are sudden and dramatic and as often as not they occur without explanation unless you factor in what the HFT algo manipulators are doing. As you consider these movements do you get the feeling the playing field is fair? Are we seeing true supply/demand price discovery? And if not then are those of us who don't have access to this kind of information - information that is inside information by any kind of logic one would use - likely to fare well over time?
In today's world the large cap index stocks are - for the most part - held by a handful of major financial institutions so the odds of mass liquidation of stocks may not occur and that too is troubling. What should we expect stocks to do if we move back into recession for instance? Sell off would be the logical answer but the market isn't moving on logic anymore. It is moving almost entirely based on the agendas of a few big banks with almost unlimited capacity to create the needed money to put stocks where they want to put them. Couple that money with sophisticated tools - think HFT algos - that the rest of us don't have that can move stocks in a counter trend direction in a matter of seconds and we are at the mercy of a handful of very sophisticated market makers.
Perhaps the biggest player in this game is JPM (NYSE:JPM). And hasn't JPM agreed to pay out almost $20 billion in fines this year for their role in market manipulations, deception, fraud and now in the case of the Bernie Madoff Ponzi scheme - criminal behavior of the worst kind? $20 billion is a pretty good size number and represents roughly the amount of their income in 2012. Not to worry though as the chart below indicates:
And it's just this kind of irrational stock price movement that so frustrates credible analysts. Here's the point - stocks must ultimately be priced relative to earnings. Here is a look at the trailing 12-month earnings yield on the S&P:
And for purposes of comparison here is the S&P 500 (NYSEARCA:SPY):
What it means of course is that stocks are being priced at ever higher valuation levels and not based on earnings. That's OK if prospects for the future look rosy but that is certainly not the case. In fact much to the consternation of those who want to argue that we are on the verge of real economic growth we really do have to consider the machinations that have driven GDP, sales and profits in this century and in particular since the Great Recession.
Specifically the way the Fed and Congress have managed to keep the economy - if one defines economy as the stock market - on a positive trajectory is through fiscal stimulus. I have created a couple of graphics that make this dynamic easier to understand. Here is how fiscal stimulus works:
The graphic above allows one to follow the cash from the banks to the US Treasury to the consumer and right back into the banks. Pretty sweet deal for the banks in that each iteration of this process increases the assets of the banks. When they buy a bond they trade an asset - cash - for another asset - a bond. However, by the time the full loop is complete they still own the bond but now have the cash they spent for the bond as well.
Some might assume that the banks haven't been the buyers of bonds under QE and in fact have been net sellers but that is not true. The following chart shows that the banks were buying bonds aggressively at the onset of the recession and only slowed the pace at that point in 2012 when the Fed announced QE3:
What's particularly informative is the next chart that shows what the banks did with the money created through their purchase of US Treasuries. At the onset of the government's significant ramp up in fiscal stimulus the banks were buying US Treasuries - in effect loaning the US government money - but after the start of QE3 and actually a little before that point in time the banks simply held onto the newly created cash. The banks still continued to buy bonds but they didn't hold the bonds - rather they shuffled them off to the Fed.
What the chart above shows is that each time the government borrows money they go to the primary dealers - the big banks - and each time they do that the banks' assets grow. In other words the government owes the banks a lot of money that the banks were able to create out of thin air through the process. One wonders why we allow the banks to grow unfettered at the expense of the taxpayer - and it is the taxpayer that ends up being responsible for all the money the US Treasury borrows - but that is just the way it works.
Here is another flow diagram - this time starting with the US Treasury and putting corporations into the loop. With a little thought one can grasp the fact that the consumer is ultimately bearing the brunt of fiscal policy and the international corporations and big banks are getting almost all the benefit of fiscal policy.
Here's what's happening. With each iteration of new debt creation by the US Treasury the government debt burden goes up. The recipient of this newly created money is first the consumer but those funds are spent and that means the newly created money flows to corporations - most of them international in scope these days. Those funds are then deposited back into the banks. The end result - the big banks and the big corporations get bigger and the consumer gets saddled with the debt burden.
That is a highly simplistic presentation but the facts remain - the big banks and the big corporations are ending up with all the money. We've already seen the sharp spike higher in bank cash assets in the chart above. Here is what cash deposits look like for the big corporations.
Now to the consumer - the chart below is expressed as a percent change YoY. Total dollar savings have pretty much flat lined since the recession but the rate of change shows that we are precariously close to seeing an actual drop in total dollar savings.
It is the consumer who is being crushed under the weight of fiscal stimulus - stimulus that Congress says is needed to keep the economy afloat. Here is what we can expect if we stay on this trajectory - the big banks and international corporations will continue to grow and build unused cash balances and the consumer/taxpayer will be burdened with paying the massive debts that allowed the transfer of wealth in the first place. It is not a good business model for long-term economic growth.
The question arises though as to how we service the debt that is driving the economy as it continues to mount. Just to put the matter in perspective as to who is bearing the brunt of the burden and who is getting the benefit here is a breakdown on tax receipts comparing personal and corporate tax contributions:
The truth is we are in a "beggar thy neighbor" market dynamic today but it is not so much a matter of one sovereign country gaining at the expense of another. It is more a matter of big banks and big corporations - with no sovereign allegiance at all - gaining at the expense of the masses in all sovereigns.
Unfortunately, the more damage done to the masses the more impact to those currently reaping the rewards of the present debt driven economy. It is not an easy thing to achieve supply/demand equilibrium but it is a much better scenario for all concerned if demand is higher than supply. As demand destruction occurs it feeds on itself with more lay-offs and higher taxes on those that are left in the work force to offset those who have left the workforce and that works to reduce demand even further.
The facts are we have moved well past the point where demand exceeds supply. It is only through a continuation of deficit spending that we have been able to keep things in positive territory but the price extracted from the middle class far outweighs the benefits received by the middle class. This is simply not a workable long-term model.
There are some encouraging signs in the economy of late but PCE is not one of them. Personal consumption - although growing in nominal terms - has been growing at a slower and slower rate:
The chart below shows debt service as a percent of disposable income and that metric has been falling steadily since the recession. That is best explained by understanding the impact of Fed policy, which has produced a much smaller carry cost to the debt resulting from the Fed's ZIRP policy.
The real disposable income that has managed to stay in positive territory can best be explained by looking at the rate of inflation, which has hovered at just above the zero line.
The conundrum from a purely economic perspective is that if we withdraw fiscal stimulus - stimulus that is contributing roughly 6% to GDP assuming a ratio of fiscal stimulus expenditures to GDP of 1:1 - we will plunge the economy into recession. On the other hand if we don't do so we are increasing the debt burden on the middle class tax payer meaning that the demand side of the equation will worsen over time. Neither scenario bodes well for significant economic growth going forward.
As that relates to stocks there is a lot of downside risk and little upside potential at this point. If stocks trade sideways and demand falls then we see even further multiple expansion. If stocks move higher and we see demand slide the multiple expansion extends even further into the danger zone.
Perhaps the biggest risk to stocks is in fact an improvement in economic metrics that prompts Congress on the fiscal side and the Fed on the monetary side to withdraw stimulus. Most disturbing to me is the misconception that Fed policy is supporting economic growth. That is true only to the extent that Fed policy is keeping interest rates in check. It is not true if one assumes Fed policy is flooding the economy with money.
M2 is almost always growing so we have expanded M2 since the recession just as we always have. The point though is that we haven't expanded M2 at a rate significantly greater since the Fed began their large scale asset purchases than we have in prior periods as the chart below reflects:
If you don't understand how M2 grows it is easy enough to buy into the rhetoric that the pundits continue to bandy about but the idea that the Fed's loose money policy is inflationary or that it is flooding the system with money is just not true. It is fiscal policy - not monetary policy - that is currently the driver for M2 expansion. And the only reason the government has moved to aggressive fiscal policy is that the private sector hasn't been in the market for credit.
So back to the point - if Congress determines that the current debt trajectory is dangerous and needs to be reined in then we will see a reduction in the rate of M2 growth and a reduction in GDP. If they continue with $1 trillion deficits then it is possible we can stave off the inevitable for a time but even that presents an optimistic scenario as the system is already wobbling under the weight of a debt to GDP ratio of approximately 100% so even if we maintain the status quo as far as deficit spending is concerned the law of diminishing returns is still problematic.
So what about stock prices going forward?
As I said at the start of this article the game has changed dramatically over the last 15 years and that has never been more evident than in the last 12 months. Market makers have expanded their tool kit in a way that allows them to do their job in a manner we have never seen before.
Investopedia defines market maker as follows:
A broker-dealer firm that accepts the risk of holding a certain number of shares of a particular security in order to facilitate trading in that security. Each market maker competes for customer order flow by displaying buy and sell quotations for a guaranteed number of shares. Once an order is received, the market maker immediately sells from its own inventory or seeks an offsetting order. This process takes place in mere seconds.
Market making is a many faceted endeavor and never more so than today. A market maker assumes risk by owning shares for the purpose of providing liquidity and attracting customer business. Many of these market makers take the matter beyond merely maintaining sufficient inventories to meet client demand and actually own stocks in excess of that demand for their own gain. That of course is the subject of the ongoing debate over the implementation of the Volcker Rule that would restrict these banking institutions from prop trading. How in the world that rule could ever be enforced is beyond my understanding but that is not really the point.
The truth is that most investors still think that markets allow for a free process of price discovery but in 2013 we have seen evidence that this is just not the case. The most recent example was with the announcement that the Fed would taper back by $10 billion a month in asset purchases. What we saw was a steep sell off followed by an almost inexplicable ramp in stocks.
You can believe one of two explanations for this seemingly odd ramp higher in stocks. The first is that once the dust settled the retail investor realized that the economy must be on fire and therefore the Fed was ready to taper meaning it was time to buy stocks. The second explanation - once the sell off started the market makers drove the market substantially higher - perhaps to some degree by flooding the system with fake quotes.
Here is my problem with that. On the one hand it can be argued that it is a good thing that market makers are doing all they can to protect investors and back stop sell offs - especially sell offs that could lead to panic selling. On the other hand it is this process of taking market making to its extreme that gives investors confidence that stocks are no longer subject to significant sell offs or crashes.
Here is the point - I have witnessed a market phenomenon unlike anything I have ever seen in 2013. The degree of control over market price demonstrated by market makers has been extraordinary. Even though these market makers have been solidly in the camp of the retail investor since the 2009 lows and very solidly in the retail investor's camp throughout 2013 can we depend on them ad infinitum?
It seems prudent to me to assume that the big banks and the big international companies are bracing for a major sell off as reflected by the build up in balance sheet cash. Cash is an investment asset in spite of the fact that the industry tells us it's not. How would you have fared if you had moved to cash in the first half of 2007 and started investing that cash back into stocks when Congress and the Fed began their massive stimulus efforts in late 2008 and early 2009?
There are a number of things that could induce a rapid and steep sell off in the coming months and very little that I can see that would produce a steep rally. Not the least of these is the very real possibility that the Fed will terminate QE. Another risk is that Congress continues to push back against deficit spending. Both of these will impact the economy negatively and depending on the degree to which they choose to rein these policies in the impact could be very significant indeed.
When considering a market that is priced at very high multiples, an economy that is dependent on monetary and fiscal stimulus, policy makers that are beginning to question the efficacy of continuing these policies, the risks of interest rates spiking sharply higher and the very fragile state of the economy at the present one would have to assume the risks outweigh the rewards and a move to cash or in the alternative - a well thought out hedge strategy - seems prudent.
Of course you can assume that the markets will continue to levitate and market makers have the tools in their tool kit to keep markets aloft for as long as they choose. If you made that argument I would agree with you but I would add this - you are depending on a group that hasn't demonstrated the highest degree of integrity in recent years and in fact is taking advantage of the public on numerous occasions as evidenced by a number of settlements for fraudulent behavior with JPM being the biggest at approximately $20 billion.
And it seems that JPM's troubles continue as reported here by Zero Hedge just a little while ago. Again I would add that if you are depending on the market makers to protect you and look out for your interests you may want to rethink that point of view. Here is an excerpt from the ZH article:
Prosecutors are working alongside regulators in a broad investigation into whether a number of Wall Street banks cheated mortgage-bond clients in the years following the financial crisis, according to people close to the probe.
The Justice Department is investigating alongside the Securities and Exchange Commission and the special inspector general for the Troubled Asset Relief Program, or Sigtarp, the people close to the probe said. The investigation, revealed by The Wall Street Journal in a page-one article Wednesday, is the first known wide-ranging probe into mortgage-bond sales by banks in the years after the economic meltdown of 2008.
The involvement of prosecutors wasn't previously reported. And guess who is involved: everyone's favorite allegedly criminal bank that neither admits nor denies manipulating everything - JPMorgan.
J.P. Morgan Chase & Co. said in a securities filing last year it had received requests for information from the U.S. attorney's office in Connecticut, as well as subpoenas from the SEC and a request from Sigtarp to review "certain activities." The requests relate to "communications with counterparties in connection with certain mortgage-backed securities transactions," according to the filing.
J.P. Morgan's disclosure refers to the government probe reported by the Journal, according to a person familiar with the matter.
The New York firm is one of at least eight banks under scrutiny in the wide-ranging probe, the people close to the investigation said.
The investigation underscores how J.P. Morgan's legal headaches are far from over, even as it shells out billions to resolve numerous probes. The largest U.S. bank has agreed to roughly $22 billion in payouts over the last year to end a slew of lawsuits and investigations into many aspects of its business, including the 2012 "London whale" trading debacle and alleged failures to stop Bernard L. Madoff's massive fraud.
Make that $22 billion plus $1-2 billion more. Oh, and in case you didn't realize it yet, this is why Jamie Dimon is richer than you.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Long PCLN puts and UVXY calls